Progress against the pun­ters:

Why banking and lend­ing don’t go to­gether with pop­ulism

The Ukrainian Week - - CONTENTS - Olek­sandr Kra­mar

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

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 PEO­PLE TO BOR­ROW, OF­TEN CLOS­ING THEIR EYES TO THEIR OB­VI­OUS UNRELIABILITY

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 first-

ly 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 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.

Who's the vic­tim? The pop­ulism that fu­els or props up pub­lic de­mands for state com­pen­sa­tion of the de­posits lost at risky banks, or a cheaper euro or dol­lar at any price, in fact wors­ens the over­all eco­nomic sit­u­a­tion in the en­tire coun­try

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