Ukraine's banking sector recorded consecutive months of deep losses and elevated provisions for bad loans as the impact of Russia's invasion on the country's lenders becomes increasingly clear.

Aggregate profitability in the sector fell to a loss of 7.27 billion hryvnia in April from a profit of 7.15 billion hryvnia in January, the latest data from the Ukrainian central bank shows. Return on equity fell to negative 9.46% from 33.3% over the same period, while loan loss provisions rose to 15.86 billion hryvnia in March from 1.58 billion hryvnia in January, with a further 11.17 billion hryvnia added in April.

Ukrainian banks are maintaining their day-to-day operations where possible, but the conflict is negatively affecting business and household income, said Vitaliy Vavryshchuk, head of macro research at asset manager Investment Capital Ukraine. This could make it difficult for borrowers to keep up with loan repayments, Vavryshchuk said.

"The key risk is impairment of the loan portfolio. The most likely scenario is that nearly all corporate and retail loans in the territories that are still occupied will be lost," Vavryshchuk said. Destruction of tangible assets due to missile strikes and shelling was another source of losses, Vavryshchuk said.

Damage assessment

The central bank has implemented a nationwide moratorium on loan repayments to help borrowers, but it still wants banks to properly measure and report their asset quality, a spokesperson for the bank told S&P Global Market Intelligence via email. "Without grasping the full scale of the damage, we will not be able to implement an effective rehabilitation of the banking system post-war," the central bank said.

Total loans in the Ukrainian banking system amounted to 1.1 trillion hryvnia as of the end of March. The nonperforming loan, or NPL, ratio for the sector stood at 27.1%, slightly up from the February level of 26.6%, which was the lowest NPL level for the sector since 2017. Because loans are only classified as nonperforming once payments are more than 90 days overdue, the full extent of NPL exposure is not yet known.

The central bank said May 11 that lenders in March had begun to gradually recognize the deterioration of loan quality caused by the hostilities.

As of Jan. 1, the Ukrainian units of Russian state lenders State Development Corp. VEB.RF and Sberbank of Russia had the highest NPL ratios, of 96.3% and 83.8%, respectively. The licenses of the two lenders were revoked shortly after the Russian invasion started and the Ukrainian state is preparing measures to seize their assets, the national bank said.

The NPL ratio at Joint-Stock Company Commercial Bank PrivatBank, Ukraine's largest lender, was close to 70%. NPL ratios at the local units of PKO Bank and Hungary-based OTP Bank Nyrt. were at 6.1%, while the local units of Raiffeisen Bank International AG, Crédit Agricole SA , BNP Paribas SA, ING Groep NV and Citigroup Inc. held NPL ratios below 2.5%.

Profitability is also under pressure due to a sharp drop in demand for banking services amid the invasion. OTP Bank posted a net loss on its Ukrainian operations in for the first quarter, having set aside the equivalent of 49.3 billion forints in up-front provision for its Ukrainian unit. RBI's Ukrainian unit reported a net loss for the quarter of €41 million. JSC Credit Agricole Bank posted a profit of 8 million hryvnia while its French parent, Crédit Agricole, set aside €195 million in provisions for equity risk in Ukraine.

The combination of lower earnings and an anticipated loss of assets may deplete banks' capitalization, which could take several years to repair, Vavryshchuk said.

The central bank has eased regulatory burdens for local lenders and refrained from imposing new capital requirements. "Banks will keep operating even if their capital adequacy ratios fall below the required threshold. After Ukraine wins the war, financial institutions will have enough time to bring their activities back to normal and re-establish their capital buffers," the central bank said.

Total regulatory capital in the Ukrainian banking system amounted to almost 219 billion hryvnia as of January 2022, up from 177 billion hryvnias a year ago, according to the central bank's most recent data. The core capital adequacy ratio dropped year over year but was significantly above the required minimum of 7%.

Road to recovery

Restoring the quality of loan portfolios will be the key post-war challenge for Ukrainian banks amid the loss of debt service capacity by local clients and the loss of collateral as a result of hostilities, according to Poland-based PKO Bank Polski SA, the parent of Ukrainian systemically important lender JSC Kredobank.

"At this point, as a result of constant monitoring, we have not identified any significant exposures that should be considered completely lost, although, of course, the final, comprehensive assessment will be possible only after the end of hostilities," a spokesperson for PKO said. The bank has set aside more than 300 million zlotys in provisions in the first quarter against its exposure in Ukraine, Russia and Belarus, its executives said during a recent earnings call.

The banking sector will likely recover quicker than other sectors of the Ukrainian economy post-war, said Vavryshchuk.

"Customer demand will recover fast. … Interest income and commission income will resume double digit growth already next year providing the war ends by then," said Vavryshchuk. "In two to three years after the war, the performance of the banking sector will be back at 2021 levels in terms of profitability."

Ukraine's banking sector has not experienced a dramatic outflow of deposits since the beginning of the war and liquidity in the sector is high, according to the central bank. While foreign currency deposits and corporate deposits have declined, retail hryvnia deposits in January through March were up by 10.8% quarter over quarter the central bank said, adding that the "uninterrupted operation of the cashless payment system reduces the population's need for cash."

RBI said it saw an inflow of client funds after the outbreak of the conflict. "We regard this as a flight to quality," a spokesperson for the bank said.

As of May 24, US$1 was equivalent to 29.63 Ukrainian hryvnia, 356.96 Hungarian forints and 29.63 Polish zlotys.