The risks to the financial sector in Estonia are small in the near future
- Faster loan growth could increase the risks to banks from real estate
- Although corporate profits were down, the ability of companies and households to repay their loans remains good
- The rate of growth of bank loans should be in line with nominal GDP growth in the years ahead
- The banks operating in Estonia are well capitalised
- The risks coming to the Estonian economy and commercial banks from Sweden remain at the same level as in spring
- The impact of Brexit on Estonian financial stability will be small, and the effect will be felt indirectly and over a long time
- Rapid growth in the deposits and assets of savings and loan associations reduces the control that depositors have over their own investment and their understanding of the possible risks
Most of the risks to the operation of the financial sector in Estonia are low. Although the uncertainty coming from the external environment increased and risks caused by imbalance in the labour market remain, the risks to the functioning of the financial sector are reduced by the financial buffers of companies, the relatively good finances of households, and the high levels of capitalisation in the banking sector.
The economy was 0.8% bigger in the second quarter than a year earlier, which is below its long-term growth potential. Value added grew in most economic sectors however, and the main obstacle to achieving potential growth was the decline in value added in energy and mining. Uncertainty about the recovery of external demand was increased by the referendum in the United Kingdom in June in which the British voted to leave the European Union. The direct impact of this on the Estonian economy and Estonian companies will be quite modest.
The ability of Estonian companies and households to repay their loans remains good. Labour costs continued to grow fast, with the consequence that corporate profits continued to shrink, though at a slower rate than previously. The contraction of profits has not yet seriously affected the ability of companies to pay, as their loan service costs are low and they have built up financial buffers, which have been kept high because investment volumes have been small. At the same time, rapid wage growth and high employment supported credit demand from households and their ability to loan servicing.
Growth in the loan and lease portfolio of the banking sector accelerated in August to 6% over the year. Loans to real estate companies and loans for buying residential property have contributed the most to the increase in the loan stock. The share of such loans in the total loan portfolio is relatively high at 55%, though this has not changed during recent years. Rising incomes and low interest rates create the risk that Estonian real estate prices and housing loans and lending to companies in real estate may start to grow faster. This would make the banks more vulnerable to risks coming from real estate. To guard against excessive growth in the risks from housing loans, Eesti Pank has introduced requirements for the issuance of housing loans by banks, and can tighten those requirements if the risks in the credit or real estate markets should increase.
Although credit growth has sped up a little, Eesti Pank is maintaining the countercyclical buffer requirement for the banks at 0% as the debt to income of the non-financial sector has not increased. Eesti Pank forecasts that the rate of growth of bank loans should be similar to the nominal rate of GDP growth in the coming years, and no developments or trends in bank behaviour are in view that would amplify lending activity. Eesti Pank continually monitors whether risks are building up and if necessary it can set additional capital buffer requirements for the banks.
The capitalisation of the banks operating in Estonia has remained strong, and this is further underpinned by the capital buffer requirements introduced by Eesti Pank. From August this year, all the banks operating in Estonia have to hold a systemic risk buffer of 1% to mitigate the risks of a sudden fall in the economy, which arise from Estonia having a small and open economy. The two systemically important banks, Swedbank AS and AS SEB Pank, have to hold a further buffer of 2% to hedge against the risks that come from the concentration of the banking sector.
In recent years the rapid development of alternative financial intermediaries has been eye-catching in the bank-centred financial sector. Attention has been drawn to the growth in the savings and loan associations, and the activities of creditors and credit intermediaries. The relatively rapid development in the real estate market has been accompanied by quick growth in real estate funds. The risks to financial stability from all these financial intermediaries are reduced by their small size in the financial system as a whole, and their weak links with the rest of the financial sector. The risks from creditors and credit intermediaries were reduced by them being brought under financial supervision. Savings and loan associations do not come under financial supervision and the rapid growth in their membership and the spread of their activities across Estonia could overshadow the original cooperative principle behind their operation and reduce the control that depositors have over their own investment and their understanding of the possible risks.
The risks to the Estonian financial sector coming from the Swedish economy remained at a similar level to that of spring 2016. With economic growth relatively fast in Sweden, real estate prices and household indebtedness continued to increase. Swedish bank groups are made vulnerable to a deterioration in credit conditions by the large share of market-based financing in their total funding. If international investors were to reassess the risks from rapidly increasing real estate prices and loans upwards, the financing conditions for the banks could worsen. Funds received from parent banks account for around one fifth of the funding of banks operating in Estonia, meaning they have an important role in the functioning of the Estonian loan market. The conditions of market-based funding have so far remained favourable for the Swedish banking groups. The parent banks of the biggest banks operating in Estonia are subject to high capital requirements at the group level in Sweden, and that has a positive effect on the financial strength of the banks in Estonia.