How Ukrainian banks managed to book exorbitant wartime profits

The Verkhovna Rada (Ukrainian parliament) is looking to introduce a windfall tax on banks as a result of excessive profits in the banking sector. NV examines why Ukrainian banks have made record profits during the war.

In October, the Verkhovna Rada proposed imposing a kind of "luxury tax" on excess profits by banks operating in Ukraine, increasing yields into state coffers by 36% from the industry.

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There is logic in this approach. After all, financial institutions, despite the war and the sharp decline of the economy, have been raking in the cash: according to the National Bank of Ukraine (NBU), in the first nine months of 2023, the banking sector generated UAH 109 billion ($3 billion) in net profits. To put this in perspective, the figure stood at UAH 7.9 billion for the same period of 2022.

But the additional tax has come about not only because of excessive bank profits, but also because this cash remains within the banking system itself, without fueling the economy.

Gifts from the NBU

The domestic banking system owes its high profitability to the decisions made by the state in response to the full-scale Russian invasion, argues Mykhailo Demkiv, a financial analyst at the ICU investment company.

In 2022, the NBU tried to increase the attractiveness of hryvnia deposits at the expense of high interest rates to avoid a collapse of the national currency. The state regulator also gave banks the opportunity to invest free funds in deposit certificates at 23% interest. The result was high liquidity in the banking system.

In other words, significantly less money is flowing into the state treasury from banks than in the opposite direction, explains Demkiv.

For eight months of the year, the total interest income of banks amounted to UAH 195.4 billion ($5.4 billion), of which UAH 94.5 billion went to state banks, 53.6 billion to foreign groups, and the rest to domestic private financial institutions.

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In this way, banks have accumulated finances, which are placed in assets, primarily in deposit certificates. The system earned almost UAH 61 billion on this alone in eight months, which is a third of all its interest income, Demkiv adds.

It was the "foreigners" who took the upper hand in profits from deposit certificates, taking in UAH 24.9 billion.

Bankers collectively earned a lot of money – UAH 16 billion – on exchange rates and operations with bankable metals. In particular, the difference between the card exchange rate, which is used by millions of Ukrainians abroad, and the official one has become a real golden goose for financial institutions that have many individual clients. After all, they received dollars at UAH 36.8 in Ukraine, and sold them abroad through card conversions at UAH 38-39.

The Chairman of the Board of PUMB bank, Serhii Chernenko, also claims that banks’ effectiveness at making money has increased primarily due to the profitability of NBU’s deposit certificates for three months at 25%. "These were very favorable conditions. At the same time, it should be noted that this is a temporary phenomenon. You can’t get used to it," he emphasizes.

According to Chernenko, the fact that repatriating cash from Ukraine is currently impossible has also kept the banking system highly profitable. "This has led to the accumulation of funds in accounts, and considering the limited demand for loans, this money has been invested in certificates of deposit," he explains. "However, this was a serious factor in reducing inflation in the country and further reducing the interest rate."

The PUMB head is convinced that banks’ current results would not be possible without the stabilization of the economy. "During this period, we had virtually no credit losses and almost no defaults. This means that the work of our clients has also stabilized," he says.

"So compared to last year, when we formed UAH 10.5 billion in reserves for credit losses, credit risks have now significantly decreased," adds Chernenko.

At the same time, he emphasizes that it is not entirely proper to evaluate banking sector performance only by the current year. It is better to look at the results of the last two years.

Thus, PUMB made a profit of UAH 5 billion in eight months of 2023, compared to a UAH 0.4 billion loss in 2022, with the reserves of UAH 10.5 billion. "That is, now we have only covered the losses of the first year of the war," Chernenko explains. And therefore, if one looks at the result over the past two years, they have no excess profit. "We made a profit of UAH 2.5-3 billion per year, while in 2021 the profit was at UAH 4.2 billion," he argues.

Yurii Soroka, head of controlling and business intelligence at Raiffeisen Bank, claims that this year's high profits are the result of banks’ caution last year. After all, they spent 2022 building reserves to hedge against risks, and it is now possible to significantly reduce this expenditure. "Therefore, the ‘excess profits’ are explained by a sufficiently weighted policy in terms of reflecting the expected risk," Soroka told NV.

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He agrees with Demkiv that the 16 % year-on-year increase in banks' gross income was the result of increased liquidity in the system and exchange rates. Thus, the National Bank increased its discount rate in mid-2022 from 10% to 25%.

In addition, according to Soroka, in the first two or three months of the Russian invasion, banks supported customers when, in combination with the reduction of rates by international payment systems, the cost of servicing accounts and transfers was reduced to zero. This made the banking system's income numbers relatively low in 2022, which also affects year-on-year comparisons.

For example, according to Soroka, for eight months of 2023, Raiffeisen Bank brought in UAH 15 billion in gross income, of which UAH 10.9 billion (73%) is attributable to net interest income, and the rest to customer account maintenance operations, payments, and foreign exchange operations

"We continue to lend to important and critical sectors of the economy, where our bank traditionally has high expertise. Additional factors include an increase in the portfolio of bonds issued by the Ministry of Finance by UAH 10 billion or +71% since the beginning of the year. At the same time, our bank became the largest holder of OVDP bonds [domestic government loan bonds] after state banks," Soroka notes.

Avoiding additional tax

Experts believe that in 2024, the banking system will begin to report losses due to the war and the windfall tax.

"The changes in the taxation of banks next year will create an incentive for financial institutions to wait before accounting for the losses caused by the Russian invasion, and to account for the deterioration of their loan portfolios after January 1, 2024," Demkiv from ICU believes. "It may be more profitable for banks to have higher profits this year, which will be taxed at the rate of 18%, than next year, when the rate will double."

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Kateryna Rozhkova, NBU’s First Deputy Head, told NV that windfall taxation is a common global practice. It is often used when a particular industry receives excess profits not from additional investments or expansion of production, but rather because of certain temporary economic conditions — the so-called economic rent. In fact, the profits sometimes come at the expense of other industries.  "Extra taxes aim to balance such a situation," the NBU official said. “For instance, Italy and the Baltic countries are considering a similar move to compensate for quantitative easing during COVID.”

Considering that Ukraine is in a state of war and the budget deficit is large — because defense expenditures are increasing — it is necessary to look for additional sources of fiscal revenue, she believes.

"In view of this, the initiative on the new tax is valid. And the banking sector understands this. After all, it received additional income not because of his extraordinary efforts, but thanks to significant excess liquidity, which was the result of receiving unprecedented financial assistance from our [international] partners," explains Rozhkova.

According to her, the NBU's position is to increase the tax for the duration of the war, but not to expand the tax base.

"Conceptually, with an understanding of today's situation, we are ready to support this extra tax. And, by the way, in Europe, the banking sector pays income tax at the rate of 25%," Rozhkova notes. She adds, "If we talk about potential fiscal effects, it is worth remembering that 70% of the system's profits are with state-owned banks."

According to Soroka from Raiffeisen Bank, a decline in banks' incomes could occur mostly because of fundamental factors. After all, the NBU is expected to gradually reduce the interest rate as part of its inflation targeting strategy. In combination with the increased competition of banks for customer deposits, this will cause a decrease in margins, which are currently at very high levels, he explains.

Instead, he explains, there will be pressure factors on the cost end, especially those which depend directly on inflation and the exchange rate — referring largely to a large component of IT costs and infrastructure maintenance costs.

Indeed, as Rozhkova claims, all banks are sensitive to interest rate risk. But in this case, she would not expect losses. After all, the NBU foresees a gradual interest rate reduction. "The bank interest margin will also decrease gradually. Today, it is quite high at 7.8%,” she said. "Thus, banks have enough reserves to remain profitable even when rates drop and to adapt their operations to new conditions."

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According to Rozhkova, the rate reduction should stimulate banks to consider other areas of investments. "During wartime, lending is depressed, and risks are high. Therefore, banks are mainly investing in highly liquid and risk-free assets. But the gradual recovery of the economy will encourage them to intensify lending. This is a more profitable business," she says.

"For the 20 largest banks, which today account for 90 % of the system's assets, we see no problems. They have strategies and diversified business models," Rozhkova believes.

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