Assessing business practices in Latvia's financial sector

The financial sector received specific attention when assessing Latvia's readiness to join the euro area, as well as in the context of the post-programme surveillance. The main concern is that some particular features of the Latvian financial sector could lead to negative spill-overs to the euro area, either because the sector might prove to be unstable and require external help or because of ambiguous business practices in this sector. The areas giving rise to concern include non-resident banking, money laundering and recent changes in the corporate tax code. This Country Focus analyses these elements and discusses whether they pose risks to financial stability. The most prominent issue in the discussion on Latvia's financial sector is non-resident banking, in which Latvia has a long tradition and enjoys several competitive advantages. After waning due to the crisis in 2008-2009, this business is thriving again. Data for 2014 show that non-resident deposits account for nearly half of all deposits in the banking system or 40% of GDP. Non-resident banking enjoys a supportive administrative environment, including an extension of temporary residence permits to investors from the Commonwealth of Independent States (CIS) in exchange for investments, a network of double-taxation agreements with Russia and other CIS countries, and a favourable corporate tax regime. However, while the expansion of non-resident deposits is associated with an accumulation of liquid foreign assets, which somewhat reduce the risks of domestic spill-overs, the increasing size of the sector might represent a source of vulnerability to external shocks. In addition, this business model needs strong policies to guard against money laundering, even if the threat is not necessarily linked with or restricted to non-resident banking. Financial transactions in non-resident banking may be more complex and difficult to investigate, while banks' business relations can be volatile, short-term, and exposed to different cycles across regions. This lower degree of transparency and predictability requires specific supervisory actions by the authorities and adequate response by banks active in this sector. Finally, Latvia is implementing a liberal corporate tax policy that favours the establishment of international holdings, aiming to benefit from large cross-border corporate income transfers. These recent tax changes may further increase the importance of non-resident financing and result in a wider use of aggressive tax planning and evasion practices.