Russian banks' bad loans are a substantial threat for the country's underdeveloped financial sector, despite hopes of improvements by mid-2010, rating agency Standard & Poor's warned on Wednesday.

While the Central Bank in November reported the share of non-performing loans in Russian banks' portfolios was a relatively low 5.5 percent, officials fear the banks may be distorting the statistics in a bid to retain public confidence while hiding the real scale of the problem.

Yekaterina Trofimova, a credit analyst with S&P, said the situation is worrying, although the amount of bad debts may level off next year.

"One must understand that we are talking about masses of bad debts. This problem will take a while to resolve," she said, adding that the timing will depend on the macroeconomic situation.

S&P reiterated its previous forecast that the banking system may lose a total 14 percent of its loans by 2012.

Russia's economy grew by 0.6 percent in the third quarter, but it is still 9.4 percent smaller than last year. The resuscitation of the economy has been volatile as sectors have posted mixed results.

"We see that the trend of the deterioration of the asset quality is still ongoing but much slower than before," Trofimova told reporters.

"We expect that by the second half of 2010 we may see a sustainable turn in this negative trend."

Trofimova said some Russian banks have reported a stabilization or even decrease in their bad debts, but added the problem of impairments is likely to persist as long as the economy is not fully recovered from recession.

"The clean-up of this mess of bad debts will remain the key strategic and operations goal for the banks," Trofimova said. The more bad debts a bank has, the more vulnerable it is.

The Russian Central Bank has cut the benchmark interest rate 9 times this year from 13 to a record low of 9 percent to spur lending, but the market is still far from a revival.

Russian banking officials have recently unveiled a plan to raise minimum capital requirements for banks to 1 billion rubles ($32.7 million). The new law would come into force next year and give the banks five years to meet the new requirements.

Officials have already predicted that the state-controlled banks, which dominate the sector, will benefit most as they absorb smaller peers unable to meet the capital requirement.

S&P expects some 50 small banks to be liquidated or merged with bigger lenders in the process, but say the consolidation is not the solution to the sector's problems.

Trofimova said that while the consolidation should help make oversight easier, it wouldn't necessarily make the system healthier. "This should also be accompanied by improvements in oversight and business practices in the sector," she said.