Russia’s banking sector made more profits in the first half of this year than at any time since sanctions were first imposed in 2014, according to the latest data from the Central Bank of Russia (CBR).

The financial sector reported robust performance in June, with a net profit of RUB314bn ($3.4bn) (chart), reflecting an annual return on capital of 29.8%, the central bank said in its monthly update. This result marks a 15% increase compared to May's profit of RUB273bn.

Following the invasion of Ukraine last year, the CBR stopped providing detailed information on the banking sector, but in the last few months it has started to report some more but not all of the information it used to publish before the war. The profits of the banking sector is one of the data points that have reappeared.

The banking sector’s monthly profits this year have already outperformed every month in the previous five years and have led to a cumulative profit of RUB1.7 trillion ($18.4bn) (chart). Despite the rosy headline result the banking sector has been hurt by the sanctions and the radical changes in the nature of Russia’s war economy.

“Approximately half of the June profit was attributed to gains from currency revaluation, amounting to RUB153bn. The weakening of the ruble by 7% in June contributed to these gains. Additionally, profits were bolstered by income from securities (around RUB30bn) and dividends from subsidiary companies (approximately RUB33bn). However, the core profit, excluding these factors, declined to RUB125bn from RUB250bn in May,” the CBR said in its report.

The decline in core profit can be attributed to the anticipated increase in provisions for corporate loans and other assets, which rose to RUB204bn (up RUB108bn compared to May).

“The cost of risk for corporate loans in June (~1.1%) is in line with historical averages (1–1.5%) and in line with our forecast estimates,” the CBR said.

Nevertheless, banks are profiting from the recovery of the Russian economy, which has received a large Keynesian boost from the government’s massive military spending, which will reverse the shocks the economy received from the imposition of extreme sanctions last year to the point where CBR Governor Elvia Nabiullina has warned the economy is in danger of overheating this year.

“The Russian economy is set to completely reverse last year’s slump. Manufacturing and construction lead the way, alongside retail. In a broad sense, all three sectors are beneficiaries of the war. The defence sector, working in three shifts, is boosting production: in June, for example, the biggest increases were in finished metal products (+45.8% year on year); computers, electronics and optics (+71.6% y/y), radar equipment (+75.4% y/y) and electrical equipment (+32.1% y/y). Production capacities are running at their maximum,” economic analyst Alexandra Prokopenko said in a note in The Bell last week.

The number of profitable banks increased to 245 in June, accounting for 75% of the total number of banks. This figure is higher than the 237 profitable banks (73%) reported in May. Over the first half of 2023, a total of 271 banks (83% of the sector) achieved profitability, representing 99% of the sector's assets.

The financial sector's performance in June indicates resilience and adaptability amidst market fluctuations and economic challenges. The gains from currency revaluation showcase the sector's ability to navigate currency volatility following the inclusion of Russian banks in the SWIFT sanctions that were imposed only days after Russia’s invasion of Ukraine in February and take advantage of favourable exchange rate movements.

Income from securities and dividends from subsidiaries demonstrate the sector's ability to capitalise on investment opportunities and generate additional revenue streams, the CBR said. However, the decline in core profit highlights the importance of prudent risk management and provisions to address potential credit risks.

“The increase in profitable banks signifies overall sector strength and the ability of financial institutions to generate profits in a challenging economic environment. As the sector continues to recover from the impact of previous uncertainties, banks have focused on maintaining sound asset quality and capital adequacy,” the CBR added.

Corporate loans driven by military investments

Russia’s economy has become a lot more state orientated as state spending and investment into the military industrial sector has soared, changing the nature of the banking business. However, rising nominal and real incomes that are a spillover from the cash pouring into the system and the extremely tight labour marketing conscription and military recruitment has caused that is feeding through into normal consumer-orientated business.

Corporate lending in Russia showed a growth of 1.3% in the latest reporting period, amounting to RUB803bn, which is an increase of 0.8% compared to the previous month. This growth rate surpasses the average monthly pace seen in 2021, which stood at 0.9%. (chart)

“The increase in corporate loans was primarily driven by lending in Russian, with loans in this currency growing by RUB960bn, a rise of 1.8%. Industries that received the majority of these loans include mining and metallurgy, chemical, transportation, telecommunications, financial, commercial real estate, and housing construction sectors,” the CBR reported.

One of the big drivers of non-military banking business is mortgage lending, which the government continues to subsidise, holding mortgage loans at 8% as a way of supporting economic activity; construction is one of the three big drivers of economic growth and cheap mortgages are fuelling a host of economic activities related to construction.

Within the housing construction sector, loans issued for project financing experienced a growth of around RUB120bn, the CBR reports. Although this is slightly lower than the increase observed in May, which was approximately RUB150bn, it still demonstrates positive growth in the industry.

Another contributing factor to the growth of ruble-denominated loans was the ongoing conversion of loans from currencies of unfriendly countries into rubles. This conversion, estimated to be around $1bn, led to a moderate contraction in the foreign currency portfolio, which decreased by RUB157bn in equivalent, representing a decline of 1.5%.

Despite the growth in lending, the indicators of the credit quality of corporate loans have remained at a satisfactory level, indicating a positive overall performance.

 

Consumer loans up as incomes rise

Consumer lending in June saw a growth rate of 1.6%, continuing the high level of consumer activity seen in the previous month, which recorded a growth rate of 1.7%.

Nominal wages have been rising strongly in the last year as companies are forced to pay more to hire increasingly hard to find men for work places. At the same time, the dramatic fall in inflation rates, which dropped to slightly more than 2% in the spring, has meant that real incomes have also risen strongly this year, although inflation is now climbing again and will undo some of these gains in the second half of this year. As a result, demand for consumption has returned and Russians are starting to buy the bigger ticket items they put off earlier on the back of war uncertainty.

The ever vigilant CBR has always watched for emerging consumer credit bubbles and has already acted to cool the consumer loans lending by increasingly prudential norms earlier this year.

“It is anticipated that the tightening of macroprudential limits from July 1, 2023 will have a cooling effect on the market. These measures are also expected to contribute to achieving a more balanced credit structure and reducing the level of over-indebtedness among the population,” the CBR said.

As of the third quarter of 2023, macroprudential limits (MPL) are being reduced by 5 percentage points compared to the second quarter of 2023. This means that the proportion of loans issued to borrowers with a debt-to-income ratio (DTI) greater than 80% should not exceed 20% of total lending. Additionally, loans with a maturity of more than five years should not exceed 5% of total lending, the CBR said.

The percentages of problem loans and overdue debt in the consumer sector slightly decreased in June. This trend indicates a positive development in the credit quality of consumer loans, the regulator added.

Mortgage lending flourishing

Nabiullina was not happy about Russian President Vladimir Putin’s decision to continue to subsidise mortgages, afraid of this fuelling a bubble, but was overruled by her boss, who is keen to boost the economy in the face of sanctions.

Mortgage lending in June saw another notable acceleration, reaching 2.5% compared with 2.2% in May. This represents the highest increase since December 2022, which recorded a growth rate of 3.3%, the CBR reports. (chart)

The main driver of this surge was the market-driven mortgage, with lending growing by 11% to RUB307bn ($3.3bn), up from RUB277bn in May. Additionally, mortgages with government support also saw moderate growth of 6% to RUB321bn, compared to RUB307bn in the previous month.

This growth can be attributed to both the "Family Mortgage" (~RUB150bn compared with RUB142bn in May) and the "Privileged Mortgage" (RUB136bn compared with RUB126bn).

“There has been a shift in demand towards the secondary real estate market, likely due to the outpacing price increases in the primary market. The allure of purchasing a property with ready-made renovations and furnishings is making the secondary market more attractive to buyers. Furthermore, the tightening of certain approaches in macroprudential regulation from June 1, 2023 may have influenced the primary market. Notably, the new requirement for an initial payment of at least 20% (30% from January 1, 2024) to qualify for preferential loans with government support could be a contributing factor,” the CBR said.

NPLs low

NPLs low

Balance sheet data shows only a slight increase in overdue non-performing loans (NPLs) for retail lending in June (+0.1%, or +RUB1.7bn) and a decrease in corporate lending (-1.2%, or -RUB37bn). In the corporate portfolio, it went down to 6.2% from 6.3%; in unsecured consumer loans, it decreased to 8.6% from 8.7%, and in mortgages, NPLs remained at 0.6%.

The volume of loan restructuring in May nearly halved compared to April, dropping to RUB233bn (less than 1% of the loan portfolio) from RUB410bn. This is even below the average monthly level in 2021 (RUB320bn). In the medium term, the risks associated with these restructured loans are moderate, with about half of the restructuring attributed to major housing developers, mainly due to an increase in the classification of construction projects. Other restructuring occurred in the oil and gas and fuel and energy companies.

As of the beginning of June, problem corporate loans were covered by individual reserves at 76% and general reserves at 115% (against 75% and 114% respectively at the beginning of May). For retail loans, the coverage was at 91% and 130% respectively (compared with 91% and 128% at the beginning of May). These figures indicate that banks have set aside sufficient reserves to manage potential risks associated with problem loans.

 

Corporate deposits down…

Corporate funds experienced a reduction in June, amounting to RUB473bn, a fall of 1.0% y/y. The decline was primarily driven by the decrease in foreign currency holdings, with a reduction of $3.6bn (equivalent to RUB289bn in terms, -3.1%). Funds denominated in rubles also saw a decrease, though to a lesser extent, amounting to RUB185bn (-0.5%).(chart)

“Among the main reasons for the outflow of funds, two stand out: the decrease in oil and gas revenues and tax payments. The impact of these factors contributed significantly to the reduction in corporate funds during the specified period,” the CBR said. “The decline in foreign currency holdings reflects the fluctuations in exchange rates and may be influenced by various external economic factors. Companies that rely heavily on exports or conduct significant international transactions are particularly vulnerable to currency fluctuations. As the global economic landscape shifts, businesses may adjust their foreign currency positions to mitigate risks and adapt to changing market conditions.”

Simultaneously, the decrease in funds denominated in rubles could be attributed to multiple factors, the CBR said. For instance, changes in business operations, shifts in investment strategies, and adjustments in working capital requirements might contribute to fluctuations in ruble-denominated funds.

 

… retail deposits up on rising incomes

In June, household funds experienced significant growth, rising by RUB816bn (+2.1%, against +1.2% in May) due to continued substantial budgetary payouts and rising nominal incomes, the regulator said.

The main driver of this increase was the growth in placements on current accounts, which saw a rise of RUB820bn (+6.2%). Additionally, ruble-denominated time deposits saw a slight increase of RUB87bn (+0.4%), reflecting the attractiveness of deposit rates (7.83% in the third week of June compared with 7.75% in the third week of May).

The balances in foreign currency decreased by $1.1bn (-RUB91bn in equivalent, -2.4%). This decline can be attributed to the ongoing conversion of foreign currency funds into rubles, overseas transfers and withdrawals of cash during the vacation season.

The growth of funds in escrow accounts that are used to pre-pay for property that is still being built experienced a slight slowdown compared to May (+RUB99bn, or +2.3%, compared with +3.8% in May). This was due to the increase in the volume of disclosed accounts (preliminarily reaching RUB254bn in June after RUB173bn in May) caused by the seasonal increase in the completion of construction projects.

“The rise in household funds is closely linked to the government's financial initiatives, including budgetary payouts. These measures have contributed to increased liquidity in the economy and provided support to households during challenging economic conditions,” the CBR said. “The preference for current accounts and time deposits can be attributed to the stable and competitive interest rates offered by banks. The attractiveness of these accounts may encourage individuals to maintain and grow their savings, which is essential for financial stability and planning for future expenses.”

The slower growth in escrow accounts is a natural consequence of the completion of construction projects. As more properties are finished and ready for occupancy, the need for escrow accounts to hold funds during the construction phase diminishes.

More state money in the banking sector

State spending is up by more than a quarter from the pre-war norms and that money is passing through the banking sector, giving it a boost. In June, government funds saw a significant increase, rising by RUB1.1 trillion (+11.7%), primarily driven by funds from the Federal Treasury (RUB1.4 trillion, approximately 50% through repurchase agreements).

The inflow of government funds was largely supported by tax revenues for the month of June, along with income generated from investing funds from the National Wealth Fund (estimated at around RUB0.3 trillion). These combined sources contributed to the substantial growth in government funds.

The liquid part of NWF currently holds about RUB6.8 trillion and will be used in part to fund the 2.5% of GDP budget deficit expected this year, or a bit more than RUB3 trillion. The Ministry of Finance (MinFin) says that NWF funds could fall to RUB2.5 trillion over the next two years, although it is likely that the ministry will find other ways to fund the shortfall if it can. For example, it is currently looking for ways to cut expenditures by 10% across the board for all non-priority payments.

Furthermore, the Federal Treasury enhanced its cash management flexibility by implementing a replenishable bank deposit agreement on the unified treasury account. This strategic move reduced the risk of cash shortfalls and allowed for greater allocation of funds in banks.

The use of repurchase agreements (repos) has proved to be an effective tool for managing government funds and providing liquidity in the financial system. Repos allow the government to temporarily sell securities and agree to repurchase them at a later date, which helps maintain cash flow and support market stability.

 

Capital and liquidity strong

The financial sector's balance sheet capital experienced a notable increase in June, reaching RUB12.8 trillion ($139bn), with a substantial contribution from the sector's profit amounting to RUB314bn. Additionally, some banks underwent decapitalisation, resulting in an injection of approximately RUB100bn into their capital reserves, predominantly through additional share issuance.

As of May 2023, the Common Equity Tier 1 (CET1) capital adequacy ratio (CAR) – the amount of cash banks hold to meet withdrawal demands – is expected to have decreased by 0.4 percentage points, reaching 12.21% – a relatively low level for an emerging market where banks typically like to hold 20% as CAR to insure against shocks, but still comfortably ahead of the mandatory 10% minimum.

“The decline in CET1 capital was primarily driven by a reduction in capital reserves (-2.9%), mainly attributable to a major bank's payment of record dividends amounting to 565bn for the year 2022 (N),” the CBR said.

The decrease in CET1 capital adequacy ratio in May, driven by dividend payments, underscores the importance of striking a balance between rewarding shareholders and maintaining adequate capital levels to safeguard against potential downturns.

Liquidity also remains good and improved modestly in June. The reserve of liquidity, which includes cash, claims on the Bank of Russia, and unencumbered marketable assets, saw a slight increase of RUB42bn (+0.2%).

“The overall volume of liquid assets amounted to approximately RUB17.4 trillion ($189bn). This level is considered adequate, providing coverage for 22% of customer funds in or 49% of funds held by individuals. An additional RUB9.4 trillion (12% of customer funds) can be raised by banks through collateralising non-marketable assets with the Bank of Russia. Thus available sources of liquidity cover around 35% of customer funds in rubles.”

The distribution of liquidity reserves across sectors is uneven, but the money market helps mitigate some of these risks. For instance, interbank lending has increased by RUB1.2 trillion (+10.3%) since the beginning of the year, providing banks with additional funding options, the CBR reports.

The reserve of foreign currency liquidity, which amounts to $52bn, is also at an adequate level, according to the CBR. It covers around 54% of customer funds and 29% of foreign currency obligations, maintaining a level similar to that of May.

This pool of banking liquidity of some RUB25 trillion is a cushion for the government should it start to run out of funds to finance the budget deficit. According to the budget plan, this year’s deficit was supposed to be held to 2% of GDP, or RUB2.9 trillion, but sanctions on the oil market and the high levels of military spending, plus the deep fall in revenues in December at the end of 2022 and in January this year, as many payments were frontloaded to ease the pressure later, means that Ministry of Finance has already increased its estimate to 2.5%.

Nevertheless, this sum can already be easily covered by the NWF. However, in some extreme scenarios suggested by some analysts the deficit could soar to as much as RUB12 trillion. The Finance Ministry has lots of options to raise more money in this case, including tapping the banking sector’s liquidity that acts as a backstop and means that the government can comfortably fund the budget for several more years in almost any scenario.

 

Bank’s holding of treasury bills

The Russian Finance Ministry’s OFZ treasury bills are the main instrument that the Ministry of Finance uses to tap banking liquidity and it is already making active use of it.

The portfolio of debt securities increased by RUB122bn (+0.6%) in June, mainly due to banks' purchase of new issues of OFZ totalling RUB135bn. These bonds, particularly the ones with variable coupon income (OFZ-PK), are favoured by banks as they reduce interest rate risks and are inflation-proof.

The emission activity of the Russian Ministry of Finance in June was comparable to that of May, with around RUB300bn worth of OFZ issued, the CBR reports. Apart from banks, there was also demand from Non-State Pension Funds (NPFs), which acquired about one-third of the total issuance volume for their clients.

“Companies continue to replace Eurobonds with local debt denominated in dollars and other "toxic" currencies but with the possibility of repayment in rubles. It is estimated that around RUB40bn worth of such bonds were placed in equivalent in June. Since February 2022, companies have issued replacement bonds totalling around RUB1.3 trillion in ruble equivalent,” the CBR said.

This trend of replacing foreign-denominated debt with ruble-denominated ones is part of a broader effort to reduce exposure to currency risks and align with the current economic conditions. It also allows companies to benefit from the relatively lower borrowing costs in the domestic market.

“The increased activity in the debt securities market indicates the ongoing confidence in the stability of the Russian economy and the attractiveness of Russian debt instruments to both domestic and international investors. The demand for OFZ from banks, NPFs and companies signals the continued appetite for Russian debt, which is seen as a relatively safe and reliable investment option,” the CBR concluded.