Good afternoon, dear colleagues
Today, we are releasing the Financial Stability Review for 2020 Q2—Q3.
The market situation in Q2—Q3 generally improved after the surge in volatility at the end of Q1 induced by liquidity issues and a loss of confidence in global markets. Measures implemented by regulators and governments helped restore liquidity and significantly increase the level of confidence. The situation almost returned to normal in a number of market segments. Nonetheless, volatility remains slightly elevated. Markets may turn pessimistic because of new restrictions, after which, on the contrary, they may respond positively to the news about the launch of vaccines or new stimulus measures. As the situation with liquidity is adequate, such elevated volatility in markets involves no risks to financial stability. Therefore, the need in measures supporting financial stability, such as foreign exchange operations or asset purchases, has either decreased considerably or ceased to exist in emerging market economies. However, individual countries’ markets demonstrated very uneven trends and a higher vulnerability to specific internal and external risks over the period under review. A number of economies experienced volatility spikes caused by concerns about budget stability. In some countries, it was unclear whether they could manage to maintain macroeconomic stability. The impact of geopolitical factors intensified. Nevertheless, as the situation with liquidity returned to normal, there was no contagion effect, and such volatility spikes remained local.
Speaking of the future, I believe that this slightly elevated market volatility, as compared to its normal level, will persist until it becomes clear when the pandemic ends. One of the drivers of this volatility may be the currently observed disconnection of market prices from fundamental factors related to the economic situation. Nonetheless, owing to the policy measures taken, this will not entail any serious risks to financial stability. In the long run, however, economies will have to address the challenge associated with the need to develop strategies how to terminate large-scale ad hoc policy measures.
Overall, the Russian market followed global trends. There were additional volatility spikes locally, provoked by geopolitical factors, but they did not require any targeted policy measures owing to adequate market liquidity.
I would like to focus on three issues: the market of federal government bonds (OFZ), ruble liquidity, and foreign currency liquidity.
As in other economies, the Russian OFZ market this year was to absorb extra borrowing needed due to the pandemic. Local market players, primarily systemically important banks, had a major role in this matter. They had such an opportunity because Russia’s public debt is rather small — even after this year’s growth, public debt will total as little as 21% by 2022. Accordingly, the portion of investment in government bonds in the banking sector’s assets is also low (6.3% as of 1 October) by world standards. The expanded share of OFZ bonds on banks’ balance sheets increases their liquid assets, thus improving their liquidity ratios, all else being equal. However, this may amplify banks’ exposure to market and interest rate risks. This is the reason why Russian banks are demonstrating high demand for variable-yield bonds. In March, the Bank of Russia introduced regulatory relaxations in order to smooth the temporary elevated influence of market risk on banks’ balance sheets, allowing banks not to re-evaluate securities on their balance sheets. This helped stabilise the Russian public debt market. This measure will remain in effect until the end of the year and is not planned to be extended, since volatility has lowered from its peak levels and the financial sector has already adjusted to the remaining volatility.
As regards the dependence of this market on non-residents’ operations, it has slightly decreased in recent months. After the peak numbers of non-residents exiting the Russian market in March, their holdings remained stable over the last six months, approximating 3 trillion rubles. As of 24 November, the portion of foreign depositories in the National Settlement Depository shrank to 22.6% after Russian market participants increased their OFZ holdings.
As to the situation with liquidity, I would like to note that we often mean different things by this term. As regards market liquidity, that is, an adequate number of bids of both types, or the market density, it stayed at a normal level for Russian markets over the period under review. This is also true for Russian market participants’ ratio of liquid assets. Specifically, the aggregate liquidity coverage ratio (LCR) of systemically important banks stayed relatively stable in recent months, totalling nearly 100%, excluding irrevocable credit lines (ICLs), although significantly varying across different banks. It was adversely affected by a reduction in borrowing maturities during the pandemic, partially explained by the interest rate policies of banks themselves. Nonetheless, the Russian market has sufficient highly liquid assets, and their amount continues to increase as banks purchase OFZ bonds. Therefore, we still intend to return the fee for using ICLs to the earlier level of 0.5% and to resume the original schedule of decreases in individual limits on ICLs beginning on 1 April 2020. Banks that are currently experiencing difficulties to ensure compliance with the ratio should gradually adjust the structure of their balance sheets so as to comply with the LCR in the future on a market basis.
There were certain changes in the market of liquidity in its narrow sense (that is, banks’ funds in accounts with the Bank of Russia and coupon bonds). I would like to dwell on this issue. In recent years, the banking sector had a substantial structural liquidity surplus. Furthermore, it was also experiencing calendar effects every year, since uneven spending by Russia’s Ministry of Finance caused a certain contraction of the structural liquidity surplus in the last quarters, significantly increasing again at the very end of the year and the beginning of the new year because of a rise in budget expenditures over the said period. This year, the structural liquidity surplus has shrunk considerably amid a surge in the demand for cash. Moreover, the calendar effects of budget expenditures have intensified since funds are transferred to the budget from banks’ accounts not only as tax payments, but also due to the considerable rise in borrowing exceeding the growth of expenditures. In these conditions, banks have raised their demand for correspondent accounts, opting to hold increased amounts of funds for one-off large payments. As a result, the structural liquidity surplus may contract significantly in the middle of averaging periods. Towards the end of averaging periods, interest rates in money and swap markets may fluctuate, since banks holding increased amounts of liquidity in their accounts against the required ratio seek to temporarily reduce excess ruble liquidity. In order to prevent the adverse impact of the uneven distribution of liquidity among banks on the market operation, the Bank of Russia introduced long-term repo auctions back in spring, namely one-month and one-year repo auctions. Recently, we have been observing rising demand for such repos, primarily one-month repo auctions. We believe that the demand for them will go down when the budget system starts to spend funds at the end of the year. Contrastingly, the elevated demand for cash will continue to affect the structural liquidity surplus for a longer period of time. However, we expect the demand for cash to resume the downward trend in the mid-run, after the end of the pandemic.
As to foreign currency, banks accumulated excess liquidity by the moment of the pandemic outbreak. This was a key reason why Russia had no problems with foreign currency liquidity in Q1 and market participants showed no demand for the Bank of Russia FX swap with an expanded limit. Banks reduced the share of foreign currency on their balance sheets in the past few years, which has also helped avoid problems with foreign currency liquidity. The amount of foreign currency liquidity has slightly decreased recently, with the difference between implied rates on swaps and money market rates returning to the normal level recorded in recent years. Therefore, we assess the situation as normal. Moreover, as is clear from our annual survey, banks themselves consider their foreign currency liquidity as sufficient for repayments on due obligations in foreign currency, which, by the way, are expected to be smaller than in previous years.
Liquidity risk was the main one for the financial system at the beginning of the pandemic, but now credit risks related to borrowers’ solvency are coming to the fore, especially given the persistent decline in the real economy. Tight restrictions and plummeting demand are adversely affecting solvency. In spring, the uncertainty about future solvency increased significantly. In order to prevent any abrupt responses to this situation on the part of banks, the Bank of Russia introduced regulatory relaxations incentivising banks to restructure loans. By the moment, the Bank of Russia has extended this regulatory easing, but now this has been done so that banks have enough time to gradually assess borrowers’ actual financial standing. By the end of the effective period of the regulatory easing, banks should show the actual credit quality on their balance sheets.
I would like to give some details regarding the impact of the pandemic on banks’ balance sheets. The portion of non-performing and bad loans remains stable since the outbreak of the pandemic (i.e. 1 March), lowering by 0.1 pp to 9.3%, but the restructured loans exceed 6.6 trillion rubles. Our Review provides more detailed information on loan restructuring across different industries and on the situation in these industries. The level of risk for banks depends not only on how drastically a particular industry has been hit by the pandemic, but also on its share in banks’ portfolios. Therefore, major oil and gas producers and mining companies account for a considerable portion of restructured loans. Commercial real estate is also a significant contributor. Contrastingly, banks’ risks on loans to such affected industries as tourism, hotels, and public catering are limited since the portion of these loans in banks’ portfolios is not large.
According to our preliminary estimates, nearly 20% of the restructured loans may turn into bad ones. Nonetheless, as shown by the stress test based on the hardest, risk scenario described in the Monetary Policy Guidelines, capital buffers accumulated by the banking sector over recent years, including both prudential (about 6 trillion) and additional macroprudential ones (around 600 billion), would be sufficient to absorb potential losses. In other words, our policy aimed at improving the quality of the banking system’s capital and preventing the accumulation of vulnerabilities we have been pursuing in recent years has enabled banks to create adequate safety cushions to cover existing risks and ensures the stability of the banking system. The Bank of Russia has started to gradually release macroprudential capital buffers in order to make it easier for banks to absorb losses.
It should be emphasised that, in contrast to the 2014–2015 crisis, now, amid the accommodative monetary policy of the Bank of Russia and stable interest income dynamics, banks continue to earn sufficiently large profit which they may also use to cover their losses.
Our Financial Stability Review also analyses the impact of the pandemic on non-bank financial institutions. Briefly, this impact was minimal owing to the good quality of their assets.
Last year, as the situation in financial markets was relatively stable, our Financial Stability Reviews predominantly focused on potential vulnerabilities in the financial sector. The experience of the pandemic has shown that the timely identification of vulnerabilities and the implementation of adequate measures help avoid problems and enhance the sector’s resilience to external shocks. Therefore, it is essential to track newly emerging vulnerabilities already now. This issue is explored in the last section of our Financial Stability Review. Furthermore, some vulnerabilities are associated with markets’ response to the pandemic and the policy pursued amid the pandemic.
The first challenge, or a potential vulnerability, is the risk of overheating in the real estate market. As the Bank of Russia shifted to accommodative monetary policy and the Government launched its mortgage rate subsidy programme, this contributed to a considerable reduction in interest rates on mortgage loans from 9.0% at the beginning of the year to 7.3% in October. In September—October 2020, the monthly growth of debt on mortgage loans equalled nearly 3%. In 2020 Q3, the price index in the primary real estate market rose by 9.4% in annualised terms. The growth of prices in the primary market exceeding inflation was also typical of Russia in 2018–2019, while then this could rather be associated with the revival after the 2015–2016 stagnation.
A quick rise in housing prices amid a quick rise in lending is often considered to be a sign of an emerging market bubble. However, this is not always true, since such a situation may be explained by recovery growth in related markets or migration processes. In our opinion, there are currently no grounds to make a conclusion about a bubble in the Russian housing market. We may rather say that these are continuing recovery processes. The portion of mortgage loans in the Russian financial market is as little as about 7.4% of GDP, which is why a faster rise in mortgage lending, compared to other segments, is a normal trend. Nonetheless, we should closely monitor this segment in order to avoid a situation where the affordability of housing starts to decrease because of price growth and the stability of the financial market worsens due to an emerging bubble.
The second challenge is the transfer of households’ savings from deposits to the securities market. Overall, the growth of the non-bank financial sector’s share is a normal process of the development of the financial market. It has been observed in Russia for a certain period already, accelerating in recent months, including after the Bank of Russia shifted to accommodative monetary policy. Pursuant to the depository reporting of non-bank financial and credit institutions, from early 2019 to 1 September 2020, households’ investment in bonds increased by nearly 1 trillion rubles, with Russian issuers’ bonds accounting for 71%.
There is a whole range of risks arising when households switch, especially rather fast, to new types of financial savings. We should closely monitor them and adjust our policy instruments when needed. The main risk for the Russian market is misselling when households, driven by decreasing deposit rates, extensively invest in high-risk products promoted as highly profitable. In addition to financial and reputational losses, such a situation amplifies the risk of volatility spikes in individual markets after households get discouraged by such products.
The second risk is the generally high exposure of some types of non-bank financial intermediaries and households’ direct investment in the market to elevated volatility induced by shocks. This problem has emerged to the full extent in the global market this year, which is why the regulators of various countries are currently analysing the situation and devising adequate macroprudential policy approaches.
The third challenge I would like to focus on is the increased exposure of banks to interest rate risk. In order to maintain their margin amid declining interest rates, banks have decided to reduce the share of their long-term liabilities. All else being equal, consumers also prefer more flexibility, opting to place their funds in short-term or demand deposits. This increases liquidity risk, but it is mitigated owing to the development of the highly liquid asset market. However, this does not solve the problem of interest rate risk. As interest rates decline, many banks have started to offer floating rates to corporate borrowers. Some banks are raising the issue of floating mortgage rates. By eliminating interest rate risk for themselves and offering this sort of instruments, banks may amplify credit risk in certain cases, which is why they should be provided very cautiously. If retail loans at floating interest rates become widespread in the market, the Bank of Russia will develop approaches to properly take into account the specifics of loans at floating interest rates in the methodology for calculating the payment-to-income ratio.
Finally, the fourth challenge is intensifying climate risks. The climate problem has been discussed for a while now. However, even despite the pandemic, both governments and investors have been demonstrating increased interest in this issue recently. For the Russian market, risks may be associated with both natural phenomena themselves and investors’ and governments’ policies in this area (e.g. the introduction of carbon taxes).
The Bank of Russia is currently exploring the channels of the transmission of climate risks and devising approaches to their assessment (including stress testing). This work is carried out in addition to the efforts aimed at developing the green financing market.
Summing up, I would like to reiterate that the situation has stabilised in the last quarters, compared to the spring peaks, but has not yet returned to normal to the full extent, with volatility remaining elevated. The issue of credit risk management in the banking system also requires close attention. Furthermore, it is crucial already now not only to focus on anti-crisis measures related to the existing shocks, but also to monitor emerging vulnerabilities.