Tag: risk

Risks of Russian Business Ownership in Georgia

Image of Tbilisi at night representing risks of Russian business ownership in Georgia

This policy brief addresses risks tied to Russian business ownership in Georgia. The concentration of this ownership in critical sectors such as electricity and communications makes Georgia vulnerable to risks of political influence, corruption, economic manipulation, espionage, sabotage, and sanctions evasion. To minimize these risks, it is recommended to establish a Foreign Direct Investment (FDI) screening mechanism for Russia-originating investments, acknowledge the risks in national security documents, and implement a critical infrastructure reform.

Russia exerts substantial influence over Georgia. First and foremost, Russia has annexed 20 percent of Georgia’s internationally recognized territories of Abkhazia and South Ossetia. Further, it employs a variety of hybrid methods to disrupt the Georgian society including disinformation, support for pro-Russian parties and media, trade restrictions, transportation blockades, sabotage incidents, and countless more. These tactics aim to hinder Georgia’s development, weaken the country’s statehood, and negatively affect pro-Western public sentiments (Seskuria, 2021 and Kavtaradze, 2023).

Factors that may also increase Georgia’s economic dependency on Russia concern trade relationships, remittances, increased economic activity driven by the most recent influx of Russian migrants, and private business ownership by Russian entities or citizens (Babych, 2023 and Transparency International Georgia, 2023). This policy brief assesses and systematizes the risks associated with Russian private business ownership in Georgia.

Sectoral Overview of Russian Business Ovnership

Russian business ownership is significant in Georgia. Recent research from the Institute for Development of Freedom of Information (IDFI) has addressed Russian capital accumulation across eight sectors of the Georgian economy: electricity, oil and gas, communications, banking, mining and mineral waters, construction, tourism, and transportation. Of the eight sectors considered by IDFI, Russian business ownership is most visible in Georgia’s electricity sector, followed by oil and natural gas, communications, and mining and mineral waters industries. In the remaining four sectors considered by IDFI, a low to non-existent level of influence was observed (IDFI, 2023).

Figure 1. Overview of Russian Ownership in the Georgian Economy as of June 2023.

Source: IDFI, 2023.

There are several reasons for concern regarding the concentration and distribution of Russian business ownership in the Georgian economy.

First, it is crucial to keep Russia’s history as a hostile state actor in mind. Foreign business ownership is not a threat in itself; However, it may pose a threat if businesses are under control or influence of a state that is hostile to the country in question (see Larson and Marchik, 2006). Business ownership has been a powerful tool for the Kremlin, allowing Russia to influence various countries and raising concerns that such type of foreign ownership might negatively affect national security of the host country (Conley et al., 2016). Similar concerns have become imperative amidst Russia’s full-scale war in Ukraine (as, for instance, reflected in Guidance of the European Commission to member states concerning Russian foreign acquisitions).

Further, Russian business ownership in Georgia is particularly threatening due to the ownership concentration within sectors of critical significance for the overall security and economic resilience of the country. While there is no definition of critical infrastructure or related sectors in Georgia, at least two sectors (energy and communications) correspond to critical sectors, according to international standards (see for instance the list of critical infrastructure sectors for the European Union, Germany, Canada and Australia). Such sectors are inherently susceptible to a range of internal and external threats (a description of threats related to critical infrastructure can be found here). Intentional disruptions to critical infrastructure operations might initiate a chain reaction and paralyze the supply of essential services. This can, in turn, trigger major threats to the social, economic, and ecological security and the defense capacity of a state.

Georgia’s Exposure to Risks

Identifying and assessing the specific dimensions of Georgia’s exposure to risks related to Russian business ownership provides a useful foundation for designing policy responses. This brief identifies six distinct threats in this regard.

Political Influence

Russia’s business and political interests are closely intertwined, making it challenging to differentiate their respective motives. This interconnectedness can act as a channel for exerting political influence in Georgia. Russians that have ownership stakes in Georgian industries (e.g. within electricity, communications, oil and gas, mining and mineral waters) have political ties with the Russian ruling elite facing Western sanctions, or are facing sanctions themselves. For instance, Mikhail Fridman, who owns up to 50 percent of the mineral water company IDS Borjomi, is sanctioned for supporting Russia’s war in Ukraine. Such interlacing raises concerns about indirect Russian influence in Georgia, potentially undermining Georgia’s Western aspirations.

Export of Corrupt Practices

The presence of notable Russian businesses in Georgia poses a significant threat in terms of it nurturing corrupt practices. Concerns include “revolving door” incidents (movement of upper-level public officials into high-level private-sector jobs, or vice versa), tax evasion, and exploitation of the public procurement system.  For instance, Transparency International Georgia (2023) identified a “revolving door” incident concerning the Russian company Inter RAO Georgia LLC, involved in electricity trading, and its regulator, the Georgian state-owned Electricity Market Operator JSC (ESCO). One day after Inter RAO Georgia LLC was registered, the director of ESCO took a managerial position within Inter RAO Georgia LLC. Furthermore, tax evasion inquiries involving Russian-owned companies have been documented in the region, particularly in Armenia, further highlighting corruption risks. We argue that such corrupt practices might harm the business environment and deter future international investments.

Economic Manipulation

A heavy concentration of foreign ownership in critical sectors like energy and telecommunications, also poses a risk of manipulation of economic instruments such as prices. The significant Russian ownership in Armenia’s gas distribution network exemplifies this threat. In fact, Russia utilized a price manipulation strategy for gas prices when Armenia declared its EU aspirations. Prices were then reduced after Armenia joined the Eurasian Economic Union (Terzyan, 2018).


Russian-owned businesses within Georgia’s critical sectors also pose espionage risks, including economic and cyber espionage. Owners of such businesses may transfer sensitive information to Russian intelligence agencies, potentially undermining critical infrastructure operations. As an example, in 2022, a Swedish business owner in electronic trading and former Russian resident, was indicted with transferring secret economic information to Russia. Russian cyber-espionage is also known to be used for worldwide disinformation campaigns impacting public opinion and election results, compromising democratic processes.


The presence of Russian-owned businesses in Georgia raises the risk of sabotage and incapacitation of critical assets. Russia has a history of using sabotage to harm other countries, such as when they disrupted Georgia’s energy supply in 2006 and the recent Kakhovka Dam destruction in Ukraine (which had far-reaching consequences, incurring environmental damages, and posing a threat to nuclear plants). These incidents demonstrate the risk of cascading effects, potentially affecting power supply, businesses, and locations strategically important to Georgia’s security.

Sanctions and Sanction Evasion

Russian-owned businesses in Georgia face risks due to Western sanctions as they could be targeted by sanctions or used to evade them. Recent cases, like with IDS Borjomi (as previously outlined) and VTB Bank Georgia – companies affected by Western sanctions given their Russian connections – highlight Georgia’s economic vulnerability in this regard. Industries where these businesses operate play a significant role in Georgia’s economy and job market, and instabilities within such sectors could entail social and political concerns. There’s also a risk that these businesses could help Russia bypass sanctions and gain access to sensitive goods and technologies, going against Georgia’s support for international sanctions against Russia. It is crucial to prevent such sanctions-associated risks for the Georgian economy.

Assessing the Risks

To operationalize the above detailed risks, we conducted interviews with Georgian field experts within security, economics, and energy. The risk assessment highlights political influence through Russian ownership in Georgian businesses as the foremost concern, followed by risks of corruption, risks related to sanctions, espionage, economic manipulation, and sabotage. We asked the experts to assess the severity level for each identified risk and notably, all identified risks carry a high severity level.


Considering the concerns detailed in the previous sections, we argue that Russia poses a threat in the Georgian context. Given the scale and concentration of Russian ownership within critical sectors and infrastructure, a dedicated policy regime might be required to improve regulation and minimize the associated risks. Three recommendations could be efficient in this regard, as outlined below.

Study the Impact of Adopting a Foreign Direct Investment Screening Mechanism

To effectively address ownership-related threats, it’s essential to modify existing investment policies. One approach is to introduce a FDI screening mechanism with specific functionalities. Several jurisdictions implement mechanisms with similar features (see a recent report by UNCTAD for further details). Usually, such mechanisms target FDI’s that have security implications. A dedicated screening authority overviews investment that might be of concern for national security and after assessment, an investment might be approved or suspended. In Georgia, a key consideration for designing such tool includes whether it should selectively target investments from countries like Russia or apply to all incoming FDI. Additionally, there’s a choice between screening all investments or focusing on those concerning critical sectors and infrastructure. Evaluating the investment volume, possibly screening only FDI’s exceeding a predefined monetary value, is also a vital aspect to consider. However, it’s important to acknowledge that FDI screening mechanisms are costly. Therefore, this brief suggests a thorough cost and benefit analysis prior to implementing a FDI screening regime in Georgia.

Consider Russian Ownership-related Threats in the National Security Documents

Several national-level documents address security policy in Georgia, with the National Security Concept – outlining security directions – being a foundational one. Currently, these concepts do not specifically address Russian business ownership-related threats. When designing an FDI screening mechanism, however, acknowledging various risks related to Russian business ownership must be aligned with fundamental national security documents.

Foster the Adoption of a Critical Infrastructural Reform

To successfully implement a FDI screening mechanism unified, nationwide agreement on the legal foundations for identifying and safeguarding critical infrastructure is needed. The current concept for critical infrastructure reform in Georgia envisages a definition of critical infrastructure and an implementation of an FDI screening mechanism. We therefore recommend implementing this reform in the country.


This policy brief has identified six distinct risks related to Russian business ownership in several sectors of the Georgian economy, such as energy, communications, oil and natural gas, and mining and mineral waters. Even though Georgia does not have a unified definition of critical infrastructure, assets concentrated in these sectors are regarded as critical according to international standards. Considering Russia’s track record of hostility and bearing in mind threats related to foreign business ownership by malign states, this brief suggests regulating Russian business ownership in Georgia by introducing a FDI screening instrument. To operationalize this recommendation, it is further recommended to consider Russian business ownership-related threats in Georgia’s fundamental security documents and to foster critical infrastructural reform in the country.


Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Belarusian Business in Turbulent Times

20231023 Belarusian Business Challenges

In the past three years, the Belarusian private sector appears to have been caught between a hammer and an anvil, experiencing domestic repressions and de-liberalization as well as collateral damage from sanctions and a deterioration of the country’s image. This policy brief discusses the challenges that Belarusian businesses have been facing since the onset of the Covid-19 pandemic and argues that the private sector may be the last hope for sovereignty and transformation of the country.

The years that have passed since the onset of the Covid-19 pandemic and the subsequent economic shocks have significantly altered the entrepreneurial landscape in Belarus. This period has seen the emergence of private businesses’ social and political activation during the pandemic, as well as during the 2020 election campaign and post-election protests (Bornukova & Friedrich, 2021). Businesses have also had to adapt to reactionary government policies, cope with sanctions against Belarus and deal with issues related to the Russian invasion of Ukraine. In the face of these challenges, the reactions and responses from small and medium-sized businesses signals that the private sector still has the potential to remain a driving force for socio-economic development in Belarus – despite the current political forces in power.

Private Sector Development; Liberalization and Regulation

The liberalization of the business environment, which lasted more than a decade and ended in 2020, allowed the private sector (enterprises without any state ownership share) to become the most dynamic part of the economy (see Figure 1).

From 2012 through 2020, the share of the private sector in employment increased by 7.7 percentage points. Similarly, the contribution from the private sector to the export of goods and services, as well as to GDP, exceeded the contribution from state-owned commercial enterprises. Moreover, even in the absence of significant privatization and restructuring of state-owned enterprises, the private sector took over the “social” function as an “employer of last resort”, absorbing workers released from the public sector (including from fully and partly state-owned enterprises) (IPM Research Center, 2020).

In addition, the development of the private sector increased the diversification of Belarus’ foreign trade. Private companies in the IT sector, advanced instrument manufacturing, electronics, and other high-value-added industries shifted their focus to developed countries’ markets, which reduced the dependency on Russian resources and markets. This increased Belarus’ economic sovereignty and its resilience to political tensions and other external shocks. The year 2020 however marked the end of the liberalization of entrepreneurial activities, as private businesses and private capital started to be seen as a threat to the political system (Bornukova & Friedrich, 2021).

Figure 1. Contributions from the Belarusian private sector to main economic indicators.

Source: Own elaboration based on Chubrik (2021) and IPM Research Center (2020).

Although there are no uncontestable figures describing business’ attitudes and activities during the political crisis in 2020, several non-academic projects documented that 58 percent of people protesting the fraud elections in 2020 worked within the private business sector (Devby.io, 2020). Dozens of businesses also openly supported the anti-regime strikes (The Village Belarus, 2020). As a consequence, legislation and law enforcement have since been steadily tightened, the tax burden has increased, and the possibility for using simplified taxation and accounting systems by small-scale businesses, in particular for sole proprietors, have been substantially reduced.

Against this backdrop, the government has also suppressed the publication of detailed statistical data including those on entrepreneurial activity. Since 2020, the Belarusian Research and Outreach Center (BEROC)’s quarterly enterprise surveys have become the main source of information and analysis on the business development situation.

In general, BEROC’s surveys demonstrate that, despite a reduced safety cushion and the lack of substantial state support during the pandemic, Belarusian businesses had, by the end of 2021,  adapted to the shocks from the post-election crisis and harsh de-liberalization, by realizing  their ability to cope, and finding creative solutions in the turbulent environment (Marozau, Akulava and Panasevich, 2021). Before Russia’s aggression against Ukraine, Belarusian entrepreneurs’ optimism about overcoming external barriers – i.e., factors that are out of a firm’s control such as macroeconomic instability, etc. – was the highest since 2015. However, increased uncertainty forced Belarusian businesses to focus primarily on maintaining the achieved scale of activity, halting investments (Kastrychnicki Economic Forum (KEF) & BEROC, 2022).

Optimism In Challenging Times

In general, the institutional environment for doing business in Belarus has deteriorated in recent years, both due to actions such as changes in tax legislation, price regulation and pressure on disloyal businesses, and due to negligence from the state, such as lack of significant support measures for private business, an outflow of businesses due to sanctions and an increasingly negative image of the country (KEF & BEROC, 2022). The Business Confidence Index (BCI, ranging from 0 – “extremely negative” to 100 – “extremely positive”), developed by BEROC and the Kastrychnicki Economic Forum based on OECD methodology, documented that at the end of 2020, the confidence level of business representatives regarding future developments was in the negative zone – arguably due to the political unrest and the Covid-19 pandemic. As firms accepted a new normality and adjusted their businesses, the BCI steadily grew before comfortably settling in the neutral zone at the end of 2021 (see Figure 2).

In March-April 2022, however, macroeconomic instability, disruption of supply chains, and shortages of raw materials and/or components following the Russian war on Ukraine became serious external barriers for Belarusian businesses. This lowered the BCI and businesses’ perception of their economic situation.

Quite surprisingly, the risks of doing business in Belarus in the second half of 2022, until early 2023, were estimated to be lower than in 2021 (see Figure 3). This may be explained by the fact that (for companies remaining in Belarus) many of the potential risks (inflation, exchange rate instability, sanctions, counter-sanctions, disruption of supply chains, tightening of price regulation, etc.) had already realized (BEROC, 2023).

Figure 2. Business Confidence Index and GDP growth rate, October 2020-March 2023.

Source: KEF & BEROC (2023) and the National Statistical Committee of the Republic of Belarus.

Figure 3. Risk perception by Belarusian Businesses.

Source: BEROC (2023).
Note: Risks were scored on a five-point scale, 1-5, where 1 denotes “very low” and 5 “very high”. Dotted lines denote the 95 percent confidence intervals.

The New Reality

The reaction from most Belarusian businesses to both pandemic- and war-related challenges has manifested in their search for new business models, an introduction of new products/services, and the entry into new export markets. Despite a bundle of powerful shocks to the economy stemming from the Russian war on Ukraine and related sanctions, some factors have dampened the anticipated drop in the economy: in particular, the increase in Russian support, export re-orientation to Russia and developing markets, alongside monetary stimuli, and interference with the activity of state-owned enterprises as well as artificial price controls (Kruk & Lvovskiy, 2022). As a result, the standard of living has remained at pre-war levels: in January-April 2023, real household disposable income and real salary grew by 1.6 percent and 3.8 percent respectively. With sanctions on Belarus being comparatively softer than those on Russian businesses, Belarusian businesses may have gained a comparative advantage and additional opportunities in both the domestic and Russian markets (BEROC, 2022). This caused optimism among entrepreneurs and in March 2023 – for the first time in the considered period – the composite BCI turned out to substantially exceed the neutral zone (see Figure 2). These positive spillovers are however likely to be bound in time – they will end both if the state of the Russian economy worsens (as this would reduce Russian support and decrease export revenues for Belarusian firms), and in the unlikely scenario that Russia’s current isolation is reduced. Whether Belarusian businesses will withstand the current protracted crisis depends on the ability of state authorities (current or new) to restore a constructive dialogue with the business community, return to the rule of law and create a business environment conducive to entrepreneurship.

According to business, the key factor needed to expand business activity is a reduction of external barriers (such as disruptions to supply chains, shortages of raw materials and/or components), rather than government support (e.g., financial, informational, etc.) (KEF & BEROC, 2022). Thus, “We do not need state support, but need the state not to worsen legal conditions for doing business” has become a motto of Belarusian entrepreneurs. Even in the context of war and political instability in the region, it allows looking at the prospects of the private sector in Belarus with some positive expectations.

At the same time, factors such as political repressions, sanctions against Belarus, problems with logistics, and the refusal of business partners to work with Belarusian companies due to the Russian aggression towards Ukraine have forced many Belarusian businesses, especially in high-tech sectors, to relocate. While the scale and direction of Belarusian business emigration is still difficult to assess (Krasko & Daneyko, 2022), these processes devastate entrepreneurship capital in Belarus and jeopardize the prospect of entire sectors such as the IT sector. In addition, the popular opinion about the lack of business opportunities implies that, unless conditions improve in terms of state policy and public confidence in the future, the socio-economic effects (employment, value added, tax revenue, innovations) from entrepreneurial activity in Belarus will diminish (GEM-Belarus 2021/2022). With operations severely affected by external barriers and restrictive legislation, halted investments and limited, if any, commercial contacts with Western countries and individual businesses, Belarusian private enterprises can hardly be seen as a source of stability for the current regime.


To promote an increased role of the private sector in the Belarusian economy, and to ensure high-quality and sustainable growth of the same, two prerequisites are critically necessary.

Firstly, a resolution of the political crisis and a restoration of authorities’ and state institutions’ legitimacy will significantly increase the populations’ confidence in state policy on business and economics. The principle of rule of law must be recognized and public and private actors must be treated equally in all spheres. It is also necessary to ensure the stability of tax legislation and economic law and the mitigation of excessive state control of business activities. All the above would lower external barriers and create stimuli for long-term business investments that, in turn, would facilitate economic transformation.

Although the sanctions’ packages imposed on Belarus by most developed countries due to domestic repressions, and complicity in the aggression against Ukraine, were directed towards the public sector, the private business suffered substantial macroeconomic and reputational consequences in their wake. The refusal of many foreign partners (suppliers, customers, banks, transport companies etc.) to work with Belarusian businesses – regardless of their affiliation with the state and attitude towards Lukashenko’s regime as well as towards the war on Ukraine – also substantially undermine businesses’ potential and Western soft power in Belarus. Such refusal is often driven by the argument that, by paying taxes, private businesses in Belarus support the current regime, when they should instead undermine the regime by halting operations (and thus tax revenues). At the same time, with the complete liquidation of civil society organizations and the termination of international projects and initiatives, the Belarusian private business may serve as the last resort in the hope of achieving independent, decentralized, and autonomous decision-making – all cornerstones of modern democracy (Audretsch & Moog, 2022).

From this perspective, the preservation of the private sector in Belarus may be of decisive importance in the future political processes, necessary to take into account by policymakers and business elites alike in developed countries.

In addition, relocated Belarusian businesses can play an important role in transforming the country by developing social ties between entrepreneurs and civil society, by providing support when solving problems related to doing business outside of Belarus and by investing in the Belarusian economy in the future. In this regard, establishing non-partisan Belarusian business associations abroad creates preconditions for consolidation of the most active part of the Belarusian community and its involvement in the envisaged economic transformation of the country.


Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes. 

Do Regional Ties Add to Depositor Trust during the Crisis? Evidence from Russia

Do Regional Ties Add to Depositor Trust FREE Policy Brief Image

The question of whether regional banks should be treated differently has recently become all the rage in the banking authorities’ debates in Russia. We add to this discussion by analyzing bank regional ties in the flight-to-familiarity context, which implies that agents naturally feel more favorable about what they are comfortable or familiar with. We use the regional or local cues in the bank titles as the most evident source of familiarity for unsophisticated retail depositors. We argue that during the financial crisis of 2008-2009 depositors of “familiar” banks become less sensitive to bank risks. These banks therefore enjoy some additional protection against a bank run even if they are more risky.

Why should we care about bank regional ties?

The question of whether regional banks, working mostly within particular regions, should be treated differently and separately from large federal banks has recently become all the rage in the banking regulator’s debates in Russia. They are usually smaller; their office networks are not vast; they may demonstrate higher risks. However, they may enjoy the advantage of additional trust by the local depositors, especially if the depositors clearly distinguish between the banks tied to the regions and all the rest. Giving those banks a special favor, the depositors may ignore their riskiness and avoid withdrawing their funds even in the period of financial crisis. This phenomenon can be explained in the flight to familiarity context. The familiarity hypothesis was first introduced by Huberman (2001). He suggested that agents naturally feel more favorable about and charitable toward what they are comfortable or familiar with.

Why should we – and banking authorities – care? Because the bank runs are not harmful for the economy if they are efficient, i.e. if more risky banks attract less deposits, resulting in lower deposit growth rates and/or lower market share (see Semenova (2007) and Karas, Pyle, and Schoors (2010, 2013) for Russian evidence). During the periods of financial turmoil this mechanism, also known as market discipline, is crucially important for the retail deposit markets, as it allows for efficient redistribution of funds from too risky banks to more reliable ones.

Market discipline can, however, be easily undermined, as the household depositors suffer from high monitoring costs and are usually unsophisticated and sensitive to non-risk related information available to them. Among other factors is the set of explicit guaranties provided by deposit insurance schemes. Peresetsky (2008) and Karas et al. (2013) show that the introduction of deposit insurance in Russia in 2004-2005 substantially reduced household depositors’ sensitivity to bank risk, as most depositors were fully protected by the introduction of insurance. In the Russian context, there are two groups of banks that may be expected also to enjoy implicit guaranties, namely state banks that are controlled and protected by the state and foreign banks, which may provide external support to their Russian subsidiaries in case of financial difficulties. As these banks are considered to be under implicit protection of the state or foreign financial institutions, retail depositors perceive them as more reliable and feel no need to monitor their financial conditions (Semenova, 2007).

For the Russian market for personal deposits, which is regionally segmented with intense region-level competition, it is extremely important to consider the regional-level sources of depositors’ confidence, undermining the market discipline. In Schoors, Semenova, and Zubanov, 2016, we hypothesize that depositors feel compelled to exert less discipline on familiar banks, measured as banks with local or regional references in their names – or in other words exhibit a flight to familiarity – especially in times of crisis.

Empirical strategy

We introduce a very simple proxy for the depositors’ regional familiarity with the bank. If the bank’s name contains words related to its regional geographical position – the name of the region (e.g. Altay Bank), the name of the city (e.g. Bank of Moscow) or a place in the city (e.g. Okhotny Ryad) – we assume the household depositor perceives more familiarity with the bank. We go through the list of all Russian banks living from 2000 to 2010 and check if they are tied to the region and hence familiar in the eyes of depositors. Using quarterly data on the Russian banks’ financial ratios provided by the Bank of Russia for 2001-2010, we check whether during and after 2008-2009 financial crisis the deposit growth at familiar banks is not sensitive to banks’ risks, measured by capital adequacy, liquidity-to-assets ratio and the share of non-performing loans. We control for the banks’ size and deposit insurance system inclusion, which stared in 2004-2005. We exclude all banks registered in Moscow to focus on pure regional evidence.

We also aim to determine the source of the lack of attention to familiar bank risks. There may be two possible explanations: high level of regional affinity (regionalism) – meaning that people feel more attached to the region and appreciate it so they trust it more to anything region-related – or high level of trust in regional governments (implicit guarantees) – implying that depositors expect the local authorities to help the banks or bail them out. We separate the regions into two groups by the regionalism index – to test the first hypothesis – and by the degree of reliance on local authorities – to test the second hypothesis. To construct the regionalism index we use data provided by Berkowitz, Hoekstra, and Schoors (2014) and choose components that may explain the current level of regional affinity based on the transition – or even Soviet – period history of the region. If the population was more stable, homogenous, less urbanized and prone to reforms, observed the substantial support the region got from the federal budget in the Soviet period (meaning that the region was favored), the regionalism is higher. We measure depositors’ trust in regional and local authorities by the share of the region’s population that supports the actions and policy of the regional government, calculated on data coming from the results of the Courier surveys, conducted regularly and nation-wide by the WCIOM and the Levada-center.


Our results suggest that during the financial crisis the sensitivity to risks became weaker for all the Russian banks, which is in line with a cross-country study by Cubillas et al. (2012). But with respect to capital adequacy this effect is clearly more pronounced for familiar banks: in the post-crisis period, the capital sensitivity of familiar banks essentially falls to zero, while unfamiliar banks retain the level of market discipline they had before the crisis.

When looking for sources of additional trust, we confirm the importance of regional affinity. Indeed, during the crisis market, discipline is undermined only in regions with above median levels of regionalism. This effect is absent in the regions where the trust in local authorities is above the median level, though.


In Schoors, Semenova, and Zubanov, 2016, we provide some evidence of an alternative source of depositors’ confidence in bank reliability – namely, the regional ties providing familiarity. They make depositors more relaxed on bank riskiness in the period of the crisis, when the efficient redistribution of funds within the banking sector is especially important. This happens mostly in the regions with high levels of regionalism and regional affinity, i.e. where people believe more in region-centrism and the idea of power of the region. This result implies that banks in these regions may explore the additional benefits provided by the regionally tied names and pursuit riskier strategies when the financial world is unstable. The clear policy implication that can be suggested is that explicit distinguishing between regional and federal banks – as the policy debates suggest – should be accompanied by increased control of regional banks’ risks. This control is justified and should indeed come from the regulator, as the market seems to be inefficient in this respect.


  • Berkowitz, Daniel, Mark Hoekstra, and Koen Schoors. 2014. “Bank Privatization, Finance, and Growth.” Journal of Development Economics 110: 93–106. doi:10.1016/j.jdeveco.2014.05.005.
  • Cubillas, Elena, Ana Rosa Fonseca, and Francisco González. 2012. “Banking Crises and Market Discipline: International Evidence.” Journal of Banking & Finance 36 (8). Elsevier B.V.: 2285–98. doi:10.1016/j.jbankfin.2012.04.011.
  • Huberman, Gur. 2001. “Familiarity Breeds Investment.” Review of Financial Studies 14 (3): 659–80. doi:10.1093/rfs/14.3.659.
  • Karas, A., W. Pyle, and K. Schoors. 2010. “How Do Russian Depositors Discipline Their Banks? Evidence of a Backward Bending Deposit Supply Function.” Oxford Economic Papers 62 (1): 36–61. doi:10.1093/oep/gpp006.
  • Karas, Alexei, William Pyle, and Koen Schoors. 2013. “Deposit Insurance, Banking Crises, and Market Discipline: Evidence from a Natural Experiment on Deposit Flows and Rates.” Journal of Money, Credit and Banking 45 (1): 179–200. doi:10.1111/j.1538-4616.2012.00566.x.
  • Peresetsky, Anatoly. 2008. “Market Discipline and Deposit Insurance.” Applied Econometrics 11 (3): 3–14.
  • Schoors, Koen, Maria Semenova, and Andrey Zubanov. 2016. “Depositor Discipline in Russian Regions: Flight to Familiarity or Trust in Local Authorities?” 58/FE/2016. WP BRP “Financial Economics.”
  • Semenova, Maria. 2007. “How Depositors Discipline Banks: The Case of Russia.” EERC Working Paper, EERC Working Papers, 07/02.

Hedge Funds Non-Transparency: Skill of Risk-Taking?

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This policy brief raises the issue of whether the secretive nature of hedge funds allows funds to misbehave and take excess risks that may in turn be contagious for the whole economy. We use a novel dataset and a new methodology to argue that at least part of the excess performance of more secretive funds during the pre-crisis period was indeed due to higher risks taken.

Hedge Funds – the Secretive Investment Vehicles

In the modern era of delegated portfolio management, hedge funds constitute some of the most interesting and complicated investment vehicles, with a global industry size of over US$2.5 trillion and an overall number of funds of about 10,000 (according to Hedge Fund Research, Inc). The industry grew dramatically during the early 2000s, often providing investors with returns superior to those available in other financial sectors.

The natural question arising is then what exactly made hedge funds enjoy these superior returns. Historically, hedge funds have operated in a relatively secretive way that did not require them to disclose the details about their operations to regulators. Some have argued that it is this secretive nature of hedge funds that has allowed fund managers to employ superior trading strategies and effectively preserve the managerial know-how (in terms of stock-picking skill, market timing or faster trading technology) from being potentially replicated by others.

At the same time the secretive nature of hedge funds might simply allow the fund managers to hide the excessive risks their strategies are exposed too, thereby earning superior returns during relatively good periods (when risky strategies earn the risk premium), but having drastic collapses during relatively bad periods (when these risks realize).

Distinguishing between these two major explanations of superior performance is critically important for potential policy implications regarding hedge funds transparency and disclosure. If the secretive nature of hedge funds attracts more skillful managers that employ proprietary know-how strategies and invests into acquiring more information about the instruments they trade (i.e. generate so called “alpha”), more disclosure would not be necessarily good. This, since it would allow other funds or investors to free-ride on these more skillful managers, reducing their competitive advantage and incentives for providing superior performance. If on the other hand, secrecy allows hedge funds to misbehave and take more systematic risk than they claim they take (i.e. they have a higher “beta”), then there may be a rationale for increasing disclosure requirements, so that investors understand what they are being compensated for in the form of superior returns.

Is There More Risk in Secretive Hedge Funds?

The traditional approach to distinguishing between high-alpha and high-beta funds involves adopting a certain model of risk, i.e. selecting a set of observable risk factors that hedge funds may load on, and then adjusting their raw performance using the estimated exposures to these different factors. This would yield alpha – the risk-adjusted return – that can in turn be used as a measure of managerial skill.

In Gorovyy et al. (2014), we argue that the above methodological approach may sometimes be misleading in evaluating managerial performance. Indeed, in the absence of the true model (e.g. not knowing all factors or not being able to observe them) such alpha would be overestimated as long as these omitted or unobserved factors are earning positive returns during the estimation period (and underestimated, respectively, if the returns are negative). For practical purposes this means that if hedge funds load on unobservable factors, which during the estimation period happen to crash rarely, but deliver a positive return most of the time, we would erroneously attribute funds’ superior returns to managerial skill and not risk.

To tackle this issue, we offer a different approach and suggest that during relatively good times high-alpha and high-beta explanations may be observationally equivalent, but during relatively bad times, they are not. In particular, if during bad times the risks that funds have been loading on realize, we would observe relatively worse performance of funds that loaded more on such factors, ceteris paribus. Thus, in order to distinguish between high-alpha and high-beta funds, we need to look precisely at periods when we would be comfortable assuming that such unobserved factors are likely to crash.

In order to implement this idea, we use a novel proprietary dataset obtained from a fund-of-funds – that is, a hedge fund that invests in other hedge funds, and, hence, has a lot of information about these other hedge funds – and spans April 2006 to March 2009, to directly measure the secrecy level of a fund that is missing in public hedge-fund databases. This qualitative measure describes the willingness of the hedge-fund manager to disclose information about its positions, trades and immediate returns to fund investors. It is based on formal and informal interactions of the fund-of-funds with hedge funds it invests in, such as internal reports, meetings with managers and phone calls.

Figure 1. Performance of Secretive vs. Transparent Funds
Source: Author’s own calculations.

First of all, we document that secretive funds significantly outperform transparent funds during the relatively good times, as suggested, for example, by the period between April 2006 and March 2007 – a growth period according to NBER, and a period of rapid rise of the U.S. stock market indices. In particular, we find that the most secretive funds earned on average about 5% in annualized terms more than the most transparent funds during this period, even when we control for differential risk exposure of different strategies over time and various hedge-fund control variables.

In order to understand whether this superior performance of more secretive funds is due to managerial skill, or some other factors that may not be observable or not known in the model, we need to see what happened to these funds during the relatively bad period of time, i.e. during the period when we would feel comfortable assuming that risk factors on which hedge funds may have loaded did indeed realize. Although we may have in mind some of the omitted factors being potentially related to rare events and tail risk (as also supported by loadings on strategies associated with option-based returns as in Agarwal and Naik, 2004), they may well represent other risks that were likely to realize during the crisis period. We therefore label April 2008 to March 2009 as the “bad” period – a recession period according to NBER, highlighted by the bankruptcy filing by Lehman Brothers in September 2008 and some of the largest drops of stock market indices in history.

As we see from the graph in figure 1, the performance comparison between secretive and transparent funds largely reversed during this bad period. In particular, also supported by our more saturated regression results, transparent funds outperformed the secretive ones during the crisis by the magnitude of about 10-15% in annualized terms, depending on the exact specification. This explicit consideration of the bad period allows us to conclude that at least a part of the performance differential between secretive and transparent funds during good times can be attributed to a higher risk-taking by secretive funds, which earned a premium during good times but faced these realized risks during bad times.

Potential Policy Implications

As a response to the recent financial crisis, many developed economies have passed regulatory reforms considerably increasing the required disclosure levels, suggesting that the secretive nature of alternative investment vehicles has been considered to be something undesirable (e.g. for contagious effects on the economy, or the ex-post bailouts of the “too-big-to-fail” financial institutions). The examples of such policies include the U.S. Dodd-Frank Wall Street Reform Act passed in July 2010, the European Union Alternative Investment Fund Managers Directive 2011/61/EU that entered into force in July 2013, and the Regulation Guide 240 issued by the Australian Securities and Investments Commission in September 2012.

However, given that hedge funds receive money from relatively sophisticated and wealthy investors (i.e. generally having at least $1 million in net worth), whether more risk in hedge funds strategies is good or bad for them in particular, and the society in general becomes a somewhat debatable question. More importantly, the essence of many of the hedge-fund strategies lies in the so-called dynamic trading – with asset positions and risk exposures being adjusted daily or even more frequently. In such an environment, reporting these positions to the regulatory authorities even on a monthly basis may not adequately describe the exact risks taken by the hedge funds.

More relevant questions, on the other hand, may be about whether investors correctly perceive the exact risks faced by the fund, how large the degree of asymmetric information is within the hedge fund industry, and whether any action may be needed to correct it. These remain open questions and we hope that future research will address them.


  • Agarwal, V., and Naik N.Y., 2004, “Risks and portfolio decisions involving hedge funds,” Review of Financial Studies, 17(1), 63-98.
  • Gorovyy Sergiy, Patrick Kelly, and Olga Kuzmina, “Hedge Funds Non-Transparency: Skill of Risk-Taking?”, CEFIR Working paper.