Opinion is divided on the Latvian banking sector. According to the country's banks and regulators, it is in rude health with the central bank declaring bluntly that "concerns about the sustainability of the Latvian banking sector have no grounds". The International Monetary Fund (IMF) begs to differ, and has joined a growing list of critics saying so publicly.
The cause of their concern is the increasingly high level of non-resident deposits (NRDs) appearing in the Latvian financial sector. On January 28, the IMF, in its own second review following Latvia's completion (and early repayment) of its €7.5bn bailout loan, warned that this rapid rise in NRDs in the banking system is "a potential source of vulnerability, with possible implications for Latvia's liquidity position and reputation."
While attracting foreign money is in many ways desirable, it comes with numerous risks, particularly when a small, relatively poor state like Latvia finds itself guaranteeing big deposits washing over the border into banks that have big question marks over their transparency and stability.
Effectively, there are two sorts of banks operating in Latvia: mainly Nordic-owned banks dealing with domestic clients and boutique banks dealing with non-resident clients.
NRDs across the Latvian banking system hold about LVL5.5bn (€7.8bn), or 51%, of total deposits. Almost two-thirds of Latvia's 29 banks specialise in NRDs, accounting for 43% of the banking system in terms of assets and 58% in terms of total deposits. NRDs account for more than 70% of deposits for two-thirds of local banks and more than 60% of deposits for all non-Nordic subsidiaries.
Not only is the size of Latvia's NRD sector big, it is growing fast. In the 12 months to end-September, NRDs increased by nearly 20%, mainly due to depositors from the Commonwealth of Independent States (CIS), the successor to the Soviet Union, relocating their funds from Cyprus, according to the IMF. At the end of September, about a third of NRDs were from EU countries, 12% from CIS countries and 55% from other non-EU jurisdictions. But with a lot of the EU money coming from Cyprus and a big slice of non-EU money coming from offshores such as the British Virgin Islands and Belize, it is estimated by the IMF that 80-90% of NRDs come from the CIS.
Not that there is anything wrong per se with attracting money from the CIS. If it's clean money, Latvia would be foolish to spurn the eagerness of investors to put their money somewhere they feel is safe, where they can speak Russian and where they have access to sophisticated, well-regulated banking services. With a treaty on avoidance of dual taxation with Russia in place, there are good reasons for Russian investors to consider depositing with Latvian banks.
But if it's money from dubious sources finding its way to Latvia because it's unlikely to ever be detected entering the main European banking stream, the ultimate payback for Latvia won't be pleasant.
"Given their short maturity and higher volatility, NRDs are particularly prone to sudden reversals," the IMF said in its report. "Given the size of the sector, a sudden reversal of NRD flows, and the potential of contagion to resident deposits, represents a source of vulnerability to international reserves and a significant contingent fiscal liability (via sovereign backing for the deposit insurance system)."
And the IMF is far from alone in its criticism. In its own second review of Latvia's post-loan situation released on January 15, the European Commission wrote: "There are risks inherent in a large non-resident banking sector... The Commission invites the authorities to follow closely what kind of financial flows are attracted, where they are invested, what are the activities of non-resident banks in the domestic market, etc. In particular, it must be kept in mind that the business, legal and regulatory environment in CIS countries is often weak and investments/loans in these countries call for caution (checking creditworthiness, enforceability of collateral, etc.).
"Also, attention should be paid to the capital hikes where the source of financing may be coming from loans between related entities/persons. The Financial and Capital Market Commission may need to further enhance knowledge of activities of individual non-resident banks and at times be more intrusive... The authorities should devote more financial and human resource capacities and attention to tackling complex economic, financial, money laundering and tax evasion crimes... There is evidence that institutions like the economic and the financial police have inadequate resources to offer attractive remuneration and keep or hire experienced and well qualified staff."
But it is what the IMF calls "reputational risk" that is perhaps the biggest danger with Latvia's NRD "success story".
Reputations at stake
The names of several Latvian NRD banks crop up regularly in connection with major financial scandals: the notorious €400m Ukrainian oil rig case (covered extensively by bne) shows Trasta Komercbanka was used to transfer funds.
In July last year, London lawyers representing the anti-corruption lawyer Sergei Magnitsky, who died in Russian custody, and his client Hermitage Capital sent evidence to thew Latvian authorities alleging that no fewer than six Baltic banks (Aizkraukles banka, Trasta Komercbanka, Baltic International Bank, Baltic Trust Bank, Paritate Bank, and Rietumu banka) were used to launder around $63m "directly from the Russian Treasury through shell companies to the Latvian banks".
In November, campaign group Global Witness said it had seen documents from a New York court alleging that Maxim Bakiyev, the son of the former president of Kyrgyzstan, had been using a $45m account at Baltic International Bank for insider trading deals on the stock exchanges of the US, the UK and elsewhere. Bakiyev is also wanted in Kyrgyzstan on charges of looting the state treasury. Baltic International Bank is majority owned by Valeri Belokon, chairman of Blackpool Football Club and a former business partner of Bakiyev's.
Following his sacking as Russian defence minister by Vladimir Putin in November in connection with a RUB3bn corruption scandal at Oboronservis - a company owned by the Russian Defence Ministry - Anatoly Serdyukov was spotted in Latvia, according to local and Russian media. While Serdyukov is currently only a witness rather than a defendant, speculation has begun that Latvian banks may be involved in the case.
The attitude of the Latvian authorities seems to be that the brakes still work just as well as they always have - as if they have sustained head injuries causing memory loss during the catastrophic crashes of first Parex Bank in 2007 and then Krajbanka in 2011.
Briefing journalists on February 5 about the Latvian banking sector's progress in 2012, Kristaps Zakulis, head of Latvia's financial regulator the FKTK, said: "Banks are adequately capitalized and liquidity is high."
Zakulis insists that "proper risk management" is in place and that, for example, the number of staff keeping an eye on NRDs has been "adjusted appropriately". In December he told bnethat the high level of NRDs was no threat, despite an admission that in contrast to other financial centres such as Switzerland or Luxembourg, "Latvian banks mainly provide financial logistics services to non-resident customers, ie. they are dealing with short-term incoming cash flows."
Nationalist MEP and former finance minister Roberts Zile isn't convinced. Zile played party pooper at a February 22 conference designed to laud Latvia's progress towards the Eurozone by pointing out the risky situation with NRDs.
"We have to think why Latvia is so different from other members of the euro area... I think the relevant authorities have to supervise and regulate this market," Zile said, adding that he had heard German politicians expressing serious reservations about the situation.
"Are they going to pay for these risks?" he asked rhetorically.
But perhaps the most explosive revelations are yet to come. On February 20, Russia's central bank governor Sergey Ignatiev sensationally claimed that $50bn of Russian money - equivalent to 2.5% of Russia's GDP - was illegally sent out of the country via offshores last year alone.
Ignatiev told the daily Vedomosti that a large proportion of that total was down to "one well organised group". If even a fraction of that money were passing through Latvian banks as part of complex offshoring schemes, it would be a scandal. But if the "well organised group" was using Latvian banks and the country's proven stock of nominee directors via shell companies, it would be sensational.
With fear of Russian military power an ever-present emotion in Latvia, it would be ironic if the country's opportunistic banks were actually sucking the lifeblood from the big, scary bear.