Ukraine - Risks and Transition : A Review of the Financial Sector (Vol. 1 of 2) : The Main Report

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 1: Main Report June 30, 1995 Privatization and Enterprise Development Division FILE C O P Y 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. CURRENCY EQUIVALENTS (April 14, 1995) Currency Unit=Karbovancts USS1=Kbvs. 130,100.0 1 Karbovanet=US$.0000076 00-4 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS CPE - Centrally Planned Economy CoA - Chart of Accounts CoM - Council of Ministers CSO - Clearing and Settlement Organization EBRD - European Bank for Reconstruction and Development EU-TACIS - European Union Technical Assistance Program for CIS countries FSU - Former Soviet Union GDP - Gross Domestic Product IAS - International Accounting Standards IMF - International Monetary Fund Kbvs. - Karbovanets MOF. - Ministry of Finance MOJ - Ministry of Justice MPP - Mass Privatization Program NBU - National Bank of Ukraine OFI - Other Financial Institutions OTC - Over-the-Counter SBF - French Stock Exchange SPF - State Property Fund SRO - Self-Regulating Organization STF - Systemic Transformation Facility TBs - Treasury Bills REPUBLIC OF UKRAINE - FISCAL YEAR January I - December 31 This report is based on the findings of a mission that visited Ukraine in MarchlApril 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. UKRAINE RISKS AND TRANSITION: A REVIEW OF THE FINANCIAL SECTOR CONTENTS EXECUTIVE SUM M A RY.. .................... . . ..... . ......... I .- . . . V1 CHAPTER I MACROECONOMIC CONTEXT OF FINANCIAL SECTOR PERFORMANCE . I A . T he Im m ediate P roblem r om ...................................... . .................. ............. .............. . . I B . C onsequences of Inflation .. ........................................ . ........... a. ...................... I C . S o m e Im p licatio ns............ .................................. ....... ........ .... ...p-o............. .. ... ... . 3 CHAPTER 2 THE EMERGING STRUCTURE OF THE FINANCIAL SECTOR . .5 A T he N um ber and Size of Banks .................. . . . . ....... ....... . . . . ..... . . . .............. .. 5 B . C hanges in M arket Shares .. . ..................................... . ....... . . .............. . .. 6 C Ownership, Control and Distribution ..... .. .. ... . ..... ... .. ...... . 7 D The Influence of Mass Privatization on Sectoral Structure ......... .. ...... ........... . . 8 CHAPTER 3 STRATEGIES FOR THE STATE AND FORMER STATE BANKS . ........ .......... 9 A . G en era l P ro b lem s .................... .................................. . ....... -....... ................. ..... 9 B . D irected Credits and Support to Enterprises..................................... ........ . . . . . ... . . ...9 C . Issues Facing State-Owned Banks .... . . ....... . . . ..... ......... . ....... . . ....... ak1...... ....... . 12 D . Should the B anks be R ecapitalized?....................................................................... ... ... .. 13 CHAPTER 4 STRATEGIES FOR THE NEWER PRIVATE BANKS ................. .......... ............. . 15 A . Patterns of R esourcing and M argins ........................ ..... ........ . . ....... ............................ I5 B . T he R ole of P ublic Policy........................... ............. . -...................... . ...................... I8 CHAPTER 5 CAPITAL MARKET DEVELOPMENTS ................................... ......... ............. . ....20 A . T h e M ain O bjectives................... ................................................... .... ... ..................... 2 0 B. Existing Products, Investors and Interm ediaries ............................................ ..................20 C. Arrangements for Registering and Transferring Stock Ownership ............ ........................23 D . E stablishing T rading Systems................................................................. ........... .... .......24 E C learing and Settlem ent A rrangem ents............................. ......... ................... . ......... 26 CHAPTER 6 TH E INSURA NCE SECTO R ................................. . . ................................................. 27 CHAPTER 7 ENABLING ENVIRONMENT: FINANCIAL SECTOR INFRASTRUCTURE ...... 28 A . The Supervision of Financial Institutions ........ ... . ................................ ............ 28 B . A cco unting R efo rm....... .................................. ......... ................................................ ..3 0 C . D ep o sit In su ra n ce................. .... .................................... .... .... .. . ...... .........................3 1 CHAPTER 8 STRATEG Y FO R SECTOR............................ ........... ..... .......... .......................... .. 33 Note: Report is contained in two volumes: Volume I is the main body of the report; and Volume 11 contains the annexes which are available upon request ANNEXES 1. The Structure of the Banking Sector II. Notes on the State and Former State-Banks III. Reforming Accounting Standards and Practices IV. Issues in Bank Supervision and Auditing V. Payments System Reform RISKS AND TRANSITION - A REVIEW OF UKRAINE'S FINANCIAL SECTOR EXECUTIVE SUMMARY This Report provides an assessment of the present situation of Ukraine's financial sector and the manner in which this has been affected by the break up of the former Soviet Union, by the high mflation which prevailed until early in 1995 and by the reform policies of the past twelve months. It provides a broad-based analysis covering issues associated with macroeconomic policy (Ch 1), the changing structure of the sector (Ch. 2), the problems of the state and former state banks (Ch. 3), the situation in newer private banks (Ch. 4); the problems in the capital and insurance markets (Chs 5 and 6); and a variety of problems pertaining to the infrastructure of the sector (Ch. 7). The objective is to assess the existing weaknesses of the sector and to define a strategy which could enable it to take a greater contribution to the economic transition and long term development. 2. The unfavorable circumstances of the past five years have already combined to diminish the size and significance of the sector, and the crisis in the banking system which emerged early in 1995 now threatens a further downsizing of its importance. Thus, the strategy which is called for needs to combine short term actions to limit the contagion of the present banking crisis with structural and institutional measures designed to promote a healthier and broader-based sector for the longer term. This summary attempts merely to outline the strategy. The analysis which justifies the strategy is presented in the main Chapters of the Report and in supporting Annexes. The Macroeconomic Fundamentals: 3. The diminished size, limited products and oligopolistic structure of the sector are the consequences of the distorting policies of the past few years, and the high rates of inflation. The first element of strategy is to complete the stabilization and other reform efforts initiated in October 1994 and recognize these as the pre-requisites for stronger and market-oriented financial institutions. Inflation control and the avoidance of severely negative real rates of interest must be the first priority amongst the set of reform policies which can influence the sector. So government pressures to repress some interest rates, and especially through programs of directed credit to favored sectors need to be ended with any residual subsidization of enterprises being moved to the fiscal accounts. These changes combined with the government's increased use of non-monetary financing of its own deficit will gradually reveal the true costs of contmuing budget deficits on monetary and credit conditions in the economy. The Banking Crisis: 4. The higher real interest rates associated with a successful anti-inflation policy have already manifested a downside in the form of liquidity and other strains on a banking system that is already in crisis. How should the reality of this crisis be accommodated in the sectoral strategy? The first answer is that although the banking system in Ukraine is extremely small there are nonetheless too many banks in that system many of which are of poor quality. The authorities should not stand in the way of failures of very small and weakly capitalized banks particularly where the main (enterprise) depositors of the bank are the same people as the shareholders. These bank failures will not impose serious costs on the system since household deposits are already very small, the danger of a "run" on banks is slight, and the signals to surviving banks are likely to be in the right direction. Additionally since many small banks which have not failed will be unable to meet the enlarged capital requirements which come into force in January 1996, the NBU should consider a restricted banking license for those not wishing to ii accept household deposits or participate in the inter-bank market. This will avoid the weakening of public confidence in banks which might be associated with large numbers of simultaneous bank closures. 5. Larger banks pose more serious problems because the downstream effects of their failure (e.g default on obligations in the inter-bank markets) may be too large to ignore Here the NBU needs to provide support but in doing so should differentiate cases of bank illiquidity from those of insolvency. The substantial practical task of doing so will be simplified by the accounting reforms which are proposed below. The NBU should not provide unconditional liquidity injections to any banks which are insolvent however large and influential they may be. Indeed, msolvent banks should be provided help if at all only on strict conditions involving major surgery of, for example, branch networks; changes in their senior management teams; and losses to their shareholders. More generally the conditions for any bail-out of insolvent banks should be tough enough to signal to other banks that reckless or incompetent management will incur high costs and penalties. Recent NBU interventions to help particular banks have communicated mixed signals in this regard and more systematic procedures are needed to avoid similar confusions in the future. 6. The final point on this matter is that the methods of providing liquidity to troubled banks should be designed so as to minimize the damage both to the banks which are required to supply the funds, and to the Government's own anti-inflation program. In this regard, ad hoc exemptions to the NBU's standard regulatory rules, the provision of liquidity to the inter-bank market on a subsidized basis, and the encouragement of increased inter-bank lending by those banks still wholly owned by the state, are all actions of the recent past which have damaging side-effects and should be avoided in future interventions. A Strategy for the Banking Sector: 7. The central objective of the strategy for the banks in the longer term is to encourage a higher quality sector in terms of the products it offers at the same time as lessening the risks and increasing the reliability of individual institutions and products. This will result in a smaller sector in terms of the number of institutions in the short-term but a larger and more effective one in the longer term. It is recommended that this be achieved by: * enforcing the new minimum capital requirement on all banks; * establishing a more restricted license for some smaller specialized banks, * closing insolvent banks; * enforcing tighter prudential rules on all surviving banks; * upgrading local supervision procedures; * encouraging all banks to undertake external audits; * encouraging more banks to achieve iternational performance standards by participating in credit lines and other programs of external donors; * freeing former state banks from obligations to provide directed credits; and * developing clearer long term strategies for the banks remaining in state-ownership. Strategies for State and Former State-Banks: 8. The contrast between the three former state banks which are now private and the two remaining in state ownership is one of degree rather than absolutes (see Chapter 2 for a list of the banks). Both are encumbered by Government requirements which compronuse their commercial aspirations The real control of the now private banks also remains ambiguous. To begin to redress these problems, subsidies to enterprises should be provided directly through fiscal transfers so as to reveal their full ill burden on the Government rather than be hidden in the form of cheap credits which damage the banks. However, ending such a deepy -embedded system is not easy since it requires among other things a change in the incentive system within banks. 9. It is recommended that the first step in achieving behavioral changes in the banks would be regular annual audits of the banks on the basis of Internationally Accepted Accounting Standards (lAS). These will also provide a much clearer measure of the degree of impairment of balance-sheet values which has already occurred. The over-statement of bank capital which these audits will reveal should stimulate the banks to achieve higher levels of capitalization to meet NBU standards of capital adequacy. It should thereby strengthen the future resolve of the banks to resist pressures to lend to failing enterprises. An important counterpart of these recommendations is that enterprises which presently benefit from subsidized credits be either closed or granted an adequate level of support through the government budget. This in turn implies that the Government needs to build the capacity within the Ministry of Finance to deliver this support. In the past, the banks themselves have discharged this function. 10. In the case of Oschadny Bank, the first priority is for the Government to clarify which of several possible strategies it expects the bank to follow. The twinning contract with the German Savings Bank Foundation will provide the diagnostic to advise on this. However, it is unlikely that Oschadny can be integrated quickly if at all into mainstream universal banking The problems of such an integration include the limited capital of the bank, its substantial over-manning relative to the present scale of its operations; and the large number of non-commercial operations which it needs to handle on behalf of Government. In the light of these problems, there are strong advantages in restricting the bank's role to enable it, as now, to fill particular gaps in the Government's own ability to handle payments and other services for the mass of the population. The bank's role, as now would also include the mobilization and safe custody of deposits from household savers and their on-lending through the NBU. Increasingly the on-lending could be through Treasury Bills and other government securities to provide a useful retail outlet for those markets as they develop. With appropriate upgrading and automation, the bank might also become an important source of financial services for households which are presently under-provided: for example, housing loans. 11. Although the full extent of their under-capitalization is not known in advance of the ongoing audits, a government-funded recapitalization of the former state-banks to deal with the accumulated non-performing loans should be avoided if at all possible. Instead, the Government should give the banks greater access to standard legal procedures for the enforcement of creditors rights as the means to collect on those loans which remain unpaid. Policy should concentrate on incentives for the banks to build their own capital and on the avoidance of future accumulations of bad loans using approaches such as those indicated above. Strategies for the Newer Private Banks: 12. The more successful of these banks have gained market-share very rapidly, but limited capital and under-developed systems of management render these banks more fragile and risky than former state banks. Many have prospered on the basis of the high margins which have been possible in foreign currency operations - one reason for their high enthusiasm for international credit Imes. The outcome of the competition between them and the former state-owned banks will depend on the ability of the newer banks to survive the pressures of the transitional adjustment period despite limited size and capital. 13 The role of public policy in dealing with the present crisis in the newer banks and the progressive evolution of that situation during the next few years is multi-faceted. First. the January 1995 reduction (to 30 percent of profits) of the tax burden on the banks needs to be sustained. Indeed given the serious undercapitalization of the banks, consideration should be given to a sustained tax holiday on the undistributed profits of the banks to give them an incentive to build their capital from internal sources. The computation of the tax base for taxation purposes also needs to be amended to ensure that loan-loss provisions can be a legitimate charge on profits for tax purposes Second. to give effect to its important public policy role in this area, the NBU's analytical capacities need strengthening to ensure adequate advance warning of impending difficulties. Above all the NBU need to be able to give good technical reasons for all its major decisions in order to avoid enticisms of political motivation Third, m the short term, a viable approach to achieve higher quality bank performance is the extended use of audits by international firms coupled with explicit institution-building programs based on the results of these audits. In other countries, the idea of encouraging a sub-set of banks to qualify as "international standards banks" by meeting tough qualifying requirements for credit lines and other programs provided by external donors, has provided a further incentive for enhanced bank performance. This idea is a good one and should be adopted officially in Ukraine on the basis of credit lines provided already by the EBRD and prospectively by the World Bank. Capital Market Development: 14. In the immediate context of the mass privatization program (MPP), it is essential that the development of active secondary capital markets be a major component of financial sector strategy. For the moment the institutions and legal arrangements to support this are woefully inadequate relative to the needs. The new Treasury Bill issues begun in March 1995 will compete directly with private issues once privatization gathers momentum. So competitive market rates on government paper and/or a much lower deficit will also be required to allow the new markets to thrive. Higher local currency interest rates will be consistent with the pre-eminent need to achieve higher levels of local currency saving although this effect may take some time to appear. 15. Already there is a high level of concentration in investment control with about 30-40 Investment Funds and Trusts controlling about 80% of privatization certificates collected/bought from citizens since February 1995. The biggest and most active funds and trusts are parts of financial conglomerates, typically including: a bank, an insurance company, a pension fund, a trust company, and an investment fund. Although universal banking has become the accepted norm and this need not be changed, the risks associated with this form of organization should be addressed in the new regulatory framework. For example, since banks are likely to play a very large role in the capital markets, it is recommended that the NBU require the banks to account for all their investments in capital-market intermediaries separately, and treat such investments as a one-hundred percent reduction of capital for the purposes of assessing the adequacy of bank capital. 16. As regards institutional developments, the most urgent need is for a reliable system of share registries. It is strongly recommended that these registrar services be separated from issuers. It should also be an ultimate goal to transfer registrar functions to pnvate operators. As regards the form of shares, the transfer of ownership of dematenalized or immobilized shares is simpler and cheaper and is therefore recommended as the best initial system for Ukraine. 17. As regards the trading system itself, any system developed now has to accommodate the fact that trading frequency and liquidity may vary substantially from share to share and over time for the same share, and that some trading will be liuted to regional markets. Various different groups of 1 companies also need to be accommodated A minority of companies able to fulfill all the rules of public trading. should find their trading place at a reformed Ukrainian Stock Exchange However, the creation of an efficient. safe and fair marketplace for shares of other companies which cannot initially meet full listing requirements is critical for the success of the MPP Conditions should be established to trade shares of these companies to the broader public in an evolutionary manner which would result eventually in a formalized over-the-counter market. In other words different trading systems should be allowed to coexist: no rigid and unified model is called for. 18. As regards clearance and settlement arrangements, few problems and nsks occur when most transactions as at present are completed in so-called "off-market" trades where the buyer and seller deal directly with each other. However, once the number of buyers and sellers grow, and retail trades assume greater significance, then inadequate arrangements for clearance and settlement will seriously undermine market reliability and enhance risks. In Ukraine the geographical and other segmentation of share trading means that a number of clearing and settlement organizations (CSOs) are likely to be needed and should be allowed. It is also recommended that clearance and settlement systems be linked to the emerging regulation of markets. This means first a self-regulatory mechanism built on mutual trust between the professional intermediaries within each CSO This might be set up loosely at first but then evolve more formalized rules for participation The new CSOs would be owned by market participants and supervised by their own self-regulatory organizations and also by a new Securities Commission which should also set required levels of capitalization Insurance Sector: 19. Insurance activity in Ukraine is and will remain fragile with a total volume of busmess at about Kbvs. I trillion (less than I percent of GDP) which is far too small to meet the legitimate and diversified insurance needs of a large and complex economy. Its product range is limited and of generally poor quality. It is recommended that this be an area in which enhanced levels of external technical support and financing be sought to ensure that new and more reliable products can be made available as expeditiously as possible. In particular, the practice of credit insurance should be reviewed: it is unlikely that this can really help to lessen significantly the risks which banks incur when they provide credit. The Enabling Environment-Financial Sector Infrastructure: 20. Banking Supervision. The rationale for, and basic principles of a strong system of bank supervision are accepted in Ukraine and much work has been devoted to the upgrading of the supervision arrangements for commercial banks by the NBU. This program has already achieved several important improvements in NBU arrangements. However, not much more progress and sophistication can be introduced until the accounting standards applied to banks are reformed to comply with IAS. The development of an accounting system capable of revealing the true financial situation of banks is the critical precursor of a sound system of banking supervision and should now receive highest priority. The same is true of the legal authority where the gradual accumulation of regulations built on the out-dated 1991 Banking Law is increasingly unsatisfactory. A third point is that the task of establishing sound regulation and supervision of banks is a long term one. Arrangements are also needed to help build confidence in the banks in the shorter term. For this it is recommended that the international audit process and the concept of the international standard bank be espoused explicitly by the bank supervisors as an element of their own short term strategy. 21. Regulation and Supervision of Other Institutions. The lax regulation and supervision of the non-bank financial institutions is increasingly indefensible in the light of the anticipated rapid growth of capital market institutions and the already difficult situation of the insurance sector There is an urgent VI need to prepare a law establishing a permanent Securities Commission as an operational body to oversee and supervise capital market participants. However, this is only the first step in creating an appropriate regulatory structure Additionally. it is essential to rationalize the fragmented roles between different governmental agencies the Ministry of Finance, the State Property Fund. the Ministry of Justice, the NBU, the Parliament. None of these institutions has appropriate staffing properly to supervise the market and enforce existing legal norms. 22. Deposit Insurance The extended coverage of deposit insurance beyond Oschadny Bank can be argued to be an important element in the process of re-building household confidence in the banking system and re-establishing a larger deposit base. This Report supports this step as a longer term objective of policy but recommends against its introduction in the absence of certain prior reforms designed to lower its cost and increase its effectiveness. These reforms would include the slimming down of the banking sector to a smaller sub-set of higher quality banks able to operate a deposit-insurance scheme on a self-financing basis. Ideas about how to achieve this slimming down were presented above 23. Payments Systems. This present review confirms the substantial improvement in payments systems achieved by the National Bank's Electronic Inter-Bank Payments System, as well as the necessity for the further refinements already planned by the NBU. The necessary improvements no%% required include: improved national telecommunications to serve better the needs of the system. improvements in security through a hardware-based encryption system: improvements in intra-bank payments in some banks; and improved back-up and disaster-recovery arrangements. 24. Overall Strategy. The core of the strategy proposed by this Report is for the NBU, and the other financial authorities to work together with external donors to produce a set of higher quality banks and other financial institutions. This involves several public policy decisions - for example, the endmg of directed credit programs and the commitment to a fair rate of taxation sufficient to allow istitutions an adequate rate of return on their capital. In the short term, the better established banks may aclueve a superior rate of return. Incentives need to be established to ensure that they will use this to re-build capital and deal with accumulated loan losses. Longer term there is a good prospect of reasonable competition in the sector and without the need for explicit anti-monopoly actions. Public policies need to be supported too by actions by individual banks to improve their own procedures and strengthen capital These actions will be partly self-motivated although strong regulation and supervision is also a crucial part of the package. There should be no illusions however that this strategy can produce large short-term improvements in the basic weakness of the sector - a chronic shortage of resources to lend and strong reasons why short-term lending predominantly for trading purposes dominates lending to strengthen productive sectors. CHAPTER 1 THE MACROECONOMIC CONTEXT OF FINANCIAL SECTOR PERFORMANCE A. THE IMMEDIATE PROBLEM 1.1 Financial system performance reflects performance in the real economy. In Ukraine the large decline in real output (over 60 percent GDP fall in the four years to end-1994) and very high inflation have been extremely damaging from this point of view. But high inflation also serves to conceal the real financial distress in a system and it is only when inflation stabilizes as it is now in Ukraine that the strains on the financial system finally show through. The near hyper-inflation in Ukraine in both 1992-1994 and through the early months of 1995 (20 percent per month) as shown in Figure I has resulted in highly negative real rates of interest which have favored borrowers but discouraged lenders. Average monthly inflation has remained close to 15-20 percent for some time and inflationary expectations are probably embedded at about that level as shown by the dotted line. By contrast, deposit rates of interest have never moved above 300 percent per annum (about 12 percent per month).2 So negative real interest rates on deposits have been the norm for several years. 1.2 Experiences in other countries indicate that the elimination of such high rates of inflation will need a transition period characterized by tight credit and high positive rates of interest for a time. During this transition to lower inflation, many enterprises will find difficulty in servicing their debts and banks, whether state-owned or private, will be under great pressure to refinance principal and interest payments as they become due. In the process some banks will encounter liquidity problems and be forced into situations of non-compliance with the prudential ratios established by the National Bank (NBU).3 In short the stabilization transition will be a period of great stress for a still embryonic financial system. The authorities have a major challenge in managing this situation. 1.3 They should respond by being very specific and disciplined about the circumstances under which NBU injections of funds to the banking system are justified. As argued in Chapter 3, directed credit programs should be phased out with the subsidy element being replaced by direct budgetary payments. Special arrangements for the working capital needs of the agricultural sector may be needed for a time while institutional reforms to improve farmers' access to commercial credit are achieved. Liquidity injections to the commercial banks should be provided through a discount window or by use of credit auctions albeit with some transitional problems associated with the collateral underpinning of such arrangements. B. CONSEQUENCES OF INFLATION 1.4 High inflation, negative real interest rates, and collapsing output together have already caused severe decline in the level of financial sector activity measured in real terms. (See Table 1.1) That decline is associated with much lower levels of intermediation, large-scale currency substitution into both cash and non-cash dollars and the collapse of household karbovanet deposits. The chart indicates a number of distnct penods of the recent inflation history. They include the surge of prces associated with the Russian price liberalization in early 1992; the gradual breakdown of financial discipine from the second half of 1993; the blip to inflation associated with the energy and other pnce increases required by the IMF Systemic Transformation Facility (STF) program in October 1994; and some moderation of inflation thereafter. 2 This assumes the compounding of the rate on a monthly basis. The fact that many Ukrainian banks still calculate the monthly interest rate associated with a 300 percent annual rate as 25 percent, may be a part of the reason why rates have been set too low 3 These are defined in Annex D. 1.5 Total monetary circulation Figure 1.1: Nlonthl Inflation (CPI) - percent (broad money) declined to the equivalent of only about 15 percent of GDP by end-1994. Within that 250. total, the Kbvs. component is now 200 only one third the. level, relative to GDP, attained at end-1992. This ISO means above all that the scope the too. government has for realizing inflation tax revenues is greatly so - reduced. For any giyen volume of .monetar fancing of the budget tdeficit, the inflationary impact will now be much larger than formerly was the case and the inflation rate is now much more sensitive to small deviations from fiscal deficit targets. The overall decline in the importance of the Kbvs. as a means of payment and a store of value is also mirrored by a rapid decline in the importance of the Kbvs. cash circulation which now amounts to only about 4 percent of GDP. The increased use of cash dollars implies a large shift of seignorage revenues to the USA. Table 1.1: Structural Changes In Finance. 1992 to 1994 1.6 On the assets side of the Amounts outstanding (% of GDP) 1992 1993 1994 account, outstanding credits fell from over 100 percent to only about 18 Net Domestic Assets of Banks 42% 11% 14% percent of GDP by 1994 with 5 (of which NBU) 15% 7% 7% percentage points of this later total Domestic Credit 55% 14% 18% attributable to direct Government (of which to Government) 19% 1% 5% borrowing and the balance to the (of which to Other Users) 36% 13% 14% enterprise sector. Mirroring what is (of which Domestic Currency) 30% 10% 6% happening in relation to monetary (of which Foreign Currency (Official. 6% 3% 7% circulation, a large element of the ER)) total assets and credits of the banking (of which Foreign Currency (Parallel. 7% 5% 8% ER) system are now denominated in foreign currencies. Specifically, Broad Money - Total 31% 12% 15% foreign currency credits calculated at Karbovaners element 29% 10% 10% the parallel/auction exchange rate of which Currency 6% 3% 4% amounted to about 8 percent of GDP Demand and Time Deposits 42% 12% 6% by end-1994: equivalent to 60 percent Foreign Currency Deposits (Official 3% 2% 5% of all credits extended to non- ER) and Foreign Currency (Parallel. ER) 3% 5% 6% Government borrowers. Dollarization is deeply entrenched and the total domestic currency loans in the economy at end- 1994 were the equivalent of only 6 percent of GDP as compared to a figure close to 30 percent just three years ago. This remarkable collapse is symptomatic of the marginalization of the domestic currency operations of banks. 1.7 A third important point revealed by Table I is the very considerable importance of the NBU itself as a contributor to total bank assets and credits. A final point is that savings mobilization through the banking system has also shrunk, in the face of very high inflation. By end-1994, demand and time deposits taken together amounted to the equivalent of only 6 percent of GDP as against a figure close to 40 percent 3 back in 1992. But even more remarkable than this is the change in the composition of those deposits. Data for 1990 (not shown in the table) indicate that prior to the on-set of high inflation household deposits represented the bulk of all deposits mobilized through the banking system. Specifically, household deposits at end-1990 amounted to rubles 84.9 billion and a 75 percent share of the total. By end-1993 the corresponding figures were 3997 billion and a share for households of only 16 percent. In dollar terms this implies a drop in household deposits from the equivalent of $8.5 billion at end-1990 ($163 per capita) to only $123 million ($2.4 per capita), by end-1993 with the Savings (Oschadny) Bank share much lower. C. SOME IMPLICATIONS 1.8 The financial sector decline experienced by Ukraine and summarized in Table 1. 1 is not unusual for countries suffering from very high inflation. Figure 1.3. below graphs the changes in the main monetary aggregates in Ukraine and compares these with the corresponding trends in Russia and three lower inflation countries from Central Europe in Figure 1.2. The contrasts are striking. Figure 1.2 shows that the relatively more inflation-stable countries of Central Europe have retained high ratios of domestic debts outstanding to GDP. This in turn has meant that the, mainly state-banks, which have provided the credits in these countries retain relatively large balance-sheets and so considerable market power. By contrast in Russia, where, unmanageable budget deficits and high inflation from 1991 onwards has written down the burden of debts, the importance of the remaining domestic credits and also the banks which have provided them, has diminished very dramatically. This latter effect has been accentuated by the very low start-up costs for new banks and by the ownership Figure 1.2: Total Credit Outstanding (% of GDP) changes associated with successful mass privatization. By end-1994, the value of Czech Republic e100e Hungy eCrprise debt to banks in Russia, for example, Yowl 0 was the equivalent of less than 10 percent of so% GDP, but still over 70 percent in 40% Czechoslovakia. 2o% 0% 1.9 Figure 1.3 suggests that the experience a so or 22 es 90 in Ukraine in this regard is much closer to that Poland of Russia than to that of Central Europe. The sons r..inexorable effects of high inflation have taken s%o, hold and squeezed credit/debt levels to the very 0% 6Dio low levels now observed. oV0o% o% 2D% Source: Gerhard Pohl, Banking and Enterprise o% 0o% -Reforms in Transition Economies, World Bank, 1995 89 90 91 92 83 34 89 90 91 92 93 94 1.10 The most important consequence of Ukraine's performance in this regard is that future policies towards the main creditor banks can be quite radically different from those pursued in Czechoslovakia, Hungary and Poland. In particular, the small size of the debts outstanding to these banks in Ukraine, and also in Russia, probably makes it unnecessary to undertake complex and expensive rescue operations for these banks. A substantial downsizing has already been achieved in, by the indirect route of fiscal indiscipline, high inflation rates, and the expropriation of bank depositors. The audits now underway will reveal how capital adequacy has been impaired by this same process. This is argued more fully in Chapter 3. 4 hiru l.2. LMoWaCC,r dOuanding(*ofGDP) 1.11 In part the decline in banking intermediation has been compensated by direct financing of enterprises by other enterprises. 414 An estimate for September 1994 indicates gross enterprise 0.3 indebtedness to enterprises and other organizations at some Kbvs.. 0.3 Cod.1 t. ,5 Etscrpn. 464 trillion or more than $4 billion, including indebtedness to 0 0 15 enterprises in other countries of the FSU. This amount is .0 - c.* equivalent to 39 percent of GDP and probably to about 12-15 percent of national gross output implying an average maturity of 99"2 1993 14 these commercial credits of 1.5-2 months. As monetary policy pressures on the banks intensify, and real interest rates rise, the authorities in Ukraine will probably observe an increase in inter-enterprise debts both absolutely and relative to the size of intermediation conducted via the banks. However, this cannot be a source of inflation and nor need it damage the stronger (lender) enterprises provided that they enter the transactions without compulsion. Therefore, official actions to try to reduce these debts are inadvisable. The amounts involved are not excessively large relative to total activity and the injection of money through the banks to try to reduce them would certainly provide a boost to inflation. 1.12 Does the down-sizing of the formal financial system matter? The answer is yes to the extent that risks are enhanced by the absence of a large and stable base of deposits to finance investment, by the threat to an adequate volume of trade and working capital finance, and by the greater concentration of risks associated with dilst rather than bank-based methods of investment financing. However, in the present situation of fledgling capitalism when many new businesses are small and localized, the inefficiencies of the direct basis of financing are probably quite small. Also, in the chaotic transition period in which the economy now finds itself, there are some merits in the high level of dependence on direct financing since this makes full use of the informational advantages inherent in lending between people or organizations who know each others circumstances quite well. It is in the medium- and longer-term that the inefficiencies, risks and gaps in financing possibilities will become more evident. 1.13 The correction of the present malaise in the sector will need the recovery of the real economy and the stabilization of inflation as its fundamental progenitors. In the absence of these macroeconomic fundamentals, more specific policy interventions designed to reverse the sector's down-sizing will be futile. Two or more years of economic stability with low inflation will be needed to achieve any real increase in levels of financial intermediation. The present actions of the Government to forbid some of the uses of foreign currency in an attempt to reverse dollarization and as a precursor to the introduction later this year of a new national currency (the hyrvnia) will also fail if inflationary trends have not been eliminated. Hence, this Report endorses the tight fiscal and monetary program initiated in October 1994 as the first indispensable element of financial sector strategy. 5 CHAPTER 2 THE EMERGING STRUCTURE OF THE FINANCIAL SECTOR 2.1 Most institutions in the sector have existed for less than five years and the impending situation of positive real interest rates will undermine the assumptions under which many have operated to date. Management is inexperienced, operating conditions are difficult, and legal rules and procedures are highly uncertain. The snap-shot of the sector based on this April 1995 review is likely to change rapidly. However, in overview it shows that the sector presently comprises some 230 banks, 500 or more insurance companies, 150 or more Investment Funds and Trusts, an embryonic stock exchange, and a large number of licensed dealers and brokers and other capital-market institutions. Dominant for the moment is the banking sector. A. THE NUMBER AND SIZE OF BANKS 2.2 There are now about 230 registered banks in Ukraine most of which are relatively small. Together, they had total assets at end-1994 equivalent to about $5 billionl; total credits outstanding of $1.5 billion; total authorized capital of $70 million; and total capital including reserve funds of $322 million. ( See Table 2.1). Thus, the Ukrainian banking sector as a whole is smaller than one medium sized Western European bank: larger banks such as Barclays or Credit Lyonnais, for example, each have total assets of about $300 billion and total capital of about $10-15 billion. 2.3 The summary in Table 2.1 implies a four-way classification of banks. First, there are the two state-banks (Oschadny and Eximbank), and second, the three former state-banks which are now corporatized (Prominvest, Ukraina, and Ukrosotsbank).2 All these banks are large and continue to be unified nationally and have dominance in their specialized markets. They all retain some monopoly power and the ability to achieve wide margins part of which are dissipated in lending to loss-making enterprises for "social" reasons. In varying ways all five of these large banks remain encumbered by explicit or implicit obligations to the state which undermines their commercial roles. (see also Chapter 3). 2.4 At the other extreme there are a hundred or more banks which are not shown in Table 2.1 but which collectively account for only one or two percent of the banking sector. These banks are very small, (assets per bank of well below $1 million) and are better described as "finance houses". Full enforcement of the NBU's new minimum capital requirement of ECU 500,000 by January 1996 will cause the closure of many of these "banks". However, an alternative to this could be to re-license some of these institutions as "finance houses" with a restricted license especially in relation to the acceptance of deposits. This is argued more fully in Chapter 4. 2.5 In between these two extremes are 90-100 medium sized banks which offer a broad range of financial services, and which are often quite well capitalized: at least 20 banks had capital of $1 million or more at the end of last year. Data for 88 of these medium sized banks as compiled by the Ukrainian Bankers Association are shown in Table 2.1. They include several "pocket" banks. I 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. 2 Fuller detail on the nake-up of the Table is in Annex A. 6 Table 2.1: Overview Of Banking Sector Structure, Dec. 31st 1994. Name of Bank Branches Statutor Capital Total Public Credits Profit for 2.6 The two state-owned Capital plus Assets Deposits O/s Year banks together with the three Funds banks formerly owned by the (Number) (Kbys (Kbys (Kbvs (Kbvs (Kbvs (KbysS billion) billion) billion) billion) billion) billion) state still account for a major part of the overall banking State-Owned Banks: system. Specifically, they Sub-Total 13466 830 3387 99192 10301 14919 5310 account for 97 percent of all Share of Total 90.7% 11.5% 10.1% 18.8% 59.7% 9.4% 12.6% bank branches; 70 percent of total banking assets; 63 percent Former State-Owned of all credits outstanding; and Banks: 79 percent of all pre-tax profits Sub-Total 901 3154.5 19033 269965 2885 84885 28192 realized in 1994. Share of Total 6.1% 43.6% 56.7% 51.3% 16.7% 53.5% 66.7% 88 Larger Private Banks. 2.7 However, Table 2.1 Sub-Total 472 3255.9 11154 157189 4068 58874 8740 does hide certain emerging Share of Total 3.2% 45.0% 33.2% 29.9% 23.6% 37.1% 20.7% tendencies and trends which are important to an understanding Totals: 14839 7241 33574 526346 17254 158678 42242 of the sector's present situation in $ million 142 70 322 5053 166 1523 406 and possible future development.(See also Annex A). First, the size of banks, although still small, has been increasing since 1991. Raising minimum capital requirements 4 has slowed the creation of new banks and has ended the virtually costless entry into the sector which applied from 1991 until early in 1994. It can also be expected to lead to the emergence of larger banks through recapitalization by shareholders and through mergers. The NBU should rigorously enforce minimum capital requirements to encourage this. Second, the relative importance of Oschadny bank is radically reduced as a consequence of the collapse in household deposits described in Chapter 1. Its continued dominance of the branch network is no longer matched by a correspondingly large role for the bank in terms of conventional banking services. B. CHANGES IN MARKET SHARES 2.8 Third, and most important 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. Data for just the two periods 1993 and 1994 are in Figure 2.1. Figure 2.1 shows the growth rates of the main balance-sheet aggregates for the three former state-banks and the leading twenty private banks in each of those two years. The arrow provides an indication of the inflation rate during 1994. 3 (i) 1994 data for Eximbank were not available. Ilus 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. Details are provided in Annex A together with some informauon about the numbers of recent bank closures. 7 Figure 2.1: Increases in Balance-Sheet Components 1993-1994 18000 |1800 600, 20 TOP-20 Private Banks 0 Ukrosotsbank Capital I Ukraina Total Assets Prominvest Deposits from Public Credit Outstanding 2.9 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.5 For most indicators, the state and former state banks failed to achieve growth sufficient to match inflation whereas the leading private banks did achieve this. 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. Indeed those dominant positions have depended until very recently on the privileged role of those banks in relation to directed and subsidized credits from the government budget and the NBU; and on their dominance of the payments network (see also Annex E). If fiscal and monetary policies are significantly tightened in the context of the IMF-supported stabilization program agreed in April 1995, the first of these factors will fade away and then some natural down-sizing of these banks is to be expected. C. OWNERSHIP, CONTROL AND DISTRIBUTION 2.10 The effective ownership and control of many Ukrainian banks is unclear although almost all banks are joint stock companies. The five largest are spin-offs of the FSU specialized banks. The remaining banks were created as completely new 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. Ownership of new, small commercial banks is frequently concentrated, with some banks owned by only a few shareholders. 2.11 Initially, state-owned enterprises were the major shareholders of the older banks when they were corporatized but during 1993, the Government ordered the transfer of shares owned by state enterprises to the Ministry of Finance. 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, is owned predominantly by about 200,000 individual shareholders, most of whom are the workers in client enterprises or its own employees. 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 5 Fuller details of the banks included in the Figure and the method of calculation are given in Annex A. 8 senior managers (see the detailed discussion of this in Annex B). If this is indeed the case, then corporate governance is compromised since those same enterprises. for the moment. remain the major borrowers from the banks. 2.12 The ownership and control 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 ("pocket banks") the shareholders are also the bank's most important borrowers. Such unclear ownership is highly detrimental to the development of the banking system for several reasons, and it poses a major challenge for bank supervision (see also Chapter 7). 2.13 Information on the geographical distribution of banks is provide in Annex A. This shows that all but 79 of the 222 banks registered as of March 1995 were oblast-based. Although Kiev dominates with one-third of all head-office locations, the regional distribution of branches, even excluding Oschadny, is relatively even. D. THE INFLUENCE OF MASS PRIVATIZATION ON SECTORAL STRUCTURE 2.14 The mass privatization program begun in February 1995 will be a radical new influence on the structural composition of the financial sector. Two factors in particular are worth stressing. First, following the collapse of household deposits, the present power of the state-banks derives from their ability to retain access to the payments balances of large numbers of state-owned enterprises. Second, the debt burden of enterprises has been radically reduced by high rates of inflation: the total outstanding loans of the industrial sector as proxied by the total outstandings of Prominvest now amount to less than 3 percent of GDP. Hence, it will be a relatively easy matter for many of the new owners of enterprises, should they chose, to pay off existing debts and shift their banking business to alternative banks. This could lead to a rapid reduction in concentration in banking on a market- basis and without explicit anti-monopoly measures directed against the state banks. 2.15 The other prospective change concerns the likely increase in the importance of Investment Funds and Trusts and other capital market institutions (see Chapter 5). The limited evidence from the first privatization auctions in the spring of 1995 indicates that the stronger institutional investors could rapidly acquire a substantial ownership of the enterprises on offer. For example, the leading Fund which hopes to acquire 10 percent of the assets on offer could find itself managing industrial assets with a market valuation considerably larger than the value of total assets in even the largest of the Ukrainian banks! The key to this surprising contrast is the enormous gap between the market valuation placed upon privatization certificates (some $500-$1000 million based on prevailing prices for those already sold to institutions), and the underlying valuation of the assets being sold (many times larger even on a conservative valuation). So any institution achieving a concentrated ownership of enterprise shares in the secondary market, could become very large very quickly. This in turn argues for a rapid enhancement of the regulatory and supervisory arrangements to be applied to the Funds, Trusts and other capital market institutions. (see also Chapters 5 and 7). Banks are the only component of the financial sector presently subjected to serious regulation and supervision. It is a major conclusion of this Report that this arrangement will quickly become deficient; could expose the system to major risks; and could thereby undermine the credibility of the mass privatization process, and even the overall reform process. 9 CHAPTER 3 STRATEGIES FOR THE STATE AND FORMER STATE BANKS A. GENERAL PROBLEMS 3.1 The contrast between the three former state banks which are now private and the two remaining in state ownership is one of degree rather than absolutes. All five banks are required to discharge budgetary functions or, in other ways, to act as agents of the Government. (See Annex B for some examples). In all cases, these activities have impaired the balance-sheets of the banks either by causing high rates of non-repayment of loans or by requiring banks to lend at subsidized rates which are inconsistent with their costs of resources. This Chapter examines the problems confronting these banks and proposes a strategy to address these. Annex B provides descriptive statements about the situation in each of the banks based on the meetings held by the Review team. 3.2 The main issue for the Government in all five banks is how far it can withdraw from its various interventions and what the consequences of such a withdrawal will be for the delivery of the services, including support for enterprises, for which it has some responsibility? B. DIRECTED CREDITS AND SUPPORT TO ENTERPRISES 3.3 In the transitional situation of the economy, continued government support to some enterprises may be necessary. However, it is a good principle to maintain a clear separation between the role of the banking system in this regard and the fiscal operations of the Government. In general, subsidies to enterprises should be provided directly through fiscal transfers so as to reveal their full costs to the Government and the economy rather than be hidden in the form of subsidized credits channeled through banks. The enforcement of this "transparency principle" provides the Government with a strong incentive to understand and eliminate the real reasons why subsidies are necessary. It also helps to differentiate those cases where subsidies are needed on a permanent basis and those where they are needed only temporarily. In a transitional reforming economy, many existing subsidies are associated with situations which will disappear as reform proceeds. Examples include subsidies to compensate for controls on output prices (a particular problem in agriculture); and for the excessive burden which enterprises face for the moment in providing social services to their employees. Transparency will help the Government to identify these situations and their costs and deal with them efficiently. 3.4 The present situation in Ukraine undoubtedly involves significant levels of subsidization of enterprises through the inefficient and non-transparent device of subsidized bank credits. 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 (60 percent of that bank's total lending and more than 7 percent of GDP) and to a lesser extent Ukrosotsbank. In 1993, the monthly real interest rates on the re-finance credits were never positive-they went as low as minus 41 percent--and they were hugely attractive to enterprises even if they only held the funds as sight deposits. In 1994 when the banks used more of their own funds to lend to the targeted sectors, real interest rates were often positive. 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 10 billion as of September 1994. As of March 1995 some Kbvs. 8-10 trillion of these credits remained unpaid. The banks themselves seem unsure how much subsidy they have delivered through these various routes and how large the associated losses actually are. 3.5 Subsidies provided via directed credits are inefficient because they also impede the development of the banking system by lessening the incentive and capacity of individual banks to develop sound commercial and profitable business. However, the strong oligopolistic power of the three main banks in Ukraine enables these banks to achieve high interest margins which are sufficient to absorb substantial losses and, thereby, to absorb some "social" as well as commercial functions.1 The analysis presented in Chapter 2 suggests that this is temporary situation. While it persists it should be used to allow banks to build their capital and not be dissipated in non- commercial activities. 3.6 So what should be done? Actions by the senior management of the former state-banks themselves can provide part of the solution. These managers who seem to be commercially motivated, need to do their utmost to resist pressures to provide credit on a subsidized basis and for social/political rather than commercial reasons. However, this is easier said than done. The political influence of the debtor enterprises of the banks to obtain increased loans to avert unemployment is undoubtedly very strong. Prominvest for example services the needs of almost all the large state-owned enterprises in the industrial and energy sectors and its managers need to face daily political pressures from oblast administrations in all major regional centers of the country as well as national political pressures. To the extent that these pressures cannot be resisted the result is bad for the economy (an inefficient use of scarce savings) and also for the banks concerned (the further accumulation of bad loans and impairment of balance-sheets). 3.7 So a second important part of the solution is to make as transparent as possible the consequences of continued non-commercial lending on the financial performance of the banks. To this end, it is recommended that the banks be subject to regular annual audits on the basis of LAS including in particular the loan classification arrangements of the international system.2 The international audits now underway will begin this process by providing a much clearer measure of the degree of impairment of balance-sheet values which has already taken place as a result of existing lending practices.3 3.8 Only the audits themselves can reveal how large are the loan-losses associated with previous lending decisions. However, Table 3.1 shows that total credits are presently some 4.5 times the magnitude of total capital and that it would require unrecoverable losses of about Kbvs 19 trillion to eliminate fully the capital of the banks concerned. This assumes that all the "funds" included in the total of Kbvs. 19 trillion are true capital. This is not the case under the Chart of Accounts system which means that the losses necessary to cause the insolvency of the three banks would be significantly less in practice.4 In 1994. for example, Ukraina, and Ukrosotsbank made apparent pre-tax profits of Kbvs. 17,613 billion, and Kbvs. 10.578 billion respectively on total capitalizations of Kbvs 7,510 billion and Kbvs 4.155 billion respectively. 2 A new regulation of the NBU issued on January 16th 1995 went some way to meeting this requirement by asking banks to provide against loan-losses using a five-way classification of loans namely Standard. Satisfactory. Marginal, Doubtful and Irretrievable. 3 Audits by international firms are already underway or contracted in four of the five banks and the fifth bank will begin with this rocess shortly. The audits were required as a condition of the Bank's Rehabilitation Loan The banks' management find it difficult to estimate the amounts of their unrecoverable loans but collectively indicate figures in the range Kbvs 5-10 trillion. Thus in Prominvest, for example, the end-1994 loans outstanding included Kbvs. 3.000 million of directed loans for mihtary conversion but up t6 another Kbvs 7,000 billion which were recognized by the staff of that bank as non- commercial. I I Table 3.1: Capital and Loans Outstanding in the Major Lending Banks 3 Although losses sufficient Dec. 1994 (Kbvs billion) to create insolvency in any one of Credit Shareholders Total Capital Credit/Total these three may be thought Outstanding Capital plus Funds Capital (%) unlikely, it is certain that the audits Prominvest 35123 2030 7367 476 will reveal a substantial down- Ukraina 30391 875 7510 405 w Ukrostotsbank 19371 250 4156 466 grading of several trillion Karbovanets in the capitalizations Totals 84885 3155 19033 446 of all three banks relative to what (in $ million) 816 30 183 is now reported by them. This outcome should have the desirable result of stimulating the banks to achieve higher levels of capitalization to meet NBU standards of capital adequacy and should thereby strengthen the resolve of the banks to resist pressures to lend further to enterprises or for purposes where repayment is unlikely. In this way it will be a critical part of the process of enforcing the hard- budget constraint on enterprises. 3.10 The further consequences of the improved information from the audits will include efforts on the part of the banks to maintain or even widen their margins in order to build-up capital. This is likely to be possible in the near-term future in the absence of banks with competitive positions sufficiently strong to rival the former state-banks. Second, the more commercial attitudes of the banks and the higher margins they will seek are likely to shift a larger part of their business to the more profitable of their client enterprises. Third, there will be more pressure on loss-making enterprises through their loss of access to credits. The impact of this is difficult to predict in the absence of a better understanding than we presently have about the distribution of enterprise performance.5 However, it is evident that there will be a small core of loss-making enterprises where, for political and social reasons, there will be a need to provide temporary subsidies through the budget to replace those formerly provided through the banks. It is an important counterpart of the recommendations made regarding the banks that these enterprises are identified and are either closed or granted an adequate level of support through the government budget. This in turn implies that the Government will need to build the capacity within the Ministry of Finance to deliver such support. In the past, the banks themselves have discharged this function. 3.11 The third element of the solution is already partly in force through the conditionality of existing IMF and World Bank loans to Ukraine. Specifically, the Government has committed itself to end directed credits through the banks and needs to be categorical about this. 6 This high-level commitment is important but does not deal with the widespread and decentralized The Bank is presently conducting enterprise surveys in Ukraine in an attempt to throw more light on this and other aspects of enterprise performance Similar surveys in Russia and elsewhere are beginning to suggest that the problem of enterprise losses may be rather less severe than was at first thought. Once a sufficiently depreciated real exchange rate has been set, the majority of enterprises seem able to service existing and prospective loans to banks 6 The Government has accepted the principle that subsidies where possible should be channeled via the budget rather than through banks. However, the practice/reality in this regard is difficult to pin down and the evidence obtained from different meetings conducted by the mission is contradictory 12 political pressures which the banks still face. For this something else. other than the audits and the pressures on bank capital may be needed. One possibility is to directly restrict the rights of the banks in question to lend thereby recognizing explicitly that the state banks will "waste" a certain portion of available savings entrusted to them.7 C. ISSUES FACING THE STATE - OWNED BANKS 3.12 The two banks which still remain under full government ownership namely Oschadny and Ukreximbank, have not been affected so severely by the problem of directed credits but they do face other difficulties. Oschadny Bank is in the difficult position that it retains most of the very large branch network inherited from the Sberbank (26 regional head offices, 646 main branches and 12,777 branch offices) but now mobilizes only a fraction of the level of deposits achieved in 1990 and accounts for less than 8 percent of total banking sector assets. The bank has responded to this collapse of its core business by attempting to widen its activities to include nearly all retail banking services for both companies and individuals and on a unified nationwide basis.8 This decision has been endorsed by large-scale investment in the electronic technologies 9 needed for the processing of mass payments and by the bank's commitment to run its operations on sound business principles. To the extent that it remains profitable it has succeeded in this regard although, as with other banks, a proper accounting loan losses is likely to undermine apparent profitability. 3.13 This behavior indicates a bank which is trying to move into the mainstream of banking and, at the same time, preparing itself for eventual privatization. However, several factors argue against this scenario. Under the 1991 Banking Law, Oschadny remains the only bank for which the Government provides a full guarantee of deposits. Partly for this reason, the public perceive the bank quite differently from the other banks and, in particular, still regard it as an adjunct of government which carries out important services on its behalf. Low levels of salaries and apparent over-manning (60,000 staff or half of all bank staff employed in Ukraine) support this impression. The Government does little to discourage this perception. Although it claims not to interfere with the bank on a day-to-day basis, the Government does regards it as a delivery instrument for public services which otherwise it would have to carry out by itself. The latest example is the major and high cost role which the bank is asked to play in the processes of mass privatization. Finally, the lending activities of the bank differ from those of the main-stream banks in that it relies very heavily on loans through the inter-bank market and on-lending through the NBU.10 The reasons are clear. Oschadny has not traditionally had a commercial bank lending role and any rapid move in this direction would expose the serious limitations of its branch management. 3.14 The first priority in this situation is for the Government to clarify which of several possible strategies, they expect the bank to follow. It is confusing to leave this question in This might be done, for example. either (i) by imposing quantitative credit ceilings on the further expansion of their domestic currency loans. The banks could still lend to non-viable clients but only at the cost of lower profitability; or (it) by establishing negative lists of enterprises to which those banks should not be allowed to make further loans. These lists could be established on the basis of the ongoing audits. Once established the lists would enforce directly the earlier recommendation that all the burden of supporting non-viable enterprises and their employees would fall directly on the government's budget. Either of these options will result in a somewhat more rapid down-sizing of the banks than will occur otherwise but should also help to produce financially more robust institutions. Whether this third and more interventionist element of the solution is really needed is a matter of political tudgment. Earlier pressures from some regional branches to secede seem to have been successfully fought off. ($6 million thus far to link 340 main branches with a further $6 million needed to limk-in the remaining 300). These investments in rum are complemented by early stage experiments with smart cards and pomt of sale software developments. 10 As at Ist March 1995. for example, of total loans outstandmg of Kbvs. 16.7 trillion. Kbvs. 7.7 trllion were in the inter-bank market, Kbvs. 5.5 trillion were to the NBU, and only Kbvs 3.5 trillion were normal commercial bank loans. 13 abeyance. Detailed ideas are likely to emerge from the twinning contract which the bank has recently agreed with the German Savings Bank Foundation. Two main strategies and their implications for policy are introduced here and discussed more fully in Annex 2. 3.15 The first, is for the bank to be approved explicitly for the course of commercialization and diversification which its senior management has determined. This would mean 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 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. The only alternative would be for the Government itself to bring its capitalization up to an adequate level: a solution which seems implausible at the present time because of its substantial fiscal consequences. Under this scenario, it should also lose its special advantages as regards deposit insurance (see also Chapter 7). 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. 3.16 The alternative is for the bank to be confirmed as an explicit arm of 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. Increasingly the on-lending could be through government securities to provide a retail outlet for that market as it develops. This option would also enable the Government to continue to rely on the bank as a source of agency services. 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: profits left after making any necessary investments, could be consolidated with the government budget balance, and any losses could be financed from the budget. This option would also avoid the risks associated with the bank's premature expansion of credit activities. For the moment at least, it appears to be the more realistic of the two alternatives. D. SHOULD THE BANKS BE RE-CAPITALIZED ? 3.17 What are the possible approaches to dealing with the accumulated stock of bad loans in the state and former state-owned banks? In some other countries such as the Czech Republic, Hungary, Poland, Slovenia and elsewhere a part of the solution to similar problems has involved a government-financed re-capitalization of the banks. However, this has had large budgetary consequences and has often failed to produce healthy banks. Recapitalization is most readily justified where the survival of a bank is in serious doubt and where the injection of new funds by government appears to be an easier or cheaper option than bank liquidation. However, its effectiveness is dependent on substantial changes in the incentive structures in both enterprises and banks which caused the bank distress in the first place. Experience elsewhere indicates that achieving this is an extremely difficult matter in practice. See box. 14 Box 3.2. Recapitalization is no Guarantee of Improved Performance 3.18 In the case of The data in the Table are all calculated relative to total assets here and are derived from banks whose Ukraine, the size of the accounts have been subject to international audit according to 1AS standards. It compares the situation 0 total loans of the banks the Russian banks where is quite small relative to no re-capitalization has occurred with that of the banks in three Central European economies all of which have made use of bank recapitalization. GDP and so too are the bad loans. Thus, re- Russia Central Europe capitalization, if it were Moscow Other Country Country Country chosen as the best Banks 1 2 3 option, would not be (average) excessively expensive in Operating Income 9.9 22.1 10.1 6.0 5.9 fiscal terms. However, less Expenses -4.4 -8.0 -3.5 -5.7 -1.6 the recommendation Net Operating Income 5.5 14.1 6.6 0.3 4.3 of this report is that less Loan Loss Provisions -4.5 -7.4 0.5 -6.4 -2.2 such a course of action Income before Tax 1.0 6.7 7.1 -6.1 2.1 should be avoided if less Income Tax -1.7 -5.1 -2.4 -0.1 -1.0 possible since it could Net Income after Tax -0.7 1.6 4.7 -6.2 1.1 make more difficult the change in the incentive structures in the banks which our earlier recommendations are designed to support. In particular, it would work against the earlier proposal that it is the target levels of audited capital (generated by the banks themselves) that should be used as the main incentive device to encourage changes in bank behavior. By contrast direct recapitalization financed by the Government is normally handled by "carving-out" the bad loans of the banks and replacing these with government bonds. However, this increases direct government involvement in the banks without the Government necessarily having the management capacity to exercise its influence in an effective manner. Worse still if the conditions for granting the additional capital are not well defined and enforced, then the short-term restoration of solvency may be followed by the later regression of the bank into the same state as before. Thus, some countries and notably Hungary have found that they have needed to repeat the recapitalization exercise for the same banks on three or even four occasions. The available evidence also suggests that the countries such as the Czech Republic which have been more robust in eliminating fiscal deficits and ending directed credits have been less subject to such problems because of the effects of such approaches on the hard-budget constraint.11 3.19 The Government should persevere with the few specific ad hoc measures which it has already developed to eliminate some of the bad loans - a loan for property swap in the case of Prominvest for example. But it should leave the remaining bad loans in the banks themselves and not attempt to carve these out of the balance-sheet. Instead, it should give the banks greater access to standard legal procedures to collect on those loans which remain unpaid. This course of action entails certain risks in a transitional environment where distinguishing the long-run profitable enterprises from the others is difficult. In particular, an over-aggressive pursuit of the liquidation option by the banks could result in the closure of some enterprises that ought to survive. However the short-term risks of this type of error are minor. To repeat, if at all possible policy should concentrate on the avoidance of future accumulations of bad loans using approaches to change bank behavior such as those indicated above. 1l This argument reies on the assessment that fiscal deficits and monetary errussions are the ultimate sources of the funds to sustain soft-budgets. Inter enterpnse lending is not a substitute in this respect 15 CHAPTER 4 STRATEGIES FOR THE NEWER PRIVATE BANKS 4.1 The new private banks have been gaining market share at the expense of the state and former state-owned banks and this trend, as described in Chapter 2 may seem unstoppable. However. these newer banks have many problems and many are high risk. They have very limited capital, their branch networks are generally small, they do not have the tens of thousands of established clients of the former state banks, they are limited in the delivery of payments services and, partly for this reason they have higher-cost and less reliable resources to on-lend. The main advantages they enjoy are their relative freedom from political intervention, and the absence of a tradition of excessive staffing and heavy bureaucracy. They ought to be more responsive to changing opportunities. The outcome of the competition between these newer banks and the former state-owned banks will depend on the ability of the newer banks to survive the tremendous pressures of the transitional adjustment period which is now underway in spite of their limited size and capital. A. PATTERNS OF RESOURCING AND MARGINS 4.2 Second only to the problem of limited capital, a major difficulty for many of the newer banks has been the funding sources which they have relied on in the absence of a larger pool of aggregate saving and a larger base of deposits (See Annex A). The limited local currency credit which is being intermediated through the banking system at present is resourced predominantly from the "passive" payments balances of large enterprise clients. These payments balances are available predominantly to the three former state-banks because of their involvement in directed credit. Specifically, about 70 percent of all enterprise payments transactions (some 2 million transactions per day) are undertaken by Prominvest, Ukraina, and Ukrosotsbank, and these banks are investing heavily in new technologies to preserve this status quo (see also Annex E). This means that these three banks command access to very large absolute amounts of resources. The resourcing situation as of end- December 1994 for these three banks and four of the larger and more successful of the newer banks is summarized in Table 4.1. 4.3 All three of the Table4.1 Fatternsof Bank Resourcng December19944 (% fttal Hiabilties) former state-banks are able to rely on substantial Forer tat-BaksNevir: PrtiateBanks client payment balances Ukraine Preminvet Ukrose Bank1 Bank 2 Bank 3 Bank 4 (presently between 24 Balancires mCIlients 23.8 47.J 44.4 20.0 55,1 39 L and 47 percent of their InttrBank Borrowing 4.1 L49 02 1.9 20.7 18.4 3.1. total liabilities) and they _also have a very low Total Liabiities (hbis biR.) 117501 95018 57446 21889 19059 4071: 994 dependence on the inter- bank market. The two larger of the newer banks (Banks I and 2) which both have significant branch networks also achieve a significant proportion of their funds from client balances. However, these banks have a very much greater dependence on the inter-bank market than do the former state-banks. Banks 3 and 4 which are much smaller and have only limited branch networks have a much lower dependence on client payment balances. Bank 3 which is a broad-based bank relies very heavily on the inter-bank market. Apart from their small size and limited capital, the nsks come from several sources. First, the management of the new banks are quite inexperienced and management information and control systems are necessarily embryonic. Several of the banks have sought to develop large branch networks faster than the information and control system which are necessary to deal effectively with the increased delegation of credit and other authority to branch managers. In other cases, the autocratic tendencies of powerful shareholder-managers seems to have been a factor slowing down the establishment of sound management arrangements. 16 Bank 4 which is closer to being a pocket bank achieves significant deposit (not payment) balances from depositors. 4.4 Recent experiences have clearly shown that there is high risk in being heavily lent in the inter-bank market. The recent failure of just one quite small bank - the Alex bank with assets of only about $10 million- proved sufficient in early 1995 to create a major banking crisis involving over fifty other banks which had lent to it. Being heavily borrowed in the inter-bank market is also problematic at the present time of economic stabilization and declining inflation. In the high inflation environment of the recent past, the majority of the new banks have enjoyed high interest margins and have been able to operate also with high administrative cost ratios. In general this is not because of monopoly power (the partial explanation of high margins in the state-banks) but because of the inertia and money-illusion associated with a period of lax monetary policy. The inflation slow-down caused by the successful implementation of the IMF program will lower these very high gross interest rate margins in both real and nominal terms. This is because of the combined effect of slackening credit demand and an even tighter squeeze on the incomes from which deposits are sourced. In the longer term of hopefully low inflation, margins will remain lower than in the past. 4.5 The review team was unable to obtain useful data on the current level of bank margins for the Ukrainian banks.2 However, the comparison in Table 4.2 below provides some indication of the type of adjustment which the newer banks on average need to make. This is based on the assumption that the Ukrainian banks currently have margins and costs close to those of Russian and Central European banks but will be pressured over time to achieve configurations closer to those of a typical mature Western Bank (either a "broader" retail/wholesale bank as in column 1 or a "narrower" specialized bank such as a British building society as in column 2). Table 4.2: Margins and Cost Structures in the Medium Term (all data expressed as % of total assets) 4.6 The banks which survive "Typical" Western Bank Russia Central Europe medium-term will need Broader Narrower Moscow Other Country I Country 2 to accept radical cuts Business Business (1) (2) (3) (4) (5) (6) in their gross operating income: Operating Income 5.0 2.5 9.9 22.1 10.1 6 pssil byas m a of which Interest Margin 3.0 2-3 n na na nap points less Expenses -3.0 -1.0 -4.4 -8 -3.5 -5.7 5 percentage points Net Operating Income 2.0 1.5 5.5 14.1 6.6 03relative to total assets. less Loan Loss Provisions -1.0 . 4.s -7.4 0.s -6.4 They will also need to Income before Tax 1.0 1.0 1 6.7 7.1 -6.1 cut operating expenses less Income Tax -0-3 -03 -1.7 -5.1 -2.4 -0.1 by I or 2 percentage Net Income after Tax 0.7 0.7 -0.7 1.6 4.7 -6.2 pOints relative to assets. These two adjustments combined will result in a net operating income possibly as low as one third of the present levels. This will leave room for loan-loss provisions of only about 1 percent of assets. With a sensible taxation policy for banks which taxes net operating income at, say, 30 percent this will ensure that the shareholders return is of the order of 0.7 percent of total assets or about 8.5 percent of capital (assuming a leverage of assets relative to capital of 12 times). 2 It is noted that the Ukrainian banks are very fast to put out balance-sheet data but are extremely reticent to publish corresponding income statements This is because these are thought likely to reveal confidential information to competitors or because they are not regarded as very useful. Neither of these judgments is justified and the greater publication of comprehensive income statements ought to be an early objective of policy. See also Annex C 17 4.7 It is noted that the hypothetical surviving Ukrainian bank will be as almost as profitable after tax as the existing banks in Russia and Central Europe in spite of very much lower margins. It is noted too that simple banks offering a narrow range of intermediation services can be as profitable as "broader" banks. This can be and is achieved in spite of extremely low interest margins by virtue of (a) very low operating expenses and (b) very limited loan-losses. These ideas and the choices available to banks are presented more generally in Box 4.1. BOX 4.1. THE PYRAMID OF RATIOS For a typical Western bank in a low inflation invironment, t1e PROFITiASSET rato wou ld be.about 1% (2% would be outstanding). This is also a rough indicator-of the size of 'MARGIN". The ratio of ASSETS/CAPITAL (capital plus.reserves but excluding loan provisions) might be 20 times. (i.e. capital assets S%) Th is asD a TDugh indicator of size of 'TURNOVER- or !LEVERAGE" So a typicaliratio of PROFIT/CAPITALwould be about 20 percent before . 1% x 20 20 % i.e., the product of MARGIN and TURNOVER). Some banks in Ukraine have recently been aggressively seeking and achieving very high assets growth for given capital (i.e figh TURNOVER). 1owever, thi does not necessriy ichieve a'higher ratio of PROFTTSCAPITAL because the risks might be :higher restilting in very high bad loan ratios and a low MARGIN; (Remember that it is the product of TURNOVER and MARGIN which determines the ultimate ratio of PROFITS/CAPITAL). The main message i$ that banks should oisider very carefully how to use sarce CAPITAL to produce any given increase in ASSETS. Different uses of the same caipital -although they May result in sharply different rates of asset growth also need to.be assessd relative 16 the MARGINS (PROFITS/ASSETS as defined above) resuing from those different strategies. E.g. some of the fastest growing Ukrainian banks:of recent yearsin terms of,ASSETS now have the biggest problems because of the poor quality som6 df those assets resulting in low or negative MARGINS and so the danger of ebmination of capital, 4.8 There are several reasons why many of the existing Ukrainian banks will not be able to meet the challenges needed to survive in the medium-term. It will be difficult for some to tighten down their high administrative cost ratio sufficiently to offset the pressures on gross margins in both the short and the medium term and so net interest rate margins will also fall. At the same time, the bad debt charges which the banks will need to make may increase in the short term as stabilization bites, especially if sounder accounting practices are introduced. This will lead to liquidity difficulties which banks without access to large deposit balances will need to accommodate through the relatively expensive inter-bank channels. The banks which will survive this short-term squeeze will be those able to adjust to the pressures on margins by achieving operating cost ratios closer to Western norms, at the same time as winning access to a resourcing base which is more secure and lower cost than the present dependence on the inter-bank market. However, that competition for the limited base of resources will imply expensive investments in the payments and other technologies needed to compete with the large former state-banks.3 This will require high levels of capitalization which many of the newer banks do not have. Even the more highly capitalized banks which are unsuccessful in living with reduced margins will not survive longer term: high capital will merely buy them a little more time. 3 To put this in perspective, Prominvest Bank in the recent past has spent some S 3 million on enhancements to its payments systems with a further S 3 million planned for the future The total of S 6 million exceeds the capital of all but a handful of the newer banks 18 B. THE ROLE OF PUBLIC POLICY 4.9 The role of public policy in dealing with the present crisis in the newer banks and the progressive evolution of that situation during the next few years is multi-faceted. First the recent moderation of the tax burden on the banks needs to be sustained. It is pointless to put banks under increasing pressure through very high tax rates (as in 1994) and then to use scarce public funds to bail out those which slip towards insolvency. Table 4.2 shows that the tax rate on net operating income (after deducting loan-loss provisions) on the Moscow banks was 170 percent in 1993. This made banks which otherwise were performing quite soundly into loss-makers. A related implication is that tax rules have to be designed with some care to cater to the realities and the peculiarities of the banking industry. In particular, loan-losses are a reality in that industry and the tax regime needs to be designed in such a way as to allow banks to offset legitimate loan-loss provisions against their tax liability. Although the national rate of profit's tax at 30 percent is realistic, the tax base is still computed in a manner that leaves the effective tax rate at more than 100 percent in some cases. In the seriously decapitalized banking situation now prevailing, a tax holiday on all reinvested earnings of banks should be considered for an extended period. 4.10 Second, the NBU needs to maintain the highest possible level of information about the evolving pressures on the banks and to respond to temporary and correctable short-falls of liquidity in individual banks. But a fine line needs to be drawn. Many of the non-viable banks established after 1991 will close and should not be sustained through liquidity injections which can only aggravate inflation. The authorities should not stand in the way of failures of very small and weakly capitalized banks, particularly where the main (enterprise) depositors of the bank are the same people as the shareholders. These bank failures will not impose serious costs on the system since household deposits are already very small; the danger of a "run" on banks is slight; and the signals to surviving banks are likely to be in the right direction. Additionally, since many small banks which have not failed will be unable to meet the enlarged capital requirements which come into force in January 1996, the NBU should consider a restricted banking license for those not wishing to accept household deposits or participate in the inter-bank market. This will avoid the weakening of public confidence in banks which might be associated with large numbers of simultaneous bank closures. 4.11 Larger banks pose more serious problems because the downstream effects of their failure (e.g., default on obligations in the inter-bank markets) may be too large to ignore. Here the NBU needs to provide support but in doing so should differentiate cases of bank illiquidity from those of insolvency. The substantial practical task to doing something so will be simplified by the accounting reforms which are proposed below. The NBU should not provide unconditional liquidity injections to any banks which are insolvent, however large and influential they may be. Indeed insolvent banks should be provided help if at all only on strict conditions involving major surgery of, for example, branch networks; changes in their senior management teams; and losses to their shareholders. More generally, the conditions for any bail-out of insolvent banks should be tough enough to signal to other banks that reckless or incompetent management will incur high costs and penalties. Recent NBU interventions to help particular banks have communicated mixed signals in this regard and more systematic procedures are needed to avoid similar confusions in the future. 4.12 To give effect to its important public policy role in this regard, the NBU's analytical capacities need strengthening to ensure adequate advance warning of impending difficulties. So far, handicapped as it is by limited resources and experience, the NBU has been able only to react to the problems as they have appeared. The mission recommends that, in addition to the ongoing 19 strengthening of its work on monitoring balance-sheet ratios, asset quality etc., the NBU should also begin to develop a system of review of the income statements of individual banks. This in turn might be associated with a number of target standards for different types of banking activity (for margins. operational expenses, loan losses), based on Western experiences, which could help it to differentiate between banks in terms of operating efficiency. costs etc. The analytical structure sketched out in the Box above and in Table 4.2 provides the bare-bones of such an approach. In time, and in conjunction with the established balance-sheet data, this could provide a good basis for judging the underlying quality of individual banks. This analytical work in turn will be facilitated by the reform of accounting reports recommended later (Ch. 7). 4.13 However, this analytical and more proactive approach will take time to develop: In the shorter term, a viable alternative to achieve higher quality bank performance, in both state and private banks, is the extended use of audits by international firms coupled with explicit institutional-building programs based on the results of these audits. Some ten or more of the newer banks have already commissioned such audits and institutional programs in order to qualify for access to international credit lines such as that available from the EBRD and prospectively from the World Bank. Their success in achieving such a qualification can act as an objective external rating of the bank which the NBU itself can use in the interim until such time as its own analytical capacities can take over a similar role. The idea of encouraging a limited number of banks to be recognized as "international standards banks" is a good one and should be adopted officially. This concept and its institutionalization in Ukraine should be studied further. Once the NBU's capacities and experience have developed, its own judgments can begin to supersede the ratings implicitly provided in the interim by international audit firms and the international suppliers of credit lines including the World Bank. It follows that the NBU should be active in the monitoring of the results of the international audits to ensure that these can be fully reflected in the development of its own assessments. 4.14 Finally, there is a strong argument that there are too many banks in Ukraine and that the numbers need to be pruned. One way to do this is to merely wait until competitive pressures, supported by the concept of the "international standards bank" take their toll and cause some banks to fail. However, this could be an expensive solution both in terms of the public confidence in banking generally and in terms of the time the NBU needs to commit to dealing with the processes of failure. So an alternative would be to provide banks with the possibility of operating on a more modest scale and with a limited license. This would recognize the point that some banks can still be profitable on the basis of narrow scope of operations - not all banks need a universal license. It also recognizes the reality that many banks are "pocket" banks or insider organizations. Such organizations are not necessarily to be discouraged in the transitional economy and have very respectable antecedents. Hence, it is recommended that consideration be given to establishing a new and more restricted class of banking license for those banks which should not be allowed to offer a broad range of banking services because of inadequate capital and security for depositors funds. This restricted license would be made available, for example, to those existing banks established by one or more state-enterprises in a sector for the specific and narrow purposes of financing the development of that sector.4 Now is a good time to introduce this reform while the levels of deposit-taking from the public are generally very low and few banks are really dependent-on this type of resourcing. 4 Shareholders, depositors and borrowers are essentially drawn from the same small group of enterprises in a cozy inside-operation that could not possibly meet the prudential requirements for a general license. 20 CHAPTER 5 CAPITAL MARKET DEVELOPMENTS A. THE MAIN OBJECTIVES 5.1 The development of capital markets in the near future will be motivated above all by the mass privatization program (MPP) and the transfer of the shares of 8000 state companies to the control of millions of ordinary Ukrainians. The scale of the MPP and its adopted design of open-stock companies will put an enormous strain on capital markets which presently are in only a rudimentary state of development. It will create many new public companies with shares owned by unsophisticated investors. The volumes of tradeable shares will be large and the initial distribution of ownership will be broader than is necessary to force the restructuring of the privatized companies. Constraints on the economy's reform process will therefore arise if capital-market weaknesses lead to substantial limitations of the trading of these shares. It is essential that the development of active secondary capital markets after MPP be a specific priority of policy. 5.2 The new markets need to be designed so as to: * offer "customer friendly" divestiture of shares by individuals; * facilitate consolidation of ownership: * allow for easy adjustment of portfolios owned by strategic and institutional investors; * prevent fraudulent behavior ; and * raise capital for privatized and/or private companies. B. EXISTING PRODUCTS, INVESTORS AND INTERMEDIARIES 5.3 Products. A growing number of tradeable financial products not related to the MPP already exists. By the end of 1994 the Ministry of Finance had registered (approved) about 2500 issues of shares with a total book value of Kbvs. 302 trillion. About 80 per cent of these shares result from privatization through lease buy-outs. About 15 percent are shares of private commercial banks and these account for about 80 percent of the overall volume of secondary trading. Most of these shares are privately placed and traded, with the shares of a few trade and industrial companies, such as Ukrrechflot, Krymskie Vina, Elektron, being most active.1 Shares of companies privatized through lease buy-outs are presently not actively traded but constitute a potentially broad base for a secondary market. Of 2000 good quality firms privatized in this way, about 50% will soon have to transform into open joint-stock companies and search for external sources of financing. 5.4 The attractiveness of shares offered under the MPP cannot be assessed until more companies are auctioned. However, there is a rapidly emerging market for privatization certificates (vouchers). Although these are registered and supposedly non-tradable there is already a de facto secondary market. This is arranged through investment intermediaries which buy the future rights of the certificate holders to shares of privatized companies through a Trust Company and an affiliated Investment Fund. One of the biggest financial conglomerates KINTO reportedly purchased 200,000 privatization certificates (10 percent of those so far issued) at Kbvs. 1,050,000 each (less than $10). These purchase arrangements are legal but advertised cautiously since institutions such as KINTO acknowledge a-clear political risk related to possible delays in privatization. Trading of Russian securities declined from 23 shares to II in late 1994 mostly due to the MMM scandal. 21 5.5 In addition to enterprise securities, the Government plans to cover about 5 per cent of the planned 1995 budget deficit of Kbvs. 331 trillion by issuing various debt instruments. The NBU began to sell Treasury Bills (TBs) on March 10 and plans to hold regular auctions in the future.2 Although the initial TB interest rate was much below the expected inflation rate, banks bought the paper because (i) some have excess liquidity which they are nervous about placing in the inter-bank market: and (ii) a government debt instrument is a novelty. These incentives ar& transitional and the following auctions will not succeed unless adequate returns are offered3. The major obstacle is the absence of a secondary market and, therefore, low liquidity of bank resources committed to the government debt instruments. The authorities also need to recognize that the mutual crowding-out of issues will happen once the MPP and the financing of the budget deficit through debt securities both gain momentum. So competitive market rates on government paper and/or a much lower deficit will be required. 5.6 Investors and Intermediaries: The Ukrainian market is dominated by institutional investors. There are 265 Investment funds, Investment companies and Trust funds licensed by the State Property Fund (SPF) to invest in privatization certificates. The Ministry of Finance (MOF) has also licensed more than 500 capital market intermediaries investing in non-voucher instruments and delivering brokerage and consulting services. Banks also invest in securities and provide capital market services based on their universal banking licenses. However, the actual number of intermediaries is smaller than these numbers might suggest as some of them have acquired licenses both from the SPF and the MOF; and others are not yet operational. It is noted that life insurance and pension funds are not yet the significant investors in the markets that they are in many Western economies (see Chapter 6). 5.7 Already there is a high level of concentration in investment control with about 30-40 Funds and Trusts controlling about 80% of privatization certificates collected/bought from citizens. The biggest and most active funds and trusts are parts of financial conglomerates, typically including: a bank, an insurance company, a pension fund, a trust company, and an investment fund. Further consolidation of funds into such conglomerates may be expected since with low or zero profit levels in the next two to three years, only about 10 percent of existing investment funds and trusts are expected to survive. Attempts to limit concentration by the rule that any single fund could not hold more than 5 % of the shares of a single enterprise have been avoided by fund managers establishing a family of funds. An April 1995 Presidential decree sensibly increased the limit to 25%. 5.8 The capital markets are intermediated by dual capacity broker/dealers licensed by the Ministry of Finance and mainly located in Kiev. The rules of licensing are liberal since although brokers have to pass an examination, there is no capital requirement. More than 500 broker/dealer licenses have been granted but only approximately 10% of brokers are actively involved in trading securities. An additional 20% provide privatization consulting. Commercial banks operate in a broker/dealer capacity on the basis of their general universal banking licenses issued by the NBU.4 Banks are allowed to buy non-governmental securities for their own account up to a limit of 10% of their own capital. 2 Bills maturing on December 30, 1995 were sold for Kbv. 5500 billion through a closed auction to eligible commercial banks with an annual interest rate was 140%. 3 At the first auction the NBU cut off offers because it was concerned that interest rates might go above 140%. It is difficult to predict what should be a return guaranteeing expected demand durng the following auctions-it should be higher than the ex post inflation rate, as under present conditions expectations are rather high. 4 At present 90 per cent of banks have obtained an additional brokerage license from the MoF 22 Box 5.1. How do Investment Trusts and Funds Differo 5.9 The motivation for banks to move into stock- market activities is diversification and the Trust companies conclude individual contracts betwee strengthening of client relations. Most of the trusts and individual investors (trustees); are obliged to banks do not separate their brokerage activities maintan individual accounts -for separate portfolios of individual investors, and need to register all operations.-on from other activities neither legally nor in terms portfolios. By cantrast Investnmen-Funds and Investment of management and cost accounting. Securities Companies p2al investors capital in:exchange for shares departments are financially not self-supporting for issued to founders and participation units issued to all oth the time being and are cross-subsidized by other investors. Invastment Atinds'and-compameis need to paY tetm en n r rs caerte inomet bas and he ieneedof to vale banking activities. There is weak understanding Rpiorate.incoie-,tax hased an the net: In eake of tlle'vOlue oftheiponfolios.Additionally, investor ar ired6 of the "Chinese Wall" concept. Floating and pay personal income tax on cipital gains: ai arrangement dealing in their own securities is one of the main wchich implies. dounble: taxaiion. By contrast, rldS activities of investment banking divisions. In companies pay a corporate income tax based on their grass vie of th e tye ft aita in m n come (commissons view the fragity of the capital in many therefore, a tax on capital gainis paid only o banks (see Chapter 4) these arrangements are However, the costs to Srare Trust Funds are higher excessively risky. (minagement 46d accounting of individual portfolios) as too aie the isks to investori,(there is :o risk pooling). Unltil 5.10 What are main issues to be resolved? recently, trust companies have been a more popular vehidCe for epilective . investment than ivestment funds a The first issue concerns the prospectively Compales. However, the (iverment has egun 6o dominant role of the larger Investment Funds. discourage. Trust Comwnies as being More exposed to This has some advantages namely risk fraud and inanijpulation. .: . .diversification, and better control of enterprise managers, but also several dangers. In particular, they will tend to trade large blocks of shares and, thereby, create problems since the trading arrangements we envisage are likely to find it difficult to handle large blocks of shares. Another serious problem concerns the governance of the funds themselves. Funds are likely to be "owned" by thousands of small investors who may have little influence in practice over the fund managers. Enhanced regulation by the government to help protect the interests of these small investors is needed (see Chapter 7), but is an enormously difficult matter to balance against the pre-eminent need to allow the fund managers to exercise effective influence over enterprises. 5.11 A third issue concerns the possibility that large groups led by commercial banks will emerge as major influences on enterprise finance. The problem here is that the banks or their subsidiaries will provide both capital and managerial expertise but are likely to insist on monitoring and probably controlling the management of enterprises in order to protect their investment in an environment of limited public disclosure of relevant company information. This will involve bank representation on the boards of directors, and their exercise of the voting rights of small investors for whom they provide brokerage and trust services. This enhanced role of banks is certainly controversial. Although the trend to universal banking in Ukraine is unlikely to be reversed, banks may have better access to information and be able to react more quickly to managerial shortcomings but, they are also likely to be more conservative and less willing to finance new entrepreneurial firms. There are also potential risks of conflicts of interest between the role of banks as lenders to and owners of an enterprise. 5.12 To mitigate these risks, the existing prudential supervision of banks should be tightened to recognize their increasing involvement in capital markets.(See also Chapter 7). In particular, it is recommended that the NBU require the banks to account for all their investments in capital- market intermediaries separately, and treat such investments as a one-hundred percent reduction of capital for the purposes of assessing the adequacy of bank capital as existing prudential rules 5Presently, there are no active trust funds managing cash funds, after 14 of them bankrupted last summer. seem to require (see Annex D). Second, lending/deposit activities should be separated from securities markets activities in a way which avoids potential conflicts of interest. This can be achieved by legal separation of securities markets activities (subsidiary) or, in a less restrictive version, organizational and financial separation within the same legal entity. Box 5.2. Forms of Shares and Shareholder C. ARRANGEMENTS FOR REGISTERING Identificato. AND TRANSFERRING STOCK OWNERSHIP There are severil alternatite arrasigements and associated 5.13 The establishment of an independent and technicalJargon to clarify. The shares mayte the form ,y of paper share :ceificktai,Which may be the only legai user-friendly" system of shareholding registration proof.of ownership: the paper tertificates may be im and transfer is the most important and the firs bilizd in a deDneicr; shares may be dmaterialized witb immediate step in the creation of a successful no paper etificates *existing bthe proof Of ownfliP secondary market. Such a system includes two being an entry in the dida base (book entry).:Shares.my characteristics: (i) the form which the shares be regsterede directly in the mnee oft shareh#lder or their. srepresentative (brokers,: trust mpantes, tastodian, C; themselves take and (ii) an identification of or may be issuedi mbejform. The differences between shareholders.(see Box) rgeitered ard lid iisbares are clear for traditional paper- based systems but they fecome blurted OnCe shares are 5.14. The recording and transfer of immbilized or demaietialized In short, there Are a largeo numberof possible perutatoiis involved bi the decisions ownership of dematerialized or immobilized on this topic which need to.be ,aken.. The merits of eah shares is simpler and cheaper and is therefore are also changing as new computer technologies merge. recommended as the best initial system for Ukraine. Under this system, transfer of Fior examiple in the Frenditsystem bearer.form shares of.a' particular coAnp n hel b r ownership can be made by an entry in a computer globi .4ertifcates with prnctically no operations o th data base without the need to transfer paper shreholdr have their accoius In s form of' deposary certificates. The mutation of the dematerialized osdierly or through a nominee (broker, and immobilized securities with two-tier securities ltoia).Thsyste36. was 4=-ess W0 0plen"d accounts seems to suit well Ukrainian conditions. imlad awd extIJAs Teposed an systspehates h It is recommended that two extremes be avoided. represeed n by lobal rtiaw but fu ie The first is a system involving registered paper individual certificates. I the US publicly traded shares are certificates requiring a costly system of deposited ii the centa depository (epository Trst registration (changing an owner, splitting Conpany) owned by thebiswebrte houses and the New ' York Stock 6trange Most of shar re deniterializod certificates, etc.). The second is a system and although registered,.the system is facilitated by involving bearer and paper form certificates issued nominee registration hysicl ad ristered share to the public and traded freely. t1ardktt are Considered to be the waest.point ftee British system (otherwise the jc&d1 BEuToPean markc 5.15 As regards registration, the lack of an independent and user-friendly system of ownership registration was a major obstacle to the development of secondary trading in shares in Russia. That problem can be avoided in Ukraine. Existing Ukrainian law determines that shares of privatized companies have to be issued in registered form (Law on Privatization Certificates) and also that an issuing company is required to keep a share registrar (Law on Securities and a Stock Exchange). However, this is not a requirement that the direct operation of registrars should be by the issuers themselves. On the contrary, it is strongly recommended that the registrar services be separated from issuers. There are many reasons for this, including the need to protect investors from arbitrary manipulation by the issuing companies; the facilitation of sales of shares owned by employees; and the protection of the rights of minority shareholders. 5.16 It should also be an ultimate goal to transfer registrar functions to private operators. This should be done as fast as possible consistently with the avoidance of incompetent registrars. A 24 regulation, setting criteria for licensing registrar services, should be adopted as soon as possible, and should address the following issues: the definition of independence from the issuing company; capital adequacy and qualified staff requirements. proper practice requirements (handling information and confidentiality, equal treatment of all clients): and public disclosure of information about any company offering registrar services. Potential candidates to operate registrars could be commercial banks and/or brokerage houses. As a temporary arrangement privatization auction centers should also be used. In these cases, a separate unit should be created within each oblast auction center, with its own staff and equipment. The unit should be subject to supervision by the proposed Securities Commission as proposed in Chapter 7 (but in the short term by the securities department of the State Property Fund). D. ESTABLISHING TRADING SYSTEMS 5.17 Present Status. The present trading arrangements in the market are wholly inadequate to deal with the imminent and large increase in volumes accompanying mass privatization. Most of the trade takes place in Kiev through an unregulated over-the-counter (OTC) market. Only recently have separate groups of commercial banks and others undertaken initiatives to establish more regulated and centralized trading systems. Theses include two initiatives in Kiev: the USE and the so-called "Central Depository" system. The USE was founded as a closed-type joint-stock company by 94 owners-- commercial banks and brokerage houses. It was registered by the Council of Ministers as an official stock exchange in October 1991 and has received technical help from the Association of French Stock Exchanges (SBF). It presently has 67 brokerage houses registered as its members. The agricultural bank Bank Ukraina is the settlement bank. Shares of two companies: "Ukrrechflot" and Bank Ukraina itself are officially listed and quoted. In addition, shares of 12 companies are traded through an open- outcry auction. Volume of trading is reportedly very small. 5.18 The development of the USE has been much slower than expected and slower than its existing capacity would allow. More seriously, the owners and managers seem to be reluctant to operate the USE as a transparent market place available to all qualified intermediaries and issuers. There seems to be little understanding of the need to manage the exchange as an open market place. 5.19 Another trading system, misleadingly called "The Central Depository", was established by a group of securities dealers linked to major financial conglomerates and led by the financial group KINTO. The system originated as the NASDAQ-type electronic network of securities dealers, envisaging in addition an integrated system of depository, clearance and settlement. In practice, the system at present is merely an electronic bulletin board which helps to match potential buyers and sellers (but does not process transactions) and provides optional settlement services, as well as transfers of ownership and payments. The system is at its nascent stage of development, and again transaction volumes are very small. The present trading and settlement rules are lax and are certainly insufficient to guarantee necessary safety of transactions once volumes grow and participation broadens. It is also not possible to assess its financial viability as facilities are provided .and costs are partly borne by the Ministry of Telecommunication. The system is entirely self-regulated. 5.20 Recommendations. The experience of mass privatization programs in other countries suggest that two new segments of a secondary stock market will emerge in Ukraine. These are namely: a market for blocks_of shares (block trading) between sophisticated investors: investment funds, strategic investors, institutional domestic and foreign portfolio investors;6 and a market for small amounts of shares (retail market) mostly owned by employees and traded between unsophisticated investors. 6 80% of the trade of shares from the mass privatization programs takes this form mrte-Czech Republic and in Lithuania. 25 5.21 There is less need to develop institutional arrangements to deal with block trading between sophisticated investors. Most of these trades (swaps, proxies. etc.) will take place as contractual arrangements with limited intermediation of regulated trading systems, and with little need for broader dissemination of price information. The emphasis if any should be put on dissemination of volumes and prices after trades have happened. By contrast. a great deal of development is needed in relation to the retail market. Here the main dangers to be averted include: the lack of safety and fairness of transactions; high transaction costs; market fragmentation; and the high volatility of prices. Trading frequency and liquidity may vary substantially from share to share and over time for the same share. Also, some of the shares/companies will be traded nation-wide when others will be limited to local markets. Any developments of trading systems which are promoted now should be flexible and open-ended enough to accommodate all of these features. 5.22 A further complication is that many companies in the MPP or privatized by employees/management buy-outs will fail to comply fully with the requirements established for publicly traded companies. Smaller companies of limited interest to the general investor should initially be absolved of some of the costli requirements normally associated with a public listing. Realistically, the population of the companies will probably divide into three groups. These are a minority of companies which will be able to fulfill all the rules of public trading; companies which fail to apply for listing or which disappear; and companies able to follow less stringent rules and traded over the counter in a more or less regulated way. 5.23 Companies from the first group should find their trading place at a reformed Ukrainian Stock Exchange. Trading in the companies of the second group should be restricted to the individual contractual arrangements with or without broker intermediation. It is recommended that even in this case the company managers be encouraged to transfer their share trades to authorized broker/dealers. This is to reduce the dangers of managers adversely influencing the decisions of employees about stock divestiture. At present, brokerage firms may not be interested in organizing such small markets but there may be some interest of smaller non-bank brokers to handle the business. The Government could also encourage it through tax incentives. 5.24 The creation of an efficient, safe and fair marketplace for shares of the companies from the third group which cannot initially meet full listing requirements is critical for the successful implementation of the MPP. Conditions should be established to trade shares of these companies to the broader public in an evolutionary manner which would result eventually in a formalized OTC market. The key to this approach is to make directors of companies fully responsible for the dissemination of information about companies either directly or by contracting-out the task to licensed brokers-sponsors of the particular companies. Directors or nominated brokers would be responsible for publishing two types of information: admission information and ongoing information. This information would include all the financial data that investors would reasonably require for the purpose of making an informed assessment about the company and the securities on offer. The Securities Commission (see Chapter 7) would not take any responsibility for admission documents, even in terms of compliance with formal legal requirements. Any legal action for non-compliance with these requirements would be initiated by investors or SROs and resolved by the Securities Commission (withdrawing permission) or through courts. This approach which can broaden access to trading quite early on, would require an extensive work program to adopt proper rules and practices of trade, including a full trading manual. It is an evolutionary approach which can respond to real needs and incur the costs of full listing and stock-exchange trading gradually and when necessary. This approach would also shift part of regulatory duties from the Securities Commission to a set of self-enforcing rules and possibly SROs. 26 E. CLEARING AND SETTLEMENT ARRANGEMENTS 5.25 The clearance and settlement of capital market transactions creates relatively few problems and risks when transactions are completed in so-called "off-market" trades where the buyer and seller deal directly with each other. In these cases, the two parties make their own arrangements and each must satisfy themselves that the other party will meet their obligations. This is the present situation of most trades in Ukraine. However, once the number of buyers and sellers grow, and retail trades assume greater significance, then inadequate arrangements for clearance and settlement will seriously undermine market reliability and enhance the risks to transactors 5.26 The key issue here concerns the obligation of the clearing and settlement organization (CSO) to guarantee the performance of the parties to the trade. The worst situation would occur if ownership of the securities is transferred but the payment is not made or if the payment is made but the ownership is not transferred. In general and in other countries, it is considered unacceptable for a regulated market to have to "unwind" a transaction because one party did not meet its obligations. 5.27 In most exchanges, the parties are brokers acting as intermediaries for the ultimate investor. These brokers must satisfy themselves that their clients will meet their obligations to either deliver the securities or make the agreed payment. If they fail to do so, the broker will be liable. A CSO (e.g. Bank Ukraina in the present Stock Exchange) can reduce this counterpart risk in basically three ways. The first and rarely used way is to require that both parties to the transaction provide the securities and the payment in adyance of executing the trade. This is essentially what is done by the RMS system in the Czech and Slovak Republics because it deals with many small investors who do not trade through brokers. The second way is for the exchange or clearing and settlement organization to restrict participation to credit-worthy parties only. This can be done, for example, by requiring the brokers to meet certain capital standards: a principle which has not yet been established in Ukraine. This usually means that the CSO has to restrict membership to a limited number of the most reputable and credit- worthy brokers, dealers, and other large market participants. Non-members need credit guarantees from members. The third way is for the members to organize a mutual guarantee system whereby all of the members to the clearing and settlement organization agree to collectively stand behind the performance of the members. 5.28 In Ukraine the geographical and other segmentation of share trading means that a number of CSOs are likely to be needed and should be allowed. It is recommended that clearance and settlement systems linked to the emerging regulation of markets as discussed later is the most appropriate solution. This means first a self-regulatory mechanism built on mutual trust between the professional intermediaries within each CSO. This might be set up loosely at first but then evolve more formalized rules for participation. The new CSOs would be proprietary organizations owned by market participants and supervised by their own self-regulatory organizations and also by a new Securities Commission.(See Chapter 7). Payment for traded securities would be completed by a selected bank where all participants of a particular CSO would hold their accounts (in appropriate cases the settlement bank could also extend lines of credit). Capital requirements for each CSO should be established by the Securities Commission. The CSO's themselves would establish the minimum capital requirements for the brokers/dealers who they accepted as members. 5.29 Further issues of regulation and supervision of the capital markets are discussed in Chapter 7. 27 CHAPTER 6 THE INSURANCE SECTOR 6.1 The other large component of the financial sector after the banking and capital markets components comprises five hundred or more insurance companies. Paralleling the easy entry into commercial banking in 1991-1993, the insurance sector as measured by the number of companies has been growing very fast. Official data indicate a growth from only 8 companies in 1990 to 150 by early in 1994 and then to about 500 companies by the end of 1994. The prevailing law ("On Insurance" of May 1993) specifies a minimum capital of only $5,000 equivalent and by April 1994, the majority of companies in operation had actual capital little more than this. With this very low level of capital, they are quite unable to assume risks of any significant magnitude. Nonetheless, many have tried and with the assistance of high inflation and rudimentary accounting methods which failed to take proper account of possible future claims, significant but illusory accounting profits have been realized. 6.2 Since the regulation of the industry was taken over by the Insurance Supervisory Committee in 1993, a tightening-up of regulations has begun. A new insurance law, drafted with assistance from an EU-TACIS program awaits Parliamentary approval. Among other things, this proposes a much more realistic minimum capital requirement of $100,000. When enacted, this should help to consolidate a trend which is already visible and desirable whereby the bulk of the business is written by some thirty or so relatively stronger companies. Specifically, about three quarters of all the business is written by the top thirty companies all of which had capital as of April 1994 in excess of Kbvs 2 billion and ten of which had capital in excess of Kbvs 10 billion. The new law will also provide for a more stringent definition of insurance reserves; provide the basis for substantially increased foreign participation in the sector; and tighten the restrictions governing the use of the capital of one insurance company to help create a second one. 6.3 Nonetheless, insurance activity in Ukraine is and will remain fragile with a total volume of business at about Kbvs I trillion (less than 1 percent of GDP) which is far too small to meet the legitimate and diversified insurance needs of a large and complex economy. Its product range is limited and of generally poor quality. Thus, many expensive items which ought to be insured cannot obtain insurance at reasonable premia (e.g., luxury cars), while much of the insurance which is written frequently fails to meet claims when they arise. Credit insurance which is popular with banks provides protection of dubious value given the inability of many companies to meet larger claims. Private life and pension cover is almost impossible to provide in the absence of securities markets and the ongoing uncertainties about inflation. There is a danger that instead of finding the insurance sector to be a source of investment funds as it is in many countries, the Government will be called upon to devote its limited resources to providing support to the sector. 6.4 The present Report has not explored the problems of this sector in detail. However, it is clear that the scale of effort so far provided to help the development of the insurance industry is wholly inadequate relative to the evident needs. Hence, it is recommended that this be an area in which enhanced levels of external technical support and financing be sought to ensure that new and more reliable products can be made available as expeditiously as possible. This might begin with a significant boost to the level of technical support and staffing provided to the Insurance Supervisory Committee. It should also include explicit consideration of the rules and practices governing the insurance of credits extended by commercial banks. This business is highly risky for the insurers since they lack the knowledge of clients which the banks themselves have. Equally, the limited capital base of most insurers makes it unlikely that they have the capacity to insure credits of any significant size. 28 CHAPTER 7 THE ENABLING ENVIRONMENT: FINANCIAL SECTOR INFRASTRUCTURE 7.1 The last substantive matters considered in this Report are a number of important topics which together contribute to the infrastructure within which individual financial institutions need to operate. This Chapter reviews the situation as regards the regulatory and supervisory arrangements for finance: accounting reform; and deposit insurance. Annexes C and D provide more detail on these same topics Annex E focuses explicitly on the payments system. A. THE SUPERVISION OF FINANCIAL INSTITUTIONS Banks: 7.2 The rationale for, and basic principles of a strong system of bank supervision are fully accepted in Ukraine and much work has been devoted to the upgrading of the supervision arrangements for commercial banks by the NBU. The external support for this is managed by the IMF and now involves a well defined program of "Management by Project". The main components of this program which is now supported hN numerous donor agencies is summarized in Annex D. 7.3 This program has already achieved several important improvements in NBU arrangements A sound basic system of prudential ratios (including solvency, liquidity, large-loan exposure consideration has been in place for some time I and is progressively being up-graded. Rules for classifying loans and establishing appropriate provisions were established in January 1995 and basically follow World Bank guidelines. The staffing of the NBU is gradually being upgraded and strengthened to equip it to deal with a very much larger work-load than it can absorb at present. Future work relates to the massive task of implementing the design which is being laid down. That task includes the training of appropriate staff. familiarizing banks with their obligations under the rules; applying the sanctions which are available. achieving the quality of information from banks which is necessary for meaningful supervision. 7.4 In this context several points need to be stressed. The first is that not much more progress can be made until the accounting standards applied for the purposes of bank reporting are reformed to comply with Internationally Accepted Accounting Standards (IAS). The NBU cannot supervise on the basis of information which is essentially very misleading. This point has been emphasized by all the main donor- agencies supporting the program and needs to be reiterated here. The development of an accounting system capable of revealing the true financial situation of banks is the critical precursor of a sound system of banking supervision. (See also Annex C). Second, the NBU needs a legal framework which is technically attuned to the nature and scope of a modern regulatory system for banks and confers adequate authority on the regulator. This is not the case with the 1991 Banking Law which for the moment provides the main authority for bank regulation. A new draft law which does provide the NBU with a stronger authority, has been available for some time but has not been legislated. In the interim the NBU has needed to work with a large number of separate regulations written on the authority of the 1991 law. This situation is not satisfactory and there is some urgency in analyzing and clarifying the existing body of law and regulations to ensure that the authority of the NBU in all areas pertaining to its regulatory and supervisory functions is properly codified. This is a task which will be handled by the USAID advisor referred to in the Table in Annex D. Strong and effective bank supervision needs the full backing of a strong legal framework. Equally, there seems little merit at this time in relocating the NBU's supervision work into a separate unit outside the NBU. This is unlikely to improve the technical quality of the work and could result in greater politicization of the supervisors decisions. 1 ne main prudential regulations are defined in the Decree of the National Bank No.114 dated 21- Decenbe 1993, and are summarized an Annex D 29 7 5 The third point is that the task of establishing sound regulation and supervision of banks is a long term one. Significant public and international confidence in banks is unlikely to be created by the work of the NBU supervisors within a period of less than four to six years. In the transition, the authorities should support the enhancement of the quality of, and confidence in. the banking system which can come from the audits and assessments of individual banks undertaken by international organizations. The EBRD credit line and the parallel operation by the World Bank together have the potential to establish performance standards for a substantial number of Ukrainian banks which will raise their profitability, lower their operating costs, reduce their risk profiles and enhance their credibility in the eyes of both the Ukrainian public and the international financial community. This potential should be taken full advantage of and the NBU should support the idea of the "international standards bank". Capital-Market Institutions: 7.6 The lax regulation and supervision of the non-bank financial institutions is increasingly indefensible in the light of the anticipated rapid growth of capital market institutions (see Chapter 5) and the already difficult situation of the insurance sector. Thus, the Report recommends a broad-based review of the various supervisory standards currently in force and proposed for the near future to establish some consistency. This is particularly important in view of the widespread diversification of banks into other financial activities and the consequent danger that the regulation and supervision of their activities is increasingly the responsibility of more than one authority. Here we deal in detail with the regulatory arrangements which need to be established for capital markets. 7.7 Present Status. The Legal framework presently addressing capital market activities includes: the Law on Securities and Stock Exchange (Securities Law-June 1991), the Law on Business Enterprises (Company Law-September 1991), the Law on Privatization Certificates (April 1992), Presidential Decree on Investment Funds and Investment Companies (February 1994), Cabinet of Ministers Decree on Measures Providing State Regulation and Control of Securities Markets. Capital market activities are also regulated by a number of lower level acts issued by the SPF, the MOF, and the NBU. 7.8 Supervision functions are fragmented and at the same type overlapping between different governmental agencies: the Ministry of Finance (MOF), the State Property Fund (SPF), the Ministry of Justice (MOJ), the NBU, the Parliament. But collectively they create a very serious vacuum since none of these institutions has appropriate staffing to supervise the market and enforce existing legal norms. 7.9 The Ministry of Finance is empowered by the decree of the Council of Ministers (CoM) to "organize the administration of securities and financial (money) markets." The MOF also licenses broker/dealers, investment funds and custodians. MoF and its territorial branches register new issues of securities. The Department of Securities and Financial Markets provides informational and secretariat services to an embryonic Securities Commission. The State Property Fund licenses trust companies, investment funds and investment companies dealing with privatization certificates. The SPF as the biggest supplier of shares is also involved in initial public offerings of shares under the mass privatization program. 7.10 The existing "Securities Commission" is a transitional body established under the CoM, and is far removed from the type of authority found in other countries and needed to oversee the markets. Its functions includes coordination of policy measures related to capital markets and initiation of capital market related legislation. The commission has not yet established its role as the major authority for overseeing the market and as presently constituted and staffed it cannot hope to do so. 30 7.1] An ad hoc committee was established to draft a blueprint for the development of capital markets in Ukraine and initiate necessary legislative motions. One of the most immediate roles of the committee is to prepare a law establishing a permanent Securities Commission as an operational body to oversee and supervise the functioning of capital markets. In addition two self-regulatory organizations (SROs) exist: The Ukrainian Association of Securities Dealers (created June 1992), and The Ukrainian Association of Trust Companies, Investment Funds and Investment Companies (created October 1994). Both associations have the same priorities but are presently merely informal lobbying groups rather than fully fledged self-regulatory bodies. This needs to change and other SROs are also needed. Recommendations: 7.12 Agencies of the government, the NBU, and local authorities will continue to play an important role in shaping the capital markets. However, problems can arise when particular market segments or functions are supervised by different parts of the Government. Therefore, the new Securities Law which we propose should be enforced by a newly established and powerful Securities Commission. The new Securities Law in turn should consolidate and extend existing law and, above all should address and regulate the areas which may have an impact on investment decisions of unsophisticated investors. These include: (i) disclosure requirements related to any initial public offering as well as secondary market transactions, (ii) basic requirements regarding market operators (broker/dealers, exchanges, collective investment vehicles, registrars, custodians, depositories, etc.), (iii) protection measures regarding minority shareholders rights ( acquisition of a substantial block of shares or take-over of publicly owned company), (iv)definitions and penalties for fraud, manipulation and insider trading and (iv) the division of regulatory functions between the government and self-regulatory organizations (SROs). 7.13 The Securities Commission itself would act independently from existing ministries and the NBU and have an exclusive mandate in the area of market supervision and enforcement. The Commission should have a different composition from the existing transitional one. It should be supported by a substantial professional staff (secretariat) and have legal prerogatives to enforce the law (enter into offices of issuers and market operators, inspect their documents, and initiate prosecution cases). The Commission would delegate some of its regulatory functions to appropriately constituted self-regulatory organizations and supervise the activities of these organizations. The review of the existing licensing criteria and activities of licensed market operators would be an immediate task of the new Securities Commission. 7.14 The basic principle of a market economy is to leave as much regulation as possible to private parties and for the government to regulate and control as little as possible. The main objective is to render capital markets fair, efficient, and transparent. So exchanges, professional organizations of financial services providers, organizations of investors, and issuers should all be encouraged to form self-regulatory organizations. However, the newly established Securities Commission should supervise their activities and give them official recognition and status (see also Chapter 5). It should also work to ensure that they do not merely oppose competition and create cartels or monopolies. 7.15 Finally, in all the areas just discussed there is a large shortage of appropriate skills and experience. Hence, all of the proposals need reinforcement by broad-based training programs on a scale and of a type already in place by banking sector staff. B. ACCOUNTING REFORM 7.16 This is a topic which should command far more priority than it has been given thus far. The Soviet Chart of Accounts (CoA) which is still the official basis for bank and other enterprise accounting and reporting in Ukraine is fundamentally inappropriate when applied in the context of a market 31 economy.(see also Annex C). The financial health and even the true size of banks is impossible to ascertain using this approach because of the double-counting, the limited use of accruals concepts. and the weaknesses of loan loss provisioning. Off-site inspections conducted by bank supervisors and the supervisors of other financial institutions (OFIs) cannot reveal much about the true situation of these institutions so long as these CoA methods are in place. Improved bank supervision needs reformed accounting as a vital prerequisite. 7.17 There is general agreement in the NBU and elsewhere that the CoA needs to be replaced by a more appropriate general standard and also that this will take a significant period of time, possibly two years. Some of the components of the necessary reform are already specified in the program of work already agreed between the NBU and the IMF (see Annex C): The three main elements of this are (i) continued support to the NBU itself including the reform of the NBU's own accounting systems as well as the systems of accounting reports which the NBU requires from the commercial banks; (ii) the coordination of the existing commercial bank initiatives to adapt, albeit only partially, to IAS. This should help to ensure that in the transition period as CoA and IAS standards are being operated in parallel, there will be some reasonable degree of consistency in the use of the new standard, and (iii) a concerted program of training for bank accountants in the IAS methodologies. 7.18 This Report endorses all of these valuable initiatives but notes that there are two higher level decisions and programs of work which need to be specified to support the initiatives which are presently confined to banking along. First, a decision is needed about the adjustment of general commercial accounting standards on to a Western basis. It is unlikely that this reform can be confined in the financial and certainly not the banking sectors alone. Second, an action program is needed to establish the precise transition process towards a new accounting system for financial institutions. C. DEPOSIT INSURANCE 7.19 At present, only the depositors of Oschadny Bank benefit from formal deposit insurance. This is specified in the still definitive law on banks namely the 1991 Law on Banks and Banking Activities. The precise nature of this legal guarantee is unclear but defacto is being interpreted to include the commitment of government to offer partial compensation for the losses of real value associated with high inflation since 1991 and not just the commercial losses associated with a bank failure. This inflation compensation cannot be provided as a direct increase in the deposit balances of the clients of the bank because of the serious inflationary consequences of such an approach. Instead, it is being processed through the issue of Savings Bank Compensation Certificates which can be used to buy shares in the mass privatization process. 7.20 There is some argument that the deposit insurance already provided to Oschadny customers should be extended as well to the customers of other banks now that many of these are beginning to mobilize household deposits and are thereby reducing the once dominant position of Oschadny. This extended coverage might also be argued to be an important element in the process of re-building household confidence in the banking system and re-establishing a larger deposit base. This Report supports this step as a longer term objective of policy but recommends against its introduction in the absence of cdrtain prior reforms designed to lower its cost and increase its effectiveness. 7.21 There are several reasons for this. First, the present population of banks needs to be trimmed back to eliminate those banks which either are not banks in the true sense-these might be re-licensed as "finance-houses"-and those which have low survival prospects. Second, some improvement in the risk characteristics of the remaining banks is needed using the combination of improved bank supervision, the external ratings already discussed, and the idea of the international standards bank. These steps combined 32 would provide any bank that then participated in a self-financing system of deposit insurance with some confidence that the scheme was viable and sustainable. This confidence might be further enhanced if the criteria for a bank participating in the scheme of insurance were regulated by bank supervisors or some external rating agency. Such a rating would then ensure that the insured banks would collect the larger part of deposits and that other non-insured banks would have a strong incentive to upgrade their own risk characteristics to join the insured group. 7.22 In the absence of these recommended prior safeguards, a generalized deposit insurance scheme would be certain to need under-writing from the government budget, as does the present scheme which protects the Oschadny depositors. This would be a bad principle to establish because it does nothing to encourage improved banking practices. Also, in a tight budget situation, payouts under such a system would be made only on a discretionary basis when funds were available. The resulting uncertainty about the size and nature of the guarantee would intensify rather than reduce depositor distrust of the banking system. For the moment the present system should be retained. The payment of partial compensation to Oschadny depositors provides an adequate response to the strong political pressures on this topic but reduces the costs of this compensation by confining it to one bank alone. 33 CHAPTER 8 STRATEGY FOR THE SECTOR 8.1 The main elements of the strategy recommended for the sector have been indicated in the individual Chapters of the Report. However, in overview the objectives of that strategy are to produce a higher quahty sector in terms of the products it offers at the same time as lessening the risks and increasing the reliability of individual institutions and products. The pursuit of this basic quality-focused objective is the best way to ensure that the sector can regain eventually its former size relative to GDP and play its part in longer term economic development. Four inter-connected elements together constitute the strategy. 8.2 First, many of the distortions in finance of the past few year will be lifted if there is a sustained program of inflation stabilization leading to positive and reasonably predictable interest rates. So inflation control must be the first priority. This implies continued discipline on the government's own budget which in turn will release resources to support the emerging private sector. At the same time the direct government pressures to repress some interest rates, and especially through programs of directed credit to favored sectors need to be ended with any residual subsidization of enterprises being moved to the fiscal accounts. These changes combined with the government's increased use of non-monetary financing of its own deficit will gradually reveal the true costs of continuing budget deficits on monetary and credit conditions in the economy. The development of monetary instruments and policies to allow the authorities to exert some influence on these conditions is the next logical step and requires more intensive analysis than is provided here. 8.3 Second, a package of measures need to be taken to achieve improved quality in the existing banking institutions including an improved allocation of available resources; a recovery of savings mobilization through banks; and the achievement of lower risks in the sector. This will require a reduced number of banks and improved performance incentives and prudential regulations for those that remain. In the short term this quality enhancement cannot be achieved through the bank supervision process. The main instrument has to be improvements in as many banks as possible encouraged by the international audits; the institutional strengthening which the audits will indicate to be necessary; and the implicit rating of banks which the completion of this process will bring about. It is recommended that these various actions be brought together in a systematic program to help as many banks as possible achieve the status of "international standards bank" with the NBU in a coordinating role. This work can begin immediately and significant results can be expected within I to 2 years. Audited levels of capital should be established as the main performance target of such a program. Also in the spirit of creating a smaller but higher quality banking sector, the NBU is encouraged to consider a new form of narrow license for those "banks" which are more correctly regarded as "finance houses" and should be permitted to mobilize deposits from the public. This will further reduce the population of recognized banks. Only when these actions have begun to have some measurable effect of the quality of banks, should the coverage of deposit insurance be extended to embrace a wider set of banks than now. 8.4 Third, a variety of environmental improvements affecting the sector should be designed and implemented. The most important of these is the thorough reform of accounting requirements for banks and OFIs to internationally accepted standards, and the associated changes in detailed tax rules which will need to go with this. Outline programs and 34 timetables for this are already available and it seems likely that much of the necessary reform can be achieved in the space of about two years. The accounting reform, in turn. will make possible a much more meaningful off-site inspection of banks than is presently possible. Helped by this and a gradual upgrading of its own analytical capacities the NBU will gradually be able to generalize the quality-assessment of banks which, during the transition, needs to be done selectively and with extensive inputs from international organizations including audit firms. That upgrading should certainly include a greater attention to the income statements of banks and to their evolving performance on costs, margins etc. The other environmental improvements will include the upgrading of both the legal basis and practice of bankruptcy, collateral registration and enforcement, and credit rating. 8.5 Finally, but of at least equal importance, is the massive task of filling the many gaps in the present arrangements for capital market operations. This task needs to be addressed with some urgency. This is especially true of those actions which are needed to enable the program of mass privatization to proceed on schedule. It cannot be stressed too strongly that without active secondary market trading, the improved corporate governance which is the major potential benefit of privatization will fail to be achieved. So within weeks rather than months, it is necessary to establish a credible, even if temporary, system of share registration. Also urgently needed is a major legislative program and in particular the drafting and passing of a new Securities Law. Among other things this should seek to clarify and rationalize the presently very confused, and overlapping systems for regulating and supervising the various institutions operating in the markets. This rationalization needs to be followed very fast 'by action programs, including increased staffing, and training, which can render the supervision process effective. It should also incorporate measures which would seek to limit the dangers associated with the cross ownership of banks and investment organizations. Again the principle of adequate capitalization of all risk-taking institutions and especially those accepting funds from the public, should be paramount. Finally, and most difficult, the authorities need to bring into being a number of specific new institutions such as a Securities Commission and a system of independent private Registries, which presently do not exist. This might normally be seen as a long term agenda but in the circumstances currently facing Ukraine many of the steps need to be achieved in the relatively near-term future.