During the last decade, the banking sector in Ukraine has been exhibiting a high growth potential and was the most dynamic and leading sector in the country.
Competition continues increasing and, as a recent wave of major acquisitions suggests, foreign capital has a particular interest in entering this sector. The goal of this article is to present a concise view of what banking in Ukraine is about, how it managed to reach its present state as well as to lay down a stepping stone to understanding the near-term future of this imperative for the country's economy.
As in most countries, banking in Ukraine is a two-tier system, with the first tier being the central bank and the second tier consisting of commercial banks. Two main laws regulate the sector: the law On Banks and Banking (1991) and the law On the National bank of Ukraine (1996). The latter law defines the two key roles of the central bank in the country, the National Bank of Ukraine (NBU), to be responsible for (i) ensuring stability of the national currency and (ii) supervising the activity of commercial banks.
Ukraine started with 76 registered (commercial) banks in 1991, reached 230 banks in 1995 and had 190 banks in the middle of 2006 (see Figure 1).
Most of the banks are universal and a few are specialized in certain activities (e.g., savings, investment, mortgage, clearing, etc.) banks. About 80 percent of all the banks are joint stock commercial banks and only 20 percent are limited liability partnerships. Remarkably, since 1994 there have been only two 100 percent state-owned banks in Ukraine, amounting to only about 10-15 percent of the total banking sector assets, which is a very healthy indicator for a transitional economy. For comparison, in 1999-2000, this share was 18.3 percent in Bulgaria, 24.1 percent in Czech Republic, 35.4 percent in Russia, 50 percent in Romania, 64.5 percent in Slovenia, while in Ukraine it was only 13.6 percent.
The two state banks in Ukraine are the Oshchadbank ("The Savings Bank") and the Ukreximbank ("The Export-Import Bank"), which are relatively large (about 6 percent each of total banking sector assets), competitive and are likely to represent a good bargain for the country if placed for privatization. The environment in the industry is quite competitive: no bank has a dominant position in most spheres of operation, but must compete with many rivals. Indeed, the so-called Herfindahl-Hirschman index (HHI) for the Ukrainian banking industry was consistently low for many years-about 400 points, which is similar to the level of concentration in the UK, France, Italy and better than in Spain, Austria, Sweden and many other countries.
This level of concentration is also 2.5 times less than required for the sector to be considered as moderately concentrated according to U.S. commercial law.
So, how did Ukraine obtain such a competitive and very dynamic banking sector that in many respects is better than those of other transitional countries? The banking system of sovereign Ukraine passed through six distinguishing stages of development. The first stage, roughly 1991-1993, was the period of reorganization and rapid growth in the Ukrainian banking industry. First of all, the NBU conducted re-registration of the banks earlier registered by the State Bank of the USSR. Most of the banks (Aval bank, Privatbank, Prominvestbank, Ukrsibbank, Ukrsotsbank, etc.) that have been the largest players in the sector until now were re-registered or opened in that period. Secondly, the industry survived the wave of rapid growth in the number of banks: a lot of small banks, many of which were so-called "pocket-banks", appeared in the industry. The number of banks registered by the NBU almost doubled from 1991 to 1992 and doubled again from 1992 to 1993. Such a dramatic increase in the number of banks was due to the fact that the entry barriers were minimal. Indeed, the capital requirement was only about the same as the market price for a 2-bedroom apartment in a large city!
The second stage of development, roughly 1994-1995, was shaped by the first large wave of bankruptcies in the Ukrainian banking sector and, at the same time, by the entrance of the first foreign banks in Ukraine. Here, the NBU (at that time led by Victor Yushchenko) strengthened its banking regulations and activity, bringing the standards closer to international standards. Some banks that had a lack of capital, a large number of bad loans, and other problems had difficulty meeting the new standards. As a result, 11 banks in 1994 and 1 bank in 1995 were liquidated, which hurt some people but also helped to improve the banking sector. Specifically, as a response to the wave of unexpected bankruptcies, the NBU adopted a system of control by beginning to regulate the required financial indicators characterizing a bank's liquidity, paying capacity, minimum risk share per client, minimum percentage of equity, etc., which contributed to the prevention of future bankruptcies. On the other hand, in 1994 the NBU also improved the operating environment by implementing the national electronic payment system that was fast, so that payments made at a designated payment center, the post office for example, would appear on the creditor's computer within an hour, despite the poor communication system at that time. The NBU also finally tightened its monetary policy suppressing the hyperinflation that had jumped from the annual rate of about 10,150 percent in 1993 to about 400 percent in 1994. The average interest rate spread (measured as the difference between the interest rates for deposits and for loans) reached its peak of about 46 percent in 1995, and started to decline since then, slowly reviving credit feasibility for Ukrainian businesses and consumers.
The third stage of development, roughly from the beginning of 1996 to the middle of 1998, was a period of further stabilization in the Ukrainian banking system and the Ukrainian economy in general. The critical step here was the introduction of a stable national currency, the hryvnia, in 1996, together with further tightening of the monetary and budget deficit policy by the NBU and the government, which led to further reduction in inflation and in the interest rate spreads. At this stage, an average bank had much more capital and resources for giving loans as well as more experience in operating in a market economy. Remarkably, the industry profit in 1996 was twice that of the previous year. However, the rapid boom of Ukrainian banking was suddenly hit by the Russian financial crisis in August 1998, which caused sudden depreciation of the Ukrainian hryvnia from about 2.1 to about 5.4 for 1 US dollar in 17 months. Sixteen banks were liquidated during 1998.
The fourth stage, roughly mid-1998 to mid-2001, was a period of modernization for the banking system in Ukraine. First, international accounting standards were adopted in 1998, making the comparison of Ukrainian banking with the rest of the world much easier. More banks with foreign capital entered the industry encouraging a widening of the spectrum of banking services. At this stage, banks became 'closer' to the client and started offering some new products on the Ukrainian market such as securities custody, registrar services, settlement schemes for the acquisition of shares, advanced retail banking, various financial consultations, etc.
The entrance of foreign banks during this early period was expected to boost the Ukrainian banking sector substantially, but it was suddenly constrained by the event that placed a 'black spot' on the sector's development. This was the fifth stage of development, roughly mid 2001-2003, which began with the inclusion of Ukraine on the 'black list' of the Financial Action Task Force (FATF), in September 2001, as a country that had not cooperated with FATF and failed to enact anti-money laundering legislation that met international standards. Nevertheless, the sector was still growing: the total loans and assets in the banking sector, for instance, grew, on average, by about 50 percent annually.
At the beginning of 2004, the FATF removed Ukraine from its 'black list' inducing a new, sixth, stage in the sector's development - 2004-2006 -marked by a wave of acquisitions of a number of Ukrainian banks by large foreign banks, which attracted considerable attention of media, government, business people, and just regular citizens. Recall that since 1994, Ukraine already had banks that were 100 percent foreign as well as banks with some foreign share (see Figure 1). Yet, the proportion of foreign ownership was relatively small, only about 15 percent, with the largest 100 percent foreign bank taking just 8th place in terms of assets. In the second half of 2005 (the deal was made on October, 20), Ukrainian media published shocking news: the 93.5 per cent share of the second largest bank, Aval, was purchased by Raiffeisen International for US $1.028 billion. A few months later, (February 14, 2006), another major business deal was announced - the sale of 85.42 percent of Ukrsotsbank to Italian investors (Banca Intesa), for US $1.161 billion. A few other large banks (Ukrsibbank, "Forum", Vabank, "Mriya") as well as some smaller banks (Index-Bank, Megabank, etc.) sold some of their shares to foreigners in 2005-2006 and yet a few more banks are in negotiation. By August of 2006, the share of foreign ownership in the Ukrainian banking sector doubled, amounting to about 30 percent (see Figure 2).
An intriguing question that the reader might share with us is: Will this trend - local banks being taken over by the foreigners - continue for Ukraine? The experience of other leading transitional countries suggests that this trend is indeed likely to continue - if the business environment in Ukraine continues to improve. Indeed, for such countries as Estonia, Slovak Republic, Hungary, Czech Republic - countries that are often presented as good examples of transition economies - the foreign share in the banking sector has been about 90 percent since 2002 (see Figure 3). Yet, it is also very likely that the portion of assets belonging to domestic investors in Ukraine will continue to be substantially higher than that in other successful transitional countries, even if the business conditions in Ukraine are attractive. This is because, relative to the just mentioned transitional countries, Ukraine has significantly more large domestically owned businesses, often referred to as financial-industrial groups, which might prefer owning their own banks or at least having substantial control over a local bank. A more robust answer to the question, however, requires deeper analysis of the reasons behind the takeovers, which is the subject of further research.
There is also a normative question: "Should the Ukrainian government allow continuation of such a trend?" As a matter of fact, both the government and the National Bank of Ukraine have been discussing the issue of placing restrictions on this trend by limiting the total share of foreign ownership in the entire banking sector in Ukraine at some level. The problem is defining the level that would be more or less optimal for the country. Indeed, the entrance of foreign banks is often associated with improvement in the sector due to increased competition. The average consumers and businesses feel this improvement directly-through a decrease of interest rates for the loans they can take, a decrease of prices for the services, an increase in quality and variety of services they can get from a bank. Such improvements in one bank induce other banks to improve as well, or cause them to leave the market - and this is exactly what brought the Ukrainian banking sector to a level that is better than that in many other transitional countries. Actually, the banking sector in Ukraine is one of the few areas of a market economy of which Ukraine can be proud at this point. This can be seen, for example, in the recent World Bank surveys "Doing Business," where Ukraine is ranked almost as the worst in the world for most criteria of business environments, but ranked fairly high for the issues related to banking-better than most transitional and even some developed countries. Nevertheless, there is still a lot of room for improvement and the restrictions on the share of foreign ownership would shake the liberal foundation that made it as well developed as it is, and would endanger its further improvement.
What the government should worry about first, instead of building the new entry barriers for foreigners or any other investor, is to make sure that the concentration within the sector remains low - to keep the competition high. In general, it should not matter who buys a bank - foreigners or locals - but what should matter is the resulting quality of services offered by the new owner, its reliability, and how that purchase would affect the level of competition in the entire financial sector of the country and its particular regions.
The second issue the government should really worry about, instead of raising entry barriers, is the weakness of many small banks that are on the verge of bankruptcy. As a matter of fact, Ukrainian banking is very likely to be approaching a large shakeout, which we think would be the seventh period of its evolution. An industry shakeout is the period of development that is characterized by a massive exit of many players and consolidation of other players in the sector. By looking at various industries in the world it appears that all of them go through such a period, with the first shakeout emerging, on average, around the 15th year of development - with some variation depending on the industry and economy specifics. Ukrainian banking has already lived through 15 years of development and satisfies one of the key factors economists believe to be detrimental for inducing the shakeout-a decent level of maturity in producing and supplying the main products (for banking, these are loans and deposits for business and consumers). So, in the next 2-3 years it is very likely that we will observe a substantial reduction of banks in Ukraine, together with enlargement of some banks, as well as an attempt of some small banks to survive by introducing relatively new products for Ukrainian consumers (leasing, factoring, etc.).
An important question is how this massive exit of banks from the environment will be performed. In the worst case, we will see a large wave of bankruptcies. A way to prevent or at least minimize the number of bankruptcies is to encourage mergers between and acquisitions of small banks-whether by locals or by foreigners. Indeed, many of the small banks that are likely to be on the edge of bankruptcy do not have fatal problems but just management and marketing difficulties that can be resolved through replacement of their management-a natural step after the merger or acquisition. One of the main reasons, however, that kept investors away from buying such banks is their low level of transparency, which did not allow getting a clear picture of true problems of the banks by potential investors. Naturally, what the government and the NBU could and should do in this respect is to make the international standards of transparency mandatory for all banks in Ukraine.
It is important to note that some positive steps have recently been taken in this respect through the new law that was passed and came in force on October 4, 2006. According to this law, all the banks must become open joint stock companies within the next three years. Note that only about half of existing banks already have the required status. Ironically, some of the banks are registered as limited liability companies and even the central bank (at least officially) does not know the true owners of some of the banks and the new law is supposed to help in solving this problem. Also, according to this law, new entrants in the banking sector would need to have minimum statutory capital of 10 million EURO (earlier the requirement varied from 3 to 8 million EURO). By the data from the second quarter of this year, 117 banks out of 166 registered banks in Ukraine (i.e., more than 70 percent!) do not satisfy the new requirement. Interestingly, however, it appears that the new law does not oblige (at least explicitly) satisfying the new requirement for the banks that were registered before the law was enforced. This might suggest that new investors in the sector, if they do not want to comply with the new capital requirement, would have the option of buying an existing bank that does not have to comply with the new requirement. Moreover, such purchase should become easier than it was before, given that the pre-existing banks would have to become relatively more transparent than they were before the law was introduced-by having transformed themselves into open joint stock companies. So these measures are likely to be very helpful in 'sanitizing' the industry.
Overall, the dynamics of the sector and the recent prophylactic measures taken by the authorities in Ukraine suggest that Ukrainian banking is about to go through dramatic changes which, we believe, would help it reaching a more advanced and robust level. o
Natalya Dushkevych is a researcher affiliated with EROC at EERC and Kyiv Economics Institute. Valentine Zelenyuk is a Senior Economist at Kyiv Economics Institute (KEI), Professor of EERC (Kyiv-Mohyla Academy), and Director of Ukrainian Productivity and Efficiency Group (UPEG). The authors thank Tom Coupe' and Albert Jaeger for insightful comments. The views expressed in this article are those of the authors and do not represent the views of above-mentioned organizations or people.
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