Summary

Against the backdrop of ongoing russia’s war, high inflation and monetary policy tightening by central banks, the global and Lithuanian economies are showing weaker growth. The world economy is expected to grow in 2023, but the projected growth rate is slower than the average of the twenty years before the pandemic. The March 2023 projections of the Bank of Lithuania forecast economic growth of 1.3% this year, but worse-than-expected GDP data for the first quarter of 2023 and a technical recession will lead to a less favourable economic development. High inflation, which is moderately easing, significantly contributes to the slower economic growth. After more than a decade, the ECB has started to tighten monetary policy by raising interest rates and reducing asset purchases in order to control inflation. As monetary policy tightens and the financial cycle eases, financial markets face higher volatility in securities prices. In the first half of 2023, several US banks with a specific business model and a major Swiss bank, which suffered from long-term problems, already encountered difficulties in the context of tightening financial conditions and ceased their operations.

With tighter financing conditions and uncertainty, the financial cycle in Lithuania, as in the euro area as a whole, has entered a slowdown. In 2022, in an environment of elevated inflation, credit institutions continued to lend to households and businesses at a pace not seen since the financial crisis. Households borrowed heavily, both for consumption and for house purchase. However, as interest rates rose, lending to both households and businesses started to slow down towards the end of 2022. With the downturn of the financial cycle, lending to the manufacturing sector slowed down the most. As the importance of MFI loans registered a long-term downward trend, companies borrowed more from each other, both for short and longer periods. Despite the rapid growth in liabilities, corporate and household liquidity remained high and indebtedness at sustainable levels. The subdued domestic economic activity, continued high uncertainty and a decline in loan demand together with the change in the interest rate environment show that the credit cycle will continue to slow down for some time to come.

The residential and CRE markets are cooling down, and a further slowdown in economic growth and tightening of financial conditions could lead to a correction in RE markets. With the unwinding of the compressed-spring effect formed during the pandemic and the deterioration of affordability, the number of house sales has started to decline since the spring of 2022, especially in the primary market. Although the annual house price growth rate is still high, the level of house prices has not changed much since the autumn of 2022. In the CRE segment, investment transactions started to decline in 2022, with the first signs of a price correction in the retail premises segment. The recorded slowdown in RE markets after a period of high activity during the pandemic is not surprising. But in the event of a more significant economic slowdown and tighter financing conditions, RE markets could face a larger correction.

The banking sector has so far successfully weathered the challenges posed by russia’s war, with good loan quality, high capital and liquidity buffers reflecting the resilience of banks to potential shocks, and rising interest rates resulting in exceptionally high bank profits. Strong domestic demand, government support and rising household and business incomes have led to a historically low level of non-performing loans in domestic banks in 2022. The banking sector is experiencing unexpectedly high profits due to the accumulation of high liquidity and rising key interest rates, which under the baseline scenario could increase by a factor of 2 to 3 in 2023 compared to the profits in 2022. However, the situation of banks differs – market participants with more fixed-loan products and relatively smaller liquidity buffers do not make significantly higher profits, and slowing economic growth may adversely affect riskier borrowers and lead to higher credit losses. The results of banks’ stress testing show that the banking sector has accumulated large capital buffers and is able to withstand even a very adverse economic scenario, and that it would be able to cover a decline in deposits of up to 40% with its liquid assets.

A macroeconomic environment affected by prolonged inflation, further monetary policy tightening or a significant economic shock could lead to a deterioration in the financial situation of households and firms, but the banking sector would be able to withstand this challenge. Slowing but still high inflation reduces the financial reserves held by households and firms and constrains their ability to accumulate such reserves, while tighter monetary policy is increasing the burden of existing liabilities. If similar trends continue in the future, the risk of a significant shock to the Lithuanian economy could be exacerbated by slower economic growth of the main export partners. In the event of a particularly significant economic shock, the largest increases in vulnerable companies and job losses could occur in the trade and transport sectors, but corporate credit risk would remain relatively low due to the accumulated reserves, better preparedness of the financial sector and the buffers put in place after the previous crisis in 2008-2010. Rising interest rates would lead to an increase of up to EUR 100 in monthly mortgage payments for most households, but the share of losses in the total housing loan portfolio would be small due to banks’ self-regulation in lending and the application of Responsible Lending Regulations (RLR).

Monetary policy tightening after a prolonged period of low interest rates and corrections in the securities markets are increasing tensions in global financial markets, while problems of individual foreign banks could negatively affect confidence in the banking sector as a whole. Several US banks with specific business models failed to manage interest rate risk and went bankrupt, while financial difficulties due to the securities price correction and previous management problems led to the forced sale of a Swiss bank. Problems at individual banks have negatively affected confidence in the banking sector as a whole. Although Lithuanian banks have no direct links to the failed banks, reduced links to parent banks, a high share of insured deposits and excess liquidity, a decline in confidence in banks could have a negative impact on the Lithuanian banking sector, either due to a possible increase in the volatility of deposits or a rise in funding costs.

In the context of war, the likelihood of financial sector participants being exposed to a systemic cyberattack by geopolitically motivated entities remains elevated. The number of cyberattacks has increased significantly since russia launched its war against Ukraine, and the financial sector is becoming an increasingly frequent target of these attacks. Attacks targeting systemically important market participants or third-party service providers may have systemic effects. Geopolitically motivated strategic attacks on critical infrastructure also increase the risk of systemic impact due to the tighter links between the real and financial sectors. However, in response to the growing threats, cooperation at national and international levels is being strengthened, information relevant to resilience is disseminated more widely and financial institutions invest more in IT system security.

As the financial technology and crypto-asset sectors have grown rapidly in recent years, it is important to further increase their maturity in order to avoid the emergence of systemic risks. Although risk management in the EMI and PI sector has been a key focus in Lithuania in recent years and the challenges in the global crypto-asset market have not had a noticeable impact on the Lithuanian financial system, significant developments related to the AML/CTF could damage the reputation of the financial system as a whole due to the shortcomings in internal procedures, descriptions, rules and processes of companies and the lack of competent professionals. Challenges posed by non-resident clients and their transactions and the threat of cyber vulnerabilities remain important factors that could increase the risks for these sectors in the future. Close cooperation and capacity building between different financial institutions can help to prevent risks and increase the resilience of the sectors, while new amendments to the AML/CTF law and the regulation on crypto-asset markets will contribute to a more sustainable development of the sectors.

Long-term climate change-related risks stemming from the transition to a climate-neutral economy continue to be relevant to the Lithuanian banking sector. Lending to the sectors that are most vulnerable to transition risk (transport, manufacturing, agriculture and energy supply) accounted for 32% of the loan portfolio of non-financial corporations in the fourth quarter of 2022. Sluggish reduction of GHG emissions enhances the likelihood of a disorderly green transition scenario. A preliminary sensitivity analysis of climate-related risks suggests that additional measures to curb GHG emissions would reduce credit losses for the banking sector in the long run. Microprudential policy measures can increase the resilience of individual institutions to climate-related risks, but macroprudential measures may also be needed in the future if these risks are assessed as systemically important.

In 2022, financial stability measures were strengthened, and the existing macroprudential toolkit reduces the potential impact of emerging risks. A sound financial position of the credit institution sector, high profitability, a recovery in lending to businesses and still strong household lending have enabled the re-establishment in the third quarter of 2022 of the pre-pandemic CCyB rate of 1%, with effect from 1 October 2023. In addition, a 2% sectoral SyRB on the housing loan portfolio of credit institutions entered into force on 1 July 2022, with the aim of increasing the resilience of credit institutions to increased risks from housing market imbalances and contributing to the mitigation of these risks. In the second quarter of 2022, Revolut Bank UAB became the third largest bank established in Lithuania in terms of assets and the second largest in terms of cross-border activity. Thus, the Board of the Bank of Lithuania recognised Revolut Bank UAB as a systemically important institution, and as from 1 July 2023 this bank will be subject to the 1% additional capital buffer requirement. Responsible lending measures, in place for more than a decade, have ensured that households in Lithuania are not over-indebted and are generally resilient to higher interest rates, and that the quality of household loan portfolios of credit institutions is adequate. The consistent introduction of additional macroprudential capital requirements since 2015 has contributed to strengthening the resilience of the sector, while the results of banks’ stress testing show that the banking sector is resilient to adverse economic scenarios and could withstand shocks while continuing business as usual.

Dalintis:

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1.Financial system and its outlook

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1.1.Financial market and economic developments

After hitting unprecedented levels in 2022, inflation has been slowly declining, the ECB increased interest rates to contain inflation and reduced its significantly expanded balance sheet.

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Lithuania’s economy is growing more slowly due to external challenges, but household purchasing power, which has been eroded by inflation, is expected to pick up again in 2023. The war launched by russia has had a particularly strong impact on energy prices, which have pushed up inflation, averaging 18.9% in 2022. Such inflation put a downward pressure on household purchasing power and had an adverse impact on the country’s economic growth which stood at 1.9%. However, the labour market was still tight: the unemployment rate equalled 5.9%, the lowest since 2008, and the average wages increased by 13% over the year. The March 2023 projections of the Bank of Lithuania forecast the economy to grow by 1.3% this year, but worse-than-expected GDP data for the first quarter of 2023 will result in a less favourable economic development. Wage growth will reach 10% and exceed the projected average annual inflation (9%), therefore, household purchasing power should start increasing again. Against the backdrop of rising interest rates, persistently high inflation and uncertainty about the war launched by russia, the balance of risks to further economic developments remains on the downside, with the potential to have a negative impact on financial stability (see more in Section 2.1.1).

In order to contain high inflation, the world’s central banks raise interest rates and the ECB shrinks its balance sheet. The ECB began raising key interest rates in mid-2022, and by May 2023 the interest rate on the deposit facility offered to euro area commercial banks was already 3.25%, the highest since 2008 (see Chart 1, central panel). Other major global banks are also raising interest rates: the target range of the US Federal Reserve interest rate is 5% to 5.25% and is the highest since 2007, while the interest rate established by the Bank of England (4.25%) is the highest since 2008. The financial market expectations show that the 6-month EURIBOR rate should reach 3.9% in 2023. In addition to raising interest rates, central banks are also gradually reducing their balance sheets, which have grown substantially as a result of the quantitative easing programmes that have been in place before and which have intensified during the pandemic (see Chart 1, right-hand panel). The sharp rise in interest rates in a context of high levels of liquidity in the euro area financial system has a positive impact on bank profitability, but a redirection of the monetary policy could create tensions in financial markets.

In 2022, yields on government securities started to rise rapidly, with significant volatility in equity prices.

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1.2.Credit developments and indebtedness

In an environment of elevated inflation, credit institutions lent to the private non-financial sector in 2022 at the most rapid pace since the financial crisis, however, there were more signs of a slowdown in lending at the end of the year. The portfolio of loans to households and NFCs grew at an annual rate of 11.6% and 17.7% respectively at the end of the year, almost twice as much as the euro area average (see Chart 3, left-hand panel). Corporations borrowed very actively, not because of improving post-pandemic expectations but because of the demand for working capital driven by higher prices of raw materials and intermediate goods. However, in the last months of 2022, the pace of lending to the private non-financial sector started to slow down significantly due to rising interest rates, uncertainty and worsening expectations. In this respect, lending trends in Lithuania are in line with the general financial cycle in Europe, where loan portfolio growth rates are also slowing down (see Chart 3, central panel).

At the end of 2022, the financial cycle entered a slowdown phase.

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In 2022, credit institutions mainly granted loans to RE companies, trade and manufacturing sectors.

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In 2022, companies borrowed more from each other, both for short and longer periods. During the year, the portfolios of short-term and long-term financial liabilities of companies grew by 9.1% and 8.1% respectively and amounted to EUR 37.4 billion and 19.1 billion respectively. Short-term liabilities still accounted for two thirds of the total liability portfolio, but the composition of liabilities changed: the peer-to-peer business loan portfolio increased by as much as 31.3% and amounted to EUR 7 billion at the end of the year (see Chart 5, left-hand and central panels), and the share of these loans in the corporate loan portfolio grew by 2.2 percentage points over the year. Despite the increase in 2022, the last decade shows a downward trend in the importance of MFI credit (see Chart 5, right-hand panel). This is partly due to the limited availability of credit to MFIs: according to the survey conducted by the Bank of Lithuania, as many as half of the companies in 2022 reported that bank financing was limited, and the share of rejected loan applications increased in the last quarter of 2022 in both the large corporate and SME lending segments.

There is a long-term downward trend in the importance of MFI credit in the structure of corporate financial liabilities.

Dalintis:

In 2022, households actively borrowed for both consumption and house purchases, however, the demand for credit fell at the end of the year and at the beginning of 2023. In the first two quarters of 2022, the high rate of household borrowing was still driven by low interest rates and low housing market activity. In 2022, credit institutions granted EUR 830.8 million (see Chart 6, left-hand panel) and other consumer credit providers granted EUR 606 million in new consumer loans, i.e. one-and-a-half and one-fourth times more than in the previous year (see Chart 6, central panel). At the same time, new housing loans amounted to EUR 2.2 billion, i.e. one-tenth more than in 2021. However, interest rates on new housing loans in December 2022 were already among the largest in the euro area (4.4%) and, based on the data of the survey conducted by the Bank of Lithuania, tighter bank lending standards also affected the consumer loan segment. As the housing market cooled down, positive expectations over house price developments were replaced by pessimism, and people’s expectations of expensive purchases deteriorated. In addition, as interest rates rose, the RLR began to put more constraints on households’ ability to borrow for house purchase. With the contraction of housing and consumer credit flows, the annual growth rate of the household loan portfolio has slowed down since the peak of the cycle, from 12.2% (September 2022) to 10% (March 2023).

Despite the rapid increase in liabilities, household and corporate liquidity remained at a high level in 2022. The household loan-to-deposit ratio increased slightly at the end of 2022, but remained low at 63.1% (see Chart 6, right-hand panel), reflecting the historically high amount of deposits held with credit institutions. Although corporate leverage increased in 2022 (the debt-to-equity ratio of 43.2% in the last quarter) and the ratio of current liabilities to current assets stood at 37.9%, up by 11.9 percentage points year on year, they were still at historically sustainable levels. The relatively stable corporate financial position and the growth in deposits are due to the moderating current account deficit, which stopped widening towards the end of the year. However, there are worrying signs: while non-performing loans are at their lowest level since the financial crisis and indebtedness is among the lowest in Europe, the rise in interest rates has pushed the corporate debt burden (debt service to profits ratio) up to 40% in September 2022, the highest in history (see more in Section 2.1.1).

With borrowing becoming more expensive and economic uncertainty still high, household lending slowed down at the end of 2022.

Dalintis:

Tighter ECB monetary policy and economic uncertainty will continue to have a significant impact on credit to the Lithuanian economy in 2023. Business confidence in Lithuania has continued to deteriorate since the outbreak of the war in Ukraine, and in the first quarter of 2023 it was still below the euro area level. Volatility in energy and raw material prices as well as weakening domestic and external demand remain a significant source of risk for Lithuanian companies. Despite a recovery in confidence in the construction, services and trade sectors, expectations in the industrial sector continued to weaken at the end of the year (see Chart 18). At the end of 2022, the assessment of the financial situation of households had deteriorated significantly: the majority of the banks surveyed claimed that the situation of households was getting worse. Although a major economic downturn is not yet expected in Lithuania, the weakening of the country’s economic activity and, according to banks, a drop in demand for private non-financial sector loans, which reached the pandemic level, suggest that the credit cycle will remain in a slowdown phase for some time.

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1.3.Trends in housing and CRE markets

The number of dwellings sold started to decline in 2022 and by the beginning of 2023 was already at its lowest level in the last five years. In 2022, a total of 47,000 dwellings were sold, 14% less than in the historically active 2021 and the same as in the pre-pandemic year of 2019. The decline in sales was due to the fading of the compression spring effect formed during the pandemic, deteriorating housing affordability, declining household real income, rising interest rates, and increased uncertainty about the future development of the economy as a result of russia’s war against Ukraine. From the second half of 2022 onwards, a more significant decline in sales is recorded, with sales in the first quarter of 2023 similar to the 2017-2018 level (see Chart 7).

Activity in the housing market declined in 2022, particularly in the primary market.

Dalintis:

Although the annual rate of house price growth remains high, the peak in price growth has now passed. According to different data sources, the annual growth rate of house prices was 13-16% in late 2022 and early 2023 (see Chart 8, left-hand panel). While this growth rate is still high, it has been slowing down gradually since 2022. In addition, monthly frequency data since autumn show prices stabilising or even declining slightly. The fact that price growth is moderating is also confirmed by the results of surveys conducted by the Bank of Lithuania. Households, real estate and financial market participants usually do not expect house prices to increase in the near future or even expect a small drop of up to 10%. Other advanced economies are also witnessing the end of the boom cycle. Meanwhile, countries with higher levels of household indebtedness and larger price imbalances are even experiencing negative annual house price changes (see Chart 8, left-hand panel).

Annual house price growth remains strong but it is slowing down, while wage growth is starting to outpace house price growth and there are signs of improving housing affordability.

Dalintis:

It is likely that the activity in the housing market will still be relatively low in the nearest future, and prices will rise at a slower pace. The expected slower economic growth, elevated inflation and rising interest rates may lead to a prolonged period of relatively low housing sales. And as sales decline, price growth should also slow down, as suggested by the historical phases of the housing market (see Chart 9, left-hand panel). Historically, it takes up to five quarters before house prices start to react more noticeably to changes in the number of house sales (see Chart 9, right-hand panel). Therefore, without significant changes in the macroeconomic environment, more subdued growth or even a certain decline in house prices can be expected in 2023.

The housing market entered a phase of declining sales but continuing price increases, with prices reacting later to the decline in sales.

Dalintis:

In 2022, new housing development was active but started to slow down again towards the end of the year. The number of permitted, under-construction and completed houses in 2022 was at a similar or even higher level than before the pandemic (see Chart 10, left-hand panel). Construction was facilitated by a decline in the growth of construction material prices (see Chart 10, central panel). Compared to the highest level, metal prices dropped by 13%, concrete and reinforced concrete by 5% and wood by 3%. Moreover, building permits were being issued more actively in Vilnius: in 2022, the largest number of building permits were issued since the beginning of the pandemic. Due to a drop in sales, housing supply in the Vilnius primary market started to grow and in March 2023 was the highest since the end of 2020 (see Chart 10, right-hand panel). However, developers tend to react to contracted sales and offer a relatively small number of new dwellings to the market each month. Furthermore, in the fourth quarter of 2022, the number of under-construction houses in Lithuania was the lowest since the beginning of the pandemic, and the number of under-construction houses in Vilnius was the lowest since the first quarter of 2018. This signals that, given the decline in sales, new housing development could be quite sluggish in 2023.

With construction price growth losing steam, housing construction was active in 2022, but housing development may slow down in 2023.

Dalintis:

In 2022, activity of the CRE market was still historically high, but signs of cooling were gradually emerging. Although still above the long-term trends, the volumes of investment transactions contracted by 8% and the number of purchase transactions declined by 21% (see Chart 11, left-hand panel). With demand continuing to be at a high level and developers completing their projects, the stock of CRE premises has grown significantly: in Vilnius, Kaunas and Klaipėda, the annual growth rate was 10.1%, 9.8% and 11.9% respectively. In the last five years, the most intensive development has been recorded in office spaces, with the stock of office space in Lithuania’s major cities even doubling (see Chart 11, right-hand panel). Despite the rapid development, in the third quarter of 2022, 38%, 40% and 67% of Vilnius, Kaunas and Klaipėda CRE market participants respectively still claimed in the survey conducted by the Bank of Lithuania that they were experiencing a shortage of office space supply, and no supply surplus was observed in any segment. Nevertheless, it is likely that slower economic growth and ongoing structural changes such as the rise of remote work and e-commerce will reduce demand for commercial space in 2023. Subject to these developments, as well as inflation and rising interest rates leading to higher construction and financing costs, CRE developers are more cautious, which could lead to a significant contraction in the supply of new premises next year.

As investors responded to the worsening macroeconomic environment, CRE investments and purchases declined, which should put downward pressure on the supply of new premises in 2023.

Dalintis:

With the exception of the retail segment, which is showing the first signs of a price correction, commercial property values continue to rise, and vacancy rates remain low, despite the significant increase in the stock of premises in recent years. Office vacancy rate in Vilnius has remained high since the outbreak of the pandemic, but it has fallen in other major cities (see Chart 12, right-hand panel). Along with the active expansion of the office stock, the value of these premises in Vilnius and Kaunas increased by around one-fifth in the period from 2019 to the first quarter of 2023 (see Chart 12, left-hand panel). Despite the low vacancy rates, prices of retail premises are lagging behind the pre-pandemic levels: during the aforementioned period, price drops of 2.5%, 5.9% and 2.5% were recorded in Vilnius, Kaunas and Klaipėda respectively. Due to higher investments in the industrial premises segment (including warehouses) and following upgrades, the value of these premises increased significantly over three years: growth rates of 29% and 23% were recorded in Vilnius and Kaunas respectively. Vacancy rates also remained very low in this segment, with the exception of Klaipėda. The increase in vacancy to 7.8% in Klaipėda could be due to a significant drop in trade with Belarus. The retail segment will continue to be the most vulnerable in 2023, with a decline of around 3% in the value of retail space in Lithuania’s major cities in the first quarter of 2023 (see Chart 12, left-hand panel, and Section 2.1.3).

The retail segment has been the most vulnerable since the outbreak of the pandemic and is showing the first signs of a new price correction in the first quarter of 2023.

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1.4.Banking sector developments

The Lithuanian banking sector has so far successfully weathered the challenges posed by russia’s war against Ukraine and has continued to perform among the best in the EU, with rising interest rates having a positive impact on profitability. The liquidity and asset quality indicators of banks operating in Lithuania were among the three best in the EU in 2022, while profitability and capital were better than in most countries (see Chart 13, left-hand panel). Moreover, the high level of liquid assets and the prevailing share of loans with variable rates in the context of rising key interest rates will lead to a significant increase in net interest income in 2023, which will further improve the sector’s profitability indicators under the baseline scenario (see more in Box 1 and Section 2.3). On the other hand, the level of concentration in the banking sector remains the second highest in the EU, although it has declined somewhat due to the growing competition in the banking sector in recent years. The high level of concentration reflects dependence on the activities of individual banks, which increases the risk of possible major impact on the banking sector.

In 2022, bank performance indicators remained among the best in the EU, but the slight deterioration in corporate loan quality is reflected in an increase in the share of loans with higher credit risk.

Dalintis:

The share of non-performing loans remained stable or declined for most economic activities and was concentrated in the construction and accommodation and catering sectors. At the end of 2022, the share of non-performing loans in these sectors stood at 8.3% (+0.7 percentage points annually) and 8.6% (-0.8 percentage points) respectively, whereas in the other sectors it ranged from 0 to 3%. Construction companies as well as accommodation and catering businesses, which have been particularly affected by the pandemic, are often viewed with more caution due to potential risks and weaker financial positions, and banks are more inclined to restrict lending to them. The manufacturing sector also remains one of the most vulnerable sectors in the current environment due to the price of raw materials, the challenges of maintaining competitiveness, the increasing cost of financing and the stronger dependence on the volatility of energy prices (see more in Section 2.1.1). Although the share of non-performing loans in this sector is low (1.2%), the impairment of loans to these companies, i.e. the probability of a loss, grew by the end of 2022, and banks also increased their overall provisioning for potential losses in view of the potential economy-wide risks.

Due to high uncertainty, rising interest rates and a weaker economic outlook, the risk appetite of banks started to decline towards the end of 2022. The pick-up in lending to non-financial corporations and households observed since mid-2021, which has been significantly affected by weakening pandemic concerns, easing constraints on operations and rising demand for funding, started to slow down towards the end of 2022. According to the bank survey, since the launch of russia’s war against Ukraine, banks have become more cautious in their assessment of risks and tended to take on lesser risk, which has resulted in a tightening of lending standards (see Chart 14, left-hand panel). The general economic environment and uncertainty contribute to the fact that financial development of companies and households is viewed less favourably, as reflected in the plans of banks to further tighten the lending standards. In addition, the loan application rejection rate has also increased slightly since the third quarter of 2022, which could increase further in the future if a worse economic scenario materialises.

The risk appetite of banks is decreasing, leading to more sluggish lending, and this could have a negative impact on the concentration in the credit market which has been declining so far.

Dalintis:

While concentration in the banking sector remained high it continued to decline somewhat with the increasing involvement of smaller market participants in the credit market over the past few years. From 2020 onwards, an increasing number of banks have started to increase their lending volumes, a trend that has prevailed in all loan segments, leading to a decrease in credit market concentration. As lending started to decline in late 2022, both as a result of a more cautious assessment of borrowers due to increased uncertainty and deteriorating economic developments, and as a result of lower demand due to deteriorating expectations of borrowers and rising borrowing costs, concentration in new corporate and housing loans stabilised, although consumer loans remained on a downward trend (see Chart 14, central panel). The declining concentration was correlated with the signs of increased competition. While new loan margins in Lithuania remain among the highest in the EU, average margins on housing loans fell from 2.2% to 2% between 2021 and 2022, and those on consumer and other loans dropped from 2.9% to 2.7% (see Chart 14, right-hand panel). However, the high share of loans with variable interest rates and rising interbank interest rates have significantly increased the overall cost of borrowing.

In 2022, while EURIBOR increased, margins on housing loans decreased and those on corporate loans remained stable.

Dalintis:

Banks’ profits increased significantly due to higher net interest income as a result of the exceptional situation in the banking sector.

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1.5.Non-banking sector trends

Against the backdrop of ongoing financial market tensions, pension fund returns were negative in 2022, and the year 2023 could also be challenging for pension funds. Pension funds were vulnerable to fluctuations in financial markets in 2022, as around 74% of pension fund assets are invested in equity funds (see Chart 17, left-hand panel). In 2022, pension fund assets decreased by almost 5% and accounted for 8.7% of Lithuania’s GDP, i.e. 2.2 percentage points less than in 2021. There was also a drop in the values of pension fund units which are relevant for pension savers. In 2022, the value of a weighted unit covering all accumulation target groups in Pillar II fell by 13.8% and by 13.1% in Pillar III. It cannot be ruled out that due to continued tensions in the financial markets the year 2023 will be challenging for pension funds.

Despite the fact that Revolut Payments UAB, the largest participant in the EMI and PI sector, has become a bank, the revenue of other participants in the sector continued to grow rapidly in 2022. At the end of the last year, licences were held by 131 EMIs and PIs. The revenues of the sector from licensed activities were higher by a factor of 1.6 compared to 2021, while the amount of payment transactions increased by 1.3 times year on year and is gaining a larger share of the overall payments market every year (see Chart 17, right-hand panel). The five largest EMIs and PIs in terms of payment transaction volume generated more than half of the total turnover of the sector, while the five largest EMIs and PIs in terms of revenue from licensed activities earned 39% of the sector’s total revenue. However, more than one third of the sector’s institutions are still operating at a loss. At the end of 2022, the share of EMI and PI client funds held with the central bank was 52%, down by 16 percentage points compared to 2021, and two institutions in the sector did not meet the equity capital requirements.

Pension funds were particularly vulnerable to financial market volatility in 2022 due to their large investments in equities, while the income of EMIs and PIs continued to grow at a very fast pace.

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2.Risks and challenges to the financial system, assessment of bank resilience

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2.1. Systemic risks to financial stability

2.1.1.Risk of a potential economic shock against the backdrop of sluggish trade growth, high inflation and rising interest rates

Continued high inflation, tightening financing conditions and deteriorating trade prospects are slowing down Lithuania’s economic growth and increasing the likelihood of significant economic shocks. Over the past five years, exports recorded a more significant quarterly decline only at the beginning of the pandemic, and in the first quarter of 2023, the country’s economy contracted by 3.6% compared to the corresponding period last year and shrank for the second consecutive quarter, putting the country in a technical recession (see Chart 18, left-hand panel). This contraction in the first quarter of 2023 is mainly due to a marked decline in activity in the industrial, transport and retail sectors. The main reasons for this slowdown are the tightening financing conditions, the imposition of international trade sanctions and the reduction in foreign demand for goods or services of Lithuanian origin. Lithuania’s major export partners are Poland, Latvia, Germany, the Netherlands and Estonia, some of which are projected to experience a small contraction in real GDP in 2023 (see Chart 18, central panel), which could be significantly higher in adverse circumstances. For example, recurrent turbulence in foreign banking sectors or financial markets (see more in section 2.1.2) could lead to a contraction in credit and a more severe downturn in these economies, which would dampen the demand for Lithuanian exports, and to an even sharper contraction of Lithuania’s GDP in 2023 than in the first quarter of 2023. A sharp contraction in exports could lead to higher losses for the most export-dependent companies and to additional difficulties in meeting financial commitments to credit institutions and other companies. Corporate profitability and the volume of liquid reserves may also decline, as the appreciation of raw materials and intermediate goods may be difficult to pass on to the price of the end product, and the sequence of events of the war in Ukraine may result in repeated shocks in the prices of energy and other raw materials in the future. This could lead to redundancies, which would cause financial problems for the population and higher unemployment rates in Lithuania, exacerbating the impact of the economic shock.

Massive inflation and rising interest rates tend to reduce the financial reserves available to households and companies and increase the burden of existing liabilities. In Lithuania, one of the highest inflation growth rates in the euro area recorded in 2022 has eased slightly in 2023 but remains high, while monetary policy tightening in the euro area due to high inflation has led to a sharp increase in key interest rates by 3.75 percentage points from mid-2022 onwards (for more details see Section 1.1). Rising interest rates, high inflation and lingering uncertainty over economic prospects constrain the potential of companies and households to accumulate financial reserves and limit household purchasing power, which has declined for the first time during the past ten years in 2022 and should remain unchanged in 2023. In Lithuania, the majority of corporate and personal housing loans are granted at variable interest rates, thus rising key interest rates affect the majority of borrowers, who, in addition to growth in other costs, face higher debt servicing costs, which may make it more difficult for individuals and businesses to meet their financial obligations to credit institutions and other companies as well as increase their credit losses. The impact of high inflation and the environment of rising interest rates is also reflected in the assessment of business confidence indicators (see Chart 18, right-hand panel), where the industrial sector provided the weakest outlook and used its production capacities in the first quarter of 2023 significantly less than usual, and the inventories of the goods produced by the sector have markedly grown as a result of the drop in sales.

The impact of high inflation and the environment of rising interest rates was reflected in a deterioration in the assessment of business confidence, while the economic contraction in Lithuania’s main trading partners may have a significant impact on Lithuania’s future economic growth.

Dalintis:

Companies in the accommodation and catering, transport and trade sectors would be the most vulnerable to the crisis scenario and significant shocks to turnover and expenditure, and they are likely be the ones with the highest potential job losses. Under the projected macroeconomic circumstances, the number of vulnerable companies in the transport and trade sectors would increase by merely one percentage point, compared to the actual company data for 2021, but in case the crisis scenario repeats itself, the number of vulnerable companies would increase by 16.7 and 14.7 percentage points respectively (see Chart 19, left-hand panel). In this case, the total number of vulnerable companies would increase by 6.5 percentage points. If turnover and expenditure of companies increases at the expected pace, the arts and entertainment, accommodation and catering, and manufacturing sectors would be most vulnerable to changes in electricity prices. At the same time, businesses operating in the accommodation and catering, administrative and service activities and real estate operations sectors would be significantly affected by higher interest rates. Micro and small enterprises, which account for more than 90% of all vulnerable companies, would be the most affected by economic shocks, while the fulfilment of the forecast under the crisis scenario could lead to a growth in the number of vulnerable medium and large enterprises (see Chart 19, central panel). At the same time, the share of jobs that could be lost as a result of the bankruptcy of vulnerable companies would increase by 9 percentage points under the crisis scenario compared to the baseline scenario. The drastic fall in turnover and expenditure would lead to an acceleration in potential job losses, mainly due to the possible closing of companies in the trade and transport sectors (see Chart 19, right-hand panel).

Under the 2008-2010 crisis scenario, the largest increases in vulnerable companies and potential job losses could occur in the trade and transport sectors.

Dalintis:

Under the crisis scenario, the credit of vulnerable companies represents a small share of the total credit of non-financial corporations (see Chart 20, left-hand panel), therefore, in the event of a significant increase in the number of such companies, the impact on the financial sector would remain limited, and the corporate credit risk would still be relatively low due to the safeguards put in place after the previous crisis. The sectoral diversification of the credit portfolio of non-financial corporations and the limited share of credit to vulnerable clients (see Chart 20, left-hand panel) significantly limit the increase in the expected loss on the total loan portfolio of non-financial corporations under the crisis scenario. Compared to the baseline scenario, expected losses on credit of non-financial corporations would double but still remain small, amounting to only around 2.7% of the total loan portfolio of non-financial corporations. The increase in expected losses under the crisis scenario is driven by loans to companies in the most vulnerable sectors, such as trade and transport (see Chart 20, right-hand panel). Loans to other sectors are not significantly affected under the crisis scenario, so their losses represent a small share of the total expected losses. The increase in expected losses remains small in the portfolios of individual banks as well: the most significant banks and branches of foreign banks, whose loans to non-financial corporations account for 91% of the total loan portfolio of non-financial corporations, would have expected losses ranging from 1.4% to 4.1% of the value of the banks’ loan portfolio under the crisis scenario.

Under the crisis scenario, corporate credit risk would remain relatively low due to the accumulated reserves, the better preparedness of the financial sector and the buffers put in place after the previous crisis.

Dalintis:

Under the severely adverse scenario, households with housing loans would be the most vulnerable to an interest rate shock, but for two-thirds of them an interest rate shock of 4 percentage points would lead to an increase in monthly payments of up to 3% of the average household income. The total number of vulnerable households would then reach 7%, an increase of almost 3 percentage points compared to the baseline scenario. Of all households with the single earning member, 9% would become vulnerable under the severely adverse scenario, and households with incomes below EUR 1,000 (before tax) would be the most vulnerable to interest rate shocks (see Chart 21, left-hand panel). At the same time, households with two earners would be slightly more resilient to adverse circumstances, with only 5% of households with two earners being vulnerable. Although households with incomes below EUR 1,000 have a higher share of loans for consumption and other purposes, housing loans account for almost 80% of the household’s total loan portfolio. Also, more consumer loan contracts are concluded at fixed interest rates, while housing loans are at variable rates, making housing loans and their holders more vulnerable to the rising key interest rates. Under a severely adverse scenario, the share of vulnerable households with an average monthly mortgage payment to income ratio above the 40% threshold specified in the RLR would amount to 4.5% of all households with housing loans, an increase of 1.7 percentage points compared to the baseline scenario. However, a rise in interest rates of 4 percentage points would only increase monthly payments by up to EUR 100 for almost two-thirds of households with housing loans, an increase of up to 3% of their average monthly income. A further quarter of households would face a monthly premium increase of EUR 100–200 (5% of average monthly income) (see Chart 21, right-hand panel). Other higher-income households would experience an increase in the repayments, from 7% to 9% of average monthly income. Persons employed in the education and transport sectors would see a smaller increase in interest expenses, while those working in the information and communications, RE operations and trade sectors would see larger increases. By region of mortgaged housing, Klaipėda and Telšiai districts would have the highest number of vulnerable households under both scenarios, while Vilnius and Kaunas districts would have the lowest number.

Households with housing loans and a single earner who earns up to EUR 1,000 would be most affected by the adverse scenario, but rising interest rates would result in a relatively small increase in monthly mortgage repayments for most households.

Dalintis:

Under the crisis scenario, one-year losses on housing loans of banks and credit unions would almost double, compared to those estimated under the baseline scenario, but they would represent only 0.1% of the value of the banking sector’s total portfolio. Under the crisis scenario, larger mortgage repayments, higher unemployment rates and falling household incomes would lead to some households struggling to repay their existing housing loans, while lenders would incur additional losses if they were unable to cover the non-performing loans with collateral. Borrowers in the transport and trade sectors would be the most vulnerable, with an almost three-fold increase in expected losses on their housing loans, accounting for around 40% of expected losses on all housing loans. This is explained by the high vulnerability of transport companies under the crisis scenario, which would contribute significantly to the almost 5-percentage point increase in the probability of default of borrowers employed there (see Chart 22, left-hand panel). However, both banks’ self-regulation in granting housing loans and the RLR with minimum collateralisation requirements would ensure that even for borrowers in the most vulnerable sectors, the expected losses on housing loans under the crisis scenario would not exceed 0.15% of the value of the corresponding NACE sector portfolio (see Chart 22, right-hand panel).

Under the crisis scenario, loans to households in the transport and trade sectors would be the riskiest, but the share of losses in the total housing loan portfolio would be small.

Dalintis:

2.1.2.Downside risk to confidence in the financial sector due to heightened tensions in global financial markets

Lithuanian banks have no direct links to distressed banks but, as investors become more cautious about banks, even profitable institutions with high liquidity may become vulnerable. For example, the prices of credit default swaps (CDS) of the German Deutsche Bank, a scandal-plagued but profitable and liquid bank, which are an indication of the perceived riskiness of the institution, rose sharply on 23 March due to the actions of individual investors (see Chart 23, right-hand panel). This led to a fall of around 14% in the price of the bank’s shares. Although share values have already recovered from the sharp fall, this case shows that panic can be sparked even around relatively safe banks in a situation of heightened tensions. The CDS prices of Skandinaviska Enskilda Banken AB and Swedbank AB, the parent banks of AB SEB bankas and Swedbank, AB, have not changed significantly since the start of the turmoil in the US, indicating that investors do not perceive any increase in the riskiness of these banks.

The problems of individual banks in the US have had a negative impact on investors’ views on the banking sector as a whole.

Dalintis:

The Lithuanian banking sector has large capital and liquidity buffers and most deposits are insured, but individual banks may be more vulnerable to a sudden drop in deposits. In the event of financial sector stress and a sudden drop in confidence in Lithuanian banks, depositors may rush to withdraw their deposits. The Lithuanian banking sector could withstand a 40% drop in deposits (see more in Section 2.3.2). With a historical peak of 6.2% month on month, banks could withstand an exceptionally large decline in deposits. In addition, just over two-thirds of total deposits in the banking sector are insured, which reduces the incentive to rush and withdraw deposits (see Chart 24, left-hand panel). However, the situation of individual banks is different. Some banks have fewer insured deposits, while others could withstand a relatively smaller drop in deposits. And problems at one bank could cause depositors to distrust the sector as a whole, increasing the vulnerability of banks with more reserves.

Most of the debt securities held by Lithuanian banks are not recorded at market value, but they represent a small part of bank assets and, unlike the collapsed US banks, Lithuanian banks hold significantly more liquid assets. Only about one-third of the debt securities held by Lithuanian banks and credit unions are stated at market price (see Chart 24, right-hand panel), so their carrying amounts may differ significantly from market values. If banks run out of liquid funds, they may have to sell their debt securities, which decrease in value as interest rates rise. And the sale of debt securities at a loss could have a negative impact on confidence in banks, which is what has happened in the US. However, the balance sheets of Lithuanian banks are very different from those of the collapsed US banks. Debt securities account for merely 9.2% of the total assets of Lithuanian banks, while cash and funds kept with the central bank make up 33.9%. In the US bank Silicon Valley Bank, cash accounted for 6.5% and cash at Signature bank accounted for 5.4% of total assets. Thus, in the event of a shock, the large liquidity buffers of Lithuanian banks would reduce the need to sell their debt securities at a loss. In addition, based on the ESRB calculations, unrealised losses on debt securities held by Lithuanian banks amount to around 2% of Tier 1 capital, one of the lowest shares in the EU.

The high share of insured deposits reduces the incentive to rush to withdraw deposits in the event of a shock and, although most of the debt securities held by banks are not revalued at market price, they represent a relatively small share of total assets.

Dalintis:

Heightened tensions in global financial markets may lead to higher funding costs for banks, but the direct impact on Lithuanian banks is mitigated by the low share of market funding and reduced links with parent banks. With only 3% of the Lithuanian banks’ total liabilities relating to market funding, banks would not be significantly affected by more expensive funding (see Chart 25, left-hand panel). However, the impact on Lithuania may occur indirectly through parent banks. Market funding accounts for 44% of the total liabilities of Swedish banks, and this is one of the highest shares in the EU. An increase in funding costs could lead parent banks to divert excess liquidity from Lithuania. An excessively abrupt withdrawal of liquidity could lead to lower lending in Lithuania, and a contraction in credit would result in a much slower growth of the real economy. However, this risk is mitigated by the fact that the links between Lithuanian banks and their parent banks are diminishing. At the beginning of 2023, deposits of foreign credit institutions in banks operating in Lithuania accounted for only 5% of total assets of Lithuanian banks, while this indicator stood at 43% during the financial crisis (see Chart 25, right-hand panel). However, more expensive funding may have an impact on Lithuanian banks, which have to issue subordinated bonds because of MREL.

The impact of higher volatility in global financial markets on Lithuanian banks is mitigated by a low share of market funding and weak links with parent banks.

Dalintis:

2.1.3.Risk of a potential downturn in residential and CRE as the financial cycle slows down

In the context of rising interest rates and sluggish economy, the cycle of activity in RE markets is also slowing down, and larger shocks in the economy and financial markets can lead to bigger corrections in RE markets. Slower economic growth reduces the demand for real estate, with a drop in sales in both residential and commercial RE markets in 2022 (see more in Section 1.3). It is likely that rising interest rates and more expensive borrowing, as well as the economic slowdown will further reduce demand for real estate in the near future. And if the economy grows even more slowly than expected, turbulence in the financial markets increases, demand for real estate could fall further and lead to shrinking financing flows and worsening of the financial situation of RE owners. This could also lead to a larger correction in RE markets.

RE markets are closely linked to the loan portfolios of credit institutions and contribute significantly to the overall economic development, therefore corrections in RE markets could have negative consequences for financial stability. Lending related to housing and commercial RE accounts for 76% of total lending to the private non-financial sector, while lending to construction and RE companies makes up 32% of total lending to non-financial corporations (see Chart 26, left-hand and central panels). The links between loan portfolios of credit institutions and RE markets make credit institutions vulnerable to a possible correction in RE markets. In addition, housing and other buildings account for around 12% of Lithuania’s GDP (see Chart 26, right-hand panel), therefore, corrections in RE markets could lead to slower growth in the overall economy. This could have a negative impact on non-RE economic activities, leading to higher unemployment, low or no wage growth and worsening of the financial situation of residents. Such economic shocks would ultimately have a negative impact on credit institutions and financial stability.

A stronger contraction of the economy and further rapid interest rate increases would have a negative impact on the financial situation of residents and could lead to a larger correction in house prices. A significantly worse-than-expected economic development would trigger unemployment growth and lower household income and, as interest rates continue to rise rapidly (see more in Section 2.1), demand for housing would drop even more compared to the present time. The worsening situation in the labour market and higher mortgage repayments may force some residents to sell their homes. And the drop in demand could lead to a significant fall in prices as a result of excess supply.

RE markets are closely linked to the financial system and the economy.

Dalintis:

A sharp contraction in credit would dampen housing demand, especially for owner-occupied housing, and could set the stage for larger house price corrections. In the context of heightened uncertainty about economic developments, banks are already starting to tighten lending standards and reduce the supply of loans (see more in Section 1.4). Although around 60% of all housing is purchased with own funds, which would reduce the impact of a credit contraction on the market, houses valued at over EUR 50,000 – i.e. people’s main residences, are commonly purchased with loans (see Chart 27, left-hand panel). Therefore, if lending flows were to contract significantly due to, for example, the turbulence in financial markets and its consequences for the Lithuanian banking sector (see Section 2.1.2 for more details), the ability of the population to acquire a primary home for their own use would be significantly reduced, and a larger correction in house prices could occur.

A contraction in demand, reduced cash inflows and rising interest rates could lead to a deterioration in the financial situation of RE companies, while contagion from problems of individual companies could lead to a correction in the market as a whole. Reduced demand, both in the residential and commercial RE markets, leads to lower cash inflows for companies involved in RE activities. Overall, RE companies have accumulated substantial liquidity buffers, which are above the levels before the 2008-2009 financial crisis (see Chart 27, right-hand panel). However, with rapidly rising interest rates and a simultaneous drop in demand, some less experienced market participants may be more vulnerable. If individual companies encounter financial difficulties and have to sell properties significantly cheaper than planned or fail to complete their projects or even go bankrupt, confidence in the market as a whole could be adversely affected. Larger market participants may also have to reduce prices and corporate funding could become more expensive. This would lead to a contagion effect, which could cause difficulties for more market participants and result in corrections in the residential and commercial RE markets.

The contraction in lending would have a particularly adverse effect on lending for owner-occupied houses, and RE companies have built up substantial liquidity buffers.

Dalintis:

The likelihood of a larger house price correction is reduced by the fact that, unlike before the financial crisis, there are fewer signs of overheating in the market. Although prices moved away from economically driven values during the pandemic, price overvaluation remained well below the pre-financial crisis levels (see Chart 28, left-hand panel). The spread of overvaluation estimates remains high, signalling that a price correction may still occur, but the overall overvaluation estimate is declining, with price imbalances which arose during the pandemic already gradually diminishing as prices rises are slowing. In addition, credit flows and housing market turnover, albeit elevated, are more in line with general economic trends than before the financial crisis and are also returning to normal levels (see Chart 28, central panel).

Housing market developments have been more in line with the economy during the pandemic than before the financial crisis, the RLR are adhered to, which reduces the likelihood and potential impact of a larger house price correction.

Dalintis:

The CRE market operates in an environment of heightened vulnerability, which poses a risk of investor retreat. Rising interest rates significantly increase debt servicing costs and reduce real yields on CRE investments. The attractiveness of new investments is also declining, with the yield spread between CRE and government securities shrinking by 2.4 percentage points over 2022 (4.8%, see Chart 30, left-hand panel). The stock market is also reacting negatively to the change in the macroeconomic environment: although it has stabilised recently, the share price index for REITs has fallen for most of 2022 and is still at a low level (see Chart 29, left-hand panel). The deteriorating macroeconomic environment suppresses the development of CRE and may even push some investors out of the market. In addition, while rising interest rates are putting downward pressure on prices, which should increase CRE yields, price corrections in the Baltic region are relatively sluggish. This means that as investors seek higher yields in markets that have experienced larger price corrections, this type of investment is likely to decline in Lithuania in the near future. On the other hand, relatively stable CRE prices give more confidence to established investors.

Although no major imbalances are visible so far, uncertainty in the CRE market is still high and there is a growing risk that the supply of premises, which has been accelerating in recent years, will not be absorbed. Compared to the major euro area countries, where CRE prices dropped by as much as 10-15% in 2022, the situation in the Lithuanian market is relatively stable (see more in Section 1.3). REITs are gradually adjusting to higher interest rates, with increased refinancing costs being absorbed by indexation-induced rental income and broader insurance coverage. In addition, unlike in Europe, Lithuania is dominated by closed-end REITs, thus the risk of a liquidity mismatch is not as relevant for local funds. On the other hand, market participants with over-concentrated positions in the retail and office segments may face liquidity problems, where a more significant price correction is most likely due to structural challenges (e.g. the increasing popularity of remote work or the surge of e-commerce). In addition, slowing economic growth may reduce demand for commercial premises, which have been very actively developed in the last three years, threatening losses for CRE firms that have started overly ambitious projects. Although the expectations of the largest CRE funders, i.e. the banks, are still better than during the pandemic (see Chart 29, right-hand panel), and only a fifth of them report imbalances in the market, it is likely that the full impact of monetary tightening has not yet been felt.

Although not as drastically as during the pandemic, stock indices and banks’ expectations have deteriorated considerably, while uncertainty about future developments in the CRE market remains high.

Dalintis:

The CRE loan portfolio remains highly risky, but its quality has not yet deteriorated.

Dalintis:

2.1.4.Risk of systemically important cyberattacks in wartime

In 2022, heightened geopolitical tensions in the world triggered an increase in the number of cyberattacks, and the likelihood of a high-impact attack from russia or other geopolitically motivated states remains strong. The geopolitical threat has increased especially since russia launched its war against Ukraine. This led to a significant growth in the number of cyberattacks against governments, the financial sector, critical infrastructure and businesses in various other sectors worldwide: in 2020-2022, the average number of global cyberattacks was 40% higher than in 2015–2019 (see Chart 31, left-hand panel). Cyber incidents have often been attributed to geopolitically motivated hacker groups or state-sponsored entities, which are considered among the most dangerous due to their well-funded and technologically advanced attacks. In Lithuania, more intense waves of attacks were recorded at the beginning of russia’s war against Ukraine and in the summer months, and a large part of these attacks were linked to pro-russian hacker groups.

The financial sector is increasingly targeted by cyberattacks. According to the Bank of Lithuania’s Survey of Risks to Lithuania’s Financial System, the share of financial institutions operating in Lithuania that faced cyberattacks increased significantly from 17.5% at the end of 2021 to 41.5% at the end of 2022 (see Chart 31, central panel). The number of cyber incidents affecting banks increased to 10 in 2022, up from 2 in 2021. The majority of these attacks were distributed denial-of-service (DDoS) attacks aimed at making banking systems inaccessible to users. There were also cases of ransomware attacks aimed at restricting access to data and data leaks. In addition, there has been an increase in the number of cases of system scanning to find and exploit security vulnerabilities. Nevertheless, these attacks did not have a systemic impact on the financial sector, but the risks remain elevated.

With strong interconnections between the real and financial sectors, the likelihood of a successful attack that could affect the financial sector is enhanced. Increasing digitalisation further deepens the interdependence between these sectors, while geopolitical tensions enhance the probability of risk materialisation. An analysis conducted by the Regional Cyber Defence Centre (RCDC) revealed that the participants of the Ukrainian financial sector were among the first targets of cyberattacks after russia launched its war against Ukraine. However, most of the destructive cyberattacks targeted critical infrastructure objects, which could have negative secondary effects on the economy and society. According to the RCDC Regional Threat Analysis, cyberattacks in 2022 often targeted public authorities, media, transport, energy and other sectors (see Chart 31, right-hand panel). If attacks targeting critical infrastructure are successful, they could disrupt financial services, lead to financial losses and a loss of public confidence.

Heightened geopolitical tensions give rise to a growing number of cyberattacks, which are increasingly targeting the financial sector.

Dalintis:

Cyberattacks aimed at systemically important financial institutions or third-party service providers are particularly dangerous because of the potential consequences for the whole financial system. The likelihood of contagion in the financial sector is also elevated by the existence of significant interconnections between financial market participants. Based on the data of the 2022 Microsoft report, IT companies are the most frequent targets of state-sponsored entity attacks (22%). Attacks against third-party IT service providers have increased in recent years. They are aimed at reaching key targets by exploiting interfaces with the companies that provide services to them or at carrying out large-scale attacks. In Lithuania, a similar type of attack was carried out against UAB BankingLab, a developer of banking systems, in 2022. During the attack, several financial sector participants were affected and their data was leaked. Although, according to publicly available information, customers were not financially harmed and services were quickly restored, such attacks are extremely dangerous as they can affect the whole sector and even lead to a loss of confidence and a significant withdrawal of liquidity.

With the growing number of cyber threats, cooperation at the national and international levels is being strengthened and financial institutions are investing more in the protection of their IT systems. In response to the increased cyber risks, the Bank of Lithuania initiated a discussion on enhanced sharing of information on cyber threats. In cooperation with the National Cyber Security Centre, banks will test technical and organisational tools for this purpose. In 2022, the ESRB also published a Recommendation on a pan-European systemic cyber incident coordination framework (EU-SCICF), which is currently being implemented. Sharing information on cyber threats is an important tool for operational resilience, enhancing the protection capabilities, threat detection methods, response and recovery phases. Credit institutions are also enhancing their preparedness by strengthening the security of their IT systems, monitoring and regularly updating business continuity plans.

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2.2.Non-systemic challenges to the financial system

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2.2.1. Challenges posed by the rapid expansion of new market participants

The improvement of risk management in the EMI and PI sector has been a key focus in recent years, but a significant ML/TF event could damage the reputation of the financial system as a whole, due to the remaining weaknesses in internal corporate processes and the lack of competent professionals. The risk monitoring model applied by the Bank of Lithuania facilitates monitoring of ML/TF risks and related indicators as well as assessing different risk categories (customers, geographic location, products and services, etc.). In the sector, the reputational risk could have a significant impact not only on a specific EMI or PI, but also on the country’s entire financial system, if a ML/TF event of high importance is identified. The impact of the risk could manifest itself through a reduced client base, lower revenues for institutions, more expensive funding, poorer market access or loss of licences. According to the Bank of Lithuania’s analysis of compliance of EMIs and PIs with risk management requirements and the application of best practices, the most frequently identified deficiencies are related to risk management measures, risk and incident registers and risk management plans. The lack of competent specialists in Lithuania makes it difficult to ensure real-time response to risks. According to the 2022 survey of financial technology sector participants conducted by Invest Lithuania, the main challenges for companies include attracting skilled and necessary talents, design and development of products and IT systems, regulatory environment and compliance.

Another channel of potential ML/TF risk is the challenges posed by the sector’s customers, especially non-residents, and their transactions. Compared to the banking sector, EMIs and PIs are more likely to serve non-resident customers. While the residency of an individual in a foreign country may not necessarily pose additional risks, the vulnerability of institutions can be increased by clients and partners who are registered in high-risk countries or in target territories – the so-called offshore jurisdictions – as their identity is not always easy to establish (e.g. in the absence of their physical presence). Although the majority of non-resident customers of EMIs and PIs are currently from EEA countries with a lower ML/TF risk, the share of payments from high-risk and third countries has recently markedly gone up. In 2022, 23% of the total value of payments to and from foreign countries was composed of payments to and from non-EU countries (see Chart 32, right-hand panel). Both the value and the number of payment transactions made by non-resident customers have been declining over the year, with non-residents from high-risk countries or target territories representing a very small share of the sector’s total customer base, which has been significantly stable lately. In 2022, the number of customers residing in the target territories decreased significantly compared to 2021, but the value of their payments rose by 13%. It is possible that the EEA, which is considered to be an area of relatively safe countries, may also show signs of increasing ML/TF risks. Against the backdrop of russia’s war against Ukraine, reputational risks in the sector could also be exacerbated by the risk of non-compliance with international sanctions. In order to circumvent the restrictions of international sanctions on trade with russia and Belarus, settlements and payments may be made through other financial institutions in the Commonwealth of Independent States. While the risk of potential non-compliance with sanctions is higher in traditional financial institutions, this risk channel is also relevant to the EMI and PI sector.

The rapid expansion of the EMI and PI sector also increases the importance of supervisory action, and around one fifth of the value of payments in the sector is related to non-EU resident customers.

Dalintis:

Reputational risks could also arise from the cyber vulnerability of the EMI and PI sector, with a recent increase in cyberattacks on the payments market. An increase in cyber incidents has been observed in Lithuania for some time now, and there is a number of data leakage examples in the non-financial sector (see more in Section 2.1.4). As new technologies and models are introduced, security systems may not keep pace with these innovations and may create gaps that lead to increased vulnerability of the systems. The likelihood of risk exposure is also increased by the ever-expanding interconnections between market participants with different levels of cyber security. Due to contagion effects, a cyber incident recorded in one institution in the EMI and PI sector could have negative consequences for the security of the entire financial system. A lack of cyber security could lead to the leakage of certain data, which would increase the lack of confidence in a particular financial institution and, in some cases, in other financial market participants involved.

Effective cooperation between the regulator, national agencies and financial institutions, capacity building and cooperation with foreign regulators can help prevent risks and increase the resilience and maturity of the sector. Supervision of the EMI and PI sector focuses on enhancing the maturity of the sector, compliance with anti-money laundering, own funds and customer funds protection requirements, and improving internal controls and compliance with applicable risk management requirements. In order to help financial market participants to properly identify and manage risks and to increase the competences of employees in the area of ML/TF risk management, the Bank of Lithuania has established a Centre of Excellence in Anti-Money Laundering. The aim is to ensure adequate training of specialists and to draw the attention of shareholders and managers of institutions to the importance of risk management compliance. In order to identify further growth challenges, new opportunities and development directions for the sector, a draft roadmap for the development of the financial technology sector in Lithuania for 2023-2028 is being prepared. It is envisaged to enhance the development and potential of the sector in Lithuania, as well as to stimulate the development of the technologies and innovations used and to improve risk management. The identified ML/TF cases show that cooperation with regulators in other countries and taking into account the recommendations of international institutions, such as the IMF’s recommendation to raise awareness in Lithuania about the higher risk countries in terms of ML/TF, is essential to avoid reputational damage.

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2.2.2. Challenges posed by climate change impact on financial stability

Transition risk is significant in Lithuania due to high bank lending to the polluting manufacturing and transport sectors.

Dalintis:

Transition risk is particularly relevant in Lithuania due to heavy lending of banks to the most polluting sectors. The transport (37%) and manufacturing (26%) sectors were the most emission-intensive in 2021, followed by agriculture (21.7%) and energy supply sectors (11.4%) (see Chart 33, right-hand panel). Transition risk that could arise from lending to firms in these sectors is the most relevant for Lithuanian banks: together, loans to these sectors accounted for 32% of the loan portfolio of non-financial corporations in the fourth quarter of 2022. Emission-intensive sectors will be more sensitive to climate policy tightening, changes in consumer preferences and other developments. During the transitional period, the costs and profitability of companies operating in these sectors may increase, which could affect their ability to fulfil their financial obligations to credit institutions. Under the disorderly green transition (or disorderly transition) scenario, this vulnerability could significantly affect bank liquidity and even solvency.

In recent years, energy independence based on renewable energy resources has become a political priority in many EU countries, but the sluggish reduction of GHG emissions increases the risk of a disorderly transition. Larger investments and subsidies towards renewable energy will contribute to reducing GHG emissions in the long term. However, since the end of the 2008-2010 financial crisis, the level of GHG emissions in Lithuania has remained broadly stable, while in 2021 emissions increased by 1.6%, compared to the previous year (see Chart 34). Even though GHG emissions in the energy and manufacturing sectors have been declining, emissions from the transport sector have more than doubled since 2008. The sluggish decline in total emissions suggests that Lithuania’s target to reduce national GHG emissions to 9.5 million tonnes by 2050 is becoming less realistic, increasing the likelihood of a disorderly transition scenario (see more in Box 4). Risk prevention is further complicated by the fact that the EU Emissions Trading Scheme (ETS) is not applicable to the vast majority of economic activities (including transport and agriculture).

The level of GHG emissions in Lithuania has remained broadly stable over the last twenty years, mainly due to the growing emissions in the transport sector.

Dalintis:

The tightening of energy performance requirements and energy market volatility could lead to a deterioration in the quality of some of the real estate used as collateral for credit, which would reduce bank liquidity. Buildings with a lower than C energy efficiency class, which accounted for 67% of the total building stock in Lithuania by area in 2019, will be affected most severely. During the transition period, potential changes in energy prices due to the shift to renewable energy could affect the cost of RE maintenance, thereby reducing disposable income of households and firm profits. In addition, the tightening of energy performance standards for buildings in the EU may lead to a fall in demand for low energy efficiency RE and a decrease in their market value. These factors may impact the ability of borrowers to repay debt and affect bank assets and liabilities.

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2.3.Assessment of bank resilience

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2.3.1. Bank solvency testing

The bank solvency testing considers three economic development scenarios. The baseline scenario is based on the official macroeconomic projections of the Bank of Lithuania published in March 2023 (for more details, see Section 1.1), extending the scenario horizon to 2025 for the purposes of this exercise. This scenario is designed to assess the resilience of the banking system in the context of the most likely economic developments. A severely adverse scenario has been developed to assess the resilience of the banking system in the event of a particularly severe economic shock. Under this scenario, domestic demand would fall by 8.8% in 2023 (2.3% in 2024), the unemployment rate would increase to 8.6% (to 9.4% in 2024), and the exports of goods and services would decline by 12% in 2023. Under a severely adverse scenario, Lithuania’s real GDP would contract by 7% in 2023 and by 1.6% in 2024. In addition, another (adverse) scenario has been developed in which Lithuania’s economic development would be negative, but the decline would be milder than under the severely adverse scenario. Under this scenario, GDP would contract by 1.2% in 2023. The main macroeconomic indicators used in the exercise and their evolution are presented in Table 1.

(percentages)

Indicators	Actual indicator	Baseline scenario			Adverse scenario			Severely adverse scenario
	2022	2023	2024	2025	2023	2024	2025	2023	2024	2025
GDP (annual change)	1.9	1.3	3.2	3.4	-1.2	-0.1	0.0	-7.0	-1.6	-0.4
Exports (annual change)	11.7	1.7	4.7	5.0	-2.9	-0.1	0.0	-12.0	-0.1	0.1
Consumption expenditure (annual change)	0.5	0.0	3.1	3.3	-2.5	-0.1	0.0	-8.8	-2.3	-0.8
Unemployment rate (average annual)	5.9	6.6	6.4	6.1	6.5	6.6	6.6	8.6	9.4	9.5
Wages (annual change)	15.5	9.3	8.1	8.4	2.2	-0.2	0.0	-5.7	-3.9	-1.1
Average annual inflation (based on HICP)	18.9	9.0	2.7	2.6	6.5	-0.1	0.0	5.6	-1.0	-0.1
Annual change in RE prices (annual change)	19.0	8.3	7.0	7.5	1.4	-0.3	0.1	-16.6	-6.7	-2.1

The stress testing results show that the banking sector is well-capitalised and resilient to potential adverse shocks, and under the baseline scenario its solvency would improve significantly (see Chart 35, left-hand panel). Over the 2023-2025 testing period, the banking sector would maintain and even slightly increase its high capital adequacy ratio (CAR, 23.9%) under the baseline scenario. Under the adverse scenario (-1.2% of GDP), bank capital positions would be only slightly affected, with an overall reduction of 0.03 percentage points. Finally, under the severely adverse scenario, which assumes an extremely severe shock to the economy (-7% of GDP), the banking sector’s capital holdings would be sufficient to meet the minimum capital requirements, including Pillar 2, with a margin. Under the severely adverse scenario, the weighted capital adequacy ratio would decline to 16.4%, with the difference from the baseline scenario equalling -7.5 percentage points. Under this scenario, there would be a minimal (0.3 percentage points) breach of the recommended Pillar 2 Guidance (P2G), which is designed to help banks survive in the event of stress. The recent strong profitability of the banking sector and the macroprudential capital requirements have allowed banks to build up significant capital buffers, so that the reduction in capital estimated in the exercise does not pose a risk to the stability of the sector, as banks would be able to cope with a more adverse shock to the economy than in the most severe test scenario. The temporary solidarity contribution, while slowing down bank capital accumulation under the scenarios being considered, does not have a significant impact on the fulfilment of capital requirements in the test scenarios.

The estimated credit losses of the banking sector under the stress scenario in 2023–2025 would amount to around EUR 1 billion, or around 5.2% of the total loan portfolio at the end of 2022 (9.1% for loans to non-financial corporations, 2.4% for household housing loans and 8.7% for household consumer loans). Compared to the baseline scenario, the decrease in the capital adequacy ratio is mainly driven by an increase in credit risk losses on loans and a decrease in net interest income (see Charts 35 and 36).

The banking sector is resilient to economic shocks. Credit losses on the loan portfolio are the main source of bank losses.

Dalintis:

Dalintis:

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2.3.2. Bank liquidity testing

	LCR calculation	LCR calculation under the adverse scenario
Liquid asset valuation haircut, %
Level 1 assets
Coins and banknotes; withdrawable central bank reserves	0	0
Central government assets; public sector entity assets	0	5
Level 2 assets
Regional/local government or public sector entity assets	15	20
Corporate debt securities; shares	15-50	20-75
Decrease in liabilities, %
Retail and operational deposits
Covered by DGS and stable deposits	5	7.5
Not covered by DGS; deposits subject to higher outflows and other (non-stable) retail deposits	10-25	15-37.5
Excess operational deposits and non-operating deposits
Deposits by financial customers[49] [49] The concept of financial customers is defined in Commission Delegated Regulation (EU) 2015/61 of 10 October 2014.	100	100
Deposits by other customers	20-40	30-60

The banking sector would be able to cover a 40% decrease in deposits with liquid assets, however, bank-by-bank situation varies (see Chart 37, right-hand panel). Results for individual banks fluctuate from 13.6% to 85.1%. By comparison, historically, in the banking sector, deposits fell by a maximum of 6.2% per month in October 2008, after depositors questioned the sustainability of one bank (deposits with that bank declined by 9.3%). Looking at individual banks, the largest monthly decline in deposits was 28.7% in November 2008 in AB Parex bankas (currently – AS Citadele banka Lithuanian branch), when its parent bank faced liquidity difficulties and the Government of Latvia had to provide it with financial support.

Dalintis:

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3.Financial stability strengthening

According to the Bank of Lithuania, an increase in the CCyB rate will not have a major impact on credit and interest rates: in the short term, business credit could grow up to 2.5 percentage points and personal credit up to 1 percentage point slower in a year, while interest rates on loans would not change substantially due to the CCyB requirement. The expected impact should be even smaller given that credit institutions are already complying with the new requirement, the sector is profitable, and bank profitability is expected to increase further in 2023 due to rising interest rates (for more details, see Box 3). In the long term, the positive impact on Lithuania’s long-term economic development will be considerably stronger due to increased bank resilience. Higher capital requirements mean that more funds are retained in the banking sector to cover potential increases in provisions in the event of a deterioration in asset quality, and less is paid out in dividends. In the event of a major shock to economic growth, the CCyB rate can be quickly reduced and credit institutions could divert the freed-up funds to the real economy when it is most needed. For instance, the CCyB rate was reduced from 1% to 0% during the COVID-19 pandemic. This has freed up around EUR 86 million of capital and strengthened the supply of credit during the pandemic.

On 1 July 2022, a sectoral SyRB of 2% for housing loan portfolios of credit institutions came into force. During the pandemic, imbalances developed in the housing market, with demand diverging from supply, prices rising faster and moving away from fundamental values. Slower economic growth, deteriorated financial situation of the population due to declining real incomes and rising interest rates may negatively affect the ability of individuals to repay their loans, and the limited imbalances still present in the housing market may lead to a market correction.

The sectoral SyRB aims to increase the resilience of credit institutions to increased risks from housing market imbalances and to contribute to the mitigation of these risks. For the purposes of this sectoral SyRB, the capital buffer is calculated on the sum of exposures to individuals in Lithuania secured by RE collateral (essentially the housing loan portfolio). It is planned that this buffer will not be applied to those institutions whose housing loan portfolio comprises an insignificant share of the sector’s housing loans, i.e. where it is lower than EUR 50 million. Therefore, based on current data, the SyRB applies to five institutions, namely, AB SEB bankas, Swedbank, AB, AB Šiaulių bankas, the Lithuanian Central Credit Union (LCKU) and the United Central Credit Union (JCKU) groups, and amounted to EUR 36 million at the end of 2022.

Countries such as Latvia, Estonia and Sweden, where licensed institutions are lending actively in Lithuania through established bank branches, also apply the SyRB to institutions with housing loan portfolios in Lithuania above the materiality threshold of EUR 50 million, in line with the ESRB recommendation. This ensures that the sectoral SyRB is applied equally to credit institutions licensed in Lithuania and to foreign banks lending in Lithuania directly or through branches.

In 2023, the 1% CCyB rate for the entire credit institution sector, and an additional 1% other systemically important institutions buffer for Revolut Bank UAB as a systemically important bank will come into force.

Dalintis:

Rising interest rates increase the burden of loans on the population, but RLR help to ensure borrowers’ resilience to interest rate fluctuations. Since 2015, the RLR have introduced a sensitivity test in the case of a housing loan, verifying that borrowers would be able to pay the increased loan repayments when the interest rate rises to 5%. The sensitivity test was intended to prevent possible over-indebtedness of the population in a low interest rate environment, so that the quality of housing loans remains good in the current context, where interest rates and indispensable costs have already risen. As of December 2022, loans granted after the entry into force of the RLR accounted for 83% of the total housing loan portfolio, while housing loans granted since the beginning of the pandemic made up 42% of the total housing loan portfolio. In 2021, in order to align the riskiness of first and subsequent housing loans and to further restrict loan-financed housing investment transactions, a stricter 30% down payment is imposed on second and subsequent housing loans. Following the entry into force of this amendment to the RLR on 1 February 2022, the share of second housing loans has slightly decreased compared to the period before the announcement of the amendments.

As a resolution authority, the Bank of Lithuania helps to ensure that, should significant credit institutions face financial difficulties, they can be resolved swiftly and continue to operate without state assistance. In 2022, early contingency preparations continued, previous resolution plans for credit institutions were updated and expanded, and new plans were drafted for newly established banks. Resolution plans for the three largest banks were updated in cooperation with the Single Resolution Board, the central resolution authority of the Banking Union, and, for banks belonging to multinational groups, with the national resolution authorities of Sweden, Latvia and Estonia. The resolution plans in place cover 99% of the total assets of the banks and central credit unions in Lithuania.

Banks and central credit unions are subject to MREL, which is designed to ensure that credit institutions in difficulty have the reserves to absorb losses and, if applicable, to continue their activities after resolution. The deadline for MREL accumulation is 1 January 2024, but credit institutions have already accrued all or most of the required amount.

The Single Resolution Fund (SRF) is an additional source of funding for resolution measures, which prevents the need to use taxpayer funds. The SRF is built up through contributions from credit institutions operating in the banking union. At the end of 2022, the SRF had accumulated around EUR 66 billion. By the end of 2023, the size of the SRF is expected to reach the target level of EUR 80 billion, i.e. 1% of the insured deposits of credit institutions operating in the banking union.

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Abbreviations

AB                    public limited liability company

CCyB                counter-cyclical capital buffer

CRE                  commercial real estate

DSTI ratio         debt service-to-income ratio

EC                    European Commission

ECB                  European Central Bank

EMI                  electronic money institution

ESRB                European Systemic Risk Board

EU                    European Union

EURIBOR          Euro Interbank Offered Rate

Eurostat           statistical office of the European Union

Eurosystem      European Central Bank and euro area central banks

GDP                  gross domestic product

GHG                 greenhouse gas

HICP                 Harmonised Index of Consumer Prices

IMF                   International Monetary Fund

IT                     information technology

LTV                   loan-to-value ratio

MFI                   monetary financial institution

ML/TF               money laundering and/or terrorist financing

MREL                minimum requirement for own funds and eligible liabilities

PI                     payment institution

RE                    real estate

REIT                 real estate investment trust

RLR                  Responsible Lending Regulations

SME                  small and medium-sized enterprises

SyRB                systemic risk buffer

UAB                  private limited liability company

US                    United States of America

Country codes

AT                                Austria

BE                                Belgium

BG                                Bulgaria

CY                                Cyprus

CZ                                Czech Republic

DE                                Germany

DK                                Denmark

EE                                Estonia

ES (in charts)                Spain

EU                                European Union

EA                                Euro area

FI                                 Finland

FR                                France

GB                                Great Britain

GR                                Greece

HR                                Croatia

HU                                Hungary

IE                                 Ireland

IT                                 Italy

US                                United States of America

LT                                 Lithuania

LU                                Luxembourg

LV                                Latvia

MT                                Malta

NL                                The Netherlands

NO                                Norway

PL                                 Poland

PT                                 Portugal

RO                                Romania

SE                                Sweden

SI                                 Slovenia

SK                                Slovakia