Financial System’s Stability in Lithuania: Risks and Potential Challenges
Recent financial data revealed that the Lithuanian financial system has successfully weathered the challenges posed by COVID-19, and that the war in Ukraine has not had a significant negative impact on the country’s economy.
The performance of most credit institutions is improving, loan portfolios are growing, the quality of loans has not deteriorated, and capital and liquidity ratios are strongly above minimum requirements. On the other hand, in its annual Financial Stability Review, the Bank of Lithuania disclosed a number of risks and challenges that await us in the future. Let's discuss them further.
According to the Bank of Lithuania, Russia's war against Ukraine may adversely affect Lithuanian credit institutions through secondary channels such as cyber-attacks and losses related to higher raw material prices, weaker trade and lower expectations of retail and business customers.
Lithuanian companies operating in the transportation, construction, manufacturing, energy, and agricultural industries are closely linked to Belarus, Russia, and Ukraine. Therefore, their profits might suffer from trade disruptions and higher energy and raw material prices. In addition, rising inflation is also having a negative effect on the financial health of business and retail segments, and could lead to a decline in aggregate demand. These factors could potentially reduce the ability of households and business entities to cover their financial liabilities, which would also mean losses for credit institutions.
In addition, due to Lithuania’s political support, states hostile to Ukraine may carry out cyber attacks against Lithuanian credit institutions, which could lead to the withdrawal of deposits. However, taking into consideration that the banking sector in Lithuania remains extremely liquid, they would be able to withstand as much as a 41% decrease in deposits.
Rapidly rising inflation and a possible increase in rates are hurting households and business entities and might lead to issues related to the ability to pay loan installments.
Higher prices reduce disposable income of households and cut corporate profits. This means that less financial resources are available for debt coverage. In addition, it is highly likely that the ECB will increase its base interest rate for the first time in a decade to reduce inflation in the euro area. This will increase household and business loan payments and reduce new borrowings.
With fewer free funds and bigger monthly payments, some households will experience financial issues, which could lead to losses for credit institutions. On the other hand, there are some risk mitigation factors. For example, many households increased their savings during the pandemic, and credit institutions were able to accumulate large capital reserves. If required, these will act as a buffer to withstand even significant losses.
According to the supervisor, the rapidly growing FinTech sector may pose challenges to the financial system in the long run, so it is important to ensure readiness in risk and performance management areas.
The growing FinTech sector contributes to the innovation, efficiency and availability of financial services in Lithuania. However, as the market has not achieved the desired level of readiness, the FinTech sector also has associated risks. One of them is money laundering and terrorist financing risk that could damage the reputation of the state and its financial institutions. In addition, FinTech companies are more vulnerable to cyber-attacks which could create damage leading to mistrust, not only in the affected financial institution but also in other market participants. To avoid these risks, it is important to increase the readiness of the FinTech sector.
Finally, the transition to a climate-neutral economy continues to pose challenges for the Lithuanian financial system, as does Sweden, as its banks hold a significant share of Lithuanian banking sector.
Loans issued to industries that are closely related with pollution (e.g., manufacturing, transportation) cover about a quarter of the bank’s loan portfolio. Therefore, new regulations and changing habits of consumers might affect these companies and also banks. In the long run, this could lead to a reduction in the competitiveness and profits of these companies or even bankruptcies, and credit institutions would incur losses due to an increase in non-performing loans.
Another challenge to the Lithuanian financial system remains imbalances in the housing market in Sweden. Household indebtedness and housing prices in Sweden are reaching historic highs. A significant economic downturn or higher interest rates could increase households’ insolvency or lead to an adjustment in house prices. This could generate significant losses for parent banks in Sweden and the deterioration of funding conditions in Lithuania. In addition, if Swedish banks decide to restrict lending in the Baltic region, then Lithuania may experience a slowdown in economic growth and a correction in the real estate market.