IMPLEMENTATION COMPLETION AND RESULTS REPORT (IBRD-77970) ON A LOAN IN THE AMOUNT OF EURO 200 MILLION (US$ MILLION EQUIVALENT)

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank Report No: ICR IMPLEMENTATION COMPLETION AND RESULTS REPORT (IBRD-77970) ON A LOAN IN THE AMOUNT OF EURO 200 MILLION (US$ MILLION EQUIVALENT) TO REPUBLIC OF LATVIA FOR A FINANCIAL SECTOR DEVELOPMENT POLICY LOAN February 14, 2010 Private and Financial Sector Development Department ECCU5 - Central Europe and the Baltic Countries Europe and Central Asia Region

2 CURRENCY EQUIVALENTS Exchange Rate as of Feb 2, US$ 1.00 = 0.51 Latvian Lati (LVL) FISCAL YEAR January 1 December 31 ABBREVIATIONS AND ACRONYMS AMC Asset Management Company IDA International Development Agency BoL Bank of Latvia IEG Independent Evaluation Group C/A Current Account Deficit IFI International Financial Institution CAR Capital Adequacy Ratio IFC International Financial Corporation CAS Country Assistance Strategy IMF International Monetary Fund CDS Credit Default Swap LDP Letter of Development Policy CEBS Committee of European Banking Supervisors LGD Loss Given Default CEE Central and Eastern Europe LPP Legal Protection Proceedings CPS Country Partnership Strategy LTV Loan to Value DPL Development Policy Loan LVL Latvian Lat DRWG Debt Restructuring Working Group MIGA Multilateral Investment Guarantee Agency EBRD European Bank for Reconstruction and Development MoE Ministry of Economy EC European Commission MoF Ministry of Finance ECB European Central Bank MoJ Ministry of Justice EIB European Investment Bank MOU Memorandum of Understanding ELA Emergency Liquidity Assistance NPL Nonperforming Loan EMBI Emerging Market Bond Index PDL Past Due Loan ESA European System of Accounts PER Public Expenditure Review EU European Union PFM Public Financial Management FCMC Financial and Capital Market Commission PRAF Prompt Remedial Action Framework FDI Foreign Direct Investment ROA Return on Assets FIAS Foreign Investment Advisory Service ROE Return on Equity FSAP Financial Sector Assessment Program SPV Special Purpose Vehicle FSI Financial Stability Indicator US$ US Dollar FX Foreign Exchange TA Technical Assistance GDP Gross Domestic Product VAT Value Added Tax IBRD International Bank for Reconstruction and Development WB World Bank Vice President: Country Director: Sector Manager: ICR Team Leader: ICR Author: Philippe Le Houerou Peter C. Harrold Sophie Sirtaine Andres Jaime Sarah Zekri

3 LATVIA FINANCIAL SECTOR DEVELOPMENT POLICY LOAN TABLE OF CONTENTS Contents A. Basic Information...ii B. Key Dates...ii C. Ratings Summary...ii D. Sector and Theme Codes...iii E. Bank Staff...iii F. Results Framework Analysis...iii G. Ratings of Project Performance in ISRs...vi H. Restructuring (if any)...vii 1. Program Context, Development Objectives and Design Context at Appraisal Original Program Development Objectives (PDO) and Key Indicators Revised PDO and Key Indicators, and Reasons/Justification Original Policy Areas Supported by the Program Revised Policy Areas Other significant changes Key Factors Affecting Implementation and Outcomes Program Performance Major Factors Affecting Implementation Monitoring and Evaluation (M&E) Design, Implementation and Utilization Expected Next Phase/Follow-up Operation Assessment of Outcomes Relevance of Objectives, Design and Implementation Achievement of Program Development Objectives Justification of Overall Outcome Rating Overarching Themes, Other Outcomes and Impacts Assessing of Risk to Development Outcome Assessment of Bank and Borrower Performance Bank Performance Borrower Performance Lessons Learned Comments on Issues Raised by Borrower/Implementing Agencies/Partners Annex 1 Bank Lending and Implementation Support/Supervision Processes Annex 2. Beneficiary Survey Results Annex 3. Stakeholder Workshop Report and Results Annex 4. Summary of Borrower s ICR and/or Comments on Draft ICR Annex 5. Comments of Cofinanciers and Other Partners/Stakeholders Annex 6. List of Supporting Documents Annex 7. Map... 41

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5 A. Basic Information Country: Latvia Program Name: Financial Sector DPL, Latvia Program ID: P L/C/TF Number(s): IBRD ICR Date: 02/14/2011 ICR Type: Core ICR Lending Instrument: DPL Borrower: Original Total Commitment: Revised Amount: USD 282.7M Implementing Agencies: Ministry of Finance Cofinanciers and Other External Partners: REPUBLIC OF LATVIA USD 282.7M Disbursed Amount: USD 295.3M B. Key Dates Process Date Process Original Date Revised / Actual Date(s) Concept Review: 05/14/2009 Effectiveness: Appraisal: 08/19/2009 Restructuring(s): Approval: 09/22/2009 Mid-term Review: Closing: 03/24/ /24/2010 C. Ratings Summary C.1 Performance Rating by ICR Outcomes: Risk to Development Outcome: Bank Performance: Borrower Performance: Highly Satisfactory Substantial Satisfactory Satisfactory C.2 Detailed Ratings of Bank and Borrower Performance (by ICR) Bank Ratings Borrower Ratings Quality at Entry: Highly Satisfactory Government: Satisfactory Quality of Supervision: Satisfactory Implementing Agency/Agencies: Satisfactory Overall Bank Performance: Satisfactory Overall Borrower Performance: Satisfactory C.3 Quality at Entry and Implementation Performance Indicators Implementation QAG Assessments Indicators Performance (if any) Potential Problem No Quality at Entry None Rating: i

6 Program at any time (Yes/No): (QEA): Problem Program at any time (Yes/No): DO rating before Closing/Inactive status: No Quality of Supervision (QSA): None D. Sector and Theme Codes Original Actual Sector Code (as % of total Bank financing) Banking Housing finance and real estate markets Payment systems, securities clearance and settlement 9 9 Theme Code (as % of total Bank financing) Debt management and fiscal sustainability 7 7 Regulation and competition policy State enterprise/bank restructuring and privatization E. Bank Staff Positions At ICR At Approval Vice President: Shigeo Katsu Philippe H. Le Houerou Country Director: Peter C. Harrold Peter C. Harrold Sector Manager: Sophie Sirtaine Lalit Raina Program Team Leader: Andres D. Jaime Sophie Sirtaine ICR Team Leader: ICR Primary Author: Andres D. Jaime Sarah Zekri F. Results Framework Analysis Program Development Objectives (from Project Appraisal Document) The Development Objective of the DPL operation is to support reforms and stabilize the financial system in order to ensure long-term financial stability in Latvia. Revised Program Development Objectives (if any, as approved by original approving authority) Noy applicable. ii

7 (a) PDO Indicator(s) Indicator Indicator 1 : Value (quantitative or Qualitative) Original Target Values (from Baseline Value approval documents) Adequate provisioning of NPLs. Provisions fully Provisions fully meet meet regulatory regulatory requirements requirements Formally Revised Target Values Actual Value Achieved at Completion or Target Years 12 banks (with market share in total assets %, in total loans %) had provisions that fully met the regulatory requirements as of end-september Date achieved 12/31/ /24/ /24/2010 Target is partially met: as of Sep. 2010, the 9 remaining banks, although Comments complying with the IAS 39 provisioning rules, as confirmed by external (incl. % auditors, have been required to increase their provisions based on previously achievement) conducted on-site inspectio Indicator 2 : Well-capitalized banks. Value (quantitative or Qualitative) Average CAR of CAR of banking system the banking was 11.8% system to remain above 10% Average CAR of the banking system at 14.2% as of March 2010 and 15.2% as of October 2010 Date achieved 12/31/ /24/ /24/2010 Comments (incl. % achievement) Average CAR of the banking system has increased from 11.8% in Dec to 14.2% in March 2010 and has reached 15.2% since then, well above the Endof-Project Target Value of 10%. Indicator 3 : Stabilization of resident and nonresident deposits. Value (quantitative or Qualitative) -4% deposit growth 0% monthly from Dec to May growth 2009 Since end of Feb.2010, the trend of loss of deposits reversed, and as of end of Oct.2010 has achieved 8.2% growth Date achieved 12/31/ /24/ /24/2010 Comments Target was fully achieved but 2 months later than it had been originally (incl. % envisaged. achievement) Indicator 4 : Adequate handling of potential bank distress by the authorities. Value (quantitative or Qualitative) Parex Banka distressed. Financial stability maintained. In late March 2010, the Latvian government, with iii

8 the approval of the EU decided to split Parex Banka in two entities, under the good bank # bad bank model. Citadele (good bank) started to operate as a new bank on August 1st. Both Citadele and Parex Banka. Date achieved 12/31/ /24/ /24/2010 Comments (incl. % achievement) Indicator 5 : Value (quantitative or Qualitative) Very positive achievement given that Parex Banka almost collapsed at the end of 2008 threatening the overall financial stability of the Latvian banking sector. Increased number of corporate rehabilitations initiated. 22 cases between January 2008 and June cases. Between July 2009 and December 2009, there were 18 cases of Legal Protection Processes (LLP), i.e. the total of LLP as of December 2009 is 40. Date achieved 06/30/ /31/ /31/2009 Comments (incl. % achievement) Exceeding original target by 10 cases of LLP in In 2010, there have been an additional 54 cases of LLP and 132 out of court legal protection processes (OCLPP) as of September 2010 (vs. 55 in 2009). Indicator 6 : Increased number of mortgage debt restructuring. Value (quantitative or Qualitative) 14% of mortgages restructured out of total mortgages. 20% of mortgages restructured out of total mortgages. Used as a proxy, the number of restructured loans as a percentage of total loans to consumers has improved from 16% to almost 23%. Date achieved 12/31/ /24/ /24/2010 Comments (incl. % Based on available data, target was fully achieved. achievement) Indicator 7 : Early identification of bank-level and system level vulnerabilities. No early identification Adoption of Value of bank-level and Maintain financial enhanced (quantitative or system-level stability. supervisory and Qualitative) vulnerabilities regulatory measures iv

9 by FCMC to early identify signs of vulnerabilities at all levels. These measures include prompt remedial action plan, active supervision of banks etc. Date achieved 12/31/ /24/ /01/2010 Comments (incl. % achievement) Indicator 8 : Value (quantitative or Qualitative) Very positive impact given that the supervisory and regulatory framework is continuously enhanced to pre-empt and address all early signs of vulnerabilities. Early remedial actions taken to address vulnerabilities. No early remedial actions to address vulnerabilities Maintain financial stability. Adoption of enhanced supervisory and regulatory measures by the banking sector regulator (FCMC) to establish an early remedial action framework. Further enhancements are planned. Date achieved 12/31/ /24/ /24/2010 Comments (incl. % Target met successfully. achievement) Indicator 9 : Decrease in spread on credit default swaps (CDS) reported spread for Latvia compared to December 2008 levels. Value CDS spreads 366bp (quantitative or Qualitative) 819bp 10% decrease (-453 bp, i.e., 55% decrease) Date achieved 12/31/ /12/ /12/2010 Comments (incl. % Exceeded the expected target by more than 5 times. achievement) Indicator 10 : Action plan established by CRPC to implement recommendations of consumer protection review. Value (quantitative or Qualitative) No action plan to expand CRPC#s role for financial services. Establish action plan to provide protection to consumers of financial services. Detailed "Action Plan on Financial Consumer Protection" based on the Diagnostic Review of Consumer Protection and v

10 Financial Capability in Latvia, as prepared with the assistance of the World Bank in November 2009 was released in March Date achieved 12/31/ /24/ /24/2010 Comments (incl. % achievement) Impressive target completion given the low staff capacity. Moreover, the action plan is already partly implemented. (b) Intermediate Outcome Indicator(s) Indicator Indicator 1 : Value (quantitative or Qualitative) Date achieved Comments (incl. % achievement) Baseline Value Not Applicable. Original Target Values (from approval documents) Formally Revised Target Values Actual Value Achieved at Completion or Target Years G. Ratings of Program Performance in ISRs Actual Date ISR No. DO IP Disbursements Archived (USD millions) 1 06/19/2010 Highly Satisfactory Highly Satisfactory H. Restructuring (if any) Not Applicable vi

11 1. Program Context, Development Objectives and Design 1.1 Context at Appraisal Country and Sector Background: Following its accession to the European Union (EU) in 2004, the Latvian economy experienced rapid economic growth averaging over 10 percent per year. This high growth was driven almost entirely by domestic demand, encouraged by rapid credit growth, large real wage increases, and expectations of a progressive catching-up with EU living standards. New investment was concentrated in the non-tradable sectors, creating a real estate boom, which culminated in an over 60 percent growth in housing prices in both 2005 and The expansion of credit was largely financed by external borrowing from private banks, resulting in high loan-to-deposit ratios. For foreign banks (which account for almost 60 percent of the banking system), their parent institutions were the main source of financing. Domestic banks relied substantially on short-term syndicated loans (as well as non-resident deposits). The overall loan to deposit ratio at 248 percent in 2007 was the highest in the region. With the bulk of the loans denominated in foreign currency (around 86.3 percent of total loans in 2007 were FX denominated, out of which 96 percent were in Euros), and much of it unhedged, the banking sector also became indirectly vulnerable to foreign exchange risk (i.e., through the risk of an increase in credit losses). In the second half of 2008, in the context of the global financial crisis, these vulnerabilities coalesced into a financial and balance of payments crisis. A large current account deficit (-12.6% of GDP), high external debt (128% of GDP), and a very high loan to deposit ratio (287.8%) resulted in the loss of access to foreign exchange funding in the second half of This led financial markets to become increasingly concerned about the sustainability of the peg arrangements. The currency peg came under substantial pressure in September 2008 and, by November 2008, the Bank of Latvia (BoL) s foreign exchange reserves has fallen by 20%. Concerns among foreign banks about their overexposure to the Baltic countries resulted in a sharp slowdown in credit. The slowdown in credit, in conjunction with a weakening in external demand in the context of depreciations against the Euro of the currencies of some of Latvia s external partners, and deterioration in economic sentiment, led to a significant downturn in domestic economic activity. The deposit run on Parex Banka led to the state taking a majority stake in the bank s capital and to a restriction on deposit withdrawals. Parex Banka is considered systemically important (and therefore too big to fail) given its role in the domestic payment system and in municipal financing, its large branch network and large market share. Therefore, in mid-november 2008, in the face of growing illiquidity, the Government took a 51 percent stake in the bank. This, however, failed to stem the 1

12 outflow of deposits and the authorities had to increase their liquidity support. In early December 2008, the Latvian Financial and Capital Market Supervisory Authority (FCMC) restricted withdrawals by corporate, and individuals from the bank and the State further increased their shareholding to 85 percent. New management was put in place to work out a resolution that would minimize losses for the state and allow for a return of the bank to the private sector. Further risks to the bank s stability came from the need to roll-over Euro 775 million of syndicated loans falling due in February and June Negotiations with syndicated lenders led to the rescheduling of payments in March A due diligence analysis, focused on the bank s asset quality, liquidity and solvency, was conducted by PricewaterhouseCoopers in early 2009, on the basis of which additional provisions were booked in the 2008 financial statements. In April, EBRD approved the acquisition of 25 percent plus 1 of the ordinary shares of Parex Banka for LVL 59.5 million ( 84.2 million) and a subordinated loan of 22 million qualifying as Tier 2 capital. These developments led the Government to seek external financial support and to agree to an international stabilization program, supported by the EC, the IMF, EBRD, Nordic and Central European countries, and the World Bank. The requested rescue package amounted to 7.5 billion, equivalent to 35 percent of Latvia s GDP. The international stabilization package was anchored to the Government strategy to maintain Latvia s exchange rate peg through strong domestic adjustment policies and substantial external financing. The 27-month program was based on preserving the Lat exchange rate peg to the Euro within a narrow band. The authorities chose to maintain the quasi currency board that served them well in the past. Among other factors, they took into consideration the balance sheet effect of a potential devaluation and the risks that this would have resulted in severe corporate, banking sector and social distress, which could further have contributed to output contraction and sever Latvia s links to capital markets for a protracted period of time. While maintaining the peg, exceptionally strong domestic adjustment policies, including very substantial fiscal consolidation and sizable external financing, was needed. Rationale for World Bank Assistance. The proposed DPL to the Republic of Latvia in the amount of 200 million (US$ million equivalent) was designed to support the Government s recovery program of end 2008 and of This program included measures to: (i) stem immediate liquidity pressures; (ii) restore long-term stability by strengthening the financial sector, correcting fiscal imbalances and adopting domestic policies aimed at improving competitiveness while maintaining the fixed exchange rate; and (iii) strengthen the long-term structural performance of the economy. In the financial sector, the immediate objective of the program was to stabilize the sector and restore depositor confidence. The program was coordinated with other development partners, in particular with the IMF and the EC to ensure consistency. 2

13 1.2 Original Program Development Objectives (PDO) and Key Indicators The objective of the DPL was to support reforms and stabilize the financial system in order to ensure long-term financial stability in Latvia. The overall 10 Project key Outcome Indicators were set as follows: Adequate provisioning of NPLs; Well-capitalized banks; Stabilization of resident and non-resident deposits; Adequate handling of potential bank distress; Increased number of corporate rehabilitations initiated; Increased number of mortgage debt restructuring; Early identification of bank-level and system-level vulnerabilities; Early remedial actions taken to address vulnerabilities; Ten percent decrease in spread on credit default swaps reported for Latvia compared to Dec levels; Action plan established by CRPC to implement recommendations of consumer protection review. 1.3 Revised PDO and Key Indicators, and Reasons/Justification No revisions were made to the original PDO. 1.4 Original Policy Areas Supported by the Program The DPL operation supported a comprehensive sector reform program including prior policy measures in five main policy areas, in line with the objectives and outcome indicators aforementioned to: Strengthen the banking sector s solvency and liquidity including: (i) conducting stress tests of the banking sector under severe macro-economic conditions and requiring banks showing signs of solvency or liquidity problems under the stress tests to prepare capital increase and liquidity contingency plans; (ii) preparing a detailed Contingency Plan for the banking sector, ensuring prompt government intervention as and where needed. Improve the bank resolution framework to enable swift bank interventions. Facilitate the renegotiations of corporate and mortgage debts with the objective to avoid the closure of viable firms and the foreclosure of residential properties wherever possible. The debt renegotiation facilitation measures included: (i) amending the insolvency framework to enable out-of-court corporate restructuring negotiations, (ii) publishing guidelines to facilitate renegotiations of corporate and mortgage debts, and (iii) organizing seminars on this subject to increase awareness of options among borrowers. 3

14 Strengthen financial supervision and regulation, including (i) asset quality and capital adequacy regulation and (ii) prudential supervision, especially through the adoption of a Prompt Remedial Action Plan by the supervisory authority. Strengthen consumer protection. 1.5 Revised Policy Areas Policy areas were not revised. 1.6 Other significant changes There were no other significant changes. 2. Key Factors Affecting Implementation and Outcomes 2.1 Program Performance The Financial sector DPL was a single tranche operation. To support the measures mentioned above, the Financial Sector DPL set 10 prior, core policy actions as detailed in Table 1 below. Table 1: Financial Sector DPL: Disbursement conditions Tranche 1 Description Status Policy action 1 The Bank of Latvia (BoL), with inputs from the FCMC, has completed Met stress tests of the banking sector in order to assess its resilience to potential worst case scenarios. Policy action 2 The Borrower has prepared a Strategic Contingency Plan for the Met financial sector on the basis of the results of the stress tests referred to in condition 1. Policy action 3 The Borrower s Parliament has approved amendments to the Credit Met Institution Law with a view to strengthen the Borrower s legal framework for bank resolution Policy action 4 The Borrower s Parliament has approved amendments to the Met Insolvency Law with a view to: (i) removing potential obstacles to outof-court proceedings for corporate restructuring; (ii) allowing prepackaged restructuring agreements; and (iii) introducing further flexibility and easier access to insolvency proceedings. Policy action 5 The Borrower s Parliament has approved amendments to the Civil Met Procedure Law in order to simplify the existing mortgage foreclosure process. Policy action 6 The Borrower has implemented a debt restructuring program entailing: (i) the approval by the Consultative Council of guidelines for corporate debt restructuring and their publication by the Ministry of Justice; and (ii) the approval and publication by the FCMC of guidelines on mortgage debt restructuring. Met 4

15 Policy action 7 Policy action 8 Policy action 9 Policy action 10 The BoL has adopted an improved stress testing framework based on multiple scenarios and a revised credit risks module to be operated on a regular module. The FCMC has adopted a remedial action framework that establishes a matrix of triggers and a range of discretionary and non-discretionary supervisory actions for use when a bank has not complied with the laws, regulations and supervisory decisions. The FCMC has: (i) issued revised and strengthened prudential regulations for asset quality and capital adequacy; (ii) prepared a draft liquidity risk management regulation to be revised on the basis of the recommendations of the Committee of European Banking Supervisors and the directives of the European Union; and (iii) included the issuance of regulations on credit risk management in its action plan for The Consumer Rights Protection Centre (CRPC) has completed a comprehensive review of consumer protection laws, regulations and institutional set-up for the financial sector in line with international good practices. Met Met Met Met All prior policy actions were met on time as planned and the tranche was released on April 11, 2009 as described in Table 2 below. The loan was closed on its original closing date March 24, Table 2: Tranche dates Tranche 1 DPL fully disbursed shortly after effectiveness Amount Expected Actual Release (US$) Release Date Date 282,650,000 11/04/ /04/2009 Regular Release The Financial Sector DPL emphasized how it supports and complements the 7.5 billion international rescue package of the IMF, EC, EBRD, Nordic countries and other lenders. The IMF operation was approved on December 23, 2008 and the World Bank team collaborated very closely with the IMF team by discussing complementarities and mutually supportive core measures. To this matter, there had been prior IMF policy actions notified in the program which were not part of the core prior actions of the Financial Sector DPL but played an important role in the realization of the program objectives: Among IMF prior policy actions, several were significant to achieve the Financial Sector DPL objective such as measures to: (i) Enhance Lender of Last Resort Facilities: the BoL issued regulations in January 2009 to strengthen institutional arrangements for emergency liquidity support; (ii) Examine the banking system by international audit firms to ensure that banks are solvent and have sufficient liquidity; 5

16 (iii) Amend banking laws to give FCMC, BoL and the Government powers to restore financial stability in case of systemic crises and enhance the special bank insolvency regime. In addition, the Financial Sector DPL was one part of the World Bank s contribution to the international rescue package. A parallel 200m DPL was approved by the World Bank Board in March 2010 to support the Government s budget to implement the Government s Emergency Social Safety Net Strategy (ESSNS). The program of two loans of 100m each focused on safety net support and medium-term social sector expenditure reforms. The objectives of the proposed program are: (i) to protect vulnerable groups with emergency safety net support during the economic contraction; (ii) to mitigate the social costs of fiscal consolidation; (iii) to ensure structural reforms lay a foundation for medium-term improvements in the social sectors. The first operation (P Latvia First Special DPL: Safety Net and Social Sector Reform Program) focused mainly on the first and second objectives. Based on the latest Implementation Report Status (ISR) produced on June 19, 2010, DO and IP are both rated Satisfactory: The Ministry of Finance (MoF), and social sector ministries, including the Ministry of Regional Development and Local Government, have met the targets for implementing the ESSNS, which they set for themselves at the outset of the program. Finally, the project went as planned, all activities were implemented as designed, and the project closed on December 31, 2010 as expected, with no change or restructuring. The second DPL operation (P Latvia Second Safety Net and Social Sector Reform Program Loan) is under preparation for 2011 and will expand the original focus to ensure structural reforms lay a foundation for medium-term improvements in the social sectors. 2.2 Major Factors Affecting Implementation There were no significant factors making implementation differ from the agreed program. 2.3 Monitoring and Evaluation (M&E) Design, Implementation and Utilization M&E and implementation arrangements were continuous and contributed to reforms implementation and the achievement of development objectives. There were enough indicators to monitor the outcomes. Targets were established for most indicators. Data were collected on a regular basis and used to monitor progress towards the outcomes. In addition, most of these indicators were supported by targets and baselines (for 6 indicators out of 10). Given that the program was designed as a stand-alone operation over a period of a year in the middle of the 2008-early 2009 global financial sector crisis, efforts were made to define in collaboration with the authorities mostly quantitative indicators to facilitate monitoring. 6

17 It is worth noting that the Program Document did recognize that some of the indicators - CDSs spreads and growth of deposits - were influenced by factors outside the control of the program, such as the general economic conditions in the region. 2.4 Expected Next Phase/Follow-up Operation A Financial Sector follow-up operation is not anticipated. However, as detailed earlier, a 2 nd DPL operation of the Latvia Second Safety Net and Social Sector Reform Program Loan (P121796) is under preparation. World Bank approval is scheduled on May 24, In addition, MoF has verbally requested a follow-on operation in the form of a developmental Financial Sector Assessment Program (FSAP) to maintain the ongoing policy dialogue initiated by the DPL operation. The FSAP mission is planned in July Assessment of Outcomes 3.1 Relevance of Objectives, Design and Implementation The objective of the DPL remained highly relevant throughout the course of the project and continues to be highly relevant. The reform program supported by the DPL was built on five objectives covering crisis mitigation measures to (i) strengthen the banking sector s solvency and liquidity; (ii) strengthen the bank resolution framework; (iii) facilitate the renegotiations of corporate and mortgage debts; (iv) strengthen financial supervision and regulation; and (v) strengthen consumer protection. All these measures were in line with the policy actions of the Government s 27-month stabilization program signed on December 19 th, 2008 with the EC, IMF, bilateral and multilateral donors and the World Bank. The DPL program focused largely on medium- and long-term measures aimed at protecting financial sector stability in response to the crisis through strengthening the solvency of Latvia s financial sector and ensuring adequate liquidity. The project s intervention was very appropriate and timely. Latvia s Government and the World Bank jointly in coordination with the IMF and the EC adapted the operation s design to respond to the immediate needs of the country in the wake of the financial crisis. 7

18 3.2 Achievement of Program Development Objectives All the PDOs were either highly or substantially achieved, as demonstrated by the policy actions taken and targets met. The independent feedback from various stakeholders about project achievements and progress on PDOs demonstrate the positive impact of the project on the reforms to stabilize the financial sector and increase its resilience to future shocks. Objective 1: Conduct stress tests and strengthen capital adequacy Objective 1 DPL Policy actions Expected Outcomes Conduct stress -Enforcement of Indicators Baseline Target Medium term policy and outcome 8

19 tests and strengthen capital adequacy the regulations on capital adequacy, asset valuation and liquidity; -Adoption of a strategic contingency plan by adopting operational guidelines for the provision of emergency liquidity; assistance in line with international practice; -Improved cooperation between BoL and FCMC in the area of stresstesting which has strengthened the authorities understanding of macro financial risks and linkages. Adequate provisioning. Well capitalized banks. Stabilization of resident and nonresident deposits. 9 Not enough provisioning. CAR of banking system was 11.8%. 4% deposit growth from Dec.08 to May.09. Provisioning to fully meet regulatory requirements. Average CAR of banking sector to remain above 10%. 0% monthly growth achieved by end of banks (with market share in total assets %, in total loans %) had provisions that fully met the regulatory requirements as of end-september In assessment of compliance of bank's provisions with the regulatory requirements it should be noted that: - all banks comply with the IAS 39 provisioning rules, as confirmed by external auditors; - supervisory provisions as an add-on to accounting provisions are required when accounting provisions are not sufficient from the prudential point of view; -all banks make adjustments to ensure provisions are not underestimated in calculation of own funds. Average CAR of the banking system at 14.2% as of March 2010 and 15.2% as of October 2010 (see graph 1). Since end of Feb. 2010, the trend of loss of deposits reversed and as of end of Oct.2010 has achieved 8.2% growth.

20 Stress-tests: Drawing on IMF and World Bank assistance, BoL has strengthened its stress-test methodologies and capacity in BoL, and with inputs from FCMC, has developed the capability to run regularly upgraded stress tests which can be calibrated according to different risk-based scenarios. Regular stress-tests by BoL indicate that a large majority of banks are well-capitalized improving the resilience of the banking sector. Provisions and CAR: Based on the results of the stress tests, the resulting provisioning needs caused banking sector losses of LVL640 million (5 percent of GDP) in the first 10 months of Banks have responded with equity and subordinated capital increases of LVL700 million through October 2009, with a further LVL300 million in January 2010 and an addition LVL150 million in the first semester of During 2009, thirteen banks increased capital, lifting the system-wide capital adequacy ratio above 13 percent. As of end-september 2010, twelve banks (with market share in total assets %, in total loans %) had provisions that fully met the regulatory requirements 1. The remaining nine banks have been required to correct capital by total amount of L43.5 million constituting 1.5% of those banks loan portfolio as a result of previously conducted onsite inspections increasing the overall CAR of the banking system to 15.2% in November 2010, well above the minimum requirement of 8 percent (see Graph 1). Graph1: Capital Adequacy Ratio since Provisions recognized in financial statements are established according to IFRS and audited by external auditors. Supervisory provisions shall take into account expected losses and, if necessary, excess of supervisory provisions over accounting figures is deducted from own funds. Bank s estimates are considered by supervisors). 10

21 Source: FCMC Both resident and non-resident deposits depositor s confidence has been restored as evidenced by the continually increasing deposits since the beginning of 2010 (see Graph 2). Between December 2008 and March 2010, resident deposits increased by 1 percent y/y and non-resident deposits by 2 percent y/y. These results reflect improving liquidity in Latvia and in neighbor s countries, the confidence effect of recent program disbursements, continued restrictions on withdrawals of large deposits from Parex Banka, and the stabilization of the banking sector. Graph 2: Evolution of resident and non-resident deposits Source: FCMC 11

22 Objective 2: Strengthened bank resolution framework Objective 2 DPL Policy actions Expected Outcomes Strengthened Indicators Baseline Target Bank resolution Parex Banka framework distressed. -A bank resolution framework strategy was successfully developed in August 2009 (joint-effort World Bank and IMF) and internal FCMC guidelines were introduced with specific prompt remedial action for troubled banks before regulatory threshold are breached; -Amendments to the Law on Credit Institutions and to the FCMC Law were approved in February 2009 to align the legal framework for bank resolution; - Restructuring of Parex by intervening as its shareholders were not deemed and proper. Adequate handling of potential bank distress. Financial stability maintained. Medium term policy and outcome In late March 2010, the Latvian government with the approval of the EU decided to split Parex Banka into two entities, under the good bank bad bank model. Citadele (good bank) started to operate as a new bank on August 1st. Both Citadele and Parex Banka (bad bank) are under state control. The split-up of Parex is considered successful. A bank resolution framework strategy was successfully developed in August 2009 (joint effort World Bank and IMF) to enable the authorities to rapidly and adequately respond to various potential sources of vulnerability in the financial sector, including liquidity or solvency risks. The strategy defines the responsibilities of each government agency in the event of a crisis and sets out how they would take decisions. It also identifies alternative options and methods for resolving problems in various sub-groups of banks in fragile state. The plans were adopted by the Domestic Standing Group and are being regularly updated. Internal FCMC guidelines were also introduced. At the same time, amendments to the Law on Credit Institutions and to the FCMC Law were approved in February 2009 to align the legal framework for bank resolution, inter alia, as per the IMF-World Bank Global Bank Insolvency Initiatives principles. As a result, these amendments significantly strengthened the FCMC s ability to intervene troubled banks (swift bank resolution) if necessary. Finally, the Law on Bank Takeovers (which came in effect in December 2008) sets out the framework that permits the government to take over banks if needed. Resolution of Parex Banka: Submitted on March 31, 2010, the long overdue restructuring plan of Parex established the transfer of performing assets and most junior liabilities into a new good bank. Remaining assets and liabilities stayed in 12

23 a resolution bank. EBRD is a shareholder in both entities. This strategy allowed relatively quick and transparent sale of viable parts of Parex, while protecting depositors and giving the government a chance to recover part of its investment in the future by selling the good bank. This strategy should have been adopted in early 2009, but the political will and legal underpinnings were then lacking. The Cabinet approved the creation of the new bank on June 1, 2010 and on August 1 st, 2010, Citadele was launched and have been fully operating since then. Objective 3: Distressed asset management Objective 3 Distressed asset management DPL Policy actions - Reform of the corporate and personal insolvency regimes (new Insolvency Law); - Introduction of out-of-court procedures; - Amendment of the Civil procedure Law. Expected Outcomes Indicators Baseline Target Increased 22 cases between 30 cases by number of January 2008 and December corporate June rehabilitations initiated. Increased of number of mortgage restructured (% of nonperforming mortgage restructured) 14% 20% Medium term policy and outcome Between July 2009 and December 2009, there were 18 cases of Legal Protection Processes (LLP), i.e., the total of LLP as of December 2009 is 40. Used as a proxy, the number of restructured loans as a percentage of total loans to consumers has improved from 16% to almost 23%. The new Insolvency Law: The new Insolvency Law aimed at speeding the exit of nonviable firms and supporting rehabilitation of individual debtors was approved on June 26 th, 2010 and it is in force since November 1 st, For individuals, the new Insolvency Law introduces two processes: bankruptcy and debt write-off. At the beginning of the bankruptcy procedure, an insolvency administrator is designated and will act upon notification to the court that the sale of debtor s property is completed so that bankruptcy can be finalized; If there is no impediment to the debt write-off process, the individual can then proceed to a debt write-off. The length of debt write-off procedures can vary from one to three and a half years, depending on the expected income of the debtor. The debtor would only have to repay the debt principal; all contractual penalties, fines and delayed interests would be waived; Unless the debt write-off process is applied, the rights of the creditors to claim the full amount of outstanding debts would be restored and suspended enforcement proceedings in the courts on awarded but uncollected amounts would be resumed; 13

24 The full benefits of this new Insolvency framework for private individuals would be better assessed once market participants and the legal system become familiar with the new framework. For corporate, the new law provides two options legal protection and insolvency at the same time which aim at simplifying the exit of non-viable firms in a possibly short time. In 2010, additional legal reforms on debt restructuring were introduced: Amendment to the Civil Procedure Law that, inter alia, make foreclosure of a mortgage a credible threat thereby strengthening incentives for debtors to participate in workouts became effective in February 2010; In order to improve the lenders' and borrowers' understanding of the general principles for out-of-court enforcement of mortgage contracts, the FCMC adopted "Principles and Guidelines for Out of Court Consumer Mortgage Workouts" on August 14, 2009 (in effect as of August 21 st, 2009) including the general principles for ensuring out-of-court enforcement of mortgage contracts. This amendment addresses inter alia rules of engagement for all parties and elements of proper restructuring; Corporate Debt Restructuring Workshop (December 2nd, 2009) - The debt restructuring workshop focused on sharing with the authorities and with practitioners (bankers and lawyers) international experience with corporate debt restructuring, corporate rehabilitations, and insolvencies under times of crises. The workshop also described the new legal framework in Latvia for out-of-court debt restructuring, as well as the expedited court approval process for corporate rehabilitation plans. Since then, the number of corporate rehabilitations and debt restructurings has been increasing significantly. Anecdotally, it has been reported that foreign-owned banks have their own internal mechanisms to deal with workouts/restructuring cases. These mechanisms have been borrowed from their corporate head-offices in Finland, Norway, Sweden, or Denmark. In these cases, foreign banks reported that the newly introduced Corporate Debt Restructuring Guidelines (CDRGs) validate their existing practices and could serve as a tool to educate debtors about out-of-court debt restructuring practices. Local banks (medium/small size financial institutions), on the other hand, were not well aware of the CDRGs, did not have a restructuring/workouts unit, or a defined framework to manage distressed corporate loans. As a result, individual (mortgage debt included) and corporate debt restructuring have increased remarkably as described in Graph.3 below. 14

25 Graph 3: Evolution of individual and corporate debt restructuring loans and loans in work-out process Individual and corporate debt restructuring loans loans in work-out process Objective 4: Supervisory and regulatory framework strengthening 15

26 Objective 4 DPL Policy actions Expected Outcomes Supervisory and Indicators Baseline Target regulatory framework strengthening -The FCMC introduced revised regulations on asset classification and provisioning and issued new Pillar 2 Basel II regulations on Capital Adequacy Assessment Process (in 2009); -Improvement of the "Regulations on Liquidity Requirements, Compliance Procedures and Liquidity Risk Management" adopted on 28 December 2009 (in effect as of 1 April 2010); -Enhancement of the "Regulations on Credit Risk Management" adopted on 28 December 2009; -"Policy on timely corrective measures for the banks was adopted on August 21, Early detection of bank-level and systemlevel vulnerabilities Early remedial actions taken to address vulnerabilities No early detection of bank-level and system-level vulnerabilities No early remedial actions taken to address vulnerabilities Early detection of bank-level and system-level vulnerabilities Maintain financial stability Maintain financial stability Medium term policy and outcome Adoption of enhanced supervisory and regulatory measures by the banking sector regulator (FCMC) to early identify signs of vulnerabilities at all levels. These measures include prompt remedial action plan, active supervision of banks incorporating stresstesting and more detailed reporting data on quality of loan portfolio for more comprehensive analysis of the loans being restructured and loans newly granted. Adoption of enhanced supervisory and regulatory measures by the banking sector and the regulator (FCMC) to establish an early remedial action framework. Liquidity risk revised: The improvement of the "Regulations on Liquidity Requirements, Compliance Procedures and Liquidity Risk Management" adopted on 28 December 2009 (in effect as of April 1 st, 2010) details the requirements for liquidity risk management, inter alia introducing requirements for management of funding structure, management of assets eligible as loan collateral as well as a requirement to develop a set of internal indicators for liquidity measurement. Based on three types of stress tests, a bank should determine the size of the 16

27 required liquidity buffer and maintain adequate liquid assets for the liquidity buffer. Credit Risk revised: The enhancement of the "Regulations on Credit Risk Management" adopted on December 28, 2009 (in effect as of January 6, 2010) contains a requirement to develop and apply the credit risk tolerance determining methodologies and lay out the rights and responsibilities of a bank s council, executive board and employees involved in credit risk management. Requirements for credit risk management strategies and the policies and procedures required for their implementation have been further specified, particularly highlighting the lending policies and procedures, and concentrating on risk management requirements. "Regulations on Credit Risk Management" request the banks to perform regular stress tests and develop contingency plans for the pessimistic scenario. Financial sector supervision has been strengthened by stronger cooperation between BoL and FCMC. Reporting requirements have been improved by increasing the frequency and quality of reporting on restructured loans to enhance assessments of asset quality. At the same time, improved cooperation between BoL and FCMC (in particular in the area of stress testing) has strengthened the authorities understanding of macro financial risks and linkages. Early remedial actions taken to address vulnerabilities Prompt Remedial Action Framework: The "Policy on timely corrective measures for the banks was adopted on August 21, 2009 and contains several preemptive actions and/or sanctions that can be used by FCMC when irregularities detected during on-site examinations. In 2009, FCMC imposed early limitations on some bank's risky activities by forbidding them to grant new loans (see Box 1). Box 1: Example of early remedial actions taken by FCMC Bank A: In order to resolve its liquidity problems, Bank A submitted a request to the BoL to grant a loan of LVL15 million for 3 months. As collateral, Bank A loan portfolio was proposed. Following the request for financing, FCMC conducted an on-site examination of Bank A during which FCMC discovered that there was no management board decision made about this. Bank A recalled the request. Taking into consideration the results of the on-site inspection, the FCMC requested Bank A to make provisions for loans to banks and customers as well as for Bank A s investments into financial institutions. This would decrease Bank A s CAR to 6.8% below regulatory CAR of 8%. On the basis of policy No.150 "Policy on timely corrective measures for the banks", Article 16 (2), FCMC took the decision to impose limitations on Bank A s activities, namely: 17

28 1. to forbid any kind of investment into capital companies, except investments in equity instruments traded in the stock exchange; 2. to request Bank A to take legal responsibility of informing FCMC before making any investments in equity instruments traded at the stock exchange; 3. to oblige Bank A to inform FCMC about any projects granting new loans exceeding LVL100,000, three working days before the decision is made. Objective 5: Strengthen consumer protection Objective 5 Strengthen consumer protection DPL Policy actions - Signature of a contract on institutional cooperation on the financial services market and consumer rights surveillance on August 26, 2010 in order to promote mutual cooperation and better consumer protection Expected Outcomes Indicators Baseline Target Action plan No action plan to Establish action established by expand CRPC s plan to provide CRPC to role for financial protection to implement services. consumer of recommendati financial services ons of consumer protection review Medium term policy and outcome Detailed "Action Plan on Financial Consumer Protection" based on the Diagnostic Review of Consumer Protection and Financial Capability in Latvia, as prepared with the assistance of the World Bank in November 2009 was released in March In April 2010, drawing on the World Bank assistance, CRPC prepared a detailed Action Plan based on the Diagnostic Review of Consumer Protection and Financial Capability in Latvia, prepared by the World Bank in November The Action Plan focuses on the main issues described in the key findings and recommendations proposing specific actions to be undertaken by Latvian authorities, financial institutions and consumer organizations so that consumer protection is strengthened and made more effective and efficient. The following regulations were adopted: Consumer Credit Regulations issued by the Cabinet of Ministers, which provides consumers with the right to obtain and review any credit contract before signing; Consumer Credit Regulations issued by the Cabinet of Ministers, which implement requirements of Directive 2008/48/EC of the European Parliament and of the Council of 23 April 2008 on credit agreements for consumers and repealing Council Directive 87/102/EEC (CCD), thereby imposing more stringent rules for pre-contractual information regarding consumer credit and information which should be included in consumer credit agreement. 18