On 23 September 1999 the Board of Eesti Pank passed a Decision On the Profit Distribution Strategy Eesti Pank (see also the Chronicle of Monetary Policy of 1999, pp 21-22). The Decision proceeded from the Central Bank Act and the basic principles of profit distribution stipulated in the Statutes of the Bank.

The Board considered the most appropriate economic indicators for determining the profit distribution in the next three years to be the ratio of Eesti Pank's liabilities-free foreign exchange reserves to the gross domestic product (GDP) and to the broader monetary aggregate M2. The Board decided to strive for the approach where, up to the end of 2003, the ratio of the liabilities-free foreign exchange reserves to the GDP would exceed 2% and to M2 -5%. Transfers to the state budget in this period would amount to 25% of the profits, according to Article 30, Section 5 of the Central Bank Act.

The profit distribution strategy and the suitability and size of the above mentioned indicators will for the first time be evaluated during the distribution of the 1999 profit in the second quarter of 2000.


The decision to analyse in more detail the principles of Eesti Pank profit distribution and, if necessary, to improve the existing framework was born in early 1999 when the Board of Eesti Pank discussed the distribution of the 1998 profit. The decision also derived from the need to analyse the correspondence of the Estonian monetary system to the good practices of monetary policy openness approved by the International Monetary Fund (IMF) and to evaluate Estonia's readiness for moving closer to the European Monetary Union. For the latter, the strong financial position of the central bank is one of the most important criteria, that guarantees the implementation of the chosen monetary policy.

The analysis below consists of three major parts. First, the analysis of the central bank's need of capital which plays a decisive role in selecting a profit distribution strategy. The second part deals with the respective Estonian legislation and the policies applied in the past. The third part presents the general principles of Eesti Pank's new profit distribution policy and its grounds,as well as the proposals submitted to the Board.

The Connections of the Central Bank Profit and its Distribution with Monetary Policy

The structure of the central bank's balance, the profitability and profit distribution of the bank have been dealt with relatively extensively in the theory of the monetary system functioning, first of all in the context of the question of the central bank's autonomy. A central bank is, first of all, in a unique position as a bank of issue which, technically, never faces direct liquidity problems. Secondly, the trust in the central bank is not based on the mechanical ratio of the external capital and equity but rather on whether the currency issue guarantees the stability of the currency and often also on how the liabilities are covered by foreign currency. Thirdly, the central bank is a part of the state power and, under normal circumstances, in the eyes of creditors it also has the state's guarantee in addition to its own capital and reserves.

However, the above arguments are still purely theoretical. First, the size of the bank's capital and reserves automatically sets an upper limit to the central bank's foreign currency cover of the liabilities. This is its potential weakness to use the external stability of the currency as the interim objective of monetary policy, which directly weakens the efficiency of achieving the stability of the currency. Secondly, the state can provide a full guarantee for the central bank and cover the losses incurred from its activities, which is inevitable in some monetary policy situations, but the state may not be able (and often is not) to support the central bank with foreign currency. Thirdly, it is extremely unclear how the central bank can keep its independence in maintaining the stability of the national currency when it has to rely on the good will and understanding of the government in some basic issues of monetary policy. Particularly, if we consider that the short-term objectives of the central bank and the government are often different in such situations and the government can thus be very interested in dictating decisions to the central bank that are uncharacteristic of it.

Consequently, in practice there are weighty arguments in favour of preserving the strength of the central bank's balance sheet (both in terms of equity and foreign reserves) without the arbitrary interference of the government.

The danger (resp pressure) to the central banks's capital and/or foreign reserves derives from the implementation of the monetary policy as well as operational risks. Although issuing cash is in essence a fairly profitable activity, the same cannot be said about monetary policy as a whole. The monetary political interference of the central bank means that often the bank has to offer the market instruments at an interest rate it is impossible to cover from the income of its assets. Therefore, the central bank's monetary policy activity can lead to a considerable loss.

The risk is even higher when, in order to avoid a systemic crisis, the central bank has to interfere in the monetary system in a situation where, unlike in the normal circumstances, it is impossible to quickly provide a reliable guarantee with a required liquidity.

Among the operational risks two are the most important. Firstly, the central bank has to take into account the possibility of a sudden and extensive change of its assets. The bank is not fully protected against the credit risk or, in the short term, against the market risks that are inherent to every institution the term of liabilities of which is unpredictable. Secondly, the central bank has to be insured, to a certain extent, against the inevitable technical risks (eg in the clearing and settlement system) as well as even malicious attacks.

Although the main activity of the central bank can, under normal circumstances, be fairly profitable, the (inevitable) choices of monetary policy as well as the technical implementation of monetary policy involve a risk of the deterioration of the bank's financial situation.

Comparing the profit distribution mechanisms of the central banks of various countries we can notice the following:

The alternatives of the central bank profit distribution are thus technically very different, but as a rule their objective is to guarantee the central bank enough financial resources to carry out its basic tasks.

Eesti Pank's Previous Profit Distributon Practice

The profit distribution of Eesti Pank and the structure of its balance are directly referred to in the Estonian legislation in two cases. The Central Bank Act lays down the minimum size of the capital of Eesti Pank as well as the basic principles of profit distribution.

This process is specified in Article 30 which says that a minimum of 25% of the annual profit of Eesti Pank shall be added to the statutory capital until such time as the amount prescribed by Riigikogu (100 million kroons) is reached and a minimum of 25% of the annual profit of Eesti Pank shall be added to the reserve capital in accordance with the decision of the Board. After fulfilling the requirements, the Board may channel part of the profit to establish and replenish the special capital and special funds prescribed in the Statute of Eesti Pank. The remaining profit shall be transferred to the state budget. Loss of the central bank is covered from reserves. If this is not enough the bank's statutory capital may be used for this purpose on the authority of Riigikogu.

The present profit distribution scheme does not oblige Eesti Pank to maximise its transfers to the state budget. The main responsibilities of Eesti Pank are those enumerated in Article 2 of the Central Bank Act, of which the most important from the point of the Constitution is that Eesti Pank manages the currency circulation both within the Republic of Estonia as well as with foreign countries and is responsible for maintaining the stability of the legal tender of the Republic of Estonia.

Secondly, the Security for the Estonian Kroon Act sets significant restrictions to the activities and profitability of Eesti Pank, affecting the bank's financial situation in practice even more than the Central Bank Act. First, the requirement that the liabilities of Eesti Pank have to be fully backed by the foreign exchange reserves automatically means that in order to secure its operational risks Eesti Pank has to maintain a substantial liabilities-free foreign exchange reserve. A similar requirement concerns the equity of Eesti Pank. Secondly, the currency board restriction on investments means that the return on Eesti Pank assets will in the near future remain below the growth rate of the Estonian economy and even more so, below the growth rate of the financial system. Therefore, the surplus of Eesti Pank's required foreign exchange reserve is unable to "reproduce" itself in a volume comparable to these indicators.

Thus, the main issues of Eesti Pank's capital, reserves and profit distribution are determined by the Central Bank Act and the Security for the Estonian Kroon Act, with the main decision-making powers vested in the Board. Before submitting profit distribution for approval to Riigikogu, the Board has to make such a decision on the profit distribution that will allow the central bank to carry out its responsibilities connected with maintaining the stability of the kroon.

Eesti Pank's profit distribution so far has been relatively stable in terms of absolute size as well as a ratio of the profit (before extraordinary income and expenditure). However, it has been much more unstable as a ratio to Eesti Pank's average net profit, which is another point of departure for the Board decision.

The earlier practice of Eesti Pank profit distribution was strongly influenced by the losses of the 1992 and 1994 fiscal years. Therefore, the main problem was under which entry to include covering of the loss from the reserves. From the point of monetary policy it was important that entering the loss into the balance sheet was done with a certain delay as compared to the events that caused the loss - mostly the monetary reform and solving the banking crises. Thus, Eesti Pank's balance sheet profitability and changes in the liabilities-free foreign exchange reserve differed in practice. This has obviously been the reason why Eesti Pank profit distribution has practically never been publicly discussed proceeding, for instance, from the foreign exchange reserves.

The distribution of Eesti Pank's 1997 profit was also exceptional in a certain way. Eesti Pank's original decision to make a traditional 30 million kroons transfer was changed because the central bank decided to support the solving of the Eesti Maapank (Land Bank of Estonia) crisis with an advance payment of future transfers, since the quick solution of the crisis was particularly important for maintaining financial stability. The nature of the additional payments and their impact on the distribution of the 1998 and 1999 profit was explained to the government as well as the general public.

As the transfer has so far been relatively stable in size and character, Eesti Pank's profit transfer into the state budget has been reflected in the statistics as a source of income comparable to the usual taxes. However, it is clear that in case of one-off transfers of exceptional size such an approach is unjustified and such income cannot be used to cover the deficit of the state budget.

Thus, the profit distribution of Eesti Pank has been relatively stable in 1991-1998 in terms of absolute size as well as a ratio of the profit before exceptional income and expenditure. At the same time the ratio of transfers to the state budget to the bank's net profit has been considerably less stable. The transfers of Eesti Pank so far have been a compromise aimed at maintaining the bank's sufficient financial strength and at the same time keeping transfers to the state budget at a stable level against the "normal profit". When distributing the profit more attention has been devoted to meeting the capital requirement specified in the Central Bank Act and less attention to the indirect indicators of monetary policy.

Eesti Pank's Profit Distribution in the Future and Monetary Policy

Proceeding from the above, it is insufficient to consider Eesti Pank's monetary policy objectives to be limited to maintaining the stability of the exchange rate of the kroon and observing the conditions of the currency board. The success of the monetary policy strategy is determined by the extra costs this goal has been achieved by.

The main such indicator is the continuing reliability of the monetary policy line and hence maintaining the lowest possible margin between the interest rate of the kroon and the anchor currency. It is equally important that the monetary policy transfer mechanisms would function smoothly in extreme situations.

Thus, it is not enough for Eesti Pank to evaluate its activities only by observing whether the main conditions of the currency board have been maintained throughout time. Even if this could be taken to be the minimum requirement of the current monetary policy doctrine, the seven-year experience of implementing the currency board system has proved more than once that in order to achieve an optimum result additional measures have to be taken to maintain the necessary level of trust through monetary policy. Here the central role is played by the adequate foreign exchange reserves exceeding Eesti Pank's liabilities which at the same time also means sufficient capitalisation.

The main objective of Eesti Pank balance sheet structure in the next three to five years is to support the smooth and reliable functioning of the currency board system, and in a longer term to maintain the central bank's financial stability for joining the European System of Central Banks as well as for the unlikely but theoretically possible change in the structure of monetary policy in case of changes in legislation.

The following conclusions can be drawn from the forecast and analysis of Eesti Pank's profit development:

According to forecasts, the profitability of Eesti Pank should remain on a level that allows to restrict both the absolute and relative rate of decrease in the currency board reserve surplus but at the same time the monetary policy framework will not allow maintaining the present ratio of extra reserves to the economically important indicators.

The above projections and analysis let us to conclude that, from the point of fulfilling the basic responsibilities of Eesti Pank's monetary policy, the main goal of profit distribution is to avoid the excessive decline of the surplus of the currency board reserve during the period determined in the strategy. This is necessary at least until Estonia becomes a full member of the European Monetary Union.

Considering the development of the economic environment, particularly the financial sector over the past 18 months, it is obviously justified that Eesti Pank's liabilities-free foreign exchange reserves decrease slightly against economic indicators because the risk level of the monetary policy environment has stabilised considerably.

The indicators against which the comparison of foreign reserves surplus would be meaningful in terms of monetary policy can be divided into two. Firstly, the surplus could be compared to the indicators of Eesti Pank's balance sheet (the volume of the balance sheet or foreign exchange reserves, volume of base money, etc). Another possibility is to compare the reserve surplus against general economic indicators, which would bring the procedure closer to the general processes of economy and the financial system. Here the most important indicators are the gross domestic product, the financial system (monetary aggregates), trade turnover and debt level of the economy.

Proceeding from the assumption that in the next three years (2000-2002) some structural changes will take place in the balance sheet of Eesti Pank, deriving from changes in the operational framework of monetary policy, it is more appropriate to stay with external indicators while determining the central bank's strategy because these will probably be more stable and relevant from the point of monetary policy during the period in question. On the strength of previous experience we suggest such indicators to be 5% of the M2 and 2% of the GDP. Proceeding from these indicators, transferring approximately one fourth of the bank's annual profit to the state budget would correspond to Eesti Pank's main objectives until the year 2003, presuming that the operational framework of monetary policy will be gradually altered.

Keeping in mind that the factors treated as assumptions for this approach are relatively unstable, it would be advisable to avoid being overly mechanical in the decisions on profit transfers. Although it is preferable to inform the general public about the profit distribution strategy well in advance, the Board has to have clear responsibility and an opportunity to review the relevant decisions during the period in question and, if necessary, to adjust them.

Proposals for Changing Eesti Pank's Profit Distribution Strategy

Proceeding from the analysis above, the future strategy of Eesti Pank on profit distribution and reserves should be approved as existing of three stages: