On Monday, December 19, 2016, the nationalization of PrivatBank was announced. The government and the National Bank of Ukraine argued that they had to do this in view of the bad quality of the bank’s loan portfolio, the large share of related party loans and the undercapitalization of the bank. The bank’s ex-management have argued that the actions of the central bank were unjust and aimed selectively against the largest Ukrainian bank.
In order to check the validity of the claims of PrivatBank’s ex-managers, a very good knowledge of the bank’s loan portfolio and other factual information of limited availability is needed. Therefore, VoxCheck has made a limited check of the claims, based on such principles:
- Those claims by the PrivatBank’s ex-management that concerned factual circumstances are accepted as true and are not checked separately. In particular, we have not reviewed whether the Dnipro-Arena is indeed secured in favour of PrivatBank, whether the NBU has accepted it as an eligible collateral and at what value;
- If the claims and examples are technically incorrect or manipulative, yet the essence of the claim may have merits (accusing the central bank of manual control, selective use of administrative measures, changing the rules of the game), we analized the essence of the claim alone;
- VoxCheck has only checked those claims that can be given a professional legal assessment. Subjective claims are left out.
“The UAH 148 billion deficit emerged after a sudden, and as we see it, unjustified change of the rules by the NBU, not because of the actual withdrawal of funds.“
1. Have the rules of collateral accounting changed? WEre the changes unjustified?
Yes, the rules for accounting for bank’s security will change for all the banks in 2017. Depending on the business model a particular bank uses, the changes can affect different banks in different ways.
In June 2016, the NBU passed Resolution №351. It replaced Resolution №23 (2012), which regulated the procedure of forming reserves. The new rules for the calculation of loan risks are to come into effect in 2017. Yet the banks had to perform and submit preliminary calculations to the NBU already in 2016.
The procedure of accounting for the collateral has somewhat changed. There are additional principles for determining the eligibility of collateral (including, for instance, the absence of specific risks of loss and the presence of a special clause in the contract that prohibits disposal of collateralized property). Liquidity ratios have also changed (e.g. apartments and vehicles have become more attractive as collateral, while the normative liquidity of an integral property complex has somewhat declined). The list of eligible collateral now does not include the “ownership claims on other property […] in possession of which the borrower will enter in the future (i.e. accounts receivables).
Therefore, depending on the business model used by a bank, the rules change can indeed have different impact on different banks since the start of 2017 (see below for more details about the possible impact of this change on PrivatBank).
2. Has the NBU really limited the list of eligible collateral to those objects that can be mortgaged?
No, the list of eligible collateral is not limited to objects that can be mortgaged (real estate). Any kind of “hard collateral” is suitable. However, in comparison to the previous criteria, the list of eligible collateral has been somewhat narrowed.
The claim  that only mortgage is suitable is technically incorrect. The list of eligible collateral contains 26 positions and includes, in addition to the fully liquid property (government bonds, cash on deposits etc.) real estate, equipment, vehicles, inventories, and some securities. As before, the list of ineligible collateral contains intellectual property, corporate rights, property rights to work, services, processes, movables, except those directly mentioned in the list. In addition to the limitations that existed earlier, in 2017 only the following will stop being taken into account by the central bank: “property rights to other property [manufactured goods, goods for sale, future harvest and increase in the livestock, receivables under executed contracts for the sale of goods/provision of services/conduct of works]“.
The limitations do not imply that banks no longer may accept such a property as collateral. However, it is not viewed as liquid; therefore, it is not taken into account when determining the compliance with the regulator’s reserve requirements. More details about the NBU’s accounting policy change can be found here.
3. Is the use of equity rights as collateral problematic?
Yes. These restrictions comply with the international practice.
As before, according to the new rules, corporate rights, except some securities, cannot be accepted as eligible collateral. This corresponds to the international practice, in particular to the Directive N 2006/48/EU that Ukraine has pledged to comply with .
The logic is clear. The value of corporate rights of a company is defined by the value of the assets it owns and the cash flow they generate. But the company’s property can be subject to various security interests in favour of a third party. The management can withdraw the assets, and the bank will be left with an empty shell. The liquidity and the value of such a collateral is low also because of the difficulties inherent in the foreclosure, unless the collateral are traded security.
Bankers understand these risks very well. Irrespectively of the central bank’s policy, corporate rights never act as self-sufficient collateral. Banks normally use them in addition to other, “harder”, collateral. The risk to lose a company that owns assets that cannot be used as collateral or alienated (for instance, licenses, goodwill etc.) stimulates the borrower to stick to the loan conditions, and the option of becoming an owner of the pledgor simplifies the foreclosure on the encumbered assets.
The specific stake in a company used as collateral (in the PrivatBank example, they use an example the corporate rights being divided between the owners in the ratio of 75% and 25%) is not especially important. Using corporate rights as a collateral is conditional upon the consent of the company’s owners. Therefore, if all shareholders are interested in the company receiving a loan, 100% of ownership rights will be used as collateral. In such case, there is no problem with the shareholders giving the consent to mortgage the company’s assets either, when such a consent is required by law or statute. Still, if the company is co-owned by the state, such a decision can be complicated by having to comply with certain procedures.
4. Can an inability to sell a real estate object, e. g. the Dnipro-Arena, be a ground for the NBU to not accept it as collateral?
Yes, the NBU may not accept an object as collateral if there is no liquid market for such property. In addition to the ban on accepting receivables as collateral (for instance, rights to future lease payments), such rules can have a substantial negative effect on those banks that fund infrastructure or other large projects and make such funding hardly possible in the future.
According to the new requirements, collateral is not eligible if an asset “faces specific loss risk [for instance, property that does not have a liquid market for disposal]” . The market for the disposal of such unique real estate objects as the Dnipro-Arena is indeed limited. Therefore, there are formal grounds for not accepting it as collateral since 2017.
Due to the exclusion from the list of the eligible collateral of “the ownership rights to other property [… receiving funds under the contracts … for providing services] “, banks are no longer able to accept as collateral for reserves calculations the receivables under lease agreements, which is the only alternative asset generated by the real estate object. Such an approach to the eligibility of receivables as collateral does not comply with the international practice. Regulators usually set rigid requirements to the quality of receivables (e. g. regarding the debtor, the quality of servicing the debt, presence of real deliveries or provision of services under the contract, their regularity and the regularity of payments, the quality of the contract itself etc.), yet accept their use as collateral subject to some coefficients.
The NBU’s new approach can be viewed as an attempt to reduce risk in the banking system. Yet such changes are destructive for the banks that fund large, and therefore less liquid, projects and for the businesses that run such projects, as large-scale projects do not generate other kinds of collateral except for the real estate object itself and future lease payment flows. At the same time, those banks that provide loans for purchasers of residential property (e. g. “khrushchyovkas”) do not have to deal with this.
Therefore, the changes, together with the narrowed understanding of what the liquid market is, which the NBU can put into practice, can prevent banks from funding infrastructure projects and shift the structure of lending from large project to small-scale consumption funding.
“The NBU has discarded the international standards of defining affiliated persons and has started to classify virtually everybody as related parties”.
1. Has the NBU really prohibited the use of the IFRS definition of a related party (affiliated company)?
The definition of a related party according to the IFRS does not fully match the related party definition used by the NBU. Differing definitions for the same term are also provided in the Tax Code and in antitrust laws. The reason lies in the difference of the purposes of the regulations.
There have been no significant changes in the use of the term “related party” for the purposes of preparing financial reports in the recent years. However, in order to determine the risk level, the bank does not use the provisions of the financial reporting standard, but instead relies on the definitions on the affiliation and related parties contained in the Law “On Banks and Banking”(no changes since 2015) and the NBU’s Resolution №315 of 2015 (amended twice in 2016, yet the changes were not very significant).
2. Does the NBU have the right to classify anybody as a related party?
Yes, the NBU has broad discretion in classifying a person as a related party for the purpose of determining the compliance of a bank with the standards. This allows to apply such standards selectively, in the PrivatBank case as well.
According to the law, the NBU has broad discretion in setting the criteria for defining a related party, which are obligatory for banks. In addition to the general criteria set in the law, which are similar to the definition of related parties in other spheres, the NBU’s Resolution №315 sets additionally very broad and detailed criteria for classifying a party as a related one. These criteria include any signals of the exclusivity of relations with a bank (the debtor borrows only from one bank), its economic dependency on the bank, joint infrastructure with the bank or the bank’s related parties (the same address, managers, the joint IT system), insufficient transparency of a borrower, non-standard relations with the bank etc. This criteria were defined in 2015 and has not changed since.
The criteria set by the Resolution cannot be used separately from the ones set in the law. For instance, the lack of information on the activities of the ultimate beneficiaries of a borrower cannot automatically lead to defining the borrower as a related party, but only under the condition that the borrower matches the criteria that are set in Article 52 of the Law “On Banks and Banking” (affiliation through the ownership rights, governing posts, other forms of control etc.). Unfortunately, it seems from the text of the Resolution that the NBU feels it can interpret these criteria as self-sufficient.
Banks determine related parties among their borrowers on their own. Every month the list is sent to the NBU, which can reclassify the debtors. The bank bears the burden of proving that the NBU is wrong. Such an approach can be justified if the criteria are clear and formalized. Yet the current Ukrainian regulations create much space for abuse by the central bank.
Therefore, given the NBU’s broad discretion in classifying a person as an affiliated one, we cannot rule it out that the criteria of affiliation were used selectively in relation to PrivatBank and the practice of applying the law could have changed selectively to the detriment of a particular bank in the past few years.
 See part 2, p. 2 of Resolution 351.
 See part 3, p. 2 of Resolution 351 See also the point of view of the NBU’s financial stability department chief Vitaliy Vavryshchuk on the results of those mock calculations.
 «What is the essence of these changes? The NBU has only allowed to count as collateral the property that can serve as collateral for a mortgage loan (e. g. a khrushchyovka in a “sleeper neighborhood”)”.
 See, e. g. p. 86 of the Appendix VI to the Directive, according to the general principle in which the risk coefficient of corporate rights is equal to at least 100%.
 See part 7, p. 107, 1) of Resolution 351.
 A separate issue is the approach to valuing such real estate objects given their suitability for the NBU. However, it goes beyond the scope of this VoxCheck.
 According to Resolution №23, such assets belonged to group V (the least liquid one) in terms of their liquidity and could be taken into account at the 0.4 liquidity coefficient.
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