By Alan Wheatley and Aleks Tapinsh
RIGA (Reuters) - They have little else in common, but the Baltic state of Latvia and the Mediterranean island of Cyprus are both magnets for Russian money, making them a focus for European officials concerned about murky banking and financial instability.
Cyprus needs a loan of at least 10 billion euros, mainly to recapitalise its banks, which have been crippled by exposure to crisis-stricken Greece.
But the euro zone, Germany in particular, is worried that low-tax Cyprus has become a conduit for money-laundering by Russians, who in turn have been withdrawing cash from the island's banks in case they are asked to contribute to the bailout, possibly via a tax on deposits.
Some of that money is washing up in Latvia, which has long catered to Russians and other foreigners.
As Latvia waits to hear whether its application to join the euro in January 2014 is accepted, its large offshore banking sector is thus under the microscope.
"It's very important to explain to our partners in the euro zone that, in the case of Latvia, this doesn't create any new risks similar to Cyprus," said Roberts Zile, a former finance minister and now a member of the European Parliament.
For a related story on Latvia's prospects if it is admitted to the euro.
Cyprus's banks have assets worth more than eight times the island's gross domestic product, dwarfing the equivalent figure for Latvia of 130 percent. But half of Latvia's bank deposits are held by non-residents, compared with 37 percent for Cyprus.
A senior banker said he looked on offshore banking in Riga with "scepticism and suspicion" but acknowledged that Latvia's EU membership and low taxes gave it a comparative advantage as an asset manager, especially serving Russian clients.
"If you know your customer, fundamentally it can be a good source of business. But one needs to be very careful. The standards are much better today, but it's not the same in every institution," the banker, who declined to be named, said.
Regulators have tightened up since the failure in 2008 of Parex bank, which did a lot of non-resident business, precipitated a bailout of Latvia by the International Monetary Fund and the European Union. The abrupt withdrawal of foreign cash depleted Latvia's international reserves by 40 percent.
Besides facing tougher capital requirements, banks catering to foreigners now invest a big chunk of their deposits in liquid foreign assets, reducing the risk of a crippling maturity mismatch in the event of a new wave of withdrawals.
Still, David Moore, the IMF's representative in Riga, said vigilance was called for. "The rapid growth is something to keep an eye on because non-resident deposits are inherently more prone to reversal than resident deposits," he said.
Prime Minister Valdis Dombrovskis said the share of offshore deposits had done no more than recover to its historical level after plunging during the crisis.
"So we don't see anything extraordinary happening right now," he told Reuters. "We're not a financial centre in the sense that Cyprus is."
Morten Hansen, an economist with the Stockholm School of Economics in Riga, said he too saw little reason for concern as long as local regulators were on the ball; taking in foreign deposits was an area of comparative advantage for Latvia.
"It's close to Russia and the other republics. It's inside the EU. Compared to those countries, it is fair, transparent and with a proper legal system. And they speak the language and understand the mentality," Hansen said.
Still, suspicions persist that Latvia is not doing enough to prevent its banks from handling illicit cash.
In a report issued in November, the Council of Europe concluded that Latvia now had the legal structures in place to combat money laundering and terrorist financing.
But in a case with international ramifications, Hermitage Capital, a U.S.-managed fund investing in Russia, filed a criminal complaint in Riga in 2012 alleging that at least $63 million had been laundered through Latvian banks.
The money was part of a $230 million tax rebate from Russia that Hermitage said was stolen. Sergei Magnitsky, a lawyer for the fund investigating the case, was arrested for tax evasion and fraud - the same charges he levelled against Russian police and tax officials - and died in prison in 2009, aged 37.
His death led to the passage of a U.S. law that imposes visa bans on Russians accused of human rights violations and freezes their assets they hold in the United States. Magnitsky is now being tried posthumously in Moscow.
The Latvian state prosecutor's office has instructed the police to investigate whether the country's banks played any part in the alleged tax fraud.
Figures from the banking regulator show that it issued seven administrative penalties totalling 265,000 lats ($490,000) in 2010-2012 for violations of anti-money laundering laws.
Erik Berglof, chief economist at the European Bank for Reconstruction and Development in London, said the Latvian banking system was very different today than a decade ago.
Anti-money laundering procedures were much more developed and regulators had learned from bitter experience to keep tabs on the build-up of non-resident deposits, Berglof said.
"It is an issue, but once Latvia is inside the euro zone the odds are that they will be quite strictly monitored," he said. "What happened in Cyprus is that no one was paying attention."
(Editing by John Stonestreet)