Latvia: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Publication Date:
15 Sep 1999
eISBN:
9781451824483
Language:
English
Keywords:
ISCR; CR; Latvia; economy; bank; export; Russia; bank management; audited bank; Latvian bank; bank closure; banks' auditor; Nonperforming loans; Loans; Credit; foreign currency
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This Selected Issues paper and Statistical Appendix highlights that the strong economic expansion in Latvia that began in 1996 and accelerated in the following year reversed sharply in mid-1998 as a result of both external and domestic shocks. The initial expansion was fueled by accelerating domestic private and public demand, as well as growing demand for Latvia’s output in both new, mostly European Union, and the traditional Commonwealth of Independent States markets. Domestic consumer and investment demand were supported by growing real incomes and tax revenues and pent-up demand carried over from previous years.

Abstract

This Selected Issues paper and Statistical Appendix highlights that the strong economic expansion in Latvia that began in 1996 and accelerated in the following year reversed sharply in mid-1998 as a result of both external and domestic shocks. The initial expansion was fueled by accelerating domestic private and public demand, as well as growing demand for Latvia’s output in both new, mostly European Union, and the traditional Commonwealth of Independent States markets. Domestic consumer and investment demand were supported by growing real incomes and tax revenues and pent-up demand carried over from previous years.

IV. The Latvian Banking Sector in the Aftermath of the Russian Crisis

A. Introduction

41. While the Latvian economy in general has outperformed most of its BRO neighbors, in terms of both higher growth and lower inflation, and has succeeded in completing all the major first generation reforms, banking sector difficulties remain a possible obstacle in Latvia’s path towards sustainable growth and convergence with the EU economies. Latvia’s banking sector faced a major crisis in 1995 and has again met with renewed difficulties in the wake of the 1998 Russia crisis. This chapter presents an outline of recent banking sector developments, focusing on the effects of the Russian crisis and the response by the banking sector and the authorities. Section B discusses the initial transition phase, section C reviews the subsequent period of recovery and financial deepening, section D covers the recent period of distress, and section E concludes.

B. The First Phase of Transition and the 1995 Banking Crisis

42. As in other BRO economies, the Latvian banking sector emerged from the break up of the old monobank structure inherited from the soviet regime.14 In the initial phase of the transition the Bank of Latvia (BoL) was set up as a the central bank, directed and subsidized credits, and interest rate controls were phased out, and a large number of commercial banks were established—as many as 63 banks were operating in the country at the end of 1993.15 Many of the newly established banks were small and weak, and their number grew very rapidly.

43. Banking sector problems first surfaced in 1994, and the BoL revoked 15 bank licenses. The publication of audited reports in April 1995 revealed that two thirds of the audited banks reported losses for 1994, and information emerged that the largest commercial bank was having difficulties in concluding its audit. The subsequent closure of the largest bank, Baltija Bank (with 30 percent of deposits), which had suffered a run, and of two other major banks triggered a systemic banking crisis in the spring of 1995. The authorities eventually decided to liquidate Baltija Bank, and several other banks, including a few large ones, had their licenses revoked.

44. The 1995 crisis had many causes, including lack of managerial experience with the banks’ new operating environment, inadequacy of internal and external governance, and an excessive number of banks given the size of the existing market. Lack of collateral laws and poor enterprise accounting contributed to credit risk, while the liberalization of credit markets and of the capital account increased the banks’ ability to engage in risky operations. As was common in transition economies, the banking sector faced scarcity of skills in risk assessment, accounting, and administration. Widespread insider lending, capitalization of interest on unpaid debt, and fraud also contributed to the banks’ problems. Moreover, liberal licensing requirements, lax supervision, and inadequate enforcement of prudential regulations led to a proliferation of unsound banks, while the absence of an explicit deposit insurance scheme led agents to react swiftly to news regarding banks’ difficulties. The banking system also had suffered a loss of inflation related revenues after the February 1994 stabilization of the lats.

45. The authorities responded to the crisis by immediately implementing tighter prudential regulations, raising the minimum capital requirement for banks, enhancing monitoring through more frequent on-site inspections and the requirements of external audits, the creation of a two-tier banking system, in which only ‘core-banks’ that comply with stringent prudential regulations and have a relatively high capital base are allowed to take household deposits, and rapid closure of banks which failed to comply with prudential standards. Nevertheless, the aftermath of the crisis was a severe decline in the level of loans extended, a sharp contraction of monetary aggregates, and a fall in economic activity. As can be seen in Table 17, the number of banks fell by 25 percent between end-1994 and end-1995, while total bank credit shrunk by 49 percent. In fact, bank credit to the private sector only surpassed the 1994 levels by 1997, and, as a share of GDP (18 percent), only in 1998. Perhaps more importantly, the crisis shook the public’s confidence in the banking sector, a fact with which the banks and the authorities have had to cope ever since. It is also important to note that although the number of banks began to decline after the 1995 crisis, the process of consolidation has been quite slow.

Table 17.

Latvia: Structure and Performance of the Financial Sector, 1994–98

(Annual end of period data, in millions of lats, unless indicated otherwise)

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Sources: Bank of Latvia, Association of Latvian Commercial Banks.

Capital includes equity and reserves.

LVL 3.4 million (about 5 million Euro) will be the minimum capital requirement from January 2000.

Banks which did not respond to the Association of Commercial Banks Survey.

C. Financial Deepening and Exposure to Russia: 1996–1998

46. Between 1996 and mid-1998 the banking sector recovered from the 1995 crisis and expanded, with banks’ assets and deposits increasing by 125 percent and 120 percent, respectively. During the recovery Latvia’s financial sector became significantly bank dominated, following the universal banking model—Latvian banks own approximately half of the domestic non-banking financial institutions (NBFIs), At end-1997 there were 31 banks, of which 2 were state-owned and 16 were foreign-owned (Table 17). Subsidiaries of Estonian, Finnish, German, and Russian banks as well as a branch of a French bank also operated in Latvia. State-controlled banks accounted for about 8 percent of the sector’s assets, but were dominant in certain activities, notably mortgage lending and accepting small household deposits.16 Seven small credit unions operated in Latvia, but their role in the financial system was marginal. During this period the share of bank credit allocated to the agricultural sector fell whereas the financial sector’s share increased, with the share of the trade sector, the largest of all, remaining relatively stable.

47. The banking system went through a long process of consolidation and came to be dominated by two relatively large banks (Parex and Unibanka), and four medium-sized banks (Rietumu, Hansabank, Riga Komercbank, and the Savings Bank/Krajbanka), who together accounted for about 50 percent of bank assets and more than 60 percent of bank deposits (Table 18). The other banks in the system were on average quite small compared with these larger institutions. Note that the 1998 banking difficulties accelerated the concentration of bank assets and deposits in the larger banks. Nevertheless, the number or banks operating in Latvia still appears to be large relative to the size of the domestic economy, which suggests that the consolidation process is as yet incomplete.17 Table 18 also indicates that traditional banking business such as deposit taking and lending, seems to be more concentrated on the largest banks than other activities such as proprietary securities trading. In fact, according to the BoL, by end-1998 the five (ten) largest banks accounted for 63 (77) percent of total bank credit.

Table 18.

Latvia: Assets and Deposits in the Five Largest Banks, 1995–1998

(End of period, percentage of total banking sector assets and deposits, unless otherwise indicated)

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Source: Bank of Latvia.

Under Bank of Latvia intensified supervision since August 1998, operations suspended in March 1999.

48. Table 17 highlights one of the main features of the Latvian banking sector, namely its degree of internationalization. Majority foreign-owned banks were responsible for more than 50 percent of total bank assets by 1996, 72 percent by end-1997, and almost 85 percent at end-1998. It should be noted, however, that the figures for foreign ownership are somewhat inflated, since tax regulations have led Latvian entrepreneurs to use off-shore companies to control their banks — these tax regulations are no longer in place, but will benefit existing banks until 2001. It should also be noted that Sweden’s SEB acquired a large stake of Unibanka in late 1998, and the Finnish-Swedish Merita Nordbanken Group took complete control of the Latvian Investment Bank. Importantly, since 1996 foreign currency denominated assets and liabilities have on average been equivalent to about ⅔ of total banks’ assets, and non-residents have been responsible for about 40 percent of total bank deposits. This significant ‘financial openness’, which was partly responsible for the vulnerability of the Latvian banking sector to the Russian crisis, has several causes. First, the economy is extremely open to foreign trade, which has been equivalent to more than ¾ of GDP in the last three years. Second, Latvia has a large population of Russian speakers, and has had strong cultural, trade (in particular transit trade through Latvia’s ports), and financial linkages with its eastern neighbors (as well as the other Baltic republics and Scandinavia) for a long time. Third, the relative success of its transition process, including inflation stabilization, political stability, and increasing ties with the EU economies, have contributed to make the Latvian banking sector a ‘safe haven’ for investors from Russia and other CIS countries. Indeed, several Latvian banks, including some of the largest ones, have traditionally had extensive links with the Russian business community and whereas larger institutions have also focused on domestic operations, many small banks have maintained profitability by holding foreign (CIS-country) government securities.

49. Before examining the extent of systemic exposure to Russia, it is worth noting that domestic credit was also expanding rapidly in the 18 months or so before mid-1998. Bank credit to Latvian private enterprises and financial (non-bank) institutions rose from LVL 208.5 million at end-1996 to LVL 418 million at end-1997 and LVL 545 million by mid-1998. This credit boom was merely bringing Latvian credit aggregates (as a share of GDP) more in line with the ratios observed in other successful transition economies, yet extremely fast credit expansion always entails a risk that credit analysis may in some cases be inadequate, and engenders a potential for a deterioration of the quality of banks’ loan portfolio, especially in the event of an economic deceleration.

50. Along with the structural factors noted above, increased competition for domestic lending business, large interest rate differentials between Latvian and Russian instruments, and an inadequate regulatory treatment and monitoring of banks’ exposure to foreign government bonds, led to the build up of Latvian banks’ exposure to CIS assets. Table 17 shows that the average lending spread fell from 16 percent in 1995 to just about 7 percent in 1997, and remained around that level until the second half of 1998, as larger institutions developed their credit making expertise, and used their stronger capital base to price smaller banks out of the market. The improvement in Latvia’s fiscal outlook, together with lower inflation, brought about a trend of declining Latvian interest rates, with the average nominal treasury bill yield (percent per annum) falling from 28.2 percent in 1995 to 16.3 percent in 1996, 4.7 percent in 1997, and 4.9 percent in the first half of 1998, when Russian treasury bills were offering an annual return (in rubles) of about 33 percent.18 With hindsight it became clear that the currency and credit risks priced into those yield differentials were not unwarranted, and, as will be seen below, would eventually cause serious losses to Latvian banks, but at the time the yield differential proved to be the dominant attraction, as happened with many banking institutions in the West. Finally, until the onset of the crisis the BoL attributed a zero risk weight, for purposes of calculation of the capital adequacy ratio, to non-OECD government bonds denominated in domestic currency, such as Russian GKOs. Although this practice was in compliance with the letter of the 1988 Basel Capital Accord, it is still the case that national supervisory authorities need to assess country risk, particularly when domestic banks concentrate their foreign exposure into a small set of non-OECD countries. In turn, this regulatory problem stemmed from inadequacies in banks’ prudential reports, which did not allow a timely monitoring of their exposure to country risk.

51. Table 19 presents Latvia’s banking system exposure to Russian securities as of July/August and December 1998. It shows total systemic exposure, exposure of selected groups of banks according to their estimated end-1998 risk-weighted capital adequacy ratios (CAR) and amounts of Russian assets, and the situation of the Riga Komercbanka (RKB), which was Latvia’s third largest bank before the crisis and was heavily exposed to Russia.19 The systemic exposure amounted to 11 percent of total assets as of August 1998, more or less evenly distributed between claims on the Russian public sector and private sector, and also between ruble denominated and non-ruble denominated securities. Moreover, it can be seen that exposure to Russia was concentrated on a set of seven institutions that together accounted for about 75 percent of the total claims. In particular, it is clear that the RKB had a very substantial exposure to Russia, equivalent to 30 percent of its total assets and almost four times the bank’s capital. This excessive exposure made the RKB particularly vulnerable to the situation in Russia. Also, banks typically kept their Russian government bonds in trust arrangements with a limited number of local institutions, who also provided hedge against local currency risk through forward contracts, an arrangement that engendered a significant element of counterparty risk. It should be noted that the banks had also accumulated some exposure to other CIS economies, such as Ukraine (LVL 46 million) and Kazakhstan (LVL 11 million), but their subsequent difficulties appear to have been mostly related to impairment of Russian assets.

Table 19.

Latvia: Banking Sector Exposure to Russia, 1998

(In millions of lats, unless otherwise specified)

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Sources: Bank of Latvia; and Fund staff estimates.

Figure for December 1998 excludes the Riga Komercbanka.

Calculated by the Bank of Latvia based on banks’ data.

Book values.

As of end-July 1998.

52. Capital availability ultimately determines banks’ ability to withstand shocks, so it is of interest to note that by end-1997 the system seemed to be well capitalized, with an average CAR of 21 percent, well above the 10 percent regulatory minimum which, once breached, requires banks to take remedial action and entitles the BoL to place institutions under a regime of intensified supervision. In fact, as can be seen in Table 20, the number of banks with CARs below 15 percent, which could be seen as particularly vulnerable to shocks that might imply a need for recapitalization, declined from 27 percent of the total number of surveyed banks in late 1994 to just 6 percent (two banks) in late 1997, before rising again to eleven percent in the aftermath of the 1998 crisis. Note, however, that up to late 1998, the banks’ CARs were biased upwards by the zero risk weight that was attached to holdings of Russian GKOs and other domestic currency denominated non-OECD government bonds.

Table 20.

Latvia: Distribution of Capital Adequacy, 1994–98 Ratios of Latvian Banks 1/

(End-of-year)

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Source: Bank of Latvia

10 percent is the regulatory minimum CAR.

D. The Impact of the Russian Crisis

Direct impact on banking system

53. The sharp depreciation of the ruble versus the lats since August 17, 1998 has considerably reduced the lats value of the ruble denominated assets held by Latvian banks, as hedges against the risk of a ruble devaluation failed to perform.20 Also, the moratorium on payments which was declared by the Russian authorities, and the ensuing negotiations with creditors clearly indicate that only a very limited portion of the nominal value will ever be repaid on ruble-denominated government bonds such as the GKOs. Furthermore, some of the private debtors in Russia are in weak financial state and credit losses are likely. Finally, in May 1999, the Russian government defaulted on ‘MinFins’, dollar denominated obligations of the Finance Ministry, which undermined the widely held assumption that dollar denominated assets would have preferred treatment. Ultimately, payments of coupons on Russian eurobonds and MinFins would hinge on Russia’s ability to enter an SBA with the IMF and use it as a catalyst for obtaining funds from other (public and private) sources.

54. Therefore, given its overall exposure it is not surprising that the Latvian banking system was significantly affected by the Russian crisis. To date three small banks have been closed or suspended while the RKB became insolvent and will need a large recapitalization package in order to avoid closure.21 There were bank runs in August-September 1998, focused on the RKB and smaller institutions, after the extent of these banks’ exposure to Russia became known, and a milder episode in March 1999, this time focused on the largest banks, when the BoL suspended operations of the RKB in an environment of uncertainty regarding the publication of banks’ audited financial statements at the end of the month. There are signs that at least one major bank still had a worrisome level of exposure to Russia by May 1999, and would need to be recapitalized as a result of losses derived from its MinFins portfolio. Table 21 presents various leading indicators of banking sector distress, and shows that the Russian crisis had a severe and immediate impact on banks’ capital base, with the average capital adequacy ratio falling by 5 percentage points between the end of June and the end of September, 1998. Moreover, as banks lost deposits their liquidity was also significantly affected. Clearly, losses from Russia also affected banks’ earnings indicators—Latvian banks as a whole posted significant losses, for the first time since 1994 (see Table 17). The substantial increase in the loans/capital ratio indicates that depletion of the banks’ capital has made them more vulnerable to an eventual deterioration of the quality of the loan portfolio. A positive impact of the crisis was the deceleration of the previously excessive asset and credit growth rates.

Table 21.

Latvia: Banking Sector Vulnerability Indicators, 1994–99

(In percentages, unless noted otherwise, end of period)

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Sources: Bank of Latvia; IMF staff estimates.This table is based on standard leading indicators of banking system vulnerability, see Lindren, Garcia, and Saal, “Bank Soundness and Macroeconomic Policy,” IMF, 1996.

Bank of Latvia estimates for third quarter of 1998.

Investment in Latvian central government bonds/total assets.

Liquid assets include cash, claims on the BoL, claims on other banks, and government bonds and Treasury Bills.

Excluding banks with suspended operations.

Effects on banks’ loan portfolios

55. Note that the indicators in Table 21 do not suggest that there was a significant deterioration in the loan portfolio, with the ratio of nonperforming to total loans increasing just to 7 percent by year-end and declining to 6 percent by March 1999, and provisioning for loan losses rebounding rapidly after a dip in the third quarter of 1998. However four caveats are necessary. First, the nonperforming loans ratio (as well as the other indicators) for end-March 1999 excludes the RKB, so that a more realistic figure, according to the BoL, would be about 8 percent. Second, the authorities are currently revising their regulations on loan classification and loan-loss provisioning, which, once implemented, might lead to an upward revision of the nonperforming loans ratio. Third, and more importantly, since the ratio of nonperforming to total loans tends to respond with some time lag to shifts in economic activity, a further deterioration of asset quality in the next few months might be expected. Fourth, two of the largest banks have recently indicated that they had losses and/or had to realize collateral, in sizeable loans to firms with strong Russian business ties. Rough calculations conducted by the staff indicate that, in the absence of other shocks, the system could probably withstand a substantial increase in nonperforming loans, up to about 13–5 percent of the total, but it could face severe difficulties if nonperforming loans increase beyond this threshold. Note, however, that the situation may be more delicate for individual banks, particularly those which have already faced sizeable losses derived from their direct exposure to Russia.

The Bank of Latvia’s role

56. The BoL’s response to the crisis was threefold: provision of liquidity to the system, improving the prudential regime, and dealing with the specific problems faced by the RKB. Liquidity has been provided when necessary through discount (refinance) and repurchase operations. According to BoL data, the central bank’s gross claims on commercial banks increased from LVL 13 million by end-June 1998, to LVL 33 million by end-September, LVL 55 million by year-end, and LVL 68 million by end-March 1999.22 Clearly, the crisis in August-September 1998 and the March 1999 runs had a significant impact on bank liquidity which had to be remedied by the central bank. In fact, in March 1999 the BoL had to provide LVL 60 million in liquidity support to the system, LVL 40 million in refinance credits and LVL 20 million through repurchase operations. In addition, activity in the interbank market diminished considerably, with the monthly turnover falling by about 50 percent between June 1998 and early 1999. Interbank credit limits were cut and smaller banks were excluded from the market, so that the BoL had to become a market maker shifting funds from liquid to illiquid institutions. In principle, liquidity credit should be fully collateralized, but, as illustrated by the case of RKB, the collateral may become significantly impaired if the borrower institution becomes insolvent.

57. The BoL has been strengthening prudential regulations, in agreement with and with the cooperation of the IMF, according to an action plan aimed at making its regulatory practices fully compliant with the Basel Core Principles of Effective Bank Supervision (BCP) and the relevant EU directives - see Table 22 for an overview of Latvia’s regulatory regime.23 In reaction to the Russian crisis, the BoL raised the risk-weight of non-OECD (‘zone B’) domestic currency denominated government bonds from zero to 50 percent, and established strict limits to banks’ total exposure to zone B countries, whereby banks cannot invest more than 25 percent of own funds on any one zone B country, and no more than 200 percent of own funds in all zone B countries. In addition, in October 1998, a deposit insurance scheme was introduced, with coverage of all deposits up to LVL 500, rising to LVL 13000 by 2008, when it will be on a par with similar schemes in the EU. Finally, the supervisory authority has been preparing new reporting requirements aimed at strengthening its ability to monitor the emergence of risk concentrations by country and currency.24 It should be noted that the BoL refrained from imposing uniform provisioning rules for the banks’ Russian exposure, leaving the issue to be decided by the banks’ auditors and their parent offices, whereas some commercial banks would have preferred the introduction of uniform standards.

Table 22.

Latvia: Summary of Regulatory Framework for Commercial Banks

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Sources: Bank of Latvia and IMF staff.

About LVL 3.4 million as of June 1999.

58. As noted above, the RKB was put under intensified supervision, as of August 28, 1998, and had to rely on BoL (collateralized) liquidity support to maintain payments. The BoL knew that the bank was insolvent but decided to support it because of its size (see Table 18), and as yet good franchise value, and particularly because of the concern that closing a large bank in a scenario of high uncertainty regarding the exposures of other banks to Russia could lead to a systemic crisis.

The banking system’s reaction to the crisis

59. Estimates undertaken by the IMF staff under favorable, neutral, and unfavorable scenarios for losses derived from Russian exposure suggested that the impact of the crisis was indeed considerable and that capital injections equivalent to about 1.5-3 percent of GDP would be needed to bring the system average CAR to a comfortable 15 percent.25 These can be seen as lower bound estimates, since they exclude the second-round effects of the crisis through deterioration of the loan portfolio to domestic firms with large turnover with Russia, and potential losses from exposure to other CIS countries.

60. Several large institutions were indeed recapitalized between the second half of 1998 and the first quarter of 1999. Unibanka, which posted the largest losses in absolute terms in 1998 (about LVL 15 million) got large capital inflows from SEB through share purchases and conversion of subordinated debt into capital, and the Swedish group now has operational control of the bank and 44 percent of its capital. The Savings Bank, which became insolvent as a result of Russian exposure, was recapitalized through a closed share issue by its private investors which brought the government’s share of the bank’s capital down from 54 to 42 percent. Nevertheless, although this operation brought the banks’ capital to LVL 2.43 million, above the LVL 2 million absolute minimum required by the BoL, the bank still falls short of the 10 percent CAR minimum and is searching for a strategic investor. Rietumu bank was also recapitalized by its existing shareholders. The largest and most controversial recapitalization operation was that envisaged for the RKB, discussed below. In addition, the BoL has recently approved the merger between Tranzitu Banka and the Latvian Oil and Chemical Bank, which will create another middle-sized institution.

61. In spite of the successful recapitalization of various banks, the system still faces downside risks. Those derive in part from residual exposure to Russia, which, as can be seen in Table 19, still accounted for 7.5 percent of total assets at end-1998, or 64 percent of total capital. In addition, the RKB’s recapitalization/rehabilitation plan could yet unravel, which under certain circumstances (e.g. if at the same time difficulties emerge in another large institution) could pose systemic difficulties. Also, if, contrary to current expectations, the present economic deceleration becomes a protracted recession, the ratio of nonperforming loans is bound to increase, causing difficulties to banks that over-extended credit lines to the private sector. In addition, a possible impairment of Latvian banks’ claims on other CIS countries could cause problems, especially in banks that have already faced large losses from their Russian exposure. While the outlook for the economy is good with economic growth likely to recover and the current account deficit to narrow, it is useful to be aware of the possible impact on the banking sector of a more pessimistic scenario. Were the macroeconomic outlook to deteriorate and/or the current account deficit to worsen, this could bring pressures on the lats. The negative impact of any devaluation is not easy to predict, but to the extent that most of the foreign currency denominated loan portfolio of Latvian banks is, according to the Bol, with firms that have some “natural” hedge(exports, transit trade), it would require a substantial devaluation for the effect to be significant.

62. The process of banking sector consolidation has continued, but at a relatively slow pace, and has been taking place more through bank closures/voluntary exit than via mergers. This reflects uncertainty regarding banks’ financial position, a certain lack of complementary branch network and product lines, the mostly hands-off stance taken by the authorities, and the fact that hitherto the system has included a host of ‘pocket banks’ that have a small number of clients and a limited range of business activities, mostly Russia related, and are therefore unattractive targets for mergers or acquisitions.26

63. The impact of the crisis on asset and particularly credit growth raised the perspective of a credit crunch, a situation in which undercapitalized banks become too risk averse and refrain from extending loans even if there is ample liquidity and buoyant credit demand. Nevertheless, it appears that the recent deceleration in credit growth reflects a simultaneous decline in the demand for as well as the supply of lending, as the real sector impact of the Russian crisis brought about an economic slowdown. Moreover some of the largest institutions appear to be well capitalized, and would seem to be able to meet any significant increase in loan demand.27 Finally, for well capitalized institutions, particularly those which may count on support from large foreign parent groups to fund their expansion plans, liquidity should not pose a constraint to a resumption of credit growth.

The situation of the Riga Komercbanka

64. Since the summer of 1998 the difficulties at the RKB have been the focal point of the problems faced by the Latvian banking sector. In September 1998, and again in March 1999, IMF staff made rough calculations (the correctness of which were broadly confirmed by the BoL and the RKB) which indicated that the own capital of the bank was drastically eroded by the Russian crisis, to the extent that around LVL 40 million would be needed just to recapitalize the bank back to a zero-capital position, under an unfavorable, but not unlikely, scenario for the valuation of the bank’s assets. In fact, the RKB’s court appointed administrator stated that the bank’s assets at end-March had a market value of LVL 45 million, and total liabilities were assessed at LVL 89 million, which indicates a solvency gap of about LVL 44 million.

65. In practical terms, the BoL opened a credit line in order to provide the bank with day-to-day liquidity—the size of the line has been gradually increased and amounted in March 1999 to some LVL 18–20 million. Since the fall of 1998 the authorities have been taking part in multi-party negotiations on a recapitalization plan for RKB. These negotiations have involved the EBRD, the bank’s largest shareholder, other lesser shareholders, as well as a group of syndicated creditors, led by Fuji bank and Dresdner bank. In March 1999, the BoL suspended the RKB’s operations (which implies that the remaining deposits at the bank have been frozen). The bank was later formally declared insolvent and an administrator was appointed with the role of preparing the bank for rehabilitation or, if additional capital could not be found, liquidation. In May, a rehabilitation plan was approved by the BoL, and it is now expected that a revived RKB would return to normal operations by end-July.

66. The plan, which has effectively been under consideration by the various parties since the fall of 1998, involves a LVL 15.5 million capital injection from the BoL, about LVL 5.3 million from the EBRD, LVL 1 million from the Latvian government, and contributions from some of the main creditors, which would take the bank’s capital up to about LVL 6.3 million. There are, however, still some doubts about the scheme’s feasibility, in particular because the RKB has made losses on residual exposure to Russia of about LVL 4 million in 1999, and there are misgivings on whether the bank, which lost a significant share of its deposits and business relations, would be viable even after the recapitalization. The BoL indicated that given these recent additional losses, large depositors are now being approached with a proposal to convert their claims into capital with the objective of increasing the bank’s capital base before resuming operations. This recapitalization plan has some worrisome aspects. First, it includes a central bank financed subsidy to a private company, whereas the preferable approach would be for the subsidy to be directly funded by the government. A central bank subsidy typically implies an increase in money supply and is a non-transparent way of funding what is in effect a quasi-fiscal operation. Moreover, there is a clear potential for conflict of interest between the central bank’s supervisory activities and its shareholding of RKB. Second, it could be interpreted that the operation is against the spirit of the Bank of Latvia Law.28 Moreover, the BoL will offer a liquidity guarantee to the bank’s remaining clients (up to LVL 18 million), which constitutes an additional contingent liability. The total commitment of BoL funds to the rehabilitation process would, therefore, amount to almost 1 percent of GDP. The BoL’s direct involvement in the rehabilitation of RKB also raises moral hazard problems and creates a precedent that could be exploited by other banks that are facing or may eventually face difficulties. It would be important, therefore, that the BoL divest its shareholdings of the RKB as soon as market conditions permit, and the authorities should be prepared to close the bank if further investment sources cannot be found to provide it with a sound capital base or if the bank finds it difficult to attract new clients and to compete with established institutions on a level playing field.

E. Conclusion

67. The Russian crisis had a significant impact on the Latvian banking system and exposed vulnerabilities that had built up during the expansion period from 1996. The most important was excessive exposure to Russian assets, relative to the banks’ capital base, which turned out to cause large losses to domestic banks—LVL 53 million, even excluding banks with suspended operations. In turn, the roots of this excessive exposure were partly structural, but banks turned to Russian assets also partly due to regulatory failure and, somewhat paradoxically, to the success of the Latvian fiscal retrenchment and stabilization, which allowed domestic interest rates to fall sharply in 1996–1998. Another key vulnerability has been the public’s residual mistrust of the banking sector, inherited from the 1995 crisis, which has led it sometimes to overreact to news about banks’ situation. Moreover, an unfinished consolidation process implied that the system still included a significant number of small banks with excessive dependence on Russia related operations.

68. Latvian banks are likely to witness a continuation of this consolidation process in the coming months and years. The reasons for that are many, including the fact that small banks that used to rely on investing in Russia would face serious difficulties in maintaining their viability, particularly after January 2000, when the minimum capital requirement will be raised to the equivalent of €5 million—Table 17 shows that by end-1998 there were 13 banks with capital below that threshold. Also, because the losses derived from the Russian crisis have already created sizeable (relative) recapitalization requirements for some small institutions. Finally, small banks face difficulties obtaining funds in the interbank market, and often face liquidity constraints, which would limit their ability to extend credit and therefore weaken an already fragile competitive position vis-à-vis the larger banks.

69. The 1998–1999 difficulties faced by the Latvian banking sector confirm several policy lessons that have been drawn from the recent international financial crises. First, is the importance of ensuring that supervisors have adequate capability to monitor the foreign operations of domestic banks in countries with open capital accounts, which should also be fully covered by prudential regulations. Second, is that lack of transparency tends to increase rather than diminish the public’s concerns with the banking sector, especially after it is acknowledged that a major institution is facing problems while there is considerable uncertainty regarding the position of other banks. Third, the crisis showed that the provisions of the Basel Capital Accord regarding risk weights, as much as the BCP, are really minimum standards, which the individual national supervisory authorities should supplement as needed according to their perceptions of the risks faced by their respective banking sectors. Fourth, is the usefulness, for countries with pegged exchange rates, of having a foreign exchange reserve cover that is sufficiently large to accommodate a significant short-term expansion of central bank credit to commercial banks in times of distress. Moreover, the Latvian banking problems indicate that a protracted period of uncertainty regarding the situation of a major bank can contribute significantly to erode the system’s credibility, and risks endangering the position of otherwise healthy institutions.

70. Under policies that take into account the lessons from the crisis, with strengthened supervisory rules, increased foreign participation, and a healthy process of consolidation, which would bring about institutions with a larger capital base without jeopardizing the competitive environment, it is expected that the Latvian banking system will emerge stronger from its present difficulties.

APPENDIX I

I. Tax Summary

(as of June 1999)

A. Taxes on Income and Property

The Corporate Income Tax
Nature of the tax

1. The Law on the Corporate Income Tax replaced the Law on the Profit Tax effective April 1, 1995. Together with the Law on the Personal Income Tax, the law forms a unified system of taxation on all types of income in Latvia unless otherwise stipulated by acts of legislation. The tax applies both to residents and “permanent establishments” of nonresidents. Taxable income is defined as the profit or loss as determined by Law on Annual Reports of Enterprises, adjusted according to provisions of the Law. The annual depreciation amount for fixed assets is set at twice the depreciation rate under the law (rates between 5 percent and 25 percent) multiplied by the remaining balance: Tax losses can be carried forward for five years. The capitalization rules limit the amount of interest payments that can be deducted in any year, and the transfer pricing rule is applied to cross-border transactions between Latvian residents and nonresidents. Amendments to the enterprise income tax law were introduced in 1997, allowing the transfer of losses between members of an enterprise group.

Tax rates

2. The standard tax rate is 25 percent. There are withholding rates of 5–25 percent on income paid to nonresidents, with a rate of 10 percent applying to dividends and interest payments. Tax credits apply to charitable deductions, small enterprises, enterprises that use prisoner labor, income from agricultural activity, income of enterprises established by associations for the handicapped, charities and health foundations, and on tax paid in foreign countries. Small enterprises are defined as those satisfying requirements on the value of fixed assets, net turnover, or the number of employees.

Tax exemptions

3. Exempt entities include nonprofit organizations and enterprises run by associations for the handicapped, charities, and health-care foundations. Amendments to the Law on Foreign Investments introduced in 1995 abolish the tax holidays for enterprises with foreign capital.

The Personal Income Tax (PIT)
Nature of the tax

4. The personal income tax is assessed on salary, income from self-employment, property income, as well as on all other remuneration, bonuses, compensation for unused vacation time, disability assistance payments, and all other kinds of payments which have not been exempted from the income tax. Tax levied on salaries and wages is withheld at source. Taxpayers must file an annual income declaration by April 1 of the following year for taxes owed during the previous calendar year. Persons whose only source of income is labor income and from whom income tax is withheld at the source do not submit declarations. The following do not file declarations: persons under 16 years of age; persons who have received income for fewer than 183 days during the year; and persons whose income does not exceed the yearly nontaxable income.

Tax rates

5. The tax rate is 25 percent of taxable income.

Exemptions and deductions

6. The income tax is imposed on taxpayers’ income for the calendar year, except for nontaxable activities. The following are deducted from taxpayer income: (a) a nontaxable minimum (LVL 21/month effective January 1, 1997), (b) a deduction for each dependent (LVL 10.50/month effective January 1, 1997); (c) state social insurance contributions; (d) expenses for the education and health care of the taxpayer or family members; (e) donations to charity; and (f) benefits for handicapped or politically repressed persons or members of the movement of national opposition.

7. Income tax is not assessed on: agricultural income of individual farmers if it does not exceed LVL 3,000; dividends or business profits subject to the Corporate Income Tax; interest income; social benefits from the budget including unemployment compensation and social maintenance, except for temporary disability payments; scholarships; child support; alimony; worker’s compensation and long-term disability payments; insurance compensation and payments; and income from the sale of private property.

Social Insurance Contributions
Nature of the tax

8. The social insurance contribution is imposed on salaries, wages, fees, other remunerations and rewards for work.

Tax rates

9. According to the provisions of the Law, On State Social Insurance, the tax rate will be 33 percent from assessable object, starting with January 1, 2002. During the transition period, the social insurance contribution rate will be 37 percent plus an additional .09 percent for insurance against job-related accidents.

10. The proportions to be paid by an employer and an employee during this transition period will be 28.09:9, with the exception that the rate for insurance against job-related accidents can change every year.

Exemptions

11. The social insurance contribution is not assessed on: income form property, dividends, interest payments, royalties, and other income which is not related to employment.

Real Estate Tax
Nature of the tax

12. The law On Real Estate Tax replaces the law On Land Tax in 1998. During a transition period through 2000 only land will be taxed. The tax is paid directly to the respective village, town or city budget.

Tax rates

13. The real estate tax is 1 percent of the cadastral value of real estate. During the transition period, the tax rate will be 1.5 percent of land value.

Exemptions and deductions
Exemptions

14. The following are exempt from the real estate tax:

♦ local government real estate used by local government and municipal enterprises in health care and social services;

♦ real estate owned by foreign countries and used as diplomatic and consular representatives;

♦ real estate of religious organizations;

♦ real estate that is a state cultural memorial;

♦ land under newly planted forest;

♦ real estate used for sports activities.

♦ individual (private) dwelling house and privately owned apartment in an apartment building; until December 31, 2003.

15. Local governments may reduce the tax for the certain groups of taxpayers in accordance with their own judgments.

Property tax
Nature of the tax

16. The property tax is paid by physical persons and legal entities on buildings and constructions located in the Republic of Latvia.

Tax rates

17. The tax imposed depends on the value of property as follows. Property worth less than LVL 1,500 is not taxed. A minimum tax of 0.5 percent is imposed on property valued at between LVL 1,500 and LVL 25,000. A maximum rate of 4 percent is applied when the value of property exceeds LVL 2.5 million. The tax is to be paid entirely to the local governments.

18. If a taxpayer owns several items of property, the tax is computed for the total value of the property, and if a taxpayer’s property is located in different jurisdictions, the share to be paid to the local budget is proportional to the value of taxable property in each administrative or territorial unit.

Exemptions

♦ Property of individuals, if not used for business purposes.

♦ Property used or meant to be used solely for agricultural purposes.

♦ Government property used for health care, sports, education, and cultural purposes, except for cinemas, etc.

♦ Roads and roadside property as well as road service facilities, bridges, and viaducts; communication lines and stretches of land beneath them; and buildings of post offices and telephone exchanges in rural areas.

♦ Property used for environmental protection and fire safety.

♦ Property of religious organizations, national culture societies, and other public organizations approved by Parliament.

♦ Residences and property used in municipal services.

B. Taxes on Goods and Services

Value-Added Tax
Nature of the tax

19. This is a tax on value added, which uses the credit system and is levied on goods and services at the manufacturing/import, wholesale, and retail stages. The new law became effective on May 1, 1995 and replaced the old Turnover Tax Law which had been administered as a VAT.

Tax rates

20. The standard tax rate is 18 percent of taxable value of supplies of goods (including imports), services, and supplies for internal consumption. A tax rate of zero applies to exports, international transportation, or services connected with export supplies of goods.

Exemptions

21. The VAT is not charged on: educational services; school books, scientific literature, and certain Latvian language literature; public library services; scientific research; services of nursing homes, day-care centers, and kindergartens; banking, financial and insurance services; betting, lotteries, and other types of gambling; registered mass media; used real estate sales and rent payments by individuals; movies (except video), concerts, cultural, and amateur sporting events, etc.; certain approved medical services, supplies and goods; certain approved baby-foods; funerals and religious services; humanitarian aid and approved gifts; consular services; certain services provided by agricultural companies to farmers; fire-fighting services; supplies of imported goods not subject to customs duties; certain approved fixed assets; catering in penitentiaries; post offices; tuition for unemployed persons’ professional training organized by the State Employment Service; sales of land; and works of art brought in to supplement museum reserves.

Excise taxes
Nature of the tax

22. Excise taxes are payable by individuals and enterprises that produce or import the products listed below.

Tax rates
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The excise tax schedule for petrol is as follows.

♦ Unleaded petrol, its substitutes and components per liter:

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♦ Leaded petrol, its substitutes and components per liter:

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♦ Gas oil and kerosene, their substitutions and components per liter:

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♦ Fuel oil, its substitutes and components per kilogram:

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♦ Heavy fuel oil, its substitutes and components, per kilogram:

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♦ Oil gases and other gaseous hydrocarbons, except natural gas, per kilogram:

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Exemptions

23. Excise taxes are not imposed on exports, on ethyl alcohol used for medical, pharmaceutical and scientific purposes, and certain automobiles with small engines or more than seven years old. For agricultural producers the tax paid for consumed gas oil shall be refunded, calculated for up to 120 liters of gas oil per hectare of land used for agricultural purposes, per calender year.

C. Other Taxes

Tax on Natural Resources
Nature of the Tax

24. A new version of the law “Tax on Natural Resources” became effective on January 1, 1996. The tax is paid by all natural and legal persons who obtain natural resources in the territory of Latvia (or continental shelf), or pollute the environment, or sell self-produced or imported goods which are dangerous to the environment. In the latter case, a permit is required for such activities.

25. The tax on acquisition of natural resources and environmental pollution is calculated on a per unit basis for each unit of natural resources or pollutant. For imports of goods dangerous to the environment, the tax is calculated in lats and levied per unit or as a percentage of the total value at customs including an import duty if applicable. The tax on the sale of self-produced goods dangerous to the environment is calculated in lats and levied per unit or as a percentage of the selling price, net of excise tax and VAT.

26. The tax on natural resources is included in as a special budget of environmental protection and in special local government budgets of environmental protection in the territory from where the resource originates.

APPENDIX II

Table 23.

Latvia: Summary Overview of the Trade System, 1999

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Sources: Information supplied by the authorities.1/ Estimated production-weighted average tariff rates.
Table 24.

Latvia: Savings-Investment Balance, 1995–98 1/

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Sources: Latvian authorities; and Fund staff estimates.

Columns may not sum due to rounding.

External current account deficit.

From 1995 includes extrabudgetary investment in the PIP.

Includes statistical discrepancy.

Table 25.

Latvia: Agricultural Production, 1994–98

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Sources: Central Statistical Bureau; and Fund staff calculations.
Table 26.

Latvia: Energy Consumption, 1994–98

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Source: Latvian authorities.
Table 27.

Latvia: Labor Market Indicators, December 1995-March 1999

(In thousands)

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Source: Central Statistical Bureau.

End of the period.

Persons unemployed for six months or more.

Data for 1994 are end-period data; beginning 1995-average number of recipients.

Defined as the full time work equivalent of working time that is reported lost due to enforced reduced hours and unpaid leave.

Until December 1994—only in the mentioned month, beginning with 1995—in the period from the beginning of the year.

Average quarterly. The number of emplyed persons has been revised on the basis of data about the economically active popuplation, employed persons as well as on the number of jobseekers obtained from the Labour Force Survey.

Data revised.

Table 28.

Latvia: Average Wages, 1994–98

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Source: Latvian authorities.

The state sector includes enterprises where central or local government capital participation in the company capital is equal to or above 50 percent.

Table 29.

Latvia: Consumer Price Inflation

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Sources: Data provided by the Latvian authorities; and Fund staff estimates.
Table 30.

Latvia: Summary of General Government Operations, 1994–98

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Sources: Latvian authorities and Fund staff estimates.
Table 31.

Latvia: Central Government and Social Security, 1994–98

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Sources: Latvian authorities and Fund staff estimates.