Banking Sector: Further Signs Of Improvement

BMI View: We maintain a relatively positive outlook towards Latvia's banking sector, where loan activity is showing signs of a nascent recover y. Asset quality continues to improve, and we believe that while the high level of non-resident deposits presents inherent risks, these have been well mitigated.

We continue to see indications that Latvian banks have turned a corner, and maintain a relatively optimistic stance towards the sector. After a weak start to the year, loan activity is showing signs of life, and profitability metrics are improving from the levels experienced in the fourth quarter of last year. The sector also remains among the best capitalised in Emerging Europe. Overall, our forecasts anticipate a modest but material improvement in loan and asset growth over the coming years, and while by no means an outperformer, the robust foundations of the financial system place it on a par with regional strongholds such as the Czech Republic.

Loan growth accelerated in Q213, with aggregate loans expanding by 2.3% year-on-year ( y-o-y ) after averaging -1.3% y-o-y in the Q113 . The expansion was primarily driven by growth in credit to public businesses , although the pace of contraction in lending to private businesses and households also slowed, indicating the possibility of a small expansion in these segments by the fourth quarter. Consumer credit growth will remain subdued over the remainder of 2013 and in 2014 due to ongoing household deleveraging, but the worst is now over for this segment, and a gradual normalisation of credit growth lies ahead.

Signs Of A Nascent Recovery
Latvia - Loan & Asset Growth

BMI View: We maintain a relatively positive outlook towards Latvia's banking sector, where loan activity is showing signs of a nascent recover y. Asset quality continues to improve, and we believe that while the high level of non-resident deposits presents inherent risks, these have been well mitigated.

We continue to see indications that Latvian banks have turned a corner, and maintain a relatively optimistic stance towards the sector. After a weak start to the year, loan activity is showing signs of life, and profitability metrics are improving from the levels experienced in the fourth quarter of last year. The sector also remains among the best capitalised in Emerging Europe. Overall, our forecasts anticipate a modest but material improvement in loan and asset growth over the coming years, and while by no means an outperformer, the robust foundations of the financial system place it on a par with regional strongholds such as the Czech Republic.

Signs Of A Nascent Recovery
Latvia - Loan & Asset Growth

Loan growth accelerated in Q213, with aggregate loans expanding by 2.3% year-on-year ( y-o-y ) after averaging -1.3% y-o-y in the Q113 . The expansion was primarily driven by growth in credit to public businesses , although the pace of contraction in lending to private businesses and households also slowed, indicating the possibility of a small expansion in these segments by the fourth quarter. Consumer credit growth will remain subdued over the remainder of 2013 and in 2014 due to ongoing household deleveraging, but the worst is now over for this segment, and a gradual normalisation of credit growth lies ahead.

Banks Well Capitalised
Latvia - Tier 1 & Capital Adequacy Ratios, %

As a result, deposit growth - which we forecast to reach 5.0% in 2013 - is likely to outp ace loan growth over the medium term, implying a reduction in the aggregate loan-to-deposit ratio, which we forecast to fall to 93.3% in 2013, from 96.9% in 2012. We note while the loan-to-deposit ratio implies a limited reliance on external and wholesale financing, around half of Latvia's deposits were from non-resident sources in Q113 . Without its non-resident deposit base , Latvia's aggregate loan-to-deposit ratio would have exceeded 200% in 2012.

Non-Resident Banking: Risks Broadly Mitigated

The importance of non-resident funding to La tvia's banking system has drawn rising scrutiny, particularly following the collapse of Cyprus' banking system earlier this year , in part due to rapid capital withdrawals from non-resident depositors. Several EU officials have raised concerns o ver the stability of the sector, particularly as Latvia approaches its entry into the eurozone in January 2014. We have previously discussed why we do not believe comparisons between Latvia and Cyprus are accurate ( see 'Banking Sector: Brighter Outlook Ahead', May 23 ) , particularly as Latvia's banking sector relative to the total economy is substantially smaller than Cyprus' and indeed the eurozone aggregate. Latvia's economy is also far less skewed towards the financial sector than Cyprus' was.

Non-Resident Deposit Base Is More Liquid...
Latvia - Deposits By Resident Type, % total

N onetheless, non-resident banking holds certain inherent risks. First, there are concerns that depositor outflows from Latvia could trigger a similar crisis to that experienced in Cyprus, and second, that the banking sector could be prone to indirect exposure to financial crimes such as money laundering. We think that overall such concerns are largely unfounded. The majority of non-resident banking is done through thirteen banks that are o riented towards foreign banking, where around 20% of their assets comprised of non-resident deposits. These banks are subject to more stringent liquidity requirements, higher capital adequacy requirements and tighter anti-money laundering regulations than domestic market focused banks, reflecting the additional risk of non-resident banking.

...But Fund Allocation Mitigates Liquidity Risk
Latvia - Foreign Customer Service Oriented Banks Asset Allocation, % total

The thirteen foreign service focused banks hold an average capital adequacy ratio of 17% - only slightly lower than the sector aggregate of 18.6% and substant ially above the minimum regulatory requirement of 8.0%. As 85% of non-resident deposits are demand deposits, the asset structure of non-resident focused banks is heavily weighted towards liquidity, with 6 5% of funds invested in high liquidity assets (cash, interbank lending, and securities). As this asset blend is relatively unprofitable in terms of interest income, most of these banks generate profit from non-interest income from commissions on FX and cashflows. The proportion of loans to total assets is around half of full service credit institutions, at around 30%

Finally, non-resident clients are subject to more stringent due diligence checks than domestic clients, with additional checks required on incoming monthly payments in excess of LVL200,000 a month, including analysis of business and personal activities of the customer, obtaining know-your-customer information, and comparing compliance of transaction performed on the customer account with declared business activities.

Asset Quality Continues To Improve
Latvia - Non-Performing Loans & Coverage, % total loans

Risks Reduced Going Forward

Asset quality across the sector has continued to improve, with loans more than 180 days overdue falling to 9.4% of total loans, from 11.4% previously, as bad debts continue to be written down. While there has been a slight rise in substandard assets, in the 'up to 30 days overdue' category over the last three quarters, this has not substantially fed through into '31- 90 days' and '91-180 days' categories, and loan loss provisioning has fallen as a result. The provisioning coverage ratio remains more than adequate at 71.3% in Q213, and overall non-performing loans as a percentage of total loans dropped to 7.4% in Q213, from 7.7% in the previous quarter. In line with our forecasts for Latvia to remain a regional growth outperformer over the coming quarters, we expect further improvements in asset quality which should to help boost bank's bottom lines.

Overall, we retain a relatively positive outlook towards the sector, and maintain our original assessment that non-resident deposits (NRDs) do not pose a systemic risk to Latvia's banking sector. Furthermore, our co ncerns that NRDs could become an obstac le to eurozone accession have been allayed by the ECB's positive convergence report, which has given the green-light for Latvia to join the single currency on January 2014.

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This article is tagged to:
Sector: Country Risk
Geography: Latvia, Latvia, Latvia, Latvia
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