Measures taken by Eesti Pank during the period of rapid credit growth
In 2005-2007, Eesti Pank took several preventive measures to hedge risks stemming from rapid credit growth as well as to support the reliability of the banking sector.
Estonia's capital adequacy ratio is 10%, which means that on average the bank must have 10 kroons of capital per each 100 kroons lent. In 2005, Eesti Pank decided to raise the risk weighting on housing loans used for calculating capital adequacy from 50 to 100 per cent. The new procedure entered into force in March 2006. Whereas the previous 50 per cent risk weighting for housing loans meant there had to be 5 kroons of equity against each 100 kroons, the new procedure mandated a level of 10 kroons. This increased the banks' capital buffers by approximately 13 per cent.
Second, in 2006 Eesti Pank adopted the capital adequacy calculation procedures based on European Union directives i.e., the Basel II framework. The new procedure for calculating capital adequacy ensures that the banks' capital conforms better to actual risks, motivates banks to enhance risk management and, as a result, strengthens the stability of the financial system. Eesti Pank kept the capital adequacy ratio at 10%, while the figure for nearly all other EU member states is 8%.
The Basel II framework mandates that housing loans carry a risk weighting of 35 per cent. When it acceded to Basel, Eesti Pank established a two-year transition period for lowering the risk weighting applicable to housing loans, forcing banks to hold significantly more capital than the level required in the European Union. It bears mention that the risk weighting requirements for housing loans dropped to 35% in 2009, which puts additional resources at the disposal of banks in the recession climate.
Fourth, in September 2006, Eesti Pank raised the mandatory reserve requirement for banks from 13% to 15%. As a result, banks must keep a greater portion of the assets of depositors and other non-equity capital in liquid form at Eesti Pank.
It should be mentioned that regulations of this stringency were established nowhere else in the European Union.
Fifth, Eesti Pank constantly monitors and analyzes the situation and risks in the banking and financial system.The central bank has developed guidelines for ensuring financial stability and evaluating risks. Eesti Pank publishes its assessment of financial stability twice a year, with the most recent review published on June 16.
Sixth, since 2002-2003 Eesti Pank has been and will continue to be in constant dialogue with the public, government and market participants to identify risks associated with excessive loan growth. Our close interaction with all parties has played an important role in shaping overall positions.
In the autumn of 2003, Eesti Pank proposed to the government to scrap the possibility of deducting interest on housing loans from taxable income. Initially, the aim of the measure was to support the development of the housing market in a high-interest-rate environment. As the loan market developed and interest rates on the international money market decreased, the measure no longer served its original purpose and sent the wrong signals to borrowers. Deduction of interest rates on housing loans has not yet been abandoned. Still, it was decided at the end of 2003 to reduce the maximum limit for all deductions from taxable annual income from 100,000 kroons to 50,000 kroons.
Due to the combination of all these steps and the changing economic environment, the increase in the volume of loans disbursed by banks in Estonia started to decrease in the second quarter of 2007 - much earlier than in other countries in the region. The Estonian banking system was thus relatively well-prepared for the deepening of the global financial and economic crisis. As of July 2009, the capital adequacy of banks operating in Estonia exceeded 20%, with the banks having excellent liquidity buffers.
The function of Eesti Pank is to preserve price and financial stability in Estonia; and based on the above, it can be said that the central bank has been successful in fulfilling its functions.
It cannot be overlooked that the primary function of banking is to accept deposits and grant loans. In a society with a free market economy, parties enter into a transaction on agreed terms, assuming that both parties consider the contract as beneficial to them. The primary function of the central bank is to ensure the capitalization and liquidity of banks on a level sufficient to keep the stability and reliability of the banking sector from declining amid changes in the economic cycle and deceleration of loan growth. The banks operating in Estonia are reliable in all facets and have continued lending even though the loan conditions currently reflect the changes taking place throughout the world.
At the same time it is clear that due to the post-EU-accession optimism, both companies and individuals suffered from overconfidence, just as the supply of loan capital from banks was too high. By now, however, it is clear that all market participants have drawn serious and important conclusions from the last loan boom.
Strong and well-capitalized Scandinavian financial groups account for 95% of the Estonian banking market. The integration of the Estonian financial system with the Nordic countries and, by extension, with the European Union's financial market, is a key part of the stability of the local financial system. A large and uniform pan-European financial market can better tolerate country-specific risks and thus avoid major fluctuations in the financial market. Examples of risks associated with a small financial market include Latvia, Iceland and Hungary. In these cases, the risks materialized and taxpayers had to bear the brunt. Estonian taxpayers have not had to bear such a burden.