How to restart lending in Ukraine despite unfavorable macroeconomic and legal conditions
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.
Great piece, as always!
ReplyDeleteSome 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.