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Booming, but Risky: The Ukrainian Banking Sector – Hot Spot for Foreign Strategic Investors Stephan Barisitz 1 This paper gives an overview and assessment of the evolution of the Ukrainian banking sector since the outset of transition, focusing on the most recent developments. While the 1990s saw turbulent changes against the backdrop of continuous economic contraction, the Ukrainian banking sector has been on a strong expansion path ever since the turn of the millennium, a path which appears to have been only briefly interrupted by the minor crisis of late 2004 and early 2005. Although the National Bank of Ukraine has certainly improved banking regulations and supervision, the country’s credit boom (sevenfold real increase of credit volume between 2000 and 2005, albeit from a modest base) has raised serious concerns about credit risks. Financial fragility continues to loom large in an environment where the practice of “pocket banking” (credit institutions acting as ex- tended financial departments of owner firms) is still widespread. Over the past months, foreign strategic investors have started to move in: Led by Raiffeisen, which purchased the second-largest Ukrainian bank in October 2005, takeovers and business expansions have raised foreigners’ share in total banking assets from 13% to 26% within a year. Austrians account for somewhat less than half of all foreign-owned banking assets in Ukraine. JEL classification: E0, E5, G21, G28, P34 Keywords: Banking, connected lending, credit boom, financial crisis, financial markets, foreign direct investment, supervision, transition, Ukraine 1 Introduction The study basically follows a This study outlines and assesses how chronological approach. Section 2 at- the Ukrainian banking sector has de- tempts to situate Ukraine in the “big veloped since the outset of Ukraine’s picture” of banking transition, identi- transition process, emphasizing the fying two waves of banking reform in most recent developments. Through- the country. Section 3 deals with out most of the 1990s, Ukraine’s eco- Ukrainian banking developments in nomic reform and banking sector de- the momentous first decade of inde- velopment lagged behind Russia’s and pendence. The crisis of 1998 outlined remained more strongly dominated in section 4 preceded a fragile recov- by the state and former state banking ery after the turn of the millennium institutions. However, the two coun- (section 5), which was eventually fol- tries have also displayed many simi- lowed by a credit boom, a politically larities in the way economic agents triggered near-crisis, which was and the authorities acted in (and re- quickly defused, and persistent, seri- acted to) given situations at different ous vulnerabilities (section 6). Sec- points in time. Most recently, how- tion 7 then focuses on the recent ever, developments in the Ukrainian strong inflow of foreign direct invest- banking sector may have entered a ment (FDI) into the Ukrainian bank- strong acceleration process. ing sector and its likely implications. 1 Oesterreichische Nationalbank (OeNB), [email protected]. The author wishes to thank an anonymous referee as well as Doris Ritzberger-Grünwald, Claus Puhr and Thomas Reininger (OeNB) for their insightful comments and suggestions. The author also thanks Jennifer Gredler for her valuable language advice. The opinions expressed by the author do not necessarily reflect the official opinion of the OeNB or the Eurosystem. 64 ◊ Financial Stability Report 12 Booming, but Risky: The Ukrainian Banking Sector – Hot Spot for Foreign Strategic Investors As Austrian credit institutions were owned enterprises) take large stakes among the first to move into Ukraine and by distributing shares to the em- and today are major Ukrainian play- ployees of these client enterprises and ers, section 7 features a box specifi- of the banks themselves. This brought cally dedicated to their experience. about a strong initial dispersion of Section 8 finally contains a summary ownership without attracting new and conclusions. funds, thus resulting in weak control of bank managers by owners. Important 2 Two Waves of managerial decisions continued to be Banking Reform influenced by close relationships be- Empirical evidence shows that transi- tween bank managers and client firms tion, as the author sees it, generally as well as government agencies. Gen- involves two waves of banking re- erally, measures taken during the first form. Almost all transition countries wave of reform, which most transition have gone through or are still going countries have completed at this point, through these distinct banking re- have favored the continued existence form waves (Barisitz, 2006a). The of soft budget constraints and weak same applies to the Ukrainian bank- property rights, establishing a tempo- ing sector. The first reform wave was rary, but not stable equilibrium. based on the abolition of central plan- New crises were just a question of ning (including central credit and time, and in many cases materialized cash plans), on price and interest rate in the late 1990s. These crises trig- liberalization and the creation of a gered new, partly painful, restructur- two-tier banking system. It was ac- ing measures, which in the author’s companied by a general and deep view generally turned into a second transitional recession, which lasted wave of banking reform (encompass- most of the 1990s. The first wave in- ing crisis-induced resolution and re- cluded the liberalization of bank li- capitalization, the upgrading of regu- censing and initially lenient regula- lation and supervision, the introduc- tion. The Ukrainian authorities prob- tion of hard budget constraints in ably thought that these measures banking and in-depth privatization would kick-start competition in a sec- measures, which put in place strate- tor otherwise dominated by the for- gic owners). In most transition coun- mer specialized state banks inherited tries, at least one large bank went un- from the ex-socialist monobank sys- der in the process, which signaled the tem. As a consequence, the number strengthening of budget constraints. of credit institutions in Ukraine mul- The second reform wave appears to tiplied from about a dozen in 1990 to have been completed in all Central 133 in 1992 and 230 in 1995. European and in at least some South- The first reform wave typically eastern European countries (namely has also included up-front recapi- Bulgaria and Croatia). It seems to talization measures and so-called have progressed far or to be almost “surface privatization,” i.e. partial, over in Romania and Kazakhstan, but insider or nonconventional privatiza- is certainly still in full swing in Ser- tion of credit institutions. In the case bia, Montenegro, Russia and Ukraine. of Ukraine, ownership in former Countries like Belarus and Uzbeki- state-owned banks was transferred by stan essentially still have both waves having clients (mostly former state- before them. Financial Stability Report 12 ◊ 65 Booming, but Risky: The Ukrainian Banking Sector – Hot Spot for Foreign Strategic Investors 3 Banking Transition tighten prudential regulations and in the 1990s increase minimum capital require- At the outset of transition in Ukraine, ments, after which the total number the largest Ukrainian banks were of banks started to level off (table 1). the specialized institutions stemming Following monetary stabilization from the split-up of the former Soviet in 1995 and 1996 and the introduc- monobank Gosbank, i.e.: Promin- tion of the national legal tender, the vestbank (specialized in industry fi- hryvnia, in 1996, Ukrainian banks nancing), Bank Ukraina (agriculture), looked for and found new sources of Ukrsotsbank (residential construc- earnings: Like their Russian counter- tion, etc.), Ukreximbank (foreign parts, they came to rely on the inter- trade) and Oshchadny Bank (savings bank market or on foreign loans accounts; former all-Union Sber- (while funding via deposit accounts bank). Unlike the rest, the last two remained concentrated, to a large banks have remained in state owner- extent, in Oshchadny Bank), then ship. Since the first wave of banking turned to investing in the quickly reform the majority of credit institu- expanding government treasury bill tions – apart from the (former) state- market. Treasury bills soon became owned banks – have been small or the main instrument to cover budget- very small and have functioned as ary gaps. Foreigners also participated so-called “pocket banks” or “agent in the seemingly risk-free market banks,” i.e. as extended financial de- (Dean and Ivashchenko 1998, p. 140). partments of owner firms (similar to Throughout the second half of the the development in Russia). Pocket 1990s, the Ukrainian banking sector banks have often engaged in con- remained quite small. Total banking nected lending. assets in mid-1998 amounted to about Back in the early 1990s, gains 18% of GDP, which was much lower from hyperinflation2 – the price level than in most transition economies jumped by over 10,000% in 1993 for and approximately corresponded to example – and from currency arbi- the total assets of a medium-sized trage were among banks’ major profit commercial bank in a developed mar- sources. Up to the mid-1990s, di- ket economy. This reflected reper- rected credit programs remained cussions of the protracted and deep prominent. Then they were officially Ukrainian recession, the relatively abolished, and the Natsionalny Bank slow pace of reforms and the lack of Ukraini (National

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