# Banking Reforms in Russia, China and India Modern Banking

Russia

Most readers are familiar with the collapse of communism throughout Eastern Europe in the late 1980s and early 1990s. The USSR6 (with 15 republics) was dissolved and Russia became an independent state in 1991. After the creation of the Commonwealth of Independent States (CIS) in the early 1990s, separate banking systems emerged in each of the new countries. All the former Soviet bloc countries had used a socialist banking model. In the Soviet Union, the USSR State Bank had been a monopoly which undertook all central and commercial banking operations. The central government channeled all available funds into the central bank. The USSR State Bank was responsible for allocating these funds in a planned economy consisting of 5-year economic plans announced by the government. In 1987, five state controlled banks were created from the existing system, and linked to specific sectors. The new banks were USSR Promstroybank (industry), USSRAgroprombank (agriculture/industrial), USSR Zhilsotzbank (housing and social security), USSR Vnesheconombank (foreign trade) and the savings bank, USSR Sberbank. Existingloans from the portfolio of the central bank were transferred to these commercial banks, hence, they commenced operations with an overhang of doubtful assets, highly concentrated by enterprise and industry. Banks were confined to doing business with enterprises assigned to them, stifling competition.

In 1990, a new law ‘‘On Banks and Banking Operations’’ created a two-tier banking system. The Central Bank of Russia (CBR) was established with the sole right to issue currency, and a statutory obligation to support the trouble. In the early 1990s, Agroprombank, Promstroybank, Sberbank, Vnesheconombank and Zhilsotzbank became universal joint stock commercial banks, which were supposed to diversify across all sectors of the economy but most remain concentrated in their specialist areas.

In July 1996, the number of Russian commercial banks peaked at 2583. Most we recreated after 1990. One reason for the rapid proliferation was the near absence of a regulatory framework until 1995, and a desire to dismantle all parts of the old communist economic system as quickly as possible, to reduce the chance of it being resurrected. The amount of capital required for a banking licence was several hundreds of thousands ofdollars8 – compare this to the UK minimum of at least £5 million.

By 1998, the number of banks had dropped to 1476 and, as a result of numerous reforms, the system consisted of the following.

• State owned/controlled banks: Sberbank, Vnesheconombank, Vneshtorgbank, Roseximbank, Eurofinance and Mosnarbank. Some have other shareholders, but are state controlled. For example, in 2003, 61% of Sberbank was owned by the CBR, 22% by corporates,5% by retail, and the rest by smaller groups.9 There is a potential serious conflict of interest because the CBR is both a major shareholder and acts as supervisor /regulator. Though the state, via the CBR, is the majority shareholder, Sberbank, with assets of $34.2 billion,is the only joint stock state bank with shares traded on the stock market. The next two largest banks, by asset size, are Vneshtorgbank ($7.3bn) and Gazprombank ($4.9bn). Overall, the state (including the central bank) has a majority holding in 23 banks. • In 2002, Sberbank had 1162 branches (18 980 ‘‘sub-branches’’), compared to a total of 2164 branches for the rest of the commercial bank sector. Sberbank’s share of household deposits has varied considerably, from a low of 40% in 1994 (newly licensed private banks offered more attractive rates) to a high of 85% in 1999 (after a large number of bank failures/closures). Since then, deposits have leveled off somewhat, but by any measure are still extremely high. In 2002 Sberbank had 75% of household deposits, and 25% ($34.2 billion) of Russia’s banking assets. With its unique combination of an extensive branch network, a state deposit guarantee and a near monopoly on pension payments,10 Sberbank has major advantages over other banks. For example, in 2004 it paid a deposit rate of 7%11 for 12-month term deposits, when other banks are paying 12–14%. Its large pool of funds means it can make long-term loans more easily than other banks. In 2003, 50% of Sberbank’s loans exceeded a year, and another 48% of loans were granted for a period of 3 to 12 months. The other top 20 banks have a portfolio consisting of loans with a maturity of more than one year (35.5%), short-term loans (i.e. one month to a year)

• Former state specialised banks: The privatisation scheme (see below) included a number of banks. Agroprombank (which was bought by the SBS Argo group – now called SBS Argo Bank), Promstroybank, Moscow Industrial Bank, Mosbusinessbank and Unicom bank.
• They were specialized banks serving the loss making agricultural and industrial sectors (e.g. machinery, steel) of the economy. The consequent debt overhang has made it difficult to diversify because their customers are the previously heavily indebted state owned enterprises (SOEs).

• Bank oligarchies or bank industrial groups: Some of the banks (e.g. Alfa-Bank) hold controlling shares in industrial groups. Their main function is to provide services to the firms under their control. Other banks were founded and owned by large industrial groups such as Gazprom bank, Guta Bank, NRB and Nikoil (recently merged with UralSibBank).
• MDM Bank provides a good example of the way these banks are structured. It is part of the MDM Group holding which is involved in energy and coal mining and metallurgy.

The connection with industrial/commercial sectors is similar to German and Japanese bank practice. The banks manage the cash flows of their shareholders, which include the large commodity exporters in Russia. None of them offer intermediary services to the public, apart from the banking services for employees of the firms. Many of the original banks including Oneximbank, Rossijskij Credit, IncombankMenatep, Mapo bank lost their licenses due to insolvency.

• Municipal banks: These banks are owned and controlled by municipal governments, and include the Bank of Moscow and the Industrial Construction Bank in St. Petersburg. Their sole function is to provide banking services to their respective local government owners, managing their budgets and revenues.
• Small unit banks: Owned and controlled by a few individuals, they offer services to small private firms.
• Banks with a high proportion of foreign shareholders: These include Auto bank, Tokobank, International Moscow Bank and Dialog Bank. They offer personal and corporate banking services.
• Subsidiaries of foreign banks: Since 1995, foreign banks have been allowed to operate in Russia after a delegation from the European Union persuaded the former President Yeltsin to lift the decree restricting their operations. By 1998, there were 29 foreign banks. In 2001, their overall market share stood at 10%, though their operations tend to be confined to the major cities. They include Credit Suisse First National, Deutsche Bank, ABN Amro, Raiffeisen Bank and Citibank. Their main function is to supply banking services to foreign corporations operating in Russia. They are also active in trading Russian government securities and foreign exchange.

Issues and problems in the Russian banking sector

The Russian banking system remains underdeveloped, even when measured against other emerging markets. Keeping in mind Russia’s fledgling bond and stock markets, the banking sector is central to financial intermediation. Table shows monetisation and bank lending as a percentage of GDP is much lower than other transition economies. The bond market is even smaller, and though the stock market looks relatively more important, the figure is due to privatization in the 1990s, which created a few large concentrated firms. The banking sector is even less developed than the figures suggest because some banks are linked to a particular industry, so that much of the lending is connected, that is, within the group.

Banking and Financial Market Indicators

Just under 65% of corporate loans made by the large banks have a maturity of less than a year. The short-term nature of the lending is partly due to a civil code which requires all retail deposits to be available on demand,21even though about 14% of deposits at large banks are for more than one year, and 57% are on deposit for six months or more. This rule leaves the banks highly liquid, as does a liquidity ratio of 7–10% of liabilities which banks are obliged to place with the CBR. There are calls to reduce this ratio or to exempt liabilities of a longer maturity. The limitations on long-term sources of finance are a problem – foreign banks, or very large corporate bond issues, are the only options for long-term finance.

The efficiency of Russian banks appears to be highly variable. Take Sberbank: its cost to income ratio (C:I) was in excess of 90% between 1999 and 2002, and in 2003 it dropped to 83%, with a ROA of 3.3%. These figures vary considerably from bank to bank. Vneshtorgbank reported one of the lowest cost to income ratios (39%) in 2003, with a ROA of 5.37%. Compare that to Citibank (Russia): its C:I ratio is 58% with a ROA of 4.6%.

The spreads between loan and deposits rates are high. These variations are probably due to the different market niches of these banks. However, it is notable that Sberbank, which operates under such favorable conditions, has such high cost to income ratios, suggesting that protectionism breeds inefficiency.

The low level of market capitalization of most banks is a cause for concern. According to Goryunov (2001), roughly 80% of the banks operating in Russia have (questionable) capital of less than $5 million, and about half of these have less than$1 million. Based on scale economy estimates, the figures suggest most of these banks are unable to benefit from scale economies because of their current size. Many question whether banks have as much capital as they claim. For example, banks can borrow from another bank and treat the loan as a capital injection. The CBR has recently imposed rules to stop this activity, but there is a general feeling that capital is over-reported by most Russian banks.

It was noted earlier that Russia lacks IAS trained auditors and accountants, which highlights a more general problem. Russia continues to be deficient in trained and experienced banking staff, both in the private and state (central bank) sectors. Few staff have experience in credit or other forms of risk analysis because so little of it was practiced in the 1990s, where connected or named lending was the norm, up to and during the crisis.

The absence of restrictions on the operation of foreign banks should help to alleviate the problem more quickly.

A major obstacle to the further growth of Russian banking has been the failure of the banks to instill confidence among potential and existing customers. This lack of trust is not surprising, given the events of the early 1990s and during the 1998 crisis. Recall, for example, the failure of the central bank to shut down failed banks, and the favouritism it showed some bank managers at the expense of depositors, investors and creditors. In the early1990s, investment funds were introduced, but these became vehicles for criminals to steal assets. Pyramid funds advertising extremely high rates of return attracted unsophisticated investors, and proved extremely popular, even after they began to collapse when some clients attempted to cash in on their investment. They continue to exist in a variety of forms, even though many originators of funds launched in 1995 have been tried for fraud and other crimes.

In the summer of 2004, the central bank revoked the license of Sodbiznesbank following an investigation into money laundering. Less than a month later a run on another Moscow bank, Credit trust, forced it to suspend business and negotiate with the RCB how to meet its debt obligations. One analyst claims that only 30 of 1200 banks in Russia are financially stable, and if the crackdown on money laundering persists, there will be more bank runs.22 Once the banking system rids itself of the problem banks, greater stability should improve confidence in the system, though it could take many years. If and when the banks do overcome this lack of trust, the growth potential for household deposits at banks is considerable. Russian retail bank savings as a percentage of GDP is just under 11%, compared with 30% in Poland and 43% in the Czech Republic. It exceeds 50% in Western Europe and 40% in the USA.

There is also a lack of trust between Russian banks (which may explain the tiny interbank market) and foreign banks do not have much confidence in Russian borrowers; foreign banks account for about 12% of US dollar loans to Russian corporates, while their share of the trouble market is just 1.3%. However, many of the financially viable Russian corporates borrow from the head offices of foreign banks, which is classified as cross-border lending.

In 2002 it accounted for about 30% of total corporate lending in Russia. This substantial (dollar) loan market is largely due to cash flows arising from imports and exports. Loans to individual customers are a very small part of the market. In 2003, they accounted for just under 3% of total bank assets.23

China

As a communist country, China operated an economic and financial system similar to the USSR. The People’s Bank of China (PBC) not only issued currency, but was the financial hub of each State Economic Plan. All funds were channelled to the PBC, which, taking its cue from the state, allocated the funds in accordance with each plan. The PBC controlled currency in circulation, managed foreign exchange reserves, set interest rates, collected all deposits (via 15 000 branches and sub-branches) and made loans, almost exclusively to state owned enterprises. In addition, there were three specialised banks. The Bank of China28became a subsidiary of the PBC, responsible for all foreign exchange and international transactions. The Agricultural Bank of China (ABC), set up in 1951, operated under the PBC, dealing with the agricultural side of the economy. Rural credit cooperatives, which pre-dated the PBC, provided basic banking services for their members – mainly peasant farmers. These coops became units of the ABC after it was formed, collecting deposits in rural areas and confining lending to farmers. In 1954, the China Construction Bank (CCB) was established as a fiscal agent for the Ministry of Finance, with control over the administration of funds for major construction projects, in line with the relevant economic plan.

Chinese bank reforms: 1979–92

In 1978, China opted for major economic reforms with the objective of increasing economic efficiency and improving resource allocation. Emphasis was placed on decentralization and the gradual introduction of a market based economy to replace the old system. Unlike the USSR there has been no political disintegration, and the plan is to create a market-like economy operating within a communist political system.

The banking system is to be reformed, with banks acting as intermediaries between savers and borrowers, together with the provision of a payments system to ensure the transfer of funds between economic units. To date, two stages of reform have been undertaken, from 1979 to 1992 and 1993 to present. Stage one began with the creation of a ‘‘two-tier’’ banking system. Between 1979 and 1984 the specialized banks were separated from the direct control of the PBC/Ministry of Finance and became state owned, national commercial banks, each specializing in a certain sector of the economy, which effectively ruled out any competition between them. For example, the CCB was now independent of the Finance Ministry, and acted as banker to state construction firms, as well as managing the fixed assets of all state enterprises.29 In 1984, the Industrial and Commercial Bank of China (ICBC) was established, to assume the PBC’s deposit taking function as well as granting loans to state owned industrial and commercial enterprises in urban areas.

Gradually the lines of demarcation that separated these banks were removed, reducing the amount of functional segmentation. In 1985, in addition to the ICBC, the ABC, BOC and CCB were allowed to accept deposits and make loans to households and corporate (mainly SOEs), via nation-wide branches.30 As universal banks, by 1986, most had expanded to include trust, securities and insurance affiliates.

In 1984, the People’s Bank of China officially became the central bank. It was assigned the tasks of formulating monetary policy and supervising all financial institutions. Though responsible for monetary policy and supervision, it differed from its western counterparts because of its continued role in economic development. Under a credit quota system, the PBC imposed credit ceilings on the state and so-called independent commercial banks, though they could exceed their limits by borrowing from the PBC. The length of the loans could be for days, months, or up to 1–2 years. Wu (1998) argues that the PBC’s role in economic development took precedence over monetary policy until 1995. For example, in 1992 it loaned 678 billion renminbi to other banks, making up 26% of the total bank lending.

Between 1985 and 1992, to promote more competition, the Chinese government permitted the establishment of new ‘‘small and medium-sized’’ commercial banks, which initially offered universal banking services to households and firms, mainly in the regions and cities.31 Total loans cannot exceed total deposits, and they are allowed to borrow short-term funds from the PBC. This group included the Shenzhen and Guangdong Development Banks, the CITIC Industrial Bank, Bank of Communications, China Merchants Bank, China Ever bright Bank and Hua Xia Bank. Many are joint stock, i.e. shareholder owned – but the state is a key player in their operations, because either central or local governments and/or state owned enterprises are major shareholders. For example, the respective provincial governments own shares in Shenzhen and Guangdong Development Banks and China Ever bright Group Limited, a SOE, owned China Ever bright Bank.

Between 60% and 70% of these banks’ shares are either owned directly by the state (or indirectly via SOEs) and cannot be publicly traded. Thus, when the Shenzhen Development Bank became the first bank to list its shares on the Shenzhen Stock Exchange in 1991, only a minority

Chinese bank reforms, 1993–present

In 1993 the State Council32 announced a second stage of banking reforms which had three objectives:33

• To further refine the central bank functions of the PBC.
• To create a competitive commercial banking sector where state banks coexisted with other forms of banking institutions.
• To ensure a sound financial market.

In 1995, the People’s Bank of China was reformed by the Central Bank Law. The PBC was to control the money supply, formulate and implement monetary policy, act as the government’s fiscal agent and supervise the financial system. From 1992, its role as financial supervisor was gradually reduced,34culminating in 2004 when bank supervision was transferred to a new body, the China Banking Regulatory Commission.

There have also been major reforms to address the problem of the increasing amount of bad debt held by the ‘‘big four’’ state banks. These banks are, by any measure, effectively insolvent, but they continue to function because of the injection of funds by central and local governments. Their bad debt problem is largely due to the loss-making state owned firms they lend to, and the banking system is used to support them.

Part of the second stage of reform attempts to address the issue of the critical condition of these state owned banks. Since 1993, a number of reforms have been put in place. Creation of new policy banks (1994): to encourage the state banks to act like commercial banks, the government created three new state owned policy banks to assume the development goals of the state banks, freeing them to meet commercial banking objectives. The new policy banks are the Export–Import Bank of China, the Agricultural Development Bank of China and the China Development Bank. All three provide financial support for key projects designated by government to be of central importance to the nation. The first two banks grant policy loans to the agricultural and trade sectors, respectively, and the China Development Bank covers industries not included by the other two.

• The Commercial Bank Law (1995): this law formalized a rule the PBC had imposed since 1993, terminating the practice of universal banking. Financial firms can only operate as banks or securities firms or insurance companies. Banks had to terminate all insurance and securities operations. The reasons given were that in an emerging market where bank finance accounts for 85% of finance, the system is not mature enough to cope with universal banking. It is blamed for many of the problems banks have, especially a real estate ‘‘bubble’’ created when some banks used their investment and trust affiliates to invest in property. When the bubble burst, they incurred a substantial amount of debt. However, the main source of the bad debt is from loans to state owned enterprises. The authorities are also worried about contagion effects, but in a country full of insolvent banks where there have been no bank runs,37this concern seems unwarranted unless the authorities are planning to let one of the major state banks fail.
• The 1995 Commercial Banking Law also made banks responsible for profits and losses, and set explicit prudential ratios, but at the same time required state banks to make loans according to the needs of the national economy and social development as outlined in the state’s industrial policy. The law sends out conflicting signals: be profitable, but at the same time, make what are effectively policy loans when called upon to do so, even though the three development banks were established for this purpose.
• At the end of 1997, the credit quota system was terminated. Under this system, the central bank had set a limit on the amount of new loans, and specified how the loans were to be allocated among the different sectors of the economy. In 1998, a new system was introduced by the PBC, which requires banks to satisfy various constraints on their balance sheet ratios.

India

Since India’s independence in 1947 (it became a republic in 1950), this democratic nation has never operated a centralized economic system to the degree witnessed in the USSR and China (until 1979). Its private sector is well established in some areas of the economy and the financial system was quite unrestricted at the time of independence. However, by the 1960s, the economy was characterized by rigid state controls designed to meet the objectives of national 5-year economic plans. The state effectively assumed control of the financial sector to raise saving and investment rates and channel funds to priority sectors, agriculture and heavy industry. In 1969 the 14 largest commercial banks were nationalized to ensure that funds were allocated in line with the economic plan, and to create branches in rural and semi-urban areas which, at the time, had no direct access to bank services.

To increase the amount of agricultural credit, the regional rural banks were established in 1975. In 1980, another six commercial banks were nationalized. Specialized development financial institutions (DFIs) were created in the 1980s, such as the National Bank for Agricultural and Rural Development, established in 1982 to coordinate and supervise the rural credit cooperatives. Other DFIs included the Export Import Bank of India and the National Housing Bank. India, like China, did not experience any serious upheaval but in 1991 severe balance of payments problems emerged because of the effects of the first Gulf War in 1990–91and a large, rapidly growing fiscal deficit. The government responded with a systematic programme of economic reform. The objectives were to increase the role of the private sector in a more open economy (including easing controls on foreign direct investment), allow market forces (rather than the state) to play a greater role in resource allocation, and redefine the role of the government in economic development. Reforms included new measures to improve fiscal discipline and sweeping changes in industrial, trade, foreign direct investment and agricultural policies, together with a plan to overhaul the infrastructure.

Not all the changes were implemented but the plan was most successful in the removal of controls in the industrial sector, abolishing import licensing, allowing foreign ownership (either 100% or majority) in most sectors, and dismantling the tariff structure. The reforms appeared to pay dividends. India became one of the fastest growing emerging markets in the 1990s, averaging about 6.7% per annum between 1992 and 1997. Gordon and Gupta (2003) produce econometric evidence (using data from the 1980s and 1990s) showing that in the 1990s, the growth of India’s service sector was due to rapid growth in communications, IT, financial services and community services (education and health). Though a high income elasticity of demand and the growth of service exports partly explains this growth, economic reforms were also found to be statistically significant. Nonetheless, between 1997 and 2002, the growth rate slowed to an average of 5.4%, which increased pressure for more reform.

This section concentrates on reforms to the financial sector,54and in particular banking, the dominant form of financial intermediation. As Table shows, India, like China (but unlike Russia) has functioning bond and equity markets. However, the bond market is largely made up of government bonds – corporate issues make up about 9% of the total market.

Reforms in the financial sector were based on ‘‘pancha sutra’’ or five principles:

• A gradual process of sequential changes;
• Measures to reinforce each other;
• Changes in the banking sector to complement macroeconomic policy;
• Financial markets to operate on market principles; and
• Development of the financial infrastructure.55

Key reforms included the establishment of the National Stock Exchange (1992) – India’s first screen based exchange56 – the introduction of an auction system for government securities (1992), and improved regulatory powers for the Securities and Exchange Board of India. In banking, the objectives were to keep banks financially sound while encouraging more competition, and reducing government ownership of state banks.