Banking fragility rooted in justice failures

CEPS Paper Download CEPS Paper (689.64 KB)

The rule of law is a general concept covering independence of the judiciary, corruption prevention, non-jobbery, effective law enforcement, and absence of state capture. It influences numerous aspects of public and economic life. CES have studied a specific example of such influence in their ‘Banking Fragility Rooted in Justice Failures’ (10 May 2019) memo developed for the Centre for European Policy Studies under ‘European Freedom and Security’ activity. Its translation is published here.

Banking sector health is a key component of the country macroeconomic stability. A robust banking system contributes to the productivity and country economy growth by granting loans for investment projects but there is no such thing in Ukraine. The corporate loans are scarce due to high credit risk, and its main components given below are in their turn related to the weak rule of law:

– The massive-scale bad debt problem, still unresolved by the banks

– High probability of borrower default materialised during the bank crisis

– Abysmal level of lenders’ funds recovery after the borrower bankruptcy and foreclosure.

The memo describes the rule of law impact pathways with regards to the above credit risk components. It is based on in-depth interviews with experts, former and acting public officials, bankers and analysts carried out in autumn 2018.

The fact that every other Ukrainian bank collapsed under a mountain of non-performing loans is down not only to the war and crisis but rather to rampant fraud and raging kindred lending at ‘vac banks’ before the crisis, ignored or unchecked by the regulator.

There were three types of supervision: the first is you describe everything as it is and then our boss makes you rewrite everything; second is you go for the on-site audit already informed of what you will have to write; and the third is you just describe everything as it is. (From an interview)

The loan default probability is linked to both common problems caused by inadequate property rights and contract performance protection in the jurisdiction and to specific problems, e.g. loans due to an ‘indispensable advice’ that may undergo insufficient risk analysis. In total, these factors result in non-performing loans share in state-owned banks twice as high as in privately owned banks.

A number of Members of Parliament enjoy an impact on financial–industrial groups and vice versa. They wish to reiterate their impact [on state-owned banks]. That is why some of them are against independent supervisory board members [in state-owned banks]. (From an interview)

Ukraine shows one of the lowest recovery rates in the world for bankruptcy or foreclosure cases. In other words, if a borrower defaults the lenders are losing almost everything whereas in other countries they may get 60% to 90% of the loan face value.

The major bottleneck for effective resolution [is] definitely the courts. The banks simply could not get their collateral because the procedure is captured by vested interests in so many stages. Corporate borrowers widely use the loopholes and corruption. (Expert at the Ukrainian banking association)

To meet the bad loan challenge, make the banking system more resilient, and drive sustainable growth, Ukraine has to focus the rule of law reform, in particular, on the radical improvement of its financial sector. This can be achieved by joint effort of the financial sector, law enforcement agencies, and judicial system reform teams.

The possible options to support improvement are establishing a special bureau for financial crime investigations, creating a database for judicial practice in financial fraud cases, streamlining insolvency procedures, empowering the independent regulator, and supporting reform of the state-owned banks.