Latvian Banking Crisis

Latvian Banking Crisis ~ Intro

As a result of the low entry barriers and privatization of state banking, more than 60 new, private banks entered the market between 1991 and 1993.

The government’s free market approach is reflected by the lack of government provided deposit insurance.

Little was known about the banks, the bank regulators, or even the currency (Lat) which was the basis for their business.

Latvian Outcomes ~ Banking Crisis

By 1993, after two

years of rapid entry into

the Latvian banking

market, there were 63

independent, private

banks.

Bank failures in 1995

resulted in the loss of

30-40% of deposits.

Today there are about

10 independent banks

operating in this market.

Deposit Interest Rates in 1993

Interest rates for 1 year deposits in either Lats or US$ at 6 of the largest Latvian banks are noted to the right.

There were no restrictions on currency conversions.

Bank Baltija had 25% share of total deposits.

Bank NameRank in

Size

Interest

Rate

Interest

Rate

(1/94)Deposit in

Lats

Deposit

in $

Baltija 1 90% 18%

Komercbank 4 50% 12%

Parex 5 12% 12%

Deutch-Lettish 9 35% 35%

Sakaru 17 40% 32%

Latin Trade 19 72% 48%

Was This a Market Equilibrium?

Why was there so much variation in 1 year deposit (in Lat) interest rates? (90% at Baltija versus 12% at Parex)

Why was the interest rate for deposits in Lats higher than for deposits in US$?

Why was the difference {Interest Rate (Lats) -Interest Rate ($)} so variable? (72% at Baltija versus 0% at Parex)

Why were interest rates so high? (48% on US$)

Which banks would survive?

Reform Strategies ~ Macro Stability

Latvia moved

quickly to introduce

their own currency

(Lat) and to use tight

monetary policy.

The currency was

new, the central

bank was new, and

the central banker

was 30 years old.

Credibility was low.

Sitting there in 1993, what would you

have predicted about the future value

of the Lat?

Equilibrization

Starting Positions ~ Latvia

Trade Patterns ~ disruption of existing trade patters with Russia. Oil, electricity, labor, telecommunications face new border restrictions.

Aged population ~ retirees without pensions

Macro Instability ~ 1991 inflation > 1000%

Loss of Soviet subsidies to state industry, and loss of cheap oil.

Lack of information/reputations for government officials, creditors, legal system

Nationalism and cultural tensions

Reform Strategies ~ Market Prices

Latvia moved quickly away from the prices

set under Soviet planning to market prices.

In the case of sugar, dairy products and

timber, this sent new information to Latvian

producers and resulted in fairly rapid

change in production decisions.

In the case of oil, transportation, electricity

this resulted in economic shortages and the

demise of some public services.

Reform Strategies ~ Privatization

Upon “liberation” all land and housing “seized” by the Russian occupiers was returned to the “pre 1939” owners.

Ownership by foreigners was debated and remained a contentious issue.

Vouchers were allocated to Latvian citizens (not including workers sent to Latvia by Stalin), and these vouchers could be used to buy state assets. Mutual funds pooled vouchers for the purchase of large factories.

Still many state assets could not be sold.

Reform Strategies ~ Intn’l Trade and

Finance

The Lat was unofficially pegged to the

SDR.

No restrictions were placed on currency

trading

Capital flows were relatively free, FDI was

encouraged.

Trade barriers were low (some protection

existed in agriculture)

Reform Strategies ~ Banking and

Finance

Rapid dissolution of state banking.

Low entry requirements for new private banks

Market determined interest rates

No Deposit Insurance

Inexperienced, understaffed, and possibly

corrupt bank examiners

Outcomes ~ Latvian Real GDP

After an initial drop, Latvian GDP has grown slowly, but steadily.

The initial dip occurred for all countries associated with the USSR (Cuba, N. Korea)

Unemployment rates rose,a good sign?

Latvian Outcomes ~ Trade Deficit

After an initial

drop, imports

and exports

rose, but Latvia

has a continuing

trade deficit.

This trade

deficit partly

reflects the high

price of the “Lat”

and capital

inflows.

Starting in 1991 the Latvian government implemented market reforms in

the banking industry. While three state-owned banks continued to operate,

the market soon became dominated by private banks. By 1993, more than

60 independent banks were operating in the Latvian market, but by 1995

the number of banks had begun to fall due to bank failures. These figures

do not reflect the fact that in 1996, in the wake of the banking crisis, the

Bank of Latvia only allowed 11 banks to take deposits from individual

Latvians

In particular the analysis must consider the influential role played by Bank

Baltija which was the largest bank, and it gained market share between

1993 and 1995. In early 1995 Bank Baltija held about 23% of all deposits

and 40% of Latvian depositors held their deposits in Baltija

In May of 1995 Baltija was declared insolvent, and the

Latvian government chose not to provide any funds to repay

depositors.