OREANDA-NEWS. Ukraine's bank regulators are allowing the country's banks to breach most prudential ratios. Without this regulatory forbearance, many Ukrainian banks would need to raise substantial capital because, since February, regulatory capital ratios have fallen short of minimum requirements, says Fitch Ratings. Prospects for solvency recovery without injections of new capital appear limited in the short and medium term because banks are unable build up capital through retained earnings.

Banking sector aggregate capital adequacy ratios (CAR) almost halved to 7.7% at end-May and are well below the 10% minimum requirement. Mounting losses are eroding capital and solvency ratios are also squeezed because hryvnia (UAH) depreciation bloats the value of foreign-currency (FC) denominated assets, which represent 51% of sector assets, when converted into local currency. The official UAH/USD exchange rate has depreciated by 38% to date in 2015, following 97% depreciation in 2014. The weak capital position of Ukrainian banks is already captured in Fitch's ratings. Ukrainian bank viability ratings, measuring intrinsic creditworthiness, are 'ccc' or 'cc', indicating that failure is either a real possibility or probable.

Profitability at the banks is weak, hit by geopolitical and economic shocks since 2014. Recession is deepening. Fitch forecasts a 9% GDP contraction in 2015, following 2014's 7.5% shrinkage. Credit demand is subdued and impaired loans have escalated, reaching 24.7% of total loans at end-March 2015. These figures probably understate the true extent of asset quality problems because loan restructuring is widespread.

Loan loss provisions written by Ukrainian banks in 2014 were more than twice the size of pre-impairment operating income for the year, equivalent to 50% of end-2013 sector equity. These trends have worsened in 2015, with 56% of end-2014 sector equity eroded through losses reported in the four months to end-April. Worsening operating conditions are putting further pressure on asset quality, forcing banks to make additional provisions.

Core profitability is being squeezed by escalating funding costs as banks seek, largely unsuccessfully, to halt deposit outflow. 2014 saw 22% of sector deposits leave the system, despite regulatory restrictions on cash withdrawals of deposits. A further 8% of deposits were withdrawn in 1Q15 (adjusted for FX-effects).

State-owned banks, which represent 22% of sector assets, were recapitalised in 2014, and foreign-owned banks (29%) received additional capital from shareholders in 2014 and during the first five months of 2015. The liquidation of insolvent banks, all of which are domestically-owned private sector entities, started in 2014 and is continuing in 1H15.

The country's top 20 banks, representing 80% of sector assets, are undergoing asset quality reviews and capital stress tests, in line with guidelines included in the IMF programme. Initial results will be reported by end-July. Banks failing to meet minimum solvency ratios will submit recapitalisation plans, demonstrating their ability to restore regulatory CARs to 7% by end-2017 and 10% by end-2018. At end-1Q15, six of the sector's top 10 banks were in breach of the regulatory CAR.

In our opinion, stress tests will uncover substantial additional provisioning requirements because sector impaired loans, net of reserves, totalled UAH112bn at end-March, equivalent to 130% of total sector equity.

The regulator's tolerance to allow capital ratio breaches until end-2018 provides some flexibility but restoring solvency to the banking sector is expected to take several years. There may be additional regulatory forbearance.