Graham Stack in Kyiv -

Erste Bank has become the first of Ukraine's banks to officially acknowledge that its bad loans are in the double digits, declaring 10% of the gross loan portfolio to be non-performing at the end of the second quarter. However, the bank claims the figure is actually well below the true market average, and more a sign of the bank's strength than weakness.

"We do not do window dressing. Honesty is the best policy," Jozef Sikela, the 42-year-old CEO of Erste Bank Ukraine, Austria's Erste Bank subsidiary and 22nd largest bank in the country, tells bne in an interview. "The result is considerably healthier than the real market average."

Sikela declines to provide a figure for the sector as a whole. National Bank of Ukraine (NBU) statistics hold that the level of non-performing loans (NPL) stood at 4.9% as of June 1, but the consensus is the real level is nearer 15-20%. Ukrainian banks have developed numerous ways of jiggering the NPL figures they publish - by extending or rolling over loans that are obviously non-performing - and thus avoiding mandatory requirements to create provisions for loan losses.

According to Sikela, Erste in fact ran a far more conservative lending strategy than most other Ukrainian banks, especially locally-owned banks. Sikela accuses Ukrainian-owned banks of inadequate risk management during the last few years' lending splurge. "Ukrainian-owned banks were lending in a specifically flexible manner in comparison to international banking groups like Erste," he says. "Our customers were complaining of how conservative our lending policy was one year ago, now they are entrusting their deposits to us."

Sikela says Erste never entered the consumer loan market, and almost all its loans are collateralized with tangible assets. As such, he expects international banks like Erste - which constitute around 50% of the banking system - to dominate in post-crisis Ukraine, while local banks will wither away. "The system will remain loss-making for the time being, and only foreign-owned banks will be able to access the resources to continue functioning."

Staying the course

Sikela's comments indicate the bank will get the supports it needs from the parent group. Indeed, CEO of the parent Erste Bank Group, Andreas Treichl, told bne in Vienna following the release of the bank's second-quarter results at the end of July that while Ukraine is not a core market for his institution, in the long term he sees huge potential in the country and so there are absolutely no plans to pull out.

However, the NBU sees things differently. Erste Bank Ukraine posted a €31.9m loss for the first half of 2009, partly due to increased provisions for NPLs. The NBU now views all loss-making banks with great suspicion, and on July 22 issued regulations placing significant restrictions on their activities. Among other things, the regulator prohibited loss-making banks from paying bonuses, growing intangible assets and providing unsecured loans, steps that Sikela decries. "There are different reasons for losses, and different capacities to cope with them. You cannot treat large international banks the same as small local institutions with minimal possibility to inject new equity." Sikela says the measures effectively freeze his bank's development, stymieing IT investment and bonus-motivated projects.

Another major headache is pending populist legislation aimed at "protecting" mortgage borrowers against repossession. Erste was a leader in mortgage lending in Ukraine, "traditionally regarded as one of the safest forms of lending if done properly," says Sikela. Mortgages account for round half of Erste's retail portfolio, which in turn is two-thirds of its total loan portfolio. If the legislation goes through, critics fear the measure will encourage even solvent borrowers to suspend payment. "You can't explain something like this to international shareholders," warns Sikela, who adds that he is "very surprised" the International Monetary Fund (IMF) has been silent on the issue.

At stake is the larger issue of whether the Ukrainian authorities will exploit foreign banks' continued loyalty to Ukraine rather than reciprocate it. This could crucially tip the scales when parent banks decide on whether to continue to support subsidiaries or withdraw altogether from Ukraine, as Dutch bank ING has done with its retail operations.

A Moody's Investors Service report published on July 31 highlights potential rating implications for Raiffeisen, Erste, Societe Generale, UniCredit and KBC due to their Central and Eastern European commitments. In particular, according to the report, the "Austrian banking system is most exposed as Eastern Europe accounts for nearly half of that country's global bank claims." The report points to a possible vicious circle arising where "deteriorating financial strength of East European subsidiaries has a negative spillover effect on their West European parents," which in turn reduces parents' capacity to support subsidiaries, forcing them to choose which country subsidiaries to support and which to drop.

A report published on August 13 by Kyiv investment bank Sokrat argues that parent banks will continue to support their Ukrainian subisidiaries due to the amount of money already invested, the strengthening position relative to local competitors, and image damage for the parent bank should a subsidiary get into trouble.

A crucial factor in the equation will be the hryvnia exchange rate. Erste is typical of Ukrainian banks in having 70-80% of its credit portfolio denominated in foreign exchange, so the ongoing devaluation of the hryvnia should cause NPLs to soar further. This means that in Ukraine a second wave of the crisis resulting from bad assets is widely expected in the autumn.

For his part, Sikela doesn't expect any second wave. "The country is still buried under the first wave," he argues. "There are two major factors. Firstly, there is the ongoing credit crunch, there is basically zero lending going on, so no liquidity even for survival. Secondly, borrowers have to make repayments from their working capital, and will be unable to pay suppliers and workers."

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