Vahur Kraft. Keywords for Estonian financial stability in light of monetary integration

Helsinki seminar on the accession process
November 10-12, 1999
Session 5: Financial structures

Vahur Kraft, Eesti Pank

KEYWORDS FOR ESTONIAN FINANCIAL STABILITY IN LIGHT OF MONETARY INTEGRATION

In shaping a new and viable financial structure the targets of Estonian policy-making has throughout the process comprised of a few key components. We have tried to bind our strategic actions around them. Most generally, these keywords consist of (1) the need for private sector management and accountability, (2) open competition and liberal capital flows, (3) dynamic consolidation and (4) international integration. The policy has tried to achieve these targets with the assistance of internationally accepted supervisory standards in a rule-based macroeconomic policy setting.

Below, I will try to specify our thoughts and experiences in this light in three subsections: the banking sector, other financial intermediaries and financial infrastructure.

BANKING SECTOR

Financial markets, and especially the Estonian banking sector, have undergone substantial development throughout the last decade. Changes, both in the quality of services as well as in business volume, have indeed been remarkable. For example, financial deepening in terms of banking sector assets to GDP has grown from 35% in 1994 to over 60% by the end of this year. Although the process of restructuring has been from time to time a difficult one both for market participants and for policy-makers, it has certainly been positive for the country as a whole. Our most important experiences in restructuring are the following:

The creation of a truly privately managed banking sector was the first key to a successful reorganisation. In Estonia privatisation, which was basically finalised by 1994-95, was achieved both through the entry of viable new institutions as well as through direct privatisation of former socialist banks.

This change did not just lay the foundations for improvements in corporate governance and risk management systems. Private dominance of the market was also very important for another key component of developing a healthy banking system – namely, consolidation. By providing a foundation that facilitated consolidation, it also served as an obstacle to often problematic political interference into the banking sector. Today, we are confident enough to declare that most of the sectoral restructuring is finalised. The next steps in development will put emphasis on improving efficiency and increasing the reliability of banking services.

Of similar importance was the early full liberalisation of capital flows. This not only provided external competition, but also speed up banking sector integration with international financial system. Today, the Estonian banking sector is almost fully integrated into the Scandinavian-Baltic banking community, a major segment of the European banking community. Two of the most important commercial banks, which together comprise over 80% of some market segments, are more than 50% owned by Scandinavian banking groups and the fourth biggest institution is a branch of another Finnish-Swedish banking group.

In addition to the factors of private ownership and liberal capital movement, one should not overlook the regulatory and monetary environment and their role in laying the basis for the development of the banking sector. In order to have an orderly convergence of the banking sector with the truly integrated European market it is better, if both supervisory activities as well as macroeconomic policy incentives do not contradict this objective.

Firstly, our experience clearly shows that to ensure the stability of the financial system in a small open economy one needs to consider the developments on the international financial landscape that have already taken place before the formal integration of the markets. Therefore, it is clear that developments in the regulatory environment in Europe are of particular importance to our open economy. Aa a result, our policy has been designed and should be evaluated strictly in accordance with this main principle.

An illustration of such an approach is our policy of enforcing internationally accepted prudential ratios and other regulations, which we have already been doing for several years. In fact, we have followed even stricter requirements in some situations. For example, since 1997 the capital adequacy requirement has stood at a minimum level of 10%. This has been prudent as it corresponds to temporarily higher macro- and microeconomic risks unavoidably characterising transitional economies.

Similarly, major steps towards adopting the regulatory environment meeting European standards have been taken in our legislation and in supervisory practices over the last year. Today, we can state that the laws and regulations governing credit institutions are fully harmonised with the relevant parts of the acquis communitaire, as was confirmed lately by the Commission and Estonian authorities in the bilateral screening meeting. Accompanied by a further increase of co-operation between the supervisory agencies both on a regional as well as on the European level, intensified by the above-described integration of ownership, we now feel even more a part of the European banking community.

Secondly, adopting a currency board-type rule-based monetary policy and conducting prudent fiscal policies, have played an important role in this rapid development and integration process. Such policies have made it clear both to the public as well as to the banking sector that the success of their businesses lies first and foremost in their own hands and that risky capitalisation strategies or poor liquidity management are not sustainable in the long run. This clarity, in turn, has certainly been a cornerstone of the success of the chosen monetary arrangement. Otherwise, the flexibility of interest rate movements and the efficiency of other market-based automatic stabilisers would have most probably been heavily restrained, for instance, during last year's Russian crisis.

OTHER FINANCIAL INTERMEDIATION

It is not only in the integration of the banking sector, but also of other parts of the Estonian financial system where keywords like prudential supervision, open capital flows and increasing international integration have played an important role. It has been especially essential for providing a solid foundation for cross-border financial flows to properly benefit economic development and monetary stability in Estonia.

During the last three years the other parts of the Estonian financial markets have made considerable progress and their role in financing patterns has been gradually growing.

However, unlike in many other countries, due to strong fiscal policies, this development does not reflect the "mightiness" of the government securities' markets as fiscal prudence has limited the need for government borrowing. This means that the securities market in Estonia is still dominated by the equities market and the debt market has developed more gradually based on private sector instruments and needs.

SETTLEMENT SYSTEMS

The third part of my presentation is settlement systems development in Estonia.

The current interbank payment system was established in 1992, and the main objective of the system was to provide a reliable infrastructure for payments made in Estonian kroons. In addition to retail payments, the payment system is also used for the settlement of securities and interbank money market transactions. The fully qualified participants in the system are the central bank, credit institutions and the central depository of securities.

Two years ago, the Bank of Estonia started to design a new interbank payment and settlement system. The objective of the new system is to improve the efficiency of money circulation and to reduce settlement risk through a shorter settlement cycle, as well as to provide a modern and reliable infrastructure that supports the development of financial intermedation. The new system, which will be operational by the end of 2000, will be compliant with EU requirements. The real-time gross settlement system will be connectable with the TARGET interface and the second subsystem, the designated-time net settlement system, and is designed for the processing of retail payments.

Furthermore, it is also not surprising, that we face similar conclusions as mentioned above. In order to maximise the effects of these reforms both in terms of quality and cost-efficiency, a small country like ours has to look outside of its borders in order to find sustainable solutions both in the areas of money clearing as well as in securities settlements. This is becoming increasingly acute as the underlying businesses continue to consolidate across European borders. Special attention has to be given to this issue during the remaining time in the preparatory period of monetary unification.

CONCLUSIONS

When choosing our strategy, it has always been clear to us that regional integration, the opening up of markets for financial business and adopting international financial regulations are not just indispensable, but are also favourable to economic development.

Therefore, any further policy step aimed at revitalising financial intermediation must not just passively accommodate regional and European integration of the banking business, but must also take an active role in supporting it.

Without such integration, which helps to spread professional know-how and produce opportunities for sufficient risk diversification, healthy consolidation and a financial safety net, it is quite unthinkable. This, in turn, is also one of the keys to monetary stability in small countries like ours both before and after monetary integration in the framework of the EMU.

Vahur Kraft. Keywords for Estonian financial stability in light of monetary integration