Ukraine's banking sector seeks a new normal

Much has changed in Ukraine’s banking sector in the past three years, so it is no surprise that the financial sector is seen as the area to have taken on the bulk of the country’s reforms. When Valeria Gontareva took office as the central bank governor at the National Bank of Ukraine (NBU) in June 2014, there were some 180 banks serving a population of about 42.5 million.

Within three years this had been reduced to 92 banks, with the largest 40 representing 97% of banking sector assets. The ‘clean-up’ process culminated in Privatbank, the country’s largest lender, being nationalised and recapitalised by the state at the end of 2016.

A new Privatbank 

“The biggest reform achievement in Ukraine has been the clean-up of the banking system with the grand finale of the nationalisation of Privatbank,” says Sevki Acuner, director for Ukraine at the European Bank for Reconstruction and Development (EBRD). “In the past years, the NBU has done lot of work to restore the financial sector to its proper function.”

The nationalisation followed an NBU assessment that Privatbank was not fulfilling the requirements of its recapitalisation plan. However, the bank had provided services to about 20 million Ukrainians, so any move needed to happen quickly and in a determined manner to avoid causing concern.

“Everybody was worried the entire economy might be hit [when Privatbank was nationalised] but the NBU and the finance ministry kept the situation under control,” says Olexiy Soshenko, a partner at law firm Redcliffe Partners.

In an effort to recapitalise the largest bank in the country, the finance ministry and NBU injected Hrv116bn ($4.27bn) in Treasury bills – more than 30% of Ukraine’s capital base – into the bank. “The main problem of Privatbank was that it had no real assets in the bank” and was providing “loans without any cash flow”, says the NBU’s Ms Gontareva, who has announced that she will leave her post as central bank governor in May. Related party lending was also an issue at Privatbank, as well as in some other institutions, she adds, but most of this has now been stopped.

“Had Privatbank not been nationalised, the whole reform result would have been nullified,” says Elena Voloshina, acting regional manager for Ukraine and Belarus at the World Bank’s International Finance Corporation. “The bank offered a very good service to customers but some of the money accumulated as deposits in the bank was then transferred to owners of the bank through related party lending.”

As part of the Privatbank nationalisation, a new management and supervisory board was installed. The next step for the bank is to “concentrate all of its efforts in banking for SMEs and retail”, says Ms Gontareva, with the aim of finding new investors within three to four years.

State-bank domination

Finding a strategy for Privatbank is now a top priority, as it is for the country’s other state-owned institutions: Oshadbank, Ukreximbank and Ukrgasbank. At 52% of banking sector assets, state-controlled institutions now dominate Ukraine’s banking sector and a strategy drawn up in 2015, which did not account for a nationalised Privatbank, now has to be revised.

The Ministry of Finance, as owner of the banks, and NBU, as their regulator, are in the process of agreeing the new high-level business strategies for the banks and their future ownership.

“At this stage, we are still very concerned about the future of state banks. They need improvement in business models and management enhancement,” says Ms Gontareva. “Their operational efficiency and credit risk standards are not up to best practice and thus state banks will remain in the focus of our, and government, attention in the foreseeable future.”

International financial institutions (IFIs) such as the EBRD are taking an active role in this process. In a memorandum of understanding (MoU) between Ukraine finance minister Oleksander Danyluyk, the EBRD and the chairman of Oshadbank, Andriy Pyshnyy, signed in November 2016, plans for the commercialisation and part-privatisation of Oshadbank have been set out for 2018, with a majority privatisation planned for 2020. The MoU includes plans for a potential equity investment by the EBRD in Oshadbank. The new strategy for all state-owned banks could be announced as early as May. 

A cleaner banking sector

The overall clean-up process of Ukraine’s banking sector has already seen institutions with unviable business models or non-transparent ownership structures, or those that were not compliant with banking legislation, cease operating. But the NBU is further emphasising the need for banks to reach capital requirements (see table).

“Compliance with the capital requirements requires not only capital injections, but also measures to pledge additional collateral against the previously granted loans, reregistration of loans to real companies with verified cashflows,” says Ms Gontareva. She adds that almost all banks have succeeded in fully implementing their recapitalisation plans. “In 2016, capital of Ukrainian banks was increased by Hrv108bn.”

Yet, in 2017, some of Ukraine’s smallest banks, which only account for 3% of banking sector assets, are expected to fail to reach capital requirements set by the NBU. In anticipation of this – and to make the processes for self-declaring insolvency proceedings and mergers easier – in March the parliament approved a new law on simplifying capitalisation and reorganisation procedures for banks proposed by the NBU. Thus, by the end of 2017 the number of Ukrainian banks could again decrease significantly – but this is something that does not particularly worry IFIs such as the EBRD.

“You simply do not need 92 banks in an economy of about $90bn [Ukraine's GDP at current prices],” says the EBRD’s Mr Acuner. “You probably need about 35 banks. This can be done in a variety of ways, but you could probably encourage regional champions to create some more significant institutions.” 

Russian capital

Apart from state-owned institutions and those owned by foreign investors, the Ukrainian banking sector still also comprises some banks that have strong relations with Russia. In conversation with The Banker in late February, NBU governor Ms Gontareva suggested banks with Russian state-owned capital should wind down their operations within Ukraine or sell them, as there was “not a very rosy future” for these banks in the country.

Two weeks later, the NBU announced proposals for sanctions against those banks after a recommendation by the country’s National Security and Defence Council. This was said to be linked to the banks’ acceptance of documents issued by the administrations of the separatist regions in the east as valid means for customers to identify themselves.

This development meant that five Ukrainian banks with Russian state capital – Sberbank, VTB Bank, Prominvestbank, BM Bank and VS Bank – were served with sanctions prohibiting financial transactions involving the transfer of funds to banks’ related parties as well as other restrictions imposed on them.

As a result, in late March, Sberbank announced the sale of its operations in Ukraine to a consortium including Norvik Bank in Latvia and a Belarusian private company.

Alfa-Bank moves on

Alfa-Bank’s Ukrainian operations, meanwhile, have been spared from these measures. Alfa, privately owned through a majority stake by Russian billionaire Mikhail Fridman, distinguishes itself from the Russian part of the bank through the separate registration of the businesses within the common Luxembourg-registered holding company ABH Holdings.

Alfa-Bank was Ukraine’s eighth largest bank by assets as of year-end 2015 and, at the end of 2016, its holding company ABH acquired 99.9% of the fourth largest bank by assets, Ukrsotsbank, from UniCredit. While the two groups are running as separate businesses so far, the aim is to create a joint Ukrainian banking group in the future.

“Alfa-Bank and Ukrsotsbank are now sister banks but in two years we will be one bank in Ukraine,” says Oleksiy Blinov, chief economist at Alfa-Bank Ukraine. “The target is to create a universal bank with Alfa’s strong retail presence and Ukrsots’ expertise in the SME sector.”

As of 2015 results, the joint banking group would remain fourth largest in Ukraine with $4bn in assets and the largest non-state-owned bank, compared with Alfa-Bank’s $1.8bn in assets and Ukrsotsbank’s $2.3bn at year-end 2015. 

The lending challenge

With capitalisation levels at Ukrainian banks improving in line with the NBU strategy, the next important step is to recover lending. But the cost of funding for both banks and customers in the country  is high, and mutual trust is low.

The high key rate of 13% is expected to be lowered with decreasing inflation and has already been reduced from 22% at the beginning of 2016 but trust issues on both sides still have to be tackled. For borrowers, the introduction of capital controls following the economic and monetary turbulences of 2014 hit confidence.

Meanwhile, customers with difficulties paying their interest on mortgages in the local currency feel aggrieved after borrowers of foreign exchange FX mortgages that have become non-performing after the 2008 financial crisis have been allowed a moratorium on their debt. For banks, this means non-performing FX mortgages are ‘forever NPLs’ (non-performing loans) as suggested restructuring plans for these NPLs were never drawn up by parliament.

Another difficulty for banks lies in that “a lot of the companies are operating in the shadow market and cannot provide any real reporting, which means they are not bankable”, says Tamara Savoschenko, the chair of the Ukrsotsbank board. This, coupled with the banking sector’s legacy NPLs portfolio and difficulties in finding ways to resolve them, is putting pressure on new lending.

“About half of all banking sector loans are non-performing. This, and the high level of bad borrowers, has created the low level of confidence among lenders,” says Volodymyr Lavrenchuk, chief executive of Raiffeisen Bank Aval. “Several reforms should be implemented to restore the confidence to boost lending, such as registers of pledged real estate assets, to have a record of which assets were pledged for loans. There needs to be better disclosure of ultimate beneficiaries of companies and better cleaning of legacy NPLs. Change is ongoing but it can’t all happen within one year.”

Enforcement difficulties

One of the particularities in working out the banking sector’s NPLs is related to the Ukrainian legal and enforcement system. Many thousands of cases have been brought to the courts to resolve NPLs – but with difficulties in enforcing decisions and creditor rights protection lacking international standards, banks mainly rely on their borrowers’ willingness to co-operate to work out problem loans.

“We still have a problem with creditor rights protection in Ukraine,” says Ms Savoschenko. “There has been a lot of regulation drafted but almost nothing was approved by parliament. This obviously drives the cost of risk higher [when banks are looking at providing new loans].”

“If you cannot get justice in our courts and cannot do proper restructurings or resolutions because of blockages in the justice system, NPL resolution is difficult,” says Ms Gontareva. She adds that the NBU has drafted a law on creditor protection but it has not yet made it through parliament. “The main problem is that we have already prepared more than 20 draft laws on the development of the financial sector and only three of them passed the stage of the first reading.”

A ‘bad bank’ for Ukraine?

One potential solution to the Ukrainian banking sector’s NPL problem is a ‘bad bank’ or asset management company to relieve banks of some of their problem loans. The idea is not new but seems to now be backed by more parties, including some IFIs. However, even if plans went ahead, decisions would still have to be made over the best set-up and whether NPLs from all banks or just state-owned institutions should be considered.

Another issue to be determined would be the governance and control of such an institution, says one expert who wished to remain anonymous. He says it could be challenging to achieve a set-up guaranteeing independent and reliable management for the institution, which is why he is sceptical of the idea.

Furthermore, as the bulk of the NPLs are related to extensive credit growth ahead of the financial crisis in 2008 and loans that have turned sour as a consequence of the crisis, others – including Raiffeisen Bank Aval’s Mr Lavrenchuk – suggest it is too late for the banking industry to create a bad bank.

In the case of Raiffeisen, no material new NPLs have been recorded since 2010, Mr Lavrenchuk says, which means the quality of those assets that are still on the bank’s books as problematic now has significantly changed and any value extraction would be difficult.

A turning point

Hopes are pinned on recent developments such as Ukraine’s new law on financial restructuring, which should offer lenders and borrowers a framework on voluntary out-of-court restructurings, aiming at allowing distressed Ukrainian businesses to return to viability through loan rescheduling, partial debt forgiveness and conversions of debt to equity. The law, which was drafted with the help of the EBRD and World Bank, was passed in late 2016.

“Two-thousand and sixteen was a turning point in Ukraine’s banking sector; the mood in the market has improved despite continued bank failures,” says Alfa-Bank’s Mr Blinov. “The market has passed the turning point.”

A gradual lifting of restrictions on deposit withdrawals has improved confidence in the banking sector and contributed to a growth in retail and corporate deposits from 64% to 73.4% in 2016. And while credit growth of about 2% in 2016 was sluggish, this is an improvement in the decline in lending previously. With much done and more reforms still to do, Ukraine’s banking system looks set for an interesting year.