74423 June 2002 SecM2002-0299 Lithuania FSA Financial Sector Assessment This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The World Bank does not guarantee the accuracy of the data included in this work. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The material in this publication is copyrighted. -1- 1. A joint IMF-World Bank Financial Sector Assessment Program (FSAP) mission visited Lithuania during November 4-15, 2001 to undertake an assessment of the financial sector.1 The principal objective of the mission was to assist the authorities in identifying potential vulnerabilities in the Lithuanian financial system and obstacles to its future development. This work was seen as being of particular importance in light of Lithuania’s eventual accession to the European Union (planned for the beginning of 2004). 2. This report provides a summary of the main findings of the mission, and the policy priorities identified.2 I. OVERALL STABILITY ASSESSMENT AND KEY DEVELOPMENT RECOMMENDATIONS 3. There appear to be no immediate threats to financial system soundness in Lithuania. Macroeconomic policies are centered around a currency board arrangement (CBA) supported by fiscal discipline. International capital flows have been liberalized for some years, with beneficial effects. Both domestic and foreign indebtedness are low, with the current account deficit financed largely by private foreign direct investment inflows. Banks have adopted a conservative approach to lending and risk management, and their capitalization and loan quality are generally adequate. Substantial improvements to the legal and institutional framework for insolvency and creditor rights put in place in the latter half of the 1990s have made bank lending a much safer proposition, even though there is still room for further improvement, especially in developing a workable financial restructuring process and improving the efficiency of the court system. Securities and insurance markets are not large enough to pose a significant systemic risk in the near term. The payment and settlement system handles only a limited number of transactions and has shown itself to be robust in previous periods of stress. Regulation and supervision of banking and securities markets are well-developed, and there is a high degree of transparency in monetary and financial policies. There are weaknesses, however, in insurance regulation and supervision. 1 The mission comprised Ms. Marie-Renée Bakker (World Bank, Chief); Mr. Karl Habermeier (IMF, Deputy Chief); Ms. Cally Jordan and Messrs. John Hegarty, Gordon Johnson, Robert Gourley, Gregorio Impavido, Marius Vismantas, Peter Modeen (all World Bank); Mmes. Anne Kester, Jodi Scarlata and Mr. Martin Cihak (all IMF); Mr. Geoffrey Mortlock (expert at the Reserve Bank of New Zealand); Mr. Tomas Hladek (Executive Director of the Payment Systems Department of the Czech National Bank); Mr. Alessandro Portolano (Anti-Money Laundering expert, Bank of Italy); Mr. Walter Zunic (Consultant, formerly of the US Federal Reserve Bank of New York and the World Bank) and Mr. Manuel Santiago (World Bank, Program Assistant). The mission was assisted in the field by Ms. Milda Vaskeviciute (World Bank-Lithuania). Two preliminary missions that visited Vilniaus during July 9-13, 2001 and September 10-21, 2001 focused on laying the groundwork for the FSAP by explaining the process to the authorities, establishing key working relationships, and identifying potential vulnerabilities and development issues, including compliance with standards and codes. The findings of the FSAP were discussed with the Lithuanian authorities in the context of the IMF’s Article IV discussion, which overlapped with the main FSAP mission. 2 The full FSAP report, comprising: (i) Main Report; (ii) Selected Financial Sector Issues; (iii) Detailed Assessment of Observance of Standards and Codes; and (iv) Supplement to Selected Financial Sector Issues: Quantitative Assessment of Vulnerabilities in the Lithuanian Banking System, was delivered to the authorities in May 2002. -2- 4. Some measures could be taken to address more effectively the impact of hypothetical large shocks to the financial system. These include, most importantly, strengthening supervisory cooperation with the home country supervisors of foreign-owned Lithuanian banks’ parent institutions, establishing sufficiently stringent limits on such banks’ exposures to their parent institutions, and strengthening provisions in existing banking legislation to allow the Bank of Lithuania (BoL) to more expeditiously resolve any banks that may fail in future. Other measures include improving the quality of borrower and bank financial statements and audits, strengthening accountability of bank directors for risk management, and revising loan classification and provisioning rules to better reflect borrower creditworthiness and the fair value of collateral. There may also be a case for modifying the present arrangements for the management of the assets of failed banks, which have proven less than fully effective. 5. Financial activity is likely to grow markedly in years to come, but a large share of the intermediation of saving and investment will not take place locally, but will instead involve a specific pattern of domestic and cross-border financial activity. Notably, domestic banks and leasing companies are likely to intermediate demand for finance from small and medium-sized enterprises (SMEs), households, and to some extent larger corporates, using domestic deposits. By contrast, large enterprises will probably continue to rely more heavily on foreign sources of financing, as they have done to date. Demand for insurance and non-bank saving products is likely to expand, but given the small size and lack of liquidity of domestic securities markets, and the difficulty of adequately diversifying risks in a small market, insurers and other institutional investors are most likely to place a large portion of these funds abroad, all the more so as the barriers between domestic and foreign financial markets will continue to diminish in the course of European integration. 6. These anticipated developments would need to be supported by changes in the regulatory, supervisory, and market infrastructure . It may be desirable to encourage consolidation of the insurance industry and strengthen the independence and the capacity of the insurance supervisory agency in connection with the planned overhaul of insurance legislation. The further development of the market for Lithuanian equity and debt securities will most likely involve some form of cooperation or merger between the National Stock Exchange of Lithuania (NSEL) and other exchanges in the region, coupled with measures to significantly improve issuer disclosure, the quality of issuer financial statements and audits, and the protection of minority shareholders. More generally, there is a need to address the regulatory and market implications of increasing international domestic and cross-border integration of financial markets and the growth of domestic and foreign financial conglomerates providing a wide range of different financial services. Given the small size of Lithuania’s financial system, the domestic financial markets will probably be highly concentrated with only a few dominant players, pointing to a need for well-developed competition and consumer protection policies. -3- II. FINANCIAL SYSTEM OVERVIEW A. Institutions and Markets 7. Institutions in the Lithuanian financial system comprise banks, leasing companies, insurance companies, and securities firms . The system is dominated by banks, which at end June 2001 accounted for 87 percent of total financial system assets (93 percent, when consolidated with their subsidiaries). Overall, the financial system is relatively small, with total assets at end June 2001 equivalent to approximately 32 percent of GDP.3 Credit to the private sector has until recently grown more slowly than money and is among the lowest in the region. At the same time, there is no evidence to suggest that the private sector lacks access to financing and financial services, as these are increasingly also provided cross-border by foreign financial institutions and foreign investors, especially to larger firms, suggesting that domestic credit at current levels is sufficient to meet the financing needs of smaller firms. 8. The securities market is not highly developed, with total market capitalization as of end December 2001 estimated at 26 percent of GDP, and little trading and liquidity. Lithuanian Government debt securities represent an increasingly large part of turnover on the NSEL (54 percent in 2001 and 2000, up from 46 percent in 1999).4 Capitalization is concentrated in a few large enterprises; and the companies listed on the Official and Current Lists (6 and 40 respectively) accounted for over 90 percent of share turnover on the NSEL in 2001. Other large enterprises are either part of the Unlisted Market5, where their securities are traded sporadically or not at all, or are closely or privately held. Brokerage firms and brokerage departments of commercial banks provide intermediation in the capital markets. In February 2002, there were 20 such intermediaries. 9. The insurance sector is small but likely to develop significantly in the years ahead. Gross insurance premiums amounted to only an estimated 1 percent of GDP in 2001 (of which 0.8 percentage points was non-life insurance), and insurance sector assets to only 2 percent of GDP. On a per capita basis, non-life insurance premiums totalled only approximately LTL 100 (US$25), and life insurance premiums LTL 25 (US$6.25). Starting from this low base, there is considerable potential for growth. Notably, it is expected that non-life gross premium income will increase by 30 to 40 percent per year for 2 to 3 years following the introduction of compulsory motor insurance in 2002. As of February 2002, there were 9 life insurance companies and 22 non-life insurance companies. In the first three quarters of 2001, the largest three non-life insurance companies accounted for 61 percent of non- life insurance policies written in terms of gross premium received. In the life insurance area, the largest three insurers accounted for 88 percent of the policies written. 3 The calculation of total assets of the financial system for the purpose of this report includes the assets of securities firms, but not the securities that are traded in the securities market. 4 Moreover, the Government draws significant financing from eurobonds traded in London, Frankfurt, and Luxembourg (equivalent to about 9 percent of GDP, compared with total public debt of about 30 percent of GDP). 5 This market comprises 895 companies in total. -4- B. Liquidity Infrastructure and Safety Nets 10. There is at present ample liquidity in the Lithuanian financial system. The foreign exchange reserve coverage of reserve money increased from 122 percent at end-1999 to 156 percent at end 2001, and official reserves are overwhelmingly invested in highly liquid instruments. Minimum reserve requirements now stand at 8 percent of deposits6; banks hold the equivalent of about another 6 percent of deposits in excess reserves and cash. However, the eventual convergence of reserve requirements to the much lower level in the European System of Central Banks will reduce the scope for further reductions in reserve requirements in periods of diminishing liquidity. Liquidity could also decline in years to come if, for example, demand for bank loans increases rapidly. 11. The BoL is the key institution in any response to episodes of financial system distress, which in Lithuania is likely to mean banking system distress. The BoL has the power to provide liquidity to a bank in distress. Other steps that may be taken by the BoL include remedial action when a bank is in breach of prudential requirements. Where there is doubt about a bank’s solvency or a bank is otherwise in severe difficulty, the BoL also has the power to place a bank into temporary administration for up to five months, conduct an audit, and identify options for resolving the problem. The BoL may also initiate bankruptcy proceedings for an insolvent bank and withdraw its banking license. 12. The payment system handles only a limited number of transactions and has shown itself to be robust in previous periods of stress. There is only one payment system in Lithuania (TARPBANK), which is a designated time net settlement system. Compliance with the CPSS’ Core Principles for Systemically Important Payment Systems is generally good. The payment system was developed by the BoL, which is also its owner and operator. The system is capable of processing both high value and low value payments (although low-value payments are preponderant at present); and it is also used to perform the settlement of the cash leg of securities transactions. Users are mainly domestic banks, branches of foreign banks, and participants in the securities market.7 Cash is still widely used for payments in Lithuania, but non-cash means are growing in importance. There have been no apparent attempts to violate payment system rules, nor attempts at or complaints of fraud. In connection with EU accession, the authorities are working to develop a real-time gross settlement system (RTGS) by 2004 and to establish an interface with the EU’s TARGET system. 13. Options being considered by the authorities to ensure the smooth operation of the planned RTGS payment system, especially in periods of financial system or market stress, include the creation of a secured intra-day credit facility, or the more frequent settlement of netted positions, which would minimize the exposure of all participants. Another possibility would be a multilateral agreement with participants in the payment system covering the provision of liquidity in the event of payment system gridlock. These considerations are all the more relevant given the expected increase in 6 The rate will be reduced to 6 percent on May 24, 2002. 7 I.e., the Central Securities Depository of Lithuania (CSDL), brokerage departments of commercial banks, and brokerage companies licensed by the LSC. -5- both the size and number of transactions through the payment system following the introduction of RTGS. 14. Deposit insurance was introduced in Lithuania in June 1996, with the establishment of the Deposit Insurance Fund (DIF). The DIF began to insure deposits in March 1997. The enactment of the Law on Deposit Insurance in March 2001 laid the groundwork for the harmonization of the legal framework for deposit insurance with that prevailing in the EU. Currently, and for the foreseeable future, the funds held by the DIF (about 0.6 percent of GDP as of end 2001) would enable the DIF to provide full insurance cover only for deposits in the smaller banks and the credit unions operating in Lithuania. The funds held by the DIF will be insufficient to meet likely insurance claims should any of the large banks fail. In the event of the failure of a large bank, the DIF would need to borrow from the Government (which it is empowered to do) in order to meet its obligations. C. Regulation and Supervision 13. The BoL is responsible for licensing and supervising banks and credit unions . The objectives of banking supervision are clearly set out in law. The BoL has a wide range of powers to license and supervise banks and credit unions, and to manage their exit from the system when necessary. A comprehensive framework of prudential regulation and supervision has been established that either fully or largely conforms to the Basel Core Principles in most respects. Staffing is adequate, and staff of the Credit Institutions Supervision Department (CISD) possess the necessary skills to carry out their responsibilities. 14. Although the regulatory and supervisory system is generally strong, banking system stability and development would be further enhanced by : (i) signing of memoranda of understanding with all remaining parent supervisory authorities whose banks have a substantial presence in Lithuania (e.g., Sweden); (ii) tightening the limit on connected credit exposures, to capture exposures to a parent bank (or other shareholder with significant influence or control over the bank) and all its subsidiaries and affiliates, with a view to minimize the risk of intra-group contagion; (iii) strengthening provisions in existing banking legislation to allow more expeditious resolution by the BoL of any banks that may fail in future; (iv) improving the quality of borrower and bank financial statements and audits; (v) strengthening incentives for bank directors to take responsibility for their banks’ risk management systems and internal controls, and strengthening the accountability of directors for inadequacies in these systems and controls; (vi) revising loan classification and provisioning rules to better reflect borrower creditworthiness and the fair value of collateral; (vii) granting approval powers to the BoL for acquisitions by banks of substantial holdings in other financial institutions; and (vii) providing explicit legal protection for the members of the Board of the BoL and CISD staff. 15. The legal basis for the sound, transparent, and efficient functioning of the securities market is provided in the Law of the Republic of Lithuania on Public Trading of Securities (replaced as of April 1, 2002 with a new Securities Market Law) , which aims to protect the interests of investors and ensure competition among participants in the market. The law allocates responsibility for the supervision of the securities market to the Lithuanian Securities Commission -6- (LSC), a Government agency accountable to parliament and whose funding comes from the state budget. The LSC oversees the compliance with laws and regulations governing public trading in securities, by conducting routine and for-cause inspections of public trading intermediaries, public companies, and investment companies. Securities legislation and supervision in Lithuania are mostly in line with the IOSCO Principles of Securities Regulation. 16. Regulation and supervision of capital markets are generally strong, as are the associated systems . Dematerialization, trading, clearing and settlement, electronic communications between market and regulator are modern and compatible with major European systems. In the absence of issuer activity (there have been no initial public offerings), the LSC focuses on regulation of intermediaries. It would be desirable to develop a more substantive approach to regulation and supervision. LSC staff should have legal indemnity for actions taken in the normal discharge of their duties; and the LSC needs to recruit staff with skills in areas such as accounting and auditing. The LSC should be given greater budgetary autonomy and be allowed to pay market-based salaries to attract and retain qualified staff. 17. The Law on Insurance regulates the activities of insurance companies and brokers and establishes the framework for the supervision of the sector. Responsibility for insurance supervision rests with the State Insurance Supervision Agency (SISA), an agency of the Ministry of Finance (MoF). SISA is charged with the protection of the interests and rights of policyholders, the insured, beneficiaries, and third persons. SISA issues licenses for insurance activity, insurance products, insurance brokers, and company branch establishments and performs other related regulatory and supervisory activities. 18. In connection with a planned overhaul of the insurance law, weaknesses in regulation and supervision should be addressed, as also noted in the assessment of compliance with the IAIS Insurance Core Principles. Particular importance attaches to increasing SISA’s independence, introducing stronger fit and proper tests and improving corporate governance and internal controls, establishing asset valuation standards, supervising derivatives activity (which is still limited), fully implementing consolidated supervision, and developing a more predictable approach to the imposition of sanctions. III. SECTORAL AND INFRASTRUCTURE ISSUES 19. The Lithuanian financial system is likely to undergo significant further development and change, driven mainly by stepped-up domestic financial system reform and the increasing integration among financial markets in Lithuania and other countries in Europe . Preparations for accession to the EU will provide an important impetus to this process, but the anticipated changes will require a more general and continuing adaptation of the regulatory and institutional infrastructure to facilitate the orderly and stable development of the financial system. Overall, the gap between financial system development in Lithuania and the most advanced transition economies in the region is expected to narrow. -7- 20. Growth of bank credit to the private sector declined in the aftermath of the August 1998 Russia crisis, but picked up in 2001. Several factors have probably contributed to this phenomenon. On the demand side, many corporate borrowers have had recourse to foreign direct investment or foreign bond markets, while borrowing for housing has until recently been dampened by low household income. Bank restructuring and privatization, cautious risk management by banks reinforced by forceful prudential regulation and supervision, weak competition among the major banks, and shortcomings in accounting, auditing, disclosure, corporate governance, and the insolvency regime may have reduced banks’ appetite to lend. It appears that at least some of the structural factors that have in recent years inhibited the growth of bank credit to the private sector are being overcome, however; the pick-up in credit growth during 2001 suggests that bank credit will in future develop more closely in line with deposits and nominal GDP. Restoration of bank credit to normal levels, as well as noticeably increased competition in the lending market during the latter half of 2001 after the privatisation of LTB, mitigate possible concerns over access to financing by SMEs. 21. Residential mortgage lending is growing rapidly from a low base. Although the market is still small, accounting for just 6 percent of banks’ lending to residents in 2001, it has for some years been among the fastest growing segments of the lending market. Despite the rapid growth in mortgage lending, real estate prices have thus far remained stable; and the size of the mortgage loan portfolios is still too small to pose a systemic risk. Even so, caution and a reorientation of policies are warranted in view of the role that real estate markets have played in triggering banking problems in many other countries. Additionally, Government support for housing finance as currently structured runs the risk of undermining lender and borrower discipline, and also could be costly to the budget. Policies to foster mortgage lending should aim for a stable, predominantly private sector-led development of this market and focus on the development of new housing finance instruments, rather than specialized housing finance institutions to avoid a further fragmentation of an already small financial system; there are signs that the Government is moving in this direction. 22. The leasing market has grown rapidly, and may offer a useful complement to bank finance , especially for SMEs without a longstanding debt service track record and access to high quality collateral. To encourage the further development of leasing and factoring, it would also be desirable to eliminate the elements of the VAT charge on leasing contracts and factoring interest and fee income that disadvantages these forms of financing relative to bank loans. Also, following some further strengthening of consolidated supervision of banks and their leasing subsidiaries, consideration could be given to easing the limit on a parent bank’s lending to these subsidiaries, which would facilitate the development of the leasing market. 23. Regional integration and cross-border transactions will play an increasingly important role in the development of Lithuania’s capital market. Lithuania is well on its way to harmonizing its legal framework for capital markets with the EU’s Acquis Communautaire. Moreover, consideration is being given by the National Stock Exchange of Lithuania (NSEL) to merge, or enter into a cooperative arrangement with, one or more other stock exchanges in the region. -8- 24. The development of the market for Lithuanian equity securities might benefit from some changes in privatization policies and improvements in corporate governance . Minority shareholder rights were frequently abused during the early years of privatization, including through majority shareholders making mandatory tender offers for minority shareholders’ stakes at artificially low prices. Additionally, the Government is routinely selling 100 percent stakes in strategic assets to foreign investors. As a result, Lithuanian equities are increasingly being privately held and no longer publicly traded. In remaining privatizations, the Government may wish to consider retaining a minority stake for future sale to small investors, coupled with measures to significantly improve disclosure, the quality of financial statements, and the protection of minority shareholders (e.g., through measures that preclude price manipulation by majority owners in mandatory tender offers, stronger sanctions on self- dealing and abusive exercise of voting rights, etc.). 25. The Government’s plans for a three-tier pension reform provide an opportunity to develop private pension funds . However, the prospects for domestic private pension funds will remain limited unless the tax advantage that life insurance now enjoys is abated; and a sufficiently large mandatory second-pillar pension scheme is in place. It is likely that foreign providers will capture a significant share of the market for third-pillar schemes, which would require a substantial upgrading in the capacity of LSC to supervise this type of activity. 26. In the insurance sector, given the small size of the market there appears to be a need for further consolidation or exit, especially of the large number of small, marginally profitable firms, to foster both financial stability and development . Many of the smaller insurance companies now active in Lithuania may not be viable in the medium term. Their cost ratios are high and their loss ratios low, possibly because they do not pay some legitimate claims. Exit could be encouraged by tightening licensing rules, adopting a file and use approach for new products to promote innovation, speeding the liquidation procedure for insolvent companies, and strengthening consumer protection to make it more difficult for insurers to withhold payment of claims. 27. As the financial system becomes more complex and inter-connected, there will be an increasing need for information-sharing and coordination between the BoL, LSC, SISA, DIF, and the MoF. Building on existing initiatives in the area of cooperation among the regulatory agencies, a regular dialogue could be held on bilateral and multilateral bases, particularly to exchange views on financial system stability and potential sources of vulnerability, on policy issues, on possible gaps or overlaps in financial system regulation, on issues relating to harmonisation of regulation with the EU and other jurisdictions, and on the nature of potential contagion between different components of the financial system (including for example through the growing activities of banks in the insurance field). Eventually, more far-reaching steps may be needed to adapt the regulatory framework and supervisory institutions to address the increasing international integration of financial markets and the growth of domestic and foreign financial conglomerates that provide a wide range of different financial services. In the longer term, it would be desirable to give consideration to the potential benefits and possible risks associated with moving towards a more formally integrated system of financial sector regulation, under which one supervisory agency would assume responsibility for the supervision of banks, credit unions, insurance companies and other financial institutions, as well as securities markets. Given the small size of -9- Lithuania’s financial system, a consolidated financial sector regulatory agency would also be more cost efficient than retaining multiple separate agencies. 28. The experience with the state-owned asset management company (Turto Bankas) has shown that current arrangements for large scale resolution of the assets of failed banks have resulted in slow recovery , owing inter alia to initial capacity constraints, legal obstacles to efficient recovery, a lack of incentives, poor asset quality, and market illiquidity. As assets age, they lose their value and become more difficult to sell. Consequently, it may be preferable not to maintain indefinitely a full-fledged asset management company. Moreover, Turto Bankas has already been and is about to be charged with many additional tasks, including a general collection function for Government overdues and arrears, and the liquidation of failed financial institutions. Although similar arrangements have been put into place in other countries, the staffing, incentives, and oversight over Turto Bankas would need to be significantly improved in order for it to successfully achieve its objectives. 29. Significant changes are underway in accounting, auditing, and disclosure rules and oversight arrangements, as the authorities seek to bring these in line with EU requirements and international standards . To this end, new laws on accounting, financial statements, and consolidated financial statements were adopted in late 2001, which will alter the accounting requirements laid down by the 1992 Law on the Principles of Accounting. A review of the legal framework for auditing, which is mainly embodied in the 1999 Audit Law, is also being undertaken. 30. Accounting, auditing, and financial disclosure rules for the enterprise sector still have significant shortcomings . It is expected that many of these will be remedied by the new laws adopted in 2001 and by other reforms now underway. Notably, procedures for the enforcement of accounting, auditing, and disclosure rules are weak, with adverse effects on compliance. Audits of many enterprises’ financial statements are considered to be unreliable; enforcement actions against auditors for inadequate work are rare. 31. Lithuania appears committed to fighting money laundering and terrorist finance.8 In recent years, Lithuania has on several occasions modified its legal framework to bring it more closely into line with current international standards, notably with respect to the regulation of customer identification. The Lithuanian authorities appear to be committed to firmly implementing their anti-money laundering (AML) legislation. Even so, some issues merit attention. The Tax Police9 may need additional human resources and improved information technology to ensure the effective enforcement and use of the AML reporting system. Moreover, the sanctions for violations of AML provisions may be on the low side and could be increased. The Tax Police should also be given the power to suspend a transaction before a criminal investigation has been initiated. There is a need to strengthen the 8 The assessment of policies in this area was based on the preliminary methodology developed by the IMF and the World Bank; and the authorities agreed to a pilot application of this methodology in Lithuania. 9 A new Law on Financial Crimes Investigation Services came into effect on April 1, 2002 which envisages the transformation of the existing Tax Police within six months into a Financial Crimes Investigation Unit with a broad mandate covering all financial crimes including money laundering. - 10 - assessments made by the Bank of Lithuania of banks’ internal control systems aimed at preventing money laundering. Furthermore, examiners could also focus more closely on the substance of transactions reported. 32. Controls on money laundering in the insurance and securities sectors fall well short of those in the banking sector. It will be essential to extend guidance on “know your customer� rules to all financial institutions, and provide specific guidance for detecting suspicious transactions. Also, exchange of information among agencies involved in AML work could be strengthened, also in the interest of reducing the impact that money laundering or other criminal financial activities may have on the safety and soundness of financial institutions. Information on suspicious transactions should be shared among the concerned agencies on a regular basis, and could be discussed in a joint forum of those agencies.