With the stocks of Russia’s largest banks plummeting during the current credit crisis, it may appear that there is an opportunity to buy into the country’s emerging financial services sector at bargain-basement prices. But given Russia’s history of severe economic and political turmoil, foreign investors may wonder if the gamble is worth the possible payoff.

The common shares of Russia’s largest bank, the Savings Bank of the Russian Federation, otherwise known as Sberbank, trade at 84¢. (All figures are in U.S. dollars.) That’s down by about 80% from Jan. 1, when they traded at $4.17. Similarly, the shares of Russia’s second largest bank, VTB Bank, have fallen by 78% during the same period, to 0.11¢ from 0.5¢.

“If you look at the fundamentals, the Russian banks are well positioned to weather this storm, both [in terms of] capital and liquidity,” says Richard McGrath, senior investment analyst and portfolio advisor at AGF International Investors Inc. in Dublin. “A lot of the bad news seems to be priced in right now.”

A bank’s capital boils down to the Tier 1 ratio, which represents a bank’s core equity capital as a percentage of its risk-weighted assets, says McGrath. And with Tier 1 ratios of 13% and 15%, respectively, Sberbank and VTB have more capital on hand than most banks do worldwide during this crisis, he points out, noting that the average Tier 1 ratios for banks around the globe fall between 4% and 8%.

Russian banks also have more liquidity than their Western European counterparts (see story on page 40), adds McGrath, as they have lower loan/deposit ratios of 100%, which means that their total loans match their total deposits. European banks, in comparison, are operating with LTD ratios of 150%. “On top of these ratios, the Russian government has decided to provide its banks with a liquidity line,” says McGrath, noting that the major banks have been granted up to $18.1 billion of subordinated debt.

So, all this begs the question: if Russian banks are richer in liquidity and capital than their European counterparts, why aren’t more foreign investors jumping in?

“In Russia, we don’t have a crisis of liquidity, we have a crisis of trust,” says Georgi Medvedev, vice chairman of the Association of Regional Banks of Russia. Foreign investors, as well as Russian citizens, fear the current crisis will lead to a re-hash of the country’s economic collapse in 1998, which saw the government default on its debt and the ruble lose about half its value. “It was mainly [because of] the young banking system, in which young analysts didn’t know how to hedge or calculate risk.”

But, Medvedev says, the banks have since learned their lesson: “The default of 1998 showed the banks they needed to tighten their assets and capitalization to be more competitive, particularly in the futures currency market.” After the collapse, smaller banks unable to hedge those risks were forced to shut down, leaving the strongest to survive. The sector has shrunk to 1,100 registered banking institutions and credit unions, compared with some 3,000 deposit-taking institutions prior to the collapse.

Foreign banks, such as New York-based Citibank, a subsidiary of Citigroup Inc., have also come to Russia and carved niches in credit cards and mortgage loans, areas that local banks had not yet tackled, which has helped further stabilize the sector, Medvedev adds: “We now have credit operations and other operations that weren’t available before.”

The most important advantage to having foreign banks operate in Russia is the technology they bring to the market, Medvedev says, as local banks have lagged in the areas of Internet banking, mobile banking and distribution of plastic payment cards. They now have businesses to model themselves after. “We have a saying about Russians: they hook up the horses quite slowly,” he says, “but once they get going, they get really fast.”

The numbers suggest that the growth of Russia’s financial services sector is indeed off to the races. In his Russian Banking Sector: Main trends and investor activitiespresentation, which relies on Central Bank of Russia data, Sergey Safonov, principal of Moscow-based Roland Berger Strategy Consultants, reveals that the country’s banking sector’s assets grew to $824.6 billion in 2007 from $553.4 billion in 2006. Safonov points out that assets have grown significantly from 2003, when they totalled $196.4 billion.

@page_break@Russians taking out mortgages on homes and vehicle financing are driving the sector’s overall growth, representing undertapped opportunities. Loans to individuals and corporations have been making up a larger chunk of the sector’s total asset mix. In 2007, all loans made up 59% of the sector’s assets, at $487 billion; in 2003, they accounted for 46% of total assets, at $91 billion.

Although corporate loans have accounted for the bulk of the growth, making up 73% or $355.5 billion of the $487 billion in total loan assets in 2007, they have dropped by 15% of the total loan mix from 2003, when they accounted for 88% of the $91 billion in loans. Loans to individuals, meanwhile, have grown to 27% or $131.5 billion of total loans in 2007, from 12% in 2003. Safonov predicts that loans to individuals will continue to grow and they’ll make up 41% of the total loan pie by 2012, which is predicted to grow to $1.3 trillion.

The undertapped credit card and debit card markets offer additional opportunities for banks to continue to grow their operations, Medvedev says. Out of a population of 140 million people, 60 million or 42% don’t have either cards. “The majority of the population doesn’t know what a [bank] card is,” he says. “They wouldn’t even know if they fell over it.”

Slowing the growth of the adoption of these cards are smaller villages and cities, Medvedev says, in which telecommunication services have been limited and citizens’ concern for fraud is constant.

“The older generation would be very wary about these products, but for the younger generation, it’s easier to see the benefits,” says Ouliana Vlasova, cards and payments analyst with London-based Datamonitor and author of the firm’s 2007 report, Payment Cards in Russia. Programs such as the Moscow social card project, launched in 2002 by the Russian government, are helping to shift consumer attitudes. The program works by giving two million welfare recipients their benefits through a VISA Electron cash card that they can use to pay for public transportation and to get discounts at local shops.

Credit cards have also taken off in popularity since they were introduced to the Russian market in 2003; they now total slightly less than 30% of the payment cards in circulation. “You have to look at 2005 to see a big spike in the credit card market,” Vlasova says. “That’s [because] the Russian Standard Bank issued 6.5 million revolving credit cards.”

RSB is the leader in credit cards in Russia, with its cards making up 54% of the market. Vlasova says RSB led the trend and a number of banks have been introducing their own credit products. Russia is now “the largest payment card market in Southeastern Europe [and it’s] experiencing the fastest growth rate.”

But banks are still being very selective in whom they issue credit cards to, Vlasova says: “At the moment, banks issue cards only to customers who can afford this product.” Much of the population still can’t. Another challenge in this area is education about financial products, which is so low that sometimes Russians don’t understand they must repay loans, Medvedev says.

As for other challenges, he cites lack of telecommunications, which continues to plague the sector’s growth. Russian banks are still a long way from being technology-savvy, Medvedev adds:.

So, it’s best to stick with the sector’s two largest players: Sberbank and VTB.

Established in 1841, Sberbank became an open joint-stock company in 1991, with the Central Bank of Russia taking a 60%-ownership stake. The bank now operates 20,000 branches across the country and provides a variety of retail, public and commercial services, such as deposits, securities transactions and project financing.

Medvedev says that Sberbank is well poised for long-term stable growth because it had a market share of 24% of the Russian banking sector’s total assets in 2007 and because it’s one of the largest issuers of debit cards, with about 6.5 million cardholders nationwide. As for credit cards, it is limited in the risk it can take on, Vlasova says, because it is partially state-owned.

Sberbank had an operating income of $3.5 billion for the three months ended March 31, up from $2.5 billion in the corresponding period in 2007. It had a net profit of $1.13 billion, an increase from about $970 million.

VTB, meanwhile, has been able to enter riskier markets such as credit cards and vehicle and mortgage financing. Established in October 1990, VTB is considered a key player in the banking sector’s modernization. It also has GDRs that trade on the London Stock Exchange.

VTB saw its operating income grow to $2.2 billion in the six months ended June 30 from $1.5 billion in the same period a year earlier. Its net profit increased to $679 million from $504 million

Loans have been a major driver, as they increased to $77.6 billion at June 30 from $54.9 billion at Dec. 31, 2007. IE