44453 FOR OFFICIAL USEONLY FINANCIAL SECTOR ASSESSMENT REPUBLIC OF LITHUANIA JUNE 2008 EUROPE CENTRALASIAREGION & VICEPRESIDENCY FINANCIAL AND PRIVATE SECTORDEVELOPMENT PRESIDENCY VICE BASED THEJOINT IMF-WORLDBANKFINANCIALSECTORASSESSMENT ON PROGRAMUPDATE This FinancialSectorAssessment (FSA) summarizesthe key findingsand recommendationsof the 2007 FSAPupdatereportfor the Republicof Lithuania.' The FSA, which focuses on developmental issues, shouldbe read together with the Financial System Stability Assessment (FSSA) inorder to get a full overview o fthe findings andrecommendations o f the 2007 Republic o f Lithuania FSAP update. The FSAP update team notedprogress since the 2002 bankingsector vulnerability assessment*, and evaluated regulatory and supervisory challenges for the banking and non-banking sectors; cross-border arrangements, safety nets, crisis management preparedness; the pensionreform, and capital market development. 'The Republic o f Lithuania FSAP update team, which visited the country inDecember 2007, gratefully acknowledges the excellent hospitality, cooperation and openness o fthe Lithuanian authorities and technical counterparts. The team consisted o f May Khamis (Leader, IMF), Sophie Sirtaine (Deputy, World Bank), Luc Laeven, Thordur Olafsson, Miguel Segoviano (all IMF), Olivier Hassler, Michel Noel, Adolfo Rouillon, and Heinz Rudolph (all World Bank); and Jan ReinPruntel (formerly De Nederlandsche Bank). Cristina Velazco-Weiss (World Bank) assisted the team. Its findings andrecommendations were discussed with the authorities at the end o f the mission. The diagnosis and assessment o f the FSAP update, and hence this FSA, are based on information as o f December 2007. See Appendix Ifor the status o f the key recommendations o fthe 2002 assessment. 2 I.OVERALL ASSESSMENT 1, Stability assessment.Lithuania's dependence on foreign financing, coupledwith its macroeconomicimbalances and the banks' loanportfolios' sensitivityto the domestic economic cycle, leaveLithuania vulnerable to regionaland global contagion risks. Lithuania's catch-up, interms o f per capita income, toward the European average has been impressive.This success, however, has taken place inthe context of emerging macroeconomic imbalances, accompanied by a significant rise in credit growth, a tripling inreal estate prices, and an increased dependence on foreign parent banks' funding. Although the foreign banks are highly rated, these ownership linkages increase Lithuania's vulnerability to regional and global contagion risks, especially against the backdrop o f the recent global turmoil infinancial markets. The largeshare of loans contracted with variable interest rates andineuro increasescredit risk relatedto domestic and foreign interest and exchangerate changes, since most borrowers are not hedged.Also, the concentration ofreal estate loans inbanks' loanportfolios increasestheir vulnerability to a reversal inreal estate prices. Helpfully, credit growth has slowed since mid- 2006, as a result o f the tightening of credit standards by banks. 2. Developmentissues. The regulation and supervisionof NBFIs,and the governanceof pensionfunds, should be strengthened.The banking sector regulatory and supervisory framework is inline with international standards, andthe regulatory framework for non-bank financial institutions (NBFIs) is largely inconformity with European Union (EU) Directives. However, highstaff turnover at the Lithuanian Securities Commission(LSC) affects its capacity to effectively supervise NBFIs. Thus, LSC must be able to pay market-based salaries to its staff and access an adequate and stable source o f funding, including market fees. Also, market surveillance should be strengthened, deficiencies inIFRS implementation remedied, andthe regulatory and enforcement framework for insider dealing revised.Inaddition, the governance structure o f pension funds managed by banks and insurance companies should be strengthenedto avoid conflicts o f interest. Closer coordinationis neededamong LSC, the Insurance Supervisory Commission(ISC), and the Bank o f Lithuania (BoL) to ensure adequate supervision of cross- sectoral linkages betweenfinancial institutions. The government's review o f the overall financial sector supervisory structure i s welcome inthis regard. 3. Opportunities to further develop the capital markets and improve the pension system should be seized. MiFIDoffers opportunities for Lithuanianissuers but requires the development of regulationfor missingfinancial instruments.The pensionreform's efforts would benefit from revisions inportfolio investmentand disclosure regulations, as well as to the pension system infrastructure. Further progress inthe areas o f lender o f last resort, bank resolution, creditors' rights, insolvencies, and housingfinance also would be helpful. 4. Appendix Ifollows-up on the status o f implementationo f the 2002 FSAP recommendations. Appendix I1provides a summary o f the main recommendations of this report. Priority recommendations are listedinTable 1.Appendix I11provides a descriptionof the financial sector in Lithuania and supervisory arrangements. 3 Table 1. Priority Recommendations Timeframe Banking:sector 0 Inthe process of IRBmodel validation under Basel11,ensure that banks' Short term internal models adequately capture the riskcharacteristics o f the Lithuanianloan portfolios. As needed, assess capital surcharges under Pillar 2 o f Basel 11, as needed, based on banks' individualrisks not captured under Pillar 1 Discuss further with banks, parent banks, and the home authorities Immediate contingency liquidity plans incase of a severe liquidity stress event 0 Update procedures for emergency liquidity support intimes o f crisis and Immediate consider includingguidelines for collateral valuation and approval to Short term and to have access to adequate and sustainable sources o f funding, includingfees from market participants 0 Reformthe regulatory and enforcement framework for insider trading by: Immediate J Requiring companies to disclosetheir ultimate controllersas partof their listing application, and to disclose any change inultimate controllership following their listing J Requiring brokers to communicate black lists to LSC J Revisingthe criminalcodeto excludeinformation sharedbyinsiders Pensionsector Immediate 0 Improve supervisory structure to take into account cross-sectoral Immediate linkages, particularly those arising as result o f a pension fund supervision by multiple supervisors 4 Contents I.OverallAssessment..................................................................................................................... 2 I1. Macro Setting and Stability Assessment.................................................................................... 6 I11. Regulatory and Supervisory Issues........................................................................................... 9 Regulatory and Supervisory Framework for NBFIs........................................................... 9 Monitoring o f Pension Funds............................................................................................ . . 10 12 IV.Developmental Issues............................................................................................................. Cross-sectoral Supervisory Issues..................................................................................... 14 CapitalMarketDevelopment., .......................................................................................... 14 Pension Reform................................................................................................................. 14 Housing Finance ............................................................................................................... 15 Appendix IFollow-up on Key Recommendations ofthe 2001FSAP......................................... . 16 Appendix I1. DetailedRecommendations o f the FSAP Update ................................................... 17 Appendix I11 .The LithuaniaFinancial System: Structure and Supervisory Framework............-20 Tables 1.Priority Recommendations,.,....................................................................................................... 3 2. Select Macroeconomic Indicators............................................................................................... 6 3. Total Assets ofFinancia1Market Participants, 2003-06........................................................... 21 4.Number o f Financial IntermediationEnterprises, 2003-06 ...................................................... 21 5. Ownership ofthe Banking System, end-2006 .......................................................................... 22 6. Financial Soundness Indicators for the Banking Sector 2002-2007 ......................................... 23 7. Financial Sector Indicators, 2002-07 (inpercent, unless indicated otherwise) ........................ 24 8. Indicators of External and Financial Vulnerability, 2002-07 ................................................... 25 5 GLOSSARY AIPTS Association o f Intermediaries of Public Trading in Securities BoL Bank of Lithuania CBA Currency BoardArrangement EU European Union FSAP Financial Sector Assessment Program FSI Financial Soundness Indicators FSSA Financial System Stability Assessment GDP Gross Domestic Product IFRS InternationalFinancialReporting Standards IOSCO InternationalOrganization of Securities Organizations IRB InternalRisk-Based ISC Insurance Supervisory Commission LoLR Lender of Last Resort LSC LithuanianSecurities Commission LTL Lithuanian Lita LTV Loan-to-Value MiFID MarketinFinancialInstrumentsDirective MoF MinistryofFinance M o U Memorandumof Understanding MTF Multilateral Trading Facility NBFI Non-Bank Financial Institution NPL Non-Performing Loan S&P Standard & Poor's SMART FirstNorth's Suspicious Transactions Detection System SME Small and Medium-Sized Enterprises SODRA State Social Insurance Board SRO Self-Regulated Organization TRS Transaction Reporting System UCITS Undertaking for Collective InvestmentinTransferable Securities VSE Vilnius Stock Exchange 6 11. MACRO SETTING AND STABILITY ASSESSMENT 5. Lithuania's catch-up interms of per capita incometoward the European average has been impressive,although imbalanceshave appeared. Inflationhas beenon the rise since 2003 and has been above the Maastricht criterion since early 2005.3The current account deficit grew from 7.1 percent o f Gross Domestic Product (GDP) in2005 to 10.9 percent of GDP in 2006. Whereas inthe early 2000s the external deficit was financed predominantly by net foreign direct investment, these represented less than half o fthe 2006 deficit and much of the deficit was financed by external debt, an increasing share o f which i s of short-term n a t ~ r e . ~ Table 2. Select Macroeconomic Indicators (Inpercent) 2002 2003 2004 2005 2006 2007e Real GDP growth 6.9 10.3 7.3 7.9 7.7 8.8 General government fiscal balance 1/ -1.9 -1.4 -2.7 -1.3 -1.5 -1.9 Average CPI (year-on-year change) 0.3 -1.1 1.2 2.7 3.8 5.8 Current account balance (as share o f GDP) -5.3 -6.9 -7.7 -7.1 -10.8 -13.0 Gross external debt (as share o f GDP) 43.9 44.9 46.5 48.8 63.7 65.8 Short-term debt (at original maturity, as share o f GDP) 15.0 17.7 16.7 19.9 19.1 17.1 Reserve cover o f short-term debt at original maturity 1.1 1.1 1.0 0.8 1.o 0.6 Source: Lithuanian authorities; and staff estimates. 1/ Includingrestitution payments. 6. Credit growth has been significant since 2002 but more recentlyhas shown signs of coolingdown. Credit grew at an average annual rate close to 50 percent since 2002. Lending for housing has beena driving force o f the rapid growth o f overall bank credit. At over 15 percent o f GDP (compared to 5.5 percent at the end of 2004), it constitutes a major component (28 percent) of banks' total loan portfolios. Credit growth has slowed from its peak rate inmid-2006. Indications are that it will slow further in2008 following a tightening o f credit standards by banks. This slowdown seems to also reflect a recent negative sentiment inthe real estate market.' 7. Rapid credit growth inrecentyears has increasedcredit risk.The rapidly rising indebtednessof households and enterprises has increased the economy's vulnerability to macroeconomic risks and developments inthe real estate market. Between2002 and 2006, Lithuania meets by a wide margin the "Maastricht" cap on government debt, and is incompliance with the ceilings on long-term interest rates and fiscal deficits. Lithuania has been participating inthe exchange rate mechanism, ERMI1with a CBA. S&P lowered its outlook for all three Baltic States inthe first halfof 2007 from stable to negative citing increasing imbalances and inflationary pressures. Fitch changed its outlook from stable to negative inDecember 2007 reflecting rising inflationary pressures, a hrther prospective delay to euro adoption, a marked deterioration in Lithuania's external imbalances, and uncertainty over how the country will secure a gradual adjustment to a more sustainable growth path. Followingseveral years o f rapid house price appreciation, the housing market i s now cooling, with house prices in Vilnius no longer risingand the volume o fhouse sales declining. 7 household indebtednessas a share o f GDP has grown from around 3 to 19 percent o f GDP and corporate sector indebtednessfrom 12 to 28 percent of GDP. 8. The characteristicsof loan portfoliosexacerbatethe vulnerability to credit risk. About 90 percent o f household mortgage debt i s contracted with variable interest rates and around 40 percent inforeign currency (largely ineuro), increasing credit risk related to domestic and foreign interest rate and foreign exchange changes (pendingeuro area accession). Approximately 50 percent o f all private sector loans are denominated ineuros, and the banking systemhas a significant concentration inreal estate loans (50 percent of the total loanportfolio). 9. Lithuania's dependenceon foreign capital leaves it vulnerable to the effects of spilloversfrom the rest of the region and global developments. The banking sector is dominated by foreign banks (93 percent o f the sector's assets), the majority o f which are Swedishbanks (62 percent oftotal assets). Until2005, foreign parents financed close to 100 percent o f bank net foreign borrowing. In2006 and 2007, these proportions fell but remained significant, at about 40 and 60 percent respectively. The dominance o f Scandinavian banks impliessignificantcontagion risks: the effect of a regionalshock on Lithuanianbanks could be accentuated givenownership linkages. Spillover effects could manifest themselves inthe form of the scaling back o f new lendingby parent banks, a downgradingo f Lithuania's sovereign rating, and/or strain on the CBA.6At a minimum, such effects would increase fundingcosts and refinancing risks for Lithuanianbanks. The recent global turmoil infinancial markets implies potentially higher contagion risks for Lithuanian banks with internationally active parents. 10. The banking system's financial soundness indicators (FSIs) are generally satisfactory, despite relatively low capital adequacy ratios (Appendix 111).Profitability has risen since the early 2000s, the returnon assets more than doubled since 2002, and nonperforming loans are low. The system's capital adequacy has increased inthe last two years thanksto actionby the BoL, but remains lowrelativeto other countries inthe regionandthe EU. 11. Capital buffers, definedas the differencebetweeneconomicand regulatory capital, remain m~dest.~ Usinga risk-based approach,the team andthe BoL estimated the economic capital of the five largest banks for the fourth quarter of 2006. Results show that the average regulatory capital inthe third quarter o f 2007 surpassedeconomic capital inthe fourth quarter of 2006 by an average capital buffer o f only 1.6 percent, which seems insufficient to cover a potential increase inunexpected losses inthe event that credit, market, liquidity or operational risks materialize. 6The team, however, considersthe probability ofa break inthe CBA to be very low. Economic capitalis defined as the amount ofcapitalthat is necessaryto cover banks' ULs at the 99.95 VaR (conversely, this meansthere would be a 1 in2000 probabilityofthe bankbecominginsolventduringthe next 12 months). 8 12. This assessment is supportedby the results of stress tests.' Undertests for credit risk, the minimumCAR of 8 percent would bebreachedfor the systemon average after the 11th quarter ina mild scenario and after the 5thquarter ina more severe scenario. Stress tests for marketrisk indicate considerably milderimplicationsthan those arising from credit risk-butthe BoL should continue close monitoring of risks arising from these exposures. Despite the dependence o f subsidiaries andbranches of foreign parentbanks on parent bank funding, stress tests for liquidity risk indicate that the prevalence o f long-termparent funding and the high levels o f liquidity banks maintain would enable these banks to withstand scenarios involving a reduction inparentbank financing. Large withdrawals of resident andnonresident deposits appear to have a more significant impact, although all systemic banksremain liquid. Liquidity positions might not be sufficient under more severe events where parent bank withdrawals are combined with deposit withdrawals. Although the probability o f such a combination of events is low, given that the BoL's LoLR operations are limited by the CBA, the central bank should discuss its contingency plans (such as the availability o f credit lines) with banks. 13. Stress tests indicate that banks' regulatory capital might not provide an adequate buffer under severe events. The BoL has taken action over the past years to encourageprudent credit risk management and strengthenbanks' capital base.9Inparticular, where the Capital RequirementsDirective (Le. the EUtransposition ofBasel 11) allows for national discretion, the BoL has chosen the more conservative option.loHowever, inview o f the importance of real estate lending inbanks' portfolios, it is unfortunate that the risk weight for residential mortgage loans with an LTV ratio below 70 percent was lowered inJanuary 2008, with the implementation o f Basel 11, from 50 to 35 percent. The BoL may wishto reconsider this." 14. In the process ofvalidating banks' IRB models, the BoL should encourage banksto capture risks under Pillars 1or 2. Inview of the limited historicalbanking and macroeconomic time series inLithuania, banks' IRB models might not capture the risk characteristics of the loan portfolios, thereby underestimating regulatory capital needs. Evenif the BoL maintains the 50 percent riskweight for residential mortgages, uncaptured credit risk should also be accounted for under Basel 11's Pillar 2. Guidedby sensitivity and stress test analyses, capital surcharges based on each bank's individual risk should be considered. 15. The BoL can also take additional measures to reducethe risksof real estate lending. These include: 8 The FSSA provides a detailed description ofthe stress tests. Measures taken include a narrowing o fthe definition o fresidential mortgage loans, which effectively raises the riskweight, andthe imposition ofa 60 percent limit on the part ofcurrent year's profit that may count towards regulatory capital. Furthermore, the BoL has requested banks to filly retain profits made in2005 and 2006, and intends to do so again in2007. loFor example, for commercial real estate loans, the BoL has chosen to apply a 100percent risk weight whereas a 50 percent risk weight would have been possible, andthe maximumamount o f a retail exposure has been set at 1 million litas (290,000 euro) instead o f 1million euro, limiting assets that receive a 75 percent risk weight. l1Discretion inthis area is consistent with the EU's Capital Requirements Directive. 9 enhancing the BoL's capacity to assess the real estate market and its implications for bank lending through: (a) usingmore diversifiedmonitoring tools including early warning signals;" (b) identifying the riskiest loans (e.g. developer loans and equity withdrawals) as separate reportingcategories; and (c) coordinatingcloser with the state mortgage insurer as defaults on the latter's loans would provide an early-warningsignal; promoting the development of fixed rate loans through BoL surveillance (for example by ensuringthat the credit riskresultingfrom variable rates is taken into account inlending parameters and pricing and inthe banks' IRBmodels); and enhancing consumer protection and education, especially on risks linkedto variable interest. Inaddition, the disclosure of information to borrowers should be improved, including through the provision of a standardized all-in rate and of stress scenarios in case o f variable rates. 111. REGULATORY AND SUPERVISORYISSUES Regulatoryand SupervisoryFrameworkfor NBFIs 16. The regulatoryframeworkfor NBFIsis inconformitywith EUDirectives,except for a limitednumber of missingregulations.Inparticular, Lithuaniahas fully implemented MiFID, includingdetailed knowyour client rules. Two detailed regulations, which the LSC is preparing, are missing: (i) risk-based supervision ofmarket intermediaries, and (ii) the the calculation o f fair value for infrequentlytraded securities and derivatives.l3 17. The authoritiesneedto redressLSC's staffingand fundingsituationas a matter of utmosturgencyifthis progressis to bemaintained.Highstaffturnover as aresult salariesthat are half those offered to qualified staffby the supervisedsector robs LSC o f its more experienced staff and leave it with weakened capability to effectively supervise securities markets.Between 2005 and 2007, 75 percent o f LSC professional staff departed; they are beingreplaced by recent universitygraduates. The authorities must change the status of LSC to enable it to pay market- based salaries to its staff with relevant market experience, and provide it with adequate and stable sources o f funding, including fees from market participants. Then LSC will needto implementa comprehensive staffrecruitment, training andincentive plan, aimedat endowing it with a stable corps of supervisors experienced inlicensing, surveillance, inspection, investigation, and enforcement. The ISC faces similar salary restrictions, but they have ledto less acute staffing issues than those at LSC where competitionfrom private employers has been stronger. l2For instance, collecting information on the speedo f sale o f new units or the stock o f unsold housing on the market. l3The methodology to determine the fair value ofsuch securities should be specified inregulation, for instance on the basis o fEVCA's rules. 10 18. M a r k e t surveillance suffers from several deficiencies. LSC should complete the ongoing implementation of its Transaction Reporting System (TRS) incollaborationwith market intermediaries and extend its coverage to the FirstNorthalternative market.I4The Vilnius Stock Exchange (VSE) expects its suspicious transactions detection system(SMART) to be operational at the beginningo f 2008. LSC should request daily SMART reports from the VSE. LSC should also ensure that the Association o f Intermediaries of Public Trading inSecurities (AIPTS) performs its responsibility as a Self-Regulated Organization (SRO) inenforcing the Code of Ethics for market intermediaries and sanctioning offenders. 19. There are deficiencies inI F R S implementation. Adoption of IFRS should be mandatory for asset management companies and financial brokerages. Since LSC became responsible for overseeing IFRS implementationinJanuary 2008, it should build its capacity by recruiting experienced accountants. 20. The regulatory and enforcement framework for insider dealing suffers from serious deficiencies. Companies should be requiredto disclose their ultimate controllers as part o f their listing application, and also report any changes inultimate controllership following listing. "Black lists" of the companies with which staff o f financial brokerages maintain business relationships should be communicated to LSC. Finally, the Criminal Code should be revisedto exclude information sharedby an insider with related parties from the category o f publicly known information. l5 Monitoring of Pension Funds 21. In2003, the government implemented a successful pension reform establishing a secondpillar allowing individuals to voluntarily allocate part o f their mandatory contributions to fully fundedpension funds. The new pension systemhas received considerable support from intermediaries and the population: currently, 55 percent o f the labor force participates inthe second pillar and pensionfund managers offer 32 differentpensionportfolios. 22. Monitoring of the new pension system should be strengthened. The second pillar - an essential component o f future pensions -requires proper oversight, traditionally achieved through (i) theregulatory framework, (ii) supervisory framework, (iii) pensionfund the safe manager governance principles, (iv) market surveillance, and (v) market contestability. In Lithuania, each o f these areas suffers from weaknesses that leave second pillar pensionfunds vulnerable. First,the legal and regulatory framework for pensionfunds needs clarification. The law establishes the administrativerights o f individualsprecisely, but i s followed by l4Alternative market platform o fthe OMX group for small firms, inoperation inthe Nordic and Baltic countries. l5At the moment, courts interpretthe definition o fpublicly known information as including information shared by an insider with related parties, which prevents the Prosecutor's Office from prosecuting cases o f insider dealing. 11 general principles on pension fund management.I6These could be challenged incourts, wherejudges may not be technically preparedto deal with such issues. Thus, the legal regime should better specify the rights and obligations ofthe asset manager andthe powers and duties o f supervisors. e Second,the supervisionofpensionfunds needsstrengthening.Supervision by LSC andISC is mostly compliance-based, which is insufficientfor a systemwith flexible organizational structures and freedom for managing investments. Also, staffing problems at LSC have weakened its effectiveness insupervisingincreasingly sophisticated pension funds. e Third, corporategovernancestandardsfor pensionfunds needto be strengthened. Pensionmanagement companies have strong operational links with their mother companies, breaching good principles o f asset management. Key issues for pension funds managed by banks include their use of the depository andthe broker o fthe mother bank, andtheir purchase o f funds offeredbythe mother bank. Inthe case ofpension funds managed by insurance companies, the key issue is the sharingo f the same management team for pensionand other activities o f the insurance company. These conflicts of interest allow for the possibility that secondpillar contributions could be managed inthe interests o f bank and insurance company shareholders rather thanthose o f the pensioners. Therefore, an assessment o f corporate governance arrangements for pensionfund managers i s needed. Supervisory agencies should clarify and ensure, through regulation, minimumstandards of corporate governance andriskmanagement, that pension funds' portfolio decisions are safeguarded from the interests o fthe mother company. e Fourth, a regulationshouldrequirethat externalauditorsto conductperiodic assessmentsof the internalcontrolsystems ofpensionfund managers. Thepension law requires that auditors provide an opinion about compliance with pensionfundrules, including internal controls, and violations o fthe law and other legal acts. However, since the supervisory commissions have not clarified these requirements, the auditing of pension funds i s cursory. e Fifth, contestabilityinthe market should beencouraged.The large gap betweenthe sophistication o fproducts that the market offers andthe population's understanding o f them should bereduced. Inaddition, contributors face administrative obstacles should l6For instance,the law says that pensionfund management companies"should try to avoid conflictsof interest" and shouldmanage, use anddisposeofthe pensionfunds under"fiduciary rights".No further explanationofthese principlesis provided.Similarly, the supervisoryauthority can imposesanctions andadministrativepenalties, but the law does not specifythe circumstancesunder whichthat canbe done, or the type ofpenaltiesthat canbe imposed. 12 they wish to switch pension fundmanagers." The informationclients receive should be streamlined and their ability to move betweenfunds facilitated. The fees that pension funds pay to UCITS-type funds should beclearly disclosed. Cross-sectoral Supervisory Issues 23. The current supervisory structure does not ensure adequate supervision of all financial institutions and their inter-relations. This results from two issues: e First,the supervision of pensionfunds requires closer coordination betweenISC and LSC. Pension funds are supervised by two different supervisory authorities dependingon whether they are managedbybanks or insurance companies. Despite coordinationbetween these institutions, funds are subject to unequal supervisory rules and processes, openingthe door to regulatory arbitrage. Significant coordinationissues could emerge during the payout phase with respect to the supervision of annuity products. e Second, the governance structure of second pillar pension funds largely escapes oversight by supervisory authorities. As mentionedabove, the governance structure o f pensionfunds managed by banks and insurance companies i s fraught with conflicts of interest. Because o f the separation of supervisory mandates across three institutions (the LSC, the ISC and the BoL) with little coordination, governance structures largely escape oversight by supervisory authorities. These weaknesses create strong reputational risk for the institutions involved, and thus also for the financial sector andpension reform. 24. Resolving these issues requires an urgent review of supervisory arrangements for Lithuanian financial markets. Future supervisory arrangements should be designed with the objectives to (i) strengthencapacity to supervise the interactions o fbanks with their related entities; (ii)improve systemic risk management by ensuring adequate monitoringo f issues affecting the entire financial sector; (iii)facilitate harmonization o f supervisory approaches and regulation; (iv) develop a unified risk-based approach; (v) increase the flow o f information betweenregulators and supervisors ofvarious institutions; and (vi) provide the supervisory institution(s) with sufficient resources including the ability to offer market-based incentives and salariesto staff. These objectives can be achieved through the implementation o f various supervision models. The team commends the establishment inDecember 2006 o f a parliamentary Working Group (WG) to explore various approaches including integrated supervision models. "DraftamendmentsoftheLawonPensionAccumulationcontemplateasimplifiedproceduretoremoveapension manager. 13 CrisisManagement,SafetyNets,Cross-borderCooperation,BankResolution,Creditors' Rightsand CorporateInsolvencyFramework 25. The BoL shouldprepareproceduresfor a rapidimplementationof LOLR operations. The April 2006 amendment to the BoL Lawprovides the the central bank with the flexibility to accept various types of collateralagainst its lending.The BoL shouldprepare guidelinesfor the pre-approval o f collateral (including for its valuation) to ensure an expeditious process inemergencies. It should also establish procedures for emergency liquidity support in case o f crisis. 26. The depositinsurancescheme, in linewith the EUDirective,could be further improved,inparticularthrough risk-based insurance premiums.Also, an increase inthe fund size to its target level would enhance its ability to cover a larger number o f small bank failures. 27. Effortsto enhancecross-bordercooperationand strengthenthe financialcrisis managementframework should continue.The BoL has concluded bilateral MoUswith all foreign supervisory authorities who supervise parent banks of Lithuaniansubsidiariesor branches, andmultilateral agreements (including the EU-widetrilateral MoUo f 2005 on crisis management cooperation). Recently the BoL signed a MoUbetween the central banks of the Baltic countries and Sweden on the management o f a financial crisis inbanks with cross-border subsidiaries or branches. The BoL participatedintwo multilateral crises management simulation exercises, and work on enhancing domestic crisis management is underway. 28. The legalframeworkfor bankresolutionshouldbe harmonizedand strengthened. The bankinsolvencyregime is embodied indifferentpieces of legislation (Law on Banks, Law on the Bank o f Lithuania, Law on Financial Institutions, and other main acts). This could lead to conflicts inlegislation and make it difficult to identifythe proper sequence o f a bank insolvency procedure. Thus, bank insolvency legislationshould be consolidated inone comprehensive law. Also, the conditions for the recognition o f a bank as insolvent should be definedmore precisely and incorporated into the law. At a minimum, balance sheet insolvency (zero net worth) should be a strict condition for the recognition of a bank as insolventandthe withdrawal o f its license. 29. Creditor rights and insolvencysystems can be improved.Makingthe simplified restructuring procedure more flexible would enhance the reorganization regime. Giventhe practice o f voluntary restructuringagreements (workouts), it could be complemented with an abbreviated reorganization procedure through which workout agreements could be converted into restructuring plans even ifunanimityi s not obtained. Also, specialization o f somejudges in large commercial centers would enhance the efficiency o f insolvency proceedings and the capacity to deal with increasingly complex financial transaction cases. 14 IV. DEVELOPMENTAL ISSUES Capital Market Development 30. The entry into force of MiFID creates challenges and opportunities for LSC. MiFID creates an opportunity to deepen the market for large Lithuanianissuers. Acceleration inthe integrationbetween the Baltic andNordic exchanges would provide large issuers with access to a deeper pool o f liquidity. LSC will need to enhance supervision o f financial brokerage firms to oversee their adoptiono f internal compliance processes inline with MiFID requirements. The launcho f the FirstNorthmarket for the Baltic countries provides a market tier dedicated to SMEs.These developments create opportunities to increasethe attractiveness of Lithuaniafor foreign investors but require improving the legal and regulatory framework for some market instruments(inparticular, municipalbonds, corporate bonds to finance local infrastructure projects, covered bonds, and asset-backed securitization). Pension Reform 3 1. The pension system relies excessively on the capacity of individuals to make a proper selection for their savings options. a First,the government should set "join the second pillar" as the default option for new entrants while preservingthe right o f individuals to elect to remaininthe first pillar only. The second pillar offers a diversifiedsource of income for retirement and long-term fiscal benefits.I8 a Second, regulation should impose limitsto maximum portfolio risk exposure and require adequate disclosure of portfolio benchmarks. Dueto market conditions, returns of pensionhnds have beenrelatively low, and pension fund managers are pressuredto find higher returns through riskier investments.This should be limitedby regulation. Also, regulation should require disclosure o f portfolio benchmarks as homogeneous point o f comparison for clients and impose penalties for moving away or not tracking the benchmark. Inorder to alignthe interest o f the pensionfund manager with those ofpensioners, the reserverequirement(capital) ofpensionhndmanagers should be requiredto be invested inthe same assets as the pension fund as inChile and Estonia. a Third,lifecycle benchmark portfolios should be designedto provide incentives to pension fund managers to invest inportfolios aligned with the long term interests of contrib~tors'~and maximize the future value o f pensions at different stages o f a However, such a change should only take place once the governance issues of the second pillar have been solved. 19For information on lifecycle portfolios, see How to Invest over the Life Cycle, A Review, Wallmeier, Martin and Zainhofer, Florian, December 2006. 15 pensioner's lifecycle. These benchmarks may be usedas default options for individuals who do not feel comfortable taking a decision about portfolio allocation. It would also facilitate comparisons among funds. Inorder to reduce marketingexpenses by pension funds, a lottery process to allocate newentrants to pension fund managerscouldbe introducedas inPoland. Alternatively, the government may define a benchmark portfolio under a "no losey7strategy.*' 32. An upgrade inthe IT system of SODRA is recommended,as well as movingto an electronic system of contributions. SODRA's contribution collection system, which is entirely paper-based, i s significantly less efficient than inother countries of the region, includingPoland, the Slovak Republic, and Estonia. Inthese countries the lag betweenthe collection of contribution and deposits inindividual accounts is less thantwo weeks, while inLithuania it takes up to three months. Also, the current delay to effectively join the system should be revised. HousingFinance 33. Revitalizing the covered bond framework could support fixed-rate lending.While today the use o f floating rate loans i s common, fixed rate loans shouldbecome more attractive as interest rates are no longer declining. This should be an opportunity to develop domestic funding instruments such as covered bonds. 34. Financial markets could help fillsocial gaps inthe housingmarket. A growing share of families i s excluded from the housingmarket because o f price increases, without being eligible for social housing. Also, the social andfinancial efficiency o f public assistanceis not optimal. A better coverage o f housingneeds inthe moderate income segment can be achieved by leveraging the government's housingpolicy with market finance by (i) developing a policy to foster a rental sector, (ii) promoting the channeling o f financial resources towards it through innovative instruments and the extension ofthe state owned insurer's business to rental products; (iii)leveraging municipal spending inthe social rental sector through structured finance solutions; and (iv) better focusing the state mortgage insurance on moderate income groups. ''Feldstein(2005) andPoterbaRauh, Venti andWise (2006) have proposeda "No Lose" strategy as an alternative to the Lifecycleone. The "No lose" strategy does not involverebalancingportfolios at each step o f an individual lifecycle,but ratherto link equity investmentswith historicalpattern of TIPS yields, which inturn determinethe amount available for stock investment, andwith the historicalreturns on equity assets.Poterbaet a1simulate these portfolios for the 401k plans inthe U S andconcludethat insome cases the "No lose" strategy dominatesthe "Lifecycle" one. See PoterbaRauh, Venti andWise, Lifecycle Asset Allocation Strategies and the Distribution of 401K Retirement Wealth, Working Paper 11974,NationalBureauof Economic ResearchNBER, January 2006. APPENDIX I.FOLLOW-UPONKEY RECOMMENDATIONSTHE 2001FSAP OF 2002 FSAPRecommendation Assessment of implementation RankingSupervision Requiregreater accountability of bank directors for risk ^_" Since 2006, banks are requiredto publicly discloseinformation on their risks managementwithin their banks. andrisk managementpractices. Reviseloanclassification and provisioning rules to better The 2005 MinimumLoanAssessment Requirementsfollow IFRS and assign reflect the economic value of a bank's loan portfolio. responsibility for properprovisioning to abank's board. CP I@) Make provision for the legalprotection of The BoL Law was amendedto include anew [Article 46(I)] that explicitly membersof the boardof the BoL and banking supervision providesfor legal protection ofBoL boardmembers and supervisorystaff. staff, while retaining robust accountability arrangements. Definecollateralacceptable for LoLR operationsmore The new BoL Law provides for awider rangeof collateral. broadly so as not to constrainBoL's ability to adequately conductthese operations. Strengthenthe legalpowersof the BoL to intervenein, The frameworkhas been substantiallystrengthenedandgives the BoL ample and quickly resolvethe failure ofbanks experiencing powers to intervene an ailing bank.One stringent definition of an insolvent financial distress or insolvencv. bank is recommendedto be included inthe regulatoryframework. Strengthen cooperationwith home country supervisorsof The policy ofthe BoL is to concludeMoUs between all financial supervisory Lithuania banks. authorities fromjurisdictions with cross-border bankingactivitieswith Lithuania as well as all neighboring countries.This has beendone. The BoL has participatedin cross-border multilateral crisis managementsimulation exercisesbased on multilateral MoUs with Sweden, the other Baltic countries andEU andwill continue to do so. Instrtvency and Creditors' Rights -"---_ Strengthenthe insolvencysystem: The following reforms were introduced: II ^------ Most insolvency proceedingswere liquidation cases, averagingmorethan 3 years and yielding little benefit A new Code of Civil Procedurewhich, among other reforms, introduceda to creditors. so-called"simplified court order procedure" Insufficient experience with the then newly enacted Application ofthe Civil Code rules to mortgages andpledges, which inthe EnterpriseRestructuringLaw preventedproper pastwere governedby aMortgage Law and Pledge Law assessment of its effectiveness. Actual use of restructuringproceedingsunder the new restructuringof The insolvencysystem in general was weak and enterprises system fragmented because three different insolvency laws- enteredinto force in 1993, 1997 and 2001- governed insolvencyproceedings(accordingto the initiation date o f cases). Strengthen the institutional framework for creditor rights The following reforms were introduced: and insolvency: Court efficiency was found to be stifled by a lack of Reformsto the Law on Courts specializationamongjudges. New rulesregulating the insolvency administrationprofession Low standardsfor licensing, as well as over-licensing, inadequatetraining and inconsistentperformanceof insolvencyadministrators, affectedthe implementation of the insolvencysystem. II -I_- (`apital markets .. - -______-. - ll__lll The 2002 FSAP rcponed that Lithuania`s conformity to Since 2002. the government has completeda numberof legal reforms to IOSCOprincipleswas high. reflect key EU directives' concerningthe capital markets. Particularly, it passeda new Law on Markets inFinancial Instrumentsand arevised SecuritiesLaw in January 2007. 'The ProspectusDirective, TransparencyDirective, Directive on MiFID, Directive on UCITS, the Collateral Directive andthe Clearingand Settlement Code of Conduct. 17 APPENDIX11.DETAILED RECOMMENDATIONS OF THE FSAPUPDATE Inthe process ofIRBmodel vzid-banks' internal Short term model capture the risk characteristics o f the Lithuanian loan portfolios adequately. Otherwise, assess capital surcharges under Pillar 2 o f Base111, as needed, based on banks' individual risks not captured under Pillar 1 Discuss further with banks, parent banks, and the home authorities contingency - . Immediate liquidityplans incase of a severe liquiditystress event Strengthen the analytical cooperation betweenthe BoL's Banking Supervision and Short term Financial Stability Departments to enhance fmancial stability analysis 0 Clarify to banks that open euro positions are included inthe capital adequacy Immediate calculations for market risks b) Securitiesmarkets regulationand s ~ ~ ~ ~ j s i o ~ .-> Complete missingregulations under EUDirectives Short term J risk-based supervision rules J valuation o f fair value o f infrequently traded securities and derivatives rules Broaden the coverage o f IFRS to financial brokerages and asset management Short term companies Modify status o f LSC to enable it to pay market-basedsalaries to its staff and to have Short term access to an adequate and sustainable source o f funding, including fees from market participants Prepare and implement a comprehensive staff recruitment, development and incentive Short term planfor LSC Strengthen market surveillance by: Short term J Completing the ongoing implementation o f TRS incollaboration with market intermediaries J Extending TRS coverage to alternative market (First North) J Carrying out enhanced market surveillance through TRS and through SMART reports to be provided daily by VSE J Imposing fmes on AITPS incases it does not enforce the Code o f Ethics for market intermediaries, inaddition to fines imposed on offenders Reform the regulatory and enforcement framework for insider trading by: Immediate J Requiringcompanies to disclose their ultimate controllers as part oftheir listingapplication, and to disclose any change inultimate controllership following their listing J Requiring brokers to communicate black lists to LSC J Revising the criminal code to exclude information shared by insiders with third parties from the concept o f publicly known information 0 Sign M o U with Russian and Ukrainian supervisory authorities Medium term e) Pension sector d)"""Gross Sectoral issues and other non-bank activities _ " ~ " " - . Improve supervisory structure to ensure adequate supervision o f cross-sectoral inter- IImmediate 18 relations inthe financial sector 0 Change status o f ISC to ensure indeDendence from Executive branch o f zovernment I Short term a) Safety nets: LOLR and deposit insurance b) Cross-Eorder cooneration and ~ r j ~ i s ~ ~ ~ n ~ ~ ~ ~ e ~ ~ Define the condition for the recognition o f a bank as insolvent more precisely inthe regulations (at a minimum as zero net worth), andpreferably include this into the la ICR framework - - 0 Amend mortgage legislationto: (1) allow creation of security interests relatedto future ~ Mediumterm obligations, (2) eliminate the role o fjudges at registration o fmortgage and pledges, and (3) simplify creation formal requirements 0 Review bailiffs fee structure 0 Amend Law on Restructuring to allow simplifiedrestructuring procedures for out-of- court plans approved by a majority o f creditors 0 Specialize a number o fjudges to deal with insolvency cases a) Capital market 0 Implement MIFID: Ongoing J Maintain TRS system J Exercise increased oversight over implementation o f client suitability and appropriateness rules Broaden the supply o f Lithuanian securities Medium term J Establish the conditions for risk pricing o f municipal bonds, including market- based regulation o f municipal borrowing, municipal bankruptcy law, and no- bailout policy J Adopt revised Law on Investments to enable PPPsboth at the national and municipal corporations level; J Design and implement the legal and regulatory framework for securitization, including possibility to register SPVs as trusts J Improve regulatory framework for covered bonds b') sector ~~~~~~~~ 0 Finalize legislation about payout phase Ongoing * After strengthening the governance structure of pension funds, change the default Mediumterm option from "not to join the second pillar" to "join the second pillar" 0 Create a Presidential Commission for the definition o fthe default benchmarks 0 Specify inthe law or regulations the maximum exposure to riskby category o f pension fund portfolios 0 Develop a regulation to optimize decisions o f default contributors, including the use o f lotteries for selecting pension managers and allocation o f contributors to different portfolios Upgrade SODRA's IT systems and eliminate restrictions for enrolling inthe second Short term pillar 19 - Strengthen the consumer protection framework for financial services, focusing on Immediate 20 APPENDIX111.THELITHUANIA FINANCIAL SYSTEM: STRUCTUREAND SUPERVISORY FRAMEWORK 1. The Lithuanian financial system is centered on the banking sector and dominated by three foreign-owned banks. The banking sector comprises nine banks - o fwhich six are subsidiaries of foreign banks - and two branches o f foreign banks. Foreign entities account for around 93 percent of the sector's assets; Swedishbankstogether account for around 62 percent o f sector assets. The three largest banks (SEB Vilniaus Bankas, Hansabankas, andDnBNORD Bankas) account for around 69 percent o f banking sector assets and have a substantial share of non-bank financial sector assets. The three banks generatedthree quarters o f the 2006 credit growth. All three banks are owned by foreign banks with A+ Standard and Poor's credit ratings. 2. Untilrecently, leasinghas beenthe largest segment ofthe non-bank sector. There are 12leasing companies, all subsidiaries o fbanks, with a total portfolio as o f July 1, 2007 of 8.4 billionlitas or around10 percent o f GDP, growing at an average rate of 48 percent a year over the last six years. Two o f the largest leasing companies, Hansa Leasing and SEB Leasing, dominate with42 and 36 percent ofthe market respectively. Leasing companies are fundedbythe direct parent company upto a limit of 75 percent ofthe capital ofthe parent company, and by their foreignparent, where applicable, up to 20 percent of the capital. The funding for the two largest companies i s mostly ineuros. Financial leasing i s the most usedform o f leasing (95 percent of all contracts) largely to the corporate sector. The main categories o f leased objects are: (i) heavy vehicles for commercial transport (3 7 percent); (ii)industrial equipments (30 percent); (iii) cars (18 percent; and 4 percent private/family cars), and (iv) commercial real estate (15 percent). 3. The non-bank financial sector i s still very small but has been growing in recent years. Since their introduction in2004, second pillar pension schemes accumulated assets at a rapidrate. The third pillar, however, has attracted less enthusiasm, but the government has introducedrecently tax advantage for all thirdpillar savings. Currently 16 second pillar and six thirdpillar pension funds operate with total assets of around 280 millionlitas (81 million euros). Compulsory motor third-party liability insurance, introducedinJune 2001, and the introduction o f UCITs inNovember 2004 have also contributedto the growth o f the NBFI sector. Finally, the rapid growth of mortgage loans has spurredthe growth of mortgage insurance. Supervisory Framework 4. The BoL is the banking supervisory authority. It has the mandate to conduct both individual and consolidated supervision o f banks and their financial groups, includingdomestic banks' foreign subsidiaries. The BoL also has the right to conduct consolidated supervision ifthe parentcompany inthe financial group is a controlling (holding) company where the group includes a bank licensed by the BoL. The leasing sector i s not regulated or supervised except where leasing companies are subsidiaries o f banks. 5. Securities market intermediaries are regulated and supervised by the Lithuanian Securities Commission (LSC), including financial brokerage firms, departments, and brokers; 21 management companies, collective investmentundertakings, pension funds, stock exchanges, the Central Securities Depository, as well as listedand non listed public and private issuers, and EU cross-border firms. In 1996, the Securities Commissionjoined the IOSCO. 6. The Insurance Supervisory Committee is responsible for the supervision of insurance companies. However, inline with EUDirectives, financial supervision of insurance undertakings of other EUmember states, providing their services inLithuania, or of branches of such undertakings established inthe Republic of Lithuania i s carried out by a competent authority o fthis EUmember state. Table 3. Total Assets of Financial Market Participants, 2003-06 InLTL million 2003 2004 2005 2006 I/ Growth (2005-06) (in%) Commercialbanks 22,03 1 29,151 44,849 52,577 17.2 Credit unions 155 230 379 462 21.8 Leasing companies 2,976 4,399 5,930 ... ... UCITS ... 161 398 602 51.3 Life insurance 401 595 838 1,059 26.4 Non-life insurance 1,010 1,090 1,233 1,409 14.2 Second pillar pension funds 21 0 127 410 770 87.8 Thirdpillar pension funds 3/ 0 11 37 47 28.7 Stock brokerage enterprises ... 79 111 143 29.1 Management enterprises ... 25 33 45 35.8 Source: Statistics Lithuania l / Endo f 43 data. 21Pensionfunds accumulating a part o f social security contribution. 3/ Pension funds accumulating supplementary voluntary pension contribution. Table 4. Number of Financial Intermediation Enterprises, 2003-06 Institutions 2003 2004 2005 2006 1/ Growth (2005-06) (in%) Commercial banks 13 12 12 11 -8.3 Credit unions 58 62 65 67 3.1 Leasing companies 20 18 15 16 6.7 Collective investment undertaking 0 10 19 24 26.3 Life insurance companies 9 9 8 8 0.0 Non-life insurance companies 19 19 17 15 0.0 Pension funds 0 34 34 36 5.9 Stock brokerage enterprises ... 16 14 12 -14.3 Management enterprises ... 9 10 13 30.0 Source: Statistics Lithuania, and ISC. l / Provisional data. 22 Table 5. Ownership ofthe Banking System, end-2006 Bank Owner Legal form Share intotal banking sector assets (`A) DnBNORDBankas BankDnBNORDA/S (Denmark); ultimate owner: Subsidiary 12.7 DNBNORBank ASA (Norway) SEB Vilniaus Bankas Skandinaviska Enskilda Banken AB (Sweden) Subsidiary 32.4 Hansabankas Hansapank (Estonia); ultimate owner: Swedbank AB Subsidiary 23.9 (Sweden) Parex Bankas Parex banka (Latvia) Subsidiary 1.3 Sampo Bankas Danske Bank (Denmark)) Subsidiary 7.2 Snoras Bankas Conversgroup (Luxembourg) Holding Company Subsidiary 7.2 (49.9 percent); ultimate owner: ZAO Conversbank (Russia) Siauliu Bankas EBRD(16.1 percent) Domestic 2.3 Ukio Bankas Mr.Vladimir Romanov(33.0 percent) Domestic 5.1 UAB Medicinos Bankas Mr. Saulius Karosas (55.8 percent) Domestic 0.7 Bayerische Hypo- und Bayerische Hypo- undVereinsbank AG (Germany); Branch 1.7 Vereinsbank AG ultimate owner: Unicredito Italian0 Spa (Italy) Nordea Bank Finland PIC Nordea Bank Finland Abp (Finland); ultimate owner: Branch 5.5 Lietuvos skyrius Nordea Bank AB (Sweden) Source: Bank o f Lithuania. Notes: The following changes in ownership structure occurred since end-2006. First, inFebruary 2007, Mr.V. Antonov, Chairman ofthe Supervisory Board o f Snoras Bankas and major shareholder ofthe international financial group Conversbank, acquired 68.65 percent o fthe registered share capital of Snoras Bankas, becoming the controlling shareholder o f the bank. Second, Danske Bank Group's purchase o f Sampo Bank fLom Sampo Group was completed. Danske Bank is now the sole owner o f Sampo Bank, and the ultimate owner o f Sampo Bankas. 23 Table 6. Financial Soundness Indicatorsfor the Banking Sector 2002-2007 2002 2003 2004 2005 2006 June2007 Capital adequacy Regulatorycapitalto risk-weighted assets' 14.7 13.2 12.4 10.3 10.7 10.5 Regulatorytier Icapital to risk-weightedassets ' 12.1 11.1 10.2 8.9 7.8 8.2 Capital to assets 10.5 9.8 8.7 7.2 7.1 7.5 Asset quality Nonperformingloans net of provisionsto capital 3,11 21.1 11.7 12.6 5.7 9.7 8.7 Nonperformingloansto total (non-interbank)loans l' 5.3 2.4 2.2 0.6 1.o 0.9 Sectoral distributionof loans to total loansl2 0.0 0.0 0.0 0.0 0.0 0.0 Agriculture,hunting,forestry 2.0 1.8 2.0 2.0 1.9 1.7 Fishing 0.2 0.1 0.1 0.1 0.1 0.0 Mining and quarrying 0.4 0.3 0.2 0.2 0.1 0.1 Manufacturing 21.4 21.8 17.5 15.2 11.9 10.6 Electricity,gas and water supply 7.3 7.6 6.4 4.2 2.5 2.1 Construction 4.0 3.2 2.9 3.9 5.7 5.2 Wholesale and retailtrade; repair of motor vehicles,motorcycles:personaland householdgoods appliances 20.2 19.2 15.7 13.0 12.8 11.0 Hotelsand restaurants 1.6 1.7 1.6 1.5 1.6 1.5 Transport, storage and communication 5.0 2.9 2.3 2.6 2.5 2.5 Financialintermediation 10.6 10.7 10.8 14.6 7.3 6.7 Real estate, renting and other businessactivities 6.8 7.6 9.8 12.5 14.5 15.3 Public administrationand defence;compulsory social security 4.3 2.4 4.1 3.3 1.5 1.7 Education 0.2 0.1 0.1 0.1 0.0 0.0 Healthand socialwork 0.4 0.6 0.8 0.5 0.3 0.3 Other utilities.social and personalservices 1.4 1.1 0.9 0.7 0.9 0.9 Other types of economic activities 0.0 0.0 0.0 0.0 0.0 0.0 Loans not attributedto economic activities 14.4 18.9 24.9 25.8 36.4 40.4 Residentialreal estate loans to total (non-interbank)loans 11.2 14.3 18.4 21.2 24.7 26.8 AII large exposuresto regulatorycapital ' 194.7 213.1 199.6 239.0 189.6 165.6 Earningsand profitability Return on equity (Net income to averagecapital) 2,4 9.1 11.8 13.5 13.8 21.4 28.5 Return on assets (Net income to averagetotal assets) 0.9 1.2 1.3 1.I 1.5 2.1 Interest marginto gross income 51.3 49.1 51.O 53.8 54.6 56.1 Noninterestexpensesto gross income 82.7 81.6 70.9 66.6 58.7 52.1 Trading andforeign exchange gains (losses)to gross income 14.1 10.3 8.1 7.8 8.5 9.0 Personnelexpensesto noninterest expenses 42.0 38.3 37.3 37.4 37.6 40.2 Spread betweenreferencelending and referencedeposit rate' 5.2 4.2 3.6 3.3 3.5 3.9 Liquidity Liquid assets to total assets 29.3 27.7 28.3 26.9 24.1 21.3 Liquid assetsto current liabilities 42.0 42.4 41.7 42.9 41.9 38.9 Spreadbetweenhighest and lowest interbank rate 9.0 3.9 1 7 3.3 2.8 3.9 Customerdepositsto total non-interbankloans 132.1 101.7 95.7 83.3 72.5 66.6 Foreign exchange risk Foreign-currency-denominatedloansto total (non-interbank)loans 51.5 54.6 58.3 65.8 52.8 48.7 Foreign-currency-denominatedliabilitiesto total liabilitieslo 44.5 46.1 45.6 51.6 52.0 53.7 Net open positionin foreign exchangeto regulatorycapital 'l3 -1.5 10.8 -1.9 -1.0 -1.4 0.5 Equity risk and exposureto derivatives On balance(assets) position in equities to capital 11.7 12.2 12.2 14.9 13.2 9.9 Gross assetsoosition in financial derivativesto caDital 0.3 0.5 0.8 1.2 4.5 7.7 Gross liabilitiesposition in financial derivativesto capital 2.0 2.1 0.8 0.7 4.9 6.2 Source: Bank of Lithuania. 11Withoutforeign bank branches. 21Capital is deflned as banks shareholders'equity and foreign bank branchesfunds receivedfrom the head office. 31From end-2005FSI is Nonperformingloans to capital. 41Net income beforeextraordinaryitems and taxes. 51 Largeexposure- means loans granted to the borrowerthe net value of which equals to, or exceeds, 10per cent of bank capital that is calculatedhaving regard to the national Rulesfor CalculatingCapitalAdequacy. In this particular case Loan- means all banks monetary claims to the borrower,acquired shares (contributionsor other portions of equity), reflectedin the bank balance-sheetand off-balancesheet items, also monetaryobligationsof the bank recognised in the bank's off-balance. 61Excludingloansand deposits to I from credit and financial institutions. 71Compositionof liquid assets is defined in the Liquidity Ratio CalculationRules approved by Resolution No. 1of the Board of the Bankof Lithuania of 29 January 2004. 81Compositionof current liabilities is defined in the Liquidity Ratio CalculationRules approvedby Resolution No. 1 of the Board of the Bank of Lithuaniaof 29 January 2004. 91Informationis based on interbank deals of all maturities (mostlyovernights)made betweenresident banks in nationalcurrency Litaswithin the last quarter of the period. 101From 2005 the major part of foreign currency loans andforeign currency liabilities are in Euros. Due to the Currencyboard arrangementand pegging Litas to Euro this does not represent such foreign exchangerisk as it would be in the othercases. 111From end-2005 NPLs are loanswith regular payments overdue more than 60 days. Until12004 NPLs are loans in Substandard,Doubtfuland Loss loans categories. 121Credit Registrydata from 2005 for sectoral distribution of loans to domestic market. 131Asdefined in Rulesfor Calculationof Capital Adequacy approved by Bank of Lithuania Board Resolution No. 172of 21 December2000. Note: The 2006 increase in nonperforming loan is related to a bankruptcy o f one electronics manufacturer and does not reflect a systemic trend. 24 Table 7. Financial Sector Indicators, 2002-07 (inpercent, unless indicated otherwise) 2003 2004 2005 2006 Sep-07 Private sector credit (year-on-year change) I / 56.6 40.3 56.1 51.4 45.8 Claims on private enterprises (in billions of litas) 9.1 11.3 16.1 22.7 28.2 of which: share of foreign currency loans 61.9 64.8 67.9 58.2 54.3 Claims on private enterprises (year-on-year change) 47.9 24.6 42.6 41.I 34.4 Share of claims on private enterprises in total private sector credit 78.0 69.2 63.2 58.9 55.1 Claims on individuals (in billions of litas) 2.6 5.0 9.4 15.8 22.9 of which: share of foreign currency loans 29.2 42.8 54.7 43.9 43.2 Claims on individuals (year-on-year change) 97.8 96.0 86.6 69.2 62.7 Share of claims on individuals in total private sector credit 22.0 30.8 36.8 41.I 44.9 Share of foreign currency loans 54.7 58.0 63.1 52.3 49.3 Official risk indicators Nonperforming loans to total gross loans 2/ 2.4 2.2 0.6 1 .o 0.9 Regulatory capital to risk-weighted assets 3/ 13.2 12.4 10.3 10.7 11.3 Liquid assets (Core) to short-term liabilities 4/ 42.4 41.7 42.9 41.9 38.9 Financial sector risk factors of deposit money banks Share of foreign currency private sector credit in total private sector 54.6 58.0 63.1 52.3 49.3 Share of foreign currency deposits in total deposits 27.1 27.0 28.0 22.4 22.7 Short-term private sector credit in percent of total private sector credit 76.9 81.1 84.5 86.2 87.4 Demand deposits in percent of total deposits 45.1 43.3 38.3 40.7 46.1 Bank profitability 5/ Return on Assets 1.2 1.3 1.1 1.5 2.1 Return on Equity 11.8 13.5 13.8 21.4 28.5 Market assessment Net open position in foreign exchange to capital 6/ 10.8 -1.9 -1.o -1.4 0.5 Total private sector credit (in billions of litai) 7/ 11.6 16.3 25.5 38.5 51.I Total resident deposits (in billions of litai) 7/ 13.8 17.2 23.4 28.6 32.3 Average annual interest rate on litas loans to enterprises 8/ 6.5 5.7 5.0 5.0 7.1 Average annual interest rate on litas loans to households 8/ 7.0 6.4 5.8 5.2 7.6 Average city centre residential prices in Vilnius (annual return) 9/ 14.3 37.5 45.5 50 25 Sources: Bank of Lithuania and National Stock Exchange of Lithuania. I / Includes credit to private enterprises, households,and nonprofit institutions by monetary authorities, deposit money banks, and other banking institutions. 2/ Includes foreign bank branches. Includes loans overdue for 31 or more days. Unconsolidated data. 2007 data for June. 3/ Foreign bank branches are excluded. 4/ Core liquid assets comprise currency and financial assets available on demand or within 3 months or less. 2007 data for June 5/ Net income before extraordinary items and taxes. 2007 data for June. 6/ Excludingforeign bank branches. Since June 1, 2000, maximum in foreign currency and precious metals is 25 percent of a bank's capital. Maximum in each currency is 15 percent. 2007 data for June. 7/ From banking survey, including monetary authorities, deposit money banks, and other banking institutions. 8/Average annual interest rate on 1-3 month loans in litai. From 2005, average annual rate on new 0-1 year loans in litai. 9/ Data for 2007 are for Dec-Aug. 25 Table 8. Indicators o f Externaland FinancialVulnerability, 2002-07 2002 2003 2004 2005 2006 Latest Dateof Est Actual Observation Financial indicators Broad money (year-on-year change in percent) 19.4 19.4 21.4 31.9 21.5 25.3 Dec. 2006 Broad money in percent of gross official reserves 196.7 196.7 249.4 268.7 239.7 250.1 Dec. 2006 Private sector credit (year-on-year change in percent) 28.3 56.6 40.3 56.1 51.4 45.4 Dec. 2006 External indicators Current account balance in percent of GDP -5.2 -6.9 -7.7 -7.1 -10.9 -13.8 Q1 2007 Exports of GNFS (in millions of U.S. dollars) 7,510 9,536 11,749 14,880 17,747 4,475 Q1 2007 Exports of GNFS (year-on-year change in percent) 24.2 27.0 23.2 26.6 19.3 15.0 Q1 2007 Importsof GNFS (year-on-year change in percent) 24.0 28.0 25.3 25.7 24.4 22.7 Q1 2007 Capital and financial account balance in percent of GDP 4.2 6.0 6.8 7.3 11.6 16.8 9 1 2007 Gross official reserves (in millions of U.S. dollars) I / 2,413 3,450 3,594 3,816 5,773 5,645 Q1 2007 Gross official reserveslshort-term debt 2/ 0.8 0.8 0.7 0.5 0.6 0.5 Q1 2007 Gross official reserveslshort-term debt 3/ 1.1 1.1 1.o 0.8 1.o 1.o Q1 2007 Gross official reserveslreserve monev 151.8 143.2 128.0 122.8 140.2 137.2 June 2007 Gross official reserves in months of imports of GNFS over the following 2.7 3.1 2.6 2.2 2.9 3.8 Q1 2007 Total gross external debt (in millions of US. dollars) 6,199 8,338 10,472 12,560 18,918 20,645 Q1 2007 in percent of GDP 43.9 44.9 46.5 48.9 63.5 56.6 Q1 2007 ofwhich: Public sector debt (in millions of US. dollars) 2,429 2,793 3,136 2,879 3,995 3,991 Q1 2007 in percent of GDP 17.2 15.0 13.9 11.2 13.4 10.9 Q1 2007 of which: Short-term external debt (in millions of US. dollars) 3/ 2,123 3,277 3,766 4,872 5,709 5,689 Q1 2007 in percent of gross international reserves 88.0 95.0 104.8 127.7 98.9 100.8 Q1 2007 in percent of GDP 15.0 17.7 16.7 19.0 19.2 15.6 Q1 2007 of which: excluding short-term liabilities of commercial banks 1,379 1,829 1,999 2,241 2,525 2,509 Q1 2007 Total net external debt (in millions of U.S. dollars) 4/ 4,463 6,202 7,112 8,198 12,902 14,459 Q1 2007 in percent of GDP 31 6 33.4 31.6 31.9 43.3 39.7 Q1 2007 of which: Public sector debt (in millions of US. dollars) 2,429 2,793 3,136 2,879 3,995 3,991 Q1 2007 in percent of GDP 17.2 15.0 13.9 11.2 13.4 10.9 Q1 2007 Total net external short-term debt (in millions of US. dollars) 51 740 1,452 1,431 2,150 2,501 2,449 Q1 2007 in percent of GDP 5.2 7.8 6.4 8.4 8.4 6.7 Q1 2007 Real effective exchange rate (year-on-year change in percent, "+" = appreciation) 7/ 4.8 3.4 0.9 3.6 1.5 1.5 2006 Financial market indicators Stock market index, end of period 81 85 174 289 449 493 520 Aug 16, 2007 Foreign currency debt rating 9/ EBB BBB+ A- A A A Aug 16, 2007 Memorandumitem: Nominal exchange rate (1itailU.S.dollar, end-of-period) 3.3 2.8 2.5 2.9 2.6 2.5 Jul. 2006 Nominal exchange rate (litaileuro, end-of-period) 3.5 3.5 3.5 3.5 3.5 3.5 Aug 16, 2007 Sources. Bank of Lithuania,Ministryof Finance,Department of Statistics,NationalStock Exchangeof Lithuania,Bloomberg, InformationNotice System, and IMF InternationalFinancialand Trade Statistics I / Gross ofkial reservesreportedhere differ from the monetarytable due to valuation differences. 2/ On an remaining maturitybasis, estimatedas short-termdebt at year-end plus amortization of medium-and long-termdebt of the following year 3/ On an original matunty basis 4/ Gross external debt minus debt securitiesheld abroad and other investments abroad. 5/ Short-termgross externaldebt excluding trade credits and currency and deposits held abroad. 6/ Debt sewice comprises interestand repayment on extemai loans,and interestand repaymenton debt securities. 7/ CPI-basedREER against the 17 major trading partnersin 2000. E/ VILSE index. 9/ S&P investmentgrade rating