Anders Aslund -

The Ukrainian banking system has gone through persistent convulsions in the last seven years. A wave of West European purchases of Ukrainian banks just before the crisis of 2008-09 has been largely reversed. Instead, Russian and Ukrainian state banks have expanded, as have banks owned by people close to President Viktor Yanukovych.

In 2006-08, Ukrainian banks were expanding lending fast and made extraordinary profits. In the spring of 2008, Ukraine's economy was experiencing all signs of overheating. Annualized inflation peaked at 31% in May 2008, and the current account deficit reached 7.1% of GDP in 2008. Commercial banks with access to the euro market could borrow short-term funds at interest rates of a few percent, while issuing consumer loans in hryvnia at up to 50% a year. The artificial peg of the hryvnia to the US dollar caused this large interest gap, and the credit boom unleashed a real estate boom.

From 2006 to 2008, West European banks purchased Ukrainian banks at crazy values of up to five times book value, while multiples of one or two would be normal. The Ukrainian owners boosted the banks' assets by issuing overly large and risky loans just before they sold their shares.

By summer 2008, 17 West European banks' share of Ukrainian banking assets peaked at 40%. Now most of them have left. By January 2013, their share of Ukrainian banking assets had plummeted to 20% - half the peak value. Leverage - total bank assets as a share of gross domestic product - has declined marginally, and the number of banks has remained stable at 175.

Many Ukrainian businessmen sold their banks because banking requires a lot of capital but offers limited return. Rising Ukrainian entrepreneurs had little capital and wanted a 30% return. To navigate the not very transparent Ukrainian environment, some West European bankers entered joint ventures with the old owners. Theirs was a uniformly unhappy experience. The Western owners wanted to increase the bank capital, but the Ukrainians owners resisted because they did not want their investments to be diluted. The only sensible alternative for the Western owners was to buy out the former owners altogether.

On September 15, 2008, Lehman Brothers went bankrupt in New York, and abruptly short-term international bank loans were no longer available for Ukraine, whose financial markets faced a sudden stop. The US dollar peg collapsed and with it much of the financial sector and real estate prices.

Prime Minister Yulia Tymoshenko did what she could to keep the economy going, but President Viktor Yushchenko vetoed whatever he could. The International Monetary Fund (IMF) assisted with a large stabilization package, but incredibly Yushchenko blocked all of her proposed structural reforms.

The Ukrainian banks faced a severe currency mismatch. They had taken large short-term loans in euros, dollars, or Swiss francs, while issuing loans in hryvnias, which were insufficient to pay back dollar loans after the hryvnia was devalued. About one-third of the thirty biggest Ukrainian banks, all owned by Ukrainians, collapsed because of these currency mismatches. A score of banks remain in bankruptcy administration or in liquidation.

Immediately after the crisis, the IMF praised the work by the Ukrainian authorities to clean up the banking system, and the Western banks all persisted until 2011. But the situation has deteriorated since then. The share of nonperforming loans remains huge, and real interest rates remain high, because once again the National Bank of Ukraine insists on an artificially high pegged exchange rate to the US dollar. Last year, the current account deficit was even higher than in 2008, at 8.2% of GDP, and the forecasts suggest as large a deficit this year. The Ukrainian banking system is undercapitalized and is making few loans, depressing the economy. The banking environment is outright hostile.

It is becoming increasingly cumbersome for foreign banks to work in Ukraine's market. Last October, Kommersant Ukraina quoted Andrey Gerus of Concord Capital: "it is difficult to work in Ukraine according to Western standards. One needs flexibility and understanding of Ukrainian or even post-Soviet reality."

Four trends have been evident in Ukrainian bank ownership in the last two years. First, as earlier stated, the West European banks are withdrawing. Only two of Ukraine's 10 biggest banks, Bank Aval and Ukrsotsbank, are still owned by West European banks, Raiffeisen and Unicredit, respectively. Two or three other smaller Western-owned banks may survive, while half of the Western owners have decided to sell and leave.

Second, the two remaining state banks, Ukreximbank and Oshchadbank, have doubled their share of banking assets during the crisis to 15%. The government uses these banks to buy state bonds for indirect state financing.

Third, immediately after the crisis, Russian banks increased their share of banking assets to 13%, with the three biggest ranking fifth, seventh, and eleventh. They are all owned by the Russian state (VEB, VTB, and Sberbank Rossii).

Fourth, businessmen close to President Yanukovych own the biggest private Ukrainian banks. As before, Igor Kolomoiskiy's and Gennady Bogoliubov's Privatbank is the dominant Ukrainian bank. Rinat Akhmetov's First Ukrainian International Bank has advanced to ninth by assets. Banker Nikolay Lagun's Delta Bank has skyrocketed to eighth place. Recently Dmitry Firtash purchased bankrupted Bank Nadra, and Vadim Novinsky bought Bank Forum from Germany's Commerzbank.

The changes in bank ownership have profoundly weakened the country's banking system, and they reflect the hostility of the Ukrainian authorities to foreign influence and to the rigorous banking standards they bring. Hopefully, the biggest and seemingly best run West European banks - Bank Aval and Ukrsotsbank - will be able to survive even in the present business climate. By contrast, in the 10 new eastern members of the European Union, the West European banks remain dominant and their share of banking assets has shrunk only marginally by 2.7% during the crisis.

Western companies prefer to do business with Western banks rather than with little known Russian or Ukrainian banks, so the departure of western banks from Ukraine will also hamper trade and investment.