70865 FOR OFFICIAL USE ONLY FINANCIAL SECTOR ASSESSMENT REPUBLIC OF LATVIA JUNE 2012 FINANCIAL AND PRIVATE SECTOR VICE PRESIDENCY EUROPE AND CENTRAL ASIA REGION VICE PRESIDENCY This Financial Sector Assessment (FSA) summarizes the key findings and recommendations of the Financial Sector Assessment Program (FSAP) Development Module for the Republic of Latvia, based on the World Bank mission1 that visited Latvia from November 1 to 18, 2011. The main focus of the mission was to examine opportunities for expanding access to finance in the private sector. The information presented is as of November 2011 unless otherwise stated.                                                          1 The FSAP team gratefully acknowledges the excellent hospitality, cooperation, and openness of the Latvian authorities and technical counterparts. The FSAP team comprised Emanuel Salinas (Mission Chief), Cecile Thioro Niang, Leora Klapper, Adolfo Rouillon, Froukelien Wendt and Sarah Zekri (all World Bank). 1    CONTENTS I. EXECUTIVE SUMMARY ............................................................................................. 4 MAIN POLICY RECOMMENDATIONS ................................................................................ 5 A. FINANCIAL SECTOR DEVELOPMENT AND THE IMPACT OF THE GLOBAL FINANCIAL CRISIS ....................................................................................................... 8 B. COMPOSITION OF THE FINANCIAL SECTOR IN LATVIA ........................................ 10 C. OVERVIEW OF THE CORPORATE SECTOR ........................................................... 11 D. SUPPLY OF SME BANKING................................................................................ 12 II. FINANCING INSTRUMENTS FROM NON-BANK FINANCIAL INSTITUTIONS ............... 13 A. FACTORING ....................................................................................................... 14 B. LEASING ............................................................................................................ 14 C. CREDIT UNIONS................................................................................................. 15 III. CAPITAL MARKETS ............................................................................................... 15 IV. GOVERNMENT SUPPORT PROGRAMS .................................................................... 17 V. CREDIT INFORMATION ........................................................................................... 18 VI. LEGAL FRAMEWORK FOR CREDITOR RIGHTS AND INSOLVENCY .......................... 18 VII. FINANCIAL CONSUMER PROTECTION.................................................................. 20 VIII. PAYMENT SYSTEMS .......................................................................................... 21 2    Glossary AML Anti-Money Laundering ATM Automated Teller Machine BoL Bank of Latvia CAR Capital Adequacy Ratio CCP Central Counterparty CLP The Certified Lenders Program CSD Central Securities Depository CRPC Consumer Rights Protection Center CTF Counter-Terrorism Financing EKS Electronic Clearing System ESCB- CESR European System of Central Banks – Committee of European Securities Regulators FCMC Financial and Capital Market Commission FDL First Data Latvia FSAP Financial Sector Assessment Program GoL Government of Latvia IOPS International Organization of Pension Supervisors IORP Institutions for Occupational Retirement Provision LC Line of credit LCD Latvian Central Depository LGA Latvian Guarantee Agency LIAA Investment and Development Agency of Latvia LPP Legal Protection Proceedings LVL Latvian Lat MLBL Mortgage and Land Bank of Latvia MoE Ministry of Economy MoF Ministry of Finance NBFI Non-bank Financial Institution NPL Non-performing Loans OCLPP Out-of-court Legal Protection Proceedings PCG Partial Credit Guarantees PLP The Preferred Lenders Program ROA Return on Assets ROE Return on Equity RSSS Recommendations for Securities Settlement Systems SAMS BoJ interbank payment system SBA The US Small Business Administration SME Small and Medium-Sized Enterprises SSS Securities Settlement Systems 3    I. EXECUTIVE SUMMARY 1. Latvia has a well-developed financial sector, but in the aftermath of the 2008-09 Global Financial Crisis, access to finance has become a major constraint for the development of private enterprises. Credit to the private sector in Latvia, at above 100 percent of GDP, is one of the highest in Eastern Europe, after significant growth over the last decade. However, in the aftermath of the 2008-09 Financial Crisis, credit growth has been negative (average annual growth of -7 percent between 2009- 2011) and access to finance has become one of the most significant obstacles for growth according to enterprises (close to 30 percent of firms identify it as an obstacle in 2009, versus 2 percent before the crisis). This contributed to a significant decline in the volume of private investment, which dropped by 48 percent between 2008 and 2010. Credit constraints are more severe in specific segments, including smaller firms 2. The ability of banks operating in Latvia to resume lending is hampered by a legacy of high non-performing loans from the crisis and lingering weaknesses in the debt resolution framework. The overhang of non-performing loans (NPLs), which increased from 8 percent of total loans in 2008 to a peak of 19 percent in 2010 and accounted for close to one fifth of total loans at the end of 2011, has had a negative impact on the supply of credit and on its affordability (with interest spreads widening from 5 percent in 2008 to 9 percent in 2011 to cover loan losses). New lending often carries high collateralization requirements and is granted for short tenors, reflecting banks’ heightened risk aversion, and limiting the ability of enterprises to finance long-term capital investments. While a strong legal framework governing creditor rights and insolvency is in place after significant reforms implemented in the wake of the crisis, some lingering weaknesses and limitations in the institutional capacity of the judiciary reduce the effectiveness of the framework translating into higher costs and longer debt resolution processes. 3. The ongoing Eurozone crisis could lead to further reduction of credit to the private sector; the authorities should manage this risk pro-actively. With the highest loan-to-deposit ratio in the region (above 200 percent), the capacity of the Latvian banking sector to resume lending will largely depend on its ability to maintain access to external financing. In particular, many large commercial banks rely on funding from foreign parents. Recent events in the wake of the Eurozone crisis highlight the risk of progressive withdrawal of funding (deleveraging) to subsidiaries in Eastern Europe. While so far foreign bank parents have maintained support to subsidiaries in Latvia, it will be important to actively manage this risk through collaboration with among authorities in home and host countries to avoid regulatory actions that could prompt deleveraging. Strategies from Latvian subsidiaries to gradually reduce reliance on foreign funding by leveraging local sources of funding such as bond markets will also reduce the risk of deleveraging. 4. In response to these challenges, the Government has supported credit to the private sector through various instruments, some of which may need to be reviewed. Support has been provided through various financial instruments aimed at enhancing the accessibility and affordability of credit and implemented trough public bodies and commercial financial intermediaries. Going forward, the evolving nature of the economy and financial markets calls for a review of the scope of these instruments, so as to ensure they target effective market gaps. It will also be important to ensure the programs create adequate incentives for financial intermediaries to expand services to underserved markets in a sustainable manner, and that the programs lever the established capacity and expertise of robust commercial lenders, minimizing competition with such lenders. 5. Measures to continue strengthening the credit infrastructure to support a sound resumption of credit will also be important, including broadening the scope of information available to banks and enhancing accessibility of existing credit information to commercial lenders. 4    6. Non-bank financial institutions can play an important role in the provision of financial services to private firms, but shortcomings in the legal environment and in infrastructure limit their potential. Leasing is instrumental in enabling companies to acquire capital goods, but deficiencies in implementation of repossession laws hamper the development of leasing of non- movable assets such as machinery. Lack of a deed registry creates risk for leasing and factoring firms and the absence of a leasing act reduces the effectiveness of the judiciary in case of default. 7. The local capital markets can become important sources of financing. Latvia’s capital markets are efficient, modern, and the legal framework is sound. Despite these efforts however, the number of listed firms and market liquidity have remained very low. This resulted mainly from the wide availability of bank loans on competitive terms in the years preceding the crisis, which have de- incentivized larger firms to list or issue bonds. Similarly, the easy availability of foreign financing have de-incentivize banks to issue on the local market. Going forward, local bond markets can become a source of financing for financial intermediaries and larger firms. . MAIN POLICY RECOMMENDATIONS BANKING SECTOR Banking â€? Maintain close monitoring of NPLs, addressing impending Immediate sector obstacles for effective resolution (see insolvency framework recommendations below). â€? Actively seek to reduce the risk of de-leveraging through Immediate close coordination with other Baltic authorities, and collaboration with Scandinavian and European counterparts aimed at avoiding excessive withdrawal of parent funding or the deleveraging from Latvia. â€? Monitor closely the evolution of the loan-to-deposit ratio Immediate and promote progressive reduction – albeit avoiding provoking undue deleveraging by banks. â€? Develop measures to reduce dependence on foreign funding, including: a) Develop measures to encourage increased domestic Immediate savings and depositors’ confidence, including efficient handling of depositor claims stemming from Kraijbanka. b) Encourage banks to issue bonds in the local capital Medium markets to reduce dependence on foreign funding. Term GOVERNMENT PROGRAMS Government â€? Consolidate the various programs supporting access to Immediate support finance to the private sector under a single agency to avoid programs duplicity and enhance efficiency. â€? Avoid providing a banking license to such agency so as not Immediate to create unfair competition with private banks. â€? Avoid or minimize direct lending by government support Short term institutions to leverage the existing expertise and networks of private financial institutions and avoid creating undue competition and market distortions. Any direct lending should be made transparently and with regular reviews to ensure that government support programs are not crowding-out commercial lenders. â€? Implement a formal monitoring and evaluation framework to a) clearly identify the market gaps or deficiencies that Short term the programs are aiming to address; b) measure the 5    additionality of support programs; c) assess the effectiveness of the support programs in reducing targeted market gaps, and; d) quantify the impact of support programs on the companies benefiting from their support. â€? Consider the introduction of streamlined processes for the Short term provision of PCGs. â€? Consider the feasibility of a portfolio or hybrid guarantee approach, which would reduce the cost and time of loan Short term guarantee approvals. â€? Reconsider the need for introduction of Mezzanine loans, assessing a) whether these instruments indeed address a Short term market gap, b) the impact that these instruments have on firms as they may lead to higher financing costs, c) whether a market gap could be covered through other instruments such as PCGs. NON BANK FINANCIAL INSTITUTIONS AND CAPITAL MARKETS Leasing â€? Improve the implementation of repossession laws to reduce Immediate the burden on overloaded courts and facilitate the development of leasing of non-movable assets such as machinery. â€? Consider the introduction of a “Deed Registryâ€?, which Short term would enhance certainty for leasing firms by allowing registry of their ownership of leased assets (such as machinery and equipment) and prevent use of such assets by lessors as collateral on other loans. â€? Consider the introduction of a Leasing Act, which would Medium benefit judges, lenders, and customers by defining an term expedited process in the case of default. Factoring â€? Consider temporarily extending the Export Credit Short term Guarantees provided by LGA to cover EU markets following the experience of other Baltic countries, and given a) the importance of these markets for Latvian exports, b) the increased risk of default by European wholesale buyers of Latvian products and, b) the lack of similar instruments provided by commercial trade credit insurers at present. â€? Consider the creation of a “Deed Registryâ€?, for the Short term registration of the receipt and transfer in ownership of accounts receivable. Capital â€? Consider a yearly reporting of capital gains instead of a Short term markets quarterly reporting for investors with small positions. â€? Assess the need to privatize state owned companies and list Medium them on the NASDAQOMX Riga. This may result in term increased appetite from domestic and foreign investors to consider investments in Latvia and the Baltic region and lead to spin-offs like the creation of a Baltic SME fund or a Baltic Exchange Traded Fund. â€? Make increased use of the domestic capital markets for Medium public issuances, with the objective to maintain an active term benchmark curve and market at all maturities. â€? Enforce disclosure regulations and exchange rules. This Medium may increase transparency and confidence of investors and Term thus increase trading activity. One possibility is to establish specialized courts of arbitration. Also training judges may 6    be helpful, to ensure they have the required expertise in corporate and securities law. Pension Funds â€? Restore the contribution rate to the 2nd pillar, among others, Short term to maintain a sizable institutional investors’ base. â€? Revise the investment regulation of pension funds to ensure that the objectives of pension fund managers are aligned Short term with the long-term objectives of contributors. CREDIT MARKET INFRASTRUCTURE Credit â€? Expand the scope and coverage of credit information in the Short term information country to a) include information from non-financial creditors and, b) enable access to commercial creditors to debtors’ relevant credit history with financial institutions. Insolvency â€? Specialize a number of judges in dealing with commercial Immediate framework and insolvency cases and provide judges with higher number of training courses related to commercial law, insolvency and basic financial issues. â€? Enhance procedural rules by: (1) establishing alternative Short term means of notification of enforcement to debtors who cannot be found or whose actual domicile is unknown; and, (2) precluding postponement of court hearings due to frivolous request of the parties (3) reducing auction publication costs and the bailiffs fees scale, in particular for auctions of high value real estate. â€? Amend the housing legislation to facilitate the eviction of Short term tenants and the transfer of possession to buyers of property sold in auction. â€? Reconsider plans to grant priority over all other claims, Short term including secured credits to building administration expenses and debts for heating and natural gas supplied to a homeowner. Payment â€? Consider stimulating the use of e-money instruments by 1) Medium Systems investigating the added value of these instruments for term payments in rural areas; and 2) developing a central bank strategy to increase the availability and use of these instruments. Consumer â€? Consider enhancing the institutional capacity of CRPC to Short term Protection undertake adequate oversight of money lenders â€? Enhance consumer protection trough collection and Immediate publication of APRs charged by moneylenders. Enterprise â€? Undertake an assessment of informality aimed at Short term sector identifying causes and devising strategies or instruments to reduce it as a way to facilitate the development of sustainable cash flow based credit practices. 7    A. FINANCIAL SECTOR DEVELOPMENT AND THE IMPACT OF THE GLOBAL FINANCIAL CRISIS 8. The Latvian economy was severely affected by the global financial crisis. After a period of rapid GDP growth, largely fuelled by domestic demand, GDP contracted by 17.7 percent in 2009 and 0.3 percent in 2010 in the aftermath of the global financial crisis. Pre-crisis rapid credit growth, especially in real estate, was a contributing factor to overheating of the economy, while exports faltered due to loss of competitiveness and slowdown in external demand. 9. Economic growth is expected to be positive in 2011, on the back of regained competitiveness and export growth, but exposure to the Eurozone crisis may affect growth prospects. GDP grew by 5.6 percent in the second quarter of 2011 (as compared to second quarter of 2010), one of the highest growth rates in Europe. GDP growth has been largely supported by increased exports as the ‘internal adjustment’ 2 has enhanced the competitiveness of the country on some industries. A sharp improvement in the current account as well as program support have strengthened international reserves and restored confidence in the quasi currency board and market conditions have enhanced market confidence in Latvia as evidenced by a recent upgrade of the sovereign rating to investment grade. The downside risk to the growth scenario stems from the fact that Latvia is a small open economy vulnerable to a slowdown in the Eurozone – although this is partially offset by diversification of exports to neighboring Lithuania and Russia, as well as Nordic countries and Poland. Other macroeconomic challenges remain, including a relatively high unemployment rate (14.4 percent of the economically active population in 3Q2011) and a sizable shadow economy (see section C below). 10. Credit to the private sector increased rapidly over the last decade, but after the crisis credit growth has been limited. In the pre-crisis years credit increased rapidly, largely fuelled by external financing (including substantial inflows from parent banks and syndicated loans). In turn, much of this credit went to construction, real estate and consumption and led to a high level of leverage in the private sector. After the crisis, credit to the private sector in aggregate basis has been decreasing as a combination of both supply and demand factors. From the supply side, significant de-leveraging by banks has reduced liquidity, while enhanced risk aversion has led to more stringent credit processes. From the demand side, many firms are seeking to reduce liabilities, lowering demand for new credit (see section 19 below). Measures undertaken by financial authorities3 have also contributed to reduce credit growth. In spite of recent reduction in new loans, credit to the private sector stands above 100 percent of GDP, among the highest in the ECA region. 11. The crisis translated into deterioration of banks’ loan portfolios, which remains a major obstacle for resumption of bank lending. As the economy contracted and real estate prices collapsed, banks experienced high levels of non-performing loans (NPLs) from individuals and enterprises. NPLs remain a high proportion of total loans (on average NPLs have been around 18 percent since 2010), even though they have reduced slightly. Banks have strengthened capitalization and increased reserves to cover losses stemming from NPLs. However, recovery rates appear limited, posing a risk of higher- than-expected loan losses, which could go beyond what is currently reserved. Banks appear to actively work out troubled loans but their resolution has so far been both time-consuming4 and costly, while overall recovery seems limited. Moreover, recent reductions in the stock of NPLs are due mainly to                                                          2 ‘Internal adjustment’ refers to the strategy of lowering nominal wages. This means restoring external competitiveness through wage cuts rather than an exchange rate adjustment 3 For example, the FCMC introduced a maximum loan-to-value of 90 percent in residential mortgages a measure to ‘cool down’ credit growth. 4 Banks estimate that enforcement processes take over two years in a simple case. 8    write offs rather than recovery, suggesting limited effectiveness of banks’ work out efforts. Credit recovery teams blame slow judiciary processes and unpredictability of outcome of lawsuits for the slow recovery. Indeed, the judiciary appears overburdened by a much-increased workload and limited institutional capacity (see section VI). Prompt resolution of NPLs will likely require heightened efforts by lenders as well as strengthening the capability of the judiciary. NPLs remain a major obstacle for sustainable resumption of credit and loan losses will likely continue to translate into higher cost of credit and increased risk aversion by lenders (see paragraph 16) and thus warrant close involvement of authorities to eliminate obstacles for resolution. 12. Bank funding base remains reliant on foreign sources, which reduces the sustainability of credit growth going forward and creates a risk of deleveraging. At the end of 2Q2011 loans to residents accounted for more than 200 percent of domestic deposits. This proportion is the highest in the Baltic countries and highlights the high reliance of commercial banks in Latvia on foreign funding, mainly stemming from foreign parents of large commercial banks in Latvia. This poses a risk of deleveraging by foreign parents, which could translate into a continued progressive reduction in credit5. Up until now this risk appears somewhat mitigated by the fact that foreign parents have demonstrated a significant commitment to their subsidiaries in Latvia (as evidenced by cash injections and liquidity support in the aftermath of the crisis). Scandinavian banks state that Latvia and the rest of the Baltic States are core markets for Nordic banks. This highlights the need for Latvia’s financial authorities to assess the risk of deleveraging and collaborate with authorities in the other Baltic states and counterparts in home countries to minimize the risk of deleveraging by foreign banks, and with European authorities to ensure that the risk of deleveraging is adequately considered when reviewing capital adequacy requirements for European banks. Also, the Latvian authorities could consider the appropriateness of implementing measures aimed at encouraging banks to gradually expand their funding to local sources such as local bond markets. The authorities are also encouraged to monitor closely the evolution of the loan-to-deposit ratio and promote progressive reduction through increase reliance on local funding sources. 13. Domestic deposits have been relatively stable after falling sharply at the onset of the 2009 crisis, as depositors’ confidence in the banking system returned, even though events at the end of 2011 tested their resilience. Resident deposits in Latvia have proved relatively resilient throughout the crisis, but the composition has changed towards shorter maturities. However, a sizable 41 percent of total deposits are from non-resident, which are volatile and short-term and thus unsuitable as funding for credit. The behavior of residents’ private deposits shows significant degree of confidence in the banking system. The enhancement of the deposit insurance – whose coverage increased from 50 thousand to 100 thousand per depositor - has likely contributed to strengthen confidence. The collapse of Latvijas Kraijbanka6 in November 2011 did not immediately translate into large deposit withdrawals throughout the banking system. However by the end of November 2011 household deposits decreased by 8.3 percent (compared to 2Q2011). A prompt and efficient implementation of the deposit insurance will be essential to maintain depositors’ confidence. 14. However, deposits alone are insufficient to finance lending, and thus local bond markets should be better utilized to reduce dependence on foreign funding. Financing through domestic bonds remain limited: indeed, no new bonds have been issued by banks since 2009 and the level of bank bonds outstanding is marginal, even though there are no regulatory or infrastructure obstacles to the development of local bond markets. The relative inactivity in local bond markets seems to stem mainly from cost considerations (where foreign funding is cheaper than local debt issuance) and the                                                          5 In the wake of the current crisis in the Euro zone, some Western European banks have announced plans to reduce their operations in selected non-core markets in Eastern Europe. 6 Latvijas Kraijbanka, a small local bank was intervened in November 2011 following allegations of fraud leading to insufficiency of funds. The bank’s operations were formally suspended on November 21st and authorities expected to start payment of deposits (up to the deposit insurance limit) on November 29th. 9    currently high liquidity in the banking sector (thereby reducing the need for additional financing). As part of prudential measures aimed at decreasing the loan to deposit ratio, the FCMC could consider encouraging banks to issue bonds in the local capital markets to reduce dependence on foreign funding. The commitment of the authorities to preserve the sustainability of the multipillar pension system and to restore the contribution rate to second pillar to 6 percent of salaries by 2013, provided improvements in the fiscal budget, will be very important to maintain an adequate investors’ base in Latvia. B. COMPOSITION OF THE FINANCIAL SECTOR IN LATVIA 14. The financial sector in Latvia is dominated by commercial banks with a strong presence of foreign banks. Commercial banks account for almost 90 percent of the financial sector’s assets in Latvia, while non-bank financial institutions remain limited in their scope and presence. In aggregate, subsidiaries and branches of foreign banks account for 59.1 percent of total assets in the sector. This concentration is even higher in terms of loans (above 70 percent). Table 1. Composition of the financial sector (Sept 2011) Assets Assets % of Total Number (LVL m) (USD m) Commercial Banks 17,964 34,133 76.8 22 Private 15,031 28,560 64.2 19 Domestic 3,954 7,513 16.9 8 Foreign 11,077 21,047 47.3 11 State-owned 2,933 5,573 12.5 3 Branches of foreign banks 2,755 5,235 11.8 9 Non-Bank Financial Institutions 2,687 5,105 11.5 172 Credit Unions 13 25 0.1 33 Leasing companies* 1,058 2,010 4.5 23 Electronic Money Institutions* 5 10 0 7 Securities companies 0 Securities brokerage companies 3 6 0 6 Investment management companies 19 36 0.1 16 Investment funds 244 464 1 41 Insurance companies (life and non-life) 371 705 1.6 12 Pension funds (Tier III) 117 222 0.5 7 State funded pension scheme (Tier II) 857 1,628 3.7 27 TOTAL 23,406 44,473 100 203 Source: FCMC 15. Non-bank financial institutions (NBFIs) are small but offer opportunities for enhanced financing to the private sector. Overall, NBFIs account for 11 percent of total financial sectors assets, with aggregate assets of LVL 2.7 billion in September 2011. This includes both entities providing financing to the private sector (such as leasing, factoring and credit unions, which in aggregate accounted for less than 5 percent of total financial sector’s assets in 2011, down from 7.5 percent in 2007), as well as institutional investors such as insurance companies and pension funds with an increasing volume of assets, which so far have not been a major source of financing to the private sector. Leasing and factoring volumes decreased substantially as a consequence of the crisis, although the potential demand for these products is still significant and appears to surpass the supply. Credit Unions, while numerous, have traditionally had a very limited participation in the financial sector and account for 0.1 percent of total sector’s assets (see section II). 10    C. OVERVIEW OF THE CORPORATE SECTOR 16. Latvia’s corporate sector is highly pyramidal and concentrated in manufacturing and transport. At the top of the spectrum, there are only almost 200 large-sized enterprises, representing only 0.3 percent of the formal companies but employing 22 percent of the workforce and generating 23 percent of total turnover. In the middle segment, 10,000 SMEs play an important role, accounting for only 14 percent of the number of formally registered firms, but generating about 57 percent of total turnover. Micro firms (1 to 9 employees) account for the vast majority of the firms (85.7 percent) and contribute to 20 percent of corporate sales. 17. The number of micro enterprises has increased rapidly after the crisis as a consequence of unemployment. The number of micro firms grew by a cumulative rate of 19 percent between 2005- 2011. In terms of economic activities, 31 percent of micro-firms, and 46.8 percent of SMEs’ activities are in the manufacturing sector, 24 percent and 23 percent in the transport sector respectively. According to views of banks interviewed during the mission, a considerable proportion of these enterprises are subsistence businesses. Accordingly, many commercial lenders treat this market segment as lending to individuals rather than enterprises, focusing on owner’s guarantees and collateral as basis for credit decisions and offering only short-term high cost credit products such as overdrafts. Most mainstream commercial lenders have not developed financial products adequate to the rapidly growing micro enterprise sector. 18. The enterprise sector is highly leveraged. After rapid credit growth before the crisis, the corporate sector in Latvia accumulated a significant volume of debt. While there has been some de- leveraging after the crisis, the overall stock of liabilities in the aggregate enterprises sector remain high. Accordingly, the demand for new credit in the economy as a whole decreased, with the exception of some economic sectors that have experienced growth.  19. While enterprises focusing on the domestic market have been deleveraging, SMEs in export-led sectors are more in demand of credit, reflecting higher growth prospects in exports. Sectors with the most growth potential since the 2008 financial crisis with active SMEs are export-led sectors in manufacturing (forestry products, metal works and food processing) and services (transportation services, air traffic, trade in financial services, trade in IT services). Growth projections of SMEs focused on the domestic market are more modest. However, there are signs that export firms, in particular manufacturing firms, are reaching full capacity. Utilization of capital in wood products and food processing manufacturing has approached historical heights. Unless these firms invest in new productive capacity, this could translate into losses of competitiveness in the future and pose additional risks to the growth prospects of the Latvian economy. 20. The level of investments in the private sector has remained low. Demand for new lending has remained low, as firms seek to pay out their debt following the crisis. This has resulted in de- leveraging in the banking sector, after high debt equity ratios in 2008. Investment levels have decreased by half since the financial crisis, a much more acute phenomenon than in the rest of Europe The investment environment has been affected by low levels of domestic and foreign demand, as well as high manufacturing capacity load. 21. Informality in the enterprise sector in Latvia may affect firms’ access to finance. According to estimations by the Ministry of Economy, shadow economy accounts for as much as 23 percent of GDP. The recent introduction of a simplified and affordable tax regime for micro enterprises may help to reduce under-reporting for tax purposes, but other factors may be at play creating incentives for informality. A formal assessment and identification of the causes of informality seems 11    warranted to inform potential policy solutions. From a financing perspective, informality affects significantly the accessibility to credit by enterprises, hampering the possibility for lenders to use cash flow-based credit analysis and enhancing their reliance in suboptimal collateral-based lending practices. The FCMC requires banks to base their credit decisions on officially reported financial figures, which often present firms as less credit-worthy. 22. Overall, the business environment in Latvia is conducive and indicators of the accessibility of financial services are positive. Latvia was ranked the twenty-first best jurisdiction worldwide under the 2012 Doing Business rankings and fourth under the ‘Getting Credit’, comparing favorably with ECA and OECD countries on all indicators with the exception of the existence of a private credit bureau (this is discussed further in section VII). This highlights the efforts of authorities toward improvement of the regulatory environment and reduction of administrative barriers for enterprises. In particular, procedures for registration of new firms are easy and affordable. However, as mentioned above, in spite of this the levels of informality of firms appear higher than those of jurisdictions with less propitious business environment. Access to finance became a more important obstacle for enterprise growth after the 2009 crisis. In 2009, 28 percent of firms surveyed7 identified access to finance as a major constraint, a more than tenfold increase compared to 2005 (2.5 percent) and the highest proportion in the Baltic region. While these figures reflect the situation in the immediate aftermath of the crisis, more recent firm-level data shows that a significant proportion of firms are still unsuccessful to access bank loans. This apparent paradox – the indication by firms of access to finance as a constraint on one hand, and on the other hand a reduced demand for credit as many firms are de-leveraging - can be explained by a number of factors: (i) while on average firms are highly leveraged, there are segments of the economy that are in need of further financing, in particular export and micro firms; ii) access to finance refers not only to availability of loans, but also to ensuring that the financial instruments provided by banks to enterprises are adequate (e.g. local currency loans for non-exporting firms, long tenors to facilitate investment) and that non-loan financial products are also available (leasing / factoring). These factors are discussed in more detail subsequent paragraphs.   15. Most SMEs in Latvia have a savings or checking account, indicating that bank penetration is high. As of 2010, the share of SMEs with a checking or saving account is 99.5 percent and other indicators on access to financial services are well in line with those observed in the region. Bank accounts can provide access to a range of financial services for SMEs, including payments, cash management, deposit facilities, and cheques. D. SUPPLY OF SME BANKING 16. The banking sector has displayed strong risk aversion following the crisis, which has had a negative impact on the availability of SME credit. Banks have shown low appetite for risk, translated into higher guarantees required by credit committees. In addition the provisioning due to high NPLs has been impacting the cost of credit and the length of available credit has been more conservative. Indeed, while the interest rates overall have decreased significantly after the crisis, the spread between passive and active interest rates (0.6 and 9.5 percent respectively) is the highest of the last decade. Loans granted by banks are typically based on variable rates indexed on the 6-months Euribor (mainly) or Libor plus a spread. 17. Given the structure of the Latvian economy, SMEs are core borrowing clients. The corporate and SME lending markets have been highly competitive. Many Latvian banks have an SME strategy and intend to increase the share of lending to this segment. Banks in Latvia focusing on the                                                          7 Business Environment Enterprise Surveys (BEEPS) www.enterprisesurveys.org 12    SME segment are primarily driven by economic opportunities in the export-led SME sector. The four banks surveyed by the team, which together represent half of banks’ market share have on average over 25 percent share of their loan portfolio in SME loans, and have an objective of increasing this business segment. SME banking portfolios have been on the rise since the beginning of the year. As opposed to this, lending to micro enterprises has been constantly decreasing since 2009. 18. Despite the growth prospects of the SME segment, not all banks have dedicated SME units with credit appraisal, client relationship managers and collection teams dedicated to this market segment. SME clients are served within the banks’ corporate departments, while microenterprise clients are in their retail activities. Foreign-owned Latvian banks (which account for more than 60 percent of the banking system) are generally using modern SME lending models from their parents companies. But the percentage of staff dedicated to SME clients is far below the share of SME banking in the banks’ portfolio. In addition, few banks use internal credit scoring models for SME banking and products and loan applications are generally not differentiated between corporate and SME clients. 19. After the crisis, banks’ lending technologies have reverted to heavier reliance on collateral-based lending. Banks cite transparency (lack of reliable or available information) as the primary reason for high loan to value collateral requirements for SMEs and micro enterprises, followed by smaller firms being perceived as less stable and with less competent management than larger corporate firms. In the absence of an encompassing credit bureau, banks rely on a number of registries8 and a credit registry with information from registered financial institutions. In addition to fixed asset collateral requirements, personal guarantees are the norm to obtain a loan. 20. Bank loans are mostly of a short maturity. Loan facilities currently typically extend to a maximum of 6 years. This is a constraint for investment growth in some industries, notably the manufacturing sector which is operating at maximum capacity and therefore in need of investment. This market gap can be addressed via government support programs aimed at incentivizing commercial lenders to enter underserved market segments such as long term financing, as discussed in section VI. 21. Access to credit is the hardest for microenterprises. Bank credit to microenterprises has declined constantly over the past years from 47 percent of total credit 9 in 2009 to 34 percent in 2Q2011. Despite the fact that various programs have been put in place to foster credit to this market segment, many commercial banks expressed limited strategic interest in this microenterprises, suggesting further decline going forward. This appears to be due to a combination of a number of factors, including a) lack of expertise and products to serve this market; b) lack of sufficient reliable information on micro enterprises to enable banks to assess creditworthiness; and c) limited availability of collateral. Usual lenders to this sector, such as microfinance institutions are not present in Latvia. To enable enhanced access to finance by micro enterprises, the government can consider reviewing the government support programs (section VI) and strengthening the credit information (section VII). II. FINANCING INSTRUMENTS FROM NON-BANK FINANCIAL INSTITUTIONS 22. NBFI’s such as factoring and leasing are underdeveloped and present a significant growth potential. Before the financial crisis, high bank competition and relatively inexpensive bank credit reduced the demand for alternative products; however, in the current environment, the                                                          8 Companies Registry, Credit Registry (Bank of Latvia), Registry of VAT payers 9 This proportion of bank credit to micro enterprises is likely overstated as many banks use a different classification for size of enterprises, which consider as micro enterprises many firms that would fall under the category of SMEs under the official definition used by authorities. Accordingly, the proportion of bank credit to micro enterprise sector is likely significantly lower. 13    development of these markets could provide additional sources of financing that respond to the financing needs (both in terms of investment and working capital) of firms in Latvia. A. FACTORING 23. The factoring industry in Latvia collapsed after the crisis, in spite of a raising demand from Latvian exporters. Factoring turnover in Latvia in 2010 was approximately EUR 328 million across eight lenders (the leading player is Swedbank, with about 25 percent of the market), a drop of 72 percent from 2007. This compares in 2010 to about EUR 1.5 billion in factoring turnover in Lithuania and EUR 1.2 billion in Estonia. Further, only EUR 93 million (less than 30 percent of total factoring) in Latvia in 2010 was offered without recourse, a much lower figure than that observed in other Baltic countries (EUR 950 million in Lithuania and EUR 235 million in Estonia). Additionally, only one bank in Latvia is a member of “Factor Chain Internationalâ€? an association of factoring firms that facilitates cross-border factoring. Market participants met during the mission highlighted the fact that this drastic reduction in the factoring market in Latvia resulted from a reduction in supply, as demand has remained and even increased as exports have grown and the risk of default by clients in Europe increases as a consequence of the crisis in the Eurozone.   24. The greatest challenge to factoring is the cost and difficulty in receiving commercial credit insurance. Domestic and international factoring without recourse to the seller generally requires commercial credit insurance (also known as “trade credit insuranceâ€?) as a way to protect lenders from the risk of the buyer’s default. During the crisis, international credit insurance providers (such as COFACE, Euler-Hermes and Atradius) refused to insure sellers in Latvia following large losses in trade credit insurance throughout Europe.10 According to market participants, because of the continued slow economic growth, at the present time only COFACE (one of the large credit insurance providers) has returned to the Latvian market, albeit on a very limited basis. Accordingly, the cost and availability of commercial credit insurance remain a challenge to the growth of factoring. 25. The legal framework in Latvia does not pose challenges to the development of factoring, but the authorities could promote the development of factoring through various actions, including the a) establishment of a registry of receivables to reduce the potential for fraud, b) inception of a system of ‘reverse factoring’; c) exploring the possibility to extend export credit guarantees to European markets; e) facilitating the creation of an independent export credit guarantee agency. B. LEASING 26. The leasing industry in Latvia is small, following a sharp decline during the financial crisis. New financial and operational leasing in Latvia amounted to EUR 272 million11 of new funding. This reflects a drop of 85 percent from EUR 1,808 million in new leasing in 2007. This compares with EUR 443 million in Estonia in 2010. 27. Deficiencies in the legal framework appear to restrict the development of the leasing industry. These include the requirement of a court order to remove assets from private property (see Chapter VIII for additional discussion), which make particularly difficult and time consuming the foreclosure of leased machinery. A Leasing Act would benefit judges, lenders, and customers by defining an expedited process in the case of default. 28. In addition, a “Deed Registryâ€? would protect lenders and can lead to greater leasing volumes. There is currently no way to register the ownership of movable assets such as machinery and                                                          10 Private export insurance declined throughout the region. For example, Lithuanian authorities reported that the supply of credit insurance dropped by about 40% in 2009. 11 Leaseurope (2010) 14    equipment (except vehicles). This allows firms to unduly use leased assets as collateral. A registry of “deedsâ€? of assets can reduce risks to lessors, thereby potentially enhancing accessibility and affordability of leasing. C. CREDIT UNIONS 29. Credit Unions have a very limited scope within the Latvian financial sector. Under the 2002 Credit Union Law, credit unions are licensed, regulated and supervised by FCMC. Credit unions can receive deposits from and grant loans to its members only. With assets accounting for only 0.1 percent of total financial sector’s assets, Credit Unions have only a marginal contribution to credit to the private sector. At the present time there are 33 licensed credit unions in Latvia, with some 25,194 members12. Credit unions seem to be well-established in rural areas, mostly focused on housing and car loans, with some participation on financing of productive activities in agribusiness, retail and manufacturing; with loans averaging around 2000 LVL. 30. The scope of Credit Union’s operations and potential for expansion is limited by the fact that they can provide credit only to individuals. Credit Unions can receive deposits and grant loans to their individual members only – credit unions cannot service legal persons. In turn, membership is limited to a shared characteristic such as geography or economic activity. Under the current regulatory environment, expansion of the scope of their activities beyond the above-mentioned parameters would require a full banking license and subject the credit unions to the banks’ significantly more stringent regulatory framework13. They would also have to significantly enhance their risk management practices and credit processes. 31. However, due to the focus of their operations, Credit Unions could have a better ability than commercial banks to serve the growing number of micro-entrepreneurs. As mentioned above, microenterprises are both the most rapidly growing segment of the economy (in terms of number) as well as the most credit-constrained, while most commercial banks do not have the products or strategic interest in this market segment. From that perspective, credit unions could have a more prominent role in financing micro-entrepreneurs. However, an expansion of their activities, beyond servicing members, should however come with enhanced supervision too. III. CAPITAL MARKETS 32. Medium to large enterprises in Latvia finance themselves mainly through bank loans and banks mainly through parent funding rather than through the capital market. Companies seeking finance have the opportunity to raise capital on the NASDAQOMX Riga or issue corporate bonds, but few companies use these instruments. At the same time, the availability of parent funding appears to have reduced incentives for commercial banks to tap local bond markets. 33. The stock market infrastructure is well developed but the stock exchange lacks critical mass. The NasdaqOMX Riga has formed an alliance with the other Baltic stock exchanges of Tallinn and Vilnius. Together the stock exchanges offer a harmonized and cost-effective package of listing, trading, clearing, settlement and data services for investing in Baltic companies. The Baltic stock exchanges are part of the NasdaqOMX group, with which they share a harmonized set of rules and a fully electronic, efficient trading and clearing platform. The NASDAQ OMX Riga has implemented all possible best practices as applied internationally for SME stock markets. However, despite these efforts the number of listed SME companies and the market liquidity are very low.                                                          12 According to data from WOCCU as of 2010. 13 Due to these restrictions credit unions have been exempted from the scope of the EU banking directives. 15    34. The main reasons for the lack of liquidity are the absence of large private companies operating on the Latvian market, an insufficiently large investor community willing to invest in smaller companies. Large private stocks have all been bought by strategic investors in the past. While institutional investors such as pension funds are willing to invest a part of their assets in stocks, the sizes of the listed companies are often too small to justify costs associated with investment (such as due diligence) by large institutional investors. Accordingly only a couple of hundred individual investors are active on the stock exchange. 35. As buy and hold investors, pension funds can be an important source of financing for the domestic capital market. The institutional investor base in Latvia consists of insurance companies, state pension funds (tier 2) and private pension funds (tier 3). The state pension funds are the largest players with 27 funds and assets under management of LVL 857 million. There are 12 insurance companies (both life and non-life) with assets of LVL 371 million and 7 private pension funds with assets of LVL 117 million. The commitment of the authorities to preserve the sustainability of the multipillar pension system and to restore the contribution rate to second pillar to 6 percent of salaries by 2013, provided improvements in the fiscal budget, will be very important to maintain an adequate investors’ base in Latvia. 36. However, the current regulatory framework for pension funds creates excessive emphasis on short-term returns. While the objectives of pension funds are to maximize the long-term replacement rate of contributors, the existence of strong competition among pension fund managers in the presence of marked-to-market portfolio valuation creates a bias to search for investments with short-term horizons. As a result, Latvian pension funds returns are among the lowest in the region. Improvements in the regulatory framework of pension funds to align the interest of pension fund managers with the long-term objectives of contributors will support the development of the domestic capital market. This can take a variety of forms, from a very ambitious project as aimed at creating a common benchmark for the investments of pension funds, as is being considered in Lithuania, to a more narrow but effective approach, such as requiring a minimum duration for the fixed income portfolio of pension funds. 37. Other actions can also enhance the volume of operations and liquidity in the capital market. This includes a) the privatization state owned companies (which would however require that the corporate governance and transparency of state-owned companies be strengthened first); b) allowing the NASDAQOMX Riga to settle in euro14; c) introduction of a yearly reporting of capital instead of a quarterly reporting for investors with small positions; d) improving the enforcement of corporate and securities laws so as to strengthen the credibility of the Riga stock exchange with issuers and investors through specialized courts of arbitration; and e) in the longer term consider further integration of NASDAQOMX Riga with the other Baltic markets or eventually with NasdaqOMX Nordic. 38. Venture Capital activity in Latvia is very limited in spite of programs aimed at fostering the development of equity financing. The total Private Equity activity in Latvia in 2010 amounted to 5.9 million EUR, of which venture capital activity represented only EUR 206 thousand15. These figures highlight the limited scope of private equity in the country, in spite of the fact that there have been significant government initiatives to foster the development of these instruments through professional private investment funds. The mission did not identify specific regulatory obstacles constraining the development of private equity in Latvia, and the low uptake of the funds is due largely to exogenous factors restricting the demand for equity financing, such as the availability of bank financing to                                                          14 Currently, trading takes place in LVL, which may expose investors to currency risk. The other Baltic stock exchanges settle in euro. Estonia had adopted the euro and the central bank of Lithuania allows euro settlement since last year. 15 “Central and Eastern Europe Statistics 2010â€? European Venture Capital and Private Equity Association 16    potential target companies, limited knowledge of equity financing instruments among local entrepreneurs, and in general a limited pool of target enterprises. Accordingly, increasing funding to equity programs will likely have a limited impact. IV. GOVERNMENT SUPPORT PROGRAMS 39. The Government of Latvia offers a wide range of government support programs to support financing to enterprises under various institutions. This includes direct lending, credit guarantees and equity instruments. These programs are managed by four pubic institutions (Mortgage and Land Bank of Latvia (MLBL); Latvian Guarantee Agency (LGA), Rural Development Fund and Latvian Environmental Investment Fund) as well as private fund managers. In addition, the Investment and Development Agency of Latvia (LIAA) provides grants for investment and technical assistance16. Most of these programs are focused on supporting manufacturing firms with a particular emphasis on export-oriented activities. 40. It is important to undertake a formal monitoring and evaluation of support instruments. A formal monitoring and evaluation framework will be necessary to ensure efficiency in the allocation of public support. Such framework should include, among other areas, a) a clear identification of the market gaps or market deficiencies that the programs are aiming to address; b) an assessment of the additionality of support programs; c) an assessment of the effectiveness of the support programs in reducing the market gaps targeted, and; d) impact of support programs on companies benefiting from support. In turn, such assessment should facilitate refinement or redesign of support instruments. 41. Going forward, rationalization of these instruments under a unified development agency will be essential to ensure effectiveness. Consolidation of the support programs under various agencies can help to avoid potential overlap of instruments and ensure effectiveness in the use of support funds. At the same time, it will be important to review the design of support instruments to ensure they are focused on underserved market segments, avoiding competition with commercial lenders and leading to sustainable credit practices. Partial Credit Guarantees (PCGs) are considered one of the more market-friendly types of public sector intervention and can create incentives for private lenders to focus on underserved markets, supporting access to finance for creditworthy firms when such access is constrained by insufficient market liquidity and collateral. PCGs can generate fewer market distortions compared to other policy interventions, such as directed lending programs or state banks, because they can entail less interference in credit allocation and use banks as the main vehicles for loan origination. By backstopping lenders on a partial basis and risk-sharing basis, public funds can mobilize a large additional banking portfolio. 42. Introduction of PCG schemes can improve the delivery mechanism to reduce costs and approval time. Guarantees can be delivered though individual, hybrid or portfolio approaches, with a decreasing intensity of analysis and approval processes respectively. At the present time LGA follows an individual approach, which is suitable for relatively large exposures. As the guarantees target smaller borrowers it will be important to consider the introduction of hybrid approach (which requires extensive underwriting processes for larger exposures and streamlined underwriting for smaller ones) and portfolio approaches (in which participating banks are allowed to extend guarantees for eligible borrowers without consulting the guarantee scheme). 43. Microenterprises appear to be an underserved market that may merit consideration for potential programs to enhance access to finance in commercial terms. Credit to microenterprises seems limited due to a range of factors ranging from lack of strategic interest by lenders to deficiencies                                                          16 Grants for investment under LIAA are provided on a refund basis, after the investment has been undertaken by the enterprise and as such are not considered to enhance access to financing. 17    in credit information and lack of collateral. Credit information can be enhanced through the introduction of private credit bureaus. Instruments such as portfolio credit guarantees may reduce some of the risks identified by banks and provide additional comfort to those lenders that consider these market segments as targets for expansion. At the same time, supporting sustainable credit growth by non-bank lenders that target micro enterprises (such as Credit Unions) should be considered, identifying and addressing the constraints faced by these lenders. However, the eligibility criteria of participating financial intermediaries should be clear and stringent in order to ensure participating lenders are robust and adequately supervised by financial authorities.  44. Partial credit guarantee schemes should have a transitory nature, aiming at ensuring long-term sustainability of credit. These programs should be implemented for a defined period of time and with a certain amount of capital. As such, these programs should aim at addressing an identified market gap, but also creating incentives for commercial financial intermediaries to serve such market segments in a sustainable way (for example by developing or adapting their credit processes to those market segments) even after the programs are terminated. V. CREDIT INFORMATION 45. The existing public credit information registry at the Bank of Latvia is widely used by the industry. According to the 2012 Doing Business Report, Latvia’s public registry covers 59.7 percent of adults, well above the regional average of 16.2 percent and the OECD average of 9.5 percent. The public credit registry is maintained by the Payment Systems Department of the Bank of Latvia and presently captures information from credit institutions registered in the country. The credit registry includes positive and negative information on all loans and without a minimum loan size. 46. However, the credit registry was not designed as a credit bureau and accordingly does not capture information from, nor provides access to, non-financial consumer service providers and other commercial creditors. The credit registry was created mainly for supervision purposes; accordingly it does not capture information usually covered by credit bureaus, such as commercial creditors (including utilities and commercial non-licensed lenders) nor provides access to credit information to such commercial creditors. Similarly it does not provide credit-scoring services usually used by bank and non-bank lenders in their credit decisions. Latvia is one of the few countries in the ECA region and the only one of the Baltic States without credit information provided by credit bureaus and this has been recognized as a constraint to access to finance to entrepreneurs in the Doing Business rankings. Expanding the scope and coverage of credit information in Latvia can be done through expansion of the mandate of the existing credit registry or through further enabling the operations of private credit bureaus. Enhancing the scope and coverage of credit information in the country can be done through i) expansion of the mandate and activities of the existing credit registry, in line with the scope of service undertaken by credit bureaus, as well as ii) enabling the activities of private credit bureaus in the country through facilitating access to credit information from financial institutions. Similarly, integration of existing databases such as tax arrears, judgments and insolvency proceedings can help to enhance the depth of information available to creditors, thereby facilitating credit decisions. VI. LEGAL FRAMEWORK FOR CREDITOR RIGHTS AND INSOLVENCY 47. The legislation governing the creation and priority of security over both immovable and movable assets is largely adequate. The law includes clear rules for granting security interests over 18    land to guarantee all type of obligations (including future obligations) to all type of creditors. Any types of business debts can also be secured by personal (movable) property. Foreign owned entities may be guarantors or beneficiaries of security interests over movable or immovable assets. Rules of priority concerning competing claims or interests in the same asset, according to the date of registration of the secured transaction, are consistently applied. Secured creditors enjoy the highest priority vis-à- vis unsecured (privileged and ordinary) creditors. However, a proposal to grant priority (over all other claims, including secured credits) to building administration expenses and debts for heating and natural gas supplied to a homeowner could produce a negative impact on the cost of mortgage lending. 48. The registration system concerning property rights and secured transactions is reliable and cost-effective. All the information concerning land registration is computerized and centralized and registration of a mortgage is fast (taking less than a week) and has a low cost at 0.1 per cent of the loan amount and no more than 1000 LVL (approximately USD 2,000). All country information is kept electronically and is accessible on-line. Commercial pledges are registered in the Commercial Pledge Register through a simple process taking approximately three days and with a cost of 25 LVL (approximately USD 50). All registered information is computerized and publicly available; searching is possible by debtors or by assets and the cost of a search is also moderate: 2 LVL (approximately USD 4). 49. Recent amendments have improved the legal framework for mortgage foreclosure. Pledges are usually enforced with neither court nor bailiff involvement whereas mortgages require court intervention and auction sales conducted by a bailiff. A number of legal reforms have streamlined mortgage foreclosure, namely: (1) Reducing the number of legally required auctions from three to two in cases where there are no bidders; (2) Allowing the winning bidder at a foreclosure auction to obtain a bank guarantee letter to facilitate the simultaneous payment of the auctioned property, transfer of title, and vesting of the first priority security interest with the bank; (3) Entitling the bailiff to evaluate whether or not the V.A.T should be applied in each particular auction; and, (4) Eliminating the bailiff obligation to notifiy all the debtor’s co-owners before an auction, which complicated and increased the cost of auction of apartments in buildings with many units. 50. However, the court system is overloaded with civil cases of debt enforcement. The debt and damages recovery claims filed in 2008 almost tripled the previous two years’ filings. The flow of new cases has also been high in recent years, and continued being elevated in the first half of 2011. After 2008 the courts have increased significantly their productivity (evaluated by the number of heard cases), but the judiciary effort could not keep pace with the flow of new filings and the backlog of pending cases is still growing. The number of pending cases, which was 4,053 at the beginning of 2007, has increased to 20,839 as of June 2011. A new procedure for small claims (below LVL 1500, approximately USD 3,000) has been recently implemented to alleviate the courts backlog. 51. Further measures could still make commercial enforcement more effective, namely: (1) Modifying the procedural rules for notification of enforcement to debtors in person or through a bailiff; (2) Reducing or eliminating postponement of court hearings due to frivolous request of the parties, which is an unsound but rather frequent procedural practice; (3) Amending the housing legislation in order to facilitate the eviction of tenants and the transfer of possession to buyers of property sold in auction; (4) Reducing auction publication costs and the bailiffs fees scale, in particular for auctions of high value real estate (currently, 3 per cent of the recovered amount); (5) Specializing some judges for dealing with commercial and insolvency cases to improve the effectiveness and efficiency of the judicial service; and, (6) Providing judges with higher number of training courses related with commercial law, insolvency and basic financial issues. 52. The insolvency system for both legal entities and individuals has been significantly amended in 2008 and 2010, but old legislation still applies to cases initiated before November 19    2010, which complicates the effective administration of many insolvency proceedings. Accelerating the transition to the new legal system can reduce uncertainty for parties involved in insolvency procedures. 53. The effectiveness of insolvency liquidation proceedings is improving. Liquidation of legal entities doubled in 2009 and 2010, but new filings have been diminishing since November 2010. The flow of liquidation cases initiated has steadily increased since April 2008 hitting the highest point in October 2010. As result of that trend, 2,583 liquidation cases have been initiated in 2009 and 2,505 in 2010 –the highest number of initiated liquidation proceedings since 1996. After the latest amendments to the insolvency legislation entered into force in November 1, 2010, the number of initiated liquidations significantly diminished. This decline could signal that the worst stage of the crisis has already passed for legal entities. It could also be revealing some difficulties to get access to liquidation under the new rules. The liquidation process seems to be working faster than in the past and a number of liquidation cases have been completed in 7-8 months. Administrative expenses have been reduced from (average) 15 per cent to 9 per cent of the assets realization proceeds. 54. The use of natural person insolvency proceedings has been steadily growing since 2008 and the flow of new cases is still increasing. After November 2010 the flow of cases significantly increased. Also the ratio cases initiated / cases declared is high: almost 80 per cent of cases filed have been commenced by the court. The new system adopted a rather friendly approach for consumers and improved the availability of the proceeding reducing its access cost. These circumstances would explain the success of the amendments introduced to the natural person insolvency proceedings in 2010. 55. Debt restructuring is typically done out-of-court and not using the insolvency law formal reorganization proceedings. Legal Protection Proceedings (LPP) are not extensively used and although utilization of Out-of-court Legal Protection Proceedings (OCLPP) has been somewhat higher before the latest amendments to the insolvency law, most non-performing loans have been or are under out-of-court restructuring. In 2009, the Latvian authorities issued principles and guidelines for out-of- court workouts (“Principlesâ€?) and, more recently, implemented several amendments to the tax legislation to facilitate debt restructuring. The Principles have been successfully used in many out-of- court debt restructurings and regarded positively by the financial community. According to bank sources, 20 percent of all loans have been or are under out-of-court restructuring, and in 90 percent of those cases the Principles have been used. The debtors and their professional advisors, however, seem to be less aware of the potential benefits of out-of-court debt restructuring using the Principles. Dissemination of successful examples of debt restructuring using the Principles could contribute to further expanding its use. 56. Drastic debt restructuring measures have not been widely applied yet. In most cases, workouts have just implemented short-term relief such as 6 months grace periods, reduction of penalties, modification of interest rates, partial capitalization of interests, and rescheduling of principal payments. In some business cases, however, more stringent restructuring measures have been used, including debt-to-equity swaps and business restructuring (shutting down unproductive units or selling not needed assets), but principal haircuts are still very rare in Latvian out-of-court debt restructurings. VII. FINANCIAL CONSUMER PROTECTION 57. Financial Consumer Protection has considerably improved since the FSAP of 2007. Specifically, consumer protection arrangements have been implemented between FCMC and Latvia’s Consumer Rights Protection Center (CRPC) on regular sharing of received complaints and inquiries and use of them for policy development. Consumer information requirements and information disclosure by financial intermediaries have also been strengthened in line with EU regulations. However, while dispute resolution is expected to improve thanks to the adoption of EU resolutions on 20    Consumer Disputes and Complaints Considerations, Latvia is still in need of an effective alternative resolution mechanism for disputes related to financial services. In 2011, CRPC has received several complaints related to high personal guarantees requested by banks as collateral for new loans. 58. The rapid growth of non-bank moneylenders focused on consumer credit may pose challenges to the institutional capacity of the CRPC. There is a nascent but rapidly growing segment of independent moneylenders focused on consumer credit in Latvia. So far this industry cannot be quantified as no formal figures are collected on volume or loans or scope of operations. As of November 1st, the CRPC has been mandated to license these lenders. While the cost of license is relatively high (LVL50,000), at the time of the mission around 40 moneylenders had applied for a license. Enhancing the institutional capacity of CRPC in line with its enhanced mandate will be necessary to ensure adequate undertaking its role with respect to this market segment. 59. CRPC can have a major contribution in consumer protection for consumer credit through development of information. While authorities do not have the mandate to place caps on interest rates charged, the CRPC can enhance the ability of borrowers to understand the implications of financial products by collecting on a regular basis the cost of credit (APRs) charged by all lenders and publishing this information though channels that are easily accessible by low-income borrowers. VIII. PAYMENT SYSTEMS 60. The national payment system is well developed. The national payment system consists of the BoJ interbank payment system (SAMS), the electronic clearing system (EKS), TARGET2-Latvija, First Data Latvia (FDL), Latvija Pasts, Itella Information, the Latvian Central Depository (LCD) and various retail payment instruments. SAMS is the only systemically important payment system. Transactions processed included 193,000 payments with a value of LVL166 billion in 2010 (more than 13 times GDP). BoL is the operator of the SAMS, the EKS and TARGET2-Latvija. 61. The payment systems in Latvia in general comply with international standards and best practices. The large value payment systems SAMS and TARGET2-Latvija comply with the Core Principles for Systemically Important Payment Systems. The EKS is the largest retail payment system in Latvia and also complies with international standards. In addition to the EKS other retail payment systems are FDL, Latvijas Pasts and Itella Information, which handle smaller volumes. Credit transfers and cards are the dominant payment instruments in Latvia and their penetration is high. Of all terminal transactions 33 percent are ATM transactions and 64 percent are POS transactions. The percentage of ATM transactions is decreasing, whereas the share of POS transactions is increasing, which may indicate a shift from cash payment to electronic payments. The Oversight department of the BoL is well established and is considered effective. 62. Arrangements to reducing counterparty credit risk can be considered. This includes the calculation of the potential losses of surviving LCD participants in case one or more LCD participants fail, using stress scenarios. The size of the potential losses should determine the size of the guarantee fund. Although the NASDAQOMX Riga or LCD does not operate a central counterparty (CCP), the existing guarantee fund does nevertheless have the same objective, which is to reduce the counterparty credit risk in the market. Since this function is of importance to the capital market as a whole the guarantee fund should be assessed against the relevant international standards. In this case either the ESCB-CESR Recommendations for CCPs may be used – with a focus on RCCP 3 to 7 – or the CPSS- IOSCO checklist for guarantee arrangements of 2004. 21    63. The future issuance of new CPSS-IOSCO Principles for FMIs in the short future17 may warrant the reassessment of the SAMS and EKS systems. The full assessments of both systems have taken place in the past, with SAMS in 2004 and EKS in 2008. The issuance of the new principles for financial market infrastructures is a good opportunity to update the full assessments, taking into account the tightened requirements. Based on the lessons from the 2008 crisis requirements are for example tightened in the areas of credit and liquidity risk, operational risk and crisis management . 64. To further increase the range of payment instruments the BoL, together with the FCMC, may consider to stimulate the use of e-money instruments. E-money instruments may support payments to SMEs from remote areas in Latvia that have less access to the already available instruments. The BoL should participate as overseer of the development of retail payment instruments in the country, whereas the FCMC is involved as supervisor and regulator of e-money institutions.                                                          17 Expected in the first half year of 2012 22  Â