Bad debts can be both a consequence of the borrower’s reduced financial circumstances and an instrument of unfair banking. Each of these problems has its regulatory solution but the key principle should be market responsibility of the owners and managers.
December 4, 2019   |   Mikhail Sukhov

In her article ‘Bad Debts and Economic Growth’, Ksenia Yudaeva, Bank of Russia First Deputy Governor, raises a problem of importance for banks and the economy. Here I express my opinion on this issue. A correct description of a process should be based on international definitions. In this regard, IFRS is financial Esperanto. The standards do not include the term “a bad debt”. It is usually used when talking about a company or a bank’s standing. “A bad loan” is rather an emotional way of describing a situation, in which loan quality deteriorates following the negative scenario, i.e. its price decrease exceeds the one projected by the bank’s risk management policy.

The bank does not take this scenario into account when extending each loan, although certain overall losses are inevitable and estimated at the outset. A bad debt is a debt, which price, estimated in accordance with IFRS, falls by 2-5% for legal persons and by 5-8% for individuals, depending on how aggressive the bank’s risk management policy is. Banking authorities, auditors, and rating agencies can evaluate the adequacy of the bank’s risk appetite and the quality of its risk management (how often and why negative events occur).

Traditional and deliberate bad debts

Recognition of an asset that is known to become impaired soon is a sensitive matter for banks. They often falsify their accounts to hide it. In Russian banking, bad debts served as a disguise for uncollectible debts as well as fraudulent schemes of obtaining capital and profit, which is why some of these bad debts are phantom. Bad debts can be identified by auditors or banking authorities; in the event of a change of control, change in management or bankruptcy of the bank, such loans are regarded as siphoning off of assets. The fair value of these loans is zero, according to both Russian and international (both old and new) accounting standards. For convenience, these bad loans can be called “deliberate”.

Popular opinion says that deliberate bad debts are the problem of criminal banks. It is not so: any bank, even a rather prominent one, extends deliberate bad loans subject to non-market incentives of its shareholders or unethical management.

For a precise estimate of the volume of bad debts, it would be necessary to divide them into traditional and deliberate ones, which is impossible since shareholders and managers of functioning businesses consider all credit losses non-deliberate. As of October 1, 2019, 9.5-10 trillion rubles of loans can be regarded as bad debts (exclusive of Trust bank of bad debts), out of which 3 trillion rubles are overdue loans (interest excluded). This number correlates with loan loss reserves, which are determined by the Russian standards and reach about 5 trillion rubles. For comparison, almost two years ago (as of January 1, 2018) bad debts were estimated at about 9.0-9.5 trillion rubles, while reserves and overdue loans were almost at the same level in absolute terms.

Upon comparing these numbers with equity (capital), which was estimated at 10.5 trillion rubles as of September 1, 2019, and at 9.4 trillion rubles as of January 1, 2018, it becomes quite obvious that this sector faces no risk of decapitalization due to bad debts.

The average numbers clearly do not give any idea about the state of specific banks applying different levels of conservatism when assessing the quality of their risk portfolio. Let’s leave public statements on what banks are more prone to erosion to rating agencies and auditors. Let’s just say that banks with excessive levels of bad debts vary in size. Banks have quite different levels of return on assets, debt-to-reserve ratio, etc.; this list of signs of bad debt pile-up goes on. At the same time, unlike in previous years, the trust that banks have built among their clients reduces systemic risks.

How borrowers, too, become too-big-to-fail

In the past, the pile-up of traditional bad debts showed that the banking sector was to some extent sensitive to macroeconomic conditions. At the same time, banks, exempted by the Central Bank from bank reserve requirements for the crisis period, were able to roll over loans to those borrowers, which they deemed capable of resolving their financial troubles, without capital or profit losses. The Bank of Russia took this decision in both 2008 and 2014. During crises, borrowers and banks delayed loan payments. That is why bad debt peaks can be statistically identified only in banks’ administrative documents. Among other factors that smoothed the bank-borrower relationship during the crises were active refinancing of banks and their recapitalization by the state.

These measures made the crises less painful for the banking sector and the economy. However, in such cases, economic slowdowns result in much fewer bankruptcies than when no supporting measures are taken. Many borrowing entities serve as collateral for the loans extended to their owners by lending banks, including the state-owned ones, which makes any change of control in these entities impossible in the event of reduced financial circumstances. The government’s paternalistic mentality towards banks and its bailing out of troubled borrowers to avoid public scandals reinforce poor performance of some companies.

It is irrational to request loan repayment during a crisis, but it is only rational to press for effective owners and new corporate management. Banks were able to turn a blind eye on poor performance of the entities owned by bad borrowers due to reduced reserve standards set by the regulator and recapitalization by the state. The banks that do not participate in structural policy implementation decide to roll over loans to improve borrowers’ performance and their loan quality. It is worth noting that this practice is not limited to crises. It is easy and convenient for bank management: they do not have to acknowledge losses; the bank’s financial performance is barely affected whether estimated in accordance with the Russian standards (due to reduced requirements) or IFRS (since there is no default). That is how the concept “too big to fail” includes a larger group of borrowers rather than banks only.

In terms of private sector, market responsibility and high-performance advantages become meaningless. The owner keeps his head above water, especially when his business serves as collateral for a loan issued by a state-owned bank. That is why potential bad debts are structural in nature: satisfactory financial performance shown by many borrowers does not reflect the levels of management efficiency and the owners’ motivation to steadily develop their businesses.

The term “bubble” is widely used now. In my opinion, the major “bubble” is the business owned by irresponsible owners that take loans with no fear of losing the asset in hard times. For instance, what will happen in the event of price shocks in the coal industry, railway cargo or new building industry? Only fundamentally solvent companies with low debt can withstand a decrease in prices or demand.

These activities came to light upon the adoption of the IFRS 9 standards for banks’ corporate portfolios. The new rules require that the 2014/2015 defaults serve as the basis for reserve calculation for quite a long time in the form of expected credit losses for all loans extended to major borrowers. Russian reserve rules focus on the current state of affairs and at best call for the analysis of previous experience. That is why upon adoption of IFRS 9, higher provisions decrease profits of the banks whose borrowers defaulted often and improves financial performance of the banks that managed risks effectively. However, the discontent of the banks that have allowed borrowers to default (in IFRS 9 terms) is more palpable than the support by the other banks, whose financial performance is boosted by the new approach.

In fact, Russian banks are still not obliged to learn from their mistakes. The sooner the regulator overcomes bankers’ resistance and accounts for the entirety of IFRS 9 standards in its reserve requirements, the less painful the new phase of the bad-debt cycle will be for the banking sector.

The decline in the share of major loan risks sends a message of optimism: as of September 1 of the current year, it amounted to 21.8% compared to 24.9% as of January 1, 2018, and 27.6% as of January 1, 2016. Further decrease of this number, including as a result of stricter supervision and regulation, will give banks more sense of freedom when dealing with every borrower that turned out “bad”.

In my opinion, the focus of the regulator has shifted from corporate to retail loans. It is not quite justified as the retail loan market shows no sign of overheating, while the cost of risk in the mortgage market is lower than in the corporate loan market by the factor of 1.5. The average monthly loan-payment-to-income-ratio (10%) is far below the level at which the regulator increases risk weights (30%). For this sector, the potential risk is covered by the real accumulated reserves. One of the reasons the retail loan portfolio is in order is that banks consistently apply market principles when dealing with retail debts and avoid unjustified delays and rollovers.

The problem of deliberate bad debts

The volume of deliberate bad debts exposed over the last six years alone is impressive. Asset losses of liquidated and resolved banks exceed Rbs3.7tn. This figure includes siphoned off assets, fictitious capital, wasteful spending associated with dumping in the deposit market.

The strategies the Bank of Russia and law enforcement agencies used to counter these activities are known: removal of banks from the market, resolution of major banks, prohibition of persons from engagement into financial activities, criminal and civil liability.

Criminal prosecution and confiscation of the property belonging to criminal managers and owners certainly create an atmosphere of inevitable punishment, which is crucial to preventing large-scale problems.

However, these tools are not enough. In 2017 and 2018, upon the appointment of temporary administrations, the value of assets of resolved banks decreased by 59.8% (by Rbs281.8bn) and by 62% (by Rbs275.3bn) respectively. Thus, creditors of the banks recognized as bankrupt in 2017 and 2018 lost Rbs297.5bn and Rbs250.3bn (negative capital) respectively already at the first stage of liquidation proceedings.

Falsification of accounts is, of course, a criminal offence. However, the problem of deliberate bad debts cannot be solved unless the regulator has an early and precise understanding of the state of banks. This data shows that there is still some room for improvement in supervision efficiency and that the future volume of bad debts is defined to a great extent by correct identification of causes and the strategy of supervision transformation.

Deliberate bad debts are a curse of bankrupt banks but there are many signs that functioning banks irrespective of the form of ownership (state, private, foreign) are not immune to the problem of deliberate bad debts. If corporate management practice allows spending for the benefit of shareholders and managers, bad loans are used as a tool. In a bank with powerful management, decisions of the board of directors are under the great influence of the bank head, who shapes the shareholders’ agenda. In such cases, directed lending bypassing market standards can offset low profitability and dividends. In other banks, the notorious “owners’ businesses” combined with cooperative management results in “bad” loans extended to risky businesses of controllers. Banks controlled by large holding companies, including international ones, use all instruments to minimize tax payments, even uncollectible loans.

Banks tend to avoid disclosing deliberate bad debts, reporting losses when there are profits rather than on an arising basis. Deliberate bad loans are easier to conceal than the traditional ones since credit risks are borne by the companies under control. As a rule, auditors and supervisory authorities find it difficult to identify these loans correctly and timely.

The problems of deliberate bad loans come to light when control shifts or management changes. At the same time, new managers and controllers will be likely to exaggerate the difficulties in order to seem effective in solving exaggerated problems. That is how real losses end up aggravated by suddenly deteriorated financial standing of borrowers.

Bad debt remedy

Traditional and deliberate bad debts are two different diseases like type 1 and type 2 diabetes. Treatment strategies for them are also different apart from one element: a healthy lifestyle. A universal remedy against bad debts is market responsibility, private property, including in banking capital. The risk of losing business, investments and accumulated capital serves as a key means of preventing a bad debt crisis.

In Russia, recent years have seen unwarranted distrust towards private bank management: black sheep have ruined the image of the whole flock. However, conscientious private capital has always been present in Russian banks. And it is not limited to hundreds of successful private banks. It is worth noting that a significant number of owners successfully sold their businesses in the mid-2000s. The Russian quality has been severely tested by the money of leading Western banks that paid for Russian businesses 3-6 times their capital.

Now, the optimal remedy against bad debts is bank privatization. Unfortunately, it will hardly happen, since the authorities are currently focused on maximizing revenues. Even the Bank of Russia has not announced its intention to sell more than a 20-percent stake of the Otkritie Bank by 2021. In my opinion, structural benefits from a larger conscientious private sector (at least due to natural competition and private businesses’ responsibility for risks) will surpass expected losses from early bank privatization.

In the current reality of state dominance in the banking sector, transitional measures seem rational. The principle of no state support for banks apart from resolution procedures (Basel III) can be adopted in the form of regulatory decisions and will deliver through banks’ business planning if it is adopted now when there is no real need for state support in the banking sector. To counter bad debt growth management should receive an unequivocal message that state banks will no longer be recapitalized and shall pay at least 50% of their profits as dividends. In this case, all losses will soon take a toll on dividend amounts indicating bank management efficiency.

Another aspect of state-controlled bank management is associated with the need for reshaping the bank-borrower relationship. In Russia, non-collateralized corporate loans are clearly a rare beast in terms of risks. Nevertheless, the situations where businesses are used as collaterals while their owners bear no responsibility for the debt should become exceptional rather than conventional.

In order not to mess things up and not to lose banks, one can start with new loans, analyzing banks’ relationships with current borrowers when risk factors arise. Anyway, banks’ boards of directors should take part in major decision making on large loans.

I would like to highlight that here bad debts should be countered by bank management rather than by supervisory authorities. The reserve encumbrance for M&A transactions, which is currently under consideration, is rather indiscriminate towards real risks and, if applied consistently, creates a structural problem: bank lending limitations will make is more difficult to remove ineffective business owners and improve corporate management quality.

A mild decrease in the business activity of state-controlled banks should not be worrisome. Some assets of their loan portfolio will migrate to private banks improving competition. Disinterest of the private sector in state banks’ lending strategies will serve as an additional bad debt deterrent.

It is not really reasonable to regard bank resolution as a means to solve the bad debt problem. Bank resolution is an emergency measure aimed at protecting the interest of creditors. Nevertheless, both the old and the new models of bank resolution have their advantages in dealing with bad debts. A bad debt remains on the balance sheet of a functioning bank allowing assets to be sold at salvage value as well as to be used commercially to maximize profit, should an opportunity arise.

Banks that used the old resolution model jumped at this opportunity, which resulted in early repayment of the loans extended by the Bank of Russia for their resolution. Trust bank has more opportunities to explore the ways to use the received assets effectively since it does not deal with market funding. Its only public activity so far is auctioning of assets, which makes Trust bank seem more of a receiver than a bank of bad debts in terms of its methods.

The opportunities of further commercial use of bad debts should be seized in bankruptcy cases as well: then divestiture might entail fewer losses to creditors. It is a pity that this goal is not taken into account by either the respective law or the amendments to it under consideration.

Reset in regulation

The role of regulation in countering the bad-debt problem in Russia, too, needs resetting. Non-macroprudential weights for capital calculation and Russian particular reserve requirements have been in place for 10-15 years. They did not deter or identify deliberate bad debts on the balance sheets of criminal banks.

The major problem with the Russian requirements is that shareholders and managers cut out for another indicator – financial performance estimated in accordance with IFRS. A robust regulatory system monitors indicators that shareholders do not consider when setting business goals and analysts and rating agencies, acting in the interest of investors, barely use. The regulatory system that does not align its reserve requirements with IFRS will fail to achieve its highest efficiency in avoiding bad debts.

IFRS prevents unwarranted disputes between the regulator and the banks over the formal application of the Russian reserve requirements. Currently, the regulatory system focuses on the ways to make borrowers repay loans in full, underestimating the fact that continuous business operation presumes a certain debt level. Excessive reserve requirements for good loans serve as an independent deterring factor for the loan portfolio since it reduces profitability of good loans in Russian accounts.

Federal Tax Service of Russia could also take part in solving the problem of deliberate bad debts. While bank reserves reduce profits, the state indirectly subsidizes siphoning off of assets through loans that have no formal indicators of affiliation with the bank. Technical bankruptcy should not be regarded as a major sign that the bank has undertaken sufficient debt collection measures. Profit tax base can be reduced only by losses incurred with reasonable risk levels (traditional bad debts).

Finally, banks are not so black as they seem to the authorities. As long as the watchdog gives owners time to improve the situation, they increase losses of creditors in the event of bankruptcy and issuing costs in the event of resolution by wasteful spending and siphoning off of assets. That is why an early intervention of the watchdog is the only option, and unnatural pauses in removal of troubled banks from the market are unjustified.

It is impossible to put a final period to the debate on bad debts. Preventive measures have a structural side: bad debts can only be got rid of along with capitalism. It is necessary to counter bad debts in such a way so that the baby (i.e. basic principles of market responsibility of bank owners and managers) is not tossed out with the bathwater. I believe that it is within this approach only that the most useful solutions for banks and the market should be explored.