A sound banking system, a moderate bad debt level, prompt recognition of the problem which bad debts pose and dealing with them effectively, are essential preconditions of not only financial stability and depositor protection but also of economic growth.
November 12, 2019   |   Ksenia Yudaeva

Bad debts are, in a way, a natural result of the banking system and the whole of the financial sector’s operation. Financial institutions assume risks, some of which materialize, turning loans into bad debts. But the financial system’s normal operation requires a total of bad debts to be moderate and covered by buffers such as capital and reserves. If, however, risks prevail, financial stability is undermined. A large volume of bad debts is payment for past sins of inefficient risk management.

Financial cyclicity

The financial system is cyclical in nature: growth is followed by a downturn and then by new growth. The key source of this cyclical pattern is that many risk prevention instruments usually rise in price as lending expands. Let’s look at collateral for example: real estate usually rises in price along with mortgage lending growth, because the construction of new real property is slightly outpaced by demand, the latter depending on lending expansion. Cycles, therefore, sometimes end up in massive crises, as in 2008–2009. To smooth cycles and mitigate their negative impact on the economy, macroprudential regulation was developed, focusing on general systemic risks and taking into account financial institutions’ reciprocal adverse effects on one another.

How do bad debts pile up to reach not merely high but excessive levels? Global economic history shows that such problems usually arise from systemic inefficiencies of risk management.

For example, the US subprime mortgage debt crisis in large part stemmed from a substantial loosening of lending standards and, as often as not, from failure to take into account the full extent of risks. Redistribution of risks among various financial institutions through securitization made lenders much less motivated to keep a close watch on risks. The system this intricate and based on ‘packaging’ and ‘repackaging’ loans into mortgage-backed securities made it increasingly difficult to see where exactly risk was concentrated, eventually bringing about a confidence crisis and market panic.

Financial innovations are fairly often accompanied by subsequent bad debt crises. There are several causes behind this: the market euphoria; failure to see when the phase of natural growth passes into a bubble; data is insufficient for risk management models to be adjusted – because if a credit cycle is still incomplete, information about what it is like is lacking.

Bad debts in the Russian banking system

Since the early 2000s, the Russian financial system has already undergone two credit cycles which ended, respectively, in 2008–2009 and 2014– 2016. We are still coming out of the trough of the second crisis now. The experience of banking license withdrawal and resolution of banks has shown that many of Russia’s financial institutions amassed an excessively large volume of bad debts in the course of the above two cycles. Bank inspections by temporary administrations showed a Rbs143bn excess of liabilities over assets on Yugra Bank’s balance sheet, a Rbs226bn hole on that of Vneshprombank, and a Rbs80bn one in RosinterBank’s accounts.

Change in bad debts (corporate loans)

Amount of 4th-5th credit category loans in bn roubles (left axis)

Share of 4th-5th credit category loans in the total amount of loans in % (right axis)

6000

14

12

5000

10

4000

8

3000

6

2000

4

1000

2

0

0

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

Source: Form 0409115, Sections 1 and 2

Amount of 4th-5th credit category loans in bn roubles (left axis)

Share of 4th-5th credit category loans in the total

amount of loans in % (right axis)

6000

14

12

5000

10

4000

8

3000

6

2000

4

1000

2

0

0

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

Source: Form 0409115, Sections 1 and 2

Amount of 4th-5th credit category

loans in bn roubles (left axis)

Share of 4th-5th credit category

loans in the total amount of loans

in % (right axis)

6000

14

12

5000

10

4000

8

3000

6

2000

4

1000

2

0

0

2009

2011

2013

2015

2017

2019

Source: Form 0409115,

Sections 1 and 2

One can now claim that the situation has stabilized. In early 2018, the share of nonperforming corporate loans (4th–5th credit category) came to a stop at about 12–13%, or 7.1%, exclusive of resolved banks (as of September 1), down 0.2 pp from the start of the year. Typical cyclical sectors: trade, construction, and real estate, are still the most troubled ones.

In retail lending, the situation is not uniform. The share of bad debts in mortgage loans was very small at just 1.4% as of August 1, but this sector has yet to complete its credit cycle. The share of bad debts in total unsecured consumer loans stands at 8.4% (5.8% for total household loans). But instead of looking at average loan quality in the retail lending segment, one needs to make a distinction between loans depending on the year when they were extended to be able to tell the accumulated problems from the situation with new loans.

With regard to such loans groups (broken down by the year of issue), only 1.3–1.5% of loans issued up until the end of last year were 30 days overdue, while Q1 2019 saw this number rise to 1.8%. These are the first signs of some deterioration. This is, however, much less than a typical 4–6% for loans issued in 2012–2013.

Change in overdue loans based on their date of issue

Share of loans more than 30 days overdue in the 5th month of loan life (%)

8

6

5,8

6,6

7

4,3

6

5

4

1,1

1,4

1,8

3

2

1

0

03.2012

03.2013

03.2014

03.2015

03.2016

03.2017

03.2018

03.2019

Date of issue

Source: National Credit History Bureau

Share of loans more than 30 days overdue

in the 5th month of loan life (%)

8

6

5,8

6,6

7

4,3

6

5

4

1,1

1,4

1,8

3

2

1

0

03.2012

03.2013

03.2014

03.2015

03.2016

03.2017

03.2018

03.2019

Date of issue

Source: National Credit History Bureau

Share of loans more than 30 days

overdue in the 5th month of loan life (%)

8

6

5,8

6,6

7

4,3

6

5

4

1,1

1,4

1,8

3

2

1

0

03.2013

03.2015

03.2017

03.2019

Date of issue

Source: National Credit

History Bureau

Another sign of stabilization is a decline in the number of revoked banking licenses.

Number of revoked banking licenses, pcs

100

90

87

80

70

70

60

56

53

50

44

40

30

23

22

20

12

10

10

7

4

4

0

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

Source: Bank of Russia

100

90

87

80

70

70

60

56

53

50

44

40

30

23

22

20

12

10

10

7

4

4

0

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

Source: Bank of Russia

100

87

80

70

60

56

53

44

40

23

22

20

12

10

7

4

4

0

2009

2011

2013

2015

2017

2019

Source: Bank of Russia

The problems identified at Russia’s financial institutions in the course of banking license revocation and bank resolution seem to have arisen from inefficient risk management and banks’ overly heavy reliance on secured lending and loans to owners. In an environment of low confidence, the latter may have looked like a more reliable protection from risks but in effect produced too heavy a dependence on cyclical processes in the economy, as well as low risk diversification.

Another problem is foreign currency loans. Banks and other financial institutions often tend to shift their foreign exchange risks onto borrowers. Meanwhile, borrowers (as, probably, financial institutions themselves) underestimate risks, for they do not understand that the difference between interest rates on ruble and foreign currency loans covers foreign exchange risk.

No less important is such a destabilization factor as attempts to conceal problems in both financial institutions themselves and, it seems, owners’ businesses. Initially, hiding bad debts helps save capital. But hidden problems distort incentives for both a bank/financial institution itself and its borrowers. A financial institution with hidden problems is more likely to assume higher risks. For if a bank pulls this off, this strategy may put the situation right or even improve it. In the opposite case, bad debts continue to build up, and when their amount becomes so large that a financial institution is no longer able to cope with this on its own, then more problems already make little or no difference to the owners’ management. But damage to the economy as a whole also builds up in this event.

Borrowers face a similar situation. Business restructuring is postponed: overburdened with debt, companies no longer look for opportunities to shake off stagnation, as potential benefits would likely go to the creditors anyway. What is more, this situation may create incentives for companies to channel funds away from creditors, which does not help economic growth either. Hiding problems may look effective tactically but is most often extremely costly and ineffective strategically. What this can be likened to is not even a Ponzi scheme but the spreading of cancer cells.

The economic literature has a special name for banks overburdened with bad debts – zombie banks. These are insolvent banks, which, however, continue to operate relying on alternative support mechanisms which preclude assuming new risks (i.e., expanding lending): through access to liquidity, including from the central bank and the government in general, or through a symbiosis with zombie firms¸ which also lack any meaningful growth incentives This is a direct road to economic stagnation. The alternative — when banks assume excessive risks — is in no way different from this situation on a macro level. High-risk projects, which banks choose to finance in such cases, do not often make a positive contribution to economic growth. They just seek extra gains from speculative (or dubious) transactions.

It is not a lack of capital that kills banks but a lack of liquidity. Apart from loss of solvency, a rapid build-up of problems arising from speculative transactions results in a loss liquidity. This in turn generates more risks to financial stability owed to the domino effect , i.e., the spreading of liquidity problems throughout the system.

The role of the state: historical options

What is to be done if the financial system is overburdened with bad debts? First of all, it is important to promptly recognize and address problems. As a matter of fact, this is what the right motivation system and an efficient supervision are, among other things, needed for. But in practice situations occasionally emerge when buffers accumulated by banks are insufficient and the situation deteriorates beyond repair by market means. This is when public funds, provided either by the budget, as in most countries, or by the central bank, as in contemporary Russia, are used to be injected into a bank’s capital – not so much to head off creditors’ losses as to prevent rapid spreading of problems throughout the system and transformation of one organization’s difficulties into a systemic crisis.

Using public funds to address the financial sector’s problems has been a fairly standard practice since the 1930s. Deposit insurance agencies which emerged in the wake of banking crises in those years, often receive public support. It is obvious that the side effect of this approach is the expansion of government ownership in the banking sector. Examples are the Nordic banking crisis of the early 1990s, the Italian crisis that occurred almost at the same time, the 1994–1995 crisis in Latin America, and the Asian crisis of 1997–1998.The program for restoring the solvency of Korea’s banking sector in the late 1990s is viewed as one of the best model cases today. The same is true of Turkey’s way of dealing with problems which arose from the banking crisis of the 1990s. In the above cases, the government merged several bankrupt financial institutions into one, often splitting banks into good and bad entities, with such good banks eventually privatized. That was how some of the largest European banks such as Nordea and UniCredit were established: they were gradually privatized over several years. The Turkish crisis of the early 2000s occurred at a time when European and American banks were massively seeking to scale up their presence in emerging markets, therefore, many local bankrupt banks were sold to foreign institutions.

A specific array of measures by the government is tailored to a specific situation, but the general rule is to have a bank operate in such a way as to return the greatest possible amount of funds provided, for these funds ultimately belong to people. To this end, financial institutions taken over by the government need to be managed under market principles in the period until they are privatized.

Moreover, from the perspective of economic growth, bail-out policy needs to be implemented as promptly as possible. One, example, a textbook one already, highlights differences between US and EU approaches to the 2008–2009 banking crisis. The US as early as November 2008 allocated public funds to capitalize the major financial institutions, literally forcing capital on them, subject to fairly strict conditions which created incentives for these institutions to get rid of this capital in the future, after the situation stabilized; then, fairly promptly, a stringent stress-test was conducted. The identification and recognition of problems, with means of overcoming them known, calmed markets, and market opportunities for stabilizing the situation by raising more capital came into play.

As a result, public funds were repaid in a fairly short time, with the economy recovering relatively fast and moving on to growth. The European approach was more complicated (true, there is suspicion that the problems were more deeply rooted): only systemically important failed banks were recapitalized, the stress-test conducted across the system was not stringent or transparent enough, while the EU recapitalization mechanisms used rather complicated procedures. As a result, Europe still struggles with problems. It was not until recently that the ECB required that banks cleanse their balance sheets of bad debts, but market mechanisms never started working properly. The European economy is recovering much more slowly than the American one, and its growth rate has been much lower over the last decade.

What is wrong with government ownership? First, public institutions tend to address political goals even if those run counter to business interests. One example from contemporary global experience is problems faced by India’s largest state-owned banks, which several years ago started to extensively finance investment projects as part of government initiatives that in many cases came to nothing. Second, these institutions have additional incentives to assume higher risks, because if the best-case scenario materializes, the management benefits from additional bonuses, while under the worst-case scenario losses are borne by the government. However, these are the problems of all, not only financial, institutions that fall under the category of those too big to fail; therefore, it is important that their corporate governance be organized according to market principles: from the motivation system and board of directors membership to general relations between the government and a company. When this is achieved, the distorting impact of government ownership on the market is neutralized, and a company operates under the same conditions as other businesses in the market: its main goal is to maximize its shareholder value, with other stockholders’ interests looked after. This makes it possible not to hurry to sell the government stake, achieving the highest possible return for the government instead.

For instance, the last government stakes in Nordea were sold as late as 10–15 years after the crisis which led to this bank’s establishment. A more recent example is the Royal Bank of Scotland, which was taken over by the government after the 2008 financial crisis and is planned to be privatized until 2024. However, the privatization of the 62-percent government stake is now being delayed on account of Brexit and disagreement over whether the privatization should be carried out soon.

Russia: a new model of bank resolution

The scale of problems facing the Russian banking system’s institutions which had their banking licenses withdrawn and went through resolution was so big that they turned into a heavy burden on the economy, undermined competition in the financial and non-financial sectors or financial markets, fostered stagnation and the build-up of risks rather than economic development. Public funds were therefore required to both maintain financial stability and promote economic growth.

One long-time problem had to do with the so-called old bank resolution mechanism designed in 2008 and modeled on the instruments which the Fed used to support the liquidity of financial institutions involved in the market mechanisms for bailing out bankrupt companies. As regards the Russian option of it, this was only formally a mechanism for liquidity provision, while in effect it enabled new capital to be gained via carry-trade operations. Meanwhile, institutions going through resolution were exempt from a multitude of requirements, and although resolution deadlines were fixed at the start of the procedure, in practice they were open to extension. Hence this system distorted the incentives of the resolving entities: some of them tried to take advantage of the situation and shift a part of their bad debts on banks under resolution, inevitably aggravating the latter’s financial position.

The new bank resolution model introduced in 2017 is free from these drawbacks. Now, the central bank can, as needed, merge the relevant financial institutions and divide them into a core bank and a bank holding bad assets. It should be noted that in doing so the central bank adheres to the principle that “good banks” should not be substantially different from ordinary ones as regards the quality of their assets, meaning that a certain amount of bad and non-core assets is left on their balance sheets on purpose to be dealt with in these banks’ further operations. An analysis of foreign experience shows that this approach to bailing out banks relies on international best practices.

The Bank of Russia and financial institutions themselves have learnt the lessons of the past. Stricter banking regulation and supervision, the establishment of an independent institution within the Bank of Russia (the Risk Analysis Service) to evaluate collateral and assess the quality of loans in general, seeks to ensure the transparency of situations at banks, accumulation of buffers and a timely problem identification. Macroprudential policy was introduced to curtail systemic risks; this policy currently lays stress on preventing the accumulation of excessive consumer lending risks and dedollarisation. A discussion is underway on additional measures to deal with heavily indebted large companies.

Following international best practices, corporate governance should now be set up in strict compliance with market principles at Russian financial institutions taken over by the government. In particular, this involves engaging independent directors as members of supervisory boards: for instance, only two out of seven directors on the Otkritie Bank’s supervisory board represent the Central Bank, and just one at Trust Bank. A goal is also set to hire a professional managerial team, to develop a strategy and a motivation system based on market principles and aiming to boost the bank’s shareholder value, gradually moving on to its privatization (in the case of “good” banks) or the sale of non-core assets. A special emphasis is placed upon the issues of safeguarding competition: for example, banks under resolution are prohibited from using the word “state-owned” in their advertising. The ultimate goal is to maximize the return of funds without distorting market competition.

The Bank of Russia’s current resolution policy is, therefore, making the most of international best practices. Economic theory and global experience suggest that at the end of a credit cycle these measures create conditions for economic growth.

It is, however, worth noting that these conditions are necessary but not sufficient. A sufficient condition would be to establish an investment climate where businesses are motivated to develop, with the country’s investors willing to risk their money if attractive business prospects are available. Unfortunately, this is not at all the case now. Which is an obstacle to developing the financial sector, banks under resolution included, and dealing with bad assets promptly and effectively.