Friday, August 22, 2014

How to restart lending in Ukraine despite unfavorable macroeconomic and legal conditions

By Yuriy Gorodnichenko (UC Berkeley) and Dmytro Sologub (Raiffeisen Bank Aval)
Bank lending dries up in recessions and Ukraine is no exception. In January-July 2014 total loan portfolio of the banking system shrank by 8% as both loan demand and supply nearly vanished in response to looming political and economic risks. Whether tight credit is a cause or an amplification mechanism in recessions is perhaps not so important from a practical standpoint because in either case the key issue is how to restart lending to minimize adverse effects of depressed economic activity. This is a challenge because default/counterparty risk in recessions is high and so banks are reluctant to issue new loans. In Ukraine, this risk is further magnified by imperfect legal environment (i.e.  pervasive loan fraud as well as weak and slow legal enforcement of loan agreements) and tight funding conditions (the access to global debt markets is shut down, while the banks faced strong deposit outflows in the first half of this year) .
Source: IIF

So, how can Ukraine’s government restart lending? In an ideal setting, the right answer is that the sustainable lending growth should be based on the stable macroeconomic conditions, adequate legal framework, and healthy and transparent banking system. Unfortunately, none of that is feasible in the short-run and even if comprehensive economic and structural reforms are started now, we will not see effects for some time. Therefore, the question is what should be done here and now to facilitate bank lending in Ukraine. This task could be understood as a constrained optimization problem: the objective is to restart lending subject to constraints, such as macroeconomic instability, imperfect legal environment and low confidence in the banking system.

To start with, let’s consider lending activity as a function of funding conditions and risks faced by banks (i.e. credit, liquidity and interest rate risks). In a nutshell, countercyclical policies aimed to stimulate lending are designed to reduce the cost of loanable funds to banks and/or increase banks’ benefit (or, in other words, minimize risks) of lending to the private sector. There is a broad spectrum of tools available to achieve a combination of these goals. If the cost of a loan is made sufficiently low or the benefit is made sufficient high, some banks will resume lending to some firms and this could be a start of a turning point in recession. Below we outline an incomplete list of options to improve funding conditions and minimize risks, which could prove effective in increasing lending.
Stabilize the deposit market. Ukrainian banking sector for the long time has been characterized by low concentration and consolidation. Specifically, there are nearly 180 banks around and almost all of them are attracting deposits of private individuals. This competitive market for retail deposits prompts some banks (especially those ones, which engage in risky lending activities) to use “predator pricing” strategies – setting unsustainably high interest rates on deposits in order to attract additional customers. Unfortunately, such aggressive pricing policies can lead to bank failures and thus affect the rest of the banking system via plunging depositors’ confidence in the banking system. Therefore, we believe that there is a clear need to improve “rules of the game” by enhancing the regulation of deposit-taking institutions to eliminate destabilizing “predatory pricing”. One option could be to penalize the banks, which set much higher (than market average) rates on deposits. For example, the National Bank might set the maximal rate on deposits and no deposits are allowed to be taken on higher rates. Alternatively, the banks offering rates substantially higher than market average should pay larger contributions to the Deposit Insurance Fund, or the deposit guarantee is not extended to the deposits, taken at higher than average rate.
Lower discount window rate or interbank lending rate: This is a standard tool used by the central banks. By lowering short term rates, they reduce the cost of loanable funds for the banks, saturates banks with liquidity and thus increase incentives to lend. For example, the FOMC of the Federal Reserve in the U.S. routinely lowers interest rates by more than 5 percent over the course of a recession to stimulate lending. In the Ukrainian context, there is an important issue with this approach in its pure form: banks may use these cheap funds to invest in projects outside country or invest them into projects with high short-term returns with limited effect on the real economy in Ukraine (for example, banks can buy foreign currency or foreign assets).  So this policy tool has to be combined with other tools to make it more effective.
Increase the guarantee on deposit insurance: Banks can be averse to lending in recessions because they may face a bank run when depositors rush to withdraw their funds from the bank. As a result, banks have to keep a lot of liquidity to meet potential spikes in withdrawals. Holding so much liquidity is counterproductive because, instead of being used for lending to the real sector of the economy, money sits in bank vaults. However, runs are less likely to occur if deposits are insured and the insurance ceiling is generous. One can adjust the ceiling on insurance in recessions to reduce the likelihood of bank runs and thus allow banks to convert some liquidity into more lending. For example, during the Great Recession in the U.S., the FDIC increased temporarily the maximum insurance from $100,000 to $250,000. While the increased insurance may deplete reserves of the Ukrainian analogue of the FDIC (as nearly happened in the U.S.), a simple solution to this problem is to allow the insurance agency to borrow funds from the Treasury and then pay it back when the situation is normalized, which is precisely the solution used by the FDIC during the Great Recession in the U.S. Given the tsunami of failed loans in the U.S., this solution allowed the FDIC to increase premiums on insurance during the financial crisis and thereby reduced the risk of bank runs and lowered the cost of funds. In the Ukrainian context, perhaps the central bank rather than the Ministry of Finance can provide resources to cover temporary shortage of liquidity in the deposition insurance fund. To minimize moral hazard problems, the central bank and deposit insurance fund can coordinate their efforts and, for example, charge higher premiums on banks that do not pass stress tests and fail to meet other quality criteria.
Tie funding to new lending: Banks need liquidity in recessions and this liquidity often comes from the central bank. While central banks typically do not attach conditions to such funds, they could require banks to use some of the borrowed funds for new loans. This is exactly the point of the “funding for lending” program created by the Bank of England. This program has been perceived as being quite effective in resuming lending and contributing to a revitalized housing market in the U.K because it reduced the cost of funds (a bank receives money from the central bank at a relatively modest, close to risk free interest rate) and increased the benefit of lending (lending not only earns interests but also provides liquidity in the housing market). In the Ukrainian context, the funding for lending can be targeted at providing loans for critical infrastructure projects (terminal to import liquefied natural gas, reconstruction of the East, roads, etc.) and/or facilitating SME business development rather than housing.
Subsidize interest rates: Governments in many countries offer programs to subsidize interest payments on economic activities (agribusiness, export, high-tech manufacturing) deemed important in their countries. For example, if a bank charges 10%/year on a loan, the government can pay 3%/year so that the out-of-pocket cost to the borrower is 7%. Also these and similar subsidy programs are often used for countercyclical purposes. For example, the Farm Security and Rural Investment Act of 2002 provided countercyclical price support to agribusiness in the U.S. in response to the 2001 recession. Student loans subsidized by the U.S. government allow deferring of payments on loans for up to three years in case the borrower is unemployed. In the Ukrainian context, subsidized, contingent loans may be directed to agribusiness (food security), military equipment and machinery, and other vital sectors of the economy. Of course, there are also the downsides to using this instrument, in particular potential market distortions and the risk of misuse of the funds. Hence, we advocate to use such scheme with extreme caution - to define the rules as clearly as possible, limit the size of this scheme and maybe even making it temporary (i.e. unless prerequisites for sustainable market lending activity are developed).
Use credit enhancement mechanisms, such as co-signing and risk-sharing. First, a great insight of micro-finance in developing countries is that collective responsibility (so called, solidarity lending) filters out bad projects and bad borrowers without banks’ involvement. With some oversimplification, if somebody from a village borrows from a bank and fails to repay, it’s the village that is responsible for repaying the loan. So the village closely monitors who gets money and, hence, greatly reduces default/counterparty risk. In developed countries, this idea is embodied via co-signers. If a borrower fails to meet his debt obligations, a co-signer on the loan is responsible for it. Obviously, the quality of the co-signer is important (it has to be a credible person or firm) but at least for small and medium-size businesses it should be relatively easy to find co-signers. Stimulating lending with co-signers can restart bank lending in the economy. Second, the government can take on more of the risk from new lending to reduce the burden on banks in case loans go bad. That is, if a loan is not performing, the government absorbs a fraction of the loss. This policy has costs and benefits. The main cost is that it can be prone to abuse. Hence, it is vital to ensure that banks have “skin in the game”. For example, the bank pays the first 10% of losses and the government pays the second 10% of losses. This is similar to a deductible in standard insurance. The main benefit that the government does not have to pay anything upfront and only has to pay later if the bad scenario materializes (one can think of this as an off-balance sheet liability). Since the government in Ukraine has scarce resources now but may have more in the future, this policy may be “cheap” for the government now. In a way the TARP program in the U.S. proved to be hugely profitable  since the government “bought” distressed assets and “sold” them at a great premium when the economy improved. However, a drawback of this scheme might be that, given junk sovereign rating, the lenders might not be willing to accept the risk-sharing scheme with the state.
Stimulate resolution of bad loans: New lending is hampered by the large stock of problem loans in banks’ balance sheets (rating agencies estimated average NPL ratio at the level of 30-40% at end-2013). Non-performing loans are damaging the banking system in many ways. The experience of Japan and other countries shows that these loans can stifle new lending and channel resources to loss-making projects. The government can help to get the bad loans off banks’ balance sheets. In the Ukrainian context, the main impediment to the resolution of bad loans at the moment is unresolved taxation issues. This problem should be tackled immediately by the authorities. 
Facilitate liquidity management for banks by improving refinancing policies of the National Bank, allowing foreign-exchange (FX) swap operations between the banks and developing domestic money and bond markets. High liquidity risk is one of the reasons of high bank margins in Ukraine, which in turn pushes credit interest rates up. In our view, there are several measures, which can be implemented immediately to tackle this problem. First is to ensure that the banks are granted unconditional access to NBU refinancing facilities if they have eligible (high-quality) collateral. Second, while FX swap operations between the banks are de-jure permitted, de-facto the banks cannot use them because of Pension Fund fee on FX purchase. To resolve the problem the fee should be either cancelled or modified in such a way to make FX swap operations possible. Finally, the authorities should make steps to increase liquidity and create interest rate benchmarks at the domestic money and bond markets.
Utilize foreign parents: The foreign-owned (non-Russian) banks comprise nearly 15% of the banking system at the moment. These foreign banks are large relative to the size of Ukraine’s credit market and their exposure to Ukraine can be quite limited. At the margin, they can take more risk and the government can provide incentives. For example, the government can ask for fresh injections from foreign parents and allow them to take advantage of depreciation and negotiate 100 percent rollovers for parent-affiliate financing. A version of the Vienna Initiative could help convince foreign parents to increase rather than cut exposure to Ukraine.
Recapitalize banks: A fascinating property of banks is that a dollar in bank capital generates more than a dollar in loans and the multiplier can be large. This is why TARP funds in the U.S. were used to provide capital to banks rather than to buy distressed assets. Given rising public debt, the government may be constrained by how much capital it can inject, but such injections can have a multiplier effect thus justifying recapitalization of the banking system.
Summary: Obviously, as noted in the introduction, removing the key risk factors such as the war risk, the macroeconomic  risk, the legal enforcement risk can be the largest sources of lending boom in Ukraine. However, even if these risks cannot be eliminated completely, there are options to keep lending flowing into the economy. A general theme of the proposed tools is to inject more capital and liquidity to banks, tie these to lending to the real sector, take more risk and provide countercyclical insurance, generate and use more information, exploit international sources of funds and expertise.   

1 comment:

  1. Great piece, as always!
    Some notes, which I guess are important.
    Setting maximum interest rate on deposits may cause banks to shift toward alternative ‘luring’ technics, such as lotteries or other, without any actual decrease in total transfer to depositors and thus the overall situation will remain unchanged. I guess that linking interest rates to payments to insurance fund is a better alternative (as noted in the text).
    Lower interbank lending rate may encourage inflow of funds to the forex market. Is the liquidity of the banking system as a whole low? I guess not, which argument is supported by relatively low short-term interbank interest rates (let’s compare with 3-month deposits) and by way higher than in 2012-2013 outstanding amounts held on banks' correspondent accounts. The problem of harmful usage of additionally lent funds is noted in the text, but I guess it should be stressed.
    Increasing the guarantee on deposit insurance will not significantly affect deposit withdrawals – 95%+ of deposits are below the current insurance amount, the rest are often over UAH 1mn per account, i.e. way above the insurance level, even doubled.