In 1997, the development of Estonia's financial sector can be mostly described by a rapid nominal growth, further consolidation of the financial system and integration of financial markets both in the domestic and international context. Compared to previous years the foreign capital inflow increased significantly in 1997. The rapidly growing economy boosted credit demand and non-banking financial intermediation accelerated as well (see Figure 1).

Most of 1997 is described by the rapid growth of loan volumes and securities market turnover in the environment of low interest rates and the deepening of the private sector's debt. The intensive inflow of foreign capital and overoptimistic expectations of local investors promoted the fast growth of prices and turnover in the stock market. 1997 was a beginning of a new stage in the development of Estonia's financial markets, especially in the international context. This is also confirmed by investment grade credit ratings assigned to Estonia (Standard & Poor's BBB+ and Moody's Investors Service's Baa1).

Financial problems in developing markets had a significant impact on Estonia as well: asset prices dropped and interest rates went up in September-October. Developments in international stock markets brought along postponing of most share and bond issues scheduled for the end of 1997 or reducing their maturities. Whereas the increasing international and domestic uncertainty did not make foreign investors leave Estonia's stock market - despite fluctuations during the year, their share increased over the year. Growth indices of banks and leasing companies did not decrease at the end of the year either and the profitability over the year was the highest ever.

Unlike previous years, the further integration of financial and real estate markets was described by more intensive movement of resources between financial and real estate markets. Although asset markets are more integrated than before, there was no high price increase in the real estate market. The latter can be explained by a relative backwardness of the real estate market compared to financial markets. The development of financial and real estate markets also means expanding investment opportunities.

The consolidation continued in the financial sector: there were 12 banks in Estonia by the end of 1997 against 15 in 1996. The state participation in the banking sector reduced further. However, implementation of the intended banks' expansion to the Baltic countries and Russia was only partially realized due to the tightened market situation at the end of the year. An important trend to be mentioned is the beginning of consolidation at the insurance market. In the legislative framework the adoption of the Investment Funds Act based on the EU norms and the elaboration of the basic legislative principles for the pension reform were the major events. In 1997, consolidated supervision became a pressing issue as financial groups developed rapidly and banks acquired a dominant position in the securities market.

The rapid nominal growth both in the real and financial sectors during the year, deepening dependence on international financial markets and financial problems in developing markets in South-East Asia determined several economic and political steps by the government and the central bank. Major long-term measures in financial regulation included raising the banks' minimum capital adequacy ratio from 8 to 10%, increasing the risk-weight of local governments' liabilities from 50 to 100% and a decision to introduce a market risk component to the capital adequacy ratio from the second quarter of 1998 as well as establishing a consolidated supervision. Among immediate steps taken were the introduction of reserve requirement to the net liabilities of domestic banks vis-?-vis non-resident banks and additional liquidity requirement to restrain capital inflow. The above steps are targeted to ensure highercapitalization and more stable development of the financial sector in future.

These measures together with the Stabilisation Reserve Fund (see Estonian Economy in 1997) are explicitly reflected in the position of economic sectors towards the financial sector. The noticeable deepening of the negative position of Eesti Pank (increase of credit institutions' reserves in the central bank; see Figure 2) and decreasing of the central government's positive position (investing the excess of budget revenue over expenditure outside Estonia) reveal that such economic steps partially smoothed the inflow of foreign money. The main objective of the above measures was to curb risks in fiscal and financial systems.

The growth in the importance of other (than banks) non-residents in the second half of 1997 was due to a structural shift in the foreign capital inflow - previous syndicate loans replaced by debt securities. The 1996 trend continued in 1997 as well marking an increasing debt burden of the business sector and weakening of the international investment position due to the continuously growing foreign debt. Nevertheless, Estonia's total foreign debt is relatively small in the international context - gross debt being 33% of GDP and net debt - 15% of GDP.


Assets of Credit Institutions

Assets of Estonia's credit institutions grew rapidly in 1997 (see Figure 3): the total assets increased from EEK 22.9 billion at the end of 1996 to EEK 40.6 billion by end-1997. Structural shifts in assets characterise the growing integration of financial markets - the decreasing number of claims on other credit institutions (their share in total assets dropped from 13 to 9% over a year) was accompanied by expanding the income base mainly at the expense of securities portfolio (its share increased from 15 to 21%, ie assets are more exposed to market risks). The reduction in claims on credit institutions and growth in lending derive from increasing creditworthiness, growing risk-taking by banks and also to a lesser extent from decreasing liquidity preferences related to the diversification of assets. Problems arising in local and international markets at the end of the year had no clear impact on the growth of the consolidated balance sheet in the fourth quarter.

In 1997, the loan portfolio of credit institutions increased mainly due to the triple increase in foreign currency lending - from EEK 4.3 billion at the end of 1996 to EEK 12.4 billion at the end of 1997. This trend confirms that the transfer of exchange rate risk (accompanying growing foreign resources in credit institutions' liabilities) to the end-borrower continued in 1997 as well (see External and Own Funds of Credit Institutions). The volume of loans in Estonian kroons remained practically on the level of the beginning of the year. The foreign currency breakdown of the loan portfolio displays that the growth of the share of foreign currency loans is not due to currency arbitrage (see Figure 4).

At the end of the year the growth of the loan portfolio slowed down. Mainly loans to financing institutions decreased; the decrease was 17% between October and the end of the year. The growth rate of loans issued to the real sector decreased less - loans to private enterprises increased by 2% during the last two months of the year.

The loan portfolio breakdown by sectors of economy displays a certain preference to service-oriented fields (see Table 1 ). The loan volume of the tradable goods sector remained on the 1996 level, decreasing from 19 to 18%. As to foreign currency loans, the share of export-oriented sectors decreased - the share of tradable goods sector dropped from 22% at the end of 1996 to 18% at the end of 1997. Summing up 1997, the share of loans to the financial sector decreased and to real estate, leasing and business services, wholesale and retail trade, other kinds of personal and social services, transport, storage and communication increased.

The price sensitivity of assets increased significantly during the year. This was caused by a stable growth of loans with price sensitive collaterals in the total loan portfolio - the share of loans collateralized by securities, mortgage or pledged buildings increased from 36 to 54% over a year. The fall in the securities market in the fourth quarter of 1997 did not bring along a significant change in the number of loans collateralized by securities. The turnover of these loans dropped little, considering the drop in the securities market.

In 1997, the share of non-collectible claims was quite stable in the banking sector, remaining within 2% of the loan portfolio like in 1996. Although the interest rate increase and drop in the stock market at the end of the year have not deteriorated the quality of the loan portfolio yet, in future the quality of assets will largely depend on the impact of the changed environment on the real economy.

The securities portfolio of credit institutions (see Figure 5 ) is characterised by the revaluation of the speculative level of financial investment policy caused by the downfall of the market in late 1997. This was displayed by the remarkable decrease in the share of residents' share portfolios quoted in Estonian kroons (from EEK 2 billion in the first half of the year to EEK 1.2 billion by the end of the year) and by the increase in the volume of fixed-income securities and bonds (from EEK 3.5 billion to EEK 5.6 billion). The significant increase in the share of foreign currency denominated securities in the securities portfolio can be explained by rapidly developing neighbouring markets.

External and Own Funds of Credit Institutions

Residents' Liabilities

In domestic deposits sector (annual growth 36%), private deposits grew faster (62%) than corporate deposits (50%), mainly because of increasing income, changing priorities and technological development of credit institutions.

Non-resident Liabilities

The dependence of Estonian credit institutions on the development of international financial markets and on foreign investors' preferences deepened significantly in 1997. Non-resident liabilities, being the main source of growth of the balance sheet volume, more than trebled over the year (see Figure 6) increasing their share in external funds from 19 to 36% within 1997. The most significant shift in liabilities structure was the increase of debt securities owned by non-residents by eight times (from EEK 0.5 billion at the beginning of the year to EEK 3.7 billion at the end of the year in absolute figures). Beginning from March 1997 the potential instability of non-resident cash flows has clearly increased, whereas the end-of-the-year crises in international financial markets did not have an immediate impact on the volume of the capital inflow facilitated by Estonian credit institutions.

The capitalization of credit institutions improved significantly in 1997 - the average capital adequacy ratio increasing from 11.6% at the end of 1996 to 14.6% at the end of 1997. The share of reserves in own funds is continuously low, decreasing from 13.2% in late 1996 to 9.2% in late 1997. The share of non-residents (incl off-shore regions) in the share capital of credit institutions increased like in previous years (from 30% in late 1996 to 43% in late 1997) verifying the continuous internationalisation of Estonia's banking. The ownership structure of credit institutions as of 1 October 1997 is displayed in Table 2.

The interest rate level was continuously decreasing until September (see Figure 7 ). The problems arising in South-East Asian financial markets in the fourth quarter had a major liquidity impact on the financial markets in Estonia, although yield curve shifts were mainly related to short-term liabilities.

Profitability and Profit of Credit Institutions

Regardless of the low figures in the fourth quarter (2%), the return of equity (ROE) reached the highest ever level in 1997 - 34.9%. This was mainly due to the rapid increase in the yield of non-interest bearing assets (the ratio of non-interest income to total assets increased from 8.4% in 1996 to 11.1% by the end of 1997), mostly based on the income from financial transactions (annual growth was 218%). The other main source of non-interest income were service charges which continued growing in the fourth quarter as well. Income from financial transactions was modest due the big losses in the fourth quarter, decreasing by 29% against 1996.

The increase in the productivity of assets would have been even higher if the interest income had not decreased. It happened mainly because loan interest rates dropped in the first half of 1997. Whereas the increasing revenue base increased income, just like the internal redistribution of the income base. The dropping price of assets was the main factor facilitating the fall in the net interest margin and spread, because the ratio of interest expenses into interest bearing liabilities increased a little.

The growth in financial leverage supported the increase in ROE by 20%.

The profit margin did not change (16.2%) despite of major fluctuations within the year. The stability of the annual level was due to a major fall in the fourth quarter based on the decreasing income discussed above. The expense structure in the fourth quarter reflected significant changes as well against the same period in 1996, manifested in the quantitative and qualitative appreciation of non-resident liabilities, the seasonal growth of administration costs and a major decrease in expenses related to financial transactions. Nevertheless, the share of administration costs decreased significantly and that of financial transaction costs increased over the year. The latter together with the fall in non-interest income in the fourth quarter served as the key reason for low growth in non-interest profitability although the non-interest income leaped up.

In conclusion, it is evident that the growth in the non-interest income was the main factor influencing the growing profitability of credit institutions compared to 1996. The growing revenue base and its structural redistribution - an increase in the share of loans and decrease in the share of deposits in assets - and the fall in the price of liabilities, mainly of debt securities, supported the growth in profitability. The growth in the profitability of own funds would have been even higher if the net interest margin had not continuously dropped. It was mainly due to falling loan interests (for most of the year) and decreasing significance of demand deposits in external funds. The increase in profitability was suspended by decreasing income from financial investments as well.


Debt Securities Market

The debt securities market plays a secondary role next to the share market in Estonia's securities market. Each structural change is of significance because of its modest size. The turnover in the debt securities market comes mostly from the primary market, with obligations of the Hüvitusfond (Compensation Fund) and privatization vouchers (EVPs) traded on the Tallinn Stock Exchange being an exception. Privatization vouchers have undergone a major development in 1997: their price and trading activity increased after registration with the Central Depository for Securities and entering in the list of tradable securities. The market capitalization reached EEK 4 billion by the end of the year. The share of debt securities traded on the stock exchange being only 6% of the annual EEK 7.5 billion turnover of the debt securities market. Upon a limited choice of instruments, partially due to the lack of central government's short-term bonds, corporate debt securities are prevailing (up to 60% of the capitalization of the debt securities market; see Figure 8).

Previously the debt securities market development was mainly supported by local government borrowing which remained on the 1996 volume level in 1997. The market demand and low interest rate shifted the main stress of the debt securities market into the business sector. Mainly municipal companies and subsidiaries of credit institutions were among the first issuers. The number of issuers expanded significantly during the year. Short-term corporate debt securities (90% with the maturity not exceeding six months) turned dominant in the market. As a result of these developments the debt securities market became a significant financing channel for the business sector over the year.

As short-term corporate debt securities were dominant, investment funds, mainly money market funds were the key investors. Local credit institutions and their subsidiaries were among the major investors as well. The share of non-resident investors in debt securities denominated in kroons in the market was about 15%. Since most of the debt securities issued in 1997 were short-term, the refinancing of liabilities became popular, in other words, it was a longer-term financial scheme. The financial scheme attractive during the high liquidity of the money market exposed issuers to interest rate and liquidity risks and in the fourth quarter companies had first difficulties in refinancing previous liabilities due to changing environment and increasing interest rates.

The interest rate of debt securities and its trends in short-term debt securities are characterised by inter-bank money market interest rates. The average interest rate of debt securities with the maturity of up to six months issued during the first three quarters of 1997 has remained within 6.5-8.5% and has followed the trends of the three-months TALIBOR (see Figure 9 ). Interest rates of longer-term debt securities coincide with interest rates of loans with maturities exceeding five years, remaining on the average within 9-12%. The favourable environment in the local money market made the debt securities interest rate drop until September. The general increase in the interest rate in the fourth quarter of 1997 influenced the interest rate of debt securities as well: the average interest rate of debt securities issued increased from 8 to 11.6%. A new trend in the debt securities market is the floating interest rate, where TALIBOR is used as its reference interest, in case of longer-term debt securities - German mark LIBOR.

Stock Market

The key part of Estonia's securities market is the stock market which underwent major changes in 1997. The number of tradable shares increased and the capitalization of the market increased from EEK 11 billion in 1996 to EEK 19 billion in 1997 mainly due to price changes (see Figure 10). The number of shares traded on the Tallinn Stock Exchange increased from 16 in late 1996 to 28 in late 1997, 22 of them being quoted either in the main or secondary list of the stock exchange. Estonia's stock market is continuously banking-dominated: the market value of the shares of five major credit institutions is about 60% of the stock market capitalization. Most of the transactions in the secondary market are concluded with the same shares (see Figure 11) and about 80% of the transactions on the Tallinn Stock Exchange are intermediated by banks.

The increase in share prices started in late 1996 involved mainly shares of credit institutions (see Figure 12). Apart from new investors coming to the market and introduction of financial leverage and derivative instruments, the behaviour of credit institutions influenced the growth of share prices as well. Income from securities transactions became an important source of income for many banks, increasing, thus, banks' profits and estimated market value as well. Capitalization of the shares registered with the Estonian Central Depository for Securities facilitated by price increase was EEK 29 billion at the end of August, reaching about 50% of GDP in 1997.

Developments in the stock market at the end of 1997 were quite similar to those in South-East Asia in the same year and to those in Central European transition economies in 1994. The overvalued stock market, problems in world's financial markets and changes in related attitudes to developing markets brought along a downward plunge in the stock market prices at the end of 1997. It was accelerated by volatility in international financial markets, decreasing the inflow of foreign funds to Estonia's securities market. Constraints in the credit market made several banks end issuing repo loans and start closing loan agreements upon the drop of share prices to the collateral value, increasing, thus, the selling pressure in the stock market.

Significantly fluctuating prices and turnover characterise Estonia's stock market. The large price fluctuation caused by the thin market was amplified even more over the last few months of the year. Statistically the monthly average standard deviation exceeds the monthly growth by 2-3 times. The unbalanced development of the market is displayed in the continuously increasing average deviation of the daily turnover, comprising about 50% of the average daily turnover in the last months of the year.

At the end of the year the value of shares estimated as price and earnings ratio, exceeded 10 as the average of companies quoted in the market, regardless serious price adjustments. During price peak the P/E ratio exceeded 18 for larger credit institutions, being remarkably high for transition economies. Different from bank shares, prices for corporate shares deviated from the average significantly less.

Foreign residents have played a major role in Estonia's stock market. At the end of the year they owned 38% of the instruments in the securities market. The share of foreign residents in the stock market has changed in the opposite direction compared to share prices. This manifests the higher price sensitivity of foreign investors compared to locals. Significant foreign investors came from Finland, Sweden, Great Britain and USA. Although the importance of off-shore regions increased among the investors throughout the second half of the year, they remained still below 7% of the market capitalization. The significance and impact of local private investors on the market development was considerably smaller. Some increase in activity of private investors was noticeable in the second quarter of 1997 when their share among investors increased from 9 to 12% for a short while. Table 3 displays total figures for the securities market.

Investment Funds

There are 23 investment funds in Estonia, most of them (18) being open-ended funds. Closed funds are insignificant since privatization vouchers find little use in privatization of companies and Central European-type privatization funds have never existed in Estonia (see Figure 13). 1997 was an important year for investment funds. Changes in the local securities market and the expansion of funds across the border increased their volume about four times compared to the end of 1996.

Developments in the stock markets of Estonia and other transition economies over the last months of 1997 had an impact on investment funds as well. In the fourth quarter of 1997 the volume indicators of all funds and yield indicators of most funds dropped. Only the yield of money market funds together with interest rates went up during the last months of the year, although their volumes decreased.

A characteristic feature of investment funds market is the dominance of asset management companies owned by credit institutions. Asset management companies managed 94% of the total volume of investment funds and no major changes took place in this market share. In compliance with Estonia's universal banking model, more than 80% of the EEK 2 billion volume of private portfolios belongs to subsidiaries of credit institutions.

Leasing Companies

Leasing companies underwent the largest change in volume among financial intermediaries in 1997: their leasing portfolio trebled. In the structure of leasing contracts capital lease is continuously dominating, its share being about 60% (see Figure 14 ). Private cars (about one third of the total volume) and investment goods continue dominating among leased goods.

The qualitative development of leasing companies becomes evident in involving finances from local and international capital markets. In the latter case the parent bank's guarantee is required for borrowing. The end of 1997 trends in financial markets have had a suspending impact on the above processes.

The internal integration of the financial sector is revealed in the bank controlled market share of leasing companies being continuously above 90%. Leasing companies are continuously expanding into the other Baltic countries as well. Apart from Hansa Leasing, several other subsidiaries of credit institutions are planning to expand apart, from Latvia and Lithuania, to St Petersburg region as well.


The insurance market increased by 37% in a year but the share of insurance is still small in financial intermediation. Leader among various types of insurance continues to be insurance against loss/damage, the greater part of which belongs to compulsory motor vehicle insurance (TPL). Nevertheless, decreasing compulsory insurance and increasing voluntary insurance against loss/damage reflect a positive trend, being at least partially related to increased borrowing and insuring collaterals. The small share of insurance in financial intermediation (the ratio of collected insurance premiums to GDP was below 2%) is mainly caused by still insignificant share of contribution-based life insurance.

Most significant changes in the insurance market in 1997 were the beginning of consolidation, active intervention of international insurance companies to the market by acquiring participation in Estonian insurance companies as well as the expansion of insurance companies into other Baltic countries. The further development of insurance will largely depend on the pension reform, too.