Emerging Europe: Latvia looks beyond its big bank clean-up

It is lunchtime in one of Riga’s trendier business restaurants and the extremely smooth banker is getting agitated. Not by the fact that the waiter has just squirted multicoloured sauces all over our paper place mats – that is standard practice at 3 Pavaru – but by the suggestion that the Latvian banking sector is being cleaned up.

“It’s totally wrong to call it a clean-up,” he says. “Totally.” Pause. 

“It’s a… transformation.”

It is a message that comes through again and again from local bankers. Whatever is going on – massive fines, bank closures, swingeing new regulations – it can’t be a clean-up because that would mean there is something dirty. And, they claim, there definitely isn’t. 

Mention of the spectacular scandals in which Latvian banks have been implicated – including, but not by any means limited to, the Magnitsky case, the ‘Russian Laundromat’ and the $1 billion Moldovan bank fraud – merely elicits a frenzy of denial and whataboutism. 

HSBC’s involvement with money laundering for Mexican drug cartels, and sanctions busting by Standard Chartered and others in Iran are favourite tropes. The firing of Swedbank’s chief executive Michael Wolf earlier this year for alleged financial crimes (Wolf was subsequently cleared) also gets a mention, presumably because the Swedish group is the face of respectable banking in Latvia. 

“You can find deficiencies in any country,” says Janis Brazovskis of the Association of Latvian Commercial Banks (ALCB).

As to why Latvia should be singled out, explanations range from the paranoid to the plausible. Euromoney’s lunch companion tends towards the former. “People need a bad guy, and Latvia was picked,” he says over ostrich tartare, a local delicacy (sourced from ostrich farms along the Riga-Tallinn highway). 

Others are more prepared to admit that there may be a reason, if not a justification, for Latvia’s bad reputation. As Citadele Bank chief Guntis Belavskis notes, Latvia is a small and little-known country – “people who haven’t visited think we just have cows running around and a couple of fishing boats” – that has made itself a prime destination for cash from the former Soviet Union. 

Of Latvia’s 24 banks, 12 are primarily or solely dedicated to servicing non-resident business. Deposits from outside the country make up nearly half of the total and, at $11.9 billion, equate to 39% of Latvia’s GDP. Around four-fifths of this is believed to be ultimately owned by companies and individuals in CIS countries, most notably Russia. 

“So we are a tiny economy with huge flows of Russian money – and as soon as you say ‘Russian money’, people assume this must be bad,” says Belavskis. “It carries a stigma. But there are hundreds of thousands of highly credible companies in Russia.”

Of course, the fact that for many years Latvia’s banks made a virtue of not asking too many questions about where the cash was coming from doesn’t help. In the wild capitalism days immediately post-communism, the country positioned – and advertised – itself as the Russian-speaking alternative to Switzerland, complete with numbered accounts and flexible ethical standards.

Locals insist, though, that those days are long gone and that Latvia’s tainted image today is merely a legacy of its youthful indiscretions. “It is an issue of perception that is rooted in the past,” says Brazovskis. “We are working on it continuously, but it is obviously easier to spoil a reputation than to regain it.”

The only problem with this argument is that several of the most notorious cases of money laundering involving Latvian banks occurred in the last five years. 

Take the Russian Laundromat, an ingeniously simple scheme whereby fictitious debts between UK shell companies were guaranteed by Russian entities, enforced by rigged Moldovan courts and then funnelled through the Latvian banking sector.

Anti-corruption campaigners estimate that more than $20 billion of stolen money was washed by Russian officials and organized criminals before the scheme was exposed and shut down. That was not, however, until early 2014.  

Even more recent is the Moldovan bank fraud. Less than two years ago, $1 billion – equivalent to more than 10% of Moldova’s GDP – went missing in one week from three of the country’s largest banks. A report by US investigators Kroll, commissioned by the Moldovan central bank, found that a large chunk passed through Latvia on its way to destinations unknown. 

Pressed to account for Latvia’s involvement in these, and many other, financial scandals, local bankers fall back on their last line of defence. “Yes, there have been mistakes,” they say, “but they were isolated incidents that could happen to anyone – or, at any rate, anyone who banks a lot of Russian and CIS cash.”

Or, as Brazovskis puts it: “We serve a high-risk customer base, so we can’t be 100% proof against suspicious transactions, but it is not our business model to serve such customers or to profit from them.” 

Bankers are equally keen to deny any suggestion that a lax regulatory environment could have played a role in attracting dodgy money to Riga. On the contrary, they say, Latvia’s anti-money laundering regulations have been far more advanced than those in neighbouring countries and western Europe since at least 2008. “It’s just that some of the penalties were lower than they are now,” says one. 

This is an understatement. Until two years ago, the highest fine that could be levied for any wrongdoing by a Latvian bank was €142,000 – less than a day’s net income for larger non-resident banks such as ABLV and Rietumu. 

Guntis Belavskis, Citadele Bank

There is also the question of enforcement. Despite copious documentation of the role of Latvian banks in a smorgasbord of financial scandals, for the best part of a decade the number of penalties the regulator dished out for money laundering could be counted on the fingers of one hand. 

In 2009, Russian lawyer Sergei Magnitsky died in prison after blowing the whistle on a $230 million fraud by Russian tax officials. An investigation by his employer, Hermitage Capital, found that some of the stolen money had passed through six Latvian banks. Four years after his death, one bank was fined for involvement in the case. Regulators refused to name it, though, on the grounds that it might destabilize the system.

The following year, Regionala Investiciju Banka received a €70,000 slap on the wrist for unspecified due diligence failures in respect of non-resident business. Other than that, there is no mention of penalties for offences related to money laundering on the website of the Financial and Capital Market Commission (FCMC), Latvia’s banking regulator, between 2008 and August 2015. 

Then, suddenly in August last year, everything changed. An official warning was issued to Trasta Komercbanka, the bank implicated in the Russian Laundromat scheme. In November, the Latvian arm of Ukraine’s Privatbank was handed a maximum €2 million fine related to the Moldovan fraud and instructed to replace its board of directors. 

Two days later, two employees of Trasta Komercbanka were arrested. In January, the bank was banned from processing transactions worth more than €100,000, and in March its banking licence was withdrawn for failure to comply with capital requirements and “serious and sustained breaches of anti-money laundering and counter-terrorist financing regulations”. 

Also in March, Baltic International Bank – a lender controlled by Valeri Belokon, owner of Blackpool Football Club and sometime business associate of Prince Charles – was fined €1.1 million for violations of AML procedures. Two months later, a second bank mentioned in the Kroll report, ABLV, was fined €3.1 million. Several other banks received smaller fines for due diligence offences.

At the same time, the FCMC itself was in upheaval. Towards the end of last year, chairman Kristaps Zakulis was hauled before Latvia’s National Security Council twice and publicly criticized by a parliamentary committee for failing to act on money-laundering concerns. In January, he was forced out of office and replaced by his deputy, Peter Putnins. 

After that, swingeing new regulations on due diligence, risk management and money-laundering prevention began to emerge from the FCMC on an almost weekly basis. Parliament passed laws to strengthen the regulator’s remit. Its understaffed AML department received an influx of new bodies. Until last autumn, just four people were tasked with combating money laundering. By late June, the number was up to 15. 

Policymakers finally seem to be getting serious about sorting out Latvia’s banking sector. The question is, why now? 

To an impartial observer, the answer seems blindingly obvious. In 2013, Latvia applied to join the OECD, an organization famed for its tough stance on bribery and corruption. As part of the application process, OECD representatives visited Riga and conducted a thorough review of Latvia’s banking system.

The result was a damning indictment of the non-resident model and of Latvia’s failure to police the sector. “Non-resident banking poses a substantial risk that money obtained from corruption committed outside Latvia is laundered in the country,” investigators noted. Also: “Lax enforcement and weak regulation heighten the risk that proceeds of foreign bribery are laundered through Latvian banks.” 

The report was released in October last year. For some reason, however, any suggestion that there might be some connection between its publication and the subsequent rush to punish and regulate makes Latvian bankers very angry – far more so, indeed, than claims that the country’s banks have been involved in malpractice. 

“Links have been made between the OECD report and changes to AML regulation but this is not justified,” says Brazovskis solemnly. “It is part of an organic development in regulation.” Others are less restrained. “It’s a conspiracy theory!” snaps one bank chief.

Presumably, although bankers are reluctant to admit it, this is because any implication that Latvia was unwilling or unable to clean up its banks without outside prompting would be considered damaging for the sector’s reputation – so indeed, as Euromoney’s lunch companion suggests, would acknowledging the fact that any such clean-up might have been necessary. 

The weight of evidence, though, is heavily against the bankers. It is not just a question of timing. Officials at the FCMC, and Latvia’s anti-corruption agency KNAB, explicitly make the connection between the OECD report and the drive to improve standards of regulation and enforcement.

“The process of OECD accession has really put the focus on foreign bribery cases and related AML procedures,” says Sintija Helviga, senior international relations officer at KNAB. “It has brought a lot of positive change, even in areas where there has been no political will for years.”

This is particularly good news for KNAB, which for years has been starved of funding and subject to repeated political pressure. Not only has its hand been strengthened and its independence guaranteed thanks to the OECD’s intervention, but staff have finally been promised a move from their current offices – in a shabby apartment block 20 minutes from central Riga – to somewhere more fit for purpose.

At the FCMC, Maija Treija, head of compliance control, ticks off one-by-one the actions taken in response to the OECD’s recommendations. Immediate steps to increase enforcement of money-laundering offences? Check. Investigation of past regulatory failures? Check. Building up the FCMC’s remit and resources? Check. A radical new due-diligence and risk-monitoring system? Check.   

In some respects, reforms in Riga have even gone beyond the OECD’s requirements. Latvia was an early adopter of the EU’s fourth Anti-Money Laundering Directive, which came into force in July last year and, among other things, sets maximum fines for AML infractions at 10% of banks’ annual turnover. “The penalties are now really high,” says Treija. “They are scary.”

Both the OECD and the EU also prescribed a widening of the definition of politically exposed persons (PEPs) – but it was the FCMC that decided to make banks fully automate their know-your-client procedures. “You can’t fool the computer,” says Treija dryly. 

Latvia’s most original contribution to the regulatory overhaul, though, has been the introduction of legislation allowing the FCMC to order banks to hire, at their own expense, external consultants to conduct a full audit of their compliance procedures. Treija says this is an “essential tool” for a regulator with still-limited resources. 

“When we get a signal that something is wrong with a bank, we can’t spend all our resources on just that one bank,” she explains. “It is up to them to get themselves in order.”

All of Latvia’s non-resident banks have already been told to call in US auditors. The FCMC is slightly cagey about the timing of the process but is clear that all recommendations emerging from it will have to be implemented. 

This all adds up to a big additional burden on banks, particularly in the non-resident sector. Surprisingly, though, there seems to be only limited pushback. One particularly libertarian banker insists that making banks do their own AML work is “imposing state functions on banks” – but most are philosophical about the changes, in public at any rate. 

“We agree that they are necessary in order to stay in line with international standards,” says Brazovskis. 

For Latvia today, that means US standards. As it happens, the OECD was not the only body putting pressure on policymakers in Riga last year. US authorities, fiercely protective of the global dollar market, also made it clear that they were losing patience with Latvia’s failure to rein in its banks. 

This matters because Latvia is rapidly running out of banks prepared to do its dollar clearing. In January 2014, following orders from US regulators to tighten up its AML standards, JPMorgan cut all correspondent banking ties with the country, leaving Deutsche Bank as the only US-based clearer of Latvian dollars.

Now Deutsche is also pulling back. In late July, it was reported that the German bank planned to end correspondent relationships with several Latvian banks. Deutsche declined to comment but people with knowledge of the matter said Citadele, Rietumu and BIB would not be affected. 

That means up to five non-resident banks – banks, in other words, that depend on international flows for the majority of their revenues – could soon lose their ability to clear dollars directly through the US system. 

This would not be a disaster, in that there will be nothing to stop them from clearing dollars indirectly through banks in more sympathetic jurisdictions – as indeed a number of Latvian banks already do. (Sberbank and Bank of Georgia are the most popular choices.) It will, however, almost certainly make transaction banking more expensive and potentially more cumbersome. 

Longer-term, there is also the risk that these loopholes could be closed as well. As Treija points out, AML standards are only going to get tougher as crooks get more sophisticated and concerns mount over terrorist financing. “To those currently benefiting from working on the border of unacceptable risk, I say this: that border will come down and you will be below it,” she warns.

The question is, will Latvia’s traditional non-resident banking model still be viable in a world of massively increased compliance costs and regulatory scrutiny?

There are signs that recent reforms have already taken a toll on the sector. Non-resident deposits were down 11.7% at the end of June, compared with a year earlier. “That’s good, because it shows banks are cleaning their databases,” says Treija. She also notes approvingly that Russian and Ukrainian media have run stories this year about Latvian banks turning away clients.

Her message to non-resident banks is that they should diversify by moving into the domestic market. “We have banks with balanced resident and non-resident business,” she says. “That is a sustainable business model and we would urge participants with high exposure to non-residents to consider such a change.”

The only problem with that idea, say bankers, is that Latvia’s domestic market is already severely overcrowded. Five big Scandinavian banks, plus Citadele, are currently going head-to-head in a country with a population of 2 million, where credit demand has yet to recover from a dramatic recession after 2008. 

Reinis Rubenis, Swedbank

“There are far too many banks here and far too many strong banks,” says Reinis Rubenis, head of corporate banking at Swedbank. “The market is very fragmented, very competitive and it’s very hard to keep costs down.”

As a result, margins are wafer-thin and returns are meagre. Even Swedbank, the domestic market leader, only managed a return on equity of 11.5% last year. For ABLV, Latvia’s largest non-resident player, the figure was 27.8%. “Non-resident banks have higher expectations of returns than are available in the domestic market,” says Rubenis.

So far, Citadele is the only bank to bridge the gap between the two sectors – and that is more by accident than design. Its predecessor, Parex, was Latvia’s largest non-resident bank until its downfall and nationalization in 2009, and the ‘good bank’ that was spun out of its ruins retained part of its foreign portfolio. 

Belavskis freely admits that, if building a bank from scratch, he would most likely not go down the non-resident route. “It’s obviously less volatile to work with domestic retail and SMEs,” he says. “At the same time, non-resident banking offers great value for shareholders and it would be a pity to lose it altogether.”

As he points out, there are plenty of entirely legitimate reasons for capital from the former Soviet Union to come to Latvia. Riga is closer to Moscow than London, both physically and culturally. Half the city’s population are native Russian speakers. The financial sector is large and sophisticated. Wealthy clients can get high-class private banking services in their own language, while for companies Latvia offers a convenient entry point to the western European financial system. 

“We will definitely have to reconsider our business models and profit expectations, but it’s premature to say that the non-resident model is no longer viable,” says Brazovskis. “We will not be able to operate in the way we did five years ago, but I am confident that the model will still work.” 

Even Treija says she would be happy to see Latvia continue to play a leading role in international transaction banking – “but with a cleaned client base”. 

There is still some way to go, though, before Latvia can become the respectable, modern financial hub of bankers’ and regulators’ dreams. Obtaining OECD membership, which Latvia finally did in June, was a big step forward. But there have since been setbacks. 

Deutsche’s decision to cut correspondent banking ties was one. Another was the release by the Organized Crime and Corruption Reporting Project, in late June, of documents apparently created by two Latvian non-resident banks containing detailed instructions for clients on how to fabricate invoices and contracts for fake transactions. Both banks implicated deny the allegations. 

The FCMC said in a statement that it is “aware of such practices in individual banks” and pays “special attention to the credibility of transaction documents in our inspections”. Officials also noted that new regulations have been introduced that oblige banks to increase their scrutiny of customer documentation. 

In a business where reputation is everything, though, such news stories are highly damaging – particularly for a country that has, rightly or wrongly, become a byword for dicey dealing. As one banker comments: “As a Latvian bank, when you meet global colleagues you don’t start from a blank sheet. You start from negativity.”

Euromoney’s lunch companion agrees. As we finish our wine and decline the dessert – pickled pear with black chokeberries – he says ruefully: “Our problem is that we are a small country. We don’t have enough resources to promote the bright side of Latvia.”

It is a shame, because Latvia has much to offer. To fulfil its potential, though, it must first get to grips with its past. Until it does, remaking Riga’s international reputation will remain an uphill struggle.