Author: | Published: 30 Sep 2004
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Despite superb growth rates in the Russian economy as a whole in the last few years (7% to 8%), the banking sector still has not experienced the structural reform that is needed to permit strong sector-specific growth and to prepare Russia's banks for competition from abroad.

The short-lived mini-crisis of May and July 2004, in which eight banks ceased operations and over $1.2 billion of savings were converted by the public into dollars, was a vivid reminder that banking has not undergone the needed reforms. The sector remains glutted by too many small, undercapitalized and poorly managed banks: the total number of licensed banks continues to hover near 1300 as in prior years. From one perspective, the central bank's action in June to revoke the banking licence of a second-tier bank considered to be in violation of money laundering rules was praiseworthy as a signal to the market that supervisory functions are operating and improper use of the public's deposits will not be tolerated. The disciplinary action was laudable, but the regulator faced a backlash from an already nervous public that led to a brief period of substantial withdrawals from privately owned banks, two of them among the top tier of larger credit organizations, until then considered to be solid. One of these large banks was taken over by Vneshtorgbank and the other funded large cash injections to support the run on deposits.

Despite the failure so far to achieve profound structural reforms in this sector, the goal remains prominent in government policy. The strategy for development of the banking sector in 2004 to 2008, the release of which has been delayed since February, makes renewed commitments to increasing bank capitalization, improving bank reliability, including through implementation of the deposit insurance scheme, enhancing weak public confidence, improving quality of service, and incentivizing the provision of loans to the non-natural-resource sectors of the economy, including the housing sector. Among the legal tasks outlined in the draft strategy are strengthening the legal protection of creditors, including secured creditors; improvement of the legal means for liquidating banks whose licences have been revoked; simplifying mergers and consolidations of banks; creation of an effective system for preservation and use of credit histories and a system for registration of pledges; provision of legal defences against takeover of control in banks by persons acting in bad faith; and continued refinement of the taxation of banks. A proposal found in Section 5 of the draft strategy is worth monitoring; it suggests the importance of broadening the use of non-judicial or extra-judicial measures for levying execution on immovable property that has been mortgaged to secure loans. This is an important right for secured creditors in any system and its introduction has long been resisted in the Russian Federation.

Mortgage financing: foundations and policy goals

Consistent with the government's goal of galvanizing the housing market, Law 152-FZ (November 18 2003) established the procedure for issuance and circulation of mortgage-backed bonds, and the procedure for monitoring disposition of mortgaged property and requirements for disclosure of information on mortgage-backed securities. Credit organizations are specially authorized to act as issuers of these securities, together with special mortgage agents or special purpose vehicles (SPVs).

In principle, this legislation provides the beginnings of a framework for securitizing mortgage loans, which is desirable when pre-existing pools of mortgage loans exist among the assets of lenders and the lenders need a method to raise financing from those assets. The opportunity to issue mortgage-backed bonds or mortgage certificates offers an entry into a secondary mortgage market. The primary mortgage market in the Russian Federation is still just developing. Widespread use of mortgage securities will depend on corresponding growth of the underlying primary mortgage market.

Under Law 152-FZ, the originator of the mortgage loans sells a pool or portfolio of loans to a special purpose vehicle, which then issues bonds or mortgage certificates. Commercially, the device is attractive to banks because it should in theory permit the lender to convert the loan portfolio to cash immediately, on terms that are cheaper than borrowing. It is attractive to governments because it increases market liquidity in mortgages and tends to act as an incentive to making them. In addition, the legislation requires insurance of the mortgage debt, which leads to greater stability and predictability in the housing sector.

From a legal standpoint, an essential feature of the legal framework for mortgage securitization will be the extent to which the legislation isolates the collateral pool that supports the securities, in this case the mortgage-backed bonds or mortgage certificates, from creditors in any potential bankruptcy of the issuer. The collateral for the securities should be bankruptcy remote so that the purchaser of the securities can be guaranteed a secure and privileged position, protected against competing claims from creditors of the issuer. Whether or not Law 152-FZ will in practice provide such ironclad protection remains to be seen when the legislation is tested.

In addition to laying the groundwork for mortgage securitizations, the government achieved a further breakthrough in the effort to build a functioning housing market with the adoption on August 25 2004 of amendments to the Law on the Notarial Fee (see Law 104-FZ). As amended, the notarial fee on mortgage loans for residential housing falls to the reasonable amount of R200 ($7), while that on non-residential mortgages is set on a percentage basis but capped at R3000. As compared to the generally applicable rate of 1.5% of the mortgage loan applicable before the amendments, the reduced notarial fees are a critical change and remove one of the larger barriers to the use of mortgage finance and to investment in the housing and property sector. The new rates come into force one month after official publication of the law, on September 25 2004.

The mini-crisis of 2004 and deposit insurance

After years of effort by its proponents, the Law on Insurance of Deposits of Individuals in the Banks of the Russian Federation 177-FZ was at last enacted on December 27 2003. When the law is implemented, all banks taking deposits from the public will be required to make mandatory contributions to the insurance fund administered by the Deposit Insurance Agency. Individual depositors will be insured for 100% of one deposit per bank up to R100,000. The limitation will incentivize individual depositors to distribute their savings among multiple banks.

Until such time as the Agency is funded to the level of 5% of the aggregate deposit level in banks, all banks are required to contribute 0.15% of the average daily balance on insured deposit accounts over each calendar quarter, although in exceptional circumstances the rate may be raised to 0.30%. Thereafter, the contribution rate will fall to 0.05%. The government will fund the Agency with an initial R3 billion.

Banks in which the Russian government holds a portion of the equity capital will continue to enjoy the special benefit of secondary coverage for individual deposits in respect of the amounts exceeding the R100,000 limit. The state will continue to bear secondary liability on these amounts until January 1 2007. These banks' insurance contributions will be segregated to pay compensation only to depositors in these banks, until such time as the share of deposits in banks with state capital represented by individual deposits falls to less than 50% of the overall share of deposits of individuals in banks in Russia, but no later than January 2007.

Unfortunately for the depositors in the eight banks that closed their doors in the summer of 2004, the national deposit insurance scheme was not then yet operational. The government rushed to provide coverage to such depositors through enactment of Law 96-FZ of 29 July 2004 entitled On Payments by the Bank of Russia on Deposits of Individuals in Banks Recognized as Bankrupt and Not Participating in the System of Mandatory Deposit Insurance for Individual Depositors. The emergency cover targets personal household accounts; it does not reach funds in entrepreneurs' individual business accounts, funds held in foreign affiliates or branches of the Bank of Russia, funds held in accounts in trust management for others, funds placed in bearer accounts or certificate of deposit accounts. The extent of payment is capped at R100,000 and payment may occur upon: the declaration of bankruptcy of the credit organization; and expiration of the period in which first-priority creditors are required to be paid under the Law on Insolvency of Credit Organizations. Although the law entered into effect one month after official publication, on August 29 2004, it applies to claims arising in consequence of bank insolvencies and revocation of banking licenses at any time after entry into force of Law 177-FZ of December 2003 on Insurance of Deposits of Individuals in Russian Federation Banks.

In parallel, in implementation of Articles 46 and 47 of the Law on Deposit Insurance, on July 16 2004 the central bank announced Directive 1476-U, a procedure for removing the right of a bank to take individual deposits. This is the enforcement tool for the deposit insurance system: a notification to a bank that it may no longer take deposits from the public may be sent either when the bank has refused to participate in the national insurance scheme, in which case notices will be due to be sent on April 1 2005, or when the bank has been designated as failing to meet the requirements for participation in that system, in which case notice may not be sent later than 21 months after the Law on Deposit Insurance enters into force. It is estimated that a number of banks will not meet the qualification criteria and might then face a loss of most of their public deposits and subsequently close.

Similarly, on July 30 2004 the central bank released its Directive 1483-U concerning the procedure for prohibiting the opening of individual accounts by banks that have refused to become participants in the national deposit insurance scheme.

Additionally, on August 20 2004, President Putin signed Law 106-FZ, which confirmed the secondary liability of the Russian Federation government for return of funds to depositors under bank deposit and bank account agreements concluded before October 1 2004, with banks in which the state holds any capital participation through January 1 2007.

Consequences of the new currency regime

Further to President Putin's pledge to move the rouble toward full convertibility by 2007, the government adopted a completely revised currency regulation law in December last year, which was slated to enter into effect on June 18 2004. (Law 173-FZ). The country's credit organizations are only now coming to grips with the practical significance of the law, as most of the implementing regulations appeared only in June 2004 with little advance time to study their interpretation before the new system entered into.

Elements of the new regime. Although the law was intended to liberalize, the implementing regulations impose bureaucratic burdens on businesses engaging in a broad range of transactions. A first set of implementing regulations governing the new special account requirements appeared on June 17, 18 and 19, 2004 at the time that the new law entered into force. The second regulatory element, dealing with the reserve requirements appeared in the official press on July 23 2004 when the central bank released Directive 1465-U setting the level of the reserve requirements applicable to five categories of regulated currency transactions (see below).

Sanctions for violations in transitional period. Article 5.2 of the Currency Law provides that, if the procedure for carrying out currency operations or the procedure for use of special accounts or reserves has not been established, then such currency operations will occur without restriction. To emphasize this point, the central bank released on July 14 2004 its Letter 78-T, which instructs the territorial divisions of the central bank to apply only warning measures and not the stricter form of sanctions to banks found to be in violation of the new Currency Law during the period of June 18 to September 1 2004.

June - July 2004 implementing regulations

Instruction 116-I On the Types of Special Accounts of Residents and Non-Residents, published June 18 2004. This instruction identifies the particular transactions that may be carried out only through eight kinds of new special accounts (a requirement from which authorized banks are exempted). Building on Instruction 116-I, the central bank published Directive 1465-U on July 23 2004, which establishes in relation to five of these eight types of special accounts, particular reserve requirements that apply to transactions occurring through those accounts.

R1 accounts are for resident businesses: (a) to receive credits and loans in foreign currency; (b) for receipt from non-residents of foreign currency from distribution or issuance of shares or debt obligations that are external securities or from issue of a promissory note or bill of exchange to a non-resident; or (c) for receipt from non-residents of foreign currency from the alienation to a non-resident of external securities not accounted for in a special sub-part of the securities deposit account.

Directive 1465-U sets a reserve requirement of 3% for 365 days in relation to R1 account transactions

R2 accounts are for resident businesses: (a) to make settlements and transfers while making loans to a non-resident in foreign currency; (b) for acquisition from a non-resident of external securities, including settlements and transfers related to the transfer of external securities (rights evidenced by external securities); or (c) for disposition to a non-resident of external securities.

Directive 1465-U sets a reserve requirement of 50% for 15 days in relation to R2 account transactions.

F accounts are for individual residents: (a) for settlements and transfers while making loans to a non-resident in foreign currency, and for receipt from a non-resident of a credit or loan in foreign currency; (b) for acquisition from a non-resident and disposition to a non-resident of external securities, including settlements and transfers, related to the transfer of external securities (rights evidenced by external securities).

S accounts are for non-resident businesses and individuals, including foreign banks: (a) for acquisition from a resident and disposition to a resident of debt obligations issued by the Russian Federation constituting internal securities.

Directive 1465-U sets a reserve requirement of 20% for 265 days in relation to S Account transactions.

A accounts are for non-resident businesses and individuals, including foreign banks: (a) for acquisition from a resident and disposition to a resident of shares and investment participations of mutual investment funds constituting internal securities.

O accounts are for non-resident businesses and individuals, including foreign banks: (a) for acquisition from residents and disposition to a resident of debt obligations of residents and non-residents constituting internal securities (other than obligations issued by the Russian Federation and constituting internal securities).

V1 accounts for non-resident businesses and individuals, including foreign banks: (a) for settlements and transfers while receiving a credit or loan in Russian currency from a resident; (b) for taking in from a resident Russian currency received from a primary distribution (issuance) of shares and debt obligations constituting internal securities, the issuer of which is a non-resident, or from issuance by a non-resident to a resident of promissory notes constituting internal securities.

Directive 1465-U sets a reserve requirement of 50% for 15 days in relation to V1 transactions.

V2 accounts for non-resident businesses and individuals, including foreign banks: (a) for settlements and transfers while making a credit or loan in Russian currency to a resident; (b) for acquisition from a resident of non-emission securities (other than promissory notes constituting internal securities and issued by non-resident account-holders).

Directive 1465-U sets a reserve requirement of 3% for 365 days in relation to V2 transactions.

Instruction 117-I and Regulation 258-P: These together govern requirements for preparation and submission of transaction passports when making settlements and transfers between residents and non-residents on: import and export of goods, services and intellectual property (foreign trade transactions); and loan and credit agreements between residents and non-residents. Transactions of credit organizations and transactions whose amounts do not exceed $5,000 are exempted.

For settlements in foreign trade transactions envisioning payment deferral for the foreign purchaser of more than 180 days but less than 2 years, the cash reservation can be avoided if the foreign purchaser provides approved security from a foreign bank. (Article 7.6 and Article 17). Under Article 17, approved security includes irrevocable letters of credit from domestic or foreign banks, foreign bank guarantees, or foreign promissory notes made available by foreign banks. According to a March Directive of the central bank released on April 28 2004, 1410-U, (also entering into force on June 18) the only foreign banks qualified to offer this alternate security, to permit avoidance of the cash reservation device, will be banks with Moody's ratings of at least AA3 or Standard&Poor/Fitch ratings of at least AA-, and which are among the top 1000 banks globally in terms of assets in the most recent publication of the Bankers Almanac.

It has been reported that amendments to the new law are being prepared to address some technical deficiencies and will be submitted in the autumn Duma session.

Other bank regulatory developments

Guidelines for judgements about risk

Central Bank Operative Directive 70-T, on Risk Assessment, was issued on June 30 2004. The directive helps risk managers and compliance officers of banks to distinguish the risk profile of banking operations for the purpose of internal control. It may also be used as a reference and glossary for risk definition in future documents. The Directive defines various risk profiles: credit risks; country risks; market risks; securities market risks; liquidity risks; currency risks; operational risks; reputation and bad publicity risks; and strategic risks. In particular, legal risk is defined as the risk of losses associated with non-compliance with normative acts and concluded agreements; legal errors in operations; imperfection of the legal system; breach of the provisions of normative acts and concluded contracts by the contractors of the entity subject to the risk.

Amendments to the Law on Insolvency of Credit Organizations

Entering into force three months after its official publication on August 26 2004, Law 121-FZ addresses a number of ambiguities in the original law. Enactment of this legislation was one of the tasks specified in Section 3 of the draft Strategy for 2004 to 2008. The new law clarifies that among the mandatory payments of a credit organization are its obligations as an independent tax payer in accordance with the definitions set out in the general law on bankruptcy, as well as its obligations to effect transfers of tax payments by its clients from the accounts held with the credit organization. Extensive new provisions concerning measures to prevent bank insolvency and measures for carrying out financial rehabilitation as an alternative to bankruptcy have been inserted. The amendments reduce the period during which a bank must be unable to meet its obligations before it is deemed insolvent from one month to 14 days. It empowers the central bank to send observers to the shareholders' and board meetings of a bank to which bankruptcy-prevention measures are being applied, a step targeted at increasing transparency and information flow to the regulator. Article 14 reiterates the potential secondary liability of founders and participants in a bank, of the board of directors of a bank, and of the managers of a bank, who either have the power to give binding instructions, or otherwise have the ability to determine the actions of the bank, for the liabilities and debts of the insolvent credit organization in cases where the bankruptcy occurs through their fault - the general principle given in Article 56.3 of the Civil Code. The novel aspect is that the court may impose secondary liability not only where instructions of such persons led to the insolvency but also where their omissions or failure to act in compliance with regulatory law to avoid bankruptcy led to this condition.

Regulations governing the bank supervisory committee of the Bank of Russia

With effect from August 16 2004, new regulations govern the workings of the bank supervisory committee. The committee is composed of the chairman, deputy chairmen, the department of bank regulation and supervision, the department of licensing and financial rehabilitation, the department of currency control, the legal department, the main inspectorate, the main division for security of information, and the Moscow main territorial division of the Bank of Russia. The bank supervisory committee adopts decisions on such critical regulatory matters as registration of new credit organizations, issuance of general banking licences, designation of banks as compliant with the requirements for acceptance into the national depositary insurance scheme, rulings that bank capital has been formed from unsuitable assets, introduction and amendment of prudential ratios; appointment of temporary administrations at failing banks; cancellation and revocation of banking licences; granting of permissions for the opening of foreign branches of Russian banks; and imposition of warnings and sanctions on banks envisioned by central bank regulations.

Investors and regulators pressing for consolidation

Although the Russian banking sector suffers from under-expansion, fragmentation of insufficient capital, and an imperfect regulatory system, it continues to attract interest from investors, both domestic and foreign, who are seeking a foothold in domestic finance. In the context of the 2003 negotiations for Russia's entry into the WTO, Minister Gref stated unequivocally that, upon accession to WTO, the Russian banking sector will be open save that "Russia will not be obligated as to the cross-border supply of services through opening of branches of foreign banks in Russia." There is no specific prohibition on opening a branch of a foreign bank, but regulations governing the preparation, composition, submission, and consideration of an application to operate a bank branch are absent, as well as regulatory standards for monitoring the health and stability of a foreign bank branch. So the promises extended in the draft strategy for simplification of acquisitions, mergers and consolidations in the banking sector take on more significance: acquiring banks or forming new banks are the only methods available to the foreign investor.

Gradual consolidation of capital would therefore seem to be the benchmark trend for the coming months, whether led by regulatory discipline as some banks close upon failing to meet the standards for the deposit insurance scheme or are closed for other reasons, or whether led by domestic and foreign investors seeking to create small banking networks or to acquire strategic stakes.

Author biography

Mira Davidovski


Mira Davidovski is a partner with Salans. Based in Moscow from 1992 until 1996 and Paris from 1996 to 2000, Davidovski now divides her time between the Moscow and London offices. She concentrates on advice to financial institutions engaged in banking, financial and investment activity, with particular emphasis on the Russian Federation and the other states of the former Soviet Union.

Mira has had significant experience in 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, advising on the assignment of debt assets, debt restructurings and the like. Her practice includes advising international financial institutions, investment funds, investment advisers, and broker-dealers in the emerging markets of the FSU.

Mira'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 sectors such as telecommunications, oil and gas, real estate, financial services, pharmaceuticals, consumer goods, and heavy industry.

Mira has been a central legal adviser on a lending programme put into place by an international financial institution involving over 20 Russian banks. After the 1998 financial crisis, she was involved in helping to recapitalize and restructure certain banks, and to pursue debt recovery claims against other banks, both in and beyond the insolvency context. She was a key player in a team that organized the recovery of certain assets and defended creditors' rights.

Mira 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 from 1985 to 1986. She received her Juris Doctor degree from the University of Maryland School of Law in 1985 with honours and her Bachelor of Arts degree from Harvard/Radcliffe College in 1981, with honours in the field of government. She is a member of the District of Columbia, Maryland, and Massachusetts Bars.

Mira is a regular speaker and writer on Russian law. A native English speaker, she is also fluent in Russian and French.

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