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WorldFebruary 3 2014

Latvia: in the eurozone but not out of trouble

With a deadline looming for the privatisation of state-owned Citadele, and the country's accession to the eurozone likely to squeeze profits in the banking sector, 2014 looks set to be a year of challenges for Latvia.
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Latvia: in the eurozone but not out of trouble

Five years ago it was the worst performing economy in the world, with gross domestic product contracting by 18% in 2009. In 2014, 10 years after joining the EU, it became the eurozone's newest member. But Latvia's turbulent fortunes do not end here, and the country's bankers are looking to the future with a mixture of hope and apprehension.

The country's currency, the lat, had been pegged to the euro for almost a decade in preparation for the adoption of the single European currency. When the financial crisis hit in 2009, many predicted that the lat would be devalued, but Latvia kept its fixed exchange rate at the cost of a severe economic downturn. Joining the euro removes uncertainty about the fate of the currency and puts paid to any future speculation about devaluation.

"For Latvia, joining the eurozone will be like boarding a large cruise ship instead of a small boat; [the cruise ship] is safer and more stable, especially in gusty weather," says Maris Mancinskis, CEO at Swedbank Latvia, the country's largest bank by assets.

It will also show foreign investors that the country is a safe and stable place for their money and will make transactions for Latvian citizens and companies much easier; about 80% of loans in Latvia are already denominated in euros. But banks expect to suffer in the short term.

Set for consolidation?

Janis Buks, head of Nordea Bank in Latvia – the country's fourth largest lender by assets, according to data from the Latvian Association of Commercial Banks – points out that financial institutions are faced with significant losses of revenue in 2014, which could lead to consolidation in the banking sector.

"Currently there are five big universal or quasi-universal banks in Latvia catering to the local population of 2 million people, some of whom are still relatively poor by western European standards. I think that is at least one bank too many," he says.

Until recently, revenue from currency exchange transactions made up 8.6% of Latvian banks' basic activity revenue, according to the Financial and Capital Market Commission's supervisory department. From this year, that revenue is gone. Joining the Single Euro Payments Area means that banks are also losing some of the fee income they used to get from processing payments to other countries in the eurozone. There will be a reduction in commission fees for euro transfers within Latvia as well, since these will get the status of domestic transfers.

"The pie will get smaller, but there are still five diners at the table. Thus, either all of the five will get less to eat or somebody will have to leave the table," says Mr Buks.

Ainars Ozols, the CEO of SEB Latvia – the country's second largest lender by assets – agrees that the euro's introduction will bring losses, and expects his bank's profits to be lower this year as the reduction in revenue will outpace the cost-cutting measures put in place to offset it.

Deadline looming

Besides consolidation due to falling revenues, Latvia's banking system will also possibly have to deal with more external competition relating to the sale of Citadele – the 'good bank' that emerged from the failure of Parex Bank, which the government must sell this year.

Parex, at the time Latvia's second largest bank, was nationalised in 2008 when the country's property bubble burst and its economy nosedived after double-digit growth during the boom years, fuelled by cheap loans. The government turned to the EU, the International Monetary Fund, the European Bank for Reconstruction and Development (EBRD) and several countries for help, obtaining a total bailout package worth €7.5bn.

In 2009, the EBRD bought 25% of Parex. Citadele was set up in 2010, with the purpose of cleaning up Parex and preparing it for privatisation. A first attempt to sell it was abandoned in 2011, because of the weak global economic environment. Latvia's former government relaunched the privatisation in 2013. Under EU state aid laws, Citadele should be returned into private hands within five years of its receiving help from the government – so the sale of the bank is becoming urgent.

Attractive proposition?

Selling Citadele will not be an easy task. First, the memory of past excesses is still fresh. Before the bail out, Parex was privately owned by two individuals and its core business was deposits from offshore accounts – non-resident business was about 80% of the bank's deposit base at the time, according to Guntis Belavskis, the CEO of Citadele bank. Today, it is less than 3%.

The issue of governance at Parex was high among regulators' worries, and there have been concerns expressed even recently. For example, a statement released in September 2013 by Bank of Lithuania’s supervision service said that it found that Citadele's internal control procedures in some cases failed to provide adequate customer identification and proper monitoring of cash transactions.

"We immediately took all the necessary steps to implement the needed changes to these procedures. There were no violations of any procedures," Mr Belavskis told The Banker during a presentation of his bank in London last year. He said that he and his team started putting in place good governance procedures at the mother bank in Latvia, and were in the process of expanding those to Citadele's operations in the neighbouring countries.

Erik Berglof, the EBRD's chief economist, says that Parex was reformed after the crisis. "We looked at this bank before and we were not convinced that they had done enough to address some of the integrity issues. The crisis gave us an opportunity to get a credible commitment from the government and from inside the bank to actually deal with these problems."

The government is open to either an initial public offering or selling Citadele to a strategic investor. Before his resignation, former Latvian prime minister Valdis Dombrovskis said during a meeting with investors in London last year that there had been "some expressions of interest" in the bank since it was cleaned up and that the government would like to see a wider range of investors beyond the Scandinavian banks.

A selling environment

This is a tough time to privatise a bank. Citadele has to compete with other banks being put up for sale in central and eastern Europe (CEE) and the former Soviet space. Most recently, executives from Austria’s Raiffeisen Bank International suggested that it did not exclude the possibility of pulling out of Hungary and Slovenia. 

Matti Hyyrynen, a senior banker for Baltic banks at the EBRD, says that the EBRD was "not in any hurry" to sell its 25% stake in Citadele and that this was not a good time to sell a bank in the region. However, he added that the bank could be attractive as it is doing well and "is the only locally owned bank".

Citadele's return on equity climbed into double digits in 2013, and Mr Belavskis forecast that it would remain between 12% and 15% over the next three years. Market observers agree that selling Citadele this year will be a challenge, but say that not all hope is lost.

"Very generally speaking, I would think that a bank in Latvia, in a country that has deleveraged pretty fast compared to other CEE countries and which has again reached sound economic growth... could be even at these depressed times for banking assets a reasonable investment," says Josef Christl, a former executive director of the Austrian central bank who is now a freelance consultant.

The eurozone’s plan to build a banking union complicates matters even further. This year, the European Central Bank (ECB) takes over as supervisor for big banks in the single currency area and, as part of preparations, is conducting thorough asset quality reviews and stress-tests for the sector. This, says Marco Troiano, an independent equity analyst focusing on European banks, adds to uncertainty regarding banks' capital positions, so some buyers may choose to delay acquisitions until the ECB's review is completed in November 2014.

"On the other hand, if the tests were to reveal capital shortfalls for Scandinavian banks operating in the Baltic region, there could be competing assets coming to the market so waiting [to sell Citadele until the ECB's review ends] could end up being even more costly," he says.

Then there is the Latvian parliamentary election, which is due to take place in October. "We have previously seen large privatisation projects, such as the attempted sale of the state stake in Lattelecom, fail because of lack of political will," says Mr Buks.

It looks like Latvian banks still have some way to go before entering calm waters.

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Read more about:  Central & Eastern Europe , Latvia