SPEED AND SEQUENCING OF MARKET REFORMS: THE CASE OF BANKING IN LATVIA

I. INTRODUCTION In 1991, Latvia withdrew from the Soviet Union and gained its independence as a sovereign state. It quickly embarked on the transition path to a market economy and, especially in the banking sector, initiated "free market" reforms. From 1991 to 1993, Latvia moved from centralized state banking to a market with 61 independent banks. In 1994 and early 1995, 11 banks failed including the largest, Bank Baltija, which held 23% of all deposits. There is no deposit insurance in Latvia, and the failure of some banks to honor their obligations to depositors has generated considerable political pressures on the Latvian government to take a more active regulatory stance. Several legislative proposals to restructure banking in Latvia have included compensating depositors who have lost deposits in failed banks, increasing capital requirements for banks, initiating deposit insurance, and limiting open foreign currency positions. The difficult experience with market reforms in banking is not limited to Latvia. In the fall of 1995, the two largest banks in Lithuania failed. Together these two banks accounted for 25% of all deposits in Lithuania. Since 1991, 24 private Estonian banks have been closed or have had their operations suspended (Economist, 1/20/96, p. 79). Other republics of the former Soviet Union report similar crises. The future path of market reforms depends critically on the political response to these banking failures. II. LATVIA'S MARKET REFORMS Market reforms must ensure that the financial sector "serves industry and trade, not the other way around" (Akyuz, 1991, p. 37). However, no single Western model establishes how to accomplish this. As Akyuz (1991, p. 19) notes, "The experience of industrial countries shows that there is no single way of organizing finance. Consequently, an important issue in financial reform in developing (and Eastern European) countries is what types of financial institutions and markets need to be promoted." Considerable variation exists in the way successful Western economies organize financial markets. A newly formed country like Latvia, might consider imitating the Japanese "administered, state led" financial system, the American "capital market, company led" system, or the German "negotiated, bank led" system (see Zysman, 1983, chapter 6). Thus, saying that "Latvia initiated market reforms in banking" oversimplifies the matter. One observer suggests that in Latvian banking "structural reform has been rapid and a laissez faire approach has been applied." Latvia has relied more on free market processes to reform its financial market than have most other countries. For example, comparing Latvia to other countries analyzed in the World Bank's Financial Reform Lessons reveals that Latvia, more than other country, has initiated "big bang" reforms in banking by deregulating interest rates, privatizing banks, maintaining low reserve requirements, lifting capital controls, and granting "universal" banking powers to financial institutions (see Capio et al., 1993, Table 1). TABLE 1 Annual Interest Rates for One-Year Deposits (10/93) Bank Name Rank in Size Interest Rate Interest Rate (1/94) Deposit in Lats Deposit in $ Baltija 1 90% 18% Komercbank 4 50% 12% Parex 5 12% 12% Deutch-Lettish 9 35% 35% Sakaru 17 40% 32% Latin Trade 19 72% 48% Source: Diena, October, 1993 Especially in banking, the Latvian government implemented market reforms quickly and with a minimum of government regulation. Government created entry barriers (e.g., initial capital requirements) were low. By 1993, 61 independent banks were operating in the Latvian market. Foreign banks were free to operate within Latvia, but by 1995, no foreign banks had exercised this option. …