**Box 2. Banking Stability Returns?**

Structural chnges: On November 15, 1995, the Latvian Economic Court decided to liquidate three banks: Olimpija. Kredo and Olti. On November 9, 1995, the Bank of Latvia also canceled the license of Riga International Bank because the bank was insolvent. The bank had no household deposits and its major creditors were Bank Baltija and the Savings Bank. On December It, 1995, the Economic Court declared Bank Baltija bankrupt and ordered its liquidation. This accion was based on the recommendation of Baltija's administrator, who concluded that the bank could not be rehabilitated. This recommendation was supported by the Bank of Latvia, the Ministry of Finance, and Ernst & Young, the auditing firm which had been assisting the administrator.

Banking System Data: The table below presents data on the size of the Latvian banking system for selected months from December 1994 through October 1995. The data includes, up to May 1995, all operating banks and those banks that were no longer operating, but whose licenses had not yet been canceled by the Bank of Latvia. This latter group of banks includes Bank Baltija, Deposit Bank and Centra Bank. After May 1995, the table only includes those banks which are actually operating in Latvia.

As indicated, the banking crisis resulted in a shrinkage in the size of the banking system during the late spring and early summer. However, since August, the total assets, total loans and total deposits of the system began to increase, suggesting that the banking system had begun to stabilize. The one negative was a continuing downtrend in the amount of bank capital until October.

While not shown in the table, there has also been a sharp shift in the composition of deposits from time and savings deposits to demand deposits. Between January and September, the amount of time and savings deposits fell from US$306 million to US$146 million, undoubtedly reflecting depositors' desires to maintain maximum flexibility when depositing in banks.

Latvian Commercial Banking System, 1994-1995

||1224||19|95|(Millio|n US Do|llars)||||
|---|---|---|---|---|---|---|---|---|---|---|
||Dec.|Mar.|Apr.|May*|May"*|June|July|Aug.|Sept.|Oct.|
|Total Assets|2146|2106|2074|2088|<br>1464|1400|1304|1378|1400|1434|
|Total Loans|730|746|756|764|<br>524|470|426|440|<br>430|424|
|Own Capital|336|326|312|316|<br>262|248|260|250|<br>242|256|
|Total Deposits|938|934|938|914|<br>644|580|**_528_**|534|<br>544|568|
|No. of Banks|57|(57)|(57)|(57)|<br>53|47|44|44|<br>39|39|

**)** From December 1994 to May 1995, data includes banks operating in Latvia, as well as those which are no longer operating but had not lost their license.

****)** Banks actually operating in Latvia from May 1995 onwards.

parties for clients and government officials. This activity was apparently undertaken as a means of insuring itself politically against any future difficuities that it might encounter. In general, systems were not put in place to properly manage the bank, particularly, as noted above, in the area of risk management.

# **The Impact of the Banking Crisis**

# **_The_** _Impact on the real economy_

Data for the real sector of the economy suggests that the positive real growth expected for 1995--a target of 5%--is not attainable. The Latvian authorities have forecast that the banking crisis will "cost" up to 1.2% of GDP in 1995 and up to 2.2% of GDP in 1996. The increasing tightness in liquidity brought about by the loss of deposits means that much more modest growth will have taken place in 1995. It is likely that the adverse wealth effects, coupled with the general effect on economic confidence, will have subsequent negative effects on the economy. The outcome might have been even worse were it not for the buoyancy of the newly emerging private sector that has little linkage with the banking sector as either depositors or borrowers. In real terms, the money supply declined by 17% during the first five months of 1995. Inflation has abated on account of the liquidity tightness while nominal interest rates have begun to increase since the middle of 1995, leading to an upturn in real interest rates. The net international reserves of the Bank of Latvia declined from a peak of $466 million at the end of 1994 to $369 million at the end of June 1995 as the Bank of Latvia intervened to maintain the Lat's parity vis-avis the Special Drawing Right (SDR).

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