Analytics, Banks, Financial Services, Latvia

International Internet Magazine. Baltic States news & analytics Monday, 25.01.2021, 06:18

Overhaul of Latvia's financial sector supervision continues in the pandemic

DBRS Morningstar, 30.11.2020.Print version
Latvia began this year with welcome news. The Financial Action Task Force on Money Laundering (FATF) announced in February 2020 that Latvia’s banking sector will not be subject to enhanced surveillance or 'gray listing' - citing Latvia's considerable improvement in setting up a strong and robust financial crime prevention system. This followed the Council of Europe's decision in January 2020 that Latvia is 'largely compliant' with most recommendations made by the (MONEYVAL) committee on the Evaluation of Anti-Money Laundering Measures and the Financing of Terrorism.

The Coronavirus Disease (COVID-19) and its associated health and economic crisis has shifted attention towards the health, social and economic crisis response. Major bank lenders have introduced schemes allowing their customers experiencing temporary financial difficulty to defer their principal loan payments, and the government has offered support to the banks via loan guarantees. These domestically focused banks arrived to the crisis with strong fundamentals. Yet, the pandemic adds to existing challenges for banks that previously focused on foreign clients and are now transitioning towards new business models. Latvia's Financial Intelligence Unit (FIU) highlights that the crisis environment could encourage criminals to exploit the current situation for financial gain, and the risk of cyber-crime and suspicious activity could increase during the COVID-19 pandemic1.


However, Latvia's FIU has made clear its commitment to continue monitoring suspicious transactions, and DBRS Morningstar expects continued improvement in the area of anti-money laundering, combating the financing of terrorist, and proliferation financing (AML/CFT/CPF). Latvia's financial sector regulator (FCMC) has developed strict procedures for determining ML/TF/PF risk levels at Latvian banks and will individually supervise financial market participants to mitigate possible adverse effects of the crisis.

This commentary aims to assess the consequences of the crisis on the banking sector, highlight the measurable progress made by the Latvian authorities prior to the crisis in the areas of risk mitigation and risk monitoring of banks that service foreign clients, and assess plans for further progress in the coming years.

COVID-19 shock will affect Latvia's segmented banking system in different ways

By way of background, the Latvian banking system is made up of two groups of banks with traditionally distinct business models. First, subsidiaries and branches of banks from the European Economic Area, mostly from Nordic countries, that focus on Latvian clients. Second, non-resident deposit (NRD) banks that service foreign clients.


Subsidiaries and branches of Nordic banks


The majority of domestic lending stems from three large banks: Swedbank, SEB, and Luminor Latvia Branch (previously DNB and Nordea). Overall risk to the Latvian financial sector from these banks was limited prior to the COVID shock. At the end of 2019, these largest credit institutions were profitable, well capitalized, and had high quality of loans. Nonperforming loans to total loans declined to 5.0% in 2019, according to the IMF.

While banking financials will inevitably be affected by the COVID-19 crisis, the short-term negative effects of the crisis have been mitigated in large part by government support to households and businesses. The moratorium on principal payments of loans to households and non-financial corporations (up to 12 and 6 months, respectively) has kept non-performing loans low, at 5.4% as of June 2020, according to the FCMC2

Non-resident deposit banks


A challenge for Latvia in recent years has been the lack of transparency of the origins and usage of the non-resident deposits. In 2016, Latvia began amending laws to tighten AML/CFT/CPF requirements. Those efforts were accelerated in 2018, after the financial sector was shaken by the statement of the US Financial Crimes Enforcement Network (FinCEN) regarding ABLV Bank and its subsequent self-liquidation. In 2019, a separate NRD bank, PNB Banka, lost its banking license after it failed to raise additional capital to continue the process of changing its business model.


DBRS Morningstar considers the COVID-19 crisis ought not to divert attention from progress made on financial crime. Prior to the crisis the government implemented various AML/CFT/CPF measures and procedures to strengthen risk monitoring and mitigation of NRD banks. Below are several indicators meant to measure the progress.

Risk Mitigation: reduction of high-risk customers and increase in penalties


Recent legislation forced banks servicing foreign clients to find a viable alternative to their business model, causing NRD banks to scale back their operations. The business volume of NRD banks and their deposit base have shrunk significantly. In 2015, over 50% of deposits in the total Latvian financial system were from nonresidents. By 2019, foreign client deposits declined below 20%.


Perhaps more importantly, there has been a compositional change of NRDs remaining in the Latvian banking system. Deposits from EU countries now represent most of the NRDs. Foreign deposits from customers based in non-EU jurisdictions - considered more likely to pose ML/TF/PF risks - amounted to 35% in 2015 (See Exhibit 1). By 2019 and underscoring a dramatic shift, foreign deposits from customers based in non-EU jurisdictions (CIS and Other Countries in the Exhibits) constituted roughly 6% of total customer deposits (See Exhibit 2).

Risk is also mitigated by the increase in on-sight inspections and the increased propensity of bank fines and seized assets. All banks have undergone money laundering risk assessment, and 17 fines worth 18.7 mln EUR were imposed on penalized banks from 2016 to 2019. In the first three months of 2020 alone, the FIU froze EUR 160 mln in assets.


Risk Monitoring: upskilling of regulatory personnel and IT solutions


Monitoring procedures have been improved in various ways. To begin, Latvia has increased the staff dedicated to financial supervision. The number of FCMC compliance control staff in the area of AML/CFT/CPF has increased from only 6 employees in 2015 to 28 in 2019 (See Exhibit 4). The growing staff has allowed for an increase in on-site inspections. In 2018 and 2019 all high risk banks were subjected to the FCMC on-site inspection, previously a less frequent occurrence.


The number of prosecutors participating in specialized anti-money laundering training has also increased in recent years. In 2019, 330 prosecutors participated in various AML training schemes, up from 193 in 2018. The increased number and upskilling of the staff promoted more effective dialogue between the regulator, the financial sector, and law enforcement bodies – allowing for cross-border dissemination of suspicious transactions. As a result, 59 criminal cases were brought before the court in 2019, up from 23 in 2018 and 10 in 2017.


The FCMC has also implemented information technology solutions that analyze unusual cash flows to help increase the efficiency of monitoring AML/CFT/CPF risk. Due to the improved IT tools and the larger FCMC staff, the number of reports on unusual transactions increased to 25,170 in 20183, nearly a threefold increase from the year earlier (See Exhibit 5).

The difficult work of overhauling Latvia's banking sector is far from complete


Many banking sector challenges remain, including (1) strengthening the capacity of law enforcement authorities to handle money laundering cases and (2) managing the transition of NRD banks to new business models.


In its 2020 semester country report, the European Commission (EC) states that Latvia should strengthen beyond the initial gains the dialogue between the regulators, financial sector participants, and law enforcement bodies. In this regard, Latvia needs more advanced training of judicial stakeholders in order to improve the quality and effectiveness of prosecuting money laundering cases, according to the EC.


The priority of the FCMC is to remain vigilant that NRD banks are effectively reorienting their business models away from servicing foreign clients. The full transition will take time and come with a cost. The downsizing of NRD banks poses refinancing and liquidity risks at a time when these banks have seen the quality of their foreign loan portfolio deteriorate. Stress in the NRD sector has had limited spillovers to the domestic economy and caused no reputational damage to banks focused on domestic clients. The stress nonetheless does point to the scale of the challenge for Latvia in addressing its legacy banking sector issues.


DBRS Morningstar considers favourably the speed and urgency with which the Latvian authorities are overhauling the supervision of its financial sector. Strengthening of the financial sector is a key driver of DBRS Morningstar’s Latvian ratings. Visit for details about DBRS Morningstar's ratings drivers for Latvia.


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