The Banking Sector in Latvia
The creditworthiness of the Latvian banking system is constrained by:
Offsetting these weaknesses are the following strengths:
Since the Russian default of 1998, which resulted in a small rumbling of insolvency and the licence revocation of two banks, the licence suspension of the third largest bank in the Republic of Latvia (A-/Stable/A-2), and overall commercial banking sector losses that year, the economic and industry risks of the Latvian banking sector have diminished sharply as a result of an improving macroeconomic, regulatory, and supervisory climate, driven mostly by EU accession requirements. These risks, however, remain somewhat higher than those of most of its continental new EU country peers, as the small Latvian economy is still sensitive to external shocks, although it has proved more resilient in recent years.
The ratings on Latvia are based on a track record of sound macroeconomic management and favorable fiscal indicators, and the authorities’ firm commitment to deepening market-based reforms. Most of the major banks’ credit fundamentals are now satisfactory; they are characterized by strengthening profitability, a low level of nonperforming assets, and satisfactory capitalization. Subsequent to Latvia’s EU accession in May 2004, Standard & Poor’s expects Latvian banks’ creditworthiness to remain broadly stable, bar any external shocks. Rapid credit growth and its concomitant riskiness is the major concern, as it is for many new EU member and EU candidate countries. Another concern is Latvian banks’ sustained reliance on foreign funding.
Latvia’s economic growth remained very sound during the recent global downturn, and is expected to be strong in the short to medium term, at more than 6 per cent, thus outpacing the EU average. Latvia is still the least prosperous of the new EU member countries of Central and Eastern Europe (CEE), but is catching up fast due to its superior growth performance. This bodes well for the prospects of the country’s banking sector. All small Baltic economies reliant on exports are highly sensitive to external shocks. Nevertheless, Latvia proved its resilience through the Russian crisis, when real growth remained positive, and has oriented more exports to the EU, although oil-transit trade from Russia still plays an important role in the economy.
The Latvian banking sector’s creditworthiness is good. In 2003, it reported a satisfactory ROA of 1.4 per cent and a sound capital adequacy ratio of 11.7 per cent. The volume of nonperforming loans (NPLs) continued to decline, providing 1.4 per cent of total loans, compared with 4 per cent in 1999, and the coverage (provisions-to-NPLs) ratio of 89.4 per cent is solid. On the back of higher domestic demand resulting from higher average incomes and lower interest rates, lending is growing fast, averaging 41 per cent annually in 2001-2003, could put stress on the system. Much of the growth is in lower risk retail – primarily mortgage – lending, however, and better credit-risk management by banks, and stronger supervision and regulation, somewhat alleviate these loan growth risks.
Standard & Poor’s has noted a marked and determined effort by Latvijas Banka (the Bank of Latvia/the central bank) to reform financial sector legislation in line with that of the EU. A unified regulator, the Financial and Capital Market Commission, was established in 2001, and is committed to effective and efficient implementation of new banking regulations. The Commission has brought about much higher levels of transparency and disclosure, and has adopted a risk-based supervisory approach.
A track record of sound macroeconomic management and structural reforms ahead of EU membership, have transformed Latvia into a more resilient and diversified market economy. In addition, economic growth this decade is brisk. The foreign currency rating on the country was recently raised and equalized with the local currency rating. Economic risks for Latvian banks have consequently lowered, which, together with substantial foreign investment, are major factors in strengthening the sector.
With a population of 2.3 million and forecast GDP of $13.2bn in 2004, the Latvian economy is small and open, and economic growth remains highly dependent on exports. Continued rapid economic growth of more than 6 per cent in the short to medium term is forecast, barring severe external shocks, to which all three Baltic countries remain highly sensitive. However, structural changes and the transition towards a functioning market economy underpinned Latvia’s resilience through the Russian crisis of 1998 when real growth remained positive, and Baltic GDP growth remained resilient right through the recent global slowdown, due mainly to competitiveness and internal demand. Exports are being successfully oriented toward the EU: Latvia’s top export partners are the UK, Germany, and Sweden. Nevertheless, all three Baltic countries remain sensitive to the important transit trade, particularly oil, from the Russian Federation (foreign currency, BB+/Stable/B; local currency, BBB-/Stable/A-3), although again Latvia has demonstrated impressive resilience since 2002 because of successful coping strategies and degrees of diversification within the transit industry. Other key export sectors – wood products, textiles, metals, and electronics – are diverse and not cyclically correlated.
In a favorable business environment, profitability in all corporate sectors is buoyant, although leverage increased slightly as companies invested in growth. The development of the manufacturing and trade sectors, which dominate banks’ loan portfolios, was sound. The number of business startups, according to the Register of Enterprises of the Republic of Latvia reached a three-year high in 2003, far outpacing the number of insolvencies, which remained low at about 1,000.
Despite skills mismatches and geographical imbalances, unemployment is trending down as a result of the dynamic economy, and this is expected to continue. Corporate restructuring post-1998 caused an increase in unemployment, but the rate decreased to 10.5 per cent in 2004 from 14.4 per cent in 2000. In 2007, 9.0 per cent is forecast. Nevertheless, Latvia is still the poorest among the EU-25, with a forecast GDP per capita of $5,714 in 2004, although wealth levels of the Baltic countries are converging slowly (see Chart 1). The income gap is less large when using purchasing-power-parity terms, at a mere 43 per cent of the EU-25 average, compared with 46 per cent and 47 per cent for the Republics of Lithuania and Estonia, respectively, in 2003.
Unlike its Baltic peers, Latvian banks are traditionally heavily reliant on foreign funding, as Latvia is believed to be an offshore vehicle for Russians. Historically, almost one-half of the banking system’s nonbank deposits were classified as “nonresident” (and are registered as short-term external debt), which sullied its reputation as a port for money laundering. Today, banking sector indebtedness is not a source of immediate concern, as foreign parent banks extend a substantial proportion of borrowing, and major debtors of Latvian banks are US and EU credit institutions. Nevertheless, nonresident deposits as a cheap source of banks’ financing is growing, and comprised 54 per cent of total deposits at March 2004, sustained by the Bank of Russia’s April 2003 resolution to exclude Latvia from the list of countries and territories with which foreign exchange operations are under special control. Standard & Poor’s understands, however, that there is significant segmentation in the banking sector with regard to this issue – nonresident deposits play a small role for the main banks, and a large role for only a handful of minor banks. Only one bank reinvests a significant amount of nonresident deposits into domestic lending; all other Latvian banks hold sizeable offsetting assets in OECD countries. The bulk of customer deposits, both resident and nonresident, is held in foreign currency, which underscores the need for the Bank of Latvia to maintain the confidence of depositors in the banking system.
Household debt at 21.4 per cent of income in 2003 is low but rising sharply; it was 15.4 per cent one year earlier. The level is very low compared with some western European countries (the ratio is well above 100 per cent in Sweden and the UK, for example) and to its neighbor, Estonia, at about 25 per cent. Thus households are still likely to be able to afford increased borrowing, or indeed, any rise in interest rate (particularly on dollar-denominated) loans from banks and leasing companies. The share of loans granted in foreign currencies (mostly dollar denominated, but increasingly in euro) stood at 58.5 per cent (54.4 per cent), which exposes households with incomes in Latvian lat (LVL) to currency risks. This euro currency risk will diminish with the adoption of the euro.
A fixed exchange rate protected the Latvian lat from speculative attack in 1998 and 1999, and lessened banks’ foreign currency risk from their direct and indirect exposures. The lat is pegged to the special drawing right, but will be repegged to the euro in January 2005. All three Baltic countries are expected to be early entrants to EMU; Latvia’s entry date is likely to be 2008.
As in neighboring Estonia, dynamic economic growth in Latvia is backing high credit expansion (see Chart 2). Rapid loan growth is one of Standard & Poor’s leading indicators of financial system stress, and the sharply increased leverage in the Latvian banking system is a concern. The system’s loans increased an average 41 per cent annually in the three years 2000-2003, and 20 per cent in the first half of 2004. Many Central European new-EU countries demonstrate similar, but not quite such dramatic, trends, as the Baltic countries sustained high economic growth throughout the recent global economic downturn.
One of the drivers of credit growth is mortgage lending, which almost doubled in 2003. Standard & Poor’s regards mortgage loans as lower risk lending, however, and its share in bank loan portfolios increased to 27 per cent by year-end. Housing loans were particularly popular, and their share in bank loan portfolios rose to 16 per cent. Mitigating high mortgage credit growth is the increased efficiency of the systems of ownership rights and collateral registration, and creditors’ rights are secured by the registered property. Some institutional weaknesses in Latvia, such as an inefficient judiciary, are likely to be addressed with EU membership.
Another mitigant to high credit growth is the broader customer base, and a shift to higher margin private customer lending from money market lending. Wealth dynamics are broadening the number of private persons taking out loans: their loans represented a 25.3 per cent of total banking sector loans in 2003, compared with 20.1 per cent in 2002. Loans to corporates were 55.8 per cent and 58.3 per cent, respectively; and to financial institutions, 10.7 per cent and 12.5 per cent.
The banking system’s loan quality has improved significantly in recent years and is now good. Problem loans have diminished to 1.4 per cent of total loans, from slightly more than 6 per cent in 1999 at the time of the banking crisis. However, many loans granted in this period are not seasoned, and the trend in problem loans could reverse.
Standard & Poor’s addresses the possible or existing problems for every banking system where banks are rated, by estimating the potential level of gross problematic assets (GPAs) in a financial system in a reasonable worst-case scenario, expressed as a percentage of domestic credit to the private sector and NFPEs in the coming year. (The assumptions behind these scenarios are severe, and therefore unlikely, although not impossible.) Deteriorating credit quality in Latvia in 1999 caused the country to be listed among those countries identified by Standard & Poor’s as facing financial system stress in 1999 There are now six categories of GPAs and, for the Latvian banking system, in the event of a severe economic downturn, Standard & Poor’s estimates that these could range from 25 per cent to 40 per cent, which is the fourth category, and is shared with new EU members the Czech and Slovak Republics, Poland, and Lithuania, but weaker than Hungary and Estonia.
The Latvian banking sector’s short but distressed history in the 1990s caused heavy scrutiny of the quality of banking regulation and supervision. There has been a significant strengthening of regulation and prudential supervision, as well as financial markets transparency in recent years, and Standard & Poor’s considers the regulators are consequently better equipped to prevent banking crises, although the effectiveness of new processes and procedures has not been tested in a stress situation.
Since 1995, the Bank of Latvia has been updating its regulations to harmonize them with EU banking directives and to reflect the Basel Core Principles for Effective Banking Supervision. It has benefited from assistance programs from foreign central banks and international financial organizations. Consolidated banking supervision became effective on May 1, 1999. In 2004, for banks, harmonization tasks included the transposing of EU directives on the supervision of financial conglomerates and on the operation of electronic money institutions into Latvian legislation. Also in 2004, a system of evaluating operational risk will be set up. Standard & Poor’s considers all these measures have bolstered Latvian banking legislation to that comparable with peers.
Latvia now has a unified regulatory agency, which Standard & Poor’s would tend to view favorably, as such unified bodies provide sharpened consolidated supervision and lead to greater disclosure and transparency. However, a track record of successful integration has not yet been established. Following the enactment of The Law on the Financial and Capital Markets Commission (FCMC) in 2000, the new supervisory body was established in July 2001 from three constituent agencies – the Banking Supervision Department of the Bank of Latvia; the Insurance Supervision Inspectorate in the Ministry of Finance; and Securities Market Commission. The work of the FCMC – particularly regarding the implementation of proposals into practice – was evaluated positively by experts from the EU in 2002, and a similar evaluation exercise with market participants was conducted in 2003. Furthermore, the FCMC received the ISO Quality Management certificate the same year. Standard & Poor’s regards as progressive and constructive such initiatives for continued improvement and transparency. Banks in Latvia operate with the following key legislation:
In recent years, supervision has been significantly improved in terms of frequency of inspections, quality of data reviewed, analysis of data, recommendations made, implementation of recommendations, and quality and number of personnel. In 2003, the FCMC conducted 41 bank examinations, which typically focused on risk-weighted assets, internal control systems, and the prevention of money laundering. In the near future, the scope of consolidated on-site inspections will be expanded to include a review of subsidiary activities.
As regards banks’ preparation for Basel II, the majority of banks will apply the standardized approach. Four banks are planning to use the foundation IRB approach for credit risk. The FCMC has elaborated guidelines for calculation of capital requirement based on the draft Directive on risk-based capital requirements. The Quantitative Impact Study will be finalized by the end of 2004. Discretions provided for in the draft Directive have been discussed with banks. No final decision has been taken yet by the Commission.
The banking system faced one major crisis and one testing period in the last decade, when the state demonstrated bridled support. The Latvian government does not bail out failing banks.
In the 1990s, a banking crisis resulted from hasty expansion, when the number of banks peaked at 63 in 1994. 23 banks failed and were closed in 1995 and 1996. The main causes of the severe crisis in 1995 were the high level of insider loans that were never repaid at many of the largest banks, as well as other criminal fraud by insiders. Furthermore, Latvia had lacked a proper legal infrastructure able to support credit risk. In 1995, the system’s NPLs reached 40 per cent, bad debts which had accumulated in 1991 and 1992, and some were inherited. Only two banks benefited from some direct state support, primarily in the form of seven-year government rehabilitation bonds given to replace bad debts, and another bank received a capital boost. These banks were singled out because of their bad debts inherited from Soviet times. In the case of the 1995 failure of Bank Baltija, there was no state assistance and depositors only received their first payments from liquidation proceeds in 1999. Despite transparency improvements, the perception of corruption in Latvia in 2003 was higher than that of its neighboring Baltic rim states, according to Transparency International.
At the time of the Russian crisis in 1998, the relative concentrations of direct exposures to Russia was alarmingly high, with 10 banks out of 31 credit institutions holding more than 10 per cent of their total assets in Russia, of which 6.6 per cent were in the form of Russian government bonds. The Russian debacle produced a small rumbling of insolvency, reducing the number of banks which had their licences revoked.
The Law on Natural Person Deposit Guarantees came into effect in October 1998. Assets are accumulated by the Deposit Guarantee Fund, and in 2003, the guaranteed compensation per person was LVL3,000, which appears to provide adequate coverage of deposits, as more than 95 per cent of all accounts opened within the Latvian banking sector in 2003 had balances of less than LVL3,000. The limit will gradually rise to LVL13,000/€20,000 per person per bank by 2008 to meet the EU directive. It is funded by initial single payments by the Bank of Latvia and the Ministry of Finance, and by subsequent quarterly payments by commercial banks. If the Guarantee Fund’s assets are insufficient to make guaranteed payments to depositors, such payments shall be paid by law from the state budget. In cases where deposits become unavailable, for example, the initiation of liquidation proceedings, the Financial and Capital Markets Commission would exercise the creditors’ right to effect compensation payments to depositors no later than three months from the unavailability date. The Fund has not been called upon since its establishment.
Standard & Poor’s considers the Bank of Latvia would be likely to provide temporary liquidity support for the largest banks, if needed. The Bank of Latvia intervenes in the interbank money market in two ways: by setting discount rates for buying and selling T-bills, and by entering into repo agreements on a tender basis. In addition, the Bank of Latvia has the power to make a short-term, 30-day loan available to any bank experiencing unexpected short-term liquidity problems. There appears to be no restrictions in terms of amount, but each loan would be assessed on a case-by-case basis. In a recent case, RKB, a small bank, experienced a “classic” run on its deposits after the Russian crisis, and the central bank reportedly provided liquidity support to the bank before it was officially declared insolvent in March 1999. In addition, following the crisis, the Bank of Latvia expressed its willingness to support the rehabilitation of RKB as an equal partner, with the bank’s shareholders and major creditors formally resolving in May 1999 that RKB’s plan for recapitalization should be completed within three months or the bank would be liquidated.
Standard & Poor’s considers Latvian banks’ accounting standards to be good overall, particularly for the larger banks. The level of transparency and disclosure is on par with new EU member country banks. All Latvian banks have been required to prepare their accounts according to IAS on a consolidated basis since 1995, and financial statements are now prepared in accordance with IFRS and regulations set by the FCMC. IAS 39: the recognition and measurement of financial instruments was adopted in 2001, and is applied in full. There is no FCMC requirement to establish general loan-loss reserves; banks may form such reserves at their own discretion. Generally, audited accounts differ little from internationally accepted norms. Audits, particularly of the larger banks, are carried out by internationally recognized firms, and consolidated accounts are compulsory.
Loan quality is defined and measured using five categories set by the FCMC. NPLs are loans where principal is 30 days or more overdue, interest 90 days or more overdue, or bank management believes that principal or interest are potentially uncollectable. Provisioning levels are set by the regulator. For substandard and doubtful loans they are somewhat higher–and thus more prudent–than some peer group countries, for example, in both Poland and the Czech Republic they are 20 per cent and 50 per cent, respectively.
Corporate taxes are far more favorable than in most EU countries; income tax was reduced to 15 per cent on 1 January 2004, from 19 per cent in 2003, and 22 per cent in 2002.
| Number of banks: 22 and one branch of a foreign bank.
System deposits: LVL4,347m. Deposits per capita: LVL1,910. Form of regulation: Latvijas Banka (the central bank; Bank of Latvia) works with the Financial and Capital Market Commission, the unified financial market regulator, established in 2001. Bank Superintendent: Mr. Uldis Cerps is Chairman of the Financial and Capital Market Supervision. |
This report is published in full by Standard & Poor’s Ratings Direct.