The banking sector has been one of the fastest growing sectors of Ukraine's economy of late. Its assets grew by 11.25 percent to 378,452 million hryvnias in the first quarter of 2007 (by 59.2 percent in 2006). Behind the explosive asset growth is the expansion of credit, with loans making up more than 70 percent of banks' assets in Ukraine. Favorable economic conditions have led to increased demand for loans from both businesses and households. Until very recently, the demand was matched by the mobilization of deposits since Ukraine had credit and deposit booms simultaneously. Undoubtedly, the increase in financial intermediation has played an important role in Ukraine's recent economic growth, contributing to higher investment and consumption.
Financial market liberalization in Ukraine has offered new profitable financial opportunities for Ukrainian banks and foreign investors. Since a good financial intermediary borrows funds from savers at low rates and lends funds to borrowers at high rates, the best a Ukrainian financial intermediary can do is to borrow abroad and to lend in Ukraine. Unsurprisingly, Ukrainian banks' borrowing from foreign lenders has skyrocketed recently and a number of foreign banks have entered the financial services market and many others would like to. More than one-forth
(25.5 percent) of Ukraine's foreign debt ($54,286 million or more than 50 percent of GDP as of January 1, 2007) is owed by commercial banks. The government, with its 25.4 percent share of the debt, has less influence and control over the level of foreign debt than commercial banks do. Moreover, the situation has been quickly deteriorating.
Ukrainian banks' foreign indebtedness doubled in 2006 from $6,748 million to $13, 870 million (see Table 1 for details). Everyone knows appetite comes with eating. So, "Finansy i Kredit," a bank with about $1,700 million in assets, has an impressive plan to borrow $700 million from abroad this year. This plan is not something unusual for the booming Ukrainian banking sector. Ukrainian banks have been replacing domestic with foreign savings, which makes the Ukrainian economy more vulnerable to external shocks.
The government has also loosened its control over companies' foreign borrowing. As a result, in 2006 alone, Ukraine's foreign debt increased by $14,667 million (or by 27 percent). Moreover, adding foreign direct investment ($4.5805 billion in 2006) and equity purchases leads to the conclusion that total capital flows to Ukraine exceeded $20 billion in 2006. In other words, pretty poor Ukraine, with a GDP of $106 billion (2006), has become submerged in relatively cheap foreign funds. Similar economic developments took place in East Asia in 1996-97, when mounting private sector debt led to the 1997 economic crisis, with total capital flows to Indonesia, Malaysia, and Thailand reaching 11 percent of before-crisis aggregate GDP. Most of the foreign funds were short-term and directed at speculative activities, essentially on equities and real estate.
The Ukrainian banking sector has lowered the share of short-term foreign debt in its total foreign debt from 62 percent in 2005 to 47 percent in 2007. However, even the last figure is very disturbing because of the banking sector's importance for the functioning of the whole economy. Moreover, since the banking sector is one of the most regulated and monitored sectors of the economy, Ukraine's ratio of short-term foreign debt to total foreign debt is without a doubt higher than 50 percent. For comparison, in June 1997, the ratio was about 59 percent for Indonesia and Philippines and 56 percent for Malaysia.
The last five months of 2006 were marked by an unprecedented growth in housing prices. The National Bank of Ukraine's (NBU) loose monetary policy can be blamed for it only in part. Last summer's changes in the discount rate and in the reserve requirements not only boosted the money supply but also sent an unambiguous signal to the Ukrainian financial industry, which responded to it with drastically increased borrowing from abroad ($6,062 million in the second half of 2006) and with making credit readily available to both good and bad risks.
The larger the foreign capital inflows, the higher the incentives for banks to engage in risky lending activities are. Since last August, many Ukrainian banks have offered zero and five-percent down payment mortgage loans. It is true that such loans help cash-strapped Ukrainians to buy an apartment. However, they have also increased the amount of risk taken by the lenders. As statistics for the United States show, three-percent down loans are foreclosed four times as often as those with ten-percent down payments.
The rapid expansion of credit to the housing sector is not necessarily welfare-improving. In Kyiv, housing price increases have not been accompanied by any significant growth in construction. The easy availability of credit has affected mainly prices. Among the market participants are a considerable number of people betting on an increase in housing prices. Many good risk consumers have been priced out of the housing market. High mortgage prices, low-income customers with no credit histories, and loans sometimes covering 100 percent of an apartment's purchase price make the whole mortgage industry look not very much different from a sub prime lending industry. As soon as housing prices stop climbing up, one can expect a meltdown to ensue, one more severe than the recent meltdown of the U.S. subprime mortgage industry.
There are a number of factors that make the rapid credit growth even more perilous. Ukrainian banks have just started setting up credit bureaus for household and small business lending. So their ability to manage credit or default risk on individual loans is pretty limited. This does not prevent banks from making decisions on extending loans to customers within a couple of days. A customer's eligibility is based on information provided by the customer about his/her sex, age, family status, place of work, salary, real estate property owned, salaries of the other family members, etc. Making a call to his/her employer is an important part of the so-called screening process.
Consequently, mortgage loan decisions are reject or accept decisions. Customers are not sorted by interest rate differentials, which undoubtedly worsens the efficiency of the market for mortgage loans.
Lending interest rates reflect, among other things, the average risk among customers. Since the interest rates offered are too high for good-risk customers, it is rational for many of them to postpone buying an apartment at a more favorable time. The people who stand ready to take out a mortgage loan at any interest rate offered are mainly bad risks and real estate speculators. In other words, banks get an adverse selection of customers. Moreover, high interest rates and inflated housing prices may also induce some otherwise good-risk borrowers to switch to higher-risk projects in order to have a chance of being able to pay off the loan. Therefore banks' unsatisfactory screening and monitoring facilities contribute to the financial instability of the banking sector.
The adverse selection problem permeates the Ukrainian banking sector. The effective rates on many consumer loans are 40-60 percent or even higher. To understand why good-risk consumers would prefer not to take out such loans, it is enough to recall that the NBU's discount rate is 8.5 percent. A number of regulations can enhance the stability of the Ukrainian financial sector. Among them are restrictions on interest rates (usury ceilings), on lending to certain sectors (to curb speculative activities), and on the currency of lending.
A growing number of banks have been offering mortgage loans denominated in Swiss francs. The claim, voiced by the banks, that these loans are beneficial to borrowers can seriously mislead inexperienced Ukrainian customers. A floating interest rate of 8.99 percent in Swiss franks sounds better than 12.49 percent in dollars and 17.5 percent in hryvnias. However, the fact, advertised by the banks, that the Swiss franc is a more stable currency than the dollar and euro is not good news to the customers who receive their income in hryvnias because the hryvnia is pegged to the floundering dollar. By extending foreign-currency-denominated loans, banks shift foreign exchange risk onto a party absolutely unprepared to deal with it.
 In a functioning market economy, the supply side of the housing market responds to soaring housing prices with a construction boom. For example, more than 800,000 homes were built last year in Spain. Unfortunately, Ukraine's construction industry does not respond to price signals, as theory would predict. This is related not only to the oligopolistic structure of the industry. On the micro level, the economy remains administrative, with many old faces still in power and no economists around.
Unsurprisingly, structural and institutional reforms are not on the top of the government's agenda. The financial sector cannot be strong in Ukraine's institutional environment because it operates in a society where many institutions the market needs to function efficiently or to function at all are at their nascent stage. With a tottering legal system, property rights protection and contract enforcement leave much to be desired. Foreign lenders and investors, in their search for higher returns, have not been paying sufficient attention to the state of Ukraine's economic and institutional fundamentals.
Of late, the NBU has taken a number of steps to tighten prudential regulation and supervision of the banking sector. So, it tightened capital requirements on problem loans and foreign-currency-denominated loans and made existing reporting requirements for banks stricter. Possible increases in capital requirements for banks with high foreign exchange risk exposure are under the NBU Board's consideration.
Hopefully these and other measures will enhance the stability of Ukraine's banking sector and it will avoid any significant problems in the near future.
Pavlo Prokopovych, Ph.D., Kyiv Economics Institute and the Kyiv School of Economics. The views expressed are purely the author's.
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