study on the present competitive performance and future ... on the present competitive...

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Study on the Present Competitive Performance and

Future Prospects of the Banking Industry in Latvia

Andrejs Jakobsons1

William C. Schaub1

Riga

2014

1 The authors of this paper would like to thank the professionals in the banking sector who shared their knowledge during preparation of this study – Mr.Mats Kjaer, Mr.Micheal Bourke and Mr.Jānis Brazovskis. We highly appreciate the Peer Review comments provided by our colleagues at Riga Business School – Dr.Raimonds Lieksnis and Mr.Raivis Lucijanovs. We would also like to thank Mr.Rūdolfs Medvedevs for providing valuable research assistance.

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Table of Contents Background .............................................................................................................................. 43

Research and Evaluation Method ........................................................................................... 43

History Of The Banking Sector Since The Early 1990’s ............................................................ 54

Banking Sector During The Last 10 Years ................................................................................ 54

Current State And Conventional Wisdom Summary ............................................................. 109

The Two Model Banking System ......................................................................................... 1211

Does the Conventional Wisdom (2 model banking) Apply? ............................................ 1211

Is This A Two Model System or Not? (Are There Banks that Do Not Fall Under The 2

Categories?) ..................................................................................................................... 1615

What are the Distinctive Features of The Current Situation? ............................................. 1817

The Risks .......................................................................................................................... 1817

The Benefits ..................................................................................................................... 1918

The Market Opportunity and The Challenges ................................................................. 2019

Conclusions .......................................................................................................................... 2221

Recommendations - Build on Best Practices ....................................................................... 2221

Annexes: .............................................................................................................................. 2423

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Background The Latvian banking sector has been distinct from the other Ballitic countries in the number

of participants and the banking models deployed. All three Baltic countries house large

Nordic banks providing banking services to its residents. These banks provide a wide range

of consumer and corporate banking services. Latvia has in addition to the Nordic banks a

number of banks who’s funding is derived from non-resident deposits. These banks also

provide significant transaction processing services as well as private banking services to the

non-resident clients. Additionally (but not significantly in terms of market share) there are a

host of foreign and locally owned small banks (commonly referred to as Pocket banks),

who’s business consists of banking activities for the shareholders or a small number of

clients.

The two primary models provide both opportunities and risks to Latvia. This paper is a

research project that evaluates the performance of the top banks under both models over

the past ten years and attempts to identify the opportunities and risks of the two models in

the future.

Research and Evaluation Method 1. Using publicly available data, capture financial statements (balance sheet and

income statement), compiling data and anlaysis on the top 10 banks competing in

the Latvian market.

2. Review annual reports and regulatory filings available on the top 10 banks.

3. Interview participants in the banking market, regulators, economists and other

competent sources for information, view points and, attitudes. about the above

questions.

4. Obtain publicly available research materials on the banking topics identified in the

questions above on the local, European and Global banking market.

5. Survey the RBS alumni on attitudes and perceptions of the banking sector.

6. Prepare analysis on the basis of the information obtained.

7. Draw conclusions from the information obtained and analysis performed.

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History Of The Banking Sector Since The Early 1990’s

The banking sector in Latvia has gone through several stages since the early 1990’s. The

initial boom was represented by emergence of a large number of banks which either merged

or vanished as the sector went through several crises. The initial market leaders – „Banka

Baltija” disappeared after the 1995 banking crisis, while the number of banks gradually

declined. The next shock to the banking system came from abroad as the Russian financial

crisis in 1998 unfolded. Several banks were significantly affected (mostly those holding

Russian GKOs). A significant change triggered by these events was the introduction of the

deposit guarantee mechanism in 1998, which initially guaranteed deposits worth up to 500

LVL, a pioneering scheme at that time aimed at restoring the confidence of depositors after

several bank runs experienced in the past decade. By 2000 the banking sector seemed to

have emerged from the crisis once again and analysts pointed to the need to consolidate

further. Foreign ownership in the banking sector gradually became more common as foreign

investors took advantage of the privatization of Unibanka (now SEB) and took over some

domestic banks. At the same time the banking sector around the turn of the century was still

mostly making money on commissions rather that borrowing-lending spreads, commercial

lending to individuals was underdeveloped compared to developed countries. A major

source of profits of any bank in a developed country - mortgage lending – almost did not

exist due to dominance of short-term funds and lack of regulation/experience.

Banking Sector During The Last 10 Years The next pattern in the banking sector was marked by increasing maturities of lending

portfolios. Starting with Latvia’s entry into the EU in 2004 mortgage lending grew

explosively. The mManagement of the sources of funds for mortgage lending differed

substantially among banks. Some of them were fairly conservative focusing on domestic

resources; some viewed foreign deposits as an area of potential growth. However, as several

subsidiaries of the bigger foreign banks „poured” foreign money into the exploding

mortgage lending sector, the rest of the sector was left with a choice; : either to lose market

share or to attract foreign funds more aggressively through other channels. Therefore, the

global financial meltdown put the banks in various positions from a financial perspective.

Some of them had been able to maintain stable positions, while others had to turn for help

to either their owners (foreign banks and other shareholders) or the government (the case

of Parex). In any case, the macroeconomic impact on the government budget was

substantial and the international rescue package included contributions from the EU, IMF,

World Bank as well as the Nordic countries.

Looking at past developments in the Latvian banking sector it becomes clear that almost

none of the crises have had a devastating impact on the whole banking sector. Rather, some

banks usually were more exposed to the risks that existed, but were not always properly

identified. Another way to phrase it is to say that the strategic objectives of the banks

differed leading to different outcomes. Therefore, one of the key objectives of this paper is

to evaluate the past trends as well as the current strategic choices to help define the key

ways forward.

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As the banking sector has gone through one crisis after another during the past 20 years, the

perception about the features embodied by a “well-managed”, „good” and „safe„ bank has

changed substantially. At the same time the centuries-old story of risk vs. return has

remained an important part of the story. Therefore, one of the goals of this paper is to

present the options and approaches adopted by various banks to handle this issue. In order

to assess the impact of managerial decisions on the performance of the banks, we will also

attempt to evaluate the strategic choices made in the banking industry.

We looked at the banking sector during the last ten years with a goal to answer the

following questions:

a. How well has the banking sector in Latvia been managed the past 10

years?

b. How was the pre-crisis performance?

c. How did the top 10 banks fair in credit and operational management

of their institutions during the crisis from the viewpoint of

sustainability?

d. How many banks were sustainable through the crisis?

e. How many needed capital infusions from their ownership to

survive?

f. How large was the average capital infusion?

The following graphs provide an overview of the changes in concentration in the banking

sector over the past 10 years. We provide the market shares of the top 5 banks as the

smaller ones are not likely to provide a big impact on the top players in this industry. Overall,

the banking sector has become slightly more concentrated.

Chart 1. Market Shares of Top 5 banks in Latvia in 20042.

Source. Association of Commercial Banks of Latvia, authors’ calculations.

2 This and the following charts measure market shares based on assets of top banks.

20%

18%

16%

8%

6%

Parex

Hansabanka

Unibanka

Rietumu

Aizkraukles

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Chart 2. Market Shares of Top 5 banks in Latvia in 2013.

Source. Association of Commercial Banks of Latvia, authors’ calculations.

The concentration can be more formally measured by several indicators – including the

market share-based concentration ratios and the Herfindahl-Hirschmann Index3 (HHI). The

calculation of HHI for the Latvian banking sector (top 7 banks) indicates that it has increased

from 1150 in 2004 to 1276 in 2013 suggesting a slight increase in the market concentration,

which bascially confirms the observations regarding the changes in the market shares of top

banks.

Next, we compare the performance of the top banks in the industry in terms of their profits.

The most straighforward way to describe the situation is to look at the cumulative profits

during the 10 year period under consideration. The performance varies considerably among

the top surviving banks as some of them suffered significant losses during the 10 year

period. Moreover, the comparison is made more difficult due to the fact that some banks

have undergone significant structural changes (for example, state intervention was carried

out in Parex), therefore the comparisons may not be complete (also, we do not have certain

information about the Nordea Latvia branch). Nevertheless, the overall performance can be

compared for the key banks (see the following chart). The Annex of this paper also provides

a more detailed calculation of the return on assets for the top banks.

3 As the changes of the market shares of smaller banks do not considerably influence size of this indicator, we have chosen for calculations the 7 largest banks whose market share in 2004 exceeded 5%.

20%

16%14%

13%

10%

Swedbank

SEB

Aizkraukles

Nordea

Rietumu

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Chart 3. Cumulative 10-year profits of the top banks in Latvia (thsd EUR, 2004-2013).

Source. Banks’ balance sheets, authors’ calculations.

The top performers in terms of cumulative profits represent different strategic approaches.

The leader – Rietumu Banka – is known for focusing on attracting non-resident deposits,

while SEB (the second in terms of cumulative profits) represents a mostly-domestic

approach. A similar distinction in approaches can also been seen if comparing the #3

(Swedbank) and #4 (AB.LV). This provides us an indication that the differing strategic

approaches have coexisted in the Latvian banking system in the past 10 years.

However, looking at just the cumulative profits may not be sufficient as the banks have

faced completely different situations during the crisis in terms of their approaches to

financing. An extreme example in this case is the situation when the Latvian government had

to nationalize Parex Bank using a significant amount of taxpayers’ money. As losses filtered

through almost all the banks were forced to look for additional capital in order to continue

their business. Capital Infusions varied across the spectrum.

Most banks infused capital into common equity (Tier 1)

Some banks used subordinated debt (Tier 2)

To sustain Parex, government capital was used

Other than government, the source of capital was deposit of parent or owners

Table 1. A Summary of Capital Infusions in Latvian Banks in 2009.

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

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Source. Bank balance sheets, authors’ calculations.

Note: A tax on dividends was implemented January 1, 2010, so many Latvian companies

declared significant dividends for yearend 2009. This in turn required recapitalization of

companies with capital adequacy obligations. Rietumu Bank is one of these companies.

The overview of the general banking sector information leads us to the next step – defining

and exploring the approaches followed in the Latvian banking sector. We will begin with an

overview of the common perceptions about this industry and will then proceed to

summarize our findings.

LVL (000)

Parex/Citadele 139 000 Share Capital

Hansabanka/Swedbank 256 600 Share Capital

Hansabanka/Swedbank 87 851 Sub Debt

Unibanka (SEB) 65 000 Share Capital

Rietumu 77 500 Share Capital

Aizkraukles/ABLV -

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Current State And Conventional Wisdom Summary This section summarizes the popular beliefs about the way the Latvian banking sector operates. They may sometimes be outdated, but the key focus of this section is to summarize the perceptions about the way this industry operates. There are 20+ banks operating in the Latvian market (20 banks and 9 foreign bank branches). Two banking model are at play among the market leaders: Nordic Banks dealing with resident clients (Nordic Banks) Banks dealing with Non-Resident deposits (NR Banks) Nordic Banks have dominated the Latvian domestic retail and corporate banking market for over a decade. They lent aggressively and grew quickly before the financial crisis and took very large losses on their Latvian business in 2009. The largest bank in the Latvian market took such substantial losses that the Swedish government provided assistance to the banks and to Latvia to survive. The Nordic Banks have slowed their lending activities since the crisis but have grown market share by buying up portfolios and business units from banks exiting the market. Nordic Banks controlled 66.5 percent of Latvia’s lending market at the end of March 2013last year, compared with 64.8 percent at the end of 2008 and 63.6 percent at the end of 2007. The Latvian government has been critical of the lending practices of the Nordic Banks recently (after the crisis), suggesting that their lending activities should be more substantial given their market share. Additionally, with the opportunistic acquisitions of the Nordic Banks over the past few years and Citadele Bank being sold in 2014, which the Latvian government has an approximately 75% stake, government officials want to see the sale price of Citadele return a maximum amount to the Latvian State Treasury. NR Banks focus on attracting deposits from depositors who reside outside Latvia. These banks are also participating in the domestic market, but their approach has usually been less aggressive. Some facts/observations about the NR Banks are summarized in the following paragraphs. The non-resident deposits are significant for the banking sector:

o They are 60% of all deposits for NR Banks; o But less than 10% for Nordic Banks.

According to the IMF, non-resident deposits have approximately 80% to 90% CIS beneficiaries, although they come to Latvia primarily via European Economic Area (EEA) routes. The benefits for Russian and other CIS clients are:

o Geography – Riga is close to Russia (Riga is the closest EU capital to Moscow);

o Language – Russian is commonly spoken in Riga; o Efficient and competitively priced banking services in an EU (and soon

Eurozone) country.

The non-resident deposit market is growing due to the following factors:

o There is a presumed flight from Cyprus;

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o The Latvian residency permit program for subordinated debt investments; o The continuing consolidation of power by the ruling class in Russia and its

impact on the newly wealthy; o Uncertainty in geopolitics this year has resulted in a flight of capital from

Russia which is estimated at anywhere from $60 billion to $200 billion; o According to a Report from Global Financial Integrity dated March 2010, the

Global Non-Resident Foreign Deposit Market is $10 trillion with European-Offshore and Eastern European Banks controlling 18% of the market. The report also identifies the substantial growth rates of European-Offshore countries Malta and Luxembourg during the previous decade.

It is commonly presumed that non-resident deposits do not benefit the local economy. According to the IMF, funds from these deposits are not invested in Latvia; approximately 50% go into EEA MFI’s, 25% into foreign loans and 25% into foreign securities mostly issued by the U.S., Canada or EEA counties. This is contradicted by a comment in an FCMC press release on Non-Resident Deposit Banking which references a KPMG 2011 study stating an approximate benefit of 1.7% of GDP by non-resident deposits.

To mitigate the risks of non-resident deposits, according to the IMF the regulators have raised capital and liquidity requirements more on NR Banks than on Nordic banks. If true, this imposes an additional cost on one model of the Latvian banking sector.

Our observations regarding the situation in the banking sector can be summarized as follows:

The market is getting slightly more concentrated – the smallest of the top 5 banks has an estimated 10.2% market share compared to the 6.3% in 2004;

3 out of the top ten banks in Latvia have experienced dramatic changes (either completely out of the market – Krajbanka, Hipoteku, or significantly restructured – Citadele/Parex);

The top Nordic banks and top NRforeign deposit banks survived the turmoil (though

the approaches taken were different – discussed in the following sections);

Locally-funded banks could not compete and lost market position;

Cumulative profits across the top banks varied considerably.

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The Two Model Banking System

Does the Conventional Wisdom (2 model banking) Apply?

In this section we proceed in examining whether there is evidence that the previously

mentioned approaches in the banking system (e.g. the Nordic Banks and the NR Banks)

indeed exist. In order to analyze the differences we proposed to compare the leading banks

by their loan/deposit ratios. A ratio below 100% indicates that the lending of the bank is

based on the resources attracted as deposits. A ratio above 100% indicates that the bank has

obtained funds elsewhere. The following graph summarizes the patterns of loan/deposit

ratios among the top banks in Latvia. Although the dataset is not complete (for example, due

to the rescue operation of Parex), it provides a more detailed illustration of the strategies of

the key banks.

Chart 4. Loan to deposit ratios of the top ten banks in Latvia (2004-2013).

Source. Balance Sheets of the banks, authors’ calculations.

The highest levels as well as increases prior to the crisis can be mostly observed in the banks

belonging to the Nordic model. In 2004-2008 they mostly funded lending with funds

available from their respective parent banks. Two banks that clearly stand out in this

comparison are Nordea and DnB, whose loan/deposit ratios exceeded 400% in 2007-2008.

As their market shares about 10 years ago were relatively small, their strategic approach can

be characterized as aggressive in terms of penetrating the growing market. 2 other banks

with direct links to Scandinavia (Swedbank and SEB) as well as the state-owned Hipoteku

Banka also have the loans/deposit ratios above 100% indicating that they were very active in

expanding their lending portfolios. Finally, several banks have consistently kept their

loans/deposit ratios below 100% indicating that their lending portfolio is based on the funds

that they have been able to attract from depositors.

0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

300.0%

350.0%

400.0%

450.0%

500.0%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Swedbank

SEB

Rietumu

Aizkraukles

Nordea

Nord/LB

Hipoteku

Lateko

Parex

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The following chart attempts to summarize the 2 approaches taken by grouping the banks in

2 separate categories – the externally financed expansion vs. a conservative approach.

Interestingly, the banks within the 2 groups differed in terms of their market position.

Chart 5. Loan to deposit ratios by group (NR Banks vs. the Nordic Banks + Hipotēku).


Analysis of the loan/deposit ratios indicate that the Nordic banking model required

significant parent funding to sustain the lending activity. As it turned out during the

following years, the Nordic banking funding ratios were unsustainable post-crisis.

We now explore the strategic approaches taken by the top banks throughout the last 10

years. As noted in the opening section, this period was marked by Latvia’s entry into the EU

and the subsequent expansion of the mortgage market. In order to characterize the strategic

approaches we split the banks into several subsets based on their loan/deposit ratios and

their market positions. The following table provides a summary for the top 7 banks in Latvia.

Comparing to the calculations above, we have excluded Hipotēku Banka as it has remained

100% controlled by the state and therefore cannot be directly compared with the banks

operating under market conditions.

0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

300.0%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

5 banks

3 banks (Parex, Rietumu,AB)

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Table 2. A Summary of Strategic Approaches of Top Banks in Latvia.

Source. Authors’ calculations.

Broadly speaking, we can divide the key banks into 2 different types (referred to as A and B

in the table above). As we can infer from the table, the banks with the highest loan/deposit

ratios (Nordea and DnB) also were “attackers” seeking to increase their market shares by

using more aggressive practices. At the same time SEB and Swedbank were already in a fairly

comfortable position in terms of their market shares and did not choose to escalate their

loan/deposit ratios to a similar degree. We also provide a more intuitive description of the

strategic approaches taken by the banks through the following charts. The vertical axis

represents the loan/deposit ratio, while the horizontal axis represents the market share

among the top Latvian banks by assets.

Chart 6. Strategic Positions of the Top Latvian Banks in 2004.

4 A - Non-Resident Deposit Model; B – Nordic Bank Model.

Loans/Deposits Ratio

Market Position (>5%) Model4

Parex/Citadele <100% Early Mover A

Rietumu <100% Early Mover A

Hansabanka/Swedbank High Early Mover B

Unibanka/SEB High Early Mover B

Aizkraukles/AB.LV <100% Attacker A

Nordea Very High Attacker B

Nord/LB/DnB Very High Attacker B

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Chart 7. Strategic Positions of the Top Latvian Banks in 2013.


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As we can see from the charts, some banks have been able to significantly expand their

market shares through choosing the attacking approach (Nordea, DNB). The expansion of

Rietumu and ABLV has taken a different path with a conservative approach to the loans/

deposits ratio (it has remained below 100% throughout the period). Finally, Swedbank and

SEB chose to defend their market positions by following the attackers and bringing their

loan/deposit ratios above 100%. A more detail set of graphs for each specific bank is

provided in the Annex.

To summarize the conclusions, analysis of loan/deposit ratios and the strategic positions of

the banks indicate that the Nordic banking model required significant parent funding to

sustain the lending activity. When the economy collapsed it became clear that the demand-

driven Nordic banking funding ratios were unsustainable post-crisis. On the other hand, the

approach taken by the banks which chose to keep the loans/deposits ratio under 100% has

proven to be more sustainable despite some slowdown in the inflow of foreign deposits

during the crisis. It should be noted that volatility of non-resident deposits is not higher than

resident deposit volatility (FCMC, 2012).

Is This A Two Model System or Not? (Are There Banks that Do Not Fall Under

The 2 Categories?)

In addition to the top banks discussed and analyzed in the previous sections, Latvia is the

home to many Pocket Banks or EU banks for Russian elites. A more detailed description of

the status quo regarding the smaller banks in Latvia is provided in a book edited by Andris

Sprūds “The Economic Presence Of Russia And Belarus In The Baltic States: Risks And

Opportunities”, published in 2012. Several chapters of the book discuss the issues related to

cases of small Latvian banks being taken over by rich persons from Russia. These banks

typically serve the shareholders and their inner-circle and have very little to offer to the local

marketplace. The history of these banks is mixed as some have gotten into trouble with the

local regulators (FCMC) over the years. Multibanka (now SMP Bank) was accused of money

laundering in 2004, Latvijas Krajbanka was taken over by regulators and liquidated after

some inappropriate related party transactions. While they are present in the Latvian market,

and as the Convergence Report quoted above indicates, the anti-money laundering activities

of the regulator will need to be vigorous if the foreign deposit business model is to be given

the opportunity to grow. Therefore, these smaller banks may present an indirect threat to

the leading representatives of the NR banking model by sending a signal that there are

suspicious activities performed in the Latvian banking sector.

In order to assess the perceptions of the leading banks in Latvia in terms of their business

models, we conducted a survey of RBS alumni with the first question asking to select what

type of bank 13 of the top banks in Latvia are: Nordic, Non-Resident Deposit and Pocket

banks.

Chart 8. A Summary Of Survey Responses Regarding The Perceptions Of Bank Types.

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Source. Original Survey.

As the above graph indicates, there is little confusion amongst RBS alumni (all MBA’s) of the

proper description of the largest Nordic Banks, but when it comes to classifying the Non-

Resident Deposit Banks from the Pocket Banks, things get a lot more varied. There is only

partial distinction between the banks belonging to the latter 2 models.

57,1%

45,7%

37,1%

22,9%

34,3%

40,0%

45,7%

57,1%

22,9%

40,0%

51,4%

51,4%

74,3%

62,9%

42,9%

51,4%

40,0%

74,3%

0,0% 20,0% 40,0% 60,0% 80,0% 100,0% 120,0%

ABLV

Baltic International

Citadele

DNB

Latvijas Biznesa

Meridian Trade

Nordea

Norvik

Privat

Rietumu

Rigensis

SEB

SwedBank

Survey Responses (1)

Nordic ForDep Pocket

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What are the Distinctive Features of The Current Situation?

The Risks

Just as the research for this paper was being pulled together, ECFIN, the European Union’s

Directorate General on Economic and Financial Affairs issued a Country Focus report on

Latvia entitled “Assessing business practices in Latvia’s financial sector”. This report covered

four areas: a) Non-resident banking sector in Latvia, b) Latvia’s anti-money laundering

framework: tight enough? c) Corporate tax regime: supporting ambiguous tax practices? d)

Conclusion. Several sections of that report are critiqued in this research paper as it captures

the supra-national attitudes toward the Latvian non-resident banking sector and the Latvian

regulatory regime. At the same time we feel that the ECFIN report somewhat ignores the

ability of the banking sector to properly identify and assess the risks.

Box 1. The ECFIN Country Report

The ECFIN Report identified seven specific potential risks of the non-resident banking sector

paraphrased below:

Credit risk – arising from cross-boarder lending in keeping lending in the country of origin of

the deposit funding, banks create additional credit risk.

Liquity risk – the report suggests that non-resident deposits are mostly on-demand and are a

more volitile source of funding for longer term loans. Additionally as some banks in the non-

resident lending area have a concentration of large depositors making up a significant

portion of their deposits and funding, this concentration creates a liquidity risk.

Market risk – to mitigate the threat of on-demand deposits needing to be funded

immediately, banks in the non-resident deposit model use investments in mostly dept

instruments and have much higher liquidity ratios than other banks. This exposes them to

the drivers of securities valuations.

Contagion risk – the Latvian economy is at risk if a local bank fails or by creating an asset

bubble. The report mentions this risk is mitigated by non-resident banks low involvement in

the local economy.

Reputaional risk – criminal groups and corrupt officals could create fraudulent business

transactions that violate anti-money laundering laws.

USD correspondent accounts – Large US banks could consider discontinuing servicing Latvian

non-resident deposit banks.

Recapitalization risks – capital increases may be difficult as many locally owned banks have

not demonstrated owners willingness to increase capital the way Nordic Banks have.

Most of the risks mentioned above are evaluated by the FCMC and the banks have a track

record in performance. Whether they are well managed is evidenced by specific and

verifiable information which both the owners and regulators review regularly. The supra-

national aspect in this report then is really having a dialogue with the local regulator. The

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obligations of the local regulator were reiterated in the 2013 Convergence Report on Latvia

in preparation for adopting the Euro.

Interestingly the report does not see a concentration risk with so much bank funding coming

from Nordic countries in a scale similar to the large deposits from non-residents from the

CIS. The behavior of these Nordic Banks has significantly impacted credit availablity to the

Latvian market and therfore economic growth.

Our own summary of the risks of the two key models is as follows:

Key Risks of the 2 Banking Models

„Nordic” Model „NR Deposit” Model

Home Country Credit Foreign Deposit Flight/Volatility

Currency (SEK, NOK, DKK vs. local lending) Currency (Mostly USD inflow, not matched by

lending in USD)

Sovereign Sovereign

Political – devaluation vs. non-devaluation

scenarios, bailouts of the banks, international

rescue package (financing sources)

Political (domestic vs. foreign) – affects the

direction of flow

Duration issues – short-term deposits are a

tricky source of funds for lending

Product/Service Mix – domestic enterprises,

consumer loans, mortgage lending

Product/Service Mix – servicing foreign

depositors, trade finance, much less focus on

domestic retail banking

Social Size – smaller banks are typical niche banks;

bigger ones have an opportunity to compete

with the top universal banks in Latvia

From the business perspective most of the risks mentioned in the summary above are

monitored and handled by banks around the globe on a daily basis. It is worth mentioning

that some of the risks are clearly specific to the model. For example, the NR deposit banks

did not suffer a sharp collapse due to the extreme slowdown in domestic lending, while the

Nordic banks may have very small exposure to non-resident deposits. See the Annex for

Liquidity and Capital Adequacy Ratio’s for the sector.

The Benefits

There are several benefits related to a successful NR banking sector. First of all, the NR

banking approach provides a growth opportunity to the banks. The domestic pool of funds

has proven to be limited, therefore, banks looking for a more rapid expansion are interested

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to turn to a larger market where a competitive advantage exists or can be easily built.

Certainly, such approach carries risks, however, we believe that they can be managed by the

banks. An opportunity of NR banking usually arises if a country has a better-established

and/or less restrictive banking sector than other countries. For example, the British banking

system is handling a significant share of non-resident funds. Other successful examples in

the European Union include Luxembourg, Malta and Finland. Although the causality link

might be questioned, empirical evidence suggests that the countries practicing non-resident

banking have also experienced positive trends in broader indicators, for example, the

Human Development Index (HDI).

The specific benefits provided to the Latvian economy are related to generating additional

employment and wage revenues for the employees of the sector. The Central Statistical

Bureau of Latvia estimates in 2014 that more than 19 thousand employees in the financial

sector. Moreover, this sector pays the highest average salary in Latvia estimated at more

than 1700 EUR per month (gross) or more than double the average (June 2014). Additional

information on related statistics can be found in the Annex.

The Market Opportunity and The Challenges As mentioned earlier, the benefits to the CIS customer of the Latvian banking sector include:

language, geographic proximity, EU membership, low fees for labor intensive compliance

checks, double taxation treaties, low administative costs for company and tax registrations

and residence permits in exchange for investments. The CIS and especially the Russian

market for foreign deposits is growing and expected to continue to grow. This trend is in

sharp comparison with the domestic market, where the growth opportunities are very

limited. While we are not saying that all of the Latvian banks are likely to pursue the strategy

of attracting foreign deposits, it certainly seems that a number of banks have been able to

take advantage of this market opportunity.

Moreover, observations suggest that the amount of capital outflows from the CIS region is

on the rise (see Figure 4 in the Annex). However, the key challenges for making this

approach sustainable are related to several aspects:

How to make foreign deposits support the local economy in a more direct way?

Currently there is a relatively weak link between the inflow of deposits and their usage for

domestic lending. Partly this can be explained by the stagnating lending market, however, in

the longer term one should certainly think of the way how Latvia can benefit more from

being able to attract foreign deposits.

How to increase the duration of the foreign deposits?

The most direct way to address this issue would be to provide more advanced banking and

investment products that would allow the foreign depositors to access a broader range of

banking services. The other EU countries mentioned in this report (for example, UK,

Luxembourg etc.) are perceived by foreign depositors not only as a place of just parking the

money, but also as providers of high-value investment services. In the case of Latvia this still

remains a challenge as most of the attracted funds are short-term.

21

Regulatory Issues

Certainly, successful operation of the NR banking model requires that domestic banks can

fulfill the needs of foreigners by maintaining corresponding accounts etc. In the case of

Latvia this has proven to be an issue due to the fact that some small banks may be more

likely to violate the international principles. The key problem is that this kind of situation

may have an impact on all of the banks in the sector.

Improve the value proposition and positioning

Implement the one bank approach where the bank offers both private client and business

banking services. Expand the wealth management products and service offering to move

beyond being a stratup banking system for the CIS newly wealthy.

22

Conclusions Some key observations:

Several of the top ten commercial banks in Latvia in 2004 did not survive to 2013.

Rietumu had the highest cummulative income over the last ten years of the

surviving banks and all other competitors in the banking sector.

While early market entrants primarily protected market share and leveraged

prudently, late entrants drove Nordic Banking behaviors to leverage to high

multiples of deposits prior to the financial crisis. Non-Resident deposit taking banks

appear not to have followed the Nordic Bank behaviors.

There are really three banking models in Latvia despite how the European and

Latvian regulators describe it; Nordic Banks, Non-Resident Deposit Banks and

Foreign Owned Pocket Banks. Pocket banks primarily service their shareholders

while Non Resident Deposit Banks broadly market their services and compete for

clients in the global banking marketplace. There is a fundamental question; : should

there be a unique „Latvian Banking Model” that should be supported?

Business People in Latvia do not recognize the distinction between Pocket Banks and

Non-Resident Deposit Banks; at the same time the Nordic model is clearly defined

and recognized by public as well as businesses.

U.S., European and Latvian central bankers and regulators focus extensively on the

risks contained in the Non-Resident deposit banking model and are much less vocal

about the rewards to the banking sector and the economy as a whole. While some

Pocket banks have violated some regulations in the past, European central bankers

and regulators have not been critical of the Latvian regulators to properly police the

non-resident deposit model banks. This imbalance in published commentary and

public dialoque distorts the more critical discussion of Latvian competitiveness and

opportunities in its regional markets.

The Non-resident deposit banking model addresses a growing and profitable market

opportunity. Latvian banks appear to outperform their regional competitors in this

service and this represents a competitive advantage that should naturally be built

upon.

The Non-resident deposit model is primarily owned and operated by Latvian

bankers. The Latvian legal system currenly does not provide for the types of

products that would help the deposits to be invested in Latvia, nor is it understood

the banks have the skills to offer and support the products.

The Nordic Model essentially offers lending products from Nordic deposits with a

limited product suite for the Latvian market.

Recommendations - Build on Best Practices There is a need for a change in perception of risks and benefits of non-resident deposit

business (managing with facts) – public, political leadership, global regulatory. Non-resident

deposit banks should seek more influence in the public dialogue. Additionally, creating a

vehicle to collect, analyze and publish the relevant facts and data on the banking sector and

its key performance indicators would substantially assist in the above mentioned dialogue.

23

Note: There does exist in Latvia an Association of Commercial Banks of Latvia which

provides data and some other services of a trade organization to the sector. Our

recommendation focuses more on additional rigor to the broader data and information for a

regionally more competitive Latvian banking sector.

Banks can lead this by adopting best practices in the know your client and anti-money

laundering controls and procedures focusing on the spirit of the regulations (transparency)

as well as the letter of the law. Adopting the Wolfsberg Principles and follow the Best

Practices they recommend is a good start.

Other important steps to make foreign deposits stickier to more directly impact the local

economy include:

Expanding the trade finance commercial product suite to broaden

the offering to non-resident business using Latvia as an EU portal.

This can include trade finance, working capital, capital asset leasing

and mergers and acquisition services.

Expanding and improving the wealth management product and

service suite to help foreign entrepreneurs meet their banking and

investment needs.

More deeply leveraging the existing language, geographic and

cultural advantages Latvia enjoys in CIS markets in bringing EU

quality banking.

Moving Latvia from an entry level foreign deposit banking system to

a more long term banking service provider.

Keeping a clear eye on the risk risk-reward equation and challenge

the central bankers and regulators to improve their oversight and

regulatory practices to allow the industry to keep up with the

demand.

The banking industry should lobby the government to enact legislation supporting more

capital market instruments and asset management services to in a well regulated fashion to

improve the service offering to a growing market opportunity.

24

Annexes:

Top Latvian bank Annual Net Income (thousands EUR)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Total

Rietumu 17 764 36 270 42 150 49 550 29 160 11 580 4 153 15 100 28 823 55 094 289 644

SEB 24 445 57 363 58 352 108 269 41 994 -180 917 -0,382 84 134 32 290 23 748 249 678

ABLV 11 540 25 613 35 689 38 682 14 537 -31 543 -9 880 38 680 23 412 43 676 190 406

SwedBank 47 950 57 760 90 970 142 695 107 085 -499 073 -79 878 139 148 106 950 112 847 226 454

DNB Nord 9 524 8 774 14 043 10 927 12 174 -12 390 -4 006 2 304 1 539 -2 662 40 227

Parex/Citadele 2 341 4 294 6 830 8 128 -25 106 -23 316 -2 764 7 170 7 840 15 290 707

Norvik 9 514 8 469 4 612 9 783 1 451 4 567 0,375 -26 811 -24 950 19 028 5 663

Source: Latvian Commercial Bankers Association and Bank Annual Reports

Top Latvian Bank Return On Assets

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Average

SEB 1,5% 2,1% 1,62% 3,0% 1,0% -4,3% -0,01% 2,2% 1,1% 3,05% 1,1%

SwedBank 3,7% 2,6% 2,4% 3,0% 1,8% -8,7% -1,5% 3,2% 2,29% 11,03% 2,0%

DNB Nord 1,50% 1,52% 1,44% 1,61% 0,38% 5,94% 1,82% 1,20% 0,43% 0,84% 1,7%

ABLV 2,26% 3.59%. 4,01% 2,85% 1.0 %. -2,19 -9,88 1,2%, 0,82% 31,03% -166,6%

Parex/Citadele 1,27% 1,94% 2,34% 0,3% -0,10% -0,10% 0,2% 0,5% 0,41% 0,96% 0,8%

Norvik 3,51% 3,19% 1,51% 1,23% 0,20% 0,94% 0,06% -4% -2,73% 0,48% 0,4%

Rietumu 2,42% 2,69% 3,21% 2,83% 1,83% 0,83% 0,29% 0,78% 1,29% 1,97% 1,8%

GE Money Bank -5,56% -17,33% -11,4%

Nordea

Source: Latvian Commercial Bankers Association

Top Latvian Bank Capital Adequacy Ratio

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

SEB 9% 9% 11% 13% 11% 13% 16% 20% 20% 17%

SwedBank 11% 10% 10% 11% 14% 16% 18% 23% 22% 25%

DNB Nord 8% 9% 9% 13% 8% 9% 9% 13% 13% 13%

ABLV 13% 12% 13% 13% 16% 15% 12% 15% 16% 14%

Parex/Citadele 12% 11% 10% 13% 13% 12% 13%

Norvik 13% 14% 13% 14% 15% 12% 11% 11% 8% 9%

Rietumu 14% 14% 15% 14% 15% 15% 16% 17% 19% 19%

GE Money Bank 14% 17%

Nordea


Top Latvian Bank Liquidity Ratio

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

SEB 55% 57% 60% 51% 48% 55% 51% 68% 51% 44%

SwedBank 56% 68% 70% 64% 58% 75% 71% 52% 43% 41%

DNB Nord 32% 36% 45% 42% 39% 43% 45% 49% 53% 53%

ABLV 67% 51% 48% 51% 32% 58% 68% 73% 66% 61%

Norvik 54% 45% 60% 58% 55% 56% 58% 59% 40% 63%

Rietumu 64% 49% 46% 54% 42% 46% 52% 68% 62% 63%

Parex/Citadele 80% 72% 56% 57%

GE Money Bank 61% 46%

Nordea


25

Salary Information By Economic Activity 2014 (Gross EUR, 2nd quarter)

Economic Activity Montly Gross Wage

(K) Financial and insurance activities 1516

(J) Information and communication 1103

(D) Electricity, gas, steam and air conditioning supply 933

(O) Public administration and defence; compulsory social security 878

(B) Mining and quarrying 825

(M) Professional, scientific and technical activities 801

(H) Transportation and storage 773

(E) Water supply, sewerage, waste management and remediation activities 707

(Q) Human health and social work activities 697

(F) Construction 688

(A) Agriculture, Forestry and Fishing 672

(C) Manufacturing 667

(L) Real estate activities 650

(N) Administrative and support service activities 639

(R) Arts, entertainment and recreation 620

(G) Wholesale and retail trade; repair of motor vehicles and motorcycles 619

(P) Education 616

(S) Other service activities 599

(I) Accommodation and food service activities 471

Average (all sectors) 715

Source: Central Statistics Bureau of Latvia

26

Employment by Economic Activity in 2014 (2nd quarter, NACE Rev. 2.)

Employment (thsd)

TOTAL 889.1

(A) Agriculture, forestry and fishing 63.1

(C) Manufacturing 121.1

(D) Electricity, gas, steam and air conditioning supply 6.9

(E) Water supply; sewerage, waste management and remediation activities 4.9

(F) Construction 78.9

(G) Wholesale and retail trade; repair of motor vehicles and motorcycles 129.5

(H) Transportation and storage 82.3

(I) Accommodation and food service activities 35

(J) Information and communication 27.7

(K) Financial and insurance activities 19.7

(L) Real estate activities 24.2

(M) Professional, scientific and technical activities 35.8

(N) Administrative and support service activities 27.7

(O) Public administration and defence; compulsory social security 56.4

(P) Education 83.7

(Q) Human health and social work activities 50.5

(R) Arts, entertainment and recreation 19.6

(S) Other service activities 15.1


Employment Composition by Economic Sector in 2014 (% of employed, 2nd quarter)

(A) Agriculture, forestry and fishing 7.1

(C) Manufacturing 13.6

(D) Electricity, gas, steam and air conditioning supply 0.8

(E) Water supply; sewerage, waste management and remediation activities 0.5

(F) Construction 8.9

(G) Wholesale and retail trade; repair of motor vehicles and motorcycles 14.6

(H) Transportation and storage 9.3

(I) Accommodation and food service activities 3.9

(J) Information and communication 3.1

(K) Financial and insurance activities 2.2

(L) Real estate activities 2.7

(M) Professional, scientific and technical activities 4

(N) Administrative and support service activities 3.1

(O) Public administration and defence; compulsory social security 6.3

(P) Education 9.4

(Q) Human health and social work activities 5.7

(R) Arts, entertainment and recreation 2.2

(S) Other service activities 1.7


27

Evolvement of Strategic Positions of Key Banks5 in Latvia (vertical axis – loans/deposits

ratio; horizontal axis – market share among top banks)

5 Data for Citadele/Parex not available for all the years under consideration.

Human Development Index and Growth for Foreign Deposit Banking Jurisdictions

Country 1980 1990 2000 2005 2009 2010 2011 Rank

U.S.A 0,84 0,87 0,90 0,90 0,91 0,91 0,91 4

U.K. 0,74 0,78 0,83 0,86 0,86 0,86 0,86 28

Luxembourg 0,73 0,79 0,85 0,87 0,86 0,87 0,87 25

Germany 0,73 0,80 0,86 0,90 0,90 0,90 0,91 9

Netherlands 0,79 0,84 0,88 0,89 0,91 0,91 0,91 3

Ireland 0,74 0,78 0,87 0,90 0,91 0,91 0,91 7

Switzerland 0,81 0,83 0,87 0,89 0,90 0,90 0,90 11

Hong Kong 0,71 0,79 0,82 0,85 0,89 0,89 0,90 13

Latvia - 0,69 0,73 0,78 0,79 0,80 0,81 43

Russian Owned Latvian Banks

Rank Bank Name Primary Owner Primary Russian Business Russian Political Connection

17 SMP Bank (formerly Multibanka) Arkady and Boris Rotenbergs Construction, Hotels, Banking

Vladimir Putin (he and Arkady attended Judo

School together)

26 Latvijas Biznesa Banka Andrei Molchanov Construction

Vladimir Putin (he and Molchanov's step father

served in the St Peterburg City Council

19 Rigensis Bank Igor Ciplakov Banking, Freight Car Manufacture General Influence

N/A Latvijas Krajbanka Vladimir Antonov Various No Clear Influence or connection

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