## Financial System Stability Assessment (Ukraine) — IMF Staff Report Excerpts (_cr03340)

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### Overall stability assessment
- Rapid growth in the financial sector as macroeconomic environment stabilized, but important vulnerabilities remain.
- Loans and deposits increased by about 50 percent in 2002 alone.
- Indicators of banking soundness showed some improvement in 2001 and 2002 but "are still at levels that give rise to concern."
- Key institutional strengths:
  - Strengthened prudential regulation of banks and other financial sectors.
  - Progress on supporting institutional reforms.
  - Deposit insurance scheme described as satisfactory.
  - Payment and settlement system described as reliable and efficient.
- Key institutional concerns:
  - Transparency concerns related to conditions under which central bank management can be replaced, and the calculation of central bank profits.
  - The new longer term refinance facility is characterized as "a step backwards."
  - Need for clearer prioritization of domestic and external monetary policy targets by the central bank.

### Banking system structure, ownership, and concentration (end-2002)
- Number of active banks: 157.
- Total assets: UAH 67,774 million.
- Assets as a share of GDP: 31.1 percent.
- Two wholly state-owned banks account for 12 percent of total bank assets.
- One major bank dominant in household deposit collection due to full government guarantee and inherited branch network.
- Foreign banks: 20 foreign banks held UAH 11.0 billion in assets, about 16 percent of the total (seven wholly foreign-owned; 13 partly foreign-owned).
- Banking: Number of active banks 1999–2002: 162, 153, 152, 157.
- Banking: Total assets (millions of UAH) 1999–2002: 25,603; 36,827; 47,204; 67,774.
- Banking: Assets as a share of GDP (percent) 1999–2002: 19.6; 21.7; 23.4; 31.1.
- Banking sector shares by size (December 2002, in percent):
  - Capital: All banks 100.0; Largest 10 banks 39.2; Upper mid-sized banks 11.2; Lower mid-sized banks 21.8; Other banks 27.8.
  - Assets: All banks 100.0; Largest 10 banks 54.1; Upper mid-sized banks 14.7; Lower mid-sized banks 17.4; Other banks 13.8.
  - Deposits: All banks 100.0; Largest 10 banks 59.7; Upper mid-sized banks 14.4; Lower mid-sized banks 15.2; Other banks 10.7.
  - Loans: All banks 100.0; Largest 10 banks 52.9; Upper mid-sized banks 15.7; Lower mid-sized banks 17.6; Other banks 13.8.

### Credit risk, loan quality, currency risks, and macro linkages
- Credit risk identified as a major threat to financial stability.
- Loan quality:
  - "More than one fifth of the loans in the banking system are nonperforming, and about two fifth are under 'watch.'"
  - In Ukrainian usage only the last two categories (doubtful and loss) are classified as nonperforming, and they "amounted to 7.2 percent of total loans at end-2002."
- Average ex post real interest rates on hryvnia-denominated loans are "still over 15 percent."
- Currency composition and exchange rate risk:
  - "Over 40 percent of loans are denominated in foreign currency."
  - Many borrowers without reliable foreign currency earnings have assumed exchange rate risk.
  - Exchange rate between the U.S. dollar and the UAH "has been very stable since the start of 2000" but seen as a by-product of monetary program rather than committed nominal anchor.
- Systemic sensitivity:
  - A mild recession or depreciation of the exchange rate could "place severe strain on the banking system."
  - Certain major banks remain under-capitalized and inadequately profitable, requiring urgent attention.

### Key banking-sector indicators and soundness metrics (selected figures)
- System-level trends (Dec. 1999 → Dec. 2002, preliminary):
  - Number of banks: 162 → 157.
  - Total assets (in millions of UAH): 25,603 → 67,774.
  - Capital (in millions of UAH): 5,891 → 9,983.
  - Loans, total (in millions of UAH): 11,891 → 40,656.
  - Loans as percent of total assets: 46.4 → 60.0.
  - Loans in foreign currency (in millions of UAH): 6,068 → 16,979.
  - Deposits, total (in millions of UAH): 12,468 → 38,865.
  - Deposits in foreign currency (in millions of UAH): 5,326 → 13,366.
  - Interest rate spreads (between loans and deposits in domestic currency): 32.7 → 17.0.
  - Regulatory capital to risk-weighted assets: 19.6 → 18.6.
  - Return on assets (after tax; end-of-period): 2.0 → 1.2.
  - NPLs to total loans: 35.8 → 21.9.
  - NPLs (including category "watch") to total loans: 53.8 → 62.4.
- December 2002 breakdown (selected):
  - Regulatory Tier I capital to risk-weighted assets: All banks 14.0 percent; Largest 10 banks 8.9 percent.
  - Regulatory capital to risk-weighted assets: All banks 18.6 percent; Largest 10 banks 12.5 percent; Others 35.8 percent.
  - Sub-standard, doubtful, and loss to total loans: All banks 21.9 percent; Largest 10 banks 23.0 percent.
  - Return on assets (after tax; end-of-period): All banks 1.2 percent; Largest 10 banks 0.9 percent; Lower mid-sized banks 1.8 percent.
  - Return on equity (after tax; end-of-period): All banks 8.0 percent; Largest 10 banks 12.8 percent.
  - Net interest margin to total assets: All banks 5.1 percent.
  - Operating cost to total assets: All banks 8.1 percent.
  - Highly liquid assets to total assets: All banks 13.3 percent.
  - Highly liquid assets to short-term liabilities: All banks 37.0 percent.
  - Open foreign exchange position to regulatory capital (absolute sum): All banks 21.4 percent; Largest 10 banks 30.5 percent (limit is 35 percent of regulatory capital).

### Profitability, provisioning, capital adequacy, and liquidity issues
- Provisioning and NPLs:
  - Average NPL ratio at end-2002: 22 percent of total loans.
  - NPLs (including "watch") to total loans: 62.4 percent at Dec. 2002.
  - Provisioning rates by loan class: 2 percent (standard), 5 percent (watch), 20 percent (sub-standard), 50 percent (doubtful), 100 percent (loss).
  - Reported provisions reached over 90 percent of required provisions at end-2002 (84 percent at end-2001).
  - Concern: required provisioning rates may be unrealistically low; recommendation to reexamine and raise minimum provisioning rates.
- Capital adequacy:
  - Minimum capital requirement remained 8 percent (risk-weighted).
  - All but two banks fulfill the 8 percent requirement as of the report; for some largest banks CAR only just above minimum.
  - Recommendation: increase minimum CAR to at least 10 percent and perhaps 12 percent; authorities indicated intention to increase CAR to 10 percent.
- Profitability and costs:
  - Reported return on assets (after tax; end-of-period) for 2002: 1.2 percent.
  - Return on equity (after tax; end-of-period) for 2002: 8.0 percent.
  - High operating costs and large net interest spreads (17 percent for domestic currency loans; 6 percent for foreign currency loans).
- Liquidity:
  - Highly liquid assets to total assets at end-2002: 13.3 percent.
  - Highly liquid assets to short-term liabilities: 37.0 percent.
  - Liquidity has fallen from 25 percent and 61 percent (end-1999) to 13.3 percent and 37.0 percent (end-2002).

### Stress-test findings and scenarios
- Stress testing based on end-2001 data; qualitative results remain valid with preliminary end-2002 data.
- Main vulnerability: credit risk driven by rapid credit growth, large share of "watch" loans, and high foreign currency lending.
- Four to six private banks among the largest 20 are especially vulnerable under stress.
- Key stress-scenario outcomes (Table 6, December 2001 basis):
  - Actual CAR (All banks): 18.3; CAR (7 largest banks 1/): 10.0; CAR (10 largest banks): 10.8; CAR (Banks 8–20): 15.1.
  - Credit risk scenario (full mandatory provisioning, reclassification): CAR adjusting for substandard/doubtful/loss: 14.6; 4.8; ...13.2. Number of banks below 10 percent CAR: 11; 4; ...4.
  - CAR adjusting for watch/substandard/doubtful/loss: 13.3; 3.4; ...11.8. Number of banks below 10 percent CAR: 13; 4; ...4.
  - Interest-rate shock (domestic rates up 10.5 percentage points for one month): selected CARs fall (Table: CAR 8.8 for some grouping); number of banks below 10 percent CAR increases.
  - Interest margin shock (40 percent reduction in net interest margin): CAR: 15.1; 6.6; ...13.3. Number of banks below 8 percent CAR: 84; ...2.
  - 30 percent reduction in value of fixed assets: Actual fixed assets to total assets: 7.6; 9.3; ...4.8. CAR: 16.1; 6.9; ...13.8. Number of banks below 10 percent CAR: 94; ...4.
- Footnote preserved: 1/ As of December 2001. 2/ Net interest margin for the banking system as a whole falls from 6.2 percent to 3.7 percent.

### Foreign-exchange and interest-rate exposures
- At end-2002, 34 percent of deposits and 43 percent of bank loans to the enterprise sector were denominated in foreign currencies.
- Absolute amount of dollar-denominated loans continued to grow by close to 40 percent per year; ratio of such loans to GDP rising correspondingly.
- NBU regulations limit open FX positions: sum of long and short open positions not to exceed 35 percent of regulatory Tier II capital; long position ≤ 30 percent; short position ≤ 5 percent of capital.
- At end-2001, 11 banks were not complying with open position requirements.
- Stress tests suggest large depreciation with all banks at maximum short positions would reduce capitalization by only a few percent; greater risk stems from borrowers without foreign-currency earnings bearing exchange-rate risk.

### Institutional, legal, supervisory, and market-structure weaknesses
- Supervisory framework:
  - Much of regulatory framework in place; recent improvements include regulations on connected lending, consolidated reporting, and major shareholdings.
  - Need for NBU to require prompt corrective action and build reputation for speed and decisiveness in resolving failed banks.
  - Move toward risk-based supervision recommended; market and country risk oversight should grow in importance.
- Legal and bankruptcy framework:
  - New Bankruptcy Law (effective 2000) improves creditors' rights and enterprise rehabilitation but practical gaps remain (limited applicability for some enterprises; excessive delays).
  - Law on Pledge reasonably robust; no modern mortgage law; land and building titling problems persist.
  - Tax claims have priority over other secured claims even if unrecorded.
- Corporate governance and accounting:
  - Weak governance: ownership and management often concentrated; insider lending concerns.
  - Large banks and enterprises: audited financial statements often unreliable; larger banks prepare accounts according to IAS with deviations; NBU should require all banks to prepare accounts fully in accordance with IAS.
- Bank resolution and deposit insurance:
  - Bank resolution typically protracted; NBU has powers but not always used promptly.
  - Deposit insurance system: FGDNP covers household deposits up to UAH 1,200 per depositor (slightly more than US$200 per depositor, equivalent to about 30 percent of GDP per head); one major bank enjoys unlimited government guarantee but does not pay insurance premiums nor has dedicated reserves.

### Financial markets, government securities market, payment systems, and NBU operations
- Government securities market:
  - Banks, companies, and households combined own under UAH 2 billion (less than 1 percent of GDP) of government securities.
  - Most domestic government securities consist of restructured bills (about UAH 9 billion outstanding), almost all held by the NBU.
  - Example: Q1 2002 government auctioned treasury bills with 20 different maturity dates; largest single issue UAH 212 million.
  - Recommendations: increase size and concentration of issues, simplify auction process, maintain a liquid secondary market; specific measures include issuing more securities than current financing needs, concentrating maturities, and reducing auction frequency to once per month.
- Market infrastructure:
  - Market capitalization low; market structure complex relative to volumes: seven licensed stock exchanges, two trading systems, four depositories, 86 licensed custodians, >300 registrars, 859 licensed brokers.
  - Only 172 of 456 issuers were actually traded in 2001 on licensed markets.
  - Recommendations: consolidate markets/registrars/depositories/brokers; increase disclosure requirements; implement fit and proper tests and risk-based liquid asset requirements for intermediaries.
- Interbank and NBU instruments:
  - NBU reserve requirements averaged 13.0 percent at end-2001 lowered to 7.9 percent at end-2002; reserve ratios differentiated by maturity and currency (range zero to twelve percent at end-2002).
  - NBU CDs issued on auction with maturities 1 to 180 days; regular refinancing facilities include overnight, up to 14 days, up to 270 days; in 2002 NBU started offering refinancing without collateral.
  - Amount of refinancing cannot exceed 50 percent of commercial bank’s paid up capital.
  - Longer-term refinance facility (introduced 2002): up to three years, priced at discount rate, collateralized by assets such as excess reserves and corporate bonds; in 2002 UAH 121.5 million provided under this facility. Risk of returning to directed credits; recommendation to phase out or tighten collateral.
- Payment systems:
  - Electronic Interbank Payment System (EIPS) operated by NBU; gross settlement in batch mode; current system efficient and reliable.
  - NBU initiated program to introduce on-line RTGS and new retail payment means (e.g., "smart cards").

### Nonbank financial institutions (NBFIs) and insurance sector
- Nonbank component limited in volume, product range and market penetration; total assets of other NBFIs estimated at less than 1 percent of GDP.
- Insurance sector:
  - Number of insurance companies 1999–2002: 263; 283; 328; 338.
  - Total assets (millions of UAH): 2001: 3,007; 2002: 5,300.
  - Premium revenue (millions of UAH) 1999–2002: 1,164; 2,136; 3,031; 4,442.
  - Insurance revenues about 1.9 percent of GDP in 2002.
  - Density approximately UAH 85 per capita.
  - Gross premium income growing at average rate of over 50 percent for last six years.
  - Large number of licensed companies (338) high relative to premium volume; many insurers linked to banks or corporations for regulatory/tax arbitrage.
- Other NBFIs (selected):
  - Investment funds and mutual funds 1999–2001: 229; 397; 362.
  - Pension funds 2000–2002: number 21; 15; 23. Total assets (millions of UAH) 23; 60; 55.
  - Credit unions 2000–2002: >350; >400; >450. Total assets (millions of UAH) 37; 50; 90.
  - Leasing companies (estimated active) 2000–2002: 22; >40; >50. Total assets (millions of UAH) 327; 280; 210.
  - Securities traders 1999–2001: 835; 839; 859.
  - Securities custodians 1999–2001: 75; 84; 86.
- NBFI supervision:
  - New independent supervisory and regulatory body for NBFIs established in 2002 under the Law on Financial Services; as of the report, not yet staffed or operational. Urgent need to make the regulator fully operational.

### Anti‑money laundering (AML/CFT) legal and institutional developments
- Ukraine passed a new comprehensive anti–money laundering law on November 28, 2002; effective six months after publication (i.e., on June 10, 2003).
- Law established a comprehensive framework broadly in line with FATF (40+8) recommendations; includes definition of money laundering, coverage of institutions, procedures for monitoring suspicious transactions, customer identification and record-keeping, and liability for violations.
- Law amended December 2002 and February 2003 to lower reporting thresholds, clarify indemnity provisions, and provide political independence of the Financial Monitoring Department (FMD).
- FATF’s February 2003 plenary decided to withdraw application of additional counter-measures in response to recent changes in Ukraine’s AML/CFT regime.
- The Law confirmed status of the Financial Monitoring Department (FMD) within the Ministry of Finance as lead agency; FMD expected to be fully staffed and operational by June 2003 with a budget for sixty staff.
- Implementation priorities:
  - Ensure agencies are adequately staffed and funded.
  - Pass implementing regulations swiftly.
  - Develop education programs for government, private sector, and public.
  - Improve coordination among agencies and ensure supervisors build AML/CFT enforcement capacity.
  - FMD should join the Egmont Group; consider eventual independence to enhance objectivity.

### Macroeconomic environment and indicators (selected)
- Total population (end-2002): 48,457,000.
- GDP per capita (U.S. dollars, 2002): 850.
- Real GDP growth (percentage change): 1998 -1.9; 1999 -0.2; 2000 5.9; 2001 9.2; 2002 4.6.
- GDP (in million hryvnia): 1998 102,593; 1999 130,442; 2000 170,070; 2001 204,190; 2002 220,556.
- Consumer price index (e.o.p.): 1998 20.0; 1999 22.9; 2000 22.7; 2001 6.1; 2002 -0.6.
- Current account surplus: US$3.2 billion in 2002, or 7.6 percent of GDP.
- Gross official reserves (end period): 1998 795; 1999 1,094; 2000 1,505; 2001 3,089; 2002 4,417.
- Reserve cover (months of imports) 1998–2002: 0.6; 0.7; 0.9; 1.7; 2.5.
- External: Exchange rate (UAH per U.S. dollar, end of period) 1998 3.4; 1999 5.2; 2000 5.4; 2001 5.3; 2002 5.3.

### Short-term and medium-term policy recommendations (preserved phrasing and priorities)
- Short term, rapidly implementable:
  - Increase the minimum risk-weighted capital adequacy ratio for banks to at least 10 percent (as intended) and preferably eventually to 12 percent.
  - Require banks through prudential supervision to limit foreign currency-denominated credits to borrowers without a reliable source of foreign currency earnings.
  - Further strengthen supervisory controls on insider and connected lending; implement consolidated supervision.
  - Maintain requirement that banks take prompt corrective action to rectify any prudential deficiency, and strictly avoid forbearance.
  - Pursue vigorously the rehabilitation and restructuring of a major bank.
  - Clarify to the public the prioritization of the central bank's domestic and external monetary policy targets.
  - Phase out the NBU’s longer-term refinancing facility, or, at a minimum, strictly limit refinancing provided under the facility, and require that only high-quality collateral of matching maturity be provided.
  - Make operational the new regulatory agency for nonbank financial institutions.
  - Increase the size and concentration of the issues of domestic government debt.
  - Make operational the Financial Monetary Department (the financial intelligence unit).
- Medium term, possibly requiring amendments to laws and regulations, or other extensive preparations:
  - Review and revise provisioning rates based on empirical evidence of loss rates.
  - Tighten regulations on bank equity investment.
  - Require banks to prepare accounts fully in compliance with IAS.
  - Integrate the insurance of deposits at a major bank into the FGDNP system.
  - Appropriately limit the conditions under which central bank management can be replaced; and determine central bank profit transfers to government on the basis of realized profits.
  - Update and extend regulation for nonbank financial institutions, notably for leasing companies, pension funds and credit unions.
  - Simplify auction procedures for government securities.
  - Consolidate securities exchanges, registrars, and depositories; increase disclosure requirements.
  - Modernize the mortgage law, land and building titling, and the law on secured transactions.
  - Strengthen shareholder rights by increasing access to corporate information, moving towards international standards in corporate accounting and audit, facilitating shareholder control of management, and reinforcing supervisory boards (including of banks).
  - Update and extend anti-money laundering regulations, for example, on recognizing unusual or suspicious transactions.

*Source: IMF staff report (chapter content provided from _cr03340)._

### 2003. The views expressed in this document are those of the staff team and do not necessarily reflect

### Financial System Stability Assessment

### Overall stability assessment
- Rapid growth in the financial sector as macroeconomic environment stabilized, but important vulnerabilities remain.
- Loans and deposits increased by about 50 percent in 2002 alone.
- Indicators of banking soundness showed some improvement in 2001 and 2002 but "are still at levels that give rise to concern."
- Key institutional strengths:
  - Strengthened prudential regulation of banks and other financial sectors.
  - Progress on supporting institutional reforms.
  - Deposit insurance scheme described as satisfactory.
  - Payment and settlement system described as reliable and efficient.
- Key institutional concerns:
  - Transparency concerns related to conditions under which central bank management can be replaced, and the calculation of central bank profits.
  - The new longer term refinance facility is characterized as "a step backwards."
  - Need for clearer prioritization of domestic and external monetary policy targets by the central bank.
- Supervisory framework:
  - Much of regulatory framework in place; recent improvements include strengthening regulations on connected lending, consolidated reporting, and major shareholdings.
  - Minimum capital requirement remains 8 percent.
  - Provisioning may not adequately reflect true probabilities of default and expected losses.
  - Need for supervisory action to reduce banks' exposure to exchange rate risk assumed by borrowers.
  - Need for NBU to require prompt corrective action and to build reputation for speed and decisiveness in resolving failed banks.
  - As the system develops, a risk-based approach to supervision and issues such as market and country risk will grow in importance.
- Anti‑money laundering:
  - Establishment of a financial intelligence unit.
  - Passage, in late-2002, of comprehensive legislation on anti-money laundering and combating the financing of terrorism.

### Vulnerabilities — credit risk and macro linkages
- Credit risk identified as a major threat to financial stability.
- Loan quality:
  - "More than one fifth of the loans in the banking system are nonperforming, and about two fifth are under 'watch.'"
  - Note: In Ukrainian usage only the last two categories (doubtful and loss) are classified as nonperforming, and they "amounted to 7.2 percent of total loans at end-2002."
- Real interest rates:
  - Average ex post real interest rates on hryvnia-denominated loans are "still over 15 percent."
  - High rates reflect credit risk and banks' high operating costs.
- Currency composition and exchange rate risk:
  - "Over 40 percent of loans are denominated in foreign currency."
  - Many borrowers without reliable foreign currency earnings have assumed exchange rate risk.
  - The exchange rate between the U.S. dollar and the Ukrainian hryvnia (UAH) "has been very stable since the start of 2000," but authorities consider this stability a by-product of their monetary program rather than a fully committed nominal anchor.
- Systemic sensitivity:
  - A mild recession or depreciation of the exchange rate could "place severe strain on the banking system."
  - Certain major banks remain under-capitalized and inadequately profitable, requiring urgent attention.

### Overview of the financial system — structure and ownership
- Banking sector (end-2002):
  - Number of active banks: 157.
  - Total assets: UAH 67,774 million.
  - Assets as a share of GDP: 31.1 percent.
  - Two wholly state-owned banks account for 12 percent of total bank assets.
  - One major bank is dominant in household deposit collection due to a full government guarantee and inherited branch network.
  - Foreign banks: 20 foreign banks at end-2002 held UAH 11.0 billion in assets, about 16 percent of the total.
    - Seven wholly foreign-owned banks; 13 partly foreign-owned banks.
    - Foreign participation often originates in Russia.
- Banking fragmentation:
  - The system is relatively fragmented; many small banks serve enterprise groups as "pocket banks."
  - Connected and insider dealing between banks, enterprises and major entrepreneurs is difficult to monitor because ownership information is often layered and opaque.
- Table data excerpts (preserve exact figures as presented):
  - Banking: Number of active banks 1999–2002: 162, 153, 152, 157.
  - Banking: Total assets (millions of UAH) 1999–2002: 25,603; 36,827; 47,204; 67,774.
  - Banking: Assets as a share of GDP (percent) 1999–2002: 19.6; 21.7; 23.4; 31.1.
- Banking sector shares by size (December 2002, in percent):
  - Capital: All banks 100.0; Largest 10 banks 39.2; Upper mid-sized banks 11.2; Lower mid-sized banks 21.8; Other banks 27.8.
  - Assets: All banks 100.0; Largest 10 banks 54.1; Upper mid-sized banks 14.7; Lower mid-sized banks 17.4; Other banks 13.8.
  - Deposits: All banks 100.0; Largest 10 banks 59.7; Upper mid-sized banks 14.4; Lower mid-sized banks 15.2; Other banks 10.7.
  - Loans: All banks 100.0; Largest 10 banks 52.9; Upper mid-sized banks 15.7; Lower mid-sized banks 17.6; Other banks 13.8.
  - (Source: NBU, and staff estimates.)

### Nonbank financial institutions (NBFIs)
- Overall: Nonbank component limited in volume, product range and market penetration.
- Insurance sector:
  - Number of insurance companies: 1999–2002: 263; 283; 328; 338.
  - Total assets (millions of UAH): 2001: 3,007; 2002: 5,300.
  - Premium revenue (millions of UAH): 1999–2002: 1,164; 2,136; 3,031; 4,442.
  - Insurance revenues about 1.9 percent of GDP in 2002.
  - Density approximately UAH 85 per capita.
  - Gross premium income has been growing at an average rate of over 50 percent for the last six years.
  - Large number of licensed companies (338) considered high relative to premium volume.
  - Regulatory and tax arbitrage contribute to growth; many insurance companies linked to banks or corporations transfer operations or assets to insurance subsidiaries for tax reasons.
- Other NBFIs:
  - Number of investment funds and mutual funds: 1999–2001: 229; 397; 362.
  - Number of pension funds 2000–2002: 21; 15; 23. Total assets (millions of UAH) 2000–2002: 23; 60; 55.
  - Number of credit unions: 2000–2002: >350; >400; >450. Total assets (millions of UAH) 2000–2002: 37; 50; 90.
  - Number of leasing companies (estimated active): 2000–2002: 22; >40; >50. Total assets (millions of UAH) 2000–2002: 327; 280; 210.
  - Number of securities traders 1999–2001: 835; 839; 859.
  - Number of securities custodians 1999–2001: 75; 84; 86.

### Structural and reform priorities (implicit recommendations and required actions reflected in text)
- Strengthen supervision and prudential policy:
  - Reduce banks' exposure to borrower-assumed exchange rate risk.
  - Establish and apply prompt corrective action frameworks and build reputation for decisive bank resolution.
  - Move toward risk-based supervision and incorporate market and country risk oversight.
  - Make the nonbank financial regulator fully operational and rapidly strengthen regulation and supervision of insurance and other nonbank sectors.
- Improve financial sector development and market infrastructure:
  - Develop market for government securities.
  - Address fragmentation of securities markets to create channels for diversified investment and corporate discipline.
- Strengthen enterprise sector frameworks:
  - Improve accounting standards in enterprises to support creditworthiness evaluation.
  - Reform corporate governance to increase transparency and reduce potential for abuse.
  - Further strengthen creditors' rights and insolvency frameworks.

*Prepared by Monetary and Exchange Affairs and European II Departments; main authors include Mr. Daniel Hardy, Ms. Nadia Rendak, and Mr. Stephen Swaray. April 22, 2003.*

### 13. Despite recent growth, the role in financial intermediation of other NBFIs

### 13. Despite recent growth, the role in financial intermediation of other NBFIs

### Other nonbank financial institutions (NBFIs)
- Total assets of other NBFIs estimated at less than 1 percent of GDP.
- Privately run pension schemes: estimated 23 schemes active, with total estimated assets amounting to UAH 55 million at the end of 2002; exist without regulatory or legislative support; no reliable data on the sector.
- Credit unions: generally limited in resource base and lending flows; at end-2002 the National Association of Credit Unions comprised 126 institutions with 171,000 members and UAH 79 million in assets.
- Housing finance and commercial property development have increased recently, but most financing derives from personal sources, sources outside the formal sector, or use of mandatory pension funds for housing construction.
- Leasing sector: dominated by public-sector institutions (in particular the company devoted to leasing agricultural equipment); private-sector leasing activity remains modest.
- Confidence in the sector affected by episodes of fraudulent schemes; financial volumes were not large, but reputational effects significant.

### Financial markets — interbank, government securities, and capital markets
- Inter-bank money market in Ukraine is thin; volatility decreased since mid-2001 due to averaging of required reserves over monthly holding periods and generally ample bank liquidity.
- Some banks with doubtful creditworthiness pay risk premiums of up to 10 percentage points to obtain interbank funds.
- Interbank foreign exchange market generally seems to operate smoothly.
- Market for Ukrainian government domestic securities is thin; volume of securities suitable for secondary market trading is small.
  - Banks, companies, and households combined own under UAH 2 billion (less than 1 percent of GDP) of government securities.
  - Most domestic government securities consist of restructured bills (about UAH 9 billion are outstanding), almost all held by the NBU.
  - Small stock distributed over numerous maturity dates; example: in Q1 2002 the government auctioned treasury bills with 20 different maturity dates; the largest single issue was only UAH 212 million.
- Recommendations to develop government securities market:
  - Lower government borrowing costs over the medium term, promote financial market deepening, provide banks with a low-risk asset, and reduce dependence on foreign borrowing.
  - Prerequisite: government discipline over the budget deficit and stock of debt; ensure no domestic arrears such as VAT refunds.
  - Technical measures in three areas:
    - (i) increase the size and concentration of stock of government securities outstanding, initially focused on short maturities;
    - (ii) simplify the auction process and make it more transparent;
    - (iii) maintain a liquid secondary market in due course.
  - Specific measures to increase size/concentration: (i) issue more securities than current financing needs (use excess to retire restructured bills at the NBU); (ii) concentrate on just a few maturity dates, or issue bills with just one maturity; (iii) reduce frequency of auctions to just once per month.
  - Auction reform: pre-announce the quantity on offer and hold one round of bidding; provide a detailed prospectus specifying all features of the bills.
- Securities markets: market capitalization low; most significant trading occurs off-market.
  - Market infrastructure complex relative to trade volumes and market capitalization: seven licensed stock exchanges and two trading systems, four depositories, 86 licensed custodians, more than 300 registrars, and 859 licensed brokers in an underdeveloped and illiquid market.
  - Only 172 of 456 issuers were actually traded in 2001 on licensed markets; significant trading in unlisted companies occurs off-market under non-transparent conditions.
- Recommendations to promote deeper and more efficient markets:
  - Consolidate number of markets, registrars, depositories, and brokers.
  - Increase disclosure requirements (for example, prompt disclosure of acquisition of 10 percent of any listed company and of legal insider buying and selling).
  - Implement fit and proper tests and risk-based liquid asset requirements for licensed market intermediaries.

### NBU instruments and operations
- NBU monetary instruments include:
  - Required reserves held on an average basis over a month-long holding period; unremunerated deposits at the NBU or up to half of cash in vault are eligible assets.
    - NBU lowered reserve requirements from an average of 13.0 percent at end-2001 to 7.9 percent at end-2002.
    - Reserve ratios differentiated by maturity and currency denomination of deposit liabilities; range at end-2002 was from zero to twelve percent.
  - Discount rate announced by the NBU as benchmark; no transactions carried out at the discount rate itself.
  - NBU certificates of deposit (CDs): issued to commercial banks on an auction basis with maturities ranging from 1 to 180 days; issued when NBU believes there is excess liquidity; CDs can be purchased and sold by commercial banks on the inter-bank market and used as collateral.
  - Regular refinancing facilities: overnight loans, refinancing for up to 14 days, and refinancing for up to 270 days; NBU may provide a “stabilization loan” to a bank undergoing rehabilitation.
    - Refinancing undertaken through either quantity or price tenders.
    - Collateral primarily government securities; in 2002 NBU started offering refinancing without collateral.
    - Banks must meet specific conditions relating to capital, solvency and a good track record of loan repayment to the NBU.
    - Amount of refinancing cannot exceed 50 percent of the commercial bank’s paid up capital.
- Measures NBU could take to better manage systemic liquidity:
  - (i) Improve short-term liquidity forecasting, including through better coordination with the Ministry of Finance, and more active domestic money market interventions to smooth exogenous shocks.
  - (ii) Refine design of money market instruments (for example, make CDs eligible as collateral for NBU refinancing).
  - (iii) Ensure speedy processing in liquidation cases of securities pledged as collateral (which would reinforce the payments system).
  - (iv) Possibly refine reserve requirement design by introducing a carry-over provision.
- Longer-term refinance facility introduced in 2002:
  - Banks can obtain refinancing for up to three years, priced at the discount rate and collateralized by assets such as excess reserves and corporate bonds.
  - In 2002, UAH 121.5 million was provided under this facility.
  - Risks: could be seen as a return to directed credits; exposes NBU to credit, interest rate, and reputational risks.
  - Recommendation: if retained, modify to reduce risks (for example, tighten collateral requirements); structural and institutional reforms preferred to promote availability of affordable longer-term financing.
- Payment systems:
  - Electronic Interbank Payment System (EIPS) operated by NBU for all inter-bank transactions; operates essentially as a gross settlement system in batch mode; current system seems efficient, reliable, and inexpensive.
  - NBU initiated program to introduce an on-line real time gross settlement system; developing new retail means of payment (e.g., “smart cards”) in cooperation with some commercial banks.

### Legal, regulatory, and supervisory framework
- Legal framework for banking system broadly adequate; recent legislation corrected some weaknesses but overall legal system inefficiencies hinder financial sector development and stability.
  - Law on the NBU (1999) and Law on Banks and Banking Activity (2000) are in most regards satisfactory but have deficiencies in provisions for effective and transparent governance.
  - Recent laws passed covering bankruptcy proceedings, supervision of NBFIs, and anti-money laundering measures; a new public debt law is currently before parliament.
  - Legal framework covering NBFIs, governance, and ownership rights described as weak and confused.
- NBU supervisory progress and remaining deficiencies:
  - Progress in strengthening banking supervision, with new regulations (for example, on consolidated supervision).
  - Recent amendments on identifying loans to connected parties and assessment of exposure to market risk prompted by FSAP May 2002.
  - Regulations on capital adequacy, provisioning and risk management broadly satisfactory in structural terms but do not sufficiently account for risk in quantitative terms.
  - Further enhancements needed:
    - (i) Strengthen NBU’s regulatory control over all significant bank investments, including equity investments in other banks and NBFIs.
    - (ii) Further strengthen supervisory controls on connected and insider lending.
    - (iii) Streamline reporting requirements.
    - (iv) Accelerate development of capacity to conduct consolidated supervision.
  - Need to improve NBU supervisory practice, reputation, and rigor in ensuring prompt resolution of emerging problems.
- Accounting and data:
  - Larger banks prepare accounts according to IAS, with some deviations; quality of data uneven among smaller banks.
  - NBU should require all banks to prepare accounts fully in accordance with IAS.
  - NBU devotes considerable efforts to verifying accuracy of banks’ accounts through on-site supervision.
  - Publication of some statistics subject to long lags; reliability of data for the enterprise sector is questionable.
- Bank resolution:
  - Process of resolving failed banks typically protracted; NBU has legal powers to act but has not always used them effectively or promptly.
  - Bank resolution should be guided by principles of prompt corrective action, least-cost reorganization, deposit safety, and systemic stability.
  - NBU must consistently act when banks violate prudential requirements, require rectification under threat of penalties, avoid supporting seriously under-capitalized banks unless viable restructuring plans are implemented and shareholders financially support the plan.
  - If banks fail to act, NBU should be pro-active (replace management, seek take-over, or close the bank).
- Deposit insurance:
  - System comprises an unlimited government guarantee on household deposits at one major bank, and limited coverage guarantee at other banks administered through Fund for the Guarantee of Deposits of Natural Persons (FGDNP).
  - FGDNP: maximum coverage UAH 1,200 (slightly more than US$200 per depositor, equivalent to about 30 percent of GDP per head); provides full coverage to vast majority of household deposits outside the major bank.
  - Current financial reserves should be sufficient to meet claims if one major bank or several small banks fail.
  - Guarantee on deposits at the major bank is mandated by law but not backed by reserves or an administrative apparatus.
- Supervision of NBFIs:
  - New independent supervisory and regulatory body for nonbank financial institutions established in 2002 under the Law on Financial Services; responsible for insurance, pension funds, leasing, credit union sectors and other nonbank sectors.
  - Effective operation is urgently needed because regulatory and supervisory regime for NBFIs remains inadequate or nonexistent and potential for rapid growth in unregulated activities exists.
  - As of the report, new supervisory agency not yet staffed and has not prepared procedures or regulations.
  - Once established, the agency should improve information sharing between supervisors and promote full transparency in regulation and supervision.

### Macroeconomic environment — recent developments and indicators
- General macroeconomic situation improved significantly starting in the latter part of 1999.
- Real GDP growth substantial; inflation fell to zero.
- Budgetary situation strengthened in 2000-02.
- Current account surplus increased to US$3.2 billion in 2002, or 7.6 percent of GDP.
- International reserves reached US$4.4 billion, equivalent to 2.3 months of imports.
- Exchange rate against the U.S. dollar stable or slightly appreciating since 2000.
- Performance marks a major turn-around from the 1990s crisis; recovery from 1998–99 government debt crisis ongoing.
- NBU gains in lowering inflation and building international reserves need securing through greater transparency in monetary policy.
  - NBU could clarify policy objectives and reinforce that overriding objective is domestic price stability; stability of the U.S. dollar exchange rate is temporary and coincidental to that goal.

Key macroeconomic indicators (selected, as presented)
- Total population (end-2002): 48,457,000
- GDP per capita (U.S. dollars, 2002): 850

Real sector (1998–2002)
- GDP (percentage change): 1998 -1.9; 1999 -0.2; 2000 5.9; 2001 9.2; 2002 4.6
- GDP (in million hryvnia): 1998 102,593; 1999 130,442; 2000 170,070; 2001 204,190; 2002 220,556
- Consumer price index (e.o.p.): 1998 20.0; 1999 22.9; 2000 22.7; 2001 6.1; 2002 -0.6
- Private savings ratio (in percent): 1998 18.9; 1999 25.0; 2000 23.3; 2001 24.7; 2002 24.2

Monetary and credit data (change in annual averages)
- Monetary base: 1998 21.9; 1999 39.2; 2000 40.1; 2001 37.4; 2002 33.6
- Money (M1) deposit + cash in circulation: 1998 36.3; 1999 10.8; 2000 47.0; 2001 43.1; 2002 56.2
- Broad money (M3): 1998 25.3; 1999 40.4; 2000 45.4; 2001 42.0; 2002 41.7
- Credit to the economy: 1998 16.7; 1999 38.6; 2000 63.8; 2001 41.0; 2002 47.5
- Reference bank lending rate (level) 1/: 1998 61.6; 1999 50.0; 2000 30.6; 2001 19.7; 2002 8.0
- Spread on Ukrainian bonds over reference rate (level, e.o.p.) 2/: 1999 ......; 2000 18.2; 2001 69.3; 2002 37.4
- Stock market index (percent change, end of period): 1998 -73.1; 1999 81.2; 2000 42.1; 2001 -21.5; 2002 23.2

Public finances (in percent of GDP)
- Central government financial balance: 1998 -2.8; 1999 -2.4; 2000 -1.3; 2001 -1.6; 2002 0.5
- Central government domestic debt: 1998 15.3; 1999 16.0; 2000 12.8; 2001 10.7; 2002 10.1

External sector (levels in millions of U.S. dollars, unless otherwise indicated)
- Exchange rate (UAH per U.S. dollar, end of period): 1998 3.4; 1999 5.2; 2000 5.4; 2001 5.3; 2002 5.3
- Trade balance: 1998 -2,584; 1999 244; 2000 779; 2001 198; 2002 710
- Current account: 1998 -1,296; 1999 1,658; 2000 1,481; 2001 1,402; 2002 3,173
- Foreign direct investment (net): 1998 747; 1999 489; 2000 594; 2001 769; 2002 698
- Portfolio investment (net): 1998 224; 1999 124; 2000 -195; 2001 -735; 2002 -1,957
- Gross official reserves (end period): 1998 795; 1999 1,094; 2000 1,505; 2001 3,089; 2002 4,417
- Reserve cover (months of imports) 3/: 1998 0.6; 1999 0.7; 2000 0.9; 2001 1.7; 2002 2.5
- Total external public debt (in percent of GDP): 1998 27.5; 1999 39.4; 2000 33.1; 2001 26.6; 2002 24.6

*Source: IMF staff report (chapter content provided).*

### 32. The National Bank also needs to work with the government in clarifying the

### 32. The National Bank also needs to work with the government in clarifying the relationship between them, for example, by making more objective the conditions under which senior management can be dismissed, and by specifying objective rules under which realized central bank profits are calculated and transferred to government.

### Central bank governance and transparency
- Make more objective the conditions under which senior management can be dismissed.
- Specify objective rules under which realized central bank profits are calculated and transferred to government.
- Current practice: the central bank transfers to government an amount based on its projected profits, with an ex post correction. This system has led to controversy.
- Expected outcome: improvements in transparency and central bank independence would ultimately translate into greater macroeconomic and financial sector stability.

### Macroeconomic sources of risk to financial stability
- Short-term growth: likely to slow somewhat from the very high levels seen in 2000 and 2001.
- Openness and external vulnerability:
  - The share of exports and imports of goods and services accounted for 108 percent of GDP at end-2002.
  - Ukrainian exports vulnerable to imposition of trade restrictions and to slowdowns in key foreign markets.
  - Certain sectors (electricity generation, metallurgy) vulnerable to a sustained rise in oil and gas prices.
- Rapid expansion of deposits and credit:
  - Recovery in confidence associated with very strong growth in deposits and credit, suggesting credit risk may be rising.
  - Rapid credit expansion casts doubt on the quality of newly extended loans and creates borrower reliance on continued credit availability.
- Real interest rates and credit risk:
  - Average ex-post real interest rates on credits rose to more than 20 percent in early 2002, and towards the end of the year were still above 15 percent.
  - High rates reflect unexpectedly low inflation, risk premia, banks’ high operating costs, and, for some banks, high funding costs.
  - Implication: much credit likely financed very risky projects; a project able to generate a real return above 15 percent is likely highly speculative.
- Currency and foreign-currency lending risks:
  - At end-2002, 34 percent of deposits and 43 percent of bank loans to the enterprise sector were denominated in foreign currencies.
  - Absolute amount of dollar-denominated loans continued to grow by close to 40 percent per year; the ratio of such loans to GDP rising correspondingly.
  - Exchange rate reversal or substantial depreciation could dramatically increase loan servicing costs and impair enterprises’ ability to meet obligations.

### Vulnerabilities and soundness of the financial system — Commercial banks
- Overall resilience: weaknesses in banks’ balance sheets, profitability, and institutional arrangements imply low resilience to macroeconomic and other risks.
- Capital adequacy:
  - All but two banks currently fulfill the 8 percent risk-weighted capital adequacy requirement (Tables 4 and 5).
  - For some largest banks, capital adequacy ratios are only just above the minimum requirement.
  - Nearly all medium and smaller banks appear well capitalized, with a CAR above 20 percent, compared to an average below 15 percent for the largest 22 banks.
  - Recommendation: a minimum capital adequacy ratio of at least 10 percent and perhaps 12 percent seems warranted.
  - Authorities have recently indicated their intention to increase the CAR to 10 percent.
- Non-performing loans and provisioning:
  - Average NPL ratio at end-2002: 22 percent of total loans.
  - NPLs (including category "watch") to total loans: 62.4 percent at Dec. 2002.
  - NPLs net of provisions to capital: (Table 4) reported as "..." for Dec. 2002; Table 5 shows NPLs net of provisions to capital for "All banks" as -1.1 percent (but positive 4.7 percent for Largest 10 banks).
  - Provisioning rates by loan class: 2 percent (standard), 5 percent (watch), 20 percent (sub-standard), 50 percent (doubtful), 100 percent (loss).
  - Reported provisions reached over 90 percent of required provisions at end-2002 (the ratio was 84 percent at end-2001).
  - Concern: required provisioning rates may be unrealistically low given rapid credit growth and difficulty of recovering assets; true provisioning deficiency may be larger.
  - Recommendation: reexamine required provisioning rates and raise minimum provisioning rates to reflect true expected recovery rates; encourage forward-looking provisioning above minimum when justified.
- Profitability and costs:
  - Reported return on assets (after tax; end-of-period) for 2002: 1.2 percent; return on equity (after tax; end-of-period) for 2002: 8.0 percent.
  - Low earnings overall; many banks may lack adequate earnings to cover declines in loan portfolio value or to maintain capitalization amid rapid credit growth without capital injections.
  - High operating and administrative costs contribute to large net interest spreads (17 percent for domestic currency loans; 6 percent for foreign currency loans).
- Liquidity:
  - Highly liquid assets to total assets at end-2002: 13.3 percent (Table 5 for "All banks"); highly liquid assets to short-term liabilities: 37.0 percent.
  - Liquidity has fallen continuously over past three years: at end-1999 ratios were 25 percent and 61 percent, respectively.
  - Liquidity tighter for the seven largest banks: ratios of 12 percent and 28 percent.
- Concentration and large banks:
  - One major bank holds 14.4 percent of total household deposits; its credit portfolio more than tripled in the two years to end-2001 and rose at similar rates through mid-2002.
  - That bank, historically a savings bank investing mainly in government securities, expanded rapidly into corporate lending and has a substantial capital shortfall relative to the NBU’s 8 percent capital adequacy rule after adjusting for necessary provisioning.
  - The bank reportedly broke even in 2001 and 2002; government provided some additional capital; stock of loans stabilized from mid-2002.
  - Estimated capital shortfall for this bank is significant, yet equivalent to less than 0.2 percent of GDP.
  - Recommended short-term measures for the weakened bank:
    - Maintain a strict credit policy to reduce loan portfolio exposure and risk.
    - Vigorously reduce operating costs.
    - Reduce cost of funding by lowering the share of expensive term deposits in total liabilities.
    - Conduct a “due diligence” to ascertain exact capital deficiency; determine conditions for any further capital injections following due diligence.
    - Once a sound business plan is being implemented and the bank is on the path to financial soundness, remove the blanket guarantee on its household deposit liabilities; insurance for deposits at the bank should be provided by the FGDNP on the same terms as for other banks.
  - Another major bank is of less systemic importance: credit growth (38 percent in 2001) below sector average; capital far less impaired; small profits during past three years; tight interest rate spreads due to mostly dollar-denominated operations; still vulnerable to borrower exposure to exchange rate movements or trade barriers abroad.
- Supervisory and structural concerns:
  - Loan workout and bankruptcy procedures poorly developed; difficulties in seizing collateral reduce its true value.
  - Historically, large proportion of "standard" and "watch" loans have eventually become nonperforming.
  - Needed improvements: creditor rights, collateral regulations, tightening of internal lending controls, consistent application of prudential regulations.
  - On-site supervision and an external audit (due diligence) are crucial for major banks with apparent problems.

### Banking sector indicators (selected figures from Tables)
- System-level trends (Dec. 1999 → Dec. 2002, preliminary):
  - Number of banks: 162 → 157.
  - Total assets (in millions of UAH): 25,603 → 67,774.
  - Capital (in millions of UAH): 5,891 → 9,983.
  - Loans, total (in millions of UAH): 11,891 → 40,656.
  - Loans as percent of total assets: 46.4 → 60.0.
  - Loans in foreign currency (in millions of UAH): 6,068 → 16,979.
  - Deposits, total (in millions of UAH): 12,468 → 38,865.
  - Deposits in foreign currency (in millions of UAH): 5,326 → 13,366.
  - Interest rate spreads (between loans and deposits in domestic currency): 32.7 → 17.0 (Dec. 1999 → Dec. 2002).
  - Regulatory capital to risk-weighted assets: 19.6 → 18.6.
  - Return on assets (after tax; end-of-period): 2.0 → 1.2.
  - NPLs to total loans: 35.8 → 21.9.
  - NPLs (including category "watch") to total loans: 53.8 → 62.4.
- December 2002 breakdown (Table 5, selected):
  - Regulatory Tier I capital to risk-weighted assets: All banks 14.0 percent; Largest 10 banks 8.9 percent.
  - Regulatory capital to risk-weighted assets: All banks 18.6 percent; Largest 10 banks 12.5 percent; Others 35.8 percent.
  - Sub-standard, doubtful, and loss to total loans: All banks 21.9 percent; Largest 10 banks 23.0 percent.
  - Return on assets (after tax; end-of-period): All banks 1.2 percent; Largest 10 banks 0.9 percent; Lower mid-sized banks 1.8 percent.
  - Return on equity (after tax; end-of-period): All banks 8.0 percent; Largest 10 banks 12.8 percent.
  - Net interest margin to total assets: All banks 5.1 percent.
  - Operating cost to total assets: All banks 8.1 percent.
  - Highly liquid assets to total assets: All banks 13.3 percent.
  - Highly liquid assets to short-term liabilities: All banks 37.0 percent.
  - Open foreign exchange position to regulatory capital (absolute sum): All banks 21.4 percent; Largest 10 banks 30.5 percent (limit is 35 percent of regulatory capital).

*Source: NBU, and staff estimates.*

### 45. Stress tests confirm that the potential vulnerabilities for the Ukrainian banking

### Stress tests confirm that the potential vulnerabilities for the Ukrainian banking system lie predominantly in credit risk

### Summary of stress-test findings
- Stress testing was undertaken using end-2001 data; preliminary calculations using available end-2002 suggest that the qualitative results are still valid.
- Potential vulnerabilities lie predominantly in credit risk given:
  - Rapid credit growth.
  - Large share of loans classified as “watch” (37 percent at end-2001 and over 40 percent at end-2002).
  - High share of foreign currency lending.
- A substantial but not implausibly large deterioration in loan quality would put significant pressure on many banks, especially the largest banks. Four to six private banks among the largest 20 are especially vulnerable.

### Key statistics from Table 6 (based on December, 2001 data)
- Actual values:
  - Capital adequacy ratio (CAR): 18.3 (All banks); 10.0 (7 largest banks 1/); 10.8 (10 largest banks); 15.1 (Banks 8–20)
  - Number of banks below 10 percent CAR: 6; 4; 41
- Credit risk scenario (full mandatory provisioning, plus all doubtful loans move to loss, 20% of substandard to doubtful, 10% of watch to substandard, 10% of standard to watch, and standard increases by 10%):
  - CAR adjusting for substandard, doubtful, and loss: 14.6; 4.8; ...13.2
  - Number of banks below 10 percent CAR: 11; 4; ... 4
  - CAR adjusting for watch, substandard, doubtful, and loss: 13.3; 3.4; ...11.8
  - Number of banks below 10 percent CAR: 13; 4; ...4
- Interest rate scenario (all domestic interest rates rise by 10.5 percentage points across all maturities for one month):
  - CAR: ...; ...; 8.8...
  - Number of banks below 10 percent CAR: ...; ...; 6; ...
- Interest margin scenario (40 percent reduction in net interest margin 2/):
  - CAR: 15.1; 6.6; ...13.3
  - Number of banks below 8 percent CAR: 84; ...2
- Scenario: 30 percent reduction in value of fixed assets:
  - Actual fixed assets to total assets: 7.6; 9.3; ...4.8
  - Capital adequacy ratio (CAR): 16.1; 6.9; ...13.8
  - Number of banks below 10 percent CAR: 94; ...4
- Sources: NBU and staff estimates.
- Footnotes preserved as in source:
  - 1/ As of December 2001.
  - 2/ Net interest margin for the banking system as a whole falls from 6.2 percent to 3.7 percent.

### Foreign exchange and interest-rate exposures
- Exchange-rate risk:
  - Risk from exchange-rate changes is mostly transmitted through credit risk rather than direct open FX positions.
  - NBU regulations limit open foreign currency positions: the sum of long and short open positions is not allowed to exceed 35 percent of regulatory Tier II capital; the long open position cannot be more than 30 percent, and the short position cannot exceed 5 percent of capital.
  - At end-2001 11 banks were not complying with the requirements.
  - Stress tests suggest even a large depreciation with all banks at the maximum short position would have reduced bank capitalization by only a few percent.
  - Most banks appear to have long positions and would benefit from a hryvnia depreciation; they are exposed should the hryvnia appreciate.
  - More important is that a significant proportion of borrowers do not have foreign currency earnings (exchange risk carried by unhedged borrowers).
- Interest-rate risk:
  - Increases in short-term domestic and foreign interest rates present some risk for most of the largest 10 banks. The mission received information only for the largest 10 banks.
  - Except for two banks, the cumulative maturity gap is negative up to a maturity of 183 days (and in many cases even up to one year) in domestic as well as in foreign currency.
  - Maturities of interest-sensitive assets and liabilities are very short: 81 percent of liabilities and 56 percent of assets fall into the 1–7 days category, where the gap is by far the largest.
  - A rise in interest rates across all maturities and currencies would be manageable by most banks, but would cause difficulties in the short run for two banks.

### Sectoral and other operational risks
- Interest-margin compression:
  - A reduction in interest rate margins is predominantly a risk for the largest seven banks, most of which have high administrative expenses.
  - Net interest margin shock (40 percent reduction) would lower average CAR substantially and weaken the banking system’s robustness to other shocks.
- Real estate exposure:
  - A few banks have large exposure to the real estate sector; a fall in real estate prices would have a significant effect on capitalization of at least two major banks.
- Nonbank Financial Institutions (NBFIs):
  - NBFI sector is still too small to present a systemic risk, but is vulnerable to reputation risk from a prominent failure or fraud.
  - Insurance sector:
    - Does not represent a systemic source of vulnerability currently, but sound development is important for long-term stability.
    - Rapid growth in the last five years raises concerns about underwriting risk management.
    - Asset risk is limited by investment regulations; interest-rate risk could be a problem due to limited supply of long-term maturities.
    - Concentration of reserves in bank deposits currently represents 60 percent of reserves.
    - Credit risk is high; companies are encouraged to reinsure locally with no mechanism to ensure reinsurance quality.
    - Overall, reputation risk is very high in the market.

### Institutional and structural weaknesses increasing vulnerability
- Risk-management capacity:
  - Risk management capacity is still developing in most banks; rapid credit growth may be outpacing management capacity, internal controls, management information systems, and credit assessment capabilities.
  - Credit expansion has outpaced deposit expansion: ratio of lending to deposits rose from 95 percent at end-1999 to 120 percent at end-2002.
  - In 2002 net loans increased UAH 18.8 billion, while deposits increased UAH 12.7 billion.
  - Ten of the 20 largest banks have experienced credit growth exceeding 70 percent annually since 1999.
  - Management capacity risk is of particular concern at one major bank.
  - NBU supervision should ensure loan evaluation procedures are forward looking and consider borrowers’ capacity to repay if credit conditions tighten and growth slows.
- Foreign-currency lending and dollarization:
  - Continued high proportion of loans denominated in foreign currency signals poor risk management.
  - Market expectations of nominal stability/appreciation of exchange rate encouraged foreign-currency lending to enterprises and households with limited or no foreign-exchange earnings.
  - Widespread disregard of borrowers’ exchange-rate exposure and still-high dollarization of deposits could harm individual banks, the banking system, and the economy if circumstances worsen.
  - Prudential supervision priority: ensure banks take borrowers’ exchange-rate exposure fully into account in lending decisions.
- Broader institutional shortcomings:
  - Quality of governance is questionable for many banks and enterprises; ownership and management often concentrated in same individuals, weakening oversight.
  - Close ownership ties between banks and certain enterprises may give rise to insider lending; many banks appear to lend disproportionately to companies owned by major shareholders.
  - Risks from links between banks and nonbanks are poorly informed by available data and supervisory arrangements (credit risk via NBFIs).
  - Accounting arrangements make true creditworthiness difficult to discern; audited financial statements are often unreliable due to absence or incompleteness of notes.
  - Institutional arrangements to seize collateral and enforce contracts are weak: court system slow and erratic; titling and registering of movable and real property still being developed.
  - State Execution Service previously had a monopoly on collecting collateral and remains dominant; perceived as understaffed, inefficient, inclined to abuse position, with high fees based on book value of assets rather than value achieved.

### Creditors’ rights, insolvency, and corporate governance
- Legal framework improvements:
  - Law on Pledge reasonably robust.
  - New Bankruptcy Law (effective 2000) offers major improvements emphasizing creditors’ rights and enterprise rehabilitation; its use by creditors to collect debts has widened.
  - New law mandates an examination of prospects for reorganization before liquidation; most restructurings involve debt reduction/rescheduling and in a few cases conversion of debt to equity.
- Remaining gaps:
  - Bankruptcy law applicability limited for certain enterprises (particularly state-owned); time delays can be excessive.
  - No modern mortgage law; land and building titling problems persist.
  - New law on secured transactions under consideration; should benefit from the state-of-the-art pledge registry created in 1999.
  - In current system registration is voluntary and does not encompass all security interests; tax claims have priority over other secured claims, even if unrecorded.
  - Securities Law could be improved to define and regulate insider trading or tenders, and to create “tag-along” rights or similar protections for minority shareholders.
- Corporate governance reforms recommended:
  - Improve roles and responsibilities of supervisory and management boards, including fiduciary liability.
  - Define duties, obligations, liabilities and conflict-of-interest requirements of directors.
  - Adopt the new Law on Joint Stock Companies as soon as possible; include provisions to discourage proliferation of joint stock companies and favor simpler corporate structures (e.g., differentiated minimum capital requirements).
  - Shareholders should have access to shareholder lists; disclosure of large shareholdings should be obligatory; company documents should be freely available in enterprise registers.
  - Accelerate development and implementation of a Ukrainian Code of Corporate Governance.

### Anti-money laundering and combating the financing of terrorism (AML/CFT)
- Recent legislative improvements:
  - Ukraine passed a new comprehensive anti–money laundering law (the “AML Law”) on November 28, 2002.
  - The new law becomes effective six months following its publication, i.e., on June 10, 2003.
  - The AML Law established a comprehensive framework broadly in line with existing international standards and FATF (40+8) recommendations.
  - The law defines the offence of money laundering and predicate offences, specifies a wide range of institutions subject to the AML regime, describes procedures for monitoring suspicious transactions, mandates customer identification and record-keeping standards, and establishes liability for violating the Law.
  - The Law was further amended in December 2002 and February 2003 to lower the threshold for reporting of suspicious transactions, clarify indemnity provisions for employees of financial institutions, and provide political independence of the Financial Monitoring Department.
  - FATF’s February 2003 plenary session decided to withdraw the application of additional counter-measures in response to recent changes in Ukraine’s AML/CFT regime.
- Operational issues:
  - Until recently Ukraine lacked a comprehensive AML statutory framework and an operational financial intelligence unit (FIU) with proper staffing and resources; many constraints have been alleviated.
  - Main challenge now lies in ensuring effective implementation of the new legislation.
- Footnotes preserved:
  - The need for improvement was highlighted by an unfavorable report issued in 2001 by the Financial Action Task Force (FATF), which placed Ukraine on its list of noncooperating countries and territories.
  - Predicate offences include acts punishable under Ukrainian criminal law by imprisonment of three years or more, or acts that constitute a criminal offence under the criminal law of a foreign state and that of Ukraine, with the exception of crimes set out in Articles 207 and 212 of the Penal Code.

*Source: IMF staff report (December 2001 data; text describing stress tests, institutional factors, and legislative developments).*

### 63. The Law confirmed the status of the Financial Monitoring Department (FMD)

### 63. The Law confirmed the status of the Financial Monitoring Department (FMD)

### Legal and institutional changes
- The Law confirmed the status of the Financial Monitoring Department (FMD) within the Ministry of Finance as the lead government agency responsible for coordinating AML efforts in Ukraine.
- The Law gives the FMD broad powers to implement the law, including the power to pass regulations in this area.
- The Law addresses terrorism financing by:
  - Including terrorism and terrorist financing among predicate crimes for money laundering.
  - Bringing combating the financing of terrorism into the AML framework.
  - Requiring mandatory reporting of all transactions suspected of being targeted at, or related to the financing of terrorism to the FMD and to law enforcement authorities.
- The Law includes provisions on international cooperation in information sharing and enforcement.

### Operational timing and capacity
- The FMD is expected to be fully staffed and to become operational by June 2003.
- The FMD has a budget for sixty staff, including the chairman and his four deputies.

### Supporting legislation and ongoing amendments
- In September 2002, Ukraine ratified the International Convention on Suppressing the Financing of Terrorism.
- The Penal Code, the Law on Banks and Banking, and the Law on Financial Services and State Regulation of the Market for Financial Services were amended to be consistent with the AML Law.
- Amendments to the Law on Combating Terrorism, consistent with the FATF 8 recommendations, and amendments to the Penal Code that would strengthen penalties for terrorism financing are currently under consideration by parliament.

### Implementation priorities and capacity building (policy recommendations and tasks)
- Main implementation tasks identified:
  - Ensure government agencies involved in combating money laundering and the financing of terrorism are adequately staffed and funded.
  - Pass implementing regulations without undue delay.
  - Develop education programs for government officials, the private sector and the general public.
  - Improve coordination among government agencies and establish a dialogue between the government and the private sector.
  - Ensure bank, securities, and insurance regulators build the capacity and expertise needed to enforce AML/CFT rules.
- Specific institutional actions described:
  - Once fully operational, the FMD should join the Egmont Group of FIUs, as the authorities intend.
  - In due course, consideration could be given to making the FMD an independent agency, outside of the Ministry of Finance, in order to enhance its reputation for objectivity and independence.

### Related findings and context from the FSAP assessment (selected relevant figures and observations)
- At the time of the FSAP assessment (May 2002): banks returned to profitability in 2001, and preliminary results suggest that profitability was generally maintained in 2002.
- More than one fifth of loans are nonperforming (as of end-2002).
- Prudential regulations then included an 8 percent minimum risk-weighted capital adequacy ratio.
- The Banking Law set a minimum capital requirement of €5 million for fully licensed banks.
- Reporting on a consolidated basis was due to start in 2003.
- The assessment was prepared in May 2002.

### Extracts of policy recommendations from the report (short term and medium term, exact phrasing preserved)
- Short term, rapidly implementable:
  - Increase the minimum risk-weighted capital adequacy ratio for banks to at least 10 percent (as intended) and preferably eventually to 12 percent.
  - Require banks through prudential supervision to limit foreign currency-denominated credits to borrowers without a reliable source of foreign currency earnings.
  - Further strengthen supervisory controls on insider and connected lending; implement consolidated supervision.
  - Maintain requirement that banks take prompt corrective action to rectify any prudential deficiency, and strictly avoid forbearance.
  - Pursue vigorously the rehabilitation and restructuring of a major bank.
  - Clarify to the public the prioritization of the central banks domestic and external monetary policy targets.
  - Phase out the NBU’s longer-term refinancing facility, or, at a minimum, strictly limit refinancing provided under the facility, and require that only high-quality collateral of matching maturity be provided.
  - Make operational the new regulatory agency for nonbank financial institutions.
  - Increase the size and concentration of the issues of domestic government debt.
  - Make operational the Financial Monetary Department (the financial intelligence unit).
- Medium term, possibly requiring amendments to laws and regulations, or other extensive preparations:
  - Review and revise provisioning rates based on empirical evidence of loss rates.
  - Tighten regulations on bank equity investment.
  - Require banks to prepare accounts fully in compliance with IAS.
  - Integrate the insurance of deposits at a major bank into the FGDNP system.
  - Appropriately limit the conditions under which central bank management can be replaced; and determine central bank profit transfers to government on the basis of realized profits.
  - Update and extend regulation for nonbank financial institutions, notably for leasing companies, pension funds and credit unions.
  - Simplify auction procedures for government securities.
  - Consolidate securities exchanges, registrars, and depositories; increase disclosure requirements.
  - Modernize the mortgage law, land and building titling, and the law on secured transactions.
  - Strengthen shareholder rights by increasing access to corporate information, moving towards international standards in corporate accounting and audit, facilitating shareholder control of management, and reinforcing supervisory boards (including of banks).
  - Update and extend anti-money laundering regulations, for example, on recognizing unusual or suspicious transactions.

*Source: _cr03340 - 63. The Law confirmed the status of the Financial Monitoring Department (FMD).*

### 92. Since the initial assessment in May 2002, the authorities have issued amendments

### _cr03340 - 92. Since the initial assessment in May 2002, the authorities have issued amendments

### Legal and regulatory changes on money laundering and terrorist financing
- In December 2002, the Law on Prevention and Counteraction to Legalization (Laundering) of Proceeds from Crime was adopted by Parliament, and will come into force (after amendment) in June 2003.
- The law introduces financial monitoring by banks and other financial and nonfinancial institutions, and oversight by the National Bank of Ukraine, the State Securities and Stock Exchange Commission and the new nonbank financial institutions regulator.
- The central organization and financial intelligence unit is the Financial Monitoring Department, which falls under the Ministry of Finance. The law describes its tasks in detail.
- Consequent amendments were made to other laws:
  - Law on Banks and Banking: articles introduced or amended relating to identification of customers for the opening of accounts and the documenting of financial transactions.
  - The Criminal Code of Ukraine was also changed.

### Implementation requirements and capacity building
- Implementation tasks identified:
  - Banks must set up systems to comply with the legal obligations of the law.
  - Bank staff will have to be trained.
  - The NBU supervision department will have to set up an inspection framework for adequately supervising banks with regard to practical aspects of the legislation against money laundering, and NBU staff will need to be trained.

### NBU regulatory responses to the May 2002 Basle Core Principles assessment
- Amendments and new regulations introduced or extended by the NBU:
  - In May 2002, an amendment to the existing Regulation of Activities of Banks in Ukraine to ensure banks have information systems to identify loans to connected and related parties to monitor these loans.
  - In May 2002, a new edition to the existing Regulation on Rating Procedures strengthening provisions for banking inspectors to assess banks for vulnerability to market risk.
  - Amendments to procedures for compilation and submission to the NBU of consolidated financial statements.
  - Draft changes to the Law on Banking and Banks to strengthen rules for prior approval of capital investments by banks; under the amendments, the NBU would determine criteria of assessing investments and the availability of sufficient bank resources for the investment, and would have the right to refuse approval; approval could be withheld on the grounds that the shareholder structure lacks transparency.
  - A change to the existing regulation is currently under discussion to explicitly exclude the revaluation reserve of fixed assets from the capital base for calculation of the capital adequacy ratio.
  - The authorities have indicated their intention to increase the minimum capital adequacy ratio to at least 10 percent.

### IMF MFP Transparency Code assessment: scope and context
- The assessment was undertaken in accordance with the IMF Code of Good Practices on Transparency in Monetary and Financial Policies (MFP Transparency Code).
- The assessment was carried out as part of the joint Bank-Fund Financial Sector Assessment Program (FSAP) mission that visited Kiev in May 2002.
- Since the initial assessment in May, authorities issued amendments to existing laws and regulations and new laws and regulations; these developments are reflected in the assessment.

### Institutional and market structure: NBU mandate and framework
- Legal bases:
  - The Constitution of Ukraine and the Law of Ukraine on the National Bank of Ukraine (the NBU Law) assign responsibility for formulation and conduct of monetary policy, oversight of payment systems, and supervision of banks to the NBU.
- NBU objectives and framework:
  - Basic function: “... is to provide for the stability of the monetary unit of Ukraine.”
  - The NBU conducts monetary policy within a reserve money framework, seeks to build up international reserves, and maintain the stability of the exchange rate.
- Governance:
  - The Council (composed entirely of appointed or elected political figures, including Advisors to the President, Members of Parliament, a Vice Prime Minister and the Minister of Finance) is responsible for developing the “basic principles of money and credit policy.”
  - The Board of Directors (Governor, Deputy Governors, executive heads of departments) ensures implementation of policy developed by the Council.
  - The NBU Law gives operational responsibility for the conduct of monetary policy to the NBU and authority to use specified monetary policy instruments.
- Payment systems and banking regulation:
  - The NBU plays the principal role in establishing principles and basic rules governing the payment system and outlines directions for electronic banking technologies, electronic payment instruments, settlement systems, automation, and banking data securities.
  - The NBU issues regulations for banks, defines general principles of banking activity, creates procedures for bank oversight, carries out enforcement actions, ensures stability of the banking system and protects depositors.
- Deposit insurance (FGDNP):
  - The Fund for the Guarantee of Deposits of Natural Persons (FGDNP) administers the deposit insurance system, established since 1998; in September 2001 its mandate was revised and codified by the Law of Ukraine On the Fund for the Guaranteeing of Deposits of Natural Persons.
  - The FGDNP insures only household deposits, up to UAH 1200 per depositor, in commercial banks with the exception of one bank.
  - One major bank is not covered by the FGDNP; household deposits in this institution are explicitly guaranteed in the Law on Banks and Banking. That bank:
    - Does not pay insurance premiums.
    - Has no dedicated government reserve fund to cover potential liability.
    - Is subject to prudential supervision by the NBU and government oversight by the Ministry of Finance.

### Transparency of monetary policy — main findings
- Legal and publication framework:
  - The revised NBU Law (1999) substantially enhanced the legal framework for monetary policy formulation and implementation.
  - The law defines objectives, responsibilities, procedures for appointment of governing bodies, NBU–government relationships, and broad accountability modalities.
  - Resolutions and regulations specify procedures and practices governing monetary policy instruments.
  - The NBU publishes the General Principles of Monetary Policy, annual report, quarterly bulletin, monthly magazine, and other material.
- Remaining transparency shortcomings:
  - The law does not provide a clear indication of priority if there is a conflict between achieving price stability and exchange rate stability.
  - The NBU has interpreted its main objective to be maintenance of price stability; it has recently ensured exchange rate stability (notably between the hryvnia and the US dollar).
  - The law suggests other objectives, such as social and economic development, which may conflict in the short term with monetary stability.
  - The governance structure, while appropriate in law, raises concerns because the NBU is perceived as not being autonomous of government in practice, notwithstanding legal operational independence.
  - The manner of allocation of NBU profits is complicated and creates the impression that the NBU indirectly and in a non-transparent manner finances the government’s budget.
- Process and disclosure:
  - Some degree of ex-ante and ex-post disclosure exists in published material; procedures governing instruments and changes and their rationale are disclosed.
  - The General Principles are not reader-friendly; published analysis of economic developments does not fully support policy conclusions.
  - The schedule of policy meetings of the NBU is not disclosed in advance to the public.
  - The Governor regularly appears before Parliament and the Cabinet of Ministers to account for monetary policy decisions.
- Data dissemination and timeliness:
  - On January 10, 2003, Ukraine subscribed to the IMF’s Special Data Dissemination Standards (SDDS).
  - Data publication has been consistent with both the General Data Dissemination Standards (GDDS) and the SDDS in terms of coverage, periodicity and content.
  - Major publications are published with lag:
    - The balance sheet of the NBU is published with a delay of approximately five months.
    - Data for analytical accounts and the analytical accounts of the banking sector are made available with a delay of about five weeks.
  - The NBU does not disclose information on emergency support provided to individual banks either ex-ante or ex-post, although consolidated amounts of such support are disclosed.
- Accountability and integrity:
  - The Bank furnishes information on the conduct of monetary policy to the President and the Parliament and consults with and submits information to the Cabinet of Ministers.
  - The NBU publishes audited annual financial statements according to the Law on Accounting; these are published on the NBU’s website and in its Annual Report with an average delay of five months.
  - Financial statements are audited by an independent auditor, in accordance with International Standards on Auditing (ISA).
  - The Board of Directors issues internal governance procedures to the Internal Audit Department via resolutions; such resolutions are publicly disclosed on the Bank’s website.
  - The NBU Law and the Law on the Public Service include provisions to prevent exploitation of conflicts of interest by officials of the Bank.
  - The NBU Law prohibits interference by the legislature and executive into NBU functions and provides a legal right of access to information.
  - NBU staff are covered by the Law on the Civil Service and have some legal protection, but the NBU Law does not provide staff with explicit statutory immunity or legal protection for bona fide actions or omissions in the conduct of their official functions.

### Recommended actions to improve observance of MFP Transparency Code — monetary policy
- Clarity of Roles, Responsibilities and Objectives:
  - The overriding objective of the NBU should be clarified in law and to the public.
  - Responsibility for determination of the exchange regime should be explicitly assigned.
  - The relationship between the government and the NBU should be reviewed to grant the NBU greater autonomy in implementing monetary policy. Specifically, dismissal of the Governor and members of the Council should require objective criteria and a full public explanation.
  - The NBU Law should be amended to simplify calculation and allocation of the Bank’s profits. Profit transfers to government should be based only on realized, historical profits, calculated according to accepted accounting standards.
- Open process for formulating and reporting monetary policy decisions:
  - The NBU may wish to reconsider disclosing in advance to the public the dates of upcoming policy meetings of the Council of the Bank.
  - Considerations underlying monetary policy decisions should be more thoroughly and regularly explained to increase public understanding and policy effectiveness.
- Accountability and assurances of integrity:
  - The NBU should work with the government to amend the NBU Law to provide stronger legal protection to staff and others hired for bona fide actions or omissions in the conduct of their official functions.

### Authorities’ response to the assessment
- The authorities were in broad agreement with the mission’s assessment, with specific comments:
  - The NBU noted that many key issues, especially those relating to greater autonomy for the NBU, are political in nature and therefore outside the direct control of the NBU.
  - The authorities do not agree that the lack of a clear explanation of priorities when conflicts arise between maintaining internal and external value of the currency is an element of non-transparency. The NBU’s view is that its constitutional mandate of promoting the “stability of the national currency” implies ensuring both domestic price stability and a stable exchange rate; the NBU should create conditions so contradictions do not arise, and if they do, the objective is to eliminate the contradiction rather than choose between components.
  - The NBU accepted that the calculation and allocation of profits transferred to government is complex and acknowledged that an amendment to the NBU Law would be needed to change procedures; it does not accept that the impression is given that the NBU provides indirect financing of government.

*Content based on the provided IMF document excerpt.*

### 116. Overall, the NBU displays a high degree of transparency in its oversight of the

### Overall, the NBU displays a high degree of transparency in its oversight of the

### Transparency of NBU oversight and supervision
- The NBU’s main objectives and responsibilities for the payment system and for the supervision of banks are clearly defined in legislation and publicly disclosed in the Annual Report, the NBU journal, and the NBU website.
- The process of formulating and implementing payment system policy and banking supervision policy, regulations and directives is generally open and transparent.
- Internal control procedures and provisions to prevent conflicts of interest for management and staff are not made public.
- Legal protection provisions for officials and staff of financial agencies are not very strong, appearing to be a general problem in Ukraine.

### Deposit insurance (FGDNP and government guarantee)
- The FGDNP operates in a generally transparent manner; the overwhelming majority of principles are fully observed for this part of the deposit insurance system.
- The FGDNP is governed by the Law of Ukraine On the Fund for the Guaranteeing of Deposits of Natural Persons, which defines scope, operations, establishment, organization, functions, and responsibilities; the FGDNP has clearly defined roles, responsibilities, and objectives.
- The government guarantee on household deposits at one major bank:
  - Is publicly perceived but, while assured by law in general terms, lacks specifics.
  - Objectives are not spelled out, modalities for making the guarantee effective are not defined, and responsibility for implementing and administering the guarantee is not explicitly assigned to a particular institution.
  - The functioning and institutional arrangements for this guarantee are essentially non-transparent.
- Participating commercial banks must keep depositors informed; the public is aware of the guarantee on household deposits at the Savings Bank, but modalities are not defined.

### Clarity of roles, responsibilities, and accountability (Principles 5 & 8)
- The NBU is the sole agency responsible for operating the payment systems and for supervising and regulating banks in Ukraine.
- Legislative framework: NBU Law, Law on Banks and Banking, Law on Financial Services and the Government Control of Financial Services Market, and draft Law on Financial Control in Ukraine.
- The NBU Law specifies objectives and responsibilities related to payments system and banking supervision; objectives are further explained in the Bank’s annual report and quarterly Herald.
- The NBU is accountable to the President and Supreme Council of Ukraine (Parliament); the Governor and colleagues appear before these bodies, host press conferences, and issue press releases.
- The NBU has developed a Code of Professional Ethics of Bank Supervisors with standards for conduct of personal financial affairs of officials and staff of banking supervision.
- Legal protection for officials and staff is not explicitly included in the Law on Banks and Banking or in the NBU Law, but follows implicitly from the Law on Civil Servants.
- Mechanisms, including reporting requirements, exist to ensure the accountability of the FGDNP; some provisions assuring integrity are in place.

### Open process for formulating and reporting financial policies (Principle 6)
- Law on Payment System and Monetary Transfers in Ukraine (the PSL) contains detailed operating procedures for payment system activities; this and subsidiary laws and regulations are available on the NBU website.
- Criteria for access to the payment system are described in regulations and instructions that are publicly disclosed.
- The NBU law contains general provisions on scope and limits of information sharing with other domestic and international institutions; there do not seem to be publicized, formal procedures for sharing information with other financial agencies when needed.
- No legal obligation exists for the NBU to consult the public or the Bankers Association on substantive changes in banking regulations; in practice, essential changes are routinely discussed with the Association of Ukrainian Banks.
- Recommendation: The Law on Banks and Banking should include an obligation for the NBU to consult the Bankers Association on changes in banking regulations and reporting requirements; subsequent public consultation procedures should be established. These changes are likely to be implemented when the draft “Law on Financial Control” comes into force.

### Public availability and dissemination of financial information (Principle 7)
- The NBU publishes developments in financial policies, payment system developments, and domestic regulatory changes in the Herald of the National Bank of Ukraine; the journal is available on the NBU website.
- The NBU has published a book on the payment system and maintains an active speaking program by senior officials.
- Aggregate financial data are disseminated via the annual report and monthly bulletin; publication lags exist and can be long and variable.
- Recommendation: Make greater use of the NBU website to reduce publication lags and to issue periodic public information on major banking system developments.
- The NBU does not publicly disclose emergency financial support to banks, neither at individual nor aggregate level.
  - It is questionable whether such information should be disclosed even at an aggregate level soon after assistance is provided, because aggregated information can be “disaggregated” for individual banks.
  - There is no reason not to make such information available after the assistance is provided and once the situation prompting it has passed.

### Recommended actions (selected)
- Enhance legal protection for bank officials and staff:
  - It is advisable that the NBU Law explicitly include legal protection for officials, staff and all those hired by the NBU for related purposes in the performance of their legitimate duties, and that existence of such protection be publicly disclosed.
- Clarify and increase transparency of the government guarantee on household deposits at the major bank:
  - Consider transferring responsibility to the FGDNP as part of the bank’s reform, noting this would require a substantial increase in FGDNP resources and would be inappropriate until the bank’s financial position, structure, and operations have improved considerably.
- Formalize cooperation among supervisors under the new Law on Financial Services and Government Control of Financial Services Market and develop adequate procedures once the authorized executive body is set up.
- Review desirability of disclosing aggregate emergency financial support to banks.

### Authorities’ response
- The authorities agreed with the mission’s assessment regarding transparency practices in financial policies and indicated willingness to address most recommendations.
- A Memorandum of Understanding spelling out institutional and operational arrangements of the guarantee of household deposits at the major bank and its eventual reform is being worked out between the Government, the NBU, and the World Bank; these arrangements are expected to be codified into law in due course.

### CPSS Core Principles assessment — Electronic Inter-bank Payment System (EIPS) overview
- Assessment focus: Electronic Inter-bank Payment System (EIPS) operated by the NBU; EIPS identified as systemically important because it is the only payment system used by all banks and handles all inter-bank payments regardless of transaction value.
- Key system facts:
  - EIPS commenced operations on 1 January 1994.
  - In 2002, 164 million transactions with a gross value of hryvnia 1.34 trillion (more than six times GDP) were carried out through EIPS.
  - The EIPS handles settlement of capital market transactions and payment cards transactions.
  - Participants include branches of the NBU, commercial banks, some branches of commercial banks, and State Treasury units.
  - Participation in EIPS is mandatory for banks involved in inter-bank payments.
  - For most commercial banks only the head office is a member of EIPS; for some banks each branch is a member, subject to an overall limit matching the balance of the bank’s correspondent account with the NBU.
  - System operated by Central and Regional Accounting Houses (CAH and RAH); transactions processed on a gross basis from 8:00 a.m. to 8:00 p.m.
  - Technical accounts are created at the beginning of the banking day to record credits and debits; technical accounts are not on the books of the NBU.
  - Participating banks aggregate payment documents into packages sent via e-mail to RAHs; RAH cycles last 15-30 minutes.
  - Processing and settlement of credit transfers generally takes from a few minutes to two hours; at end of day settlements are reflected in banks’ actual correspondent accounts at the NBU.
- Development: Main project is introduction of procedures allowing for on-line real time gross settlement (RTGS); EIPS expected to stay in operation until 2010 at least; NBU and some commercial banks developing new retail means such as “smart cards”.

### CPSS assessment — main findings and recommendations
- Design and functioning: EIPS is generally secure, reliable, and efficient; areas for improvement are narrowly focused.
- Legal foundation (CP I):
  - Legal basis: various laws, notices, decrees of the NBU, internal regulations, contracts, agreements, and other regulations provide the NBU fully adequate powers to operate and regulate the system.
  - Concern: Existing laws do not exclude from insolvency procedures collateral security provided in connection with participation in the payment system or in operations with the central bank; Article 26 of the Law on Restoration of Solvency of the Debtor or Application of Bankruptcy Procedures includes collateralized assets into bankruptcy procedures but prioritizes compensation to the pledgee as first priority, implying potential liquidity risk for the pledgee because bankruptcy procedures take time.
  - Current legislation does not contain provisions ensuring that transfer orders are protected from insolvency law provisions from the moment they enter a designated payment system; NBU Directive on Interbank Settlements states interbank electronic settlement documents received by EIPS may not be revoked, but a directive has less legal force than the Bankruptcy Law.
- Understanding and management of risks (CPs II–III):
  - Laws and regulations provide necessary information for understanding system functioning; NBU provides training and support services to ensure banks can manage risks.
  - Procedures for management of credit risks and liquidity risks and responsibilities of NBU and participants are well defined; incentives to manage and contain risks are adequate.
  - Within a business day, the inter-bank money market is the only source of liquidity for banks; liquidity in the banking system is high at present.
- Settlement (CPs IV–VI):
  - Settlement is generally prompt and reliable, but situations could arise where transactions are not finally settled during the day of acceptance.
  - Assets used for settlement are claims on the central bank.
- Security, operational reliability, contingency arrangements (CP VII):
  - EIPS has a high degree of security with many mutually-reinforcing features; no security incident since January 1994.
- Efficiency and practicality (CP VIII):
  - EIPS is practical and efficient; transactions are settled promptly, reliably, and at low cost.
- Criteria for participation (CP IX):
  - Any credit and finance institution may become a participant if it has correspondent accounts with one of the NBU regional branches and meets technological and operational requirements of the electronic payments system.
- Governance (CP X):
  - EIPS is owned, managed, and operated by the NBU; responsibilities are laid down in law and detailed information is established in published regulations.
- Central Bank responsibilities:
  - Responsibilities and powers of the NBU to oversee EIPS are laid down in the NBU Law and in the Law on Payment Systems and Money Transfers in Ukraine; the NBU promotes development of a safe and efficient payment system and cooperates with central banks in other countries and with the CPSS.

### CPSS recommended actions (selected)
- Legal foundation – Principle 1:
  - Implement new regulations providing that:
    - transfer orders and collateral securities be explicitly protected from insolvency law provisions from the moment they enter a designated system;
    - the retroactive effects of insolvency rules on rights and obligations in the system be explicitly prohibited.
- Management of risk – Principle 3:
  - Introduce intra-day liquidity management measures (for example, credit facilities) to improve risk management, especially in the context of a new on-line RTGS system.
- Criteria for participation – Principle 4:
  - Consider measures to ensure final settlement for all payments at least at the end of the business day.

### Authorities’ response to CPSS assessment
- The authorities were in broad agreement with the assessment and noted it was generally positive.
- They maintained that protection of transfer orders from insolvency proceedings (relevant for Principle 1) is adequate because of provisions contained in NBU directives.

*Source: _cr03340 - 116. Overall, the NBU displays a high degree of transparency in its oversight of the*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2003/_cr03340.pdf_