Reconsidering Ukraine's State-Owned Banks

BY VADYM SYROTA

Ukrainian pensioners experienced some unwanted surprises in July. Their modest pensions, paid out of state pension funds, which in turn are financed out of the national budget, were delayed for several days. That delay signaled shortfalls to Ukrainian state budget revenues. But an additional cause of delay was the precarity of state-owned banks, the financial institutions through which most pension payments are channeled.

Ukrainian state-owned banks have struggled to meet reform goals and leave behind the constant need for capital injections. The size of their public needs is difficult to grasp. Francis Malige, managing director of the European Bank for Reconstruction and Development (EBRD) in the countries of Eastern Europe and the Caucasus, estimates that since 2008 Ukraine has invested U.S. $15.5 billion to support its state-owned banks, including $5.8 billion spent on nationalizing PrivatBank, the country's largest. That $15.5 billion is equivalent to almost 14 percent of Ukraine's GDP in 2017. Overdue corporate loans that are unlikely be repaid are the main cause of the problems Ukrainian banks confront today.

Unfortunately, the continuation of some pre-reform practices, even in more subdued way, means that Ukraine’s state-owned banks are still actively involved in politically motivated and related-party lending. The financial needs of business groups with close ties to Ukrainian authorities are often met through funding from public banking institutions. The renewable energy business entities owned by the brothers Serhiy and Andriy Klyuev (Head of the Presidential Administration of Ukraine under Viktor Yanukovych) tend to come up early in any conversation about the overdue loan problems facing Ukraine’s state-owned banks. The businesses of these political allies of the former Ukrainian president owe approximately $1 billion to local state-owned banks, their largest creditor. The debt is largely being paid down by society: ordinary Ukrainians each pay out of pocket about $70 per annum of banks’ incurred losses via capital injections into public financial institutions.

Such improper lending practices, to which private banking institutions are not immune, have led to a difficult situation for the Ukrainian banking system. According to National Bank of Ukraine (NBU) estimates, Ukraine ranks first in the world in non-performing loans, which accounted for 55 percent of loans at the beginning of 2018. Such impaired loans were mostly concentrated in the state-owned banks, which held 67 percent of the outstanding amount of nonperforming loans. For comparison, the nonperforming loan rate in the United States was 1.1 percent, in the UK it was 0.8 percent, and in China it was 1.7 percent. Even in economically straitened Greece, the figure was only 46 percent. Unfortunately, Ukraine’s local banking regulator has not found an effective tool to solve this problem.

The paradox of Ukraine’s situation is that banks harboring “black boxes” of toxic assets have monopolized banking services in the country. According to NBU estimates, at the beginning of July 2018 state-owned banks held 55 percent of net assets and 63 percent of individual deposits in the local banking system. This situation looks much like the Soviet financial system, in which the state had a monopoly on banking. A state monopoly on banking is more congruent with the realities of an administrative economy than with a market economy. The Soviet period of Ukrainian banking featured by covering incurred losses at the cost of state funding. The described improper banking practice resulted in a tremendous hidden inefficiency that was accompanied by the long-term accumulation of damages. But modern Ukrainian banking sector hasn’t enough resources to disguise the urgent financial problems within a long period of time.

In larger purview, the banking situation in Ukraine works against the country’s financial stability. Investment outflow in the context of higher interest rates from the U.S. Federal Reserve and Turkey’s currency collapse has the potential to trigger a financial crisis in Ukraine. The outsized presence of the state in the banking sector is regularly on the agenda of the IMF’s Permanent Mission to Ukraine. In September, an expert delegation arrived in Kyiv to discuss the conditions under which Ukraine might receive further tranches of financial aid against a backdrop of an increased risk of contagion from the financial problems unfolding in neighboring states. Improvements in corporate governance, widely touted by Ukrainian officials, cannot alone tackle the problems that have accumulated in Ukraine’s banking sector.

Several options exist for addressing Ukraine’s banking challenges, and likely more than one will be needed. It is certainly possible to reduce the share of state-owned banks. Those banks should be sold, even if doing so would create multibillion-dollar losses. Another tack may be to radically transform their function. For example, public financial institutions could be reorganized along the lines of a development bank. In that capacity they could act as specialized institutions for promoting the public interest and welfare while avoiding competing in traditional banking fields (credit card operations, holding demand deposits, and so on). But it is undisputed that international creditors will do their best to make the Ukrainian state-owned banks lose their reputation as bottomless money pits. Because the situation of Ukraine’s financial system does not inspire confidence over sovereign’s and banks’ ability to meet the obligations in future, but rather intimates the possibility of non-repayment, the international creditors are expected to be especially vigilant.