Standard & Poor’s is warning that Russian banks face increasing challenges from greater regulatory and competitive pressures.

In a new report, S&P says that banking reform has begun to move again in Russia after nearly a decade of inactivity. While several new initiatives have been introduced since 2003, meaningful implementation of existing and new rules will be key in reining in risky practices in the sector, it says.

Earlier this year, investors were reminded of the Russian banking crisis of 1998, after one bank there was closed and another was sold off after a run on deposits. This time, the effects of liquidity problems were very limited, but in 1998 the trouble cascaded throughout world financial markets.

Standard & Poor’s credit analyst Ekaterina Trofimova, author of the report, said that the last three years’ upward trend in ratings on Russian banks is likely to slow down as a result of current market developments, but is not expected to reverse.

Standard & Poor’s credit outlook for Russian banks is still somewhat positive, but the average bank rates just ‘B-‘, among the lowest in the world. The risk profile of the banking sector balances an improved economic environment with institutional weaknesses and an immature credit culture that could lead to high loan losses in an economic downturn, it says. And, S&P warns that any projection of credit trends in Russian banks must factor in a low-probability but very high-risk scenario of a banking industry meltdown.

According to the report, the longer-term view of the Russian banking sector is one of tremendous opportunities, but high risk. The recent turbulence in the banking sector underscores the importance of the implementation of the reforms needed for a stronger and better disciplined banking system, it notes.

“If the Central Bank of Russia can summon the political will and make a clean break with the past, a clean-out of the system’s deadwood might permit the emergence of a more robust banking sector,” said Trofimova. The rating agency says that this path will be anything but smooth, however, as the Russian banking sector works its way through the reform process.

“While the second half of this year and year 2005 are still likely to be periods of uncertainty and require more cautious management, because of regulatory changes and expected announcements from the CBR regarding banks’ membership in the deposit system, this will not reverse the overall sector expansion and further improvement of Russian banks’ creditworthiness,” said Trofimova.