The optimistic banker

Nils Melngailis is, in a business sense, a man for all seasons. With his long history of working in Eastern Europe, he’s developed solid experience and credentials as a business leader and problem-solver.  

He led Latvia’s telecoms provider Lattelecom as CEO and chairman, starting in 2004, and before this was working with IBM, as well as member of the management board of the Nordic Business Unit. He has held various management positions, has been a partner in the consulting firm Coopers & Lybrand and has been with PricewaterhouseCoopers as part of their Strategic M&A practice in London. This includes managing partner in their Baltic operations and as member of the Central European management team.  

When Latvia’s Parex bank collapsed in late 2008 in the midst of the global financial crisis, the Latvian government turned the reins over to the steady hands of Mr. Melngailis with the expectation that he bring stability to the bank, and ultimately to Latvia’s wobbly financial system.  

The Baltic Times sat down with this ‘jack-of-all-management-trades’ to get his perspective on the bank’s current condition, and in what direction he’s taking it.    

The Latvian government has invested 840 million lats (1.2 billion euros) into Parex since 2008.  

It’s important to classify the different types of relationships we have with the government. Basically, there are three types of support we have. [Your] number pertains to deposits we have from the state Treasury and the central bank.  

Cash deposits?

Just like any deposits you or I would put in the bank. I wouldn’t call them investments; they’re deposits that get interest What happened at the beginning of the financial crisis was that many depositors took their money out. The government replaced this individual deposit money with their [own money], it’s important to make that distinction. In terms of other capital investments, that’s much lower, in terms of what the government has invested into the capital of the bank.  

The equity capital?

The equity capital, yes, that’s much less.  

There was a recapitalization of 24 million lats in September 2009, from the Privatization Agency that partially diluted the EBRD ownership.

Yes, the EBRD has a condition where they can increase their participation, capital, in the bank when the restructuring plan is approved by the European Commission. Given that we’ve been contemplating this reorganization of the bank, that’s been delayed, they’re simply waiting for us to finalize the decision. Once we restructure the bank, and get that approved by the EC, then they’ll be free to increase their proportion, their investment.

And the third form?  

The third form of support is where we have a government guarantee on the syndicated loans. We essentially had two syndicated loans which we consolidated into one loan and agreed a staged payment schedule; there’s one syndicated loan, there are 2 remaining payments.  

Will the Latvian taxpayers get their money back?

I think there’s every reason to believe they will get it back; a lot of it depends on what the government strategy is – it’s important that the government restructure the bank. The extent to which, in terms of when, all of the government involvement ceases, is largely a function to which the real estate market in Latvia recovers, and when that happens. I think we have to get used to the fact that the government is likely to have to have some direct or indirect stake, much less than it has now, in a portion of our asset portfolio, like Sweden did in the 90s and like they did recently in the UK, and Ireland, where selling any of these assets, these buildings, where if you had to sell it today the price would be less than it cost to build. Three to five years from now there is every reason to believe that value will return.  

But that’s still a bit of speculation.

Yes, it depends on… there are different opinions as to how soon these prices will go up. Some people think prices will return to higher levels, probably not reaching the recent top levels, but the question is, will that happen in three years, five years, seven years, eleven years. As long as the government restructures the bank and is ready, sets up a structure where they can dispose of the bank’s assets at a time when it’s advantageous to do so, when the price levels are high enough, there’s every reason to believe that the money will be returned.

What specifically will the bank restructuring be; we’ve heard it’ll be splitting the good assets and the bad assets.

We try to avoid saying they’re good or bad. The main criterion, from one point of view, is that they’re either core or non-core. The strict definition which we’re using in determining which assets to split is non-core and non-performing. Those assets which, or those loans where there’s a risk, we’ll have to increase provisions, those are the ones that we would transfer to this [real estate] fund. Because one of the issues the bank is facing currently is [the need] to increase our provisions every quarter as part of our loan portfolio deteriorates. That also hits us in the capital; we have to keep increasing capital. If we split the bank, and make a substantial split of assets, then it’s unlikely the bank will ever need additional capital. We’ll have a well-capitalized [bank], on the core side.  On the non-core side it wouldn’t be a bank, so it wouldn’t require [additional capital]; it would be a fund of some sort.

And managed until sold off or until prices recover…

Exactly, then the government could gradually exit. There is investor interest in the fund, specialist financial investors, funds that have been set up specifically to invest in these types of real estate or distressed assets.

Are most of the assets that would be in this distressed fund local, Latvian assets, or are they spread around regionally?

They’re spread around. First of all, there hasn’t been a final decision made on exactly which assets and what size the fund could be. It can be as large as 1 billion lats; it could be up to roughly a third of our assets.

That’s face value or market value?

That’s book value.

How soon will this restructuring plan be finalized?

If it were up to me it would have been last year.

The holdup is?

It’s a sensitive issue, of course.

That means political?

Politically sensitive, sure. Also, in order to do the reorganization, everyone has to agree with the EBRD as well, in terms of what assets are split and whether or not there are any changes in their relationship. In terms of these two entities the goal is to decide, in principle, by the end of February and actually make all final decisions by April 1, so that we can start implementing. Operationally, the bank is already preparing itself to manage these two separate businesses. We’re ready to operationally execute the split once it’s agreed on.

You’ve worked in Latvia for a long time. You’ve worked in consulting, with…

Coopers and Lybrand, and afterwards with PwC.  

Then as chief of Lattelecom, but you’ve had no banking experience per se.

When I worked in PwC and in IBM, I was in their banking groups; in terms of client work I did most of my professional careeer, work, with banks, both as an M&A advisor and as a consultant. For example, one of my clients was the government and the EBRD when Unibank was sold to SEB. I did that transaction, and when I was with IBM we restructured the largest bank in Turkey, so I’ve seen quite a lot of banks, [though] I haven’t run a bank before.  

It’s a little different from this side?

Yes. In some ways I think it’s a bit of a myth that banks are different than other businesses. They have clients, they have products, and I think in some ways it’s actually helped to be outside the banking industry in this situation, because I think the banking industry itself is going to have to change fundamentally. Banking as it was done three years ago probably will never happen again.

That’s globally…

Globally, yes. It’s a very interesting time to get into banking.

What have you learned in this position?

First of all, I’ve learned a great deal about how the wholesale finance market is structured. We had a very intense time renegotiating our syndicated debt at the beginning of the year. I dealt with banks in other situations, but what’s interesting is there’s quite a lot of support that commercial banks give to each other. I’ve worked as a client looking for funding from commercial banks, but as a bank, from this side, it’s quite interesting in terms of how much moral support the banking industry is ready to give Latvia and the Baltics. It’s very important, when we restructured the syndicated debt, [that] the government gave a guarantee to the syndicated banks. Many people criticized this. ‘Why is the government helping out these banks?’ In Ukraine, Kazakhstan, banks are not meeting their obligations, but Latvia is unique in this sense – our reputation among the banking industry is quite strong.    

Parex specifically?

Yes. I think our ability to go out and get new lending is going to be much easier than other banks in similar situations. Among the banking industry our reputation is very good. The only issue really is that there are still concerns about political stability. But in general, the fiscal policy and negotiations with international lenders is going as planned; otherwise, the other thing that’s quite striking is how loyal the clients and the staff are to the bank. It was hard to tell; I was only given essentially 24 hours, from the time that I knew I could come into Parex until I had to decide. I had this 24 hour decision-making time when I took on the job. I always knew the franchise was very strong. It’s quite remarkable and quite moving, in a sense, that the employees and clients are so loyal, and for that reason we’re still here today.

You’ve gone through drastic cost cutting; staff reductions; public pressure is there. You’re trying to keep stability in the bank. How can you manage to keep the morale up?  

It’s obviously not easy. I can’t speak for all of the staff; I think they see what’s happening and that we’ve done quite a lot, we’ve focused a lot on the internal communication over the last year; prior to the crisis there was very little internal communication between the senior management and the staff. We’re very open about what we think is happening and we publish interviews weekly from managers who, including myself, very openly explain what’s going on… If you’re open and honest with your staff and with your clients, you have a chance of retaining them. The staff… it still amazes me, with all that we’re trying to do, that we’re able to retain the trust of these two critical elements, but it’s also, most people understand, that a lot of the noise around Parex is really politically driven as well. Elections are coming up in eight months so pre-election time has started. We’re going to be a major football in this game, unfortunately. People understand that, so I think people just take a lot of the negative pressure with a grain of salt.  

Bringing in modern management type of…

Yes, people really appreciate that. If you’re open and honest with your staff and with your clients, you have a chance of retaining them. The staff… it still amazes me, with all that we’re trying to do, that we’re able to retain the trust of these two critical elements, but it’s also, most people understand, that a lot of the noise around Parex is really politically driven as well. Elections are coming up in eight months so pre-election time has started. We’re going to be a major football in this game, unfortunately. People understand that, so I think people just take a lot of the negative pressure with a grain of salt.

The Japanese bank Nomura is advising on the restructuring. Considering that the Swedes had a similar crisis in the early 90s and went through a similar restructuring, splitting the assets, were the Swedish experts considered to advise on Parex?

We have some independent consultants, who are funded by the EBRD, and the U.S. Treasury as well. One of these consultants was involved in the Swedish split; we have one advisor who was involved in the Securum, which was the entity set up to hold the bad assets in the 90s in Sweden, so we have these advisors who are helping us to conceptually understand a lot of things. Nomura’s involvement in the restructuring is more related to the sale of the bank. They were originally selected almost a year ago to work on the sale of Parex.

But not necessarily on the restructuring?

Not at that time. As time went on it became clear that the bank needs to do this restructuring, for this capital arbitrage, if you will, but the other reason is also to make it more attractive for buyers. It’s quite clear there are buyers for the bank, and buyers for the fund, [but] they’re not the same. Financial investors are interested in the fund, the real estate; commercial banks are interested in the bank. Within that context they’ll be advising on the restructuring to make sure it is done in such a way that facilitates the sales process.

Considering the political situation, or interference, it was last year when former Prime Minister Andris Skele said, considering continuing losses, to just sell the bank for 1 lat, regardless. Is this something our political leaders should be saying; is this a reasonable strategy?

I’m not sure exactly what he had in mind when he said that, because I think the main issue, in terms of the sale of the bank, is that the government has to have some vision of how it will get its deposits back because. How that happens, and when that happens, and what ultimately the price of the equity, will be is very hard to predict. It depends on how the restructuring is done, if and when it’s done. It’s easy to say: the government paid 2 lats for the bank. But they also took on a huge funding responsibility, so it isn’t reasonable just to talk in terms of the sale of the bank for 1 lat. Does that mean that the government gets it deposit back as well, or not? It should be a major question. That’s a very populist and over-simplified statement, to say that you could sell the bank for a lat… [it] doesn’t reflect reality in the markets.  

The equity and the liabilities...

Ideally, the government would get all of its equity investment back and there would be some security regarding their deposits. Any transaction will be very complicated. It’s just a matter of the timing of when the government gets its funding back. This should be the main issue, and whether some small part of that [amount] is either funding, or some sort of a guarantee that remains for some time for those assets that need to recover their market value. That’s a very populist and over-simplified statement, to say that you could sell the bank for a lat. The other reason being that it’s quite clear that the situation among the buyers is complicated as well. There are some buyers interested in the banking operations, and other buyers interested in the non-core assets. Just hoping that there’s someone out there willing to buy [the bank] for 1 lat doesn’t reflect reality in the markets.

Do you have serious offers from some buyers?

Yes, there’s a lot of interest, in different parts of the bank. It’s getting that interest coordinated to the extent that the government could try to resolve the Parex situation in one transaction, or in simultaneous transactions. I think the government’s concerned about spinning off certain assets, and holding on to others, without a clear solution. Nomura’s job would be to work with these buyers and try to get them together in some kind of consortium.

How about a public offering with some of these pieces?

The group as it is currently is very difficult to value. It would be difficult to do, say, an IPO with the level of uncertainty and different businesses the bank has; I wouldn’t rule out that there could be some kind of public offering on some parts of the business, but the group itself needs to be restructured first.

Considering that there are more than 20 banks in Latvia, already too many, the buyers that are looking to buy the core assets, are they new to the Baltics, to Latvia, or they already have a presence here?

Both. There are some new entrants to the market.

Even though it may be a very crowded market?

Obviously it’s a concern. Until the government finalizes a decision on the restructuring and is able to present clearly what is for sale, and until these buyers give binding offers, it’s going to be very hard to answer that question. There’s a lot of interest from many parties. What they’ll be willing to pay, and what they want, is still another matter.

The U.S., when they kicked off this global financial crisis, stepped in to bail out some banks, AIG, for example. These bailouts were more or less transparent. Why was the Parex bailout seemingly not very transparent? The people feel that they have no idea what went on. It’s still shrouded in secrecy.

To be honest, I wouldn’t agree with that. I think that what you see now is that the U.S. government, as Congress investigates what happened in AIG and some other cases, there were many decisions that were made by the Fed, and the government in a very short time scale made decisions about the allocation of billions and billions of dollars of taxpayer money, both directly and indirectly to the banks in the form of guarantees and direct deposits, and in the form of equity. In some ways, I don’t think there’s an issue of transparency [with Parex]; I think there is a debate about how the assistance was given, was it done very efficiently, but I think if you compare the Parex takeover with other cases, there’s been much more information and it’s been in a much simpler form of assistance than you’d find in other places. To the average reader, to understand the financial instruments used in the AIG case, I’m sure that many who have a doctorate in economics… not many people [will] understand. I think the [U.S.] government probably did understand the instruments at the time, but these are very complicated financial instruments that they used, and that in [the Parex] case it was relatively simple and in light of the global financial crisis, as a result of the wholesale market disappearing, Parex was exposed on a number of its liabilities. It could not refinance its syndicated debt, the market for that type of debt disappeared. That led to a run on the bank. You can always say the bank can be more efficient, but the reasons why are quite clear, and how the government took over control, they did it gradually. That’s one potential criticism, why didn’t they take full control.  

The issue is the previous owners; they’re getting this huge sum of monthly interest payments from deposits in the bank. What happened… they had equity in the bank that was transferred into deposits… people don’t know this.  

I think it’s a question for the people who negotiated the deal... in the end that was part of the deal. It’s very hard to say for me whether the government could have received better terms because there is a limit, in terms of if you’re going to do a so-called ‘friendly takeover’ of an asset, both sides have to agree. One of the problems that has to some extent been rectified by legislation is that the government did not have a legal right to take over the entity. I think that’s the type of legislation globally that has been changed to give regulators, since the crisis, and governments [these] special rights. At that time the legislation wasn’t in place to allow the government to take over, unilaterally, an entity.  

Even though it was threatening the collapse of the financial system?

All they could do was to shut it down, and essentially force the bank into liquidation, which I think everyone understood that, given that Parex is a systemic bank, that was not something that anyone wanted to contemplate, because the costs of doing that versus supporting the financial system were enormous. It’s estimated that at least 3 billion lats in a fairly quantifiable cost would have hit the economy, in terms of further loss of confidence in the financial system, further delays in improvement in GDP and so on.  

There’s no question that state had to step in.

There’s no question, and again, the question is certainly that only the people who negotiated with the former shareholders can explain why the terms were what they were. How transparent, that’s obviously a good question. I think, if you look on balance, the general public in Latvia knows a lot more, and probably understands more about this transaction than you’d find in other economies. For example, right now there’s a big debate about Goldman Sachs; it’s one of the biggest and most profitable banks in the world, and it had received state aid at one point, indirectly they did get support from the government, so they’re profiting in some ways, they’re getting bigger market share, because a lot of their competitors went out of business. Is that fair or not? In that sense, I think the situation here is quite simple, relatively speaking.

Considering the Latvian economy is still struggling through this downturn, companies complain that they cannot get loans, or loans at reasonable terms. How is Parex approaching commercial lending?  

We’re really focused on, and we see a lot of our future tied to, small and medium enterprise lending, which is a segment where we can get funding from a number of commercial banks and a number of international financial institutions, like the European Investment Bank, the EBRD and others, so we see this segment as one where we would resume lending in the second quarter. We’re close to negotiating credit lines which Parex could issue to these segments, using funds from these banks.  

Can you say if loan volumes are decreasing?

Currently we’re not doing any lending; we still have restrictions on lending from the regulators, with the exception of credit cards and some existing loan restructuring. We haven’t been out lending a great deal. Also, the risks have been quite high over the last year. Especially if you need collateral for any of these loans, because there’s no real estate market, effectively, it’s impossible to value real estate, even though that situation’s improving. What we will do is focus more on cash flows of companies, operating performance, and start lending to small enterprises, and realistically start lending in the second quarter.

Considering that Latvia has already had two big banking crisis – Banka Baltija and Parex – though you were not in the banking sector then, can you say if the bank regulators failed, or we just didn’t have the regulations in place?

I saw what happened back in the first crisis. There’s a huge difference in each. First of all, since the banking crisis of ’95, the regulators have developed significantly, having also benefited significantly from the experience of the EU. Clearly our regulators looked to other European regulators, so that’s been obviously very helpful for the regulatory environment, but there’s a huge difference between the two situations. In the case of Banka Baltija, the bank was simply emptied of all of its assets overnight, or in a very short time frame, so there was nothing to speak of, nothing like that has happened in Parex. The Parex situation was that there [was] a run on the bank as a result of the disappearance of the ability to refinance the syndicated debt. The government essentially had to come in and replace those deposits, also to commit to refinance the syndicated debt. Once that happened and once we got the EBRD to come in as a shareholder, confidence in the bank was certainly restored. For example, in ’95, no one wanted to invest in Banka Baltija because there wasn’t anything to invest in. It was just empty. There’s no such problem with the assets of Parex. Parex’s balance sheet is better than many other banks.

Where will Latvia’s economy be at year end?  

I’m afraid it’s not going to be a good year, or an easy year for the average individual in Latvia. It’s going to be very difficult. Unemployment is going to remain high. The government will probably struggle to meet its social support obligations. There will be a gap between investment coming into the country. [It will be an] improved investment climate. Actually, it’s a good situation. Speculation about currency devaluation is much lower; from that standpoint Latvia is seen as much more stable, in terms of its currency environment. Unemployment is high, which is good for investors, which means that labor is available and cheap.  

That’s an interesting twist.  

Yes, but you look at history and other economies as well. It’s a very good time to invest in Latvia. Prices are very low, real estate prices, lease prices are very low, so I think it’s just a matter of time before the neighboring economies realize that our costs are five times lower than Sweden and Germany; in other respects, they will move production here, back office functions. They’ll start investing in real estate. There’s an enormous amount of money which has been accumulated in pension funds globally over the last 18 months as people wait for the crisis to bottom out. Given that Latvia is relatively small, it doesn’t take much investment to make a positive impact, but it will take a year for that investment to translate into real jobs and real benefits for the entire population…  

Where would you like to be at year end? Still at the bank?  

Skiing, hopefully! I really hope that by year end we have restructured the bank and that private sector investors have been found, for both the fund and for the bank itself, so what I would be doing will depend on who these investors are; [if] they have their own ideas about management, if they want me to stay on, just like any other manager in the bank. The main reason I came to Parex was to help Parex get out of this situation; I think it has to be solved this year. It’s quite clear the market outside of Latvia has improved substantially, and the investment climate in Latvia is becoming very attractive, so I think we’ll get it taken care of.