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    • BANK RESTRUCTURING IN UKRAINE 1. Introduction 2. Observations on the Ukrainian Banking Sector 2.1. Building Healthy Financial Institutions 2.2. Creating a Competitive Financial Sector 2.2.1. Foreign Bank Operations in Ukraine 2.2.2. Transparency in Banks’ Operations 2.2.3. Non-bank Financial Institutions 2.3. Economic Stability 2.4. The Effects of External Funds
    • BANK RESTRUCTURING IN UKRAINE 1. Introduction The institutional structure of the Ukrainian banking sector has major weaknesses which requires close supervision and auditing of banks to avoid a possible financial crises during its transition to market economy. The majority of banks are undercapitalized and have poor asset quality and weak management systems. The lack of transparency about banks’ operations also creates a general mistrust in the formal financial sector. Currently, a large number of international consultants are assisting banks to adopt international accounting standards, modern banking techniques and external auditing, but there is still a substantial amount of work to be done. After a period of hyperinflation between 1991-93, the Government followed a strict monetary policy and brought the inflation down from over 10,000 percent in 1993 to around 40 percent in 1996. Controls on interest rates were abolished and new private banks were allowed to enter in the financial sector. The financial sector of Ukraine, however, remains uncompetitive and fragmented despite the financial reforms and liberalization of the interest rates. The real deposit rates are still negative, or at best, close to zero, whereas the real loan interest rates remained at very high levels. The negative deposit rates and the lack of public confidence in banks results in a shallow financial market where the size of the financial sector shrank with respect to the size of the real sector. Currently, the total household deposits is less than 2 percent of GDP. This report discusses the major constraints in financial intermediation in Ukraine and policy actions that may help to strengthen the role of banks as financial intermediaries. Currently, the large volumes of external funds, soft loans and credit lines from international financial organizations compensate for the shortage of the domestic funds. External resources, however, may not be sustainable and are not a reliable source to finance the economic growth in the long run. Recent cross-country analysis of a large number of countries suggest that high economic growth requires a high domestic savings rate and efficient financial institutions to finance productive investments. 1
    • 2. Observations On The Banking Sector in Ukraine In market economies, financial intermediation, i.e. mobilization of savings and allocation of credit, is one of the most important function of banks. Successful financial intermediation, i.e., attracting a large volume of domestic savings and an efficient means to channel these savings for business finance is crucial for rapid and steady economic growth. Successful financial intermediation however, requires healthy financial institutions, a competitive financial sector, and economic stability. In Ukraine, these factors are yet to be achieved. 2.1. Building Healthy Financial Institutions In total, there are 232 banks currently operating in Ukraine. This include two state-owned banks, Oschadny Bank and Ukreximbank; three privatized banks, Bank Ukraina, Prominvestbank and Ukrsotsbank, and a large number of new small private banks (Table 1). The capital structures of a majority of the banks are weak. A large number of small private banks are not able to meet the minimum capital requirement of ECU 500,000. The NBU recently decided not to liquidate these small banks, which is contradictory with their recent objective of enforcing the prudential regulations. A large number of banks have huge bad loans that were disguised by the old Soviet accounting system and the lack of external auditing. Banks are now in the process of adopting international accounting standards. It is expected that all banks will operate with the international accounting standards by the mid-1998. To strengthen their capital base and to avoid insolvency, banks should be given the following incentives: • Provisions for loan-loss reserves should be made tax deductible, and • The prudential regulations should be strictly enforced and undercapitalized banks should be closed. To gain the confidence of public in the formal financial sector • The Law on National Bank of Ukraine and the Law On Commercial Banks should be approved and the legal and regulatory infrastructure should be established • The National Bank of Ukraine should adopt its supervisory role and ensure that the prudential regulations are observed by all banks with no exceptions • Transparency in operations of banks should be provided with prudential reporting Information on banks’ performance should be publicly disclosed and published annually 2
    • Table 1. Largest 28 Banks in Ukraine NAME BRANCHES CAPITAL ($ million) State-Owned Banks Eximbank 17 21.7 Oschadny 13, 427 10.8 Former State-Owned Banks Prominvest 250 9.5 Ukraina 535 8.4 Ukrosotsbank 116 2.4 Largest 23 Private Banks Gradobank 23 17.2 Peroyi NMB 5 12.3 Privatbank 41 8.8 Ukreditbank 2 7.5 Inko 83 7.4 Vidrodzhenya 43 6.1 Ukrinbank 26 6.1 Aval 42 4.6 Lesbank 16 2.1 Nadra 0 1.7 Econombank 16 1.6 Perkombank 0 1.4 Krymbank 10 1.2 Zapykrkombank 13 1.1 Metallurg 0 1.1 Transbank 4 1.1 Trant 7 1.1 Legbank 2 1.0 Electronbank 4 0.9 Azhio 13 0.9 Pravecs Bank 11 0.6 Nobyi 4 0.5 NPK Bank 8 0.6 3
    • 2.2. Creating a Competitive Financial Sector The financial sector of Ukraine is dominated by the two state owned and three formerly state owned banks (Table 1). The combined assets of these five banks are equal to 70 % of total assets of the banking sector, in other words, the banking sector is highly concentrated. Although there are over 200 newly established private banks they are still very small and they are not able to influence the interest rates set by the largest five banks in Ukraine. For example, the Oschadny Bank, known as the safest bank in Ukraine, holds 90% of total bank deposits in Ukraine and offers a rate of only 20 % on its deposits, well below the rate of inflation. Due to lack of competition, banks operate inefficiently with high costs and high profit margins that caused large spreads between deposit and loan interest rates (Table 2). In 1994, the spread between deposit and loan interest rates was as high as 41%. In 1995 and 1996 the spread declined to 39% and 37 %, however, these spreads are still too high by international standards. Table 2 The Inflation Rate, The Average Annual Interest Rates and The Spreads, 1993-1996 (%) 1993 1994 1995 1996 Annual Inflation Rate 10,256 501 282 45 Loan Interest Rate (hryvnia) 202 249 113 63 Deposit Interest Rate (hryvnia) 163 208 74 26 Spread Between Deposit & Loan rates 39 41 39 37 _____________________________________________________________________ In 1993, the interest rates were freed, however, the deposit rates were kept repressed, below the inflation rates until 1996. Negative deposit rates between 1991-1996 discouraged savers from saving in banks which resulted in a major financial disintermediation. The total bank deposits shrunk from 42% of GDP in 1992 to only 3% of GDP in 1996. On the other hand, real loan interest rates for first time became positive in 1996 as a result of the decline in the inflation rate. In comparison to the rates in the international financial markets, however, the spreads on domestic loan rates remained high. These findings suggest that the banking sector in Ukraine is not responding to the market forces 4
    • to adjust the prices in the financial markets. Despite the low liquidity in the banking sector, banks did not increase deposit rates to attract the household savings. In order to create an efficient banking sector that will mobilize the domestic savings and allocate these savings to the growing businesses, it is absolutely necessary to increase the competition in the financial markets. The experiences in other countries have showed that the most effective way to increase competition is to allow foreign bank operations in the domestic market. 2.2.1. Foreign Bank Operations in Ukraine In Ukraine, the government does not seem to have a clear policy with respect to the foreign bank operations and, until recently, foreign banks were systematically discouraged from entering to the market. The first foreign bank, Credit Lyonnais obtained its license in 1993 through personal contacts. Until 1996, the NBU did not extend any other licenses to foreign banks. The second bank, Societe Generale obtained its license to operate in Ukraine in November 1996, and the ING bank is in the process of obtaining its license. In addition to these, there are over 20 foreign bank representatives in Ukraine that are waiting to obtain full licenses. The existence of foreign banks in Ukraine has already started to show its impact on the domestic banking sector. Foreign banks brought know how and speeded up the modernization process in the Ukrainian banking sector. Over 70 domestic banks now have correspondence banks abroad, and 32 banks became affiliated to the SWIFT international payments network. Some of these banks also began to offer credit cards to their customers. It is important to note that, in some transitional countries, such as Kyrgyzstan, where the foreign bank operations were not allowed, some of these developments did not take place, or it took much longer time to initiate similar banking services. Our interviews indicated that larger and established domestic banks are in favor of foreign bank operations because they are benefiting from cooperating with foreign banks. For example, Bank Ukraina and Commerce Bank find mutual interest in helping to each other. Although there is no evidence that the foreign banks are a threat to the domestic banks, some pressure groups are trying to influence the government and create an unfavorable environment for the foreign banks. • The Government should adopt a clear policy with respect to the foreign bank operations and speed up the licensing process of the foreign banks. 5
    • 2.2.2. Transparency in Banks Operations In Ukraine, there is a widespread secrecy about the operations of banks. Banks do not disclosure information even on their lending and deposit interest rates, whereas in other countries banks often use the media to advertise their interest rates as well as their financial services and performances. In a free market economy, information flows between the financial markets and customers largely determine the interest rates and create a rational behavior among lenders and borrowers which affects the market competition. In Ukraine, the lack of transparency in banks’ operations are creating uncertainties, causing fragmentation in the financial markets and reducing the competition among banks. Lack of information about banks also does not allow the public to distinguish good banks from the bad banks. In recent years, the sudden closure of some of the new private banks became very common. The existing system encourages banks to take high risks to maximize their short-term profits rather than having a long term objective of healthy growth. • The Bankers Association of Ukraine should adopt a bank accreditation program that will encourage banks to disclose information periodically on voluntary basis. This will help the banking sector to adopt the international performance standards and create confidence in the financial markets. 2.2.3. Non-Bank Financial Institutions In Ukraine, the non-bank financial sector is at its early stage of development. At present, the non-bank financial sector has a negligible size and role in private sector finance, however, the development of the non-bank financial institutions, such as insurance companies, leasing companies, pension funds and investment funds, are important to create a competitive financial sector. Legislation for investment funds, trust companies and building societies should be introduced and the development of these sectors should be promoted in order to increase competition in the financial markets. 2.3. Economic Stability Economic stability is a major distortion for the financial markets because it affects both the availability and allocation of financial resources. In Ukraine, the households lost almost all their savings due to hyperinflation in the early 1990s. During the last two years the inflation rate declined steadily and the national currency, hryvnia, was introduced successfully in September 1996. 6
    • The inflation rate, however, is still too high and it creates uncertainties in the financial markets. Banks are lending on short term to the least risky sectors and increasingly are now investing in Treasury Bills and interbank loans to minimize their overall risk. Unless the government budget deficit is reduced or financed by tax revenues and foreign aid, the Government will have to rely on domestic sales of Treasury Bills to finance its deficit. Although this does not have an inflationary effect on the economy, the available domestic financial resources for the private sector will be in short supply. In the transitional economies, such as Ukraine, the loan market is very risky due to a large number of start up businesses. Given the high credit risk, banks naturally prefer to invest in Treasury Bills rather than private businesses. Therefore, there is no need for the Government to make the Treasury Bills tax exempt to attract the investors. This will unnecessarily cost the Government tax revenues and also distort the financial prices by providing the safer investment higher rate of return. Given the high inflation rate, however, interest earnings from financial investments represents nothing more than a compensation for inflation. Therefore, it is not advisable to subject interest earned from financial institutions or on Treasury Bills to full income taxation. A preferred option is to levy a low rate of withholding tax of 4 or 5 percent on all interest earned by individuals and non-financial businesses. 2.4. The Effect of External Funds Similar to other transitional countries, Ukraine has been given millions of dollars worth of credits by international assistance agencies to finance private sector investment. International financial organizations such as the World Bank, EBRD, IMF and other aid agencies such as KfW (Germany) and Euroasia (USA) are providing long term loans to a selective group of banks with the guarantee of the Government of Ukraine. These loans provided liquidity to the domestic banking sector and increased the availability of long-term credits for investment. It is important, however, to note that the excessive capital inflows also began to affect the domestic financial prices and the functioning of the domestic markets adversely. Two important observations are: • The local currency hryvnia began to appreciate against US dollar, • By providing liquidity to the Ukrainian banks it eliminated the need to increase the deposit interest rates to mobilize the domestic savings. Therefore, capital inflows are becoming a substitution to the domestic savings. These affects have important implications for the economy in the long run and they should be taken into account by the authorities. 7