Dmitry Leus: “Risk management is the bank’s most important task”
Every retail bank operates within its own risks universe. Some banks take less than a few minutes to give credit at incredibly high rates. Others credit at lower rates, but take weeks to scrutinize you. We have spoken to Dmitry Leus, Chairman of Bank , about risk management, the reasons behind the spectacular growth of the Russian mortgage market, and about his Bank’s expansion plans.
– Bank launched a 500m roubles capital increase in December last year, pushing the Bank’s overall capitalization to 1.5bn roubles as a result. Why did the Bank increase its equity and which opportunities came with growth?
Photo: “Bank ”
– Dmitry Leus: A capital increase is always good news for a bank, as it allows us to better meet the requirements and guidelines set forth by the Central Bank of Russia (CBR). Secondly, it gives us room for expansion. For example, CBR Instruction N139-I regulates the minimum capital adequacy ratio (N1) for banks (10%). If a bank wants to expand and scale up lending volumes it has no choice but to increase its capital. Thus, a bank’s earnings power is proportional to its capitalization.
– However, your N1 ratio of 11.32% is only slightly above the 10% minimum threshold. Could that turn into a problem for the Bank?
– Dmitry Leus: The capital adequacy ratio (CAR) is a measure of a bank’s capital expressed as a percentage of its risk-weighted assets (RWA). These assets are typically the bank’s loan portfolio. Each loan is assigned a percentage number with riskier (unsecured) loans weighing heavier (and thus requiring more capital reserves) than loans which are secured with collateral.
This implies, from a business perspective, that a bank with a capitalization of 1bn roubles has a “working capital” which is tenfold higher. The calculation basis for interest income from its lending business is thus 10bn roubles. By the same token, the bank’s owners can use leverage to earn much more than would otherwise be possible using only the bank’s equity capital. Now, if the bank had 12bn roubles at its disposal, and not only 10bn roubles and, furthermore, if the margin between the bank’s cost of funds and its lending activities was 7%, this would result in an additional 140m roubles in net earnings. This is the main reason why banks are interested in keeping their CAR close to the minimum threshold without, obviously, falling below it. In the wake of the credit crisis of 2008 and the subsequent regulatory crackdown, people tended to forget that a bank, like any other business structure, pursues the objective of creating profits for its stakeholders.
– Are you considering further capital increases in light of your expansion plans?
– Dmitry Leus: Yes, we do. We aim at a capitalization of 3bn roubles, with a long-term objective of 5bn roubles.
– Are you planning to further increase the Bank’s capital by way of an additional issue of shares?
– Dmitry Leus: Yes, either through an additional share issue or through a merger with another bank.
– Let’s speak about your merger plans. What characteristics should the merger candidate have?
– Dmitry Leus: It should be a bank equal to us in size and capitalization. The most important factor for us is the quality of the target’s assets, as the business model will be imposed by us. Our advisers have developed a wheel of opportunity / fit chart for us, which represents a systematic, logical, step-by-step process of choosing among competing investment opportunities.
– Is the business model of the merger candidate a relevant parameter to you? In other words, is the target likely to be a retail bank?
– Dmitry Leus: No, it doesn’t necessarily have to be a retail bank. Even if it is a retail bank, it will have a different business model from ours. However, I think the model of Bank is currently working very well.
– You mentioned before that a bank’s overall capital is key to the growth of its asset base. Which assets do you have in mind?
– Dmitry Leus: The bank’s credit portfolio, of course.
– Bank ’s recent financial statements feature over 40% of investments in securities, a large part of which are owned through repurchase (or repo) agreements. Are you planning to change this capital structure and reduce your exposure to securities?
– Dmitry Leus: At the present moment, we own securities worth 3.2bn roubles. Of these, 1.2bn are owned through repo agreements. However, we plan to sell the repo agreements due to the currently high rates for such transactions.
– Which issuers are we talking about?
– Dmitry Leus: We own 587m roubles in federal treasury bonds and the rest in securities recommended by CBR. We intend to downsize the share of our securities portfolio to 10 to 15% of the Bank’s overall assets, as a bank always needs to hold liquid positions. This is approximately the percentage recommended by leading consulting firms, including our auditor KPMG.
– Are you planning to engage in corporate lending? At the present moment, your corporate lending portfolio is quite slim.
– Dmitry Leus: Correct. We are not lending to corporate entities.
– Dmitry Leus: We believe that our core skills are in private lending. That’s what we are good at. In fact, the Bank’s business model is grounded in a private lending philosophy. We recently asked three consulting firms – Deloitte, KPMG, and Accenture – to analyze our working methodology and potential in the segment of consumer lending. Without planning to exclusively focus on consumer lending, and running the risk of becoming a monolithic bank, we have nevertheless set the objective for our regional offices to actively grow these activities. We continue to engage in mortgage lending (“yesterday’s breadwinner”), albeit not on the same scale as before, in addition to car loans.
Recently, we’ve even developed a new product we market under the term of “private enterprise mortgage”. It allows private entrepreneurs to collateralize their business assets in order to reinvest the resulting credit in their business.
– How far away is “recently”?
– Dmitry Leus: Basically, two weeks ago.
– Why did you design such a product?
– Dmitry Leus: We noticed that we were the first to offer this kind of service. Hence, we wanted to exploit this market gap.
– From 2010 through 2011, the Bank showed an impressive growth rate. In 2011 alone, Bank ’s deposits and credit portfolio grew 5 times, and its assets increased threefold. How do you explain such stellar growth?
– Dmitry Leus: A significant level of invested assets is a normal thing for a retail bank. A bank capitalizing on a margin of 7% above the cost of funds can earn as much as 17.5m roubles per month. In our case, we pay 25m roubles in salaries every year. Put differently, business volume is important to compensate your employees for a well done job.
– However, over the last 2 months the Bank’s assets fell over 19% and customer deposits decreased by 8%.
– Dmitry Leus: Let me explain. This is because we owned a considerably large portfolio of securities through repurchase agreements. As I explained above, we are currently decreasing this exposure due to high transaction costs, which has a negative impact on the Bank’s assets. Whereas in the past we used repo agreements to invest our cash into securities with a higher yield, we now invest this cash into our credit portfolio at an even higher profit margin.
The outflow in customer deposits is due to the elimination of a few expensive deposits on the Bank’s balance sheet. We also observe a certain slow-down in the acquisition of fresh deposits due to falling interest rates.
– Customer deposits constitute a large share of Bank Zapdny’s liabilities. Are you not planning to somewhat diversify your funding mechanism?
– Dmitry Leus: Yes we do. By means of our recent capital increase, for example. In addition, we hope that this year we will be able to place a bond issue of 1.5bn roubles we registered in November last year. In the past, such steps were not possible because of the overall economic trend – the market in general has seen few placements recently. Now it seems that market conditions are more favourable. We intend to open our books for subscriptions this summer.
– Which are the terms of the bond issue? Will you be able to influence them?
– Dmitry Leus: Terms will depend on market forces.
– In which regions do you plan to open new branches this year?
– Dmitry Leus: We plan to open a new branch in St. Petersburg and Novgorod.
– At the moment you own 58.3% of Bank ’s shares. The remaining shares are owned by the Bank’s management team. Are you planning to increase your share in the future?
– Dmitry Leus: I think I will buy back the remaining shares by the end of this summer.
– Let me ask you a question related to the seizure of documents by law enforcement authorities at the end of March this year. What happened exactly?
– Dmitry Leus: In 2010, we opened an account for a company. Exactly 16 days after the account opened we had to close it, as the activities of the company seemed suspicious. At the end of March this year, law enforcement visited the Bank and seized all documents concerning this company.
Let me add that we practically do not have company accounts. We are a retail bank. In 2011, only one client executed foreign trade operations through our Bank. I think he traded in builders’ hardware. Over the entire year, he purchased products worth 700k euros. These were the only foreign trade operations conducted through our Bank. All necessary foreign trade information is regularly transmitted by us to a special accounting department at CBR.
– But the 1.5bn roubles on your balance sheet – are these not company assets?
– Dmitry Leus: These are the accounts of the companies with which we enter into repurchase agreements.
– Didn’t this story about the seizure of documents have a negative impact on the Bank’s day-to-day business and its relationship with clients? Were there some reputational issues?
– Dmitry Leus: No, there were none. The inspectors did their job and that’s where the story ends.
– How do yo deal with the fact that the old story with the Russian Depositary Bank from 2002 bounces back on almost every occasion Bank is mentioned in the press?
– Dmitry Leus: I always knew that this story would follow me. But I did not entirely expect that the press would comment on every significant event at Bank Zapady with reference to a story which is older than 10 years. I think these references lack any legitimate reason. Bank has made some brilliant achievements over the last years such as the purchase of “KIT Finance”; it has made several capital increases; it displays a double-digit growth rate… Oscar Wilde once mentioned that “every effect that one produces gives one an enemy”. In other words, you will always find someone who will be making far-fetched conclusions or be trying to distort the true picture. There are different ways to deal with this. I plan to continue my path, work hard, and develop the Bank.
– I see. Let us return to Bank . Where are you giving more credits, in Moscow or in the regions? In general, where do you prefer to work, in the capital or in the periphery?
– Dmitry Leus: The repayment discipline is far greater in the regions than in Moscow. In general, life in small towns is different and people know each other quite closely. On the other hand, in Moscow there exists a large population of borrowers who only seek to get credit and try not to return it. When we set up our current scoring system we had to adjust it several times, as in the meantime fraudsters discovered its weak points and adapted their behaviour. This is a perpetual battle which will never end.
– What is your refusal rate? Do you have statistics?
– Dmitry Leus: This is a very difficult question. Outsiders tend to ignore that there is a hierarchy of complex steps leading up to final credit approval. At the very beginning, a front-office employee meets the borrower directly and prepares the credit documentation. Thereafter, the credit file is being forwarded to the credit sanctioning department which verifies the applicant’s personal information using a set of databases. If the credit sanctioning department approves the new borrower the file is subsequently transferred to our security desk which again enters into direct contact with the borrower for further checks. If the security desk gives a positive feedback the client is handed over to the underwriting department for final approval. Any of these steps may result in a refusal. A reason why we don’t keep records is the significant activity of fraudsters during the first months a product is launched, trying to outwit our scoring system. Such a dynamic tends to distort statistics. In general, risk management is a bank’s most important task, but also the most complex. In addition to our own experience, we draw on the expertise of domestic and international organisations to clearly identify risks at an early stage. This is a subject which is not always openly discussed in today’s banking community, but I see in the variety of risk management models the true distinctive feature between banks – and a major competitive advantage.
– Are you not concerned that a borrower may change his mind and walk away when confronted with all this scrutiny?
– Dmitry Leus: If a client walks away when confronted with the Bank’s legitimate on-boarding and credit sanctioning procedures we must ask ourselves if he is the right client for us in the first place. After all, credits are just another way to look at the savings of our depositors – toward whom we have fiduciary obligations.
– I agree, but a potentially good borrower could be tempted to switch to an institution where the credit process takes less time and is less burdensome.
– Dmitry Leus: The risk of losing business through compliance always exists. However, our business model does simply not allow us to further streamline this process. A more “liberal” client screening presents important risks which will have to be factored into the final pricing of a loan product as a risk premium. Some banks may take less than a few minutes to come to a positive credit decision, but only at the cost of interest rates exceeding 60%. On the other hand, it is precisely our risk averseness that allows us to propose interest rates which are substantially lower than market, even in the segment of consumer lending. Bottom line, if a client wants to profit from our low rates he must be patient.
– Fair enough. However, a borrower may default on a loan despite all your screening efforts. Are you prepared for this?
– Dmitry Leus: For such cases we have our security desk which is active in so called soft collection, sending a series of increasingly urgent letters, usually ten days apart, instructing debtors to pay the amount owed. It is not realistic to engage in consumer lending without operating a soft collection desk. Our soft collectors are experienced specialists who know how to speak with late payers. They are authorized to propose different solutions to address arrears. Bank has worked over half a year on an internal document laying out the rules according to which our communication with late payers should be structured. These internal rules draw on our own experience, in addition to the experience of other banks, legal practice, and the law. The document was approved by an external consulting firm working with collection services. Put differently, our collectors are acting based on hard rules, not on intuition.
– Bank ’s net profits for 2011 were 58m roubles. What profit margin are you expecting for this year?
– Dmitry Leus: Our first-quarter results show a net profit of 9m roubles. Our expenses have significantly increased following the acquisition of “KIT Finance” and their set of branches, including cost items such as rent, professional equipment, wages, professional training, marketing campaigns, taxes, and so on. We have worked over a year to streamline the collaboration between all our new branches, but only now do we start to see the first results. There is an unprofitable investment period through which every new business venture must go before it breaks even and starts to be profitable. You cannot buy a business and get back your money the next day. And, again, there are always risks involved…
– So what would be a good end year result for 2012?
– Dmitry Leus: Net profits of 300m roubles.
– In general what is your benchmark? Are you a top-200 Russian bank by assets or not?
– Dmitry Leus: You know, we have completely stopped paying attention to these rankings. Size is certainly important but, generally, it is not an indicator of the quality of your business.
– What growth rate are you expecting?
– Dmitry Leus: Our grow rate is directly proportional to our CAR. Wherever the capital adequacy ratio allows us to grow — we will.
– Are there any concrete plans, for example, growing your credit portfolio?
– Dmitry Leus: When it comes to our credit portfolio we have very ambitious plans. Bottom line, we plan to award high-quality credits ranging around the mark of 1bn roubles every month.
– What is the current level?
– Dmitry Leus: Approximately 300-500m roubles per month.
– And you are planning to double this amount in the next year already…?
– Dmitry Leus: Not in the next year… We are already starting next month!