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Why do Ukrainian banks, having significant volumes of deposits, not lend to Ukrainian business?

In the December Financial Stability Report, the NBU clearly and unequivocally stated that “since September, the financial system has fully restored the function of financial intermediation.”

However, it is not entirely clear what kind of mediation it is.

It is well known from the economic literature that the main function of financial intermediation is the transformation of savings into investments, i.e., in the case of the banking system, it is a “transformation” of deposits into corporate loans.

However, if we accept this correct point of view, the logic of the NBU fails. Let us find out everything based on specific figures and facts for 2020.

According to the NBU, household deposits (including sole proprietors) in 2020 increased by UAH 154.2 billion (26.8%) to UAH 730.3 billion, including in the national currency – by UAH 94.2 billion (27.8%) to UAH 433.4 billion.

The rapid growth of hryvnia deposits was caused by the spending of budget funds for social needs (the primary budget balance was about UAH 96 billion, or 2.3% of GDP), the conversion of remittances of migrant workers (totaling USD 12.1 billion), wage growth (by 10.4% compared to the previous year), etc.

The growth of deposits in the national currency was mainly due to an increase in demand deposits by UAH 82 billion, or 48.7%, which was caused by a decreased propensity to consume in conditions of crisis uncertainty.

An additional factor in the accelerated growth of current account funds was the narrowing of the spread between interest rates on demand deposits and deposits up to 1 year from 5.8 percentage points to 3.2 percentage points during 2020.

The total volume of deposits of non-financial corporations in 2020 went up by UAH 115.8 billion (26.7%) to UAH 549.5 billion, including funds in the national currency – by UAH 93.1 billion (34.7%) to UAH 361.3 billion.

The increase in corporate deposits was mainly due to the inflow of funds from economic activities (including export earnings) against the background of low investment activity of enterprises (in January-September, capital investment fell by 35.4% compared to the same period last year).

According to some researchers, the growth of deposits also resulted from the spending of previously accumulated savings for consumption purposes with the subsequent accumulation of these funds in the current accounts of entrepreneurs.

In total, the volume of deposits in the banking system in 2020 grew by UAH 276.5 billion (25.8%) to UAH 1,348.1 billion, including in the national currency – by UAH 197.5 billion (30.7%) up to UAH 840.2 billion.

The rapid increase in liabilities was to be adequately reflected in the active part of the banks’ balance sheets. It was to be reflected and has been reflected, but not on the loan portfolio of banks.

In 2020, the volume of loans to customers decreased by UAH 69.8 billion (6.8%) to UAH 963.7 billion.

The NBU rightly emphasizes that the reduction in the gross banks’ loan portfolio was due to the write-off of non-performing loans (NPL).

Implementing one of the structural benchmarks of the program of cooperation with the IMF, state-owned banks have developed work plans to reduce the NPL and begun to implement them.

As a result, the volume of NPLs in the banking system in 2020 went down by UAH 100.4 billion (to UAH 430.4 billion), including in the national currency – by UAH 32.8 billion, in foreign currency (in hryvnia equivalent) – by UAH 67.6 billion.

The volume of working loans rose by UAH 52.4 billion in 2020, in particular in UAH – by UAH 31.0 billion, in foreign currency (due to exchange rate revaluation) – by UAH 21.4 billion  (in dollar equivalent – a decrease of USD 0.7 billion).

Of this increase in loans in the national currency, corporate borrowers account for only UAH 14.1 billion, which is even less than the volume of loans granted under the program 5-7-9% (UAH 17.5 billion).

A similar trend is also shown by the indicator of net loans (total loans decreased by the amount of reserves): sluggish growth after a reduction in the second quarter (at the end of the year the volume of net loans to corporations did not reach the level of the end of the first quarter).

However, one fundamental question remains unanswered by the NBU: why did the volume of working (as well as net) loans to corporations shrink in 2019, when there was no pandemic?

The true answer is not of benefit to the National Bank: low lending activity of banks is largely due to unbalanced interest rate policy of the regulator over the past few years and unreasonably strict requirements for assessing the amount of credit risk on active banking operations (Resolution of 30.06.2016 No.351).

Simply put, the NBU has “weaned” banks from lending to businesses over several years.

The introduction of long-term refinancing of banks by the National Bank is unable to significantly revive lending activity, as it has no purpose.

UAH 48.5 billion was given as long-term refinancing for a period of 1 to 5 years during May-December 2020 (in particular, UAH 32.2 billion in the fourth quarter).

Banks are not motivated to lend to business and choose alternative areas of investment: the largest increase in bank assets in 2020 was due to investments in securities and long-term investments (by UAH 251.9 billion, or 46.7%), correspondent accounts in other banks (by UAH 57.8 billion, or 48.9%), time deposits in other banks (by UAH 15.4 billion, or 44%), against the background of the above-mentioned reduction of the loan portfolio by UAH 69.8 billion (6.8%).

In particular, banks’ investments in government issued bonds grew by UAH 183 billion (54.4%) to 519.5 billion in 2020, significantly exceeding the volume of net loans to economic entities (UAH 436 billion).

At the same time, the portfolio of government bonds owned by the NBU decreased by UAH 12.5 billion (3.7%) due to the planned redemption.

In the February “Banking Sector Review”, the NBU reports that the increased investments in government issued bonds provided two-thirds of the nominal annual growth of banks’ net assets and almost 80% in the fourth quarter of 2020.

The higher attractiveness of government issued bonds investments was due to an increase in their profitability.

Owing to the devaluation surge in March, rising interbank market rates and yields on government bonds in the secondary market, the Ministry of Finance lost the opportunity to place government issued bonds in hryvnia on acceptable terms for almost two months.

Auctions resumed only at the end of April after the weighted average yield on bonds rose to 11.24% (compared to 9.79% in February).

The reduction of the key policy rate to 6%, the conclusion of an agreement with the IMF and the hryvnia strengthening in the second quarter led to a decrease in the weighted average yield of government issued bonds in July to 8.10% (in particular, up to 1 year – 7.71%).

However, due to the end of the NBU interest rate easing cycle, problems with the IMF and intensification of devaluation processes against the background of the Ministry of Finance’s growing needs in raising funds to finance budget expenditures, starting from August rates of government issued bonds began to rise again and in December the weighted average yield reached 11.03 %.

Given the experience of countering the crisis of other central banks in developing countries, the main reason for the increase in the cost of government borrowing should be the complete inaction of the NBU in terms of impact on the secondary market of government issued bonds.

The NBU could make use of the example of the other 20 central banks of developing countries and (in addition to a deeper key policy rate) implement a program to purchase government securities.

This would not only contribute to the sustainability of public finances by reducing the cost of borrowing, but would also “get” a favorable assessment from the IMF.

However, in the December “Financial Stability Report”, the NBU stressed again that “it does not intend to indirectly finance the budget deficit by expanding its portfolio of government securities”.

The fact that the central bank’s portfolio may increase in order to reduce the yield on government bonds, for unknown reasons, remains outside the logic of the NBU.

As a result, in January 2021 the weighted average yield of government issued bonds in hryvnia in the primary market was already 11.29%, including up to 1 year – 10.62%, from 1 to 3 years – 11.79%, from 3 to 5 years – 12.15%, over 5 years – 12.49%.

In February, there was a slight reduction in rates of government issued bonds, which does not fundamentally change the situation.

The fact that the yield on government issued bonds is twice the inflation rate and the key policy rate is clear evidence of the inadequacy of the NBU’s monetary policy to the challenges facing the economy in the global crisis.

Thus, returning to the initial thesis, it can be clearly stated that the function of financial intermediation by the banking system not only has not been restored, but completely “failed”.

In the absence of a full credit process and the NBU’s unwillingness to take effective anti-crisis measures, the Government is, in fact, forced to take over the function of redistribution of financial resources in the economy (programs “Affordable loans 5-7-9%”, “Affordable mortgage at 7%”, etc.) that falls a burden on taxpayers’ shoulders.

The NBU Board should take into account all the above circumstances when making the next decision on the key policy rate.

In addition, it is never too late to stop ignoring the provisions of the law on the NBU (including Article 25) and to resume operations with government securities in the open market to reduce the cost of government borrowing and increase the attractiveness of lending to banks.

The recovery of the function of financial intermediation by the banking system is possible only when the pace of lending to the real sector of the economy at least approaches the pace of expansion of the resource base of banks.

Founder and Chairman of the Board of the Growford Institute Vitalii Lomakovych for