The Latvian Banking Crisis: Lessons Learned

Abstract

Lessons from Latvia's banking crisis can be applied in other transition economies.

In the spring of 1995, Latvia experienced the largest banking crisis in the former Soviet Union to date, involving the loss of about 40 percent of the banking system's assets and liabilities. Fleming and Talley outline the Latvian authorities' strategy for developing the banking system and identify how and why it unraveled. They discuss the World Bank's role and the lessons to be learned from the crisis, including the following:

Banking systems are exposed to stress in several major ways. Enterprises - the main borrowers - become subject to hard budget constraints (are cut off from government funds) and are privatized. Inflation declines so enterprises can't rely on rapidly increasing revenues to service bank debts. Economic reform tends to produce banking systems that are mainly privately owned - making them vulnerable to withdrawals, as the public does not assume that failing banks will be bailed out.

The government must protect against this vulnerability by establishing a proper legal framework for banking, developing effective bank supervision and regulation, and implementing solid accounting, disclosure, and auditing standards. It must also develop effective ways to handle problem banks and to close insolvent banks promptly.

For banks in the state sector to be a source of strength to the banking system, they must have strong effective management and be relatively free from political influence.

Outlier banks - those expanding assets very quickly or offering particularly high deposit rates - should be subject to intense supervision.

Four things must be done to prevent fraud, incompetent management, and excessive risk-taking: Carefully screen those who want to get into banking; subject all banks to thorough, frequent onsite examinations and assign the best examiners to the largest banks; require annual audits of all banks by reputable auditing firms required to report significant irregularities to authorities; and act decisively when fraud or bank difficulties are detected or suspected.

This paper - a product of the Enterprise and Financial Sector Development Division, Europe and Central Asia, Country Department IV - is part of a larger effort in the region to distill the lessons of the first five years of transition.