• Overall the risks to financial stability are small. The risks are mitigated by the rising incomes that follow from economic growth, large financial buffers and the strong capitalisation of the banks
• The biggest danger to Estonian financial stability comes from the risks in the Nordic real estate market, as their realisation would hurt the ability of banks to lend and would reduce demand for Estonian exports
• Pressures from wage growth continue to threaten the profitability of companies, and low profitability may affect the ability of companies to service their loans, and so harm the quality of the loan portfolios of the banks
• Eesti Pank is currently keeping the countercyclical buffer rate for commercial banks at 0%
• The central bank is identifying LHV Pank as a systemically important bank and its capital requirements will rise by 0.5%
• The new regime for income taxation introduced for the banks will favour a reduction in capital and weaken the ability of banks with low and growing levels of capital to increase it

The risks to the functioning of the financial sector are small in autumn 2017. Risks are being reduced above all by the rise in incomes as the economy grows, the relatively large financial buffers of companies and households, and the high equity level of the banking sector.

As economic activity has increased, so the financial position of Estonian companies and households has strengthened. Exports, and consequently economic growth, have been supported by an improvement in the external environment, and also by domestic demand. Most sectors have seen modest growth. Moving forward it is important that companies again increase their investment after it has declined in previous years. The economic position of households is good as well, as is shown by improved confidence, rising incomes and low unemployment.

Corporate profits started to increase as sales revenues rose, but the wage pressures will continue to endanger profitability in the future. Faster growth in the economy makes it more likely that sales revenues will continue to grow in future. This depends though on whether companies are able to increase their productivity as wage growth may start to accelerate again. Low profitability and a fall in investment may reduce the competitiveness of companies, and over the longer term incomes as well. A decline in corporate profits may reduce the ability of Estonian companies to service their loans and may harm the quality of the loan portfolio of the banks.

Faster economic growth may increase activity and accelerate the growth in prices in the housing market. In the past couple of years a lot of new residential real estate has come to the market, and this has helped offset price pressures from the demand side. However, improved household confidence and a continuing rapid rise in wages could lead households to overestimate their ability to pay. Eesti Pank does not consider the current growth in loan volumes to be excessively fast, but monitors carefully the number of transactions in the loan market and the lending standards of the banks, and is ready if necessary to tighten the requirements for issuing housing loans for the commercial banks. Faster growth in loan volumes could increase the vulnerability of the banking sector to risks from the real estate sector.

The risks from the funding of commercial real estate have increased. As supply has increased substantially, there may not necessarily be enough demand for all of the office buildings, and the ability of their owners to service their loans may deteriorate. Commercial real estate is largely financed through own funds, and loans from other companies and the non-bank financial sector. The share of loans to real estate companies in the loan portfolios of the banks has not increased, but it remains large.

The financial position of the banking sector remains strong. The quality of the loan portfolio of the banks is good and loan losses are small. A similar amount of profit was earned as in the previous year, and most banks increased their own funds. The special regime for income taxation introduced for banks effective from 1 January 2018 may encourage the banks to pay out more in dividends. This would then weaken the resilience of the banking sector in the face of a crisis. There is also a risk of a possible transfer of lending operations to subsidiaries of banks, which may be intensified because of the tax changes.

The risks from the Nordic countries could threaten the Estonian financial sector through a reduction in liquidity and a deterioration in the ability of the exporting sector to repay loans. Swedish real estate prices have been rising for a long time and the household debt burden is very large compared to those of other countries. The rapid rise in real estate prices and in borrowing in Sweden continued in the first half of 2017. Were the risks stemming from the Swedish real estate market to be realised, the parent banks may reduce the funding of subsidiaries or branches operating in Estonia, which would then reduce the loan supply and the financing of the Estonian economy as a whole. A decline in economic activity in the Nordic countries would equally impact demand for Estonian exports, which would harm the capacity of exporting companies to service their loans.

The macroprudential supervision measures imposed by Eesti Pank are currently sufficient to cope with the main risks to the functioning of the financial system. The 1% systemic risk buffer requirement that applies to all banks helps their resilience to risks arising from a reduction in the ability of companies to pay because of a fall in exports. The additional buffer requirements for systemically important commercial banks support their resilience further. The requirements for lending conditions, which Eesti Pank introduced as a preventative measure, help to reduce the risks from rapid growth in housing loans. A state fiscal policy that focused on the need for balance in the economy would be of help in reducing the risks from excessively fast wage growth and expanding construction activities.

AS LHV Pank was added to the list of systemically important commercial banks in Estonia. Eesti Pank generally assesses the importance of banks operating in Estonia for the local financial system once a year. In October this year, Eesti Pank decided to add AS LHV Pank to the list alongside Swedbank AS and AS SEB Pank. Since the assessment a year ago, the market share of LHV Pank in the financial system has grown. An additional buffer requirement of 0.5% is imposed from 2018 on LHV Pank as a systemically important bank. The additional buffer requirement of 2% continues to apply to Swedbank and SEB Pank.

Eesti Pank considers it currently appropriate to keep the countercyclical buffer rate at 0%. There has been no increase in indebtedness in the real economy, which is the ratio of debt to GDP, in the past three years, and the growth in total debt has been relatively modest. Debt liabilities will grow faster in the coming years as the economy grows, but the rate of growth will not exceed that of nominal GDP consistently and significantly. Furthermore, the banks have not loosened their lending standards and conditions and have not increased their leverage. Were the growth in the debt burden of companies and households in Estonia to accelerate substantially and consistently, Eesti Pank could set a requirement for the banks to hold a countercyclical capital buffer.

Full publication

Financial Stability Review 2/2017