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The Russian Banking Crisis of 1998

Trond Gabrielsen

It’s late summer in Moscow 1998. The Asian crisis has shaken the world financial markets for a year. Investors are about to lose faith in the Russian pyramid of financing growing budget deficits through issuing of high yield government bonds. The federal budget deficit is at 7-8 percent, and in July 1998 monthly interest payments reach 51 percent of budget revenues. At the same time world oil prices drop from around $23 a barrel in mid 1997 to $11 a year later, depriving Russia of hard needed export revenues. As a result, the Russian government has an increasingly hard time meeting the growing debt obligations and budget deficit. The government is unsuccessful in raising significant tax revenues and the fixed exchange rate regime makes it impossible to borrow from the Central Bank. The interaction between the fixed exchange rate and the large financing need also cause very high interest rates, that in turn hurts already weak banks. Thus on Monday August 17th 1998 the Russian government sees no other choice than to devalue the ruble by widening the lower target band, declare a 90 days moratorium on payment by Russian commercial banks to foreign creditors, and default on domestic government bonds worth $43 billion in August. By the end of the year the value of these bonds decreases to nearly $14 billion as the ruble fell from six to nearly 21 to the US dollar.


The story of Russia’s economic recovery was almost over before it had begun. Since the breakup of the Soviet Union in 1991 the Russian economy has shrunk by almost 50 percent. During the Soviet period, the economy was built around the goal of winning the arms race with the U.S. When the Soviet Union broke apart, it had to be transformed into a civilian economy overnight. This was an almost impossible task. In 1996 the Russian economy started to grow again at a modest 2 percent. The promise of a restructured and wealthy Russia was a very strong attractor for investors. In 1997 foreigners were also allowed to buy Russian high yield government bonds. However, what investors in 1997 called the “summer of heights” also meant a farewell to Russia’s short growth period.

Through the fall of 1997 Russia’s budget deficit and external debt increased steadily. The first part of the problem was the poor tax collection. The Russian tax system is very complex to follow and easy to get around. In addition, the collapse of the Soviet Union and the social welfare system had made Russians more reluctant to pay taxes. Russians’ skepticism toward politicians was at the rise and so was the belief that they would never get anything in return for their taxes. The second part of the problems was the fixed exchange rate that effectively blocked the Russian government to print money, leaving the Russian government with one way of financing the high deficit, namely through issuing of government bonds, the short-term GKOs and the longer-term OFZs. As the government found it increasingly difficult to raise funds, it had to rely on every rising interest rates, which, by the end of 1997, reached between 25 and 30 percent annually, far above comparable rates abroad. As a result, Russian banks took up loans in foreign currencies, notably dollars and euro, to be able to invest in the lucrative bond market. Their foreign liabilities as a proportion of assets rose from 7 percent in 1994 to 17 percent in 1997. The capstone to the Russian financial pyramid was laid in the end of 1997 when foreign investors were allowed into the domestic bond market. By the time of default foreign investors held 280 billion rubles, the bulk of the frozen debt. Some 20 large foreign banks held most of these bonds. A further drop in world oil prices reduced the government’s revenues even further, and made the balance of payment unsustainable in August 1998.

The Soviet banks were never banks by Western standards. Rather, they served as the service arm of large state enterprises to take care of wage payments and other financial services. What’s more, they lent extensively to money-losing state owned enterprises. When Russia introduced market economic reforms the banks were supposed to immediately help building up a productive real economy. During the transition years of the 1990s the almost 2000 Russian banks were never able to provide loans to small and medium private enterprises based on sound lending principles. Rather than functioning as financial intermediaries Russian banks functioned more as financial speculators.

The Russian banks also borrowed extensively. When the Central Bank issued short-term bonds in 1997 the domestic banks were among the most eager to purchase them. In addition to borrowing in dollars and lending in rubles, the banks borrowed short term and lent long term. This caused a maturity mismatch when the people started running on the banks. The Russian banks were hit harder by the devaluation and default than any other sector of the economy. First, the banks’ debt obligation in foreign currencies skyrocketed as the ruble lost its value to the dollar. Second, the banks did not get back more than a 20 percent portion of what they had invested in the domestic bond market. Some banks had up to 70 percent of their assets in bonds that were now worthless. As a result, the Russian payment system fell apart.

The Crisis

After the moratorium on domestic banks’ payment of foreign debt panic set in and people started a run on the banks. During August, some 10 percent of retail deposits from 30 largest banks were withdrawn creating a shortage of bank liquidity. This was brought under control when the Central Bank allowed 50 percent of ruble deposits and 10 percent of foreign currency deposits to be transferred to Sberbank, which is owned 58 percent by the Central Bank of Russia and the only bank with sovereign guarantee. After a year Sberbank held between 75 to 80 percent of household deposits.

What first appeared to be a temporarily liquidity problem in the banking sector, turned into a long-term insolvency problem. By Western accounting standards, the entire Russian banking industry was insolvent in 1998. The Russian government’s support to the ailing banks was, however, modest by international standards and mainly targeted towards the 20 largest banks. People thought most of the banks would go under and that this would create a sounder banking sector. This proved wrong mainly due to the lack of bankruptcy enforcement. In the fall of 1998 only some 200 bank-licenses were withdrawn, and no major steps were taken to clean up in the ailing bank sector through reforms and bankruptcy enforcement.


It may be argued that the crisis was due to the fact that Russian banks were dealing more with financial manipulation than providing loans to productive enterprises in the real sector. On the other hand, one can argue that since the banks were not involved in the real economy their failure did not hurt GDP that much either. An additional explanation is the lack of supervision and regulation of the banking sector. Russia had loose capital adequacy requirements and most of the former state-owned banks expected the government to bail them out in case of financial problems. This belief led to massive risk taking by bank managers and asset stripping of credit institutions by major shareholders for their own benefits. Many of the well-connected oligarchs have later been accused of building up their fortunes by stripping the banks they had acquired cheaply for cash. As a result of extensive risk taking, non-performing loans (NPLs) accumulated. According to the Russian Central Bank (RCB) overdue loans were over 7 percent of total lending in September 1998. Moreover, RCB said there was a “dangerous concentration of bad loans” because half of the NPLs were on the books of the 5 largest banks, which account for one-third of the total lending to the economy. Bad debts of bank lending to the agriculture sector counted for 60 percent of total loans. By the end of July 1998 the commercial banks’ foreign liabilities, including deposits, exceeded their foreign assets by R115 billion ($18 billion before the devaluation) and accounted for 30 percent of all liabilities. The devaluation and default led to a depreciation of banks’ assets that worsened the mismatch between assets and liabilities even further.

However, the main cause of the banking crisis was the interaction between the need for financing and the fixed exchange rate regime, which combined led to very high interest rates to attract funds. These high interest rates in turn hurt already weak banks.


Following the devaluation, the value of accumulated private savings over the Soviet period lost almost 70 percent of its value to U.S. dollar. Consequently, ordinary Russians lost purchasing power and saw their life standard falling to under Soviet standards in months.

Some would argue that the banking crisis demonetized the economy even further and led to increased barter, which had been so common during the Soviet years. However, as the ruble was floated, liquidity came back into the system and the barter declined sharply.

The insolvency of the banking sector also meant that banks’ payroll function at the local level stopped. Russians went to work, but did not get their wages. This is what Padma Desai and Todd Idson at Columbia University called “work without wages” in their book with the same name published in 2000. Conversely under the Soviet period one had often the situation of “wages without work”.

Even though Russia hade been downgraded by the leading credit rating agency, Moody’s, already in March 1998, the actual default in August worsened Russia’s reputation as an emerging market. As a result, short-term investors pulled out. Due to the chaotic political aftermath of the crisis, Foreign Direct Investment (FDI) also declined. Russia started a long process of rescheduling some of the sovereign and commercial debt with international creditors, a process that is still going on.

Due to the default, Russia’s cost of borrowing at international capital markets went up. Therefore many feared that the Russian government under a flexible exchange rate regime would start printing money to finance the large budget deficit. In 1998 the inflation went up 50-60 percent, but was brought down to around 20 percent in 2000. The reason Russia avoided hyperinflation as was the case in 1992-93, was merely due to the high oil-prices, which gave Russia much needed export revenues in dollar and created a current account surplus. Russia’s rapid recovery was also helped by favorable political changes, restrained fiscal policy which in addition was helped by reduced debt servicing, and a devaluation, which caused a very important positive supply response from the manufacturing sector.

Looking Ahead

Despite growth of assets and increasing efficiency it is still too early to speak of an end of the banking crisis in Russia. Due to the lack of effective bankruptcy enforcement, there are still some 1,400 banks left. Only a portion of them, are solvent. According to an academic paper by Mikhailov and Sycheva from 2001, the problem of capitalization has not been resolved and neither the absolute magnitude of aggregate capital of the banking system nor the share of the capital in assets, have returned to their pre-crisis levels.

Organizations (ARCO) was set up in 1998 to overhaul the ailing banking industry, but has not yet proven successful in getting rid of the insolvent banks. There is not only a need for new laws. More importantly is the need for effective law enforcement. The Russian government has stopped many attempts by the legal system to liquidate banks. Evidence shows that countries that start early with banking reforms are more successful than the ones that start late. Russia started very late.

However, there are signs of improvement. By the end of 2000, non-performing loans (NPLs) were restored and total assets of Russian banks in constant prices had returned to their per-crisis level. The liquidity crisis in the banking sector was helped by the high inflation following the crisis. Inflation devalued the loans not repaid to the banks and reduced their share in the balance sheets. As a result the ratio of assets to liabilities in currency changed from negative to positive.

By 2002 banks have started to make profits again. Russian banks are now less exposed to overseas creditors meaning that foreign assets and liabilities as percentage of total assets and liabilities have gone down. Yet there are still many risks is the Russian banking system: High taxes, low credit worthiness of borrowers, lack of transparency and legally weak support for creditors. About 80 percent of the banks have less than $5 billion in capital, 50 percent of them less than US $ 1 million. A way of improving the liquidity problem has been to allow more foreign banks into Russia. According to a report from the Bank for International Settlement (BIS) foreign banks now have an overall market share of 10 percent in Russia as opposed to only 4 percent in the beginning of 1998.


Suggestions for further readings on the Russian Banking Crisis:

- Bernstam, Michael S. and Rabushka, Alvin, “Stop the bailout”, Hoover Digest, 1998 No. 4
- Desai, Padma, “Why Did the Ruble Collapse in August 1998?”, American Economic Review, 148, May 2000
- Desai, Padma and Idson, Todd: Work Without Wages, MIT Press, 2000
- Goryunov, Vladimir, “The Russian Banking Sector in 2000”, BIS papers no. 4
- Mikhailov, L., Sycheva, L., Timofeev E., Marushkina E. and Surkov S., “1998 Russia’s Banking Crisis and Stabilization Phase”, Moscow, 2001
- Korhonen, Vesa, “Russian Banking Sector Reform in 2004?”, Transition Newslatter, The World Bank
- Tuminez, Astrid, “Still Hobbling Along: An Update on the Russian Banking System”, AIG and Councel on Foreign Relations, April 2000
- “Resolving the Banking Crisis”, Russian Economic Trends, November 1998
- “Min Fin Market Forecast”, Vedi Financial Markets, 1999

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