Keeping financial markets honest

When the financial market works smoothly, nobody pays attention. When things go wrong, such as when a bank collapses, all eyes turn on the financial market regulator. This role in Latvia is done by the Financial and Capital Market Commission (FCMC). Its chairman is Kristaps Zakulis, in office for one year. He took over as chief after Latvia’s last bank failure – the collapse of Vladimir Antonov’s Krajbank in 2011 – forced out the previous head on charges including failure to properly supervise the Krajbank’s activities, which proved to be fraudulent. Zakulis has long experience in banking, previously being head of the security department at Swedbank. The chief regulator sat down with TBT to give his views on the Latvian banking environment.

The FCMC is not the regulator of the sms-, or fast-credit market, as the easy credit companies are not deposit-takers, but they do lend to the general public. Considering that over the years, interest rates that they charge to individuals have gone up to, sometimes, over 1,500 percent. It appears that the consumer protection bureau isn’t doing its job in protecting consumers from what are exorbitant rates, or in regulating this business from these abuses. Shouldn’t the FCMC have oversight of this industry?
We see that the growth of this industry has raised this question, and there are some terrible examples seen in the media. But I would not fully agree with this statement that the office of consumer protection has fully failed. There are two parts to supervision. One is related to prudential supervision, looking over what is going on with the institution, how it’s balanced, what is the strategy, what is the risk appetite, risk mitigation systems in place, and so on. This is because they attract deposits. But on the other side the banks provide lending to the general public as well. There is the question of consumer protection issues, starting from those advertisements, how honest are they regarding these commercial practices. Is it honest to the customer; do those paragraphs in the credit contract protect more the customer or the credit institution? So those questions have been all the time already in the lending process of the credit institutions as well.

But the separation of duty in Latvia is as follows: the FCMC is doing the prudential supervision work, and the consumer protection office is doing the consumer protection work. So when we switch our focus on the banks, we cooperate with the consumer protection office, and I would say that there was very good cooperation because there were, in those times of aggressive lending, there were issues of how were those contracts written up, and how are they protecting the mortgage taker, and so on. And all those questions were disputed [by] the consumer protection office; there were even some penalties for some banks, if I remember correctly, and they changed those paragraphs in their contracts, so they became more consumer protective in this area. From our perspective, this main point of judgment, whether it’s necessary to involve the FCMC in this process is related with the proportion of prudential supervision needed, and protection of consumer rights. In our opinion, those pay-day companies, it’s about their commercial practices. What are they doing, how they are convincing people to take those loans, what they are hiding, how honestly are they saying in their advertisements what’s going on, what are the consequences, and what is the liability of the customer.

So, this business, from our perspective, it’s mainly about consumer protection, and as before, there was this separation of duty, and the FCMC was not growing its knowledge and competences and skills in this area. I would acknowledge we are close to zero in this area, because we are separating all the time those duties and providing all those claims related to consumer rights protection to that office. So it means that this work, that was built up over 10 years - that we have already been cooperating with [the consumer protection] office - and to just make a quick judgment that, oh, they failed, oh, there may be some other institution that may be doing things better, ok, let’s start from scratch...
I’m not sure it’s a quick judgment. I’m referring to this easy credit business and their very high interest rates, which don’t seem fair. And it’s been going on for years. When they can charge 500 percent, 1,000 percent, it doesn’t seem like the consumer is being protected by the protection agency. But you know they started to regulate this market one year ago, just from 2011, when they made this obligation to register, to have licenses.

That’s a start.

Actually, I would say yes, there is some effort needed, some additional effort needed. From that perspective I was talking about best commercial practice, what they are doing. There are already some initiatives on the table, there are some initiatives already generated in this working group set up by the Ministry of Economics, there are a lot of representatives from this industry, from the different ministries. It’s mainly about understanding what are the best tools right now. And I could agree that there could be a place for discussion whether it’s needed to change this supervisor.

The FCMC could add some ideas?
Talking about these consumer protection issues, we are not the smartest guys in this market. The consumer protection office has been, for 20 years, in this market. They have accumulated all the competences, skills and knowledge. [The FCMC has to] build up from zero; from my perspective this time will be spent to reorganize the work, to invent, to collect that knowledge needed. It’s just better [now] to start and change some advertisement practices, some commercial practices applied by those consumer lenders. There is quick action needed, I fully agree. But in this arsenal, which will be right now used, those different tools regarding the maximum level of interest rate, or maximum level of penalties paid by the customer, those things should be put in place pretty soon.

European Parliament member Roberts Zile has said that the large, non-resident deposits in Latvia pose risks. Do you see that this high level of deposits, in Latvian banks totaling around 6 billion lats, is a problem?
The wording used by Mr. Zile, that it’s about containing risks, has never been denied from the Latvian state authorities, that having half of your deposit base from non-residents [doesn’t] contain risks. On the other hand, if we read those reports produced by the European Commission and the IMF, it is stated that those risks are mitigated. For example, liquidity risk, where [depositors] could suddenly change their minds, as most of [the deposits] are on demand, and move [their money] to a much safer harbor, to another jurisdiction, [this] is about liquidity, how liquid are those assets.
This is so-called hot money. It can move in a day.
So that’s why we are keeping such a high level of liquidity.

And you believe that the liquidity levels are high enough?
Yes. It’s on average some 70 percent. The liquidity ratio.

That’s the regulation, or just how the banks are operating?
That’s what is additionally asked for those non-resident banks. The standard ratio is 30 percent. The average is 70 percent, so we are pushing those that are dealing with non-residents, and not only regarding the liquidity; we are asking [for additions] related to the capital adequacy. And of course one of the biggest risks is related with IML [international money laundering], with potential involvement in money laundering schemes, that’s what we are asking in keeping with the best practice, high level standards which are asked from the financial institutions, not only in Latvia or in the European Union, but from the United States, from other jurisdictions, from the Swiss banks as well.

What does this non-resident money do in Latvia? Is it getting into the economy?
The biggest part of this money is not in the Latvian economy. To fulfill this liquidity ratio, yes, some part of this money is cash in the branch networks of those banks; some of it is kept in the central bank. Some of it is invested in Latvian government bonds, but the biggest part is kept in those correspondent accounts to fulfill those repayment orders issued by the customers, and of course those liquidity portfolios kept by those institutions. It’s mainly about the prime papers we’re talking about. When we look at the country-issued government bonds, it’s mainly the U.S. and Canada. So, triple-A.
So this non-resident money is not getting down to, let’s say, corporate lending.

Some part is getting to corporate borrowing; the biggest part is going outside Latvia. I’ll avoid using the word ‘problem.’ It’s about the angle, how do you look [at it]. If you [say], your funding base consists of non-resident deposits… most of them are on demand… [then] that’s a potentially big problem. But if you understand that you are just dealing with this money as a resource, and the main income is from those transfer payments and commissions, and it’s up to keeping this high level of liquidity, and [that] it’s not standard universal banking, like the biggest banks are doing - retail banking, attracting of deposits – [that] there is a term structure to those deposits, and then up to this term structure you are building your lending portfolios, and so on, it’s not about this. First of all, it’s about exporting financial services. So, it’s those commissions received in transferring this money, just dealing as a financial center.

And that’s what gets into the economy.
Yes, that part is the highly paid employees that are working in Latvia, and trained in Latvia from the banking colleges, other institutions, universities. And there’s no secret, there is different speculation about the volume of the shadow economy in Latvia. Then we see that the banking, the financial industry is one of the most transparent ones. It’s about generating tax revenues in Latvia as well.

Banks went from a 179 million lats loss in 2011 to profits of 122 million lats last year. With the current strong economic rebound, why do you think banks aren’t lending more to support growth? Is there a lack of loan demand?
Lending is not the only financing source for different investments needed. There is of course the ability for businesses to finance themselves. What is their balance [sheet] structure; what are their own capital and other financial tools. That’s one issue, because you know, this growth, and especially making investments in new areas and products, some part of it is covered by risk capital. Banks are not the first and only lenders in the market. So it’s a combination, where there are some state programs which are provided by the state-owned [Mortgage Bank], there are some risk capital programs, then there is typical commercial lending. So when we look at this we see that there is an increase in the newly issued loans.

But with GDP growth pretty strong, 5 percent or so, bank lending isn’t keeping up with that level.
When we look at new issued loans, then there is growth; the problem is that the loan portfolios were reaching their maximums during the boom times, and the deleveraging is still in place. It’s about the price of funding, of capital, and this gained experience of losses, which are calculated in as well. This is why maybe commercial lending is not so attractive for some [banks].

What does the FCMC do?
The two biggest issues related with us, one is about the stability on the market, the financial sector, and the second is about the protection of the depositors, insurance takers, and those which are making investments in the capital market.

So the FCMC is charged with regulating banks, credit unions, insurance companies, pension funds… This is quite a lot. Is your staff sufficient for all this?
Yes. We are more than 100. We [have] almost 130 employees. We are financed by payments made by those market participants. But of course we see this trend that those regulations and those efforts needed in this regulatory area are just growing. So, that’s actually bad news for the market participants. In the 21st century I’m afraid that the general public is demanding stricter regulation, so that there’s less [chance] for crises to happen.

Last October Moody’s announced that the Baltic banking system outlook remains negative. Are Latvian banks healthy?
Do you have more detail about Moody’s announcement? They usually have something in addition to the statement. It was something about, I think, the vulnerability on the credit quality side, as we’re seeing some improvement with corporate lending, the corporate loan-takers. But we see, and we’re talking about households, there is still potential, if there is some stagnation in our main export markets, then this chain will go through the exporting companies, and then get to those households. So there is fragility in the markets. Things are pretty stable right now, but not so good to say the households are happy with this situation. We haven’t seen an increase in income in households.

People are still paying back their debts.
Of course.

In the last five years or so we have had the collapse of Parex Bank, Krajbank, Snoras, and now Ukio Bank in Lithuania. Each had one or two dominant shareholders who seemed to use the bank for their own personal advancement, with the consequent risk to depositors and to the general system. Yet, the FCMC allowed another such bank to set up in Latvia: Expobank from Russia, just when Krajbank was failing. And last year, another single-owner bank, Rigensis Bank, opened. What is FCMC’s approach to controlling privately owned banks?
Regarding the privately owned banks, it’s of course a question of the ability of those persons to support the bank if needed. But I would not agree to put in one basket the Parex case, the Snoras/Krajbank case and the Ukio case. For example, the Ukio case, we saw what happened when the biggest shareholder was not able to support the bank, from the capital side. He even acknowledged he could not support his famous basketball club, Zalgiris. When we talk about the Snoras/Krajbank case, yes, there was fraud. Fraud by the shareholders. It’s the most painful case for the regulators, because you are dealing on a regulated market, you are looking at the information provided by those market participants, and if those market participants are ready to falsify, or hide some valuable information, and actually [commit] fraud, yes, then it’s the biggest challenge for the regulator to identify such a person already when they are entering the market. Even if at the point when they enter the market they were not fraudsters, the ability to follow what’s going on with the business activities with this person, especially in this global [environment], you saw from the Krajbank case, the Snoras/Krajbank, [that] Mr. Antonov’s problems didn’t start in Latvia and didn’t start with Krajbank. His empire, which was working around the world and having business activities in Russia, even some attempts in Sweden, and in the Baltics and some other jurisdictions, and then he landed in London. It’s the hardest task for the regulator to catch up with all those activities, what this person has, and if there was some problem raised in some other jurisdiction, and this person was ready to commit this fraud, and cover some holes in some other jurisdiction by taking out some funds from their controlled institutions in Latvia, then yes, that is the hardest topic.

Moody’s says that these little banks represent a huge risk; does Latvia need all of these small banks, what purpose do they serve?
That was already answered; they are producing this financial export [service], and we as a small open economy and not very rich in natural resources are exporting. We are not only exporting logistical services through our ports.

Latvia has 26 banks.
We have 20 banks plus the branches… and another nine.

When you cut the top tier, the Scandinavian banks, you get to the Aizkraukle, Rietumu, the smaller banks.
We have never hidden the fact that there are two sectors in the financial industry in Latvia. One is the local oriented banks, currently dominated by the Scandinavians. And there is another part of the industry, which understands that maybe they are not the biggest competitors to the Scandinavians, and the shareholders are not able to finance huge investments into capital and set up widely spread out branch networks and to deal with more than one million customers. They are just focusing on their business niche and are working with some ten thousand non-resident customers and they are just providing the services.

And their business niche seems to be focused on Russia, Ukraine, CIS…
Yes, of course. It depends on the country, who are the customers, from Ireland, from the Bahamas, from Switzerland, Luxembourg. This is a financial center. London is the biggest, in my opinion. They attract and provide different services, not the simplest, but [those] with very big value added to the customer.

When you have a focus with a small bank, to the East, Eastern money, it adds a suspicion of money-laundering.
If you look at the crisis, at money-laundering, the biggest fines are put on HSBC and [other] such big brands. We see that the biggest violations and the biggest fines are on those Western banks.

Who have the larger facilities.
It’s not only about the customer base. If you are a big bank and [involved] in fraud with Western customers, then again you are in violation of the rules. Ok, but that’s maybe not answering the question. Yes, these are risks in dealing with the Eastern customer, taking into account their business environment. We can look on those global indexes, openness and corruption. Yes, those risks should be considered and taken into account when dealing with those customers.

Recently there have been rumors that Russian money has flowed out of Cyprus as the banking crisis developed there, and that this money was flowing into certain Latvian banks. The EU is very worried about this; the Germans say they will not support a bailout of Russian depositors in Cyprus. What is FCMC doing to control money laundering through Latvian banks, and can Russian money in Latvian banks be a real obstacle to Latvia joining the eurozone?
Let’s start with this outflow from Cyprus. There are official statistics provided by the central bank of Cyprus about those deposits. There was one big outflow in June 2012, more than one billion euros from a total base of 72 billion euros. Not only from locals and non-residents from the East and West; this was one outflow, but we didn’t see that at one moment one-and-a-half billion euros left Cyprus and landed in Latvia. And there was the second case in January this year. The statistics from the central bank of Cyprus showed another 1-1/2 billion euros leaving Cyprus. And again, we didn’t see a 1-1/2 billion euro non-resident deposit increase in Latvia. So that’s a good question, where is that money going. We could just acknowledge that Latvia, if it’s receiving some part of that money, it’s very small. And on the other hand, it’s not coming directly from Cyprus. And we are warning our banks to understand the situation on the market, that maybe some are leaving not so safe harbors and are looking for safer harbors. On the second part of the question, regarding the potential obstacle, that’s maybe for the [EU] Commission to answer. From our side, we are just showing how we do things in Latvia. For example, if we carefully read this European Commission report, there was this Article 7, there was something about non-resident deposits, about the huge proportion, but on the other hand, there was nothing that the Latvian authorities are not doing fully. In a sub-paragraph, there was something about additional resources may be needed for law enforcement, for the economic police, the prosecutor office, the courts to be educated and well-trained to fight economic and tax crimes.

What are the near-term risks to our banking system, and what do you worry about the most today?
We are separating those segments; we are identifying the risks in each of them. [We are] talking about the non-resident business, working with those biggest risks, liquidity risks, potential involvement in IML, and if they are financing and dealing with other jurisdictions, then those legal and country based risks. When we talk about the local market, we are not so happy about the situation with households. It’s a fragile situation, what will happen next, the stagnation in the eurozone and the European Union, how it will hit the exporting companies, and how that would come back to the labor market in Latvia. And then how it will hit the incomes of the household. That’s one part of the story. [The other is] about the risk related to the banks’ appetite to finance corporations, and to provide commercial loans. We see the impact of those losses. We would be happy to see banks lending more; from the other side we understand what are the risks they are counting in, what is the situation with their corporate customers, which are their top customers who are already well-serviced and financed by themselves, and which are receiving very attractive offers from the banks. And what are the areas where we think that other financing tools are needed, and not from the banks as a general financier.

When we do join the eurozone next year, what role will the FCMC have?
There will be additional duties. [There will be] this single supervision mechanism, when it goes into force. [Latvia’s] three biggest banks should come under some part of the supervision of the ECB [European Central Bank] - the biggest players on the market come under the umbrella of the ECB single supervision mechanism. But, [as for] the rules, the ECB is taking under their supervision just some basic issues. The everyday issues related with the licensing process, preparing all the documentation, the IML issues, customer protection issues, it’s all still up to us. From our perspective, we would say we still have a lot of work to do; we are still the responsible ones. We will be the local support; it doesn’t mean there will be some wall between us and the ECB.

You’ve been in this position now for a little over one year. What would you say are your biggest accomplishments?
I would start with this one issue: we have changed our communication strategy. If the previous approach was [about] banking secrecy, [where] it’s not so polite to speak publicly about your banking issues and problems related with banks, we understand that in those times different accidents happened in the markets, big turbulences in the markets, [but] you can’t calm markets [with] this approach. One [thing] that helps is what you are telling people, to be open and honest in your communication, and you are telling [them], of course, [that] there are some [legal] limitations, [in] showing what you are doing. [And there’s] the issue of financial literacy. We understand that it’s not only about communication; a big proportion of it is understanding [financial] issues. We are inviting roundtable participants who could help: the Ministry of Education, the central bank, us, the consumer protection office, and so on, even those market players. In schools, where everyone is participating, [this] is one of the biggest areas of concern. Financial literacy should be delivered at the secondary school level. If you have one lats, then it’s trying to teach [school children] how to get some additional lats out of the first one. It’s not only teaching about spending this lats… but to spend money wisely, and [also] how to start to make investments. That was one part. Then we can talk about this biggest challenge for the regulator: how to deal with a potential fraudster in a supervised market. We have some additional supervisory tools in place, some practices in place… to ask more from management so they understand that just one person cannot pledge some balances on correspondent accounts... [and] that the board members, together, hold this responsibility. We are looking keenly on those correspondent accounts, which of them are used on an everyday basis, and which are dormant. If dormant we would ask them to move it to some other bank, to show that they aren’t tied to some hidden agreements. We have also improved our cooperation with law enforcement agencies, asking for advice, exchanging information. These are from lessons learned, some conclusions made, some improvements in practices.