Speech by Bank of Russia Governor Elvira Nabiullina at the 23rd International Banking Congress (St. Petersburg, 1 July 2014)

I’m glad to welcome the congress participants. I hope that the two-day discussions will be vigorous and useful and the congress will be able to discuss new and perhaps unconventional approaches to the solution of problems because the situation is also not quite standard.

I would like to explain the rationale of the Bank of Russia’s actions on a number of issues and tell about measures, which we are going to take in the near future.

What are the key objectives of the Bank of Russia? Price stability is the first objective. We have set a specific parameter for achieving this objective gradual inflation reduction to 4% in the next three years and keeping it at this level during the period of time sufficient for our economy’s restructuring and the adaptation of the ratio of prices in the economy. The objective of inflation reduction is being resolved simultaneously with a transition to the inflation targeting regime. This regime is better, so to speak, than simply an inflation reduction policy because it creates greater predictability and makes economic agents more confident in price stability.

Our second objective is to strengthen the banking sector and make it financially healthy by improving the system of regulation based on both the implementation of international standards and national regulatory requirements, and also through consistent and timely supervisory response measures. The third objective is to prevent the emergence and accumulation of systemic risks in the financial sphere, as well as overheating and bubbles in specific market segments (for example, consumer lending). The top priority objectives also include measures to develop the payment system and financial markets and ensure the Bank of Russia’s evolvement into a full-fledged mega-regulator.

Achieving of these objectives of strategic importance for us prompted the need for specific tactics in their implementation in the wake of specific developments at the start of the year. So, what are the specifics of the current situation? The first half of the year registered several intertwined trends, which had different nature but made a large cumulative impact on the Bank of Russia’s policy, first of all, its monetary policy. To speak concisely, these factors included the slowing of economic growth, global investors’ jittery sentiments in anticipation of monetary policy normalisation in advanced economies and the exacerbation of the geopolitical situation. So, the slower economic growth is the first trend (we expect economic growth at 0.4% this year). The Bank of Russia believes that the slowdown is attributed to internal rather than external and market factors as slower investment growth (investments have been in the negative field since the second quarter of 2013) and the low quality of management result in stagnating labour productivity. Meanwhile, the long-term demographic trend (working age population has been contracting by about 500,000 people a year since 2006) makes virtually impossible a recovery in high growth rates based on the employment of additional workforce. Higher labour productivity is the sole method to raise growth rates sustainably, while investments and the improved management quality are a critical factor of growth.

What does this mean for the Bank of Russia? First of all, this means that the methods of monetary pumping, monetary stimulation of demand without adequate supply or structural and institutional measures leaded to an increase in private investors’ motivation to invest money in production and make efficient investments may only lead to the emergence of considerable inflation risks and the higher probability of the worst-case scenario, namely production stagnation amid high inflation. Another consequence for monetary policy, which stems from this understanding of the slower economic growth, is the awareness of the need of solving the problem of long money in the economy and the financial sector’s readiness to provide long-term financing when there is demand for investment loans.

At this point, I would like to make a departure in my speech. We believe that demand — the effective demand — for investment loans in the country is low. There are wishes — wishes and desires, as the phrase goes, but the demand based on financially viable investment projects is still low and the financial insolvency of most projects surely does not stem only from high interest rates. Incidentally, the real interest rate in Russia had been among the lowest for many years as compared with other emerging market countries. Nevertheless, we expect the demand for investment loans to grow as structural reforms are implemented and banks should be ready for this and should resolve the problem of the so-called bank scissors when the maturities for liabilities become shorter, while the maturities for assets increase.

Let me proceed further. The second factor. Global investors’ expectations of a tapering of quantitative easing programmes and normalisation of monetary policies in advanced economies exerted and continue to exert influence on the Bank of Russia’s policy, along with the internal factor of the slower economic growth. These expectations appear in fears and complacency, which change each other amid statements made by leading central banks. International capital flows, which have actually lost touch with fundamental factors of the state of the economy in a particular country, have become more volatile than usual and, apparently, this volatility will grow. Incidentally, low volatility observed in financial markets lately justifiably gives cause for concern to many analysts precisely because it may increase sharply, which may turn out to be a lull before the storm. This autumn will mark six years since the countries issuing reserve currencies launched unconventional, accommodative monetary policies. At present, these policies are still continued, although the USA and the UK have already started to speak about their possible tapering in the coming years. Meanwhile, these policies in Europe and Japan are only expanding. As a whole, six years are quite a big term to assess at least interim effects.

Accommodative monetary policies have undoubtedly helped keep economies afloat but they have also given governments a respite and a possibility not to hurry with complex structural reforms. This approach has resulted in the accumulation of debts, including emerging market corporate liabilities, larger than before the crisis. Bubbles are forming in financial markets; moreover, they are frequently emerging in the segments where they provoked the crisis in 2007. Apart from this, emerging market countries are experiencing certain financial destabilisation due to highly volatile capital flows. In our view, this situation discouraged a growth of investments in the real sector and structural changes in the economies. Therefore, accommodative monetary policies, which are not accompanied by structural reforms, only reproduce conditions and risks typical of previous crises and do not lead to the formation of a new economic model. This is an important lesson for our country. We cannot help taking this experience into account when we develop the Bank of Russia’s strategy and work out a balance between inflation reduction, financial stability and economic growth. There are also examples from our history, from the mid-2000s when a massive inflow of cheap capital not only and not so much led to the growth of investments in the creation and modernisation of production capacities but was seen to intensify the process of mergers and acquisitions. As a result, companies sharply increased their debt burden, frequently without any considerable improvement in their competitiveness. And this debt factor continues to be felt today. The excessive loan burden of some of our companies amid their low competitiveness is largely the result of the factor of cheap money without required structural reforms.

It is necessary to take into account such a specific feature of our country as high or unanchored inflation expectations, to speak professionally, due to which any incautious monetary policy action may unwind an inflation and depreciation spiral. Returning to the issue of volatile international capital flows, I would like to note that in our view these fluctuations do not pose a systemic threat for Russia where capital inflows in the previous periods were not very large. We are more concerned over the fact that growth in the countries that are Russia’s main trading partners remains weak, despite accommodative monetary policies. Specifically, growth in the European Union is predicted at 1.2% in 2014 and 1.5% next year. The expected slowdown in the growth of the Chinese economy, which is estimated at 7.5% this year and 7.3% next year, is also a cause for concern. The fragile growth in the euro area, along with the undiversified structure of Russian exports, suggests that while the current account remains positive, its surplus already contracted by about a half last year and will apparently continue to fall. This means that long-term stabilisation and a stable foreign exchange rate can be achieved only in case of a decrease in capital outflow. At the same time, capital outflow is largely of autonomous nature and primarily stems from investors’ search for a more favourable business environment rather than from adjustment of balance of payments accounts as a whole amid the refusal to conduct regular foreign exchange interventions as in many countries with a floating exchange rate. The Bank of Russia estimates that overall capital outflow will remain high this year, even after the effect of temporary factors is exhausted, which caused the conversion of savings into foreign exchange in the first quarter for a considerable part of capital outflow (up to two-thirds of the total amount).

The geopolitical situation, which caused a strong pressure on the ruble and a surge in inflation and devaluation expectations, is the third factor that influenced the Bank of Russia’s policy. As a result, the issues of maintaining financial stability came to the fore for the Bank of Russia. We took a decision to adapt our tactics to the conditions of increased uncertainty and foreign exchange market threats to financial stability, without giving up our strategy of switching to inflation targeting. The Bank of Russia implemented measures in three areas. We tightened foreign exchange policy by increasing almost fivefold the cumulative volume of interventions that triggers a shift in the boundaries of the exchange rate band. This was done to prevent destabilisation in the foreign exchange market and a mass conversion of household and corporate savings into foreign currency, including foreign currency cash. The regulator also raised interest rates by a total of 2 percentage points to prevent an unwinding of the inflation spiral.

Finally, we increased the volume of gross credit by about 1 trillion rubles compared with the forecasts made last autumn in order to prevent a liquidity crisis and ensure control over market interest rates. Work is also constantly under way to extend the list of eligible collateral. Considering that banks have encountered problems with the maturity mismatch of their assets and liabilities, we have extended the terms of providing liquidity against non-marketable assets through standing facilities and are going to hold a repeat twelve-month liquidity provision auction late in July.

The situation has largely stabilised by now. There are currently no significant threats to financial stability. The ruble exchange rate has strengthened and currently stays in the area where the Bank of Russia does not conduct foreign exchange interventions. The ruble is currently a leader in terms of its appreciation among emerging market currencies. Investors’ interest in Russian assets has increased. Share prices have grown, paring previous losses and returning to the January levels. Bond markets are gradually recovering both inside the country and abroad.

The cause for our concern is that annual inflation continues to grow (the latest figure is 7.66%), while weekly inflation demonstrates the signs of stabilisation and reduction. In this situation, the most important task is to ensure macroeconomic financial stability and simultaneously implement those structural reforms that have long been known. Instead of this, we currently see stronger calls for monetary policy easing. Moreover, proposals have been made both expressly and implicitly to actually start budget financing through money issuance or monetary financing of enterprises’ debts. I consider these proposals as unacceptable. They may push our county far back to the period of the early 1990s. Let me repeat once again that the Bank of Russia deems it necessary to stabilise medium-term inflation at around 4%, develop long-term financing institutions on this basis, ensure control over financial stability and raise the resilience of the banking sector and the financial system as a whole to fulfil its role in creating conditions for economic growth and higher living standards.

Now I would like to proceed to the next issue, which concerns us very much, namely, the policy of improving the banking sector. I have to say that this policy is linked with uneasy and sometimes quite painful decisions that are taken. In this respect, various questions are asked: Why are there so many licence revocations instead of financial rehabilitation procedures? Why are the consequences of the funds’ flow into large credit institutions from small regional banks and, generally, the risks of the lower confidence of citizens and businesses in the banking system are not taken into account? How can early response measures be implemented to prevent a lethal outcome at certain banks?

These questions are appropriate but before answering them, I would like to note that this work is inevitable and necessary. The accumulation of risks and failure to clear backlogs in this sphere are fraught with the banking sector’s inability in the future to demonstrate resilience to external shocks and ensure continuous financing of the economy’s needs and proper protection of the rights of banks’ creditors and depositors.

This work cannot be judged only by the number of revoked licences, which is its most noticeable and sensitive manifestation.

In our estimate, the banking sector’s health improves when expressly weak or criminal players quit it, when banks employ more effective risk management practices, evaluate assets more adequately and refrain from fictitious capital build-up. This adequate response is demonstrated by a majority of banks, which can be evidenced by both the reduction of dubious operations through banking channels and the growth of provisions for household loans by more than 20% in the first five months of the year. Stress tests also show the banking system’s stability as a whole despite increased uncertainty and risks. The banking system’s health can also be evidenced by its readiness to implement Basel international standards.

The Bank of Russia revoked licences from 33 credit institutions in 2013 and from another 38 banks in the first six months of this year.

Which banks have their licences revoked? These are exclusively banks engaged in servicing the shadow or criminal economy and banks experiencing serious financial problems, which their owners and managers cannot and do not want to resolve.

Now let me speak about financial rehabilitation and licence revocation. Before deciding on the recall of a licence, the Bank of Russia considers financial rehabilitation as an alternative.

The Bank of Russia takes a decision on financial recovery when three conditions are met.

First of all, a bank is systemically important and the consequences of the termination of its operations go beyond the scope of problems encountered by the bank and its customers, i.e. the cessation of its activities may create problems for the national banking system or banks in a particular region. This does not mean that systemically important banks are given indulgences. On the contrary, we must be sure that these banks conduct the most prudent policies and do not put their depositors’ and customers’ money at risk. For this purpose, the Bank of Russia’s head office established a special division last year for supervision over systemically important banks. We’ll also use enhanced regulatory requirements for these banks. These requirements are currently under discussion.

The second condition for financial rehabilitation is whether financial recovery is economically substantiated, i.e. whether the volume of funds channelled for this purpose is comparable with payments by the Deposit Insurance Agency to insured depositors. All else equal, we undoubtedly try to rescue a bank. Incidentally, a decision on financial rehabilitation in the absence of any economic substantiation may improperly motivate bank owners and managers: they may think that they can manage ineffectively and withdraw assets because the government will all the same come to their rescue and write off their debts and they will be clear before their creditors and none will demand a return of funds from them. These practices may ruin market discipline, deteriorate risk management standards and develop unfair competition in the market of banking services.

And the third condition requires that the business model of a bank must not be criminal and the bank must not be deeply involved in servicing the shadow economy.

When all these three conditions are met, we always take a decision on financial rehabilitation.

Let me proceed further. How significant are the trends of the customers’ re-distribution in favour of the largest banks and does the level of confidence in the banking sector suffer from licence revocations? There is a flow of customers, including depositors, into the largest banks but it is not as large as it sometimes seems and, which is more important, this is an absolutely reversible trend, in our view. We are concerned over this flow because in our view there is no direct cause-and-effect relationship between the financial health and the size of a bank. Many regional banks are reliable, manage their customers’ funds properly and play an indispensable role in creating a competitive environment with the real right of choice for citizens and businesses. They frequently service more promptly and flexibly and better know small and medium-sized businesses in regions. And, of course, we are very much interested in their development and fair competition. We expect a reverse flow as the banking sector improves and customers and funds return to healthy small and medium-sized banks.

As for confidence in the banking sector, the work we are carrying out is designed to raise this confidence substantially. Confidence based on deceit and faith based on ignorance, as it sometimes happens, result in big losses in the future. We need to terminate the practice when unscrupulous owners use unreliable reporting data and fake documents to withdraw quality assets from banks they control into companies also under their control. Frequently these offences relate to criminal law rather than to banking supervision. Nevertheless, the Bank of Russia sees its task in raising the extent of its preventive actions.

We face a number of acute issues, including the issue of enhancing the responsibility of bank owners and managers for banks’ stability and the need for the Bank of Russia to explain its banking supervision policy more actively. We believe that partially the answers to these questions have been found and partially they still have to be found. We’ll work on this issue. But the main answer is that the ongoing work to improve the banking sector actually has no alternative. At the same time, our task is to ensure its more qualitative implementation for the purpose of raising the banking sector sustainability and reliably protecting the interests of creditors and customers.

Overall, the work on regulation and supervision will proceed further and there is much that has to be done. I would like to enumerate the Bank of Russia’s main priorities in this sphere in the immediate future.

The first priority is to prevent large-scale falsification and unreliable financial reporting by some banks. We hope for the quickest adoption of the law on criminal liability for the provision of unreliable data and will also develop interaction with law-enforcement agencies in exposing the signs of offences in the banking sphere.

The second task is to limit risks arising from the banks’ practice of loan provision to their owners and related parties, which is still widely spread. We intend to adopt a regulation defining borrowers’ relatedness (with a credit institution, its shareholders and between themselves) with the help of an informed judgment and introduce a new standard limiting the risk on borrowers related to a credit institution and its shareholders to 20% of bank capital.

The third area is to continue the struggle against the withdrawal of funds from the banking system through shell firms and require banks to check borrowers with the signs of fictitious activity and create provisions across all loan portfolios (this requirement applies so far to loans issued after 1 January 2014).

The fourth task is to create conditions for fair competition in lending. We hope that legislators will pass a decision on credit institutions’ differentiated payments to the deposit insurance system, depending on the level of credit institutions’ risks.

The fifth area is to raise banks’ resilience to liquidity shocks and implement Basel short-term liquidity requirements (they will apply only to the largest banks and will be accompanied by contractual committed liquidity lines).

The sixth area is to introduce consolidated supervision and apply disciplinary measures for non-compliance with prudential requirements (standards) on a consolidated basis, and also spread risk-based approaches in supervision.

The seventh area is to protect borrowers’ rights and fight against usurious interest rates through the implementation of legislatively-established limits on the full cost of consumer loans.

The eighth area is to improve bank risk management, including the permission to use advanced approaches to credit risk assessment (the Basel II IRB-approach) from 2015, and also to enforce requirements for banks’ internal procedures of capital adequacy assessment.

The ninth task is to introduce additional supervisory and regulatory requirements for systemically important banks so that there is no impression that systemically important institutions are better protected.

It is impossible to enumerate all specific measures. Let me add that proceeding from our latest experience we are also going to implement methods of banks’ express assessments to help reveal hidden deposits (this is the problem we have encountered lately) and use the practice of professional valuations of banks’ non-financial assets and property more widely.

In general, we count on switching to preventive measures in our supervisory practice but the supervision experience is convincing us that not only prevention but also therapy do not always help in the treatment of banks and sometimes a surgical intervention is required to arrest the growth of the disease.

I dwelt on these two issues in my speech (the development of monetary policy, as well as banking regulation and banking supervision) probably because they have been the focus of most discussions and have drawn larger public attention. Nevertheless, I would like to say that the banking sector is generally developing sustainably and this can be evidenced by figures that demonstrate a growth in assets and an increase in lending to non-financial organisations. Capital levels are absolutely adequate. Banks are really beginning to implement policies of more adequate risk assessment, which is very important in current conditions in our view, and are generally resilient to stresses. A key task for us is to focus banks’ activity on financing the current needs of the economy connected with the increased share of investment lending, but for this purpose we need to create corresponding macroeconomic conditions.

I hope that the forum participants will be able to discuss various issues in the next two days that relate to the development of the banking system. I believe it is very important during these discussions to understand the direction, in which the banking business is developing, and which new banking business models will develop globally and in Russia. We see the introduction of new technologies and the development of our payment system, which holds key importance, and the recent developments convinced us of this. I hope that we’ll be able to exchange opinions in an open format and discuss all these issues. This discussion will also help formulate proposals that will increase the efficiency of the Bank of Russia’s work as a regulator and, as a result, our banking sector will become more stable and develop more dynamically.

Thank you very much for your attention. I wish the congress a success in its work!

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