Interfax: EBRD financials “masking” negative trends, creating risk of rating downgrade, recapitalization – Oreshkin

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NICOSIA. May 10 (Interfax) – The financials of the European Bank for Reconstruction and Development (EBRD), while formally showing positive figures, are “masking” a number of negative trends and management assumptions, and continuing the current approach to the EBRD’s activities could lead to a downgrade of its ratings and the need for recapitalization, Russian Economic Development Minister Maxim Oreshkin said in a statement for the EBRD’s annual board meeting seen by Interfax.

Oreshkin, who was appointed as Russia’s representative on the EBRD’s board of governors in April, said in the statement that, since it was created, the EBRD has developed a business model with an emphasis on support for the private sector and commercially-oriented state enterprises, and this model managed to ensure the bank’s stable financial position in past years.

“However, in recent years we have become witnesses to the bank’s deteriorating financial condition and prospects for development. While the formal figures in the report look positive, they conceal a whole range of negative trends and management assumptions. Maintaining the current approach to doing business will make the bank’s position unstable in the coming years, could lead to the downgrade of credit ratings and require recapitalization of the bank,” the statement said.

The minister said the profitability of the bank’s operations is unstable in the long term. The bank’s total income, according to the official report, amounted to 1.699 billion euros, of which almost a third was generated in Russia, in which the EBRD stopped investing in July 2014 due to European Union and U.S. sanctions against Moscow.

The bank’s Russian portfolio shrank to 3.7 billion euros by the end of the first quarter of 2017 from a high of 10.4 billion euros in the third quarter of 2012.

“Good management practice is demonstrating a result without so-called ‘discontinued operations,’ since it is obvious that the absence of operations in Russia in the coming years will reduce this indicator to zero. Without taking into account Russian operations, the bank’s actual income amounted to just 1.202 billion euros,” the statement said.

The minister also said that more than 200 million euros of the EBRD’s income was the result of the nonrecurring effect of options and hedging, as well as revaluation of the existing portfolio.

According to the business plan for 2017-2019, the amount of annual investments will decrease by 1 billion euros from the targets set in the five-year strategy: 8.9 billion-9.1 billion euros instead of 9.8 billion-10.25 billion euros.

The minister also said that the amount of deals agreed with and approved by the bank but cancelled at the last minute by clients and the amount of early repayments have increased considerably, to respectively 1.3 billion euros and 2.1 billion euros in 2016. This dilutes the EBRD’s revenue base and calls into question the stability of its business model, he said in the statement.

The minister also said that the bank’s operational efficiency has declined. The ratio of operating expenses to operating revenue was 42% in 2016, well above the five-year target of 33%, and is expected to deteriorate further this year, as well as on average over five years. The exclusion of income from the Russian portion of the portfolio would significantly increase this figure, the statement said.

The minister also said that the mandate for EBRD operations, which was historically based on observing three main requirements – assistance for transition to the market, complimentariness and sound banking practices – has been diluted.

In 2016, of the 56 major transactions signed, 32% were either completely or to a significant degree transactions involving clients restructuring or refinancing existing market debt or retroactive financing. Of the 149 individual projects approved by the board of directors, 28% had an element of refinancing of clients’ obligations to private banks or restructuring of existing debt.

“This shows that right now the bank, to a large extent, is not complimenting but pushing out the private sector. In order to maintain consistency with the basic principles of the bank’s work, new approaches to determining the EBRD’s complimentariness in projects with refinancing/restructuring were introduced in April 2016,” the statement said.

“The bank’s equity investments are increasingly moving forward along the chain: the share of participation in IPO financing, rather than pre-IPO as before, is increasing. Financing of leveraged buyouts has become common practice in countries of operation at an advanced stage of transition to market, where EBRD funds are going completely to previous private owners in countries that are not countries of the bank’s operations rather than to the development of the companies,” the statement said.

The minister also questioned the bank’s risk management policy. The bank does not classify transactions involving restructuring of clients’ existing market debt as distressed assets, thus masking real problems with their quality. Due to the EBRD’s special status and the absence of a regulator overseeing it, the bank has a fairly loose attitude to classification of such transactions and provisioning for such loans, he said.

“Some of the EBRD’s approaches, which in our view can be qualified as regulatory arbitrage, would be impermissible if there was some kind of regulatory body over the bank,” the statement said.

In January 2017, management decided to completely abandon the practice of setting internal country ratings, on which the assignment of ratings for private clients usually depended. For example, for Russia they were historically 4-5 rungs lower than the sovereign level. This approach dramatically worsens the return/risk ratio on the EBRD’s new operations, the minister said.

“The deterioration in condition and the need to adopt questionable management practices are to a large extent related to the acceptance of ‘political guidance’ on the complete cessation of new investment in the Russian Federation since July 2014. The EBRD’s operations in Russia were always notable for their high credit quality and good turnover of resources, and made it possible to achieve significant financial results and conduct operations in riskier countries/regions without hurting capital or worsening the bank’s risk profile,” the statement said.

“In order to justify its activities, the EBRD is trying to compensate for the lost amount of business by implementing projects that do not always meet the bank’s key mandate requirements. In the current situation, having exhausted other ways of resolving problems and in order to protect the interests of the Russian Federation as a shareholder and country of EBRD operations, the Russian side is forced to make efforts to find a legal solution to the current situation,” the statement said.

Besides dealing a serious blow to the bank’s financial condition, the implementation of ‘political guidance’ violates a set of legal norms, beginning with the agreement on the establishment of the EBRD, the statement said.

For example, the suspension or other change in the access of a bank member to the bank’s resources falls exclusively under the authority of the board of governors and cannot be delegated to the board of directors [as was the case with Russia]. In addition, the agreement on the establishment of the bank talks about the impermissibility of any attempts to influence EBRD management in the interests of certain shareholders or groups of shareholders that lie outside of the bank’s clearly defined mandate.

“Essentially, this is discrimination on the grounds of nationality that is impermissible in the activities of a multilateral development institution. Such an approach carries with it the danger of future arbitrary interpretation of the bank’s charter and its members being denied their shareholder rights without taking into account or in spite of the charter objectives and principles of the EBRD. In raising this subject, we are not only pointing to the unlawfulness of the decisions made in regard to Russia. We are concerned about the fate of the bank itself, since as a result the most profitable loan portfolio is decreasing, the bank’s mandate in regard to assisting the transition to market is not being carried out and its operating results are deteriorating, which could have serious and far-reaching consequences,” the statement said.

“The Russian side remains open to constructive and engaged dialog on the issue of finding legitimate, mutually acceptable ways out of the current situation and urges the bank’s management and its shareholders to make decisions that will ensure the bank’s sustainable development,” the statement said.

In 2016, the Russian authorities sent a letter to the chairman of the EBRD’s board of governors, Luxembourg Finance Minister Pierre Gramegna, stating that Russia believed the freeze on the EBRD’s operations in the country was a violation of its rights as a shareholder and country of operations of the bank. The EBRD’s board of directors considered Russia’s appeal and did not find the freeze on investment in Russia to be a violation of the official principles of the EBRD’s work.