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Main elements of Ukraine’s banking sector rehabilitation strategy

OP-ED: By Ceyla Pazarbazioglu, IMF Mission Chief to Ukraine and Assistant Director, European Department, International Monetary Fund (IMF) and Martin Raiser, Director for Ukraine, Belarus and Moldova, World Bank (WB)

Dzerkalo Tyzhnia (Mirror Weekly) No 19 (747), in Russian
Kyiv, Ukraine, Saturday, May 30 to June 5, 2009 
U.S.-Ukraine Business Council (USUBC), in English
Washington, D.C., Tuesday, June 2, 2009
The International Monetary Fund (IMF) and the World Bank (WB) have been working very closely since October 2008 with the National Bank of Ukraine (NBU), the government and other authorities to implement a comprehensive bank resolution strategy.

One important recent outcome of this was the government’s announcement of its intention to recapitalize several systemically important banks. This article explains the reasoning behind the proposed solution and why state involvement in individual commercial banks is necessary.
In the wake of the global financial and economic crisis, Ukraine experienced significant stresses in its banking sector. These have become evident in two major ways. On the asset side, the quality of loan portfolios has worsened. As a result of the deteriorating economic environment and the sharp depreciation of the exchange rate, an increasing number of individual and corporate borrowers have encountered difficulties in servicing their loans.

On the liability side, deposits plunged by 20 percent system wide between October and March, although since then the situation has stabilized and deposits have started to flow back into the system.
Signs of stress have varied significantly across banks in Ukraine, but the risk remains that difficulties in some banks turn into a systemic banking crisis. This occurs when confidence deteriorates to the point where concerned depositors deem no bank sufficiently safe and, rather than changing banks, leave the banking system altogether.  The extent of such contagion typically depends on the size of the banks that face acute liquidity or solvency problems.
If a systemic crisis is likely, the state must step in. While the central bank provides liquidity to the financial system, the government uses budgetary resources to provide new capital, loans, and/or guarantees for systemic banks, whose shareholders are unable to raise additional capital.


In this situation, the authorities pursue these three important objectives:

         (1) restore society’s confidence in the country’s banking system,
         (2) protect the system at a minimum cost to taxpayers, and
         (3) strengthen the system to make it more resilient to future crises.
These objectives are at the core of the Ukrainian authorities’ strategy to strengthen the banking sector, which they developed with the support of the International Financial Institutions and the donor community. It is precisely with the purpose of restoring trust in the system that the Government of Ukraine announced its intention to provide new capital to a number of banks, which together hold a large share of deposits from Ukrainian citizens and businesses.

The intention is to restore free and full access for the depositors in the problem banks, in the shortest timeframe possible, and have depositors safely return their money to the banks. In turn, this confidence of depositors will allow credit flows to resume, reduce pressure on interest and exchange rates, and thus facilitate economic recovery.
The government's bank recapitalization program, the legislative aspects of which were passed by Parliament in November, is designed to help the banking system survive the current depressed state of the economy, while still holding bank owners liable for the banks’ losses. This involves no bailout of private bank owners with public funds.

The scheme is considered necessary at this point, given the scarcity of new capital from existing owners or new investors in Ukraine and abroad under present market conditions. The IMF and the World Bank support this scheme as the least costly solution to strengthen the Ukrainian banking system.

Let us look at the specific elements.
[1] DIAGNOSTIC: The recapitalization scheme started with targeted valuations of the loan portfolios of the largest banks to identify possible losses and capital shortfalls. Where needed, existing bank shareholders have been asked to put in additional capital to meet the minimum required by NBU regulations.  For those banks defined as systemic by the NBU (banks with assets accounting for at least 2% of system assets or 1% of total deposits of individuals) and owners are unable to inject capital, the state has agreed to step in.
  Good crisis management calls for the state to be an investor of last resort, and to choose very diligently how to spend limited public funds. Troubled financial institutions, like any other private corporation, face a hierarchy of claims on their resources. First and foremost are depositors, then come secured creditors, then non-secured creditors, and last come existing shareholders.

Prudent crisis management must ensure that public funds are used first and foremost to satisfy the claims of depositors and secured creditors.  Existing owners and unsecured creditors of problem banks will loose some or indeed all of their investments. Once liabilities have been restructured, the banks benefiting from recapitalization should have access to liquidity from the central bank to ensure that all their liabilities can be duly serviced.
[3] CORPORATE GOVERNANCE AND CONTROL: Once the state, represented by the Government, injects capital into a bank, it will need to take full control of the bank, install new managers who are experienced bankers and do not have conflicts of interest in relation to the assets or liabilities of the bank, and are tasked first of all with the fast restoration of depositors’ access to their funds. De facto nationalization of troubled banks has been a point of debate in other countries.

However, in Ukraine, the capital needs of the several systemically important problem banks are such that the state inevitably will become the major shareholder.  Moreover, in Ukraine’s specific circumstances the interests of the state as a shareholder are best secured if it has full corporate control. Other countries, including developed countries, are now moving in the same direction.
[4] ASSET RESTRUCTURING AND SALE: When access to deposits has been restored and the financial condition of the bank has been stabilized, management should seek to maximize asset values and prepare the banks for future sale back to the private sector.

The banks may be resold as a going concern, but in some cases, asset values will be maximized, or the need for additional state capital minimized, by merging the bank with another bank, selling assets in lots or transferring assets and liabilities to other financial institutions.

Whatever the route chosen, the resulting revenues will at least partially compensate taxpayers for the initial capital outlays for crisis resolution. Indeed, the state’s involvement should be viewed as temporary, covering the period of macroeconomic uncertainty when private sector sources of funding are scarce or non-existent.

Needless to say, the newly recapitalized banks should be managed without political interference; they should be subject to the normal regulatory and supervisory framework maintained by the NBU, and should not distort the playing field.
 There are other elements of the banking sector rehabilitation strategy developed with the authorities. For the many commercial banks in Ukraine that may not be considered systemic but face acute liquidity and capital shortfalls beyond what their owners can deal with, the NBU must have a full range of resolution tools to act quickly and minimize risks. These include not only the option of liquidation but also the ability to merge weaker banks with stronger institutions and to transfer their assets and liabilities to other banks.

As with the systemically important banks, the least costly solution to tax payers means that equity holders and unsecured creditors will need to pay the price for the risks they have taken and cannot expect to have their investments protected. For effective bank resolution, legislative amendments are critically needed and have been elaborated jointly by the Ministry of Finance and the NBU – the success of the strategy will need the support of Parliament for these amendments. Voters should take note.
These are the main elements of Ukraine’s banking sector rehabilitation strategy. They have been extensively discussed within the Government and with the NBU. Now is the time to move forward decisively with the implementation of the strategy. Delays would lead to further losses of assets and increase the costs of the state.

The stabilization of deposits during May 2009 so far provides welcome tail-wind and increases the chances of success. Consistency and persistence will also be critical. Counter-productive moves such as the recent ban on foreclosures should be avoided.
In Ukraine as elsewhere, the unprecedented economic and financial crisis is casting the state in a leading role. To rise to this challenge requires leadership and consistency in implementation, often in the face of strong private sector resistance.

The IFIs will continue to support the authorities in making sure scarce public funds are well spent. Private investors interested in rapid crisis resolution and the emergence of a healthy and efficient financial sector following the current turmoil will want to ensure the same.

NOTE: Ceyla Pazarbazioglu is the IMF Mission Chief in Ukraine, and the Assistant Director for the European Department of the International Monetary Fund (IMF).  Martin Raiser is the Director for Ukraine, Belarus and Moldova for the World Bank.  The U.S.-Ukraine Business Council (USUBC) expresses our appreciation to the World Bank office in Kyiv for providing a copy of this important OP-ED in English. 

Ceyla Pazarbazioglu spoke at the USUBC annual meeting last December in Washington and also brought remarks at a luncheon USUBC held recently in Washington for Dr. Hryhoriy Nemyria, Vice-Prime Minister of Ukraine for European and International Integration. 

LINK:  http://www.mirror-weekly.com/2000/2040/66272/