IMF published its staff report and selected issues report in context of the 2019 Article IV consultation with Latvia. The IMF Directors highlighted that the financial system needs to become more supportive of the domestic economy. Efforts to revive credit growth should focus on completing the ongoing insolvency reforms to lower lending costs. Careful oversight of risk-reduction for banks and business model reorientation toward the real economy should encourage consolidation and ease lending constraints. New preemptive macro-prudential measures should support sound lending standards and mitigate medium-term financial sector vulnerabilities amid persistently rising property prices.
The staff report noted that the banking system is solvent, profitable, and liquid, but credit growth remains elusive. Capital levels of about 40% higher than the euro area average suggest ample capital buffers. With average liquidity coverage four times the regulatory minimum, the banking system has the highest share of excess reserves (about 20% of total assets) in the euro area. While profitability has slightly decreased since 2016, it remains solid, as slow credit growth has helped stabilize net interest margins amid lower lending rates. Asset quality continues to improve, with nonperforming loans (NPLs) of retail and nonfinancial corporation (NFC) lending further declining to almost 3%—far below the euro area average. The risk-reduction and deleveraging of the banks servicing foreign clients (BSFC) sector further dampened already weak credit growth. Total household credit declined by 5.4% and credit to non-financial corporations declined by 5.8%.
Legal gaps and evolving supervisory capacity continue to amplify challenges from the fragmented resolution regime for euro area banks that are deemed less significant or whose failure is not expected to have a destabilizing effect on the financial system and the wider economy. Refocusing BSFCs’ business models and aligning them with the financing needs of the real economy would help restore confidence in the banking sector. The Financial and Capital Market Commission (FCMC) has assessed these business models under the Supervisory Review and Evaluation Process (SREP)—considering future business strategies and risk impact—but their sustainability is yet to be proven. Monitoring closely BSFCs with a focus on continued risk-reduction, prudent lending practices, and enhanced operational efficiency would ensure that their new activities are carried out in line with the appropriate risk-mitigation strategies and do not increase financial stability risks or create contingent liabilities for the government. A risk-based business model review involving opaque entities could use a harmonized SREP methodology for less significant institutions, to limit supervisory capture.
The selected issues report examines financial integrity and stability aspects of recent developments in the Latvian banking sector through a combination of qualitative and quantitative analyses. Monitoring the risk-reduction process of the banking system in Latvia requires effective prudential and conduct regulation to support the re-orientation of BSFCs and mitigate the remaining and emerging risks associated with their new business models and changing liquidity risk profiles. A review of the evolving anti-money laundering/counter-terrorism financing (AML/CFT) regime generates important findings about the risk context and the scope for potential risk mitigation. The prudential impact is reflected in a liquidity stress test of banks’ capacity to control and mitigate vulnerabilities from large cash outflows and restricted market access under an adverse AML/CFT scenario.
Insights from the stress test help inform supervisory expectations of adequate liquidity risk management required by existing and emerging money laundering and terrorism finance (ML/TF) risks. The stress test exercise confirms a sufficient degree of resilience of the sector. After more than two years of continuous risk-reduction, banks are still profitable and hold high levels of capital and liquidity. Asset encumbrance is relatively low, with large available liquidity buffers relative to the amount of short-term liabilities to depositors and creditors. Going forward, the supervisory assessment of liquidity risk should expand the current indicator-based framework to integrate ML/TF risks and their impact on banks’ viability in the development of stress test scenarios to enhance macro-prudential surveillance.
Keywords: Europe, Latvia, Banking, Macro-Prudential Measures, NPLs, Liquidity Risk Management, SREP, Stress Testing Resolution, FCMC, Article IV, IMF
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