A Year of Ominous Decline

In 2008, the Russian stock indices tumbled for six months in a row. For the first time, short selling was banned to prevent the share prices of domestic issuers from crashing even further. The state also intervened in trading in an effort to prop up the stock market by scooping up dramatically undervalued shares. The year also marked the break-up of UES, from which a great many subsidiaries had been spun off. In contrast to such regrettable events, noteworthy is a new historical high on the RTS, when it came close to 2,500 in May.

Russian banking shares have been the objects of suspicious attention throughout 2008. While in the first few months of the year banking shares were affected by the negative repercussions of foreign peers, they faced their own problems in the second half. However, the YTM performance (-82%) of the RTS Financials Index is nearly in line with the market as a whole.

Before the second half of 2008, the capital position of the Russian banking system seemed able to sidestep the crisis affecting financials across the globe. However, in September and October it became clear that the country's banks continue to face a lack of cash and a lack of counterparties with the confidence needed to endure the shock without state funding.

The help provided by the state contributed to the government's intensified control over the banking industry. Sberbank, VTB and Gazprombank providing the cash to other banking system participants have essentially tied the system more closely to the state. The takeovers of troubled private banks by VEB, Gazpromenergobank, RZD and Alrosa were another way to place the industry under state control.

In the near future, banking activity could face restrictions, since authorities expect banks that have received help from the state to act as agents of state economic policy. Therefore, Russian banks could be more focused on implementing projects that are more profitable to the government, rather than shareholders.

Economic slowdown could badly affect commercial banks given their pro-cyclical nature. Even worse, the S&P downgrade of Russia's rating with a negative outlook could raise the cost of borrowing for Russian banks.

The most foreseeable trend for the first half of 2009 is deceleration of the pace of banking sector expansion and acceleration of non-performing loans that could trigger profitability drawdown and badly affect banks' net income.

Next year, the problems faced by Russian banks in 2008 could lead to a serious industry reshuffle. At the same time, M&A activity is likely to expand, as the lack of retail deposits and a surge in the cost of borrowing could force mono-liners and regional banks to sell their business to more diversified banking structures.

We believe that mid-sized banks could face the most severe troubles, which will make them primary targets for possible acquirers given their low retail deposit base and strong addiction to large lenders.

However, this creates a new opportunity for their larger peers to expand their market share via M&A transactions.

In turn, small banks (they are mainly captive) look rather protected due to their exposure to funding provided by few lenders, who are often their owners. Therefore, we expect that banks with assets from 10 billion rubles to 60 billion rubles could face the most significant changes in their shareholder structures.