Playing catch up

With extreme volatility and liquidity concerns hitting Russia in the second half of 2008, large cracks were exposed in the country's bank risk management practices. Alexey Simanovsky, director of banking regulation and supervision at the Bank of Russia, describes the challenges of developing a robust risk management culture. By Alastair Marsh

Russian banks have experienced a dramatic reversal of fortune in recent months. With oil prices hitting record highs in July last year, the Russian banking sector appeared to have escaped relatively unscathed from the worst effects of the global financial crisis. But when the bottom fell out of the commodity market in the second half of 2008, the picture changed drastically.

From its high of $146.32 a barrel on July 14, 2008, the active-month West Texas Intermediate crude oil futures contract on the New York Mercantile Exchange plunged to $42.44 on February 18 this year. In response to growing problems in the economy, the government was forced to allow a sharp devaluation of the rouble, pushing the currency from 27.5199 to the dollar on December 18 to 36.4267 on February 19.

With Russian banks heavily exposed to the commodities sector, and with a large portion of outstanding corporate debt denominated in foreign currency, the financial sector looks a lot less secure than it did a year ago. According to research by Italian banking group UniCredit, Russian banks are facing an "avalanche" of bad debt, with $229 billion of loans from corporate borrowers falling due in the period between March 31, 2009 and April 1, 2010. The bank's analysts reckon 20% of outstanding corporate loans could be in default by the end of the year.

With such a gloomy prognosis, the need for robust risk management within the Russian banking sector seems more important than ever. If anything, however, the recent crisis has only served to delay the development of sound risk management practices.

Since January 2004, Russia's central bank has been working towards implementing the standardised approach of Basel II. Initially, Pillar I of Basel II was to be implemented in 2008, with pillars II and III set to be introduced in 2009. However, full implementation is now expected in 2010 at the earliest. In an exclusive interview with Risk, Alexey Simanovsky, director of banking regulation and supervision at the Bank of Russia, says the global crisis accounts for the delay to Basel II implementation.

Risk: Why was the implementation of Pillar I of Basel II in Russia delayed in April 2008? Is there any decision on when it, and pillars II and III, will be implemented?

Alexey Simanovsky: Basel II is important, but the implementation of Pillar I of Basel II was postponed in April 2008 for two reasons. First, in that month we commenced a three-year co-operation programme with the European Central Bank to get advice and expertise from the Eurosystem (which consists of the European Central Bank and the central banks of the member states that belong to the eurozone) on the implementation of Basel II. And second, the crisis has led us to identify other priorities beyond Basel II implementation.

Initially, Russia is going to implement the simplified standardised approach of Basel II, which has very similar requirements to the Basel I Accord. Together with the banks, we will work to take the first steps towards the internal ratings-based approach, and we shall factor in any alterations to the framework that are recommended by the Basel Committee on Banking Supervision. The preparatory work on Pillar II and Pillar III implementation is under way and is also included in the co-operation project's framework. So while we have covered a certain amount of preparatory work, the implementation of these pillars cannot be achieved earlier than 2010.

Risk: What progress are you seeing from Russian banks in terms of Basel II? What are the main obstacles to its implementation?

AS: Financial crises teach us not to hurry with the implementation of regulations from scratch. Before we go further with implementation, we would like to have at our disposal some final recommendations in the areas of banking regulation and supervision. It doesn't mean we shall immediately implement all the recommendations, but we are interested in seeing the outcomes of international consultations on the matter.

The obstacles to implementation are what you would expect: the resistance of banks to an additional regulatory burden; our own lack of experience; complexities in making decisions; the legal environment; and perhaps concerns over whether there is a robust banking and supervisory culture.

Risk: How satisfied are you with the general standard of risk management among Russian banks? Have any particular weaknesses shown up during the turmoil of the past six months?

AS: In my opinion, while the general standard of risk management in Russian banks is steadily improving, the glass of satisfaction is only half full - or rather, half empty. The crisis opened many people's eyes to the poor standard of risk management at a number of banks and, even worse, to the lack of integrity of a number of banks' top managers and owners.

Of course, risk management deficiencies are nothing new in the banking sector. And the problems among Russian banks are not dissimilar to previous guidance on how supervisors should deal with weak banks, issued by the Basel Committee as far back as 2002. We see poor lending practices, excessive loan concentrations, excessive risk-taking, senior managers overriding existing policies and procedures, and even fraud and criminal activities.

Owners and managers were sometimes too ambitious and greedy, and consequently started taking excessive risks. But, at the same time, they tried to conceal the true nature of risks being taken in their accounting and reporting. From our perspective, we should acknowledge we were sometimes too naive or overly optimistic in terms of risk assessment. Besides weaknesses in risk management and supervisory culture, this crisis has shown deficiencies in the legal and regulatory framework of the banking system. Of course, we have detected some weaknesses in our own regulation: now is the time to fix mistakes and cover gaps.

Risk: Are you satisfied Russian banks have the necessary personnel and infrastructure to put in place effective risk management policies?

AS: Partly. I believe the root causes of ineffective risk management policies in a number of Russian banks lay not in the infrastructure, but in the core issue of the ownership and management structure.

Risk: What initiatives has the Bank of Russia introduced to improve risk management practices at Russian banks?

AS: We have improved credit risk regulation (through loan loss provisioning) and issued recommendations in the areas of risk concentration, liquidity and country risk management. We have continued to develop risk-based supervision and launched the institution of curators - effectively, people within the supervision team personally responsible for gathering and analysing information about banks. And we have allocated more resources to monitor larger, systemically important banks.

Risk: What challenges has the financial crisis posed from a regulatory perspective?

AS: We have recognised gaps in regulation in different areas, such as poor lending practices, the concentration issue and so on. In my view, the key responses should be conducted through the comprehensive implementation of the Basel Committee's core principles for banking supervision, with regulation and supervision based on the substance-over-form approach.

Beyond that, there are a number of global regulatory challenges, including whether the international regulatory regime is sufficient in its current form, and whether it is in any way pro-cyclical. If it is, do we need a counter-cyclical approach, and how should we go about achieving that? These issues are rather new and complicated, and it would be prudent to discuss the pros and cons of all the proposals being put forward in a calmer environment. Any attempt to make key strategic decisions too quickly often leads to mistakes.

Risk: The current financial crisis is very much global in nature. How would you assess the level of co-operation between the central bank and regulators in other countries to address the weaknesses in risk management practices?

AS: We have close contact and effective practical co-operation with supervisors from a number of European Union (EU) countries, eastern European countries and the US, among others. Consultation forms an important part of co-operation, and discussions are especially intensive with our project partners from a number of EU central banks and regulators. This process helps us to address the weaknesses in regulation and supervision. At the same time, it is our responsibility to supervise Russian banks and we cannot share that with our foreign colleagues.

Risk: Do any major changes need to be made to the international regulatory framework as a response to the crisis? If yes, what measures would you recommend?

AS: Essentially, I would like to see a shift away from the current capital-orientated model of supervision to what the Basel Committee refers to as the comprehensive approach. Under this methodology, regulation would take into account a number of factors, including capital, liquidity and broader risk management. Assets, earnings and off-balance-sheet exposures need to be properly examined when assessing a bank's soundness. So it would very much resemble the 'Camels' concept of capital, asset quality, management competence, earnings, liquidity risk and sensitivity to market risk.

From my own perspective, I would advocate assessing the soundness of risk capacity during normal economic conditions on an individual institution basis. But for systemic-wide protection under stressed conditions, I advocate something called a collective safety scheme. The thinking behind this is that systemic threats need systemic responses - and the collapse of any bank under such conditions is probable. Some form of safety insurance scheme, whereby banks make contributions throughout the economic cycle, would be beneficial in terms of systemic stability protection. We might also consider relaxing the capital and liquidity regulatory requirements in stressed conditions.

Risk: Is there a need for some form of international financial regulatory body to identify and prevent possible future crises?

AS: The tasks of identifying and preventing crises are very different missions. Both are challenging, but the latter is extremely ambitious for an international body.

There are differences between the problems experienced by various nations, even if the crisis is global in nature. Traditionally, it is the mission of a national government to use its power and resources to address these problems in the first instance. For that reason, I do not think nations are ready to transfer a part of their sovereignty to a global crisis manager. Furthermore, would such a supreme international regulator be held accountable for making wrong decisions leading to the worsening of the situation in a country?

If an international anti-crisis entity does have a role, it should purely be focused on the identification of material imbalances and making recommendations to the various interested parties.

The view from the banks

Banking supervisors in Russia are keen to improve risk management practices at the country's financial institutions, but with experienced risk managers at a premium, a shortage of reliable data on which to base analysis, and with many banks employing rudimentary risk management systems, there is unlikely to be a quick fix, say some observers.

"Very few banks, especially the non-state-owned institutions, can afford to take on risks in the course of everyday business and, at the same moment, dedicate sufficient time and resources to developing a risk management culture," says Alexey Kurilin, Moscow-based head of risk management for Russia at Citi. "The activities of banks have often been driven by profit margins, rather than risk aversion."

One of the main challenges for Russian banks is finding people with the right blend of local knowledge and risk management expertise. "It is tough to find people who understand the local market and are based locally but also have a good grasp of risk management to help develop systems for the specific rouble-denominated financial products," explains Andrey Dzubandovsky, Moscow-based managing director of global trading business in Russia at Pennsylvania-headquartered software vendor SunGard.

Numerous Russian banks have recruited foreign professionals to take on risk management positions in an attempt to overcome this lack of experience. For example, the position of chief risk officer is filled by either European or US nationals at VTB Capital, Troika Dialog and Alfa-Bank. However, Warsaw-based Bartlomiej Paszkiewicz, business specialist for central and eastern Europe at technology vendor FRSGlobal, cautions that this recruitment campaign is far from a panacea for improving risk awareness because knowledge and expertise are rarely passed on.

"This problem is exacerbated by the huge turnover of personnel in the Russian financial sector. As experienced risk managers change jobs, their expertise tends to remain with them rather than permeating the mindset of the organisation they have left," he notes.

Additionally, the technology required to support risk management at the majority of Russian banks is not very advanced. Paszkiewicz describes the landscape as being close to a 'green field', where firms have lacked the capacity to invest in operations technology capable of doing anything beyond the most basic internal reporting.

And there are few signs of any immediate improvements, he says. In the wake of the financial crisis, many banks have temporarily put a freeze on new technology investments, while the rouble depreciation has increased the potential project costs, which tend to be quoted in euros or dollars. As a result, the majority of banks are not willing to pay software vendors for consultation, software or implementation, preferring to develop their own in-house systems at a smaller cost.

Systems work is further constrained by insufficient data to feed risk management models, explains Anna Kuznetsova, operational risk manager at Alfa-Bank: "The lack of historical data makes it hard to evaluate risk. There is no data that spans a complete economic business cycle: we can only use the data available."

Ludmila Markina, director of risk management at the Bank of Moscow, agrees: "We have been working on Basel II implementation for seven years and have gathered a mass of data to put through our risk models. But the data cannot be considered very representative and instead we end up just observing the market."

However, hindrances to effective risk management are not only 'material' in nature but also 'moral', says Markina. The risk awareness of bank owners and management boards must be improved, and decisions need to be based not only on potential profits but also considering possible risks, she says.

Rectifying this, though, will prove extremely difficult, says one Moscow-based chief risk officer for Russia at a large international bank. "The affiliations of banks' owners determine the spheres of activity and investment for many firms. Some banks are still making sizeable loans to the real estate sector, which in an ideal situation you wouldn't touch right now," he notes.

With such an array of challenges, it is little wonder Basel II implementation has been delayed in Russia, say risk managers. "As well as the international efforts to test if Basel II is pro-cyclical, there are other obstacles to its implementation that are typical for Russia: lack of market transparency; lack of historical data; and lack of data about numerous new banking products. Also, Russian accounting standards do not conform to Basel II recommendations," says Philip Halperin, director of risk management at Alfa-Bank.

Nonetheless, some market participants suggest the conservative attitude of the central bank is stifling progress. "In principle, a significant proportion of Russia's largest banks are ready for Basel II implementation - some are even ready for the advanced or ratings-based approaches. However, the regulator is stalling in defining the criteria for operating under Basel II," argues Evgeny Goncharenko, head of financial risks at Petrocommerce Bank.

Halperin says Alfa-Bank "is actively implementing the essence of Basel II recommendations" in its operational risk activities, covering self-assessments, risk audits and loss data collection. However, he adds the firm is reluctant to start operational risk capital provisioning before the Bank of Russia makes clear its position in this regard.