Financial sector supervision

Licensing developments

There were minor changes in the banking sector. On 10 March 2023, the ECB took the decision to withdraw the licence of Baltic International Bank SE, and after the licence was withdrawn, the bank went into liquidation. On 24 January 2024, insolvency proceedings for the bank were announced.

There were also minor changes at cooperative credit unions as the licence of the cooperative credit union AVOTS 37 was withdrawn in 2023 at the decision of the general meeting of its members.

Six new insurance brokers were registered in the insurance sector in 2023. They were SIA CREDEO, SIA Moller Auto Insurance Services, limited liability company HWCA, Inchcape Insurance Services SIA, limited liability company FIRST BROKER, and Mango Insurance SIA. The entry of SIA E-aģents in the register of insurance and reinsurance brokers was cancelled in 2023. The Lithuanian insurance corporation INVL Life uždaroji akcinė draudimo bendrovė, operating in Latvia through a branch, handed over all of its insurance contracts to Gyvybes draudimo UAB SB draudimas, another insurance corporation licensed in Lithuania, on 1 December 2023. The Latvian branch of INVL Life, uždaroji akcinė draudimo bendrovė discontinued its operations as of 1 December 2023. Gyvybes draudimo UAB SB draudimas opened a branch in Latvia on 15 September 2023, and continues operations in Latvia through its branch following the transfer of the insurance contracts from INVL Life uždaroji akcinė draudimo bendrovė.

One new licence to operate as a payment institution was issued in 2023 to SIA JOOL PAY, while two payment institution licences were withdrawn. The licence of SIA Nordigen Solutions was withdrawn at the company's application, and the licence of SIA Baltic Payment Solutions was withdrawn because it had not been operating as a payment institution since September 2021, and it had no holdings of customer funds and no liabilities to customers.

A licence as an electronic money institution was issued in 2023 to SIA xpate. The licence gives it the right to issue electronic money and to provide several payment services that are set out in the licence. Registration was withdrawn for one electronic money institution, AS LatCard, at its own application requesting that its registration in the register of electronic money institutions be cancelled. AS LatCard had no liabilities to its customers, who were electronic money holders.

There were several new entrants in the investment services market. A licence was issued in 2023 to SIA Nectaro, and at the end of the year, authorisation to open a branch in Latvia was granted to UAB FMI INVL Financial Advisors. Authorisation for the operation of the AK JENSEN NORWAY AS branch in Latvia was withdrawn in 2023.

A licence to provide investment services was granted to VAIRO IPAS in 2023, while the licence of the joint stock company Rietumu Asset Management investment management company was withdrawn.

Three new alternative investment fund managers were registered in 2023, and they were SIA Merito Real Estate Management AIFP, SIGNET ASSET MANAGEMENT LATVIA IPS, and SIA ASP Asset Management AIFP. During the year, the licence of one alternative investment fund manager, SIA 2B Capital AIFP, was withdrawn. The licences of the joint stock company BIB Alternative Investment Management and the joint stock company AIFP Baltic Asset Management were also withdrawn.

SIA BALTTOMS was registered in the register of foreign exchange trading companies in 2023, while the entry of SIA VIAL in the register of foreign exchange trading companies was cancelled.

Crowdfunding service providers are a new and gradually developing sector, and an authorisation in the sector was granted to SE Capitalia in 2023. Towards the end of the year, another authorisation process was started for SIA LANDE Platform.

Latvijas Banka had set five priorities for supervision of the financial market in 2023, which were macroeconomic and geopolitical risks, operational and financial resilience, transition risks, ML/FTP and sanction risks, and protection of consumers of financial services. The financial sector continued to face challenges in 2023 from managing the risks of sanctions circumvention while still preserving a risk-based approach. Latvijas Banka worked to ensure that the two areas were in balance and that honest customers had access to the financial services they needed.

Microprudential supervision and compliance monitoring

Supervision of credit institutions

Latvijas Banka regulates and oversees the Latvian credit institution sector in close cooperation with the ECB within the framework of the ECB’s Single Supervisory Mechanism (SSM), and with European supervisory authorities following the best international practice and the fundamental principles of supervision of credit institutions.

The primary principle of supervision is that problems in the financial market or the operations of individual market participants should be identified as early as possible so that the supervisor can give their opinion and recommendations promptly or demand that the problems be resolved or mitigated.

Latvijas Banka further reinforced the supervisory framework for credit institutions in 2023 to ensure a comprehensive supervisory process and to foster the operation and development of a stable and resilient credit institution sector.

Supervisory priorities of credit institutions

Latvijas Banka performed comprehensive and consistent supervision of credit institutions in 2023. To take appropriate actions that match the supervisory priorities of Latvijas Banka while applying a risk- based approach, supervisory programmes were developed for individual market participants together with a plan for horizontal activities. Close attention was paid to the principle of proportionality and better application of it in supervisory processes.

The credit institutions sector continued to have to operate in a highly uncertain environment in 2023. The escalation of events in the Middle East meant that geopolitical risks, which had previously mainly caused by Russia's full-scale invasion of Ukraine, remained strong. Macroeconomic risks, particularly those caused by soaring inflation and rising interest rates, warranted further in-depth monitoring of the credit risk and sanctions risk faced by credit institutions and of their operational risk management. Meanwhile, the failure of two major regional credit institutions in the US financial sector drew increased attention to liquidity risk management.

The capital buffers built by credit institutions and the efforts of previous years to strengthen the sustainability of their business models, which included having reduced or initially small exposures to jurisdictions affected by the current geopolitical risks, supported the financial resilience of credit

institutions and their capacity to absorb the shocks they faced. The prevailing risks appeared to have no significant effect on asset quality.

The year 2023 saw some changes in the list of participants in Latvia's credit institution sector. In addition to the tendency towards consolidation observed previously, a new market player announced its interest in joining the credit institution sector. New market entrants can be expected to strengthen competition in the credit institution sector.

Following risk assessments of credit institutions and taking account of the priorities set by the ECB and the EBA, the 2023 supervisory priorities for credit institutions were set:

The supervisory activities plan that was developed from the supervisory priorities included on- site and off-site activities both at individual credit institutions and at the level of the whole sector.

Supervisory dialogues were held on fulfilling financial projections and the progress made in implementing business models, the framework for internal governance, the impact of the geopolitical and macroeconomic environment, and sustainability issues.

 

The potential and actual effect of macroeconomic and geopolitical risks on asset quality and the approach of credit institutions to integrating those risks into the most significant processes and documents came under closer scrutiny. Targeted inspections were carried out at some credit

institutions where exposure to those risks had been detected, so that the impact of geopolitical and macroeconomic risks on asset quality could be assessed.

The focus in operational and financial resilience was on the quality of the recovery plans of credit institutions, and the quality of their ICT risk and credit risk management. The approach to the management of non-performing loans and the improvements made in it at credit institutions with large exposures to non-performing loans were discussed in focused supervisory dialogues. Latvijas Banka assessed the management and organisation of the internal audit and compliance control functions in less significant institutions within the framework of a horizontal review, and also the effectiveness of those functions and the adequacy of the resources allocated. The review identified some gaps and weaknesses as well as some examples of good practice. Following the results of the review, several supervisory expectations for the processes assessed were formulated and were discussed with the Finance Latvia Association in December 2023. On-site inspections were carried out at individual credit institutions into the regulatory compliance of their internal capital adequacy assessment process.

The focus with transition risks was on sustainability and the challenges of the digital transformation. Less significant credit institutions conducted a self-assessment of sustainability for the third consecutive year, tracking the progress made in integrating issues of sustainability into the operations of the credit institutions and monitoring the self-assessment of compliance with supervisory expectations. Surveys and dialogues about the digital transformation were used to identify the credit institutions that are more open to it and how they track their progress towards their objectives for it.

Latvijas Banka focused in the protection of consumers of financial services on the two important points of providing critical financial services when there is a threat to national security, and reducing financial fraud.

The best practices for detecting and preventing financial fraud that are applied by significant credit institutions were identified, as were the risks associated with any possible gaps and weaknesses in those practices, and feedback and recommendations for improvements in preventive measures were given to credit institutions.

Focus on clear communication of the supervisory approach and supervisory expectations

In 2023, Latvijas Banka continued to improve cooperation with the supervised institutions and promote practices with a better focus on providing support, advice and communication of supervisory approach and expectations. The most significant activities were carried out in the field of diversity and business strategy.

Experts analysed the diversity practices of the boards and councils of credit institutions. As a result, the best practices and gaps were identified and supervisory expectations were formulated. In November, an extensive discussion was held with both significant and less significant credit institutions of the sector. A summary and findings have been also published on Latvijas Banka website, section Inspection results and the best practice.

In 2023, recommendations were also made on the scope and quality of credit institutions' strategy documents, the process of strategy definition and its management.

With a view to further improving the supervisory transparency, a practice was introduced to publish the results of horizontal activities, including the most significant findings, conclusions and recommendations on Latvijas Banka's website, section Inspection results and the best practice, in addition to communicating those results to market participants individually.

Supervisory Review and Evaluation Process

Latvijas Banka conducts regular assessments of credit institutions' risks within the framework of the SREP taking a risk-based approach and applying the principle of proportionality. The risk assessment:

• analyses the quantitative indicators characterising the level of risk and their thresholds using the ECB's methodology;
• analyses the information on risk management found during on-site inspections, thematic and horizontal reviews;
• uses the information at Latvijas Banka's disposal about regulatory compliance at credit institutions, the gaps identified in internal control systems, the quality of capital and the liquidity adequacy assessment process, and the assessment of the recovery plan.

Overall, the process follows the EBA Guidelines on SREP and the ECB guidelines on SREP for credit institutions. No significant changes were made in the methodology in 2023 from the previous year, while sustainability aspects continued to be integrated into the SREP.

The supervisory priorities for 2023 and the individual supervisory programmes of credit institutions led Latvijas Banka to focus on the following risks and areas within the framework of the SREP:

• the resilience of business models, through assessment of their viability, profitability and sustainability, given the current macroeconomic and geopolitical conditions;
• the framework for internal governance and risk management, particularly the quality of the compliance and internal audit functions;
• the level of credit risk and the measures to mitigate it, particularly where this concerned risk management practices, given the current macroeconomic and geopolitical conditions;
• liquidity risk, particularly funding concentration and risk management practices following the failure of two major regional credit institutions in the US.

In 2023, the following requirements were set for nine credit institutions, including the credit institutions under direct ECB SSM supervision, within the framework of the SREP:

• own funds requirements to cover the risks inherent or potentially inherent in their business;
• recommended capital buffer requirements (P2G).

The overall SREP score is assigned between 1 and 4, and the following risk scores were assigned to Latvia's credit institutions, including those under direct ECB SSM supervision, in 2023:

Chart 1. Risk scores within the framework of the SREP in 2023

The risk scores were broadly unchanged from the previous year. Credit risk, internal governance risks, and ICT and ML/FTP risks remain the highest risks in the credit institution sector, largely because of the geopolitical and macroeconomic risks.

In addition to the quantitative requirements, a number of qualitative requirements and recommendations were made within the framework of the SREP, and they will make a further contribution to improving the internal control systems of credit institutions and strengthen their resilience to shocks. They were mainly focused on internal governance, ensuring sustainability, credit risk management, capital adequacy planning, and operational risk management, including management of ML/FTP risk. There were 28 quantitative requirements and 40 recommendations issued to credit institutions within the framework of the SREP.

Single Supervisory Mechanism

The ninth anniversary of the establishment of the SSM, the European banking supervision system, fell on 4 November 2023. The SSM comprises the ECB and the national competent authorities of the euro area, which are the central banks and national supervisory authorities of the Eurosystem. Latvijas Banka is also a part of the SSM, and the main objectives of the SSM are:

• to ensure the safety and soundness of the European banking system;
• to increase financial integration and stability;
• to provide consistent

At the turn of 2023, there were 113 significant credit institutions under the direct supervision of the ECB, and 1956 less significant credit institutions under the direct supervision of the national competent authorities.

Three credit institutions in Latvia, Swedbank AS, AS SEB banka and AS Citadele banka, remained under the direct supervision of the ECB in 2023. Supervision of those credit institutions was carried out by the ECB and Latvijas Banka staff members working together in the Joint Supervisory Teams that are the basis for the routine supervision of significant credit institutions. Latvijas Banka staff also participated in the on-site inspections of the significant credit institutions by the ECB.

Latvijas Banka continued to supervise the less significant credit institutions in 2023 in close cooperation with the ECB and in communication with the EBA, in order to ensure consistent supervision throughout the European banking sector and promote the safety and sustainability of credit institutions and the stability of the financial system.

Experts from Latvijas Banka continued to play a part in the committees and working groups of the ECB in 2023, helping improve the ECB's common supervisory methodology and to align various regulatory frameworks within the European Banking Union.

Like other European supervisors, the ECB's SSM continued to implement supervisory processes and activities, increasing confidence in the ability of credit institutions to withstand macro-financial impacts, including the consequences of high inflation and high interest rates. The supervisors have monitored closely the evolution of the quality of credit institutions' loan portfolios and the build-up of sufficient provisions, the strengthening of governance structures, the solutions to the challenges associated with digitalisation, and the efforts made to ensure compliance with climate-related supervisory requirements.

Participation in the ECB's SSM decision-making

The Latvijas Banka representative on the ECB's Supervisory Board participated in the SSM's decision- making process for significant credit institutions under the direct supervision of the SSM and for the methodology governing the supervision of euro area credit institutions.

The ECB's SSM adopted 2403 supervisory decisions in 2023. Like in previous years, about half of those decisions were approved at the meetings of the ECB's Supervisory Board, while the other half were taken by written procedure.

The bulk of those decisions were the 48.4% that related to the fit and proper assessments, the 9.6% on own funds, the 7.9% on national powers, 7.7% on internal models, 4.7% on the SREP, and 4.7% on reporting.

Supervisory activities with regard to cooperative credit unions

The supervision of cooperative credit unions in 2023 was carried out by monitoring their performance results using analysis of their financial statements, with a particular focus on checking whether the loan loss provisions set aside by the cooperative credit unions are sufficient to cover possible losses, and by carrying out on-site inspections. Latvijas Banka's auditors carried out three on-site inspections during the reporting year to assess the financial standing, management performance, asset quality, income and expenditure composition of the cooperative credit unions, and also their regulatory compliance.

The licence of one union was withdrawn at its own decision within the framework of supervision of cooperative credit unions.

Insurance supervision

Insurance premiums and claims continued to increase in the insurance market

There were 17 insurers in Latvia at the end of 2023, as there were two life insurance companies and four non-life insurance companies, and 11 branches of insurers from other European Union countries, of which four were branches of life insurers and seven were branches of non-life insurers. The register of insurance and reinsurance brokers maintained by Latvijas Banka contained entries on 81 insurance and reinsurance brokers, which is five more than at the end of 2022.

Premiums written in Latvia's insurance sector increased by 10.2% in 2023, while the claims paid out grew by 8.4%. As high inflation gradually abated in 2023, its effect on insurance services also diminished, and so the rate of growth for insurance premiums and claims was lower in 2023 than in 2022, when the premiums written increased by 15.9% and claims grew by as much as 23%.

The global growth of the insurance sector is confirmed by developments in insurance premiums written abroad by the six insurance undertakings registered in Latvia Their premiums written in Lithuania, Estonia, Poland, France and Italy increased by 15.5% and their claims paid out by 13.8% in 2023.

Chart 2. Gross premiums written and claims paid out by insurers
(amount; millions of euro; annual growth; %)

The high inflation of the past two years pushed up both the prices of insurance products and the claims paid out. Inflation had a direct effect on the size of insurance claims, fuelled by rising construction costs, and higher prices for spare parts and repairs of vehicles, and for healthcare and medical services. That was taken into account when insurance products were priced, and in most cases the prices to be paid by customers increased. The most significant rises in insurance premiums in 2023 were of 21.1% for health insurance and 19.4% for land vehicle insurance.

The biggest increases in claims paid out were of 43.7% for property insurance and 14.6% for health insurance. Property insurance claims increased under the influence of inflation in 2023, but also because a larger number of claims were made as climate risks materialised as floods and storms.

The year 2023 was unfavourable for the life insurance segment as the premiums written in Latvia decreased by 18.9% over the year. The most notable fall in the premiums written was of 38% in annuity insurance, as changes in the conditions for pension disbursement meant fewer people in Latvia chose to transfer the capital accumulated to life insurers and receive their pensions from them after retirement. The impact from the uncertainty caused by the tense geopolitical situation and high inflation on the population's purchasing power meant there was less willingness to build up long-term savings, and so contributions to life insurance with savings decreased.

Inflation also caused a steep increase in interest rates, which made the insurance companies reconsider the composition of their investment portfolios. The financial results of the insurance companies were positive in 2023, and the six insurers between them closed the year with a profit of 44.4 million euro.

The insurance companies registered in Latvia also continued to maintain stable, albeit lower, solvency capital ratios that were higher than the minimum requirement. The ratio was 158% at the end of 2023, while the minimum limit is 100%.

Chart 3. Solvency capital ratios of insurance undertakings (%)

The supervisory focus on market conduct risk has consumer protection at heart

Supervisors are paying ever more attention to consumer protection because of the rapidly changing external environment with high inflation, volatility in financial markets, increasing risks from natural disasters and climate change, and the digitalisation of financial services.

To provide an adequate level of protection to their customers, insurers and insurance distributors must have an effective product oversight and governance process and must reinforce the trust of their customers by offering clear and understandable information about the financial products and the service provider. Regulatory requirements oblige insurers to develop products that meet the needs of their customers and also to make sure constantly that their products are still appropriate for their target market and suit the needs and demands of their customers. Moreover, customers with different levels of financial literacy should be able to understand the information they get about the insurance services however it is distributed, be that through digital communication or through a consultant.

Insurance products meeting the needs of customers

Special attention within the framework of continued supervision of product oversight and governance was paid in 2023 to the value for money that life insurance with savings offered customers. Latvijas Banka's reviews detected an elevated risk that some unit-linked life insurance products were failing to provide value for money in their net return on investment. This was because of the quite weak performance of the underlying investment funds in the previous period, and the relatively high total cost of the product for the customer.

Latvijas Banka carried out targeted supervisory work at specific insurers, and reminded all insurers about the importance of considering a product's value for money for customers during the process of product design and distribution.

Sufficiency of insurance cover in face of macroeconomic shocks

Given the spike in inflation over the last two years, Latvijas Banka analysed not only how it had impacted the solvency position of insurance companies, but also whether the amounts insured remained consistent with current cost of property restoration. Both the insurers and the insured themselves need to pay close attention to the amount insured that is given in a property insurance contract. The analysis shows that the amount insured in insurance contracts does not always correspond to the estimated cost of restoring the property insured. This creates the risk that if there is an accident, the potential insurance indemnity will not cover the total costs of property restoration

for the owner. As a result of the supervisory work, all the insurers brought the amounts insured in line with the current costs of restoration, thereby protecting the insured against unforeseen losses. Insurance providers and distributors certainly need to continue to offer appropriate insurance cover and sums, but the customers themselves also need to pay close attention to the terms and conditions of their policies.

Supervisors are paying ever more attention to consumer protection because of the rapidly changing external environment with high inflation, volatility in financial markets, increasing risks from natural disasters and climate change, and the digitalisation of financial services.

 

 

 

 

Completeness of information provided to customers

As customers are becoming increasingly more inclined to buy insurance online, it is important to ensure that the information provided to customers in the digital environment is timely and high quality.

As part of the continued monitoring of the compliance of information disclosures with the regulatory requirements (for insurance brokers) which started in 2022, Latvijas Banka inspected the digital distribution sites of insurers, insurance agents and ancillary insurance intermediaries in 2023. The overall conclusion was that the requirements concerning the disclosure of information to customers were not fully complied with. Often they were complied with only formally, as the information was difficult to understand, and the information displayed on digital distribution websites was not updated regularly. These gaps detected by the inspection have been eliminated, and the implementation of Latvijas Banka's recommendations to the insurers can be expected to result in a better customers' understanding of the received insurance services.

To provide customers with easy-to-read, understandable and comparable product information, insurers are obliged to produce a standardised information document for non-life insurance products, thereby enabling their customers to take informed decisions. Latvijas Banka carried out a thematic review of the regulatory compliance of information documents for travel insurance products by assessing the scope and quality of information provided to customers and the document design.

The findings about the necessary improvements in some aspects were communicated to all involved market participants.

Dialogue to promote meaningful changes

Latvijas Banka maintained its dialogue with the insurance sector and continued the tradition of organising annual strategy meetings with the management of all the insurers operating in Latvia. During the meetings, the strategic development priorities of the insurers were discussed, the findings from the supervisory work were analysed, and the individual risk scores allocated by Latvijas Banka to each market participant were communicated to the insurance companies and branches of foreign insurers. The supervisory priorities and the supervisory activities scheduled for 2024 were also communicated to the insurers.

Supervision of pension and investment funds

Supervision of the 2nd pillar pension managers

Competing for customers and searching for higher returns

One more asset manager joined the managers of the second pillar state-funded pension scheme assets in Latvia in 2023, and there are currently eight managers. A licence to manage the assets of the state-funded pension scheme was granted to a new market player, VAIRO AS. Meanwhile, Integrum Asset Management IPAS was renamed Signet Pensiju Pārvalde IPAS following a change of ownership.

As at the end of the year there were 33 investment plans with varying degrees of risk on offer to pension savers to manage their second pillar pension capital. Most of the investment plans, almost 70% of them, were active investment plans with higher long-term returns than the balanced and conservative investment plans, allowing their participants to accumulate larger additional pension capital in the long term.

The number of participants in active pension plans is increasing rapidly year by year, and one of the reasons for this is the changes in regulatory requirements initiated by Latvijas Banka that assign all new participants of the state-funded pension scheme as of 1 January 2023 to active investment plans, where up to 100% of the investments are made in equities. As of 1 January 2026 moreover, all new participants who have not made their own choice will be assigned to one of the investment plans that have demonstrated the highest returns over the past three years, with half of the managers included in the allocation.

Life-cycle investment plans became increasingly popular in 2023. These plans automatically balance the participant's age against the proportion of equities in the investment portfolio, so that there is a reduction in equities, and consequently in risk, as the participant approaches retirement age.

Chart 4. Return on state-funded pension plans (%)

The year 2023 was one of the historically most successful years in the management of second pillar pension assets. It was marked by large returns for all types of investment plan, which helped to reduce significantly the negative effects that the financial market had had on asset values in 2022.

Chart 5. Developments in net assets of the state-funded pension scheme
(millions of euro)

The value of assets reached 7.06 billion euro in 2023, which was an increase of 24.5% from 2022. The increase was particularly impressive at 35.9% for the assets accumulated in active pension plans.

Chart 6. Investment plan management expenses (%)

Management fees did not change significantly in 2023. Since limits on management fees came into force in 2018, the management costs of investment plans as a share of total assets have stabilised, and there is a slight downward trend as asset levels increase.

Larger contributions to the 2nd pillar pensions mean a larger accumulated pension capital

Every participant in Latvia's second pillar pension scheme has the right to change their fund manager once a year and to switch between investment plans twice a year. At the end of 2023 however, more than half a million people in Latvia had opted for an investment plan that was inappropriate for their age.

More active involvement of the participants in the state-funded pension scheme in choosing appropriate investment plans could be achieved by managers providing more detailed disclosures and consultations to participants, which would also increase the financial literacy of participants. Latvijas Banka consequently amended the legislation in 2023, setting managers the obligation to make sure that the investment plans selected by pension scheme participants are suitable for their age and preferences. This represents a fundamental change in the role of managers in engaging with participants. In addition to that, a procedure was established for asset managers to identify the preferences and needs of participants so that they could offer them the most appropriate investment plans. These changes are expected to increase engagement from participants and their understanding of their second pillar pensions, and the investment plans and opportunities that they offer.

Latvijas Banka introduced changes that apply from 1 January 2024 to the requirements for the basic information given to participants in the state-funded pension scheme and for the identification of their needs so that they can have clear information materials where the details of each investment plan are presented in a simple and concise way. This will standardise the information on the main details of investment plans, allowing participants to compare them, assess whether they meet their needs and preferences, and take an informed decision when choosing a suitable plan.

Latvijas Banka reviewed its cooperation with the State Social Insurance Agency in 2023. The aim was to optimise the flows of documents circulating between the two institutions, improve the transparency of disclosures, and reduce the administrative burden, all of which would ultimately lower fees for customers. The first outcome achieved in 2023 was that the sign-off process for circulated documents was improved and the information exchange procedure in the Cabinet Regulation on the Operation of the State-Funded Pension Scheme was updated. The result of this cooperation is that participants benefit from clear, transparent and comparable disclosures in the investment plan prospectus, and participants with a higher level of financial literacy are able to use that to decide on the appropriate investment plan.

Challenges in implementation of the new procedure

These new regulatory requirements grant the managers of state-funded pensions additional rights when they access participant data, but also impose new obligations on them, as they have to make sure that the investment plans selected are appropriate given the age, needs and preferences of the participant, and must provide consultation about the second pillar pensions and the performance results of their fund. The information published about second pillar pensions also needs to become more comparable, understandable and accessible.

To ensure that these changes are implemented smoothly, Latvijas Banka intends to work closely with the asset managers and the State Social Insurance Agency, overseeing the progress made, providing timely support and advice on implementation, and ensuring clear flows of information between all the parties involved.

Supervision of private pension funds – the 3rd pillar pensions managers

Population increasingly entrusts private pension funds with the build-up of their retirement savings

There were six open pension funds and one closed pension fund registered in Latvia at the end of 2023 for accumulating third pillar pension savings, between them offering 21 pension plans with various degrees of risk. The number of participants in the pension plans increased by 6.7% over the year to 412 thousand.

The net assets of the pension plans totalled 810.4 million euro at the end of the year. For the first time in their existence, the net assets of the active pension plans exceeded those of the balanced and conservative pension plans, as they increased to 51.2% from 47% in the previous year while the balanced and conservative assets fell to 48.8% from 53%.

An increasing share of pension plan participants at 61.6% opted for the active investment strategy. This strategy is characterised by higher long-term returns than those of the balanced and conservative pension plans. The number of participants in the active pension plans increased by 12% in the course of the year, whereas the number in the balanced and conservative plans dropped by 2%.

Chart 7. Developments in net assets of the private pension funds
(millions of euro)

The value of the total net assets of pension plans grew by 17.5%. This can be explained by the strong performance of the financial markets, which gave the participants in pension plans a weighted average annual return of 10.3%, with the returns on individual pension plans ranging from 7.1% to 17.6%. The highest average return on capital at 12.6% was produced by the pension plans that employ active strategies, followed by the return of balanced plans at 9.1% and that of conservative plans at 7.3%.

Chart 8. Annual returns of private pension plans (%)

The year 2023 was also remarkable for the contributions of participants, which went above 100 million euro for the second time in the history of private pension plans in Latvia and reached 113.5 million euro.

The overall level of the pension plan management costs, combining administrative expenses and investment management costs to net assets, hit a historical low at 0.78%, down from 0.84% in 2022. The administrative expenses and the costs of investment management have been generally declining since the first quarter of 2019.

Chart 9. Pension plan management expenses in private pension funds (%)

A wider range of products and greater clarity on the expected pension amount

At the start of 2023, a new passively managed pension plan was registered, and since that point, all the open-ended pension funds offer pension plans with a 100% asset investment strategy.

The focus of private pension funds last year was on projections for pension benefits. Regulations issued under Article 39 of Directive 2016/2341 of the European Parliament and the Council on the introduction of pension benefit projections took effect in Latvia. In implementing the Regulation, private pension funds developed easy-to-use calculators for projected pension benefits or individually tailored statements that are sent each year to the participants in each particular plan to inform them about their projected retirement savings when they reach retirement age.

Latvijas Banka intends to update these regulations to reflect the experience of market participants, the lessons learned and practical recommendations, so that the projections from the private pension funds can be made even more accurate.

Supervision of investment funds and alternative investment funds

The segment of businesses making collective investments in transferable securities is shrinking in Latvia

There was one fewer investment management company managing businesses that make collective investments in transferable securities, or fund managers, in 2023 than in 2022, and there were three fund managers in Latvia at the end of the year managing 13 funds, which were six bond funds, four mixed funds and three equity funds.

The value of the funds' net assets fell by 13% over the year in 2023 to 167.15 million euro at the end of the year.

Chart 10. Net assets by fund type
(millions of euro)

The bulk of the funds at almost 70% were bond funds, which have had lower returns in recent years than mixed funds and equity funds. The performance of the funds was significantly better in 2023 than in the previous year, when all types of fund had negative average returns.

Chart 11. Returns of investment funds (%)

Investments were mostly made in financial instruments issued in the EEA countries and the United States. The investments by funds in financial instruments from issuers incorporated in Latvia was 3.9% of their total assets. Investments in Latvia were primarily in debt securities, and these were 76% of the total value of investment in Latvia.

Chart 12. Geographical distribution of the funds' investments in December 2023 (%)

Challenges faced by the funds registered in Latvia

The biggest challenge faced by the industry in Europe, and consequently also in Latvia, is the tight competition with exchange-traded funds. The general global tendency that has already been observed for several years has been a shift of capital from actively managed funds to passively managed ones, and 2023 was a special year in this respect. Data from the research company Morningstar show the total assets of passively managed funds of about 13.29 trillion US dollars exceeded the total assets of actively managed funds of about 13.23 trillion US dollars for the first time in the history of investment funds. The interest in passively managed exchange-traded funds can be explained by their quite simple investment strategies, as they mainly track market indexes, their low management fees, their broad selection of products, and their simplified approach that can easily be understood by the consumer. All these factors will continue to support the performance of exchange-traded funds, while at the same time posing significant challenges to the funds registered in Latvia.

Alternative investment funds and their managers

There were 31 alternative investment fund managers (AIFMs) operating in Latvia in 2023, of which 27 were registered AIFMs and four were licensed AIFMs. Three new AIFMs were registered, while the licences of two licensed AIFMs were withdrawn, and the registration of one registered AIFM was cancelled in 2023. The total number of AIFMs consequently remained unchanged from the previous year.

Although there has not been rapid development in the alternative investment sector, new players have entered the market with more dynamic and forward-looking strategies that enhance economic growth in Latvia, such as investments in houses for rent and solar parks. The dominant strategy of the funds is to invest in private equity, which accounts for about 70% of the total assets of the alternative investment funds.

The role of the supervisor in ensuring financial stability

Within its work of monitoring financial stability and stress resilience, Latvijas Banka carried out various supervisory activities in 2023 that were adjusted to the intensity of supervision in each segment supervised, the shortcomings detected by previous inspections, and the principle of proportionality:

• on-site inspections were carried out in 2023 at individual investment managers, covering SIGNET ASSET MANAGEMENT LATVIA IPS and the investment management company SEB Investment Management, and at the private pension fund AS SEB atklātais pensiju fonds and the alternative investment fund manager SIA SG Capital Partners AIFP;
• a survey of greenwashing risk management was run in AIFMs and investment management companies that manage investment in transferable securities, to see how ready the risk management systems of those market participants are to comply with the new sustainability requirements;
• thematic inspections of all supervised segments were held, with an operational compliance inspection of the core functions and an inspection of compliance with the requirements for sustainability disclosures;
• aspects of risk management, fee calculation procedures and the consistency between strategic planning and operations were also examined and assessed in addition to that, as part of the annual strategy review of Latvijas Banka.

The broad range of supervisory activities undertaken gave an in-depth insight into different operational dimensions of the market participants' business models, while also assessing how various risks impact them. This let Latvijas Banka identify several examples of good practice and potential for improving the operation of individual market participants. Latvijas Banka will continue to follow up on closing the gaps identified in 2024.

Latvijas Banka ran risk assessments at the level of individual market participants and at the sectoral level to maintain the individual supervisory approach to market participants that takes their individual features into account while also gaining a horizontal view of the performance of the whole segment and the impact of the risks from it on the Latvian financial market. The overall operational risk score is different for each manager, but the impact of the risks assessed on the financial market as a whole is medium-low, which can be explained by the long experience of the fund managers and their relatively good skills in asset management.

The individual risk scores were communicated and explained to each market participant during individual meetings, while the sectoral risk scores were communicated at the annual meetings with the managers of market participants that are organised at the market segment level to maintain an active dialogue with the market participants supervised. During those meetings, the supervisory conclusions were also shared with the participants, and particularly important operational aspects for each market segment were highlighted.

Supervision of payment institutions and electronic money institutions

There were ten payment service providers, which covers both electronic money institutions and payment institutions, operating in Latvia at the end of 2023.

The total value of payments to payment institutions increased by 2.5% from 2022, while the average amount of each payment increased by 2.2% from 2022, but the value of payments to electronic money institutions was down by 36.9% and the average payment amount by 43.3% from 2022. Liabilities to customers, including balances on customer accounts, increased by 1.5% at payment institutions and by 10.8% at electronic money institutions over 2022.

Chart 13. Payments to electronic money institutions and payment institutions
(millions of euro)

Chart 14. E-money circulation in electronic money institutions (millions of euro)

Chart 15. Liquid assets and current liabilities of electronic money institutions and payment institutions
(millions of euro)

Chart 16. Income from services of electronic money institutions and payment institutions
(millions of euro)

The total value of payments made with e-money grew by a significant 57% over 2022, while the total value of e-money redeemed increased by 59.1%.

The income of payment institutions edged up slightly, gaining 3.8% over 2022, while the income of electronic money institutions from the provision of services increased by a more substantial 48.1%.

A risk assessment is carried out each year in payment services as part of the supervisory process. The level of risks at Latvia's payment institutions and electronic money institutions is viewed as ranging from low to medium-high. The market participants covered by supervision in 2023 provided safe services to their customers. One full on-site inspection of the operation of a market participant was held during the year, which did not cover AML/CFTP, and off-site supervisory work was carried out at all participants to suit their risk assessments. Strategy meetings were also held with market participants on business development plans, compliance issues, internal control systems and governance. The supervisor paid particular attention in 2023 to the protection of customer funds by assessing accounting and management methodologies, data quality, business continuity risk management and other points.

The fallout from the Covid-19 pandemic has been absorbed in payment services, and the market participants have turned to working on improving their operational efficiency in response to rising inflation and costs. Significant challenges are posed by the management of ICT security and cybersecurity risks and by ensuring business continuity.

Supervision of crowdfunding service providers

Two authorisations to provide crowdfunding services had been granted in Latvia by the end of 2023, one of them to a service provider that had previously operated under the arrangement of the transitional period that expired on 10 November 2023.

Regular meetings on business development issues, and the main challenges, risks and opportunities are held with the crowdfunding service providers. The discussions in 2023 identified that the public could be interested in using the services of crowdfunding service providers to raise funding and make investments, but at the same time, investors remain quite cautious, which is typical in the startup phase of any new segment. The interests of the project owners and investors as stakeholders are continuously being analysed in consequence to ensure that the services offered evolve accordingly.

At the same time, supervisory work was also carried out to check compliance with the regulatory requirements for disclosures and the organisation of payment flows related to the provision of services.

Supervision of foreign exchange trading companies

There were 15 foreign exchange trading companies operating in Latvia at the end of 2023. One new authorisation was granted during the year, and one authorisation was withdrawn at the application of the company itself. Four new trading venues were registered for companies trading foreign exchange.

Strategy meetings on business development issues and the main challenges and risks were held during the year with the companies trading foreign exchange. They highlighted the willingness of the companies to improve the range of services provided by considering the option of offering automated solutions. Latvijas Banka gave appropriate consultation individually and together with other public institutions.

Given the geopolitical situation and the amendments to the Immigration Law, the amount of US dollars sold was 48% higher in 2023 than in 2022. This came from sales of real estate by Russian and Belarusian nationals and their conversion of euro cash into US dollars when they left Latvia. The amount of Russian roubles sold was 18% higher than in 2022, and roubles purchased was 21% higher.

One of the challenges faced by Latvia and the rest of Europe is trading in Scandinavian currencies.

Correspondent banks either limit the amounts they accept or refuse to accept those currencies at all because it is difficult to gain sufficient assurance that the AML/CFTP requirements are being adequately met, making it difficult for foreign exchange trading companies to trade in those currencies. Within the framework of supervision, the balances of those currencies held by Latvian companies trading foreign exchange were identified and communicated to the central banks of the countries concerned. The companies trading foreign exchange were invited to assess the risks associated with exchanging cash in those currencies and holding cash in them, and to adjust their holdings to reflect their ability to manage the risks associated with trading those currencies.

Additionally, a survey was conducted and discussions were held on the access to banking services of companies trading foreign currency. Latvijas Banka used the survey results to develop an action plan to promote access to banking services for companies trading foreign currency. The most important task is to develop a new methodology for risk analysis and present a sectoral risk assessment to credit institutions each year. Joint discussions with industry representatives and individual meetings with market participants will also be held to discuss their areas of operation, business models, challenges to the community and the sector, and opportunities for development.

Supervision of investment service providers

At the end of the reporting year, authorisation to provide investment services in Latvia had been granted to nine investment firms licensed in Latvia, nine credit institutions registered in Latvia and one branch of a credit institution from an EU Member State, and also to seven investment management companies registered in Latvia. In accordance with the principle of freedom to provide services, more than 600 investment service providers from EEA countries also had the right to provide investment services.

One new licence was granted to an investment firm in 2023. Latvijas Banka also continued to engage actively with the investment platforms licensed as investment firms and subject to a transition period by following up on the implementation of the measures planned for the transition period.

Supervision of investment services was focused on the following issues in 2023:

• development of the SREP methodology and conducting the SREP at one investment firm;
• in-depth inspection of three individual market participants, which were two investment firms and one credit institution;
• a horizontal review of the operational integration of customers' sustainability preferences at investment service providers;
• integration of the sustainability risks of investment firms into the risk management framework and questions about sustainability disclosures;
• participation in the ESMA's common supervisory action on marketing communications and advertising;
• evaluation of the reports submitted by market participants and data quality control;
• addressing complaints about investment service providers.

Supervision of the trading venues for financial instruments and the Central Securities Depository

The focus in supervision in 2023 of the stock exchange run by the regulated market operator Nasdaq Riga and the multilateral trading system or alternative market First North Latvia was on:

• on-site operational inspection of the stock exchange;
• pre-trade and post-trade disclosures;
• cooperation in the context of new issuers entering the market and issuers leaving the market;
• the means to ensure adequate trading in financial instruments;
• supervision of trading in financial instruments;
• the operational adequacy of information technology systems and the prevention of incidents;
• assessment of the compliance of the regulations and decisions of the stock exchange.

In 2023, supervision of the Central Securities Depository Nasdaq CSD SE focused on:

• the annual Review and Evaluation in accordance with Article 22 of Regulation (EU) No 909/2014 of the European Parliament and of the Council of 23 July 2014, covering financial stability, business risk, capital requirements, operational risk, business continuity risk, legal risk, evaluation of the operation of the securities settlement system, the functioning of links, incident management, cyber resilience, recovery plans, internal control systems, governance, the availability of the core CSD services, outsourcing, disclosures, external audit assessments, and default procedures for CSD participants. No recommendations were issued to the depository following the assessment;
• regular off-site supervisory activities, covering evaluation of the statements, reports and other information submitted, and meetings with the staff of Nasdaq CSD SE;
• cooperation within the Nasdaq CSD SE supervisory college between the supervisory authorities and the central banks of Lithuania, Estonia and Iceland, and Latvijas Banka. Two meetings of the supervisory college were held in 2023.

Supervision of issuers

The focus in supervision of issuers in 2023 was on:

• the timely disclosure of regulated information;
• observation of the placement process for initial public offerings;
• a horizontal review of the lists of managers and people closely associated with them;
• a horizontal review of the conduct of shareholders' meetings;
• an in-depth inspection of annual statements and interim reports;
• disclosure of corporate governance notifications and remuneration reports, and non-financial disclosures;
• assessment of the compliance of prospectuses for public offerings;
• webinars and presentations on the application of regulatory requirements;
• sustainability issues.

No administrative processes were initiated against issuers within the framework of supervision in 2023. In one of the administrative cases initiated in 2022 for a failure to disclose information to the supervisory authority, specifically the failure of a timely disclosure of the interim report and resolutions passed by the shareholders' meeting, the Supervision Committee of Latvijas Banka imposed a fine of 10.7 thousand euro on the issuer.

Development of the capital market

The capital market is essential for the healthy development of a country's economy, as it provides the infrastructure that businesses and the government need to raise capital, allocate resources efficiently, manage risks and ensure economic growth. Latvijas Banka focuses on growth in the market.

Latvijas Banka passed several measures in 2023 to support the development of the market.

Latvijas Banka organised the Latvian Capital Market Forum 2023 on 8 February 2023, bringing together experts and opinion leaders to discuss opportunities for private investors and businesses in the Latvian and Baltic capital markets, and opportunities for development at the European level. The Forum was well-attended and received positive feedback.

Latvian Capital Market Forum 2023 "Growth Loves Those Who Dare"

A significant move for the development of the Latvian capital market was the Securities Sandbox, which is a unique support mechanism developed jointly by Latvijas Banka and its partners that lets a potential issuer receive an initial assessment from Latvia's most knowledgeable capital market experts and recommendations for the improvements needed before it enters the Latvian capital market.

The support mechanism may be used by private companies and by companies based on public and local government capital. Both companies that intend to issue shares and those that intend to raise funding by issuing bonds may apply for advice. In 2023, four companies participated in the Securities Sandbox that was set up in 2022, and seven companies have by now participated in it since its inception.

In 2020, the FCMC in consultation with participants in the Latvian capital market and other stakeholders developed a ten-step programme for development of the capital market in 2021–2023. The programme was highly rated by the market participants, and in 2023 it was in the final stage of its implementation. Development of new measures and the approval of a new programme are scheduled for 2024.

Active cooperation between the Baltic States continued during the reporting year and has resulted in the content and format of the offering document being aligned across all three Baltic States.

A number of educational events were also organised for market participants on the latest regulatory issues.

Latvian capital market indicators 2023

Supervision of trading in financial instruments and investor activities

Supervision of trading in financial instruments and investor activities in 2023 focused on:

• supervision of trading in financial instruments;
• a review of reports on suspicious transactions and orders submitted by market participants;
• in-depth inspections of suspicious transactions such as market manipulation or insider dealing;
• cooperation and information exchange with the supervisory authorities of other countries;
• timely and correct submission of investor notifications.

No administrative sanctions for market manipulation or insider dealing were imposed on trading venues within the framework of supervision of markets in financial instruments in 2023. The file of one case of market manipulation that was inspected was handed to the police so they could open criminal proceedings. In some cases, Latvijas Banka carried out in-depth inspections and sent letters to investors outlining the regulatory requirements that prohibit market manipulation, so that the investors would discontinue or abstain from behaviour that could mislead other investors as to the price, demand and supply of shares.

In one case, Latvijas Banka started administrative proceedings for a failure to provide a timely manager's notification in accordance with the requirements of Regulation No. 596/2014 of the European Parliament and of the Council. The administrative proceedings were closed without any sanction being applied to the person in question.

Supervision of sustainable finance

Latvijas Banka carries out financial supervision over sustainable finance in accordance with the requirements of the legislation and supervisory expectations, based on the roadmap for a sustainable financial sector in Latvia.

The annual surveys of financial market participants continued in 2023 to collect information on their self-assessment of compliance and to evaluate the progress achieved in various aspects of sustainability, including the management of sustainability risks and assessment of risk significance, and the incorporation of sustainability issues in the development strategies of the institutions supervised.

Latvijas Banka conducted a thematic inspection on compliance with the requirements for sustainability disclosures in most segments of the financial market, covering insurance companies and branches of insurance companies, investment management companies, alternative investment funds, and private pension funds. This provided insights into the overall understanding of the sustainability requirements and the scope of disclosures, and assessed the presence of possible greenwashing risks. The progress achieved by the various market participants is uneven overall, but some examples of good practice could still be identified. Many areas are not fully compliant with the supervisor's expectations yet, but the overall understanding of sustainability issues and the related risks has improved. Latvijas Banka has communicated the main conclusions of the assessment to the financial market participants, and it will continue to provide support in implementing the supervisory expectations set out for the different steps on the roadmap.

The understanding of sustainable finance and its role in implementing the EU Green Deal is evolving gradually but the regulatory framework is expanding very rapidly, and so it is very important to ensure that financial market participants are constantly improving their skills and are able to comply with the requirements. To this end, Latvijas Banka maintained a dialogue on sustainability with the financial sector by launching a series of Sustainability Breakfast events on 9 March 2023 and inviting representatives of various financial market segments, cooperation partners and public administration representatives to attend them. The objectives of the series are:

• to discuss practical issues related to sustainability;
• to promote the exchange of views, knowledge and experience;
• to promote the skills of the financial market participants and give stakeholders a better understanding of sustainable finance.

Four events were organised in 2023, covering both general issues like the supervisory priorities of Latvijas Banka for sustainability and the public perception of sustainability, alongside specific subjects that are of importance to market participants like the incorporation of aspects of sustainable finance in development strategies, disclosures, responses to the sustainability preferences of customers in consultations, and management of sustainability risks. Given the high rate of response from the stakeholders, the Sustainability Breakfast series will be continued in 2024.

To promote the development of internal capacity and ability in sustainability risk management in the financial sector, Latvijas Banka and the central banks and financial supervisory authorities of several other EU Member States joined the flagship project ESG risk management framework for the financial sector of the European Commission's DG REFORM financed from the Technical Support Instrument (TSI). Experience and knowledge will be shared within the project, and internal tools will be developed for sustainability regulation, extraction and processing of sustainability data, sustainability risk identification and management, and the prevention of greenwashing. The project is scheduled to be completed in 2026.

Supervision of information and communication technology and security risk management

To ensure that financial institutions and their customers are protected against cyber threats and to improve the resilience of financial services, Latvijas Banka continued its work to strengthen the ICT risk management of financial sector participants, with the main priorities being to improve the quality and efficiency of how ICT security, business continuity and third-party service providers risks are monitored.

The banking sector continued to face ICT security challenges in 2023. The frequency of cyber attacks increased, outsourcing arrangements were used and changed increasingly, and new providers of outsourced services were chosen. The participants continued to implement new technological business processes to improve their financial services, thereby increasing their reliance on ICT solutions.

Latvijas Banka carried out nine inspections of market participants in 2023:

• three full on-site inspections;
• one targeted on-site inspection;
• five targeted off-site inspections in banks and financial institutions looking at ICT and security risks.

The inspections paid particular attention to changes in critical systems, management of operational risks and business continuity, and safeguarding of the three lines of defence against ICT security risks. Regular monitoring of risks including geopolitical risks was carried out in addition to inspections of financial institutions for risk-based ICT supervision. From September to December 2023, experts from Latvijas Banka participated in the on-site inspection of a significant credit institution organised by the ECB. This inspection involved all three Baltic States.

Various security risks were assessed within the supervisory work on risks at investment firms, together with the risks associated with the accessibility of ICT, changes in outsourcing arrangements, and data integrity. The focus was on ICT governance, ICT organisation, risk management, and operational activities, with a view to gaining assurance that the sector is capable of ensuring the required data protection and regulatory compliance.

Meanwhile, the supervisory activities for payment institutions and electronic money institutions were focused on the ICT areas of governance and strategy, organisation and outsourcing management, risk and security management, continuity management, and internal audit.

An ICT security risks assessment was also carried out in 2023 for Latvia's insurance sector, focusing on outsourcing management, data integrity and quality risks, security governance risks, change risks, and accessibility and continuity risks.

Data security is essential for insurance companies. They need to make sure that customer data and financial data are secure and reliable. These data can be highly sensitive, and loss or leakage of them may have serious consequences. Data encryption, access control, back-ups and other security measures are therefore extremely important.

To strengthen the management of the ICT security risks, Latvijas Banka prepared recommendations for managing ICT security risk for medium-sized and small financial institutions in 2023. This is a practical guide for financial institutions to assist them in managing ICT risks and improving their internal control systems. The recommendations have been supplemented with practical examples and guidance on issues where a common understanding among market participants and compliance with the requirements are important.

Latvijas Banka carried out a horizontal review of incident management in payment institutions, electronic money institutions and investment firms in 2023.

Chart 17. Main reasons behind significant incidents in payment services of Latvia's financial sector (%)

The number of significant incidents decreased overall in 2023, though wide-scale cyber attacks on Latvia continued. The reasons for the incidents were mainly related to operational risks that arose as a result of an error or third-party influence.

Market participants need to continue to develop and improve their operational risk management to enable more effective monitoring of risk levels and timely review of existing controls. When security incidents happen, market participants with more mature incident management capabilities are able to detect incidents earlier and take the preventive and containment measures required. Market participants that are able to maintain a higher level of cyber resilience are more successful at taking appropriate defensive action in the event of an attack. This helps to reduce the impact of any potential incident.

Although the number of cases of financial fraud prevented exceeds that of the cases of fraud committed, the amounts of money defrauded from the population are increasing. Latvijas Banka carried out a thematic inspection in 2023 to find out how able the largest commercial banks are to identify and prevent fraud, and prepared recommendations for the banks on ways to reduce financial fraud.

The development of level 2 regulation under the Digital Operational Resilience Act (DORA) and the planning for implementation of it continued in 2023 in cooperation with other EU supervisors. Latvijas Banka organised consultation meetings with finance and insurance industry associations in 2023 to explain the new regulatory requirements and the level 2 regulatory technical standards that will apply from 2025.

As of 17 January 2025, Latvijas Banka will have new functions as the supervising authority for the ICT processes of financial market participants under the DORA, and the scope of the market participants supervised will also change. The DORA gives the supervisor a new mandate and tools for ensuring effective supervision. Latvijas Banka experts participated in the working group organised by the Ministry of Finance to make recommendations for the legal changes needed for the DORA to be implemented.

Supervision of ML/FTP risk and sanctions risk

The goal of supervising ML/FTP risk and sanctions risk is to ensure that the financial sector has adequate and effective control mechanisms in place to prevent the sector being used for money laundering and sanctions violations. The supervision is also important as it means that financial institutions are able to interact with other financial institutions around the world, the costs of international payments can be reduced and the speed of payment execution can be increased. If financial institutions were unable to demonstrate that they have effective control systems, other financial institutions would refuse to cooperate with them as they would be unwilling to expose themselves to the risk of being involved in money laundering and violation of sanctions.

The most significant risks in 2023 were associated with circumvention of the EU sanctions against Russia and Belarus, both through the use of complex ownership structures to hide the controlling interest of sanctioned individuals and the use of countries bordering Russia for exports or imports of sanctioned goods. The total value of the frozen assets of people subject to sanctions or companies under their control was 75 million euro at the end of 2023. The assets of six natural persons and 35 legal entities owned or controlled by people under sanctions were frozen.

The broad scope and complexity of the EU sanctions imposed on Russia and Belarus led Latvijas Banka to provide various types of clarification about how the requirements should be interpreted and applied and to work closely with other national supervisors. To make sure that the requirements were applied in a harmonised way across the Baltic States, Latvijas Banka established and chaired a working group for both supervisory authorities and financial intelligence services.

Latvijas Banka also made improvements to its supervisory tools and methodologies in 2023 to make supervision more effective and more efficient in its use of resources. An ICT tool was developed for example that automatically aggregates and groups the data submitted by credit institutions, thereby significantly reducing the resources required for data processing and allowing staff resources to be primarily focused on data assessment and risk identification. The inspection process was also improved to strengthen the application of a risk-based approach in on-site inspections of financial institutions.

The goal of supervising ML/FTP risk and sanctions risk is to ensure that the financial sector has adequate and effective control mechanisms in place to prevent the sector being used for money laundering and sanctions violations. The supervision is also important as it means that financial institutions are able to interact with other financial institutions around the world, the costs of international payments can be reduced and the speed of payment execution can be increased. If financial institutions were unable to demonstrate that they have effective control systems, other financial institutions would refuse to cooperate with them as they would be unwilling to expose themselves to the risk of being involved in money laundering and violation of sanctions.

Inspections and the results of them

Inspection results in ML/FTP risk management in 2023 reveal that financial institutions have continued to enhance their internal control systems, including those for sanctions risk management and transactions monitoring. The most common shortcomings identified during the AML/CFTP inspections came from failures to adjust internal control systems to the institution-specific risks inherent in the business. Latvijas Banka carried out nine on-site inspections, one targeted off-site inspection and two horizontal reviews in 2023, covering a total of 39 financial institutions.

Latvijas Banka imposed fines for violations of the AML/CFTP rules on two credit institutions in 2023 for a total amount of 2.26 million euro, and also imposed the legal obligation to address the gaps identified and improve the internal control systems. The gaps that triggered the application of financial sanctions were shortcomings in the risk management processes and insufficient risk-based due diligence of high-risk customers and monitoring of their transactions. Both credit institutions acknowledged the gaps identified in their internal control systems, and administrative agreements were signed in both cases, imposing a legal obligation on the credit institutions to strengthen their internal control frameworks and ensure compliance with the AML/CFTP legal provisions. Latvijas Banka continues to monitor the implementation of the plans to address the gaps identified.

Latvijas Banka carried out two horizontal reviews in 2023 in all the credit institutions and the largest non-bank financial institutions. These were:

• a horizontal review of ML/FTP risk assessments. Overall, the credit institutions have significantly improved their risk assessment methodologies, they have a good understanding of how to identify and assess money laundering risks, and they conduct and update risk assessments on a regular basis. Institutions need to continue to improve their processes for identifying and assessing the financing of terrorism and proliferation and sanctions risks, particularly sectoral sanctions risks, and must pay attention to the procedure for evaluating the effectiveness of their ML/FTP and sanctions risk management activities;
• a horizontal review of the effectiveness of sanctions screening in financial institutions. The main conclusion was that the ICT systems in place are able to identify the subjects of various sanction lists effectively and in a timely manner, even with incomplete data. At the same time, the institutions need to make further improvements to their ICT systems, particularly to the quality of screening of manipulated data and the efficiency of the system in order to reduce the resources needed for processing false positive alerts; the scope and procedure for testing the ICT systems also need to be enhanced.

The objective of the horizontal reviews was to identify and compile a list of the good practices of financial institutions and to identify areas for improvement, thereby helping financial institutions to strengthen their internal control systems for managing ML/FTP risk and sanctions risk.

Latvijas Banka not only aligns new products and services, but also reviews and evaluates policies, procedures and risk assessments, which includes making comprehensive evaluations of AML/CFT and sanctions risk, for each new product or service. After examining the procedures, Latvijas Banka makes recommendations for addressing any shortcomings to ensure that the internal control systems operate as effectively as possible well in advance.

Changes in the regulatory framework

Improving the legal framework for financial market participants

Improvements continued to be made to the legal framework governing the operation of financial market participants in 2023, as the requirements laid down by EU directives and the guidelines of the EU institutions were incorporated into it and the application of the directly applicable EU legislation was ensured.

Review and approval of external regulations and guidelines, and recommendations for improved regulation, which:

• strengthens the resilience of the financial sector to any future economic shocks;
• facilitates investment in the green transition;
• provides additional supervisory tools to protect financial stability;
• improves the effectiveness of the financial market and access to information for market participants and investors.

To facilitate sustainable and prudent lending, Latvijas Banka issued a Regulation on Credit Risk Management to replace the FCMC's Regulation on Credit Risk Management.

The new Regulation:

• includes sustainability issues (see section "Sustainability");
• takes a more flexible approach to buy-to-let housing loans and other income-generating housing loans to individuals following from the credit risk monitoring of previous years. Previously, there was a loan-to-value (LTV) limit of 70% for such loans, whereas the new Regulation allows duly justified derogations from this The quantitative LTV requirement of 70% for housing loans where the borrower's income from real estate exceeds 20% of their total income has been lifted, and the restriction that the borrower's income from real estate should only be taken into account at 70% has been removed. These restrictions have been replaced with a qualitative requirement to assess the credit risk of such a borrower prudently;
• makes transfers of loan commitments from one credit institution to another easier. The rules have been supplemented by a requirement for a credit institution to set the criteria under which it requires a new collateral assessment from the borrower so that it can properly assess the credit risk associated with the transaction in its internal regulations.

In addition, Latvijas Banka decided on 18 December 2023, within the framework of its regular review of the risk weights applied and following a comprehensive data analysis, to reduce from 100% to 80% the risk weight applied in calculating the capital requirements of credit institutions for credit risk to exposures secured by a mortgage on commercial real estate (CRE) located in Latvia. Credit institutions from Latvia and other EU Member States that use the standardised approach for calculating the capital requirements for such exposures will be able to apply the reduced risk weight as of 30 June 2024.

Latvijas Banka has estimated that the risk weight of 80% is enough in the current circumstances to ensure that credit institutions are sufficiently resilient to the risks associated with such CRE exposures, without creating unjustified obstacles to lending. Given that credit institutions currently do not classify a large part of their CRE exposures as fully secured by a CRE mortgage, which is the criterion for applying the reduced risk weight, the related capital requirements are bound to decrease, with credit institutions granting new eligible loans and reclassifying a part of their existing portfolios. The reduced risk weight will allow a more consistent approach to be taken to calculating credit risk capital requirements across credit institutions that use the standardised approach and those that use the internal ratings based approach.

The ESRB has found the decision to reduce the risk weight to be an appropriate one, describing it in its assessment as an effective and proportionate measure. Latvijas Banka will continue to review the adequacy of the risk weight every year at least, and will recalibrate it again if required.

To improve and expand the requirements and procedures for managing interest rate risk and for assessing and overseeing credit spread risk in credit institutions, and to strengthen the resilience of those institutions to possible future shocks, Latvijas Banka issued the Regulation for the Management of the Interest Rate Risk in the Non-trading Book and the Credit Spread Risk in the Non-trading

Book, effective as of 31 December 2023. This Regulation replaces the FCMC's Regulations on the Management of Interest Rate Risk, Preparation of a Report on the Calculation of Economic Value Depreciation and of a Report on the Term Structure of Interest Rate Risk.

The new Regulation implements the EBA Guidelines by improving the requirements and procedure for managing interest rate risk in the non-trading book in institutions, which includes identifying, assessing, analysing and overseeing the risk, and it lays down the requirements for internal regulatory documents, the system of limits, the set-up of the management information system and information technology systems, risk assessment models, validation of the model applied, and assessment of that model's risks.

Latvijas Banka approved the Regulation for the Preparation of the Basic Information Addressed to the Participants of the State-Funded Pension Scheme and the Identification of Participants' Needs, which lays down the requirements for the format and contents of the basic information about state-funded investment plans and the procedure for preparing it, the information to be disclosed to participants, the frequency of those disclosures, and the criteria that the managers of the assets of the state- funded pension scheme must follow to let participants select the most appropriate investment plan for them, and which also requires that an internal control system for disclosures to participants be established. It sets out a new and innovative approach to receiving information from pension managers and for integrating that information into a universal format that is a standardised, simple and user-friendly product in the form of a booklet containing the basic information about the second pillar pension investment plans. The regulation is binding on the asset managers of the state-funded pension scheme, while the users of the booklet are all the 1.3 million or so participants in the second pension pillar, who will be able to gain a better understanding of where and how their personalised pension capital is accumulated, while also engaging in a dialogue with the pension manager to clarify important points jointly.

Latvijas Banka started the extensive process of reviewing and re-approving the external regulations issued by the FCMC in 2023, updating and improving the regulatory framework of the financial sector at the same time.

The most important upcoming amendments to the regulatory framework for credit institutions are the proposed amendments to Directive 2013/36/ EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC, which must be transposed into the legal acts of the Republic of Latvia within 18 months of the publication date and is scheduled for mid-2024; and to Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, which will enter into effect from 2025, as these will complete the implementation of the Basel III international supervisory standards in the EU.

Latvijas Banka continues to participate in the development of the EU's regulatory framework for the financial sector as well as ensures the development of binding regulations for Latvia's financial sector based on the best international practices and local market development trends.

Latvijas Banka evaluated in 2023 whether the existing reporting burden on credit institutions for the purposes of supervision, resolution and statistics could be reduced and discussed this with market participants. Some 114 data queries were assessed and five requirements were cancelled, and further ways of reducing the reporting burden were identified and are scheduled to be implemented in 2024.

Work will also continue in 2024 on developing the regulatory framework for sustainable finance. To promote the development of sustainable financial instruments, the EC published a Recommendation on facilitating finance for the transition to a sustainable economy on 27 June 2023, and on 23 October 2023, it adopted the EU green bond standard regulation, laying down a uniform set of requirements for bond issuers that wish to use the designation "European Green Bond" or "EuGB" for their environmentally sustainable bonds. Latvijas Banka will ensure the application in practice of these regulations.

A business environment that favours innovative and secure financial
services

A major share of Latvian financial sector businesses have introduced and are using innovations that improve the customer experience and provide modern and user-friendly services. Businesses are also already employing artificial intelligence solutions, machine learning and big data processing or technologies that could bring significant changes to financial services and the market. Application programming interfaces (API), data cloud services and digital onboarding are the three technologies that are most frequently used by market participants.

Chart 18. Technologies most often used by market participants in 2023
(number of respondents confirming)

Source: Survey of financial market participants conducted by Latvijas Banka.

For the third consecutive year, credit institutions, insurance brokers and insurance corporations have been the market segments that innovate most frequently in their operations. The new and innovative processes used most often are data cloud services, digital onboarding, payment initiation services, biometric solutions, and artificial intelligence. Big data, machine learning and account information services are used less frequently. An innovation that had previously not used by Latvian market participants, the distributed ledger technology (DLT), was mentioned for the first time in 2023. This innovative process is employed by one of the survey participants.

Chart 19. Innovative processes used by businesses
(number of respondents confirming)

The most notable increase from 2022 in the use of any innovation is in the use of artificial intelligence and instant payments. Artificial intelligence is already employed by several insurers, credit institutions and investment firms, and by individual market participants representing such financial market segments as insurance brokers, payment institutions, private pension funds, and crowdfunding service providers.

Artificial intelligence, big data and machine learning tend to be the drivers behind the development of innovative technologies, and they are really able to change the market and the services provided. Not only do artificial intelligence solutions provide the best methods for data processing and enhancing customer experience, they also simplify, accelerate and redefine the traditional processes, making them more efficient. Elsewhere in the world, machine learning is already used in revenue and stock price projections, risk supervision, and management processes.

Latvijas Banka continues to support innovation by providing support tools to the financial sector through the Innovation Hub and the Regulatory Sandbox, which are designed to help in the development of innovative services at inception and to give feedback on compliance risks with the regulatory requirements of the financial sector that are identified during participation in the testing process for the services. Consultation was provided in 52 cases in 2023, and the areas that got the most attention from FinTech companies, and more than 80% of the consultations, were payments, crypto-asset services and crowdfunding.

Artificial intelligence, big data and machine learning tend to be the drivers behind the development of innovative technologies, and they are really able to change the market and the services provided. Not only do artificial intelligence solutions provide the best methods for data processing and enhancing customer experience, they also simplify, accelerate and redefine the traditional processes, making them more efficient. Elsewhere in the world, machine learning is already used in revenue and stock price projections, risk supervision, and management processes.

In 2023, Latvijas Banka was actively involved in implementing the tasks outlined in Latvia's FinTech strategy, as access to services was improved through a dialogue between the supervisory and controlling authority and market participants, and the authority conducted outreach activities on improvements to licensing.

Several initiatives to promote the development of the FinTech environment were also launched in 2023. Latvijas Banka expanded the operational capacity of the Innovation Hub by working with the stakeholders in it, which are the Ministry of Finance, the Fintech Latvia Association, the Investment and Development Agency of Latvia and the Latvian Blockchain Association, and by organising round table discussions and promoting the FinTech sector at more than 15 local and international public events. One of the central events of the Latvian FinTech ecosystem is Latvia's FinTech Forum, which was now organised for the second time by Latvijas Banka jointly with the Investment and Development Agency of Latvia, and which brought together around 300 in-person attendees from Latvia and abroad. The participants were briefed on the implementation of Latvia's FinTech strategy and the progress made in FinTech development, and they received advice from Latvijas Banka and other organisations and learned about the latest trends in FinTech. FinTech Facor, a competition for start-ups, was held for the first time, as the creators of innovative ideas presented their business ideas to the jury and received awards.

Latvijas Banka conducted a survey in 2023 on cooperation between banks and FinTech companies. The survey identified several potential opportunities for cooperation between the two segments, and defined specific tasks, including some for Latvijas Banka, that could promote awareness and allow various FinTech business models access to routine banking services. Following the survey results, Latvijas Banka organised a dialogue between the participants and committed itself to taking measures to improve cooperation.

The AML/CFTP Manual was supplemented in 2023 with information on the risks associated with payment service providers, virtual assets service providers, and other current FinTech models and their management, so that a common understanding could be built between the banks and the supervisory authority for applying the legislation on preventing financial crimes, and for promoting a risk-based approach.

Latvijas Banka has committed to presenting an annual risk assessment of the non-bank financial sector to credit institutions, which would help those credit institutions strengthen the application of a risk-based approach, partly by building their understanding of the existing and emerging risks that are specific to the non-bank sector. There are several initiatives underway to foster cooperation and raise capacity in the application of regulatory requirements and in the compliance of innovative services with those requirements.

In 2023, Latvijas Banka started the preparations needed for implementing Regulation (EU) 2023/1114 of the European Parliament and of the Council of 31 May 2023 on markets in crypto-assets, and amending Regulations (EU) No 1093/2010 and (EU) No 1095/2010 and Directives 2013/36/ EU and (EU) 2019/1937 (MiCA). This will apply from 30 December 2024, with the exception of Titles III and IV, which will apply from 30 June 2024. Latvijas Banka consequently worked hard on drafting the Law on Crypto-Asset Services, and this work will continue in 2024. A working group was set up for that purpose with members from the Latvian Blockchain Association, the Ministry of Finance, the Ministry of Economics, the Ministry of Justice, the Register of Enterprises, the State Revenue Service, the Financial Intelligence Unit, and Latvijas Banka. In addition, a special task force was set up in Latvijas Banka to make the preparations for the implementation of the MiCA regulation. The Law on Crypto- Asset Services is scheduled for adoption in the first half of 2024. It will confer the role of competent authority in this field on Latvijas Banka, which will then have the right to grant authorisation for providing crypto-asset services to crypto-asset service providers.

Development of innovation and supervisory technologies (SupTech) at Latvijas Banka

Supervisory technologies or SupTech is a specialised development area at Latvijas Banka that is intended to provide high-tech supervisory services.

Significant preparations for integrating the supervisory function into Latvijas Banka had already been made in 2022, but 2023 was the year when the integration of technologies and processes was most intensive. The internal migration of various systems was carried out and processes were reviewed and streamlined to maximise the practical benefits from the integration of Latvijas Banka and the FCMC. One of the benefits of this integration was an additional information protection capacity that provides a high level of protection for supervisory information at a time of increasingly high cybersecurity risks.

Following Latvijas Banka's general strategy, the SupTech strategy was reviewed to ensure targeted and well-coordinated development of SupTech. The international aspect is also important, so Latvia does not create any SupTech solutions in isolation, but rather builds on the opportunities provided by the EU's centralised institutions.

Supervisory services were fully integrated into the internal cooperation platform of Latvijas Banka in 2023, while additional functionalities in the supervisory information system were introduced, and the single reporting portal was developed, which will provide smooth access to various analytical resources.

Timely and reliable information is very important in the provision of supervisory services. With both the amount of information and the number of various analytical tools increasing, the risks of data fragmentation have grown. The reporting portal will let the supervisor retrieve the most relevant data and make full use of all the information available to provide more effective and higher-quality supervisory services.

SupTech solutions are also an important part of Latvijas Banka's in-house innovation. Latvijas Banka, like the FCMC before it, introduced an innovation laboratory or iLab during the reporting year. This is an environment for cooperation where innovative ideas can be evaluated and prototypes of them can be built in the shortest possible time and with minimum resources. This allows the practical development of innovations, while also minimising losses if an initiative turns out to be unviable.

The supervisor must handle very large quantities of financial information, but also quite a lot of textual information. In 2023, the iLab started working on automating text processing with a view to reducing the human input into reviewing lengthy textual documents. A study into the practical aspects of artificial intelligence and the prospects for applying it was also conducted.

Integration of the two institutions secured these benefits, but it also entailed, and will continue to entail, various challenges in the provision of better services to Latvijas Banka's customers that will need to be addressed in the near term. The potential development of artificial intelligence solutions for supervision and the benefits of this are currently still hard to evaluate. These issues will definitely remain on the SupTech development agenda in 2024 and beyond. The subject requires a high degree of practical involvement, and target and result orientation, though this new area of technology is one that is developing very quickly and is therefore quite unpredictable.

Latvia's FinTech Forum on 10 October 2023