Formation of universal banking system in Lithuania

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Formation of universal banking system in Lithuania

  1. 1. 1 Formation of universal banking system in Lithuania Šarūnas Kraujalis Department of International Economics and Trade Economics and Management faculty Kaunas University of Technology Fax: (8-27) 301375, Phone: (8-27) 301374, E-mail: Sarunas@ub.lt Abstract. All developing countries experienced restructuring of economy, financial market liberalization and deregulation. Every developing country should make a decision concerning the role of banks in their market and the best moment for financial market reforms. Lithuania’s independence and market liberalization marked the crash of the Soviet system. Another feature of Lithuanian development is its’ aim of integration in the EU. This increases political pressure for economical decisions and on the other hand gives an impulse to create financial and legal system aligning with the leading European countries. The universal German banking market conditioned more universality in Lithuanian banking system. Initially the activities of Lithuanian banks in securities and insurance market was partly restricted, but restrictions are gradually diminishing. Formation of universal banking system in Lithuania raises a question: is the choice of universal banking under conditions of complicated economical situation and the weak legal basis right? In this article, I have made an attempt to determine the main positive and negative peculiarities of universal banking system in Lithuania. This article analyses the following problems: • Should universal banking be promoted? If yes, can it be applied only under the special conditions or is it suitable for any economical-political-social situation? When and how banking activities in securities and insurance market should be limited? How should universal banks be supervised to ensure stability and reasonable profitability of banking activities? • Should commercial banks be interested in the activities in securities and insurance market? If yes, how active should banks be in securities and insurance market? Should banks expand all kinds of non-traditional activities or should they be partly universal: for example just serving their clients in securities and life insurance market with no activities and risk on the banks own account? • It is of a special importance to evaluate factors that help to forecast changes in securities and insurance market. Keywords: universal banking, investments, securities market, insurance market, non-traditional banking activities. Introduction. The dilemma of choosing between universal or specialized banking was especially important in the USA in 30-ies. Governmental commissions and supervision authorities analyzed the USA market crisis and decided that universal banking was partly responsible for the crisis. They decided to limit banks possibilities to choose the kind of activities and organizational structure. Some essential restrictions (for example, separation of commercial and investment banking) remained until now despite strong discussions about the expediency of restrictions. One of the main arguments of specialized banking supporters is ostensibly higher stability of specialized banking system and lower opportunities for coming out conflicts of interests between banks and their clients. The opponents of specialized banking system claim that limited activities of financial institutions diminish their competitive power in international financial markets and cause consumers losses because of artificially reduced competition in the national financial market. Recently the US
  2. 2. 2 commercial banks have more opportunities to expand non-traditional activities and the other US financial institutions are less limited in deposits and loans market. Canada, Mexico and partly Japan liberalized banking system through some last decades. The rapid development of universal banking in many countries reveals it’s huge potential. The universal banking system is widely used in Western European countries. There are not much opponents of universal system and disputes are made only about partial restrictions of non-traditional banking activities. The main object of disputes: did universality of the banks and pressure on their clients’ effect the development of securities market negatively? German banks control firms using own and their clients voting rights and banks can make pressure on the firms preventing them from the use of securities market instruments. Purrucker (1983) finds that 95% of private shareholders do not use their rights to instruct a bank to vote on their behalf. Bank gets the right to vote upon their own will using clients voting rights. Banks control firms in such a way and can force them to take loans and refuse new securities emissions. Researches reveal (Cable, 1995) that profitability and productivity of firms grow in those countries where banks have no investment restrictions. The analysts of banks and firms relations claim that the tighter and more permanent relations are, the higher is the productivity and the lower costs of supervision. Dittus and Prowse (1995) analyses what type of financial market would be better for Central and East European (CEE) countries. They propose financial market with restricted banking activities in securities market and motivate it by the weak, non-competitive and state controlled CEE countries banking system. I think such motives are out of dated as situation changes rapidly in the CEE countries financial markets. Attention should be concentrated not on the banks investments under the present situation but on the creation of strong and flexible supervision system that would be able to prevent abuse of power in all areas of financial system and to provide equal opportunities to all financial intermediaries. I would like to point out the following reasons for the expansion of universal banking system in Lithuania: 1. Lithuanian banks are restricted from the investments into shares if such investments exceed 40% of eligible bank capital (last year restrictions were lowered from 10% to 40% of eligible capital). Lithuanian banks have not enough funds to be able to gain monopolistic power to control Lithuanian joint stock companies. 2. Lithuania is planning to join the European Union as soon as possible. Local legal system should be adjusted considering the EU directives regulating investment activities. According to such directives financial institutions (so the banks) should create securities portfolio under the strict portfolio structure / quality requirements. 3. The control of Lithuanian banking system is constantly improving and the state influence is reducing. Discussions and researches of the advantages of banking activities diversification have increased recently. The banking activities diversification is often reviewed under the broader sense: what is the influence of non-traditional banking activities on their results and on the stability of financial system. Various methods and indices were used in those researches although no one could be thought as absolutely exact. Methods that were used to evaluate the effectiveness of the non-traditional banking activities are as follows: • Wall and Eisenbeis (1984) and Litan (1985) compared the generalized results from the banking activities and securities market mediation activities.
  3. 3. 3 • Stover (1982) decides about the effectiveness of non-traditional banking activities considering the evaluation of results from the individual banks and financial institutions. Boyd and Graham (1988) modelled merges of bank holding companies and other financial companies and evaluated changes of profitability and risk. • Kwast (1989) compared the correlation of results from the banks activities in securities market and other financial activities The results of researches of universal European and Lithuanian banks could be very different from the results of Kwast research because of restrictions on the US commercial banks activities in securities market. • Kwan (1998) compared results of banks and their securities subsidiaries. Kwan research has not revealed clear profitability trends. The banking subsidiaries activities were more risky comparably to banks, although the correlation was low and suggests the possible benefits of banking activities diversification. Kraujalis (2000) compared the effectiveness of Lithuanian banks’ activities in traditional and securities market. The research has shown that Lithuanian banks should be interested to act in securities market. The investment services are inherent activities of universal banks. The universal commercial banks cannot bear the risk to lose their client: the latter can turn to competitor to receive additional services and later can use all services of competitor. Banks own investments can affect the structure of assets but its have less influence for their client decision to choose serving bank. The large banks should fully engage in non-traditional activities because of better diversification of assets. The investments of Lithuanian banks into shares are limited according to the eligible bank capital. I think that universal banks should limit non-traditional activities by themselves to 20% - 40% of their assets depending on their investment and insurance activities risk. The development of non-traditional banking activities The number of banks and their branches increased rapidly after the restoration of Lithuania’s independence in 1990 (figure 1, created according to the data of the Bank of Lithuania). The process of banking system formation was chaotic. The supervising institution had no relevant experience and power to adequately control banks under the new market conditions. In 1994 the Law of Commercial Banks was issued. The first edition of the Law had many shortcomings, especially concerning the audit of bank results. Until the end of 1994 commercial banks were engaged only in traditional activities: deposits, loans, currency exchange and payments services. The narrow specialization of commercial banks was conditioned by some factors: • The high profitability of traditional banking activities, especially carrying out operations with foreign currencies. • The non-existence of main financial market institutions. The National Securities Exchange of Lithuania (NSEL) began activities only at the end of 1993. The turnover of listed shares began to increase more rapidly only in 1997. • The low activity of foreign banks and other financial intermediaries in Lithuanian market caused the low activity of Lithuanian banks in securities market. The low values of traditional concentration indices in Lithuanian banking market did not reveal the real competitive situation. The majority of banks were weak and badly capitalized, created by individual persons or firms with an aim to attract as much funds as possible for their own business. The banks promising economically unjustified interest on deposits after some time met with the problems of returning funds and bankrupted. The rest of the banks are
  4. 4. 4 competing more aggressively to expand their market power. At present foreign financial intermediaries are penetrating more actively into Lithuanian financial market. 40 300 35 ber of banks ( uni t s) ber of br anches and 250 r epr esent at i ves ( uni t s) 30 28 200 25 22 20 20 150 15 15 12 11 11 10 10 10 100 The num The num 10 7 50 5 0 0 1995 12 1990 12 1991 12 1992 12 1993 12 1994 12 1996 12 1997 12 1998 12 1999 12 2000 12 A t t h e e n d of p e r i o d Commercial banks The number of branches and representatives of commercial banks (secondary axis) Figure 1. The changes in the number and branches of Lithuanian commercial banks 50 In 1992 – 1994 the spread between 40 the interest rates on deposits and loans in c e n t Lithuania was 20% – 35%. Such situation 30 stimulated banks to expand their activities 20 in traditional market. The returns of p e r 10 banking activities were highly unstable: 0 some banks announced the profits more than twice exceeding share capital and the 93 12 98 12 00 12 94 12 95 12 96 12 97 12 99 12 next year suffered the losses more than d u r i n g t h e l a s t m o n t h twice exceeding share capital (mainly The spread in LTL because of the reserves for bad loans). The The spead in foreign currencies spread between the interest rates on deposits and loans stabilized on the 8% Figure 2. The spread between the interest rates on level since the end of 1996 (figure 2, deposits and loans in Lithuania calculated according to the data of the Bank of Lithuania). Investment (privatization) vouchers were the main securities in Lithuania until the creation of NSEL. The number of investment companies accumulating vouchers from the individual holders grove rapidly. Banks were not permitted to participate actively in privatization process and to
  5. 5. 5 establish investment companies. NSEL capitalization and turnover reveals the changing situation in Lithuanian securities market (figure 3, created according to the data of the Bank of Lithuania). Lithuanian securities market is distinguished by the large fluctuation and growth trends. The turn- over and capitalization was low at the beginning of NSEL activities. At the end of 1994 capitaliza- tion was LTL 635 million, turnover was LTL 36.9 million. In 1995 the more rapid growth began. During 1995, capitalization increased by LTL 2636 million, turnover increased by LTL 178.2 mil- lion (583%). During 1996, turnover decreased by LTL 74.6 million, capitalization increased by LTL 3940 million (282%). In 1997, the activity of foreign investors induced the constant growth of securities turnover and the growth of Lithuanian banks activities in securities market. 1 6000 800 1 4000 700 api t al i zat i on, 1 2000 600 LTL m l l i on LTL m l l i on Tur nover , 1 0000 500 8000 400 i i 6000 300 4000 200 C 2000 1 00 0 0 94 I V 95 I V 96 I V 97 I V 98 I V 99 I V 00 I V IV I 98 I 99 I 00 I 97 I I 97 I I 98 I I 98 I I 99 I I 99 I I 00 I I 00 I I I I I I 93 97 Capi t al i zat i on - at t he end of per i od Tur nover - dur i ng t he quar t er Figure 3. The capitalization and turnover of the National Stock Exchange of Lithuania The most promising Lithuanian firms widely use securities market instruments to finance the expansion of the activities. This caused the constant growth of the NSEL capitalization in time of 1993 – 2000. The development of Lithuania’s Government securities market was an important factor that induced non-traditional activities of Lithuanian banks. The first emission of Lithuania’s Government securities took place in the second half of 1994 and since then commercial banks of Lithuania were the most active investors and intermediaries in Lithuania’s Government securities market. Figure 4 (compiled according to the data of the Bank of Lithuania) reveals distribution of investors in Lithuania’s Government securities market. Investments into Lithuania’s Government securities promised similar return as of loan making from the beginning of 1995 to the middle of 1996 and from the beginning of 1998 to the end of 1999 (figure 5, compiled according to the data of the Bank of Lithuania). It was a paradox in Lithuania when Lithuania’s Government securities interest rates exceeded the interest rates on the loans. In August 1995 Lithuania’s Government securities interest rate 1.3 times exceeded average interest rate on loans, in March 1996 it exceeded almost 1.8 times.
  6. 6. 6 1385 1.400 1276 Commercial banks of 1127 1.200 1080 Lithuania m i l l i o n 1.000 890 847 Insurance companies 800 695 585 of Lithuania 600 527 Other resident 400 L T L investors 200 0 Non-rezident 96.12 97.06 97.12 98.06 98.12 99.06 99.12 00.06 00.12 investors A t t h e e n d of p e r i o d Figure 4. Investors in Lithuania’s Government securities 40 35 30 c e n t 25 20 p e r 15 10 5 0 95 9 96 3 .09 98 6 00 6 94 9 95 2 95 3 95 6 96 2 96 6 96 9 97 2 97 3 97 6 98 2 98 3 98 9 99 2 99 3 99 6 99 9 00 2 00 3 00 9 .12 .0 .0 .0 .0 .0 .0 .0 .0 .1 .0 .0 .1 .0 .0 .1 .0 .1 .0 .1 .0 .0 .0 .1 .0 97 94 A v e r a g e d u r i n g t h e mo n t h Aver age i nt er est r at e on Li t huani a' s Gover nment secur i t i es Aver age i nt er est r at e on l oans i n LTL Aver age i nt er est r at e on t i m deposi t s i n LTL e Figure 5. The comparison of the average interest rates on deposits and loans in Lithuania with the interest rates on Lithuania’s Government securities (the vertical doted line indicates the periods when average interest rate on Government securities was higher than the interest rate on loans) Lithuanian banks established many subsidiaries/associated companies for the expansion of non-traditional activities. Such organizational form is not compulsory but is more suitable for
  7. 7. 7 commercial banks as well as for supervising authorities. The advantages of the activities through the individual companies are as follows: • The possibility to attract supplementary capital from the local and foreign partners. • It makes easier to evaluate the results of non-traditional activities. • Such organizational form is more acceptable for clients as it is supposed to leave less opportunity to arise the conflicts of interests. The bank has close relations with its subsidiary/associated company but it is supposed that individual company has less informational relations with the bank in comparison to bank subdivision. Insurance activities in internal division in Lithuania were realized only by ‘Vilniaus’ bank, although in 1999 even this bank founded life insurance subsidiary. Other Lithuanian banks have founded subsidiaries/associated companies at the beginning of their non-traditional (insurance) activities. Securities Brokerage Companies (SBC) or Departments (SBD) serves securities trading in Lithuania. All Lithuanian banks provide their clients with at least minimal services in securities market. Such services are usually provided through banks’ subdivisions – SBD. Banks have widely used subsidiaries for expansion of their own investment activities, provision of consulting services in securities market and organization of new share and bond emissions for their clients. Investments of Lithuanian banks in investment/insurance subsidiaries and associated companies are calculated and presented in figure 6 (according to the data provided in annual reports of Lithuanian commercial banks). Lithuanian banks became the leaders serving clients in securities market. The non-banking institutions have been controlling the insurance market until now. The strong positions of ‘Lietuvos draudimas’ in insurance market and the slower entrance of Lithuanian banks in insurance market cause it. 45 42 40 m i l l i o n 35 34 30 25 20 20 16 14 15 12 11 L T L 10 8 5 0 0 0 1996 1997 1998 1999 2000 A t t h e e n d o f p e r i o d Investments of Lithuanian commercial banks into the market of insurance services Investments of Lithuanian commercial banks into the market of securities services Figure 6. Investments of Lithuanian banks into subsidiaries/associated companies providing services in insurance and securities market
  8. 8. 8 Investments of Lithuanian banks in subsidiaries/associated companies providing non-traditional services began to grow from 1997. This is not a casual process as it coincides with the growing activity of foreign investors and financial intermediaries in Lithuania’s market and the increase of financial market stability. Investments of Lithuanian banks in subsidiaries/associated companies acting in securities market have been constantly growing. Lithuanian banks’ activity in insurance market diminished in the period of 1998 – 1999. This is related with Vilniaus and ‘Hermis’ banks investment in Lithuanian Export Import Insurance Company and their withdrawal in 1998. The subsidiary ‘Hermio Draudimas’ began its independent activities after the merge of Vilniaus and ‘Hermis’ banks in 1999. Activities in securities market are related to the services for the clients and the use of assets. Insurance payments that banks receive in insurance market are related to the liabilities and off balance items. Specific risk exists in securities as well in insurance market and the bank employees should acquire relevant qualifications and professional experience. The expansion of non-traditional activities is inevitably related to additional costs to enter the market. The subsidiaries providing non-traditional banking services usually should compete with the companies that entered the market earlier. New companies providing non-traditional banking services usually suffers the losses during the first years of activities. The expansion of non-traditional banking activities is the investment of the banks in their future prosperity. Non-traditional banking activities helps to improve bank services and to retain strong and competitive positions in financial market. Conclusions As worldwide banking experience suggest, universal banking has good development prospects, increases economical welfare and contributes to expansion of the financial market. The universal banking system is also relevant for the developing countries, however the developing countries should adequately prepare for the liberalization of financial market and implement the modern measures of banking supervision. I have evaluated Lithuanian financial market peculiarities and changes and I would forecast further expansion of Lithuanian banks in non-traditional markets. Until now, the increase of Lithuanian banks investments into subsidiaries/associated companies providing non-traditional services has been more related to the establishment of new companies. Further expansion should be more related to the increase of the share capital of earlier founded companies. Lithuania’s pension system should be reformed and individuals / firms should be stimulated to invest more funds in Lithuanian capital market. Lithuanian banks were the first financial institutions to begin preparation to the entry in this market and they have good prospects to fortify their positions and to compete with the foreign financial intermediaries. Lithuanian banks should keep their aim to expand the life insurance market as the life insurance services are more closely related to the traditional banking. On the other hand, the whole package of insurance services ensures complexity of financial mediation, therefore the non-life insurance services could also be provided by commercial banks. Universal Lithuanian banks provide high-quality services and they can successfully compete with foreign financial intermediaries in non-traditional market. I am of the opinion that Lithuanian banks will maintain their competitive power and good profitability results after Lithuania’s integration into the European Union.
  9. 9. 9 References 1. Annual reports of Lithuanian commercial banks (1997 – 2000). 2. Cable J. (1985). Capital Market Information and industrial performance: the role of West German Banks. The Economics Journal, No.95. 3. Dittus P. and Prowse S. (1995). Corporate Control in Central Europe and Russia: Should Banks Own Shares? World Bank Transitional Economies Working Paper No.1481. 4. Kraujalis S. (2000). The efficiency of Lithuanian banks in securities market. Dissertation. Kaunas University of Technology. 5. Kwan (1998). 6. Kwast M.L. (1989). The Impact of Underwriting and Dealing on Bank Returns and Risks. Journal of Banking and Finance 13, p. 101-125. 7. Litan R.E. (1985). Evaluating and Controlling the Risks of Financial Product Deregulation. Yale. Journal on Regulation 3, no.1, 1-52. 8. Monthly and quarterly bulletins of The Bank of Lithuania (1995-2000). 9. Purrucker, M. (1983). Bank in der kartellrechtlichen Fusionskontrolle, Berlin. 10. Stover R.D. (1982) A Re-examination of Bank Holding Company Acquisitions. Journal of Bank Research, 101-108. 11. Wall L.D. and Eisenbeis R.A. (1984). Risk Considerations in Deregulating Bank Activities, Federal Reserve Bank of Atlanta Economic Review, 6-19.

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