Moody’s outlook for Baltic banking systems remains negative

The fundamental credit outlook for the Baltic banking systems is negative, reflecting the significant decline in banks' financial metrics within the context of the severely weakened economies of Estonia, Latvia and Lithuania, Moody's Investors Service said in its new Banking System Outlook on the Baltic countries.
The negative outlook on the Baltic banking systems reflects Moody's expectation that the difficult credit and business conditions will continue in the short-to-medium term. After several years of above-trend growth, the three economies have been undergoing a severe recession, which is exerting significant pressure on the banks' asset quality, profitability and capitalisation. The rating agency expects to see a continued significant increase in problem loans in the region, with the real estate and consumer-lending segments being among the hardest hit by the economic slowdown.
The three banking systems are dominated by the subsidiaries and branches of Nordic banks. Moody's noted that foreign ownership has played a major role in the evolution of the Baltic banking systems towards international standards. Capital injections have also helped subsidiaries to strengthen their respective franchises. In addition, Moody's positively notes the EBRD's recent active involvement in the region.
Baltic banks exhibited strong profitability prior to the crisis, but this has deteriorated rapidly in 2009. Moody's considered the losses largely the result of the banks having to increase their loan loss provisioning that started to affect asset quality indicators, as well as the growth of the banking sector, which had supported the increase in profitability in recent years, slowing significantly as demand for new loans fell and banks tightened their lending conditions.
The number of corporate bankruptcies has increased rapidly in all three countries and Moody's expects this trend to continue given the poor economic outlook. Moody's is particularly concerned about the banks' loan exposures to real estate developments and SMEs, both of which have grown rapidly in recent years. The rating agency is also concerned about the banks' exposures to the retail sector. The indebtedness of households has been growing rapidly in all three countries, which is a source of vulnerability, especially given the severely declining house prices, rapidly increasing unemployment and salary cuts.
Moody's is also mindful of the Baltic banks' high foreign currency-denominated loan portfolios exposing them to the risk of a currency devaluation. Although currency risks are mitigated by the fixed exchange rate peg (Latvia) and currency boards (Estonia and Lithuania), there has been speculation that the Bank of Latvia may be forced to devalue the lat while the current exchange rate to the euro will be maintained until euro adoption, possibly in 2014-15. That said, the possibility of a devaluation will remain a concern, even after this year, a further concern is that would force neighbouring Estonia and Lithuania to follow suit.
In Moody's opinion, the three Baltic banking systems have not yet reached the bottom of their respective downturns. Of the three, Latvia remains the most adversely affected by the current recession. Although the Lithuanian banking system is performing somewhat better, Moody's expects Lithuanian banks to be affected by further deterioration of the domestic economy. The rating agency also expects Estonian banks to report higher problem loans in the short term, but it acknowledges the higher capitalisation of the Estonian banking system, which provides an additional buffer against expected losses.