Andrii Volkov: How the NBU’s Key Rate Affects the Cost of Loans and What Banks Can Do with Their Excessive Liquidity

A column by Andrii Volkov, a financier, Investohills Group’s founder and managing partner, for Interfax Ukraine news agency.

In early June, the National Bank raised the discount rate at once from 10 to 25%. Since that event, three weeks have passed. Now, we can draw certain conclusions about the impact of this NBU’s step on the banking sector and the economy as a whole.

In fact, the refinancing rate (the NBU’s discount rate) affects two indicators only. The first such indicator is the set of conditions for refinancing from the National Bank and raising funds from depositors available to the banks. The second indicator is the rate the Ministry of Finance offers on debt instruments, such as OVDPs (domestic government bonds) or military bonds.

How will the banking sector respond? First, refinancing will become much more expensive than earlier for banks that receive loans from the National Bank. Therefore, in the short term, the banks will curtail their lending business. One can hardly find borrowers prepared to borrow at 25%. In addition, banks can aggressively raise rates on deposits or current account balances, effectively to the same 25%. Thus, it will be more profitable to raise deposits than to seek refinancing facilities from the NBU.

Banks short in liquidity (usually smaller financial institutions) will be the first to dare make this step. And the rest will follow. The competition in the market is high, and no banks will be willing to lose clients who will start closing accounts and seek better conditions for their deposits.

As a result, the cost of funding for the whole banking sector will go up. It will affect the lending business because loans will also become more expensive. Lending rates will grow to 30% or even higher by the autumn because banks include a risk premium in the cost of their loans in addition to their margin.

The increase in the lending rates will certainly drive the lending volume down. Although, according to the NBU, the corporate lending portfolios kept growing, albeit slowly, in April, adding 0.2%.

In the near future, only overdraft facilities, short-term working capital loans, and lending programs with interest compensated by the government will be in demand. However, these programs will tend to get smaller with the growing lending rates.

It is because only highly profitable businesses (exceedingly rate in the current environment), retailers, or traders exporting agricultural products will be able to service loans on new terms. The profit in these sectors is quite high at the moment, so these borrowers will be able to pay interest at a 35% or 40% rate. However, there are so few of them.

Furthermore, the curtailment of the lending business will result in the banks’ getting less funding from the NBU and the depositors because they won’t be able to do anything with their money.

Nevertheless, purchasing domestic government bonds – indirect lending to the state – can become a viable alternative for the banks against the backdrop of sluggish lending activity. The rates there are still much lower; however, the Ministry of Finance will have to raise the rates to a level close to 25%, with the growing cost of funding for banks.

Thus, if government bond rates grow to 25%, they can become a nice liquidity support tool.

In our current realities, domestic government bonds are as safe and profitable as they can get, and not only for banks. The government bonds offer an opportunity to keep savings and compensate the population and businesses for the impact of inflation, especially against the backdrop of restrictions imposed on foreign exchange transactions.

The increased demand for domestic government bonds will influence the economy positively. The NBU will reduce its hryvnia issue, thus positively influencing the exchange rate pressures and the rate of inflation. It is not a secret that the national budget deficit is partially covered by the “printing press.” The printed hryvnia absorbs foreign reserves, which the NBU spends actively on maintaining a stable exchange rate. And it becomes a vicious circle of sorts. Of course, we will not be able to break free from this vicious circle by raising the discount rate only. However, banks and private investors will spend at least some domestic currency they have on lending to the state via domestic government bonds instead of trying to buy foreign currency by hook or by crook.

One should not forget that an increase in interest rates could exacerbate the issue of toxic loans in the banks’ portfolios. However, the impact of this factor on the NPL percentage in the economy (officially, close to 30% in May) will not be significant. Let me explain to you why. Under the current conditions, no borrowers are prepared to get loans to refinance their old debt or expand their businesses. They have something else to do now. Their goal is to survive. Thus, corporate clients will definitely not increase the credit portfolio; in turn, it will mitigate the risk of distressed debt accumulation.