The rapid growth of the banking sector in Ukraine could be thrown off course, if the shift to exchange rate flexibility is not accompanied by prudent regulation, credit analysts warn. They also argue that political paralysis continues to derail efforts to improve financial risk management and without pivotal reforms, the country’s banking system is severely vulnerable if liquidty conditions deteriorate.
“Exchange rate flexibility may have dangerous consequences for the banking sector. For retail loans to borrowers who don’t have access to dollar streams, this would be disastrous,” Dmitri Angarov, associate director in Fitch’s financial institutions group told Emerging Markets. He warned that plans announced at the end of July to free the exchange rate, could lead to a weaker local currency given the political instability.
By the middle of 2006, over 40% of all credits were denominated in foreign currency and many were extended to unhedged borrowers. Analysts are concerned that a free exchange rate will be implemented before foreign-currency lending has been regulated, and public awareness of exchange-rate risks is raised. In the context of poor risk management and lack of political reforms, exchange rate flexibility could be the straw to break the camel’s back.
To date, political instability has not led to a serious outflow of deposits in the banking system. But there are fears that the central bank will not be able to contain politically induced investor jitters as it did during the turbulent “orange revolution” in 2004, by restricting withdrawals and intervening in the forex market.
“The unstable political situation has led to a very poor operating environment for banks. The sector may have boomed lately, but there is significant scope for doubt that this growth is sustainable given the systemic risks and poor regulation,” said John Gibling, director of EMEA financial institutions at Standard & Poor’s.
Standard & Poor’s last week affirmed the negative outlook on its BB- foreign currency sovereign credit ratings on Ukraine. Gibling said that to the lack of political momentum behind efforts to tighten banking supervision is one of the reasons for the negative sovereign outlook.
Since 2000, total assets in the Ukrainian banking sector have increased at an average annual rate of 45% per year, reaching $67 billion last year. Gibling is concerned that credit underwriting techniques, risk management and increases in the minimum capital adequacy ratios have not have not kept pace with such credit expansion.
“Intermediation in loan market has increased so much since 2004, the ability to provide support if there is a similar crisis is seriously in doubt,” he told Emerging Markets.
Gibling is sceptical that the National Bank of Ukraine (NBU) will have the resources and political support to deploy refinancing mechanisms to banks, such as through unsecured overnight loans and short-term loans backed by government securities.
Volodymyr Ovadenko, head of portfolio investment services at Ukraine-based ART Capital agreed that the co-ordination between the finance ministry and central bank governor Volodymyr Stelmakh would be inadequate to provide such support.
“I very much doubt whether the NBU would be able to manage such problems in this changed environment, especially under growing political pressure,” he told Emerging Markets.
Svetlana Dryhush, Kiev-based equity analyst at Renaissance Capital, conceded that central bank attempts to regulate the sector were constrained by the lack of a suitable legal framework. But argued that increased foreign ownership of banks in the country would offset any liquidity crisis.
“In an attempt to obtain foreign funding sources, many banks have disclosed information to potential lenders and submitted themselves to an audit. This reduces the risks of banks falling into liquidation and in any event, foreign parents will most probably bail them out,” said Dryhush.