Opinion of the European Central Bank of 4 November 2024 on the imposition of a temporary solidarity contribution on credit institutions for national security purposes (CON/2024/35)

OPINION OF THE EUROPEAN CENTRAL BANK of 4 November 2024 on the imposition of a temporary solidarity contribution on credit institutions for national security purposes (CON/2024/35)

On 4 October 2024 the European Central Bank (ECB) received a request from the Latvian Ministry of Finance for an opinion on a draft law on the imposition of a temporary solidarity contribution (hereinafter the ‘draft law’). The ECB’s competence to deliver an opinion is based on Articles 127(4) and 282(5) of the Treaty on the Functioning of the European Union and Article 2(1), third and sixth indents, of Council Decision 98/415/EC , as the draft law concerns Latvijas Banka and rules applicable to financial institutions insofar as they materially influence the stability of financial institutions and markets. In accordance with Article 17.5, first sentence, of the Rules of Procedure of the European Central Bank, the Governing Council has adopted this opinion.

1. Purpose of the draft law

1.1 The draft law imposes an obligation to pay a temporary solidarity contribution on credit institutions established in Latvia as well as branches of credit institutions from other countries in Latvia (hereinafter the ‘solidarity contribution payers’). The contribution is temporary in nature – it applies during the payment periods starting in 2025, 2026 and 2027. 1.2 The objective of the solidarity contribution is, under conditions of increased national security risks, to seek direct or indirect additional resources to meet fiscal needs relating to the national security of the State, in solidarity with Latvian society as a whole. The draft law provides that the solidarity contribution payers are to make solidarity contributions to the State budget through atypically high net interest income, or indirectly by significantly increasing lending amounts to non-financial corporations, households, and non-profit organisations that provide services to Latvian households. This will translate into an increase in economic activity and promote total budget revenues, which will in turn enable an increase in the financing of growing national security needs in the coming years. 1.3 The explanatory memorandum accompanying the draft law states that the rationale for the draft law is based, inter alia, on the following elements. First, the profitability of credit institutions was mainly supported by the ECB’s policies to reduce inflation, which led to a sharp increase in market interest rates. As loans with variable interest rates account for more than 90 % of the credit portfolios of Latvian credit institutions, the interest rates applied to loans increased with market interest rates, resulting in a significant increase in the interest income of credit institutions. The assets of credit institutions in Latvia

consist mainly of loans, while loans to non-financial corporations and households account for more than 50 % of the total assets of credit institutions. For most loans in Latvia, the interest rate is composed of two components: the base rate, which is variable over time and largely follows the short-term Euribor rate; and the fixed interest rate added, which is determined by credit institutions on an individual basis, taking into account credit risk and other factors. As a result of this principle of credit pricing, higher central bank interest rates were almost automatically reflected in higher lending rates, consequently resulting in higher interest incomes for credit institutions. Second, the interest income of credit institutions has increased as a result of excess liquidity placed at the central bank and other credit institutions. Third, deposits from non-financial corporations and households account for around 70 % of credit institutions’ liabilities. This means that the price of funding and interest expenses for credit institutions are also closely linked to the cost of deposits. While deposit rates have increased, in particular for longer-term deposits, they have increased at a slower pace than money market rates. One reason for this is the high proportion of demand deposits, for which interest is not paid in most cases, in total deposits. As a result, credit institutions’ funding costs have increased at a much slower pace than credit interest rates. Fourth, the returns on equity and on credit institutions’ assets were strong in 2023 and well above the euro area average. As income grows much faster than costs, the cost-efficiency of credit institutions has significantly improved. Fifth, lending in Latvia remains sluggish, with credit to non-financial corporations and households remaining at only 27.5 % of gross domestic product (GDP) in the first quarter of 2024. Sluggish lending has been a persistent and structural problem in Latvia. The outstanding amount of credit to non-financial corporations, measured against GDP, is currently not far from 2004 levels, but in the housing sector the current level is the lowest since Latvia’s accession to the EU and is closer to low and lower-middle income countries than high-income countries. 1.4 The base for the temporary solidarity contribution is calculated as the net interest income that is 50 % greater than the average net interest income in the credit institution’s consolidated financial statements in the five-year reference period from 2018 to 2022. The net interest income and the average annual net interest income are multiplied by the base calculation factor of the solidarity contribution. The base is reduced by the deposit insurance premiums paid to the Deposit Insurance Fund and by contributions to the Single Resolution Fund in accordance with Regulation (EU) No 806/2014 of the European Parliament and of the Council . The solidarity contribution is 60 % of the base. 1.5 The draft law provides for a solidarity contribution rebate which ensures that a discount of up to 100 % is applied if the credit institution reaches a certain rate of credit growth during the payment period. The credit growth indicator is the annual growth rate of total loans from the solidarity contribution payer to Latvian non-financial corporations, households and non-profit institutions serving households. The information contained in the Credit Register maintained by Latvijas Banka will be used for the calculation of the credit growth rate. The rebate is calculated by comparing the credit growth rate of the solidarity contribution payer with the forecast annual growth rate of GDP at current prices set out in the Law on the State Budget for the payment period. In order to apply the rebate, the solidarity contribution payer must ensure that the growth rate of credit during the payment period is at least 1.75 times higher

than the annual growth rate of the GDP at current prices used by the State Budget Law for the calendar year corresponding to the payment period. A rebate of 100 %, 75 %, 50 % and 25 % of the amount of the solidarity contribution calculated in the payment period is applied if its credit growth rate reaches or exceeds, respectively, the growth rate of GDP multiplied by a factor of 2.5, 2.25, 2 and 1.75. 1.6 According to the explanatory memorandum accompanying the draft law, the motivation for the introduction of the rebate is to provide an incentive for credit institutions to significantly increase their lending to the economy, as this would support economic activity and thus indirectly contribute to increasing the revenues of the Latvian State, in the context of sluggish lending growth. The draft law sets a ceiling for the payment of the solidarity contribution at 33 % of the amount of the payer’s profits before the application of corporate income tax and the solidarity contribution. Furthermore, the solidarity contribution is not payable if the solidarity contribution payer suffers losses as a result of its economic activity during the payment period. 1.7 The solidarity contribution payer makes quarterly advance payments of the solidarity contribution during the payment period. The advance solidarity contribution must be paid by the 23rd day of the second month following the respective quarter of the advance payment period into a special income account of the State Budget opened for this purpose. The rebate also applies to the quarterly advance payments of the solidarity contribution. 1.8 The solidarity contribution is administered by the State Revenue Service. Latvijas Banka submits the information required for the administration of the solidarity contribution that is at its the disposal to the State Revenue Service by 10 June of the year following the payment period, or at the request of the State Revenue Service.

2. Monetary policy considerations

2.1 The euro area inflation rate reached record levels over the course of 2022 and posed significant challenges for the conduct of monetary policy. Guided by its primary objective of maintaining price stability, the ECB has taken determined action to ensure a timely return of inflation to the 2 % target over the medium term. Key ECB policy rates were raised by a cumulative 450 basis points between July 2022 and September 2023, with the intention of dampening demand and guarding against the risk of a persistent upward shift in inflation expectations. More recently, following a period of rate stabilisation, key interest rates have been reduced in view of the ongoing disinflationary process. 2.2 The conditions under which credit institutions operate play a key role in the transmission of monetary policy to financing conditions in the economy, and thus in the impact of monetary policy on aggregate demand and ultimately on inflation rates. The ECB's observations as to the impact of the draft law on monetary policy are set out below. 2.3 First, the draft law adversely affects the conditions at which credit institutions operate, so that its overall effects on lending growth and thus indirectly on the State budget are unclear, especially over the long term. On the one hand, the draft law will lead to a decline in credit institutions’ profitability, albeit from a relatively high position compared with the situation in other euro area jurisdictions, and thus erode the taxation base relevant for the standard tax on credit institutions’ profits. A decline in profitability, if prolonged, might limit credit institutions’ ability to provide credit to the Latvian economy

in the long run. On the other hand, the rebate that is conditional on the lending amount of the individual credit institution provides an incentive for its provision of credit in the short run. The incentive achieved by the rebate may be especially effective in increasing lending to Latvian nonfinancial companies, which has been assessed to be structurally subdued in particular because of credit supply constraints in a context of relatively low competition among credit institutions . Careful monitoring and assessment of the two opposite effects of the draft law on lending growth and State revenues will be needed. 2.4 Second, the draft law may create distortions in the transmission of monetary policy depending on the credit institutions’ business models, which could adversely impact the efficient allocation of credit in the economy. Credit institutions might optimise the profitability and fiscal impact of the application of the draft law over the three years of its application, depending on their individual situations. These may differ, notably as regards each credit institution’s business model, including its sector of activity and client base, so that the implications of the draft law will be heterogeneous. This concern is, however, offset by the fact that most Latvian credit institutions have similar business models and it is assessed that the current allocation of credit in the economy is not efficient in view of existing supply constraints. 2.5 Third, the draft law entails pro-cyclical effects: it was designed for a phase of increasing policy rates but will not have the envisaged effects on State revenues in an easing phase of monetary policy. Past increases in policy rates have so far been rapidly transmitted to interest rates on loans issued in Latvia, but the recent monetary policy easing is reverting this and lending has rebounded to a greater extent in Latvia as compared to the euro area as a whole without the State’s intervention through such a law. 2.6 Evidence shows that credit institutions’ net interest income typically tends to expand on impact as policy rates increase. This effect is faster the greater the weight of short-term or variable interest rate loans within balance sheets of credit institutions. However, the tightening cycle has also resulted in lower lending volumes, a higher cost of funding, losses recorded in the securities portfolio and an increase in provisions resulting from potential deterioration of the quality of the credit portfolio. The realisation of downside risks in the current environment may significantly reduce the repayment capacity of debtors and translate into lower profitability of credit institutions. The net effect of tighter monetary policy on profitability when measured across the policy cycle may therefore be less positive, or even negative, over an extended horizon. Against this backdrop, and noting the latest ECB key interest rate reductions, which could limit credit institutions’ net interest income, care should be taken to ensure that any measures taken do not hamper the ability of credit institutions to maintain solid capital bases, which are required to ensure the smooth transmission of monetary policy.

3. Financial stability considerations

3.1 The ECB has previously warned about possible negative effects of extraordinary tax regimes on financial stability owing to such legislative measures having the potential to make it more difficult for

credit institutions to build up a sound capital base, as their retained earnings will be reduced, thus making them less resilient to economic shocks . At the same time, the temporary solidarity contribution may make attracting equity capital investors and wholesale funding more costly for credit institutions, as domestic and foreign investors may have less appetite to invest in Latvian credit institutions. 3.2 Regarding the rebate, the mechanism is designed to incentivise credit institutions to increase lending by providing discounts on the solidarity contribution, hence supporting financial intermediation, economic activity and revenues for the State. However, by setting larger rebates for stronger credit growth rates, the draft law may have the unintended effect of incentivising credit institutions to provide lending to riskier borrowers. Competition among credit institutions for a limited pool of borrowers may also induce them to charge lending rates which are not commensurate with the risks they are taking. Borrower based measures are already in place in Latvia, which should limit a deterioration in standards in respect of lending to households. At the same time, the authorities should make sure that lending standards are also maintained for other lending categories. The maintenance of adequate lending standards is important to avoid higher losses for credit institutions in the medium and long run, which could have an impact on credit institutions’ capital. Moreover, incentivising stronger lending growth could erode solvency positions by increasing risk-weighted assets, causing credit institutions to be left with smaller solvency ratios after the expiration of the rebate. Finally, as the rebate is based on the nominal GDP forecast at the time when the budget is adopted (the year prior to the calculation of the solidarity contribution and rebate), it is possible that credit institutions may need to make lending decisions in an environment that could be very different from that envisaged at the time the budget was adopted. 3.3 Two welcome features of the draft law are, first, that it sets a ceiling for the payment of the solidarity contribution at 33 % of the amount of the solidarity contribution payer’s profits before the application of corporate income tax and, second, that the solidarity contribution is not payable if the solidarity contribution payer suffers losses because of its economic activity during the payment period. At the same time, it would also be useful to analyse potential behavioural effects associated with the ceiling, inter alia by shifting the cost base, in order to minimise credit institutions’ profitability and the solidarity contribution. 3.4 The proposed solidarity contribution may lead to fragmentation in the domestic and European financial system because of the heterogeneous nature of the banking sector. This may particularly be the case where the interest income of some credit institutions is relatively high compared to other activities. Moreover, the temporary solidarity contribution is implemented for a three-year period, which is long. Finally, it is the ECB’s understanding that credit institutions established after 2022 are to be exempted from the temporary solidarity contribution due to the impossibility of calculating the contribution base, which could contribute to the creation of an uneven playing field as between incumbents and new players.

3.5 In the light of the above, the ECB recommends that in order to assess whether the application of solidarity contribution poses risks to financial stability, and in particular whether it has the potential to impair the banking sector’s resilience and cause market distortion, a thorough analysis of potential negative consequences for the banking sector should be undertaken . Careful analysis of the potential negative effects of the temporary solidarity contribution on the banking sector and its impact on financial stability is particularly important in the current context of elevated geopolitical uncertainty and volatility in financial markets.

4. Considerations relating to the prudential supervision of credit institutions

4.1 The ECB understands that the draft law would apply to significant credit institutions directly supervised by the ECB and less significant credit institutions directly supervised by national competent authorities under the oversight of the ECB within the framework of the Single Supervisory Mechanism. 4.2 The basis on which the temporary solidarity contribution would be established does not take into consideration the full business cycle . 4.3 The solidarity contribution may affect the credit risk strategy of credit institutions and incentivise them to increase their loan portfolios to benefit from the rebate mechanism and reduce their payments. While the draft law’s objective is acknowledged in the light of subdued lending, it should not result in a worsening of credit institutions’ credit risk profiles as a result of pursuing imprudent credit growth, opting for relaxed credit loan origination and underwriting standards with limited restrictions for entering into new market segments. Credit institutions must ensure sufficient capital positions and adequate levels of provisioning on a forward-looking basis, as well as robust risk management practices, as a prerequisite for a sustainable increase in credit supply and ensuring well-managed credit risk exposures. Potential negative effects of increased credit risk exposures and their impact on the safety, soundness and stability of credit institutions should be reflected in credit institutions’ business, funding and capital plans. Moreover, any impact on credit institutions’ overall risk profile needs to be closely monitored.

5. Role of Latvijas Banka in providing information to the State Revenue Service

The ECB understands that the obligation imposed on Latvijas Banka under the draft law to submit to the State Revenue Service the information necessary for administration of the solidarity contribution is not a new task of Latvijas Banka. In accordance with the Law on Latvijas Banka, Latvijas Banka already has the duty to provide all necessary information and data for the performance of the functions of the State Revenue Service . The ECB understands that this duty of Latvijas Banka is

without prejudice to the obligation to maintain professional secrecy in respect of confidential prudential supervisory information under Union law .

6. Other observations

The draft law ensures that the solidarity contribution is to be temporary in nature. The ECB has previously recommended that a clear separation is necessary between the extraordinary proceeds and the general budgetary resources of a government to avoid their use for general fiscal consolidation purposes . In this regard, the draft law seems to take previous ECB recommendations into account, as the ECB understands that the proceeds of the solidarity contribution will be specifically directed to increasing fiscal spending to address increased national security risks.

This opinion will be published on EUR-Lex.

Done at Frankfurt am Main, 4 November 2024.

[signed]

The President of the ECB

Christine LAGARDE