In recent years, there has been a lively debate in the public sphere about the fact that banks in Latvia are not lending enough to businesses and that interest rates on loans are higher than they should be¹. Industra Bank's CFO, Artūrs Veics, looks at a number of aspects that affect this and outlines a simple and practical step to boost business lending.  
Arguments so far
Banks and the Financial Industry Association (FIA), which represents them, have repeatedly pointed out that the volume of lending to companies is constrained by Latvia's still unsettled legal framework for credit recovery and the large share of the grey economy that hides companies' true financial data, thus rendering them uncreditworthy². They also mention the low level of investment in the economy, which means that there are simply no good projects to lend to.

The Bank of Latvia and business organisations accuse banks of too cautious lending and credit risk appetite³.

Another view is that rates are high because there is not enough competition among banks.

Willingness and ability
I don't think there is one simple explanation, because there is some truth in all the above arguments. In this article, I would like to point out a concrete and practical reason that has so far not been mentioned by those engaged in the discussion. It is a seemingly small difference in the application of the Regulation imposing requirements on credit institutions in Latvia. Two years ago, when I took over as CFO and rebuilt Industra Bank's business model, which is now focused on lending to local businesses, I gained a very practical perspective on this issue. Banks have money to lend, liquidity has long been a non-issue in the low interest rate environment of recent years. Credit volumes and prices are determined by a bank's lending appetite and capacity. 

The willingness to lend depends directly on the bank's chosen business model - whether the bank wants to earn interest on loans, fee income from various products, asset management, or a combination of all these. Not all banks with unused capital that they could "convert" into loans do so because lending is not a primary source of income in their business model or they have already reached their desired lending volume.

Lending capacity, on the other hand, depends directly on the bank's capital levels and the rules adopted by the local banking regulator (FCMC)⁴. The Regulator sets a minimum ratio of capital to risk-weighted assets for each bank, depending on its risk profile (see below). If a bank has a capital/loan ratio of, say, 14% and its capital is, say, €20 million,  then it can issue €20/0.14=142 million of loans with an average risk weight of 100%. The European regulation⁵ sets this risk weight at 50% for secured corporate loans, but local regulations⁶ issued by the FCMC set the risk weight in Latvia at 100%. The FCMC has deliberately chosen to apply a higher risk weight than allowed by EU regulation and used by many EU countries. In very simplified terms, this means that the FCMC has determined that banks in Latvia are allowed to issue twice less loans to companies against their own capital than the regulation allows. This affects not only the overall lending capacity of banks, but also the cost of credit, as lower lending capacity also means lower total return on invested capital, which banks compensate for with relatively higher interest rates. The above regulation not only reduces the overall lending capacity of banks in the corporate segment, but also similarly, through the application of risk weights, limits the maximum amount of credit that banks can extend. But this limits smaller banks from competing with the big banks for larger loans. 

Local regulation on risk weight stricter than the Regulation
It should be noted that this particular point of the Regulation allows Member States and their capital market regulators to opt for stricter requirements or, in this case, a higher risk weight. As shown in the European Banking Authority (EBA) Dashboard⁷, e.g. Estonia, Austria, France, Spain, Germany do not choose to increase this risk weight for their bank corporate loans.

By changing this point of application of the rules and aligning the risk weighting of corporate loans with the European regulation, I can assure you that this would enable a number of banks in Latvia to significantly increase their lending capacity in the corporate segment, which will also result in a reduction in their lending rates. That is why we have appealed to the FCMC to change these rules so that banks and companies willing to lend, which are important for the development of the Latvian economy, are not put in a worse situation than they would be in other European countries.

Back in the spring, we approached the FCMC through the FIA with this suggestion and - together with SEB banka - also raised the issue of equating the risks of Latvian municipalities with national risk for the purposes of calculating own funds for credit risk. The FCMC is to be commended for its swift and positive resolution of this situation⁸. We can expect that borrowing will now become cheaper for local governments than under the old arrangements. We hope that the decision in favor of Latvian companies will also be made soon.

Artūrs Veics
Chief Financial Officer and Member of the Board of Industra Bank

¹ https://www.makroekonomika.lv/kapec-kreditu-procentu-likmes-baltija-ir-augstakas-neka-citviet-eiro-zona
² https://www.financelatvia.eu/news/uznemeju-velme-un-speja-aiznemties-sogad-sasniegusi-rekordlimeni/
³ https://www.makroekonomika.lv/gausa-kreditesana-klupina-latviju-cela-uz-particibu
⁴ Of course, there are many more regulations in this area, but in this article my focus is on one specific point.
⁵ Article 126 of Regulation (EU) No 575/2013 of the European Parliament and of the Council 
⁶ 'Regulatory provisions on the application of the options and transitional periods provided for in directly applicable European Union legislation on prudential requirements', Paragraph 6
⁷ https://ej.uz/5xf2
⁸ https://www.fktk.lv/jaunumi/pazinojumi-medijiem/fktk-pielidzina-latvijas-pasvaldibu-risku-valsts-riskam-kreditriska-pasu-kapitala-aprekina-vajadzibam/