International Research Journal of Finance and Economics ISSN 1450-2887 Issue 6 (2006) EuroJournals Publishing, Inc. 2006 http://www.eurojournals.com/finance.

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Case Study Foreign Capital Entry to Banking Systems of Economies in Transition: Prospects for Ukraine
Olena Etokova Business Administration Department Ukrainian-American Liberal Arts Institute Wisconsin International University (USA) Ukraine 8/14 Turgenevska Street, Kyiv 01601, Ukraine E-mail: olena_etokova@ukr.net Tel: +38067 500-06-61 Abstract The paper focuses on peculiarities of the foreign banks entry into the economies in transition. As a case for research case was selected Ukraine, the post-soviet state currently facing an ever increasing interest of foreign investors, in particular in the banking sphere. The paper compares Ukraines progress in the area with a number of Central and Eastern European (CEE) states, such as Bulgaria, Poland, Hungary, and Baltic states. The paper finds that the CEE model of foreign banks almost 100%-dominance in the banking system will not be implemented in Ukraine due to the initial differences: banking system is stable, majority of the banks are private-owned, and banking sector is significantly protected (foreign banks are prohibited to open subsidiaries in Ukraine). At the same time, the national banking consolidation, which could help to sustain big national players, is complicated due to overregulation of Ukraines legal environment. Currently there is evidence that the banking system of Ukraine is preparing for foreign capital inflow and most of the bank managers are obsessed with the task of profitably selling their bank. Key words: banking system, transition economies, acquisition, merger, liberalization, foreign capital entry JEL classification: G21, F23

I. Introduction
More and more foreign companies carry out acquisitions at the CIS markets or declare their intentions to purchase assets in this region. Local players also dont miss a chance to grow by acquisition. Russia, in particular, in 2004 became one of the regional leaders by M&A as total value of the deals with participation of Russian companies reached $30 bn. In Ukraine the value of deals with participation of Ukrainian companies equaled $2.6 bn in 2004, which was 150% higher than in 2003. The deals conducted in 2005 between the banks Raiffeisen and Aval ($1.028 bn) and metallurgical companies Mittal Steel and Krivorozhstal ($4.8 bn) caused almost three times increase in the indicator for Ukraine. Due to specifics of transitional market not all traditional M&A mechanisms are used in the CIS states. In particular, public offers (purchase of shares at the stock market) are used rarely because of non-developed stock markets. According to Ernst & Young, the share of company stock publicly traded does not exceed 20-25% on average. Also there are practically no companies in the property of

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portfolio investors. The positive trend at the regional M&A market is appearance of buy-outs, in particular management buy-outs. At present the number of such deals is not big, but with wider opportunities for borrowing their number is expected to increase. The companies of some CIS states obtained easier access to credit resources for M&A financing, both on domestic and foreign markets. Increasingly more companies are using Eurobonds and other mechanisms of international borrowing, which is facilitated by growing sovereign ratings of the states, in particular Russia, Kazakhstan and Ukraine. Also the companies are actively using domestic bonds and initial public offerings. At present the M&A market is becoming more transparent, predominantly in Russia. As more and more big Russian companies are borrowing at international financial markets, they are stimulated to disclose their M&A or divestiture operations. Besides, many of the companies concluded that making their plans regarding M&A public may be a free PR-action. It also should be noted that improvement of corporate governance principles led to companies recognizing the importance of financial due diligence, market evaluation of shares value, support in negotiations from experienced consulting companies. Currently Ukraine is facing the increased interest of foreign investors, willing to purchase assets in the country. Thus national banks need to elaborate the strategy towards foreign banking giants expansion. They have a number of options: either merge with their national counterparts to gain the size that will allow competing with the foreigners, or look for a foreign acquirer. They also can adopt a short-term strategy aimed at finding the niches, which will not be filled in by the foreign banks at their initial entry stage. With this aim analysis of the Central European states experience will be useful, taking into consideration that privatization and economic liberalization in Poland, Czech Republic and Hungary resulted in foreign control over 60 to 95% of banking assets.

II. Literature review

Entry of foreign banks to the economies in transition is a contradictory topic for research. In particular, Galac, T., and Kraft, E., (2000) discuss the consequences of foreign banks entry for Croatian banking system, among which they find introduction of new products and services; possession of cheaper funding sources; having equal knowledge of local market; and employing better cadre than local banks. Also they argue that the foreign banks raise deposits both from domestic and foreign clients, but lend more to domestic clients. The foreign banks also played important role via channeling funds to domestic banks during 1998-99 banking crisis. Experience of foreign banks entry into Bulgaria was studied by Bitzenis A., (2004). The key findings on the factors of importance for foreign banks are as follows. The factors considered as negative include macroeconomic instability, unstable legal framework, slow transition progress and lack of managerial skills. Such aspects as corruption, crime and mafia are not considered at all. The incentives to enter Croatian banking sector are low-cost skilled labor force, following-the-client ideology, lack of local competition, existence of globalization pressures. The study focused at foreign banks entry into Hungary, Czech Republic, Slovakia, Poland, Slovenia by Mr, K., and Valentinyi, M.E., (2003) has shown the positive consequences as foreign banks helped to recapitalize troubled domestic banks, to improve the quality and quantity of financial services, to spread technology and know-how, to exert competitive pressure on domestic banks. It has also found relatively low number of foreign branches as a form of entry due to remaining restrictions prior to joining the EU.

III. Foreign banks motivations for entering the CEE banking sector
Banking sector is traditionally regarded as one of the last bastions of national ownership. Even in the developed countries of the West, which advocate for free capital movement, the foreigners were let into the banking sector reluctantly. Though transnational capital is tending to overcome all possible barriers as it is directed by efficiency and competitiveness considerations. In almost all Central and

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Eastern European states, except of Slovenia, the majority of banking assets are owned by the foreigners. In Bulgaria, Czech Republic and Lithuania this accounts for about 90% of the banking sector, in Romania and Latvia more than 50%. The leader of banking sector globalization is Estonia with 98% of banking sector foreign owned (see Graph 1). In comparison to these countries the closed banking sector of Ukraine and Russia is looking at least unusual. Before October 2005, when a purchase of Ukrainian Aval by Raiffeisen was exercised, the share of foreign capital at Ukraines banking sector was less than 10%.
Figure 1: Share of foreign banks in banking assets of selected CEE
100% 80% 60% 40% 20% 0%
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2% 98%

10% 90%

10% 90%

10% 90%

39% 61%

45% 55%

47% 53%

49% 51%

65% 35%
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Foreign ownership

Source: Die Bank.

The first foreign banks entered the CEE states in the mid-90s predominantly by the method of privatization. The state was forced to look for strategic foreign investors due to crisis condition of banking system and absence of funds for recapitalization of big national banks. Thus, the biggest local banks from the very beginning became owned by the foreigners. Their sale was not a chaotic wave of acquisitions, but was exercised according to the strict state program. The banks purchased by foreign investors received a number of preferences aimed at developing credits provision to the real economy sector. Nevertheless, these banks quite often preferred to invest money into state obligations or provide credits to transnational corporations instead of directing them to the local business. This was the most harmful to the small and medium business. In general, the entry of foreign banks gave the positive results. It became a source of capital and know-how, e.g. in risk management. Foreign banks also played a role of the main banking system stabilizers. The level of competition among the banks increased, innovations appeared, quality of services provision and their range enlarged. For example, after foreign banks entry to Hungarian market substantial interest rate spread reduction occurred (in line with the EU level).

IV. Methods of Foreign Banks Entry to the CEE Markets

The foreign banks operating at the CEE markets may be divided into two groups. The first group includes the banks, which focus their external expansion strategy on Central and Eastern Europe. These banks are setting priorities at this region and use the possibilities to enter the market as soon as those occur. This group includes HypoVereinsbank, Citibank, Raiffeisenbank, Socit Gnrale, BNPParibas etc. (see Table 1).

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National ownership

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Table 1: The main banks with subsidiaries or control packages of shares in the CEE states
Name HypoVereinsbank Raiffeisenbank Unicredito Erste Steiermaerkische Citibank Dresdner Bank ABN Amro KBC Socit Gnrale BNP Paribas The country of origin Germany-Austria Austria Italia Austria Austria USA Germany Netherlands Belgium France France Number of CEE states, where the bank has subsidiaries More than 10

From 5 to 10

From 3 to 5

Depending on the situation these banks use all methods of market entry acquisition of a local bank, opening of the branch, creation of judicially independent bank. In Bulgaria, an acquisition as entry method was used by such banks as Bank Austria, UniCredito Italiano and Socit Gnrale, subsidiaries were opened by HypoVereinsbank, ING and Citibank, and independent legal entities were established by NP-Paribas and Raiffeisenbank. Specific preferences of foreign banks in methods of activities expansion to the CEE markets may be observed. KBC, Erste Bank and UniCredit predominantly were buying already existing local networks of banks. In contrast, Raiffeisen used the strategy of own new networks creation, acquisitions were a rare case. As a result it occupied the first place by network cover and is working in 15 markets of the region. This bank is strategically oriented to the markets of Russia, Belarus and Ukraine. The second group includes the banks from neighboring states. They are directed by the follow the client strategy and start operations at the markets, to which move the enterprises they are serving. In Bulgaria those are the Greek banks National Bank of Greece and Commercial Bank of Greece, which came to the market having acquired the local banks. As well as the banks, which entered the market by establishing the branches or independent companies: Greek Alpha Bank and Piraeus Bank, and Turkish Demirbank and T.C. Ziraat Bankasi. In Romania Greek Alpha, Piraeus, EFG Eurobank, Egnatia and National Bank of Greece (NBG). In the Baltic states the banks from the neighboring Sweden and Finland dominate. The most important criteria for making a decision on market entry, in particular the market of Bulgaria, became the market size, absence of competition from the local banks, as well as necessity to follow the client. At the same time, low value of qualified workforce and geographic proximity (the often sited as competitive advantages of Ukraine) occupied the bottom places by priority. Among the factors, which deprived the banks of desire to enter Bulgarian market the most important were legal and macroeconomic instability, absence of skills of work at this market. The factor of high investment risks was at the last place (Bitzenis (2004).

V. Market Strategy of Foreign Banks at the CEE Markets

As a rule, big international banks work on the foreign markets under their own well-known brand. After entry to foreign market majority of their operations constituted credits and services to big corporate or private VIP clients. Correspondingly, the sector of micro financing as well as retail banking, in particular consumer credits and mortgage, remained a niche for smaller national banking capital. After becoming familiar with the new market the international business starts to fortify positions in these areas as well. In 2003-2004 foreign banks in Central Europe were making stronger strategic accent on credits to small business as well as development of network for services to retail clients, in particular payment cards. The banks realize high potential of this segment of the market, as in 2003 in the CEE the share of this market in overall bank operations was insignificant. For example, in Hungary it equaled only to 6%, at the same time in the EU states it is up to 50%.

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Hungarian example shows that foreign banks have advantages in the form of lower bad-debt ratio, as well as higher profitability. Initially, having entered the market they started working in a certain niche, but as time passed their operations were extended to practically all types of banking activity. For example, Citibank started from a quite limited market segment services to rich private clients. But later similar to other foreign banks, it moved to active work in retail and corporate banking.

VI. Recommendations for Ukrainian banking system

As proves the CEE states experience, the big sustainable foreign banks entered their markets, which practically left no room for national capital in the banking sector. Selling of the biggest national banks to foreign ownership was initiated by state with the aim to draw banking system from the crisis. Such a model is inappropriate for Ukraine due to a number of reasons. First, in spite of the fact that Ukrainian banking system is fragmented and consists of more than 150 mainly small banks, it remains in the state of relative stability. Besides, big state banks, such as Oshadbank and Ukreximbank are in the most profitable top-5. And there are no signs of considering their selling to foreigners so far. Second, Ukraine is unlikely to open its banking sector as fast, as it was done by the CEE states, which were preparing to enter the EU. More likely is the policy of Ukrainian government directed at improving of banking sector competitiveness level by merging national banks. Third, foreign banks came to Poland, Hungary, Slovakia and Estonia only after activation of foreign investments inflow to other sectors of economy, e.g. metallurgy, energy, machine building. In spite of high rates of foreign investments growth last year, the level of investments per capita in Ukraine is only $177, which is low comparing to the CEE states. As foreign banks both in the CEE states and in Ukraine prefer to provide services to big corporate clients and the micro financing and retail sectors and not involved that actively, this segment may be used as a niche for the local banks aiming to stay independent. The situation with Ukrainian banking sector is complicated due to strict regulation. In particular, foreign banks are not allowed to open subsidiaries in Ukraine. Currently the draft law, which among other envisages abolition of such restriction, is under parliamentary investigation. The capital of foreign bank should be not less than 150 mln euro, and statute capital of subsidiary not less than 5 mln. euro (Draft Law of Ukraine On Amendments to the Law of Ukraine On Banks and Banking Activity, Article 24). Though it has not been passed yet and may finally contain provision on abolition of the restriction only in a 5-year period after joining the WTO. In any case, increasing concentration at Ukraines banking market is inevitable. As shows the experience of many Central European states, the process of enlargement in the banking system is a usual phenomenon. In Bulgaria the number of banks reduced from 81 in 1992 to 29 in 2002. In Poland consolidation resulted in reduction in the number of banks to 60, Croatia to 43, Czech Republic to 35. In the Baltic States the number of banks also reduced dramatically there are 14 banks in Lithuania, 7 in Estonia, 23 in Latvia. According to the survey of Croatia National Bank among the top-managers of the local banks only 30% of respondents expressed confidence that they will be able to maintain independence. The fact that Ukrainian companies are in the area of interest of foreign buyers has been proven by the recent M&A Raiffeisen/Aval and Mittal Steel/Krivorozhstal. In the near future this list is likely to be increased by Russian Vneshtorgbanks purchase of Ukrainian bank Mria, having a network for retail services provision in all regions of Ukraine. As well as purchase of controlling package of the fourth by size Ukraines bank Ukrsibbank by one of the well-known Western bank. Five foreign banks are interested in this acquisition: French Socit Gnrale, Austrian Erste Bank, Hungarian OTP, Italian Banca Intensa and German Commerzbank. Besides, the third Ukraines bank Ukrsotsbank is renewing negotiations with some of the abovementioned investors after annulment of the deal with Russian Alfa Bank. As we can see, M&A at Ukrainian market are mainly exercised by the transnational banks, which dominate the markets of Ukraines Central European neighbors.

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VII. Conclusion
The CEE model of foreign banks almost 100%-dominance in the banking system is not likely for Ukraine due to several reasons. First of all, Ukraines banking system is fragmented, but stable. There is no need in crisis managers, there is a need in application of Western standards and practices of banking services provision. Majority of the banks are private-owned, so there is an immediate difference from Central European states, which were selling banks in the process of privatization. Ukraines banking sector is significantly protected, foreign banks are prohibited to open subsidiaries in Ukraine and the amendments to the law are not supported by the parliament, though this is required by WTO entry rules. So far, the only opportunity for foreign banks is purchasing the national banks. Also, we dont observe significant inflow of foreign investments to other sectors of Ukrainian economy, which preceded the foreign entry to banking sector of the Central European states. At the same time, the experts say that banking system of Ukraine is preparing for foreign capital inflow and most of the bank managers are obsessed with the task of selling their bank expensively (Levitskyi (2005). The logical process of national bank consolidation, which could help to sustain big national players, is complicated due to overregulation of Ukraines legal environment. The merger of two Ukrainian financial institutions on average takes as long as one year. Thus, the state regulators should make efforts to facilitate the process of national banks M&A, as increase in concentration at Ukraines banking market is inevitable.

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