2018 ISSN 2500-9729 Financial stability: the condition in which the financial system (financial intermediaries, markets and market infrastructures) is capable of withstanding shocks, without significant disruptions in the financial intermediation process and the supply of general financial services. Systemic risk: the risk that the inability of one participant to meet its obligations will cause other participants to be unable to meet their obligations when they become due, potentially with spillover effects threatening the stability of or confidence in the financial system, economic growth and welfare. The purpose of the "Financial Stability Report" is to raise public awareness of development of the Latvian financial system and draw attention to systemic risks representing potential threats to the stability of the Latvian financial system. The "Financial Stability Report" analyses and evaluates the performance of the Latvian financial system and risks, in particular focussing on the credit institution operation on the basis of financial market data available up to the end of March 2018, economic data available up to the end of March 2018 or at the moment of compiling the current report and credit institution, NBFS and financial infrastructure data available up to the end of March 2018. Forecasts are also based on the most recent available data. The "Financial Stability Report" uses the division of credit institutions into two groups since Latvia's credit institution sector is composed of two different segments. Group 1 comprises credit institutions which granted more than 50% of their loan portfolio to domestic customers and received more than 50% of their deposits from domestic customers over the past three years. The major portion of funding of these credit institutions consists of deposits by domestic customers and financing provided by their Nordic parent banks. Group 2 is made up of other credit institutions which primarily provide services to foreign customers and receive deposits from foreign customers. Data on the branches of foreign banks registered in the Republic of Latvia have been disregarded for the purposes of calculating ROE, the total capital ratio, Tier 1 capital ratio, Common Equity Tier 1 ratio, the liquidity ratio set by the FCMC; nor have they been used for liquidity and credit risk sensitivity and stress tests. Curly brackets enclose year-on-year data. Charts and tables have been compiled on the basis of the following data sources: Charts 1.1 and 1.2 – the EC, Charts 1.3 and 1.4 – Bloomberg, Table 1.1 – financial statements of credit institutions, Chart 1.5 – the CSB, Chart 1.6 – the EC, Chart 1.7 – the CSB, Chart 1.8 – estimates by Latvijas Banka based on data of Latvijas Banka, Chart 1.9 – estimates by Latvijas Banka based on data provided by Latvijas Banka, the CSB and FCMC, Chart 1.10 – estimates by Latvijas Banka based on data provided by Latvijas Banka and the CSB, Chart 1.11 – Latvijas Banka and Bloomberg, Chart 1.12 – estimates by Latvijas Banka based on data provided by the CSB, Latio Ltd., Ober Haus Real Estate Latvia Ltd. and Arco Real Estate Ltd., Chart 1.13 – Eurostat, Chart 1.14 – the CSB, Charts 2.1 and 2.2 – Latvijas Banka, Chart 2.3 – Latvijas Banka, Chart 2.4 – Latvijas Banka and the FCMC, Charts 2.5–2.7 – Latvijas Banka, Chart 2.8 – the FCMC, Chart 2.9 – Latvijas Banka, Chart 2.10 – estimates by Latvijas Banka based on data of the FCMC, Charts 2.11–2.14 – Latvijas Banka and the FCMC, Table 2.1 – the FCMC and ECB, Table 2.2 – estimates by Latvijas Banka based on data provided by Latvijas Banka, Chart 2.15 – estimates by Latvijas Banka based on data of Latvijas Banka, Charts 2.16–2.20 – Latvijas Banka, Chart 2.21 – the FCMC, Chart 2.22 – estimates by the ECB, FCMC and Latvijas Banka based on data provided by the FCMC, Chart 2.23 – estimates by Latvijas Banka based on data provided by the FCMC, Chart 2.24 – estimates by the ECB, FCMC and Latvijas Banka based on data provided by the ECB and FCMC, Tables 2.3 and 2.4 – estimates by Latvijas Banka, Chart 3.1 – estimates by Latvijas Banka based on data provided by Latvijas Banka, the FCMC and CSB, Chart 3.2 – estimates by Latvijas Banka based on data of Latvijas Banka, Chart 3.3 – estimates by Latvijas Banka based on data provided by the CSB, Chart 3.4 – estimates by Latvijas Banka based on data provided by Latvijas Banka and the CSB, Charts 3.5 and 3.6 – Latvijas Banka, Chart 3.7 – estimates by Latvijas Banka based on data provided by the European Insurance and Occupational Pensions Authority (EIOPA), FCMC, Lietuvos bankas and Pensionikeskus, Chart 3.8 – estimates by Latvijas Banka based on data provided by the OECD and the Law on State-funded Pensions, Charts 3.9 and 3.11 – estimates by Latvijas Banka based on data of the FCMC, Charts 4.1–4.3 and A1.2–A2.5 – Latvijas Banka, Chart A2.1 – the credit institution survey conducted by Latvijas Banka, Chart A2.2 – Latvijas Banka and the CSB, Charts A2.3–A2.5 – Latvijas Banka, Tables A3.1 and A3.2 – the FCMC, Charts A4.1–A4.3 – the credit institution survey conducted by Latvijas Banka. Latvijas Banka K. Valdemāra iela 2A, Riga, LV-1050 © Latvijas Banka, 2018 Tel.: +371 67022300 [email protected] The source is to be indicated when reproduced. http://www.bank.lv FINANCIAL STABILITY REPORT • 2018 CONTENTS EXECUTIVE SUMMARY 4 1. MACROFINANCIAL ENVIRONMENT AND LENDING GROWTH 7 Box 1. Early impact of tax regulation changes on financial performance of non-financial corporations 11 Box 2. Amendments to the state support programme for house purchase 15 2. DEVELOPMENT AND RISKS OF THE CREDIT INSTITUTION SECTOR 17 Box 3. Developments in Group 2 credit institutions 17 Box 4. Changes in the credit institution sector in relation to the establishment of Luminor Bank AS 21 Box 5. Changes in liquidity requirements 23 Box 6. Liquidity stress test results 24 Box 7. Changes in the regulatory framework related to evaluation of asset quality and supervisory provisioning 27 Box 8. Changes in total capital requirements of credit institutions in 2018 34 Box 9. Credit risk shock-absorption capacity 35 3. DEVELOPMENT AND RISKS OF THE NON-BANK FINANCIAL SECTOR 39 Box 10. Growth prospects of crowdfunding in Latvia: risks and opportunities 41 4. SYSTEMICALLY IMPORTANT PAYMENT AND SETTLEMENT SYSTEMS 48 APPENDICES 1. Heatmap: analytical tool for the analysis of systemic financial stability risks in Latvia 52 2. Latvijas Banka's survey-based assessment of household borrowers 57 3. Performance indicators of credit institutions 60 4. Credit institution survey on the potential financial stability risks and the financial stress index 63 2 FINANCIAL STABILITY REPORT • 2018 ABBREVIATIONS AML/CTF – anti-money laundering and FinCEN – Financial crimes enforcement network counterterrorist financing GDP – Gross Domestic Product AS – joint stock company IT – information technologies BRRD – Directive 2014/59/EU of the European LCD – Latvian Central Depository Parliament and of the Council of 15 May 2014 LCR – liquidity coverage ratio establishing a framework for the recovery and LGD – loss given default resolution of credit institutions and investment firms Ltd. – limited liability company and amending Council Directive LTV – loan-to-value 82/891/EEC, and Directives 2001/24/EC, MFI – monetary financial institution 2002/47/EC, 2004/25/EC, 2005/56/EC, ML/TF – money laundering and terrorist financing 2007/36/EC, 2011/35/EU, 2012/30/EU and NBFS – non-bank financial sector 2013/36/EU, and Regulations (EU) No 1093/2010 and NPL – non-performing loan (EU) No 648/2012 of the European Parliament and of OECD – Organisation for Economic Co-operation and the Council Development CCB – countercyclical capital buffer O-SII – other systemically important institution CDS – credit default swap PD – probability of default CIS – Commonwealth of Independent States PIT – personal income tax CIT – corporate income tax ROA – return on assets CRD IV – Directive 2013/36/EU of the European ROE – return on equity Parliament and of the Council of 26 June 2013 on RWA – risk-weighted assets access to the activity of credit institutions and the SH – solvent household prudential supervision of credit institutions and SREP – supervisory review and evaluation process investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and SRMR – Regulation (EU) No 806/2014 of the 2006/49/EC European Parliament and of the Council of 15 July CRPC – Consumer Rights Protection Centre 2014 establishing uniform rules and a uniform CRR – Regulation (EU) No 575/2013 of the European procedure for the resolution of credit institutions and Parliament and of the Council of 26 June 2013 on certain investment firms in the framework of a Single prudential requirements for credit institutions and Resolution Mechanism and a Single Resolution Fund investment firms and amending Regulation (EU) No and amending Regulation (EU) No 1093/2010 648/2012 SRS – State Revenue Service CSB – Central Statistical Bureau of Latvia TARGET2 – the second generation of TARGET CSD SE – Central Securities Depository Societas (Trans-European Automated Real-time Gross settlement Europaea Express Transfer system) DENOS – the securities settlement system of LCD TARGET2-Latvija – a component system of TARGET2 DGF – Deposit Guarantee Fund of Latvia in Latvia whose operation is ensured by Latvijas Banka EBA – European Banking Authority in conjunction with the national central banks of the EC – European Commission ESCB participating in TARGET2 ECB – European Central Bank UK – United Kingdom ESRB – European Systemic Risk Board US – United States of America EU – European Union VAS – state joint stock company EURIBOR – euro interbank offered rate VH – vulnerable household FCMC – Financial and Capital Market Commission 3 FINANCIAL STABILITY REPORT • 2018 EXECUTIVE SUMMARY The Latvian credit institution sector has historically consisted of two distinct groups: credit institutions mostly providing services to domestic customers1 and those providing services primarily to foreign customers2.