FRANKFURT, Feb 21 (Reuters) - The European Central Bank appears to have been blindsided by Latvia's banking troubles, highlighting how thinly it is spread in supervising Europe's biggest lenders and raising questions about a system of euro zone supervision just three years old.
Latvia's third-biggest bank was accused by U.S. authorities of facilitating large scale Russian money laundering while the governor of the central bank, who plays a key role picking the head of the local supervisor, was detained over the weekend for allegedly soliciting a bribe.
"That a member of the ECB's Governing Council has been implicated in doing these alleged things looks very bad," said Guntram Wolff of Brussels think tank Bruegel. "It's bad for the eurosystem. That includes bank supervision as well as the ECB."
In the wake of the allegations against ABLV Bank, the ECB was forced to stop all payments at the lender to prevent its collapse amid an exodus of deposits.
Officials with direct knowledge of the ABLV case now wonder if the payment moratorium can be lifted given how heavily the bank is skewed towards taking deposits from foreign clients, many from Russia, who appear keen to leave, fearing U.S. sanctions that might freeze their assets.
ABLV denies any wrongdoing. U.S. authorities have given the bank 60 days to respond to the allegations. Central bank chief Ilmars Rimsevics has denied separate bribery allegations, saying he was the victim of a smear campaign because he had been leading a drive to clean up banking sector corruption.
A sign of the ECB's difficulties is that top supervisors, who made the ultimate call to order the payment moratorium, appear to have known little of the brewing trouble at ABLV before the U.S. accusation, according to several people with direct knowledge of the matter.
The ECB's Governing Council, which signs off on major decisions, including bank failures, was only briefed about the case over the weekend.
As the problems unfolded, the Association of Latvian Commercial Banks urged the "immediate and direct involvement of the ECB", saying the ECB had been responsible for the supervision of ABLV since 2014.
But it was still left to a U.S. Treasury bureau and not the bank's own supervisor to detail evidence of money laundering, bribery, illicit deals with Russian shell companies, poor risk management and breaking North Korean sanctions.
The root cause of the problem was hardly hidden. Latvia's banks hold around $13 billion worth of foreign deposits, roughly half of all deposit in the sector, an issue highlighted as a source of risk by authorities year after year.
Experts believe the case points to two key shortcomings: the ECB's failure to spot the evidence of illicit dealings pointed out by the U.S. authorities, partly a function of its resource constraints, and inadequate EU legislation.
While the ECB is a prudential regulator focussing on ensuring banks meet financial regulations with no powers to unearth corruption, it could have spotted clues.
It can review whether some bank officials and shareholders are "fit and proper". It can also attend board meetings and review whether the bank manages risks properly.
It is obliged to report to authorities when it suspects criminal wrongdoing. Still, it is not clear if such evidence was ever uncovered and reported to Latvia's Financial and Capital Market Commission, a supervisor whose head is named on the recommendation of the central bank governor.
But in reality, the ECB does not have the resources, particularly in the case of smaller banks like ABLV, to carry out in-depth reviews. Instead it concentrates on ensuring a lender is properly capitalised and meets financial obligations.
Still, deals with Russian shell companies could have been seen as a financial risk, which is ultimately a prudential issue within the ECB's remit.
The ECB declined to comment for this article.
Another hurdle is that the supervisor's work is carried out in joint teams with national supervisors and the process is often slowed by language barriers, which require cumbersome and time consuming translation work.
With less than 4 billion euros worth of assets, ABLV is one of the smallest banks directly supervised by the ECB, a drop compared to the 21 trillion euros worth of assets held by the 119 banks under its watch.
The broader issue is beyond the ECB's control: anti-money laundering efforts are carried out at the national level and rules differ from country to country.
The ECB has many times called for European-level rules but for now, it has to work with 19 different authorities and 19 different sets of laws.
"Over the long term, you will want the ECB's remit to be extended," said Bruegel's Wolff. "But it is quite difficult to do." (Additional reporting by John O'Donnell; Editing by Toby Chopra)