On 28 January the
International Monetary Fund published a detailed staff report on Latvia 27
November 2012 , was completed on 19 December 2012 . Below
are reproduced verbatim the sections of the report that deal with the banking
system, with emphasis as per the original.
[...]
POLICY DISCUSSIONS
[...]
B.
Credit Conditions Are Improving Gradually
7. The banking system is recovering.
Banks returned to
profitability in 2011 and the average return on equity was around 10 percent in
the first 9 months of 2012 (Figure 5). The share of non-performing loans (NPLs)
has been decreasing steadily from its mid-2010 peak of about 19½ percent and
now stands at 12½ percent. Loan loss provisions are more than ¾ of NPLs. The
improvement in the corporate loan portfolio has been more marked than the
household loan portfolio, partly because the latter was particularly hard hit
by the collapse of the housing bubble (over three-fourths of household loans
comprise mortgage lending). The share of NPLs is now about 11 percent for
corporate loans but 16 percent for household loans. The system-wide capital
adequacy ratio now stands at 17.4 percent, well above the 8 percent regulatory
minimum.
8. Credit to residents is still
contracting but will likely level off soon. The balance sheet of the banking system has shrunk
substantially from its pre-crisis peak. Since end-2008 total assets of the
banking sector have decreased by about L3½ billion (15 percent). The nominal
stock of loans to residents is about 30 percent lower. The stock of credit
outstanding is still decreasing as some borrowers, especially households,
continue to deleverage. The still negative credit growth also reflects the
ongoing process of dealing with insolvent loans (write-offs) and banks (Parex
Bank and Latvijas Krajbanka were removed from the credit statistics in March
and May respectively). Excluding these effects, loans to residents contracted
by 2 percent year-on-year by end September, a leveling-off from the 6 percent
rate of contraction at end-2011. Meanwhile, new credit is increasing,
especially to the corporate sector. The volume of new loans to residents
granted in the first three quarters of 2012 was 28 percent higher than in the
same period in 2011, and less than 18 percent of these new loans were to
households.
9. Deleveraging by foreign-owned banks
has been large over recent years. Subsidiaries of foreign banks in Latvia have reduced reduced
their liabilities to parent banks by about L3.5 billion since end-2008; of
this, L3.2 billion correspond to deleveraging by Nordic banks (Figure 7). With
stable or increasing deposits over the same period, the loan-to-deposit ratio
(LTD) of subsidiaries of foreign banks has dropped significantly from almost
260 percent to 176 percent. The pace of deleveraging is still strong.
Liabilities to parent banks decreased by 26 percent from end-2010 to end-2011,
and by roughly the same rate in the first three quarters of 2012. However the
rate of deleveraging by Latvian subsidiaries is expected to slow down in the
coming quarters, given that the loan portfolio of these banks has stabilized,
resident deposits are growing modestly and outstanding liabilities to foreign
parent banks have declined to about 40 percent of their peak-levels. The recent
pace of deleveraging seems to be driven mainly by the ongoing deleveraging of
households and weak credit demand by firms, rather than funding constraints
from abroad. That said, tighter lending standards applied by the subsidiaries
themselves might be playing a non-negligible role.
10. Non-resident deposits (NRDs) in
the banking system have been expanding rapidly (Appendix I). NRDs in Latvia
increased by 19.7 percent in the year to end-September (15.7 percent if exchange
rate effects are excluded), while resident private deposits have grown by only
1.3 percent over the same period. While NRDs have been historically high in
Latvia, they now exceed deposits of private residents in the banking sector.
The recent acceleration is believed to be mainly due to CIS depositors
relocating their funds from countries with banks under stress in the euro area.
The rise in NRDs has been associated with a strong accumulation of foreign
assets, mostly liquid assets such as government securities and claims on MFIs.
11. The financial regulator (FCMC)
found significant undercapitalization in a mid-size
bank specializing in non-resident
clients. Negotiations
are ongoing with a strategic private
investor who
has already contributed to an injection of L8.2 million in fresh capital.
[...]
C. Banking Sector
Vulnerabilities
21. The rapid rise in non-resident
deposits in the banking system is a potential source of vulnerability, with
possible implications for Latvia’s liquidity position and reputation (Appendix I).
· Given their short maturity and higher volatility, NRDs are
particularly prone to sudden reversals. This became apparent during the
financial crisis, when NRDs fell by 30 percent in the 12 months following
August 2008. Given the size of the sector, a sudden reversal of NRD flows, and
the potential of contagion to resident deposits (largely denominated in foreign
currency), represents a source of vulnerability to international reserves and a
significant contingent fiscal liability (via sovereign backing for the deposit
insurance system). Although banks specializing in non-resident clients allocate
a significant share of their portfolio to liquid foreign assets, the quality
and availability of some of these are harder to verify than for domestic assets
(for example, the insolvency of Latvijas Krajbanka in November 2011 was
triggered by the discovery that €140 million of assets in correspondent
accounts were actually encumbered). The authorities recognize the higher risk
of NRDs as a funding source and the potential of contagion to domestic
depositors in the event of severe outflows. But they believe the risk to
international reserves is small given the accumulation of liquid foreign assets
by banks experiencing rapid growth in NRD deposits.
· The higher reputational risk associated with non-resident
activity represents an additional source of vulnerability. Staff, the
authorities and banks’ managers agree that it is significantly more difficult
to ensure compliance with AML/CFT regulation when dealing with non-resident
clients, and that an incident in an individual institution could spill over to the
reputation of the whole banking system. Staff welcomed the amelioration of
previous deficiencies in AML/CFT regulation, particularly on prevention—as
recently reported in the Council of Europe MONEYVAL report—but stressed the
need for risk-based, comprehensive, and frequent supervision.
22. The FCMC has appropriately
adopted regulatory measures to reflect the higher risks associated with
non-resident activities, and the implementation of Basel III regulation should maintain
this approach.
· Since mid-2011 the FCMC has required banks that hold either
non-resident loans of over 5 percent of total assets or non-resident deposits
of over 20 percent of total assets to hold additional capital. The extra
capital requirement ranges from 0.5 to 9 percent of risk weighted assets, and
depends on both the level and growth rate of the exposure to nonresident business.
The authorities plan to keep higher capital requirements for non-resident banking
when adopting Basel III regulation—either within Pillar II or by applying a
capital add-on to address systemic risk within Pillar I.
· Staff and the authorities agreed that the parameterization
of the Liquidity Coverage Ratio (LCR) in the context Basel III implementation
should ensure that NRDs are backed by more liquid assets than other deposits.
The FCMC will start monitoring the new liquidity ratios from January 2013 and
plans to deviate from the baseline specification as needed, in particular by
applying higher run-off factors for NRDs.
· Given the large contingent fiscal liability associated with
NRDs (45 percent of insured deposits comprise NRDs), staff discussed with the
authorities the possibility of charging NRDs a higher contribution to the
Deposit Guarantee Fund (DGF), consistent with the risk-based pricing of insurance
schemes. The authorities argued that the effective premium charged is
indeed higher for NRDs: their average size—and hence average DGF contribution—is
significantly higher than for resident deposits, but the insured amount is restricted
to 100,000 euros in both cases.
23. Staff welcomed recent steps by
the authorities to strengthen the supervision of banking activities with
non-resident clients. The FCMC has amended its off-site and on-site inspection framework to
ensure a deeper focus on the dynamics and quality of banks’ non-resident assets.
Other measures include the more active use of the Pillar II framework to
establish minimum requirements for maturity mismatches between assets and
liabilities; and requiring banks to do periodic liquidity stress-tests based on
FCMC prescribed scenarios.
24. Progress had been made in
restructuring the banking sector (Box 2). Staff urged that the disposal of legacy assets
proceed expeditiously, subject to the goal of obtaining value for taxpayers.
Staff recommended that the authorities request a new FSAP to take stock of the transformation
in the financial sector since the previous, pre-crisis FSAP. The authorities
welcomed the suggestion and will consider undertaking an FSAP sometime in 2014.
Box 2. Completing the Restructuring of the
Banking Sector
The sale of the
commercial part of Mortgage and Land Bank (MLB) is close to completion. The sale of assets
accounting for almost 60 percent of MLB’s commercial activities by book value
has been completed. The sale of the remaining commercial assets, comprising
loans to real estate corporates and non-performing loans, is planned by 2013Q1,
but the government has not excluded transferring these assets to the Latvian Privatization
Agency if the price offers are deemed unsatisfactory. Staff agreed with the
authorities that obtaining value for taxpayers is an important objective, while
reiterating that the process should continue as expeditiously as possible.
The authorities are
making progress on the strategy to create a single development institution
(SDI). The
strategy envisages the merger of MLB’s non-commercial part with other
development institutions (the Latvian Guarantee Agency, Latvian Environmental
Investment Fund and the Rural Development Fund) to form the SDI. A discussion
on whether the Ministry of Finance or the Ministry of Economy should be the shareholder
of the SDI is currently delaying further progress. Staff urged that the process
be expedited, and that the SDI operate without a banking license to ensure that
it does not enter into commercial activities in the future.
The sales process for
Citadele has been postponed due to weak market conditions, and the authorities
are now planning to modify the restructuring plan. Under new management, the
bank has restructured its operations and increased its profitability. But the
prospects of attracting an investor have been limited by the moribund global
M&A market. The government intends to propose a new restructuring plan to
the European Commission aimed at facilitating the sale process and maximizing
the recovery for taxpayers. Its main elements are: i) postponing the original
commitment date to sell the wealth management business, so that it can be sold
together with the rest of the bank, thereby preserving the overall attractiveness
of the bank; and ii) allowing partial sales of the State stake in Citadele to
attract smaller investors.
Progress has been made in
recovering assets from Latvijas Krajbanka. Krajbanka’s administrator KPMG has already
sold assets and repaid about L90 million to the deposit guarantee fund (DGF).
The sale of the loan portfolio, with a book value of about L160 million, is
underway. Final offers for loans grouped in five bundles will be received by
end-January and the authorities expect the sales process to be concluded by the
first quarter of 2013. While the progress to date is encouraging, asset sales
will nevertheless be insufficient to fully compensate payments to depositors by
the DGF, of about L340 million. Staff concurred with the authorities that legal
action should be pursued to recover other missing assets in correspondent
accounts (amounting to about L130 million).
As
the DGF was depleted after Krajbanka’s failure, staff discussed plans to
replenish the fund with the FCMC. Deposit insurance premia have been raised by 50
percent. A proposal to extend the period of increased contributions is being
considered; under current legislation higher contributions can only be charged
for one year after the DGF covers deposits.
[...]
Appendix I. The Non-Resident Banking Sector in
Latvia
The financial sector in
Latvia is dominated by commercial banks, with a strong foreign presence. Commercial banks’ assets
accounted for almost 90 percent of total assets in the financial sector and 150
percent of GDP at end-2001. There are 20 commercial banks—including 8
subsidiaries of foreign banks from Sweden, Norway, Austria, Russia and
Ukraine—and 8 foreign bank branches in Latvia.
The banking sector is
segmented between banks dealing with domestic clients and banks dealing with
non-resident clients (NR banks). This split in business models is to a large
extent correlated with bank ownership. In broad terms, the subsidiaries of
Nordic banks and the branches of foreign banks deal with resident clients while
the other banks focus on non-resident clients. NRDs account for: more than 70
percent of deposits for 2/3 of local banks; more than 60 percent of deposits
for all non-Nordic subsidiaries; and less than 10 percent of deposits for all
but one branch of foreign banks and for all Nordic subsidiaries.
A large fraction of
foreign depositors are from CIS countries. As of end-September 2012, about 1/3 of
NRDs were from EU countries, 12 percent from CIS countries (70 percent of them
from Russia) and 55 percent from other non-EU jurisdictions. The latter,
however, corresponds largely to offshore companies from jurisdictions such as
the British Virgin Islands and Belize, whose ultimate beneficial owners are
mostly CIS residents. Also, 58 and 25 percent of EU deposits are from the U.K. and
Cyprus respectively, but the ultimate owners are mainly CIS residents. Overall,
80 to 90 percent of NRDs are estimated to come from CIS countries. CIS
depositors have historically found Latvia attractive as a provider of banking services
for a number of reasons: (i) its geographical location; (ii) widespread fluency
in Russian; and (iii) efficient and competitively priced banking services.
Banks specialized in
non-resident clients constitute a large and increasing fraction of the banking
sector. NRDs
across the banking system are about L5.5 billion or 51 percent of total
deposits. Almost 60 percent of banks in Latvia, accounting for 43 percent of
the banking system in terms of assets and 58 percent in terms of total deposits,
specialize in non-resident customers according to the FCMC’s classification
rule—which considers a bank as specialized in non-resident clients if NRDs
represent more than 20 percent of its assets. While the size of the
non-resident segment in Latvia has always been large, it is expanding at a
rapid pace. In the 12 months to end-September 2012 NRDs increased by 19.7
percent (15.7 percent if exchange rate effects are excluded). The recent
acceleration is believed to be mainly due to CIS depositors relocating their
funds from countries with banks under stress in the euro area, mainly Cyprus. Another
potential driver of recent NRD flows is the fact that since mid-2010 Latvia
grants EU residency permits to foreigners investing at least L200,000 in the
form of subordinated debt of a credit institution (other eligibility criteria
include investment in real estate or in nonfinancial companies). But this
factor seems to have played a minor role, as only about L50 million in investment
(out of L290 million) claimed for obtaining EU residency permits were made in
the banking sector.
A large share of NR
banks’ assets is invested abroad. The share of foreign assets in NR banks’ total
assets is about 55 percent, while it is only 12 percent for banks dealing with
residents. More than 90 percent of these assets are issued by counterparts in
the European Economic Area (EEA, 62 percent), CIS countries (18 percent) and
the U.S. and Canada (13 percent).
· Almost half of total foreign assets held by NR banks
are claims on foreign MFIs, 80 percent of which are from EEA countries
(of which banks from Germany, Austria, the U.K. and Switzerland account for 77
percent).
· Foreign loans account for about ¼ of NR banks’ foreign
assets. About 70 percent of these are granted to clients from CIS countries,
either directly (40 percent of total foreign loans) or indirectly through
jurisdictions such as the U.K., Cyprus, British Virgin Islands and Belize.
· Foreign securities account for ¼ of the
foreign assets of NR banks, almost half of which correspond to government
securities. Among the latter, 93 percent is issued by the U.S., Canada or
EEA countries. These countries also account for 57 percent of non-government
securities, while 28 percent is issued by corporates from CIS countries. assets. Claims on foreign MFIs (with
maturity up to 30 days) and government securities account for more than 90
percent of the foreign assets accumulated over the last 4 years. Foreign loans,
instead, are at essentially the same level as in 2008.
Consequently, NR banks have become
more detached from the domestic economy. Domestic assets held by NR banks have decreased by
L0.5 billion between 2008 and 2012 (while total assets increased by 0.7
billion). Loans to residents granted by NR banks decreased by almost L1 billion
over the same period.
NR banks
have smaller capital buffers than the rest, but are subject to higher minimums.
While the average
capital adequacy ratio of banks dealing with residents has increased from about
10 percent in 2007 to close to 20 percent in 2011, it has increased from
slightly above 10 percent to about 15 percent for banks dealing with
non-residents. NR banks face higher minimum levels, though: since mid-2011 the
FCMC requires these banks to hold extra capital (from 0.5 to 9 percent of risk
weighted assets) depending on the exposure of each bank to the non-resident
business, and the growth rate of this exposure.
[...]
Source:
Republic
of Latvia: 2012 Article IV Consultation and Second Post-Program Monitoring
Discussions (2013-01-28)
Mark Pleas
[contact]
