The Determinants of Bank’s Stability: Evidence from Latvia, a Small Post-Transition Economy

Abstract Introduction – Stability of commercial banks is on the back stone of a country’s economy and its development, making bank stability one of the main concerns of financial regulators. The bank stability models for large and small economies differ significantly. Purpose – In this chapter we examine the determinants of bank stability in a small post-transition economy, based on the case of Latvia. Latvia has a well-organized banking system, providing a wide range of services to local and international customers. Besides, the Latvian banking sector is quite unique in Europe as it comprises two sets of banks with radically different target groups of customers and sources of revenue. Methodology – To carry out this study we analysed panel data of the quarterly financial statements of Latvian banks operating during the period 2012-2017. Findings – We found evidence of a negative significant relationship between size and bank stability, negative significant impact of liquidity risk on bank stability, a positive significant relationship between capital adequacy and bank stability, as well as a positive significant relationship between credit risk and stability. These results increase the importance of a sufficient level of capital adequacy ratio and liquidity to maintain bank stability. In general, the results of the study confirm the results of other studies on bank stability of small economies, with some exceptions due to the unique situation in term bank business models applied by Latvian banks. The current study provides valuable policy implications to small post-transition economies and stakeholders in general.