Support for Second-Tier Banks: What the Criticism Is About

The state's support for second-tier banks has prompted a great deal of debate. I cannot say whether it was the right decision, but today I would like to explain how this support works and what its withdrawal would now entail.

In Kazakhstan, support for banks has been provided in three ways, of which only support in the form of debt remains:

Equity injections, with an option for the principal shareholders to buy back their stakes within a set period. This method was widely used in 2009.

Purchase of distressed assets at face value by the Distressed Assets Fund. Under this scheme, loans and collateral were bought at the amount of the borrowers' debt, even though their real value was considerably below market value. The bank thus got rid of loss-making assets and could release the provisions it had built up to cover those losses. This is the easiest method to understand, but also the most unfair.

Provision of debt instruments at rates significantly below market. This method became popular in the most recent rounds of state support. Below I describe how exactly this form of support works.

Such a debt instrument may take the form of bonds or a long-term deposit placed in a second-tier bank by the state or the quasi-public sector.

The main problem for second-tier banks is that, to comply with prudential requirements and remain stable, they need capital. If capital is insufficient, a bank cannot perform its functions and must either be recapitalized or liquidated. Capital adequacy is calculated as capital divided by risk-weighted assets (loans, fixed assets, intangible assets, receivables, securities). When the risks on assets rise, banks are required to create provisions or recognize discounts, which are expenses and reduce profit and capital. When crises hit, loan defaults and interest rates rise, and banks create provisions and recognize discounts, which erodes their capital adequacy.

To help second-tier banks, therefore, an instrument was needed that would allow them to generate a substantial amount of profit during a crisis to sustain their capital.

For this purpose, long-term financial instruments carried at fair value under IFRS 9 were used. I will show how this works with an example.

Suppose a bank obtains a financial asset (bonds or a deposit) at, say, 4% per annum for 15 years, while the current rate is, say, 14% per annum. Over 10 years the bank would earn a 10% margin for each year it holds such an asset on its balance sheet, and this profit, discounted for the time value of money, is recognized as profit at the moment the asset is obtained. For example, obtaining such an asset in the amount of KZT 100 billion would yield a one-off profit of KZT 57 billion, and capital would immediately increase by that amount. The debt is then carried on the balance sheet at its present value, in our case KZT 43 billion, and the accounts accrue the market rate of 14% per annum on it instead of 4%. By year 15, through the accrual of interest, the amount of the debt will equal KZT 100 billion. When the bank repays KZT 100 billion, the debt is fully extinguished, while the profit was recognized at the very outset, when the instrument was received.

Therefore, if the instrument were withdrawn early (which is not so simple to do legally), the bank would have to recognize at once the difference between the carrying amount of the debt at the time of withdrawal and its nominal value. Since many banks received support not long ago, the losses would be substantial and would significantly affect the banks' capitalization.

At the same time, I fully support the position that dividends cannot be paid while state support is in place. However, the question of which banks actually received support, and in what amounts, requires more detailed analysis, as the matter is not as clear-cut as it seems.