Russia

MARKET STRUCTURE AND TRENDS

General remarks

Considering the renewal and stabilization of the Russian economy in 2000-2001 and into 2002, the banking sector has not seen the significant structural reform necessary to accelerate lending to the real sector of the economy and for restoration of public and investor confidence in Russian banks. Nevertheless, certain important trends are emerging and may lead, over the medium term, to gradual improvement.

In late June 2001, substantial amendments to the Law on Banks and Banking Activity (the Banking Law) were adopted, which strengthen monitoring of the influence of affiliated groups and bank holding companies on individual banks. They also define extreme circumstances which for the first time require by law the Central Bank to revoke the licence of banks, cutting back its previous discretion not to revoke.

In March 2002, the chairmanship of the Central Bank passed to former first deputy finance minister Sergei Ignatiev, and chairman Gerashchenko retired from his third posting since 1991 as the head of the Central Bank, closing an era of tight personal control and relative resistance to reform.

Ignatiev made improvement in bank supervision the keynote of his first annual address to the Association of Russian Banks in April 2002.

The Government and Central Bank Strategy for Development of the Banking Sector for 2002 (the Strategy for 2002), released on December 30, 2001, renewed the government's commitment to reform measures. Some of these have already appeared in the amendments to the Banking Law and secondary regulations, while others are to be enacted. The government has undertaken to divest positions in some 300 commercial banks, excepting its position in the Savings Bank of Russia until such time as a deposit guarantee system has been implemented.

An entirely updated version of the Law on the Central Bank, the key to defining the authorities of the Central Bank, has been adopted by the State Duma as of June 5, 2002, and is under consideration by the Federation Council and expected to become law. The draft of the amended law attempts to balance the independence of the Central Bank with creation of a National Bank Council and with specific types of accountability to the government.

The number of licensed bank credit organizations in mid-2002 was 1280, virtually the same number as in mid-2001. At the same time, in early 2002 the number of banks whose licences had been revoked but remained unliquidated exceeded 700, reflecting the continuing absence of an effective and streamlined system for fair distribution of assets upon bank failure.

Currency liberalization

The new leadership of the Central Bank confirms commitment to gradual currency liberalization in conditions of improved bank supervision and macroeconomic stability. July 2001 amendments to the Law on Currency and Currency Control (the Currency Law) permitted individuals to transfer up to $75,000 a year outside of Russia for investment in foreign currency-denominated securities without prior consent of the Central Bank (Law 72-FZ). In August 2001, Law 130-FZ amended currency rules to reduce the level of mandatory sale of currency proceeds from exports from 75% to 50%. In October 2001, this trend gathered momentum with Central Bank instructions that permitted most foreign currency loans with a term in excess of 180 days to be made pursuant to a registration procedure, rather than subject to consent (Instruction No. 1030-U, 101-I). In February 2002, it was clarified that borrowers authorized to obtain and repay foreign currency loans (other than from authorized Russian banks) under the prior consent regime, must now present evidence of their compliance with the registration rules to the paying bank at each payment or disbursement, as well as quarterly reports on the status of the financial obligations (Instruction No. 1110-U).

MAIN REGULATORY BODIES

The Russian Federation Central Bank, the Bank of Russia, is the regulatory body with licensing and supervisory authority over the country's credit organizations. It also regulates monetary policy and currency and capital controls. As primary regulatory authority the Bank of Russia derives its powers from the constitution and three laws: the Law on Banks and Banking Activity (1996) (the Banking Law), the Law on the Central Bank (1995), and the Law on Currency Operations and Currency Control (1992) (the Currency Law).

As noted above, the State Duma adopted on June 5 2002 a new version of the Law on the Central Bank, which, having been under consideration for four years, continues to be debated as it is reviewed by the Federation Council. If adopted in its current form, it will provide renewed and more specific and solid grounding for the powers which the government and the administration of the Central Bank consider necessary for implementation of current policy goals.

The powers of the Central Bank in its bank supervisory role were also strengthened and refined in the June 23 2001 amendments to the Banking Law (Law 82-FZ). Chief innovations in the Banking Law amendments are:

New definitions for 'bank groups' and 'bank holdings' are introduced and reach informal groupings of banks and companies in which one 'head company' has a 'material influence' on the rest. These supra-corporate amalgamations, which can include non-banks, are now subject to reporting and other obligations. Articles 8 and 43 of the amended law require the leading credit organization of a bank group and the leading company of a bank holding to publish annual audited consolidated financial statements pursuant to the procedures and deadlines to be established by the Central Bank.

Article 20 - Grounds for Revocation of Bank Licenses - has been amended to distinguish between grounds for discretionary licence revocation, which existed before, and grounds which require the Central Bank to revoke a banking licences, a critical legal mechanism lacking at the time of the 1998 banking sector collapse. Grounds for mandatory revocation are:

• Capital adequacy of below 2%;
• A fall in capital assets to below the minimum charter capital set by the Central Bank for such category of bank at the time of its registration;
• Failure by the bank to modify its charter capital or capital assets in accordance with Central Bank orders within the period established by the law on insolvency of credit organizations; and
• The inability of the bank to satisfy demands of creditors and to make mandatory payments for a period of one month from the date due, provided that such demands shall exceed 1000 times the minimum monthly wage (previously a ground for discretionary revocation).

In Article 11, the requirement of prior Central Bank consent for acquisitions by any one person or group of affiliated persons of more than 20% of a bank's shares is extended to reach trust management holdings. The grounds on which the Central Bank may refuse to give such consent (inadequate financial condition of the acquirer or violation of antimonopoly legislation) have been expanded to include cases where people are ruled by a court to have committed illegal actions in bankruptcy or in fictitious or intentional bankruptcies. A new clause has been inserted, listing the grounds on which the Central Bank must refuse to give such consent. This when a person has been found guilty by a court of causing damage to any credit organization while acting in the capacity of member of the board of directors, of individual executive or member of management.

A new Article 11.1 seeks to restrict related party links between the management bodies of credit organizations. For example, it provides that an individual executive, deputy executive, member of a collegial executive body, chief accountant or branch manager of a credit organization may not (simultaneously) occupy positions in other credit and insurance organizations, be professional participants in the securities markets, in companies engaged in leasing activities, or in persons affiliated with the credit organization in which that person works.

Two new examples of 'Discrepancy in professional qualifications' - which constitutes a ground for refusal to register a credit organization under Article 16 - are given: (i) cases where in the three years preceding application demands for the resignation of the candidate, then serving as executive of another bank, were made; (ii) a business reputation not corresponding to the requirements of federal law or regulations enacted under it.

The law prohibits formation of bank capital from borrowed funds and requires the Central Bank to establish a list of the types of non-monetary assets which may be used to form bank capital.

TYPES OF FINANCIAL INSTITUTIONS

The Banking Law recognises several types of financial institutions: credit organizations, which include banks and non-banking credit organizations, as well as foreign banks, i.e., entities recognised as banks by the laws of their jurisdictions of incorporation. Banks have the exclusive right to carry out a specific set of banking operations in combination with one another, while non-banking credit organizations may be granted licences to carry out separate banking operations. The key cluster of banking operations normally permitted only to banks consists of:

• taking deposits from the public;
• lending out or placement of such funds in the name of and for the account of the bank, on condition of timely and liquid repayment; and
• opening and managing bank accounts for individuals and legal entities.

ESTABLISHING A FINANCIAL INSTITUTION

The procedure for establishing a credit organization (banking or non-banking) is governed by Central Bank Regulation No. 75-I. The main requirements are:

• if foreign capital is involved, submission by the founders of an application for preliminary permission to create a bank with foreign capital;
• if foreign capital is involved, issuance of the preliminary permission of the Central Bank, Department for Licensing of Banking and Auditing Activity;
• submission by the founders of an application for the registration and licensing of the bank, together with a business plan corresponding to Central Bank criteria established in April 2000;
• payment by the founders of the registration fee, equal to 0.1% of the stated charter capital;
• registration of the bank by the local division of the Central Bank;
• within one month following registration, payment of 100% of the charter capital; and
• ruling by the Central Bank on whether a licence should be granted. Founders must present three years of audited financial statements and may not have outstanding tax liabilities. Article 11 of the Banking Law states that the promoters of a bank may not withdraw from the credit organization for three years following its registration.

Under Regulation No. 437 of the Central Bank, where a bank has elected a management in the form of a general director, and that director is to be a foreign citizen, at least 50% of the management board must be composed of Russian citizens. If foreign persons are nominated as candidates for the chairman of the management board or the chief accountant, their applications must attach a work permit issued by the Federal Migration Service, as well as a document showing evidence of at least one of these candidates' knowledge of Russian if all applicants are not Russian. At least 75% of the total staff employed by a bank formed with foreign capital must be Russian. These numerical limits were lifted in June 1999, when a brief directive made clear that the Committee for Bank Supervision is entitled to alter these restrictions. The bank's charter may not allow the board of directors or its chairman to intervene in the operational activity of the credit organization. This is possibly an attempt to cure some of the abuses in management observed in pre-crisis banks which were de facto but not de jure controlled by various oligarchic groups.

FINANCIAL SERVICES ONLINE AND E-BANKING

A law on electronic signatures entered into effect on January 23 2002. The law specifies that a digital signature on an electronic document has the same force as a hand signature on a paper document as long as:

• the key certificate for that signature has not lost force;
• the signature is confirmed in the electronic document; and
• the signature is used in accordance with the terms specified in the key certificate for that signature.

Creation of signature keys and related functions, as well as maintenance of a register of key certificates, is to be conducted by a licensed oversight centre, with details still to be implemented. Banks may file their periodic reports on activity and financial condition in electronic media. By concluding a contract with the relevant branch of the Central Bank, the reporting bank may establish the agreed use of an e-signature and the regular electronic submission of reports.

ACQUIRING FINANCIAL INSTITUTIONS

Acquisitions of shares in financial institutions are regulated by both company and banking legislation.

Company legislation

Under the Joint Stock Company Law (amended July 2001 with effect in 2002), a company's charter may prohibit or restrict acquisitions by one or an affiliated group of persons of shares in excess of a stated threshold. In addition, the Joint Stock Company Law recognises pre-emptive rights of existing shareholders in closed joint stock companies, which must be honoured if the legality of any share transfer in such a company is to be ensured. The recent amendments permit the charter of the company to reduce the exercise period for such rights from the previous 30-60 days, to 10 days.

Banking legislation

Banking legislation, in turn, establishes restrictions when an acquiring entity reaches the thresholds of 5% and of 20% of a financial institution's outstanding share capital. Separately, all acquisitions of any kind by a foreign person or entity of shares in a Russian bank are subject to the consent of the Bank of Russia. Banking legislation also imposes certain restrictions on the manner in which bank shares may be acquired.

Notification and Consent Thresholds

Article 11 of the Banking Law requires that the acquisition of more than 5% of the shares of a Russian bank by a single person or by a group of persons, bound by contract or in a parent-daughter relationship as defined by the Civil Code (an affiliated group), must be notified to the Central Bank. Pursuant to Article 105 of the Civil Code, a company is deemed the daughter of a principal company if that principal company has the power to determine the decisions of the daughter company, whether by virtue of its majority shareholding, a contract, or another basis. A shareholding of 20% is deemed to make one company dependent on another as a matter of law (Art. 106).

In late March 2002, the Central Bank published Regulation No. 184 On the Procedure for Recording and Reporting Information on Affiliates of Credit Organizations which adopts the definition of affiliated persons used in the antimonopoly legislation. Credit organizations are required to file their list of affiliations in full yearly, with the first date falling on July 10 2002, and to update changes within three days of their occurrence.

Article 11 of the Banking Law also provides that acquisition of more than 20% of the shares of a Russian bank by a single entity or by an affiliated group is subject to the prior consent of the Central Bank. As noted above, the recent amendments to the Banking Law extended this rule to investments through trust management, and also prohibit the granting of such consent to persons judicially found guilty of damaging a credit organization while acting as a member of the board or management.

Restrictions on foreign acquisitions

Unlike the restrictions on purchases by any one entity or affiliated group, which are based on reaching the threshold of 5% or 20% of the charter capital of a bank, the restrictions on foreign investment affect any acquisition, regardless of amount. Article 18, paragraph 1, of the Banking Law provides that a limit or quota on foreign capital in the Russian banking system will be established by federal law. Since no such limit was established, the pre-existing quota of 12% established by the board of directors of the Central Bank applied by default. Central bank statistics indicate that as of April 2002 the share in the Russian banking sector held by foreign capital is 6.1%. In order to monitor compliance with the systemic cap on foreign investment, Article 18, paragraph 3, of the Banking Law requires any credit organization to obtain the prior written consent of the Central Bank for:

• Any increase in charter capital at the expense of foreign investment; or
• Alienation (including sale) of its shares for the benefit of a non-resident, and requires any resident shareholder (participant) of such credit organization to obtain such prior consent to any disposition or alienation of shares belonging to it for the benefit of a non-resident.

Although an increase in charter capital at the expense of foreign investment, or an alienation of shares for the benefit of a non-resident, that has not been sanctioned by the Central Bank, is null and void, under part 5 of Article 18. If the Central Bank fails to issue its consent or a reasoned written refusal to an applicant within two months from the date of filing, the proposed disposition of shares will be considered permitted.

Anticipated modification of restrictions on foreign capital

The Strategy for 2002 and the new leadership of the Central Bank indicate the intention of creating a level playing field for investors in the banking sector, whether foreign or domestic. It is intended that no specific restriction on foreign capital would apply, suggesting that the quota principle and per-transaction controls established in Article 18 would be abolished. Moreover, these announcements indicate that the current 20% threshold, at which any acquirer is required to obtain Central Bank consent for acquisition, would be lowered to 10% for both domestic and foreign investors. Such changes would require further amendment of the Banking Law.

COMPETITION REGULATIONS

Acquisition of more than 20% of the shares of a bank by a single person (or an affiliated group of persons as defined in the Antimonopoly Law) requires the preliminary approval of the Ministry of Antimonopoly Policy and Support of Entrepreneurship (MAP). In February 2002, the Ministry for Antimonopoly Policy issued Letter No. AK/2362 which requires all credit organizations to obtain the Ministry's consent for acquisition of control by any person or group of affiliates, for any creation of a credit organization, for merger or consolidation, or for changes in the size of charter capital. The Letter appears to go beyond the prior regime applicable to stakes of 20% or more, and will represent a substantial change in policy if enforced. The Strategy commits to heightened monitoring of the competitive environment in the banking sector through proposed amendments to the Law on Protection of Competition in the Market for Financial Services.

The issue of monitoring of acquisitions in the banking sector by MAP is interwoven with the difficulty experienced through the present in tracking and restricting the undisclosed influence of affiliated groups. The Strategy for 2002 repeatedly emphasizes the importance of determining who the real owners of regulated banks are at any particular time, and certain regulations requiring intensified reporting on affiliates have already been implemented. This continues the trend of 2000-2001 aimed at avoiding concentration of capital and market power in oligarchic groups.

SUPERVISION

The Strategy for 2002 renews commitment to strengthening bank supervision on the basis of the principles recommended by the Basel Committee on Bank Supervision, "envisioning transition from formal restrictions and regulation to maximum weighting and evaluation of materiality of risks; the adequacy of the judgement of the credit institution about real levels of risk; the quality of intrabank systems of governance and monitoring of risk". A critical aspect of truly improving bank supervision, which continues to be inadequate in identifying problems at banks in advance of crises, remains the successful implementation of International Accounting Standards (IAS) and of transparency in bank reporting.

Bank Reporting

Central Bank Instruction No.1, 1October 1997, established what are called mandatory economic norms (N1-N10). Compliance with these, as well as other types of performance criteria, is measured and supervised through the system of periodic reporting. Banks are required to submit to their territorial division of the Central Bank periodic reports on operations and financial condition, some every ten days, some monthly, some quarterly. The scope, contents, and frequency of reporting are determined by Directive 7-U and in parallel, Instruction No. 17. While the Strategy for 2002 outlines changes in legislation that would require banks to publish in the public media quarterly information on their assets, profit and loss, and liquidity, these amendments remain in the future.

Bank accounting and IAS

Pursuant to Article 5.2 of the Law on Accounting and Articles 4 and 56 of the Law on the Central Bank, the rules for accounting and reporting by banks and other credit organizations are established by the Central Bank and these are the Rules for Maintenance of Accounting by Credit Organisations, approved in June 1997. In 2001, the Central Bank initiated a pilot programme of six banks for introduction of IAS. This year, the leadership of the Central Bank has committed to develop the legal and regulatory framework for implementation of IAS in banks by the end of 2002 to permit a full year of use prior to full transition in January 2004.

Restrictions on interlocking management

From January 22 2002 (Letter 7-T), the Central Bank introduced a prohibition on contemporaneous management in more than one bank, insurance, securities, investment or financial leasing organization or in entities affiliated with credit organizations. Unfortunately this does not reach to parallel positions on boards of directors which are deemed to constitute consulting engagements rather than official positions under labour legislation.

Sanctions

Sanctions on non-complying banks, arising under the Law on the Central Bank (replacing management, introduction of financial health measures, limitation of or prohibition on selected banking operations, through full licence revocation), are enforced under the March 1997 Instruction No. 59, as amended in January 2002.

Disclosure requirements

Change of management/control/money-laundering controls
Central Bank Instruction 75-I regulates both changes in management and changes in the composition of the shareholders of a Russian bank. But it does not set forth a particular provision on change in control as such, although the provisions of Article 11 of the Banking Law concerning acquisitions of 5% and 20% govern part of this monitoring function. In the case of a change in the composition of shareholders, Chapter 18 provides that banks which are in the form of closed joint stock companies or limited liability companies must submit for certification by the relevant territorial division the corporate resolutions approving a change in the shareholders and a complete list of all shareholders or participants. Banks in the form of open joint stock companies, whose shares are traded on the secondary market, need not obtain consent for changes in shareholdings, but must regularly submit a list of all shareholders with a position in excess of 5%. Any shareholding, whether or not above 5%, by foreign persons, must be specifically reported by all banks. Within 10 days following the annual general meeting of banks in the form of open joint stock companies, such banks must electronically provide to the Central Bank the complete list of its shareholders.

Chapter 22 requires prior submission to the Central Bank in the event of change in the management of a bank or in the case of replacement of a bank or a bank branch chief accountant. The territorial division Supervisory Department must agree persons nominated to fill these positions. The Supervisory Department is required to conduct an inquiry and prepare an analysis of acceptance or rejection of the candidate within one month, and only then may the bank appoint the new executive. The new executive's signature is then accepted within the Central Bank's clearing system and the Central Bank's Licensing Department registers the new executive in the registry of credit organizations.

The Law on Prevention of Money Laundering enacted in August 2001 (Law No. 115-FZ) led to promulgation of Central Bank Regulation No. 160-P in December 2001 governing bank reporting on potential money laundering and establishing the right of spot inspections of banks in this regard. Regulation No. 161-P established reporting methodologies that entered into force on February 1 2002. In April and May 2002, the regulations governing the operations of the new Committee of the Russian Federation on Financial Monitoring appeared, setting out the tasks, functions and authority of the Committee which is charged with prevention of money laundering operations and coordination of federal agencies on this topic.

Bank insolvency

The Russian legal framework for dealing with bank insolvency appeared in reaction to the August 1998 financial crisis and the hundreds of bank insolvencies that followed in its wake. Two specific laws apply: the Bank Insolvency Law of March 1999, and the Bank Restructuring Law of July 1999, together with the general Law on Bankruptcy. All three laws were amended in late 2001 and attempted to increase accountability of bank managers as well as to streamline the bank insolvency process. Notwithstanding these partial amendments, the Strategy for 2002 recognised that "the lack of resolution of the problem of effective liquidation of credit organizations creates significant obstacles on the path of reform of the banking sector and of renewal of confidence in it among investors and creditors."

The Bank Insolvency Law envisions two categories of measures, one dealing with rehabilitation measures which the banks are required to implement themselves, the other with other measures implemented by a Central Bank temporary administration. Grounds for mandating self-rehabilitation include violation of the Central Bank minimum ratios for capital adequacy and liquidity, a decrease in capital assets of more than 20%, as well as a certain degree of payment failure (three days).

The Central Bank may (but need not) impose its own temporary administration, an independent management body, within a failing bank if any of five grounds are present. These are:

• violating the Central Bank liquidity ratio by more than 20 per cent in the prior month;
• a decrease in capital assets of more than 30 per cent together with violation of other Central Bank ratios;
• failure to carry out self-implemented rehabilitation, grounds permitting licence revocation; and again,
• a specified degree of payment failure.

The obligation to self-rehabilitate, or the power of the Central Bank to impose an ordinary temporary administration under the Bank Insolvency Law, can arise in relation to banks of any size or relative national and regional importance.

The Restructuring Law of July 1999 introduced a special state-managed restructuring phase, preceding liquidation, for a limited class of banks whose banking assets were of overarching national or regional significance, whose insolvency was sufficiently deep (such as payment failure of seven days or capital adequacy of 2%), and whose eligibility was recommended by the Central Bank. The Agency for Restructuring of Credit Organisations (ARCO) was charged with implementation.

The relevance of ARCO in this role has effectively ended insofar as the Strategy for 2002 announces that ARCO will not undertake further restructurings. The focus of concern has shifted from rehabilitating the failed banks to liquidating the more than 700 whose licences are revoked. In this connection, the Strategy for 2002 stresses the need for centralization at the Central Bank of data on the liquidation processes managed by individual liquidation administrators under Article 48 of the Law on Bank Insolvency. It is now intended for ARCO to be converted to a company charged with the liquidation of banks within the context of a deposit guarantee framework, and in May 2002 ARCO confirmed it had submitted legislation to the government concerning the evolution of its role.

The framework for dealing with insolvency of banks will be affected by the pending sweeping changes in the general Law on Bankruptcy under consideration by the Duma, which may be adopted during 2002.

CAPITAL REQUIREMENTS AND BANK SECRECY

The Central Bank announces the minimum charter capital requirements for banking and non-banking credit organizations, as well as for credit organizations with foreign capital, on a quarterly basis. The most recently announced thresholds, for the second quarter of 2002, were:

• RUR 135, 738, 500 for newly created domestic banks,
• RUR 13, 573, 850 for newly created domestic non-banking organizations, and
• RUR 135, 738 500 for subsidiaries of foreign banks.

A bank which wishes to receive a general licence for banking must demonstrate the presence of capital assets of at least RUR 135, 738, 500.

At the same time, despite repeated expressions of support for more stringent capital adequacy standards, the goal of establishing minimum bank capital at an equivalent of €5 million is not yet implemented with respect to already licenced banks. The government and Central Bank are seeking legislation that would establish a capital adequacy ratio for existing banks of 10%, to apply from 2005 to banks with capital of less than €5 million, non-compliance with which would trigger licence revocation. After a two year transitional phase, that standard would apply to all credit organizations and all banking credit organizations would be required to maintain capital of at least €5 million in rouble equivalent.

The Strategy reiterates the government's commitment to preservation of the institution of bank secrecy.

Salans Hertzfeld & Heilbronn
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