Three years on, bank loans remain largely out of reach for medium- and small-sized businesses and individuals.

And the banks that weathered the 1998 crisis are no more accountable to the authorities or transparent to the public than before.

The government intends to change all that.

After tackling tax and other legislative issues affecting the investment climate for the past year, Prime Minister Mikhail Kasyanov and his team are finally setting their sights on banking reform. Official Cabinet talks on the issue are set to start Sept. 27.

Ten days before the government convenes, two teams -- the Central Bank and the Union of Industrialists and Entrepreneurs, or the RSPP, the country's influential business elite -- are shrewdly fine-tuning their reform plans to present at the talks.

Kasyanov is promising that the government and the Central Bank will develop a unified approach -- but it remains to be seen whether the reform plans in themselves will be able to create a well-greased and healthy banking sector.

"[There is no] clear system of transferring capital to sectors that need it," Kasyanov said last week.

Reform No Easy Task

The three main problems that have hindered growth in the banking sector are lack of trust, lack of secure places to invest and lack of free competition, banking experts say. Thus, the existing system is small, lopsided and fails to perform one of a banking sector's most important functions: financial intermediation, that is drawing in savings and putting them to work by lending to and investing in the real economy.

Total banking assets are only about 5 percent of gross domestic product. Out of 1,322 licensed banks in the sector, the two largest -- Sberbank and Vneshtorgbank, both majority owned by the Central Bank -- together hold about 26 percent of total bank assets. The next 200 largest banks by capital hold about 72 percent.

"Every dollar that is kept under a mattress or in a bank account abroad is not working for the economy," said Christof Ruehl, chief economist of the World Bank in Moscow. The World Bank is advising the Central Bank on banking reform.

"Large financial industrial groups are awash in cash, but the intermediation mechanism is not working," Ruehl said.

He said the ultimate goal of banking reform is to support small- and medium-sized companies, which can be taken as a proxy for new companies.

"The banking sector is not linking the need for capital in small- and medium-sized companies, which drive growth in other transition economies, to the large amount of existing capital generated by the large [natural resource] exporters," Ruehl added.

Small- and medium-sized businesses account for roughly 60 percent of the economy in Central and East European countries, but for only 30 percent in Russia.

Bank loans are one of three main sources of investment for companies. The other two are capital markets and retained earnings. However, domestic capital markets are small and relatively illiquid. Domestic companies tend to have lower profits than comparable companies in more developed countries and, thus, have less to invest. New or small companies in particular need alternative sources of financing.

The Economic Development and Trade Ministry estimates that only 3 percent to 5 percent of investment financing in the country is from banks, compared to 15 percent to 30 percent in developed countries and 25 percent to 30 percent in developing countries.

Forced Reform or Laissez Faire?

Against this backdrop comes a proposed set of swift changes known as the Mamut plan. The plan, named after MDM-Bank's supervisory board head Alexander Mamut, who leads the union with Alfa Bank CEO Pyotr Aven, was hammered out by the RSPP, which has won major victories in influencing government policy in legislation such as the reduced profit rate and currency liberalization.

The Mamut plan focuses on consolidating banks through minimum capital requirements, reviewing the Central Bank's ownership of commercial banks and the role of state-owned banks in general, and speeding up a transition to international accounting standards.

"After the RSPP's first plan came out, the Central Bank spoke in favor of maintaining a two-tier system and deposit insurance," Ruehl said. "We support both of these -- but if one wants a two-tier system, one has to destroy the monobank system, which means the Central Bank has to leave Sberbank and Vneshtorgbank."

The Central Bank's approach over the past three years had been to maintain stability and "not to force reforms on the banking sector," as Central Bank chairman Viktor Gerashchenko said last month, until other reforms -- legal, judicial and economic -- have been carried out.

The Central Bank has also decried the low concentration of capital and assets in the sector and vowed to work on corporate governance.

Quality Not Quantity

The most controversial point in banking reform is not doubt one that both sides agree upon in principle: the need to consolidate, that is increase banks' capital and reduce the number of institutions calling themselves banks.

The Mamut plan proposes splitting the sector into three tiers: the Central Bank, federal banks and regional banks. Banks with capital above $100 million would be eligible for federal licenses granting the right to perform countrywide and international transactions. Banks with $6 million to $100 million would get regional licenses.

The plan has drawn harsh criticism because it would leave about 20 powerful federal banks, selected purely on capital requirements, or size.

Size does matter because a bank's capital -- shareholders' equity and retained earnings -- determines how much a bank can lend and is the basis for its operations. Below a certain level, banks cannot be profitable.

However, size is not equivalent to stability, as the 1998 crisis proved when the country's largest banks collapsed.

"An increase in capital does not mean an increase in stability or security. It allows banks to lend more money, but if they lend more money to one client, they may increase their risk," said Mikhail Matovnikov, deputy director of Interfax Rating Agency, which rates banks.

"The risk-level of small and large banks in Russia is almost equal," he said.

The Central Bank has expressed dissatisfaction with the lack of consolidation. But Gerashchenko has also said that wiping out a large number of small banks could destabilize the system. The Central Bank raised the minimum capital requirement from 1 million euros to 5 million euros (now about $910,000 to $4.55 million) in June, but the limit applies only to newly registered banks.

Economic Development and Trade Minister German Gref waded into the discussion Thursday, telling journalists that demands for minimum capital requirements must be tightened.

And Alexander Shokhin, head of the State Duma banking committee, said at a banking conference early this month that the Central Bank should revoke smaller banks' licenses, converting them into deposit-lending institutions rather than liquidating them.

"If [small banks] didn't serve an economic function and if the economy didn't need them, they wouldn't exist," said Richard Hainsworth, head of RusRating, a bank rating agency.

But, he said, if they are not performing banking functions, they should not have general banking licenses

Last week, the RSPP softened its stance, backing away from the two-tiered structure. Nonetheless, the group lowered its minimum requirement to at least $10 million for banks to receive a general banking license to take retail deposits, participate in the deposit guarantee system and open accounts with Western banks.

Still, say defenders, small- and mid-sized banks play a vital role.

"Major Russian banks are basically wholesalers. They are banks that specialize on wholesale clients, oil and gas, large loans. These banks neither specialize in or work with medium-sized and small businesses," said Sergei Suchkov, head of KMB Bank, whose acronym stands for Credit for Small Business.

"In the regions there are already small- and medium-sized banks that are starting to work with medium-sized and small businesses," he said.

Guaranteeing Deposits

Banks are currently operating on a lopsided playing field, in particular where retail deposits are concerned. Only Sberbank, which monopolizes the retail banking market with about 75 percent of all deposits and a network more than 300 percent larger than its nearest competitor, has a government guarantee for deposits.

For the average middle-class Westerner, holding a bank account is a fact of life, like learning how to drive or getting a job. In Russia, the majority of the population has more reason to distrust than trust banks, especially those who lost much of their savings to hyperinflation.

"When people trust banks, banks will have more capital available and [lending rates] should come down," Ruehl said. "The high cost of capital for small companies is one of the biggest barriers to growth."

Sberbank's monopoly stranglehold on the market is a key factor, but one that is unlikely to be resolved in the short-term and one the Central Bank has resisted.

Both the Central Bank and the RSPP have suggested deposit insurance for other banks as a way to start rectifying the situation in the meantime.

The Central Bank has drafted a deposit insurance bill for the government under which banks would pay a premium of 0.6 percent of its retail deposits into a proposed state deposit guarantee corporation. Sberbank would also be subject to such a premium but would pay it into a special account at the Central Bank.

"Deposit insurance could be used to kill two birds with one stone, that is, meet the need for consolidation and for competition on equal grounds," Ruehl said. "But it will only be effective if there are stringent conditions, such as proper accounting standards, disclosure, capital adequacy ratios and prudential reforms. The quality of reform can be judged by the quality of the set of requirements that are designed."

Capital adequacy is a measure of a bank's capital as percent of its assets, such as the loans it has provided and the securities it holds. The riskier the assets and the environment, the higher the ratio should be set. In developed countries, minimum capital adequecy ratios are usually set at about 8 percent to 10 percent. The Central Bank has set it at 8 percent.

If improperly structured, however, such a guarantee, could backfire horribly. "Without proper structuring and careful oversight, which has not been the Central Bank's strong suit, deposit insurance could give depositors a false sense of security and lower banks' incentives to manage risk carefully," said Kim Iskyan, a banking analyst at Renaissance Capital.

The Central Bank willingness and ability to offer adequate oversight has raised some fears.

"It is not that the Central Bank doesn't regulate at all, but it regulates in a Soviet way by demanding reams and reams of paperwork," Iskyan said. "The Central Bank should try to assess the validity of financial results, what banks are doing, who owns them and their transparency."

The Central Bank has also been lax about implementing existing laws, Iskyan said. For example, Russian law sets loan exposure limits, that is, the amount of capital that a bank can lend to one customer or one group of related parties, at 20 percent. Renaissance Capital estimates that seven of the 20 largest banks generate more than half of their business from one client or small group of related companies.

The Central Bank has also failed to instill a healthy fear of reprisal in banks, Iskyan said. Relatively few banks have lost their licenses since the crisis. Reports of asset stripping have remained for the most part reports. Bank managers who oversaw the collapse of their banks in 1998 have moved, with bank assets, to new banks.

"Bank regulation in less developed countries is generally extremely difficult and doesn't work all that well," said Peter Boone, head of research at Brunswick Warburg. "The most important thing that drives banks to behave and be careful is the value of a reputation they have built up. The problem here is all these banks are new ... and so they really don't have much of a reputation and it's not very valuable for them and that is why they are willing to take risks."

Accounting Standards

Introduction of international accounting standards, or IAS, is a major plank in the plans for banking reform. IAS demands greater disclosure and provides more transparency than Russian accounting standards.

The Central Bank has proposed implementing IAS as of Jan. 1, 2004. The Mamut plan calls for its implementation as a matter of urgency, although Mamut himself last week said the matter was open to discussion.

The Central Bank has supported a gradual implementation, stressing the time and effort involved in retraining its staff, banks' accountants and auditors and the possibility that more banks will be insolvent under IAS. Others see this as a benefit and say the faster IAS is introduced, the better.

"IAS reveals [banks'] weakness. If we put off IAS, we will need to forbid X-rays because they show that patients are very sick," said Vneshtorgbank CEO Yury Ponomaryov. "We will be ready by 2004 only if we start quickly now. Under no conditions should we delay."

IAS, however, does not guarantee transparency. Russian accountants can fiddle with IAS statements as easily as RAS financial statements if the sector watchdog -- the Central Bank -- is not vigilant. This means moving from requiring data to analyzing the information.

"Control means reporting requirements, the reams of paper, whereas regulation is analysis, talking to banks, fine-tuning the mechanisms," Iskyan said.

IAS could also benefit the sector because it is more geared toward the economics of running a business than Russian accounting standards. For example, it allows banks to form reserves -- a cushion against unpaid loans -- from pre-tax earnings, which is more reasonable economically. Russian accounting rules discourage reserves because they involve additional tax exposure, but low reserves increase a banks' level of risk.

No Loans

Lending has surpassed pre-crisis levels, but less needy export companies have greater access to credit than small- and medium-sized businesses and individuals.

"Foreign and large domestic banks, have the money to loan, but the problem is the tax and legal environment and the lack of good borrowers," said Hainsworth.

Banks need the tools and incentives to perform thorough risk analysis and the assurance that a strong legal system will protect their loans, he said.

Duma deputies, together with the Central Bank, have taken a step to boost lending activities by drafting a law to create a credit-history bureau.

The Mamut plan demands that the Central Bank's commercial activities be reviewed. Its role as regulator is in conflict with its role as majority owner of the two largest banks in the sector, Sberbank and Vneshtorgbank.

State-controlled banks tend to loan to government-owned companies, as industrial pocket banks do to their related companies at nonmarket rates, distorting the market and frustrating competition, bank watchers said.

The RSPP proposes limiting the function of state-owned banks. For example, Rosselkhozbank, set up to serve the agricultural sector, would be limited to that sector.

The Central Bank, however, has insisted banks that met quantitative requirements be allowed to operate without regard to their ownership.

Nature Abhors a Vacuum

The proposed reform plans begin to address important issues within the sector, but without broader reforms -- and improved sector regulation -- they may not lead to true growth.

"It is like changing the oil in a car that has no wheels," Iskyan said. "It needs to be done, but the sector also needs active regulation, a reliable judicial system and enforceable legislation, in particular, bankruptcy law, contract enforceability, recoverability of collateral."

"Gerashchenko is right that the effectiveness of any banking reforms, which may look nice on paper, depends on the effectiveness of legal, judicial and other reforms. Banking reform cannot take place in a vacuum," Ruehl said.