Compared to previous years, the growth rate of nominal indicators in the financial system slowed down considerably in 1998. The second half-year saw even small declines - the banks' consolidated balance sheet decreased and credit turnover diminished. The biggest setback hit the securities market where the stock market was limited only to the secondary market activities. By the trading volume debt securities took over the lead from shares and a precedent was created when a public company voluntarily terminated its listing. The volume of the leasing portfolio which had grown steadily during the first half-year, decreased somewhat during the second half-year. In reality the operations of investment funds gradually died out and insurance companies faced their first difficulties (see Figure 3.1).

Figure 3.1. Estonian financial intermediation in 1998 (volume in EEK billion and structure by % of GDP)

1998 saw a wave of mergers and restructuring in the banking sector. Four major banks formed two big banking groups. The merged banks received equal ratings from Moody’s Investors Service [1] . Bankruptcy proceedings were commenced against Eesti Maapank (Land Bank of Estonia) and EVEA Pank, a moratorium was declared to ERA Pank, and Eesti Pank acquired a majority holding in Optiva Pank. By the end of the year there were five banks and one foreign bank’s branch office operating in Estonia. The entire system became healthier when Swedish banks and other Nordic investors joined the circle of owners of banks and insurance companies, thus strengthening the pillars of the financial sector and improving its future outlook.

Compared to 1997, the nature of the capital inflow through the financial sector changed radically. In the first half-year it had been net outflow, but investments made into the share capital of two major banks in the end of the year increased once again the inflow of foreign capital. Thanks to equity investments, the banks had no difficulties in refinancing their external liabilities and the average date of maturity of the residual fixed-term external liabilities was extended notwithstanding the fact that the attitude of international financial markets towards transition economies had remained cautious. Despite various external shocks, especially the financial crisis in Russia, no essential change in attitude towards the Estonian economy and banks on the whole was noted. The proof of it was that Estonia's sovereign rating received in 1997 was upheld[2] .

In order to fortify the banking system against any potential internal or external shocks, Eesti Pank continued to improve the regulatory norms for the banking sector. Beginning from July 1998, the capital adequacy, risk exposure and investment requirements are applied also on the consolidation basis. A new procedure for calculating the capital adequacy ratio was established which includes in the risk estimation base additionally also interest and positions risk concurrent with the trading portfolio. The enforced liquidity and capital requirements enabled the Estonian banking system to adapt with less pain to the changing business environment and to increase risk buffers for the future need.

Of the net positions of sectors of economy against the banking and securities markets, the positive net position of the government sector weakened (see Figure 3.2). It was caused by the shrinking of the general government deposits by 1 billion kroons. The balance of loans and issued bonds did not change much. The positive net position of the external sector grew at the expense of the reduction of the banking sector’s foreign claims. This growth was offset by the decrease in claims caused by the falling share prices and the increase in liabilities related to bonds issued. Although the deposits of the population increased by 1 billion kroons during the year, the net position grew only by 0.3 billion kroons due to the falling share prices. Corporate loan stock increased by 3.8 billion kroons during the year. The change in the net position was to some extent offset by the increase of deposits, share prices deflation and reduction of issued debt securities. As the result, the amount of resources incorporated by enterprises via the banking sector and securities market grew by only 0.4 billion kroons. Partly due to the enlargement of the reserve requirement basis, the net position of the central bank grew by 0.7 billion kroons.

Figure 3.2. Position of the Estonian economic sectors and institutions against the consolidated financial sector (EEK billion)


Banks’ Assets and Their Quality

Changes in the external environment manifested themselves in the quantitative development of the banks with nearly a six-month time shift. The declining trend in volumes that had started in mid-1998 continued until the year’s end - the banks’ consolidated assets diminished to 41 billion kroons during the second half-year and the annual growth was a modest 1% (see Figure 3.3). The consolidation groups also exhibited a slow growth rate, by the end of the year their total assets amounted to 47.9 billion kroons. This tendency indicates that, in general, financial intermediation is shrinking.

Figure 3.3. Banks' total assets (EEK mn)

As a reaction to the 1997 autumn liquidity crisis, lending to the financial sector slackened and the importance of liquid assets increased. The recovery of the assets structure to the pre-crisis situation during the first months of the year reflected the adjustment process to the changing conditions. A new feature in the first half-year was the substitution of financial investments with loans and the growing importance of the real sector enterprises in the loan portfolio. Due to the inhibited flow of external funds the lending progress actually stopped in the second half-year and the banks focussed primarily on the restoration and maintenance of their liquidity positions. At the end of 1998 the loan portfolio accounted for nearly 60% of the assets (23.9 billion kroons).

Within one year the share of foreign currency loans increased from 56 to 76% (out of it loans in German marks from85 to 89%). The share of the German mark in the loan portfolio grew to 9.2 billion kroons (see Figure 3.4). One of the reasons for the growth of foreign currency loans may have been their lower nominal interest rate in comparison with kroon loans (1-2 percentage points difference). It was an intentional behaviour by the banks that had been triggered by a high level of foreign borrowing (mostly DEM) and the need to cover the positions of the Estonian kroon-German mark forward transactions and to create buffers for the future.

Figure 3.4. Banks' loan portfolio (EEK mn) and share of foreign currency loans (%)

The share of the open sector in the loan portfolio increased from 57 to 63% within one year and the share of the export-oriented sector from 18 to 22%. Among major sectors of economy trust was retained towards the industry as its loan stock had grown steadily throughout the year. In the second half-year the share of credits given to trade and financial sector decreased (see Figure 3.5).

Figure 3.5. Loan portfolio by sectors of economy (EEK mn)

The immediate impact of the Russian crisis on Estonian financial markets was relatively limited as the direct position of our banking sector in Russia constituted less than 1% of the assets. Almost half of the consolidated position was attributable to EVEA Pank, as 15% of its assets were eurobondsissued by the government of Russia. An indirect danger to the banking sector stemmed from the decelerating turnover of Russia-oriented enterprises that caused problems with debt servicing. In the banks’ loan portfolios the share of enterprises, which exported at least 30% of their output to Russia and other CIS countries, amounted to 6.9% in late August (1.5 billion kroons).

By the end of the year the overdue loans remained within the range of 1.1 billion kroons. Approximately half of them were overdue loans for more than 60 days (see Figure 3.6). By sectors, overdue loans of wholesale and retail trade, fisheries and industry, ie open sector grew the most. If the industry was mostly affected by the changes on its target markets, then trade was primarily affected by low sales results at the year’s end and decreasing consumption of imported goods. Although both the companies and the banks have undergone initial restructuring with respect to their markets and funding facilities, the pressure on the quality of the loan portfolio has not been lifted in the slow economic growth conditions. At the same time the banks also increased their provisioning that grew from 2 to 4% of the loan portfolio (together with the general reserve from 4 to 6.6%). In the consolidation group segment doubtful claims of the banks formed two thirds and claims of their subsidiaries’ one third of all doubtful claims.

Figure 3.6. Volume of overdue loans (EEK mn) and share of provisions in banks' total loan portfolio (%)

In the second half-year, the shrinking of the securities portfolio that had begun in the beginning of the year continued. By the year’s end it had diminished to 6.3 billion kroons (see Figure 3.7). A considerable reduction was undertaken during the third quarter with the aim to generate liquid funds and save the residual value of securities. However, in the fourth quarter, following the share issues of the banks, the securities portfolio served as a liquidity buffer and its size did not change much. The share of German mark denominated non-resident government bonds increased on the account of credit institutions’ and commercial undertakings’ claims. With regard to maturity, long-term resources were redirected into short-term instruments.

Figure 3.6. Volume of overdue loans (EEK mn) and share of provisions in banks' total loan portfolio (%)

Liabilities and Own Funds

Changes on the business landscape and the depression in the financial sector affected also the incorporation of external funds. Due to the outflow of external funds in the second half-year, their size decreased by 6% in a year. If deposits of private and corporate customers had increased in the beginning of the year, then in the second half-year deposits of all customer groups decreased and, as predicted, the importance of credit institutions became minimal. Despite the downward trend, deposits of private customers grew by 919 and corporate deposits by 323 million kroons. Due to the strenuous fiscal position and shortcomings in liquidity management, government deposits with the banks had decreased by the end of the year by 1.2 billion kroons (see Figure 3.8).

Figure 3.8. Banks' external liabilities (EEK mn)

The balance of non-resident liabilities had diminished by 9.9% in a year (see Figure 3.9) and the share of non-residents in total liabilities fell from 37.5 to 34.3%. The greatest source of outflow was non-resident private companies. Non-resident term liabilities diminished by 741 million kroons. At the same time liabilities were partly replaced by share capital which has a greater importance from the financial stability perspective. Capital injections contributed to the successful refinancing of mature external commitments and helped to defer the due dates of the outstanding ones. The average balance sheet maturity of the commitments was extended from 21.4 months of the end-1997 to 27.5 months of the end-1998. Nevertheless, compared to 1997, refinancing was done at 1.5 percentage points higher interest rate. In the early months of the year, the flow of non-resident external funds from loans to securities that had started in 1997 gained momentum. In the second half-year, however, a reverse tendency was observed and non-resident external funds were attracted into banking predominantly as syndicated loans.

Figure 3.9. Banks' non-resident liabilities (EEK mn)

In the course of the restructuring process foreign banks continued to increase their stakes. Optiva Pank was formed on the basis of Eesti Forekspank (Estonian Forexbank) and Eesti Investeerimispank (Estonian Investment Bank). The outcome of the restructuring was that the banks’ share capital increased all in all by 3.1 billion kroons. Equity investments by Swedish banks in Hansapank and Eesti Ühispank (Union Bank of Estonia), increased the share of non-resident owners in the banking system to almost 60% (see Table 3.1. Owners of credit institutions as of 31 December 1998). Concurrently with the increase in share and equity capital of the banks, the capital adequacy of the system improved considerably in the fourth quarter, having risen from 13.5 to 17% within a year. The rise in adequacy was facilitated also by transformations in the structure of risk groups in connection with the changes in liquidity positions.

Table 3.1. Owners of credit institutions as of 31 December 1998



Estonian legal persons


Non-resident legal persons





Other legal



Other legal

Eesti Krediidipank











Eesti Ühispank






















Optiva Pank











Tallinna Äripank






















Return on Equity

1998 was noted for a distinctive widening difference in the banks performance ratios, typical to a changing environment (see Table 3.2. Banks' return on equity). Among ROE components the fall of the profit margin had the greatest impact. Income affects this factor more than expenses and, therefore, the drop in profit margin should not lead to a conclusion that cost control has deteriorated seriously. The increase in total expenses was mostly due to the increase in interest-related expenses. Another important factor was the write-off of assets at the end of the year, resulting in the increase of the losses to 676 million kroons, caused by the change in claims and off-balance sheet items. Other operating costs that reflect a potential restructuring of the system had a relatively insignificant impact on the growth of total expenses. Service fee-related expenses, which were lowered mostly in the second half-year, are an indirect reflection of the problems in the domestic real sector.

Table 3.2. Banks' return on equity







Equity multiplier






Return on equity






Return on assets






Profit margin






Assets utilisation






Earnings per share






Despite an almost twofold decline, the impact of the assets utilisation on ROE was insignificant. The main cause for the drop in assets utilisation was an almost two-and-a-half times decrease in the income from financial transactions. Another essential factor was a fall in the income from service fees, which was a reflection of the shrinking economic activities. An almost eight-and-a-half times decrease in the income from financial investments is partly a reflection of unsuccessful financial strategies of the banks. Shifts in the recovered revenue from the written-off assets, other operating profit and extraordinary income had no critical influence.

A significant cutback in the interest income from conventional banking operations was a main reason for the abrupt drop in net interest margin and spread. The above shift was mainly due to the decrease of the assets value (especially the loans) and, to a lesser extent also the shrinking of the earning base. A fall in the interest income would have been even 50% greater if the Estonian banking system had not earned a considerable interest income from derivative instruments. Among the consolidation groups the share of interest expenses and interest profit in the total income decreased.

Institutional Development

The consolidation of the banking sector that took place in 1998 marked the beginning of a new, rightful phase in the development of the Estonian as well as the entire Baltic banking market. It showed that the development of Estonian financial markets was in harmony with the global trend and reflected the ever growing competition in the banking and financial sector at large. With the harshening of the business environment in 1998 these wrong economic and management decisions that had been made earlier under the tough competitive pressure surfaced and resulted in the dropout of three banks from the marketplace in July-October. These interrelated system factors that had encouraged wrong management decisions or enabled them to be made, were the expansive development in the recent years, lack of experience in doing business in the changing market conditions, insufficient transparency of the market and the owners’ weak control over executive management, toughening of competition at the banking market, insufficient risk hedging and external shocks.

The reorganisation of the banking market in 1998 started with the declaration of Eesti Maapank’s (Land Bank of Estonia) bankruptcy market share 3%) on 1 July. The cause of the bankruptcy lay in Maapank’s business profile and some general trends on the Estonian financial markets. In the years 1996-1997 Maapank had pursued an aggressive expansion policy in traditional banking as well as in new market segments, predominantly the securities market. At the same time the evolution of the bank’s management structures, internal risk management and control mechanisms lagged behind the bank’s development. Therefore Maapank was, in fact and technically, unable to compete with other more successful universal banks, which would have been an essential prerequisite for the realisation of the strategy chosen by its owners and the management. The harshening of the business environment in end-1997 revealed Maapank's unwarranted big positions on the stock market and the management’s unreal expansion strategy. As the result of losses in the securities portfolio, deterioration of the loan portfolio’s quality and internal violations, the bank’s net worth became negative.

The toughening of competition was also the main argument for the mergers of Hansapank and Eesti Hoiupank (Estonian Savings Bank) as well as Eesti Ühispank (Union Bank of Estonia) and Tallinna Pank. In the first case an important driving force was also problems in the general management of Eesti Hoiupank as the executive management had failed to make public the critical information concerning the 1997 share issue (Daiwa case). On 13 July 1998 Eesti Pank approved the merger of Hansapank and Hoiupank. Total assets of the new bank constituted 46% of the consolidated balance sheet of the banking system as of end-July. On the same day the merger agreement between Ühispank and Tallinna Pank was approved and total assets of this new credit institution accounted for 34% of the consolidated balance sheet as of end-July. After the completion of the mergers, Scandinavian banks started to show greater interest towards the banking groups that had been established through mergers and in the first stage it was manifested in their buying up Hansapank’s shares on Tallinn and Helsinki stock exchages. Ultimately, Swedbank acquired 56%[3] of Hansapank and Skandinaviska Enskilda Banken 32% of Eesti Ühispank.

Besides the changes in the external environment, Estonian small banks were affected also by negative development trends in Russia. On 1 October Eesti Pank decided to initiate bankruptcy proceedings against EVEA Pank (market share 2%) as approximately 15% of the bank’s assets were tied in Russian government debt securities. On 6 October Eesti Pank declared a moratorium to ERA Pank (2%) which had acquired together with its affiliated companies a 36% stake in EVEA Pank. Deposits of both banks’ depositors were compensated under Deposit Insurance Fund Act that took effect on 1 October. Depositors of Eesti Maapank received compensation from the government in accordance with the principles set forth in the same legal act but compensation rates were higher than prescribed by the law.

In order to reduce system risk and to implement Eesti Forekspank (Estonian Forexbank; market share 5%) and Eesti Investeerimispank (Estonian Investment Bank; 4%) merger plan, Eesti Pank bought 50% of Eesti Investeerimispank’s shares that had belonged to Eesti Forekspank and acquired also a majority stake in Eesti Forekspank at nominal value during the additional share issue. The acquisition by Eesti Pank of the 58% holding in Optiva Pank that was established through the merger of Eesti Investeerimispank and Eesti Forekspank was prompted by the monetary and banking policy objectives chosen by Estonia, the need to forestall the risk of instability in the Estonian banking system and was supported by the opportunities foreseen by the law. Eesti Pank intends to sell its shares in Optiva Pank to a strategic investor as soon as it is possible in view of the need to ensure the stability of the financial system.


Debt Securities Market

Trading at the debt securities market picked up after the shrinking of transaction volumes on Tallinn Stock Exchange and the stock market on the whole. Until November 1998 the volumes of new issues had been decreasing but during the two last months of the year the primary market was revitalised thanks to the Estonian kroon denominated bond issues by Finnish and Swedish financial institutions. After a sharp rise in interest rates in late 1997, local enterprises have constantly curtailed funding through debt instruments.

Due to the domination of up to 3 months debt securities and the dependence of short-term bond interests on the money market interest rate level, the average interest rates of debt securities have followed the inter-bank loan interest rate (TALIBOR). In the beginning of the year the average interest rate had sustained a downward move, hitting the 11% level by the end of the second quarter, but during the second half-year the average interest rate level rose to 15% (see Figure 3.10). However, the interest rate of the kroon denominated debt securities issued by non-residents with a higher credit rating followed the established interest intervals.

Figure 3.10. Volume of bonds issued in a quarter by maturity (EEK mn) and average interest rate (%)

A new trend was the increase in the turnover of the debt securities secondary market. In previous years and also in early 1998 the monthly turnover of the debt securities market had been around 1 billion kroons, while beginning from August it reached the 2 billion kroon level (see Figure 3.11). Initially, the turnover grew on the account of transactions with long-term government bonds, during the last months of 1998 kroon denominated non-resident debt securities and some local corporate bonds contributed to it too. The structure of investors did not change much, although the share of non-residents increased from 50 to 60% in the second half-year. Among foreign investors Finland, Latvia, Austria and United Kingdom prevail.

Figure 3.11. Turnover recorded at the Estonian Central Depository for Securities by instruments (EEK mn)

Stock Market

Since the abrupt drop in share prices in the third quarter of 1997, trading intensity on the stock market has been steadily falling by turnover and number of deals. Accordingly the share of the stock market in financial intermediation decreased (see Table 3.3. Most important indicators of stock market, between 1995 and 1998) and the stock market capitalisation ratio to GDP decreased from 29% of end-1997 to 14% at the end of 1998. A low interest of domestic investors in investing in the Estonian stock market has stimulated non-residents to acquire Estonian enterprises relatively cheaply. Strategic equity investments of Swedish banks and several other Nordic investors in Estonian companies have since August 1998 crucially increased the share of non-residents in the investors’ structure. It has grown from 42 to 45% in one year. After two Swedish banks had bought a strategic holding in Hansapank and Eesti Ühispank, the position of Swedish investors among non-residents rose to 49%.

Table 3.3. Most important indicators of stock market, between 1995 and 1998 (EEK billion)






Capitalisation of stock market





o/w by issuers










Central government and local governments










o/w by investors










       o/w private individuals










       o/w private individuals




















Investment fund stocks and shares





Subscription rights





Turnover of all market





Capitalisation of Tallinn Stock Exchange





Turnover of Tallinn Stock Exchange





Capitalisation of all market/GDP





Turnover of all market/capitalisation





Turnover of Tallinn Stock Exchange/capitalisation





Typical to 1998 was also oozing trading on Tallinn Stock Exchange. Changes in share prices depended more on the liquidation of short-term positions and intensity of trading with collateralised stock or long-term shares from the stock portfolio than the improved outlook projections of the companies listed on the stock exchange. Irrespective of the price level, buying interest was strongly outweighed by selling pressure. Liquidation of positions and write-off of losses subsided in the fourth quarter when the market signalled hitting the bottom. A steady decline in share prices culminated on 14 December when TALSE index reached the lowest point in the last two-and-a-half years - to 87 points (see Figure 3.12). In one year TALSE fell by 66%.

Figure 3.12. Indices of shares traded on Tallinn Stock Exchange by sectors of economy and TALSE (points)

In 1998, only one new enterprise was listed at the Tallinn Stock Exchange. Because of the falling share prices, the market value of a number of companies from the main list decreased and they were transferred to the additional list. The number of marketable shares decreased from 28 to 25 in the second half of 1998. It was partly due to the mergers in the financial sector and acquisition of the majority shareholding by foreign investors. With the change of their core investors, several companies submitted an application for the termination of their quotation on the stock exchange. So far the governing bodies of the stock exchange have granted permission to only one company to end the trading of its shares on Tallinn Stock Exchange after the company had offered compensation remedies to its minority shareholders.



Compared to other segments of the financial market, the insurance market’s progress in 1998 was still modest. The gross premium volume from insurance against loss/damage grew at the same rate with the GDP. Insurance companies collected 1.2 billion kroons in gross premiums during the year (see Figure 3.13). In the non-life insurance sector the growth originated from property, travel and accident insurance taken by private individuals whereas in the life insurance sector from capital insurance. The 12% annual growth that was achieved in comparison with 1997 was mostly due to the progress in the first half-year. The gross premium volume in life insurance, however, doubled in comparison with 1997. But this achievement had no great importance for the entire insurance market because life insurance gross premiums account for less than 15% of the total premiums.

Figure 3.13. Gross premiums received by insurance companies (EEK mn)

A specific problem for the insurance market was the profitability of the companies as the majority of the companies have indicated a loss for 1998. It may have been caused by the unsuccessful investment of reserves, more rapid growth of operating costs than that of gross premiums and selling of the products below their cost value under the competitive pressure.

Institutional changes on the Estonian financial market have started to exercise influence also on the development of the insurance business. Insurance companies that so far had belonged exclusively to Estonian investors have started to search for strategic investors and non-resident insurance companies, that have acquired a strategic participation in companies with foreign shareholders, have increased their presence.


The depression on the domestic financial market manifested its effect on the activities of leasing companies only in the second half of 1998. The annual 25% growth of the leasing portfolio was achieved mainly due to business activities in the first half-year. In the second half-year, the leasing portfolio cum factoring decreased - from 6.8 billion kroons in late June to 6.5 billion kroons at the end of the year. In this new situation the importance of capital lease has grown again and cars have continuously dominated in the structure of leasing contracts (see Figure 3.14).

Figure 3.14. Volume and structure of leasing companies' portfolios (EEK mn)

In institutional development it was significant that non-resident-owned leasing companies mobilised their activities, which was reflected in their market share that had grown during the second half-year from 7 to 12%. The two biggest bank groups still hold almost 85% of the leasing market.

Investment Funds

The depression on the domestic stock market and the price decline on the neighbouring stock markets lead to the decrease in the total volume of investment funds from 1.5 billion kroons to 0.4 billion kroons in just one year (see Figure 3.15). Investment funds have lost their role in financial intermediation. In addition to open-end and closed-end funds that invest mainly in stocks, also money market and interest funds lost drastically in volume during the second half-year, although it had been on the rise in the early months of the year.

Figure 3.15. Volume of investment funds (EEK mn)

In 1998, the number of investment funds dropped from 23 to 13. One of the reasons was that the net worth of some funds fell below the required 5 million-kroon level. Therefore the Securities Inspectorate suspended their activities, to be followed in most cases with liquidation. Another reason was the situation that had evolved after bank mergers when the latter started to close down duplicating funds administered by asset management companies that belonged to these banks. Earlier closed-end funds had forfeited their function when they bought minority shareholdings in the privatised state-owned companies and, all but one, have initiated liquidation proceedings. Thus, in reality, at the close of the year investment funds were managed by the subsidiaries of only three major banks.

[1] Moody's Investors Service gave to the merged banks the following ratings: Eesti Ühispank (Union Bank of Estonia) received for the first time long- and short-term credit rating Baa3/P-3 and financial stability rating D. As a result of Hansapank merger with Eesti Hoiupank (Estonian Savings Bank) Hansapank’s long-term liabilities rating fell from Baa2 to Baa3 and short-term liabilities and financial stability ratings accordingly to P-3 and D+.
[2] The rating awarded to Estonia by Standard & Poors was BBB+, by Fitch IBCA - BBB and by Moody's Investors Service - Baa1.
[3] Towards the end of the year Swedbank reduced its shareholding to 49%.