GENERAL DEVELOPMENT OF SUPERVISION IN ESTONIA
The Estonian banking supervision proceeds from the internationally acknowledged principle that full stability of the banking system is impossible to achieve but that the task of the supervision is to make an effort to support stability, thus reducing the costs of possible financial crises for society. In the course of supervisory work, attention is focussed on the banks that play a dominating role in the stability of the entire system, and in a concrete bank, on areas that are most important from the point of view of this bank.
Estonian society has come to understand that in the conditions of market economy banks are independent in their activity and carry full responsibility for the results of their business activities. The task of supervision is not to replace the management of the bank or curb the disciplining impact of the market. The supervisory authorities intervene with the banks' everyday activities only in case:
- they fail to observe the Law on Credit Institutions or other legal acts regulating the activities of banks, or
- take too high risks.
Banking supervision is independent in its activity, free from any kind of political influences. All its functions, from setting up a database to applying sanctions, working out regulations and organizing international cooperation from an integral whole.
In 1996 the banking supervision focussed on observing the work of credit institutions. In particular, inspectors studied capital adequacy, changes in the circle of owners, and in connection with the latter also the possible concentration of the share capital, the quality of assets, the level of inter-bank procedures and risk management systems. According to the annual plan, all commercial banks were inspected and follow-up examinations were made. Supervision of capital was improved, off-site and on-site supervision were united and a new integrated supervisory procedure was developed which includes all stages and areas of supervision. With its implementation, the contacts between the supervision and commercial banks will become closer and the supervisory work will become more efficient.
Changes in the work procedures allowed to focus more on the specialized study of major risks and to put the resources, which are at the disposal of the banking supervision, to a more effective use. Watching over the legality of the banks' activity is more and more becoming the task of the banks' strengthening internal audit units, while the task of the banking supervision focuses on assessing the banks' development strategy and forecasts.
DEVELOPMENT OF BANKING AND PRIORITIES OF SUPERVISION
The Estonian banking market has not fully developed yet, although rapid progress has taken place over a short period. However, not all banks have been able to determine their place on the market and the unification and organisation of the market will obviously continue for some time.
In 1996 the Estonian banking market was under the strong impact of the tightening competition. The standardization of processes and procedures clearly became the basis for improving quality and increasing stability.
Small banks have an important role to play in shaping the competitive environment. Although it is difficult for them to act the same way as larger banks, the final decision is still made by the market where the main emphasis is on the quality of the banking services. If the development that began in 1996 continues, the complexity and reliability of financial services targeted at different groups of customers will increase and different individual service packages will be developed. The toughening competition also makes it necessary that the increase in the services volume be accompanied by the increase in the banks' own funds.
The share of operations with securities in the activities of banks is increasing. This is a global process which starts to manifest itself also in Estonia by giving the banks an opportunity to find an additional and quick use for their capital. We can presume that due to the reorientation of investments to the securities market the traditional role of banks as depositors, lenders and payment intermediaries will be reduced on the Estonian financial market as trading in securities gains more importance. This will also change the criteria of evaluating the market share of the banks. The volume of the balance sheet will not be the main criterion but also the share of total market income. However, the criterion of the banks' reliability will still be the balance sheet which will increase through additional investments and the increase in own funds.
The current stage of development of banking is characterised by the constant complication of the banks' activities. As a result, consolidated groups of credit and financing institutions are emerging as well as conglomerates of various financial and mixed-activity institutions. This means a new organizational quality which sets new and higher requirements on the banking supervision as well.
Management and Internal Audit Unit
The success of the management of a credit institution depends on the quality and adequacy of the information at the disposal of the management on the activity of the institution and the risks involved at every given moment of time. Flaws in the information systems and vagueness in the authority and responsibility of the staff facilitate taking unjustified risks and misinterpretation of the actual size of the risk. Lack of correct information makes it difficult for the management to adopt competent decisions and this can damage the interests of both owners and customers.
It is the task of a well-functioning independent internal audit unit to avoid the emergence of such problems since their main role is to study and assess the organisation of work of the credit institution, its trustworthiness and efficiency. Although organising the work of the internal audit unit is the task of the internal audit unit itself, the board and executive management of the bank have to provide the necessary conditions and environment for this.
With the enforcement of the Law on Credit Institutions in 1995 the activity of internal audit units acquired a legal framework in the Estonian banking. 1996 can be called a starting year from the point of acknowledging the necessity of the internal audit unit and understanding its nature by the commercial banks. The decree of the President of Eesti Pank in February laid down the methodological recommendations which the banks followed in setting up their internal audit units during the year. The most difficult problem was guaranteeing the independence of the audit units and finding qualified staff. Technical skills and experience are not enough for examining the work of one's colleagues and in some banks there is still a lot to be done to find determined internal auditors.
Security and Reliability of Information Systems
The problems of the banks' information systems and internal audit units are closely linked with the security of the information systems. In 1996 it became one of the priorities of the banking supervision. The security situation of the information systems of all commercial banks was studied and on the basis of the generalized data further steps were envisaged. The reliability and security of information systems is an important component in guaranteeing the security of the bank's activity, and its management and inspection deserve full attention. In order to increase awareness of the risks involved in new technologies the banking supervision in cooperation with the Information Systems Audit and Control Association organised a seminar for the staff of commercial banks, called "The Role of Management in Guaranteeing Information Security". In addition to the auditing of the 1996 financial results, the auditing of the information technology is also carried out in commercial banks.
The wider spread of automatic teller machines and payment machines, telebanks and Internet banking in 1996 - all presuppose a high level of data protection. The quality of the respective security systems can only be examined by qualified experts.
Risk Management Systems
Like in international banking supervision, the problems of risk management systems of credit institutions have become topical also in Estonia. Since the obligatory information submitted to the banking supervision cannot cover everything, only some general conclusions can be made. Therefore, it is very important how each credit institution itself manages its current risks. The banking supervision focuses on implementing the minimum requirements on the efficiency and expediency of the credit institutions' risk management systems and meeting these requirements by banks.
Eesti Pank has for some time made banks to provide the descriptions of procedures used to manage different risks. The 1996 decree on updated prudential ratios for the first time clearly states that the bank must formulate a separate risk management strategy for every risk category, approved by a written decision of a competent executive body of the bank.
In the further treatment of the bank's financial management two areas have to be specified, capital management and expenses management. The aim of the capital management is to increase the bank's own funds without damaging the bank's credibility. The expenses management has to guarantee the planned increase in income and a firm management of all interest and non-interest expenses.
REVISION OF BANKING-RELATED LEGISLATION
Although Estonian banking legislation can be regarded extensive and developed enough as compared to other financial sectors, there are still some worrying gaps. There is still no the law on guaranteeing deposits and the Law on Credit Institutions has to be improved. The Ministry of Finance is working on the anti-money laundering law which will also regulate the cooperation of credit institutions and investigation organisations in this sphere. The team working on the draft law also includes a representative of the banking supervision. There are also problems with the inadequacy of legislation regulating the non-banking spheres of the financial system, the insufficient regulation of debt and contract matters, etc.
Law on Guaranteeing Deposits
The draft law on guaranteeing bank deposits provides for the creation of a fund aimed at paying out deposits to the extent provided by the law and according to procedures described in it in case of insolvency of a credit institution. Thus, the fund would be in the general interests of the society and it would increase the credibility and stability of the banking system. The draft law is in conformity with the respective directive of the European Union.
When the law takes effect, deposits of up to 20,000 kroons per depositor will be guaranteed to both companies and private persons. Over the next 15 years the size of guaranteed deposits will be gradually increased to 20,000 ECU. The draft law also provides for the depositor's own responsibility of 10%, meaning that the fund will compensate 90% of the guaranteed deposits. This principle is in accordance with international practice. The depositor will have a right to claim the part of the deposit that was not compensated for from the bankrupt bank. Also the fund is entitled to a share of the bankruptcy estate that covers the size of the compensations it paid to depositors.
Taking into account the recommendations of the Ministry of Justice and the Ministry of Finance, as well as amendments in the Civil Code, some changes and additions were made in the draft law at the end of 1996. The draft law is expected to be discussed by Riigikogu (the Parliament) in 1997.
New Version of the Law on Credit Institutions
During the two years that have passed from the enforcement of the current Law on Credit Institutions the Estonian legal system has developed rapidly and several new laws have taken effect. The banking sector too has undergone rapid changes. Hence the need to renew the Law on Credit Institutions.
The general trend of the new version was concretisation. The main emphasis was put on details and increasing the responsibility of the board and management for the results of the work of the
credit institution. The task of the Banking Supervision as a state supervisory institution working for maintaining the stability of the banking market and protecting the rights of creditors is to study the conformity of the activity of the managing bodies of credit institutions with the existing legislation and instructions based on them. Direct intervention in the activity of a credit institution takes place only under circumstances specified by the law.
Banking is the most important part of the state's financial system and the well-balanced development of the banking has to facilitate the balance of the entire financial system. The Law on Credit Institutions regulates the development of banks within the system but banking can also be endangered by other influences from the legally unregulated spheres of the financial system. This applies to various institutions that act as financial intermediaries such as pawn shops for example. The regulation and supervision of these spheres is not covered by the law.
The first step in preventing money laundering in Estonia was taken by including a respective chapter into the Law on Credit Institutions that took effect in January 1995. Under the law, credit institutions have to identify all their customers and collect and keep information on their large-scale transactions. The decree of Eesti Pank President in May 1996 introduced certain requirements on due diligence and procedural matters in observing the provisions of the law which concern the combatting of money laundering. By today, it has become clear that further regulation is needed for the procedures of forwarding information on the initiative of credit institutions on sufficient evidence.
It is important to determine the rules for keeping and using the confidential information by bodies of investigation, as well as the legal protection of the credit institution and its staff in case the bona fide closure of potentially suspicious information causes damage to the customer.
In order to assess the activity of the banking sector in preventing money laundering it has to be kept in mind that at the present moment money laundering is not qualified as a criminal offence in Estonia. In all credit institutions there are contact persons with respective authorization to liaison with the banking supervision authorities and investigation organisations to the extent the current legislation makes possible. In order to maintain international cooperation in this sphere contacts have been established with respective institutions in Finland, Denmark, the Netherlands and Belgium.
From the beginning of 1996 new instructions on calculating and reporting the prudential ratios of credit institutions came into force. The regulation of capital adequacy and risk concentration was thoroughly improved, the liquidity reporting underwent major changes and as a new feature a report on investments was introduced. From 1996 Estonian credit institutions have to meet similar requirements in this sphere as banks in the European Union member countries, with the exception of some details.
In Estonia, capital adequacy is measured as follows: the bank's own funds are divided by the risk-weighted assets and off-balance sheet liabilities and the sum of the net foreign currency position exceeding the 2% level of own funds. The minimum ratio is 8%.
The following limits apply to the risk concentration:
- the loans to one customer or connected parties must not exceed 25% of the bank's own funds;
- the total sum of large exposures must not exceed 800% of the bank's own funds;
- the total sum of loans to the bank's parent company, subunits and the subunits of the parent company must not exceed 20% of the bank's own funds.
From 1996 the liquidity regulation of the banks can be divided into two: liquidity ratios and liquidity based on money flows. There are three liquidity ratios which all characterize the size of a certain liquidity buffer as compared to the bank's potential liabilities. Liquidity I covers assets and off-balance sheet claims which can be turned into cash within two banking days as compared to potential liabilities that may have to be met in two banking days. Liquidity II sets a one-month time limit on the assets and liabilities. From 1 May this ratio also has a lower limit - 35%. Liquidity III measures the ratio of all assets to the sum total of all on-balance and off-balance sheet liabilities. It is more of a strategic indicator that compares the liquidity preferences of different banks.
The improvement of prudential ratios in the Estonian banking continues in accordance with the recommendations and practice of the European Union and the Basel Committee. At the moment, the capital requirement is only applied on credit risk and of the market risks only to cover the foreign currency risk. Other market risks, most notably the interest rate risk, are not covered by the capital requirement. Introduction of the respective regulations is apparently going to be complicated and time-consuming. Among the planned changes in the regulations we could mention the separation of the bank portfolio and the trading portfolio in the balance sheet, observation of the interest rate risk, introduction of the capital tier 3, surveillance of various connections between banks and scrutinization of off-balance sheet activities.
The reporting procedures of consolidated banking groups and their supervision have to be improved. The primary goal of the consolidated supervision is to avoid the multiple use of the credit institutions' capital, eliminate the income from transactions within the group from total income and thus treat the group as one entity from the point of capital and income. This does not mean, however, that the activity of the group's non-credit institutions would be subject to banking supervision.
RESTRUCTURING OF BANKS
Even good banks operating in the best of business environment can give out loans they have problems with repayment and investments that do not justify themselves. If the bank's risk management is not at a required level the problems start to accumulate and it is only a matter of time the critical point is reached. The solution of the problems of a number of "old" banks came to an end in 1996. In all cases restructuring measures were applied in good time before the development of a crisis.
In all those cases the main problem was careless loan policy and legally incorrect loan and collateral agreements. The problems have been amplified by the insufficient checking of the borrower's background, namely, some borrowers have turned out to be economically linked and loans to them have been guaranteed by one and the same capital.
In addition to features common to almost all the problem banks, each case also had its peculiarities that have been taken into account when choosing the appropriate measures. The restructuring of a problem bank is always a unique and exceptional activity but the solution must not proceed from the narrow interests of a single bank. For the Banking Supervision the aim of the restructuring is not the preservation of one bank but rather improving the banking system as a whole and protecting the interests of creditors.
Preparations for the merger of Eesti Tööstuse ja Ehituse Kommertspank (Estonian Commercial Bank of Industry and Construction; ETEK) and Eesti Hoiupank (Estonian Savings Bank) began in May 1996. The ETEK with its hidden dangers in the form of insecure loan guarantees stemmed from the former socialist system. The market share of the bank was constantly shrinking although its customers included several large corporations. The latter was the only attraction of the bank. At the same time the bank was unable to meet the corporate clients' growing needs for financial services at the required quantitative or qualitative level and their leaving for some other major bank was just a matter of time.
The suggestion made to the ETEK to find itself a partner triggered a merger process that ended with the signing of an agreement with the Eesti Hoiupank on 2 September. The process itself was very complicated for the parties, both from the legal, economic and psychological aspect. However, all the problems of the ETEK were solved in good time and at minimum costs.
The individual problems of Rahvapank (People's Bank), Keila Pank and the former Eesti Maapank (Land Bank of Estonia) that emerged at their merger with Virumaa Kommertspank (Virumaa Commercial Bank) were amplified at the beginning of 1996. The main problem was the long-term covering of the loss of previous periods. Several measures were taken in order to guarantee the smooth functioning of a new bank and by the end of the year the losses were fully covered and other necessary changes made, thanks to the efforts of the bank's owners and management.
The problems of Põhja-Eesti Pank (North Estonian Bank Ltd.) also arise from earlier periods. On the positive side, the number of private and corporate customers has been slowly but constantly increasing. However, the high concentration of liabilities in the form of state budget funds predicted the piling up of serious problems. After solving the problems of loss covering, the merger process with the Eesti Ühispank (Union Bank of Estonia) was launched in cooperation with the government and Eesti Pank, but will find a technical solution in the first half of 1997.
INTERNATIONAL COOPERATION IN THE FIELD OF SUPERVISION
The international integration of the Estonian banking market presupposes close cooperation in the sphere of banking supervision, both in the everyday work and in applying general principles and new theories.
The practical international cooperation is carried out in two main directions:
- supervision of consolidated international bank groups;
- examination of the background of owners and potential investors.
The general requirements on the supervision of banking institutions and consolidated groups active on an international scale has been determined by the Basel Agreement and later amendments to it. Detailed cooperation conditions are specified in the mutual cooperation agreements between the supervisory authorities of different countries. The memorandum of mutual understanding between the Finnish Financial Supervision and Eesti Pank was signed already in 1995. In 1996 cooperation was continued in the spheres of both auditing and exchange of information. In connection with the need to strengthen consolidated supervision over the Hansapank group, Eesti Pank proposed a similar cooperation agreement with the Latvian banking supervision authorities. Unfortunately, the limitations on the exchange of confidential information deriving from the Latvian legislation do not allow such cooperation at the present time.
In order to establish the credibility of non-resident owners and potential investors and their financial status, the Estonian banking supervision authorities exchange confidential information with the supervision institutions of other countries, at the same time observing the requirements of keeping the bank secrets and the business secrets of the banks' customers. According to the international practice, the exchange of information is mutual, without special prior agreements. In 1996 such information was exchanged with the banking supervision authorities of seven countries on three continents.
In the interpretation of the theoretical issues of banking supervision Estonia has received substantial help from colleagues in Finland, Iceland and Norway, as well as from the Group of Banking Supervisors from Central and Eastern European Countries and the Basel Banking Supervisory Committee. The Group of Banking Supervisors from Central and Eastern European Countries arranges regular round-table meetings which are also attended by the representatives of the Basel Committee. The Group also represents its member countries in the Basel Committee, thus providing them with an indirect opportunity to take part in the activity of the Committee. Although Estonia is not a member of the Basel Banking Supervisory Committee and will never become, our bank supervisors have benefitted greatly from the methodological material provided by the Basel Committee on a regular basis. A representative of the Estonian Banking Supervision also attends the international congresses the Basel Committee holds every other year.
Foreign banks, other financial intermediaries and potential foreign investors coming to the Estonian credit market as a rule take great interest in the methods and credibility of the Estonian banking supervision. This too points to the need to strengthen international contacts and cooperation.