Fear and loathing in the banking sector

5 September 2019, 05:31

Five years have passed since the start of reforms in the banking sector. Most Ukrainians remember this as a time of mass bankruptcies, financial losses that affected both individuals and businesses, and huge public scandals that included protests outside the NBU offices. Reforms changed friends into enemies, offered public figures an opportunity to siphon off political capital, and clever individuals to catch some financial fish in muddy water. More than anything, however, it made a major contribution to a tectonic shift in the political landscape that led to a completely unpredictable election outcome.

At this point, passions have died down somewhat. Most of the transformations the banking system needed are completed and early results are in. Some changes are still in process or planned down the line, but the reforms are no longer leading to screaming headlines. The only exception is the waves still being made over the nationalization of PrivatBank. But the press and the politicians have largely lost interest in the banking system. With no one to blow on the informational bonfire, the rustle around the NBU and the country’s commercial banks has noticeably died down. And so this seems like the right time to take an in-depth look at whether the game was worth the candle.

But before going on, we have to keep in mind that bank reform is a complicated process cannot be looked at unidimensionally. It involved a mass of components and restrictions. Some aspects worked out, others did not; some changes were effective, but some led to too many negative side effects.

What was achieved

Analysis should start with a simple question: Did the reform reach its goals? More so than not. The main purpose was to ensure that the banking system carried out its own functions properly. Looking at the situation from different angles, there are three functions: one business-related and two related to macroeconomics. For the banks themselves, the main function is to turn a profit. Here, the results are very impressive: according to the NBU, in H1 2019, the system’s return on equity or ROE was nearly 38%. This is an unprecedented record and one that is unlikely to be repeated in the future. Its weight was increased by three factors: a fair surplus of capital – without which profitability would be even higher, as the denominator in the ROE formula would be even lower; a substantial surplus of liquidity that represents relatively low interest earnings – money that would have earned far more if it had worked in the economy – and an economy that is far from its peak of performance, where the profitability of financial institutions is at its highest.

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Profitability is the fair reward received by bankers who trusted in reform, conscientiously followed the requirements of the NBU, and accepted their responsibility before their customers, regulators and society during difficult times. Banks now have a right to be satisfied with themselves. For five years, they invested resources, both financial and human, in order to meet the conditions of reform.  Now they are being repaid, lost capital is coming back, and they can compensate for the opportunities during the crisis period.

What testifies to this record profitability? Either the financial institutions that survived have gained a monopoly and are using this to their advantage and not that of their customers, or they have optimized their business model and become a lot more efficient. The first hypothesis is unlikely: the remaining 76 banks offer more than enough competition today, even if the four state-owned banks account for more than half of the sector according to many indicators. Interest rates offer another strong against monopoly: at 18-19%, business hryvnia lending rates are far closer to the prime rate, 17%, than they were prior to the 2008-2009 financial crisis, when money was relatively cheap, with the prime rate 7-10% and commercial loans 13-16%, while commercial hard currency loans are currently the cheapest they have been since independence. Other rates paint a similar picture.

The second hypothesis is closer to the truth. The cost: income ratio (CIR) shows that Ukraine’s banks have become more efficient, as do a number of other indicators. In short, the high profits are more likely a sign of greater efficiency across the banking system, that is, the result of reforms that have benefitted everybody.

Macroeconomic benefits

The other two functions of the banking sector are macroeconomic. Firstly is arranging payments among economic agents. Ukraine’s banking system was able to perform this function even during the most difficult times. It’s hard to imagine what problems might prevent it from doing so, and so that this is one area where reforms did not have any fundamental impact, other than perhaps to develop and diversify the payment system. The second function, transforming savings into investments, is complicated and needs to be broken down into its components. Here, again, a number of basic questions arise.

First question: Has it become safer to keep money in a deposit? Definitely yes. People remember well the last few months of the Yanukovych regime, how depositors were unable to get their money out prior to the collapse of banks. Deposits were simply not returned as the situation was completely ignored by the NBU under Arbuzov’s governorship. Such cases were not rare and led to huge scandals. Today, the situation is the opposite: customers can easily withdraw their deposits, trust in banks is on the rise, and the deposit base has been expanding. Of course, no one is protected against a new crisis or a panic among depositors. But the real level of capital and liquidity in Ukraine’s banking system is at a record high. This ensures that the banks are ready to return money to customers, even if a crisis arises.

The list of arguments continues. The Physical Persons’ Deposit Guarantee Fund was able to cover all deposits guaranteed by the state under extremely difficult circumstances. And so it will probably manage just fine in the future as well. The mechanisms have proved themselves. To ensure reliably high liquidity among Ukraine’s banks, the NBU has instituted new norms, including for the liquidity coverage ratio or LCR. In this way, it will control the readiness of financial institutions for a high rate of payouts to depositors during a crisis. This adds to the stability of the system.

The government guarantees all deposits in the state-owned banks that dominate the system today. This offers a choice to even the most untrusting customers. The discussion now is to raise the guaranteed sum of UAH 200,000 to European levels, which is a six-figure sum in euros. In short, this part of its macroeconomic functions Ukraine’s banking system is now performing immeasurably better than in the past and the risks to depositors have gone down considerably.

Getting back to the business of lending

Next question: Have its banks started to finance Ukraine’s economy better? Well, yes and no. Mainly, the banking sector has once again started lending to consumers. This is a definite achievement because this segment was frozen after the 2008-2009 crisis because of the tendency to unsecured lending prior to the crisis. Reform has led to significant shifts, but the situation remains far from ideal. Although consumer lending is growing quickly, it’s still at a very low level. Considering the very high interest rates – over 30% per annum – demand for such loans is considerable, but banks are in no rush to satisfy it.

Meanwhile, the mortgage sector remains dormant. Whether this is good or bad is hard to say. On one hand, growing personal loans would spur business activity and that’s good, but it would also increase imports, which is not so good. On the other, the weakness of Ukraine’s economy means that there is considerable alternate credit available that would contribute to the country’s development more than living on borrowed money. Given this, the inclination towards consumer lending is not the best or most desirable macroeconomically.

Nor is the situation in the corporate sector any less unambiguous. After the 2008-2009 crisis, many of the loans went bad as debtors refused to pay them back. But banks were not keen to show this in order not to show losses and engaged in a slew of paper machinations to avoid it. Still, having been burned once, they began to select potential borrowers far more carefully. The result was that the lion’s share of loans began to go to companies whose owners were the same as the bank’s, what is called “interested parties.” Even without this, the economy didn’t have enough capital in savings accounts, while the level of concentration in oligarchic hands complicated the situation even further. There simply wasn’t enough cash for a normal, market-oriented business, and if the banks did decide to lend it money, the interest rate was huge even by today’s standards.

In short, reforms have changed things, but the picture is far from ideal yet. Paper manipulations at banks have largely disappeared, while transparency and accountability have grown immensely. The NBU forced banks to show the actual state of corporate lending, as a result of which banks were forced to declare more than half of their corporate loans non-performing. To prevent a repeat of the mistakes of the past, financial institutions raised their requirements of borrowers significantly, including accounting and transparency.

It turned out that not that many companies could meet the new requirements. And so Ukraine’s banks are ready to lend to business and have the necessary resources, but the market doesn’t have enough quality borrowers. Meanwhile, a real competition for the business of those borrowers who are creditworthy is taking place, leading to interest rates that are so low, they sometimes are even below the prime rate. The bottom line is that corporate lending is only slowly recovering, but it’s structurally sound because the bias towards oligarchic business has disappeared, giving SMEs access to financial resources. Down the line, quality should lead to quantity, but this will take both time and the introduction of a few key changes.

Interest: Why so high?

The main accusation from critics of the reforms is the high cost of borrowing. There are two components at work here. First of all, strict financial and crediting policy. It’s not a direct result of banking reform but more a wisely chosen ornament for the period that the economy is undergoing transformation. Better to secure the economy than to chase after unreliable growth. Ukraine’s experience has convincingly shown the wisdom of this: the country would have been far better off growing slowly but steadily, rather than losing a decade to overcome consequences of the crashes that came after every growth spurt. 

Secondly, credit risks. A big portion of interest rates today is a premium on the lenders’ risks – fear has big teeth. That’s also why the requirements for borrowing are also high. On one hand, few meet the high standards, so they may have to be lowered somewhat to adapt to reality. On the other, this approach by the NBU, as the inspiration behind the reforms, carries out an important function: teaching business to work according to international standards of publicity, transparency and efficiency – all of which makes it more competitive on global markets. It’s a matter of choosing between cheaper credits today and the long-term capacity of Ukrainian business to compete down the line.

Of course, the reform can be looked at from yet another angle: has the banking system become more reliable? So far the system has not been tested for durability, so this is also not easy to answer. The next crisis will show. But it’s already clear that Ukraine’s banks have gotten rid of many bad habits thanks to the reforms, habits that contributed to risk factors over 2014-2016. Restricting lending to interested parties and raising the requirements for borrowing reduced the threat of loan defaults. With the issue of collateral now regulated, the risk of loss because of a poor decision on the part of the courts and the unscrupulous behavior of borrowers was also reduced. 

The institution of a credit register stopped the practice of parallel lending in several banks at once, often with no intention of paying any of them back. New rules, regular stress-tests, and active engagement between the NBU and the banks has made them more transparent and more trustworthy by reducing illegal actions on the part of bankers. The list can be extended. But the essence of all these changes is the same: where there are no bad habits, there won’t be problems. This logic is good for individuals, so it’s probably fair for financial institutions as well.

The cost of reforming

Prior to the crisis, Ukraine had 180 banks; today there are 76. Critics say that some of the liquidated banks could have been saved. But the new conditions were really tough and so it was natural that many did not make it. It wasn’t just those that were unable to give up their various underhanded schemes and begin to engage in proper banking, but also those who, in very lean times, simply could not find the financing to increase their statutory capital from UAH 120mn in mid-2016 to UAH 450mn by the beginning of 2019. Possibly it was overkill, but from the point of view of Ukraine’s experience, facing extremely tough conditions has been better at mobilizing and persuading people that they have to do things differently from now on. Now there is no question that those banks that made it through the gauntlet of reform are far more stable and really do deserve the profits they are earning.

The reality is that Ukraine’s business environment remains quite toxic, overloaded with artificial restrictions, the interference of bureaucrats and enforcers, a shortage of entrepreneurial knack and capital poor. This raises another set of questions: Should they have reformed the banking system from the bottom up and drive out everyone who did not fit the new format even just a bit? Or would it have been better, after all, to approach the issue a bit more softly, overlooking non-critical violations, and giving more time to meet the new requirements? It’s hard to say. In Ukraine, any kind of softening is seen as either a sign of weakness or a sign of corruption – with all that that entails. Perhaps if the reformers had managed to save a dozen or two more banks, they would have been branded even more harshly, as no one would have been able to properly evaluate all the exceptions.

Ukraine’s bank reforms killed more than 113,000 jobs in the system. On one hand, this indicates growing efficiency. On the other, it left many households devastated. The reforms also led to massive losses on the part of the customers of banks that were declared insolvent, both individuals and businesses. According to the Deposit Guarantee Fund, by June 1, 2019, more than UAH 89bn had been paid out to the depositors of bankrupt financial institutions within the established caps. But only a quarter of that was covered by the sale of assets belonging to the liquidated banks. The rest, nearly UAH 60bn, came from taxpayer money in the form of government bonds lent to the Fund by the government. This means that every Ukrainian will pay around UAH 1,500 for these reforms down the line if the banks don’t return this money to the Fund through their own contributions. Was this price fair? Only time will tell.

At this point, the creditors of bankrupt financial institutions have presented a bill for UAH 242bn, of which only UAH 34bn have been returned. The Deposit Guarantee Fund is disposing of UAH 531bn worth of assets belonging to insolvent banks, but has assessed them as worth only UAH 94bn. Whether or not it will be possible to get even this sum out of the Fund is a big question, because various dealers are trying to get their hands on these assets for peanuts. For instance, it was revealed not long ago that a company belonging to agri-business tycoon Andriy Verevskiy wanted to pick up the assets of Delta Bank at a 96% discount. Examples like this are far from rare, and it’s no surprise. The situation today makes it a buyer’s market for the assets of bankrupted financial institutions: distressed assets are plenty and capital is scarce.

Still, there’s no point in saying that the bankruptcy of banks means thousands of criminal cases and tens of thousands of litigations tied to those who drove these banks into the ground and afterwards over their assets. In this context, Ukrainians are paying a high price, but not for reform but for the business practices that led to the process being so tough. And had it not taken place, the price would undoubtedly have been much higher.

The socio-political impact

Something like bank reform also has its socio-political aspect. On one hand, the number of physical entities who lost more than the state was prepared to compensate was not so huge. According to the Deposit Guarantee Fund, the deposits of 99% of the customers of working financial institutions did not exceed the sum guaranteed by the state. This covered almost 42% of all personal deposits. Prior to the crisis, the ratio was just a bit lower because many depositors did not expect mass bankruptcies and had not spread their savings in UAH 200,000 shares in different banks, the way depositors do now. Altogether, those who lost amount to about a few hundred thousand, but this is still just 1-2% of the entire population.

What’s more important is that not just ordinary Ukrainians lost, but businesses as well, especially the former owners of bankrupted banks, including about a dozen well-known oligarchs. In short, reform affected various socio-economic groups both directly and indirectly. Some lost money, but were given the equivalent in compensation from the state. Others only lost the exchange rate difference because the bankrupted bank was initially placed under administration at a set currency rate, while the sum guaranteed by the state was paid later, when the dollar had a very different value. And there were those who lost their bank, money on commercial accounts in it, and personal savings as well. Many influential people also suffered, which is why this reform had such a high profile – and also why the reformers felt the full brunt of public outrage and distrust over it.

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Time will put everything in its proper place. At one point, there were those who made some political capital leading protests under the NBU. Indeed, politicians all took advantage of the situation. As soon as Ukrainians stopped reacting to this topic, politicians also lost interest in reforming the banking sector. Interestingly, in the latest elections, not one platform included a plank proposing undoing the reforms although many candidates and parties proposed cancelling another unpopular change – the rise in household natural gas rates. The grandest “defender of deceived depositors,” Yulia Tymoshenko, limited herself to vague formulations about “restoring trust in the banking system… justice for those who lost their deposits… changing the ineffective policies of the NBU…,” while Ihor Smeshko proposed investigating the NBU’s actions over the last five years without any explanation or alternative propositions. And that was it. The rest seemed satisfied with the reforms – which only goes to show just how exaggerated the scandal around this process was.

Interestingly, external assessments of this reform have been unanimously positive. Most western economists praised both the reform and the reformers. Of course, they have no interest in Ukrainian politics…

Ukraine’s bank reform was an avalanche that covered the entire country. Probably every aware Ukrainian knows about it and its consequences. As many people as there are, that many assessments and interpretations there will be of the correctness and effectiveness of these changes. The one thing that does not raise any doubts is that this reform has been a true milestone in Ukraine’s young history, an example of how, even in the country’s economic, legal and regulatory murk something this big can be carried out.


Translated by Lidia Wolanskyj

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