Ukraine - Risks and Transition : A Review of the Financial Sector (Vol. 2 of 2) : The Annexes

Document of The World Bank FOR OFFICIAL USE ONLY CONFIDENTIAL Report No. 14526 UA UKRAINE RISKS AND TRANSITION: A REVIEW OF THE FINANCIAL SECTOR Volume 2: Annexes June 30, 1995 FIL COP Privatization and Enterprise Development Division Country Department IV Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. UKRAINE RISKS AND TRANSITION: A REVIEW OF THE FINANCIAL SECTOR VOLUME II: ANNEXES ANNEX A The Structure of the Banking Sector A. The Number, Size and Geographical Distribution of Banks B. Bank Ownership @00 A Taxonomy of Banks D. The Sectoral Pattern of Bank Lending ANNEX B Notes on the State and Former State-Banks A. Prominvestbank B. Oschadny Bank C. Ukreximbank D. Ukrosotsbank E. Bank Ukraina ANNEX C Reforming Accounting Standards and Practices A. Bank Accounting Reform B. Strategy C. Professional Organizations D. Conclusions ANNEX D Issues in Bank Supervision and Auditing A. Prudential Ratios B. Future Work C. Qualifying Conditions for Banks under IBRD's Russia Program ANNEX E Payments System Reform A. Background B. The Reform Program To-Date C. The Current Status of the New System D. Development Issues for Commercial Banks E. Observations and Recommendations Note: Report is contained in two volumes: Volume I is the main body of the report; and Volume II contains the annexes which are available upon request. This report is based on the findings of a Pre-appraisal mission that visited Ukraine in March/April 1995. Members of the mission included Messrs. Roe (task manager and team leader), Pohl, Minners, Bueno, Jedrzejczak, and Robbie (Consultant). Messrs. Siegelbaum and Kavalsky are the managing Division Chief and Department Director. ANNEX A page 1 of 12 THE STRUCTURE OF THE BANKING SECTOR A. THE NUMBER, SIZE AND GEOGRAPHICAL DISTRIBUTION OF BANKS I. There are now about 230 registered banks in Ukraine most of which are relatively small. Together. they have total assets equivalent to about $5 billion': total credits outstanding of $1.5 billion; total authorized capital of $70 million; and total capital including reserve funds of $322 million. A possible scale indicator is the size of a larger Western European bank such as Barclays or Credit Lyonnais which each have total assets of about $300 billion and total capital of about $10-15 billion. The broad structure of the Ukrainian banking sector is indicated a by the summary information presented in Table 1. Table 1: Overview Of Banking Sector Structure, Dec. 31st 1994. Name of Bank: Branches Statutory Capital+Funds Total Assets Public Deposits Credits Pretax Profit Capital Outstanding for Year (Number) (Kbvs (Kbvs billion) (Kbvs billion) (Kbvs billion) (Kbvs billion) (Kbvs billion, billion) State-Owned Banks: Eximbank 17 750 2258 58244 0.4 11661 na Oschadny 13449 80 1129 40948 10301 3258 5310 Sub-Total 13466 830 3387 99192 10301 14919 5310 Share of Total 90.7% 11.5% 10.1% 18.8% 59.7% 9.4% 12.67 Former State-Owned Banks: Prominvest .250 2030 7367 95018 430 35123 ni Ukraina 535 875 7510 117501 1726 30391 1761-4 Ukrosotsbank 116 250 4156 57446 729 19371 10578 Sub-Total 901 3154.5 19033 269965 2885 84885 28192 Share of Total 6.1% 43.6% 56.7% 51.3% 16.7% 53.5% 66 7% 88 Larger Private Banks: Sub-Total 472 3255.9 11154 157189 4068 58874 8740 Share of Total 3.2% 45.0% 33.2% 29.9% 23.6% 37.1% 20.7% Totals: 14839 7241 33574 526346 17254 158678 42242 in $ million 70 322 5053 166 1523 406 Notes: (i) 1994 data for Eximbank were not available. Thus figures shown are derived by extrapolation from 1993 data. (ii) For reasons of consistency the credits outstanding by Oschadny bank exclude credits to other banks including the NBU. Source: Bankers Association balance-sheet data supplemented by direct information from some banks. This figure can be reduced substantially to take account of the known double-counting of the Soviet Chart of Accounts which is still the basis of the Ukrainian accounting system for banks. It is likely that the adjustment for double counting would reduce the total assets of the banks by about 30 percent. ANNEX A page 2 of 12 2. It is noted that the two state-owned banks together with the three banks formerly owned by the state still account for a major part of the overall banking system. Specifically, they account for 97 percent of all bank branches; 70 percent of total banking assets: 63 percent of all credits outstanding; and 79 percent of all pre-tax profits realized in 1994. Not shown in the table are 100 or more very small "pocket" and other banks which together account for only one or two percentage points of the sectors total business. Many, of these are not "banks" at all and are more aptly classified as "finance companies", treasury departments of their parent organizations. 3. The broad summary of the sector's structure as presented in Table 1 hides certain emerging tendencies and trends which are important to an understanding of the sector's present situation and possible future development. First, the size of banks, although still small, has been increasing since 1991. In particular, the increase in minimum capital requirements has exceeded inflation. Raising minimum capital requirements2 has slowed the creation of new banks and has ended the virtually costless entry into the sector which applied until early in 1994. It can also be expected to lead to the emergence of larger banks through recapitalization by shareholders and through mergers. Eight bank mergers took place during the second half of 1993 and three banks were closed. Eleven more banks were reported as closing in the twelve months to September 1994, and a further ten banks closed during the banking crisis of early 1995. The NBU has indicated that it will rigorously enforce minimum capital requirements, and an increase in both mergers and closures is to be expected in 1995. 4. Second, the relative importance of Oschadny bank is radically reduced as a consequence of the collapse in household deposits during the period of high inflation. Back in 1990, total household deposits most of which at that time were mobilized by Oschadny had a dollar equivalent value of almost 5 10 billion which was equal to $200 for every person in Ukraine. Today the total of deposits held with Oschadny stands at the equivalent of only $100 million implying a fall in average household deposits held there to only $2 per person: a decline of 99 percent since 1990.3 So although Oschadny continues to dominate deposit mobilization from the public with a 59 percent share of the total, the massive diminution of that total has also caused a corresponding decline in the size of Oschadny. It now accounts for less than 8 percent of total banking sector assets. 5. This has implications too for the interpretation of some of the other data in Table 1. For example, while Oschadny still accounts for the dominant part of the branch network with about 90 percent of all branches, the significance of that numerical dominance is reduced to the extent that the deposit mobilization function of the bank is much reduced. For broader-based banking services, the three former state banks (Prominvest, Ukraina, and Ukrosots) are well ahead of Oschadny in terms of the depth of genuine banking service provided at branch level.4 It is significant too that the former state banks are no 2 From late in 1992 to January 1994, minimum capital requirements increased from Kbvs 0.5 billion to Kbvs. 2.0 billion, i.e. by 300 percent. In July 1993 the NBU raised the minimum capital requirement to Kbvs 2.0 billion for banks with a domestic license and to Kbvs. 4 .0 billion for those with a foreign exchange license. All banks needed to meet these new requirements by January Ist 1994. The minimum was raised further to Kbvs 5 billion thereafter. In foreign currency terms, minimum capital requirements for domestically licensed banks increased from roughly S 3,000 in 1992 to about $ 60,000 by January 1994. From January 1996 they are to be set in foreign currency terms at ECU 500,000 or ECU 3 million for new entrants to the banking sector. 3 The distribution of Savings Compensation Certificates later in 1995 is expected to provide Kbvs. 287 trillion of value to Oschadny depositors. (185 million certificates with a face value of either Kbvs 1 million or 2 million each). This is the equivalent of about $2.5 billion and so will restore about one quarter of the real value of deposits lost since 1990. 41t can be noted that the control discipline exercised by head offices over branches is quite limited by Western standards. Until relatively recently, for example, it was normal for individual branches to hold clearing balances directly with the National Bank of Ukraine (NBU) and to undertake their clearing through that direct route rather than via a consolidated clearing account in their ANNEX A page 3 of 12 longer that far ahead of the newer private banks in terms of their overall coverage of branches: 901 branches in total compared to 472. However, the latter figure is associated with only a handful of the new banks and the majority have none or at most one branch (see also Table 2). 6. Similarly the very low ratio of capital to assets of Oschadny (a ratio of below 1 percent for the statutory capital and less than 3 percent for total capital), means that the two state-owned banks together are substantially under-capitalized relative to the other two categories of bank shown in Table 1. These fully-owned state banks account for about 19 percent of all bank assets but only 10 - 11 percent of total capital. The three former state-banks seem much better placed from this point of view with 57 percent of the systems total capital including reserve funds, supporting some 51 percent of the system's total assets. However, this is before allowing for loan-loss provisions which are likely to affect the former state banks more substantially than the newer private banks. 7. Third, there is distinct evidence that the more successful of the newer private banks have already made up considerable ground on the state-owned and former state banks. Available time series data are limited but the data for just the two periods 1993 and 1994 indicate just how rapidly this catching-up process seems to be occurring. Table 2 shows the main balance-sheet aggregates for the three former state-banks and the leading twenty private banks in each of those two years. 8. The last row of numbers in the table shows the combined size of the top-20 newer private banks relative to the three former state-owned banks. So, for example, in relation to total capital, the top-20 private banks in 1993 had combined capital equal to only 12 percent of that of the former state banks. By 1994 this had risen to 42 percent. The corresponding numbers for assets, household deposits and credits outstanding are 9.4 percent against 48 percent; 9 percent against 47 percent; and 12 percent against 55 percent. This does not signify the imminent disappearance of the dominant positions of the larger banks, but it does suggest that competition for their business is alive and real. 9. The 23 banks which appear in one or more columns of Table 2 together with the relevant balance- sheet totals for them are shown in full in Table 3. It is noted that all but the last three of the banks shown in Table 2 are the strongest banks when they are ranked by capital (as in Table 3). The exceptions are the Pravecs Bank, Nobyi Bank and NBK Bank which figure in Table 2 by virtue of quite high levels of public sector deposits. However, these banks all have low levels of capitalization. own head offices. Some individual banks as well as the NBU itself have been developing systems to establish consolidated clearing of banks in at least some regions/provinces of the country. Nonetheless the high degree of autonomy which remains with branches in relation to many aspects of their operations raises difficult questions about the most appropnate form of restructuring to advocate for the banks and also about the mechanisms of monetary control. ANNEX A page 4 of 12 Table 2: The Changing Structure Of Banking, 1993 And 1994 Name of Branches Capital Assets Public Deposits. Credits Bank: (Number) (Kbvs. (Kbvs. (Kbvs. (Kbvs. (Kbvs. (Kbvs. (Kbvs. (Kbvs. billion) billion) billion) billion) billion) billion) billion) billion) 1994 1994 1993 1994 1993 1994 1993 1994 1993 Former State Prominvest 250 7367 2461 95018 22379 2591 430 35123 11434 Ukraina 535 7510 1018 117501 58751 1726 159 30391 10971 Ukrosotsbank 116 4156 701 57446 9356 729 42 19371 3497 Sub-Total 1 2895 21027 6172 271959 92479 7040 2623 86879 27895 Other Banks Bank 1 83 1791 104 21889 1910 757 32 7361 798 Bank 2 43 1280 99 20236 1768 465 28 6478 516 Bank 3 42 912 94 19058 768 385 27 6059 362 Bank 4 41 779 76 14304 764 299 22 5342 270 Bank 5 26 771 73 12014 603 190 20 4243 219 Bank6 23 637 51 7980 415 138 18 4195 219 Bank 7 16 634 46 7034 392 112 9 2671 217 Bank 8 16 475 30 6497 349 104 7 2594 133 Bank 9 13 214 29 4071 335 103 7 2328 108 Bank 10 13 173 23 3578 279 98 5 1142 102 Bank 11 11 163 17 2153 272 97 5 724 101 Bank 12 10 145 16 2113 164 83 5 621 33 Bank 13 8 128 16 1713 120 77 5 575 31 Bank 14 8 116 13 1249 112 73 5 509 30 Bank 15 7 116 12 1228 88 69 4 479 28 Bank 16 6 114 11 1189 86 67 3 475 27 Bank 17 6 112 10 1109 67 66 2 455 20 Bank 18 5 109 9 1097 61 61 2 445 19 Bank 19 5 97 9 994 56 50 2 379 18 Bank 20 4 96 9 940 46 44 2 370 18 Sub-Total 2 386 8862 746 130446 8655 3338 211 47445 3269 Share or Top- 20 Private Banks 13.3% 42.1% 12.1% 48.0% 9.4% 47.4% 8.1% 54.6% 11.7% Source: Compiled from Bankers Association balance-sheet data and the balance-sheets of some banks obtained directly by the mission. See also Table 3 below. Note: The Top-20 banks are not always the same or in the same order for the various balance-sheet aggregates which are analyzed. ANNEX A page 5 of 12 Table 3: Twenty-Three Leading Private Sector Banks Name: Branches Capital Capital Assets Public Deps. Credits Profit (Number) (Kbys. bill.) ($ million) (Kbvs. bill.) (Kbys. bill.) (Kbvs. bill.) (Kbys bill.) Gradobank 23 1791 17.2 19058 0 6478 75 Peroyi NMB 5 1280 12.3 7034 2 4195 614 Privatbank 41 912 8.8 20236 757 5342 1086 Ukreditbank 2 779 7.5 4071 66 2594 520 Inko 83 771 7.4 21889 465 4243 603 Vidrodzhenya 43 637 6.1 14304 299 6059 138 Ukrinbank 26 634 6.1 12014 83 7361 696 Aval 42 475 4.6 7980 67 2671 763 Lesbank 16 214 2.1 6497 97 2328 272 Nadra 0 173 1.7 1109 7 575 317 Econombank 16 163 1.6 3578 69 1142 66 Perkombank 0 145 1.4 1713 138 306 82 Krymbank 10 128 1.2 665 104 195 232 Zapykrkombank 13 116 1.1 2153 11 479 188 Metallurg 0 116 1.1 310 44 196 74 Transbank 4 114 1.1 1097 23 370 152 Trant 7 112 1.1 1249 9 455 142 Legbank 2 109 1.0 1228 190 509 221 Electronbank. 4 97 0.9 994 77 379 155 Azhio 13 96 0.9 2113 103 724 155 Pravecs Bank 11 59 0.6 1598 385 508 62 Nobyi 4 47 0.5 1007 61 477 53 NPK Bank 8 61 0.6 1006 73 348 23 10. Finally, in relation to the geographical distribution of banks it can be noted that about half the banks which appear in the list of 88 major private banks shown in Table I have their main headquarters in cities other than Kiev. The NBU in its list of 222 registered banks as of March 1995, categorizes all but 79 of these as oblast-based banks. More detailed information on this and the distribution of branches mainly for end-1993 but with the 1995 figures, where available, shown in brackets in column 2 is presented in Table 4. 11. Although the geographic distribution of bank headquarters is highly skewed towards Kiev, where more than a third of banks are based, the geographic distribution of branches is relatively even. The overall density of the coverage of branches (excluding Oschadary branches) at about 3000 inhabitants per branch is below that of the USA but higher than is experienced in either Russia or Japan. The credits granted also correspond to this pattern. It is noted that Kiev branches account for about 27 percent of all lending with the other important oblasts in order being Dnipropetrovsk ( 10 percent); Donetsk (8.4 percent); Kharkiv (5.5 percent) and Lugansk (5 percent). Together these 5 oblasts account for 56 percent of all outstanding loans compared with their 38 percent share of total population. This discrepancy is accounted for by the disproportionately large lending role of the Kiev branches due to the dominance of the head office functions in that region. ANNEX A page 6 of 12 Table 4: Geographical Distribution Of Banking System REGION No of No of Credits Population Population per Banks Branches Outstanding (millions) Branch (000) Dec.- 93 Dec - 93 Sept 1994 Dec. - 93 Dec. - 93 (March -95) (Kbvs, billion) Kiev 67 (79) 175 33,577 4.6 26.3 Vinnitsa 1 42 4,131 1.9 45.2 Dnipropetrovsk 8(11) 85 12,313 3.9 45.9 Chernigiv 5 43 1,779 1 4 32.6 Donetsk 15 (17) 108 10,444 5 4 500 Chernivtsky 1 28 1,759 0.9 32.1 Zhitomir 6(4) 49 1,519 1.5 306 Cherkassy 1 43 3.274 1.5 34.9 Zakarpatie 3 33 1,533 1.3 39.4 Chmelnitsk 2 40 2,554 1.5 37.5 Zaporoshie 4(6) 59 3,355 2.1 35.6 Cherson 4 44 3,484 1.3 29.5 Ivano-Frankivsk 6(3) 37 1,587 1.4 37.8 Kharkiv 19 (18) 94 6,785 3.2 34.0 Kirovograd 2 41 2,070 1.3 31.7 Ternopil 3 44 1,850 1.2 27.3 Krim 9(13) 87 4,645 2.6 29.9 Summy 4 41 3,955 1.4 34.1 Lugansk 1 61 6,134 2.9 47.5 Lviv 12(10) 67 2,909 2.8 41.8 Mikolaiv 5 (5) 51 3,937 1.4 27.5 Odessa 9(16) 73 4,091 2.6 35.6 Poltava 2 (3) 47 3,245 1.8 38.3 Rivno 6 39 1,850 1.2 30.8 Volin 0 33 1,163 1.1 33.3 TOTAL 195 1,464 123,945 52.2 3.1 Source: NBU-branch data as of December 1, 1993 Ministry of Statistics-population estimates ANNEX A page 7 of 12 B. BANK OWNERSHIP 12. The effective ownership of many, Ukrainian banks is unclear. Most banks are joint stock companies. The five largest banks are spin-offs of the FSU specialized banks. The remaining banks currently numbering some 230 were created as completely hew institutions by their shareholders after 1990. The ownership structure of these two groups is very different. Large banks are often owned by thousands of individual shareholders. Among the large banks. Oschadny Bank and Ukreximbank, which remain directly state-owned entities, are the two major exceptions. Ownership of new, small commercial banks is frequently concentrated, with some banks owned by only a few shareholders. 13. Oschadny Bank was formed in 1991 from the Ukrainian branch of the FSU Sberbank (Savings Bank). Ukreximbank was created out of necessity in January 1992 when the FSU Vnesekonombank ceased to process Ukrainian foreign trade payments. While it remains dominant in international payments as a whole, this historical reason has limited its involvement in payments within the former ruble area where other banks have gained the significant market share. Three of the FSU specialized lending banks - Agroprombank, Promstroibank, and the Social Investment Bank - were each transformed in 1990 into Ukrainian joint stock companies--Bank Ukraina. Prominvestbank. and Ukrsotsbank, respectively. While there is a move towards universal banking , all five of the banks which derived from the old Soviet system retain their traditional sectoral specializations which are agriculture (Ukraina), industry (Prominvest), and social sectors (Ukrsotbank),5 As shown in Tables I and 2 above these five institutions were still the largest banks in Ukraine as of December 1994. 14. Initially, state-owned enterprises were the major shareholders of the older banks when they were corporatized. Their ownership evolved dramatically during 1993, however, in response to a government directive to transfer shares owned by state enterprises , and of course the dividends, to the Ministry of Finance. For the most part, Bank Ukraina, Prominvestbank and Ukrsotsbank, responded by transferring ownership from state-owned enterprises to new "private structures" or to the employees of the same state- owned enterprises. Some two-thirds of Prominvestbank's capital, for example, comes predominantly from about 200,000 individual shareholders, most of whom are the workers in client enterprises or its own employees. Ukraina also has over 250,000 shareholders of whom all but 13,800 are individuals. Of the three former state-banks, Prominvest is the only one which is constituted as a closed joint stock company. The other two banks have extended their shareholdings quite significantly during the past two or three years and are also major sponsors of the Kiev stock exchange on which their own shares are quoted. In all cases however there is ambiguity about where the real control of the banks actually lies. In particular there is a strong suspicion that the parent enterprises of the thousands of employee shareholders still pull the strings when it comes to major decisions in the banks such as the appointment of senior managers. If this is indeed the case, then it is quite serious from the viewpoint of effective corporate governance since those same enterprises, for the moment, remain the major borrowers from the banks. 15. As noted earlier, Oschadny and Ukreximbank remain under very direct government control. 16. The ownership of new commercial banks in most cases, is also very unclear. Most new commercial banks report their primary shareholders to be "new commercial structures" which are supposedly private. In many such cases shareholding is reported to be highly concentrated and in some cases the shareholders are also the bank's most important borrowers. However, a few banks which started out as "pocket" banks have extended their shareholdings very considerable in the past two years. 5 Unlike in some other countnes of the FSU where the former specialized banks have split into a large number of new banks, each of the offshoots of the specialized banks has remained a single bank. ANNEX A page 8 of 12 17. Such unclear ownership is highly detrimental to the development of the banking system for three reasons. First, it renders the rights of shareholders vis-a-vis management very ambiguous. For example. the present managers are themselves the founders of many of the banks and it is unclear whether the other shareholders have any real power to change the management. Second, the ambiguity about true ownership renders it difficult for the NBU to utilize one of the possible instruments to assist an ailing bank namely that of requiring the shareholders to put up more capital. Third, unclear ownership raises serious problems in enforcement of restrictions on connected and insider lending. Initially. most banks appear to have lent primarily to their own shareholders. Connected and insider lending are very tightly controlled in developed countries, since such practices can lead to serious problems of fraud and put household deposits (as well as government funds for deposit guarantees) at risk. In Ukraine, these risks are not yet as serious as elsewhere, since there is only a negligible amount of household deposits outside of Oschadny Bank and overall deposit levels have fallen sharply as we saw earlier. It may be perfectly sensible during the difficult transition period of the next few years for the NBU to allow some banks to operate as tight groups with a dominance of insider lending practices because such arrangements can make full use of the specialized knowledge about each other of the insider group. However, the NBU should not allow such "banks" to actively seek depositors from the wider public and thereby put such depositors at a considerable disadvantage relative to the insiders. 18. This last issue is likely to become more important over time' as inflation abates and deposit mobilization from households begins to recover. Prudential regulations are needed to deal with it, and the mission recommends a two fold approach.6 First, the NBU should enforce the regulations issued in December 19937 and then tightened in March 1995. These regulations impose restrictions on the loans (including 50 percent of off-balance-sheet items) provided to any single borrower if they exceed 10 percent of bank capital. Second, it is recommended that the NBU consider a new and restricted form of license for what might be called "finance companies." This would enable the narrow pocket banks which exist mainly to do insider lending transactions to continue in business provided that they -did not seek to extend their operations to deposit-taking. This recognizes the realities first that some 100 or so of the 230 newer banks presently in operation will be quite unable to meet the new January 1996 minimum capital requirement, and second, that the majority even now do not really attempt to mobilize household deposits. So while closing them down is an option, keeping them alive with an explicitly restricted role may be a realistic alternative. 6 To the extent that the present lack of clarity in ownership masks a structure in which banks are owned largely by enterprises it could also complicate an attempt to stabilize the economy and delay the process of restructuring of the enterprise sector This occurred, for example, in Yugoslavia, where banks which were owned largely by enterprises continued to lend to insolvent enterprises, thus retarding the development of both sound enterprse and banking sectors. 7 Regulation No. I14 of 21st December 1993 ANNEX A page 9 of 12 C. A TAXONOMY OF BANKS 19. The following categories classify banks according to their main activities. It is meant as an organizing tool to analyze a bank's activities and identify problems. rather than as a description of any particular bank. Many banks perform activities linked to more than one of the proposed categories and most banks appear to be scrambling to provide a universal range of services irrespective of whether they have the staffing and experience to provide all services effectively. Hence, the relative importance of their various activities is quite likely to change over time. 20. Directed Credit Banks. These banks comprise mainly the big three of Prominvest, Ukraina, and Ukrosotsbank whose main activities until quite recently has been to channel directed credit resources from the NBU or the Government to state-owned enterprises with whom the banks are linked. These banks accounted for a large share of total lending given the importance of directed credit programs in overall credit growth through end-1994. Table I above indicates that in December 1994 with total loans of Kbvs 84,885 billion they accounted for over 54 percent of all bank credits outstanding (down from 90 percent one year earlier). In 1993 the credits channeled to enterprises through the budget amounted to Kbvs 778 billion (0.5% of GDP) of which the major beneficiaries were the sectors of Energy (Kbvs. 275 billion). Industry (Kbvs. 219 billion); Agriculture (Kbvs. 48 billion); and Military industries (Kbvs. 12 billion) However, these sums were dwarfed by the off-budget directed credits to Agriculture of Kbvs. 11.387 billion mostly through Bank Ukraina and to a lesser extent Ukrosotsbank. The total amounts still outstanding associated with NBU refinancing operations (most of them subsidized and to Agriculture. Mining, and Industrial Conversion)) amounted to Kbvs. 14,760 billion as of September 1994. Much of this related to the NBU - directed credits in 1993. By 1994, there has been.a significant shift involving greater dependence of the banks' own resources for on-lending. As of March 1995 some Kbvs. 8 billion of the 1993 credits remained unpaid. 21. So long as directed credits continued, the dominant position of the three leading banks derived from the banks' privileged access to government or quasi-government funds, and this clearly gave them an unfair competitive advantage. If tighter fiscal and monetary programs can be sustained, this advantage should decline and a down-sizing of these three large banks, and especially Ukraina can be expected. However, those banks are likely to retain access to the large payments balances of state-enterprise clients and use these to retain much of their relative position. This will change only as mass privatization proceeds and the inter-linking of bank and enterprise ownership diminishes. In the meantime, the situation creates the most difficult problems for banking sector reform since the restructuring of these banks is intimately tied in with the fate of the large state-owned enterprises who still constitute their major clients. Because it will be politically very difficult to close large numbers of such enterprises in the short term future some residual support role from these banks needs to be anticipated in any reform agenda which is defined. 22. Savings Bank. Oschadny Bank, the former Ukrainian branch of the Soviet Sberbank, constitutes a category by itself. Its primary function is the mobilization of household deposits. It has over 13,000 branches and an office in virtually every district of Ukraine. Until recently it held a monopoly on household deposits and continues to hold a dominant share of such deposits (see Table I above). 23. Traditionally most of the funds mobilized by the bank have been passed on to the NBU for re- lending although some increase in its own loan portfolio is now occurring partly through the intercession of the inter-bank market. This bank more than any other needs to define and establish its note in the new environment. ANNEX A page 10 of 12 24. Emerging Commercial Banks. There are a small number of banks that are evolving into real commercial banking institutions. Most fundamentally, these banks lend to their clients only when they expect to be repaid although their basis for assessing the prospects of repayment are often relatively primitive by Western standards. Upgrading programs in a small number of these banks and for some of their activities especially their foreign currency lending are being undertaken in the context of an initial EBRD credit for ECU 100 million and a corresponding World Bank operation.8 Most loans from these banks are secured with collateral, third party guarantees or loan insurance.9 A substantial portion of their lending is moreover to private commercial structures and to joint stock companies. Those amongst these banks which survive the stresses of the next few years are likely to form the mainstay of a new banking structure along with the restructured elements of the banks inherited from the FSU. 25. Company or Group Banks. The main objective of company or group banks is to provide services to a single company or enterprise group, which is frequently the owner of the bank in question. These services may include such legitimate activities as recycling short-term funds among enterprises of the group, much like the treasury department of a conglomerate. Others may exist primarily to offer more efficient financial services to its owners, e.g., access to the payment and clearing system. Some may exist solely to focus on less legitimate services such as draining resources from a state enterprise, keeping their insolvent owners liquid for a while longer, or accessing cheap NBU credit. It is likely that many of these banks will fade away or will merge once tighter supervisory rules on connected lending are enforced. However, the idea of a separate and restricted form of license for the better of them should be considered. 26. Foreign and Joint Venture Banks. The foreign bank penetration of the Ukrainian market has so far been quite limited although several Western banks are very active in technical assistance projects. At present foreign banks are allowed to operate in the country either through wholly-owned Ukrainian subsidiaries, representative offices in Ukraine, or through a shareholder participation in a Ukrainian bank. Only Credit Lyonnais operates a subsidiary company at present but at least one other bank is in negotiations to establish one. At least five banks are known to have established representative offices in the country namely Commerzbank, Deutsche Bank, Dresden Bank, West LB, and Societe General. Additionally, the Banque National de Paris has some presence in the country, and the First Ukrainian International Bank established in Donetsk is operating with foreign equity participation. Russian banks are known to be active in foreign trade financing in the border regions and a significant entry of Russian banks is a distinct possibility. In the unstable circumstances of the past few years, the foreign banks which have been established have not been able to exert much influence and are important mainly in foreign trade financing for expatriate companies and through their participation in technical assistance projects. This could change rapidly if more stable and liberal conditions are established and significant private sector business projects begin to materialize. 27. The formal restrictions on foreign bank entry do not appear to be particularly stringent.'0 They are required to have minimum capital of ECU 5 million if the foreign involvement is less than 50 percent, and ECU 10 million in the case of a greater than 50 percent foreign ownership. These are larger amounts than required for purely local banks and to that extent there is indeed some disincentive to local banks to work with foreign partners rather than on an independent basis. However, the serious banks in the country would expect to have capitalizations of greater than ECU 5 million in any case. 8 A Financial Institution Development Loan (FIDL) is now in preparation. 9nere is an urgent need to examine the insurance industry and its role and, in particular, its role in msuring loans. A large number of commercial bank loans are insured, but the value of such insurance were a banking crsis to emerge is questionable. 10 These are specified mamly in the NBU Resolution No 24 dated February 7th 1994 ANNEX A page 11 of 12 D. THE SECTORAL PATTERN OF BANK LENDING The sectoral lending patterns as of mid-1994 are summarized in Table 5 Table 5: The Sectoral Pattern of Lending (July 1994). Sector Amount Share (%) Outstanding (Kbvs bill.) Short-term Power Generation 1460 1.6 Machinery and Metals 5647 6.1 Light Industry 1735 1.9 Food Processing 13189 14.3 Other Industry 2164 2.3 Industry Total 24195 26.2 Agriculture 9099 9.8 Transport and Communications 595 0.6 Construction 1406 1.5 Retail Trade and Catering 5233 5.7 Wholesale Supply 7197 7.8 Procurement 1784 1.9 Other Material Sphere 27855 30.1 Housing and Communal Services 310 0.3 Other non-Material Sphere 7146 7.7 Joint-Ventures and Non-Residents 446 0.5 Other 1297 1.4 TOTAL Short-Term 86562 93.6 TOTAL Long-Term 5933 6.4 TOTAL 92495 100.0 Source: National Bank of Ukraine 28. Other developing and reforming countries have found that foreign banks can be an important element in the process of attracting foreign direct investment. They are also important in transferring know-how and in providing many banking services to foreign companies with which they also work in their home countries. These potential benefits are particularly important for the Ukraine in the light of its relative paucity of Western banking experience. While opposition to their establishment is likely from domestic banks who will fear some loss of market share, this is less of a problem than may be supposed because of the limited appetite of foreign banks for cross-border exposures. Thus there is scope for a healthy division of responsibilities with the Ukrainian banks being likely to preserve their dominance of the domestic businesses based on their superior knowledge of the complexities of local business operations and rules. In the light of this an open and encouraging approach to foreign bank involvement is to be recommended. ANNEX A page 12 of 12 29 Contrary to what might have been expected, lending to industry is dominated by the Food- Processing sub-sector ( 14 percent of all short-term lending ) with the rest of industry accounting for only 12 percent of the total. When lending to the Agricultural sector itself is added in. almost one quarter of all lending is shown as going to agriculture and agriculture-related activities. Less surprising is the fact that loans for Housing are so small (less than 1 percent of the total). Ukrainian banks have never needed to work directly with this sector and it will require a major adjustment of their operations to bring housing lending activity up to the levels needed by a more private-ownership oriented economy. ANNEX B page 1 of 19 NOTES ON THE STATE AND FORMER STATE-BANKS 1. These notes are based on interviews conducted by the review mission and are intended merely to provide some background about the current situation in each bank. The work on Prominvest and Oschadny banks has been more detailed. The information on the other three banks will be elaborated during later missions. However, it is likely that much of the detail of organizational and operational arrangements established for Prominvest will have relevance too for the other main lending banks namely Ukrosotsbank and Bank Ukraina. A. PROMINVESTBANK Legal Status, Governance and Organization 2. Since August 1992 Prominvestbank has been a closed joint-stock company. With more than 200,000 shareholders, legal entities and individuals, its ownership is widely spread. 98% of the shareholders are private companies and individuals, and only 2% of shares are owned by state enterprises. Individuals alone account for 80% of the shares, while 20% are owned by 526 private and state owned companies. The nominal value of one share is Kbvs. 10,000 and each share representing one vote, is registered and cannot be sold. Shareholders wishing to sell shares have to give them back to the bank. Shares are not listed on the stock exchange. All shareholders are enrolled in a computer register maintained by the bank itself. 3. The huge number of small individual shareholders comprises employees of the bank as well as employees of the private and state owned companies, which are clients of the bank. In principle, the employees of the companies are independent in exercising their voting rights: in reality however, it can be assumed that many of the rights are exercised by the managers of the different companies. The shareholders elect the council of shareholders, which consists mainly of professional members. At present the director of an important power plant is head of the council. The council in turn appoints the management board, which consists of the Chairman and 6 members, for a period of 5 years. The council controls the activities of the management board. 4. Each regional branch has its shareholders. 15 out of 25 regional branches have their own regional council consisting in its majority of the managers of the companies, which are customers - in most of the cases borrowers - of the branch. It has become a custom that the managers of the 10 most important companies of the region form the regional council. They are also the proxy holders for their employees and participate in the general shareholders meeting in Kiev. Normally about 200 council members participate in this meeting. Banking strategy questions, issues on capital formation etc., are discussed by general shareholders meetings and any reform of the structure of the bank will have to be approved by the shareholders meeting. 5. The Managers of the regional branches and the Managers of the branches are appointed by the Management Board. The Head Office has 15 departments and under each department a number of divisions. Business Strategy 6. The strategy of the bank's management is to develop its wholesale and retail banking further. The bank is considered as the financial center of Ukrainian industry. The possibility of splitting the bank into smaller units in order to improve competition in the industrial sector, has been raised ANNEX B page 2 of 19 several times. However, this idea has been rejected by the shareholders. The decisive argument seems to be that each sector of the Ukrainian economy had its financial center There are banks specialized in energy. posts and telecommunication. construction. agriculture and forestry etc. Prominvestbank is trying to remain the dominant bank : -r industrial clients. It is facing competition from other banks and has constantly to prove its abilities. 7. The bank is strengthening its organizational structure and completing its technological upgrading. In the latter field the bank is well advanced compared to its competitors. Therefore great emphasis is given to the further development of computerization. These circumstances give it advantage too in retail banking, a sector which is developing fast. It seems to have few problems in raising its share capital by way of profit allocations and capitalization of dividends. It does not intend to increase its number of shareholders. Credit Control Department 8. With regard to credit policies and procedures, recommendations on short term lending have been issued by the Management Board to regional branches. These recommendations include an orientation towards sectors which are thought to need a more active approach by the bank, such as export-oriented companies, ship building, aircraft industry, infrastructure projects. etc. The department head is working on a new structure with regard to credit authorization, the credit committee and a work-out team for bad loans. Long term loans are dealt with in the Investment Department and loans in hard currency in the International Department. Only the Head Office is dealing with these types of loans. 9. At present the procedures in force involve some attempt at risk evaluation. The customer submits, his loan application, a business plan, a description of the purpose of the loan, an assessment of the market, the evidence of repayment capacity and possible collateral. With regard to the latter item, guarantees of third parties who have real estate are sometimes offered. Insurance is also accepted as collateral. Mortgages on real estate are not good collateral in a Western sense since there is no register yet where charges could be recorded. Nor are there good arrangements for enforcement and recognized legal procedures and practices of bankruptcy are missing. In some cases, the bank has acquired real estate pledged as collateral for loans to third parties but in only in a few cases has it been able to sell the property. In the agricultural sector the situation is easier due to the 99 year lease structure, whereas in urban areas only 15 year leases are known. 10. The documentation submitted by the client is first considered by credit inspectors, who analyze the financial status of the client during the previous years, visit the client and formulate recommendations. As soon as the department head has signed the recommendation it goes to the Credit Committee of the branch, which consists of the heads of the departments connected with customers, before it is forwarded to the Manager for his signature. Lending limits are determined as follows: * up to 4 million Kbvs. Manager of the branch * over 4 up to 6 million Kbvs. Credit Department of the regional branch and Credit Committee of the regional branch * over 6 million Kbvs. Credit Control Department of the Head Office ANNEX B page 3 of 19 11. The Credit Control Department prepares a recommendation for the Credit Committee of the Head Office which consists of three representatives of the Credit Control Department. and the heads of Investment. International. and Finance (also in future Accounting) Departments and the Deputy Chairman in charge of the Credit Control Department. From there, the recommendation is passed on. as follows: * up to 50 million Kbvs. to a Deputy Chairman * over 50 million Kbvs. to the Management Board 12. According to the bank's rules new loans should have a validity of only 3 months: in case of a prolongation, the interest rate is increased. A prolongation can take place only 3 times and only for I month each time; after this the loan is deemed overdue and the interest will be doubled before the collateral (real estate or guarantee) will be enforced. Authorizations for prolongation follow the same procedure as for new loan applications. Clients are not obliged to have all accounts with the bank. although, it is the policy of the Board that all clients should have their current account with the bank and most do. This makes for a tight link between control over lending and the payments balances of clients. 13. Of the total amount of outstanding loans of Kbvs. 42.2 trillion as of January 1, 1995, some Kbvs. 3.4 trillion are considered as overdue. The banking sector is expecting a new law regarding "interest not paid". So far this item is considered as income on which tax has to be paid. The Operations Department is under the impression that this method has been abolished in October 1994 and that Ukrainian banks are now following mainly the Western Banking procedure of accrual of interest, (i.e. interest income should be calculated on an accrual basis, meaning that the bank should calculate the interest due from its clients over the exact period covered by the income and expense statement, whether or not the client has actually paid this interest. The exception is that interest on individual loans should not be accrued if any portion of the credit exposure to that client is overdue by more than a certain, specific period. Interest accrual is commonly discontinued after 90 days, with any interest accrued during the 90 days reversed out of income.) Interest-Rates 14. There are no longer any interest rate control by the NBU. Each bank can freely consider the pricing of loans and deposits. At branch level this is done independently for loans up to the limits defined above. Interest rates for larger loans are determined by the Management Board based on recommendations of the branches. For determining the interest rate the cost of funds, the risk involved in the transaction and the quality of the management of the borrower are all taken into consideration. Prominvestbank takes a serious approach to pricing in the sense that loans to industry - production and construction - have priority over short-term speculative lending which may command much higher rates. The March 1995 interest rate on loans was approximately 150% p.a. Interest rates on deposit accounts differ: on payments balances only 40% p.a. is paid, on deposit agreements - depending on the amount - between 100 to 200% p.a. International Department 15. The International Department, which is working profitably, is organized according to standard banking practice. Ukrainian imports are handled by advance payments or letters of credit; exports mainly by collections. With regard to import-financing, raw material, foodstuff, chemicals and machinery for large importers play a major role. Letters of credit are opened on a covered basis. The ANNEX B page 4 of 19 bank enjoys. however, credit lines for opening letters of credit with several American and Western European banks: Chase Manhattan. Bankers Trust. Credit Suisse. Commerzbank, Berliner Bank and Dresdner Bank (under negotiation). 16. A subdivision deals with medium- and long-term credit lines in hard currency and a few specialists have been trained in medium- and long-term business. From time to time Prominvestbank assists foreign banks in financing Ukrainian projects by analyzing the market and evaluating the credit risk. There is a strong competition between the banks also for hard currency accounts. Prominvestbank is trying to acquire customers by more efficient service and claims to be increasingly successful in attracting clients with foreign business from Eximbank. 17. Interest rate risk is well monitored and actively managed. For swap transactions there are internal limits for each counterpart bank. The limits are authorized by the Management Board. as is foreign exchange risk. Foreign exchange dealings (spot and forward) are principally handled by Head Office, not by the branches. The latter only exchange hard currencies and lend small amounts to private customers, which normally do not exceed $1,000 to $3,000. For these amounts competencies are given to the branches. Competencies and lending limits for all the other transactions in hard currency are regulated in a similar way to the domestic credit business of the bank. The limits for position taking are strictly supervised. At present there are three active dealers. 18. Every day detailed information regarding all foreign exchange transactions has to be given to the NBU. The bank follows a very conservative policy by keeping its lending in foreign currencies lower than deposits and borrowing. The interest rates follow the rates on Western markets. Reuters considers Prominvestbank as a good address on the international foreign exchange markets and for Ukraine the bank is one of the important market makers. Besides extensive in-country training, an exchange of personnel with foreign banks is going to be organized. Operations Department of the Head Office 19. Although situated in the Head Office, the function of this department is comparable to a regional branch. This structure is common in many West European banks, which locate a branch in their Head Offices to serve the local clients. The main clients of the Operations Department are Ministries, Government departments, State enterprises and also small businesses. Ministries and Government departments account for 70% of the clientele. 20. In the context of the 25 regional branches of the bank, only 2 branches are larger in total assets: Donetsk and Dnepropetrovsk. With regard to profits this department is the front-runner, mainly because of the very favorable deposit position. Due to these circumstances an important part of the interbranch funding is done by this department. It is directly connected with the 25 regional branches and the 263 operating branches through its on-line E-Mail system (see Annex E). 21. The department works with most of the Ministries. Loans given to Ministries are normally secured by real estate or against guarantees of the Cabinet of Ministers. Due to the fact that these loans are usually not paid back, they can more accurately be considered to be "loans in advance of subsidies". .The amount outstanding as per January 1, 1995 was Kbvs. 1.5 trillion Subsidies are provided by the budget. ANNEX B page 5 of 19 22. As long as the bank was state-owned. the Ministries could force the bank to provide loans for special projects. Today. the bank theoretically can refuse to lend money. In practice. however, the bank will negotiate with the Ministries and provide the loan if the bank is convinced that there will be a return and the loan will be repaid on time. If a request for a loan is considered weak, the bank has the right of refusal. It is worth mentioning that the bank won a court case against a Ministry lately and was refunded Kbvs. 300 billion. The bank has also instituted other legal proceedings against Ministries and Government departments. Financial Department This department has 4 functions, namely: * analysis of financial results and recommendations concerning distributions of profits: * recommendations concerning formation of shareholders capital; * participation in third companies; and * planning 23. The distribution of profit is decided by the shareholders meeting. In particular the meeting decides, which part of the profit should be transferred to the different funds, such as reserve founds, insurance funds, which lower doubtful loans but also other purposes, centralized funds for the development of the Head Office (technology, construction, etc.), bank development funds for the branches, funds for social development, bonuses and incentives, funds for the payment of dividends. In 1994 dividends were paid quarterly: in total, 150% on the nominal share capital. 24. Increases of capital are also discussed at shareholders meetings. On several occasions the shareholders have been asked to re-invest their dividends for this purpose. In view of the risky development of new investment funds in the country, the use of dividends to acquire new shares of the bank was widely adopted. During 1994 share capital was increased from Kbvs. 565 billion to Kbvs. 2.925 trillion by cash injections and the indexation of assets. The latter was carried out on the basis of the price increases of the fixed assets of the bank and the utilization of part of the resulting profit. The recent shareholders meeting, which was due at end-March 1995 had to decide on an increase of the share capital by a further Kbvs. 915 billion. As pointed out earlier Prominvestbank is one of the few closed joint stock companies. However, the bank has been invited by NBU to change its status into an open company, which would provide a much broader access to new capital. A recommendation to this effect was passed on to the same shareholders meeting. 25. Participation of banks in third companies are restricted by law. Each bank'can invest up to 10% of its authorized capital in third companies. The bank can, however, acquire only up to 15% of the capital of a company. In principle, this restriction also applies to bank investments in investment funds and trusts. However, several banks claim to have their own investment funds and there is a strong suspicion that holdings, direct or indirect, are frequently larger than the 15 percent limit. 26. In the case of Prominvestbank 10% of Kbvs. 2,925 trillion of capital has been invested in 98 financial companies, insurance companies, investment funds and other enterprises. With the authorization of the Head Office investments are also effected by branches. In most cases companies, in which the bank holds participation are also borrowers of the bank. In the balance sheet these participation is shown under "other assets". Investments can also be made in Government Securities including Treasury Bills which were available from March 1995 onwards. It has not yet been ANNEX B page 6 of 19 decided. if these bills are to be included in the 10% regulation. On the other hand bonds certainly will be included for liquidity purposes. 27. The financial department is also in charge of forecasting the potential results for 1995. Investment Department The functions of this department are: * long term lending * re-channeling loans from NBU for military conversion At present, the scope of activities for this department is under discussion at Board level. and it is likely that with the enhanced importance of Security Markets, a further function will be added shortly. Long term lending is refinanced by own funds and borrowing on the market. 28. In 1994 the department considered 48 projects including 19 hard currency projects to be financed by profits of the bank - 36 projects of these were refused. 12 were positively recommended out of which 5 were implemented. The average size of theses projects was approximately $5 million - all of them claimed as successes. Due to its comparatively strong capital base - the statutory capital of all Ukrainian banks amounts to Kbvs. 9 trillion out of which Prominvestbank accounts for 3 trillion - the bank can play an active role without violating the 10% participation rule. As the Investment Department is concerned with the analytical work only and not with the crediting as such, it is neither informed about the realizations achieved in detail nor about the return on the projects. Most investments are done jointly with other investors. The bank insists that there is no pressure coming from the Government; the investment decisions are done independently. Cooperation with foreign investors have not yet been established. The bank, however, is looking for foreign partners. 29. Targeted loans from the NBU for the conversion of military industry are based on Parliamentary approvals. The Ministry for Machine Building, Military and the Industrial Complex plays a key role in this. The Ministry of Finance provides the funds, but the loan agreements are concluded between NBU and Prominvestbank. 98% of the conversion programs are channeled through this bank. The bank supervises the use of funds and services the loans routed through its books. Although it has no influence on the credit decision the bank is responsible for the repayment of the conversion loans. Normally real estate or property on the products manufactured with the converted machinery is offered as collateral. 30. The department was not familiar with how these loans are shown in the balance sheet of the bank. As of January 1, 1995 about Kbvs. 10 trillion loans out of total loans of Kbvs. 42.2 Kbvs. were not lent for commercial purposes. Out of the 10 trillion Kbvs., 3 trillion were conversion loans supported by NBU under the instruction of the Ministry of Finance and Kbvs. 7 trillion Kbvs. were lent by Prominvestbank itself to industrial companies and financed by its own funds and borrowed money. It can be assumed that also these financings have been effected under some pressure. Repayment of the total amount of 10 trillion Kbvs. is considered doubtful. Each. regional branch seems to have its special department for conversion loans. Prominvestbank is trying to influence the parliament to abolish these programs and a decision for 1995 will be included in the budget when finalized. Due to the fact that deputies will vote in favor of their constituencies, the programs will most probably be extended and the bank will continue to act as agent of the Government. ANNEX B page 7 of 19 Accounting Department 31. The Accounting Department follows to a large extent the old Soviet Chart of Accounts rules. Exceptions. which are regulated by the NBU, are currency transactions and transactions with budget funds. Prominvestbank has developed its own instructions for creating and servicing its funds. (Details are described under Financial Department). The bank maintains two parallel accounting systems, one for local currency and one for hard currency. 32. The branches prepare their balance sheets daily and report them to the regional branch also on a daily basis. Each regional branch consolidates the data received from the branches and submits a consolidated balance sheet to the Head Office also daily, where all incoming balance sheets are again consolidated for the entire bank. A reporting system for the NBU works in parallel with this. 33. About 5,000 employees are working in the accounting departments of the whole bank. Each local branch has a chief accountant and in the Head Office 14 employees are working in the Accounting Department. The Department is inspected by the internal audit department once a year and each regional branch has its own audit department which also looks after the local branches. Branch Organization 34. This part of the report is based on a visit to a branch in the suburbs of Kiev, which is reporting to the department in the Head Office in charge of branches of the Kiev Region. The town has 100,000 inhabitants. With 10 banks established there, the competition can be' considered high. All enterprises of the town have an account with Prominvestbank, mainly because of the advanced technology of the banks: Prominvestbank being the only bank fully computerized. Furthermore, the staff of the branch has developed a good banking experience and two cash desks have been opened in large enterprises quite recently. 35. The branch is servicing 487 enterprises and organizations including 47 state owned enterprises and 1,500 individuals. Total loans amount to Kbvs. 339 billion of which 70% are lent to state owned companies, 20% to private enterprises and 10% to individuals. Short term lending accounts for 90%, long term for 10%. The lending is done mainly to import oil, gas, oil derivates and machinery. The branch has no conversion loans on its books. Of the total loan amount of Kbvs. 339 billion it is claimed that no credits were overdue. In 1994 the income earned amounted to Kbvs. 80 billion and the profit shown in the balance sheet was Kbvs. 70. billion. So the branch is highly profitable. 36. The branch has the capacity to do credit analysis. A credit committee, which consists of credit specialists, lawyers and economists reviews each recommendation and submits it to the Manager. When the loan amount exceeds the lending limit, the documentation is forwarded to the department in charge of branches of the Kiev region. Information on payments is given to the NBU and Head Office on a daily basis. The branch is not allowed to deal in hard currency, and has no customers asking for hard currency loans. If applications are received they are submitted to the department in charge of branches at the Head Office. However, the branch is active in interbranch business, which is done independently. Inter-bank lending, however, has to be approved. Interest rates on interbranch lending are set at a very low level: currently 20 percent per annum. ANNEX B page 8 of 19 37. The financing of the loan portfolio amounting to Kbvs. 339 billion is effected as follows: 5% deposits from individuals. 45% payments balances of enterprises and corporations and 50% credits purchased from branches. The own-funds of the branch are negligible. In January 1995 the average interest rate on liabilities amounted to 100 percent and the average interest rate on assets amounted to 195 percent giving very large gross spreads. By way of comparison, the NBU refinancing rate in January 1995 was approximately 204%. Technology 38. Prominvestbank is well advanced in payments and other technologies and is fully computerized. The information between Head Office and the 25 regional branches is achieved by electronic mail, between regional branches and branches by radio channels and between branches and cash desks by telephone channels (see also Annex E). 39. All payments are effected by electronic mail. It is claimed that paper instructions for payments are no longer used although it is not clear how this squares with the present legal requirements. Payments between own-clients are done through the central settlements center of Prominvestbank. Payments to other banks go through the central settlement center and to the settlements center of NBU. 12 regional branches from 25 are able to apply this system and by April 1995 the remaining regional branches will follow. Prominvestbank has only one account with NBU in Kiev on which it is centralizing funds for payment purposes. This has caused a significant improvement in its liquidity management: both NBU penalties and manpower needs having been reduced. Funds can be channeled within hours. Remittances from a regional branch to another bank will take 1 day only. At oblast level there are regional settlement centers in the regional branches which do the clearing with their connecting branches. 40. A special electronic mail system has been developed with the settlement center of the Central Bank of Russia. International payments are done through SWIFT and 80 percent of all payments are settled by electronic mail: a high percentage compared to European standards. 100,000 enterprise payment orders are handled per day. The equipment is of high standard: Digital, Nokia, Tandem, Hewlett Packard, etc. In 1995 the bank intends to invest a further $3 million in technology explained that it will be difficult to find a grant or to obtain a long term loan for these investments. 130 technology specialists are working in the bank. 41. With regard to accounting, NBU is working to replace the Soviet Chart of Accounts (see also Annex C). The NBU intends to finalize the work in 1996. Only then can Prominvest introduce the new accounting system into their own technology. The implementation period for the Ukrainian banks is estimated to be about 3 months. B. OSCHADNY BANK Ownership and Present Situation 42. The Ukrainian State Savings Bank (Oschadny Bank) is 100 percent state owned. Its branch network is by far the largest in Ukraine with 26 regional head offices, 646 main branches and 12,777 branch offices. Its total staff of around 60,000 people represents about half of the total bank staff employed in Ukraine. However, its deposit base and therefore its assets have been severely eroded by inflation and now amount to only about a third of the total assets of Bank Ukraina (the agricultural bank), which has the next largest branch network. Overall it now has less than 8 percent of assets of the Ukrainian commercial banking system. ANNEX B page 9 of 19 43 Oschadny Bank management wishes to make the bank a universal mainstream operation. Formerly the bank was specialized, attracting deposits from the population and giving deposits to NBU (on conditions dictated by the Government). Although its legal remit is still to serve the household sector. it has chosen to widen its activities to include nearly all retail banking services for both enterprises and individuals and to run the bank on sound business principles. Beginning in 1990. it started lending and now controls both sides of its balance sheet. The Government appears to acquiesce in this expanded role, but still guarantees the safety of deposits of the population. However, the Government still looks to the bank as the conduit for public payments from the population and requires the bank to perform nation-wide tasks, including the maintenance of records for privatization and the distribution of certificates to 48 million people. Traditional Banking Activities 44. Nearly all citizens of Ukraine have at least one account with the local branch of Oschadny Bank. In many areas, the number of accounts exceeds the local population. These accounts are used to receive salaries and pensions and to enable individuals to draw cash and pay household bills. There are also term deposit or savings accounts, including special accounts for children. 45. The bank's deposit gathering role remains the cornerstone of its operations. Unfortunately the amounts mobilized in recent years have fallen far short of inflation. At the beginning of 1993 deposits amounted to Kbvs 2.5 trillion: two years later the figure had only increased fourfold, whilst inflation had been 4735 percent in 1993 and a further 842 percent (IMF estimate) in 1994. Given the government's need to restrict budget expenditure, it has so far not been possible to compensate depositors in cash for the erosion of their savings although there is strong political pressure to do so. However, compensation by means of privatization vouchers for shares and rights to housing have been agreed but not yet implemented (see Annex A). Ironically the methods of implementation (the distribution of over 200 million of certificates for both methods) will expose the bank itself to millions of dollars of costs which are unlikely to be reimbursed fully through the budget. 46. The erosion of the bank's deposit base has been exacerbated by the severe competition which its formerly monopoly position has faced from both the private commercial banks and former state banks. Its share of household deposits now stands at only 59 percent compared to around 95 percent of a much larger total four years ago. There has always been a strong tendency in Ukraine for the population to use cash for payments and also to maintain their savings in cash. Inflation has exacerbated this tendency by creating an enormous incentive to use dollars as an inflationary hedge. The commercial banks have been able to offset this effect in part by maintaining dollar accounts for wealthier citizens and small private businesses. Oschadny bank seems not to have provided such possibilities on a significant scale. In addition, with the general economic decline, average real wages are much reduced and more than 70 percent of persons now receive salaries of $10 per month or less: insufficient to provide any surplus for saving. The Strategic Response 47. All this has led to a severe contraction of the bank's asset base in real terms and therefore a diminution of its economic role as a financial intermediary. Nevertheless, the bank has responded positively to these changed circumstances reaffirming its business policy objectives to compete as a unified retail financial institution across the whole territory of Ukraine. It has invested heavily in payments technology and is now a full member of the NBU payments system. It has diversified its asset base by expanding its lending activities to both commercial enterprises and banks, controlled ANNEX B page 10 of 19 costs. made good profits and is in a strong position to diversify further using its huge customer base and extensive branch network. The bank's role in privatization and extending non-cash payments services to the population at large is currently being expanded and this will further enlarge the bank's range of business activities. 48. Beginning in 1990, the bank started lending (an arrangement extended to branches in 1992) and it now employs surplus resources in the money markets with a high degree of independence from the NBU although it still intermediates some funds through the NBU. The mechanisms of credit control have been largely delegated to the regional branch offices (each of which is responsible for credit allocation to branches). The regional limit to one borrower is presently Kbvs. 10 billion, but there are plans to increase this to Kbvs. 50 billion. Head Office specialists provide guidance and go to regions to supervise work. Interestingly, in the light of its extensive branch network, the bank is beginning to develop guidelines for giving credits to farmers. Overdue credits are currently 1.45 percent of loans outstanding for the Head Office Credit Department and 9 percent for the whole bank. This high figure for branches is indicative of the difficulty of maintaining credit standards across such a large network. Total credits outstanding as at the end of 1994 (these figures include lending to NBU and the inter-bank market) amounted to about 38% of the bank's total assets or 83% of assets when "other assets" are excluded. It has thus become a major activity albeit of a very much smaller bank. The types of credit issued for the first two months of 1995 and balances outstanding as at Ist March 1995 are as shown in Table 1: Table 1: Oschadny Bank - Credits Issued and Outstanding. Credit issued for Balances outstanding as first two months of 1995 at 1st March 1995 Kbvs. 8.8 trillion Inter-bank Kbvs. 7.7 trillion Kbvs. 1.3 trillion NBU Kbvs. 5.5 trillion Kbvs. 0.9 trillion Commercial Kbvs. 3.5 trillion Kbvs. 11.0 trillion Total Kbvs. 16.7 trillion 49. The Head Office requires regions/branches to be very strict on security and repayment. Security may comprise a guarantee letter from a bank or a mortgage. Inter-bank lending is only allowed at regional offices and is limited to twice capital. The bank specifies interest rates for all credits and relates the level set to both risks and demand. Interest rates as of March 1995 were in the range 204% - 250% (NBU discount rate 204%): there is no maximum rate set by NBU. Relationship with Government 50. The bank's relationship with the Government is still unclear. It has been treated differently for supervisory purposes, although it is closely observed by the NBU, and now faces the same reserve requirements as other banks. On the one hand, its senior management determine its policy. Neither the NBU nor the Finance Ministry are represented on the bank's Board of Governors, which comprises Head Office executive directors and 26 regional representatives. The Bank's Chairman states that no government pressure is exercised over the bank's activities with only general issues being discussed. Activities to be carried out for the Government on an agency basis and the payments therefrom are said to be mutually agreed. On the other hand, the bank is experiencing payment difficulties for work ANNEX B page I 1 of 19 alreadv undertaken on behalf of the Government and much of the general population still regard the bank as an adjunct of the state. The bank's general stance is that it wishes to be treated on equal terms with other banks and stands ready to bid for government contracts. The bank's true status needs to be clarified before it can really move ahead and address its numerous problems. Technology and Systems Upgrading 51. The main focus of the bank's investment has been on a system of mass payments. The bank started participating in the national payments system from the beginning of 1994 after being clients of other banks for a time. A system of local networks and communication channels has been developed dealing with the settlement system and the bank has access to the NBU system. The system of inter- bank settlements only takes 15-20 minutes, although not every branch is connected to the system directly and many need to use other routes. The bank has begun this work with 340 main branches. 199 of these work directly into the local NBU center and the remaining 141 branches into operational departments of the bank's regional office. This investment has already cost $6m and it is estimated that it will cost an additional $6m to bring the rest of branches into the system. The bank's management is confident this can be achieved within a realistic time frame. 52. The bank is also experimenting with consumer on-line methods, such as electronic cards (including point of sale methods), and is definitely interested in being at the forefront of a mass payments system involving households as well as enterprises. However, it faces numerous legal and other problems, as the country's laws and social behavior are not geared to the use of electronic money. Limited pilot projects to provide customer and market information services have been initiated but these are available at only a few branches. There are no plans to make them available bank-wide. 53. Senior executives of the bank have also welcomed close links with international counterparts and western businesses practices are being employed increasingly. In this respect, the bank can be regarded as a dynamic institution. Recently it has been receiving training advice and consultancy support from an Irish banking consortium funded by EU Tacis. It is about to embark on an extensive World Bank financed twinning arrangement with the German Savings Bank Foundation. Financial analysis 54. The bank has a small department which is just beginnirig to do some serious analysis of management ratios and bank performance. Much of its information is regarded as confidential and what follows is a limited selection deduced mainly from the 1994 accounts. (i) The bank's gross interest margin is wide at $65m in 1994 (interest income $160m, interest costs $95m). For much of 1994 it seems that the bank was able to charge an interest on credits which was almost twice what it had to pay on deposits. This accounts for most of the bank's profit of about $50m. (ii) About 95% of income comes from interest. Service income, commissions and fees amount to $9m ($7m net of commissions paid) and these account for a little over 5% of total income. Net fee income (after paying for service commissions) is about 4% of income. However, these figures reflect non-payment for some services delivered to the Government. (iii) Total non-interest expenses amount to about 20% of total costs. Service commissions seem to cover most staff costs but only a little over a third of total non-interest costs, but ANNEX B page 12 of 19 (iv) Staff, office expenses and other fixed costs appear quite modest $20m - $23m (depending on what is included), which presently is only about 12% - 15% of total income. The traditional cost/income ratio used in Western banks would be about 33% (average 50% - 60% in Western retail banks). (v) Very little is spent on marketing (S40.000 in 1994). recurrent computer costs ($310.000) or repairs (S350,000). Even the salary bill is low ( the average salary appears to be only about $100 per annum). This all leads to the conclusions that the bank presently is run on a shoestring! (vi) Deposits - About one half of the interest paid was to individuals and the other half is described as "loans and deposits of commercials banks" (i.e. inter-bank). However, it is strongly suspected that some of this is intra-bank, as it is understood that there was no netting between branches in the first three quarters of 1994. Interest on deposits to enterprises (including cooperatives) is low and the figure for such deposits on the balance sheet is also small, but still significant at Kbvs. 212 bn. ($220,000). This is all in national currency. Interest paid on hard currency deposits was very small Kbvs. 11 bn. ($11.000), confirming the bank's limited involvement in this business. (vii) Credits - Interest received in 1994 divides between inter-bank (possibly including intra bank) 55%, NBU 25% and legal persons 20%. There were few credits in hard currency. All credits were short-term. (vii) It is not possible to calculate average interest yields and margins from the data provided by the bank. However, NBU data for September 1994 indicate an average deposit interest rate in Oschadny of 176.2 percent and an average lending rate of 196.1 percent. This implies a very much reduced margin from mid-1994 when it was equal to almost 60 points. Alternative Strategies for the Government 55. The first possibility is for the bank to be approved explicitly for the course of commercialization and diversification which its senior management has determined. This would have the great advantage of intensifying the competition within mainstream banking especially at the regional level. However, it means that the bank should be required to build its capital to an adequate level on a par with all other banks within a short period of time- perhaps, two years-and agree to supervision and audit at the same level of intensity as other banks. This would probably require its explicit full or partial privatization as the means to raise the additional capital. Under this scenario, it should also lose its special advantages as regards deposit insurance (see also Chapter 7 of Volume 1). Above all. it should no longer be obligated to take on specialized social functions such as the payment of pensions and the distribution of privatization certificates as an adjunct of government on an exclusive basis, and certainly not if the remuneration for this work was inferior, as it is presently to the costs involved. This option would be attractive to the bank's management. However, the establishment of alternative delivery mechanisms for the services presently delivered through the bank, or the full payment for these would prove difficult for the Government in the transition. It is also risky in the sense that the bank presently achieves high margins but on a relatively small volume of lending (interest income about $160 million and interest costs of about $ 95 million), and with a very low ratio of staff and other expenses to income (only about 12 percent as against 50 percent or more in Western retail banking). It is unlikely that this favorable conjuncture could be preserved if the bank moved more aggressively into larger scale commercial lending during the difficult stabilization period. ANNEX B page 13 of 19 56. The alternative is for the bank to be confirmed as an explicit arm of the Government with certain well-defined but nonetheless restricted functions including several social functions. This recognizes the various gaps. in public service delivery which the nationwide branch system of Oschadny can partially fill, as well as the limitations of Oschadny in several banking functions such as credit management. The bank's role would include, as now, the mobilization and safe custody of deposits from household savers and their on-lending through the NBU, and increasingly the government securities market as that market develops. This option would also enable the Government to continue to rely on the bank as a source of agency services such as the distribution of privatization certificates, though not necessarily on an exclusive basis: some limited contracting out might also be attempted. Some part of the costs of delivering such services might be financed explicitly from the high profits associated with deposit mobilization on Oschadny's favorable protected basis and the associated on-lending. This second option would avoid compromise with any commercial aspirations. Any profits left after making any necessary investments, could be consolidated with the government budget balance, and any losses could be financed from the public purse. This option would also enable the Government to restrict the provision of deposit insurance to just the one bank at least until the conditions for extending it more widely were fulfilled (see also Chapter 7).It might also avoid the risks associated with the bank's premature expansion of credit activities. C. UKREXIMBANK History of the bank and scope of business 57. The State Export-Import Bank of Ukraine (Ukreximbank) was established on January 3, 1992, one month after the independence of Ukraine. There are no legal links with the former Vnesheconombank. Its main task is the development of Ukraine's foreign economic sector. The bank's own funds, as well as funds it has obtained are actively employed in foreign trade, industry, transportation and development of the export potential of the country. It has invested significantly in computer equipment and telecommunication networks, facilitating banking operations with about 180 leading banks worldwide. In 1992, the bank joined the SWIFT network. The major portion of the bank's business is done in hard currency. The bank has only limited business relations with former Soviet Union Republics. Main functions of the bank 58. The task of the bank is twofold: (i) it works as a normal commercial bank; and (ii) it acts as an agent of the Ukrainian Government. 59. At end-1994 total assets amounted to $1.8 billion, 80% of which represents hard currency. The capital of the bank amounted to $30 million. 60. As a commercial bank Ukreximbank has business relations with 12,000 companies, most of them private and engaged in export business. They are serviced by the bank's Head Office in Kiev and by 17 branches in regional and large industrial centers of Ukraine. Loans outstanding to this clientele amount to $100-million. The refinancing is done out of own resources. The business is considered profitable for the bank. Bad loans according to the bank's own reporting amount to about 24 billion Kbvs. (less than $1 million). However, the Arthur Anderson audit, even for 1993, shows $34.8 million. ANNEX B page 14 of 19 61 The import business is handled 90% by Letters of Credit. Cover at 100% for confirmation of LCs is no longer required. German and Swiss banks ask for 30% cover at present, some European banks confirm without cover. Negotiations with EBRD also center around LC confirmations without cover. In 1993 the volume of imports financed by LC amounted to $2 billion; in 1994 the same volume was slightly lower. Export financing is performed at 70% - 80% through LCs opened by European banks and 20% - 30% on a collection basis. 62. As an agent for the Government, the bank is involved in the conclusion and allocation of interbank and intergovernmental loans in hard currency. In 1992 credit lines were established with Ausfuhrkreditanstalt (AKA) and with Kreditanstalt fuer Wiederaufbau (KfW) from Germany for approximately 2 billion DMark to finance exports from East Germany. Further loans have been contracted with agencies in USA for grain and other imports ($900 million), France (Fr500 million), Italy and the EU. Ukreximbank is handling the agreements, and granting and servicing the loans. The banks themselves should not represent any risk for the bank because they are Government guaranteed. The loans contribute about 25 percent of the overall profit of the bank. 63. At the time the loan agreements were concluded in 1992, the future of the country's economy was regarded optimistically. Most of the projects were calculated on stable prices for imported energy and low price levels for local metals. Both of these assumptions proved erroneous and to the detriment of the companies which had borrowed. Hence, the bank is now reliant on the Government to meet some of the defaults which have arisen. The grace periods for the loans mentioned expire between 1995 and 1996. First installments for repayment will then be due. The Government of Ukraine has entered into negotiations for new loans. 64. Up to 1994, Ukreximbank was the only bank lending foreign exchange to other Ukrainian banks. Since then also EBRD is lending hard currency to banks for on-lending to Ukrainian enterprises. Conflicting supervision arrangements 65. The projects which are financed by the bank as agent of the Government, are selected by the Ministry of Economics and analyzed by Ukreximbank as to their feasibility and repayment capacity of sub-borrowers in hard currency. In addition a committee of hard currency has to be consulted. The bank reports to the Ministry of Finance. At the same time, the bank is governed by the supervision of the NBU. In the event that new credit lines obtained from abroad and passed on to customers at the order of the Government inflate the balance sheet of the bank, the NBU asks for the adjustment of certain required ratios. Consequently the bank is facing conflicting pressures: on one hand from the Ministries, and on the other hand from the NBU. There is no clear overall supervisory entity for the bank. The Chairman of the bank is appointed by the President, and the Management of the bank is appointed by the Government. Prospects and Strategy 66. The prospects in its commercial banking activities for Ukreximbank are bright. In foreign trade transactions competition is considered moderate. Ukreximbank, together with Prominvestbank and Bank of Ukraina handle 95% of the Ukrainian foreign business: 2/3 of it this being transacted by Ukreximbank. However, this favorable situation might change if more foreign banks are given permission to open branches or subsidiaries in Ukraine. There are practically no foreign banks ANNEX B page 15 of IQ working with branches or subsidiaries in Ukraine at present. Credit Lyonnais is the only foreign bank havine a wholly-owned branch and American and Dutch interests are involved in the ownership stake in First Ukrainian Bank Up to now, a strong presence of foreign banks has not been thought to be desirable. In future, the situation is likely to be different and Eximbank would be affected more than most banks by the accelerated entry of foreign banks. Russian banks with a strong involvement in companies trading with Russia are waiting to be licensed in Ukraine and are helped in their endeavors by the Russian Government. which is using Ukraine's growing energy debt as a bargaining platform for more liberal entry. There is already considerable cross-border activity by Russian banks in the Eastern part of the Ukraine. This dependence of Ukrainian companies on Russian assistance seems to favor Prominvestbank, which still maintains close relations with the Russian financial sector; has developed an efficient computer network--also with Russia--and whose employees are well trained to handle foreign business. 67. The growth of the bank based on its role as agent of the Government in the conclusion and allocation of interbank and intergovernmental loans, seems to be less bright. Although this business has been very important in the past, it is now likely to grow more slowly and , in any case, is relatively less profitable. 68. The management of the bank has a good understanding of the structural problems of the bank. However, the interaction of the management with the Government creates, many problems. Since Independence, the country has had 6 Prime Ministers and each of them has had their own ideas about how best to restructure the bank. In 1993, there was intensive discussion about whether to separate the bank into two parts but in view of the difficult economic situation a decision was postponed. For the Government, the bank assumes the function of a "fire-fighter", which does not allow it to take longer-term decisions. For the Government too, the bank is a lender of last resort which can help solve national problems which no other bank can deal with. Under these circumstances, a privatization of the bank is premature. The management feels it desirable if other Ukrainian banks participate in the capital of the bank. The participation of the Government, however, has to remain for the moment. For the clients too,, it often is advantageous to have a combination of a commercial bank and a government agent bank in one place. Such an arrangement is also necessary while the Government owes substantial amounts to the bank in respect of the agency business. D. UKROSOTSBANK History 69. Ukrosotsbank was founded in 1990. The bank is one of the spin-offs from the former Jilsotsbank network, which concentrated its business in servicing local administrations. Jilsotsbank transformed its branches into independent banks and then ceased to exist. Ownership 70. The bank is an open joint-stock company. The statutory capital, which amounts to 400 billion Kbvs. is quite small, -together with important reserve funds and insurance funds, however, the total capital is significant. The bank's own reporting indicates that it has three times the Cooke- recommended ratio of capital adequacy at the end of 1994. Capital increases have been achieved out of profits. In 1994 the dividend was fixed at 350% and later on increased to 400%. This was paid quarterly. ANNEX B page 16 of 19 71. The bank has 27,000 shareholders including 2.455 legal entities. The legal entities consist mainly of private commercial companies. Only 6% are state owned companies. which hold 5 to 6 billion Kbvs. of the statutory capital. This compares with 1991 when 90% of the statutory capital was still held by state-owned companies. Of the approximately 24.500 individual shareholders, 10.500 are employees of the bank. The rest are employees of companies. which are clients of the bank. Business Strategy 72. Like the former Jilsotsbank in Russia, Ukrosotsbank is still conducting banking operations for local administrations and services. Funds from the state budget earmarked for state-owned organizations are routed through Ukrosotsbank and so, like Prominvest, it has access to large and low- cost payments balances. The bank handles cash settlements and credit services for these organizations. 30,000 budget organizations are serviced by the bank. It has branches in 126 cities and consequently, it is the bank for most of the cities' administration offices, such as tax offices, etc. In general terms, the bank has taken over a social role of disbursing budget money into the system. The balances on the accounts of these local organizations are paid interest and the funds are used to refinance short-term loans. Due to the fact that these budget funds are not placed for longer periods, they cannot be employed for long-term financing. 73. The bank is involved in financing the construction of schools, hospitals and houses. Construction of schools is financed with funds from the state budget. Commercial banks are normally not financing the construction of schools. However, there are exceptions when, for instance, the construction is for an agricultural school of an agro-industry complex, which is a client of the bank. For the construction of hospitals and houses, bank credits are provided at normal interest rates. If preferential rates are applied, the necessary compensation is paid by the budget. The credits are normally used to buy the necessary building material. Diversification of Lending Business 74. Over time Ukrosotsbank has diversified its clientele. It has retained its state-owned organization clients and some agro-industry connections at the regional branch level and acquired, in addition, clients from other sectors of the economy, such as light industry and energy plants. Especially in the sector of light industry the bank seems to be very important. 75% of Ukrainian light industry enterprises are now banking with Ukrosotsbank, many of them exclusively. Here again relations have been established with the Ministry of Finance in connection with directed credits for conversion of the light industry. In fact, the Ministry of Finance directs funds to the Ministries, which are in charge of the particular projects. Accounts are opened with the commercial banks working on a daily basis with the projects and the funds are then channeled through NBU. Ukrosotsbank reported end of 1994 directed credits outstanding to the agricultural sector amounting to 2 trillion Kbv and conversion credits to light industry amounting to Kbvs. 1.5 trillion. Profitability 75. The directed loan business is not much liked by the bank because of its lower profitability and slow repayment of the loans compared to normal commercial business. Directed loans had to be extended often and in some cases the Government has effected the repayment. As a whole, the bank does not feel responsible for directed credits. Concerning the normal commercial lending, the bank claims that during its 4- 1/2 years of existence has not yet been obliged to write-off loans. It reckons that its reserve funds and insurance funds would serve for this purpose in case of need. It could well happen that they will be needed this year, because of doubtful loans in the balance sheet. The possible losses, would compare well the profit for 1994, which amounts to Kbvs. 10.5 trillion. ANNEX B page 17 of 19 76. The situation in the agricultural sector is difficult at present. The Ukrainian banks are doing their utmost to help this sector in the ongoing spring campaign. However, due to the critical situation in the sector, Ukrosotsbank does not object to providing credits to the agricultural sector out of bank resources at preferential interest rates International Audit 77. So far the bank was audited by Fonk Audit, a local company. For the first time, the bank will have an international audit for the 1994 figures, executed by Arthur Andersen. A contract for Arthur Andersen is under preparation. E. BANK UKRAINA 78. These notes are based mainly on meetings with Credit Agricole, which is giving technical assistance under an EU-Tacis project aimed at the restructuring of the bank. History 79. Bank Ukraina was founded in 1990. The bank is one of the spin-offs from the former Agroprombank network. The principal founders were the Ministry of Finance, the National Bank of Ukraine, the Soviet Rosselkhozbank and the Ministry of Agriculture. Since 1995 the bank has been registered as an open joint-stock company. It is the second largest bank in Ukraine and on a par in most respects with Prominvest. Ownership 80. The authorized capital of the bank has been increased 5 times and now amounts to 875 billion Kbvs. as per January 1, 1995. Capital increases were effected by share issues to new shareholders, investment of dividends and profits. Reserve capital amounts to Kbvs. 887 billion and other funds to Kbvs. 5,684 trillion. Total capital shows a figure of Kbvs. 7,510 trillion according to the Soviet accounting system. 81. The bank has about 250,000 shareholders including 13,800 legal entities, many of which are also holding current accounts in the bank and getting loans at the same time. The shareholders consist of 31 % collective farms, 28% private enterprises and 41% individuals, mainly employees of Bank Ukraina. The founders now account for only 0.07% of the total shareholding. The bank has 25,500 employees, including 5,000 non-banking staff. Female employees account for 80% of employees in the whole bank and 20% in the Head Office. Organization 82. The Head Office of the bank is in Kiev and 8 branches depend directly on the Head Office, 5 of them are situated in Kiev city. There are 26 regional branches, 530 branches and 273 sub-branches so the total number of banking entities amounts to 829. In addition there are 600 cash offices. Lending Business 83. Total loans outstanding were 32.6 trillion Kbvs. as of January 1, 1995. It is thought that 30% were overdue. Due to the unfavorable economic situation in early 1995, the overdue portion by now could have increased to 40%. ANNEX B page 18 of 19 84. Of the overdue amount of approximately Kbvs. 10 trillion. Kbys. 7 trillion originate from the 1993 agricultural season when directed credits were large and 3 trillion Kbvs. derived from the 1994 season. The bank is trying to reduce the 1993 portion slowly. Due to the fact that this portion represents directed credits from the Government channeled through the NBU, the bank has sought and obtained greater access to standard legal procedures of liquidation of assets and bankruptcy and it hopes to collect successfully many of the outstanding credits. It has to be mentioned that the evaluation of credits to agriculture is difficult, because short term credits are usually lent on the basis of 2 months. They are often not paid back in time within this period due to the agro-cycle, and therefore cannot be considered as evergreen. The loans should have been given a lifetime of 6 - 8 months at the beginning. Once the agro-cycle comes to an end, many of the outstanding 1994 credits may be repaid. 85. 95% of the loan portfolio is short-term and 5% is long-term. 75% of the total loans are to the agro-complex and 25% to other sectors of the economy. The bank is diversifying its loan portfolio as few years ago the agro-complex still accounted for 90%. From the total loan portfolio 60% can be considered as commercial business, 40% is government influenced. The latter portion saw a change to less bdirected credit lines (13% of the total down from 60% a year ago) and instead bank lending from its own resources but with a subsidy component rose (27% of the total in 1994 up from O%in 1993). Interbranch business 86. Arthur Andersen, the international auditor of the bank, has looked carefully at the bank's recording of its interbranch business in the balance sheet. This is shown under "Other Assets" and "Other Liabilities" and accounted for nearly 60% of the balance sheet a year ago. (see Also Annex C). It is expected that the consolidation of these items will lead to a significant reduction in the size of the bank's overall balance-sheet. The IAS audit showing this and other adjustments will be finalized in June 1995. Investment 87. The bank has 83 investments in enterprises, such as agro-industry, insurance, capital trusts and the stock exchange. The investments in agro-industrial activities normally involve a 100% stake for the bank. Profitability 88. In 1994 the income figure before tax amounted to 17.5 trillion Kbvs.; and 7.9 trillion Kbvs. after taxes. The dividend was fixed at 400% and paid quarterly. The average interest rate charged for loans in 1994 was 104%. The reason for this low figure was the subsidized business. In comparison, other Ukrainian banks charged up to 200% on the average. The average cost of the funds was not known although the average cost of Bank Ukraina deposits by the end of the year was over 120 percent: i.e., higher than the average lending rate. If it were not for subsidized lending, the interest margin should be wide due to cheap payments balances from ministries and government agencies. The bank has 1,300,000 individuals as depositors, who have Kbvs. 1,725 billion on their deposit accounts. Total deposits (current plus time ) of individuals in Ukraine are about 8,097 billion Kbvs. Technology 89. The bank has Reuters and SWIFT connections and has established 300 correspondent relations with foreign banks, including 100 Russian banks. Like Prominvest it has made big strides in computerization and has rapidly developed relatively sophisticated payments technologies complementary to the NBU network. ANNEX B pagc 19 of 19 Future Strategy 90. The bank is anxious to get out from under the influence of directed credit programs. To this end it has already ihtroduced changes in its organizational structure to give more autonomy to local branches and also to protect these from political intervention. It is not clear how far these changes have gone or whether they are successful. The banks has also been briefed about the governance of Credit Agricole in France and apparently has shown an interest in this. The arrangement is characterized by a mutual shareholding between Head Office and branches. The Head Office has the function of a holding company for the whole group, with the branches being its shareholders. This structure will be further discussed in Bank Ukraina. The banking law in its amendments of 1992 and 1993, and a letter from the NBU, are the authority for dealing with foreign banks ANNEX C page I of 5 REFORMING ACCOUNTING STANDARDS AND PRACTICES 1 In former Centrall\ Planned Economies (CPEs), the main function of accounting was to keep records of financial transactions and to exercisc control over the economic activities of banks and enterprises. There was little room for accounting to be used as an analytical or decision-making Instrument. As economic reform progresses in Ukraine, it will introduce numerous economic events and financial transactions that were unknown to accountants in the past and reforms will place important demands on the development of accounting and auditing systems. Accounting and auditing are also essential ingredients for the development of a market economy and the integration of Ukraine into the international economy. The adoption of new accounting and auditing principles consistent with international standards for the commercial banking sector and the corporate sector will require significant effort in a number of areas including: (i) the adoption of a legal framework setting out new accounting principles and policies compatible with International Accounting Standards (AS); (ii) the development of a strategy for accounting reform -- including the required transitional arrangements; (iii) significant institutional strengthening of the agencies in charge of developing and implementing the reforms; (iv) the establishment of professional bodies and certification requirements; and (v) large-scale training of trainers, practitioners and future professionals in both fields 2. This Annex does not pretend to provide a detailed review of the whole of this long and complex agenda, but rather it will examine existing deficiencies in bank accounting practices in Ukraine and make some specific recommendations to deal with them. Nonetheless, it is emphasized that the full agenda will need to be addressed sooner rather than later since accounting is a basic information system which constitutes an essential early step in moving towards both a better financial system and a market-oriented economy more generally A. BANK ACCOUNTING REFORM 3. At present, commercial banks largely continue to use an adjusted version of Gosbank's 1987 "Regulations on Accounting and Statements of the Banks" as well as the old Chart of Accounts. The latter was established by Gosbank, the Central Bank of the former USSR, to serve the informational requirements of a CPE 's - book keeping, statistical recording, as well as to control the sectoral allocation according to the credit plan. The onentation of Gosbank's reporting requirements were aimed at. (i) controlling the direction and use of financial funds according to the instructions of the national development plan; and (ii) tracking credits on an institutional (i.e., credits were granted per Ministry) and sectoral basis. 4. These two objectives are clearly inadequate for a more decentralized and market-oriented economy. Equally important, the lack of an adequate loan classification system and the vanous accounting conventions of the Gosbank system lead to financial statements which are grossly misleading and inadequate both for NBU to exercise its supervisory and regulatory functions, and for providing meaningful financial information to bank managers, auditors and other users. This is why international organizations providing credit lines to Ukrainian commercial banks have required international audits according to IAS standards as a first step. ANNEX C page 2 of 5 Reporting Requirements 5 The financial statements of commercial banks in most accepted systems of accounts consist of six components namclh the Balance Sheet. the Profit and Loss Statement. Off-Balance Sheet Items. and Notes to the Financial Statements (describing the accounting principles applied and the main changes in the Balance Sheet and Profit and Loss Account during the last financial exercise). the state of movements in the bank's Cash Position. and the published (audited) Annual Report. 6 The main deficiencies of Ukraine's financial reporting system seen in this perspective are both formal and substantive. From a formal point of view, banks submit their Balance Sheets although they are generally un-audited and without Notes. However, the Profit and Loss Statement has traditionally been kept confidential (i.e., it is often not published) and the level of aggregation, among other problems, makes it quite useless for analyzing bank performance. In addition, there is little information on Off-Balance Sheet Items or the Cash Position of the bank. Although an Annual Report is usually published, it is not very informative and it is made public only after a long delay. It is sometimes kept confidential, as in the case of the NBU itself The delays and lack of publication is a serious handicap in Ukraine's hyperinflationary environment in which the financial condition of a bank can change overnight. Content and Interpretation of Bank Statements: 7. From a more substantive point of view, there are significant discrepancies in the content of some major accounts, making very difficult the interpretation of the financial statements of Ukrainian commercial banks Two major drawbacks are: (i) the content and relative size of "Other Assets" and "Other Liabilities", and (iD) the size, meaning and legal ownership of the stockholder's equity account (particularly in the joint stock banks) The following remarks are made on these two issues. (i) Other Assets and Other Liabilities. It is not uncommon to find that "Other Assets" represent more than three-quarters of the Total Assets of Ukrainian commercial banks (ex., 88% and 70% in early 1992 and 1993, respectively, for Bank Ukraina). A similar concentration is observed in the banks' "Other Liabilities" as a percentage of Total Liabilities (ex., 87.7% and 78% in early 1992 and 1993, respectively, also for Bank Ukraina). According to accountants reports inter branch settlements represent most (about 95%) of the "Other Assets" and "Other Liabilities" because banks fail to consolidate before presenting the balance sheet. The recommendation is to revise the reconciliation procedures netting-out inter-branch balances in order to have a more meaningful presentation of the financial conditions of banks. While such accounts after reconciliation should be nil, the reconciliation itself implies changes in the national payment system. These include changes in intra bank procedures and further automation of bank operations. (ii) Stockholder's Equity. The presentation of the balance sheets of Ukrainian banks do not allow the accurate identification of the stockholder's equity in the bank. The main shortcoming in this area is the proliferation of funds (i.e., fund for the depreciation of fixed assets, consumer fund and the accumulation fund) and, more substantively, the misclassification of these funds as part of the banks' equity proper (Capital and Reserve Accounts), when in reality some of them are either deductions to the banks' gross fixed assets (depreciation) or represent accrued liabilities of the banks (personnel-related expenses for bonuses and pensions). While these practices follow Ukraian norms, they are far from international standards. Income Statements 8. As indicated above, these Statements are often not published and are still regarded as confidential information, even for open joint-stock banks listed on the Stock Exchange Nonetheless, while banks do not release any meaningful profit and loss statement, banks usually release information on their annual profits The problem, as could be expected from the discussion above on the Stockholder's Equity Account, is that the announced profits are largely overstated. The obvious reason is that major expenses are shown below the line ANNEX C page 3 of 5 resulting in a gross over-statement of bank revenues or understatement of operational expenditures It is not clear to what extent this problem is aggravated further by the booking of interest on non-performing loans Off Balance Sheet Items 9. While Ukrainian ba. record some off balance sheet accounts. these are generally not published Moreover, the banks' main o:jcctive in recording them is not the standard Western one of trying to capture contingent risks assumed by banks as a result of operations which do not fall under the balance sheet but which have similar effects (see Box). Rather their reporting is related to the banks' settlement processes and to the CPE information requirements formerly requested by Gosbank. Both banks and regulatory authorities in Ukraine will need to address this issue becoming increasingly aware that these "below the line" items do carry credit risk and deserve as much attention as that devoted to loans Accounting Policy Notes 10. Consistency is one of the basic accounting conventions, meaning that the same accounting prnciples should be applied by banks from year to year. If any change is introduced in the bank's accounting policies during the accounting period, international practice requires full disclosure of the change in the financial statements of the bank, including comments on the possible effect on the net income of the period. Thus the Notes, which are considered an integral part of the financial statements of Western banks, are important to comply with the objective of "full disclosure", making possible a "true and fair" interpretation of the financial condition of the bank. The Notes include three broad groups of explanations: a summary of significant accounting policies; explanatory notes; and supplementary information notes In Ukraine banks are a long way from being able to produce the required Notes. Above all, the NBU's strategy for reforming bank accounting must contemplate an early disclosure of the accounting policies which must be mandatory for all banks B. STRATEGY 11. The NBU's objective should be modernize the accounting and reporting systems in the financial sector in order to harmonize these with international practices. The first step is to carry out the upstream work necessary to initiate the process of accounting reform in Ukraine's banking sector, as well as to train a selected group of senior central bank staff (accountants and bank supervisors) and the most senior accountants in the commercial banking sector. This step is essential for future reforms in the sector as well as for the activities which are being supported by donors. The recently approved EBRD line of credit will complement this process for six to eight banks by requiring as a condition for the loan that these convert to Broadly Accepted Financial Statements (BAFS) - an intermediate step en route to IAS - by end- 1995. 12. Various donor organizations have indicated that they are prepared to make a significant commitment of people and money to this aspect of reform in 1995 and beyond. The program as presently mapped out under the guidance of the IMF includes three main components as follows: 13. Direct assistance to the NBU to reform the commercial bank reporting to the NBU and also to reform the NBU's own accounting to IAS standards. The first of these requires a complete overhaul of the reporting requirements placed on commercial banks. This will eliminate much of the sectoral and other detail which is merely a hang-over from the days of central planning. But it will also establish new forms for submitting an income statement, a balance-sheet and a schedule of non-performing loans. This task is likely to take between one and a half and two years. ANNEX C page 4 of 5 BOX A.1 OFF-BALANCE SHEET ITEMS DEFINITION: Off-Balance-Sheet Items are defined as "commitments made by the bank 14. A pilot training on behalf of clients that could force the bank to disburse funds (possibly creating a loan if its chent does not have cash) represent a credit risk to the institution, and are thus added o risk weighted assets for calculating capital adequacy. 20 Ukrainian accountants qualified in ]AS. It should be COMMON CATEGORIES (Basle Comminee Recommendations): completed by early in 1996. Contingent Liabilities 15. A program of Off-Bala nce-Sheelredit substituis support to the existing Madi n-isk tot1ingeit liabilties private sector initiatives to Mdium/Low contingent liabilities upgrade bank accointing. Lowv-tirk omingent liabilities vThis will include work with rintciehtiate risk a selection of banks and their Maiiing one year or less auditing firms to establish an Maturing over one year:: Forwaid iieignexchange risk initial independent auditing Maturing over one year or less standards-setting and aturi over ne year monitoring body. This body in turn would then be pan of Repurchase Obligatios the process of helping the Other.' NBU and its advisors to develop and implement new Imp ications. eginning on Janua- 1--99.. ban4s in.signatory countries of the Basle accounting standards, new Agreement are subjected to the risk-based capital standais set fortb in the Agreement, . *-reporting requirements and a meaning that all off-balance sheet items must be included in the calculationof -the capital- .d a.... ...e. new uniform chart of accounts. This task will also Sourd Chis 1. Baltrop and Diana McNao td Banking Institutions in Developing take between one and two Markets (Volo 2) ntegratipg nanciarStatements World Bank. 'ashgron DC years to complete. This w 3work is of great importance --__---: and some urgency. Ukraine, by signing the Geneva convention has undertaken to comply with IAS standards by end-1996. The programs of work already identified should make this possible. 16. Reforming Accounting for the Corporate Sector. One of the main comparative advantages of the banking system in market economies is the efficient processing of information. In order to be able to fulfill that role banks need reliable, meaningful and consistent financial information and reporting from their clients. To improve the allocation of resources it is not only important to correct price distortions and give banks the correct incentives (in terms of autonomy and accountability), but the informational basis for their decisions also needs to be substantially upgraded. Reforming general accounting standards and principles in the corporate sector plays a crucial complementary role to the proposed reforms in the banking system, in particular once privatization of enterprises gets underway on a massive scale. This task needs to be initiated as soon as possible. However, there is a logical sequence in that reformed banks will themselves become a powerful lobby for improved enterprise accounting practice. C. PROFESSIONAL ORGANIZATIONS 17. Sound and active professional organizations need to be operational to serve the ongoing development of accounting practices and qualification needs of accountants, evaluate the concepts and standards to be proposed, recommend forms of training and updating for practicing accountants, set various levels of training (lower, middle and upper), set up sub-groups in such areas as: financial accounting; management (cost) accounting- accounting information systems- government accounting, financial analysis; auditing, codes of conduct and other practice-oriented needs. A clear charter of such a ANNEX C page 5 of 5 professional body should be outlined, setting forth its specific functions. Whether this association should cover both accountants and auditors needs to be evaluated. It might be desirable to have one overall organization (parent body) to cover all Ukrainian accounting and auditing activities, while a separate chamber or sub-association may deal with the statutory auditors, auditing examinations and tests; updating of auditors. etc. Such a framework requires in depth analyses by Ukrainian authorities and persons in order to come up with a viable vehicle (or entities) to be hnked with international organizations. 18. Substantial efforts will be needed by the existing and newly-trained accountants [auditors, the professional body (or bodies), and the educational institutions] to drastically transform the prevailing methods and practices. The transformation of the economy--all sectors--is highly dependent on the efficacy and efficiency by which accounting and auditing systems operate. D. CONCLUSIONS 19. It has become apparent that accounting and auditing in Ukraine should be subject to a major overhaul and restructuring in all sectors of the economy. Although efforts have already been out to make improvements to the former Soviet system, much greater efforts are warranted of a systems, institutional development and training nature. Accounting, as an information system, forms the basis for many economic decisions in a market economy. With the present information and reporting system (Gosbank Forms 254 and 700) it is very difficult to make sense of the financial conditions of the banks, making even more difficult the supervisory function of the NBU. Accounting and auditing were never regarded as real professions in the FSU, and accordingly the demand upon sound accountancy skills did not exist. Accounting used to be a profession to be avoided due to its low status and pay. Personnel were not regarded as having profound accounting and auditing knowledge, just technical skills in reporting. All this must change. As part of the adjustment to a market-oriented economy large demands exist already - and will increase even more - for expert knowledge in accounting and auditing and the related branches of knowledge. No economy can function effectively without sound accounting and auditing systems and methods, and Ukraine will be no exception. ANNEX D page 1 of 6 ISSUES IN BANK SUPERVISION AND AUDITING 1 Considerable progress has been made by the NBU in designing a sound system of prudential regulation and supervision of banks A detailed work program for the future development of this system is also established Hence. this Annex summarizes the existing prudential norms established by the NBU and compares these with both the main elements of the Basle agreement standards, and the qualifying conditions for Russian banks used in a recent Bank program for that country Table I summanzes the work program for further improvement of NBU bank supervision practices A. PRUDENTIAL RATIOS 2, The NBU has established three main types of ratios for prudential purposes, namely. a solvency ratio, various liquidity ratios, and several maximum exposure ratios. These are additional to the required reserve ratios of the commercial banks which are in place more for monetary control purposes 3. Solvency: The present requirement is for a ratio of capital to assets of 8 percent For this purpose gapital comprises the authorized capital as registered by the NBU as well as retention from post- tax profits and supplementary capital which includes revaluation reserves and reserves to cover credii risks. The latter item has been a source of significant capital increase in recent year when nominal property price have risen sharply. It is noted that NBU rules require capital to be reduced by the amount of all investments by banks into other enterprises and institutions. It is doubtful if this rule is followed in practice. Assets for the purpose of the solvency ratio are risk weighted with weights varymg from zero (cash and NBU balances) to 10 percent, 20 percent, 50 percent and 100 percent (unsecured loans, debtors, overdue secured loans etc.). A puzzle is that government securities also carry a 100 percent weight. The comparison of these arrangements with the internationally - recommended norms is shown in the Box The major differences at the present time are in the interpretation of the terms used in the regulations. For example, the Basle rules require the inclusion in risk - adjusted assets of relevant off - balance sheet items It is not clear that NBU arrangements do this. Similarly, the retained profits and reserves used in the Basic definition of capital exclude provisions for explicit credit risks. It is not clear that NBU arrangements do this. Finally, there is ambiguity about the treatment of uncovered foreign exchange positions and the exchange rate at which banks are required to convert this for inclusion in the required capital assets ratio 4. Liquidity: The NBU uses three liquidity ratios namely measures of current, short-term and general liquidity. The current liquidity measure which must not exceed unity is the ratio of liabilities payable on demand or with up to a month matunty, with assets of corresponding maturities. The short-term measure which also must not exceed unity is defined as the ratio of assets and liabilities with up to three months maturity. Finally, the general liquidity indicator which must not exceed 0.95 is the ratio of all bank assets to liabilities. In general, the first two of these ratios provide the supervisors with good indications of the liquidity status of a bank and are consistent with practice in many other central banks. The third ratio is somewhat less useful - it is really a measure of the leverage achieved on the resources available to the banks rather than a measure of liquidity as such. ANNEX D page 2 of 6 Internationally Recognized Ratios. 5. Large Loan Exposures: The NBU defines large The Cooke Ratio is the most internationally wel-known ratio which exposure as any debt to a single measures the adequacy of own funds (F) compared with the borrower (including 50 percent weighted risks (R) of the Bank. In the Cooke ratio: F/R of any off - balance sheet must be above 0.08. exposure) which exceeds 10 percent of the bank's own funds Te own funds used for this regulatory purpose -s (Tl + T2 - P), (authorized capital plus retained where after-tax profits) The first guideline is that the sum of all Ti: the tier I of own funds which consists of: these large exposures should not 1Cap +Reserves + Retained earnings + General Banking Provisions exceed 8 times the bank's own which diot cover any spedific risk]- [Non-paid Capital + funds. Breaches of thus Own shares held by the Company ± Intangible fixed assets) guideline result in first a doubling of the solvency ratio to T2: the tiet 2 which must not exceed the amount of tier 1, represents 16 percent and then a tnphng to other funds: JRevaluation reserve + Subordinated debts 24 percent. Additionall, the under certain conditions (limitation .f certain upper limit on credit to anv subordinated debts to50/c of Tier 1)] single borrower is set at 40 percent of own capital P: anount of investment i fmancial institutions in Which the stake However, a decision already of the Bank is above 10% and the amont of investment made will bring this to a more in fim.ncial institutions that exceed 10% of the ow conservative level of 25 percent. fimdis It is not clear whether this ratio applies equally to connected and Weigbti afactors he commitents of the Bank fro the un-connected parties. However, alan ect and the offbalance sheet statements are the protection of unonty into account with a discount factor deperding on the quality shareholders as well as of th Cd weighted at 0% (th risik is sdered depositors would argue for a asll) include: cash, credits granted.to the Central B k and substantially lower limt of central adinistration or guaranteed by theri-or securities probably 10 percent of own issued by them. Credits weighted at 20% are credits to capital for any single connected western banks ad Ial authorities orgaranteed by them, borrower and an aggregate credits to other banks r guaranteed by themwhose nai exposure limit of 20 percent of is under one year. Credits weighted.at 50% are mortgage capital for all such borrowers loans. Other credits and assets are weighted at 100%. 6 Investment Limits: The off balance sheet iterns are alo take into consideration: 100% Additional to these standard for uarantees giveni, irrevocable credit lines not used; 50% or 20% for prudential rules, banks are also documentary credits, letters of credit according to their characteristics; limited in the extent to which 0% for revocable'credit lines of less than oneyear. It is also-necessary they can invest directly in other to include irisks on off balance sheet financial nstrument :(swaps, enterprises on their own etc.), which are very limited instruments in Ukraine at the moment, account. Specifically, they are allowed to hold up to 15 percent of the shares of any one company and cannot commit more than 10 percent of their own capital in total for such purposes. 7. Finally, in a new regulation promulgated in January 1995, banks have been required by the NBU to establish a fund ("insurance fund") to compensate for possible credit losses For this purpose the amounts to be reserved are zero for standard credit, 5 percent of outstanding loans for satisfactory credits, ANNEX D page 3 of 6 30 percent for marinal credits. 80 percent for doubtful, and 100 percent for irretrievable credits Onl irrctrievablc credits will be written-off against the insurance fund Irretrievable amounts exceeding the balance of the insurance fund can be written-off directly against profits for the year It is not entirely clear how this new% insurance fund is factored into the calculations of the capital adequacy ratio described earlier B. FUTURE WORK Table 1: SUMMARY OF IMF-MANAGED WORK PROGRAM IN BANK SUPERVISION Issue Goal Technical Support/Status Organization, Staff and Training To develop an attractive career path to USAID resident expert in in the NBU ensure competitive salaries and place from Spring 1995 reasonable job prospects, including traimung, for banking supervisors at NBU and regional branches. Expand staffing as necessary Follow up on provisions of Regulation on Bank Supervision of July 12th 1994, Section 3.3 Reporting Framework. A complete overhaul of reporting (a) British Know-How fund Accounting Reform for Commercial requirements in accordance with resident expert. Banks. internationally accepted standards. (b) Netherlands Bank These include submission of incomes accounting team (not resident) statements, balance-sheets and off- (c) Netherlands Banks balance-sheet items. They also supervision experts (not include rules for loan resident) classification and provisioning (i.e. an (d) Liaison with accounting insurance fund for bad loans) firms that are advising Ukrainuan banks. Prudential Rules (a) make existing rules known to all banks (via pamphlet) (b) Develop new guidelines on * Rules for FX limits * Lending limits Regulation issued March '95 * Analysis of asset quality (i) solvency of clients (ii) classification of credits Regulation issued January '95 (iii)Provisions Regulation issued January '95 (iv) decision-making/management On-Site Inspection Conduct on-site visits based on analysis (c) Netherlands Banks of available financial statements, resident) and prudential rules ANNEX D page 4 of 6 Issue Goal Technical Support/Status Off-sitc Inspection Maintain an overview of developments (a) US AID resident expert in in the banking sector and develop place from Spring 1995 methodologies for analyzing the (b) Netherlands Banks soundness of the sector Ultimatel supervision experts (not publish aggregate prudential data resident) Licensing/Closing Banks Up-date the licensing manual guide US AID resident expert in lines on when and how to close a bank place from Spring 1995 (See also Chapter 4 of Report) State-Banks (a) Design governance reform for No action See also Chapter 3 of the state banks this Report (b) Draft a plan to approach restructuring of bad debt Filing System Develop a join filing system for all departments involved in bank supervision Enforcement of Prudential Create sound legal basis for enforcing Support from US-AID legal Regulations prudential reporting requirements, expert during 1995 prudential regulations and access to information to on-site visits; develop a scale of sanctions for non-compliance with more severe sanctions for severe non-compliance C. QUALIFYING CONDITIONS FOR BANKS UNDER IBRD's RUSSIA PROGRAM Capital Adequacy 1 The schedule for meeting the minimum capital adequacy ratio would be as follows: Year End Minimum Equity Capital to Risk Weighted Assets and Off-Balance Sheet Items 1994 4 percent 1995 5 percent 1996 6 percent 1997 7 percent 1998 8 percent ANNEX D page 5 of 6 2, Risk weights per class of asset would be the following Class ofAssc Risk Weights Cash, Claims on the Government of the Russian Federation, and Deposits at Central Bank of Russia 0 percent Claims on Banks in OECD Countries 10 percent * Claims on Banks in Russia and non-OECD Countries 50 percent All Other Assets and Off Balance Sheet Items 100 percent 3. The above risk weights are designed to capture the major types of assets that should be risk weighted, but avoid getting involved in a complex formulation. Exposure to a Single Party 4. Exposure to a single party would be decreased as follows Year End Maximum Exposure to a Single Party as a Percent ofa Bank 's Equity Capital 1994 50 percent 1995 35 percent 1996 25 percent 5. This limitation would apply to the aggregate of a bank's exposure to a single party and all parties related to that single party. Also, the single exposure limitation would apply to both extensions of credit and off balance sheet exposures. 6. The limitation for year end 1994 would be more restrictive than the present single exposure limit in the Central Bank's regulation because: (1) the existing limitation vanes from 50 to 100 percent of bank capital, depending on the status of the bank involved, and (2) the present regulation does not include parties that are related to the borrower. 7. It will be necessary to develop a precise definition for "related parties" for later use. It should be noted that Auditors in future years almost surely will have difficulty tracing "relatedness", given current information available in Russia. However, "relatedness" cannot be ignored without great risk that the single exposure limitations (and the connected lending limitations) will be circumvented by many borrowers who might create subsidiaries or holding companies to increase their borrowing capacity from a given bank For guidance, references should be done to International Standards on Auditing. Aggregate Large Exposures 8. A large exposure is defined as any credit and off balance sheet exposure to a single party or parties related to the single party that exceeds 10 percent of the bank's equity capital PBs would have to reduce their aggregate large exposure ratio as follows. ANNEX D page 6 of 6 Year End Maximum Aggregate Large Exposures as a Multiple ofa Bank s Equity Capital 1994 12 timcs 1995 10 times 1996 8 times Exposure to a Single Connected Party 9 Limits for PBs would be as follows: Year End Maximum Exposure to a Single Connected Party as a Percent ofa Bank's 1994 30 percent 1995 25 percent 1996 20 percent 1997 15 percent 1998 10 percent 10. An additional requirement would be that all of a bank's lending and off balance sheet exposure to connected parties would have to be on commercial terms. 1. The above quantitative limitation would apply to the aggregate of a bank's exposure to a single connected party and all parties that are related to that single party. Moreover, the limitation would apply to both extensions of credit and off balance sheet exposures. Aggregate Exposure to Connected Parties 12. Given widespread connected lending that now pervades the Russian banking system, this limitation may be very binding on many banks. However, it should not be unduly binding on those banks that were created to serve the banking needs of the public, as opposed to the interested of their owners. Year End Maximum Aggregate Exposure to Connected Parties as a Percent ofa Bank 's Equity Capital 1994 100 percent 1995 80 percent 1996 60 percent 1997 40 percent 1998 20 percent ANNEX E page 1 of 4 PAY1MENTS SYSTEM REFORM A. BACKGROUND 1. Payments methods for internal transactions in Ukraine sub-divide into two distinct categories namely cash and non-cash payments. For consumers, cash is used for virtually all payment transactions. The post office offers a postal money order service, but fees are said to be as high as 15% of the value transferred. For the majority of relatively low-income households, who are deeply suspicious of banks, cash is likely to continue as the most effective means of making most consumer payments for the time being. 2. By contrast, the vast majority of cashless payments are made between businesses. Until the early part of 1994 these payments were exclusively paper-based and were mainly dependent on the instrument of the payment order (credit transfer), which then accounted for about 60% of all payments. The payment order is a multi-part paper form which was generally processed and sorted manually and sent to the recipient (payee) bank by mail. Payee crediting was based upon. the receipt of the paper document which, because of mail delays, used to take 3 days for a local item to clear and up to 10 days for a non local item within Ukraine. A second payment instrument, similar in nature to a "limited value" check, accounted for 2-3 percent of cashless payments. 3. At end-1993, it was estimated that the size of the median payment was the equivalent of about $12,500 -- this large amount reflecting the dominance of business transactions in the cashless payments circuits. The three large former state-banks (Prominvest, Ukraina. and Ukrosotsbank) together accounted for about 70 percent of such transactions and the average number of daily transactions was understood to be between 500,000-700,000 in the two largest banks and 100,000 or more in Ukrosotsbank. The majority of payments were then, and still are, intra-bank (payee and payer use same bank, although perhaps different branches), but there are also large numbers of inter-bank payments (20-30 percent of all transactions are cross-border transactions with other CIS countries). B. THE REFORM PROGRAM TO-DATE 4. The Bank's Institution Building Project (IBP) for Ukraine approved in May 1993, included a USS2.5 million component for the immediate implementation of improvements in the Payment System (PS). This included US$450,000 for consultant services, US$1,500,000 million for associated automation and telecommunications equipment, and US$150,000 for training in the use and operations of the PS. Two main conditions were attached to this component. The first was the establishment of the National Payment Council (NPC) to coordinate the development and implementation of the system between the National Bank of Ukraine (NBU), the commercial banks (including Oschadny Bank), and the second was the hiring of an external consultant to assist the NBU in payments system development. 5. The agreed work program focused on payment transfers and clearing between corporate enterprises and also between banks on their own behalf for money management purposes. The development plan included the establishment of 26 regional clearing-houses, their interconnection to provide nationwide clearing and settlement, and the implementation of a large value payment component to facilitate same-day transfer of funds between commercial banks through their correspondent accounts held at the NBU. The primary considerations in system design were accounting, security and control, and consistency with intra- bank system plans. Additionally, emphasis was placed on the need for an appropriate legal and regulatory framework to define the rights, responsibilities and sanctions applying to all parties to payment and settlement transactions. The outcome which is the present electronic payments system is overviewed in Box 1. ANNEX E page 2 of 4 Box 1 Overview of the Electronic Interbank Payment System (EIPS) The electronic interbank payment system operates through tweny six regional clearing centers and a national center in Kiev, all of which are managed and operated-by the NBU. Virtually all of the commercial banks' branches (some 1600 in July, 1994).are connected directly to the regional network of clearing,houses through an E-mail system developed by the NBU. The participating commercial banks and their branches enter the -payment nstructions which are then batched into files, typically containing five:to ten transactions which are generally he-corporate enterprises' payment orders. About every fifteen minutes, the E-mail picks up the.fites from the participating banks which are then processed. The files are received a the regional clearing house wh6re the transactions are sorted and the settlement balance verified for tie necessary funds* li-region transactions are batched into files for E-mail transfer: io dte bank. Iner-regional-transactions files, on the other hand, are sent to a receiviig clearing house through the national clearing center in Kiev. If a sendingibank-does not have the necessary funds in its settlement account to clear a transaction, ithe entire file is rejected and retrned to die originating bank through the Enasil systera lfthere are sufficient funds, the originating bank settlement accoun is debited wh ilethe receiving bank's stement acoubt is crdited for t1 amount cleard. Settlement account balance information is sent through he Email system to each partcipating bank every fifteen or thirty minutes hroughout the operational day. i.e. from 0800 to 1800. Intra-regional: transactions are cleared and settled within thirty minutes of entry into the.E-iail system while. inter-regional transactions are settled and cleared within one hour. Security is provided through software encryption.and access to perational facilities are controlled. .Security control procedures at the participatinj comnieicial banks, however, are said to need strengthening. erall, the NBU and the parti'pating banks ar pleased with the operations of the current EIPS. Of particular note is the ducio' in the' float days from five/six days to one day increasing the availability of funds for more productive use., In addition, the massive paper flow aind physical documents wbich followed the electronic entries for control purposes, and for advises to the receiving bank branches and their customers, have stopped In:most, if not all. regional centers as a resultof a more efficent use of the EIPS. The IPS service is ft:e of charge. Fees an low transachon volumes during the start-up stages of the EIPS will not cover the system's administrative and operating cost at this time However, the desire toincrease the minber of participating banks, the reduced float days, and better control of the' ElPS outweigh the disadvanage of subsidies, at this time. C. THE CURRENT STATUS OF THE NEW SYSTEM 6. The National Payments Council was formed as agreed and it now meets monthly on a regular basis Both the NBU and the commercial banks are content with the functioning of and the initiatives put forward by the NPC. The Government issued an order in mid-1993 to achieve the implementation of the proposed electronic payment system by early 1994. In response, the NBU created the Electronic Interbank Payment System (EIPS) which started its operations on a pilot basis in September, 1993 and went live nationwide in January, 1994. The EIPS was designed to handle the payment orders between bank branches made by corporate entities (but not individuals). NBU has relied on design and implementation guidelines from the Austrian National Bank, related IMF missions, and from study-visits by NBU payment system staff to other European countries. The original EIPS software design and the procurement of the appropriate hardware was done by the NBU itself. 7. The NBU realizes that the current EIPS is a "first generation" system that still requires major improvements, if the system is to effectively and securely support the country's economic development and growing business activities. Improvements in security through a hardware-based encryption system. are currently being tested in several clearing centers with full implementation expected in 1995. This work includes the certification of both the integrity of the software and the procedures used by the participating banks to ensure proper security and control. A cost of US$1.1 million has been estimated for these software and hardware improvements for some 1600 participants. Another proposed improvement is to streamline the clearing/reserve option. This option will allow a payment to be cleared through one branch even if the customer's settlement account had insufficient funds as long as the same customer had excess funds in a another branch of the same bank. A key initiative is to improve the EIPS back-up capabilities. Some ANNEX E page 3 of 4 limitation of funds has restricted the back-up capabilities of the system and the NBU, having experienced some system failures, is now attaching great priority to "disaster recovery systems." USAID has supported some of the work involved in upgrading the first generation system but substantially more funds will be required. Lastly, there are plans to have the Oschadny Bank participate in both the EIPS and the NPC to handle transactions for its household customers such as bill paying Should Oschadny participate. it would add their 670 main branches to the existing 1600 branch network and use up a great deal, if not all, of the spare capacity of that system. 8. Eventually, the plan for the EIPS would be to have the banks migrate to a single account, nationwide. However, such migration will require massive investments and development in more efficient intra bank systems within the commercial banks and their branch networks, and even more costly, it will require improved automation and telecommunications facilities within Ukraine. D. DEVELOPMENT ISSUES FOR COMMERCIAL BANKS 9. Most of the major commercial banks are in the process of enhancing their individual interbank payment and clearing systems. This is increasingly a key element in their relative competitive positions. While there can be significant efficiency gains from adopting a common approach, each bank must assume responsibility for its own in-house systems consistent with the NBU and NPC's authorized models for interbank settlement. The terms of reference for the original consultancy services include a review of each participating bank's system's compatibility with these models. In essence there are two authorized models. The first requires that the settlement balances of each regional branch of the same bank be aggregated into a master account controlled by the region's lead branch. The lead branch would be able to assign overdraft limits to each of its branches subject to the funds in the bank's master account. The limits could be assigned daily or up-dated as needed. This model makes better use of available settlement balances but does not reduce the number of EIPS interfaces. 10. The second model would permit a bank to route all of its regional branch transactions through its lead branch in each region. The lead branch would then transmit all interbank entries through a single settlement account and a single interface to the NBU regional clearing center. This model improves the efficiency of the settlement balances and reduces EIPS interfaces enabling the lead branch to capture the EIPS transactions without going through the EIPS. In practice, the more sophisticated practitioners such as Prominvest bank have already gone further than this by developing their own in-house system which allows the inter-regional settlements as well to be done before invoking the EIPS network. This is a source of very considerable savings for the bank since they under the previous system they were subject to NBU charges for deficit positions on some regional settlement balances even though they had surplus positions elsewhere. E. OBSERVATIONS AND RECOMMENDATIONS I 11. This present review as well as earlier work by the Bank confirms the substantial improvement in payments systems achieved by the EIPS, as well as necessity for the further refinements already planned by the NBU. The substantially reduced payment clearing time; the elimination of voluminous paper-handling; and the improved ability of the NBU to manage payment transactions and reduce the potential for fraud, are all significant benefits of the new system. It also feeds information into the bank supervision process The commercial banks as the clients of the system find it relatively easy to operate, convenient, acceptable, and greatly prefer it to the old paper-based system. For the future, there is broad agreement on the importance of strengthening telecommunications , and especially intra regional communications, and on enhancing the security in the network. There have already been several attempts at fraud, all of which failed apparently. Nonetheless with 1600 participants, any breach in security could lead to large financial losses, and the NBU is very well aware of this. The lack of system back-up is also recognized to be a major problem. Because of I Tkus section ries m pan on the findings of a small specialized mission from the Bank which visited Kiev n July 1994 ANNEX E page 4 of 4 the relatively weak infrastructure of telecommunications and also power, a back-up system for the EIPS needs to be developed with some urgency. 12. The main observations of the Bank's most recent specialist mission on this topic are as follows: (a) the EIPS has been well-designed and developed, and while needing improvement, now serves as an appropriate first generation platform for payments and clearing; (b) the present national telecommunications system is inadequate to serve the needs of a developing national payments system; (c) certain enhancements to the current EIPS should be implemented as quickly as possible; (d) as the capabilities for interbank payments are further advanced than there will be a requirement in most commercial banks for intra-bank payments, and for major development expenditures in those banks to improve their own internal systems and related services; and (e) the NPC remains an effective vehicle for addressing issues related to EIPS implementation, operations, and proposed improvements. 13. In short, the progress of the NBU in the development and implementation of the EIPS to date, has been impressive. While the recent USAID initiative to provide a US$2 million technical assistance grant, US$1.2 million of which was for equipment, has reduced the need for consultant payment-system services under the IBP, the Bank should, nevertheless, provide support to further enhance the improvements which Ukraine has been able to make to-date. Because of the rapid and unexpected pace of development of the EIPS, the full scope of the payment system services envisioned in April, 1993 are no longer necessary. The current technical assistance needs for consultant services as briefly outlined above remain valid and consistent with the improvements which the NBU proposes for the system. The budget for the new TA tasks are unlikely to exceed US$100,000, half of which would provide for the review of the EIPS improvements and development plan, and half for the NPC intra-bank systems and services procurement assistance, education, and training. The Bank needs to work closely with USAID to ensure that the technical assistance is demand driven and based on the needs identified by the NBU. Should USAID be able to fund a substantial part of the technical assistance required, the Bank could reallocate the hardware funding under the IBC towards its "best use" in enhancing the EIPS. 14. To this end, it is recommended that the Bank continue to work in this area with the Ukrainian specialists and reallocate IBP funding towards targeted technical assistance to meet the high priority improvements necessary for the EIPS, including: (a) network security both at the NBU and the commercial banks; (b) back-up capabilities, including safety and reliability of the EIPS; (c) intra-bank payments and clearing; (d) technical and financial support for telecommunications infrastructure development; and (e) development of functional, technical, operational, and legal/regulatory standards for the current and potential inter-bank payments and clearing. CATALOGUERS/FILE CONFIDENTIAL Report No: 14526 UA Type: SR