F I N A N C I A L S T A B I L I T Y R E V I E W

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1 ISSN ISSN (ONLINE) F I N A N C I A L S T A B I L I T Y R E V I E W 2011 VILNIUS 2011

2 Abbreviations CDS credit default swap CIS Common Wealth of Independent States DTI debt-to-income ECB European Central Bank EU European Union FRS Federal Reserve System GDP gross domestic product IMF International Monetary Fund ISC Insurance Supervisory Commission LGD loss given default LTV loan-to-value MFI monetary financial institution p. p. percentage points RR recovery rate RoA return on assets RoE return on equity SC Securities Commission VaR value at risk US United States Symbols and Conventions Category not applicable Data not available, although the phenomenon existed The Review was prepared by the Economics Department of the Bank of Lithuania. The lead author is Mindaugas Leika. The authors are: Jūratė Butkutė, Kristina Grigaitė, Šarūnas Grigas, Simonas Krėpšta, Audrius Mozūras, Virgilijus Rutkauskas, Vaidotas Tamulėnas, Nijolė Valinskytė. The Review is available in the pdf format on the website of the Bank of Lithuania at The Review is based on the data available by 1 May The Financial Stability Review is available online at EBSCO Publishing, Inc., Business Source Complete: Lietuvos bankas, 2011

3 Contents INTRODUCTION SUMMARY Challenges to the Financial System Stability I. FINANCIAL SYSTEM Development of the financial system s structure Banking system Bank assets and liquidity Loan portfolio quality and financial standing of debtors Profitability Capital adequacy II. RISKS AND OUTLOOK FOR THE FINANCIAL SYSTEM The risk of export decline The growth of risk premia Risk of the Scandinavian housing market overheating III. STRENGTHENING THE RESILIENCE OF THE FINANCIAL SYSTEM Towards the Macroprudential Policy: Responsible Lending Principles Possibilities of the financial sector taxation Basel III liquidity requirements and standards for banks ANNEXES BOXES Annex 1: Development of the interest rates of loans to the private sector and the interest payment burden Annex 2: Glossary Annex 3: Tables Table 1. Key financial stability indicators Table 2. Key performance indicators of non-financial corporations Table 3. Net financial assets of Lithuania s economy Table 4. Financial system of Lithuania Box 1. Simulation of adverse conditions in the LITAS-RLS system Box 2. Loss given default Box 3. Liquidity risk stress testing

4 Introduction Financial system stability is defined as the state of the market, when market participants (banks, financial market intermediaries and other institutions, markets and market infrastructures) are capable of efficiently reallocating limited financial resources in time and space and are ready to withstand shocks and the correction of the emerging imbalances without substantial impact on the efficient reallocation of resources. The policy for ensuring and strengthening financial stability is based on the constant monitoring of the market situation and advance identification and prevention of potential risks. The main objective of the financial stability analysis is to identify internal and external threats to the financial system, to evaluate the system s ability to withstand the effects of unfavourable internal and external shocks, to foresee appropriate response measures and to provide recommendations to financial market participants on the management of the emerging risks. The financial stability assessment is therefore different from the regular supervision of credit and other financial market institutions. The purpose of the financial stability reviews of the Bank of Lithuania, which are published once per year, is to contribute to the comprehensive understanding of potential risks to the financial system of Lithuania and to indicate its capabilities to offset them, as well as to encourage discussions on the issues of financial stability by financial market participants, economists and all those interested in financial markets. The Review analyses the changes in the domestic financial system, the situation of the banking system and its debtors households and non-financial enterprises and their ability to withstand external and internal macroeconomic environment changes. This year, the Review focuses on the capability of the banking system to absorb potential additional losses due to a slower than expected growth of the country s exports, the rise of risk premia and the correction of the real estate prices in the Nordic countries. It should be noted that shock scenarios were prepared on the basis of the information available at the time of the preparation of this Review and reflect the most probable sequence of events, if such shocks occurred; however, they are not the main (forecasted) scenario of the development of the economy and the financial system of Lithuania. By considering the experience of Lithuania and other countries gained during the recent global economic crisis, the Bank of Lithuania seeks to reduce the probability of large-scale crises in the future by taking preventive measures in advance. For this purpose, the Responsible Lending Principles were prepared and the possibilities to apply other macro-prudential measures are under discussion.

5 SUMMARY Internal environment is more favourable for financial system stability than the external environment. 5 Currently, the domestic environment is more favourable for ensuring financial stability than the international environment: successful consolidation of the public finance helped to reduce the country s risk premia and to secure a more favourable opinion of foreign financial institutions about the capability of Lithuania to manage the rising public debt 1. Meanwhile, the international environment remains unfavourable due to the deepening of the debt crisis in highly indebted EU states. The tension in the global foreign exchange market and the growing prices of commodities and energy pose a threat to the global economic recovery and financial institutions. The latter are forced to compete strongly among themselves when attempting to attract the funds for the increase of the capital and long-term financing. According to the assessment of the Bank of Lithuania, the domestic financial system remained stable. In recent years, the financial sector encountered large challenges: the necessity to increase capital and to search for long-term financing sources. It is expected that, when this task is completed, higher financial system stability will be ensured. Bank losses decreased, whereas in the first quarter of 2011 the banking system managed to earn profit. The decline of the loan portfolio slowed down as well. It is expected that this year and the coming years will be profitable for the banking system of Lithuania. Both the recovery of the domestic economy and the successful public finance consolidation, which helped to reduce the country s risk premia in the market, are contributing to this. The majority of banks have sufficient reserves of capital and liquid funds, however, this does not mean that it is not necessary to improve capital adequacy further. It is necessary to assess risks conservatively and to form required provisions to cover the impairment losses for loans granted during the economic growth cycle. This, in addition to the strengthening of capital, will allow domestic banks to increase the system s resilience to the impact of potential negative shocks. The main economic development scenario of the country covers the growth of the domestic economy and the decline of the budget deficit and unemployment: this will create a positive environment for the operation of banks and, if their operation is profitable, will allow to increase capital gradually. Under the baseline scenario of the country s economic development, active foreign demand and a gradual recovery of domestic consumption will have the largest influence on the improvement in the economic situation of Lithuania. The situation of both enterprises and households will improve, therefore, the probability of insolvency and bank losses will decrease. The profit earned will allow banks to increase capital by using internal funds. Three risk scenarios. In addition to the baseline scenario, the Bank of Lithuania also takes into consideration the fact that the situation of the financial sector may deteriorate, if one or several adverse economic development scenarios materialize. The baseline scenarios of unfavourable economic development are related to the shock to the country s exports (this would slow down the country s economic recovery), the rise of risk premia due to the spill-over effect or unsustainable public finance consolidation and the spill-over effect related to the housing market overheating in the Scandinavian countries. Stress testing results. Stress testing results show that the banking system requires additional capital to cover loan impairment losses even under the baseline economic development scenario. However, the amount of the required capital is not large: around LTL 60 million or 0.8 per cent of the current capital base of the system. In the case of the exports shock, in order to maintain the domestic banking system s capital adequacy level above the minimum requirement established by the Bank of Lithuania, the additional capital of over LTL 230 million should be attracted by the end of The growth of risk premia would have the largest impact on the banking system s capital adequacy: in this case, in order to maintain the domestic banking system s capital adequacy level above the minimum requirement established by 1 Public debt is the consolidated amount of the liabilities assumed, but not yet fulfilled, by the government, municipalities, social insurance funds and related entities that have the right to borrow. Hereinafter it means the net internal and external public debt.

6 6 the Bank of Lithuania, the additional capital of almost LTL 650 million should be attracted by the end of In the case of housing price correction in the Scandinavian countries, the domestic banking system would encounter liquidity problems first of all, therefore, interest rates would rise and the amount of liquid funds in the system would decline. Liquidity stress testing results show that even in such case the banking system would be capable of withstanding a short-term impact of the shock. Challenges to the financial system: the need to strengthen the capital base and attract more longterm financing sources. In the short term, banks will need to solve the remaining balance-sheet problems: not all banks adequately estimated the loan impairment losses and formed the necessary provisions. If the economic recovery slows down, the loan portfolio quality will not improve rapidly, thus, there will be no possibility to reduce provisions and earn additional profit. It is in the interests of the banks themselves to have sufficient capital buffers in the case of additional losses and to ensure safe and stable operating environment. In the medium term, banks need to consider further balanced expansion of the loan portfolio to avoid past mistakes: the rapid growth of real estate prices and the stimulation of unfounded speculations in the market. In the long term, banks will need to comply with the new capital adequacy and liquidity ratios: to increase Tier I capital and attract a larger number of stable long-term financing sources. To reduce systemic risk, the Bank of Lithuania intends to apply the Responsible Lending Principles. The Responsible Lending Principles, which are based on the loan to value ratio, the debt to income ratio and the rules of adequate disclosure of information and risk management, will enhance the domestic financial system s resilience to potential market imbalances, particularly those related to price bubbles (especially real estate).

7 Challenges to the Financial System Stability 7 Analysis of the banking system s risks is based on two economic development scenarios: baseline and adverse. The baseline scenario is based on the latest macroeconomic forecasts of the Bank of Lithuania available at the time of the preparation of the Review (February 2011). Adverse economic development scenario may be determined by many causes, of which, the following may have the largest negative impact: Favourable developments of the main macroeconomic indicators forecasted for the next year. Chart 1. Annual changes of the real GDP a) the risk of export decline, b) the growth of risk premia, c) the risk of the housing market overheating in the Scandinavian countries. Under the baseline scenario of the country s macroeconomic development, active foreign demand and a gradual recovery of domestic consumption will have the largest influence on the improvement in the economic situation of Lithuania. With the decline in the impact of short-term factors, such as treasury measures and the reserve cycle, the growth of the global economy slowed down slightly. Slower growth is projected in developed countries, where the economic development is unfavourably affected by the poor situation in the labour market and the state of public finance. The economic development in emerging economies is also becoming more moderate. However, there are some favourable changes in economic activity in several larger foreign trade partners of Lithuania. Recently, the economy has been growing rapidly in Estonia and Latvia, particularly good development indicators remain in Poland, Germany and Sweden. It is projected that the real GDP will increase in Lithuania by 5.6 per cent and 4.8 per cent, respectively, in 2011 and in Chart 2. Dynamics of the unemployment rate Growing demand in foreign countries has a favourable effect on exporting enterprises and reduces their credit risk to the banking system The value added created in the industry and transportation activities has been increasing for several consecutive quarters, whereas the expectations of enterprises are optimistic. At the same time, the turnover of enterprises oriented towards domestic demand is stabilising and starting to grow gradually. The assessment of domestic demand shows that both investment in fixed capital increased earlier than expected, and the development of private consumption exceeded previous assessments. Investment in engineering constructions and production facilities grew in the public sector, whereas private sector investment remained sluggish. However, investment in this sector is expected to rise with the growth of demand. The need for investment in the private sector has been reflected already for some time by the rising production capacity utilisation level. From Q to Q1 2011, the capacity utilisation of industrial enterprises rose from 60 per cent to 69 per cent. It is currently projected that investment, after stabilising in 2010, will grow by 17.9 per cent and 11.3 per cent, respectively, in 2011 and in 2012.

8 8 Chart 3 Developments of the average annual inflation...therefore the losses incurred by the banking system from lending to business customers should not grow this year and next year. With the growth of sales to foreign markets and the recovery of consumption in the domestic market, the financial situation of non-financial enterprises is improving and their ability to repay debts increases. Investment will recover gradually and the demand for labour will increase with the growth of operation volumes of enterprises and the capacity utilisation reaching the level observed in previous years. However, enterprises in economic activities oriented towards domestic consumption, which were actively credited in previous years, are recovering slower, therefore, the improvement in the loan portfolio quality of the banking system will not be fast. The quality of loans to households should stabilise Although the quality of the portfolio of loans to households worsened in 2010, it still remained the best, compared to other borrowers, and, considering the recently observed signs of economic recovery and the improvement in the situation of enterprises, it is expected that the quality of the portfolio of loans to households will stabilise or even improve slightly in the second half of however, the risk remains due to high and slowly decreasing unemployment... Over the upcoming year, the banking system will face the challenges related to the management of the credit risk of individuals. Owing to the still relatively high unemployment rate, increasing inflation risk and only slightly higher wages, the risk of insolvency of households will remain elevated in The highest unemployment rate was reached in the second quarter of 2010, whereas in the third quarter the unemployment declined already, however the decline was partly determined by seasonal factors. In the next two years, with the rise of economic activity, the unemployment rate will decline gradually. However, the situation in the labour market will also depend on the ability of the unemployed persons to ensure their qualification meets market needs and to change it if necessary, as well as on their geographical mobility.... and the rising inflation, which would increase the interest payment burden and necessary expenses for borrowers. The annual inflation in Lithuania accelerated almost since the beginning of the year, whereas at the end of the year it was noticeably higher than in the EU and in the euro area 2. Inflation in Lithuania was mostly determined by the rise of the prices of food products, fuel and administered prices over the year. As domestic demand remained sluggish, there was no upward pressure on the prices of industrial goods and market services, however, such pressure may emerge later, since the prices of these goods usually respond to the growth of fuel prices after a certain period of time. In the nearest future, the prices of food products and energy resources may increase further. It is projected that the inflation will be 3.8 per cent in 2011 and 3.9 per cent in Due to bigger weights of food and fuel in the Lithuanian consumer s basket vs. the euro area consumer s basket.

9 Owing to low real estate prices and better expectations of market participants, the real estate market recovered slightly after the three-year period of downturn. 9 It was reflected by the increase in the number of transactions and discontinued decline in the prices of housing offered for sale. On the other hand, fast recovery of the real estate market is not expected, as households developed more conservative and at the same time more reasonable economic development and income expectations, as well as more responsible borrowing habits, whereas banks applied more cautious lending practices.

10 10 Main Risks to Lithuania s Financial System The Survey of Risks to Lithuania s financial system 3 of April 2011 revealed that the growth of inflation due to the increase in energy and food prices raises the strongest concern of Lithuania s financial institutions. Instability of the political environment and the discontinuation of reforms and necessary further consolidation of public finances is one of the most important risks indicated by financial institutions. Financial market participants are also closely monitoring the economic development trends of the main export partners, with which the pace of the economic recovery in Lithuania is particularly closely linked. Although the situation in the labour market remains complicated, the possibility of a rise of state risk premia is smaller and the danger posed by the credit risk of nonfinancial corporations and households is less significant. Real estate prices are not expected to fall further. Chart A. Risk Map of Lithuania s financial system Table A. Risk Map of Lithuania s financial system Similar to the end of 2010, a potential slow economic recovery of the country together with labour market problems remain important risks to the stability of the financial system of Lithuania. The recovery of domestic demand remains sluggish, therefore, less intensive than projected economic activity of the main export partners of Lithuania or the financial system instability in other EU states would slow down the growth rate of Lithuania s economy. The ways used to resolve long-term structural unemployment and other labour market problems will have an effect on the growth possibilities of Lithuania s economy in the future. The shortage of qualified labour force, emigration and the possibility of wage growth surpassing the level of labour productivity were among the risks indicated by the Survey respondents. Risk source The price of financial resources in the future will also be increased by the new international requirements of Basel III, which will obligate banks to mitigate risk, attract additional capital and hold more high quality liquid funds. According to the assessment of the surveyed financial market participants, better possibilities for the state to borrow more intensively in the domestic market are perceived the impact of the competition with the private sector for loans on the financial stability of the country is insignificant. The risk of a fall in real estate prices to the stability of the domestic financial system declined: both risk probability and a potential negative impact on financial institutions are among the smallest compared to other risk sources, according to market participants. Note: Out of 44 participants of the Survey, representatives of 29 (66 %) institutions (board members, managers, risk management heads with the experience in the field of financial markets of over 11 years on average) responded to the questions of the Survey. Risk score Probability Impact 1 Inflation, rising energy prices Instability of the political environment, discontinuation of reforms and consolidation of public finances* Slow recovery of Lithuania s economy or economic downturn Problems in the labour market* Slower growth of foreign economies* Soaring sovereign risk of other European countries (e.g., risk premia of issued bonds) Rising interest rates, other challenges for banks* Increasing credit risk of Lithuania, downgrade of borrowing ratings Growing credit risk of enterprises Incapability of a systemically important financial institution to operate further (insolvency) Increasing credit risk of households Liquidity shortage of financial institutions Imbalances in the Scandinavian countries* The State borrowing in Lithuania crowding out the lending to the private sector Declining real estate prices Source: Risk Survey, April Notes: * risk sources indicated by respondents. Probability: 1 small; 2 average; 3 large. Impact: 1 small; 2 average; 3 large. 3 Representatives of Lithuania s financial institutions had to indicate themselves five risks important to the entire domestic financial system and assess the probability of occurrence of the presented ten risks and the scope of their potential impact on the domestic financial system. Risks were ranked by a risk score calculated by multiplying the averages of risk probability and potential negative impact assessments.

11 I. FINANCIAL SYSTEM Development of the financial system s 4 structure 11 No major changes were observed in the Lithuanian financial system in 2010: the banking system assets decreased marginally, while assets of pension funds and other capital market participants saw an increase In the latter case, the asset growth is related to the recovery in securities market, while the decrease in the banking system assets was driven by the new loan size which decreased due to the falling borrowing demand and conservative lending policy, as well as repayment of earlier granted loans. No major changes in the Lithuanian financial system were observed in Chart 4. Changes of the Lithuanian Financial System Participants assets however the competition in the banking sector remained unchanged: the three biggest banks retained their positions, although they adhered to conservative lending policy and were unwilling to compete for new customers. Concentration in the banking system decreased slightly due to a decrease in the market share of the three largest banks, which contracted over the year in terms of assets by 3.5 p. p. to 60.8 per cent, while the Herfindahl-Hirschman index 5 went down by 124 points to 1,586. On the one hand, conservative attitude towards customers helps the banking system to keep historically high capital adequacy ratio (loan portfolio amortisation leads to a decrease in both risk-weighted assets and capital requirement). On the other hand, the three biggest banks encounter growing competition both from Group II 6 banks and smaller market participants. The growth of assets and the market share of Group II banks was driven by the growth in their lending to non-residents and entities related with the major bank shareholders. The portfolio of loans to non-residents was increasing rapidly in Group II banks last year. Chart 5. Annual change of the bank s loan portfolio Loans to non-residents made up 12.3 per cent of Group II banks assets, an increase of 2 p. p. over one year. On the one hand, such loan portfolio growth helps banks to diversify geographical risk and earn extra income in foreign markets. However, the concentration of lending to individual business segments and the assumed project risk raise some concerns. In addition, liabilities financed by non-residents and non-residents equity account for 23.4 per cent of the assets of banks in this group. The range of loan portfolio concentration 7 remained wide 4 In this report, the term financial system consists of banks, credit unions, Central Credit Union, leasing companies that are members of the Lithuanian Leasing Association, insurance companies, capital market participants, and pension funds. The data for the third quarter of 2010 were used in the analysis. 5 Herfindahl-Hirschman Index is one of the most commonly used concentration indicators. The index is calculated as:, where: X b - B s market share in terms of assets, B number of banks. The higher the index value, the more the system is considered to be concentrated. In practice, the index value between 1,000 and 1,800 shows the average concentration. 6 The Group I banks includes banks with a larger part (more than 50 %) of equity interest held by foreign parent banks or financial institutions. The Group I banks are the AB SEB bankas, Swedbank, AB, AB DnB NORD bankas, AB Citadele Bank and all branches of foreign banks. The Group II banks include banks with larger equity interest (more than 50 %) held by natural persons and non-financial institutions. The Group II banks are AB bankas SNORAS, AB Ūkio bankas, UAB Medicinos bankas and AB bankas Finasta. 7 The bigger the bank s loan portfolio share made up of loans to customers engaged in the same economic activity, the higher the concentration.

12 12 Development of the non-bank financing and savings market remained sluggish. Chart 6. Annual change in non-banking funding instruments Loan portfolio concentration by borrower activity remains high, but banks continue to focus on safe loans. Chart 7. Change in banks loan portfolio concentration Some participants of the Lithuanian banking system preferred focusing on individual types of loans by building up more than one-third of their loan portfolio from loans for house purchase. The others, by contrast, were issuing loans to finance various businesses, but did not allow loans to one type of economic activity to exceed one-fifth of the total portfolio. The range of loan concentration in the domestic banking sector remained broadly unchanged in 2010 and relatively wide. however the concentration risk continued to be low, as loans for house purchase 8 made the biggest share in banks with the most concentrated loan portfolios. Although these banks are dependent on one group of borrowers, loans for house purchase were historically among the safest. Since 1999, the number of cases when bank loans for house purchase in Lithuania were recognised as non-performing was three times lower, compared to total loans in the portfolio. Despite the leasing market recovery last year prompted by improving services sector expectations, the share of the leasing companies assets in the domestic financial system went down, while their market concentration remained high. The asset value of these companies continued to decrease for the second consecutive year following the contraction by 16.4 per cent last year. The portfolios of two largest companies accounted for 69.0 per cent of the total portfolio (a 6.9 % decrease compared to 2009), whereas the Herfindahl-Hirschman index fell by 445 points, but still remained at a high level of 2,534. The expansion of the non-bank funding and savings market and the capital market remained small basically due to high alternative financing costs in Lithuania and the shortage of investors. New capital attracted through non-bank financing and saving instruments, such as equity and debt securities, made up only 2.0 per cent of the financial system s total assets in During the period of economic growth, borrowing from banks was less expensive for corporations, whereas owing to the fall in share prices and interest in shares during the recession, attracting additional capital became expensive. Domestic corporations with plans to have their shares listed on the stock exchange focused on larger and more active Warsaw Stock Exchange, whereas the Lithuanian market of publicly traded debt securities of corporations remained sluggish securities of only four issuers, with three banks among them, were traded. The disposable assets of institutional investors however actually remained unchanged, accounting for 8.4 per cent of total assets of the financial system. 8 Loans for house purchase in this case are considered as one loan group.

13 Banking system Bank assets and liquidity The ongoing adjustment of economic imbalances made an impact on the development of both Group I and Group II banks assets and loan portfolios. Activities of Group I banks is not restricted by additional capital or liquidity needs, therefore the lending by these banks depended mostly on the demand for lending among corporations operating in most promising business sectors and households with proper financial standing. The loan portfolio of Group II was growing more rapidly driven by the need to invest deposits attracted last year, which were relatively expensive, and the necessity to assume higher risk with the purpose of keeping the net interest rate margin positive. Newly attracted funds, especially deposits, were used for restructuring and refinancing of non-performing loans. It should be noted that more than a half of new loans issued in 2010 by Group II banks were loans to non-lithuanian residents, while deposits from the latter increased by 2 per cent or LTL 27 million. But this either had no impact on the assumed risk or led to its increase, mostly due to the need to immediately address the loss recognition and capital increase problems; moreover, further growth of the loan portfolio by focusing on customers with relatively higher risk increased the need for strengthening the capital base of Group II banks. It should be noted that the decrease in banking assets is decelerating, which can possibly lead to a positive growth rate of assets and the loan portfolio at the end of the year, provided that financial markets avoid new shocks. A moderate decrease in bank assets last year was driven largely by a continuous decrease in lending to corporations and households, as well as a decline in bank funds held with other credit institutions. Changes in the lending market were still driven by the consequences of the economic recession that started in 2009: lower economic activity resulted in lower investment needs of corporations, while households were reluctant to assume additional financial liabilities in the context of growing unemployment and the reduction of wages. Lending supply, on the other hand, was going down due to tight bank lending standards, which better corresponded to the assumed credit risk level, as this is one of the prerequisites for longterm financial stability. This was also confirmed by the results of the latest bank lending survey, which showed that bank lending is going to be more active this year. Group II banks were actively operating in the loan market, and, striving for higher return, tended to assume higher risk, compared to Group I banks. Chart 8. Annual changes in loan portfolio The annual growth rate of bank assets and the loan portfolio is most likely to turn positive at the end of Chart 9. Changes in loan portfolio Changes in loan portfolio growth were driven both by demand and supply factors. Chart 10. Credit standards and demand 13 Many banks expect that a moderate growth of their loan portfolios in 2011 will match the GDP growth rate. Banks link these changes with a slow recovery of the borrowing demand among corporations and households and increasing competition in the bank lending market. It should be noted that many banks plan to keep their credit standards tight, but tend to compete by reducing interest margins. Liquidity risk in the banking sector remained low despite a decrease in liquid assets

14 14 The flow of repaid loans and attracted deposits was used to reduce liabilities to parent banks. Chart 11. Change in value of banks assets The main factors that determined the changes of bank funding sources and pushed down liquidity reserves were reduced lending, active competition of Group II banks in the deposit market and the aim of parent banks to increase the share of assets covered by internal financial resources. as banks started slowly absorbing the historically high liquidity that was accumulated in 2009 through more effective use of the financial asset holdings and the redistribution of funds. The increasing savings by households allowed banks to attract cheap deposits and boost liquidity holdings, the excess of which together with cash flows from loan amortisation were used for repaying loans to parent banks 9. Last year, the loan portfolio, excluding loan impairment, contracted by LTL 2.8 billion, deposits went up by LTL 4.4 billion, while loans to parent banks decreased by LTL 7.4 billion. Average liquidity ratio in the banking system was 43 per cent at the end of 2010, close to the last five-year average. Despite lower liquidity in the system, funds from parent banks are considered as a permanent source of financing and ensuring liquidity for the banking system, taking into account close links between parent banks and their affiliates and a possibility to rapidly attract financial resources in the event of their shortage (for more information, see chapter III). Four factors that will have an impact on liquidity management may be singled out. They are the following: (a) tension within global and domestic interbank markets; (b) the need for a larger share of long-term liabilities in the funding structure with a view of tighter liquidity requirements to be gradually implemented; (c) reduced debt to parent banks; and (d) increased public borrowing needs in The liquidity risk due to disturbances in the interbank lending market remained insignificant. Liquidity risk in the interbank market is contained by high required reserves, the ability to manage local and foreign currency (i.e. euro) liquidity by utilising currency exchange and overnight lending facilities provided by the Bank of Lithuania and topological features of the market, i.e. the domination of a few large market participants in interbank payments and the absence of structural hierarchy (for more information, see Box 1). The simulative calculations showed that market participants would not sustain big losses, even if the payment system failed. 9 The biggest growth was observed last year in the concentration of government deposits: deposits by government institutions and local government enterprises went up by 42 per cent, with their share growing from 6 to 10 per cent of total deposits.

15 Box 1. Simulation of adverse conditions in the LITAS-RLS system LITAS-RLS is the system for real time gross settlements in litas managed by the Bank of Lithuania. It is used for operations related to the functions of the Bank of Lithuania, interbank market and settlements made by external systems. The system is also used to process urgent payments submitted by customers of credit institutions. The average number of payment operations conducted during a day in 2010 was 1,200, with a total value of LTL 1,114.8 million. As a rule, such settlement services do not have an alternative due to their specific features. The safety and stability of this systemically important infrastructure has been given high priority by the Bank of Lithuania. Recently, the traditional tools of payment systems oversight have been supplemented by the Bank of Lithuania with innovative solutions, which allow for the imitation of various adverse situations in the system (e.g. perational disorders, insolvency cases) and checking the efficiency of the existing measures (for example, how liquidity saving solutions implemented in the system would act in these adverse situations). For this, the software developed by the Finland s central bank was used (hereinafter referred to as the simulator). Liquidity need in the system Historically, the system LITAS-RLS has been characterised by a relatively high liquidity of the settlement accounts, which is determined by the reserve requirement ratio that is 4 per cent of the established reserve base and is higher than in the euro area. All system participants (credit institutions, except the Central Credit Union of Lithuania) hold their required reserves at the Bank of Lithuania. The aim of the simulation was to determine the liquidity level in settlement accounts, based on historical one month system data, which is sufficient to ensure smooth processing of payment orders, i. e. without a delay in the queue of payment orders. During the reported period, actual average system liquidity was LTL 1,875 million, although it fluctuated each day. The simulator showed that an average minimum amount sufficient to ensure smooth operations was LTL 988 million, or 47.3 per cent lower than the actual figure, whereas the remaining amount of LTL 887 million in the accounts of the system participants could be treated as excessive in terms of payments. Nevertheless, it should be noted that ex-post liquidity is not the same as ex-ante liquidity, as credit institutions cannot forecast future inflows precisely. As a result, a general trend would be observed with liquidity going down, under which the system would become less resilient to the fluctuations in payment flows: payment queues would form more often and the intraday credit facility would be used more actively. The amount of excessive liquidity, which is related to payments, varies depending on system participant. Several banks with marginal fund holdings were discovered. Any additional liquidity absorption operation would be impossible for such banks without violating the requirement of ensuring smooth payment processing. Operational malfunction in the participants information systems To ensure the payment processing as planned, the operational stability is important both in the LITAS- RLS system and internal information systems of its participants, as the LITAS-RLS regularly exchanges payment information and payment results with the latter. The system participants, especially those who make a large number of payments, are important distributors of liquidity, which send liquidity to other participants via outgoing payments (see Chart A for mutual payment flows of the LITAS-RLS system participants). In the event of a failure in the information systems of such participants, liquidity would accumulate in their settlement accounts (as a result of incoming payments). If regular payments do not reach other participants, the latter are likely to face a liquidity risk. A scenario in which two major system participants individually encountered technical failures was chosen based on one day historical data. As a result, such a participant could not enter any payment orders in the system from the start of the day to 2 p.m. Also, the payment positions of the LITAS-MMS system, which uses LITAS-RLS accounts for making settlements, were recalculated accordingly. The results revealed no systemic risk was possible Chart A. Mutual payment flows of the LITAS-RLS payment system participants (by payment value) in such case. The settlements of only several other participants would suffer, i.e., the payments of these participants would be conducted with a delay rather than immediately (many of them in less than 1 hour). It could be avoided, if participants used the intraday credit facility and had a sufficient amount of eligible assets to be used as collateral. 15

16 16 The loss of the banking system can grow further as a result of lending to households (due to non-performing loans), rather than lending to enterprises Chart 12. Banking system s non-performing loans improving financial indicators of enterprises however give hope of a more rapid improvement in the loan portfolio quality within this sector Chart 13. Non financial firms activity main indicators The bankruptcy probability among enterprises within individual economic activities however remains high Chart 14. Share of initiated bankrupcy proceedings over the amount of nonfinancial firms present Loan portfolio quality and financial standing of debtors The banking system has already sustained major losses prompted by the economic downturn. Effective management of non-performing loan portfolio in order to reduce the lending losses has remained one of the major challenges encountered by banks last year. The growth of non-performing loans has stabilised and loan impairment losses were 6 times lower in 2010, compared to 2009 (LTL 0.7 billion and LTL 3.9 billion, respectively). In view of the improving macroeconomic situation, the loan portfolio quality of the banking system is expected to improve gradually this year, provided neither domestic nor international markets encounter new shocks, which may increase financial institutions risk aversion and/or cause a slowdown in the economic recovery. The loan portfolio stabilisation is driven by... The quality of loans to corporate customers has stabilised, but remained the lowest. This can be explained by better performance results of non-financial corporations due to faster recovery in foreign markets. The quality of loans to households for house purchase deteriorated due to higher unemployment, but still remained the best. Such a situation with the household loan portfolio should not last long, as an improvement is expected in the second half of 2011 due to the growing corporate activity, which will lead to higher labour demand and an eventual improvement in the households financial situation....corporate sector that has been showing signs of modest recovery... The number of enterprises facing lower demand started decreasing in the beginning of 2010, and a smaller number of them sustained financial difficulties. After a loss in 2009, more than a half of enterprises again were generating profits that made up LTL 5.3 billion before taxes, accounting for one-fifth of their total liabilities to banks. Growing demand in foreign markets and a decline in companies expenses, which went down as a result of the operations optimisation in previous periods, had a major effect on the sales recovery. Business prospects became more attractive and the companies economic sentiment indicator was positive again after nearly a three-year period. After having sold their inventories, companies boosted the output and increased efficiency of the utilisation of their production capacity. Also, some of them began increasing investments (e.g. companies engaged in transportation, storage and energy supply economic activities), others (e.g. companies engaged in industry and construction economic activities) started looking for additional labour force, which in turn reduced unemployment. which is not expected to contribute to the growth of borrowing in the nearest future.

17 After tightening credit standards since 2006, banks have reported to ease them during the reporting period and they expect increasing demand from non-financial corporations. No significant growth of the demand for services by credit institutions among non-financial corporations is expected in the first half of On the other hand, the survey of non-financial enterprises on business financing 10 commissioned by the Bank of Lithuania showed that non-financial corporations used mainly internal financing recourses to finance their operational needs in 2010 and were not planning to make any significant changes in their business financing structure in the coming year. However, corporations, which plan to change their business financing structure, intend to borrow from banks. Real estate, manufacturing and commercial corporations, which are mostly indebted to banks, continued to reduce their financial leverage with their profitability and their capability of financial liabilities repayment gradually growing. The results of the bank lending survey by the Bank of Lithuania suggest that after a prolonged period the banks see the financial situation of enterprises as improving and the number of overdue loans as stabilising. The risk for the banking sector is still there because of uneven recovery of the corporate sector: enterprises with the lowest indebtedness have been recovering faster than enterprises in the construction and real estate sectors, the debt level of which is the highest. The profit earned by non-financial corporations in 2010 was close to the 2004 level, although their liabilities to the banking system grew over the reporting period by almost three times. Notwithstanding the decrease of 14.5 per cent in the number of new bankruptcy proceedings, the probability of a bankruptcy 11 for individual enterprises (such as construction, transportations enterprises) is still relatively high, and the capability of debt repayment 12 by corporations closely related with real estate enterprises is one of the lowest, compared with other sectors. In 2010, the amount of written-off loans was the highest in recent years, while a half of such write-offs were related with real estate, trading and manufacturing enterprises, which are the largest debtors of banks. Although the financial situation of businesses has been improving, a more moderate recovery of enterprises within economic activities focused on domestic consumption will prevent a more rapid recovery of the loan portfolio quality, as loans to the latter account for three-fourths of the total number of loans to nonfinancial corporations. In 2009 to 2010, households managed to reduce their debt to the banking system and at the same time to boost their financial assets holdings, primarily their deposits with banks. The household loan portfolio has been already decreasing for two consecutive years Chart 15. Changes in household loan portfolio composition therefore, the write-downs of the banking system loans remained high. Chart 16. Loan write-downs Household indebtedness is still one of the lowest among EU countries. Chart 17. The ratio of loan portfolio to households and nominal GDP in selected countries 17 In March 2011, the household loan portfolio value declined by more than 13.7 per cent from the highest value registered in January 2009 driven mainly by more rapid repayment of loans, other than loans for house purchase. 10 For more information, see the survey of non-financial enterprises on business financing commissioned by the Bank of Lithuania and conducted in May The ratio of new bankruptcy proceedings to the number of enterprises. 12 Profit before taxes, amortisation and depreciation, compared to financial liabilities.

18 18 In 2010, the average share of household income 13 for the repayment of loans for house purchase made up 25.9 per cent of the disposable income, a slight decrease compared to The most significant contraction of the income share for the repayment of loans for house purchase was observed in households with income up to LTL 1,200. Only slight changes were observed in the income share allocated by households from other income groups for the repayment of their loans for house purchase. Moreover, households boosted their financial asset holdings by more than 3.2 per cent, in particular currency and deposits, which grew over the year by almost LTL 2.3 billion or 8.0 per cent. Regardless of a decrease in interest rates on deposits, the household deposit growth rate in 2010 was two times higher than in 2009; however, households preferred their savings to be in litas rather than in euros more often. Households financial capability improved as a result of a slight improvement of the situation in the labour market and wages which started increasing Chart 18. Changes in unemployment and income The quality of the banking system s portfolio of loans to households remains the best, compared to loans to other borrowers. The household default risk was partially contained by the wage growth, which started in mid-2010, and decreasing unemployment. As a result, the financial situation of households is expected to improve along with a decrease in the number of overdue or non-performing loans. In addition, the changes in households financial situation materialise with longer time lags, compared to the changes in the financial situation of corporations, and, considering the recent economic recovery signs and improving situation of corporations, the quality of the household loan portfolio is also expected to stabilise or even improve slightly in the second half of The majority (43.1 %) of indebted households view the repayment of their loan for house purchase as a minor burden 14. the financial situation of households however remains sensitive to the interest rate and inflation developments. Chart 19. Interest rates on household loans The households perception of a burden related to loans for house purchase has improved, compared to the last year survey results. The burden related to loans for house purchase for households, especially those with lower income, may have eased in 2010 driven mainly by low interbank interest rates following the withdrawal of monetary policy accommodation implemented by the ECB and by an increase in net wages, which continued for more than six months. In addition, it was influenced by higher than average wages of indebted households and accrued financial reserves. On average, the income of a working member of a household is 1.5 times higher than the average net wage in the country. Moreover, the survey of the households with loans for house purchase revealed that 85.4 per cent of the survey respondents hold at least one saving instrument, 33.7 per cent hold liquid reserves (savings held at home or a deposit with a bank). The saving instruments held and accrued reserves may ease the burden of loans for house purchase for households in case of unexpected developments and reduce risks for the banking system. Two factors had an impact on the growth of financial vulnerability of households: a prevailing short fixation period of initial interest rates Based on the data of the 2011 survey of households with loans for house purchase, which is available on the Bank of Lithuania website. 14 Based on the data of the 2011 survey of households with loans for house purchase, which is available on the Bank of Lithuania website.

19 The price is the most important factor for the decision of households to borrow. When choosing the loan repayment conditions and terms (currency, interest rate fixation period, etc.), they usually focus on the lowest loan repayment costs rather than the risks. The results of the survey of households with loans for house purchase showed that almost two-thirds of households have their initial interest rate on loans for house purchase fixed for a period shorter than 1 year. The key interest rates along with the costs of lending to households continued to be low following the implementation by the ECB of an accommodative monetary policy for more than one and a half years. The growth of inflation expectations and stable signs of economic recovery however made the pressure for raising the key interest rates; thus, in April 2011 the ECB took a decision to increase the key interest rate. The interest rate change had an immediate impact on the loan repayment burden of households and other borrowers (see Annex 1).... and the growth of inflation risk. Increasing prices for food, services, utilities and other necessary expenses of households have an impact on the households solvency, as the growing necessary expenses lead to a decrease in the balance of free income, which poses a risk to the capability of households to fulfil their liabilities. Banks expect the demand for lending to households to recover in the nearest time, although the lending standards are to remain tight. Following the growth of competition among banks, the margins on loans to households started narrowing in mid-2010, whereas the prices of real property, which stabilised in the second quarter of 2010, and increasing consumer confidence had a positive effect on the formation of the borrowing incentives for households. The bank lending survey results revealed that banks expected the lending demand among households to start growing in the beginning of The assessment of the balance of households free income 15 and the dynamics of the loan portfolio show that the most poor quality of loans to households in the event of the baseline domestic economic development scenario 16 may be expected in the middle of 2011, while later a gradual improvement is to begin. Despite the growing inflation and increasing interest rates, which lead to the growth of the necessary expenses and expenses for loan repayment of households, the number of households capable to make regular repayments of the loan for house purchase will increase as a result of lower unemployment and increasing income, therefore, non-performing loans will go down in a long run. Table 1. Return on investment and profitability Bonds* Lithuania Housing** Latvia Estonia Shares Deposits Pillar III pension funds Shares Deposits Bonds* Housing** Shares Deposits Bonds* Housing** Sources: national central banks, OMXV, OMXT and OMXR. * Average yield of long-term government bonds used for convergence evaluation purpose. ** Including only the increase in housing price, without housing rent income. A recovery of the activity was observed in the real estate market Chart 20. Changes in housing prices and number of transactions The balance of free income of a household is the difference of the household s income and expenses (for loan repayment, subsistence, etc.), which shows the solvency of the household. 16 For more details on the methodology of stress testing of households, see Appendix 2 of the Financial Stability Review.

20 20... the diminishing residential housing supply and no improvement in the real estate market expectations did not create incentives for investment to increase. Chart 21. Changes in housing supply factors The calculations based on the evaluation of real property price changes showed that at the end of 2010 the value of the pledged assets of 36.1 per cent of households with loans for house purchase was lower than the outstanding loan amount 17. If the said households encountered solvency problems and faced the need to sell the pledged assets, they would need to search for additional sources to cover their assumed financial liabilities, as the proceeds of the sale of the pledged real estate would be insufficient to repay these liabilities. Households with negative net equity (negative difference between collateral value and outstanding loan amount) do not pose a major risk for the banking system due to the current legal system in the country,as there is no personal bankruptcy law. The results of the stress testing under the adverse scenario showed that the loan quality would continue to deteriorate until the end of Due to the impact (in case of the adverse scenario) of shrinking exports on the solvency of households, which would materialise through growing interest rates, higher inflation and lower household income, the banking system would sustain additional loss in the nearest one and a half years, which may go up as high as LTL million. When testing an interest rate increase, an assumption is made that, irrespective of the interest rate fixation period, this effect will materialise immediately after the rise in interest rates, reflecting basically a more pessimistic result than the actual one. The financial vulnerability of households depends on other factors, such as terms and conditions of loan agreements or other legal factors, although the impact of these factors is difficult to forecast or simulate 18. In 2010, the activity of the real estate market was growing, as evidenced by the increasing number of real estate purchase and sale transactions. Following an improvement in the domestic economy and real estate market prospects and the growth of indicators of economic assessment and construction sector confidence, the number of housing transactions was larger by one-third in 2010, compared to 2009, the year of the lowest market activity throughout the whole period of monitoring since A positive contribution to this development was made by the decline in real estate prices,... Since spring 2010, the real estate price changes were insignificant, compared to the preceding period of decline for more than two years; consequently, it may be expected that the market has already reached the trough or is very close to it. Compared to the highest level observed at the end of 2007, housing prices are almost two times lower.... improved expectations of market participants Based on the data of the 2011 survey of households with loans for house purchase, which is available on the Bank of Lithuania website. 18 Based on the IMF survey Households Indebtedness and Financial Fragility which analyzes the impact of the change in legal factors on the solvency of borrowers, the law on bankruptcy of natural entities expected to be adopted soon may prompt an increase in the number of insolvency cases.