Madis Müller. Keynote speech at the seminar dedicated to the 10th Anniversary of the Financial Supervision Authority

Seminar dedicated to the 10th Anniversary of the Financial Supervision Authority

20 January 2012

Keynote speech

Madis Müller, Deputy Governor of Eesti Pank

Minister, honorable Chairman of the Financial Supervision Authority, dear guests,

The Financial Supervision Authority (FSA) is celebrating its tenth anniversary today. This is an anniversary that marks the establishment of joint financial supervision in Estonia in its current form. Prior to that, our financial sector was supervised by several different institutions, with Eesti Pank being directly responsible for banking supervision for about ten years. It is therefore fair to say that Eesti Pank and the FSA with its predecessors have a history of cooperation that goes back for as much as twenty years already. This has been a twenty-year period with many changes in the Estonian financial sector and in regulation and with a handful of crises, all of which have shaped the financial supervision to what it is today.

The roots of joint financial supervision in Estonia go back to the 1997 Asian and the 1998 Russian crisis. Both were significant international events with ramifications for other economies and markets, including the Estonian economy and financial sector. The Asian crisis coincided with a crisis of our own, with a period of ballooning prices in the Tallinn stock exchange followed by an effective collapse of the listed equities, and the local market index falling by more than 80%. The impact of those international crises on the Estonian economy was severe and led to bankruptcies of several banks and insurance companies in 1998. These were events that provided some quick and painful lessons, and it was thereafter widely recognized that supervisory authorities need to cooperate more closely. Eventually, this led to the establishment of the joint financial supervision as we know it today. The idea of bringing the so far separate three institutions responsible for financial supervision in Estonia under a single roof was also specifically suggested in a report on the bankruptcy of Maapank by the Danish expert Eigil Molgaard.

The establishment of the Financial Supervision Authority certainly allowed for a much more effective architecture for ensuring financial stability in Estonia. We now have a well-functioning triangle between the FSA, the central bank and the Ministry of Finance, each with its own tasks and responsibilities. Creating a new institution made the decision makers tackle several difficult issues, including how to ensure the independence of the new FSA's decision-making, finding an agreement on its sources of financing and so on; but also more practical questions, such as where to physically locate the organization. Answers to all those questions were found and the FSA has been successfully operating ever since.

For a central bank, successful cooperation with the Financial Supervision Authority is obviously of utmost importance. First, any central bank needs a functioning banking sector in order to properly implement monetary policy. And second, we need a strong and professional supervisor for the financial sector in order to be able to ensure financial stability in the country. Therefore, to make it possible for the central bank to accomplish its main tasks, the FSA needs to successfully carry out theirs.

As we work together with the goal of ensuring financial stability, the central bank focuses on the functioning of the financial system as a whole, taking the so-called macro view, whereas the FSA is in charge of the micro view, ensuring the stability of single institutions.

Close linkages between the macro and micro prudential work and their complementary roles are well reflected in the work of the European Systemic Risk Board that was launched just over a year ago. Once a quarter, governors of central banks and heads of financial supervision authorities provide their assessment of risks to the European financial stability along with policy recommendations for putting the financial sector on a sounder footing. Several countries are now setting up institutional structures similar to that of the ESRB. It is fair to say that the cooperation between Eesti Pank and the FSA has in fact followed the same principles all along. There have been no problems with the exchange of information between us, and we have at times jointly communicated our views to the market participants. For example, this was the case during the credit boom of 2006-2008, when both Eesti Pank and the FSA called the attention of market participants, as well as central banks and supervisory authorities of the home countries of international banking groups active in Estonia, to risks accompanying rapid credit growth. This was in addition to specific measures taken by the central bank itself, including an increase in the reserve requirement and a doubling of the risk weight for mortgages to 100%, which implied a de facto increase in capital requirements.

Along with the creation of the ESRB, which carries out macro-prudential oversight in the EU, also the principles of micro-level supervision have changed in the European Union. Three pan-European supervisory agencies were created at the start of 2010 to replace the third level committees with small bureaus that had been operating so far. This means that supervision expertise is now better involved already at the stage of designing the EU's financial sector regulations, which in turn contributes to the quality of supervision related cooperation in the EU.

Risks in macroeconomic and financial environment both in Europe as well as in Estonia have increased over the last six months. After a somewhat calmer period early in 2011, the international financial environment deteriorated significantly by the end of summer. There was evidence of the sovereign debt crisis, which first affected only a few distressed countries, spreading to several other euro area Member States and at least indirectly having an impact on almost every economy. Growing mistrust towards the European banking system built up, resulting in distress in the interbank market and complicating banks’ funding access. The deepening of the crisis and the deterioration in the global macro-economic environment put additional demands on the liquidity and capital buffers of European banks.

These difficult times are testing not only banks but also central banks and supervisors, including the young European System of Financial Supervisors. The deepening stress in the interbank and funding markets has added to the role of the Eurosystem central banks in providing liquidity. The Eurosystem has maintained unlimited liquidity support to the euro area banks and decided to provide additional measures to alleviate the immediate liquidity concerns. The supervisory agencies, similarly, have an active role in managing the crisis. The European Banking Authority has conducted stress tests on major EU banking groups and called for an increase in banks' capital buffers, to ensure that they are able to survive the turbulent times in the markets.

For now, Estonia has been largely spared from the direct effects of the latest turmoil. Proactive use of macro-prudential policies in the run-up to the bubble paid off during the crisis. High capital and liquidity requirements served as an extra buffer for the strong Nordic-owned banking sector, supporting investor and customer confidence. Proactive cross-border cooperation was equally relevant. It is worth emphasizing that euro area membership has reduced both perceived and actual risks to financial stability in Estonia, in particular with respect to liquidity risks. Unlike under the currency board arrangement that we had before, Eesti Pank can now provide liquidity support to commercial banks.

Since we are a small and open economy, the fortunes of the Estonian businesses and households are highly dependent on developments in the rest of the world. Therefore, banks operating in Estonia need to make sure - also at group level - that they have in place substantial capital and liquidity buffers. These are crucial for any successful long-term banking operation, given that the growth of the Estonian economy will most likely continue to be relatively volatile.

Taking a step back from the immediate problems, the challenges facing central banks and supervisors in Europe are twofold. On the one hand, they must find a balance between the supervisory and the broader macro-prudential objectives - for instance, how to provide incentives for banks to strengthen their balance sheets while avoiding disruptive deleveraging that could negatively affect the real economy. On the other hand, Estonia, like all other Member States, is facing the challenge of addressing these risks not only from the viewpoint of our domestic or regional situation, but increasingly taking a broader European-level perspective. Both considerations are within the scope of the European Systemic Risk Board, which provides an overarching cooperation framework for the central banks and the supervisory authorities.

I already highlighted some of the measures that central banks and supervisors have taken to address the risks in the European banking sector. But aside from immediate steps for restoring stability in the financial system, there is also a global effort to strengthen financial sector resilience by improving the regulatory and supervisory environment. This holds true also, and perhaps especially so, in the EU. The improvements to the EU supervisory framework have already been mentioned. One of the more fundamental changes we are facing is the overhaul of the Basel capital requirements framework and its application in the European Single Market.

The new regulatory framework establishes stricter requirements for own funds held by credit institutions and tightens liquidity requirements. It also introduces new countercyclical elements. Eesti Pank has supported the strengthening of banks' capitalization requirements, as well as the harmonization of the rules for minimum capital levels across the European Union. However, it is important that various elements of the financial sector regulation, financial sector safety net and crisis management move forward in a balanced way. Alongside, the needs of the common market, as well as the risks to financial stability in individual Member States must be addressed effectively.

The agenda for regulatory changes is very ambitious and timely adoption of it requires concerted efforts from everyone involved.

To sum up, you have probably noticed that I have repeatedly referred to cooperation and coordination. Both are absolutely crucial in our case, not only between the FSA, Eesti Pank and the Ministry of Finance, but given the close integration of the Estonian financial sector with Nordic and Baltic markets, we need to work very closely with our Nordic and Baltic colleagues. Looking further ahead, we should focus on how to take what we have learned from our local and regional experience and try to use it to the benefit of the EU Single Market and financial sector development.

With this I would like to wish a happy anniversary to the Financial Supervision Authority.

Thank you for your attention and I hope you will have a fruitful seminar.