Msc. International Economics & Business
Master’s Thesis
Financial Globalisation, Institutional Reforms and
the Development
of the Banking Sector in Russia
Author: Supervisor: Co-Supervisor:
Margarita Stepanova Dr G.J. Lanjouw Dr E.H.van Leeuwen Faculty of Economics Faculty of Economics Faculty of Economics University of Groningen University of Groningen University of Groningen The Netherlands The Netherlands The Netherlands
m.stepanova@student.rug.nl g.j.lanjouw@rug.nl
e.h.van.leeuwen@rug.nl
S1544888December 2007
Table of Contents
Abstract……….………3
1. Introduction……….4
1.1 Problem statement……….………4
1.2 Research objectives………..5
2. Russia’s banking sector transition: Where to?………7
2.1 Russia. New institutions : national pride or a new oligarchy?………..7
2.2 Banking sector development………..8
2.3 Legacies of planning post-communist transition in Russia and its influence on financial intermediation………..……….11
3. Literature review……….17
3.1 Influence of banking sector development on economic growth………..17
3.2 Influence of institutional reforms on banking sector development…………..…18
3.2.1. Main concepts of political economy approach………..………19
3.3 Political economy of banking reforms in Russia………..………20
4. Model and empirical methodology………..………..23
4.1 Data and methodology………..………23
4.2 Empirical model………..………….24
5. Analysis of results……….…………..30
5.1 Analysis of findings Model 1……….31
5.2 Analysis of findings Model 2………..…….33
6. Conclusion and discussion.………..……….….35
7. Limitations ………..………..……….………...37
Bibliography……….…38
Appendix 1 - Descriptive statistics Model 1.
Appendix 2 –Correlation table Model 1.
Appendix 3 - Descriptive statistics Model 2.
Appendix 4 –Correlation table Model 2.
Abstract
It has been extensively documented that economic growth of a country to some extent depends on the level of its financial development, and vice versa. The financial system’s depth is not driven solely by differences in the general level of economic development – but also by the differences in the rules pertaining to a financial system and their enforcement. So policies matter. Policy reforms induce competition in the banking sector. But real effects follow mainly from allocation of the influence over the banking sector. In this work the development and restructuring of the banking sector in Russia is presented. A significant positive relationship between policies directed to the trade liberalisation and the number of financial institutions in the country is found. Also I found proof for the fact that, as soon as the overall development of Russia is improving, the demand for both domestic and foreign financial services increases. Increased presence of foreign ownership in the banking sector leads to a lower share of governmental “connected lending” in overall volume of loans. On the other hand, I found a significant positive relationship between state ownership of the financial institutions and non-performing loans. Concerning the main measures directed to improve overall performance of the banking sector- Strategy for the development of the banking sector, I only found evidence that this reform was instrumental in disclosing the “habits” of Russian banks to lend to doubtful clients.
In my work special attention is paid to the major policy measures, institutional and regulatory changes, i.e. the factors that influence the emergence of a developed and sound banking system. Time-series analyses allow us to show the different stages of the banking sector reform and different policies that influence the change of the main indicators of financial activity.
Keywords: banking sector development, Russian Federation, political economy approach, theory of economic regulation, interest groups
1. Introduction
1.1 Problem statement
While the financial sector is a key catalyst for sustainable development of a country, many of the developing countries are struggling to keep up with the forces of globalisation and liberalisation that are transforming the global financial markets.
Compared to other transition economies, and in particular to the new EU member countries, the degree of financial intermediation has remained relatively low in the Russian banking sector, even though the situation improved in the period from 2001 through 2006, when the gap was somewhat reduced.
The banking sector is certainly one of the branches of the Russian economy that has shown considerable uncertainty and lack of trust. Banking development in Russia has been fraught with structural problems, a great deal of which are rooted in the Soviet past (Vernikov, 2004).
In less than a decade since the financial crisis of 1998, Russia’s banking system has emerged from obscurity to become a popular area of study for scholars, experts, and investors. Researches typically examine select aspects of the banking system or segments of the financial market, often relying heavily on econometric and mathematical models. This growing body of literature, however, rarely goes into depth about the interaction between reforms, ownership, institutions, and the management of Russian banks (Vernikov, 2007).
The focus of the literature on financial efficiency is on the importance of the financial sector to the growth of the economy. Hence, it is crucial to identify the factors that determine the performance of the financial sector. My work is linked to several aspects of the studies, taking into account not only financial characteristics, but also elements of the political economy approach, dealing with the importance of domestic and imported institutions on the structural changes in the banking system. Under institutions I include formal and informal structures, relations and mechanisms that govern the behaviour and reforms in the economy. My paper attempts to integrate both institutional and financial factors considered in the literature, by examining the key drivers that contribute to better performance of the Russian banking sector. I want to touch upon the issue of globalisation in the sense of not only financial inflows, but also the import of institutions that has occurred after the transition process has started.
degree of globalisation, the change of the political and economic regime, that has happened during the transition process in Russia, on the development of its financial system. In order to show why Russia requires different policies from the rest of the economies in transition, the peculiarities of the Russian transition process will be analysed.
My paper focuses on the balance of interests of those, who benefit and loose from changes in the post-communist transition of Russia.
My paper has three major parts. The first part describes the developments, policy measures and adjustment efforts that aim to establish the legal, institutional and structural background for the functioning of a healthy banking sector. From the extensive literature overview on the topic of banking sector development, covering the experience of other economies in transition, some issues are highlighted and compared with the ones relevant for the Russian economy. Together with an overview of Russian banking history, some of the major financial, political and co-ordination problems are touched upon. Also I evaluate the factors that have directly influenced the post- privatisation development pattern of the banking sector. Building institutions, enhancing market discipline and deepening the financial sector takes time, so in my work I am using a period of 13 years: from 1995 to 2007, which is reflecting the beginning of significant steps in the transition of the Russian economy up to the present.
The second part of the paper presents methodology and two empirical models. The first model shows the relationship between different interests of economic agents
Thus, the following questions arise:
• What are the characteristics of the Russian banking system that distinguish it from other economies in transition and how did that system develop?
• What are the main interest groups, that will likely affect the reforms of the Russian banking sector?
• What is the impact of the reforms in the banking sector on the performance of the banks in Russia?
• What is the Russian state’s current role in banking?
emerging after the collapse of the communist system and the reforms in the banking sector.
The second model aims to explain the influence of these reforms on the performance of the banking sector in Russia.
Finally, the conclusions and the lessons from other countries are presented to show the similarities and differences with the Russian banking sector development.
2. Russia’s banking sector transition: Where to?
2.1 Russia. New institutions : National pride or a new oligarchy?
Foreign journalists are debating whether the word stolid was a good one to describe Russia these days (ING 2007) when they have discovered that the economist JK Galbraith had beaten them by several decades, with his description of “the incredibly massive and stolid bureaucracy of the (then) Soviet system”. While Putin’s bureaucracy does not match this definition, still, the current state of Russian markets is likely to be dictated by the state’s plans in the economic sphere, and particularly the creation of so-called “national champions”.
I believe that two important themes are currently emerging from this policy: first, the creation of “national champions” (world-scale Russian companies in key industries that are at least state–friendly, if not state-owned); and second, the establishment of conditions for a major surge in (state and private) bank lending to, amongst others, the national champions. These companies, either state-owned or with strong links to the state, could well benefit strongly from preferential access to credit from state- owned banks or from government spending (ING 2007).
Since the early 1990s, state withdrawal, partial privatisation and liberalisation accompanied the introduction of a set of institutions through which new owners control and protect their property. Since that time Russia adopts a broad set of market institutions borrowed from various developed market economies, but the degree to which they regulate the actual relations in the banking sector varies greatly from one area to another (Vernikov, 2007). Unlike CEE (Central and Eastern European) countries, Russia chose to borrow separate institutions from a variety of sources, resulting in a set of inconsistent and mutually contradictory norms and institutions. For instance, Russian Law contains vague definitions of beneficiary ownership, and public disclosure is essentially voluntary, which started improving only after 2005 in the context of the introduction of deposit insurance (Vernikov, 2007).
Although the continental European and the Anglo-American model of banking sector development has essential common features such as reliance upon rule of law, transparency, trust, contract enforcement and property right protection, these features have not existed in Russia which business culture and governance are traditionally associated with disregard of legal norms, opportunism, lack of trust, strong reliance on personal relations and close networks, lack of transparency and secrecy (Nikitin, 2002).
The business system that has emerged in Russia represents a compromise between the endogenous priority of defending business against external challenges and the push for innovations coming from exogenous sources, namely the government and the central bank as top bank regulators (Drobyshevsky, Paschenko, 2006).
Russia no doubt develops in its own way, with some of the emerging features reminding of crony capitalism 1, with the creation of a new state-oligarch system (Sharafutdinova, 2007).
I intend to look at the themes such as power of the state, bank lending and the role of the most powerful industries with respect to their ability to influence the reform and development of the banking sector in Russia.
2.2 Banking sector development
With the breakdown of the system of central planning, the need for an effective and efficient system of financial intermediation became apparent. Since banks were already present during the communist era, the transition countries used their monobanks as the starting point for creating bank-based financial systems. In many countries almost all of the large state banks have by now been privatised (Brouwer, Haas and Kiviet, 2003).
But the Central European experience is not relevant for Russia. Major state-owned banks (Sberbank and Vneshtorgbank) remain by far the biggest players in the market.
As of end-2006, they together accounted for one third of the total amount of Russian banks’ credit portfolios (Russia: Country Profile, 2006). Thus, the large state-owned banks have become predominant not only in deposit taking, but also in lending.
Initially, central bank supervision of commercial banks also was vague because the banking sector grew rapidly as the centralised economy collapsed and because Russia had no experience in establishing a market-based system. In the early and mid-1990s, the failure of regulation led to a growing number of new commercial banks, most of which were of dubious quality.
Today, Russian commercial banks can be subdivided into four basic groups:2
• first, the big state-owned banks Sberbank and Vneshtorgbank;
• second, the next 15 to 20 mostly private banks, currently dominated by institutions owned by big raw material producers;
• third, numerous small banks;
• fourth, foreign-owned credit institutions.
1 Crony capitalism is a term describing an allegedly capitalist economy in which success in business depends on an extremely close relationship between the businessman and the state institutions of politics and government, rather than on the free market competition, and economic liberalism. It may be exhibited by favoritism in the distribution of legal permits, government grants, special tax breaks, and so forth (Sharafutdinova, 2007).
2 Source: Nikitin, 2002, Vernikov,2004.
The weakness of Russian banking sector as a financial intermediator is also revealed when comparing its indicators in relation to other transitional economies (see Table 1).
Table 1. Russian banking indicators in 2004 (in ratio to GDP).
Assets Deposits Loans M2
Belarus 29.6 17.2 15.5 20.3
Czech Republic 89.9 67.0 35.2 46.8
Estonia 104.2 40.5 48.2 46.8
Hungary 71.4 41.4 47.0 48.1
Latvia 120.1 37.1 53.3 47.6
Lithuania 47.1 28.2 27.2 36.9
Poland 53.0 36.8 28.6 43.4
Russia 44.0 24.1 26.6 34.3
Ukrain 43.9 30.3 31.4 45.8
Source: Pollisinski, 2006 (based on IMF Report, 2005).
Below, I highlight the major problems/characteristics of Russian banking sector:
1. The capitalisation of the banking sector is still low.
The equity of about a third of the banks exceeds 4 million Euro, but the minimum EU requirement for banks’ capital is 5 million Euro.
2. Single major banks dominate the fragmented and decentralised Russian banking sector.
By the end of 2004 state banks represented 41% of the banking sector in terms of the volume of assets (incl. Sberbank 28%, Vneshtorgbank 6%, Gazprombank 5% and Vneshekonombank 2%). The share of the remaining 1,295 banks reached a total of 59% of the market (Pollisinski, 2006).
3. The Russian banking system is regionally concentrated.
The largest two dozen banks have more assets than all the remaining 1,300 credit institutions put together. So far, banking in Russia has been concentrated in large cities. For example, Moscow, which accounts for 7% of Russia’s population, has a 30%
share in retail loans and a 35% share in retail deposits. The loan-to-GDP ratio in Moscow is nearly 70%, compared with less than 10% in the Urals (Russia: Country profile, 2006). In my view, this highlights opportunities in the regions, which have been growing faster than Moscow in recent years. If this trend continues, banks with nationwide distribution networks, such as Sberbank, could capture profitable market
shares, which would allow these banks to upgrade their balance sheets and increase profits and overcome competition. Also, the acquisitions involving foreign participants should include banks with sizeable regional presence. I think this would help to raise confidence among foreign banks in the regional economies.
4. The concentration of Russian banking is high also in terms of ownership3 (see Table 2).
Four major state banks are the largest creditors as well as the greatest depositors. All in all, the state controls 21 banks through federal/regional authorities or state enterprises.
Table 2. The relative weights of major financial institutions in Russian banking sector at the end of 2004 (% of total banking sector).
Sberbank 4 largest state banks*
5 largest banks
**
30 largest banks
Assets 28 43 66 70
Credit to economy 30 38 44 68
Deposits 42 52 54 72
residents’ deposits 60 67 68 79
* Sberbank, Vneshtorgbank,Gazprombank,Vneshekonombank
** The abovementioned four and Alfa-Bank
Source: Pollisinski, 2006 (on the basis of the Bank of Russia’s data).
5. Lack of competition4.
The competitive environment in the banking sector can still be described as benign, especially for Sberbank, which has several advantages over its peers including capital, distribution and brand recognition. The sector is very fragmented, and the presence of foreign banks is limited to around 10% of the banking sector’s capital (Pollisinski, 2006).
However, things are beginning to change. VTB, the number–two bank, has announced a very aggressive expansion programme, which assumes significant market share gains,
3 Bonin et al. (2005) studying privatization in Bulgaria, the Czech Republic, Croatia, Hungary, Poland and Romania confirm the propositions in the literature that state ownership of banks is inefficient and that the entry of foreign banks, which are the most efficient of all bank types, improves the performance of banking sectors in transition countries. Vernikov (2007) shows that current banking sector’s ownership structure in Russia hinders further advancement of market institutions.
4Demirgüc-Kunt et al (2003) find that greater bank concentration is associated with lower bank efficiency in emerging economies. Claessens and Laeven (2003) find that greater foreign bank entry and lack of entry and activity restrictions are associated with more competition. Moreover, there is evidence that competitive pressures are greater in those areas where foreign banks are active (Moreno & Villar 2005, p. 11).
including through M&A. I believe that in light of the expected relaxation of foreign banks ownership regulation, these trends will intensify in the near future.
2.3 Legacies of planning post-communist transition in Russia and its influence on financial intermediation
Market economies in transition (e.g. Hungary, Czech Republic, Slovakia, Slovenia, Poland) and the group of developing countries that have actively participated in financial globalisation have clearly shown better growth outcomes compared to those countries that have not participated (Bonin et al, 2005).
Although Russia did not go as far in its institutional change as CEE countries, which essentially adopted the body of European law (acquis communautaire), the exposure of the Russian economy to the international markets continues to grow. External or global factors and forces now dominate the Russian economic and political scene. By introducing convertibility of the national currency and liberalising both the current and capital account of her balance of payments, Russia fully exposed herself to globalisation (Vorobyov, A & Zhukov, S, 2000). This processes includes opening of the national economy; disintegration of the Soviet (and Russian) empire; progressive political and economic decentralisation; degeneration of the inherited economic system; and deep institutional changes and restructuring of the social fabric of the society (Tompson, 2004). Starting from liberalisation reforms in 1991, and up the present, Russia has also borrowed from a broad set of formal institutions to regulate relations in the financial sphere. Besides an independent central bank, there are now also agencies for federal deposit insurance, corporate governance, anti-money laundering, supervision of derivatives trading. But the problem is that these imported institutions do not necessarily match with the traditional norms of Russian behaviour, so promoting these new transplanted institutions has imposed some costs on society in terms of additional bureaucracy (Vernikov 2007). The rule of law and equality of all economic actors clash with social networks where informal institutions dominate. Russia’s economic structure means that its banks are subject to a very high degree of economic risk (Penkina, 2004). Tompson (2004) places Russia in the category of the LDEs – less diversified economies, due to Russia’s high ratio of foreign trade turnover to GDP (58.1% in 2003) and the predominance of oil, gas and metals in its export profile. The sector’s market power gives natural monopolies the ability to influence the direction of economic reforms in the country.
It is interesting to notice that, while the emerging structure of the Russian banking sector is unique among transition countries, it is similar to the design of the financial system of Russia in the early twentieth century before the Bolshevik regime, when the number of players was restricted by high barriers to entry and the prevailing oligopolistic power in the hands of the main operators. (Vernikov, 2007).
Below I will touch upon the major issues of banking reforms in Russia.
State, private and foreign ownership
During communist times, governments were in complete charge of banks’ credit granting process. A first step in reducing this involvement was the privatisation of state banks. According to Brouwer, Haas and Kiviet (2003), who did research on CEE transition countries, the government ownership has decreased remarkably by the end of the 90-s (they take period 1996-2001). Opposite to most economies in transition, empirical literature on Russia (Nikitin, 2002, Erochkine, 2006, Vernikov, 2007) reports that the state’s withdrawal from commercial banking has been inconsistent and limited in scope. The state still remains the owner of the major Russian banks, and plays an important role in influencing the reform of the banking sector in Russia. According to Fries (2005), the factor that can disturb such equilibrium in emerging markets and promote financial reform is a banking crisis that would impose the real cost on the bargains between state and private ownership.
The paradox of privatisation of the banking institutions in Russia, is that the owners (enterprises, associations, ministries, social organisations, etc) of the banks were, at least nominally, public sector entities themselves. We see that banking shares do not belong directly to the state, nor become private in the legal sense. Stark (1997) proposes the term “recombinant property” to reflect special features of ill-defined transitional form of ownership.
Private ownership can be seen as a fundamental institution, a driving factor of a market economy (Vernikov, 2007).
A second important step in reforming of the banking sector of transition countries was the sale of majority stakes in the largest banks to foreign strategic investors.
The fact that branches of foreign banks are not allowed has always been a sticking point in the talks on Russia’s WTO accession. The idea of changing the ownership structure of the banking sector in favour of privatisation poses the principal challenge to Russia’s WTO aspirations (Bush, 2006).
The informal ban on foreign banks establishing branches in Russia illustrates the power that informal institutions can take over formal institutions. Russian leaders, including
the president, consistently claim that foreign bank branches must not be allowed for reasons that include protecting the national market, ensuing “fair competition”, and fighting money laundering. In arguing against greater access to foreign institutions, Putin raised concerns over national security, noting the difficulty of tracing capital movements in a globalised world economy. “The activity of branches of foreign banks in the Russian Federation should be restricted”, he said. “In practice it must be prohibited”5.
The diagram below gives a reader of this work clear impression about the distribution of the banking sector ownership in Russia over the last few years.
Diagram 1. “Breakdown of the Russian banking sector by form of ownership, % of total banking assets.”
Source: Vernikov, 2006.
5 RIA Novosti (http://zeebeam.blogspot.com/2005_12_01_archive.html/ Putin for banning foreign banks' branches in Russia).
0%
20%
40%
60%
80%
100%
2001 2002 2003 2004 2005 2006
Foreign ownership
Private national
ownership
State ownership
Strengthening the legal, supervisory and accounting framework: Introduction of Deposit insurance and the Strategy for development of the banking sector.
Adequate institutions, such as a legal framework that specifies the “rules of the game”
for a market economy, are crucial for the development of a deep, stable and efficient banking sector. The challenges that Russia faces over the coming years in improving its legal, supervisory and accounting framework are basically twofold. On one hand, the lack of sound creditor protection has been an important impediment for banks to start lending to small, new and innovative enterprises. Providing banks with the right incentives, financial laws and supervision, allows the banking system to allocate the available resources more efficiently (Erochkine, 2006).
On the other hand, the lack of trust of population and enterprises (who prefer to keep their money on offshore accounts)6, induces low saving rates and shortage of resources for banks. Empirical results suggest that poor law enforcement hinders the development of banking sector in transition economies (Pistor, Raiser, Gelfer, 2000).
Since the beginning of the transition, Russia has shown some improvement in its reforming activity, commercial laws and legal environment. In 2004, the Central Bank and Russian government launched a major reform initiative that could fundamentally change the Russian banking sector and its structure over the next years - the Strategy for the development of the banking sector. A state insurance program for household deposits represents a primary element of this reform. Other key elements include new standards of accounting, disclosure requirements, bank monitoring, procedures for bank resolution, and the protection of creditor rights. There also has been a set of regulations, increasing the supervisory power in the area of money laundering and terrorist financing7. Although the introduction of the above mentioned Strategy aimed to increase stability and improvement in the banking sector overall, the process of its implementation has caused high resistance from some commercial banks. I could call it not only problematic, but even to some aspect tragic8.
Deposit insurance exists in almost all developed economies. It has often proved an effective instrument for increasing the confidence of the public in banks, and in helping
6 Although fforeign investors became less suspicious about Russian economy, large domestic investors, who possess more information about the local market, still prefer to invest from abroad in order to secure against risk of expropriation. The profits of private enterprises are transferred abroad to offshore accounts. It is estimated that this capital flight has been running at the rate 50 bln per year, which is much higher than inward FDI. The cumulative Russian capital flight offshore could by now substantially exceed the Russian external debt of US$ 160 billion
7 According to the “Globalisation report 2006”, Russia has fallen from 53 place in 2005 to 62 in 2006 due to the money laundering activity and lack of transparency in banking sector.
8 In September 2006, the vice president of central bank of Russia, an initiator of Deposit insurance scheme, and the active opponent of money laundering activity, Andrew Kozlov, had been assassinated outside of the sport complex in Moscow. The official sources state that the reason was his initiative of withdrawing licences from the number of banks due to the money laundering activity.
to prevent the self-reinforcing mass hysteria of bank runs. Despite the de-dollarization of recent years, Russian households continue to hold a huge share of their savings outside banks in foreign (paper banknotes) assets, which suggests a strong potential for additional financial intermediation if household confidence in banks can be improved.9
As Vaithilingm, Nair and Samudram (2006) have shown, the institutional environment has a positive and significant effect on the soundness of banks. A broad variety of institutions, ranging from the legal framework to the strength of auditing and accounting standards has been used as a proxy for institutions in their work. Their empirical model also suggests that banks performance is dependent on the measures taken to limit illicit financial activities such as money laundering and terrorist financing.
For this reason, I think that the Strategy for banking development and the introduction of a deposit insurance scheme are important issues deserving attention when explaining strength of institutional influence on the performance of the banking sector in Russia.
Trade and capital account liberalization.
The essence of the argument is that trade liberalisation decreases incumbents’ rents and consequently both their ability and willingness to oppose financial sector development. Braun and Raddatz (2004) show that on average the countries that liberalised trade during the last three decades of the 20th century gained around 4 spots in the ranking of private credit to GDP. With respect to the economies in transition, the decision to liberalise trade and capital accounts is not entirely endogenous, but also influenced by external policies, such as shift in the economic regime, privatisation and growing exposure to the globalisation forces.
As one of the fastest growing economies in the world, investors are finding it hard not to consider Russia, in particular its large and booming internal market with a population of 145 million and increasing income per capita. In a separate survey of oil and gas investors, Russia came second only to Australia (ING report, 2007). Its significant hydrocarbon reserves are considered an important prospect for FDI. In July 2006, Russia fully liberalised capital account transactions, making the rouble convertible and opening up new avenues for foreign portfolio investment.10 Foreign investment inflows have dramatically accelerated in 2006. In first half of 2006 net FDI was five times higher than in 2005 as a whole. Although Russia may not strictly need foreign capital, it
9The OECD Economic Survey of the Russian Federation (2004) reports estimates of “mattress money” in Russia range from USD 40-80 bln, as compared to USD 48 bln in household deposits in commercial banks.
10 These changes were positively accepted: S&P upgraded Russia by one notch to BBB+. This would move Russia into the next credit group of A-rated countries, stimulating investment flows (ING report, 2007).
is particularly interested in the new technologies and modernisation that typically follow foreign investment. Unfortunately, the lack of a regulatory environment and still low trust of foreign investors mitigate the potential inflow of long-term investments to the country. In this case portfolio investment is likely to increase as a larger proportion of total inflows originates from investors that are not so much interested in providing finance for long-term investments, but rather focused on exploiting short-term gains.
Generally, it is assumed that short-term investments, such as portfolio investments and short-term bank loans, are more often related to the self benefits, than long-term bank lending and especially FDI more often concern the issue of stability of financial system (Kalotay, 2005). It is widely known that FDI can also increase local market competition when foreign-owned firms enter the local product market (Markusen, 1997;
Navaretti&Venables, 2004; Kalotay, 2005).
Growing foreign capital inflows require solid and trustworthy financial intermediaries, and, as a result, they put indirect pressure on the banking sector reforms.
3. Literature review
3.1 Influence of the banking sector development on economic growth
Financial intermediaries play an important role in economic development since they can reduce the costs of acquiring information, conducting transactions, and can facilitate savings modernisation. Banks enhance resource allocation and accelerate growth. In the growing pool of theoretical literature and empirical research devoted to the topic of the influence of the banking sector development on economic growth, I want to review the literature that describes the impact of banks on productivity growth, capital accumulation, private savings rate and overall growth.
Beck, Levine and Loayaza (1999) explore whether differences in the level of banking sector development are the causes of cross-country differences in total factor productivity growth. Beck et al (2000) and Levine (2003) suggest that a well- developed and sound financial system can contribute significantly to economic growth by recognising the important role financial intermediaries play in bridging the gap between savings and investment needs within an economy.
Claessens and Laeven (2005) in their paper relate an industrial organisation-based measure of banking system competition to growth of industries, and find that greater competition in countries' banking systems allows financially dependent industries to grow faster.
To sum it up, it is proved that the countries with more developed financial systems will grow faster than countries with less developed financial systems.
Most of the studies were conducted for developed countries where significant reforms are already undertaken over the last decades to enhance efficiency and competition.
Russia, as a clear example of a transition economy has attracted attention not only of native researchers (Vernikov, 2005, Nikitin, 2004), but also foreign ones, specialising in different spheres of banking research: Barisitz (2004) uses a chronological approach to trace and analyse the development of the Russian banking sector since the final years of Soviet rule. His work deals with legal foundations, banking supervision, banks’ major sources of assets, liabilities, earnings and related changes, bank restructuring, rehabilitation programs, the role of foreign credit institutions and FDI. Unfortunately, Barisitz (2004) only gives a descriptive analysis of the indicators of the banking sector development. He does not provide the reader with the empirical results, showing what factors have an impact on financial activity in Russia.
In general, the results show that banking sector development is related to economic growth. This literature is advancing our knowledge of the mechanisms through which financial development has an effect on real outcomes.
But it is interesting to examine whether economic growth also has a causal impact on banking development. Economic growth triggers the demand for more comprehensive and diverse financial services. These services can not be introduced without policy reforms designed to promote financial sector development. Policies matter: financial system depth is not driven solely by differences in the general level of economic growth –a proxy for the demand of financial services- but also by differences in the rules pertaining to financial systems and their enforcement (La Porta et al., 1997).
3.2 Influence of institutional reforms on the banking sector development Since economic transition is a long-term process, consisting of several key phases which are spread over several years, the process of reforms in financial sector involves interest rates, credit allocation, bank ownership, prudential regulation, security markets, openness of the capital account and competition.
Below I highlight some works related to the influence that institutional reforms have on the development of the banking sector.
Drakos (2003) analyses 11 transition economies during the period 1993-1999. He finds that the countries with the lowest share of the state-owned banks have narrowing interest margins than the countries where the state ownership prevail. A cross-country comparison suggests that the net interest margin is negatively correlated with the share of foreign capital in the banking sector (Vernikov, 2005). Trends in the net interest margin feature the degree of competitiveness of the banking system.
Berglof and Bolton (2002) as well as Fries and Taci (2002) deal with the effect of macroeconomic stabilisation and institutional reform on the banking system. Buch (2000) compares interest rate spreads across three CEE countries (Hungary, Poland and Czech Republic). In their comparative study, Brouwer, Haas and Kiviet (2004) use the approach based on the analysing the potential risks that may accompany further development of the CEE banking sectors. They state that addressing such risks is the best method authorities of CEE countries can use to stimulate the development of the banking sector as well as financial markets. They provide the reader with the information on the main sources of risk, such as: macroeconomic instability (with respect to inflation and volatility of GDP growth); capital inflows and lending booms;
exchange rate regimes; limiting currency mismatches in the banking system; adequate preparations for financial liberalisation; reducing government involving and connected lending; strengthening the legal, supervisory and accounting framework, well-balanced incentive management.
In some of the latest studies on banking sector development, institutional and political economy approaches have become popular. Literature on the politics of financial development in market economies emphasises the link between financial development and intensity of competition in the non-financial sectors of an economy and the distributive consequences of policies that enhance product market competition.
3.2.1. Main concepts of political economy approach
Political economy context refers broadly to the interrelationships between political and economic institutions and processes, particularly as related to policy decisions and reforms (Abonyi, 2002).
The approach taken in this paper may be summarised as follows: reform of banking sector, as an element of policy reform, is essentially about change: transforming one set of policies and institutions to another in order to resolve a perceived problem and/or to help bring about improvements in socio-economic conditions. The process of change and its outcomes are shaped by the complexity of policy issues, and associated processes and institutions. The effectiveness of banking reform depends fundamentally on a mutual understanding between government and market agents. This set of existing policies and institutions involve a particular distribution of benefits and power, which are in turn, based on an existing system of incentives, structures, and behaviours.
Below I present studies on financial reform that use the political economy approach.
Rajan and Zingales (1998) show that industries that are more dependent on external sources of finance grow more rapidly in countries with more developed financial systems. Fries (2005) provides empirical evidence to the hypothesis that progress in banking reform and development is positively associated with reforms that liberalise trade and that reduce the share of industry in total employment. That is, banking reforms have advanced when the interests from the previous regime in real sector have been weakened.
Financial reform can also have significant distributive consequences within the financial sector itself. Kroszner (1999) has conducted the analysis of bank branching reforms in United States, based on economic theory of regulation11 (Stigler, 1971), which emphasises the role of well organised industry groups in influencing public policy with the aim of capturing the state and using its authority to appropriate rents (or
11The theory of economic regulation first developed by George J. Stigler (1971), point out that the power of the state – is a potential resource or threat to every industry in the society. With the power to prohibit or compel, to take or give money, the state can and does selectively help or hurt a vast number of industries and market participants. With respect to the reformation process, the results of the same economic reforms can be ambiguous for different economic agents.
resources) at the expense of less organised or powerful groups. He also argues that governments in developing countries often use the financial system to direct bank lending to privileged industries or groups at below-market interest rates. More recent work of Braun and Raddatz (2004) examine how trade liberalisation changes the balance of interests in conducting the reforms of financial sector. Their findings are consistent with a positive association between financial development and product market competition in the non-financial sector.
The level and pace of financial reform are determined not only by their distributive consequences and the political process but also by factors that are not entirely dependent on policy decisions. The existing literature on financial development has emphasised several such factors, such as economic openness to international trade, intensity of competition, capital account liberalisation.
Talking about banking reforms for economies in transition, we consider the shift in economic regime. In other words, banking reforms develop when the interests from previous regime in the real sector are weekend.
3.3 Political economy of banking reforms in Russia
In this chapter I want to draw the conclusion from my literature review and highlight main issues, that, to my opinion can better answer my research question. In order to develop and test hypotheses about the development of Russian banking sector, I turn to studies based on the political economy approach.
The Soviet Union has spent 70 years eradicating competition from all spheres of economic activity, where, in line with Stigler’s theory, the power of the state was the main driving force of all economic processes.
According to Stigler (1971) the main policies which an industry may seek from the state are:
- Direct subsidy for money/connected lending - Limit access to their market for new entrants.
The central tasks of the theory of economic regulation are to explain who will receive the benefits or burdens of regulation, what form regulation will take, and the effects of regulation upon the allocation of resources (G. Stigler 1971).
Thus, I introduce the political economy variable, measuring the change in relative strength between those that promote and those that oppose financial development. My variable is based on the following propositions:
1) Industries that are more dependent on external sources of finance grow more rapidly in countries with more developed financial systems. Developed banking sector provide for such industries better access to finance, that facilitates the entry of new firms in the markets and increases the degree of product market competition. So, more efficient incumbent firms and market entrants (local and especially, foreign) are potential gainers from competition enhancing policies, such as trade and capital liberalisation.
Thus, trade and capital liberalisation can be seen as an exogenous shock that supports financial reform and a higher level of financial development.
2) In the context of privatisation of the banking sector in Russia, reforms that increase competition in the banking sector would result in decreasing share of state-owned banks. Since the state often uses the financial system to direct bank lending to privileged groups, such as natural oil and gas monopolies, those “state-friendly”
enterprises will lose some of their benefits to new entrants. In these industries rents are more affected by the development of financial markets, so they are probably more willing to organise and spend resources to maintain policies that keep the financial system underdeveloped. Thus, more likely that the most predominant industrial sector (energy and natural resources) will use its power to oppose above mentioned reforms.
The interconnection of groups of interest is shown in Diagram 2.
Diagram 2. Equilibrium level of financial system development.
reforms reforms
reforms
Market firms (local and foreign) Gain via reforms of banking sector,
that increase competition in the market
Equilibrium level of financial system development State ownership
of financial institutions
Private ownership of financial institutions
Foreign ownership of financial institutions
State – friendly and governmental enterprises Gain via reforms of banking sector, that increase the power of state banks
So, given significant distributive consequences associated with banking reform in the post-communist transition of Russian economy, the relative strength of promoters and opponents (market firms on one side and state-friendly and governmental companies on the other) determines the political equilibrium level of financial system development.
So, I would like to test the following hypotheses:
I will provide the empirical support of these arguments in two ways.
First, I want to investigate the link between the progress in banking reforms on one side and factors such as trade and capital account liberalisation, and share of natural monopolies in total export volume on the other.
Second, I examine the relationship between the progress in banking reform and banking performance as measured by the set of variables, including the spread between bank lending and deposit interest rates, the share of non-performing to total loans, the share of loans to government to total loans, loans to real sector and volume of deposits. These variables have been chosen after careful consideration of numerous studies on banking development (Barisitz, 2004; Buch, 2000, Rossi, Schwaiger and Winkler, 2005…,etc).
Hypothesis 1. The progress in banking reform is positively associated with reforms that liberalise trade and capital account and reduce power of natural monopolies.
Hypothesis 2. Banking reform is instrumental in improving banking sector
performance.
4. Model and empirical methodology
4.1 Data and methodology
Using a chronological approach and structuring data time-wise, I want to perform time- series analysis. My data cover a 13-year period starting from 1995 up to May 2007. I use monthly aggregate data for the banking sector of Russia. The reasons why I focus on time series data of one country, but not considering Russia together with the other countries in transition, are the following:
- I want to know how particular reforms of the Russian economy affect the performance of its banking sector. If I were to analyse Russian performance together with other economies in transition, I would have to use cross - section (country) data. But after careful study of the facts and reasons underlying the changes in the development of Russian banking sector, I come to the conclusion that Russia has its own way of development, sometimes more peculiar and unpredictable, that distinguish it from other economies in transition. So, I think the more precise way to answer my research question would be to abstract from the common issues for all economies in transition and concentrate on the policies and events of Russian economy.
- In the absence of accurate information on each bank’s development (there are around 1300 banks in Russia at the moment), I am talking about the banking sector in general. The data taken from the most reliable source on Russian banking activity: Central Bank of Russian Federation12, allow me to cover the whole banking sector.
- The major part of the empirical literature reports use of the most appropriate accounting standards (they prefer financial statements using IAS over those using national standards and use consolidated balance sheets whenever they are available). The problem with Russian data – is that it is still reported according to Russian Accounting Standards (RAS), and although the intention to switch to IAS has been already made in 2004, the real implementation has been postponed till 2007. Using data on Russian banks in cross-section analysis would lead to unreliable results due to incompatible measurement standards.
12 Official site www.cbr.ru. I also want to thank Mr A.Vernikov (a_vern@bk.ru), the professor of Moscow State University and Higher School of Economics, and the author of articles on Russian banking sector development to which I refer in present work, for kindly providing me with his own calculations on Russian banking sector ownership data.
Also, what I have noticed from the empirical literature review, is that many works (Taci&Zampieri (1998); Tompson (2004); Demirglic-Kunt&Huizinga (2004), Rossi, Schwaiger and Winkler (2005)) omit countries with different levels of economic development. So, it is wise to consider such countries separately, which makes me concentrate on Russian data.
4.2 Empirical model
In my analyses I follow the two-step methodology of Fries (2005), because I find his model more transparent and consistent than the one proposed by Braun and Raddatz in their earlier work on political economy approach with respect to banking sector development (2004). Fries already focuses on particular policies of banking reform that affect the development of the banking sector.
Step 1. Banking reform, its dimensions and determinants
Now I model empirically the level of the banking reform in Russia at time t, B_REF t, as being determined by balance of interests influenced by trade liberalisation (TRADE), capital account liberalisation (FDI+ portfolio investment, PORT) and power of natural monopolies (NATUR). The change in the equilibrium of banking reform can therefore be expressed as the following function:
∆B_REF t = α+ (β∆TRADE t + β∆FDI t + β∆PORT t + β∆NATUR t) + βGDP t + ε t
My Hypothesis 1 implies that the coefficients βi should be significantly positive for the parties which welcome banking sector development via the banking reform, and negative for those, which fear to lose the privileges associated with the current situation.
The change in share of output of natural monopolies is used as an indirect measure of policies that shift the control over the main natural resources from the state to the private interest groups, that might oppose some reforms in banking sector undertaken by the state.
In the empirical implementation of equation, I use contemporaneous as well as lagged explanatory variables.
Regarding the dependent variable, ∆B_REF t, I focus on four dimensions of banking reform:
• Y1 Total number of banks (reflecting the influence of reforms on the development of the banking sector in general);
• Y2 Share of private-owned banks in total banking assets (reflecting the transformation of the ownership in banking through the entry of new private banks and privatisation of state banks);
• Y3 Share of foreign-owned banks in total banking assets (reflecting the degree of openness to competition, and the banking sector liberalisation reform);
• Y4 Number of banks adopting deposit insurance scheme (reflecting the reforms aimed to increase confidence in the banking sector).
Also, in contrast with other studies (e. g. Barizits, 2004) I leave out one of the most commonly used measures of banking development – the ratio of bank credit to private sector to GDP. The reason is that in the post communist transition, an easing of financial constraints in the real sector was not necessarily reflected in an increased scale of bank lending to the private sector for the following reasons: first the privatisation of state owned enterprises led to significant increases in the ratio of bank loans to the private sector to GDP even in the absence of reform of the banking sector;
and, second, reform of socialist banking was aimed to reduce the scale of misdirected lending and to promote the use of healthy banking principles when making new loans.
As a result, an easing of financial constraints associated with banking reform, took the form of changing the composition of bank assets and improving loan quality rather than simply expanding the scale of bank lending (Fries, 2005).
Regarding the independent variables, I use four variables that are likely to explain the balance of interests in favour of and against banking reform. An important aspect of trade liberalisation is the removal of tariffs and quantitative restrictions that can have an immediate impact on the volume of commerce of a country. So, I use volume of foreign trade as a ratio to GDP as a proxy for trade liberalisation.
Another measure is the capital account liberalisation which result in the entry of new foreign firms that trigger the demand for a sound local banking sector and brokerage services (in case of portfolio investment). And the last measure – the share of export of natural monopolies in total exports – is reflecting the power that oil, gas and metal companies (national champions and state-friendly companies) have over the policy decisions in banking sector.
Step 2. Banking performance and reform
The second part of my empirical model examines the relationship between banking performance and reform. Main assumption here is that banking reform is instrumental in promoting improved banking performance. I model this relationship such as the level
of banking performance at time t is a function of banking reform, B_REF, plus a general set of control variables, C t.
Change in the banking sector performance can be expressed as:
∆B_DEV t = α+ β∆B_REF t + χ∆C t + ε t
In contrast to the work of Fries (2005) whose model served as the basis for my paper and where the only variable to measure the performance of banking sector is the interest rate margin, I extend the set of measures of banking performance to four variables, in order to diversify between the effects the reforms have on certain spheres of banking activity:
• Y1 interest rate margin (as a measure of competitiveness of banking sector and improvement of assess to finance)
• Y2 share of non-performing loans in total value of loans (to reflect the influence of reforms directed to improve the loan quality)
• Y3 share of the loans to the government and social sector in the total value of loans (to reflect the problem of connected lending)
• Y4 total volume of household deposits (to reflect the credibility of reforming in the deposit sector).
In addition, control variables, that are related to changes in banking sector performance are the banks’ reserve ratio and the introduction of the Strategy for banking sector development.
To summarise this part, the variables, their corresponding measures and code names are presented in the tables below:
Table 3. Definition of variables.
Model 1- Interest groups and reform of the banking sector
Definition of Variables
Indicator Measure Dependent/
Independent
Code Name
Number of banks UNIT D BANK
Share of state banks in total banking assets
% to total assets D ST_BANK
Share of foreign banks in total banking assets
% to total assets D F_BANK
Number of banks, entitled to insure deposits
UNIT D INSUR_BANK
Table 3- continued
Volume of trade to GDP Export+Import to GDP
I TRADE
Foreign direct investment Mln $ I FDI
Portfolio investment Mln $ I PORT
Share of natural monopolies in total export
% to Export I NATUR
GDP Mln $ I GDP
Model 2 –Reforms and banking sector performance
Interest rate margin: Price of deposits- Price of loans
% D MARGIN
Share of non-performing loans to the total value of loans
% D NON_PERF
Share of loans to government to the total value of loans
% D GOV_LOAN
Total volume of household deposits Mln $ D DEP
Number of banks UNIT I BANK
Share of private banks in total banking assets
% to total assets I PR_BANK
Share of foreign banks in total banking assets
% to total assets I F_BANK
Number of banks entitled to insure deposits
UNIT I INSUR_BANK
Implementation of Strategy for banking sector development
DUMMY I STRAT
Reserves ratio % I RES
Since the development of the financial system can have different effects across groups along various dimensions of banking reform, the expected signs of such relationships are presented in Table 4.
Table 4. Expected signs of regression coefficients in Model 1.
Dimensions of banking reform
results
Expected signs of regression coefficients
Foreign trade FDI, PORT Natural monopolies
GDP
N of banks
+ + + +
Share of state banks
- - +
Share of foreign banks
+ + - +
N of banks with
deposit insurance
+ + + +
Positive signs for foreign trade and capital account variables mean that progress in the reforms that liberalise trade and capital account trigger the change in banking sector development such as: increasing the overall number of financial institutions, increase the power of foreign banks and the number of banks adopting a deposit insurance scheme. When the negative sign for these variables with respect to share of state- owned financial institutions also suggest progress in banking reforms.
Positive signs for Natural monopolies variable show the increase in number of financial institutions overall, but with the preference to the state–owned banks and decreasing share of foreign institutions.
GDP is a control variable, which supports the general proposition, that the development of the financial sector is positively related to overall economic development.
Table 5. Expected signs of regression coefficients in Model 2.
Dimensions of banking reform
results
Expected signs of regression coefficients
N of banks
Share of state banks
Share of foreign
banks
N of banks
with deposit insurance
Strategy for develop
ment
Reserves rate
Interest rate spread
- + - - +
Non-performing loans
+ - -
Governmental loans
+ - -
Deposits/GDP
+ + + +
In this model I show how the banking reforms might influence the banking sector performance.
An increasing number of banks and, consequently, increasing competition, would lead to narrowing of the interest rate spread of the banks on one side, and an increasing amount of deposits.
A positive sign for the share of state banks means increasing interest rate spreads, an increasing share of non-performing loans, and more loans to the governmental sector.
For the deposit volume I can also suggest that still major trust to the state institutions from the population can overweight low deposit rates, offered by state banks.
An increase in the share of foreign institutions in Russia is suggested to mitigate the negative sides of banking sector performance, such as high interest spreads, volume of non-performing loans and “connected” lending factors.
An increase in the number of banks performing deposit insurance is positively related to the total volume of deposits.
Positive signs for dummy variable “Strategy for development of banking sector” mean that the Strategy has come in power to rule out the loopholes in the Russian banking sector with respect to non-performing loans, “connected” lending and high interest rate spread.
The reserve ratio is a control variable, its increase leads to higher interest rates exercised by the banks.
5. Analysis of results
Stationarity
The first step in my statistical procedure was to make sure that my variables are stationary (time series, that return to average). Since most of the macroeconomic data is usually non-stationary, it is very important to perform this analysis.
The econometric consequences of nonstationarity can be quite severe, leading to least squares estimators, test statistics and predictors that are unreliable.
From the visual analysis of the scatter plots of my time series variables, I concluded that all of them are random walks with a drift (e.g. showing definite trend either upwards or downwards), which confirms the nonstationarity of data. To overcome this problem and bring data to stationary, I used the Dickey–Fuller test for every variable in my models; based on its results I use the first differences. I have performed this analysis for a few lags, and used the ones that minimise the Schwartz criterion. Also I support my choice based on the comparison of R2 with Durbin-Watson statistics: the values of the level model report spurious results: (R2) > (DW), which states the little confidence in my estimation results. For the first differences model for all observations:
(R2) < (DW).
Autocorrelation and heteroskedasticity.
I have checked my data for the presence of the autocorrelation (using the Lagrange multiplier test), and when it was required, using regressions, corrected for autocorrelation, for the following reasons:
The presence of autocorrelation can cause that:
1. The least-squares estimator is still a linear unbiased estimator, but it is no longer best.
2. The formulas for the standard errors usually computed for the least-squares estimator are no longer correct, and hence, confidence intervals and hypothesis tests that use these standard errors may be misleading.
When checking for heteroscedasticity (when the variances for all observations are not the same, the importance of an explanatory variable is different over time) I used White’s Heteroskedasticity Test, which allows to compute correct standard errors of the ordinary least-squares coefficient estimates.
