THE RUSSIAN BANKING SECTOR is in the early stages of undergoing what may be a long, difficult and wrenching reform process. If reform ends up giving Russia the semblance of a bona fide banking sector (i.e., one that engages in market-driven intermediation), then there may be increased interest by international banks in investing in the Russian banking sector.

Until there is evidence of real change, both in the banking sector and, perhaps more crucially, in the fabric of the Russian investment environment, hopes that a river of foreign investment will flow into the Russian banking sector are gravely misguided. Encouragingly, though, the government's banking sector reform program contains a number of provisions designed to make the sector more attractive to foreign investors, and initial indications with respect to the implementation of change provide reason for optimism.

Does foreign investment in Russia's banking sector matter? In fact, yes. There is little doubt that encouraging and facilitating greater participation by foreign banks in the Russian banking sector would, in the long term, significantly improve the stability of the sector and potentially ease it out of its present state of stagnation.

In addition to providing a wider range of services than is currently available, at relatively lower prices, foreign banks could play a large role in bringing about improved regulation, dramatically increasing the level of professionalism throughout the sector and generally smoothing the path of Russia's banking sector into the next stage of its development. The facilitation of foreign interest – and subsequent investment – has been central to the evolution of banking sectors throughout emerging markets.

But the presence of foreign banking institutions in the Russian banking market over the past several years has, with a few minor exceptions, been largely nominal. Many foreign commercial banks with a presence in Russia are focused largely on servicing global customers that have operations in the country – so if the banks' operations in Russia are money-losing propositions, then they at least add global franchise value.

Some foreign banks have set up shop in Russia because they are concerned about being left to scramble to make up for lost time if sentiment suddenly shifts in Russia – a view predicated in part on the experience of the valuation bubble of 1995-97. The logic underpinning this idea is that it is preferable to have a small outpost in Russia that can easily be bulked up if the operating environment perks up than to be left exposed by having no presence at all.

The key exception to the trend of global commercial banks ignoring Russia has been a small number of European institutions, primarily from Eastern Europe, that have focused on Russia as a source of future growth. For these institutions, which often have historic links to Russia, a strong presence in Eastern Europe and few opportunities for expansion in Western Europe or elsewhere, building a base for the long term in Russia makes sense. But even these institutions have been slow to move forward with any sense of urgency and have until only recently focused on the most basic banking services and on serving clients who need support for their Russian operations.

Why has there not been more interest on the part of international banks in Russia? Simply put, for the same reasons that foreign direct investment in Russia overall is a fraction of the levels of emerging market comparables: The risks are perceived as being too high, and the potential rewards too slim. The list of reasons why only the most risk-hungry investors in virtually every industry have tended to regard Russia warily – a tradition of non-transparency, oft-changing laws upheld by a weak judicial infrastructure, political and economic instability, the lack of the rule of law, and so on – goes a long way toward explaining why there has been little interest in the banking sector.

However, the banking sector has an additional black mark against it. It is one of the least-reformed segments of the entire economy, where government agents and well-connected insiders unabashedly dominate. Market dynamics are often irrelevant, and it is far from clear that there is even much demand for real banks, given the dominance of so-called pocket banks that exist to serve a small number of parties closely linked to the banks' ownership.

Additionally, foreign banks have been treated in a discriminatory fashion, further discouraging investment. Finally, xenophobic protectionists of Russia's banks who warn darkly of one of the motherland's "strategic industries" being overrun by foreigners clearly want to maintain the present chaotic environment – in which they thrive – for as long as possible.

But in the long term, there is significant opportunity in the Russian banking sector. Russia will, over time, need an efficiently functioning banking sector if the present trend of economic growth is to continue and expand throughout the economy to include small- and medium-sized enterprises, which should become the engine of growth. The small size of Russia's banking sector – the sector's loans-to-GDP ratio stands at just 12 percent, compared with double that figure for Poland and Argentina – also suggests that there is significant growth potential.

Encouragingly, the government has recently taken concrete steps toward improving the environment for foreign investment in the banking sector and for the eradication of limitations – formal or otherwise – on foreign investment and foreign bank involvement in the sector.

A key government banking sector reform strategy calls for the removal of limits on foreign equity participation in Russian banks and reduced limitations on the number of branches that foreign banks can operate in Russia. Meanwhile, there are indications that the government may seriously be considering the sale of a stake in Vneshtorgbank, one of the largest state-controlled banks, to the European Bank for Reconstruction and Development, possibly as part of a broader privatization strategy. While these are only small steps, they are at least in the right direction, suggesting that there is hope for significant foreign investment in Russia's banking sector – albeit not in the short term.

(The author is a Moscow-based freelance journalist specializing in banking issues.)