Governor, Bank of Latvia
After the initial period of rapid development, commercial banks in Latvia experienced serious problems in 1995. Four major banks, including Bank Baltija, by then the largest in the Baltic States, were declared insolvent. Though the failure of major banks did not provoke a systemic crisis (chain reaction), its negative impact on public confidence in the whole banking system was considerable, especially in May to August 1995 when an increased withdrawal of deposits from banks with a fundamentally stable financial position took place.
The reasons underlying banking problems in Latvia are most probably common to transition economies.
On the one hand, the banking system in Latvia developed much ahead of the overall economic environment. Banks rapidly accumulated significant funds - total assets of all commercial banks doubled each year from 1992 to 1994 - but encountered difficulties in utilising them.
The transition to a market economy could not immediately create appropriate land, real estate and capital markets, therefore loans were often not properly secured. Moreover, the recently established private businesses, as a rule, had no credit history, and banks had to allow for a significant risk that deteriorated their credit portfolios.
On the other hand, the banks themselves were frequently pursuing inconsiderate and irresponsible credit policy. In many cases such policies were undertaken by the management of commercial banks, due to strong pressure on behalf of shareholders. That resulted in risky insider or connected lending and often led to violating the law and regulations established by the Bank of Latvia. Quite often this was aggravated by falsifying accounting and other information submitted to supervisory authorities.
In the midst of this troubled situation, the Bank of Latvia, together with the Government, commenced an extensive programme of reform with the following main objectives:
Law on Credit Institutions
The reforms comprised a new Law on Credit Institutions, strengthening requirements in respect of the use of International Accounting Standards, more frequent on-site examinations by the Bank of Latvia, international audits for all banks, and a programme of reporting accountants engaged by the Bank of Latvia. Finally, the Bank imposed restrictions on the operations of several non-compliant banks. In particular, the number of banks which were allowed to continue accepting deposits from individuals was severely reduced.
Following the initiative of the Bank of Latvia and the Government, in October 1995 the Latvian Parliament passed the 'Law On Credit Institutions' that substituted the 'Law On Banks' adopted in 1992. The new Law considerably improved the powers of the Bank of Latvia in regulating the banking system for the future.
With the new Law taking effect, the Bank of Latvia regulations were harmonised completely with EU Directives or in several cases made even tighter, and most of the regulations acquired legal force.
In December 1993 the Bank of Latvia required that the Financial Statements of large banks must be audited by international auditors according to International Auditing Standards. The new Law now requires that all banks must meet these requirements, as well as comply with International Accounting Standards. This has improved the quality of accounting in banks, especially with regard to recognising losses on loans and investments.
It is important to note that many banks have met the auditing requirement since 1993 and have continued to produce Financial Statements according to International Accounting Standards with clean external audit reports. This has been a major achievement for the banks which now form the core of the Latvian banking system.
Most banks aimed to achieve honesty and transparency in their accounting, namely in recognising losses and in reporting these in their annual Financial Statements. The average level of loss provisioning in banks is currently around 20 per cent of the original gross value of loans, which is considered to be realistic so as to reflect the level of risk in the economy during the early years of transition to a market-based economy.
The new 'Law On Credit Institutions' also contains important provisions for dealing with bankruptcy and liquidation of banks.
Organisational and structural reforms undertaken by the Bank of Latvia within its Supervision Department since June 1995 have led to a major improvement in the management procedures and the effectiveness of the supervisory function. The Bank has increased the frequency of on-site examinations by its own supervisory staff since mid-1995. The examiners have been increasingly trained to conduct either full-length examinations or, quite often, to act as 'quick response hit teams' to deal with very focused issues as they arise.
This has placed a major burden on commercial banks, but they have accepted this as an important external check on their operations. Bank of Latvia examinations are recognised to be an additional support to the local management in building a strong regime of internal control. The increased level of examinations has also helped in developing dialogue between individual banks and the Bank of Latvia and there is a strong degree of co-operation in tackling major issues.
In order to restore public confidence, especially in the aftermath of the problems in 1995, the Bank decided that it would hire teams from the international auditing companies - reporting accountants - to carry out periodic examinations in the stronger banks. The performance of these teams is professional and independent of the Bank of Latvia's own examinations. The findings are discussed with the management in each bank and corrective measures are agreed.
Again, the commercial banks have co-operated fully with this process and have used the findings very positively. The Bank of Latvia hires a different firm as reporting accountant from that which carries out the annual audit in an individual bank. This means that both the Bank of Latvia and the individual bank get a second opinion on problem areas. The scope of these specialised examinations has included internal control procedures in banks, special exposures, accuracy of reporting to the Bank of Latvia and more recently, independent reviews of the Financial Statements of banks as at 30 June 1996.
Restrictions on weaker banksIn order to protect the compliant banks, the Bank of Latvia had to place restrictions on the weak and most vulnerable banks. If banks continued to fail, then this would damage recovery and could also cause further pressure on the strong banks. The scope for further failures had to be reduced. Accordingly, many of the weak banks have had major restrictions placed on their operations since mid-1995 so as to prevent a worsening in their financial position. These restrictions cover activities such as further lending, especially to insiders, speculative investments, deposits with unsound banks and extensive investments in fixed assets. In particular, the Bank has prohibited many banks from raising new deposits from individuals. Restrictions are part of the normal sanctions used by banking regulators in developed economies and the Bank of Latvia will continue to apply restrictions when required.
The measures undertaken by the Bank of Latvia and commercial banks themselves from 1995 to 1996, have led to a considerable stabilisation of the Latvian banking sector.
The banks which have survived the problems in 1995 have learned a major lesson and the better banks have undertaken reforms of their operations themselves. Many banks have tightened their internal control procedures, and have installed better accounting and management information systems aimed at monitoring exposures. The banks have accepted that the burden of increased supervision is an important independent check on their operations and exposure.
As a result, many banks have not only survived but have also made real profits and strengthened their capital base. Most banks are now much tougher, better experienced and in a stronger financial position, and this is a good platform for the future.
There has been ongoing rationalisation within the system, with activity now largely concentrated in under 20 banks. The 15 largest banks account for just over 80 per cent of total assets of all commercial banks. These banks are continuing to strengthen their capital position both through self-generated capital and by attracting new investors from reputable sources, such as the EBRD and Swedfund.
The total level of real capital in the banking system has increased by more than 30 per cent since September 1995, and has reached LVL103.6 million. The considerable contraction of assets ended in 1995, and now total assets of commercial banks in Latvia (LVL913.5 million) have reached the pre-crisis level. The confidence of depositors has been restored, banks have become better capitalised and lending to the productive sector of the economy is increasing again.
A highly reputable German bank will soon open a subsidiary in Riga, reflecting growing international confidence in the banking system.
Summing up the developments in the Latvian banking system in the second half of 1995 and in 1996, it can be concluded that the problems of early 1995 have been successfully overcome and the banking sector is strengthening. Improvement of the legislative and regulatory frameworks, development of supervisory procedures, as well as the growing acknowledgement fof the necessity of tight rules have contributed to creating a basis for the development of an efficient and sound banking system in Latvia.
Einars Repse has been Governor of the Bank of Latvia since September 1991