The risks to financial stability in Estonia are low



The risks to financial stability in Estonia are low. The situation in international financial markets has improved in the last half year, partly through the steps taken to strengthen the financial framework of the euro area and the efforts of the euro area central banks. The main threat to Estonian financial stability remains the fragmentation of the euro area debt markets, which could hinder growth across all of the European Union. The markets partly recovered their confidence at the end of last year, but this could disappear rapidly if not all member states contribute sufficiently to implementing the European Union reforms or if they do not improve their own national fiscal position. For any potential banking crisis to be resolved quickly and effectively, it is necessary for public finances to be in good condition.

The financial environment is also weakened by the delay to the recovery of growth in the euro area, as the worsening ability of borrowers to repay loans is increasing the loan losses of European banks and may erode their capitalisation. The assessments by banks of the quality of their own assets should be conservative and transparent for uncertainty to be reduced and the economy to be stably financed in the euro area. Problem loans should be written down rather more than less, because this helps confidence to recover.

The parent banks of banks operating in Estonia have borrowed funds on better terms than other big banks in Europe. However, it should be noted that the financing model of Swedish banks continues to be based in large part on short-term funding from the financial markets. The Swedish central bank and financial supervision authority have placed new liquidity requirements on the biggest banks from the start of this year in order to strengthen financial stability and maintain the confidence of the markets. Eesti Pank considers this to be quite appropriate given the indebtedness of the private sector, real estate market risks and the relatively large and concentrated banking sector in Sweden.

Despite the poor state of the external economy, Estonian growth accelerated in the second half of 2012 with support from private consumption and investment. The increased confidence of households meant that private consumption grew faster than wage income and savings decreased to some extent. Low interest rates and the income from the sale of emission quotas continued to support investment activity. Although the confidence indicators of Estonia's trading partners show that their expectations for the external environment have improved, a recovery in external demand is not yet evident. The outlook for Estonian growth depends to a large extent on exports, as economic growth based solely on domestic demand is not sustainable.

The short-term risks to financial stability arising from the Estonian economy remain small. Although the loan portfolio started to increase again last year and the real estate market picked up, it is too early to speak of excessive loan growth. Against the output growth of recent years, loan demand has been moderate. However, the volatility of the external environment needs to be taken into account when new financial obligations are taken, as it may affect the ability to service debt. Most loans in Estonia are taken with a floating interest rate, so borrowers need to bear in mind that interest rates have been very low for a relatively long time, but at some point they will start to rise. To cope with that happening, the borrowers need to be able to adjust their spending levels. Having sufficient financial buffers helps to reduce the risks to loan repayment ability.

The low interest rates have reduced the profitability of banks, adding pressure on them to increase their lending margins. The larger banks have so far avoided widening their revenue base with riskier loan projects or other high-yield investments. If the lending margin remains high for too long, it could start to hinder the financing of viable projects that support the long-term development of the economy.