A speedy qualitative and quantitative development of the Estonian banking system that continued in 1995, made it necessary to develop the complex supervisory system both organisationally and methodically. Proceeding from the Law on Credit Institutions, which determines the goals and essence of the supervisory work more clearly, the Board of Eesti Pank confirmed the new statute of the Banking Supervision based on internationally acknowledged banking supervisory practice at the same time taking into account the level of development of the Estonian banking system. Pursuant to the new statute, three new sub-units were established inside the Banking Supervision: general supervision, off-site supervision and on-site inspection. The aim of the organisational changes was to promote specialisation, which as a result of cooperation between sub-units would result in better final result. A credit institutions' register which includes data on licensing and supervision was created for the better consolidation and systematisation of information necessary for the supervisory work.

General Supervision

The task of general supervision is to establish a legal basis for the activities of the Banking Supervision pursuant to the Law on Credit Institutions and other legal acts (instructions, regulations and procedures regulating the establishment of credit institutions, their activities and their termination according to the legislation).

The most important part of general supervision is licensing credit institutions. Basic requirements for the activities of credit institutions are established by the licensing instructions and these requirements must always be followed by the credit institutions. Especially important is the work prior to licensing because the suspension or withdrawal of a licence already issued often leads to legal problems and may harm the interests of creditors by having a negative impact on both the development of the economy and trustworthiness of the banking system.

In granting a credit institution an establishment permit, the existence and origin of capital, the competence and business reputation of the management as well as the prospects of the envisaged credit institution in the banking system are evaluated. As to the protection of creditors, special attention is paid to shareholders, especially those having a qualifying holding in the credit institution. The previous business activities of the shareholders are scrutinised and the feasibility of their business plans is assessed. Only if Eesti Pank is convinced that the credit institution has good prospects for the future, and that the financial status and competence of the shareholders guarantees support to the bank if necessary will the institution be granted a licence. Where the stipulations of the Law on Credit Institutions have been violated, the severest sanction is revoking the licence and, as a rule, this is followed by the winding up of the activities of the credit institution.

To meet the 50 million kroon minimum own funds requirement in force since 1 January 1996, banks issued shares, several banks merged or they attracted foreign capital. Several banks entered international capital markets and a number of banks are considering expanding their activities abroad. These processes have influenced the internal integration of the Estonian financial sector and stressed even more the necessity of cooperation between different supervisory institutions in Estonia.

The establishment of subsidiaries of foreign credit institutions in Estonia, the attraction of foreign capital by the Estonian credit institutions and the more active participation of Estonian banks in the international financial markets show that the Estonian banking system is internationalising. Banks becoming more open and international in their character is a positive phenomenon, but it brings along with it new problems that can be solved only in cooperation with the supervisory authorities of other countries.

Cooperation takes place on the basis of mutual agreements that regulate the division of tasks and exchange of professional information regarding consolidated supervision of foreign banking institutions. Such a cooperation agreement has been already signed with the Finnish banking supervisory authority. Similar agreements are to be signed with the supervisory authorities of several other countries.

The second aim is the cooperation with the Basel Banking Supervisory Committee and the Banking Supervisory Group of Central and East European Countries. The above institutions have provided the Estonian Banking Supervision with methodological material on current supervisory problems and the Estonian Banking Supervision has attended the meetings organised by those institutions.

In line with international practice, a draft law of deposit insurance was elaborated in 1995. At the beginning of 1996 it was presented to the Government for revision. In drawing up the draft law, interests of small depositors were considered above all, although the principles of the respective directive of the European Union were also simultaneously taken into account.

Off-site Supervision

Off-site supervision gathers as much information as possible on a credit institution without carrying out on-site inspection. The main source of information is the financial reports presented to the central bank by credit institutions as well as data from other sources (including results of on-site inspection). In addition to the analysis of individual credit institutions, the banking sector is also monitored as a whole (with regard to the development of the Estonian economy as a whole and compared with the banking sectors of other countries). Off-site supervision provides an early-warning system and informs the on-site inspection teams of signs of danger. The latter will then examine the situation further.

To make the supervisory work more effective, the Off-site Supervisory Unit was formed within the Banking Supervision in summer 1995. Although analogous work was earlier carried out by the Banking Statistics and Analysis Department and the banking inspectors, concentration of supervision biased banking analysis as well as direct relations with the on-site inspection enable a more systemic approach than before.

A system for monitoring credit institutions was established and complemented by new indicators and methods over the year. Since credit institutions present their profit and loss statement to the central bank once a quarter, a more systemic analysis also takes place quarterly. Banks have been divided into comparable groups where the changes in their indicators are compared with, apart from other things, the averages of the given group, of the Estonian banking sector and the respective indicators of some countries with a developed banking sector. The analysis is, as a rule, based on the interconnection of profit and loss accounts (profitability, productivity, structure, margins, etc.) and in assessing the results considering the so-called risk factor (credit, liquidity and foreign currency risks). Although a positive assessment has been obtained from the IMF, a further enhancement of the early warning system is one of the immediate tasks.

New possibilities for systemic improvements are created by the new prudential ratios for banks that take effect in 1996. Profound changes will take place in the regulations governing capital adequacy and its calculation as well as procedures for reporting large exposures. Reporting on liquidity will change considerably and a new report form for investments will be introduced. The new ratios are more or less in line with internationally concerted standards. Thus, starting from 1996, Estonian credit institutions are to a great extent liable to similar regulations in this field as the banks of countries with a developed banking sector. Therefore, the indices are also comparable with those of other countries.

In the future, the monitored areas have to be expanded. This could include the separation of the so-called investment portfolio and trading portfolio in the balance sheet, the monitoring of interest risks, the implementation of capital tier 3, monitoring the relations between banks and different economic sectors, more profound surveillance of off-balance sheet activities, etc. The introduction of consolidated reports leading to consolidated supervision is inevitable.

Especially important is the credit institutions risk management system. Since on the basis of information received by the central bank only general conclusions can be drawn, how a credit institution manages its risks is of great importance. Switching the main attention to the adequacy of risk management systems used by credit institutions is the biggest change in banking supervision both nationally and internationally.

On-site Inspection

The aim of the on-site inspection is the detailed and complex investigation of all spheres of activities of a credit institution. This investigation has to provide a picture of the adequacy of the credit institution's management system, the validity of its strategy and policies as well as the accuracy and quality of reports presented to the off-site supervision. The on-site inspection can be divided into planned inspections that include all or certain spheres of bank activities and emergency inspections that can be called for in the event of danger signals being sent out by the off-site supervision or if there are significant changes in the work of a credit institution.

In 1995, as before, on-site inspection dominated because the off-site supervision was still in the establishing phase and the reports submitted by banks did not give a full picture of their financial situation.

The development of on-site inspection has been ensured by the organisational and methodological changes in the Estonian Banking Supervision. Specific banks have been allocated to specific inspectors carrying out on-site inspection, and this has strengthened the continuity of supervision.

The development of the banking sector has brought about the necessity to change the hitherto existing supervision, concentrating mainly on the assessment of the loan portfolio, into a more integrated and purposeful one. Inspection is carried out regularly and on the basis of internationally approved methodology. The methodology comprises complex assessment of assets quality, stability and strength of capital, profitability, assets and liabilities management and management efficiency. Great attention is paid to the harmony of internal rules of procedure and the existence of effectively operating risk management and monitoring systems. The task of the on-site inspection is to notify banks of the necessity to form internal control units and to provide the necessary conditions for their operations.

On-site inspection has paid attention to a wider information exchange between bank inspectors and foreign auditors. A precondition for that is the precise description of their authority and procedures of cooperation stipulated by legislation. Cooperation has become closer between the inspectors, the Off-site Supervision and the General Supervision Group which provides inspectors with legal acts, instructions and procedural materials and gives legal advice.