Its Banks Put Russia in the Hole

To find an illustration of the chimera that is the Russian economy, one need look no further than the fortress-like building where the offices of Bank Menatep rise above one of this capital’s busiest thoroughfares.

From the outside, the building still resembles the headquarters of what was once Russia’s sixth-largest bank, with more than $3 billion in assets and a work force of 3,700 spreading from here to the timberlands of Siberia.

But figuratively speaking, the building is a gutted shell. Like most of Russia’s more than 1,500 banks, Menatep is functionally dead.

Its capital base, once valued at more than $300 million, is now at least tens of millions of dollars in the red. The work force has shrunk to less than 1,000. And though the parking lot is packed and the corridors echo with the misleading buzz of activity, virtually no business is being transacted.

“The only thing going on in this building,” said the chairman of the bank’s executive committee, Alexander Y. Zurabov, “is negotiations with our creditors.”

Menatep’s life cycle is a microcosm of the rise and fall of Russia’s banking system. Today, the entire sector is effectively bankrupt. Billions of dollars in debts to foreigners are pending or have been written off by angry creditors; the confidence of depositors, never strong, has vanished.

Government officials have proposed a program to revive the system by closing some banks and nationalizing others, but the measures depend on two uncertain events: the swift passage of enabling laws by parliament, which is unlikely given Russia’s fractious political climate, and infusions of capital from foreign lenders and international bodies such as the World Bank and International Monetary Fund on a scale that observers say is implausible.

“Restructuring a banking system is quite a phenomenal exercise,” remarked Nick Page, Russian banking analyst for Banque Paribas in London. “It requires enormous political willpower, which isn’t in evidence” in Russia.

That’s a serious drag on any efforts to revive the Russian economy. The country’s gross domestic product in September was 9.9% lower than a year earlier, according to government statistics that are widely assumed to understate the drop. As long as no system is operating to facilitate financial transfers, extend credit and provide a place for depositors and enterprises to park their money safely, Russia’s economic situation is almost certain to become bleaker in coming months.

“I have every confidence that there will be a new banking system,” said William F. Browder, a longtime observer of the Russian economy from his perch as managing director of Hermitage Capital Management, an offshore investment firm with significant interests in this country. “But every day it doesn’t happen, you’re losing a significant portion of your GDP.”

Meanwhile, government and central bank officials and leading bankers have engaged in an extended round of finger-pointing over who is to blame for the collapse of Russia’s banks--once among the most visible symbols of the country’s supposed economic reforms, now the most visible signs of the international finance community’s naivete.

Government Made Series of Missteps

The immediate cause of the banks’ disintegration was a series of steps taken Aug. 17 by the government. It effectively defaulted on about $60 billion in government short-term bills, known as GKOs, of which 25% were held by domestic banks in their asset portfolios. It also stopped supporting the ruble’s value, in effect triggering a devaluation that wiped out most of the remaining capital of the banking system, which had bet billions of dollars that the ruble would remain stable at least through mid-October.

Finally, the government imposed a 90-day moratorium on the repayment by Russian banks and other companies of debts to foreigners--a step that gave the domestic banks breathing room, but only at the expense of further undermining their standing abroad and leaving collateral they owned outside Russia, including securities, subject to seizure by creditors.

These steps almost instantly rendered the country’s banks insolvent. Ruble and dollar deposits were frozen, leaving savings accounts at the mercy of the continued volatility of the nation’s currency. With even functioning businesses and their customers unable to gain access to their accounts, payments on bank loans also ceased.

Of course, the roots of the banks’ problems are much deeper. They extend back to 1988, when private commercial banking was legalized here, but without the creation of a strong regulatory system. In the intervening decade, Russia’s banks assumed many of the trappings of their Western counterparts. They were regularly audited by such outside accounting firms as Arthur Anderson & Co. (which reviewed Menatep’s books), issued annual financial statements, floated shares on European and U.S. stock exchanges and published glossy brochures to attract investors.

But most of this was only a veneer, banking analysts say.

“I personally wouldn’t want to try to audit a Russian bank, not with a management team that might not be telling you everything you want to know,” said Steven Shevoley, a securities analyst for Thomson BankWatch in Cyprus, where many Russian banks maintain offshore branches. In any event, he said, the banks reported their financial results only once a year, “and those might be five months old by the time you saw them. A lot can change in five months in Russia.”

Most important, the Russian institutions did not perform the same role that commercial or investment banks do in other industrialized countries.

“Our banks are not real banks,” said Oleg T. Bogomolov, director of the Institute for International Economic and Political Studies at the Russian Academy of Sciences. “They didn’t invest money in production or provide enterprises with working capital. They were more interested in speculative deals than investing.”

Nor were they conventional depository institutions. For the most part, the Russian public gave Menatep and other large banks a wide berth. Only about 25% of Russians have bank accounts, and more than 70% of those were in the government-owned Sberbank, the only bank in the country that offers a deposit guarantee (though not one that will protect depositors from devaluation-related losses).

“There’s never going to be confidence among depositors here, but there never has been,” said a Western economic observer in Moscow. “Two-thirds of the monetary base of Russia was in the mattress.”

Young Communist Founded Menatep

Menatep was founded in 1988, the year that private banking was legalized under former Communist Party chief Mikhail S. Gorbachev. The organizers were a group of technologists headed by a Young Communist League activist named Mikhail B. Khodorkovsky, then 24. The bank’s name is a Russian acronym for the organization Inter-Branch Center for Scientific and Technical Programs.

Initially the group’s profits came from selling used computers and from currency speculation. By 1991, the bank was strong enough to become the first Russian enterprise to offer shares to the public since the 1917 Bolshevik Revolution.

But its entry into the realm of real wealth came in 1995 with the “loans for shares” scheme. The government, in exchange for loans, offered the most politically well-connected financiers and industrialists cut-rate shares in Russia’s richest natural resource companies through a series of fixed auctions. The next year, the government exercised its option not to repay the loans--leaving the companies in the business leaders’ hands.

Khodorkovsky, whose political connections extended into the Kremlin, was among the elite. At the auction--where the bidding was so openly rigged that it even provoked three other powerful banks to complain--Menatep’s prize was Yukos, the second-largest oil company in the country, which it bought at a price reported to be as little as $168 million. Yukos revenues at the time were $3 billion a year.

Eventually, Khodorkovsky assembled an empire of 40 oil, mining, chemical, publishing and construction companies. Yukos remained the most important.

That was fine when Yukos shares hit their high of about $3 in trading on the Moscow stock exchange last year, and oil prices remained high enough to give the company positive cash flow. But earlier this year, Yukos turned into something more resembling dead weight. With production costs that are the highest of all Russian oil firms, Yukos operated at a loss whenever the price of Ural grade oil fell below $10 a barrel, as it did early this summer.

That proved a double-barreled disaster for Menatep: Not only was Yukos pulling capital out of the bank, analysts say, but the bank had pledged Yukos shares as collateral on loans from several Western banks. As Yukos shares plummeted in value--they were recently quoted at 89 cents, with no takers--Menatep’s creditors inundated it with margin calls, or demands that the bank make up the lost collateral in cash.

“Menatep was a little bank sitting on top of the Yukos elephant,” said one banking analyst here, “which was typical of a bank in a financial and industrial group.”

Most such large Russian banks, indeed, appeared to exist largely to speculate in government securities and funnel cheap loans to their sister companies, rather than to outside enterprises. To Western eyes, this resembled the insider deals that helped provoke the U.S. savings and loan crisis of the 1980s.

“In the U.S., there’s a concept of fraud,” said Hermitage Capital’s Browder. “Here there’s a concept that conflict of interest is a business opportunity not to be missed.”

But bankers defend the practice as the most prudent commercial lending they could do in Russia, where the absence of reliable financial reporting makes dealing with strangers especially perilous.

“From a pure banking point of view,” Menatep’s Zurabov said, “extending credit to related parties was a less risky business, because you know personally what was going on in those enterprises and could be certain they weren’t going to cheat you. You didn’t even need to see audited statements from them.”

But by last summer, most bankers saw storm clouds ahead.

“We started to feel something was wrong late in July,” Zurabov said. “The prices of all tradable securities were coming down, irrespective of actions by the government. This was really a trap for the Russian banks.”

In the first two weeks of August, he said, Menatep paid out more than $50 million to meet margin calls. Industrywide, such margin calls cost the banks an estimated $3 billion--a hemorrhage that ceased only when the Central Bank gave permission for them to stop paying foreign creditors for 90 days.

Adding to the impending disaster were the banks’ positions in so-called currency forwards, which were speculative bets on the stability of the ruble against the dollar and other foreign currencies.

By the end of June, estimated Page, the London banking analyst, this bet was so large that a mere 10% devaluation would have wiped out a third of the banking sector’s $6.4 billion in capital. At Menatep, executives watched the situation nervously as the ruble weakened slowly. At the end of July, they figured they had already lost $70 million on existing currency forwards--if the ruble remained where it was.

The crash was much worse. In the week following the government’s Aug. 17 actions, the ruble lost about half its value.

Menatep, like the rest of the banking sector, was irreversibly in the red.

In the two months since, bankers and financial analysts have waited in vain--and with rising dismay--for the government and Central Bank to take steps to revive the all-important sector.

“When there’s a fire in the room, you don’t sit down in committee and ask, ‘Who smells smoke?’ ” remarked a Moscow banking analyst who requested anonymity.

Plan Would Classify Banks

A draft of a Central Bank program to classify the failed banks into four categories of solvency so it can save only the strongest was recently leaked to the Moscow newspaper Kommersant Daily, but few formal steps in that direction have been taken. In any event, critics of the program observed that the very process of classifying banks would probably fall prey to political interference--the sort of favoritism that allowed mismanaged banks to grow larger.

The restructuring plan also is almost certain to require an infusion of capital from abroad. Where that money will come from is uncertain; although the Central Bank has suggested that it might allow foreign banks to convert the unpaid debts owed them by Russian counterparts into ownership shares in the Russian banks, few foreign institutions are likely to relish investing further in a bankrupt system that has already cost them hundreds of millions of dollars.

On the other hand, some might argue that now is the time to invest, for the banking system in Russia has nowhere to go but up.

“Obviously, there’s been a general collapse,” Zurabov said. “Now, we’ll have to rebuild the entire system from scratch.”

Tomorrow: The downfall of Russia’s seven leading tycoons.