By Aleks Tapinsh
RIGA (Reuters) - Offshore funds flowing from crisis-hit Cyprus have helped boost bank deposits in Latvia, strengthening the small Baltic state's position as an offshore banking centre for neighboring Russia and other ex-Soviet states.
Non-resident deposits are near 50 percent of total bank deposits, a record high, with Latvia's location next to Russia its key advantage. It has drawn funds from both businesses and rich individuals, who see it is as a stable proxy for Western banks, with the added attraction that Russian is widely spoken.
Regulators are keeping a wary eye on the development as Latvia, which aims to join the euro single currency in 2014, suffered a deep crisis after the crash of a bank with heavy non-resident business in 2008, and some of its banks have been implicated in alleged money laundering.
Credit ratings agency Moody's also sees the dependence of small banks on such deposits as one of the vulnerabilities of the whole Baltic banking system.
"The same way as we export logistics services, we also export financial services," Kristaps Zakulis, chairman of the FKTK banking sector regulator, told Reuters in an interview, referring to ports, railways and transit traffic.
"We are close to that eastern market. We can speak the same language with them, not to mention all the historical nostalgia," he added.
A European Union source said Latvia had improved supervision of its banks after a crisis that lopped 25 percent off its output over 2008-2010, and the country was now attracting funds as a gateway to the EU, and, potentially to the euro zone, which Latvia wants to join in 2014.
Latvia was part of the Soviet Union for 50 years but broke away with its Baltic neighbors in 1991 to regain independence. It joined the European Union and NATO in 2004.
Latvia and Russia still have differences, particularly about history and the rights of a large Russian minority, but business links have stayed. That includes banks set up to cater to the financial needs of rich Russians and other former Soviet people.
"There are signs that some of the money and business, which until recently were at the Cypriot banks, have moved to Latvia," said Baiba Melnace, a spokeswoman for the Latvian Association of Commercial Banks.
FKTK data show that while domestic deposits fell between the end of 2010 and July 2012, non-residents' deposits have risen 25 percent to a record 5.8 billion Latvian lats ($10.78 billion).
In contrast, data from Cyprus, which suffered from Greece's woes and has requested a bailout, shows bank deposits by businesses resident outside the EU fell from 13 billion euros in August 2011 to just over 11 billion euros ($14.33 billion) in August this year.
The coincidence is striking but does not make it possible to quantify the hot money flowing from Cyprus into Latvia.
In a report released on Tuesday, Moody's affirmed its negative outlook on the Baltic banking system, citing deposits from customers in Ukraine, Russia and other Eastern European countries as one of the issues.
Banks were "sensitive to political and economic trends in their customers' domicile countries, which can change suddenly and unpredictably", it said. However, it noted that the FKTK regulator had tightened capital requirements for such banks.
Latvia increased its attractiveness for foreign depositors by passing a law in 2009 allowing anyone who invests 100,000 lats ($187,700) to get a residency permit.
The measure was aimed mainly at Russian clients, for whom a residency permit would allow them to move more freely around the EU, but it also prompted interest from Chinese and Indian investors, newspaper Diena reported.
While the growth in deposits is good news for banks, which say it will help an economy still recovering from a deep depression, the banking sector has had its problems.
Latvian banks have been implicated in money laundering in the past or had crises due to fast moving foreign money.
The 2008 failure of Parex bank, which had a lot of non-resident business, was one reason Latvia had to take an IMF bailout, which entailed austerity measures that contributed to a cumulative 25 percent economic contraction over 2008-2010.
Money laundering allegations arose afresh this month, when prosecutors launched a probe into whether banks handled funds from alleged tax fraud in Russia.
"There are potential risks in that business of non-residents," Zakulis added.
"The money can leave at a sign of instability, which also hurts our reputation. It also can attract some questionable capital and our job is to make sure that those who work in this non-resident business recognize the risks," he added.
But Zakulis said Latvia had strong laws and good banking practice to make sure banks did not aid money laundering.
The EU source said Latvia had indeed made strides in boosting supervision of the bank sector after the crisis.
A nation of 2 million people, Latvia boasts 29 banks, down from 61 in 1993. Scandinavian banks - Swedbank, SEB, and Nordea - dominate the retail market, while non-residents are served by often small, boutique banks.
Several Russian banks have offices in the Baltic states.
A study by an association representing smaller banks catering to non-residents said the industry contributed between 2-3 percent of gross domestic product.
ABLV Bank is the largest locally owned bank by assets and the fourth largest behind the Scandinavian outfits.
At its head office in downtown Riga, well-dressed men walk past one bodyguard outside and another inside the building.
Clients are greeted with futuristic lamp stands and artsy armchairs and are served in a private meeting room.
"Working with foreign clients, being a financial centre, it's not just beautiful offices, expensive cars, tasty coffee and smart clients," said ABLV chief executive Ernest Bernis.
"It also carries with it a large degree of responsibility," he added, calling regulation "top-notch". He predicted growth in the sector, in part due to the crisis in southern Europe.
Some remain wary, given the open borders in the European Union, which means money can flow freely.
"This means that our system of defense against dirty money is only as good as the weakest country," said Rosie Sharpe of London-based Global Witness, which campaigns against corruption and conflict based on natural resources.
(Additional reporting by Patrick Lannin; Editing by Paul Taylor)