Robert Anderson in Stockholm -

Swedish banks have made the Baltic states their second home market over the past decade. They have poured in funds to be used for loans and drawn off healthy profits as the countries boomed. But now the banks are rushing to turn off the lending tap as fears grow the tiny Baltic economies are overheating and they face awkward questions about their role in this mess.

Swedbank and SEB dominate the banking markets of Estonia, Lithuania and, to a lesser extent, Latvia. Since SEB bought into Vilniaus Bankas in Lithuania in 1998 and Swedbank entered Estonia in 1999 via Hansabank, the two banks have expanded throughout the Baltic countries organically and by acquisition to achieve higher market shares than they enjoy at home.

SEB is the number one in Lithuania, second largest in Estonia and is just third behind Parex Bank in Latvia. Swedbank is number one in Estonia and Latvia and is in second place in Lithuania. According to SEB, the two banks have a market share of 73% in Estonia, 55% in Lithuania and 43% in Latvia.

The two banks have grown lending at a dizzying rate as they sought to profit from higher margins and faster growing volumes than in their mature home market. Even after belatedly tightening its policy, Swedbank has still expanded lending to Latvia and Lithuania by around 50% over the past 12 months.

Unsafe as houses

For buying property, banks were prepared to offer loans worth more than 100% of the house value and they based their loans on real salaries, including unofficial "envelope" payments. Interest rates were also affordable as competition between lenders forced margins down.

The easy credit fuelled housing bubbles and spending booms. Business became so good that, despite their size, the three countries now account for a significant proportion of these banks' profits. Operating profit for Swedbank in the Baltic states grew by 59% in the first nine months of this year and now represents around a third of the bank's total. For SEB the profit share of its Central and Eastern European operations, which is dominated by the Baltic countries, is 19%, even though the proportion of group lending in the Baltics is only 12.5%.

However, the banks' growing credit exposure to the Baltic states and their even greater dependence on that market for profits has begun to make analysts and shareholders jittery as signs of overheating became evident. The US sub-prime mortgage turmoil made things worse by tightening global credit conditions. Speculation grew that Latvia might be forced to devalue, with a knock-on effect on Estonia and possibly Lithuania if locals panicked or hedge funds took short positions hoping for an easy killing.

Central banks and finance ministries in the Baltic states are voicing criticism of the way these banks have behaved. "They are absolutely responsible for the situation here," Irena Krumane, state secretary at the Latvian finance ministry, told bne. The former banker accused the banks of whipping up a public outcry that torpedoed an anti-inflation package in 2005. Latvia's package in March this year - which amongst other measures forced banks to use only tax-declared income as the yardstick for assessing loans - was widely derided as too little, too late.

The Swedish banks deny responsibility for the current problems of the Baltic economies, claiming they have been privately lobbying for restrictive measures for some time. However, their argument is weakened by the fact they also complained about the recent credit curbs imposed by the Latvian government.

The banks also claim their lending rules are similar to Sweden and that, compared with Western Europe, Balts are still relatively un-indebted. However, the real comparison should be with Central Europe and here the Balts are catching up fast their wealthier neighbours.

Moreover, what makes the lending splurge even more dangerous is that much of it is in foreign currencies, typically euros. According to SEB, some 60% of its lending in the region is in foreign currencies. This means that if the kroon, lat or litas - whose exchange rates are all fixed - were to be devalued, this debt would be even harder to repay and defaults more likely.

Self-regard

The speed with which the banks restricted credit growth this year, first in Estonia and then in Latvia, suggests that they themselves had become concerned. SEB in particular cut lending growth significantly, with quarter-on-quarter growth in lending in Latvia falling from 47% in the first quarter to 0.4% in the third quarter.

Swedbank, which increased lending more aggressively, has also been slower to ease back and has, therefore, seized market share. Swedish latecomers such as Nordea and Handelsbanken have also tried to grab a place in the slowing market by expanding lending and cutting margins. The Latvian banking association says over the first nine months, lending increased by 30%, but Swedbank's lending was up 21.4% and SEB's only 14.3%.

The two big banks insist their lending slowdown is in large part a response to declining demand for loans as consumers begin to be more nervous and interest rates rise in line with the Eurozone. They add that they started tightening lending even before the Latvian government announced its anti-inflation package. "There is no need to restrict lending any more as demand is also falling very quickly," says Erkki Raasuke, head of Hansabank.

So far, the lending slowdown has had the most dramatic effect on the housing market, with prices in first Tallinn and then Riga falling this year. Real estate development has almost stopped in both countries, says Raasuke. Balsts, a Latvian real estate agency, says Riga prices were rising 5-7% a month at the start of the year, but are now falling 1-2% a month.

Banks insist that they are easing their foot off the pedal and are not braking too sharply in order to prevent a "hard landing". So far it is working: defaults - though rising - are still very small. Swedbank has a loan loss level of 0.4% of loans, for SEB just 0.3%. "As the adjustment started to happen later than it should have, it will probably be more compressed and harsher than we would like to see," says Raasuke. "Nevertheless, we are still seeing a good orderly adjustment going on."

Swedish banks may have been irresponsible in the way they expanded credits, but they are now being more careful in the way they are restricting them gradually. The big Swedish banks are said to have hamstrung attempts by hedge funds to take short positions in Latvian assets earlier this year; they must now ensure that domestic clients also have no reason to panic.

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