The Russian Banking Sector: On the Cusp of the Next Growth Cycle

Vladimir Savov
Head of Research
Otkritie Investment Bank

Russian banking stocks have staged a tremendous recovery in the year to date, but we believe there is potential for further growth. As banking stocks were among the first to suffer from the perception of the pending crisis in summer 2008, they are also the first to benefit as expectations of an economic turnaround mount.

While the macro framework in Russia is still weak, it is showing signs of bottoming out. With crude oil solidly more than the $70 per barrel level, it seems safe to assume that Russia’s economy will rebound more visibly in the coming months.

Structurally the Russian banking sector remains attractive: penetration levels are still very low with banking assets at about 67 percent of GDP and loans at just 40 percent of GDP. Retail penetration is even lower: just 10 percent of GDP, with per capita personal debt accounting for about $870. This suggests substantial medium-term growth potential.

The number of licensed banks in Russia is still excessive, given the miniscule lending/deposit operations of the vast majority of them. Russia still has 1,078 licensed banks, but over 80 percent of total banking assets are concentrated in the top 50 banks. Consolidation and M&A should accelerate in the coming years.

Non-performing loans are a key threat to bank profits and equity. As the economy is showing slow signs of recovery in 2009, we expect NPLs to peak in the middle of 2010 due to a lag effect. Hence, provisions will be putting pressure on profits in 2009-2010.

Judging from the history of the international financial system (we have looked at an IMF study of banking crises over the last 30 years), the current situation in the Russian banking system is far from the most severe crisis episodes. The consensus estimate is for NPLs to peak at 15 percent to 20 percent, compared to a 25 to 30 percent historic average. Similarly, despite the significant budget outlay that the Russian government is ready to make to recapitalize banks (an estimated 7 to 8 percent of 2010’s budget), it is still far from the levels seen during other crises—on average, 15 percent of GDP.

History shows banking takes about 2 to 3 years to recover from a crisis. In line with this, the Russian banking sector is likely to start growing materially after 2010. In 2011 to 2013 we predict lending to be growing by 23 percent per annum on average.

What helps Russian banks in the crisis environment is their higher core profitability, as they have higher net interest margins relative to their foreign peers (6 to 7 percent versus 5 percent for EM banks). The main reason for this is that the banking market is still immature and fragmented. While NIMs will taper off in the coming years, the relatively low competition will help them stay at above-average levels.

One positive effect of the crisis has been the increased focus on overhead expenses. Even banks that were notoriously inefficient in that respect in the past, such as Sberbank, have made significant strides (in Sberbank’s case, led by a new management) to address their overheads over the past year. As a result, cost-to-income ratio at the publicly listed banks has fallen to on average 40 percent or below.

We expect that from 2011 onward, Russian banking will return to normalized levels of lending and profitability. More positive macroeconomic conditions, coupled with more prudent decision-making and risk-management (to avoid repeating past mistakes), will result in explosive earnings growth, at an overall higher quality. We expect ROEs to reach pre-crisis levels (over 20 percent) by 2013.

Of course, this is not going to be a one-way street for all. Our bet for investing in banking stocks will be to identify the strongest banking franchises, those that are able to weather the upcoming months without incurring major losses or depleting their capital base. Such banks will be sufficiently capitalized, with increased market share and improvements in core profitability and overhead efficiency, once the next growth cycle starts in earnest.