Fitch Ratings says today that a series of adverse shocks and mounting pressures in the banking sector have tilted risks more to the downside although, as signalled by their Stable Outlooks, Fitch does not currently expect to change Russia's Long-term foreign and local currency Issuer Default ratings of 'BBB+'.

Widespread downgrades of Russian banks are also not anticipated at present, but individual negative rating actions are possible, with smaller and mid-sized banks generally more at risk in light of their typically weaker funding franchises and lesser access to government liquidity facilities. Fitch will continue to closely monitor events.

"An unpalatable cocktail of heightened global financial turbulence, falling oil prices, the war in Georgia and corporate governance concerns has dented investor sentiment towards Russia and increased pressure on the banking sector," says Ed Parker, Head of Emerging Europe in Fitch's Sovereigns team. "Nevertheless, the Russian sovereign's strong balance sheet underpins its 'BBB+' rating and gives it the capacity to provide support to the banking sector."

The Russian banking sector is a long-standing rating weakness for the sovereign, after a period of rapid credit expansion on relatively weak foundations. Fitch's Macro-Prudential Indicator (MPI) for Russia is '3', signalling a "high vulnerability" to systemic banking stress from above-trend credit growth coupled with asset price bubbles or significant real exchange rate appreciation. The banking system has become used to operating with markedly negative real interest rates, but now faces a squeeze on liquidity and difficult period of adjustment. Net private sector capital inflows have receded, the value of equity collateral has fallen and confidence in counterparties has weakened - exacerbated by payment problems at the small investment house, KIT Finance - causing inter-bank interest rates to jump to 12% today from only around 4% in July. Aggressive borrowing in recent years has seen the Russian private sector's external debt rise to USD436bn at end-March, from USD109bn at end-2004, increasing its exposure to global capital markets and international investor sentiment.

Yesterday in an effort to alleviate the liquidity squeeze, the Central Bank of Russia injected RUB360bn (USD14bn) of liquidity through one-day repo auctions into the market, with the level rising slightly to RUB365bn today. The Ministry of Finance also increased its limits for placements of fiscal deposits in the three largest banks, Sberbank, VTB and Gazprombank, to RUB1,127bn (USD44bn), and increased the deposits offered to banks at today's auction to RUB350bn, following yesterday's placement of RUB150bn. Banks only took up RUB118bn of the amount offered at today's auction, but Finance Minister Alexei Kudrin has indicated that in future the three largest banks may on-lend fiscal deposits to smaller institutions. In addition, bank reserve requirements have been cut today by 4% to support overall sector liquidity. Reduced levels and the higher cost of bank funding are likely to lead to a marked slowdown in credit growth, with some knock-on effects for investment and GDP growth. Government support to banks underscores that the sector is a contingent liability to the sovereign. Fitch would not necessarily view the use of the sovereign wealth funds (SWFs) to help stabilise the banking sector as warranting negative rating action if moderate in size and limited in scope. However, it would look unfavourably on attempts to prop up the equity market or an open-ended or substantive commitment of public resources to the banking sector that significantly weakens the sovereign balance sheet.

Relatively weak and concentrated funding franchises have been a major rating constraint at many Russian banks, in particular at smaller and medium-sized institutions which tend to be more dependent on shorter-term customer and bank deposits. "The fact that liquidity facilities offered by the Central Bank and Ministry of Finance can generally be accessed primarily by larger, more highly-rated institutions, coupled with the ongoing cutting of limits on the inter-bank market and the drying up of the commercial repo market, could result in severe liquidity constraints at some smaller institutions," comments James Watson, a Senior Director in Fitch's Financial Institutions Group in Moscow. "Provision of liquidity by state-owned banks could, however, help to relieve these constraints - although the volumes and conditions of this funding remain to be seen - while the reduction of reserve requirements should provide at least short-term liquidity support for the sector as a whole." While banks have generally not been major investors in the stock market in recent years, some have significant direct exposures and others have built up considerable volumes of equities-backed credit exposures on the loan and repo markets, which could also become sources of losses. In addition, a sustained period of low credit growth and suspension of lending operations by some banks could also exacerbate liquidity pressures in parts of the corporate sector, in turn feeding back into asset quality problems for banks.

Notwithstanding current financial market and banking sector weaknesses, Russia's sovereign ratings are underpinned by its strong public finances. General government debt was just 8.6% of GDP at end-2007, compared with the 'BBB' range median of 28%, and Russia has accumulated around USD175bn in its SWF. Fitch expects Russia to run a general government budget surplus and current account surplus of around 6% of GDP in 2008, buoyed by high average annual oil prices. Its foreign exchange reserves of USD574bn (including the SWF) provide a substantial liquidity buffer.