Investors, observers and depositors will be encouraged by the improvement in the Russian banking over the course of 2005 and into the first half of 2006, considering its high rate of growth and a continued commitment by legislators and regulators to stiffen regulatory oversight and sanctions.

Against the backdrop of a general rate of growth in the Russian economy in 2005 of 6.4%, the reported 30% to 40% rate of growth in Russian banking sector assets looms large. Bank capital grew by 32% in 2005, compared with growth rates of 15.5% in 2004.

Recent achievements in regulatory control have been attained, in particular those raising the thresholds of minimal bank capital and capital adequacy. These follow on from the stability achieved by the full implementation in 2005 of the deposit insurance scheme and introduction of credit history bureaux.

Amendments to the Banking Law

On May 3 2006 Federal Law 60-FZ was adopted, amending the Law on Banking with effect from January 1 2007. The amendments set the higher and generally applicable level of €5 million, in rouble equivalent, for the minimal charter capital of any new banking credit organization. Similarly, the threshold of €5 million (in rouble equivalent) is set for a bank's capital assets (€500,000 for a non-banking credit organization). Banks with capital assets under this threshold on January 1 2007 will be permitted to continue operating but cannot decrease their capital assets from whatever that level may be.

The application of an increasingly stringent standard should promote the trend of consolidation as stronger, better-capitalized banks take over weaker players.

On April 12, the Bank of Russia published its Letter 47-T setting out the rouble equivalents – applicable for the second half of 2006 – for minimal charter capital for banking and non-banking credit organizations, for capital assets of banking credit organizations when seeking new banking licences, and for the capital assets of non-banking credit organizations seeking bank status.

Capital adequacy more controversial

In January, legislators approved on second reading banking law amendments that would raise the mandatory capital adequacy standard for banks. Article 20 of the Law on Banking, containing the list of grounds for bank licence revocation, would include as a ground a drop in capital adequacy below the threshold of 2% of capital, and maintenance of capital adequacy below 8% of capital for more than three months. In parallel, the Law on Bank Insolvency would be amended in Article 4.5 to specify that allowing capital adequacy to fall below 10% of capital would constitute grounds for application of measures to prevent insolvency to a particular bank. This would be a big change in management of individual bank risk and has evoked extensive debate in the sector. From the policy point of view, it will enhance sectoral stability and brake risk factors. Opponents argue its adoption would appreciably curtail the volume of lending.

Regulators take action

In the first four months of 2006 the Central Bank revoked banking licences at 16 credit organizations, all on grounds related to non-compliance with regulations aimed at preventing money-laundering activities. The chairman of the Central Bank, Sergey Ignatiev, has observed that only one of the entities to lose their licences was a qualified member of the national depositary insurance scheme. In other words, they were already marginalized players in the sector. In contrast to the mini-crisis similar actions triggered in 2004, the banking sector took these corrective measures calmly and within its stride. The strict approach of the regulators will, ultimately, pay dividends.

Level playing field deferred

Notwithstanding Central Bank statements in 2005 concerning the intention to establish a uniform standard for when acquirers of shareholding stakes in RF banks must seek the consent of the Central Bank, a bifurcated mechanism remains in place. As before, domestic investors must obtain the approval of the regulator when seeking to purchase 20% or more, while foreign investors must obtain consent for the acquisition of any size stake, no matter how small, in a Russian bank. Although it is not clear how long this dual system will remain, so long as it does remain, domestic investors maintain a mild competitive advantage in respect of acquisitions and consolidations of Russian banking assets.

Currency law developments

In late March 2006, the Central Bank announced its intention to liberalize currency control rules, as from May 2006, based on the principle that there was no longer any economic case for maintaining currency reserve requirements for certain types of transactions at the same levels as before. It forecast plans to decrease the retention reserve requirements in relation to capital operations by half, so that the retention reserve requirement for lending operations would become 1%, as well as to decrease mandatory sale of export proceeds from 10% to zero.

Instruction 1676-U dated March 29 2006 introduced the necessary implementing changes in Central Bank Instruction 111 on mandatory sales of export proceeds.

Similarly, with effect from May 1 2006, Instruction 1675-U of the same date amended the 2005 regulations on the reserve requirement for transfers made by Russian individual residents from Russian bank accounts to their accounts held abroad. The current reservation requirement consisting of 25% of the total for a period of 15 days was halved to 12.5% for the same period.

Also with effect from May 1 2006, Instruction 1674-U amended the 2004 regulation 1465-U concerning reservation requirements for capital operations. The new regulations will reduce these by one-half.

In parallel with the currency liberalization trend, the Central Bank released in late April its Regulation 286-P, which establishes official exchange rates for a number of currencies against the rouble. There has been a wide range of pronouncements from President Putin to Ignatiev indicating that the full termination of all currency restrictions, projected in the Currency Law to occur on January 1 2007, is to be moved forward to 1 July 2006, but full regulatory implementation of this concept has not occurred.

On May 29 the Central Bank's board of directors adopted a decision in principle to cancel as of July 1 reserve requirements for certain capital operations, permitting an early refund of reserved amounts to transaction parties. It also cancelled as of July 1 the mandatory use of special accounts for capital operations, although special accounts may electively be used until the end of 2006.

Bank shares

Consistent with the government's firm policy of supporting the development of the domestic capital market in general by insisting that Russian corporate groups (including those structured through offshore holding companies) must list on domestic exchanges before undertaking offshore listings, the Central Bank in early 2006 set out its own plans and incentives for Russian banks to engage in domestic flotations. In April, the Bank of Russia announced a proposal to require banks above a certain size to float at least 10% of their shares on the Russian market. The initially suggested threshold was a capital of R2.5 billion, which about 67 banks meet or exceed.

Legislation still requires that foreign persons must obtain the consent of the Central Bank to acquire even one share in a Russian bank. So such flotations would prioritize domestic buyers unless and until the legislation is amended. In parallel with the proposed flotation plan, the Central Bank is discussing measures permitting banks greater flexibility in setting the price range for initial public offerings, to release them from the necessity of setting it in advance of the book building process.

Cracking down on abuses in bank management and insolvency

In late May, the Agency for Insurance of Bank Deposits submitted proposed draft amendments to the Law on Bankruptcy of Credit Organizations that would introduce several material changes in dealing with insolvent banks. First, the law would clarify that the arbitration courts would have exclusive jurisdiction over civil law claims against individual bank directors for their role and liability in bringing about the insolvency of banks. This would resolve and eliminate a convenient procedural defence used by bank directors, who, as individuals, would normally have to be sued in the ordinary courts. The draft amendments would place the burden of proof on the director to show they were not responsible for the bankruptcy – otherwise civil (not criminal) liability will follow.

Of particular interest to bank creditors and counter-parties is the proposed amendment to the rule on invalidation of preferential transactions. The revised legislation would clarify that, among the insolvent bank's transactions subject to review and potential retroactive invalidation, are transactions known as non-cash money transfers carried out in the form of bank account operations. There has been debate over whether these could be classified as civil law transactions that fall into the range of evaluation. The proposed amendments are remarkable also in that they would serve as a powerful support to Central Bank authority: the new rules would provide that transactions entered into in violation of any Central Bank prohibitory order imposed on the bank before revocation of its licence will be deemed null and void. This rigorous measure clearly targets the widespread tendency to evade such orders. Lastly, creditors should be aware that the amendments envision extending the preference period from the current six months to 12 months before the designation of temporary administration in the given bank. Where there is evidence of intent to harm the bank or its creditors, or of knowledge among counterparties of the insolvency of the bank, the period may be extended to three years.

Financing trends: The Concession Law

It is of considerable import to private sector lenders, investors, municipal governments, and development banks that the Russian Duma adopted on July 21 2005 the new Concession Law 115-FZ. Its provisions were intended to create the framework for private-sector investment in, and operation of, Russian public utilities and infrastructure.

The Concession Law applies to all forms of concession arrangements in various public sectors, including but not limited to construction, reconstruction and operation of electric power and heat generation, transmission and distribution facilities, and heat, gas and electric power supply facilities. It can extend to all manner of infrastructural facilities required by municipal governments.

The Law pays particular attention to creating an open and transparent public procurement process. This aspect could help to reduce the likelihood of legal disputes challenging a concessionaire's rights later on in the life of a project.

International practice demonstrates that concession authorities must undertake certain guarantees of a project to render it bankable (that is, to protect the reasonable interests of the project's lenders, for example, banks and bondholders), because in large projects debt will always constitute the bulk of financing (60% – 80%). The current version of the law does not address this commercial concern.

Equally discouraging is the law's failure to envision the concessionaire's ability to assign the concession agreement by way of security to its lenders, both before and after project completion. This is a recognized mechanism allowing the lenders to assert control in an event of default, and shepherd the project through to completion. On the contrary, the law prohibits assignments of concession agreements before project completion, and prohibits pledges of the concessionaires' rights under such agreements, irrespective of timing.

Also absent are enabling provisions permitting concession authorities to enter into direct agreements (project support agreements) with lenders. Though theoretically these agreements might still be possible, in practice lenders might be hard-pressed to convince regional and local government authorities to undertake direct obligations in the absence of clear legislative guidance from the federal Duma.

The law authorizes the RF government to adopt model concession agreements for various types of projects in Russia. The RF Ministry of Economic Development and Trade commenced this process in November 2005, inviting the local and international infrastructure community to attend a roundtable meeting and comment on models developed by the Ministry.

Financing trends: growth in consumer lending and associated risks

In his annual address to the Association of Russian Banks in April, Ignatiev devoted particular attention to a near doubling in 2005 of consumer lending compared to 2004. This intensive year-on-year growth suggests a need for caution to avoid a spike in overdue loans and bad debts. In this connection, the Central Bank has called upon the Federal Antimonopoly Service to establish recommendations for banks to provide full disclosure to consumers when issuing loans.

This almost 100% growth by far exceeded the rate of growth of Russian bank assets in general in this period, estimated to be around 35%, as well as of their credit portfolios estimated to be around 40%. Consumer loans are thought to make up almost 20% of bank loans and 10% of bank assets.

At the same time, the Fitch rating agency has reported that the volume of bank lending to the private sector grew 19.7% over 2004 to 2005, triggering risk factors at the 15% threshold, which resulted in Fitch reducing the Russian bank sector's rating. A portion of this growth was attributable to an increase in consumer lending.

Author biographies

Mira Davidovski Salans Mira Davidovski is a partner with Salans and divides her time between the Moscow and London offices. Davidovski concentrates on advice to financial institutions engaged in banking, financial and investment activity, with particular emphasis on Russia and the CIS. Davidovski has experience advising on cross-border financings in north America, Europe and Asia, including the preparation of lending documentation, consideration of inter-creditor issues, structuring of international security arrangements, and advising on the assignment of debt assets and restructurings. Her practice includes advising international financial institutions, investment funds, advisers, and broker-dealers in emerging markets. Davidovski has advised on mortgage financing transactions for numerous offshore lenders taking advantage of enabling legislation and policy initiatives in the Russian Federation. Davidovski's practice in eastern emerging markets embraces acquisitions and dispositions of equity holdings in a broad range of industries and negotiations on behalf of multinational corporations in the telecommunications, natural resources, real estate, financial services, pharmaceuticals, consumer goods, and heavy industry sectors. Davidovski is a central legal adviser on a lending programme put into place by an international financial institution involving over 20 Russian banks. Davidovski is a member of the District of Columbia, Maryland, and Massachusetts Bars in the US and is qualified as a solicitor in England and Wales (July, 2006). She was the recipient of an International Research and Exchanges Board (IREX) fellowship for post-graduate study in the former Soviet Union, where she conducted research in 1985-1986. Davidovski holds degrees from the University of Maryland School of Law – JD (Hons, 1985) and Harvard/Radcliffe College – BA (Hons, 1981). She speaks regularly at international conferences on subjects in Russian banking and finance (Adam Smith Institute, Russo-British Chamber of Commerce, Harvard Symposium). The Legal 500 (2005) guide recommends her for cross-border financings in the area. Davidovski speaks English, Russian, and French. Timothy Stubbs Salans Timothy Stubbs is a partner in the Salans Moscow office. He concentrates on corporate and commercial law, with a particular emphasis on central and eastern Europe and the CIS. Stubbs returned to the firm in January 2003 after a two-year working sabbatical at the Office of General Counsel (OGC) of The European Bank for Reconstruction and Development (EBRD) in London, where he was responsible for structuring and bringing to completion about $450 million of transactions, including the EBRD's investment in the Europolis fund. Stubbs concentrates on cross-border debt and equity financings, corporate matters and real property transactions in Russia and central and eastern Europe. Stubbs worked in the Salans Moscow office for six months and later as managing partner of the St Petersburg office, where he was based for six years. Since returning to Salans in 2003, Stubbs has acted as team leader in the firm's assistance to EBRD on numerous projects, including in the CIS/CEE commercial property sector. Most recently, Stubbs has secured and is supervising the firm's assistance to several local Russian developers of retail shopping and entertainment centres in Russia being financed on a limited recourse basis (including a €230 million centre in St Petersburg). In 2005 he successfully led a three-office Salans team advising a leading Russian bank on a $670 million trade finance facility. He is advising a leading Russian natural resources firm in the negotiation of an aggregate $250 million in senior syndicated facilities from western European banks.