SPEECH

Financial integration in the Baltics: lessons in
resilience and transformation

Keynote speech by Claudia Buch, Chair of the Supervisory Board of
the ECB, at the International Financial Markets Conference
organised by the Ministry of Finance of Lithuania, Lietuvos bankas
and the Lithuanian Banking Association

Vilnius, 4 October 2024

This year we are celebrating the tenth anniversary of European banking supervision under the Single

Supervisory Mechanism (SSM). With the SSM and the banking union more broadly, Europe has
demonstrated its ability to respond to crises in a united way - with greater harmonisation and
integration rather than retreating to national solutions and fragmentation. A lot has been achieved in
the past ten years in terms of enhancing resilience, reducing risks, and applying common rules and
supervisory standards.

But these achievements pale in comparison to the transformation and integration witnessed in the
Baltic region. Over the past 30 years, the Baltic states have gone through an unprecedented process
of institution-building following the disintegration of the former Soviet Union. There has been a
massive economic transformation in response to changes in relative prices and an almost complete
reorientation of trade flows. Accession to the European Union and the adoption of the euro around ten

years ago have been the most visible symbols of this transformation.I2]
Progress has been impressive. While the GDP per capita of the Baltic states was around one-third of

the euro area average in the mid-1990s, it has now reached two-thirds. In many areas, the Baltics
are leading the way in terms of the digital transformation. They have attracted foreign direct
investment, know-how and capital inflows. And their banking markets are closely integrated, in
particular with the Nordic region.

But the Baltics have also experienced the downside of integration. In the run-up to the global financial
crisis, inflows of capital fuelled a real appreciation of their currencies and an unsustainable credit
expansion. When cross-border capital flows suddenly stopped, the region had to weather the storms
of the global financial crisis, and it went through a painful recessionary period. Real wages declined

and unemployment increased. 4] Flexibility in the real economy made it easier to adjust to changes in
relative prices.

The Baltic experience holds important lessons.

First, financial integration and resilient banking systems make a key contribution to economic
transformation. The entry of foreign banks into the Baltic countries has improved the quality of financial
services and financed economic growth. Following the crisis, foreign-owned banks opted to remain in

the region, rather than withdraw, contributing to the recapitalisation of the sector and facilitating the
clean-up of balance sheets. Their shift from wholesale intragroup funding to more resilient local
funding further supported the recovery.

Second, financial integration needs to be accompanied by strong and harmonised regulation and
supervision. The post-crisis reforms and the creation of the banking union have made important
contributions by establishing common rules and supervisory standards, introducing essential
safeguards against the build-up of risk, and further enhancing trust in the financial system. The Baltic
region has benefited greatly from these institutional changes.

Third, the digitalisation of financial services can further enhance financial integration and development,
but it also demands robust safeguards to address associated risks. Digitalisation facilitates the cross-
border provision of financial services, reducing the importance of regional proximity. While this brings
many benefits, it also introduces risks through cyberattacks or money laundering, that must be
addressed by banks. Moreover, the EU can make further progress in establishing a more secure
foundation for financial integration. Among the key priorities, the European crisis management
framework should be strengthened and a European deposit insurance scheme is needed to complete
the banking union.

The upside: economic transformation and financial integration
Over the past 30 years, the Baltic region has gone through an unprecedented period of economic
transformation and financial integration. Estonia, Latvia and Lithuania have navigated the complex
path from centrally planned Soviet economies to market economies, eventually becoming full
members of the European Union, the euro area and the banking union. This transformation was not
without its challenges, requiring deep adjustments and imposing costs on the population. Economic
transformation requires broad societal consensus around a willingness to endure the inevitable
hardships.

In the Baltics, there was indeed a strong consensus to embrace the reforms necessary for EU
membership in 2004. Euro adoption followed in 2011 in Estonia, 2014 in Latvia, and 2015 in Lithuania.
Estonian and Latvian banks came under European supervision at its inception in 2014, with Lithuania
following a year later.

Banking sectors have developed rapidly. The Baltic banking sector has grown substantially, with total
banking assets accounting for more than 130% of GDP in 2023 (Chart 4), compared to around 30%
in the mid-1990s.l

The 1990s were characterised by banking sector instability and consolidation. Economic

transformation left its mark on banks' balance sheets and banks were burdened with non-performing
loans (NPLs). Moreover, the Ruble crisis of the late 1990s had negative spillovers into the region.

Chart 1: Total financial assets relative to GDP

a) EU
(ratio to GDP in percentages; annual data, 1999-2023)

HE Monetary financial institutions (other than money market funds) Other financial institutions
Tl Money market funds lm Insurance corporations
Investment funds Pension funds

800

700

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

b) Baltic States
(ratio to GDP in percentages; annual data, 1999-2023)

6

=
s

5

3
Ss

4

&
s

3

Ss
s

2

8
s

1

Ss
Ss

MM Monetary financial institutions other than money market I Remaing other financial institutions
Money market funds lm Insurance corporations

investment funds I Pension funds

800

700

600

500

400

300

200

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

1

Ss
s

Sources: ECB quarterly sector accounts, balance sheet items and main aggregates, and national accounts (MNA)
statistics.

Governments in Estonia, Latvia and Lithuania opened up their markets to foreign ownership. Assets
held by foreign-controlled banks increased significantly up until the financial crisis and have remained
elevated in the post-crisis period. In 2020 foreign-owned bank assets accounted for 80% in Estonia,

86% in Latvia, and 91% in Lithuania.)

Initially, interbank markets integrated strongly across borders (Chart 2). In the Baltics, loans from non-
resident banks, combined with their holdings of debt securities, more than doubled in proportion to
GDP between 2005 and 2009.

Chart 2: Interbank financing through non-resident banks

a) EU
(ratio to GDP in percentages; annual data, 2005-2023)

@ Loans
© Holdings of debt securities

45

40

15
10
0

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

mn

b) Baltic States
(ratio to GDP in percentages; annual data, 2005-2023)

@ Loans
© Holdings of debt securities

25
20
15
L Dieeanll

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

nm

Notes: Panel a) shows the connections between monetary financial institutions (MFIs) from all EU countries
where Estonia, Latvia, and Lithuania are not included as counterpart areas. Panel b) shows the connections
between MFIs from all EU countries where only Estonia, Latvia, and Lithuania are included as counterpart areas.
Values are normalised by GDP in both panels.

Overall, up until the early 2000s, economic integration and transformation progressed. GDP per capita
was increasing, capital inflows were strong, productivity improved, and EU accession promoted the
transformation of institutions. Foreign bank ownership brought with it expertise, credibility, and funding
from groups' parent entities. Before adopting the euro, the Baltic countries had pegged their currencies
against it, with limited room for exchange rate adjustments. Across the region, levels of public debt

were well within the Maastricht criteria.

Yet at the same time, vulnerabilities were building up in the financial system. These vulnerabilities
were eventually exposed during the global financial crisis. Banking markets became dependent on the
financial health of foreign parent entities, real estate markets showed signs of overvaluation, and real
exchange rates appreciated, gradually eroding the competitiveness of firms in the small, open Baltic

economies./I Overoptimism about future productivity growth and the benefits of EU accession may
have further fuelled these developments, with growth ultimately proving unsustainable.

The downside: the sudden stop of cross-border capital flows

Due to their exposure to cross-border capital flows, the Baltic economies were severely impacted by
the global financial crisis. Banks came under funding pressure, largely because of their heavy reliance
on intragroup liquidity. Lending in the interbank market came under strain, and credit conditions
worsened. Exports dropped, and capital flows came to a sudden stop.

Similar sudden stops happened in other small, open economies. But the situation in the Baltics was
special due to the quasi-fixed exchange rates. Abandoning exchange rate stability and devaluing
national currencies could have allowed the corporate sector to adjust to external pressure - but only at
the cost of losing the hard-won credibility of fiscal and monetary prudence. This dilemma was less
acute in other European periphery countries which had access to the enhanced liquidity provision

provided by the Eurosystem.4

The burden of adjustment fell on real wages and labour markets. This ultimately enabled the Baltic
economies to regain competitiveness, but it also required painful adjustments in the real economy.
While the specific patterns differed across countries, unit labour costs were lowered through a

combination of lower nominal wages, layoffs and increases in productivity." Because of the lack of

additional shock absorbers, adjustment was faster than in countries that had access to Eurosystem
liquidity,42]

The Baltic economies fell into deep recessions. The cumulative output loss in 2008 and 2009 was
around 18% in Estonia, 21% in Latvia and 12% in Lithuania,"3] and unemployment rates increased to

between 15% and 20% in 2010.4] Governments implemented structural reforms to alleviate the
effects of the crisis. Non-performing loan (NPL) ratios increased up to 20% in Latvia and Lithuania,

and up to 5% in Estonia. [4]

Foreign-owned banks active in the Baltic region downsized activities but did not withdraw in the
aftermath of the crisis. While reducing their reliance on intragroup funding, they remained active in
these markets. These foreign-owned groups bolstered the capital positions of their Baltic subsidiaries
and played a key role in the swift resolution of NPLs. Better-capitalised subsidiaries were better
equipped to provision for risks and resolve NPLs. The resolution process was further facilitated by

group-wide asset management company strategies being rolled out to foreign subsidiaries."

Banking union: rebuilding resilience and strengthening supervision

Europe learned vital lessons from the global financial crisis and the European sovereign debt crisis. In
an integrated banking market, national supervision alone cannot address cross-border risks. With the
banking union, supervision of the largest banks has been moved to the European level and a
framework for the resolution of banks has been established. But the third pillar of the banking union -
a European deposit insurance scheme - is still missing.

One lesson learned from the crises was that bank capital needs to be strengthened in order to boost
resilience. Baltic banks have in fact been strongly capitalised from the start of the banking union (Chart
3). In 2015, the average Common Equity Tier 1 (CET1) ratio of Baltic banks stood at over 28% - more
than twice the average of European supervised banks of less than 13%. Currently, capital ratios in the
Baltic region remain above 20% compared with a banking union average of slightly less than 16%.
Similarly, the profitability of Baltic banks has been higher, with an aggregated annualised return on
equity of 20% compared with an average of close to 10% in the first quarter of 2024.

Chart 3: Capitalisation and profitability of banks

CET1 ratio for significant institutions

mm = Weighted average Baltics

em SSM area

35%

30%

25%

20%

15%

10%

5%

0%

¥z02 ZO
vz0d LO
E202 pO
£202 €O
E20 ZO
E20 LO
7202 FO
e202 ED
éZ0 ZO
e202 LO
bz0z FO
bz0z €O
bc0¢ ZO
bz0z LO
0202 PO
0202 ED
020 ZO
0202 LO
6102 pO
6102 £0
6102 cO
6102 LO
8102 pO
BL0Z ED
8102 ZO
8102 LO
2402 PO
2402 £0
2402 2
2402 LO
9102 FO
9L0¢ ED
9102 20
9102 LO
SLOZ pO
SL0¢ £0
S102 cO

Return on equity for significant institutions

mm =Weighted average Baltics
em SSMarea

25%

20%

15%

10%

5%

0%

Q2 2015
Q3 2015
Q4 2015
Q1 2016
Q2 2016
Q3 2016
Q4 2016
Q1 2017
Q2 2017
Q3 2017
Q4 2017
Q1 2018
Q2 2018
Q3 2018
Q4 2018
Q1 2019
Q2 2019
Q3 2019
Q4 2019
Q1 2020
Q2 2020
Q3 2020
Q4 2020
Q1 2021
Q2 2021
Q3 2021
Q4 2021
Q1 2022
Q2 2022
Q3 2022
Q4 2022
Q1 2023
Q2 2023
Q3 2023
Q4 2023
Q1 2024
Q2 2024

Source: ECB supervisory banking statistics

Strong micro and macroprudential supervision have underpinned this resilience. Integration of the
region's banking systems into European banking supervision has contributed towards high supervisory
standards. Active macroprudential policies have helped maintain financial stability. Capital-based
measures, such as countercyclical buffer requirements and buffer requirements for systemically
important banks, are complemented by borrower-based measures and risk weight measures targeted

at systemic risks arising in the real estate sector.

The strong role played by banks from other Nordic countries requires that supervision is closely
coordinated across countries. Nordic-Baltic cooperation in banking supervision and macroprudential
policy is primarily facilitated through the Nordic-Baltic Macroprudential Forum established in 2011. In
addition, the Nordic-Baltic Stability Group, established in 2010 to enhance coordination and
preparedness for potential financial crises, brings together finance ministries, central banks, financial
supervisory authorities and resolution authorities from the Nordic and Baltic countries. It conducts
financial crisis simulation exercises to test and improve the region's ability to respond to complex,
cross-border banking crises.

Despite this close integration, financial systems in the Baltics have some distinct features. The five
largest credit institutions have a market share of around 90% in the Baltics compared with an EU
average of 68%. The relatively small size of markets may be one explanation, as fixed entry costs
weigh more heavily than in larger markets. Each country has specific regulations and legal frameworks
in place that govern, for example, insolvency procedures or mortgage lending. These factors create
fixed costs to enter the market.

Chart 4: Banking markets in the Baltics are relatively concentrated

Shares of the five largest credit institutions in total assets
== EU simple average

50%
40%
30%
20%
10%

0%

GR CY LT EE LV HR NL FI BG SK M S BE PT ES IE CZ DK RO HU PL SE IT FR A

eat

DE LU

Source: ECB structural financial indicators as at 2023.

The Baltics' financial sectors are relatively small compared to GDP. For Europe as a whole, growth in
financial markets occurred predominantly in non-bank financial intermediation. The Baltic financial
sector, in contrast, is dominated by banks with two-thirds of financial assets. Across the EU, banks and

non-bank financial intermediaries hold similar amounts of assets.

The future: integration and development through digitalisation

Over the past 30 years, financial integration in the Baltic region has had a strong regional component.
The next phase of integration could be less reliant on regional proximity. The region is, in many ways,
leading the way in digitalisation. For the provision of digital financial services, borders and physical
infrastructures matter less. This provides new opportunities as well as new challenges.

The Baltic economies are highly digitalised, which is clearly reflected in their financial services sector.
Numerous fintech companies are based in the region, many of which offer payment services, often to
non-residents. In Lithuania, for example, the number of fintech licences increased from around 40 to
140 between 2015 and 2021, although it has declined somewhat since then.

This rapid growth in digital financial services also brings risks. Fintechs, like any other financial
institution, must have a good understanding of regulatory and supervisory demands related to
consumer protection, fraud, and cybersecurity as well as compliance with financial sanctions and
AML/CFT rules. Digital banking business models must be supported by investments in risk
management, particularly in managing third-party risks and risks associated with digital strategies.
Generally, European banking supervision has identified banks' digital transformation activities as a
supervisory priority. Based on the principle of technological neutrality, the SSM has updated its
methodological toolbox!12] by defining criteria for the assessment of digitalisation strategies and
collection of sound practices./29]

The ECB monitors risks related to digitalisation from a prudential perspective. While not all fintechs fall
directly under the ECB's supervision, national competent authorities play a crucial role in overseeing

these entities. Together, the ECB and national authorities ensure robust supervision across the region,
coordinating their efforts to address emerging risks in the sector. Across the Baltic region, the growth
of the fintech sector has led to increased regulatory oversight, particularly in relation to money
laundering and terrorist financing risks.

Cyber risk is a growing concern for the Baltic region, as geopolitical tensions and digitalisation expose
financial institutions to cyber threats. The ECB's recent cyber resilience stress test assessed European

banks' readiness to recover from a cyberattack./24) Generally, banks have response and recovery
systems in place. But the test also highlighted areas for improvement in protecting critical functions
and customer trust, and the results emphasised that banks must further invest in cutting-edge
cybersecurity technologies and build a culture of cyber resilience. Moreover, there is close cooperation
across the region to address cyber risk. The European Systemic Risk Board's (ESRB)
recommendation to set up a pan-European cyber incident coordination framework is being
implemented to ensure information is shared across borders.

The Baltic region has significantly stepped up its capacities to counter money laundering and financial
crime. A series of banking scandals between 2018 and 2020 highlighted weaknesses in national anti-

money laundering (AML) frameworks. 241 In response, local authorities have made substantial
improvements, enhanced their supervisory capacities and introduced tighter enforcement measures.
These efforts contributed to the establishment of the Anti-Money Laundering Authority (AMLA), which
centralises and strengthens oversight across the EU. Violation of anti-money laundering and
combating the financing of terrorism (AML/CFT) rules can indeed seriously undermine the reputation
and viability of financial institutions. The ECB works closely with national authorities to strengthen
AML/CFT measures and participates as an observer in AML/CFT colleges. It also ensures that the
implications of AML/CFT risks are properly addressed in ongoing supervision, authorisation and fit-
and-proper procedures.

Looking ahead: promoting further integration

Strengthening the resilience of European banks and promoting integration have been two key
objectives of the banking union. When banks operate across borders, consumers and firms can truly
reap the full benefits of the Single Market. For financial institutions, cross-border activities and mergers
can provide opportunities to generate economies of scale and scope. To realise these benefits, banks
must have sound risk management practices and strong governance in place. From a prudential
perspective, the ECB assesses the prudential and governance implications of mergers, using the

same criteria for both domestic and cross-border mergers.I25]

The Baltic region serves as an interesting case study in the cross-border integration of banking
markets. As small, open economies requiring deep economic transformation, the countries in this
region pursued a focused strategy of fully integrating into the European Single Market and allowing
foreign access to their banking sectors. At the height of the global financial crisis, the region faced a
sudden withdrawal of capital flows, but its banking sector was able to recover, largely thanks to the
response of foreign banking groups. Today, banks in the region maintain strong capital buffers. This

financial resilience, together with a strong operational resilience, is crucial in the current phase of

heightened geopolitical risk.

The next phase of integration will be increasingly digital, rendering regional proximity less relevant.
This makes the establishment of a European deposit insurance scheme all the more urgent. For
consumers, such a scheme would provide reassurance that deposits with domestic banks are
protected by the same standards as deposits with non-resident banks. In addition, risks associated
with digital transformation require close attention of banks and supervisors.

The Baltic region's experience offers a compelling case for broader European integration of financial
markets through the capital markets union (CMU). A key element of CMU is the harmonisation of
national rules and regulations that currently serve to effectively segment financial markets. Prime
examples include national insolvency legislation or national rules affecting mortgage markets. CMU
would also help innovative European firms gain access to equity financing and promote private risk-
sharing, both in the Baltics and across the whole euro area.

1.
I am grateful to Jonathan BeiRinger, Pascal Busch, Massimiliano Rimarchi and John Roche for their

assistance in preparing this speech. All errors and inaccuracies are my own.

2.
Buch, C. (2022), "30 years of monetary reform in Estonia: Lessons learned for the decade ahead",
keynote speech dedicated to the 30th anniversary of monetary reform in Estonia, Deutsche

Bundesbank, Frankfurt.

3.
IMF Country Report No. 24/285 Latvia, (2024).

4.

The Baltic region's adjustment to the sudden stop of capital flows during the global financial crisis has
been documented widely. See, for example: Gros, D. and Alcidi, C. (2015), "Country adjustment to a
'sudden stop': Does the euro make a difference?", International Economics and Economic Policy, Vol.
12, pp. 5-20; Hansson, A. and Randveer, M. (2013), "Economic Adjustment in the Baltic Countries",
Working Paper Series, No 1, Eesti Pank; and Kang, J.S. and Shambaugh, J. (2014), "Progress
Towards External Adjustment in the Euro Area periphery and the Baltics", Working Papers, No 14/131,
IMF.

5.
ECB quarterly sector accounts, balance sheet items and main aggregates, and national accounts

(MNA) statistics.

6.

Eesti Pank (1995), "Financial Intermediaries", Annual Report; International Monetary Fund (1999),

"Republic of Lithuania: Selected Issues and Statistical Appendix", IMF Staff Country Reports, No
99/96.
7.

Baudino, P. et al. (2022), "The 2008 financial crises in the Baltic countries", FS! Crisis Management

Series, No 3.

8.
ECB (2008), Convergence Report, May.

9.
Hansson, A. and Randveer, M. (2013), op. cit.

10.

Buch, C., Buchholz, M., Lipponer, A. and Prieto, E. (2017), "Liquidity provision, financial vulnerability,
and internal adjustment to a sudden stop", Deutsche Bundesbank (mimeo). See also Deutsche
Bundesbank (2016), "The influence of central bank liquidity provision on internal adjustment to a
sudden stop", Monthly Report, September, 50-52.

11.

See, for example, Blanchard, O.J., Griffiths, M. and Gruss, B. (2013), "Boom, Bust, Recovery:
Forensics of the Latvia Crisis", Brookings Papers on Economic Activity, pp. 325-388; and Kang, J.S.

and Shambaugh, J. (2014), op. cit.

12.

Hansson, A. and Randveer, M. (2013), op. cit.

13.

Staehr, K. (2013), "Austerity in the Baltic states during the global financial crisis", Intereconomics, Vol.
48, No 5, pp. 293-302.

14.

International Monetary Fund (2024), "Republic of Latvia: 2024 Article IV Consultation - Press Release
and Staff Report", IMF Staff Country Reports, No 24/285, p.9.

15.

Baudino, P. et al. (2022), "The 2008 financial crises in the Baltic countries", FS! Crisis Management
Series, No 3.

16.

Ibid.

17.

See "Overview of national macroprudential measures" on the ESRB website.

18.

Lietuvos bankas (2024), Financial Stability Review, p.47.

19.
McCaul, E. (2024), "A key step in assessing SSM banks' digitalisation journey and related risks", The

Supervision Blog, ECB, 11 July.

20.

European Central Bank (2024), Digitalisation: key assessment criteria and collection of sound
practices.

21.

European Central Bank (2024), "ECB concludes cyber resilience stress test", press release, 26 July.

22.
McNaughton, K.J. (2024), "The tale of the Baltics: Experiences, challenges, and lessons from

reforming their national Financial Intelligence Units (FlUs)", Journal of Economic Criminology, Vol. 5,

September.

23.
In 2021 the ECB published a Guide on the supervisory approach to consolidation in the banking

sector, which outlines supervisory expectations in this area.

CONTACT
European Central Bank
Directorate General Communications

> Sonnemannstrasse 20
> 60314 Frankfurt am Main, Germany
> +49 69 1344 7455

> media@ecb.europa.eu