Vahur Kraft. Factors influencing the financial system stability oriented policies of a small country soon to become an EU Member - Estonian Experience

To be published by SUERF in a special issue dedicated to the colloquium

FACTORS INFLUENCING THE FINANCIAL SYSTEM STABILITY ORIENTED POLICIES OF A SMALL COUNTRY SOON TO BECOME AN EU MEMBER - ESTONIAN EXPERIENCE

Vahur Kraft
Governor of Eesti Pank

Keynote speech at 24th SUERF Colloquium 'Stability and Efficiency of Financial Markets in Central and Eastern Europe', 12-14 June 2003, Tallinn

1. Introduction

Ladies and Gentlemen,
Dear guests,
Esteemed colleagues,

It is an honour and a pleasure for me to deliver one of the keynote speeches at the concluding session of the first ever SUERF Colloquium to be held in Tallinn.

This Colloquium has been dedicated to the issues of financial efficiency and regulation, foreign and domestic bank strategy, financial and macro-stability - that means issues that are certainly topical from the point of view of any EU candidate country.

The efficiency of financial systems is particularly important for Central and Eastern European countries where modern financial systems have been built up almost from scratch over the last ten years. In line with the EU accession process, full integration of Central and Eastern European countries' financial systems to the EMU has increasingly become a priority. The integration and flexibility of financial systems plays an essential role in promoting full convergence and supporting economic stability within the monetary policy framework of the EMU. On the day of a country's accession to the common currency area, its monetary policy transmission channels via financial sector should be very similar to those of present Member States. That would ensure effective and full pass-through of ECB monetary policy signals.

One of the developments many Central and East European countries have experienced is the entrance of foreign banks. Foreign capital has generally had a positive impact on the financial sector, increasing competition and making it possible to import more advanced management culture and professional skills. But there are also some differences between individual countries' experience that make comparisons all the more interesting.

In my presentation today I would like to take a closer look at the factors influencing the financial sector policies of a small country like Estonia, soon to become an EU member, and I would like to do that from the point of view of the central bank who is at the same time the lead regulator of the banking sector in a country where banking sector forms more than 80% of the whole financial sector.

2.1. What is the central bank's role in supporting financial stability

Directly or indirectly, the primary goal of most central banks is price stability. Regardless of the exact monetary policy regime under which price stability is targeted, financial systems always have a crucial importance in this process. On the one hand, stable and well-functioning financial systems are, in themselves, promoting price stability via effective resource allocation. On the other hand, monetary policy can be successfully implemented only through effective and well-functioning financial systems.

Monetary transmission cannot be efficient if a weak financial system distorts interest rate signals by increasing margins, or if financial markets have ceased to function for the reason that some of the participants do not trust other players. The causality can also run in the opposite direction. Over the past decade we have, once and again, in many countries, witnessed a weak financial system causing a currency crisis that results in capital flight, devaluation and deep recession. This particular threat is particularly relevant to fixed exchange rate systems where financial sector assets and liabilities usually tend to have a currency mismatch. And finally, central banks are interested in financial stability, as they often have to take the leading role in crisis resolution by providing emergency assistance and working out restructuring plans.

2.2. What are the most important responsibilities of a central bank in maintaining financial stability

A central bank's direct responsibilities in maintaining financial stability, apart from its direct supervisory functions, can be divided into three large areas.

First, central banks are responsible for the monitoring and analysis of financial system developments and have to take note of any early signs of possible financial difficulties. Central banks are well positioned for that task because of their close relations with market participants and because of the analytical skills that provide a natural background for analysing the so-called macro-prudential indicators and performing regular stress testing.

Second, central banks are by definition involved in designing and building up financial system safety nets. The so-called "traditional" central banks are directly responsible for short-term emergency liquidity support to prevent the problems of one institution from developing into a systemic crisis. Even if the ability to provide liquidity assistance is limited like it is in case of a currency board, central banks take - or are supposed to take a leading role in crisis resolution.

Third, central banks are often responsible for the banking system regulation. That is also the case in Estonia, even after the recent restructuring of the supervisory function. From the central bank's point of view, banking regulation policy goes somewhat beyond the traditional micro-prudential approach that is the basis for the Basel capital accords. For a central bank, a really important question is to what extent does banking policy depend on the general macroeconomic conditions, should regulatory changes take into account business cycles or should they be guided solely by concerns on the micro level.

2.3. Monitoring and analysis

The successful fulfilment of the central bank's financial stability supporting functions highly depends on the quality of information and analysis available. A thorough understanding of the functioning of modern complex financial systems is a prerequisite for developing an adequate framework for financial intermediation. The availability of timely and high quality information on changes in the general operating environment, especially risk exposures and potential contagion channels, would enable a central bank to implement timely and effective counteractive measures to support the stability and sustainability of the system.

The key to vulnerability analysis is successful implementation of, ideally, several analytical tools, including early warning systems and macro-prudential analysis. As we know, early warning systems typically try to estimate the impact of external factors on domestic financial systems, i.e. how vulnerable the banking sector is to a decline in exports or to a worsening market sentiment, sudden changes in the exchange or interest rates. Macro-prudential analysis undertakes to broaden that approach to a variety of economic indicators, using stress-testing models. Several international organisations focus on the development of macro-prudential analysis, including the BIS, ECB and the IMF.

There are several prerequisites for the development of a reliable and robust early warning system and even more so for the development of a meaningful macro-prudential approach. Reliable data and reasonably long time series are a necessity as well as high-quality analysis. Of these prerequisites long time series of data are in relatively scarce supply in the EU accession countries with only ten years of independent banking history. However, we have the basic building blocks in place.

It should also be noted that creating early warning systems in small countries like Estonia with a highly concentrated banking sector is probably very different from large countries. If you only have 7 individual banks to supervise, close individual monitoring of each bank might be more cost effective than building up a sufficiently sophisticated aggregated system. The situation is probably very different for a banking sector including hundreds of individual institutions. Still, it is necessary to have both - individual monitoring and early warning systems in both cases.

For Estonia, some harsh lessons from the late nineties have underlined the need for as good as possible understanding of the key vulnerabilities in the financial system. This need has become even more pressing now, when Estonian banks have become an integral part of major Nordic financial groups. While this development has somewhat lessened our concern for immediate liquidity and capital, the new structure of the financial system is yet to be tested during an economic downturn. Cross-border supervision has been and will remain an important priority for Estonian supervisors. At the present time Estonian supervisors have co-operation agreements with the respective authorities of the Baltic countries, Finland, Sweden, Germany and Denmark. We continue to attach high importance to the development of bilateral co-operation with financial supervisory authorities in countries with companies that have subsidiaries or branches in Estonia.

At the end of 2002, Estonian Financial Supervision Authority launched, with assistance from the Nordic Council of Ministers, a co-operation project with the Norwegian financial supervisory authority. The subject of the project is the application of the stress test in Estonia with respect to the asset and liabilities management of insurance companies. Under the USAID/FSVC program, an employee of FSA advised the insurance supervision department of the Ministry of Finance of Macedonia on the accounting, legal and reporting aspects of insurance activities.

The Bank of Estonia has a well-developed and sufficiently sophisticated monitoring system in place, making it possible to observe the developments on the level of the whole banking system, a group of banks, a bank's consolidated group or an individual bank, on a monthly basis or on a daily basis - whatever is necessary. The system has been successfully tested over the last year. The Bank of Estonia has also dedicated significant resources to improve its analytical skills. Against that background, we plan to pay considerable attention to the further upgrading of our financial system analysis and we are looking forward to cooperate in that field with experts of European institutions as well as international organisations.

2.4.Safety nets

Estonian financial system safety net has been developed in compliance with EU practices. Thus, EU membership would not mean any sweeping changes in this sphere. It must be noted, however, that this is one of the very few financial sector related issues where Estonia has asked for a transition period in full adoption of an EU directive. Namely, the level of funds to be reimbursed by the deposit guarantee scheme is presently somewhat lower than required in the EU.

I would like to stress the importance of dialogue with market participants. Constructive discussions with bank managers serve two purposes. The commercial bankers know - and in their own way understand - both the market situation and the prevailing trends in the so-called "real economy". Thus, these regular discussions are a most welcome complement to the economic analysis produced by the central bank experts. But regular contacts also provide a unique channel for moral suasion, for explaining the central bank's concerns. Obviously, these contacts are easy to arrange in a small country like Estonia. We have made use of that advantage and established a dialogue with our financial sector on financial as well as general economic issues, both on a regular and ad hoc basis. Another essential element for crisis prevention is the pre-emptive involvement of the private sector in crisis resolution.

While the "soft" policy principles support crisis prevention by providing a relatively stable and transparent environment, the resilience of the system still ultimately depends on the actions of market participants themselves. The task of the authorities is to provide an adequate regulatory framework and effective supervision of the implementation of the regulations.

There is another interesting, albeit still debated issue: to what extent should the supervisors rely on banks' internal risk control models and ratings - a subject that has been lately under international spotlight in connection with the development of the New Basel Capital Accord. Estonian banking supervisors have taken a relatively forward-looking approach in that respect by increasingly relying on the risk-based approach of supervision. At the same time, and having in mind the rapidly developing economy and currency board arrangement, we believe that our banking system should have robust liquidity buffers and sufficient capital to withstand the fluctuation of asset prices. Therefore, we have set a relatively high reserve requirement (13 per cent of the banks' liabilities), half of which the banks can hold in high-quality foreign assets.

Finally, I would like to stress that as an essential element of the safety net, our Guarantee Fund which is based of the principle of compulsory payments by the market participants, is functioning well and has already proved its usefulness in practice. At the time of the 1998 closure of several smaller banks the depositors were compensated rapidly and without any problems. In addition to the deposit guarantee scheme the Fund also includes separate sub-funds to offer investment protection and pension protection schemes.

2.5.Regulations

The Bank of Estonia is responsible for regulating the banking system in Estonia. A detailed description of Estonian banking regulations goes far beyond the scope of this presentation, however, I would just like to point out that one advantage of being a transition economy has been the possibility to draw the legislation from scratch. This has very much facilitated the compliance with good practices and the de facto full adoption of the EU acquis.

It is important to note, however that adoption of the aquis means not only issuing new legislation but also ensuring compliance with the regulations. Compliance issues have been a long-time priority for us. We can take pride in the fact that Estonia was among the first countries to participate in the pilot project under the IMF and World Bank Financial System Assessment Program (FSAP) in 1999-2000. The assessment involved implementation of recognized norms in the financial sector policies and supervision (banking supervision, insurance supervision and securities market regulation and supervision, payment and settlement policies). The FSAP also assessed the transparency and openness of Estonia's monetary and financial sector policy. The results of the mission showed that Estonia's compliance was good already five years ago.

What is a real regulatory challenge for the central bank in our case is the question to what extent should regulatory measures be taken into account in a broader financial policy context. There are arguments for designing the regulations with a view to business cycles, especially as it seems that in the modern world financial systems have become more procyclical than before. In that case, anticipatory measures may pre-empt the possibly devastating effects of asset price volatility and loan losses once the economy starts to cool down.

This approach has a particular appeal under the currency board as the active use of monetary measures is excluded and reserve requirements are essentially the only available monetary tool. In these circumstances, sound prudential measures have had an important role. It should be underlined that in a heavily bank dominated financial system, banking regulations might also serve as an instrument to affect domestic demand more directly than under other circumstances. Indeed, the Bank of Estonia increased the capital adequacy ratio with a view to promoting resilience against cyclical risks in 1997 at the onset of Asian contagion, before the peak of the cycle.

Having said that, one should take a look at the possible problems of the "macro-prudential" policy approach. It is obvious that as the financial markets mature and financial instruments become more complex, the tightening of banking regulations will simply intensify capital flows outside the banking system. In that case, major capital flows will be channeled to less regulated areas that will bring about new risks of potentially systemic nature. The second problem is that the determination of the exact stage of a business cycle is simply not possible. In this regard devices able to dynamically react on cyclical factors are a great challenge. We have understood that we are not the only ones to think about these issues, the topic is debated also in several present EU Member States.

Adequate framework is a moving target

I have already mentioned that the majority of work required for the implementation of the acquis communautaire has been completed in Estonia and our financial sector is following internationally approved standards and good practices. Still, due to the fast development of Estonian economy we have found it necessary to keep our regulations sometimes even tighter than those considered necessary by international authorities - so, what we might see upon Estonia's accession to the EU might very well be more lax regulations in some areas.

At the same time, it is obvious that while talking about the creation of adequate regulatory framework we are talking of aiming at a moving target.

Within the EU the realisation of the Financial Services Action Plan should lead to a complete integration of European financial markets by 2005 and securities markets by 2003. Creating a more fully integrated European financial market would certainly mean some changes in the regulatory environment the outcome of which should be a more flexible framework and better cooperation between regulators and supervisors. One must also keep in mind that effective supervision is, evidently, an important priority from the point of view of the Monetary Union.

Speaking about broader international standards, Basel II framework related work offers a good example of the continuous development of prudential frameworks to meet the constantly changing complex modern challenges. Setting up the new framework might not be easy - and the implications would be different depending on the particular environment and also the size of financial institutions. But comparing the financial system of 1988 to the present day it is clearly apparent that regulatory reforms are necessary. We can only welcome the active international debates which have accompanied the process. The process of developing the New Accord has, in itself, served the goal of financial stability by bringing various important issues like the problem of potential procyclical effects of various regulatory approaches under international spotlight and initiating extensive research in this area.

I would like to stress the word awareness in relation to the modern approach to safeguarding stability. It is one of the aims of the New Accord to make banks monitor and assess their risks more closely and to increase market discipline through enhanced disclosure by banks. It is of utmost importance that a bank's risk assessment considers the specifics of the risks of the institution. Naturally, a more detailed approach means more complicated calculations and manuals and it will also require a more intensive exchange of information between the banks and the supervisory institutions to guarantee that all risks will be adequately evaluated.

In Estonia - and probably in many other accession countries as well as EU member countries - capital adequacy calculation principles have been recently fine-tuned. It is very clear that these adjustments shall not be last ones. The fast development of the international financial system demands continuous regulatory adjustments - both by international institutions and individual countries.

And that leads me, once again, to the crucial importance of the analysis and research backing up the regulatory decisions in a rapidly changing and increasingly complex environment.

3. The papers presented

The papers presented here during the last three days have provided a valuable contribution to the discussion about the stability and efficiency of financial markets.

The link between the banking sector and real sector was analysed and found to be significant in many papers. An efficient banking sector accelerates economic growth. Financial deepening and increase of financial sector efficiency have been simultaneous in most Central and Eastern European countries. But there are also risks that should not be ignored. For instance, it is not any level of indebtedness that is sustainable. That has been shown not only in theoretical work but also on a historical basis. That, in turn, highlights the crucial role of financial regulation and supervision. In the context of globalisation financial regulation is not a domestic matter any more as the financial markets become more and more integrated both by sectors and nations. Integrated markets need a more unified regulatory framework. The unification of the regulatory framework is one of the major challenges the current and future European Union members have to face.

One of the developments characteristic of many CEEC countries is the entrance of foreign banks. Foreign capital has had a positive impact on the financial sector, increasing competition and making it possible to import management culture and professional skills. It is noticeable that no proof of significant negative effects related to the foreign banks entry has been found. It seems that the foreign banks credit policies have been less sensitive to local economic downturns and the entrance of foreign banks has not imported instability in any form.

Among the determinants of financial stability, institutional factors have been found significant. The exchange rate regime, the quality of regulatory and supervisory framework and the degree of liberalisation of economy significantly influence financial stability.

The existence of contagion and the effects of common external shocks have important implications for the candidate countries during their accession to the EMU. The existence of external shocks indicates the need for sufficient flexibility.

That is, of course, only a short overview of the wide range of issues discussed in the papers presented during the last few days. I sincerely hope that every participant of this colloquium has obtained useful new information and found some additional insights into the topics of the present colloquium. SUERF, rather uniquely, brings together three important groups in its membership: central bankers, academics and private financial market practitioners. That has been instrumental in creating a most stimulating atmosphere for the exchange of ideas and viewpoints.

***

Before concluding my remarks I would like to make a short but important announcement.

The Bank of Estonia became a corporate member of the SUERF already in 1996. Since then our economists have attended the Annual Colloquium.

It was Mr Urmas Sepp, former Head of Research Department of the Bank of Estonia, who took the initiative of organising this year's event in Tallinn. Unfortunately, he was not able to see the success of his endeavour. It is therefore most appropriate that we announce the winner of a Reward commemorated to our dear colleague here at the SUERF Colloquium. The aim of the Bank of Estonia's Reward is to show that the central bank highly values graduate studies in economics and facilitates economic research in Estonia.

To our delight, a number of high-quality papers were submitted for the Award. Ladies and gentlemen, it is my pleasure to now announce the winner of this year's Award: Mr Toomas Hinnosaar, doctoral student from the University of Tartu.

It is with congratulations to this promising young scholar and sincere gratitude to SUERF and all the participants at this Colloquium that I would like to end my speech. These three days have once again demonstrated how valuable is the co-operation between the Academia, financial sector and central banks.

Vahur Kraft. Factors influencing the financial system stability oriented policies of a small country soon to become an EU Member - Estonian Experience