As compared to 1997, the growth rate of nominal indicators in the financial sector has slowed down significantly - in the first six months of 1998 the consolidated balance sheet of commercial banks increased only by 5% (during the same period in 1997 by 33%). The capitalization ratio of the securities market in relation to GDP diminished from 29% of end-1997 to 16%. The insurance market continues to stagnate and only the volume of leasing activities continued to grow also in the first half-year (see Figure 5.1). The greatest decline happened on the securities market which featured only as a secondary market by the end of the first half-year and has, at least temporarily, forfeited the function of attracting new capital.

The inflow of capital through the financial sector has undergone drastic changes - rather, the first six months of 1998 saw the net outflow. Nevertheless, the refunding of the banks' short foreign liabilities has not created major problems. The international financial markets have maintained a cautious attitude towards transition economies, and it has deteriorated again due to the developments in the South-East Asia in the second quarter. It is still too early to assess the scope of impact of the financial crisis in Russia. Considering that the capital inflow into the banking sector stopped during the first half-year and uncertainties on the international capital markets persevere, the growth so far has been mainly achieved at the expense of domestic deposits. Further enlargement of the capital base is also problematic. By the end of the first half-year it was evident that if same tendencies continued, the growth rate of the financial system would clearly fall behind the nominal growth of the economy.



The 4.4% growth of the liabilities in the first half-year was mainly due to the 17% increase in the deposits of private individuals. Thus, the problems attributable to Eesti Maapank (Land Bank of Estonia) and Eesti Hoiupank (Estonian Savings Bank) in the second quarter did not cause significant financial confusion. The deposits of resident private undertakings decreased in the first half-year by 6%. The outflow of deposits that took place in the first quarter was reversed into a minimum growth in the second quarter, supported probably by partial restoration of loan facilities and to some extent by the fall of interest rates.

The portion of non-resident external funds diminished by 4 percentage points (from 39 to 35%) during the first half-year (see Figure 5.2). This is the reflection of the ongoing instability on the developing markets continuous uncertainty of the external environment with respect to the development prospects of the Estonian economy.

The movement of non-resident liabilities from loans to securities, which had started at the turn of the year, deepened[1] . The maturity of short-term non-resident liabilities has shifted from 1-3 months to longer positions, however, these changes affected predominantly terms shorter than one year. The liquidity crisis that evolved in the autumn of 1997 has been overcome by now, but uncertainty towards the banking sector has remained and the share of long-term liabilities has not increased.

There will be no major repayments of foreign liabilities before the end of 1998 and the size of the end-of-the-year cash flows is not critical for the time being. High portion of short-term foreign claims entails a risk that the failure of some issue might raise the cost of liabilities for the entire sector which, in turn, will have a negative effect on the banks' profits.

Banks' Assets and Sector's Adaptation to the Changing Environment

The changes in the external environment manifested themselves with an almost six-month time lag - during the second quarter the volume of the banks' consolidated balance sheet decreased by 0.4% (for comparison, in the beginning of the year the volume had been bigger by 5.3%). Due to the slowdown in the net flow of non-resident liabilities and changes in the regulatory environment, foreign funding into creditworthy companies, where domestic banks acted as intermediaries, grew in the summer.

The first half-year marks the end of the adaptation period that followed the autumn liquidity crisis. In connection with the liquidity crisis in the autumn, lending to the financial sector declined and the share of liquid assets increased. During the second quarter, the banks' liquidity positions improved considerably. Adaptation to the changing circumstances was reflected in the fact that by the end of the first half-year the pre-crisis structure of the assets was restored. Also the banks' allowances for uncovered interest risk positions fell. Presently, the dynamics of the cost of assets and liabilities by sectors was reflected in the post-crisis period, where the stability of assets and liabilities price has been achieved thanks to a more conservative approach of future development prospects.

The decrease in the spread of the kroon and German mark denominated long-term liabilities can be interpreted as the regained trust in the kroon by the external environment. Adjustments by the financial markets were also reflected in the decline of the banks' return on equity (ROE; see also Profitability).

Banks' Loan Portfolio and Asset Quality

In the first half-year the loan volume grew by 11%. Changes in the loan portfolio do not corroborate that the focus of the lending increase moved into the export sector[2]. During the second quarter, the loan portfolio became again more dependent on the increase of domestic demand and price stability of properties (incl real estate).

The alleged fall in the real sector's growth rate will probably cause additional problems in collection of assets. In the second quarter, the share of loans in the banks' asset structure grew from 52 to 55%, mainly at the expense of securities and claims on other credit institutions (see Figures 5.3 and 5.4). This can be interpreted through more stringent asset management policies applied by the banks as well as continuous strong credit demand prompted by the real economy.

The halt in the growth of lending to private individuals in the second quarter (only 0.7% growth) is an indication that the lending policy has become more conservative. The drop in corporate loan volume growth to 4% may create liquidity problems for smaller companies whose liabilities are predominantly short-term. The increase in the share of foreign currency loans in the loan portfolio to 67% (see Figure 5.5) can be interpreted as optimism by banks, who displayed that it would be possible to attract non-resident funds also in the future as the position of the German mark at the end of the first half-year remained positive for approximately EEK 6.5 billion and the sustained deepening continued. This means the augmentation of uncovered currency risk of the real sector. To some extent the situation is mitigated by maturity terms longer than the average for foreign currency assets.

The capitalization of the banking system cannot be considered critical at the moment because the 'excessive balance' of the aggregated equity would also cover for the almost two and half times increase of the doubtful loans (up to 6-7% of the total loan portfolio). However, it is difficult to explain why the share of overdue and doubtful loans has remained stable[3] whereas the growth rate of the loan portfolio has dropped considerably (see Figure 5.6). It can be sustained either by the rapid growth, experienced by the real sector during the first half-year, low debt load in the economy, or refinancing of loans, but also by a longer time shift during which weaker credit projects are singled out. In addition to this, the stability of overdue loans is to some extent supported also by the stability of interest on loans to the real sector. If higher interest rates, external shocks, limited foreign funding opportunities etc do not have an abrupt braking effect on the real economy and the banks are able to adjust their orientation quickly to the financing of projects less dependent on the internal demand, the deceleration of the lending volume will not necessarily be followed by the increase in the so-called classical credit risk factor.


In the first quarter, the increase of the ROE was mostly influenced by the profit margin, the growth of which was due not to the decrease in costs, but to the increase in yield of assets to a rather high level. In principle, the entire growth of the ROE originated, to a large extent, from the income earned from financial investments and transactions, ie from the growth of the non-interest income. Income from interest showed only a marginal increase. Regarding costs, the greatest impact on the profit margin had lowered administrative costs, and relatively slow growth of interest-related costs. The latter was supported by both the structural appreciation of liabilities and their price rise (except, loan interest). For the above reasons, also the spread and net interest margin diminished.

The fall in the ROE, that happened in the second quarter, was in comparison with the first quarter the deepest of all times: -6.7%. This slide should not be considered fundamental because the key indicators for the return and yield varied significantly within the system in comparison with the previous periods. Negative profit margin was effected not so much by cost changes as by the changes on the income side. Hereby, we can assume that profit margin will grow considerably during the forthcoming quarters since costs in the second quarter were largely contingency costs[4] .

The decline in asset yield was caused mainly by an abrupt reduction of income from financial transactions, ie decrease in non-interest income sources[5] . The fall in the interest income was mainly caused by the fall of loan interest rate. As regards interest costs, the banks managed to lower the price of all major types of liabilities (with the exception of debt instruments since their price formation is relatively more rigid for the banks). This helped to offset the fall in external instrument prices and to sustain the interest net margin as well as the spread more or less on the level equal to the first quarter level (see Table 5.1).

Bank Mergers

Rigorous external environment and toughening competition in Estonia and in neighbouring countries brought about further consolidation of the banking sector in the first half of 1998, and this process is likely to continue also in the future. The monetary environment, toughened by external shocks, revealed also some hidden management problems, including corporate governance, which were associated with excessive risk-taking (undertaking a securities issue and underwriting risk in the case of Eesti Hoiupank, credit and (stock) market risks in the case of Eesti Maapank). The above problems facilitated further consolidation of the banking sector.

On 13 July 1998, Eesti Pank approved the merger of Hansapank and Eesti Hoiupank. As a result of this merger the new bank constituted about EEK 20 billion balance sheet volume, ie 46% of the consolidated balance sheet of the banking system as of the end of July. On the very same day the merger agreement between Eesti Ühispank (Union Bank of Estonia) and Tallinna Pank was authorized, and this new credit institution seized approximately EEK 15 billion, ie 34% of the consolidated balance sheet. Thus, two major institutions in the banking sector held almost 81% of the market. The merged banks were assigned equal ratings of Baa3 by Moody's, which for Hansapank meant a step backward and was caused by the above mentioned management problems in Hoiupank. Ühispank did not have Moody's rating before.

Under stable external and internal conditions banks with a greater market share and larger equity capital should have better access to cheaper non-resident funds. This could be amplified through the unification with strategic foreign partners. A scenario of this nature today is more likely than ever before because big banks established through mergers fall into a more attractive category. For foreign investors this argument is corroborated by the actions of Swedish major banks (Swedbank and SE Banken), who were actively buying Hansapank's shares on Tallinn and Helsinki Stock Exchange in August 1998.

Greater diversification of money flows provides more flexible distribution of asset maturity dates, presumably income base will expand also. Risks are likely not to shift much. The credit risk level should not change essentially in the stable environment, whereas the impact of bank mergers on market risks is insomuch greater as volumes allow to penetrate new markets - both for geographical areas and for instruments. As regards system risks, monopoly/oligopoly of the market may lead to a greater moral risk. Also dependence on foreign markets will grow.


Bond Market

Together with the fall in interest rate levels on the money market, the first half-year saw somewhat livelier activity on the bond market. Several companies and local governments continued to issue their bonds, the share of non-residents' issues started to grow again[6] . The subsidiaries of the banks had still major part of new issues.

The volume of issues did not exceed the amount of the preceding period (see Figure 5.7), but as the average maturity date of the issued bonds was longer, the overall volume of the bond market increased. Although the growth of the market turnover indicates the increasing importance of the secondary market, its role is still of second-rate importance[7] . In 1997, the common approach used 3-month maturity roll-over issues, while in the first half-year of 1998 it was noted that maturity dates became longer to some extent; in an unstable market situation the role of interest arbitrage has lessened.

As of March the interest rate levels of bonds, especially that of short-term interest rates, started to fall, sliding from 16 to 11%. The latter became a balance point for interest rate levels by the end of the second quarter, and it should reflect the price level and development characteristics of the local money market. As the situation normalized, the yield curve regained its pre-crisis shape.

Stock Market

After the price bubble explosion in the third quarter of 1997, trading activity on the stock market has been constantly subsiding both in the number of transactions and turnover (see Figures 5.8 and 5.9). Accordingly, the importance of the stock market in the financial intermediation diminished and the market capitalization ratio to GDP decreased from year-end 29% to 16% in June. Currently, the stock market has only the functions of the secondary market; contracting of new capital has halted due to uncertainty of the domestic and foreign financial markets.

Unlike the decline in 1997, in the first half-year of 1998 share prices fell more smoothly and persistently (see Figure 5.10). Some odd price rise periods were elicited not so much by changes in fundamental indicators of companies listed on the stock exchange but by the publication of the banks' merger notices. Notwithstanding bank mergers and the resulting better synergy, the price of the banks' shares and the more tradable shares of the main list fell the most. Tallinn Stock Exchange (TSE) index TALSE hit the bottom on 8 July[8] , just before Eesti Hoiupank and Hansapank shareholders' meeting was convened to decide the merger.

Price fluctuations of the shares depended more on the liquidation of short-term positions and frequency of sale with the collateral and long-term securities within the stock portfolio than on the future prospects of the companies. Irrespective of the price, the buyers' interest was far less than sellers' offers. The low level of share prices that carried on for a relatively long time, has necessitated the sale of most of the shares used for collateral. In combination with the liquidation of short-term positions, it will escalate the selling pressure on the thin market.

Our domestic stock market was also influenced by the trends in the external environment. Problems in the Russian economy and investors more conservative attitude towards developing markets have lessened foreign investors interest in Estonia's stock market: in late December 1997 the share of non-resident investors amounted 38% (42% on the stock market), in the end of the second quarter 1998 it was 33% (38% on the stock market).

Other Non-banking Financial Intermediaries: Insurance, Leasing and Investment Funds

Compared to the other financial markets, the development of the insurance market was as modest as before, premium volume of non-life insurance grew at the same rate as the nominal GDP. Compared to 1997, the total amount of gross premiums from life insurance doubled. Nevertheless, from the point of view of the insurance market this change is insignificant since gross premium from life insurance constitutes less than 15% of the total amount of premiums. On the insurance market the problem is the profitability of the insurance companies because most of them reported substantial losses for 1998. This may be caused by unsuccessful investment of reserves and selling of some products for less than their prime cost. The current consolidation of the insurance market is expected to have a positive effect on its development.

Leasing. The crash that shook financial markets in Estonia at the end of 1997 did not affect the development of the leasing market despite higher interest rate levels in early 1998. During the first half of 1998 it was the most rapidly developing segment of the financial sector (see Figure 5.11). Quantitative development was fostered by the additional requirements imposed on the banks. The rapid development of the leasing market was the result of market distortions because under normal circumstances lending activities would have partly been carried out on the banking market. The growing tension on the credit market at the end of the second quarter started to inhibit the volume of leasing contacts. This was indicated by higher interest on contracts and falling car sales. Within the product structure the capital lease grew the most, the increase in other leasing services was notably modest. A new element in 1997 had been the growing importance of lease agreements with private individuals and a boost in the number of real estate leases.

Investment funds. The decline of the domestic stock market and share prices on the neighbouring markets had an adverse impact on the gross volumes and profitability of equity securities oriented investment funds. On the other hand, the volume of debt securities oriented money market and interest funds grew (see Figure 5.12)[9] . Thanks to higher interest rates on the money and securities markets their productivity did not change in comparison to 1997. In the light of the movement of the market situation, managers of several closed funds have announced the liquidation of these funds. At the same time, information about the closure of small open-end funds has reached the press. Due to the developments in Russia, the volumes of Eastern European investment funds have decreased substantially. As the money market and interest funds are administered by assets managements owned by the banks, the importance of the latter in the market structure should increase even more.

[1] Non-resident liabilities of credit institutions decreased by 9% - from EEK 6.4 billion to EEK 5.8 billion. This outflow was largely compensated by the increase of the bonds balance from EEK 3.2 billion to EEK 3.6 billion and to a lesser extent by the intake of companies assets.
[2] The share of export-oriented sector in the loan portfolio increased from 20.9 to 22.1% during the second quarter of 1998.
[3] For overdue loans the situation did not change much during the first quarter, except for the more export-oriented sector where the share of over 60 days overdue loans in the total loan portfolio diminished from 3.82% at the end of the first quarter to 3.12% by the end of the second quarter.
[4] If Hoiupank's operating costs are deducted from the consolidated costs, the ROE of the banking system will grow from -6.7% to -1.7%.
[5] Income from financial transactions decreased by EEK 586 million compared to the first quarter (from EEK 616 million to EEK 30 million).
[6] In the second half-year of 1997, only one bond issue with the total volume reaching EEK 44 million was organized by foreign residents, while in 1998 already three issues with the total volume over EEK 150 million have taken place.
[7] The volume of bond issues amounted to almost EEK 1.2 billion in the first two quarters of 1998, but the turnover increased from EEK 0.6 billion in the first quarter to EEK 1.1 billion in the second quarter.
[8] On 8 July TALSE closed at 110 points which was by 58% lower than in 1997 and 78% lower than the highest level for 1997 that was registered on 30 August.
[9] In end-1997 the total volume of money market and interest funds amounted to EEK 680 million, at the end of the second quarter of 1998 it was almost EEK 900 million.