I. Financial Sector Issues
1. Banks dominate the financial sector. They hold the majority of assets in the financial sector, including the nonbank sector. The nonbank sector is still small, albeit growing rapidly. This growth of the nonbank financial companies, however, is partly an extension of rapid bank credit growth. Staff’s analysis of financial sector vulnerabilities therefore focuses on banks.
2. Despite rapid credit growth, banks can withstand nonsystemic shocks. Rapid credit growth is always a source of concern since poor credit decisions are not revealed until it is too late. Nevertheless, there are four mitigating factors. First, bank’s financial indicators look sound; however, such indicators are not reliable because they may be backward looking. Second, bank-by-bank and aggregate stress tests indicate that nonsystemic shocks can be weathered both on average and by the systemically important banks. Third, the systemically important banks are all owned by reputable parent banks with A+ Standard and Poor’s credit ratings. Fourth, bank supervisors have taken steps to strengthen banks’ capital.
3. The mitigating factors notwithstanding, proactive supervision will have to keep pace with new challenges. First, banking sector stress tests generally do not include scenarios of a broader macroeconomic slowdown. Hence, modeling efforts have to be expanded. Second, as the nonbank sector becomes larger and more sophisticated, the possibilities of unregulated credit risk will increase and will have to be more closely monitored. Close coordination of bank and nonbank supervision will become more important than at present. Finally, Basel II, to be introduced on January 1, 2008, raises new challenges, including ensuring greater modeling expertise by the supervisory authorities.
B. Structure of Financial Sector
4. Three foreign-owned banks, dominate the financial system. The bank asset-to-GDP ratio is currently about 64 percent. Recent estimates suggest that the nonbank asset-to-GDP ratio is 27 percent. This implies that banks account for 70 percent of the financial system (Table I.1). The banking system, in turn, consists of nine banks—of which six are subsidiaries of foreign banks—and two branches of foreign banks. The three largest banks (SEB Vilniaus Bankas, Hansabankas, and DnB NORD Bankas) not only controlled 69 percent of banking sector assets at end-2006 but also a substantial share in some nonbank market segments (text table right and Table I.2). The heavy concentration was reinforced in 2006 as these three banks generated three-fourths of the credit growth during the year. The three are, however, all owned by foreign banks with A+ Standard and Poor’s credit ratings (text table below). The parent banks have an incentive to enforce credit management techniques in their Lithuanian subsidiaries to match their headquarter risk management approaches.
|Second-pillar pension funds||94|
|Third pillar-pension funds||93|
|Collective investment undertakings||51|
|Bank||Parent bank||Parent bank’s|
credit rating 1/
|SEB Vilniaus Bankas||SEB (Skandinaviska Enskilda Banken AB) (Sweden)||A+||32.4|
|Hansabankas||Hansapank (Estonia); ultimate owner: Swedbank AB (Sweden)||A+||23.9|
|DnB NORD Bankas||Bank DnB NORD A/S (Denmark); ultimate owner: DNB NORD Bank ASA (Norway)||A+||12.7|
5. The nonbank financial sector has benefited from structural reforms. First, the pension reform in July 2003 introduced second- and third-pillar pension funds. Participants could start to sign up on a voluntary basis in 2003, and first assets were accumulated in 2004. Second, compulsory motor third-party liability insurance was introduced on May 1, 2004. Third, collective investment undertakings (CIUs) were introduced in November 2004. In turn, they have helped develop the stock market because they invest a substantial portfolio share in Lithuania (Table I.3). Other spillover effects include the growth of mortgage insurance along with the rapid growth of mortgage loans.
6. The nonbank sector has grown rapidly since 2003. Leasing has, until recently, been the largest segment of the nonbank sector, growing at 30 percent a year. Second-pillar pension funds have shown the highest rate of growth and their assets are currently of the same order of magnitude as those of leasing companies (text figure). Total assets of funds, leasing companies, insurance, stock brokerage, and asset-management industries rose to 23 percent of GDP in the third quarter of 2006 from 13¼ percent of GDP in 2003 (Table I.1).
Development of Nonbank Sector, 2003–06
Source: Statistics Lithuania; Baltic News Service; and IMF staff calculations.
7. Capital markets are still small and illiquid by regional standards. Liquidity of capital markets has increased since 2003, but is still lower than in Estonia (text figure). Two factors largely account for low liquidity in Lithuania. First, several listed companies are held by only a small number of shareholders and are, thus, not traded frequently. Second, few new companies have entered the market, whereas, in Estonia, it is these new companies that have generated significant turnover.1
Baltics: Liquidity of Securities Markets, 2002-05
Sources: Word Bank World Development Indicators; Vilnius Stock Exchange; and IMF staff calculations.
1/ In 2005, corrected for trades related to Hansapank’s takeover bid.
C. Banking System Vulnerabilities and Mitigating Factors
8. Of concern, rapid credit growth has been channeled into consumer and real estate lending, and is increasingly financed by foreign borrowing. Private sector credit growth in 2006 was 51.4 percent year on year. Although corporate lending that was not related to real estate transactions, was a substantial contributor to credit growth, (accounting for 18¼ percentage points or about one-third of the credit growth), real estate and consumer lending accounted for the rest (text figure below). Net foreign borrowing financed on average one-half of credit growth in 2006, compared with one-tenth in 2005. Parent banks were the source of some of this foreign borrowing, but banks increasingly accessed other sources: whereas, throughout 2005, foreign borrowing from parent banks had accounted for practically all of banks’ year-on-year growth in net foreign liabilities, by end-September 2006 parent banks accounted for only three-fourths of that year-on-year growth.
Destination and Financing of Private Sector Credit Growth
Sources: Bank of Lithuania; and IMF staff estimates.
9. The financial soundness indicators (FSIs) suggest a sound banking system, but may be lagging measure of financial system health. The FSIs look sound by regional standards (text table). The share of nonperforming loans (NPLs) deteriorated somewhat in mid-2006 to 1 percent of loans, but the deterioration was nonsystemic innature2. During the first half of 2006, banks’ capital adequacy ratio worsened. At the urging of the Bank of Lithuania’s Bank Supervision Department, however, steps were taken to raise the capital adequacy ratio to 10.8 percent of risk-weighted assets at end-2006. The FSIs suggest—and stress tests confirm—that the key risk to the banking system is credit risk. Therefore, the following descriptions focus on stress testing credit risk.
10. Aggregate stress tests indicate that the banking system could withstand a significant negative credit shock. Despite the recent increase in capital, the capacity of banks to bear loan losses has declined since end-2004 (text figure below). To stay above their minimum capital adequacy ratio of 8 percent of risk-weighted assets, at end-2006, banks could have increased their specific provisions by 3.2 times, down from 4.9 times at end-2004; or they could have increased loans by 35.8 percent of total loans, compared with 60 percent of total loans at end-2004. Nevertheless, an aggregate stress test suggests that, at end-2006, the banking system could have withstood a three- to fivefold increase in NPLs, before falling below the regulatory minimum capital adequacy ratio. This stress test assumes that banks provision against the increased NPLs, and that this amount is fully subtracted both from regulatory capital and from risk-weighted assets. The post-shock capital adequacy ratio was calculated for the three alternative provisioning rates of 80, 90, and 100 percent. The actual provisioning rate in January 2007 was about 97 percent, but, historically, higher provisioning rates were also seen.3 To put the results of the aggregate stress test into context, staff calculations indicate that a 20 percent decline in house prices could cause a 2½-fold increase in NPLs (Appendix I).
Capacity for Additional Asset Risk and for Loss Absorption, 2002-06
Note: Increase in 2004: Q4 due to lowering of regulatory minimum capital ratio from 10 percent to 8 percent.
Source: IMF staff calculations.
11. The results of the aggregate stress tests are confirmed in bottom-up credit risk stress tests for the six largest banks. In the context of the Article IV discussion, the Bank of Lithuania (BOL) requested the six largest banks to conduct stress tests based on a common set of scenarios. The stress tests show that NPLs in the real estate-related lending portfolio could increase by several multiples before banks fall below the minimum capital adequacy ratio. This is a reflection of the current negligible level of NPLs in the real estate-related lending portfolio. Of course, it is difficult to judge if NPLs could, in fact, increase by significant amounts. In this regard, there are offsetting considerations. On the one hand, the stress tests do not incorporate the effects of a macroeconomic slowdown. On the other hand, they also do not incorporate some mitigating factors, such as (i) the diversification of the corporate real estate sector; (ii) the predominance of first-household mortgages and the international experience of low default rates for such mortgages; (iii) the low household indebtedness in Lithuania; and (iv) the wide profit margins on corporate real estate lending (needed to compensate for risk). The stress tests further show that NPLs in the export-related lending portfolio could increase substantially from their current levels before banks fail to meet the minimum capital requirement.4 Finally, a sudden contraction in parent-bank lending to subsidiaries would require the sale of other liquid assets, probably at a loss, thereby reducing the capital adequacy ratio. The materialization of this risk is considered unlikely unless parent banks face a crisis at home.
12. The fact that systemically important banks are owned by reputable foreign banks with A+ Standard and Poor’s credit ratings further contributes to the resilience of the banking sector. The Lithuanian subsidiaries have profited from knowledge and technology transfers, in particular as foreign parent banks enforce credit management techniques in their subsidiaries similar to those in their home institutions. Furthermore, the Lithuanian subsidiaries have standing credit lines with their parent banks that guarantee rapid access to liquidity.
13. Bank supervision has been proactive with respect to credit risk. The BOL has taken action to encourage more prudent credit risk management:
In 2005, the BOL urged domestic banks and foreign bank branches operating in Lithuania to follow conservative principles in establishing the value of property and to apply reasonable judgment in evaluating the level of undertaken risks, taking into account potentially unfavorable market developments. The BOL instructed the banks to make sufficient general provisions on potential risk-related losses. Banks responded to these requirements when allocating profits in 2005: they retained 96 percent of profits, the largest part of which was later transformed into share capital.
In mid-2006, the BOL limited the use of current-year profits for the purpose of defining regulatory capital.
In 2006, the BOL urged banks to manage risks conservatively, strengthen their capital base, and prudently plan operations in the coming year. As a result, several banks undertook capital injections in late 2006.
In 2006, the Board of the BOL adopted a resolution placing limits on the type of housing loans eligible for less than 100 percent asset risk.5
14. Finally, the BOL has concluded cooperation agreements with the home supervisors of foreign parent banks and continuously refines this interaction. These agreements deal, inter alia, with issues of information exchange (Table I.4). In preparation for the introduction of the Basel II Accord, the exchange of information has intensified. The application procedure for the internal-risk-based (IRB) approach and coordinated recognition of external rating agencies (for the standard approach) have begun, as have joint inspections of cross-border bank groups, including their subsidiaries in Lithuania. Crisis-management mechanisms are covered by an EU-wide MOU on the Management of Financial Crises in Banks Operating on a Cross-Border Basis as well as by an additional MOU, signed on December 18, 2006, by the Swedish Riksbank, the Bank of Lithuania, the Bank of Estonia, and the Bank of Latvia.6
D. Challenges Ahead
15. The current stress tests do not include a scenario with an economywide recession that could describe broader systemic risks to the banking system. There are substantial modeling difficulties with linking macroeconomic scenarios to NPLs. Currently, the BOL only discusses the risks from such a scenario qualitatively. It perceives a slowdown in the real estate market and a liquidity shortage in parent banks, in combination with difficulties in Nordic financial markets, as the most severe risks. The FSAP update later this year will discuss some of the modeling issues that need to be addressed to develop a more quantitative assessment of the impact of such scenarios.
16. With the growing nonbank sector, it will become even more important to strengthen cooperation between the supervisory agencies for banks and nonbanks. The BOL conducts consolidated supervision, which covers most of the nonbank sector. Cooperation with other nonbank supervisors is covered by a memorandum of understanding (MOU). However, the interlinkages between banks and nonbanks are increasing due to cross-ownership and a rapidly growing nonbank sector. Furthermore, there are loopholes in the supervisory structure. For example, leasing companies that are not owned by banks are not supervised. In order to strengthen the cooperation among the three supervisory bodies, a working group was charged in 2005 with establishing a combined financial stability and crisis management system in Lithuania.7 This group has recommended that, to introduce an effective system of cooperation and exchange of information, the Ministry of Finance, the Bank of Lithuania, the Insurance Supervisory Commission, and the Securities Commission should sign a MOU on financial stability and crisis management. This MOU will cover such issues as the horizontal and vertical exchange of information and the coordination of information disclosure to the public. This is a step in the right direction.
|Supervisory Authority||Supervised Institutions|
|Bank of Lithuania||Banks|
|Insurance Supervisory Commission||Insurance companies, insurance brokers|
|Securities Commission||Asset management companies, stock brokers|
17. Basel II, which will be introduced on January 1, 2008, will bring new challenges. The new capital accord will run in a test phase during the fourth quarter of 2007 and will be the official standard from January 2008 onward. The application period for use of credit risk models under the IRB approach started in the first quarter of 2007. With the full introduction of the Basel II Accord in 2008, the lower risk weight on mortgage loans under pillar 1 will likely decrease capital requirements. Furthermore, whereas most banks will implement the standard approach, the three largest banks will implement the IRB approach in accordance with their parent banks. It remains to be seen whether their nonbank subsidiaries will also opt for the IRB approach. Supervising the IRB approach demands new skills from the supervisory authorities. Finally, under pillar 3, the BOL requires an extensive list of bank-by-bank information disclosure, which encompasses most of the FSIs currently reported on an aggregate basis only.
Q3 2006) 2/
|Other financial||Leasing enterprises 3/||2,976||4,399||5,930||7480||26.1|
|intermediation||Other credit-granting enterprises||17||8||9||…||…|
|Collective investment undertaking||161||398||602||51.3|
|Other financial intermediation enterprises||594||1,124||1,781||…||…|
|Insurance and||Life insurance||401||595||838||1,059||26.4|
|pension funding||Nonlife insurance||1,010||1,090||1,233||1,409||14.3|
|Second-pillar pension funds 4/||0||127||410||7,414||1,708.30|
|Third-pillar pension funds 5/||0||11||37||47||27|
|Auxiliary financial||Stock brokerage enterprises||…||79||111||143||28.8|
|Other enterprises with activity auxiliary to insurance agents||15||15||5||…||…|
|Other enterprises with activity auxiliary to finan. intermediation||603||701||846||…||…|
|DnB NORD Bankas||Bank DnB NORD A/S (Denmark); ultimate owner: DNB NOR Bank ASA (Norway)||Subsidiary||7,510,001|
|SEB Vilniaus Bankas||Skandinaviska Enskilda Banken AB (Sweden)||Subsidiary||19,063,040|
|Hansabankas||Hansapank (Estonia); ultimate owner: Swedbank AB (Sweden)||Subsidiary||14,070,226|
|Parex Bankas||Parex banka (Latvia)||Subsidiary||759,565|
|Sampo Bankas||Sampo Pankki Oyj (Finland)||Subsidiary||4,233,110|
|Snoras Bankas||Conversgroup (Luxembourg) Holding Company (49.9 percent); ultimate owner: ZAO Conversbank (Russia)||Subsidiary||4,212,355|
|UAB Medicinos Bankas||Domestic||426,605|
|Bayerische Hypo- und Vereinsbank AG||Bayerische Hypo- und Vereinsbank AG (Germany); ultimate owner: Unicredito Italiano Spa (Italy)||Branch||1,010,356|
|Nordea Bank Finland Plc Lietuvos skyrius||Nordea Bank Finland Abp (Finland); ultimate owner: Nordea Bank AB (Sweden)||Branch||3,248,080|
|Number of funds||11 management companies (29 CIUs, of which 17 equity funds, 8 fixed income funds, and 6 funds of funds).||7 investment management companies (21 funds) and 3 life insurance companies (9 funds).||6 funds|
|Total assets under management||LTL 832 million|
EUR 237.7 million
|LTL 905 million|
EUR 220 million
|LTL 74 million|
EUR 21.1 million
|Portfolio||Mostly shares (63.87 percent); Lithuania (27 percent), EU (33.4 percent), non-EU (39.6 percent).||Mostly government bonds (43.46 percent) and CIU units (3.75 percent); Lithuania (16 percent), EU (82 percent), non-EU (2 percent).||Mostly CIU units (50.22 percent) and government bonds (15.06 percent); Lithuania (41 percent), EU (57 percent), non-EU (2 percent).|
|Participants||19,735||785,000 (55 percent of working population).||20,154 (1.3 percent of working population). 1/|
|Supervisory authority||Securities Commission||Securities Commission (investment management companies, LTL 770 million, 610,000 participants) and Insurance Supervisory Commission (life insurance companies, LTL 135 million, 170,000 participants).||Securities Commission|
|Bank of Lithuania, Insurance Supervisory Commission, and Securities Commission|
|2000||MOU on cooperation in the area of supervision of credit and financial institutions.|
|Bank of Lithuania|
|1997||MOU between the Bank of Lithuania and the Central Bank of Russian Federation.|
|2000||MOU on co-operation in the area of supervision of credit institutions.|
|MOU between Bank of Lithuania and Latvijas Banka on co-operation in the area of credit institutions’ supervision.|
|MOU on co-operation in Banking Supervision.|
|2001||MOU between the Bank of Estonia and the Bank of Lithuania on co-operation in the area of credit institutions’ supervision.|
|MOU between Lietuvos Bankas and the Bundesaufsichtsamt fur das Kreditwesen on co-operation in the area of credit institutions’ supervision.|
|2002||MOU between the Bank of Lithuania and the National Bank of the Republic of Belarus.|
|MOU on the amendment to the MoU on co-operation in Banking Supervision concluded on the day of December 7, 2000 in Vilnius.|
|2004||MOU on co-operation in the area of credit institutions’ supervision.|
|2005||MOU between the Central Bank of Russian Federation (Bank of Russia) and the Bank of Lithuania in the field of banking supervision.|
|2006||MOU between Rahoitustarkastus in Finland and Lietuvos Bankas in Lithuania regarding cooperation in the supervision of Nordea Bank Finland Plc’s branch in Lithuania.|
|MOU between Financial Supervision Authority of Finland (Rahoitustarkastus) and the Bank of Lithuania regarding cooperation in the supervision of the Sampo Bank Group.|
|MOU between the Bank of Lithuania and the National Bank of Ukraine.|
|MOU between the Bank of Lithuania and De Nederlandsche Bank concerning their cooperation and exchange of information in the field of prudential supervision of banks and their cross-border establishments.|
|MOU between the central banks of Estonia, Latvia, Lithuania and Sweden on financial crisis management at cross-border subsidiaries and branches.|
|1999||Agreement between the Securities Inspectorate of the Republic of Estonia, the Lithuanian Securities Commission and the Securities Market Commission of the Republic of Latvia.|
|2000||MOU on the Exchange of Information between the Lithuanian Securities Commission and Securities and Exchange Commission of France.|
|2001||Agreement on Technical Co-operation between Superintendency for Pension Funds of the Republic of Poland and the Securities Commission of the Republic of Lithuania.|
|2002||MOU between the Lithuanian Securities Commission and the Central Bank of Cyprus on Mutual Cooperation and Exchange of Information.|
|MOU between the Polish Securities and Exchange Commission and the Lithuanian Securities Commission on Cooperation and Exchange of Information.|
|2003||IOSCO Multilateral MOU Concerning Consultation and Cooperation and the Exchange of Information.|
|MOU between the Lithuanian Securities Commission and the Danish Financial Supervisory Authority.|
|2004||Multilateral MOU on the Exchange of Information and Surveillance of Securities Activities.|
|MOU between the Lithuanian Securities Commission and the Romanian National Securities Commission.|
|2006||Participation Arrangement on the Regulatory Interpretation and Enforcement of Financial Reporting Standards between the Lithuanian Securities Commission and the International Organization of Securities Commissions.|
A back-of-the envelope calculation suggests that a 20 percent correction in the housing market may raise banks’ NPL ratio by 1–1½ percent of loans from the current ratio of 1.0 percent. A 20 percent drop would approximately reverse the annual average compound house price increase in Vilnius for 2000–06. It would result in an increase in the ratio of NPLs to loans by approximately one percent of loans due to a direct effect (working through a contraction in the construction and real estate sector), and by 0.10–0.51 percent of loans due to an indirect wealth effect working through household spending (text table).
|Indirect wealth effect (effect on household consumption)|
|In millions of litai||−699.49||−139.9|
|As a percentage of 2006 GDP||−0.88||−0.18|
|Impact on ratio of NPLs to loans|
|Impact of direct effect||1.07||1.07|
|Impact of indirect wealth effect||0.51||0.1|
|Total impact on ratio of NPLs to loans||1.58||1.17|
The direct effect assumes historical averages for the transmission of the house price increase to NPLs. During 2001–05, on average, a 10 percent annual house price increase was associated with 4.5 percent growth in the nominal value added of the real estate sector. In turn, a 10 percent increase in overall nominal value added was, on average during 2002–05, associated with a 5.8 percentage point decrease in the overall NPL ratio. We assume that this elasticity also applies to the real estate NPL ratio, since a breakdown of NPL is not available. Assuming that the share of real estate loans in total NPL is 20.2 percent—the same share as in total loans—this implies that the overall NPL ratio will rise by 1.07 percent.8
The indirect wealth effect assumes historical averages and cross-country experiences. Housing wealth is estimated as the product of the stock of housing per capita in 2004 (24.97 square meters), the population in 2005 (3,585,906), and average house prices in Lithuania in 2006 (LTL 1953 per square meter). A 20 percent housing price decline would reduce housing wealth by 20 percent. Cross-country evidence for non-Anglo Saxon countries suggests that a LTL 100 change in housing wealth should reduce consumer spending by LTL 2. The BOL estimates an effect of only LTL 0.004 because only a low share of consumer loans is secured by real estate. Given this range for the elasticity, a 20 percent housing price decline would thus reduce consumption by LTL 139.9–699.5 million, or 0.18–0.88 percent of GDP. Given the average elasticity of the NPL ratio to nominal GDP growth in 2002–05 (0.58; see above), this implies an increase in the NPL ratio of 0.10–0.51 percentage points.
According to the Vilnius Stock Exchange, the most effective measures to enhance the overall market liquidity are (i) initial public offerings and the attraction of new companies into the market, and (ii) secondary public offerings, where a strategic investor sells publicly part of its equity, thus increasing the freefloat.
The deterioration mainly reflected bankruptcy proceedings at a single electronics manufacturer.
The FSIs suggest that the ratio of provisions to impaired loans has at times been above 100 percent. However, as banks use their own judgment to provision against a wider pool of NPLs, the actual provisioning rate is typically lower.
The stress tests showed that banks could withstand shocks to interest rate and foreign exchange risks. Neither a steepening nor an inversion of the yield curve would have major repercussions on banks’ loss-absorption capacities. Furthermore, a 15 percent depreciation or appreciation of the U.S. dollar would have only minor effects on banks.
For example, only those loans that do not exceed 70 percent of the market value of the mortgaged property may carry the lower risk weights allowable to housing loans.
In the EU-wide MOU, all EU central banks, ministries of finance, and supervisory institutions concluded trilateral cooperation agreements on crisis management.
The working group was set up under the initiative of the Commission for the Regulation of Activities and Coordination of Supervision of Financial Institutions and Insurance Companies. It comprises representatives of the following institutions: the Ministry of Finance, the Bank of Lithuania, the Insurance Supervisory Commission, the Securities Commission, the Financial Crime Investigation Service under the Ministry of the Interior, the Deposit and Investment Insurance, and the Crisis Management Center under the Ministry of National Defense. Its aim is to draft procedures for cooperation, exchange of information, coordination of actions, and decision-making in financial stability and crisis management, draft the National Plan for Arrangements in Contingencies, and draft the Procedure for Stress Testing, as well as draft legal acts and other measures necessary to enhance the financial stability and crisis management system.
1.07=20 percent house price increase *0.45 elasticity of real estate value added to percent change in housing prices *0.58 elasticity of real estate NPL to percent change in real estate value added *0.202 share of real estate NPL (incl. construction) in total NPL.