The Latvian banking crisis: lessons learned

In the spring of 1995, Latvia experienced the largest banking crisis in the Former Soviet Union to date, involving the loss of about 40 percent of the banking system's assets and liabilities. The authors outline the Latvian authorities'strategy for developing the banking system and identify how and why it unraveled. They discuss the World Bank's role and the lessons to be learned from the crisis, including the following: 1) banking systems are exposed to stress in several major ways. Enterprises - the main borrowers - are subject to hard budget constraints and are privatized. Inflation declines so enterprises can't rely on rapidly increasing revenues to service bank debts. Economic reform tends to produce banking systems that are mainly privately owned - making them vulnerable to withdrawals, as the public does not assume that failing banks will be bailed out; 2) the government must protect against this vulnerability by establishing a proper legal framework for banking, developing effective bank supervision and regulation, and implementing solid accounting, disclosure, and auditing standards. It must also develop effective ways to handle problem banks and to close insolvent banks promptly; 3) for banks in the state sector to be a source of strength to the banking system, they must have strong effective management and be relatively free from political influence; 4)"outlier"banks - those expanding assets very quickly or offering particularly high deposit rates - should be subject to intense supervision; and 5) four things must be done to prevent fraud, incompetent management and excessive risk taking: 1) careful screen thosewho want to get into banking; 2) subject all banks to thorough, frequent onsite examinations and assign the best examiners to the largest banks; 3) require annual audits of all banks by reputable auditing firms; and 4) act decisively when fraud or bank difficulties are detected or suspected.