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It is a well-known fact that over the last two decades all governments of European countries, without any exception, have gone through multiple major challenges in the economic sector. If we were to look at the economic development of the European Union countries over the last decade, we can say that even the global financial crisis of 2008 had a significant impact on the European Union’s economy and financial sector. The combined crises,starting with the Great Recession of 2008-2009 and continuing with the sovereign debt crisis, have significantly affected economic growth, investment (both private and state), employment and the fiscal stances adopted by the governments of many EU Member States. During the global financial crisis of 2008-2009, the EU implemented short-term measures to rescue banks and kick-started reforms to correct weaknesses. In the longer term, the EU worked to improve economic resilience through financial sector stability, strengthened economic governance and structural reforms.
Ten years on, with the European economy barely stabilizing, the COVID-19 pandemic brought new challenges and opportunities for the European banking sector. The negative side of the pandemic on the banking sector was the fall in bank revenues due to reduced demand and government interventions. On the positive side, there has been an acceleration of the digitalization process. It is well known that over the last decade, the European banking sector has been vulnerable to geopolitical risks and cyber-attacks, fluctuations in energy prices and structural changes in the euro area economy. This is why the study by the ECR Party, partly funded by the European Parliament, looks at how the banking sector in the EU has transformed and the impact on competition in the Baltic States.
Banking sector transformation in the Baltic States
After the break-up of the Soviet Union on the 26th of December 1991, three ex-Soviet countries, Estonia, Lithuania and Latvia, showed their willingness and “opened their borders” for foreign bank investments. Estonia and Lithuania attracted international banks, especially Swedish banks, which served both local residents and international clients.
Latvia, on the other hand, tried to become a financial hub for the Russian Federation and the countries of the Commonwealth of Independent States (CIS), attracting financial deposits from these regions. This Latvian strategy has led to problems and accusations of money laundering from former Soviet Union countries. Today, all three Baltic countries have implemented much stricter regulations and are trying to transform their business models to be more sustainable, digitized and business-friendly.
Although foreign investment has played a significant role in the development of the Baltic countries’ banking sector, it has also led to a high concentration of banking assets. In Estonia and Lithuania, more than 85% of banking assets are controlled by foreign institutions, while in Latvia the figure is 76%. This dominance of international banks may limit competition in the banking markets of the three countries, compared to the much larger Northern European region. In the future, balancing foreign investment with domestic participation could be the key to a healthy and dynamic long-term banking environment in the Baltic States.
The impact of labor market and credit transformations in Europe
In the pre-financial crisis period (1998-2008), the EU experienced a 19% increase in the number of banking personnel and a 23% increase in the number of bank branches. In the Baltic States surveyed in the ECR Party study, Latvia saw an impressive 76% increase in the number of employees, followed by Estonia (38%) and Lithuania (16%). Well, in the post-crisis period (2009-2022), the EU saw a significant decrease in the number of bank offices (40%) and employees (20%). In the Baltic States, Estonia and Lithuania continued to record increases in the number of employees, while Latvia experienced a dramatic 57% drop in bank staff, the largest “bank staff shedding” in Europe. In the area of lending, the Baltic paradox shows high interest rates and low lending. Although banks operating in the Baltics are criticized for insufficient lending, the problem does not seem to be a lack of resources, but rather a cautious approach. High interest rates suggest a competition problem in the Baltic banking sector, in contrast to more favorable rates in the Scandinavian countries.
Digital transformation and the impact on the European banking sector
As expected, digitalization has significantly changed the European banking sector. This digitization has led to increased use of online banking services and a decrease in the need for physical infrastructure for banks. In this context, it has been observed that traditional banks are facing increased competition from neo-banks, which operate exclusively digitally, without having physical branches (offices that the average citizen has to call on). In 2022, Europe had the highest value of transactions in the neo-bank market globally, followed by the US. The projected average annual growth forecast for the European non-banks market is 25% between 2022 and 2027, indicating continued growth in this sector. The transformation of the banking sector in the European Union is an ongoing process, influenced by external factors such as geopolitical risks, the 2008 financial crisis, the COVID-19 pandemic and other factors that have accelerated regulation, digitalization and risk assessment.
The transformations in the European and Nordic banking sectors have had a significant impact that has boosted competition in the Baltic States. Despite uncertainties, there are clear directions in which the global banking sector will continue its transformation. These transformation directions include geopolitical risk management, regulatory pressure and compliance, digitization and FinTech, implementation of a sustainable business model. The adoption of ESG (environmental, social and governance) criteria represents a paradigm shift, offering both environmental benefits and new opportunities for the financial sector.
After the transition from a planned to a market economy, the Baltic countries liberalized their financial systems, allowing foreign investors to enter the banking sector. This led to a significant increase in the number of banks owned by foreign investors, especially from Scandinavian countries and Germany. In Estonia, this process was much faster than in Latvia and Lithuania, where foreign-owned banks held more than 90% of bank assets in the early 2000s. As can be seen, the business models of banks in the Baltic countries have evolved differently. In Lithuania, for example, foreign (mainly Swedish) banks focused on local customers. In Latvia, the banking sector has been influenced by geopolitical factors, with local banks serving both domestic and international customers, mainly from the Russian Federation and CIS member states. This banking policy has turned Latvia into a regional financial center. However, this position has been undermined by repeated allegations of money laundering, leading to a fall in non-resident deposits and financial difficulties for some banks. In Estonia, the banking model has followed an intermediate path, similar to that in Lithuania, but with a significant reduction in non-resident deposits, as part of efforts to combat money laundering risks. Banking sector concentration in the Baltic region is high, dominated by a few large banks such as Swedbank and SEB, indicating a low level of competition compared to the Nordic countries and the EU average. In Sweden, although the banking market is more dynamic and competitive, in the Baltic countries the high level of concentration suggests a negative impact on competition.
After the global financial crisis, the number of bank branches and bank employees in the EU banking sector declined. This trend was similar in the Baltic countries, with the exception of Lithuania, where the number of branches increased before the crisis. The number of employees increased significantly in Latvia and Estonia between 1999 and 2008, but fell sharply in Latvia after the crisis. Bank lending to the private sector in the Baltic countries is below the EU average, but interest rates on loans are higher than in other European countries. This reflects limited competition between banks, allowing them to maintain high interest rates. Baltic banks are more profitable than banks in the Nordic countries due to higher profit margins and more efficient operating practices. However, this may also be influenced by a lower level of competition and higher risks in the region.
Competitiveness of the Nordic Banking Sector
After a short transition period from planned to market economies, the Baltic countries liberalized their financial systems and allowed foreign investors to enter the banking markets. Foreign capital entered the Baltic banking sector mainly from Scandinavian countries and Germany, and later also from the USA. The entry of foreign capital was not uniform in all three Baltic countries. In Estonia the penetration of foreign capital has been rapid, so that in the late 1990s foreign-owned banks accounted for about 90% of bank assets. In the case of Lithuania, the massive entry of foreign capital came later, and by 2002, foreign banks held just over 90% of bank assets. In Latvia, by contrast, the presence of foreign capital was lower, but gradually increased, reaching 80% by 2022.
What are the banking business models in the Baltic countries?
Banking business models have evolved differently in the three Baltic countries. While Lithuania has been oriented towards domestic customers, offering a wide range of universal banking services, mainly through Swedish banks, Latvia in contrast has adopted a different model, focused on two segments: services for domestic customers (dominantly through subsidiaries of Scandinavian banks) and international services, oriented towards customers in Russia and CIS countries. Estonia has chosen a similar middle path to Lithuania, with a significant reduction in non-resident deposits after 2015, in particular to mitigate money laundering risks.
According to the ECR Party study, the entry of foreign investors into the Baltic financial markets has increased the resilience of the Baltic banking sector to external shocks, but has also raised issues related to banking competition. Thus, at the end of 2022, 90% of banking assets were held by foreign-owned banks in Lithuania, 85% in Estonia and 76% in Latvia. The Herfindahl-Hirschman Index (HHI) showed a moderate to high concentration of the banking sector in the Baltics, compared to low concentration in Sweden and Denmark. The dominance of large banks of Swedish origin, such as Swedbank and SEB, indicates low competition in the Baltic banking sector, in contrast to the Nordic markets where competition is much more dynamic. As mentioned above, in the period 1999-2008, the EU credit institutions sector expanded significantly, but the global financial crisis led to a decline in the number of branches and employees. In Lithuania, the number of branches increased by 35% between 1999 and 2008, but in Latvia and Estonia it fell after the crisis. The number of employees increased significantly in Latvia until 2008, but fell rapidly by 57% between 2009 and 2022. By contrast, in Estonia, Lithuania and Sweden, the number of employees continued to increase.
Lending and interest rates in the Baltic countries, efficiency and profitability of the banking sector
In the Baltic countries, lending to the private sector is systematically lower than the EU average, with Latvia leading the way. Although Baltic banks do not lack resources, they seem to adopt conservative lending practices, preferring to maintain a higher proportion of deposits in liquid assets. Although lending practices are conservative, interest rates are higher than the euro area average, suggesting limited competition in the banking sector. These high rates could also be influenced by a reduced demand for loans.
In markets with little competition, banks may earn higher profits than necessary to meet investor demand. In March 2023, return on equity (ROE) and net interest margin (NIM) in the Baltic countries were among the highest in Europe. Although ROE in the Nordic countries was higher than the EU average, the differences between the Baltics and Sweden were not significant, suggesting efficient use of capital in both regions. Net Interest Margin (NIM) NIM in the Baltics was significantly higher than in Sweden, indicating higher profits from lending activities. Low customer mobility was identified as a potential barrier to promoting greater competition in the banking sector. Between 2017-2022, around 29% of EU residents switched their financial services provider. While Sweden was an EU leader in this respect, Lithuania was not far behind the European average. Profitability is the main indicator of a bank’s success. The study analyzed the financial data of SEB and Swedbank banks in all Baltic countries and Sweden in the period 2005-2023. Thus according to the centralized data it was found that there were no significant differences between the Baltic countries and Sweden in terms of ROE, except in Estonia, where SEB’s ROE was lower than in Sweden. Return on Assets (ROA) in the Baltics was significantly higher than in Sweden, indicating a higher return per asset in the Baltics. The Net Interest Margin (NIM) was significantly higher in the Baltics than in Sweden, suggesting that banks in the Baltics derive a higher profit from the difference between interest on loans and interest on deposits. The analysis indicates that Swedish banks operating in the Baltics earned higher profits from their lending activities and managed their assets and capital more efficiently compared to the Swedish market. However, the high level of banking sector concentration in the Baltics suggests less competition, which may contribute to higher interest rates and higher bank profitability.