Publications. Financial Articles : # 17
"Protection of investors should be based on contractual obligations between bank founders, bank managers and bank clients"
|Article in the lead
Russian economic Magazine "THE EXPERT" # 20 (184), 31 of may 1999, page 18.
Author - Dmitry Lyubomudrov
Working with foreign and local investors we may say, that many investors consider the absence in Russia of strict financial control over expenditure of funds as one of the reasons that slows down any investment project.
Existing banks are not prepared to provide financial control and do not offer such services to clients. Even if a bank would offer such services it is not advisable to use it as bank's contractual obligations to its clients cannot be considered as sufficient security when the majority of large banks are almost out of business, and small banks may collapse at any moment. Clients often cannot even rely on their bank for money transfers. Bank shareholders and clients cannot obtain authentic information with respect to current risks, assets and liabilities of their banks. Auditor's findings are often no more, than a public facade for a half-bankrupt bank.
It is possible to resolve the problem by amending the civil and criminal legislation. This can take years and decades, but the business should be developed today. However, the situation can be remedied. Defects in legislation may be corrected by contractual obligations between the bank's shareholders, managers and clients. My more than eleven years of investment project management gives me the right to make the following suggestion: within the framework of the current legislation it is necessary to organise a new type of bank - "Special-purpose Settlement/Control Bank" (Special Bank).
Confidence in the technology We have the following methods for establishing a Special Bank. In order to create a Special Bank a big investor with a several million-dollar project (or a number of investors with smaller projects) purchases a small non-working bank, reorganises it and converts it into a Special Bank. Of course, he can create a new bank. The majority of clients think this scheme is preferable from the point of a good image and a clean credit history of the bank. However, this scheme is more expensive and time consuming. According to the current legislation, the minimum charter capital of a new bank is US$ 1,350,000 for a Russian owned bank, and 10,000,000 Euro for a bank with foreign participation. These funds should be placed on an account with the Central Bank of the Russian Federation before the registration of the bank. The in kind contribution to the charter capital of the bank should not exceed 20 percent and in practice in kind contributions considerably complicate the registration of the bank.
On the secondary market, however, an existing bank clear of debts and with a license for operation in Roubles is worth approximately between US $ 300,000 and US $ 700,000. For this amount, a client (clients) buys a bank with a charter capital in the form of "dead assets". Though the shareholders must fill up the charter capital, the advantage is that it can be done gradually and that the purchase price of the bank would be several times smaller than in case of incorporating a new bank.
The Charter of the Special Bank shall stipulate, that the bank's management shall undertake only those risks, which are secured by funds assigned by the clients for that specific operation and risk and which are placed in the Special Bank.
A Special Bank voluntary restricts its rights. Its main goal is to provide cash settlement services to its clients and to control the use of clients' funds in specific projects. In addition to the Charter of the Special Bank, such restrictions are provided in agreements with the management of the Special Bank and with its clients. The advisable legal form for a Special Bank is a closed joint-stock company, with a limited number of shareholders, which are also the clients of the Special Bank and which are, therefore, liable for the activities of the Special Bank. Each shareholder participates in recruiting the bank managers and in controlling the activity of the Special Bank by determining or modifying the risks, which are acceptable for the Special Bank.
Here is an example of how a Special Bank works: An investor from Moscow has purchased a large factory, for example in Tumen, has opened abroad a credit line and is reconstructing the factory. A dozen of contractors, suppliers, consumers are working with this factory. The total amount of investments exceeds US $ 50,000,000. Local banks are burdened with large debts and are near to bankruptcy; the branches of large Moscow banks are closed.
Less than for $1,000,000 the investor purchases a small local bank, reorganises it into a Special Bank which would manage all the accounts of the factory, the settlement of payments with suppliers and collection of payments from consumers. Although this is only a simple cash settlement service, it provides the safety of funds on the bank accounts, which in the atmosphere of general instability of banks is also a problem of life or death for an enterprise.
In addition to cash settlement service, a Special bank can perform many other important functions. A Special bank may also classify the expense sub-accounts of the enterprise (including all its branches, affiliates and companies in which the enterprise has a majority interest in the charter capital). The Special Bank performs money transfers only if the required payment corresponds to the detailed budget of the enterprise approved by the investor (shareholder). This provides a high degree of control over the use of funds. In order to fulfil such task a special department is created within the Special Bank to work with the accountant of the enterprise on a daily basis.
In addition, the Special Bank maintains expense sub-accounts of the Investment Project Management Company. ** (An Investment Project Management Company (IPMC) is a legal entity created to perform the first stage of the investment project. The IPMC is responsible for the costs of the project and for the financial success of the development.)**
This scheme permits to avoid losses of funds in the event of a non-fulfilment of contractors' (supplier') obligations. Instead of an advance payment the Special Bank issues a letters of credit or a bank guaranty; instead of transferring funds to the bank account of the contractor, where such funds may disappear, the Special Bank pays invoices presented by the contractor after their thorough verification. A Special Bank may credit the consumers of the enterprises' production if such credit is secured by current assets of the enterprise and subject to the collection of proceeds from the consumers in the Special Bank, thus controlling the return of the credit. In practice a bank opens a line of credit in the amount of 30 % of the average monthly turn-over of the company calculated for the last three months, and considers it to be a sufficient security for credits to trading companies.In this case, the enterprise and/or the investor bear the credit risks. The philosophy of a Special Bank provides that the entity, which orders the credit operation, bears the risk of such operation. In order to increase production sales of a company, and using the standard procedure of crediting consumers as provided by the Civil Code and widely used by banks, the enterprise may guarantee the credit. In the event of non-return of credit funds the enterprise becomes the creditor. A Special bank has more legal instruments to return the credit.
A Special bank also ensures the management of the employees personal bank accounts, transfers salaries to plastic cards, advises the enterprise on taxation optimisation issues.
A Special Bank is entrusted to conduct financial and economic audits of the enterprise on a regular basis and to present a report to the investor and creditors.
The investor may work out a program according to which the Special Bank will invest the investor's funds into profitable assets. The investor shall entirely bear the risks of such operations. In the event of a loss of funds by one of the Special bank's clients, the funds of other clients would not be threatened. The Special Bank shall provide to its client full consulting support in preparing calculations of all the risks and shall suggest financial schemes to minimise such risks. However the client makes the final decision with respect to the investment.This is only a small number of operations of a Special bank that are provided by the current legislation. The difference between a Special bank and other Credit organisations is that a Credit organisation may only provide cash settlement services.
The services of a Special Bank should be purchased by its clients. Before the crisis practically all banks offered cash services free of charge. Clients got used to this "free cheese in a mouse-trap". Banks compensated free cash service by high incomes from hazardous operations. For the money paid to the Special Bank the client has the right to demand risk-free operation and absolute transparency of the Special Bank with respect to the client's funds with all the bank's credit, guarantee, documentary, broker, trust and other services in force.
It is possible to contravene this and say that a Special Bank is a typical so called "pocket bank" and that such bank controlled by one enterprise is expensive for the owner. This is true for the beginning of the privatisation process when the enterprises did not have a single owner or a real investor. The former management of an enterprise used the "pocket bank" for transferring assets of the enterprise in their own pocket, lending funds from a "pocket bank" to their own firms before leaving the enterprise to start their own business with the accumulated money. The instrument is, therefore, not responsible for being badly used: on the one hand, a hammer may be used to hammer nails, on the other hand, it may be used to knock down somebody. It is possible to prevent the pressure of the bank's owners on the managers of a Special Bank by giving the management special rights in the in the Charter of the Special Bank, including a right to veto hazardous operations.
While the laws are written The best solution for reducing bank risks is certainly the creation of a new legislative status of Special Banks with a special license, as well as different legal regulations. However, new laws can take a long, long time to come into force. Already for more than 5 years the Construction Banks Association of Russia is asking the Central Bank of the Russian Federation to provide a special legal status for investment banks.
I offer an intermediate, but quite realistic solution of contractual restrictions within the Special Bank. Practical work of Special Banks shall stimulate the legislative work on their special legal status.
I assert that it is possible to control the operations of a Special Bank and to penalise careless managers if clients and shareholders of the bank have a contractual basis to control the operations of the Special Bank. This includes personal material liability of the managers of the Special Bank, as well as supervision by special supervisors (provided for in the Charter of the Special Bank) who have an agreement with each client (shareholder). In such circumstances clients and shareholders cease to be helpless, doomed to watch how their money is stolen.