Banks’ Domestic Lending to Private Sector in Baltic Countries Lower than EU Average

Trade and Economics - June 1, 2024

Over the past decade, EU Member States have faced a number of significant challenges, starting with the global financial crisis of 2008, which had a profound impact on the EU economy. The interconnectivity between the economy and the financial sector facilitated the spread of the financial crisis from the United States to Europe, creating a domino effect. The EU initially faced the Great Recession in 2008-2009, followed by the sovereign debt crisis in several Member States, the most publicised case being Greece. 

These combined crises had significant consequences for economic growth, investment, the labour market and the fiscal measures adopted by governments in many EU countries. In response to the crises, the EU implemented short-term measures, including financial aid measures to rescue banks from bankruptcy and reforms to address weaknesses. In the longer term, efforts have been made to improve resilience, such as strengthening financial sector stability, reinforcing economic governance and carrying out structural reforms. Also, the COVID-19 pandemic, which has significantly affected the European banking system, has brought both challenges and opportunities. European banks have faced declines in earnings due to reduced demand and government capital market interventions. At the same time, we can say that there was also a positive side, in that the digitisation process in the European financial institutions industry was accelerated. The last decade has also brought increasing geopolitical risks and vulnerabilities to the banking sector. It is well known that the banking sector has to address issues including cyber attacks against financial institutions, energy-related bad loans and the impact of energy price fluctuations on loan quality, structural changes in the euro area economy affecting banks, and interconnected risks between energy markets and financial institutions. Despite these uncertainties, there are still clear areas where the banking sector will continue the transformation process: geopolitical risk management, regulatory pressure and compliance, digitalisation and FinTech, implementation of a sustainable business model, such as integrating environmental, social and governance considerations into financial institutions’ operations and decision-making processes.

Europe’s banking system marked by strict EU regulations

The transformation of the banking sector in the European Union and Northern Europe is marked by a number of significant developments that have reshaped the regional financial landscape. This is why in recent years, economic integration and strict EU regulations, together with rapid technological advances, have prompted banks to adopt new business models, improve operational efficiency and innovate in the services they offer. In particular, as mentioned above, digitalisation has had an extremely strong impact, leading to the development and widespread adoption of online and mobile banking. These changes have also had significant consequences for competition in the banking sector in the Baltic States (Estonia, Latvia and Lithuania). Banking markets in these listed countries have become much more diversified and therefore much more competitive, influenced by both international banks and innovative local players. 

Financial consolidation and the entry of new players offering financial services, such as fintechs, have increased competition, leading traditional banks to review their strategies. This has forced traditional banks to adapt to the new competitive market conditions. These developments have helped to improve the quality of services for consumers and increase the accessibility of financial products, but they have also brought challenges related firstly to cybersecurity and secondly to related regulations. The recent turmoil in the global banking sector has amplified the challenges of monetary policy and inflation, further complicating the economic situation already affected by the pandemic, the conflict triggered two years ago by Russia in Ukraine and the alarming rise in inflation. Banks play a key role in economic growth by providing capital and financial services, thereby supporting community development.

What is the role of banks in economic development?

According to the study commissioned by the ECR Party, five factors that banks play in the economy were identified (financing infrastructure projects, promoting financial inclusion, supporting international trade, supporting small businesses, encouraging savings and investment). 

Banks are known to support economic growth by financing key infrastructure projects such as roads, bridges and airports, which inevitably create jobs and boost productivity at the same time. Another role banks play is to promote access to financial services for all income groups and geographic locations, thereby reducing poverty and supporting economic development. By providing letters of credit and trade finance, banks facilitate cross-border transactions, promoting global cooperation. Banks provide capital and financial services to small businesses, which are drivers of local and regional economies, creating jobs and stimulating economic growth. By offering savings accounts and investment products, banks help individuals and businesses build wealth and plan for the future, thereby stimulating economic growth.

What are the internal and external factors influencing banks’ performance? 

The state of development of the financial system, monetary and fiscal policy, competition (we are talking about healthy competition), import-export policies, the general level of income and access to the money market can be considered external economic factors. On the other hand, rising energy prices have been the main factor leading to record inflation of 9.6% in EU countries and 8.6% in the euro area in June 2022. The European Central Bank (ECB) raised its key interest rate to 0.5% in July 2022, the first increase since March 2016, and continued to raise it almost monthly up to 4.5% in December 2023. High inflation has driven up mortgage rates in Europe, affecting the cost of living. Mortgage rates rose significantly in 2022, with rates doubling in many countries. In Hungary, the average mortgage rate reached almost 10% in the first quarter of 2023, compared to around 3.5% in 2022. One extremely positive thing is that the Nordic countries managed to keep mortgage rates lower due to financial stability. Digitisation and competition from non-banks has led to increased penetration of online banking, with a reduced need for physical branches and structural changes in banking employment. The digital-only non-banks are gaining ground by partnering with traditional banks and expanding their services.

The transformation of banking in Europe

The transformation process of the European banking sector is influenced by external factors such as geopolitical risks, regulatory pressures and digitalisation. Banks need to adapt to new technologies and implement sustainable business models. What does it mean to adopt Environmental, Social, Governance (ESG) criteria?  Banks are integrating ESG criteria into financial services, reflecting their responsibility to shape a sustainable future and the European Banking Authority (EBA) has launched guidelines on ESG risk management.

Competition in the Nordic banking sector: Banks, owners and business models

In the Baltic countries, the transition from a planned to a market economy has led to the liberalisation of financial systems and the removal of restrictions for foreign investors in banking markets. Since then, the proportion of banks owned by foreign investors has steadily increased, contributing to and significantly shaping the landscape of the banking sector in the region. In the early years, foreign capital entered mainly from Scandinavian countries and Germany, and later also from America. For example, in Estonia, the entry of foreign shareholders (capital) was faster than in Lithuania and Latvia. Thus at the end of the 1990s, foreign-owned banks accounted for about 90% of all bank assets. In Lithuania, the massive entry of foreign capital took place later, but by 2002, foreign banks held more than 90% of bank assets. In Latvia, the presence of foreign capital was lower, reaching around 80% in 2022.

According to the ECR study, the business models of banks in the Baltic countries have developed differently. Lithuania for example has focused on domestic customers, offering a wide range of universal banking services for businesses and individuals, mainly through Swedish banks. In Latvia, the banking model has been influenced by historical and geopolitical factors, with the banking sector consisting of two main segments: services for domestic customers, dominated by subsidiaries of large Scandinavian banks, and services for international customers, offered mainly by local Latvian banks. Latvia has positioned itself as an international financial centre for Russia and the Commonwealth of Independent States, attracting significant international deposits. Estonia followed an intermediary business model, similar to that of Lithuanian banks, focusing on serving Estonian or Estonian-related companies and households. The entry of strategic foreign investors into the largest Baltic banks has made the industry more resilient to external shocks, but has raised the issue of bank competition. In 2022, 90% of banking assets in Lithuania, 85% in Estonia and 76% in Latvia were held by banks whose main shareholders were foreign. The level of bank asset concentration was significantly higher than the EU average, indicating less competition. Between 1999 and 2008, the EU credit institution sector expanded significantly, but after the global financial crisis, the number of bank offices and employees declined. In the Baltic countries, the number of branches and employees increased initially, but declined rapidly after the crisis due to massive redundancies. This decline reflects, among other things, the transition to digitalisation and greater efficiency.

In the Baltic countries, banks’ domestic lending to the private sector is systematically lower than the EU average. Despite available resources, conservative lending practices and limited competition have kept interest rates high. In terms of profitability and efficiency, the Baltic countries had better indicators than the EU average, with high return on equity (ROE) and net interest margin (NIM). However, the cost-income ratio (CIR) was lower, suggesting less competition and potentially higher risks in the region. It is well known that customer mobility is a key factor for competition. In EU countries, customer mobility was 29% between 2017 and 2022 and 38% in Sweden, but in Lithuania and Latvia, switching mortgage providers was much rarer. Low customer mobility may be influenced by cultural or other local market-specific factors.

The story of two markets: Swedish banking in the Baltic States and Sweden

Profitability is the main indicator of a bank’s success. There is a perception that Swedish banks in the Baltic region earn more than in Sweden. This study analyses the financial indicators of Swedish banks SEB and Swedbank in all Baltic countries (Estonia, Latvia and Lithuania) and Sweden, based on annual financial data from 2005-2023. The study examines return on equity (ROE), return on assets (ROA), net interest margin (NIM) and cost-to-income ratio (CIR) to assess the competitive dynamics of the banking sector in these regions. The data was obtained from Moody’s Orbis (2024) database. Using statistical tests, the financial performance of banks in different country combinations was compared.

Return on Equity (ROE) is an indicator that reflects the bank’s return on equity. In March 2023, ROE in the Nordic countries was among the highest in Europe. The analysis showed that, over the long term, ROE in Sweden is significantly higher than in Estonia. The insignificant differences between the Baltic countries and Sweden suggest an efficient use of invested capital by SEB and Swedbank in all regions due to strategic capital management and standardisation of operations.

Return on Assets (ROA) indicates the bank’s profitability relative to total assets. The study found significant differences between Sweden and the Baltic countries, with ROA being higher in the Baltic region. The highest ROA values were recorded in Estonia and Swedbank had higher ROA than SEB in all countries. This could be caused by a larger and potentially less profitable asset base in Sweden compared to the Baltic countries. 

Net Interest Margin (NIM) is the difference between interest income and interest expense. In the Baltic countries, the NIM was significantly higher than in Sweden, suggesting that banks earn more from interest rate spreads. Latvia had the highest NIM values, probably due to higher lending rates.

The Cost-Income Ratio (CIR) measures the efficiency of managing expenditure relative to income. In Sweden, the CIR was significantly higher than in Estonia, moderately higher than in Latvia and slightly higher than in Lithuania, indicating a higher cost structure in Sweden. The results suggest that SEB and Swedbank manage costs more efficiently in the Baltic countries. The analysis shows that although Swedish banks had higher NIM and ROA values in the Baltic region, differences in CIR and other factors influence overall profitability. Future research will investigate through expert interviews the development of the Latvian banking industry in the Baltic and North European context to understand the future challenges and opportunities for financial services in this region.

The authors of the research commissioned by ECR Party are: Prof. Dr. Gundars Bērziņš, University of Latvia; Prof. Dr. Ramona Rupeika – Apoga, University of Latvia; Prof. Dr. Jānis Priede, University of Latvia; Mg. soc. Elmārs Kehris, Latvian Economists Association. The study received partial financial support from the European Parliament.