Why banking and lending don’t go together with populism
The large number of domestic banks that have been taken off the market by the National Bank of Ukraine in the last few years is creeping up to 100: 33 financial institutions were declared insolvent in 2014, another 33 in 2015, and 21 in 2016, and the process continues. As of January 1, 2017, the Deposit Guarantee Fund had already paid out a total of UAH 80.87 billion in cash to depositors from these bankrupted banks, more than 80% of it out of the public purse.
The other source for infusing the banking system with cash to mitigate the impact of this crisis was a major refinancing campaign by the regulator. In 2014, the NBU gave out over UAH 222bn in credits. Although most of them were paid back, as of November 1, 2016, outstanding unpaid loans to 24 insolvent banks added up to a hefty UAH 55.9bn. Among solvent institutions, the nationalization of PrivatBank means that 90% of the extinguished refinancing now also falls to the public purse.
In addition to the refinancing in 2014, support for banks was provided through government bonds issued by the Finance Ministry to increase the statutory capital of Oschadny Bank by UAH 11.6bn and the State ExIm Bank by UAH 5.0bn. These were issued at the average annual exchange rate at the time of UAH 11.80/USD. In 2015, UAH 3.8bn was allocated to increase the statutory capital of UkrGazBank. The recent nationalization of PrivatBank will cost the state an additional UAH 148bn according to MinFin.
Overall public spending for the not-yet-paid refinancing, support for the Deposit Guarantee Fund, and capital infusions into state and nationalized banks has amounted to at least UAH 300bn in taxpayer money over the last few years. This figure includes planned spending on PrivatBank that has not yet taken place. Just for comparison, this figure is comparable to the amount on personal deposits at all Ukrainian banks, which is currently a bit more than UAH 400bn.
However, in fact the scale is considerably larger because a large chunk of this money was spent at an exchange rate that was severalfold lower. Similarly, the already paid off refinancing was issued at a cheaper dollar rate but was repaid at a higher rate, one of the factors that has caused the depreciation of the hryvnia. Once again, the burden falls on Ukrainian taxpayers, regardless of whether they had money on deposit or a loan from a bank and what amount that was.
Populists and players, punters all
For many years, the banking and financing sector was a playing field for no-holds-barred operators and competing populist politicians. Of course, it should really be an environment where resources are accumulated to be used the most effectively based on responsibility both among lenders and borrowers. Only in this way can it change from being a slowly ticking time bomb and a national catastrophe-in-the-making into an instrument for sustainable economic growth.
The main participants in the political games steadily promoted mutually exclusive conditions: from limiting liability for lenders for not making payments to service their loans to returning deposits even to those depositors who expected high returns on their investments but categorically refused to take responsibility for their own high-risk actions.
In the end, Ukrainians, most of whom had nothing to do with any of this, ended up being engaged in the campaign of the state’s unjustifiable generosity, which was the price for the speculative ratings of the populists. Moreover, most ordinary Ukrainians do not understand the direct link between their worsening standard of living—whether it’s a falling hryvnia or rising prices—and widespread public and populist demands to limit the sale of property someone acquired on loans that have gone bad. Nor do many people understand the link between their worsening economic position and the rallies of “robbed depositors” in front of the NBU, demanding the Government to compensate for the loss of their deposits despite the fact that the money was often deposited with the banks offering high interest rates with little care for the security of such banks.
No less dangerous and popular propositions are making the rounds more recently, talking about a mechanism for expanding the volume of loans. This can be heard more and more frequently in political circles, supposedly as a panacea for jump-starting the economy. Experts, by contrast, point out that while commercial banks may have a surplus of cash on hand that could be used for lending, they lack creditworthy borrowers whom they can trust with their money. In addition, the legal guarantees protecting the rights of lenders are far from adequate, so there is a risk that during the next crisis the problem will once again fall on the backs of taxpayers or ordinary folks, but in geometrically larger volumes.
The opinion that the domestic economy is being held back, among others, by the lack of substantial cheap credit in the real sector is quite valid. But what no one talks about is that their source can only be a generous emission of hryvnia by the central bank—which carries a heavy price, such as further devaluation—or savings based on the real earnings of ordinary Ukrainians. External borrowings are important and useful, but only as an added factor. Otherwise, the country once more becomes hostage to factors it has no control over and forex risks.
Savings as the source
So the most important non-inflationary resource for expanding credits is domestic savings. For loans to be issued at the lowest possible interest rate, there needs to be as much credit capital as possible. Unfortunately, the share of gross savings in Ukraine, and consequently of investments, is very low compared to countries that are developing rapidly. By contrast, in most of the eastern “tigers,” the high share of domestic savings provided an investment resource that spurred their growth.
A banking system is not simply a cheap resource for anyone who wants it. It has to firstly be an instrument to motivate individuals to increase their savings and to be responsible about the way it invests them. Only then can it become a source of credit to support economic growth, with the side effect that financial institutions earn income as intermediaries. For this, the heart of the banking system has to be the individual who is accumulating investment resources.
Until recently, the entire system was operating upside-down. In its chase for the middleman’s profits, bank workers and managers tried at all costs to persuade to people to borrow, often closing their eyes to their obvious unreliability. What’s more, they developed a dependence on injections of external credits to support this destructive habit. Meanwhile, the question of guaranteeing depositors their savings was completely shifted to the Deposit Guarantee Fund, whose own resources weren’t close to being enough, and the state ended up paying for everything... meaning all the country’s taxpayers.
Based on the interests of the society, expanding credit portfolios as a general rule makes sense only when the risks arising out of actions taken in the banking sector will be completely laid at the feet at those who were part of the process of issuing and getting loans. After all, they are the ones who stood to gain from this transaction. In short, these risks cannot be transferred for political reasons or because of protest rallies to those who had no relation to the loans or any benefit from them but will later be forced to compensate someone else’s miscalculations. Until this basic condition is in place, trying to expand credit portfolios will only prove damaging and dangerous.
The system of state guarantees for deposits, which is intended to protect depositors when an insolvent bank is removed from the market and prevent a panic, works very idiosyncratically. For it to function properly, the key source of capital for the Deposit Guarantee Fund should be contributions from working financial institutions and resources from the sale of the assets of failed banks. In Ukraine, it’s just the opposite: the lion’s share is compensated by the state with taxpayer money, while the resources accumulated by the Deposit Guarantee Fund amount to only 10-20%.
Changing, slowly but surely
Given the critical situation that has taken over the country’s banking sector in recent years, it’s not the case that the state and the NBU haven’t done anything to prevent future recurrences of the most extreme problems that made themselves felt during this last crisis. True, reactions were often post-factum and not preventive, which ended up costing Ukraine very dearly, but a slew of changes took place in recent years in the way that the financial sector was regulated and supervised. More detailed information about financial stability can be found in a number of NBU reports that are available on its official website. Only a few of the most important measures that have been initiated or carried out at this point will be mentioned here.
Among others, new rules were instituted to increase the transparency of the sector and to improve the regulation of solvent institutions. As of December 1, 2015, the National Bank of Ukraine required all banks to switch to international financial reporting standards (IFRS). The criteria for declaring a bank insolvent have been increased, especially if any evidence is found that they were drawing up or renewing contracts that could increase losses for the Deposit Guarantee Fund.
The NBU completed it diagnostic examination of most solvent banks that continue to operate on the domestic market. Only 39 of the smallest financial institutions remain to be reviewed, but they represent less than 2% of the system’s assets. The list of parties related to banks has been expanded and a requirement set that such parties need to provide updated information about themselves on a regular basis. The investigation into loans issued to related parties is almost concluded.
This was one of the biggest problems in Ukraine’s banking system: money that was collected from individuals in the form of deposits was then lent to entities related to the owners of the bank. According to the regulator, 28 of the 58 banks reviewed had violated restrictions on lending to related parties. What’s more, they generally received preferential interest rates, often with no intention, and therefore little chance, of actually returning the funds. The NBU now requires banks to substantially reduce crediting to related parties, but only for the next five years. Meanwhile, it continues to monitor the clients of financial institutions to identify new related parties.
The requirements to reveal the ownership of a bank have also been increased: banks are obligated to disclose information about physical persons who directly, or indirectly through other legal entities, have ownership rights. For instance, on January 19, the NBU declared PAT Narodniiy Kapital Bank insolvent precisely because its ownership structure did not meet the requirements for transparency.
Meanwhile, legislation has been amended to increase the liability of related parties who have driven a bank to bankruptcy. Such actions will be punishable by being restricted or imprisoned for a period of up to five years. Of course, this will also require proof of malice.