After regaining their independence in 1991 and introducing national currencies shortly thereafter, the Baltic countries undertook to stabilize their economies against a background of high inflation, large declines in output, and significant deterioration in their terms of trade.1 The implementation of prudent financial policies has allowed the Baltic countries to achieve a steady decline in inflation since its peak in 1992 and to resume economic growth. Moreover, the first phase of transition has been completed in respect to structural reform, including price and trade liberalization and small-scale privatization.
As part of the transition to a market economy, the Baltic countries introduced major reforms in the financial sector, involving, in addition to the liberalization of the financial system, the buildup of institutions, expertise, markets, instruments, and changes in the legal and regulatory framework. During this period of financial liberalization and before a sound, market-based financial system was fully in place, all three experienced banking crises. These crises resulted from serious deficiencies in the internal management of banks, and the absence of an adequate regulatory and supervisory environment, both reflecting weaknesses in governance inherited from the planned economy of the Soviet Union.
Having weathered the banking crises, the Baltic countries have moved to face the challenges lying ahead in the area of financial sector reform. The authorities are taking the appropriate measures and giving the necessary signals for the resumption of financial market deepening. In each of the three countries, the banking sector has undergone systemic restructuring and in the process, ways have been found of dealing with bad loans and problem banks, and a healthy financial environment is being established to help prevent another crisis from taking place.
Background
Liberalization of the financial system inherited from the Soviet Union was accomplished early on in the reform period: subsidized and directed credits were almost completely phased out; controls on interest rates were removed; external current accounts became convertible; and almost all restrictions on capital movements were eliminated. Although financial deregulation has been largely completed, financial sector reforms are still continuing with efforts to develop a more competitive and sound banking system and an effective regulatory framework.
Early in the transition, in an effort aimed at developing a competitive and sound banking sector, the Baltic countries (1) established a two-tier banking system; (2) introduced central bank and commercial banking laws largely consistent with the requirements of a market economy; (3) incorporated and reorganized state-controlled banks; and (4) moved toward universal banking by mobilizing savings for all banks and developing skills for credit risk evaluation and portfolio selection. In the process of building up a market-based financial system, the Baltic countries have taken a number of important additional steps to build up considerable capacity for banking supervision; develop money, securities, and capital markets to facilitate the operations of the banking system and enhance monetary control; and set up efficient payments systems in which financial transactions can be effected quickly and safely.
During this period of financial liberalization and before an effective market-based financial system could be fully established, all Baltic countries underwent banking crises. Because of the low level of financial intermediation,2 even the failure of large banks had limited systemic effects and a minor negative impact on output and incomes. The crises, however, slowed down the pace of financial reform by disrupting the process of financial development and reduced the banking system's role in credit intermediation.
A positive effect of the banking crises was a consolidation of the banking system and the emergence of more cautious and prudent behavior among surviving banks, as the financial system retrenched before resuming financial deepening. As of the end of 1997, there were 11 banks in Estonia, 31 in Latvia, and 11 in Lithuania, down from a peak of 43, 63, and 28, respectively (Figure 5.1). These numbers do not include a foreign bank branch each in Estonia and Latvia and several representative offices in Estonia and Lithuania. In addition, all three Baltic countries have operating and growing stock exchanges, as well as a growing number of licensed financial intermediaries and brokers.
The development of money markets and monetary control procedures followed different paths in the Baltic countries. In respect to the interbank market, Estonia developed an important vehicle for managing day-to-day liquidity; already in 1994 the daily volume of transactions exceeded 1 percent of reserve money and interest rate trends followed closely the interbank money market rate. By contrast, in Latvia and in Lithuania transactions on the interbank market peaked at ½ of 1 percent of reserve money in December 1994 and in the summer of 1995, respectively, before activity declined as banking problems surfaced; activity picked up again in 1996.
Indirect instruments of monetary policy have also been introduced as part of the reforms. Money markets are still underdeveloped and the shift toward market based monetary policy is by no means complete. With the adoption of currency board arrangements (CBAs), in Estonia in 1992 and Lithuania in 1994 discretionary monetary policy was effectively ruled out.3 Given the central banks’ limited experience in formulating and implementing monetary policy, a currency board rule allowed the central banks to devote more of their resources to developing banking regulations and improving monitoring of the banking system.
Both Latvia and Lithuania have successfully established a primary market in treasury bills through an auction procedure.4 Amounts outstanding have increased steadily since their introduction in December 1993 and July 1994, respectively, except in the context of the banking crises, when there was a substantial weakening in demand for bills reflecting banks’ liquidity problems. A few months after the crises, however, demand rebounded in each of the two countries as banks opted for holding safe and liquid treasury bills rather than offering credit to the private sector.
Financial Deepening and Financial Intermediation
If the Baltic countries were to seek to broaden their options for conducting monetary policy, they would need to rely further on indirect instruments of monetary control. At the same time, the financial systems would need to play the role of generating saving and directing it to productive use. To meet this dual challenge and facilitate the economy's move toward greater financial intermediation, the financial system would have to become deeper and broader, and at the same time remain stable.
Financial sector developments during the period leading up to the banking crises were characterized by an initial increase in the number of banks, in the ratio of money to GDP, and in the holdings of financial assets by the private sector.5 At the same time, there was a decline in the ratio of currency to deposits and in the banks’ reserve-to-deposit ratio, leading to an increase in the money multiplier. One of the consequences of the banking crises was the disruption of these trends and thus the slowdown or reversal of the modest amount of financial deepening that had begun during the early reform period (Figures 5.2–5.4). The Baltic countries now face the challenge of resuming the process of increasing financial deepening and intermediation.
Indicators of Financial Intermediation I
Indicators of Financial Intermediation II
The remonetization of the Baltic economies must come about with a shift in the demand for money, which will require improved public confidence in the financial system. Despite early and fast financial deregulation, the role taken on by the banking sector in financial intermediation has been modest. Banks are far from playing a comparable role to those in other transition economies of central and eastern Europe (Table 5.1). The required confidence has been slow in coming: in Latvia and in Lithuania, where the banking systems are still dealing with the effects of the banking crises,6 the currency-to-deposit ratio, which followed an upward trend after the crises, remains high as economic agents continue to rely heavily on the use of cash for transactions and deposits have declined as a ratio to GDP. In Latvia, which experienced its banking crisis and took a number of policy measures before Lithuania, a moderate resumption of financial deepening began in the third quarter of 1996. Even more so in Estonia, there has been steady growth of credit and deposits as percent of GDP, which began in the aftermath of the banking crisis of 1992 (Figure 5.5).
Indicators of Financial Intermediation
(End-1997)
Pazarbasioglu and van der Vossen (1997).
Indicators of Financial Intermediation
(End-1997)
| Broad Money/GDP | Bank Claims on Private Sector/GDP |
Deposits/GDP | ||
|---|---|---|---|---|
| Estonia | 31 | 35 | 24 | |
| Latvia | 26 | 11 | 16 | |
| Lithuania | 20 | 12 | 13 | |
| Other central and eastern Europe (end-1995)1 | 55 | 35 | 45 | |
| Poland | 40 | 24 | 33 | |
| OECD (end-1995)1 | 75 | 90 | 70 | |
Pazarbasioglu and van der Vossen (1997).
Indicators of Financial Intermediation
(End-1997)
| Broad Money/GDP | Bank Claims on Private Sector/GDP |
Deposits/GDP | ||
|---|---|---|---|---|
| Estonia | 31 | 35 | 24 | |
| Latvia | 26 | 11 | 16 | |
| Lithuania | 20 | 12 | 13 | |
| Other central and eastern Europe (end-1995)1 | 55 | 35 | 45 | |
| Poland | 40 | 24 | 33 | |
| OECD (end-1995)1 | 75 | 90 | 70 | |
Pazarbasioglu and van der Vossen (1997).
The return of confidence will allow interest rates to begin to play a more important role as price signals in the market and increase incentives for the public to participate in financial intermediation. The process is further advanced in Estonia than in Latvia, and somewhat less in Lithuania. In all three countries, nominal interest rates originally responded sluggishly to the decline in inflation, which is not uncommon when interest rates are liberalized rapidly and early in the reform process, before significant progress has been made in enterprise and financial sector reform and while effective banking supervision is not yet in place. The persistence of large interest rate margins between foreign currency and domestic currency loans and deposits, and between lending and deposit rates reflected (1) the uncertainty surrounding the nature of capital inflows; (2) high default premiums; (3) banks’ attempts to recapitalize; and (4) large stocks of nonperforming assets in banks’ portfolios. These margins—relevant particularly in Latvia and Lithuania—contributed to financial instability and had a negative impact on investment and growth.
Despite their originally sluggish response, bank interest rates are increasingly reflecting economic conditions. In 1996, Latvia experienced a declining trend in market rates following lower inflation, positive fiscal developments, and stabilization in the financial market, including the publication of improved annual audit reports for commercial banks. Interest rates in Lithuania, after an initial doubling immediately following the banking crisis in early 1996, were on a sharp and continuous declining trend through the end of the year and during much of 1997. Spreads between lending and deposit rates have also been declining in the Baltic countries (Figure 5.6).
Interest Rates
1 The spread is defined as the difference between the nominal lending rate and the nominal deposit rate.2 Real rates have been deflated by the six-month forward inflation rate.Development of the Money, Securities, and Capital Markets
Although the financial sector in the Baltic countries has so far been dominated by commercial banking, some inroads are being made toward the establishment of more mature money, securities, and capital markets. The desire to develop these markets further and to increase monetary policy options must, however, proceed with caution and after a period of adequate preparation intended to protect economic agents from destabilizing surprises. Progress must be made in the continuing improvement of the financial condition of the banking sector and the restoration of the public's confidence in it. In turn, the establishment of confidence will help develop the financial markets.
The central bank of Latvia offers three types of loans to banks, namely, daily repurchase auctions, an automatic overnight Lombard window, and longerterm Lombard credits, and two mechanisms for withdrawing liquidity, nonnegotiable deposits and reverse repurchase agreements. Despite the availability of instruments, however, the level of activity has been low as most banks have been pursuing a cautious approach fallowing the banking crisis and, after the immediate period following the crisis, there has not been a need for liquidity injection because of balance of payments surpluses. In Estonia and in Lithuania, where the CBA limits the central bank's monetary operations, monetary instruments until recently have been nonexistent or dormant. Lithuania has introduced some monetary operations (treasury bill repurchase operations, deposits auctions) to build up its institutional capabilities prior to its eventual introduction of a monetary policy regime that would allow for a greater degree of policy discretion.
Within the constraints of the CBA, the interbank market in Estonia has become an important vehicle for managing banks’ day-to-day liquidity. As banks gained experience in evaluating counterparty risk and became familiar with each other, they depended less on the use of collateral (certificates of deposit issued by the central bank); consequently, most interbank activity is now uncollateralized. In Latvia and in Lithuania, the interbank market is now showing some signs of growth, especially in Latvia; before it had always been thin and virtually collapsed around the time of the banking crises. With the tightened enforcement of prudential requirements and the increased familiarity with other banks’ financial position, banks are more willing to lend to each other, although the market is still thin and volatile.
In the aftermath of the banking crises in Latvia and Lithuania and following the immediate postcrisis period of low bank liquidity, activity in the primary market for treasury bills has surged, a direct result of the cautious approach followed by banks reluctant to lend in a fragile and potentially volatile environment. As a result, primary auctions have become more competitive, making interest rates more stable, especially in Latvia (Figure 5.7).7 At the same time, the primary market for government securities is becoming deeper and broader with the introduction of longer maturity paper and the availability of onemonth, three-month, six-month, and one-year maturities on a regular basis in Latvia and also increasingly in Lithuania. The availability of longer maturities is also likely to boost activity further in the secondary market, which has been increasing in both countries. In Lithuania, where securities traded before maturity are subject to tax but others are not, a change in the tax treatment would also contribute to the development of a smoother and more active market.
Treasury Bill Rates
(In percent)
1 Real rates have been deflated by the current inflation rate.As the money and securities markets develop, the authorities should be mindful of the reduced effectiveness of such instruments when weaknesses in banks’ loan portfolios or management lead to interbank market segmentation and make banks unresponsive to price signals.8 Market segmentation occurs when sound banks receive a disproportionate amount of deposits, which, in their attempt to retain safe and liquid assets and to cut their exposure to risk, they invest in treasury bills whose yields tend to decline. At the same time, unsound banks, which may not have access to interbank borrowing, may face shortfalls in their required reserves and overdrafts in their clearing accounts and be forced to resort to distress borrowing. Such a situation can complicate the development of market-based instruments and distort interest rates.
For the effective implementation of monetary instruments, preparation and testing will be required to ensure that the technical arrangements are fully adequate and sufficient institutional capacity is in place at the central banks. A full framework must exist at the central banks for the analysis and forecasting of conditions affecting the central bank balance sheets and the markets in which they will operate. More important, the authorities must feel that monetary policy should be conducted in a context of central bank independence and with a clear mandate to enforce price stability.
The domestic capital market in the Baltic countries started from a low base and has been slow to develop due to credit constraints and insufficient depth in the financial system. During the initial years of reform and before sufficient macroeconomic stability, the uncertainty and volatility of the markets and the level of real interest rates were excessively high and had a negative impact on investment. Later on, although real interest rates declined and, in some cases, became negative, credit availability remained low, as most enterprises either lacked the collateral or a long enough credit history. The problem was compounded by the lack of an established legal and institutional basis on which the use of collateral could develop.9 In this context, it is important to recognize the links between structural reform in the enterprise sector and in the financial sector, and that unless reform progresses in all sectors of the economy, structural bottlenecks can have substantial spill-over effects.
The availability of foreign capital in the Baltic countries has often filled the gap where domestic capital has been in short supply, especially in Estonia and Latvia where foreign direct investment, at least until 1996, has been higher than in Lithuania.
Restructuring the Banking System
After having experienced “structural” banking crises, the Baltic countries have had to restructure their banking sectors so as to render them viable and allow them a more active role in financial intermediation. As a first step, this has implied finding ways to deal with the stock of bad loans and problem banks. As a second step, it has meant establishing a healthy financial environment that would help prevent another crisis from happening. In addressing both issues, the Baltic authorities will face a number of constraints, and the path they follow could have different implications for the near and longer term.
Addressing the Stock Dimension of the Problem
In deciding how to deal with the stock of bad loans and the questionable viability of problem banks, the authorities in the Baltic countries have had to weigh whether or not to bail out banks or creditors, or both. Aspects to consider in these decisions concern questions of contagion, moral hazard, helping build public confidence, fiscal costs, and consequences of government ownership of banks and eventual privatization. A related issue has been examining the advantages of a centralized loan-recovery agency, as opposed to leaving it up to the individual banks to recover bad loans.
An advantage of direct financial assistance by the government in addressing the stock of nonperforming loans and the solvency and liquidity problems of banks is that budgetary costs are transparent. Such assistance has taken many forms, including acquisition of bad loans (Estonia and Lithuania), recapitalization schemes (all three countries), assisted mergers (Estonia), and liquidity support (all three countries).
The experience of the Baltic countries has shown that minimizing bailouts contributes to boosting the public's confidence in the banking system; it builds trust that the central bank will back only viable banks and that the authorities in general will not support problematic entities that will drain the system indefinitely. In this context, the no-bailout approach also reduces moral hazard by helping to contain the flow problem. In Estonia, which was the first to experience banking problems, the authorities dealt quite differently with the 1992 and the 1994 episodes. In the earlier crisis, after initial liquidity support when the crisis was thought to be temporary, the central bank moved quickly to close the problem banks and to deal with them in a decisive manner—in one case, without bailing out creditors.10 In contrast, the Social Bank crisis of 1994 dragged on for a year drained large resources from the central bank (equivalent to 6 percent of base money), and, with the exception of shareholders, created no losses to creditors who were bailed out at government expense. In Latvia, after Bank Baltija had become insolvent in early 1995 and had received one emergency liquidity loan from the central bank, its operations were suspended and it entered bankruptcy and liquidation procedures. Creditors received no bail-out of any kind despite the size of the bank (it accounted for 30 percent of deposits of the banking system) and the extent of its complex connections.
In Lithuania, on the other hand, the authorities did not show the same resolve in dealing with the larger banks that they had shown with problematic small banks. Moreover, the implementation of measures to strengthen the banking system, following the suspension of operations of Innovation Bank and Litimpeks Bank in December 1995, was delayed repeatedly. The ensuing political turmoil, a number of contradictory laws passed by parliament, and the initial inaction of the authorities concerning the affected banks further undermined the public's confidence in the financial system. For instance, it took more than a year after its operations were suspended and after it came under its full control for the government to decide to liquidate Innovation Bank.
In addition to questions of moral hazard and the building of public confidence, bailing out problem banks can imply large and open-ended expenditures for the government budget and the central bank, as was the case with Estonia in 1994. An alternative approach followed in Latvia, Lithuania, and Estonia (in 1992) was for the government to issue long-term bonds to replace nonperforming loans in statecontrolled banks and to recapitalize these banks.11 In Lithuania, current costs of this scheme amount to interest payments on the long-term restructuring bonds, whose rates are based on the average interest rate in banks’ term deposits plus 1 percentage point; at the end of the ten-year maturity the principal is expected to be rolled over.
Following the banking crises, the government or the central bank assumed control of banks that had required direct financial government support. This was not so in Latvia, where the banking sector had become predominantly private early on in the transition and where the government by and large refrained from supporting the banking sector financially during the crisis. In Estonia and Lithuania, however, state involvement in bank ownership brought on the government the responsibility for eventual privatization, which presented a number of challenges, including asset valuation, especially for banks that have questionable loan portfolios, and finding appropriate private owners given banks’ special systemic vulnerability and issues of contagion effects.
Establishing a proper market value for a bank can be especially difficult with a lack of proper accounting on the part of debtor enterprises, a problem that has been present in all three countries; as a result, legitimate potential buyers can be in short supply. In Estonia, privatization of the three state-controlled banks following the crises took the form of either an increase in total equity by sale to private investors or the partial sale of existing equity held by the state; the process included aggressive restructuring and mergers. The result was the gradual privatization of the state banks, with the central bank guiding the process to ensure that privatization proceeded smoothly and systemic risks were minimized.12 A year after the outbreak of the banking crisis in Lithuania, the government increased its ownership share in the three state-controlled banks and now owns what used to be the largest private bank before the crisis. The authorities now face the multiple challenge of restructuring, rendering viable, and privatizing these banks as part of their effort to modernize the financial system with a view to eventual accession to the EU.
The consolidation of the banking sector that followed the closure of banks during the banking crises in the Baltic countries has been desirable, given the large number of nonviable banks that had sprung up early in the reform because of liberal licensing policies and low minimum capital requirements. Care should be taken, however, that the number of banks does not go below the minimum number required to foster a competitive banking sector.
Addressing the Flow Dimension of the Problem
Experience in the Baltic countries confirms that recapitalization of banks cannot be successful without simultaneously restructuring the banking sector, since the proper incentives are not created for avoiding the accumulation of new bad loans. In addition to handling the stock of bad debt, in facing the challenge of building a stable and well-functioning banking system, the Baltic authorities will have to (1) adhere to a consistently strict enforcement of prudential regulations while improving other aspects of banking supervision; (2) move ahead with restructuring the enterprise sector so as to open up sound investment opportunities for banks; and (3) develop an appropriate legal framework for the overall economic environment. This must be done in the context of continued fiscal restraint so that resources can be freed to the private sector.
Although banking supervision alone may not have been able to prevent the banking crises in the Baltic countries, strict enforcement of prudential regulations and closer monitoring would have reduced their magnitude. The formal establishment of prudential, regulations (Table 5.2) did not guarantee their effectiveness. In particular, although insider and connected lending was formally limited in 1994 in all three countries, these limits have been either disregarded or actively circumvented as became evident from the major bank collapses. Given the close ties between companies and banks, a legacy inherited from the Soviet system and still in effect to some degree, it is particularly important that insider and connected lending limits be strictly enforced in the future.
Prudential Regulations and Deposit Protection
LVL 2 million on April 1, 1998 for new banks, January 1, 1999 for all banks.
Foreign exchange risk is covered by the regulation on capital adequacy, although there are limits on “Zone B” currencies (e.g., ruble, lats).
Prudential Regulations and Deposit Protection
| Estonia | Latvia | Lithuania | ||
|---|---|---|---|---|
| Prudential regulations | ||||
| Minimum capital requirement (January 1, 1998) | EEK 75 million (ECU 5 million) | LVL I million1 (ECU 1.4 million) | LTL 24.2 million (ECU 5 million) | |
| Maximum connected lending | 20 percent of bank's capital | 15 percent of bank's capital | 10 percent of bank's capital | |
| Maximum lending to a single borrower | 25 percent of bank's capital | 25 percent of bank's capital | 25 percent of bank's capital | |
| Maximum foreign exchange exposure | From 1996, there are no special limits2 | |||
| Overall open position | 20 percent of bank's capital | 30 percent of bank's capital | ||
| Any one currency | 10 percent of bank's capital | 20 percent of bank's capital | ||
| Deposit protection (January 1, 1998) | Law submitted to parliament | Proposal with parliament | Up to LTL 25,000 (US$6,250) per deposit account | |
LVL 2 million on April 1, 1998 for new banks, January 1, 1999 for all banks.
Foreign exchange risk is covered by the regulation on capital adequacy, although there are limits on “Zone B” currencies (e.g., ruble, lats).
Prudential Regulations and Deposit Protection
| Estonia | Latvia | Lithuania | ||
|---|---|---|---|---|
| Prudential regulations | ||||
| Minimum capital requirement (January 1, 1998) | EEK 75 million (ECU 5 million) | LVL I million1 (ECU 1.4 million) | LTL 24.2 million (ECU 5 million) | |
| Maximum connected lending | 20 percent of bank's capital | 15 percent of bank's capital | 10 percent of bank's capital | |
| Maximum lending to a single borrower | 25 percent of bank's capital | 25 percent of bank's capital | 25 percent of bank's capital | |
| Maximum foreign exchange exposure | From 1996, there are no special limits2 | |||
| Overall open position | 20 percent of bank's capital | 30 percent of bank's capital | ||
| Any one currency | 10 percent of bank's capital | 20 percent of bank's capital | ||
| Deposit protection (January 1, 1998) | Law submitted to parliament | Proposal with parliament | Up to LTL 25,000 (US$6,250) per deposit account | |
LVL 2 million on April 1, 1998 for new banks, January 1, 1999 for all banks.
Foreign exchange risk is covered by the regulation on capital adequacy, although there are limits on “Zone B” currencies (e.g., ruble, lats).
The smooth function of a market-based financial system and the effectiveness of indirect instruments depend decisively on a consistent and stable valuation of financial assets. In addition to dealing with the stock of nonperforming loans, this can be achieved by adhering to international accounting standards and prudential norms. After the adoption of international accounting standards and the calculation of the capital base, according to the definition of the Bank for International Settlements (BIS), by Lithuania at the end of 1996, all three Baltic countries are now on board. The process of developing a system of adequate financial risk management is far from being complete, however.13 The Baltic authorities, as part of their consolidation of financial market development, must strengthen the supervision of securities and capital market activities of banks and foster the establishment of well-capitalized and well-supervised financial dealerships.14
The degree of maximum foreign exchange exposure can have strong performance implications for banks that have become accustomed to strictly fixed exchange rates under either a CBA (Estonia and Lithuania) or a rate tied to the SDR (Latvia) if the Baltic authorities decide to move to more flexible exchange rate arrangements in the future. In this context, the manner and timing of a change in the exchange rate regime, as well as the degree of banks’ foreign currency exposure, can be a substantial source of shock to individual banks.
In addition to the enforcement of prudential regulations (external governance), the Baltic banks will be required to develop strict internal control procedures and practices to govern operations and to ensure that they function in a safe and sound manner (internal governance). This will require that Baltic banks diversify their portfolios, develop further their credit evaluation skills, improve their accounting systems, and eliminate fraud. The quality of existing internal governance is not homogeneous across banks or countries. Certain banks (particularly state-controlled) need to undergo major adjustment in respect to political interference in lending, poor management, and insider lending, while other banks are functioning under strict market conditions.
An area in which there is pressing need for transparency and consistency for a smooth functioning of the banking system is the legal framework, particularly as it applies to the use of collateral and bankruptcy laws. Although bankruptcy laws are effective on paper, they are still being tested in practice.15 Transparent and stable laws and regulations on banking and investment will also facilitate the entry of foreign financial institutions into the Baltic countries, a process that can provide quickly the much needed capital and know-how to the financial sector.
Looking Ahead
After having confronted the banking crises, the Baltic countries took a number of important measures to safeguard the health of the financial system and to help prevent another crisis from happening. Restructuring activity, prudential norms, and supervisory procedures have been refined and modified according to the level of market development and of the governance of financial institutions. As more experience is gained, the Baltic countries are making inroads in financial intermediation and consolidating the development of their financial markets.
The three Baltic countries, however, are not at the same stage in the development of their financial systems. Estonia, being the first to have experienced a banking crisis, has also made the most progress in consolidating its banking system and in returning gradually to a trend of increasing financial deepening; on the other hand, the existence of the currency board arrangement has restricted the development of money markets, as has also happened in Lithuania. Latvia, which may avail itself to a number of monetary instruments, has made only modest use of them so far. At the same time, as the public regains confidence in the banking system, financial intermediation in Latvia is increasing. Lithuania is still implementing its bank-restructuring program following the banking crisis. Despite the banking crises and the different degrees of government and central bank involvement in them, the three Baltic countries have maintained a tight fiscal policy even if one includes long-term government debt issued to restructure the banking system.
The experience of Estonia has shown that resuming trends of financial deepening and increasing financial intermediation occurs slowly. The authorities can facilitate the process by adopting appropriate measures, but regaining confidence cannot be rushed. The parallel strengthening of internal and external governance of banks is likewise slow. In the meantime, the financial sectors in the Baltic countries remain fragile. A pertinent, though not necessarily speculative, question thus becomes: What could be the source of a future crisis? Even if there are no evident answers, one can identify several considerations that are relevant to the Baltic financial systems:
-
residual fragility in the banking system;
-
the possibility of rapid growth of credit against the backdrop of slow growth in the enterprise sector;
-
risks of reappearance of macroeconomic imbalances and serious external shocks; and
-
the possibility of asset bubbles (e.g., rising prices of real estate or stock shares used for collateral when borrowing to purchase additional real estate or stock shares).
As banks vie for position in claiming the profitable opportunities in the economy, competitive pressures may increase to the point that decisions are made based on expectations of rapid economic growth and underestimation of the risks involved in asset-based lending. Recent rapid rises in the Baltic stock markets may not necessarily be based on sustainable economic fundamentals. As the experience of the Nordic countries in the late 1980s and early 1990s has shown, a number of distortions and structural rigidities following rapid liberalization may magnify the impact of a negative shock to the system and put the stability of the whole financial system at risk.16 The Baltic countries may be vulnerable to such banking crises of a more traditional nature.
Before the Baltic financial systems reach a critical point of stability and maturity, they remain vulnerable to macroeconomic imbalances or exogenous shocks. Such a shock may materialize for instance in the form of a crisis in a large neighboring country, which may then motivate the massive exodus from the Baltic countries of foreign capital, in the form of foreign direct investment, foreign share participation in financial and other institutions, or foreign participation in Baltic government securities.
The paper is a follow-up to “Financial Sector Reform and Banking Crises in the Baltic Countries” by Castello Branco, Kammer, and Psalida (1996).
See Saavalainen (1995) for the Baltic countries’ early record on stabilization.
Wealth effects were small and investment demand was insensitive to the level of interest rates.
For the operation of the currency board arrangement in Estonia, see Bennett (1992) and (1994). Camard (1996) describes the process leading up to the establishment of the currency board arrangement in Lithuania and the country's early experience with it. See also Berengaut and others (1996) for a discussion of Lithuania's experiences under the currency board arrangement.
Treasury bills have not been issued in Estonia as there has been limited need for domestic financing of the budget.
Castello Branco, Kammer, and Psalida (1996) contains a detailed discussion of financial sector reform in the Baltic countries after they regained independence.
The banking crises took place in Latvia in the spring of 1995, in Lithuania in late 1995/early 1996; Estonia experienced a major crisis in 1992 and a lesser one in 1994.
See van der Mensbrugghe (1996) for more detail.
See Lindgren, Garcia, and Saal (1996) for a detailed discussion of the effects of bank soundness on the conduct of monetary policy.
Land registers, for example, did not exist.
For more detail see Knobl (1993).
In Estonia and Latvia, the value of the long-term bonds amounted to about 2½ percent of GDP; in Lithuania, where the value of bad loans transferred was after full provision for losses, the value did not exceed ½ of 1 percent of GDP.
See Lorie (1996) for more details.
The role of the European Bank for Reconstruction and Development (EBRD) and the formation of “twinning arrangements” between individual Baltic commercial banks and established commercial banks abroad have advanced this process.
See Sundararajan (1996) for a discussion of prudential supervision and financial restructuring during the transition.
A general bankruptcy law was introduced in Estonia in 1992, while bankruptcy procedures for banks became effective in Lithuania in 1994 and in Latvia in 1996.
References
Bennett, Adam, 1992, “The Operation of the Estonian Currency Board,” IMF Paper on Policy Analysis and Assessment 92/3 (Washington: International Monetary Fund).
Bennett, Adam, , 1994, “Currency Boards: Issues and Experiences,” IMF Paper on Policy Analysis and Assessment 94/18 (Washington: International Monetary Fund).
Berengaut, Julian, and others, 1996, Republic of Lithuania—Recent Economic Developments, IMF Staff Country Report No. 96/72 (Washington: International Monetary Fund).
Camard, Wayne, 1996, “Discretion with Rules? Lessons from the Currency Board Arrangement in Lithuania,” IMF Paper on Policy Analysis and Assessment 96/1 (Washington: International Monetary Fund).
Castello Branco, Marta de, Alfred Kammer, and L. Effie Psalida, 1996, “Financial Sector Reform and Banking Crises in the Baltic Countries,” IMF Working Paper 96/134 (Washington: International Monetary Fund).
Drees, Burkhard, and Ceyla Pazarbaşioğlu, 1995, “The Nordic Banking Crises: Pitfalls in Financial Liberalization?” IMF Working Paper 95/61 (Washington: International Monetary Fund).
Knobl, Adalbert, and others, 1993, Republic of Estonia, IMF Economic Review No. 4 (Washington: International Monetary Fund).
Lindgren, Carl-Johan, Gillian Garcia, and Matthew I. Saal, 1996, Bank Soundness and Macroeconomic Policy (Washington: International Monetary Fund).
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