Interviewed by: Although the acute phase of the crisis has passed, the problems of bad debt, non-core assets on balances and the quality of risk management policy remain pressing for Russian banks. They are also pressing for the Central Bank of the Russian Federation, the regulatory body of the Russian banking market. Vladimir Chistyukhin, Deputy Director of the Banking Regulation and Supervision Department, told NBJ how the Central Bank expects the toxic assets problem to develop, what it offers bank to get rid of non-core assets and what can be the consequences of bad risk management for banks.

NBJ: Mr. Chistyukhin, there are various estimates of toxic debt volume in the Russian banking system. For instance, Moody's believes that 20% of credits are problematic, while S&P puts this number at 40%. What is the share of toxic credits in the Russian banking system according to the Central Bank? What is the reason for such discrepancies in estimates?

V. CHISTYUKHIN: The reason for such discrepancies in the estimates of toxic debt by the Bank of Russia and these rating agencies is that there is no single definition of “problematic” or “toxic” debt, neither in Russian nor in international banking practice, and each entity uses a different method to calculate the volume of such credits. Some include restructured loans into this definition, some do not, and there are other differences, too.

The Bank of Russia traditionally calculates the share of overdue debt, which remains since January 2010 at 5.1-5.4% of the total volume of loans. We also calculate the coefficient of category IV and V loans to total loans. These are the loans that the Bank of Russia defines as “problematic” or “irrecoverable”, and that are close to the toxic debt evaluated by the rating agencies. As of September 1 this year, they accounted for 9.6% of the total loans. We currently see some stabilization in the credit overdue level.

NBJ: Banks have been actively restructuring debts. In your opinion, what is the current amount of restructured loans?

V. CHISTYUKHIN: Debt restructuring is one of the most efficient methods of dealing with customers to ensure credit repayment, and banks have used this method a lot during the crisis. The importance and scale of restructuring has been reflected in regulatory approaches of the Bank of Russia, which granted banks more freedom to estimate the quality of restructured loans where borrowers were likely to resume payments. This regulatory measure has been effective until July 1, 2010.

As for the volume of restructured loans, we currently have information about large-volume restructured loans, e.g. loans exceeding 5% of the bank's capital. The percentage of large-volume restructured loans in the total loans and similar debt was 7.2%, or about 1.5 trillion rubles, as of October 1, 2010. However, the percentage of restructure large-volume loans in the total large-volume loans has grown from 29.1% at the beginning of 2010 to 35.7% as of April 1, 2010, and then started decreasing and equaled 30.6% as of September 1, 2010.

NBJ: Most banks have been actively creating reserves for toxic debt. Some of them have started to decrease such reserves. Does it mean that the portfolio quality has suddenly increased or that such banks are trying to earn profit?

V. CHISTYUKHIN: Accumulation of risks by the banks during the credit expansion has caused worsened assets quality during the crisis, which has necessitated additional reserves for possible losses: net contributions to reserves (excluding the recovery amounts) in Q1 2009 were almost 10 times more than in Q1 2008. In a number of cases, this was due to the very conservative estimates of assets quality, but they were based on the situation at that time and significant problems with debt repayment their customers had. Solvency of borrowers has relatively stabilized afterwards, which was reflected in the amount of reserves, and the situation of the banking sector is now much more stable than, say, one or one and a half years ago. It is unlikely that the quality of credit portfolios could suddenly increase. However, some borrowers show more stable repayment results and have good chances for the development of their business, which is why banks may decrease their reserves and record such amounts as income.

At the same time, it would be wrong to deny that some banks may overstate the quality of their assets. But that's what supervision is about - to deal with such cases.

NBJ: According to existing regulations, if a bank takes losses within a quarter, its license may be cancelled. Many banks today have to deal with the “fork” of expensive deposits and cheap credits. Is there any risk that some banks may have their licenses cancelled due to unsatisfactory financial reports?

V. CHISTYUKHIN: During the financial crisis, some banks tried to solve their liquidity problems by aggressively attracting expensive resources - mainly deposits from private customers. However, banks were often unable to use their existing assets to earn sufficient profit with a margin that would allow them to sustain their business. Such policy sometimes was a sign of threat to the bank's financial stability and interests of its creditors/investors.

Obviously, the regulatory authority could not ignore this problem. The Bank of Russia has taken measures to correct policies of banks and to limit their risks. Local departments of the Bank of Russia have been instructed on how to discover and estimate any disproportions between assets and liabilities of banks and how to deal with them. Whenever an intervention was required to increase the quality of business and restore the financial stability of a bank, serious supervisory action was taken with regard to the management and owners of such banks on the local and upper levels. All such actions werepreventive , but in most cases they worked: banks revised their policies, decreased interest rates on deposits by private customers,and, accordingly, reduced their risks. Only in some cases when transactions of a bank were threatening the interests of its creditors/investors, local departments of the Bank of Russia have taken forceful action, such as imposing a maximum interest rate on deposits. It should be noted that the Bank of Russia has resorted to this measure less than 10 times since it went into effect in October 2008.

One should also keep in mind that some of the metrics required from banks to be eligible for the deposit insurance system, such as profitability metrics, were suspended by law until the end of 2010. It is possible that this will be extended for some more time, but in any case banks should start thinking about improving their results, including for the purpose of being eligible for the deposit insurance system.

NBJ: The Central Bank has developed guidelines to evaluate the risks of transfer of toxic credits to closed unit investment funds. According to these guidelines, if the loans being transferred represent an essential part of a credit fund's assets, the resulting unit should be valued basing on the risks of such loans. How do you think these guidelines will affect the balance in banks and the volume of reserves?

V. CHISTYUKHIN: During the crisis, banks have often transferred toxic or non-core assets to trusts and unit investment funds. Banks use such transactions to clear up their balances from any toxic debt, and the Bank of Russia has a neutral attitude to such transactions provided that banks adequately calculate their risks.

The official approach of the Bank of Russia to estimating risks of banks participating in management efforts for overdue/toxic debt via transfer of rights/claims for such debt to assets of closed unit investment funds has been described in the Letter No. 106-T of the Bank of Russia issued in September 2009.

It basically states that if a bank invests into units of credit closed unit investment funds whose main assets are debts earlier owed to banks and deemed toxic, the main source of income on units will be repayments of such debt by borrowers. The value of units of such investment funds on the balance sheet of the bank may not exceed the value of assets/loans of the bank earlier recorded on its balance, i.e. the reserve for possible losses from investments into units of such funds with toxic debt as their assets may not be less than the reserves for such toxic debt. Thus, if these guidelines of the Bank of Russia are followed, the amount of reserves on loans will not be affected when the loans are transferred to closed unit investment funds.

Of course, if the quality of transferred assets increases over time, this should be taken into account when such assets are evaluated, with an appropriate effect on the amount of reserves created by the bank.

NBJ: The Central Bank will stimulate banks to get rid of non-core assets, such as real property. Why is the Central Bank concerned with this? What is your estimate of the volume of real property on balance sheets of banks?

V. CHISTYUKHIN: It is obvious that during the crisis, much more real property on the balance sheet of banks was obtained under pledge agreements or compensation agreements. The Bank of Russia as the supervisory authority is concerned about this because banks basically receive non-liquid, non-core assets.

When a bank accepts a non-core asset, it raises doubts whether the bank is able to manage this asset efficiently, adequately determine its value, or sell it in the nearest future.

For the purpose of adequate estimation of risks related to such assets, the Bank of Russia considers several possible approaches, such as to demand to create reserves for possible losses basing on how long the non-core asset remains on the balance of the bank (i.e. the longer the bigger reserve is required). It is somewhat similar to the existing mortgage provision of the Civil Code of the Russian Federation that if a pledgee receives any pledged property that it may not own due to the nature or purpose of such property, it is required to dispose of such property within one year.

Anyway, I would like to point out that this issue has not yet been settled and I am sure that the Bank of Russia will be very careful at selecting the best approach.

NBJ: On May 25, the Central Bank has issued a letter recommending banks to publish their capital data (using the form “Calculation of own assets (capital)”) and ratios (using the form “Statutory ratios information”). How many banks have agreed to publish the amount and structure of their capital and their statutory ratios (Form 134 and 135)?

V. CHISTYUKHIN: On September 23, 2010, the Bank of Russia has started publishing monthly reports of banks regarding the amount and structure of their assets and  statutory ratios (report forms No. 0409134 and 0409135).

As of mid-October 2010, 730 credit institutions have agreed to disclose information as recommended by Letter of the Bank of Russia No. 72-T “On the disclosure of information by credit institutions using Forms 0409134 and 0409135” dated 25.05.2010, or over 70% of the total number of credit institutions. Twenty-two of the top 30 Russian banks have agreed to disclose such information.

NBJ: The institution of financial ombudsman has been recently created on the basis of the Association of Russian Banks. In your opinion, how efficient it will be with regard to out-of-court settlements of customer claims? If this practice was to be used on a large scale, how would it affect the institution of financial ombudsman?

V. CHISTYUKHIN: Both the headquarters and local departments of the Bank of Russia receive a lot of complaints of bank customers. And we certainly realize that it is essential for a customer to have a tool of fair and quick settlement of the dispute with a bank.

The opportunity to settle the conflict between a bank and its private customer out of court by an independent arbitrator competent in banking issues is extremely helpful to speed up the conflict resolution, simplify the procedure, and reduce the burden on Russian courts.

I believe that initially banking associations and banks themselves should work with their customers to explain the procedures of out-of-court settlement so that they were transparent and clear to the customer and so that the customer knew where to apply for conflict resolution.

The efficiency of the new institution of financial ombudsman will be determined basing on monitoring and evaluation of resolved conflicts.

NBJ: Banks have started active development of related businesses not controlled by the Central Bank, such as factoring or microfinancing. How do you evaluate the actions of the banks which detach these businesses into separate entities? How can it affect the banking system?

V. CHISTYUKHIN: In general, development of new business areas by banks may be viewed as a positive trend due to the diversification of risks. However, it is important that banks realized the nature of such risks. For example, factoring and microfinancing are essentially a form of credit, and, consequently, all requirements concerning reserves and sufficiency of capital equally apply to such transactions.

As for subsidiaries that banks create for any special purpose, identification of appropriate risks is a task for consolidated supervision. The Bank of Russia is immediately involved into improving approaches to such supervision. For several years, we have been trying to amend banking laws to align it with best international practices. The consolidation range should be expanded, information exchange procedures should be improved, such as information exchange between members of a banking group/holding and supervisory bodies, and the supervision powers of the Bank of Russia to take action in case of non-compliance with requirements to consolidated risks management. A law that regulates the range of consolidation within a banking group/holding will enable us to have all information about the risks and capital of such banking group/holding without any changes in the reports submitted to the Bank of Russia. This draft law is currently discussed in the Government of Russia.

NBJ: After the so-called shock therapy during the crisis, when investors escaped from banks, creditors demanded to settle the debt and so on. How did banks change their risk management policy? What effect did it have on the ratios?

V. CHISTYUKHIN: Before the crisis, strategies of most banks were aimed at expanding their business, winning a bigger market share, developing new lines of business and granting as many credits as possible. However, the crisis has forced banks to think more about increasing the financial efficiency to keep their business, such as about reducing operational costs, more responsible approaches to claiming overdue deb and optimizing business processes.

The financial crisis has clearly demonstrated that risk management policies and procedures should be a focus of banks, and that existing risk management policies and systems are most important for the financial stability at times of market shocks. We see that indeed, banks started to improve the quality of their risk management. When we speak about the quality of a banking business today, we basically mean the quality of risk management.

One should also remember that risk management is not only performed because banks want it. The Bank of Russia takes into account the management quality, including the risk management system, when it evaluates the financial stability of a bank. Unsatisfactory indicators may cause the most serious consequences for the bank.