10 portfolio, compared to 90.7 percent two years earlier.<sup>16</sup> Obviously, these figures reported by the Central Bank must be used with caution in view of the adoption in mid-2004 of a new loan classification system, which for the first time introduces “the principles of estimated recoverable amount on loans and qualitative judgments on borrowers’ creditworthiness”.<sup>17</sup> Still, shortcomings with the quality of Russian banks’ loan portfolio are undeniable especially when the reported level of non-performing loan figures is contrasted with loan loss reserves of only 5 percent (see table 2). Doubtful and irrecoverable loans of 1.2 percent of the aggregate loan portfolio, as reported at year-end 2005, are also very likely to be seriously underestimated. All this combined with large credit risks<sup>18</sup> -- still amounting to about 70 percent of the aggregate loan portfolio -- illustrate well the challenges currently faced by Russian regulators.

**_<u>Table 2: Selected soundness indicators for Russian banks</u>_**

||Jan-03|Jan-04|Jan-05|Jan-06|
|---|---|---|---|---|
|Large credit risks (bn. RUR)<br>_in % of outstanding portfolio to real sector_|1328.9<br>_80.3_|1964.4<br>_82.4_|2298.2<br>_70.3_|2978.1<br>_69.7_|
|_in % of equity_|_272.7_|_241.1_|_242.8_|_239.8_|
|% Standard Loans|-|90.7|46.9|48.2|
|Loan Loss Provisions, in % of outstanding<br>portfolio|-|5.90|5.3|5.0|
|Outstanding loans with real sector (bn. RUR)<br>_growth rate (%)_|1,654|2,385<br>44|3,268.7<br>37|4,274.8<br>31|
|Totalequity of Banking sector|581.3|814.9|946.6|1,241.8|

_Source: CBR Banking Supervision report 2005, 2004 and 2003_ In an environment like the one described above, deposit insurance can not, by itself, be a panacea and stimulate savings in the domestic banking system. Given the increasing monetization and rapid growth of the Russian economy, financial sector assets are expected to continue growing as they have since the transition began—in spite of the economic crises of 1998 and to a lesser extent 2004, as well as the strong decrease in real interest rates observed since 2000. As the deposit base grows, the rate of growth of deposits will moderate, and in fact has halved since the introduction of the deposit insurance system. With the overwhelming share of retail deposits held by public banks, mainly Sberbank, an implicit state-sponsored insurance guarantee was already in place, creating a market advantage for Sberbank (i.e., flight to “quality” of cheaper funds).

> 16 Although the underlying trend may be clearly be towards a deterioration of credit quality, this apparent surge in sub-standard loans may also reflect a tightening in loan classification rules by the Central Bank of Russia.

> 17 The new loan classification system increases the number of categories from four to five, setting a range for the loan loss provisions within each category (in parentheses). The 5 risk categories are:  Standard (0 percent), Watch (1-20 percent), Substandard (21-50 percent), Doubtful (51-100 percent) and Loss (100 percent). See S&P, Bank Industry Risk Analysis, “The Russian Federation”, June 28, 2005, page 10. 18 Large credit risks are defined as exposure to a single borrower / group in excess of 5 percent of the lender’s capital.