Financial Stability Report: PrivatBank Litigation and Possible Pause in Cooperation with the IMF Constitute Key Risks to the Financial Sector
Systemic risks to financial stability are near all-time lows and macroeconomic conditions are favorable for the banking business. However, the sector is still facing risks related to the PrivatBank litigation processes, as well as to possible pause in cooperation with the International Monetary Fund (IMF). These themes are explored in the latest Financial Stability Report (Ukr).
The key near-term task is to secure a new IMF program
In May, an IMF review mission visited Ukraine and announced that the IMF stood ready to continue discussions after the forthcoming parliamentary elections and after a new government was formed. The current program expires early next year. Bearing in mind the long list of reforms Ukraine still has to implement and given the vulnerability of the Ukrainian economy to external shocks, the National Bank of Ukraine (NBU) deems it prudent to initiate a new long-term program with the IMF, ideally before the expiration of the current Stand-By Arrangement.
Consumer lending grows rapidly, but not all banks are prepared for the risks
Consumer lending is growing quickly for the second consecutive year. Unsecured retail loans for current needs are growing at more than 30% yoy for the eighth consecutive quarter. This market segment offers high margins and is thus attractive to banks. Retail loans currently account for 18.4% of the banking sector’s total loan portfolio while generating almost 40% of loan interest income. Household demand for consumer loans is stable and high. That demand supports the high growth rates of the consumer loan portfolio and forms the basis for the segment's considerable growth potential.
Most banks are appropriately estimating potential losses against those loans and are making sufficient provisions based on current macroeconomic conditions. Nevertheless, their loan loss estimates for a crisis are sometimes overoptimistic. To estimate required provisions, some banks use models that are not sensitive to a sharp deterioration of macroeconomic conditions. These financial institutions may fail to form sufficient provisions in preparation for an adverse scenario. To mitigate that risk, the NBU may raise its risk weightings for unsecured consumer loans. The higher risk weighting would mean that capital would cover potential losses on those loans.
Banks must direct record profits to build capital buffers
Ukraine’s banking sector is currently generating record profits. In the first five months of 2019, banks' net income reached UAH 23.4 billion (+83% yoy). The high profits are a product of consumer lending growth and a rapid increase in demand for banking services, which drives high commission income. The short-term risks to profitability are insignificant, but banks must be conservative in their medium-term planning and must assume that profitability will fade in the future.
The NBU recommends that banks use their ample profits to build capital buffers. Capital requirements will increase substantially over the coming years; banks will need to build a capital conservation buffer and a systemic importance buffer (for systemically important banks), and will need to use capital to cover operational and market risks with capital (currently only credit risk is covered with capital).
This is especially important for state-owned banks, which are currently meeting capital requirements by only a small margin. Those banks will now have to distribute 90% of profits from last year via dividends. However, the NBU believes it is more prudent to use a portion of profits to increase capital to comply with future capital requirements.
The dollarization of banks' balance sheets is gradually decreasing
In recent periods, the dollarization rate has fallen at banks with foreign and private domestic capital. Now, the ratio of foreign currency deposits and loans slightly exceeds 40% of their total value. Some banks still have corporate clients with foreign currency borrowings whose earnings are almost exclusively in hryvnia. The NBU expects the dollarization rate to gradually decrease as market forces take hold. Sustained macroeconomic stability, a slowdown of inflation, and a sizable gap between hryvnia and foreign currency deposit rates will propel that decrease. The NBU estimates the natural dollarization rate for Ukraine at around 20%.
On the other hand, the dollarization rate for the public debt exceeds two thirds. This is a source of risk for Ukraine’s public finances. However, investment by nonresidents in hryvnia-denominated domestic government bonds, made easier by Ukraine’s recent connection to the Clearstream international central securities depository, should facilitate a gradual increase in the proportion of hryvnia-denominated public debt.
The NBU will push for a further strengthening of the resilience of the banking sector
A priority in strengthening the resilience of the banking sector is the approval of a regulation on the process for managing non-performing exposures (NPEs) at Ukrainian banks. Financial institutions will have to design and implement a strategy and action plan to resolve NPEs. The execution of those strategies and plans will reduce the ratio and volume of NPLs. To enable state-owned banks to adopt the NPE management approach, Ukraine’s Cabinet of Ministers will need to adopt a regulation to streamline the NPL resolution process at state-owned banks and launch the cleanup of NPLs from their balance sheets. The resolution of NPLs is the key objective for the newly appointed supervisory boards of the state-owned banks.
Works are ongoing to design a new liquidity requirement, the net stable funding ratio (NSFR). The NBU plans to approve the NSFR in late 2019 and introduce the new requirements in 2020. The initial NSFR requirements and the duration of the transition period will be identified based on a series of tests.
The NBU has also started updating its methodology for calculating capital adequacy in order to account for operational and market risks on top of credit risk. In 2019, the NBU will publish a draft methodology for the calculation of capital needed to cover operational risk. The calculation will be run in test mode in 2020, and the requirements for operational risk coverage will be fully introduced in 2021. The NBU intends to offer a lengthy transition period to allow banks sufficient time to ensure adequate capital levels without breaching regulatory requirements.