Fitch: Ukraine Banks - Elusive Recovery Despite Debt Agreements

Ukrainian bank ratings are likely to remain at current weak levels for the foreseeable future despite signs of some improvement in the operating environment now that agreement to restructure USD18bn of sovereign external debt has been reached, says Fitch Ratings.

The country's three largest banks also restructured around USD2.9bn of debt owed to international creditors, easing near-term liquidity risks. Nonetheless, capital shortfalls for the sector are considerable and capital adequacy ratios no longer meet minimum requirements. Viability Ratings assigned by Fitch to Ukraine's banks are mostly in the 'ccc' level, indicating substantial credit risk and likelihood of default.

Deposit trends are nevertheless becoming less negative, with outflows slowing to 2.5% in 2Q15 against 8% in 1Q15 and a 22% outflow reported by the sector in 2014, adjusted for exchange rate effects. Stabilisation of the hryvnia since 2Q15 supports deposit stability but confidence levels are low and deposit volatility is likely to return if the exchange rate comes under renewed pressure. In our view, it could take several years before deposit stability reverts to pre-crisis levels and pricing normalises.

We believe capital will become further strained as unexpected credit losses continue to surface. Impaired loans have surged and loan restructuring is widespread. Impaired loans, net of reserves, totalled UAH95bn (USD4.3bn) at end-June 2015, equivalent to 95% of sector equity. In addition, risk weightings increased due to substantial hryvnia depreciation, which inflates the local currency equivalent of foreign currency assets, further weakening capital ratios.

Recovery prospects are highly dependent on macro-economic improvement but the operating environment is particularly weak. Fitch forecasts GDP to contract by 10% in 2015, following contraction of 6.8% in 2014.

The asset quality review and stress test being performed on the country's 20 largest banks, which together represent 81% of sector assets, are likely to uncover additional problem loans. Regulators will have to agree bank recapitalisation plans with shareholders to reach targeted 5% capital adequacy ratios in 2016. In the meantime, regulators are applying forbearance, allowing lenders to continue to operate while in breach of solvency ratios until end-2018. We expect a protracted solvency recovery, driven by general shareholder reluctance to inject additional capital into the failing banks.

Regulatory forbearance, cash withdrawal restrictions and exchange controls are important elements that support the banking sector's ability to function. We do not expect these measures to be fully lifted in the foreseeable future.

Reaching agreement with creditors on USD18bn of sovereign bonds in August unlocked the inflow of IMF funding, part of a USD40bn assistance programme. Agreement still has to be reached about how to restructure a USD3bn bond owed to Russia.

Ukraine's foreign currency issuer default rating was downgraded to 'Restricted Default' on 6 October 2015. Ukraine's ratings will be upgraded shortly after Fitch determines that the exchange has been successful. The new rating will be consistent with Ukraine's prospective credit profile and debt structure.