Presentation of the 2005 report to the Riigikogu

Esteemed Chairman! Esteemed members of the Riigikogu!

Thank you for allowing me the opportunity to provide you with an overview of the development of the Estonian financial sector in light of last years Financial Supervision Authority results. In my short report I would like to highlight the most important developments and the possible risks for the financial market in developing a stable and credible economic environment.

The Estonian economy is doing well. This is hardly news. Therefore, I can only repeat the facts that also allow us to claim that the financial sector is presently at its peak.

Profitability remains high in banking, insurance and brokerage of securities. For instance, in unaudited results that exclude subsidiaries, banks made an aggregate profit of EEK 3.1 billion in 2005. The bulk of income remains lending: the share of interest income in total income was a little over half at the end of 2005.

At the same time it is necessary to emphasise that the share of service fees in the banks’ total income in Estonia is clearly higher than the average in the European Union. Therefore, larger bank groups are able to use their relatively high service fees to balance their income portfolio on the highly competitive loan market, characterized by high volumes and low margins. When one adds the ongoing consolidation on the banking market, of which 80 pct was controlled by Estonia’s two largest banks Hansapank and SEB Eesti Ühispank, at the end of 2005, it is inevitable that there are issues about the functioning of competition in the banking sector in general and not only in one of its segments, the loan market.

Assessing recent developments in the banking sector I would highlight the following trends.

First, in the opinion of the Financial Supervision Authority, loan growth is likely to slow down during 2006, especially in terms of housing loans. However, loan growth will remain significant in comparison with the European Union. The banks’ loan portfolio is unlikely to deteriorate noticeably and, therefore, the banks’ risk profile would not worsen. Yet, credit risk will remain the main risk source and the Financial Supervision Authority will remain vigilant in monitoring it.

Secondly, in the opinion of the Financial Supervision Authority, there are signs of hidden affiliation. Already now, many business lines of banks registered in Estonia that are subsidiaries of Scandinavian banks are extensively managed by parent banks and the role and responsibility of on-site management in Estonia is going to fall significantly. Although the Financial Supervision Authority does not, in itself, oppose the trend of affiliates taking over from subsidiary banks, it will bring us more challenges, mainly in developing cross-border cooperation, since direct supervisory responsibility is, in this case, being carried out outside Estonia.

We already have efficient cooperation with the supervisory institutions in Finland and Sweden. However, such developments pose a further and larger challenge to our cooperation. In the European dimension we cannot rule out the possibility where pan-European consolidation results in the mergers of parent banks of Estonian banks with other European banking groups that would change the way cooperation in banking supervision is carried out.

It should be emphasised, however, that the Financial Supervision Authority does not support the situation where, instead of setting up an official affiliate, the management of subsidiary banks gradually becomes more formal.

 

Looking at the developments on the insurance market one can highlight four trends.

First, competition on the non-life insurance market is becoming notably tougher: Hansapank is entering the non-life insurance market and the offering of cross-border services continues to grow. In 2005, the insurance market expanded 25.2 pct in comparison with 2004 (20.4 pct). Reflecting the trends on the banking market, the growth of the insurance market was supported by the sale of so-called loan insurance. It could be expected that the step taken by Hansapank will trigger a reaction by other larger banking groups and insurance companies that will be forced to adjust their business strategies. This is likely to put further pressure on the market’s profit margins and bring about a significant change in market shares.

 

Secondly, the developments on the life insurance market are strongly correlated with choices that the state needs to do in the near future in developing a system for payment of second pillar pension schemes. According to the model of the second pillar (compulsory endowment pension), the funds for payment will be transferred to the insurance company selected by the customer. A precise model of how it will be done has not yet been developed. Driven by public expectations and the need to minimize the risks of insured persons, the Financial Supervision Authority considers it necessary to adopt, as soon as possible, a political decision under which the investment risk with regard to payments of the funds collected in the second pillar schemes would remain with the insurer and not the insured.

This decision is paramount for further developments. If it is decided that the investment risk remains with the service provider, all relevant components must be considered in further choices. This concerns implementation of the public guarantee scheme, principle of separation of assets and the process of identification of customer preference, as well as the obligations of the service provider with regard to the base assets. In addition, it would be necessary to draw up a unified mortality table and, on a wider scale, establish joint rules for Estonian and foreign insurers to avoid regulative arbitration.

 

Thirdly, the Financial Supervision Authority considers it possible that a restructuring will occur in the management of insurance companies, whereby the insurance companies that operate in the Baltic Sea region are transformed into European business companies, and their management will be carried out from Tallinn. This would notably increase the role and responsibility of the Financial Supervision Authority. Fourthly, the transparency and the clarity of insurance products remains a problem and one of the priorities for the Financial Supervision Authority for this year. This concerns both non-life and life insurance products. We will attempt to solve the problem through developing essentially unified service standards and by public awareness campaigns. We will launch a consumer website that should notably increase the role of the Financial Supervision Authority in educating and advising consumers.

 

A key event in the securities market in 2005 was the takeover of Hansapank by Sweden’s FöringsSparbanken (Swedbank) and the delisting of Hansapank from the Tallinn Stock Exchange. The success of the process was proof that the mechanisms for protecting small shareholders are working well. Financial sector regulation is functioning well in terms of takeover rules, while the public regulation and market standards in force ensure protection of investor interests. While the delisting of Hansapank from the stock exchange cast doubt over the future of the Estonian stock market, the four IPOs that followed the delisting, Tallinna Vesi, Starman, Tallink and Eesti Ehitus, cast positive light on the market.

Assessing possible developments on the securities market, the main focus in the next few years will be on continuing the introduction of good market practices and implementation of corresponding service standards. For instance, last year the Financial Supervision Authority filed an application with the public prosecutor’s office to open a criminal investigation into the activities of investment company LHV. The criminal proceeding will be based on the section of the penal code that concerns illegal security trading by persons who have confidential information. The LHV case highlights the fact that it is time that we study in depth the market’s legal environment and good practices.

Looking at the developments from the regulative aspect, the implementation of Basel 2 principles will have a major impact on the investment companies. This regulation concerns methods for calculating the capital required for business activities and, when implemented, will place additional reporting obligations on credit institutions and investment companies as well as changing the framework for risk management. The so-called MIFID Directive that regulates investment services, that will take force in 2007, will also have an impact on quality and transparency of services. With regard to implementation of MIFID, the Financial Supervision Authority considers it necessary to ensure that investor interests are protected while ensuring that the investment services market continues to operate effectively. Implementation of both Basel 2 principles and MIFID will notably increase the administrative burden on the providers of investment services and direct financial cost of operating on the securities market.

The implementation of these two principles in Estonian law will be one of the most significant changes in the regulation of the Estonian banking sector and, what’s more important, in terms of supervision principles. In essence, it is a simple regulation or agreement on the basis of which the credit institutions that are able to better and more effectively define and manage their risks will be allowed to involve less equity.
In comparison with the existing regulation, the range of risks has increased mainly with introduction of operational risk. For cross-border banking groups it is important that implementation of European directives by member states would be as harmonized as possible in order to avoid regulative arbitration, additional administrative burden on market players resulting from different interpretation of directives, etc. In this light, the Financial Supervision Authority considers it necessary to use pragmatic considerations when harmonizing directives by defining the minimum required amendments in the laws on credit institutions and the securities market, and by allowing technical issues to be regulated by relevant regulations and guidelines. This will create the necessary experience on the basis of which we will be able to supplement the regulations. An alternative option would be to lay the whole regulation down in law. This would create a situation where, in addition to the new drafts of the laws on credit institutions and securities markets, we would have to draw up a separate law on how to understand and interpret these laws. In their technical content, the laws would no longer be clear for the general public.

Dear Members of the Riigikogu! I hope that the respective draft amendments that I mentioned will arrive on your desks by the beginning of the autumn work session. I also hope that in your debates you will be able to form positions that would constructively support the rapid and in-depth implementation of Basel 2 principles in the Estonian legal environment.

It is also necessary to note that the wish to excessively criminalize economic fraud is reducing the capacity of both the Financial Supervision Authority and the state in general to award penalties for violation of legal norms in a competent, effective and proportional manner. A significant fine is clearly more effective than a long criminal procedure as a result of which the offender would receive a conditional criminal sentence and a fine of up to 50,000 kroons. At the same time illegal gain from the fraud may reach into the hundreds of millions of kroons. The penal code and other laws state that maximum fine for criminal crime at present is EEK 50,000 although there are plans to increase it to 500,000 kroons. The maximum fines for offences laid down in the penal code should be notably increased. Today, the Financial Supervision Authority has no powers or right to award fines according to the gravity of the violation. We cannot agree with the penal policy under which mishandling of insider information and market manipulation is penalized only under criminal proceedings.
In essence, crimes committed in the financial sector are misdemeanours that need to include the possibility for awarding high fines. There is no need to legislate that the only penalty for market manipulation is a criminal penalty. Banking, insurance and security brokerage are businesses based on public trust, the violation of which must be penalized swiftly and effectively, and in proportion with the committed crime. The main objective of the financial business is to earn income. Therefore, a logical penalty would be elimination of income. The handling of financial sector crime as an administrative offence, by a competent authority, would not only prevent, but also cut costs and benefit from the informational exchange of information.

According to the consumer survey commissioned by the Financial Supervision Authority, consumers have a dispersed overview of banking and insurance terms and customer rights. From the customers’ viewpoint some banking services are relatively expensive and the way in which they are informed about them is insufficient or even misleading. This is undoubtedly because the advertising of financial services only highlights selected features and creates illusionary and unjustified expectations. The measure of aggressiveness and morality of advertising of banking, fund, and insurance products, can develop only on the basis of the conscience of service providers and advertisers. Until now, the state has not established separate requirements for advertising financial services. Unfortunately, the Financial Supervision Authority has reached an understanding that self-regulation no longer works in such an aggressive competitive environment. In cooperation with the Ministry of Finance we plan to bring you proposals for more accurate and in-depth regulation of advertising and information activities.

In conclusion, the list of issues that I touched upon today in my report is not exhaustive and does not provide a full picture of the challenges and possible developments facing the financial sector. However, I would like to hope that the issues that I referred in my report would enable us to look positively into the future and make the right choices.

Thank you for listening, and I wish you courage and conviction in making your decisions!