Presentation by MārtiņšKazāks, PhD, Deputy Group Chief Economist of Swedbank at Country workshop: "EU Balance-of-Payments assistance for Latvia: Foundations of Success" organized by the European Commission, Directorate General for Economic and Financial Affairs, and the Bank of Latvia. Brussels, March 1, 2012

1. From boom to bust and recovery:
the role of the banking system
Mārtiņš Kazāks, PhD
Deputy Group Chief Economist
Chief Economist in Latvia
Swedbank
March 1, 2012
Joint ECFIN and Bank of Latvia seminar “EU balance-of-
payments assistance for Latvia: foundations of success”

2. From boom to bust: who is to blame?
Domestic credit as % of GDP
100
• Global environment?… yes!
80
– False belief that income convergence in
60
CEE will be very fast no matter what
40
– Excessive risk taking globally
20
0
• Commercial banks?… yes!
-20
– Undue optimism on customers’ income
2004 2006 2008 2010
growth and banks’ ability to price risk Nonfinancial corporations
Households
– Fight for market shares, sales-based Total domestic credit annual growth, %
remuneration packages
Structure of domestic credit, %
100
• Government?… yes! Other
– Procyclical fiscal policy, political cycle 80 Transport & storage
– Real estate as a tax free zone Agriculture, etc.
60
Manufacturing
• … and all the rest, too?… yes! 40 Domestic trade
– Customers: undue optimism and poor Construction
20
financial literacy RE & other com.serv.
– Institutional framework: Basel 2, lack of 0 Households
all-inclusive credit register, grey economy 2004 2007 2011
Source: FCMC, BoL, CSBL, Swedbank calculations
© Swedbank 2

3. From boom to bust: massive hit taken by banks
• Local contraction made worse by the Loan overdues over 30 days, % of portfolio
2008 global crash 20
– Extreme volatility: currency attacks, bank 15
runs, liquidity squeeze and bank bail out,
unemployment to above 20% 10
– Total bank loses in 2009-11 at 10% of GDP
5
• How come Latvian banks suffered more 0
than Estonian banks? 2004 2005 2006 2007 2008 2009 2010 2011
Estonia Latvia
– Nonlinearity: GDP drop by 24% vs. 19%
– Initial position, e.g.: Real wage bill (2008=100)
110
• Larger imbalance = larger income fall
100
• Less savings = less stress tolerance -21%
90
– Institutional framework:
80
• Risk assessment, e.g. credit register, -32%
70
grey economy
60
• Judicial system, e.g. debtor discipline,
50
efficiency of asset repossession 2005 2006 2007 2008 2009 2010 2011
Estonia Latvia
Source: National banks, Reuters EcoWin
© Swedbank 3

4. From boom to bust: response of the banking sector
• During the bust: damage control Loan stock of domestic credit, bn EUR
11
– Support to the exit strategy and lock in by
Nordic parents (Vienna Initiative) 10
– Credit crunch, initially aggressive asset 9
repossession due to weak judicial system, 8
lack of experience, low macro visibility
7
– Asset restructuring, e.g., grace periods
6
– Full recapitalisation with current capital
2007 2008 2009 2010 2011 2012
adequacy at above 17%
Households Non-financial corporations
– Cut dependency on external funding: L/D
down from 260% to 195% Domestic credit structure in 2011, %
100
• Where now: deleveraging to continue? Other
80 Financial sector
– Portfolio quality is improving Transport & storage
– Strong competition and low risk appetite: 60 Agriculture, etc.
aggressive lending to a narrow clientele, Manufacturing
40
others are credit rationed Domestic trade
Construction
– Deleveraging is done for corporates, but 20
RE & other com.serv.
not yet for households 0 Households
Credit stock New loans
© Swedbank
Source: Bank of Latvia, FCMC 4

5. Lessons and policy implications: it is critical to
repair the entire system…
No more easy
berry-picking!
© Swedbank 5

6. Lessons and policy implications: it is critical to
repair the entire system…
• Looking Backward
– Banks individually do not fully appreciate systemic risks: room for improved macro prudential
framework
– Banks’ risk taking: room for rules but predominately common sense and a comprehensive
credit register
– Fiscal policy during boom years inconsistent with monetary policy: room for fiscal rules
– Strong and locked in foreign parent banks is an asset: limits capital flight, provides extra
confidence and reduces funding burden on the sovereign
– Grey economy is a threat: obstructs risk management and exaggerates credit crunch
© Swedbank 6

7. Lessons and policy implications: it is critical to
repair the entire system…
• Looking Forward
– Too many banks chasing shrinking number of clients?
• Risk tolerance: what about margins and resistance to shocks?
• Reassessing market size and profitability: smaller than expected, incumbent banks’
reaction will depend on severity of the EZ crisis and possible new entrants
– Credit growth: what is the causality of credit vs. economic growth?
• Income and productivity convergence is not God’s given – structural reforms are
needed to boost growth potential, e.g. labour market, regional development
– Policies necessary to fill in the market gaps: it is not banks alone!
• Poor financial infrastructure to support sustainable growth, e.g.: no noticeable stock
market, banks will not become risk capitalists again any time soon…
© Swedbank 7

8. Thank you!
© Swedbank 8