A surge in third-quarter earnings at Ukrainian banks was not enough to dispel increasing concerns around credit risk as the war with Russia beds in.

Aggregate net profit for banks operating in Ukraine rose to 12 billion hryvnia from a 4.5 billion hryvnia loss in the previous quarter, according to the National Bank of Ukraine, or NBU. A key policy rate hike to 25% in July boosted revenue that lenders generate from placing funds with the central bank.

Foreign-currency operations are also providing solid income, while fees and commissions income have started to recover following a significant decline in the first months of the war, said Vitaliy Vavryshchuk, head of macro research at Investment Capital Ukraine.

"Business models of most market participants proved to be stable and effective even in wartime conditions: banks generated operating income, managed to reduce costs and ensured the formation of provisions with a minimal impact on capital," the central bank's first deputy governor, Kateryna Rozhkova, told S&P Global Market Intelligence.

Still, the sector's profit for the nine months ending Sept. 30 fell more than 85% year over year to 7.4 billion hryvnia, largely due to war-related loan loss provisions. Ukrainian banks' prospects remain highly uncertain for as long as the invasion continues, with credit risk the key challenge, market observers said.

Positive quarter

Ukraine's state-owned banks, including the country's largest lender Joint-Stock Co. Commercial Bank PrivateBank, were the biggest contributors to the sector's improved performance in the third quarter, adding 8.8 billion hryvnia to aggregate net profit.

The local units of Raiffeisen Bank International AG, OTP Bank Nyrt. and other non-Russian foreign banks earned 4.9 billion hryvnia in the quarter. The is an improvement on both a quarterly and annual basis, Market Intelligence calculations show.

JSC Alfa-Bank, a systemically important bank with Russian ownership ties, generated losses for the second and third quarters. Ukrainian authorities recently took initial steps toward nationalizing the lender, according to local news outlets, making use of new legislation that simplifies the withdrawal from the market of systemically important banks amid Russia's ongoing invasion.

According to NBU's Rozhkova, the law provides an effective and nonselective mechanism that applies to all systemically important banks and is designed to minimize potential risks to the financial system stemming from Russia's invasion.

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Mounting risks

Credit risk remains the main challenge facing Ukrainian banks, and credit risk losses may grow more significantly next year than previously expected, putting additional pressure on banks' capital, Rozhkova said.

Local banks have already formed almost 100 billion hryvnia in loan loss provisions since the invasion began, equivalent to 14% of the performing loan portfolio in annual terms. However, this would need to exceed 20% to cover losses from the war, according to Rozhkova, who added that the formation of provisions in the sector will continue.

Many banks delayed recognition of nonperforming loans in previous quarters, but ignoring them as of the end of the year will be impossible, Vavryshchuk said. Lenders will have to make a thorough assessment of the quality of their loan books in the fourth quarter as the central bank plans to carry out an asset quality review in 2023 that will most likely be based on 2022-end balance sheet data, he said.

Russia's attack on Ukraine reversed the gradual decline in nonperforming loan ratios in the banking sector, the NBU said on its website. The sector-wide NPL ratio stood at 33.6% as of the end of September, growing 3.9 percentage points over the quarter and 7.0 percentage points since the war started.

Lenders owned by Western banks, including ING Groep NV unit JSC ING Bank Ukraine, BNP Paribas SA unit JSC Ukrsibbank and Intesa Sanpaolo SpA unit JSC Pravex Bank, have already showed an increase in NPL ratios, albeit significantly below the sector's average.

More positively, the recent income growth means many banks may be able to cover credit losses from revenue without capital deterioration, said Anastasiya Tuyukova, senior analyst at Ukraine-based investment management company Dragon Capital.

Moody's also recently pointed to elevated foreign exchange risks that banks in Ukraine and several other emerging markets are facing. "Most of these countries have high levels of dollar deposits, high foreign-currency debt, weak foreign exchange reserves and/or restrictions on capital flows," the ratings agency noted.

The Ukrainian banking sector is also facing higher operational risks as the result of Russia's recently intensified missile attacks. In addition, liquidity risks are increasing for individual banks, particularly smaller institutions. These are mostly financial institutions that did not have an effective business model before the war, and the NBU will pay particular attention to this segment regarding risk control, Rozhkova said.

Several small banks may go bust, but their bankruptcy will be "hardly noticed due to their marginal size and role in the financial sector," Vavryshchuk said.

Under new leadership

With the recent appointment of Andriy Pyshnyy as new governor, the NBU's banking regulation and supervision policies are expected to remain broadly unchanged, according to analysts.

The NBU will continue implementation of Basel standards and alignment of local banking legislation with that of the EU, Vavryshchuk said. "None of the reforms that made Ukraine's banking sector so resilient during the crisis will be reversed," he said.

The NBU is also expected to maintain its regulatory forbearance approach whereby banks will not be removed from the market for the breach of prudential ratios as long as they remain liquid and have viable business models, according to the analyst.

Macroeconomic stability and cooperation with the IMF will remain priorities for the NBU, according to Tuyukova. The NBU will likely remain an institutionally strong and independent central bank, although this will very much depend on the new governor's ability to withstand political pressure, the analyst said.

As of Dec. 5, US$1 was equivalent to 36.70 Ukrainian hryvnia.