Andres Sutt. Estonian Financial System and Currency Board

Estonian Financial System and Currency Board

Andres Sutt
Bank of Estonia

Ladies and Gentlemen,

Ten years of national currency is an important milestone for a transition economy. I would like to offer my sincere congratulations on the success you have achieved. Certainly, you can look back with pride to the last ten years. Certainly the next ten years will bring new challenges and new achievements, to be met with the same success.

I would like to share with you some thoughts about financial sector development and stability in Estonia and the role that the currency board arrangement has played in this process. The modernization of Estonian financial sector has taken place within a very short time frame, essentially within one decade - the 1990s. However, the process towards the present stability has been anything but easy or straightforward. Looking back to the nineties one has to admit that it has been a period of incredibly rapid development. The re-introduction of the national legal tender in Estonia in June 1992 was the real starting point for Estonian economic reforms.

From cash economy to a modern financial industry

Estonian financial intermediation is based on the universal banking model, where the banking sector has a dominant role and the share of securities market is relatively minor. Estonian banking market is concentrated and competitive, fully privatized, with predominantly foreign-owned market participants and with a very high degree of international and regional integration. The small size of the country, relatively short period of development, and the upcoming EU membership have undoubtedly influenced and shaped the evolution and the present structure of Estonian financial market. Currently, there are six banks and one branch office operating in Estonia. Approximately 85% of the share capital of the banking sector is foreign-owned. Banks' assets amounted to 90 billion kroons as of September 2003 (i.e. more than 80% of GDP).

How have we achieved this? Let me give you first a short historical overview. Estonian financial sector reforms started in 1992 with the first - and the most radical - monetary reform to take place in the former ruble zone. This meant the introduction of a fixed exchange rate and a currency board arrangement (CBA), liberal external policies, and, most importantly, an immediate abolishment of most restrictions on capital account transactions. Given the limitations set to the lender-of-last-resort ability by the CBA, the strength of the financial sector became a crucial issue almost immediately. Moreover, bearing in mind that fiscal stability is one of the cornerstones of CBA, the real economy was faced with a hard budget constraint since the beginning of the reforms.

In broad terms, the financial sector development could be divided into three stages. The fist stage of Estonian financial sector development really meant starting from the scratch:

- Drawing up modern banking legislation and implementing necessary prudential regulations (minimum capital requirements, capital adequacy ratios, limits on risk exposure, etc);
- Setting up banking supervision;
- Privatizing state-owned banks;
- Resolving banking crises caused by imprudent lending practices, weak governance and not always "fit and proper" owners, shortcomings in legal framework, etc.

The key of the relatively rapid development lies, to a large extent, in the initial steps taken. The currency board posed certain constraints on fiscal policies. An early depolitization of the banking system accompanied by liberal licensing led to the rapid emergence of new, private-owned, dynamic commercial banks. A new banking act was one of the very first new-economy-type acts to be approved by the Parliament. The introduction of effective bankruptcy rules, relatively tough minimum capital requirements and prudential regulations (capital adequacy ratios, limits on risk exposure, etc) was accompanied by the setting up of a supervisory framework that gave the supervisors 'enough teeth' to enforce compliance. That made it possible to resolve the banking crises inevitably ensuing form imprudent lending practices, unsound management, shortcomings in legal framework, etc, with a limited cost to the society.

The second phase started in mid-1990ies. It was marked by an increased availability of credit to Estonian enterprises and a growing presence of Estonian banks in European financial markets both in terms of investing and borrowing. Inevitably, that also meant early integration with the European markets and a trend towards the internationalization of Estonian financial industry. This was the period of extensive privatization and consolidation in the financial sector.

Among the most important drivers of the second phase were the first investment grade ratings from international rating agencies in 1997[1] and increased foreign borrowing. During 1996 and 1997, capital inflow into Estonia to a large extent reflected local banks' active borrowing from international markets and attracting additional funds in the form of syndicated loans and bond issues. At the time, real sector companies had very limited possibilities for financing from international markets. While foreign borrowing reduced the banking sector's dependence on domestic resources, it made local banks vulnerable and dependent on global investor sentiment.

The end of 1996 marked an important watershed. From that time banks' loan portfolios started to grow rapidly and the ratio of banks' assets to GDP exceeded 60%. While foreign borrowing supported the initial acceleration of credit by, it also brought along domestic deposit growth. In 1997 the growth rates of real GDP and nominal wages topped 10% and 19% respectively, reflecting the brisk development of convergence processes. Rapid technological modernization supported increasing use of banking services, too. Domestic securities market emerged as an important financing channel and securities market instruments started to play an important role in real sector financing.

The successful opening of the Tallinn Stock Exchange (TSE) in 1996 was backed by strong interest from the part of investors (both local and foreign) and remarkable investment levels. From November 1996 until September 1997, the number of traded companies increased fivefold. It was certainly a period when markets developed by far faster than regulations and regulators. Excessive optimism of investors, over-leveraging and favourable external environment helped the stock index to triple within a year. Not surprisingly, the subsequent Asian and Russian crises brought along harsh adjustment. The number of bankruptcies and unemployment increased dramatically, several investment firms and banks failed; many investors lost their money. In order to safeguard systemic stability and restore depositor and investor confidence, the authorities had to have recourse to a policy tool of a last resort and to save one systemically important banking institution.

The Asian and Russian crises also marked the beginning of the third stage of restructuring. Further consolidation of the banking market and takeovers by strategic investors (mainly Nordic) took place - the number of banks dropped to 5 (plus one branch office). The internationalization of Estonian financial markets deepened to a considerable extent. On the domestic level, all leading banking institutions evolved into financial groups covering all main financial sector activities - leasing, investment fund management, insurance, electronic banking services, etc, and started to provide a wide range of investment opportunities and other financial services.

Currency Board and financial sector development and stability

Performing the main central bank task - maintaining price stability - Eesti Pank has relied on fixed exchange rate within a currency board arrangement during the last eleven years. The stability of the kroon is technically secured via foreign exchange market - we are ready to buy kroons for foreign exchange and foreign exchange for kroons at any time. A standing facility is provided by Eesti Pank on the forex market, which can also be interpreted as an unlimited forex window where transactions of buying/selling foreign exchange against reserve currency are initiated by commercial banks. The margins on buying/selling foreign exchange have been narrow throughout the whole history of the Estonian CBA. Since the introduction of the euro in 1999, the margins have been compressed even further. The central bank does not have any margin on buying/selling the euro (as the anchor currency). To facilitate smooth functioning of the forex market there have been no restrictions on capital account transactions since 1994.

Under the CBA there is no control over interest rates. Thus, the inter-bank market and deposits held with the central bank play a crucial role. The central bank has no monetary target except exchange rate target and no base rate and/or discount window. The monetary instruments, used in Estonia are limited to required reserves, a standing deposit facility and, historically, central bank certificates of deposit (until 2000).

Under Estonian CBA, the liquidity management of the banks is focused on reserves held with the central bank and liquid foreign assets - i.e. liquidity management takes place predominantly on the forex market (over the forex window). Indeed, Estonian banks have been active in international financial markets since the introduction of the CBA. During the early nineties, their activities covered mainly depositing (foreign assets as additional liquidity buffer under a de facto missing LLR facility), since mid-1990s, also international borrowing has been developing. The domestic money market is very shallow due to the small number of banks and high degree of concentration.

Strong financial sector is a Must for a successful CBA

It is well known that financial sector soundness is crucial for monetary policy to effectively safeguard price stability and support economic growth. This relationship is even more critical under the CBA, where the real economy lacks one adjustment channel, namely the exchange rate. Under the CBA, financial sector is the first line of defense at the time when external or domestic shocks dry up liquidity and force market interest rates to rise. If the financial sector is not capitalized enough to withstand the losses caused by high interest rates on the real economy, the very existence of the CBA might come into question. In Estonia we experienced this real test scenario during the Asian and Russian crises.

That is why we have been investing a lot into safeguarding financial stability in Estonia. The key to financial sector stability is a high standard of legislation, transparency and supervision. The recent accession negotiations and enhanced exchange of information between acceding countries and the European Union have resulted in a major modernization and restructuring of regulatory framework and supervision of banking and financial markets.

Banking supervision in Estonia has been developing together with the banking sector and it has evolved into a professional partner to its peers abroad. Ever increasing cross-sectoral integration and internationalization has led us to merge the supervisory functions of all financial market segments (banking, insurance, securities market) into a single entity - Estonian Financial Supervisory Authority. Rapid development and dynamism of the financial sector are the key words for banking supervision in Estonia today. In terms of banking sector soundness, both the EU Peer Review and the Financial Sector Assessment Program by the IMF concluded that banking supervision is strong and in compliance with best international practice. Estonian financial sector crisis management policy has the necessary legal framework and a comprehensive set of tools. Regarding the financial sector safety net, all major building blocks are there, comprising of (i) a monetary operational framework that is supportive despite the limited lender-of-last-resort facility under the CBA, (ii) effective deposit protection scheme and (c) an effective crisis prevention and resolution.

While the currency board arrangement and the strict limits it sets on the lender of last resort function are often referred to as a potential source of instability, Estonian experience provides a convincing counter-example. The banks' forced reliance on their own capital and liquidity have had a direct impact on the market structure as banks were forced to look for strong partners and the authorities were keen to have foreign reputable institutions 'coming in'. Foreign ownership has provided Estonian banks with both strong capitalization and transfer of international best practices. And that, together with high liquidity requirements, has clearly reduced the likelihood of sudden liquidity shocks. At some instances, banking sector regulation has been used as a complimentary tool for monetary management. For example, for purposes of fostering the financial sector ability to resist the shocks in the environment of vast credit growth, the capital adequacy ratio of banks was increased from 8% to 10% in 1997. Reserve requirements were increased too.

It is fair to say that Estonian banking system is presently strong, well capitalized and liquid. Indeed, over the recent years, Estonian banking sector has proven its robust creditworthiness and competitiveness. Banks offer their clients a wide range of modern banking services from depositing to pension products. Their efficiency has increased (average cost/income ratio is slightly above 50%) and banks are profitable (the ROE in Q III 2003 was close to 13%). About a quarter of our bank customers regularly use electronic channels (customers of major banks also use investment services, including on-line services). 96 per cent of payment orders are submitted electronically. Rapid improvements in the legal and regulatory infrastructure have resulted in now generally sound banking system that is comparable to the best international practice.

What are the main challenges down the road?

Taking a look at the future of Estonian financial system, it is necessary to stress that we have taken on some very serious commitments as a future euro area country. It is universally expected that Estonia shall fulfill these commitments - and fulfill them sooner rather than later. Rapid adoption of the euro would benefit Estonian economy and, at the same time, constitute a successful "exit" from the currency board.

Without any doubt, in this setting for the supervisors the key challenge will be an increased cross border activity of banks, where the importance of close cooperation between home and host country supervisors is growing exponentially in time.

Increased internationalization is also a key challenge for the industry itself. Declining margins, innovation and tightening competition put all pressure on banks' efficiency and product mix and call for more efficient governance and risk management.

We are well positioned in Estonia to meet these challenges but we need to keep in mind that this is a demanding task, where complacency should be avoided.

Thank you very much!


[1] Estonia received BBB+ from S&P, BBB from Fitch IBCA and Baa1 from Moody's. The ratings have been upgraded to A- (Fitch and S&P, 2001) and A1 (Moody's 2002).

Andres Sutt. Estonian Financial System and Currency Board