Hard-pressed Russian banks eye M&A route to survival. Oleg Khokhlov for The Banker
A sluggish economy, high interest rates and greater scrutiny are hitting Russia's banks, especially smaller institutions, with some opting for consolidation as a way to survive, as Stefanie Linhardt reports.
The business of banking is under pressure in Russia. An ongoing contraction in the economy, high interest rates and Western sanctions are challenging lenders, and the regulatory environment is adding another layer of difficulties. But since necessity is the mother of invention, some banks have big plans to come out of this situation stronger and, especially, larger.
As The Banker’s 2016 Top 1000 World Banks ranking showed, Russia’s banking sector has taken a hit. Having suffered a plunge in its banks’ profitability of about 50% in fiscal 2015, most lenders also faced a drop in their capitalisation, leaving only 11 Russian banks among the world’s largest 1000, compared with 19 in the 2015 ranking.
While fluctuations in the Russian rouble have had an impact on this ranking, the overall domestic environment is not favourable. After a 3.7% fall in gross domestic product in 2015, the Russian central bank, the Bank of Russia, is forecasting a contraction of about 0.5% for 2016. The economy is expected to return to sluggish medium- to long-term growth of 2% on average between 2016 and 2021, according to International Monetary Fund data.
And the problems do not stop here. While the extension of Western sanctions until the end of 2016 mainly affects the large state-owned banks, the small or medium-sized lenders – of which there are plenty in a sector that has 680 registered credit institutions with the right to operate – are those that are worst hit by the economic downturn and regulatory pressures.
Since Elvira Nabiullina took office as governor of the Bank of Russia in July 2013, hundreds of banking licences have been withdrawn for infringing Russian law. During her first six months in the job, Ms Nabiullina revoked 35 licences (compared with only three by her predecessor in the first six months of 2013).
“We have to be able to be competitive in all sectors… and this is also relevant for the financial sector,” Ms Nabiullina said at the St Petersburg International Economic Forum (SPIEF) in June. “The first stage of our work was to make sure that the unstable players or players engaged in the shadow economy are out of the market. We wanted to make sure that there is fair competition in the financial market because if [you have] players who do not stick to fair play rules, the situation is bad for other actors.”
Reasons for the withdrawal of banking licences range from allegations of money laundering and involvement in the criminal money market to insufficient equity, or other unsatisfactory financial standards such as unreliable reporting results.
Tough on small banks
While such measures may be better for the banking sector as a whole, dwindling liquidity at smaller banks can put them in line for central bank scrutiny. As of July, some 120 banks were facing liquidation, according to a July 4 research note by Renaissance Capital global chief economist Charles Robertson.
“Small and mid-cap banks are feeling the pressure and are trying to find solutions but are struggling to do that,” says Oleg Khokhlov, a partner of banking and finance at law firm Goltsblat BLP. “Depositors are reacting to what the central bank is doing and are slowly, day by day, transferring their funds to bigger banks. There is a growing amount of small and medium-sized banks that are facing liquidity shortfalls and if you add to that the pressure from the central bank, the small and mid-cap banks are clearly at risk.”
To rival the larger competitors, small and mid-cap banks used to lure customers with higher interest rates on deposits. The strategy saw savers jump on the deals and bulk up the banks’ funding sources, but it also created difficulties in the long run.
“Often they couldn’t sustain these higher interest payments,” says Mr Khokhlov. “Now the central bank very clearly monitors the interest rates for deposits and once they see that deposit interest rates are going over certain thresholds, they impose limits on deposit taking for these banks, which means now banks can only play the deposit interest game in a limited way.”
A bigger contender
With the size of a bank seemingly making a stark difference to future business opportunities, several lenders are looking to grow their operations through consolidation. And while mergers and acquisitions (M&A) always come with a risk of the unknown regarding the target’s portfolios and operations, some players are keen to go down the inorganic route.
One that has already done so is Otkritie FC Bank. Established as a small retail brokerage operating on the Moscow exchange MOEX in 1995, the group grew in the early 2000s. It made the key acquisitions of the larger Nomos Bank in 2012 and of Petrocommerce Bank in 2013, and now operates in the two segments of corporate and investment business and retail banking.
Anatoly Aksakov, president of the Association of Regional Banks of Russia, says the consolidation of assets in the Russian banking sector is increasing, with one of the reasons being “a result of rehabilitation and revocation of licences”.
Under the so-called 'sanation process' (a Bank of Russia-directed rescue plan), banks receive cheap loans from the central bank in exchange for taking over and rehabilitating failed institutions. In late 2014, Otkritie also took part in one such transaction to save mid-sized lender Trust Bank.
Other institutions interested in expansion are as diverse as Bank of Saint Petersburg, Promsvyazbank, Expobank and broker BCS Financial Group. Regionally focused Bank of Saint Petersburg is considering both opportunities from straight M&A to bail-ins by the central bank.
“The ongoing activity of the central bank of Russia on the revocation of several licences in the banking sector creates not only challenges but also opportunities for the whole system,” says Alexander Savelyev, chairman of Bank of Saint Petersburg’s management board. “We are [interested in] taking part in the sanation process but several times so far we haven’t agreed on the price.”
A better balance
Historically a corporate bank, Bank of Saint Petersburg is seeking to close the gap to balance corporate and retail banking. It is the largest privately owned bank in its home market of St Petersburg – Europe’s fourth largest city with about 7 million inhabitants – and has the third largest share of overall loans and deposits in the region.
Mr Savelyev says the bank is looking both in its home region and outside for opportunities as “there will be limits for growth” in St Petersburg.
“The most important thing for us is the economic potential of the deal,” he says. “If we find a good bank, which we can buy at a good price, with a business model similar to ours, we will do that.”
And the bank already has a blueprint it can use for integrating operations outside the city’s scope. In 2014, Bank of Saint Petersburg acquired Bank Evropeisky in Kaliningrad and merged and connected it to be working as a branch.
“Kaliningrad was our first example and now we know that we can do that, the only question is to find a good target,” says Mr Savelyev.
Bank of Saint Petersburg is a public company partly owned by management, investment fund East Capital and the European Bank for Reconstruction and Development, but it also has a 31.9% free float listed on the Moscow Exchange.
Window of opportunity
Promsvyazbank, the eighth largest Russian bank by capital, is also looking to expand. In early July, the lender’s investment firm owner, Promsvyazcapital, added Samara-based lender Pervobank and completed its integration in early July.
“Growing organically is not as efficient as M&A,” says Vlad Khokhlov, a member of Promsvyazbank’s board of directors. “We think now is the time for acquisitions. There is a window of opportunity of two years before valuations will rise again.”
Promsvyazbank focuses mainly on corporate banking, but also offers services for retail customers and has increasingly added small and medium-sized enterprises to its client base in recent years. The lender’s international business is currently run out of a legal branch in Cyprus, operations that the bank is seeking to expand.
“We would like to buy a licence in Europe to spin off our Cyprus branch,” says Mr Khokhlov. “We are generating very good business with our branches and want to grow this further as a core of our international business.”
Expo's increasing exposure
Another consolidator that has already made its way into the European markets is Expobank, owned by millionaire Igor Kim. Mr Kim bought the bank from Barclays in 2011, renamed it Expobank and since added to its portfolio.
The bank has grown through acquisitions in Russia such as Stromkombank and Sibbusinessbank in 2013 and MAK-Bank in 2015, all of which left Expobank with about Rbs9bn ($140m) of capital, net assets of Rbs71.3bn and Rbs2.1bn of net profits as of January 1, 2016.
Performance is expected to get a further boost through the purchase of the Russian subsidiary of Royal Bank of Scotland in April this year. And Mr Kim is not yet done with his expansion plans.
“We are always involved in negotiations,” he says. “But we only want to grow if we can grow in efficiency and we only want to grow if the business can support the growth – otherwise it would negatively influence the work of the banks. We only have one goal, which is profit.”
While Expobank focuses on corporate business, private banking services and M&A transactions, Mr Kim can see a future target come from any possible area of banking, including retail banking, but “the question is when should we do it and under which conditions”.
In Europe, Expobank already has operations in Latvia and the Czech Republic, but also here the bank is seeking to expand further, without specific restrictions as to which jurisdictions are considered.
Investment banking opportunities
More specific are the expansion plans at Russian brokerage firm BCS Financial Group. Roman Lokhov, chief executive of global markets and investment banking for the company, believes the Russian banking market is lacking a credible, non-state-owned investment bank.
“International investment banks are leaving Russia but the more competitors are leaving, the more space there is for us,” he says. “That is why we are aggressively investing in our investment banking division in Russia because we think there is a lack of independent, privately owned local investment banks that offer a combination of local know-how and international presence.”
BCS, which was founded in 1995, received a financial broker and investment advice licence in 1998. In 2013, BCS Prime Brokerage became authorised and regulated by the UK Financial Conduct Authority to provide investment banking services to professional investors and in 2015 it ventured out of Russia to acquire US broker Alforma Capital Markets from Alfa Bank, supporting BCS’s strategy of attracting foreign investors to Russia.
“We feel that now there are a lot of opportunities in Russia,” says Mr Lokhov. “In terms of investment banking, a lot more things will happen locally because there have been improvements in terms of infrastructure, making it easier for international investors to invest, so our local investment banking knowledge will help.”
He adds that BCS has already started bolstering its investment banking team by acquiring an asset management company from Russian Standard Bank last year and recruiting a senior investment banker from Credit Suisse to build a 15-strong team of investment bankers within six months.
“We have to acquire people from banks that are leaving and that is exactly what we are doing,” says Mr Lokhov. “We have everything – we have distribution, strong research, strong sales and trading – but we have to be fast and aggressive.”
Is M&A the key?
Yet can M&A be the answer to all of Russia's banking problems? One mid-cap bank, which was seeking to create a regional association of banks to bolster the institutions’ financial positions, was forced to halt its plans after its financial footing worsened and it came under scrutiny from the central bank.
“A lot of M&A activity stops at the level of a roadmap because everything is moving so fast that before you implement a new strategy you might face another round of central bank licence revocations,” says Goltsblat BLP’s Mr Khokhlov. “You don’t have a lot of breathing space to do proper due diligence and to do beautiful M&A transactions. It’s moving too fast.”
Meanwhile, the sanation process also comes with the downside of adding a failed bank with weak capital positions to the group – a fact that does not leave all institutions comfortable with such bail-outs. According to Fitch Ratings’ Russian Banks Datawatch report for the first half of 2016, some banking groups are operating with very low or even negative equity on an aggregated basis, due to them having rescued failed banks. On this score, the report highlights B&N Bank and SMP Bank groups.
Other issues could arise from these practices as these bank recapitalisations have “not been preceded by bad loan write-offs, so future capital injections to the banks may be needed”, Renaissance Capital’s Mr Robertson said in a strategy note.
Ekaterina Trofimova, chief executive for Russia at Analytical Credit Rating Agency, a Russian rating agency, has similar concerns, noting at a panel discussion at SPIEF that while consolidation brings the number of banks down, “the quality is not [necessarily] changing”.
Promsvyazbank’s Mr Khokhlov agrees, and explains why his bank’s strategy is not to take part in sanation processes. “Every bank has a significant cushion of non-performing loans. Acquiring a bad asset for nothing might help to solve their problems but we prefer to buy a premium asset for cash,” he says.
And rating agencies remain cautious on the medium to long term for Russian banks. While non-performing loans, at an average of 9.4% at the end of May, are not sky high – especially considering a coverage ratio of about 90% – Fitch Ratings suggests some 15% of “potentially problematic restructured loans” are “weakly provisioned” and thus riskier. Fitch believes banks will recognise these loans as problematic gradually.
Also in relation to the regulatory environment, Russia’s banks will have to stay vigilant, especially concerning the future liquidity at lenders smaller in size.
“The regulatory risks have gone up but we take that as normal,” says Expobank’s Mr Kim. He adds that while the management of a bank has more work to do, he considers this “the normal price we have to pay to ensure the whole sector is healthy. The higher the regulatory hurdles, the more qualified the banking sector is”.
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