ASSETS AND LIABILITIES: Citadele Bank and Latvijas Krajbanka have served as cautionary tales in the Latvian banking sector.
The recent crisis and the ongoing economic slack have shed light on the importance of the financial industry for macro-economic stability. Regulators and public decision makers have become aware that there is an insufficient understanding of banking business models and their concomitant risks. This has led the EU Commission to kickstart an analysis of EU banking system structures. Their aim is to research and outline the various possibilities for banking reform in the EU.
Where does the Latvian banking system stand in relation to its EU counterparts in this respect? Our analysis below takes a look at the balance sheets of 17 Latvian banks as a means of evaluating their business models, allowing for a wider understanding of the Latvian banking system’s stability and financial viability. Bank business models are typically characterized in terms of several key dimensions: the size of the bank; the bank’s customer base, asset structure and income model; the capital and funding structure; the ownership and governance structure; the corporate and the legal structure; and the way cross-border operations are organized. This article focusses on the first three characteristics, with the last three characteristics forming the basing of a sister article in the following issue.
There are more than 8000 banks in Europe and they can be split in three groups according to their size. The first group consists of small banks operating in a region or a country. Often, they are small savings and cooperative banks with assets less than 1 billion euros. A second group consists of medium-sized banks with assets ranging from 1 billion to 100 billion. Those banks typically operate on a country-wide scale. A third group consists of the large banks having assets that exceed 100 billion euros. They are very big banks with business abroad. When we classify Latvia’s banks it should not come as a surprise that the country does not have large multinational banks, except for subsidiaries of other large multinational banks.
According to our analysis, 6 banks qualify as medium-sized banks:Swedbank, SEB, ABLV, Rietumu banka, Citadele and DNB. The European Banking dataindicates that there is a clear difference in the activities of small and large banks. Smaller banks engage more in traditional commercial banking business with a higher proportion of loans as a ratio of total assets compared to larger banks who boast a higher proportion of assets held for trading. Net interesting income in total operating income is also higher for small banks.
From that viewpoint, the business models of small banks are better for the macro-economic stability of a country. In Latvia, the set of small banks indeed has a ratio of deposits to loans that is very high and they thus seem to follow the standard commercial banking model. Medium banks, however, had a ratio of deposits to loans that was relatively low in 2008, but the ratio converged to a high level of loans covered by deposits and could indicate a shift in the business approach. Still, for both types of banks, assets held for trading as a fraction of assets increased and customer loans as a fraction of assets decreased. Also, for both types of banks, the fraction of customer deposits as a fraction of the total liabilities has increased over the last years. For medium banks, the fraction of deposits from other banks in the total liabilities decreased to below 20% in 2013, whereas the fraction of customer deposits in the liabilities increased to 80%. This higher proportion of total customer deposits implies that the banks’ funding base became more stable.
Typically, small banks have a high net interest income as a fraction of total operating income. However, in Latvia, small banks have less net income as a proportion of operating income than medium banks. Even though during 2010-2011, small banks exhibit an increase in the ratio of interest income to operational income, the ratio has been on a decline since. A deeper understanding of the eventual business models adjustments, however, warrants further research.
Traditional banking versus investment banking
The largest groups in the EU are typically “universal banks” in the sense that they offer a broad array of banking services, ranging from traditional banking services of deposit taking and lending to investment banking activities that include sales, trading, market making, underwriting and so on. As the foregoing data indicates, investment banking in Latvia is at early stage in the sense that the banking market is dominated by large commercial banks that do traditional banking activity, namely, by providing loans and receiving deposits.
The notional amount of derivatives outstanding relative to the size of total assets is a typical indicator of investment banking activity. In the European Banking sector the notional amount of derivatives outstanding as a percentage of total assets ranges from 3000% to 0% for large banks. The amount of derivatives outstanding in Latvian banks constitute a comparably small part of total assets. Therefore, the investment banking activity, that is, the proprietary trading of complex financial instruments, in Latvia is minor.
From the largest banks, only one bank ABLV has comparably the highest amount of financial assets on the balance sheet.
This first very general analysis is a first step in a more detailed analysis of the Latvian banking business models. This study is implemented with two aims in mind. First, to analyze the eventual instabilities in the banking sector. Second, to analyze where the potential entry-points for the development of a financial center in Latvia could be.
Dr. Michel Verlaine is managing director of SLF, specialists in law and finance (www.slf.eu.com).