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8 Issues for Banking Reform in Ukraine

Patrick Lenain, and Peter Cornelius
Published Date:
February 1997
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Julio M. Jimenez

The usefulness of an efficient banking system for economic growth and development is well understood. Efficient financial intermediation moves savings from surplus individuals to those who need additional resources to carry out investments, production, and consumption. Increased financial savings expand the mass of loanable funds for these purposes. An efficient payment system assures the rapid transfer of financial resources for the opportune and safe conclusion of economic transactions. A well-functioning banking system also allows growth of an interbank market, improving the market orientation of interest and exchange rates. In this way, monetary policy implementation is facilitated. It is therefore clear why Ukraine needs to attach a high priority to the reform of its banking system. For this purpose, an appropriate strategy for dealing with the reform needs to be developed and implemented. At this stage, it is not possible to develop a quick and easy recipe for the strategy. There are many details that are not known about the banks, such as their structure, operations, and internal governance and ownership. In addition, there is also a shortage of supporting infrastructure for the reform and the operation of an efficient banking system, as will be enumerated below.

This paper will stress general principles and issues for the reform process. It is important to keep in mind that banking reform, as well as other needed reforms, should be properly sequenced and supported in a wider sense by the attainment of macroeconomic stability. Moreover, the costs of reforms should be commensurate with the expected return, and the burden of the costs should be spread among all interested parties and be fully reflected in the financial macroeconomic framework.

Certain characteristics of Ukraine’s current banking structure are important to keep in mind in developing a proper strategy. Chief among these are the following:

• The institutional infrastructure to support a modern banking system is lacking and should be built up quickly.

• The size of the banking system has declined significantly in real terms and is becoming insignificant.

• Many institutions licensed as banks are not actually carrying out banking business.

• Banks as a group are laboring under a heavy load of nonperforming assets.

• The population has little faith in banks as a savings vehicle.

Another important characteristic has been the on-and-off intervention carried out by the government in banking business, reflected in directed lending to certain sectors and enterprises, fixing of interest and exchange rates, ad hoc exemptions to regulations, and delays in the implementation of an adequate legal/institutional framework for the banking sector. Finally, even efficient banking systems are negatively affected by macroeconomic instability and high inflation.

Institutional Infrastructure

Legal and institutional reform to provide an adequate playing field for banking operations is a priority. It has been recognized for some time that the legal framework introduced in Ukraine since 1991 has major deficiencies. It is regrettable that the reformulation of laws and regulations has suffered such a delay. The approval of a new charter for the National Bank of Ukraine (NBU) and a reformulated banking law based on international best practices would be a major accomplishment. In the present legal framework, there is no clear definition of a bank. Regulations should explicitly require that a bank acquire a general banking license and should detail the requirements for it, including “fit and proper” management and ownership in addition to a minimum capital requirement. Procedures for denying applications that do not meet the requirements of a “good bank” should be specified.

Presently, financial institutions obtain commercial registration and specific licenses from the NBU for certain banking activities such as foreign exchange operations. The NBU is able to remove specific licenses, but it cannot close an enterprise. Thus, it is handicapped compared with modern central banks; it lacks the most important weapon of central banks around the world—the ability to close banks. Institutions whose specific banking licenses are revoked by the NBU can continue business based on their enterprise registration. The NBU also lacks sufficient independence and can be subject to political interference in the setting of monetary policy objectives. Finally, Ukraine has neither an efficient legal system for debt recovery nor a bankruptcy law. This makes debt recovery uncertain and perpetrates the existence of enterprises and banks that are obviously insolvent.

The prudential regulations currently in effect need to be reviewed as to whether they cover and properly protect against the common risks faced by banks and whether they promote proper credit management procedures in the banks, including proper asset classification and provisioning. Among the important items that should be covered are foreign exchange open positions, risk concentration (large exposures), connected lending, liquidity measurements, interest rate risks, and maturity mismatches.

On a positive note, in the last few years important progress has been made in strengthening other aspects of the institutional banking infrastructure. An efficient payment system has been established. Progress has also been made in developing modern methods of accounting and auditing that could bear fruit early next year with the introduction of national accounting standards. This will require banks to incorporate accrual accounting, establish stronger rules for the recognition of income and doubtful credits, and provide better defined measures of profits and losses. The IMF is providing technical assistance on the introduction of a modern accounting framework in the NBU. Some private banks have begun to implement modern management systems. They are rapidly incorporating modern technology into their business, are increasingly aware of market forces, and have an improved understanding of risk measurement.

Much has been done to develop a modern supervisory/prudential system that will function better when the proper legal backing and regulations are introduced and the accounting reform completed. The IMF and other international and bilateral donors have provided assistance in this field. An important accomplishment has been the strengthening of the NBU’s Banking Supervision Department, which has begun to establish off-site supervisory procedures and is developing the capability to undertake on-site inspections. The development of an interbank foreign exchange market is also a positive achievement, although there is a need to ascertain that banks follow proper risk management procedures, especially since foreign exchange trading is becoming an important source of profits for them. Banks can be driven by profit motives to take unreasonable risks. The interbank foreign exchange market now has a larger dealing volume than does the auction system run through the stock exchange, which has led the NBU to become more active in the former. The progress made in interbank foreign exchange dealings can be useful in developing a domestic money market, which is key to generating market-oriented interest rates and supporting a system of monetary intervention based on indirect monetary instruments.

Size of Banking System

The great macroeconomic imbalances that existed in Ukraine in the early 1990s and, in particular, the high rate of inflation significantly reduced the size and importance of the financial sector. Monetary data, especially on deposit money banks, remain weak. Available information indicates that during 1995 deposits in banks fell to the equivalent of 7 percent of GDP from about 16 percent at the start of the year. The Ukrainian population has lost a large proportion of the value of the savings kept in financial instruments and has begun to rely on savings in the form of foreign exchange and goods. Currency in circulation has risen in relative importance, accounting for nearly 38 percent of broad money at end-1995, compared with 25 percent a year earlier, but it fell in relation to GDP, reaching only 5 percent of GDP at the end of 1995, compared with 7 percent at end-1994. If the growing problem with nonperforming assets is taken into account (there is no turnover in these assets), the amount of new credit that the deposit money banks can provide the economy is small and becoming less significant. Indeed, in 1995 the banking system provided almost as much credit to the government as to the non-government sector, significantly raising the share of the NBU in the banking system’s total net domestic assets—to 55 percent at end-1995 from about 45 percent a year earlier. In this setting, it is not clear what role commercial banks have been playing.

The lack of financial savings has meant a fall in funds for banks to lend. Banks’ net domestic assets contracted from about 14 percent to 8 percent of GDP over the same period. While this is a regrettable outturn in many respects, it also meant that the financial institutions had fewer resources with which to make mistakes. This limited potential losses and reduced the possible restructuring costs.

The recent developments in the banking system have also negatively affected monetary policy formulation and implementation. In the last few years, significant currency substitution has taken place. Foreign currency note holdings by the public have increased and they are frequently traded against local currency notes in an unpredictable manner. This limits the authorities’ ability to program monetary and exchange operations and to meet predetermined monetary and exchange targets. Indeed, there is no accurate information on the amount of foreign notes in circulation.

The permissiveness of Ukraine’s original banking laws allowed the issuance of many banking licenses, resulting in about 200 institutions—about half of which may not really function as banks and collectively account for only a small percentage of total banking sector assets.

The banking system also includes about 6 large former state banking institutions (including the Savings Bank) and a group of about 90 mediumsized banks. The role played in the economy and the problems faced by each of the three major groupings vary, as do the implications for their reform. In addition, there are different ramifications for the proper prudential oversight of each group that should be recognized in the regulations and in the supervision of the banking system.

Issues of Reform Strategy

The efficiency of the banking reform will depend on developing a general framework and strategies for each major grouping of financial institutions. But the authorities need to be mindful of the costs of this process, particularly with respect to the macroeconomic implications, and the need to spread the burden of the reform among the interested parties. In addition, a vision of the projected reformed banking system should be forged, in terms of its size and the mix of ownership. The availability of human capital, not only for the management of the institutions, but also for the proper supervision of the financial system, should play an important role in this decision.

The framework should include general principles on how to treat depositors and other stakeholders in the reform process, and in particular the extent of implicit or explicit deposit guarantees. In setting up the strategy’s general principles, a prior analysis of the estimated financial assistance required by the banking system and the possible impact that the restructuring could have on government finance is necessary. This process will undoubtedly be affected by the availability of staff and relevant analytical expertise, some of which could be made available from abroad. The accuracy of such an analysis will depend significantly on the accounting systems, while the usefulness of any solution will depend heavily on the strength and clarity of the legal framework. Also important in the development of a general framework is the establishment of a strategy for un-viable institutions, that is, a clear exit policy.

The fact that some of these elements are not in place should not deter the government from taking initial steps toward restructuring. Clearly all decisions in this regard, including that to do nothing, will affect the health of the banking system and the future cost of its restructuring. Thus, even while developing the needed strategy, two important measures should be carried out. First, steps should be taken to arrest the growth of impaired assets, improve provisioning, and limit dividend distribution in institutions with weak financial structures. Second, the number of unsound financial institutions should be reduced significantly. The number of banks, especially unsound banks, is an important limitation on the government’s ability to prepare and implement a restructuring strategy because of the mass of human resources required to do so. A temporary moratorium on issuing new licenses may be required.

The government restructuring policy has multiple elements that are brought together at the same time that the deterioration in the financial system is curtailed and the number of unsound banks reduced. The major contraction in deposits of commercial banks in real terms has significantly reduced the potential cost to the government of undertaking such a restructuring. If all deposits are guaranteed by the government and if all institutions need to be restructured, the maximum cost would be 7 percent of GDP. However, this clearly overestimates the size of the problem, and ways of financing the needed resources should be possible. The real problem is the development of the strategy.

Strategies for Major Groupings

The large number of very small banks provides an advantage for the reform process. The strategy for small banks and banks related to enterprises or other institutions should be to clean house. That is, if these institutions’ main line of business is not banking and if they are not prepared to increase their minimum capital significantly, they should be encouraged to close or at the very least be relicensed with restrictions placed on their ability to receive deposits. Next, there are banks that are linked to enterprises or other institutions that function largely as the financial arm of the enterprises and provide a significant amount of their credit to their owners. A regulation on large exposures should greatly facilitate the closing of these institutions as they would then prove useless for the purposes set up by the enterprises. The withering away of these groups of banking institutions should only be seen as beneficial. They are not conducting banking business, they take up the time of bank supervisors, and they can provide an outlet for unregulated activities that could have a negative impact on legitimate financial institutions.

A different strategy needs to be developed for the largest banks. The former state banks are a special problem because of their importance. They may be too big to fail and may need to be restructured. The strategy for the remainder of the banking system should be one of closing the hopelessly insolvent institutions and strengthening the foundation of the rest through mergers, recapitalization, and government assistance with nonperforming assets.

The five major banks, in particular, have a significant amount of non-performing assets and more nonperforming assets might be generated when public enterprises are restructured. The importance of these banks in terms of their size and customer base may make them difficult to close, but the policy toward them will depend on the government’s vision of the prospective banking system and the cost of a possible restructuring. Those banks that are candidates for restructuring should be set on a path of downsizing, raising new capital, improving their internal governance, and increasing their external accountability. Possible acquisition by “reputable” foreign banks could be encouraged. The burden of nonperforming assets needs to be handled through downsizing (writing off bad loans) and capital increases. As some nonperforming assets arise from government-directed lending, there is a responsibility on the government to contribute to the process. Also, the ability of banks to write off loan losses for tax purposes is an important issue that should be sorted out as part of the strategy. Capital increases will be needed, not only to write off loans, but also to guarantee a minimum capital base that can adequately meet the banks’ risk-weighted capital requirements. The process for increasing capital will also help establish who actually owns and runs these banks. This is important for the internal governance of banks. Are they being unduly affected by certain enterprises that control blocks of shares? Is management inadequately controlled by stockholders because shares are so widely held? Finally, for external accountability, banks need to be subjected to periodic auditing based on internationally accepted accounting principles. The audited accounts should be made public.

With respect to medium-sized banks, those banks that are clearly insolvent should be closed. There are only small amounts of household deposits in these institutions and losses to enterprises arising from their deposits to some extent will reflect their close linkages to these banks and the privileges received in terms of preferential lending. The government should provide a limited deposit guarantee. However, those medium-sized institutions that can efficiently survive need to be encouraged to follow the same path as the large banks in terms of downsizing, restructuring, and increasing internal governance and external accountability.

As mentioned earlier, key elements of the banking infrastructure should be strengthened during the restructuring of banks. This is essential to keep the banks from once again becoming insolvent. In this regard, it is important that an accounting system based on internationally accepted accounting standards be introduced, so that the extent of the impairment of assets can be more easily estimated. Also, further strengthening of the supervisory prudential system is required, in the form of strong laws and regulations and more frequent and thorough reviews of banks’ conditions. An adequate number of bank supervisors need to be trained in modern banking supervisory techniques. Here, care should be taken that the trained supervisors are appropriately remunerated.

An additional element that could speed up the reform is to encourage foreign financial institutions to begin operations in Ukraine. Such institutions will bring modern methods of banking, proven practices, and unimpaired capital. Similar benefits can be obtained from cooperative arrangements between domestic and foreign banks.

Enterprise Reform

The cost of the reform of the banking system will depend to a large degree on the processes and objectives used in restructuring enterprises. Those that are closed for economic reasons will leave unpaid debts to the banking system. Enterprises that are restructured and become self-sufficient can become good banking customers. Also, an important element to keep in mind is that the process of restructuring has a cost, and in the end, the costs are borne through write-offs arising from enterprises that are closed and through the additional capital support that will be needed to offset some of the losses and provide new capital for enterprises that can be restructured. So far, the policies that have been followed tend to hide the extent of subsidies in the system. Part of this procedure has had a negative impact on banks when they are required to provide loans that they would not normally extend and when such arrangements are carried out at below-market interest rates.

The advantages of a reformed banking system should begin to be felt very quickly as people regain faith in banks. The level of financial savings will increase and the foreign currency notes now being squirreled away in mattresses will return to the banking system as deposits. With additional resources to lend, banks can play a useful role in supporting viable enterprises and creating strong financial markets, which in turn will be important in helping to generate market-determined interest and exchange rates. It will be very important for those involved in monetary programming to recognize the legitimate increases in the demand for domestic money that a reformed banking system can generate, and to program accordingly.

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