The past year was a successful one for Ukraine’s banking system. Systemic risks remain moderate, but they may rise next year. The key risks to financial stability include the suspension of cooperation with the IMF, the slow pace of structural economic reforms, the low efficiency of state-owned banks, and the weak legal system. Those are the key messages of the fourth Financial Stability Report, published on 18 December 2017.

A lengthy delay of the next IMF tranche is the key risk to financial stability

There were few changes in Ukraine’s macroeconomic environment in the second half of 2017. Economic growth remained sluggish, but it will accelerate to above 3% in 2018. Exchange rate volatility was modest. Inflation overshot the expectations communicated in early 2017 and is currently above the NBU’s target. Higher inflation is an impediment to lending over the medium- and long-term. In Q4, the NBU hiked its key interest rate twice by a combined 2 pp to 14.5% to tame inflation risks. However, those rate increases should not derail the longer-term trend of a decline in interest rates.

In the aftermath of the clean-up stage, the banking sector earned profits again. This trend is to hold in 2018. The major short-term challenge for banks is implementation of IFRS 9. The transition to the new standard may affect banks’ equity substantially. The impact on regulatory capital will be less significant.

The key macroeconomic risk to financial stability over the coming years is the suspension of cooperation with the International Monetary Fund (IMF). Without support from international institutions, a successful roll-over of the more than USD 20 billion of sovereign and state-guaranteed debt maturing in 2018-2020 is unlikely. Ukraine would do well to launch negotiations on a new IMF program before the current program expires early in 2019.

Consumer lending does not pose a risk to financial stability for now

Lending to businesses and households has restarted after a three-year break. Lending first recovered in the retail segment, and banks are growing their retail loan portfolio primarily in consumer loans. Ukraine currently has the lowest retail loan penetration in Europe, and the NBU expects household credit to grow rapidly over the next few years.

Retail lending does not currently have a material impact on private consumption and it does not pose a significant risk to inflation or the current account. Therefore, the NBU does not yet see a need to act to restrain retail lending. The NBU will remain vigilant on developments in retail lending to mitigate potential risks. If necessary, the regulator will tighten requirements on credit risk assessment at banks for retail loans or introduce macroprudential policy instruments to limit excessive credit growth. The NBU will report twice annually on consumer lending developments and will communicate in a timely manner about risks and propose measures to mitigate those risks.

Interest rates are at record lows for foreign currency retail deposits and at five-year lows for hryvnia deposits. Given the cheaper funding base, the NBU expects interest rates on loans to decrease significantly over the next 12-18 months.

The protection of creditor rights must be enhanced to reinvigorate corporate and mortgage lending

High interest rates are still holding back the recovery of mortgage lending. However, new mortgages will be more affordable in 2018. Secured long-term mortgages currently account for less than 5% of new loans, but that share is due to grow in the coming years.

The shortcomings of the foreclosure procedure when a borrower fails to service a loan is the major obstacle to the recovery of mortgage lending over the medium term. The foreclosure mechanism must be reformed to make housing mortgages more affordable.

The financial standing of companies is no longer an obstacle to a recovery of corporate lending. Profit margins for most industries in the real sector are higher than before the crisis. Companies are generating sufficient cash to service loans in time, and new attractive corporate borrowers are emerging. If macrofinancial conditions remain stable and the protection of creditor rights is improved, new corporate loan formation will grow, especially to small- and medium-sized enterprises (SMEs).

The key internal risks to the banking sector have remained the same over the last few years: the high market share of state-owned banks and the high share of non-performing loans (NPL) in banks’ portfolios. A strategy for reforming state-owned banks must be finalized as soon as possible. Any delay to its implementation will raise the fiscal costs of covering future losses at state-owned banks. The program must set clear timeframes for the state’s divestment of banks. Meanwhile, banks must be more proactive in resolving NPLs by using restructuring and write-off mechanisms.

New NBU regulations will focus on crisis prevention

During the crisis years, the NBU focused on normalizing the work of the banking sector. Now, the regulator’s attention is shifting towards crisis prevention. In 2018, the NBU will work actively to formalize requirements based on the recommendations of the Basel Committee on Banking Supervision (Basel III) and EU directives.

In 2018, the NBU will introduce a new liquidity requirement, the liquidity coverage ratio (LCR). The LCR aims to enhance banks’ resilience to sudden outflows of funds. The NBU will also share with banks a draft regulation on the new structure of regulatory capital and eligibility criteria for its components. The requirements will only be implemented after the completion of a detailed quantitative analysis to study their effects on the banking sector.

Banks will be stress-tested annually, which will become an important component in ensuring banking stability. Banks with combined assets of at least 90% of the sector’s total will be subject to the stress-test.

The NBU will further enhance disclosure standards for banks’ financial and prudential reports. Starting in 2018, the NBU will publish reports on the regulatory capital structure, and disclosure requirements will grow stricter with time. The NBU’s goal is to ensure the complete transparency of banks’ operations and financial positions.