Public Disclosure Authorized Ukraine The Financial Sector and the Economy The New Policy Agenda Public Disclosure Authorized Alan Roe, Team Leader and Editor Katalin Forgacs Andriy Olenchyk Public Disclosure Authorized Stephen Peachey Angela Prigozhina Yuri Vlasenko Ihor Zhyliaev Public Disclosure Authorized 2001 Copyright 2001 The International Bank for Reconstruction and Development/ THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Printed in Ukraine Printing September 2001 The proposed document presents the study of the financial sector of Ukraine. This paper is published to communicate the results of the Bank’s work and encourage discussion and feedback of the stakeholders involved in identification of the financial sector development strategy and its implementation in Ukraine. The typescript of this paper therefore has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors and should not be attributed in any manner to the World bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. The material in this publication is copyrighted. The World Bank encourages dissemination of its work and will normally grant permission promptly. Permission to photocopy items for internal or personal use, for the internal or personal use of specific clients, or for educational classrooms use is granted by the World Bank, provided that the appropriate fee is paid directly to Copyright Clearance Center, Inc., 222, Rosewood Drive, Danvers, MA 01923, U.S.A., telephone 978-750-8400, fax 978-750-4470. Please contact the Copyright Clearance Center before photocopying items. For permission to reprint individual articles or chapters, please fax your request with complete information to the Republication Department, Copyright Clearance Center, fax 978- 750-4470. All other queries on rights and licenses should be addressed to the World Bank at the Address above or faxed to 202-522-2422. ISBN: 966-514-034-5 Alan Roe is the professor of economics in the Warwick University of the United Kingdom and consultant at the World Bank’s Financial and Private Sector Development Unit (ECSPF), region of Europe and Central Asia. Stephen Peachey is the consultant at the World Bank’s Financial and Private Sector Development Unit (ECSPF), region of Europe and Central Asia. Katalin Forgacs is the Financial Sector Specialist at the World Bank’s Financial and Private Sector Development Unit (ECSPF), region of Europe and Central Asia. Angela Prigozhina is the ECSPF Financial Sector Specialist at the World Bank mission in Ukraine. Andriy Olenchyk is the former vice-President of the National Association of Credit Unions (Ukraine) and the financial consultant at the World Bank mission in Ukraine. Yuri Vlasenko is the Chairman of the Investment and Structured Financial Products Co. (Ukraine). Ihor Zhyliaev is the senior advisor at the Supreme Rada of Ukraine’s Committee on Science and Education. Contents Chapter 1: Introduction and Outline ......................................................................5 Chapter 2: How and Why is the Financial Sector Failing the Economy ............8 Malfunction in the Sector The Main Consequences - for Enterprises and Growth - for Social Policy and Poverty Selected Causes - Compromised Reforms after 1994 - Damage from the 1998 Crisis Conclusion Chapter 3: A Framework for Understanding the Failures and Designing the Solutions...........................................................................................................17 High-Cost Banking Causes of the High Costs Conclusions Chapter 4: A Perspective on Achievable Progress through 2005........................23 Placing Ukraine in the Wider Context of Banking Transition Two Possible Paths for Ukraine to Take What is at Stake for Ukraine Summary and Policy Issues Chapter 5: Banks: Consolidation around Efficient Low - Cost Banks...............32 Structure of the Sector Other Critical Trends since 1995 Implications for Larger Banks Where will the Banking Sector go from Here? - State-Owned and Former State Banks - Foreign Banks - Larger Local Private Banks - Overall Main Policy Implications Chapter 6: Non-Bank Financial Institutions .......................................................42 Introduction Scale of Activity – Now and in the Future Situation and Performance in the main NBFI Categories The Regulation and Supervision of NBFIs - Pension Funds - Insurance Companies - Credit Unions - Leasing Companies - Investment Companies, Funds and Trusts - Overall Conclusions and Policy Agenda Chapter 7: An Integrated Strategy and Program for Reform..............................53 An Integrated Approach Component 1: A Sounder Client Base for Banks. Component 2: Lowering Externally Imposed Costs On Banks. Component 3: Regulatory Improvements for Commercial Banks. Component 4: A New Approach to Non-Bank Financial Institutions. Component 5: Should Government Promote New Financial Institutions? Annexes Annex 1: The Macroeconomic Environment and Performance, 1990-2000......61 Annex 2: The Impact of Barter and Non-Payment on the Sector.......................71 Annex 3: Survey of Enterprise Regarding the Use of Banking and Financial Services..................................................................................................99 Annex 4: Money Market Malfunction and Volatility.........................................109 Annex 5: Non-Bank Financial Institutions – Performance and Prospects......115 Ukraine: The Financial Sector and the Economy: a New Policy Agenda Section 1: Introduction and Outline 1.1 This Report provides an up-dated assessment of the situation in Ukraine’s financial sector (banks as well as non-banks) and defines a policy agenda for the next stages of reform. An earlier version was discussed in seminars in Kiev and Washington in August and October 2000 and April 2001. The Report is addressed to those in authority in Ukraine who have influence over the future development of the sector. To economise on space the main body of the Report is supplemented by six substantive Annexes providing elaboration on key points. The reader who wishes to obtain an overview of the main policy components of the reform agenda can consult Section 7 of the Report. The other chapters provide the arguments and justification for this agenda. 1.2. The report updates a 1995 report prepared by the Bank that has served as the framework for much of the Bank’s involvement with the sector in the intervening six years,1 and has also been a significant influence on the government’s own reform efforts in the sector.2 The earlier report gave considerable emphasis to improvements in the legal, regulatory and supervisory framework for banking including the urgent need to move to an IAS system of accounts. Considerable progress has been achieved in these areas in the past six years and the authorities are to be commended for this.3 1.3 Regrettably this progress has not translated into a major improvement in the financial health and general performance of the sector. Nor, more importantly, has it led to the significant increase in the size of the sector and its capacity to deliver credit and other products in the amounts that Ukraine’s large productive sector needs. This fact is clearly documented in a special survey of businesses undertaken for this study and reported in Annex 3. There is broad agreement, within and outside Ukraine, that the reforms already put in place have been necessary, even essential, but they have demonstrably not been sufficient to motivate the recovery of the sector. This is why a new and deeper agenda of reform is now called for. 1.4 In designing this agenda, this present Report has tried to learn the lessons from the past six years. They tell us that the building of an effective and deep financial system in a transition economy such as Ukraine, is a complex multi-facetted exercise. It cannot be achieved by focusing narrowly on the activities of banks and the non-bank financial 1 Ukraine: Risks and Transition: A Review of the Financial Sector, Green Cover, Report No. UA 14526 UA., June 30th 1995 2 The Bank and the authorities worked closely together beginning in early 1997 to develop as Financial Sector Adjustment Loan. This loan was approved by the World Bank Board in September 1998 and so far $260 million of the agreed $300 million has been disbursed to Ukraine. 3 A recent summary of the changes and remaining gaps in the regulatory structure is contained in IMF, Banking Sector Reform, Basel Core Principles Compliance Assessment, Monetary Operations, and Central Bank Accounting, Monetary and Exchange Affairs Department, January 2000. Because the IMF Report already exists there is no need for this present report to examine the regulatory system for banks in any detail. institutions (NBFIs) , and the manner in which they are regulated. 4 In addition, it is vital to recognise that the environment in which banks and NBFIs operate has been and remains extraordinarily unfriendly: improvements achieved in 1999 and 2000 notwithstanding. It is unfriendly