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B. Recent Changes in the Financial Secto R - 21 - References Calvo, Gullermo A.,1983, “Staggered Prices in a Utility-Maximizing Framework,” Journal of Monetary Economics, Vol. 12(3), 383–398. Gali, Jordi, and Mark Gertler, 1999, “Inflation Dynamics: A Structural Econometric Analysis,” Journal of Monetary Economics, Vol. 44(2), 195–222. Kara, Amit, and Edward Nelson, 2004, “The Exchange Rate and Inflation in the U.K.,” CEPR Discussion Papers No. 3783. Roberts, John M.,1995, “New Keynesian Economics and the Phillips Curve,” Journal of Money, Credit, and Banking, Vol. 27(4), 975–984. Walsh, Carl E., 2003, Monetary Theory and Policy, 2nd Edition, Cambridge, The MIT Press. - 22 - 1 III. FINANCIAL SECTOR STRENGTHS AND VULNERABILITIES—AN UPDATE A. Introduction 1. This chapter reports on strengths and vulnerabilities that may have developed in the financial system since the time of the Latvia Financial System Stability Assessment (IMF Country Report No. 02/67), and discusses measures available to the authorities for further strengthening of the system. The FSSA found that the banking system was well capitalized, profitable and liquid. It was “fairly resilient” to interest rate increases, rapid credit expansion and possible withdrawal of nonresident deposits. The FSSA recommended continued vigilance by banks and the Financial and Capital Markets Commission (FCMC) to ensure that new vulnerabilities did not develop in these areas. Nonbank financial institutions were judged not large enough to be a source of systemic risk. Supervision and regulation were judged to be robust. 2. The present assessment is based mainly on an analysis of financial soundness indicators, including macroeconomic indicators such as inflation, and on stress tests of the financial system. Section B provides an update on the growth and composition of the financial sector. Section C assesses the exposure of the banking system to credit, exchange rate, interest rate, liquidity and real sector risks; examines the capital adequacy and profitability of banks; and tests their resilience under various hypothetical stresses. 3. The rapidity of credit growth in Latvia continues to be a source of potential vulnerability, as it is in many countries of Eastern Europe and East Asia (see IMF, World Economic Outlook April 2004, Chapter IV). Section D of the present chapter therefore explores the prudential controls that may be used to ensure that the transition to a more sustainable rate of credit expansion is a smooth one. It discusses various prudential measures individually, and goes on mention factors which affect the efficacy of all prudential actions. B. Recent Changes in the Financial Sector 4. Financial institutions’ assets have expanded rapidly, mainly on account of credit growth, reaching 94 percent of GDP at the end of 2003, compared with 59 percent just three years earlier. However, bank credit to the private sector remains only about half the banks’ asset portfolio, and is equivalent to 44 percent of GDP. Banking remains the dominant financial activity, with banks accounting for an estimated 90 percent of financial assets. The remainder is accounted for by insurance companies and leasing, while credit unions and pension funds have tiny shares (see Table III.1). 1 Prepared by DeLisle Worrell. The mission gratefully acknowledges the contributions of Dr. Medvedevshiha, Ms. Ivanova and the staffs of the BoL and the FCMC, who prepared the stress tests. - 23 - 5. Foreign banks with headquarters in the EU now own majority shares in Latvian banks, in an amount that comprises 54 percent of total banking capital, and the remainder is in domestic private hands, except for a share of about 6.5 percent, owned by the government. Most of this represents the capital of the Latvijas Hipoteku un Zemes bank, which has successfully married development and commercial banking activity, and has remained profitable. 6. The degree of concentration in the banking system remains relatively high, with the 5 largest banks, in terms of deposits, having over half the market for deposits, loans and total assets. The 10 largest banks, in terms of deposits, account for 85 percent of total deposits. There are 23 banks operating in Latvia. 7. Leasing has been the fastest growing method of financing consumer durables and transport equipment. Three banks offer leasing services, in addition to other banks which have leasing subsidiaries, and there are a number of nonfinancial enterprises which also offer leases. The lats volumes outstanding with the leasing subsidiaries of banks, and with nonfinancial firms, are estimated at about 2 percent of GDP. 8. The total investment assets held by insurance companies at September 2003 (the most recent data posted by the FCMC) were equivalent to 2 percent of GDP. The contributions of credit unions and private pension fund assets (other than their balances with commercial banks, included with bank deposits) were very small, less than ½ percent of GDP. C. Banking Stability Assessment Capital adequacy and profitability 9. The risk-weighted capital adequacy ratio (CAR) for the banking system remains comfortably above the FCMC’s stipulated minimum of 10 percent (see Table III.2). A decline in the CAR, from 14 percent at the time of the FSAP (end-2001) to 12.5 percent at the end of the first quarter of 2004, reflects the extraordinary pace of credit growth, given that bank capital and reserves increased by more than 50 percent over that period. Major banks with access to the international market claimed that their issues of new capital in 2003 were oversubscribed, and that their capital market advisors recommended that they increased the size of the issue; however, they declined because the amount offered provided ample funding for their prospective needs. However, one bank reported that its most recent lats bond issue, early in 2003, was too expensive in view of the returns available in the competitive credit market, and that, since that issue, it has supplemented its deposits by funding from its foreign head office. Other banks also reported slow uptake of bonds issued in lats. 10. Banks continue to be profitable, even though returns have declined slightly, with the interest margin falling in response to competitive pressures. The return on equity (RoE) for 2003, at almost 17 percent, was down 2 percentage points from the end of 2001, but there - 24 - was a recovery in the first quarter of 2004. The proportion of bank income derived from fees for services has increased only slightly (by 2 percentage points) to almost 25 percent. Credit, overheating, and financial risk 11. This sub-section begins with an analysis of the potential of credit growth to cause overheating, in the sense of contributing to general price inflation, or creating expectations of future general price inflation. The second part of the sub-section deals with the increased financial sector risk, as a result of the rapid credit growth, and the resilience of banks in the face of a deterioration of credit. Credit expansion and overheating 12. The evidence on overheating is drawn from international comparisons of credit to GDP ratios, international comparisons of household debt loads, unpublished indicators of housing prices, rental prices included in the CPI, econometric predictions of credit growth, data on the funding of new credit, inferences from credit to the construction sector, and the results of interviews with the managements of leading banks in Riga. 13. At the end of February 2004, the annual growth rate of credit to the private sector was above 40 percent, with household credit, mostly for mortgages, growing most rapidly, although the level of credit for corporates was larger. However, the ratio of private sector credit to GDP for Latvia remains low, compared to the ratio for a selection of European countries (see Figure III.1). The average for the euro area is 113 percent, and, apart from transition economies and Turkey, the lowest ratio is Finland’s 65 percent. Although household credit grew at the rate of 77 percent in 2003, the third year the growth rate has been over 50 percent, the ratio of household debt to GDP at year end was only 21 percent, compared with the European average of 57 percent (Austrian National Bank, 2003). The ratio of household debt to disposable income for most industrial countries is over 100 percent. Cottarelli, Dell’Ariccia and Vladkova-Hollar (2003) indicates that private sector credit in Latvia remains below the expected level, given the country’s per capita income, debt/GDP ratio, inflation record, degree of financial liberalization, and the level of its legal/regulatory/corporate culture. The fact that these indicators are low suggests that, for the present, there remains potential for credit to grow rapidly, without significantly increased risk of macroeconomic instability, provided that regulatory and supervisory capability is adequate, financial risks are well managed, and financial indicators are closely monitored. 14. Based on unpublished data extracted from the land title registry by the Bank of Latvia, inflation in housing prices decelerated rapidly in 2003, and prices in the fourth quarter were significantly lower than a year earlier. However, average inflation of housing prices for 2003 as a whole was still over three times the rate for general inflation (Table III.2). To date, rental prices included in the CPI have not reflected this pattern of higher than overall inflation. The deceleration of real estate inflation is consistent with discussions with bankers, the majority of whom indicated that the increasing supply of new apartments was easing housing supply pressure, and that prices of older Soviet-style - 25 - apartments from the 1960s had either stagnated or had begun to fall. Data compiled by the BoL indicates that apartment prices in Latvia are among the lowest (in relation to per capita income) in a comparison with selected countries, including major industrial and European countries. Apartment prices in Latvia are 8 percent (of per capita income) per square meter, compared with a range of 7–21 percent (see Figure III.2).
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