The contemporary Russian financial system began to emerge twenty to thirty years ago on the ruins of the Soviet banking structure, which was unable to serve the evolving demands of the nascent free market. In the “wild 1990s,” the financial system was rife with profitable but gray activities, including the accumulation of liquidity for privatization investments, the illegal export of capital, tax evasion, and money laundering. Every local “oligarch” had his own bank, and geographic expanse and the informality of economic ties helped create a very fragmented banking sector. In time, many of these banks naturally failed, while their owners “privatized” the funds of their clients. Gray activities lost their attractiveness, while normal banking activities still entailed high risks.

Most of the banks that survived, even the larger ones, maintained systemic, but otherwise hidden, problems from the 1990s and failed to generate positive incomes. Instead, these banks bet on the expectation that Russia’s economic development and resulting future profits would allow them to cover these hidden losses. However, the 2008 financial crisis revealed that even major global banks had problems generating income, not to mention those small banks in a peripheral country like Russia, with a lower-than-average GDP per capita and an undiversified economy.

In 2013, after five years of economic stagnation, consolidation of the Russian banking sector would have been a natural response to signs of a possible recession, but mergers and acquisitions are rare in the Russian financial sector. In fact, the central bank created conditions under which forbidden transactions and asset stripping yield significantly larger incomes for the banks’ stakeholders than a potential merger, which would entail both a loss of control over the bank and a revelation of the skeletons in the closets.

The deleterious impact of the central bank is roughly twofold. First, its supervisory wing has pushed banks into the abyss with a multitude of meaningless and excessive regulations. The requirements for never-ending reports have forced banks to develop and buy incredibly complex software and hire thousands of people. In part because of these requirements, today, Russian banks have five times as many employees per dollar lent as their U.S. counterparts.

The regulator also instituted complex and limiting rules for capital and asset calculation, which stipulated harsh deductions for most types of loans and investments in securities. Because of these rules and the system of protecting against losses, banks could only issue loans secured by real estate or liquid assets in the amount exceeding the loan size.

Loans to new businesses and for business development automatically decreased the banks’ capital at up to 100% of such loans. In order for banks to comply with the requirements, loans to new businesses and for business development could only be provided at very high interest rates. These regulations were justified because of the low quality of the judicial system and limited collection abilities, but they did not help banks generate revenue. Mid-size and small banks would have failed long ago if they had obeyed the regulations.   

As always in Russia, bankers have survived by finding ways around the law. They started providing loans with fake collateral, using intermediary special purpose vehicle (SPV) companies and counterfeit documents. “Forced” to breach the law, bankers developed a feeling of impunity and a desire to continue breaking the rules. Over time, laundering and cash conversion operations constituted a significant and lucrative business again, just as they did in the 1990s. Rumors about Russian law enforcement agencies directly orchestrating such activities and receiving the lion’s share of illegal banking profits are abundant.

No later than in the early 2000s, the central bank suddenly joined the bankers’ side. Despite the multitude of daily reports, checks, and draconian limits on operations, the controllers and overseers seem to have been surprisingly blind to what was going on under their noses. Rumor has it that some regulators were not just blind but even provided occasional active help in hiding losses and inflating capital.

Since the mid-2000s, the Bank of Russia has always learned of problems at various banks either right at the moment of a catastrophe or even afterwards. The central bank routinely issues statements along the lines of: “It has emerged that land lots appeared on Bank X’s books at a price ten times higher than the market price.” These statements have been worded as if it was not the central bank’s primary responsibility to check the validity of banks’ reports. None of the auditors of the said financials were blamed for misrepresentation either. Land issues aside, the central bank head Elvira Nabiullina said in her latest statement that Otkritie had been overstating the prices of Russia’s sovereign debts on its balance sheet.

This is preposterous. The market prices of bonds issued by Russia are available on most financial data terminals—from Bloomberg to Cbonds—and are updated every few seconds. Checking their value is an elementary task, and if Otkritie was manipulating their prices, then uncovering such manipulations was the direct responsibility of the central bank.

Still, while the central bank prefers to be blind and deaf, banking problems accumulate, and banks’ stakeholders are forced to choose between unlikely hope for future improvement in the business climate and the opportunity to make money here and now. Bankers have tended to prefer the latter, even at the expense of the law and their clients. Over the past fifteen years, more than 80 percent of banks in Russia have exhausted their clients’ deposits and balances through losing money in risky trades, offshore transfers to the personal accounts of the banks’ top managers and shareholders, and investments in illiquid real estate. The death toll continues to grow—even the largest banks are failing to survive. Not a single death was prevented by regulators or forecast by the central bank.

An interesting comparison can be made with the institution of Eurobonds. They are issued by companies that file 20-page-long public reports once a quarter. No supervisory body oversees the issuers of Eurobonds or regulates their activities. The covenants are usually loose, and the bonds are audited only a few times a year, based on normal reporting. According to Moody’s, about 10 percent of the issuers—and only 2 percent of issuers who were assigned an investment-grade rating at the moment of issuing securities—default on their debt. The number of failed banks in Russia might have been one-eighth of what it is today if the central bank wasn’t overseeing the banking system at all.

But shouldn’t market mechanisms have regulated Russia’s banking sector? After all, so few issuers of Eurobonds default because investors and agencies monitor the market and business closely. An issuer that had previously frightened the market with its financial condition or business behavior would never attract new funds. A similar self-regulating mechanism could have worked among Russia’s banks had the central bank not interfered. Realizing that private clients’ funds are the key resource for the banking system, the central bank created a system of guaranteeing deposits, stripping the market of its crucial regulator: investment risk.

The Deposit Insurance Agency of Russia has put dishonest banks in a privileged position. Clients, with assurances from the government, began taking their funds to banks offering higher interest rates, regardless of their financial state. This has given birth to a new kind of “professional” activity: serial depositors. Thousands of middle-class citizens divide their savings between a rather large number of dying banks with higher interest rates. They enjoy the high rates until the very moment of bankruptcy, and then get their money back in full from the state. Needless to say, they do not wait for long before depositing the proceeds in accounts at other dying banks.

Such inflows provide the living, but slowly dying, banks with a few months of positive cash flow that can be moved out via fly-by-night companies or funneled offshore. Those few months also give the owners and top management an opportunity to relocate abroad, where their previously accumulated capital is located.

It’s hard to argue with the idea of protecting investors’ interests. But such protection should also be coupled with protections by the system against investor malpractice and conspiracy. To achieve these protections, the central bank could, for instance, guarantee no more than 80 percent of the deposit amount, instead of the current 100 percent. A 20 percent loss would not be too painful for mistaken depositors, but would discourage people from searching for dying banks with the highest interest rates.

Furthermore, the central bank found more benefits from this situation, particularly that it is possible to squeeze assets from dying banks for use by other dying banks. The central bank started the process of “sanitation” for smaller banks on the edge of bankruptcy—they were reorganized with larger banks that also have problems. The central bank provided the larger banks with capital injections, formally dedicated to rescuing the smaller banks but usually with excess capital that could extend the life span of the large banks.

The first deal of this kind was the merger of VTB with Bank of Moscow, in which VTB received financial help from the central bank that allegedly exceeded Bank of Moscow’s deficit by a few billion dollars. Dozens of similar deals followed, and they have only prolonged the troubles of the rescued banks and increased the gaps in their books. As was recently revealed, the saviors like “Otkritie” not only received lavish help from the central bank in rescue deals but also sucked up the remains of the balances of other banks given to them, possibly for the personal benefit of owners and managers.

The number of Russian banks continues to decline, while the quality of banks’ balances increasingly worsens, including those of the state-owned giants. Banks do not perform their main function of being efficient intermediaries in capital markets. On the contrary, in recent years, the primary legal activity of banks has been rerouting customer deposits to investments in Russian corporate and sovereign bonds. In other words, banks have become a redundant intermediary in the investment market. And since the inflow of banks’ money inflates prices on the market, banks repo the bonds from the central bank multiple times, using significant financial leverage to achieve meaningful returns. The central bank, motivated by what can only be explained by the desire to save dying banks even at the expense of the economy, provides them with this leverage.

This in turn pumps prices up even more and makes markets unappealing for third-party investors, even amid low global interest rates. The Russian government is not afraid of mass default either. After all, the entire banking system’s official capital is less than 9 trillion rubles, small enough to be fully replaced by state funds without impacting financial stability. As in many other aspects of Russia, in the banking sector, the state turns a blind eye to a system that does not function the way it is supposed to, and is content with the fact that its appearance roughly conforms to standards.

The problems of the Russian banking system seem so serious and intrinsic that perhaps the best solution is to kill all private banks except for a handful of the truly healthy and substantially large banks. The remaining banks would then be allowed to conduct voluntary cleanups by removing all fictitious assets and adjusting inflated asset valuations, without the risk of losing their licenses. These banks would increase their capitalization at the expense of the government and investors, and drastically reduce the burden of regulation.

At the same time, banking operations should be made much more transparent. The banking system needs to recreate a system of professional supervision, one that is independent from the central bank, which would be able to uncover fraud at an early stage. The supervisory system would also introduce a system of risk differentiation, for example, by prohibiting retail banks from investing in non-liquid assets, and would also move banks out of the liquid securities market and save it for investors, among other measures.

Perhaps we also need to encourage the market to distinguish between lending and transactional businesses by developing non-banking credit institutions and forming a marketplace for a loan market. These measures will significantly reduce the risk of transactional operations, although they may increase the cost for clients.

And, of course, we need to return the element of risk to the market. Deposit insurance must be funded by depositors themselves, for instance through instituting an insurance fee on deposits and expanding it to all types of bank accounts opened by nonfinancial organizations. Most importantly, deposit insurance should not cover 100 percent of the balance, regardless of the size.

Finally, we will need to de-monopolize and privatize the state banking sector, dividing state-run banking giants into parts and selling them in the market. In the future, we must prevent a single entity—primarily the state—from owning more than 10 percent of the balance of the country’s banking system.

A healthy banking system could become one of the main drivers of economic growth. But without these measures, Russia’s banking system will remain a bankrupt structure that merely facilitates the circulation of money while being a constant source of scandals and a place for the easy enrichment of unscrupulous businesspeople and officials, all at the expense of taxpayers.

A longer version of this article was originally published in Russian at RBC.