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Western EuropeAugust 3 2008

Nordic banks braced for Baltic slowdown

As recessions loom in the Baltic states, Scandinavian banks have reason to be grateful for their reliable domestic earnings, reports Karina Robinson.
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Scandinavian banks are being forced to factor in the possibility of a hard landing from their exposure to banking in the Baltics, a component in their international expansion and diversification strategy.

Mostly however, they are reasonably well insured from even the worst case scenario due to the solidity of their domestic earnings and the relatively minor role played by their north ­European neighbours in their total profits.

However, for SEB and, even more so, for Swedbank, the economic problems are set to play a bigger role than for Danske Bank, Nordea and DnB NOR, which have smaller exposures to the Baltic countries of Latvia, Lithuania and Estonia. The banks insist they had insured well against the end of the Baltics boom, not least because it was clearly forecast.

“We had anticipated it for many years. In the following 10 years, there will be another correction,” says Thomas Neckmar, head of new European markets at Nordea, pointing out that this is natural when countries are growing so quickly during the better part of three decades on the road to converging with the average EU income.

“We had taken precautions already. We had very harsh instructions on credit and to which companies [loans could be extended],” he adds.

Small share

For Nordea, the Scandinavian bank headquartered in Norway, the Baltics represent only 1% of group profits and this percentage looks set to remain ­constant during the next few years. The bank has an average 10% market share in Latvia, Lithuania and Estonia.

Its strategy has been to build on ­existing relationships by servicing ­Scandinavian companies – 30% of its corporate loan book consists of Nordic companies – while only extending additional services to retail customers who already have mortgages with the bank.

Danske delay

The Baltics represent 1% of net profits for Danske Bank, the largest bank in Denmark, which bought the banking operations of Finland’s Sampo last year. Although the bank expects the Baltics to become a larger component of ­profits over time, this process will be delayed because of the economic ­slowdown.

  “We were in fairly late through the acquisition. Some argue we were too late,” says Mads Jacobsen, the senior executive vice-president in charge of the Baltics. “We have only been part of developments for the past two years so we are slightly more immune [to the slowdown] than our competitors.”

Danske Bank is number three in the Estonian market with a 10% market share, number four in the Lithuanian market with 8%, and in Latvia has only a 1% market share.

Mr Jacobsen is wary of using the solidity of the bank’s balance sheet in the downturn to increase market share via acquisitions.

“If you make an acquisition in the present environment, you would spend most of your time covering bad loans,” he says. “[The wider question is] do you want a cheap acquisition in a ­contracting market? Or do you want an expensive acquisition in an expanding market? I would prefer to buy something more expensive in an expanding market.”

Polish salvation

DnB NORD, a Danish bank that was formed as a joint venture between DnB NOR in Norway and NORD/LB in Germany, makes 83% of its profits before tax from the Baltic countries. However, consolidating parent DnB NOR only has a 3% exposure to the Baltics. Additionally, DnB NORD is integrating Polish financial institution BISE Bank, which, added to the decrease in economic growth in the Baltics, will see Poland assume a large role in profits.

  “Especially in times of change, opportunities do come along. Together with our parent companies, we have our eyes open to increase our market position,” says Sven Herlyn, group CEO of DnB NORD.

He foresees a soft landing in the Baltics, as defined by “a decline of ­economic growth, even with some recessionary elements and increasing uncertainties in the economy, increasing bankruptcies and risk costs – but all in a manageable volume”.

“History shows that such slowdowns are the normal ‘breathing in and out’ of the world economy,” he adds. “From a banking perspective, our job is to try to foresee these slowdowns, prepare for them, and when the consolidation comes to manage it in the most efficient way. I am certainly not worried.”

The bank is expecting the residential and commercial real estate markets to be affected, while the slowdown in growth and high inflation will weigh on the ability of consumers to increase spending, with an effect on the consumer loans and credit cards business.

But Mr Herlyn points out that “we should not forget that the wealthier segment of the population is able to bridge this period through increased leverage of its wealth, which also opens opportunities”.

SEB worries

For SEB, the second largest bank in Sweden, the Baltics provide 20% of ­operating profits, a heftier amount than Danske or Nordea. This is up from 10% in 2002, equivalent to the ­contribution from the other Nordic countries, excluding Sweden, in Nordea’s results. But that huge jump from 10% to 20% is obviously not set to continue due to the worsening ­economic circumstances.

SEB’s strategy to deal with the situation encompasses preparation and a slightly different product focus.

“Of course, we are concerned, because the slowdown in both Estonia and Latvia has been sharp, but we are not surprised with the development,” says Anders Arozin, SEB’s head of Baltic development and integration. “SEB already took action in 2006 to curb growth and instilled return rather than volume growth/market share as the primary key performance indicator for management.

“Growth will come from a focus on household and corporate lending, with an increased emphasis on savings ­products and extended service to our corporate clients,” he says.

SEB’s well-funded balance sheet and access to international capital markets allow it to act with flexibility to ensure it supports core clients on both the ­corporate and retail side with an ­advisory-based banking relationship, adds Mr Arozin. He also points out that the bank has increased internal co-operation by integrating the business units with other divisions such as merchant banking more closely.

All of the Scandinavian banks are aware of the responsibility inherent in their dominant position in these three countries. “In such a sharp correction of the economy, where domestic demand – for example, retail sales – is reduced, the economy may encounter severe difficulties,” says Mr Arozin. “Therefore, all banks and all other participants in the domestic economy must find a balance between risk aversion and healthy credit growth so that the economy does not come to a full stop.”

The Scandinavian bank with the largest exposure to the Baltics is ­Swedbank. About one-third of its ­earnings are generated in the region – this percentage is not set to change during the next five years – with a market share of 50% in Estonia, and more than 25% in Latvia and Lithuania.

Swedbank exposure

Johannes Rudbeck, head of investor relations at Swedbank, says that “an acquisition is not on top of our agenda although it cannot be ruled out. As proven in the past, we expect to outperform the market in more challenging times, which will further improve our position when the market turns.”

He sees major growth potential from savings products as wealth increases in the Baltic states – a longer-term goal, presumably, as the bank is worried about the slowdown and is making the necessary adjustments. In the long term, Swedbank – whose other major international plays are Ukraine and Russia – “is convinced that the underlying growth potential in the Baltics is well above the EU average”, says Mr Rudbeck.

Redburn Partners, an independent research house, wrote in a recent report that Swedbank’s shares are due to fall further as worsening economic news emerges from Estonia and Latvia. It notes that the bank has always permitted local management a high degree of independence and that in just two-and-a-half years, customer loans in Estonia have doubled to €7.8bn and in Latvia have tripled to €6.1bn.

Redburn estimates that as the downturn in the Baltics develops and non-performing loans increase, there is the possibility of a hit of SKr5bn (€534m) to Swedbank, equivalent to 10% of group tangible equity. If it also loses market share, then losses could reach SKr12bn, equivalent to 23% of group equity. Having learned from other periods of credit stress, Redburn forecasts that the worst in Estonia and Latvia will arrive in 2009 or even 2010.

It also does not rule out write-offs of SKr7.3bn in Lithuania for Swedbank. The research house notes that SEB’s loan book is biased towards less risky Lithuania.

Crisis avoidance

 

The Scandinavian banks have been ­relatively insulated from the credit ­turmoil last year, despite some increases in costs of funds and moderate adjustments on their fixed-income ­securities, notes rating agency Fitch in a recent report.

However, the first quarter of the year saw more negative pressure on the banks’ profitability levels as a consequence of the credit turmoil, although this varied among the banks, with operating return on equity ranging from 10% to 20%, adds Fitch.

“This year will almost certainly mark a turning point for performance, with greater disparity between the banks’ performance levels than over the past two years,” says Alison Le Bras, managing director in Fitch’s financial institutions group.

Fitch is expecting “economic fundamentals for the Nordic region to remain broadly sound, although a slowdown in these economies is probable, affecting revenue growth”, says Ms Le Bras.

“While arrears will likely increase from unsustainably low levels, Fitch expects any increase to be moderate. The net interest margin should benefit from lower competitive pressures and the gradual transfer of higher funding costs to customers. Fee income generation from capital markets and investment banking activities is likely to be more volatile due to uncertain financial markets,” she adds.

All rating agencies are expecting the sharp slowdown in the Baltics in the first quarter to continue. In its report, Fitch noted that “although long-term growth prospects for the region remain good, the medium-term profitability of these operations [for Scandinavian financial institutions in the region] will likely decrease and arrears will pick up. Nevertheless, Fitch considers that the major Scandinavian banks should be able to absorb a material level of stress in the various markets where they operate while delivering a still adequate performance.”

Split opinion

Views are divided as to whether a hard or a soft landing is on the cards. “What we are seeing in the Baltics is a significant collapse in domestic demand in the past six months, but exports have held up,” says senior Moody’s analyst Kenneth Orchard.

He adds: “For it to turn into a hard landing we would need to see a sharp slowdown in the eurozone and/or ­Russia.” He doubts that this scenario is likely.

Nordea’s Mr Neckmar believes that a hard landing is possible if governments do not act responsibly. They must tell the people to moderate their wage demands – Estonian wages, for instance, are at Czech levels although productivity is not – and avoid overspending, a difficult decision for weak coalition governments, he says.

Inflation differences

Although the Baltic countries are often grouped together, there are differences in their economies, highlighted by the latest inflation figures. It climbed to 11.4% in Estonia and 11.7% in ­Lithuania. But in Latvia, it hit 17.5%.

The currencies of all countries ­participate in the EU’s Exchange Rate Mechanism 2, which paves the way for eventual membership of the European Monetary Union. Although the dates at which the Baltic region will adopt the euro have moved into the next decade – Estonia announced 2011 as a target recently – Moody’s is positive that this will happen, unlike some analysts who expect a devaluation.

Meanwhile, Estonian gross domestic product shrank by almost 2% in the first quarter compared with the previous quarter, while Lithuanian growth slowed to 6.9% and Latvian growth halved year on year to 3.6%. Estonia may well already be in recession, say analysts, while Latvia may soon be.

Moody’s is concerned that in Estonia “although the gradual adjustment over the past six months has been smooth, the possibility of a more turbulent adjustment over the next 12 to 18 months has increased. Persistent inflation and low unemployment continue to drive large increases in wages and salaries, jeopardising external ­competitiveness.”

For Latvia, the rating agency fears that the return to sustainable growth is not easy and often leads to turbulence. Moody’s is less worried about ­Lithuania.

The slowdown in the real estate market is weighing on sentiment in all the markets, but on the commercial market side, as opposed to the residential market, bankers believe the need for prime office space, of which there is not enough, will sustain that market.

Good times end

Peter Elam Håkansson, chairman and founder of investment fund East ­Capital in Stockholm, which has been involved in the Baltics for many years, notes that the years of very high growth to convergence are ebbing away.

“But I am quite optimistic for the long term for the Baltic states, because they are very good in the sense that they are small, open economies that have to be quick to adapt and have to be export-oriented because their home markets are not big enough to sustain their companies,” he says.

Mr Håkansson believes the problem of the overheating of the economies, along with their high current account deficits, mostly due to imports, will be solved by the cooling off they are ­experiencing. Scandinavian banks are counting on the same scenario.

Additional reporting by Philip Alexander.

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