Excessive liquidity in the banking sector is something predictable and expectable after any financial crisis. However, this predictability and expectedness don’t make it less painful, especially considering that excess liquidity may lead to revenue losses in the banking sector. Experts say it’s a temporary 'disease', but in Russia, it may linger because of the sharp correction of key economic indicators, i.e. refinancing rates and inflation level. There is a significant gap between costs of liabilities and assets in the banking business. And numerous Russian financial and crediting organizations are dreaming of breaking even by the end of 2010.

IT HURTS TO FALL WITHOUT A ‘CUSHION’

During the post-crisis period, indicators of instant and current liquidity grew two-or threefold in many banks, having exceeded the minimal norms by several times. As of April 1, 2010, for instance, current liquidity norms in the banks were as follows: in the VTB24 bank, 102.4%, in Raiffeisenbank, 143%, and in the Russian Standard Bank even higher, 173%. According to many experts, excess liquidity is typical for the crisis abating.

‘High liquidity level in a system is a direct consequence of a financial and economic crisis’, notes Irina Veliyeva, head of rating service of credit institutions at the Expert RA Rating Agency. The initial defense reaction to a crisis is to wrap up active operations and to save up a ‘cushion’ for a possible new shock; to review one’s attitude to risks and to get more conservative. Then, at the next stage, another limiting factor came forward: lack of quality borrowers in the economy and a certain drop of demand for credits. Thus, there are no ways to allocate the liquidity accumulated.'

Mikhail Zavaraev, leading analyst at the Arbat Capital Company, shared a similar viewpoint. ‘I don’t think that excess liquidity during the acute phase of an economic crisis is bad’, he emphasized. ‘Liquidity shortage is almost always a problem, especially during times of financial upheavals. Its excess during the normal period of economic development is bad as well, however in crisis, it’s a regular occurrence. It’s better to be overcautious, since many processes cannot be predictable, which may eventually lead to significant problems for banks’.

Ekaterina Trofimova, director of ratings and financial institutions group at the Paris office of the Standard & Poor’s rating agency, agrees with her colleagues. ‘From the viewpoint of steadiness of particular banks and whole banking systems and consequently of the economy, liquidity shortage is seen as especially threatening, as it may lead to default and bankrupcy in absence of emergency sources of funding.

Excess liquidity is rather a manifestation than the initial cause of negative economic trends, decrease of investments, consumption and economic activity in particular’, the expert explains.

Therefore, experts share the same opinion that excessive liquidity is expectable and even inevitable. However, whereas we know that liquidity deficit can be fought by pumping cash into the banking system, the universal recipe of countering excess liquidity is yet to be found. And all market players can do now is trying to overcome this 'disease' on their own.

RECIPES NOT FOR RUSSIA

There's just one thing that can comfort the Russian players: they are not alone in their trouble; their foreign colleagues, financial and credit organizations are also struggling with the excess liquidity issue. 'This situation is typical not only for Russia, but for other countries as well', Irina Veliyeva shares her observations. 'Many still haven't recovered from the crisis shock and don’t rule out chances of further economic upheavals, considering budget problems in the Eurozone. Therefore, banks all over the world are still cautious and, consequently, are marked by excessive liquidity'.

Ekaterina Trofimova also believes that, amid continuing market uncertainty in many developed and developing countries of the world, banks are facing shortage of quality investment projects, which results in increasing liquidity reserves. However often, it's intentional choice that banks make to maintain high level of liquid assets, considering that high volatility of markets still lingers. 'From the viewpoint of credit stability of Russian banks, Standard & Poor’s classify the current liquidity level as feasable rather than excessive in conditions of high concentration and volatility of their resource base and instability of market trends', the expert states.

In order to speed up the process of allocating excessive liquidity (and thus coming out of the crisis), some countries resort to rather drastic measures, says Irina Veliyeva. For example, some central banks have introduced fines for storing money on correspondent accounts; commercial finance and credit institutions keeping their money in a central bank are obliged to pay interest for the ‘excessive luxury’. ‘I don’t think the Russian authority is prepared to follow suit of its most ‘desperate’ foreign counterparts’, the expert says. In her opinion, bringing such measures to the Russian soil may spur new problems.

The saying about one's meat being another man's poison works only too well here. Market processes occurring in the international economy tend to gain extra nation-specific peculiarities in Russia; therefore, international anti-crisis measures are not always applicable here. This is also exactly the case with the phenomenon of excess liquidity, which has taken on some quite new colors in its Russian ‘interpretation’.

First of all, the liquidity Russian banks are brimming with is short-term, while medium- and long-term liquidity levels still remain rather low. Compared to the pre-crisis period, the N4 norm remains practically unchanged and is far from the maximum in most banks. This factor greatly impedes asset and liability management and reduces the number of investment options. Second, the problem of excessive liquidity is caused not only by massive inflow of cash into the banking system, but also by high asset costs.

These two factors prevent banks from ‘releasing’ money into the economy, which is why market mechanism of money functioning fails to work.

THE STATE AND THE PEOPLE ARE TOGETHER

One of the key sources of excess liquidity formation in Russia's banking system is deposits. ‘In Russia, people's savings have nearly doubled from some 7% in summer 2008 to 14% of disposable income in the beginning of this year’, says Ekaterina Trofimova. ‘Amid only a slight increase in real income over the last months, this fact, coupled with the state's successful efforts to maintain trust in the banking system, allowed banks to increase their retail deposit levels. They grew by some 27% in 2009, an unprecedentedly high figure for a crisis year in Russia's financial history, especially amid decreasing inflation’.

Another source of excess liquidity is state money that went into the banking system during the acute phase of the crisis.

Vasily Solodkov, Director of the banking institute at the High School of Economics, explains, ‘The government allocated substantial sums to the banking sector, hoping that banks will begin crediting the private sector. However, banks, fearing high risks, did not release that money to credit production’.

As a result, the money that many banks held as a ‘cushion’ got stuck on their Central Bank accounts, went to the stock market, and so on. Thus, at some moment, some banks made a good profit on state-furnished money, but when interest rates corrections began, values changed.

INFLATION: DREAMS COMING TRUE?

The rates at which funds were attracted and allocated were changing quite quickly on the Russian market. Deposit Insurance Agency points at two phases in the change of interest rates on deposits:   from   2008   to   mid-2009, deposit interest rates grew from 6.8 to 10.3%. In the second half of 2009, the rates began to go down, and the trend remains even today.

The key factor triggering the slump in deposit profitability over the last few days is a steep decrease in price growth rate. After all, isn’t this what all had been dreaming of - to see one-digit inflation rate in Russia? However, nobody thought the dream would come true right after the peak phase of the crisis.

Mikhail Matovnikov, Director General of Interfax-CEA, explains, ‘The crisis in Russia unfolded to a different scenario than that in the rest of the world. The key difference was in the fact that in six months, we went from a country with a 15-percent inflation rate to one with a 5-percent inflation, which is an actual fall by 10 percent. At the same time, deposit rates cannot fall by 10%, as they cannot equal zero. And credit rates, which are in the area of 15%, are hard to get down to 5%’. Thus, the process of rate correction, expected to take several years, happened in mere months. That resulted in banks ending up with ‘expensive’ assets on their hands, while items they can invest the money in are either risky or offer very low return.

Forced to choose between two evils, credit organizations prefer items issued by the Central Bank as the most reliable, albeit low-yielding. Nobody knows, however, how long banks will be able to keep funds on Central Bank accounts. Having already passed many an all-time low, the refinancing rate seems likely to continue its way south, causing further decrease in the yield rate of CB-issued items. The irony here is in the fact that this policy doesn’t make liabilities any cheaper, so it looks very likely that banks will soon have to find a new haven for their ‘excess’ money.

WHERE MONEY COMES TO

Anyway, such wandering of cash in search of a better fate is an indispensable consequence of the crisis. ‘At first, banks brought their money to the bond market, driving yield rates to a level that was far lower than those on Centrobank deposits’, Mikhail Matovnikov says. ‘That resulted in a significant part of the funds being withdrawn from the stock market. Some of that money was put on Central Bank deposits, while the part went towards lending’.

Mikhail Zavarayev also thinks that money is in the middle of a certain cycle now and will find some ‘dwelling’ at some time. ‘The crisis is past its peak, and reliable borrowers are too scarce to absorb all the cash available, so banks are looking for ways to invest money now. During the peak phase, that money was stashed in items that were considered highly marketable. By now, banks reinvested it into less marketable yet higher-yielding items (equities). The next step for banks will be transferring the money from equities into credits’, - the expert thinks.

Indeed, now banks can be observed flocking to the stock market, analysts say. A Central Bank bulletin says that the equity portfolio has grown 2.1 times to RUR 1052 billion this year - mostly due to purchase of corporate bonds and Central Bank bonds. That allowed diversifying the bank's assets and increasing the share of equity-derived profits in the overall revenues. ‘Since the beginning of the year, the bank has increased its corporate bond investments by 3.5 times to RUR 296 billion. The bank has been buying bonds from the country's top issuers in various industries, thus financing the Russian economy. Its corporate bond purchases peaked in the 3rd quarter of 2009. In the 4th quarter, in order to allocate excess liquidity, corporate bonds and Central Bank bonds were purchased for a total sum of nearly RUR 320 billion, nearly doubling the total portfolio of state-issued securities to RUR 640 billion. In the bank's investment portfolio, the share of corporate bonds went up from 17% to 28%, while the share of state-issued items and subfederal bonds reduced from 80% to 70%. The share of stocks in the bank's securities inventory is slightly more than 1%’, the document says.

However, while banks are siphoning excess liquidity off to the stock market, the risk of asset costs overheating remains high. For example, German Gref noted that in this situation, it is important not to miss the swelling of yet another ‘bubble’. ‘Today, herd behavior amid extreme excess of cash supply leads to artificial pumping of the stock market and all kinds of commodities; it is evident that we will soon have to face another collapse of this ‘bubble’, Gref notes. Thus, the ex-Minister of Economic Development, now head of the country's biggest state bank, is warning us that the market may never switch from the speculative stage to investment stage, as it will blow up on another landmine - or, better to say, another bubble.

RELUCTANT CREDITING

However, while excess liquidity is a pain in the neck for the banking industry, for the real economy it means hope for a drop in the cost of credit resources.

Many banks are making their way back into the lending market and have to lower their interest rates in efforts to attract borrowers. ‘Finance and credit organizations know what's good for them; they will gradually drop the cost of their credits, which will lead to an inflow of clients willing to borrow’, says Mikhail Zavarayev. ‘This process is occurring now, albeit slower than many would like it to. At the moment, banks are transferring funds into securities; credits are the next in line’.

At the same time, many banks will have to shrink their profit margin to the break-even level.

Mikhail Matovnikov thinks that going into the lending market will be easier for major players, as they traditionally have lower liability rates than the average on market. ‘We see how aggressively Sberbank has acted on the credit market recently. Other players have to adapt. Small and medium banks are going to have it tough, because it's hard to see how they are going to survive with zero profits’, Matovnikov concludes.

Experts say, however, that lower margins are an inevitable sacrifice to the crisis. Banks will have to tighten their belts. Their options are rather limited today: either a bank lends at low rates and gets minimal profit or it doesn’t lend and gets no profit at all. Profit margins have dropped, and it’s a fact. Getting out of the current abyss is only possible through resuming lending.

Most likely, until banks ‘absorb’ excess liquidity and get rid of costly liabilities, profitability in the banking business is going to stay rather low. Moreover, it is still likely that some banks will fail to adapt to the new economic situation, fall in the red and leave the market. On the other hand, the pressure of excess liquidity will force banks to lower their interest rates and go out into the crediting market. Lower fund costs and increased supply may revive the production sector and contribute to a more sustainable restoration of the economy.

Thus, excess liquidity will lead to the transformation of the financial market. At the same time, whether positive or negative factors will prevail throughout the transition phase will depend on banks' ability to give up their wet dream of quickly getting back to year 2007.