CREDIT INSTITUTIONS SUPERVISION DEPARTMENT ANNUAL REPORT 1999

Transcription

1 CREDIT INSTITUTIONS SUPERVISION DEPARTMENT ANNUAL REPORT 1999

2 CREDIT INSTITUTIONS SUPERVISION DEPARTMENT ANNUAL REPORT 1999 ISBN

3 Latvijas Banka, 2000 Photographs by J. Krūmiņš, I. Stūrmanis and A.F.I. The source is to be indicated when reproduced.

4 The Credit Institutions Supervision Department of the Bank of Latvia was established in Since then brief accounts on the Department's activities and the development of Latvian banks and credit unions have always been included in the Bank of Latvia's Annual Reports. However, in view of the importance of the banking sector in the financial system and the public's interest, we decided to publish the Annual Report of the Credit Institutions Supervision Department. The publication introduces the Credit Institutions Supervision Department, highlights and comments upon trends in the development of credit institutions, and reports changes in and amendments to Latvian banking laws and regulations was a year of steady and orderly growth for Latvian banks and credit unions. Positive banking indicators are proof of the recovery from the Russian financial crisis. Banks have expanded lending and introduced new financial services. The introduction of consolidated supervision enables us to assess risks arising from capital ties and to take more informed decisions about banks' financial standing. A qualitatively new stage in banking supervision has been achieved. During the challenging years since the Department was established, its staff has gained experience and skills. Likewise, a regulatory framework for banking activities, based on international standards, has been developed. The Department's achievements have also been recognised internationally, and Latvia's system for banking supervision now ranks among the strongest in the countries of Central and Eastern Europe. Latvia is one of the first countries to have received a positive evaluation by the IMF's experts regarding compliance of its legal framework and supervisory practice with the Basle Core Principles for Effective Banking Supervision. Our main priority, however, is to maintain domestic confidence in the Latvian banking sector, as public confidence is a prerequisite for a successful operation of banks. Public confidence can be achieved by ensuring that market participants are well-informed about the supervisory system and events in the banking sector. To enhance competition in the banking sector, the public is kept well-informed and market discipline is combined with traditional supervisory practices. We hope that this publication will increase the public's understanding of how the Department has fulfilled its responsibilities, and explain methods of credit institutions supervision, as well as current developments in the banking sector. Armands Šteinbergs Head of Credit Institutions Supervision Department Bank of Latvia

5 CONTENTS SUPERVISION OF CREDIT INSTITUTIONS 6 Evolution of Credit Institutions and Supervision in Latvia ( ) 6 Organisation and Tasks of the Credit Institutions Supervision Department 8 Banking Regulations and Analysis Division 8 Legal and Licensing Division 9 Supervision Division 9 Activities of the Credit Institutions Supervision Department in Developments in the Regulatory Framework for Banking Activities 13 ACTIVITIES OF BANKS 16 Development of Banks 16 Assets 16 Structure of Assets 16 Securities 17 Loans 17 Liabilities 18 Structure of Liabilities 18 Deposits 18 Liabilities to Credit Institutions 19 Equity 19 Profitability 20 Quality of Loans 21 Large Exposures 22 Capital Adequacy 22 Liquidity Risk 22 Foreign Exchange Risk 23 ACTIVITIES OF CREDIT UNIONS 25 APPENDICES Number of Credit Institutions in Latvia ( ) Number of Licences Issued by the Bank of Latvia ( ) Organisation of the Credit Institutions Supervision Department Credit Institutions Licensed in the Republic of Latvia 29 5

6 CREDIT INSTITUTIONS SUPERVISION DEPARTMENT. ANNUAL REPORT 1999 SUPERVISION OF CREDIT INSTITUTIONS Evolution of Credit Institutions and Supervision in Latvia ( ) The Bank of Latvia, which is the central bank of the Republic of Latvia, was established on July 31, The Laws "On the Bank of Latvia" and "On Banks", which came into effect on May 19, 1992, set forth the obligations and rights of the Bank of Latvia, among them supervision of credit institutions. (From the outset, entities subject to supervision were banks, credit unions, pawn shops and branches of foreign banks, but with the Law "On Credit Institutions" coming into effect in 1995, pawn shops were excluded from the list of institutions under supervision.) With this task in mind, the Bank organised the Credit Institutions Supervision Department. From 1992 to 1994, the Latvian banking sector expanded at a rapid pace, and during this period, banks' assets grew more than threefold. In 1993, over 60 banks were licensed in Latvia (see Appendix 1). In 1994, the Bank of Latvia licensed the first branch of a foreign bank, the Riga Branch of Société Générale (France). The first permit to open a representative office was issued to the German bank Dresdner Bank AG (see Appendix 2); it is the only representative office of a foreign bank operating in Latvia. Growth in the banking sector was more rapid than in the other sectors of the national economy; and this highlighted two short-term goals. A system for supervising credit institutions had to be set up and appropriate legislative and regulatory frameworks had to be designed. It was in the period from 1993 to 1994 that the Bank of Latvia adopted a set of banking requirements, basing them mainly on the recommendations of the Basle Committee on Banking Supervision, which embrace global experience and in many cases are the source for the standards of EC directives. Pursuant to Bank of Latvia regulations, credit institutions started making loan loss provisions. All credit institutions had to meet a number of requirements, among them capital adequacy and liquidity requirements and restrictions on exposures. The 1995 banking crisis was a crucial event for the Latvian banking sector. The banking sector's rapid expansion, which was accompanied by rash management policies in several banks and took place in an environment of slower economic growth, led to the crisis. Deposits of corporate and individual customers grew dramatically; however, domestic facilities for profitable placement of funds were inadequate. Ownership transfer was not carried out at a sufficiently rapid pace, and markets for real estate and securities were weak. In 1995, in the wake of the crisis, the activities of 15 banks were discontinued. Among the fifteen there were also sizeable banks: the JSC Banka Baltija, the JSC Latvijas depozītu banka and the JSC Centra banka. To reinforce the banking sector, the Latvian Government and the Bank of Latvia initiated an extensive reform program. In 1995, the adoption of the Law "On Credit Institutions", which replaced the Law "On Banks", was followed by a set of the Bank of Latvia's regulations, based on the Law. The new Law detailed the obligations and rights of the Bank of Latvia with respect to the supervision of credit institutions. The Law, along with amendments to the Administrative Code of Latvia and the Criminal Code of Latvia, increased the responsibilities of credit institutions, their shareholders, management, employees and customers. In several cases, the Law "On Credit Institutions" sets even stricter requirements (capital adequacy, 6

7 SUPERVISION OF CREDIT INSTITUTIONS restrictions on exposures to third parties related to a credit institution, etc.) than EC directives, which are targeted at developed economies and are not sufficiently rigorous to provide for a stable and smooth operation of the banking sector in a transition economy. Pursuant to the Law "On Credit Institutions", accounting procedures in credit institutions are to be conducted in accordance with the Law "On Accounting" and Bank of Latvia regulations. The latter are to comply with Republic of Latvia laws and International Accounting Standards. Annual financial statements of banks have to be audited in accordance with International Standards on Auditing. As of 1995, the Bank of Latvia approves a list of auditing companies, therein including only international companies. Since 1993, the list is binding on the largest banks, and since 1995, on all credit institutions. In 1995, steps were taken to enhance supervision, and, under the PHARE program, international auditing companies began to conduct audits of banks' interim (among them, semi-annual) financial statements and internal control systems. Also, to make banking activities more transparent and clear to the public, the Bank set a requirement to banks to publish their quarterly balance sheet. As a result, bank customers could follow developments within banks, and this improved decisionmaking when choosing a bank for transactions. From 1996 to 1997, the Bank of Latvia expanded the regulatory requirements, achieving a number of positive results: banks' capital base strengthened; their profitability increased; the quality of assets improved; and depositors' confidence grew. Major foreign investors acquired holdings in a number of banks. Initially, the focus was on on-site supervision; however, it shifted to off-site supervision and contact with banks' management because the banking sector grew, management quality in banks improved and banks' safety increased. To reinforce the achievements of the banking sector and to provide for further growth, the efficiency of internal control systems at credit institutions became the priority. As part of the ongoing harmonisation of the Latvian legislation with EC directives, the Saeima of the Republic of Latvia adopted the Law "On the Prevention of Laundering of Proceeds Derived from Criminal Activity" (in 1997) and the Law "On Natural Person Deposit Guarantees" (in 1998). In the second half of 1998, Latvian credit institutions' financial standing was impaired by the Russian financial crisis. A number of banks had acquired securities of the CIS countries, and these constituted a large part of their assets. Even those banks that had not made large investments in this region felt indirectly the impact of the crisis, because deposits of and transactions with customers related to eastern markets decreased. As a result of the Russian crisis, the licences of two small banks were revoked. The deterioration in the overall situation in Zone B countries (non-oecd countries) and the unprecedented events in Russia were the reasons why the Bank of Latvia resolved to reassess the degree of risk for claims on central banks and central governments in Zone B countries denominated in the national currencies of these countries and to raise the degree of risk assigned to such assets from 0% (as established in accordance with internationally approved practice and EU requirements) to 50%. Restrictions regarding exposures that arise from transactions with residents of Zone B countries as well as total exposures to residents of Zone B countries were established. These requirements enhanced the diversification of banks' investments in Zone B countries and reduced country risk. 7

8 CREDIT INSTITUTIONS SUPERVISION DEPARTMENT. ANNUAL REPORT 1999 In May 1998, the Saeima of the Republic of Latvia adopted amendments to the Law "On Credit Institutions" establishing consolidated supervision of credit institutions. The amendments also laid the legal foundation for the Bank of Latvia's cooperation with other domestic and foreign supervisory authorities. Substantial changes were made to the procedure for liquidating a credit institution, the process of insolvency and bankruptcy, the procedure for applying rehabilitation, and the activities of the administrator and liquidator. The Bank of Latvia was granted the right to control the activities of the administrator and liquidator. The skills and professionalism of the Bank of Latvia's supervisors was recognised by the IMF's invitation to the project "Contingency Planning for the Largest Banks of Ukraine" in the second half of The tasks under the project were as follows: to evaluate the seven largest Ukrainian banks in accordance with the CAMELS rating system; with a view to the overall situation in that country and banks, to develop recommendations concerning banking regulations; and work out proposals for restructuring and rehabilitating particular banks. Organisation and Tasks of the Credit Institutions Supervision Department The main objective of the Bank of Latvia's Credit Institutions Department is to promote the stability, soundness and development of the credit institutions system. The mere existence of a supervisory system, however, cannot fully guarantee the soundness of credit institutions. Having such strict guarantees in place would be an unacceptable interference in the market. The purpose of supervision is to detect potential problems and to assist banks in preventing them or curbing their adverse economic consequences. The Bank of Latvia, therefore, places the activities of credit institutions under various restrictions whose aim is to minimise risks, while influencing the management decision making process as little as possible. The Credit Institutions Supervision Department has three divisions (see Appendix 3): the Banking Regulations and Analysis Division, the Legal and Licensing Division, and the Supervision Division. Banking Regulations and Analysis Division The objective of the Banking Regulations and Analysis Division is to develop and improve banking regulations, implement the requirements of EC banking and accounting directives, and follow the Core Principles for Effective Banking Supervision as set forth by the Basle Committee on Banking Supervision with the aim of promoting the stability and evolution of the system of credit institutions. With a view to the Division's main objectives, its staff has the following tasks: 1) to participate in drafting and amending Latvian banking laws and regulations as well as accounting regulations, and preparing Bank of Latvia regulations; 2) with trends in the Latvian banking sector in mind, to analyse regulatory requirements of other countries (especially of those in Central and Eastern Europe), EC banking directives, recommendations of the Basle Committee on Banking Supervision and the IMF's analytical papers; and work out proposals for introducing and improving regulatory requirements; 3) to cooperate with the Association of Latvian Commercial Banks and provide consultations with respect to banking regulations; 8

9 SUPERVISION OF CREDIT INSTITUTIONS 4) to produce analytical papers on the development of the Latvian supervisory system and the banking sector; 5) to inform the public about the development of the Latvian banking sector, supervision and the requirements of laws and regulations; 6) to collaborate with international organisations and other domestic and foreign supervisory authorities. Legal and Licensing Division The objectives of the Legal and Licensing Division are as follows: to provide for the compliance of the supervision of credit institutions with the requirements of the Law "On Credit Institutions", other Republic of Latvia laws and regulations, and Bank of Latvia regulations; to receive, review, compile and analyse documents and information concerning the licensing of credit institutions and granting other Bank of Latvia permits to credit institutions; and subsequently submit this information to the Bank of Latvia's senior management for further consideration. With a view to these objectives, the staff of the Legal and Licensing Division has the following tasks: 1) with respect to the activities of credit institutions and supervision, to provide information on legal issues, provide consultations on and explanations of Republic of Latvia laws and regulations; collaborate with the Association of Cooperative Credit Unions of Latvia; where required, participate in teams conducting on-site supervision of credit institutions; 2) to participate in drafting banking laws and regulations; express opinion on and work out amendments to draft regulations prepared by other organisational units of the Bank of Latvia; upon request of other public institutions, assess draft laws and regulations prepared by these institutions; 3) to represent the Bank of Latvia in court where proceedings have been initiated with respect to the liquidation or insolvency of a credit institution and other activities of a credit institution; 4) to collaborate with the liquidator and the administrator in the insolvency process of a credit institution; compile and analyse information submitted by liquidators and administrators; participate in reviewing rehabilitation plans submitted by administrators and working out draft resolutions for submission to the Executive Board of the Bank of Latvia; 5) to receive and review documents submitted by credit institutions seeking to obtain licences and Bank of Latvia permits; prepare draft resolutions and forward them to the Executive Board of the Bank of Latvia. Supervision Division The main objectives of the Supervision Division are as follows: to detect causes of possible problems in credit institutions on a timely basis; within the scope of competency, to take measures to eliminate these causes; and to react adequately so as to mitigate the adverse effects of problems in individual credit institutions on the banking sector. To pursue its objectives, the staff of the Supervision Division ensures ongoing and comprehensive banking supervision. The Division's staff has the following tasks: 9

10 CREDIT INSTITUTIONS SUPERVISION DEPARTMENT. ANNUAL REPORT ) to analyse and assess banking indicators and risk management policies; review the founding documents submitted by a credit institution seeking to obtain a licence; monitor the quantitative and qualitative changes in banks' performance indicators, and compliance with banking regulations; 2) to analyse risk management policies and procedures with respect to new financial services, submitted by banks; 3) to conduct on-site inspections in credit institutions at least once a year (the Bank of Latvia decides on the scope and frequency of inspections in each bank, taking into account the ongoing analysis of banking activities); 4) where necessary, conducts special-purpose inspections in banks, examining selected financial services (lending, management of the trading book, trust operations) and compliance with regulatory requirements; 5) where intensified supervision procedures have been applied, acts as proxy for a credit institution. Activities of the Credit Institutions Supervision Department in was a tough year for Latvian banks as they had to cope with the consequences of the 1998 Russian financial crisis; however, it proved that the Latvian banking sector was stable and flexible in adapting to the overall market conditions. In 1999, the Bank of Latvia did not issue licences to banks, but it licensed four credit unions: Raunas Kooperatīvā krājaizdevu sabiedrība, Pūņu Kooperatīvā krājaizdevu sabiedrība, Jūrnieku forums and Zosēnu Kooperatīvā krājaizdevu sabiedrība. The Bank refused to issue licences to four credit unions, because the submitted founding documents failed to meet the requirements of Republic of Latvia laws and Bank of Latvia regulations. Pursuant to the Law "On Credit Institutions", as of December 31, 1999, the paidup share capital of registered banks has to be the lats equivalent of 5.0 million euros, translated into lats by applying the Bank of Latvia's exchange rate for the euro. In 1999, 14 banks received the Bank of Latvia's permission to increase their share capital, among them were six banks that had to raise their share capital to comply with the said requirement of the Law. For the first time, in accordance with the 1998 amendments to the Law "On Credit Institutions", the rehabilitation process was initiated in two banks recognised as insolvent, and ended successfully with the restoration of these banks' solvency. During the rehabilitation of the JSC Rīgas Komercbanka, the bank which had suffered from the Russian crisis most severely, most of creditors' claims were capitalised, additional funds were attracted from shareholders and the number of shareholders was increased thereby restoring the bank's solvency. The bank's name was changed for the JSC Pirmā Latvijas Komercbanka. When rehabilitating the JSC Latvijas Industriālā banka, the bank was reorganised by merging it with the JSC Baltijas Starptautiskā banka, to which all liabilities and rights were transferred. In 1999, the Bank of Latvia revoked the licences of four banks. The licence of the JSC Bank Land was revoked for the failure to meet the capital requirements stipulated in the Law "On Credit Institutions" and regular non-compliance with the requirements governing the activity of credit institutions set out in the same law. The JSC Latvijas Kredītbanka was reorganised into an undertaking other than a credit institution. Two banks the JSC Rīgas Naftas un ķīmijas banka and the

11 SUPERVISION OF CREDIT INSTITUTIONS insolvent JSC Latvijas Industriālā banka were reorganised by merging them with other banks. As they ceased to exist, their licences were revoked. In 1999, the liquidation of 32 banks and two credit unions was continued (the liquidation of five banks was completed). In 1999, the Bank of Latvia's staff conducted 56 inspections, of which 49 were in banks. As in previous years, attention was mainly directed at the assessment of risk assets, analysis of internal control systems and evaluation of internal audit. The growing lending activity of banks throughout 1999 led to an increase in loans granted and the introduction of new types of credit. Hence, in bank examinations attention was increasingly paid to the assessment of borrowers' financial standing and solvency so as to timely detect difficulties that might arise in repaying loans. As banks expanded their activity and introduced new financial services, the focus was on the improvement and development of internal control systems at banks to provide for a prudent management of traditional and new risks. During on-site inspections, a comprehensive assessment was conducted with respect to the ability of a bank's management to identify and manage operational risks. Attention was directed at the quality of a bank's internal audit function: the qualifications of internal auditors, suitability for the position and independence from the management were evaluated. Likewise, the Bank's examiners assessed the adequacy of audits conducted, i.e. whether these audits had been sufficient to ensure adequate monitoring of the internal control system and assessment of its effectiveness. To get a timely, comprehensive and safe assurance that the Bank's information and other systems will be capable of smooth operation throughout the Year 2000 rollover period, a working group for coordinating solutions to the Y2K problem was formed in October The Credit Institutions Supervision Department participated in the Bank of Latvia's programme for addressing the Y2K problem where the compliance of the banking sector was involved. On May 13, 1999, the Board of Governors of the Bank of Latvia adopted the "Regulation for Year 2000 Compliance". The regulation was binding on all banks and branches of foreign banks registered in Latvia, which had to report to the Bank of Latvia on the course of their activities to achieve Year 2000 compliance. The information received was analysed and submitted to the Board of Governors of the Bank of Latvia and the working group for coordinating solutions to the Y2K problem. The staff of the Credit Institutions Supervision Department regularly checked on banks to determine whether they complied with the said regulation and followed their own plans when addressing the Y2K problem, and discussed the course of measures taken with banks' management. Cognisant of the possible effect of the Y2K problem on financial institutions, the Credit Institutions Supervision Department, in collaboration with the Information Systems Audit Division of the Internal Audit Department at the Bank of Latvia, conducted the relevant audits in 18 Latvian banks. Upon the Bank of Latvia's request, Arthur Andersen, Deloitte & Touche and PricewaterhouseCoopers assessed the Year 2000 compliance of five banks. During the rollover period, none of the banks had liquidity problems and none of the credit institutions reported any operational disturbances in Latvia. Under the agreement concluded between the Bank of Latvia and the European Commission, the On-Call Audit Assistance Programme continued to be implement- 11

12 CREDIT INSTITUTIONS SUPERVISION DEPARTMENT. ANNUAL REPORT 1999 ed. This programme enabled the Bank of Latvia to assess banks' internal control systems, their Year 2000 compliance, and the correctness of consolidated financial statements and reports on compliance with the regulatory requirements. The credit institutions information system, an in-house information system aimed at enhancing the effectiveness of credit institutions supervision, went live in Information is used for analytical reports, and it can be classified and grouped by topic for supervision purposes. In the course of time, the system has been expanded and improved. In 1999, the system was updated to reflect amendments in banking laws and regulations. Where the Bank of Latvia has decided on applying the intensified supervision procedures to a credit institution, an employee of the Supervision Division may be appointed as a proxy. The responsibility of a proxy is to monitor whether restrictions imposed as a result of the intensified supervision procedures are complied with, to assess the financial standing of the bank and to undertake a set of measures to stabilise the activity of the bank. In 1999, the Bank of Latvia appointed its proxies in three banks. Cognisant of the significance of cooperation in the field of supervision, the Bank of Latvia concluded its first agreement on cross-border supervision with the Financial Supervision Authority of Finland (Rahoitustarkastus) in September Likewise, the Bank reached accord with the supervisory authorities in Estonia, Lithuania, Russia, Sweden and Germany with respect to draft agreements on crossborder supervision. 1 The staff of the Credit Institutions Supervision Department continuously improve their professional skills by participating in seminars and conferences both in Latvia and abroad, by paying visits to supervisory authorities outside Latvia and by inviting advisors to the Bank of Latvia. Most training programmes for the staff of the Credit Institutions Supervision Department have been organised in collaboration with the Banque de France, the Deutsche Bundesbank, the Federal Reserve System and the Joint Vienna Institute. Also, staff members participate in training programmes organised by the Group of Banking Supervisors from Central and Eastern Europe. In 1999, upon request of the National Bank of Ukraine, employees of the Credit Institutions Supervision Department participated in a seminar organised for members of the Ukrainian Parliament to discuss draft banking laws, reporting on Latvian banking laws and regulations that establish and govern the status and activities of the central bank and credit institutions, and set forth banking requirements and procedures for a credit institution's liquidation and insolvency. The Credit Institutions Supervision Department successfully collaborates with the Association of Cooperative Credit Unions of Latvia, which was established in 1999 with the aim of promoting, developing and supporting a movement of credit unions in Latvia, training individuals connected with credit unions, and collaborating with similar organisations in other countries. Active cooperation was continued with the Association of Latvian Commercial Banks with respect to the harmonisation of draft banking regulations and organisation of training programmes for employees of credit institutions to ensure a better understanding of and compliance with new banking regulations The agreement with the Bank of Estonia was signed in March 2000 and with the Bank of Lithuania in June 2000.

13 SUPERVISION OF CREDIT INSTITUTIONS Developments in the Regulatory Framework for Banking Activities In 1999, the Credit Institutions Supervision Department continued to harmonise banking regulations with the requirements of EC directives and the Basle Core Principles for Effective Banking Supervision. The "Regulation for Receiving Bank of Latvia Permits Governing Credit Institution Operations" came into effect on May 1, 1999, replacing the "Regulation for Amending the Charter, Changing the Shareholders, the Initial Capital, the Management, the Chief Accountant, the Legal Address, the Name of Credit Institutions, and Undertaking Merger or Split-Up of Credit Institutions", which was approved by the Board of Governors of the Bank of Latvia on March 15, In the new regulation, the requirements concerning the identification of a credit institution's shareholders, their financial standing and qualifying holdings in other undertakings (business ventures) are set out more explicitly and expanded, with particular care expended to establish whether said undertakings (business ventures) include credit institutions, financial institutions or financial holding companies. The regulation lists the relevant documents to be submitted. The "Regulation for Receiving Bank of Latvia Permits Governing Credit Institution Operations" establishes that a credit institution that intends to render new financial services must inform the Bank of Latvia in writing 30 days in advance and concurrently submit to the Bank a description of policies and procedures for managing the inherent risks. Pursuant to the amendments to the Law "On Credit Institutions", the consolidated supervision of banks was introduced in Latvia on January 1, In view of this, the Board of Governors of the Bank of Latvia adopted the "Regulation for Consolidated Supervision of Banks" (in effect as of May 1, 1999). This development is vital for the harmonisation process of Latvian banking regulations with the requirements of EC directives and enhancing the effectiveness of supervision. Pursuant to the Law "On Credit Institutions", banks must comply with the capital adequacy requirement, limits on exposures, restrictions on investment in the movable property and real estate and the share capital of undertakings (business ventures) on a consolidated basis. The regulation is binding on banks whose subsidiaries and joint ventures are credit institutions or financial institutions and on banks whose parent undertakings are financial holding companies registered in Latvia. The new regulatory requirements were introduced to restrict the transfer of banking activities to unregulated or underregulated related undertakings, to evaluate additional risks inherent in the activities conducted by banks through related undertakings and to make more informed decisions about the financial standing of these banks. At present, Latvian banks mainly control small leasing companies and have also acquired qualifying holdings in the share capital of insurance, brokerage and investment companies. When preparing annual financial statements for 1999 and the subsequent years, credit institutions have to comply with the "Regulation for Consolidated Annual Financial Statements of Banks". The regulation is based on the relevant EC directives and, pursuant to the Law "On Credit Institutions", has been designed so as to include the requirements of International Accounting Standards. Consolidated annual financial statements must disclose information about the financial standing and activity results of the group consisting of a bank (a parent undertaking) and its subsidiaries to any person or investor wishing to obtain such information. The "Regulation for Compiling 'Report on Country Risk' " (adopted on July 15, 1999 by the Board of Governors of the Bank of Latvia; in effect as of October 1, 13

14 CREDIT INSTITUTIONS SUPERVISION DEPARTMENT. ANNUAL REPORT ) will regularly provide the Bank of Latvia, the supervisory authority, with information that will enable it to evaluate country risk inherent in credit institutions' operations. Country risk is associated with assets and off-balance-sheet liabilities arising from transactions with non-residents (including governments), and is related to losses that can occur if the foreign borrower (including governments) defaults on its liabilities due to political, social or economic conditions in the borrower's country. Pursuant to the regulation, the Bank of Latvia regularly receives information on the concentration of banks' assets and off-balance-sheet liabilities in individual countries, the maturity profile of assets, and factors influencing country risk. The "Regulation for Assessing Assets and Off-Balance-Sheet Liabilities" (adopted on July 15, 1999 by the Board of Governors of the Bank of Latvia; in effect as of January 1, 2000) was worked out in view of considerable qualitative changes in lending and credit risk management practices of Latvian banks. The regulation replaced the "Provisions for Evaluating Credits and Off-Balance-Sheet Items" approved by the Board of Governors of the Bank of Latvia on January 17, The "Regulation for Assessing Assets and Off-Balance-Sheet Liabilities" applies to evaluation of all types of loan, and other assets and off-balance-sheet liabilities involving credit risk. The regulation provides guidelines for evaluating the quality of banks' assets and off-balance-sheet liabilities, classifying assets and off-balancesheet liabilities in accordance with the assigned credit risk, establishing provisions for losses, and reporting changes in the quality of assets and off-balance-sheet liabilities in financial statements. The regulation was worked out in accordance with the consultative paper of the Basle Committee on Banking Supervision "Sound Practices for Loan Accounting and Disclosure", which was published in October 1998 and details the requirements of the Basle Core Principles for Effective Banking Supervision. The "Regulation for Calculating Capital Adequacy" 1 has been developed in view of the need to introduce EC banking directive 93/6/EEC "On Capital Adequacy of Investment Firms and Credit Institutions". The directive establishes capital requirements with respect to market risks. The new regulation will replace the procedure for calculating the capital adequacy ratio set out in the "Regulation for Calculating Credit Institution Performance Indicators". Previously the procedure was based on credit risk evaluation. Pursuant to the new regulation, the capital requirement is also imposed to cover market risks, including foreign exchange risk, which is inherent in all activities of a credit institution, and position, commodities, settlement and counter-party risks, which are inherent in a credit institution's trading book. The regulation will come into effect in stages. As of July 1, 2000, credit institutions will be required to calculate the capital adequacy requirement for assets and offbalance-sheet liabilities with respect to credit and foreign exchange risks. As of January 1, 2001, the capital adequacy requirement will be imposed on a credit institution's trading book positions to cover inherent market risks. Where the total of a credit institution's trading book positions exceeds the minimum criteria, the credit institution has to comply with the capital requirements with respect to position, commodities, settlement and counter-party risks. In 1999, work on a number of draft laws and regulations was begun to continue the harmonisation of the Latvian banking legislation with EC directives and intro- 1 Adopted on March 16, 2000 by the Board of Governors of the Bank of Latvia. 14

15 SUPERVISION OF CREDIT INSTITUTIONS duction of the Basle Core Principles for Effective Banking Supervision, and to reflect the acquired experience in supervision of credit institutions. The Bank of Latvia staff participates in drafting the new amendments to the Law "On Credit Institutions". The definitions for the following terms are to be changed slightly: "credit institution", "bank", "credit union", "branch of a foreign bank" and "means of payment". A number of proposed amendments refer to requirements with respect to close links between a credit institution and natural or legal persons, as set forth in Directive 95/26/EC "On Reinforcing Prudential Supervision". If these requirements are introduced, the Bank of Latvia will be able to monitor more successfully holdings of credit institutions in undertakings (business ventures), financial institutions and foreign banks. Likewise, where necessary, the Bank will be authorised to prohibit the acquisition of such holding or to ask for its termination. The amendments might also expand the range of officials subject to the requirements concerning education and professional experience, as set forth in the Law "On Credit Institutions"; at present, only persons applying for the office of chairperson of the executive board, member of the executive board, executive director, chief accountant, chairperson of the audit commission, member of the audit commission of a bank or a credit union, or manager of a branch of a foreign bank are subject to such requirements. The proposed amendments set forth that the Bank of Latvia has the power to require the dismissal of officials not complying with the above requirements. Likewise, it is stipulated that credit institutions, for supervisory purposes, may be asked to submit auditors' long-form report covering a number of specified issues. Work on the draft "Regulation for the Register of Credit Institutions' Debtors" has been begun, because the Law "On Credit Institutions" requires that for the purposes of establishment and functioning of the register of credit institutions' debtors, a credit institution, pursuant to Bank of Latvia regulations, provides the Bank of Latvia with information on its debtors and the course of settling their liabilities. To follow best world models in minimising money laundering, the "Guidelines for Developing Procedures for Identifying Suspicious Financial Transactions" 1 were drafted. The Law "On the Prevention of Laundering of Proceeds Derived from Criminal Activity" sets forth that the management and employees of a credit institution must report to the Office for Preventing Laundering of Proceeds Derived from Criminal Activity (Disclosures Office) any facts that due to any circumstances are suspected to involve money laundering or attempted money laundering, and refrain from transactions involving money laundering or attempted money laundering. It is difficult to recognise operations that may be related to money laundering, and this process directly involves decisions made by individuals. The Bank of Latvia recommendations lay down core principles to be observed by credit institutions when describing control procedures for identifying and avoiding suspicious financial transactions. 1 Adopted on July 13, 2000 by the Board of Governors of the Bank of Latvia. 15

16 CREDIT INSTITUTIONS SUPERVISION DEPARTMENT. ANNUAL REPORT 1999 ACTIVITIES OF BANKS Development of Banks At the end of 1999, in Latvia, there were 23 banks (see Appendix 4), the Riga Branch of Société Générale (France) 1, and the representative office of Dresdner Bank AG (Germany). Foreign investment was made in 20 banks; in 12 of these, foreign shareholders owned over 50% of the share capital. Six banks were subsidiaries of foreign banks: the JSC MeritaNordbanken Latvia 1, the JSC Hansabanka, the JSC Latvijas Unibanka, the JSC Saules banka, the JSC Vereinsbank Rīga and the JSC Latvijas Biznesa banka. The Latvian Government was the sole owner of the JSC Latvijas Hipotēku un zemes banka. Capital concentration in the banking sector continued. As at December 31, 1999, the assets of five largest banks, in each of which assets totalled over 100 million lats, accounted for 61.7% of banks' assets. Assets The three years following the restoration of Latvia's independence were marked by rapid expansion in the banking sector. From December 1992 to December 1994, banks' assets increased more than threefold. Having coped with the aftershocks of the 1995 crisis, banks started gaining stability. The 1996 results confirmed growth in the banking sector. From December 1995 to December 1997, banks' assets increased more than two times (see Chart 1). Positive development trends characteristic of Latvian banks in 1996 and 1997 continued in the first months of An increase in banks' assets could be observed every month, as both residents and non-residents placed their funds with Latvian banks, predominantly as deposits. In the second half of 1998, when the Russian crisis broke out, banks' assets decreased. In 1999, the ongoing positive development of Latvian banks was reflected in strong performance indicators: assets rose by 16.4%, reaching million lats, the largest amount since the restoration of Latvia's independence. Structure of Assets Different growth patterns of assets items resulted in changes in the structure of banks' assets (see Chart 2). 1 The licence of the JSC MeritaNordbanken Latvia was revoked as of May 26, The bank's assets were taken over by the newly established Riga Branch of Merita Bank Plc. Likewise, the Riga Branch of Merita Bank Plc. took over the assets of the Riga Branch of Société Générale, whose licence was revoked as of May 2,

17 ACTIVITIES OF BANKS Securities Investment in securities, which accounted for 10.0% of banks' assets in 1994, has shown considerable changes. After the 1995 banking crisis, banks looked for profitable investment opportunities, and at the end of 1997, their investment in securities increased 3.9 times over the end-1994 level. At the end of 1997, securities accounted for 25.2% of banks' assets. Until early 1996, banks mainly acquired Latvian government securities. The share of these securities in banks' portfolio of government securities was 93.1% in 1994, 84.8% in 1995, and 67.2% in In 1997, due to higher yields, banks' started investing in foreign, predominantly CIS, government securities. In 1999, the situation was different and the share of securities in banks' assets decreased to 17.0%; however, banks increased their security portfolio by 8.1%. The share of securities of OECD countries increased in the portfolio. Loans In 1994, lending was one of the major activities of Latvian banks: gross loans accounted for 44.4% of assets (see Chart 2). After the 1995 banking crisis, banks' assets decreased, as did the loan portfolio and the share of loans in banks' assets. In 1996, as banks started to expand lending, the loan portfolio increased by 38.9%; however, the share of loans in banks' assets continued to decrease. The 74.4% increase in loans granted during 1997 was a result of improving economic environment and falling discount rates of Latvian Treasury bills. Of loans, 75.1% was issued to domestic borrowers. In 1998, gross loans continued to increase (by 46.0%), yet at a less rapid pace than in The share of loans reached 43.4% of banks' assets. Loans to residents accounted for 78.3% of loans. In 1999, banks' loan portfolio increased by 16.1%, totalling million lats. The share of loans in banks' assets remained at the 1998 level, 43.4%. The share of loans to residents continued to increase in 1999, reaching 79.0% of the total. The expanding shares of loans granted to and deposits received from residents are indicative of the banking sector's growing interest in the domestic market. The Russian financial crisis eliminated profitable, yet risky, investment possibilities provided by that country, and this made Latvian banks focus on financing the Latvian economy. At the end of 1999, loans to manufacturing, trade, and transport, storage and communication, the three major sectors of the Latvian economy, accounted for 26.4%, 24.8% and 13.0% of loans to domestic enterprises, respectively. 17

18 CREDIT INSTITUTIONS SUPERVISION DEPARTMENT. ANNUAL REPORT 1999 The most widely used type of credit was commercial credit, which accounted for 41.4% of loans to enterprises and private persons. The share of industrial credit in loans to enterprises and private persons also continued to expand, reaching 25.1% at the end of the year. With the Latvian economy growing, the share of loans to the public sector decreased (see Chart 3). As the market for real estate developed, loans to private persons increased. The maturity profile of loans showed positive development trends. Loans with a maturity of over one year increased, and their share in banks' loans was 34.0% in 1996, 43.4% in 1997, 45.0% in 1998, 64.8% in 1999 (for the maturity profile of banks' loan portfolio, see Chart 4). These changes are indicative of a gradual transition from short-term lending to trade to lending to the goods-producing sector and the service sector. Liabilities Structure of Liabilities Different growth patterns of liabilities items caused changes in the structure of banks' liabilities (see Chart 5). Banks received funds mainly in the form of deposits. The share of deposits in banks' liabilities increased from 61.8% at the end of 1998 to 65.8% at the end of Although Latvian banks' liabilities to credit institutions increased by 6.2% during 1999, their share in total liabilities decreased by 1.2 percentage points. Deposits The banking crisis, which was concurrent with a decrease in depositors' (mainly private) confidence in the first half of 1995, and the blocking of depositors' funds in banks, whose licences were revoked due to insolvency, led to a decrease in deposits held with Latvian banks (for deposits in breakdown by depositor, see Chart 6). In 1996, the increase in deposits, especially those of private enterprises, pointed to gradual improvements in the country's economic position. At the end of 1996, deposits amounted to million lats (a year-on-year increase of 29.5%), exceeding the pre-crisis level (623.8 million lats at the end of 1994). At the end of 1997, deposits totalled million lats, exceeding by 57.5% the end-1996 level. The increase was mainly achieved by attracting funds from private enterprises. At the end of 1998, deposits received by banks declined by 37.8 million lats or 3.5%. Influenced by the Russian financial crisis, non-residents' deposits declined by 15.7%. At the same time, residents' deposits grew. 18

19 ACTIVITIES OF BANKS At the end of 1999, deposits reached million lats, increasing by 23.8% compared with the level at end The 1999 level is the all-time high recorded for deposits with Latvian banks. This confirms public confidence in Latvian banks. The maturity profile of deposits showed positive changes: growth was recorded for the shares of short-, medium- and long-term deposits. The share of demand deposits declined from 74.9% at the end of 1998 to 68.3% at the end of At the same time, short-term deposits increased by 65.2%, reaching 28.1% of total deposits (for the maturity profile of deposits, see Chart 7). Liabilities to Credit Institutions In 1995, the domestic interbank market was inactive. In 1996, the situation was much different, and at the end of the year, liabilities to domestic credit institutions reached 21.2 million lats (see Chart 8). Liabilities to credit institutions in non- OECD countries accounted for 54.4% of liabilities to credit institutions. At the end of 1999, the market situation again changed significantly: liabilities to credit institutions in OECD countries constituted 63.2% of liabilities to credit institutions. The maturity profile of liabilities to credit institutions in OECD countries changed significantly during At the end of 1999, the largest part of liabilities to credit institutions in OECD countries were long-term. At the end of 1997, liabilities having a maturity of one year or over one year constituted 57.2% of liabilities to credit institutions in OECD countries, whereas at the end of 1999, 73.1%. Equity Pursuant to Republic of Latvia laws and regulations, the own funds of banks had to be at least thousand lats before March 31, 1996, 1.0 million lats as of April 1, 1996, 2.0 million lats as of April 1, 1998, and as of January 1, 2000, the lats equivalent of 5.0 million euros according to the Bank of Latvia's exchange rate. This requirement promoted a gradual increase in banks' equity. The paid-up share capital of banks grew by 34.2% in 1997 and by 29.6% in 1998 (for banks' paid-up share capital, see Chart 9). In 1999, the paid-up share capital of banks increased by 4.3%. As banks incurred losses in 1998, their equity fell below the paid-up share capital in 1998 and At the end of 1998, foreign investment in the share capital of Latvian banks was 67.7% (a year-on-year increase of 2.7 percentage points; for banks' share capital in breakdown by investor, see Chart 10). Foreign investment was made in the capital of 24 banks (out of 27 banks operating in Latvia). 19

20 CREDIT INSTITUTIONS SUPERVISION DEPARTMENT. ANNUAL REPORT 1999 In 15 banks, foreign shareholders owned over 50% of the share capital. In 1999, the share of foreign shareholders' holding in Latvian banks declined slightly (by 1.5 percentage points), to 66.2% at the end of the year. In 1999, shareholders from Estonia and Sweden significantly increased their share in Latvian banks' share capital (by 3.3 percentage points and 5.0 percentage points, respectively). This can be explained with the fact that two large Scandinavian banks Skandinaviska Enskilda Banken AB and FöreningsSparbanken AB (Swedbank) expanded their activity in the Baltic financial market. The holding of the European Bank for Reconstruction and Development in the share capital of Latvian banks increased; however, its share in the total decreased. Russian investment in banks' capital decreased by 1.4%, as did its share in the total (by 1.4 percentage points). Shareholders from the United States increased their investment; however, its share in the total decreased by 3.5 percentage points. The breakdown of Latvian banks' share capital by shareholder revealed positive trends: the number of shareholders related to off-shores decreased, as did their share in the total. Profitability In 1996, banks had successfully recovered from the 1995 banking crisis, and their profit was 30.3 million lats. The main sources for profit were investment in securities and foreign exchange transactions (for banks' income and expense, see Chart 11). In 1997, the profit of banks reached 46.0 million lats. Income on trading securities almost doubled. With the quality of banks' assets improving, net impairment charges decreased considerably. Latvian banks held mainly Russian government securities with a view to high income from risky CIS markets; therefore, banks' losses for 1998 were considerable. Banks that had lent to domestic enterprises exporting their services or goods to eastern markets also incurred considerable losses. The losses of the latter, however, were much lower than those incurred due to holdings of Russian government securities. At the end of 1998, in the monthly financial position reports, banks reported a loss of 28.4 million lats. At the beginning of 1999, when many Russian banks were insolvent and defaulted on their liabilities, assets placed in Russia were reassessed. As a result, according to banks' annual reports for 1998 (submitted by March 31, 1999) losses totalled million lats. In 1999, banks' profit for the year amounted to 17.9 million lats. The main sources for profit were interest income on loans, commission and fee income and income on foreign 20