Publications. Financial Articles : # 23


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Article in Italian business-magazine “Diritto ed economia” #2-3, 2001, page 32


text of article in Italian language you can see HERE

Dmitry V. Lyubomudrov, Banking and Finance Expert, Investment Commission of the Consultative Council on the problems of national security of the
State Duma of the Russian Federation.

There is a number of unresolved problems, which strongly complicate work for any Investor, especially for the one who does not trade in portfolio transaction with shares and other securities, but carries out financing projects: creates new manufactures, purchases and modernizes plants, creates regional wholesaler networks. Low financial discipline is one of the most serious problems. This problem may be found in all payment chains within any Investment Project. Cash flows from the parent company’s account with a major international bank to the account of the Moscow representation office (as a rule - with an affiliated Russian bank of the major international bank) are not problematic. However, further problems practically always arise.

Some Typical Problems Investors Face in the Financial Sector:

1. A Russian bank which manages the accounts of the Project Management deliberately holds back entering into account and transfer of money with the purpose of receiving additional income from the moneys’ short-term allocation. Frequently this is done in a deal with local managers of the Project with which the banks splits such income. Sometimes we see banks practicing absolutely unlawful games such as transferring money using obviously false bank details and intentionally conducting long "searches". There is large number of unfair ways of dealing which we do not have the possibility to reveal in this article. Such ways of dealing exist due to the absence of strict statutory norms and judicial practice to punish banks for similar conduct.

2. A Russian bank which manages the accounts of the Project Management and which is located not in Moscow, but in a far-away region where there are no affiliated international banks suddenly stops all payments and actually goes bankrupt. This is often due to non-repayment of credits issued by the bank. In this event not only all money on the accounts is actually irrevocably lost, but even worse, the whole settlement system of the Project is blocked since in all agreements (and there can be not tens, but hundreds of agreements) the payment bank details of this bank are indicated and modification of all these agreements usually take many months. During this time the Project can be lost. As practice shows, judicial claims to bankrupt banks in reality give nothing to its former clients - money on the balance of such accounts is stolen by the owners and the managers of the bank through off-shores using methods that everybody knows and which there is no sense to describe in this article.

3. The Project Management in agreement with the manager of the Russian Representation office of the Investor unreasonably overestimate expenditures of the Project with the purpose of subsequent draw back of money through deliveries of goods by affiliated firms which quote excessive prices. While managing Projects together with security services I repeatedly had to stop similar infringements, but due to the lack of effective control mechanisms these cases inevitably came back again.

4. Money is transferred directly to the plant which is the object of the investment. The control over the accounts is vested in the accounts department of the plant, which always manages to find many internal expenditures, for which on perfectly lawful grounds it will irrevocably write off any sums. Auditing directed by the Investor may subsequently reveal this, however, it will never be able to return the money or prove that the funds were spent improperly. Money as well as can be written off by tax authorities or sometimes by dummy companies of the creditors in a non-negotiable way. And, naturally, in this case there is no possibility to return the money.

5. The investor transfers money directly to subcontractors under the Project without crediting the settlement account of the plant (the object of the investments) upon a request of the plant. The investor therefore loses its unconditional right of demand to the plant and highly complicates itself further claming of the money through arbitration in the event of defaults.

6. The plant (the object of the investments) transfers money received from the investor to a dummy subcontractor, which does not perform/deliver goods, does not repay the money and disappears, making any suit senseless. This often occurs under a preliminary deal with the management of the plant. Alas, the Investor’s money is once again irrevocably lost.

7. Money is transferred directly to the plant (the object of the investments) under guarantees of federal or local authorities and their budgets. The present pitiable status of the profitable part of any budget, no less than poor payment discipline allow us to recommend Investors not to accept such guarantees, or to accept them only as additional guarantees. The practice of major banks’ crediting of the subjects of the federation has shown that the majority of such credits are political credits and they are practically irretrievable since local judicial and executive bodies, as a rule, take the party of the local governor, instead of the Investor.

There Are Proven Ways to Prevent Such Problems.

All of these problems have one thing in common: they arise because of the imperfection of the Russian banking system. However, already today it is possible to effectively solve many investors’ problems related to Russian banks, even without passing new governmental laws and resolutions, within the framework of the already existing legislation. It is for the purpose of creating an effective protection mechanism for the interests and money of the investors that the initiative group under my management during several years has been developing a mechanism for a new type of credit institutions in Russia - Specialized Low-Risk Clearing-Control Banks (hereinafter - «Special banks»). Today the first “Russian Low -risk Special Bank” already services first clients. The proposed Special banks differ essentially from existing "universal" banks. The main "low-risk" principle of the Special Bank’s activities is to carry out active transactions with clients’ money only under direct order of the clients. When no transactions are due the funds are located on a correspondent account with the Central Bank of Russian Federation (the so-called "portfolio principle"). In addition, the Special bank will provide budgeting services and detailed daily control over the investment projects, as well as any client’s business in any city, including technical supervision and providing a settlement system with suppliers, contractors and marketing companies. Today such services are not provided by banks, and the unsatisfied demand is huge. Crediting and other active transactions which entail risks for the bank may be carried out by a Special Bank only subject to a 100 per cent money guarantee from the client ordering this transaction. The Special Bank will receive its main income in the form of higher commissions for transactions and no-risk credit margin.

The division of the Russian banking system into the existing "high risk" universal banks and "low risk" banks (which include Special Banks that I propose) may become one of the strategic steps in decreasing the probability of banking crises and may strengthen general trust of businesses and investors in Russian banks. We know that similar measures to restrict and separate risks by dividing the banking system into "high risk" and "low risk" banks were undertaken, for example, in the USA during the period of "the Great Depression" (Glass-Stigal law), as well as in France after of the Second World War, and proved to be efficient in reducing of banking risks in the economies of these countries.

Why Did Major Russian Banks Go Bankrupt?

The existing universal banks have proved their inability to guarantee smooth settlements under the conditions of crisis. The main reasons is that universal banks combine the functions of a settlement center which keeps corporate and personal accounts with the functions of a high-risk investment bank which trades in forward contracts, high-risk corporate shares, options, promissory notes, and bonds. The owners and managers’ desire to maximize profits, coupled with inadequate liquidity of the financial instruments listed above lead to frequent bankruptcies. Investors take the hardest blow because of the longest economic cycles, which make it difficult to stop or cut down project financing when the servicing bank turns bankrupt.

The downfall of many banks, including major ones, in the August 1998 crisis showed lack of efficient controls and management of cumulative risk, on the one hand, and failure of the effective law to define the bank’s (owners and managers’) liability to corporate and individual clients (including criminal liability), on the other. Many owners deliberately brought their banks to the state of “false bankruptcy” as an opportunity to withdraw the funds, leaving the depositors and clients with “dead” assets represented by obligations of dummy companies. Being a professional with more than 12 years of experience of work in banking and the financial sector, I am ready to assert that in a modern balance sheet of a major universal bank it is possible to hide any sums from their owners - the Investors, despite international audit, twinning-projects and introduction of western accounting standards. We all know cases when the account balance statement shows that money is available, but effective payments are not made because of "temporary financial difficulties of the bank". And at this moment money is used by the bank to purchase a factory for the real owner of the bank.

Let us turn to the recent history of major Russian banks, for example, the oligarchic ones, which have used their own and clients’ money and the managerial potential to grab as much property as became available in the course of privatization. These banks failed to establish real and efficient control over use of this property, to say nothing of their clients’ projects. It is common knowledge that the Russian legislation gives bank clients very limited rights to control real processes in the bank. The same is true of small shareholders. This was dramatically demonstrated by the recent crisis. While the majority of banks’ clients, including both individuals and legal entities, suffered unrecoverable losses, owners of the banks succeeded in taking out all valuable property, controlling shares of the best enterprises, and funds in bank accounts and are now building new financial empires with the money of their cheated clients with perfect impunity.

We should also say a couple of words about affiliated banks of major foreign banks in Russia. Despite of all respect towards their "parent" banks we should note that not all credits, investments in stock and other assets successfully have survived the check by the 1998 crisis. Official reports show that these affiliated banks make the greater part of the list of the most unprofitable banks. This advocates that applying in Russia well known international financial practices without taking into account real Russian economic practices can result in the damages and loss clients’ money. As a result many affiliated banks had to ask their "parent" banks for stabilizing credits in the amount of hundreds of million dollars, and face an uneasy task of repayment of these credits from their profit in the nearest future.

The proposed financial technology of a “Special Low-Risk Bank” was designed to prevent bank crises in the future and to reduce investor risks related to the functioning of the banking system.

Who Needs Special Low-Risk Banks Most?

The financial technology of a “Special Low-Risk Bank” can be used in many segments of the economy where the goal is the protection of clients’ funds rather than capital gains. Some of the examples are:

  1. Maintenance of accounts and control over designated use of funds in investment projects, especially long-term ones;

  2. Maintenance of accounts for non-profit organizations, philanthropic, environmental organizations, venture and other targeted funds;

  3. Maintenance of accounts for attorneys, legal advisers, notaries, deposit accounts of courts and any other organization which does not intend to make commercial use of the money;

  4. Mortgage savings schemes (German model, Baushparkassen system);

  5. Functions of an agent for Consortium credits for regional projects.

Two Models for a Special No-risk Bank

The effective law On Banks and Banking Activities permits maintenance of bank accounts for two types of legal entities only: Banks and Non-banking Credit Organizations (NCO). Therefore, at present special no-risk banking technologies may be realized in Russia in two ways:

  1. By making an ordinary bank operate in a no-risk mode through special provisions in the Charter and a system of contracts between the bank’s owners, managers, and clients.
  2. By using the status of a non-banking credit organization which is legally restrained in terms of risk exposure but has equal rights with banks to maintain corporate accounts and carry out cash and currency operations.

Selected Features of a Non-banking Credit Organizations (NCO) status:

NCO do not compete with banks in their traditional field of activity: deposits, issuance of credits on behalf of the bank, guarantees and other transactions which entail various business risks for the bank. Nor NCOs service individuals. NCO is not only a no-risk credit organization, but also is an independent Clearing Chamber, which according to its license has the right to perform interbank and intercorporate clearing settlements that allow to redistribute cash flows and to liberate additional working capital.

NCOs follow more stringent rules than traditional commercial banks and cannot use their clients’ funds without permission. This permits to create on their basis No-Risk Settlement and Control Financial Systems as both corporate and public entities (municipal, regional). In contrast to banks, NCOs may not attract deposits for their subsequent allocation in their own name. As a result, major corporations can use NCO to organize control over financial flows between the head company and extended branch network, and improve the efficiency of subsidiary banks and their interaction with partner banks, including regional banks.

Higher transparency of NCOs permits their clients to obtain higher income as compared to traditional banks which pay fixed interest and retain all profit from use of the funds. Real bankruptcy risk is carried by the clients. On the contrary, in a NCO all income goes to the client, while the NCO takes a limited commission. Under the conditions of economic instability and insufficient liquidity of financial instruments this arrangement is more profitable and safer for the client.

For this reason, NCO cannot service clients’ accounts free of charge or for a small fee. However, for the money, the clients get guarantees for the safety of their basic settlement accounts and operations which is unattainable in a universal bank. The commission charged by NCO does not compare with the losses which may result from bankruptcy of the servicing bank. Independence of NCOs is supported by non-participation in the clients’ business, full segregation of clients’ cash flows, possibility of participation in the NCO capital for major clients, NCO Board, and control over internal cash flows. None of these options are possible in a universal bank where assets are impersonalized and are used as the bank’s credit resource without client’s knowledge or control.

NCO may become an effective financial service instrument of any major Investor which sets up the performance of investment programs, for budgeting Projects, including technical supervision of the serviced projects. This is done through the creation of Financial Settlement Centers (FSC). FSC is a structural department of a NCO or Special bank servicing the accounts of the Investor’s plants. Medium-size projects are serviced by a central FSC in Moscow. In order to service Projects outside Moscow NCO representation offices with 3-4 staff members should be created directly on the object. Settlements are made through the Internet’s electronic «Bank-Client» system. For the major Investor NCO can organize a separate FSC immediately at the location of the Project, which budget should be controlled. FSC on a monthly basis receives from the Investor authorized budgets of the subjects of planning and certified copies of all contracts under which budget payments are allocated. Then payment orders of the controlled subjects are checked in FSC’s departments which supervise their conformity to the contracts, pricing schemes and observance of technological discipline directly on object. In case of discrepancies FSC stops the payment and initiates an auditing procedure on behalf of the Investor. Each month FSC sends to the Investor a performance report of the budget for each subject. An individual technology for each Investor is developed for the FSC, proceeding from the features of the Investor and goals to be reached by its plants.

At present, banks do not provide these services, while unsatisfied demand is very high. In addition, this arrangement will permit better management and control over cash flows of subsidiaries and subordinate units. Until the present, NCOs did not service no-risk corporate bank accounts. However, economic feasibility and the need to protect basic bank operations and reduce risks by segregation and control over cash flows created the demand for no-risk banking structures.

This approach was approved by the Investment Commission, based on positive response from the following Russian and foreign experts :

You can find full texts of these references at the Internet site: .

The above stated mechanisms were analysed by a Ratings Service "EA-Ratings" (affiliated with Standard and Poor’s), which considers that they will reduce banking risks of major investment projects, including international ones. Official results of this research were published by "EA-Ratings" in the Analytical Bulletin “Credit Russia” #18 (21), September 2000, as an article “NCO or banks - who is more stable ?”. Text of this publication you can find on the below mentioned Internet site.

Evaluating this issue from the point of view of the Russian legislation, the Moscow City Bar came to the conclusion that since the existing legislation is not perfect it is necessary to raise the role of contractual restriction of risks for banking activities, including through the creation of Special Banks that I propose. Besides, I got a positive official assessment of this Technology the «Banca Commerciale Italiana».

Upon a specific request of the Investment Commission, during my trip to the US in December 2000, I met with the representatives of the World Bank, International Monetary Fund, American Bankers Association, Department of Energy, Environmental Protection Agency and other official organizations, to discuss my project on the Special Banks. As a result, I got a unanimous positive response and feedback.

Anyone wishing to receive more information can find the complete texts of the above mentioned documents on my site on the Internet site : .

Cooperation Between Practical Workers, Scientists and Politicians in Dealing with a Problem.

Deputies of the State Duma, the Federal Assembly of the Russian Federation, are interested in the issue of reducing risks in the Russian banking system. Especially for discussing such an issue an open discussion on the subject named “How to minimize risks in banking system of Russia ” was held as a follow-up to the official request of the Deputy Ivan D.Grachev in the premises of the "International Fund for Economic and Social Reforms" under the presidency of Khandruev, Principal of the Analytical Center of the Academy for National Economy of the Government of the Russian Federation. In order to initiate a wide discussion of this issue I have published some materials in one of the leading Russian economic magazines "The EXPERT" (# 20 (184) of May 31 1999, pages 18-20), 2 articles in "Analytic Banking Magazine", (November 2000, #11 (66), page 77, and July 2001, #07 (74), page 60), article in the magazine “Securities Market” (December 2001, #23 (206), page 63). You can find the Russian texts of all articles on the above mentioned Internet site.

In summary I would like to state that using the no-risk banking technologies I offer will promote transparency within and responsibility of Russian banks, as well as protect the rights and cash flows of the Investors in the Projects carried out in the Russian Federation, and first of all - of major industrial Investors. No doubt that the business practice of international banks and financial companies, first of all in the US, has developed many financial mechanisms for resolving similar tasks within the framework of the legislation of different countries involved. In our work we try to take into account similar international experience and we will be grateful for any assistance or recommendations in this field.

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