FROM THE OFFICE OF PUBLIC AFFAIRS

April 15, 2005
JS-2381

Assistant Secretary for International Affairs Randal K. Quarles
U.S.-Russia Banking Conference
Washington, D.C
“Russian Integration in the Global Financial System”

I would like to thank the U.S.-Russia Business Council and the Russian Banking Association for sponsoring this timely and useful conference.  Russia needs a high quality financial sector, which is integrated into the global financial system, to sustain its prosperity over the long term.  An event like this can help Russia's banking system move closer to that goal.

Why Russia Needs A Top-Notch Financial Sector

To be sure, Russia's strong growth in recent years has come without a substantial contribution from the financial sector, so it may not be obvious why a first-class banking sector is so important.  But we should not forget that the commodity export boom of recent years has obscured Russia's  relatively low investment level – just 18 percent of GDP (i.e., gross fixed capital formation) – compared to 25-30 percent of GDP in other dynamic emerging markets.  Moreover, the high proportion of natural resource exports makes the economy vulnerable to commodity price swings and, in the current high oil price environment, to Dutch disease, with real exchange rate appreciation sapping the competitiveness of the non-oil sector.

To reduce vulnerability and increase investment and growth rates, the economy needs greater economic diversification.  A sound, competitive, and private financial sector open to foreign participation is the most efficient means for reallocating natural resource profits and household savings to the most productive uses outside of the oil sector.  It is also important for getting credit to small and medium-sized businesses.  Economic research has found that an open financial sector is associated with increased lending to small- and medium-sized enterprises, with the larger foreign presence associated with better access to credit.[1]  The crucial role of small business in a country's economic success is well documented, accounting for roughly 50% of GDP and 50% of employment in developed economies.  Not surprisingly, the more advanced transition economies in Central Europe, which have implemented successful banking reform, also enjoy a higher contribution of small businesses to economic output.

[1] See, for example, George R. G. Clarke, Robert Cull and Maria Soledad Martinez Peria, World Bank Development Research Group.

Reform Effort to Date

The importance of a vibrant banking sector that meets international standards of transparency and governance has not been lost on the Russian authorities.  At their summit in September 2001, Presidents Putin and Bush launched the U.S.-Russia Banking Dialogue to solicit reform recommendations from private Russian, U.S. and other bankers.  With these recommendations in hand, the current team of Chairman Sergei Ignatiev and Deputy Governor Andrei Kozlov at the Central Bank of Russia initiated important reforms.  In particular, the creation of the deposit insurance system has elevated the regulatory and supervisory standards of the banking system.  With the initial round of deposit insurance entry complete, the results are encouraging.  Still, the full benefit of the reform will be realized only if it continues to encourage further consolidation of the sector and helps level the playing field between public and private banks.

Separately, the Russian government, led by the Financial Monitoring Service, has made significant strides in establishing a robust anti-money laundering regime in a relatively short period.  Russia went from the Financial Action Task Force (FATF) blacklist in June 2000 to FATF member in June 2003.  This "conversion" was real.  Between January 2002 and April 2003 alone, over 1,405 money laundering cases resulted in the seizure of funds and property worth over 1 billion rubles (~$33 million).  From October 2002 to June 2003, Russia detected 369 cases of terrorist financing, freezing over 500 million rubles (~$16 million) in related funds and property.  And now Russia is becoming a regional leader by establishing a FATF-style regional body in Central Asia, which will build standards and capacity in a region crucial to the fight against money laundering and terrorist financing.

Assessment of Banking Sector Performance

The authorities should be commended for their efforts in the last several years, which have helped foster the rapid growth of the banking sector (assets grew on average 31%; deposits 40% since 2002).  However, a quick snapshot of the sector reveals that much work remains.  Particularly striking features are:

• Out of more than 1,200 banks, just 400 have authorized capital above $6 million (Euro 5 million), or the minimum required by the EU. 
• Foreign participation is low at an estimated 10-12% of total sector capital.  That compares to well over 50% in Central Europe. 
• Not surprisingly, the banking sector fails to intermediate savings and investment effectively, providing just 5% of total capital investment for the economy.  In the more advanced transition economies, banks provide closer to 40% of investment finance.

Five state banks control over 40% of sector assets.  State-owned Sberbank accounts for roughly 25% of sector assets, controls an estimated 60% of the retail deposit market and is responsible for around a third of all the bank branches in the system.  State-owned Vneshtorgbank (VTB), the second largest bank, is the largest commercial lender in the country.  Again, in Central Europe, the state bank share of assets ranges from 1.5% in Slovakia to 25% in Poland.

• Despite strong growth over the last several years, deposits and credit to the private sector are just under 20% of GDP.  This compares unfavorably to the more advanced transition economies in Central Europe where deposit and credit levels are at least twice as high as a share of GDP. 

All this suggests that the Russian banking sector is functioning well below its potential.  Moreover, confidence remains fragile.  The closure of two small banks because of anti-money laundering regulations in June 2004 sparked deposit runs on healthy domestic banks.  While the Central Bank did its best to contain the fallout, the episode raised questions about the capacity of the authorities to facilitate a much needed consolidation of the sector.  Not surprisingly, the state banks – enjoying a blanket deposit guarantee at the time – appeared to have benefited.

Banking Reform and WTO Accession

Part of the weakness of the banking sector can be attributed to its lack of integration with the global economy.  The agenda going forward, therefore, should focus on closing the gap.  In the view of the U.S., this should include openness to foreign participation, elimination of state ownership and the continued development of anti-money laundering and terrorist financing standards. 

Foreign banks bring best practices, technology, and competition.  It stands to reason that if Russia wants a world class economy, it needs world class companies that have access to the same financial services available to their competitors in other countries.  The best means to secure this resource for Russia's businesses and households is the completion of WTO financial services negotiations on standards comparable to industrial nations and other recent WTO members.  In this context, removing limits on foreign bank branching has become a standard for WTO accession.  Foreign bank branches with their direct access to a more global pool of capital can have a stabilizing effect on the domestic economy during a downturn.  For example, the share of commercial lending attributable to branches of foreign banks in the U.S. is normally around 20%, but rose to 25% during the savings and loan crisis in the late-1980's.   

Reforms needed for WTO membership require adjustment and some costs to uncompetitive parts of the economy.  However, the benefits for Russian households and businesses are potentially huge.  In a report issued last month, the World Bank estimated that 99% of Russian households will see as much as an 18% consumption gain over the medium-term as result of WTO membership.  This translates into total income growth of $64 billion per year.  A separate 2003 study suggests that about a third of these gains will result from financial services liberalization alone.

Much of the Russian leadership understands the tremendous gains involved with WTO membership and have made accession a top priority.  It is important, therefore, that the priorities of the Russian leadership are reflected at the negotiation table, particularly in financial services.  The U.S. stands ready to admit Russia on the same terms applied to everyone else.  Those terms include removing limits on foreign participation in financial service sectors.

We are aware that the specter of greater foreign competition in the financial sector has drawn concerns from some domestic interests in Russia.  However, it is our firm belief that worries about a lack of Russian competitiveness in the financial sector are exaggerated and, ultimately, misplaced.  Rather, state banks are the greatest single obstacle to the international competitiveness of Russian domestic banks.  International experience shows that state-owned banks cannot become the basis for building a world-class banking system.  State banks are less efficient and less effective at intermediating savings and investment.  They distort financial sector development by providing subsidized credit or politically directed lending or weakening judgments of creditworthiness.  The longer-term health of the sector is hampered by the accumulation of contingent liabilities arising from explicit guarantees or the implicit assumption that these banks are "too big to fail".  For these reasons, various researchers have found a negative correlation between the level of state ownership in the banking sector and a country's rate of economic growth.[2]  Notably, efforts by governments to improve state bank performance have not succeeded while privatization has led to greatly improved performance. 

Fighting Money Laundering and Terrorist Financing

Russia's anti-money laundering regime is still relatively new while Russia's reputation for under-regulation in this area was many years in the making.  We are aware that this often has real practical consequences to the business environment in which Russian banks operate.  It will take time and aggressive implementation of Russia's laws and regulations on money laundering and terrorist financing to overcome.  Russian financial institutions themselves have a strong interest in taking all appropriate steps to ensure that they are not being abused for illicit purposes.  This involves instituting world-beating standards of transparency and corporate governance. 

Moving forward, the U.S. is committed to continued cooperation with Russia.  There are many opportunities to take bilateral and multilateral actions to attack money laundering and terrorist financing.  For example, the U.S. has targeted corrupt financial institutions, especially in Eastern Europe.  In August 2004, the Treasury Department designated Infobank of Belarus under Section 311 of the USA PATRIOT Act as a "primary money laundering concern".  These types of actions would certainly be more powerful if done in concert with our partner nations, and in particular with Russia, which has such financial and political importance in the region.

Conclusion

It is important to applaud the authorities for the progress they have made over the last few years on banking reform and the fight against money laundering, which have brought the Russian financial sector closer to best international practice.  However, without additional reforms, the full benefits of integration will not be realized and Russia's banking sector will contribute little to Russia's growth and living standards.  WTO membership is within Russia's reach.  International experience has shown that the most competitive economies are underpinned by a sound, competitive and private financial sector.  Anti-money laundering standards must continue to evolve such that Russia's regime is second-to-none.  These efforts present tough challenges, no doubt, and will require strong leadership.  But, at the end of the day, Russian households and businesses will be the big winners as they gain access to the best financial services the world has to offer.