Presentation of the 2007 report to the Riigikogu
Dear Chairman! Dear Members of the Riigikogu!
First of all, I would like to assure you that the Estonian financial system is currently functioning in a stable manner, without any systematic risks. At the same time, it is obvious that the unprecedented events in the world's capital markets are having an indirect and significant impact on the Estonian economy. The effect of the global financial crisis on the Estonian people manifests itself in both the decrease of the value of investments as well as in the inflation of debt finances. The risks in the financial sector, in general, have grown.
In my report today, I will provide a short overview of the events taking place on the world's capital markets, and the effect they are having on our economy, and I will provide a short overview on the present state of affairs in the Estonian financial sector. I will outline supervisory priorities, which form the basis of Financial Supervision Authority operation, and point out the regulatory changes which need your attention.
I. The Current Situation on the World's Capital Markets
Since last summer, the high liquidity and stability of capital markets have been replaced by instability, the rapid decrease of mutual trust among market participants and by a substantial increase in the cost of money. According to International Monetary Fund estimates, the losses realized by this August, due to the so-called US sub-prime or junk mortgage loans, which triggered the financial crisis, amounted to half a trillion dollars. Today, it is not yet possible to speak about the end of the crisis. However, as a result of the forceful intervention of the United States Government and the Federal Reserve, the market situation has started to stabilise. Bearn Sterns, Lehman Brothers, AIG, Northern Rock, Fannie Mae and Freddy Mac are the financial institutions, the strength of which was not questioned at the beginning of summer 2007, neither in capital markets nor by their managers.
Under the influence of the crisis, these financial institutions have either gone bankrupt, or been nationalized, or have been merged, under the support of government guarantees, with other more viable enterprises. The crisis on the capital markets has forced a critical review of the entire framework of stability of the financial system, and a reassessment of the recent paradigm of state interference, so far mainly in the context of the United States of America. The global nature and effects of the markets also forces us to critically assess our own ability to handle market turbulences.
Instability on financial markets progressively influences the world economy, causing a significant slowdown in the economic growth of advanced markets. This has caused the situation, where the economic growth last year in Denmark - one of our Scandinavian neighbours -was negative for two successive quarters and according to the official definition, there is a reason to speak about economic depression. Though there is no reason to speak about the economies of other neighbouring countries in such dark tones, the cooling off period in the general economic climate is not helping to halt the decline stage of the economic cycle in Estonia. Tensions on the capital markets, low mutual trust of banks and a reassessment of risks taken, partly on rational and partly on emotional grounds, directly affects loan offers. This naturally does not help to improve our economic climate.
II Overview on Estonian Financial Sector
Dear members of the Riigikogu! When speaking about the present state of affairs in the Estonian financial sector, I would like to call your attention to the following developments.
The period of rapid growth of bank loan portfolios ended in the summer of 2007. The increase in joint loan portfolios of up to 60% accomplished by the banks for last year has been replaced, on the basis of current year, with an increase of approximately 15%. We presume that loan growth in the near future will slow down even more. The main factor causing the growth of loan portfolios to slow down is the more conservative borrowing and lending policy of the two largest banks - Swedbank and SEB, when compared to earlier trends. This has meant some redistribution in the markets, in favour of banks with a smaller market share.
This year, the Estonian banking sector has been characterized by the relatively rapid growth of overdue loans. At the end of August, the residue of loans overdue by more than 90 days constituted approximately 1.4% of the joint loan portfolio. The corresponding level is quite high for small banks and for lesser foreign branches. Delays in payments have become more frequent in all client groups, meaning that we are dealing with the consequences of a general reversal in the economic cycle, not with single problematic clients. The level of interests on arrears can be currently considered being in the central stage of the decline cycle. According to banks' own estimates, next year an increase in interests on arrears and credit loss are expected to continue. At the same time, the banks capital buffers are sufficient, and banks are able to form the provisions for covering up to four times bigger loans that accompany overdue loans, without the need for supplementary capital. According to the Swedish Financial Supervision Authority estimations published last Friday, Swedbank and SEB in the Baltic States can - according to so-called hypothetical worst case scenario - on the group level suffer credit losses of up to 10% of the loan portfolio, given that credit losses coming from the rest of the loans reach up to 0.5%, without any need for additional capitalization by these banks. Thus, the Swedish parent banks have very strong capital buffers, which should enhance the sense of security felt towards Estonian subsidiary banks. Furthermore, the banks started off the year with an extremely high level of profitably, thereby offering an additional buffer to help alleviate the effects of discounting. The profitability of banks has decreased less than expected, which happened only due to received special incomes. The increase in banks' factor costs have had an additional negative influence on profitability, but it is substantially more limited than credit losses.
When speaking about the insurance sector, it must be stressed, that the main risks of life insurance, in comparison with other sectors, substantially derive from external environmental factors, since the investment strategies of insurance undertakings are directed outside of Estonia.
The general decline of securities markets is clearly reflected in the total net gain of associations' economic activities. At the same time, the sector as a whole is well capitalized and the Financial Supervision Authority does not question the sustainability of these associations. Developments in the life insurance sector, on the positive side, are characterized by the formation of European companies. In connection with this, the headquarters and management of many of the Baltic State's insurance undertakings are brought to Tallinn.
Non-life insurance payments have grown slower than last year. At the same time, the growth slowdown has not had an impact on the sector's profitability, and the profit indicators in the first half of the year were higher than a year ago. Profitability improved due to the smaller proportion of loss events and the increase in insurance rates at the beginning of the year. The non-life insurance sector is currently least affected by domestic and foreign trade developments.
As a consequence of negative developments on the securities markets, the market value of many Estonian investment funds and pension funds is smaller than a year ago. The profitability of management companies has also decreased, although fund management is still one of the most profitable areas of activity in the financial sector.
III Overview on Supervisory Priorities of Financial Supervision Authority
The priorities for maintaining the stability of the financial sector, for the Financial Supervision Authority, are risk-based capital supervision and cross-border cooperation; the reinforcement of the framework of national and cross-border crisis management and promotion of consumer education.
First of all, we pay increasingly more attention on analyzing banks' credit and liquidity risks. In addition to supplementary analysis, we paid more attention to the conducting of different strength analyses, that is, to stress testing in both the credit institutions and insurance undertakings. The results of stress tests, as well as the supervisory analysis on our most important market participants, point to the fact that the current level of provisions made to cover possible loan losses of subjects' capital buffers and banks' loan portfolios enables relatively confidently to face the future. Hereby, I would like to accentuate the work done by large banks in introducing the adequacy framework of risk sensitive capital. The role of the Financial Supervision Authority is to estimate their work, which has turned our attention on the quality of their risk management. For this purpose we are conducting thorough procedures and we have conducted substantially more on-site checks.
Secondly, the integration of our financial markets with Scandinavian markets as well as the cross-border entity of global financial crisis, forces us to intensely cooperate with both the Swedish Financial Supervision Authority and our colleagues from the Baltic States. In the case of banks, for example, the liquidity risk may appear as being not central to the Estonian market, but rather as crossing borders. During the last two years, cooperation with our neighbours has shifted from ad hoc cooperation projects towards so-called supervisory boards of cooperation, which cover, by way of multilateral arrangements, the whole spectrum of supervisory work. The work of those boards can be planned in the long run and it is based on common risk estimations. The abilities and rapid development of the Financial Supervision Authority received good assessments in spring, in the framework of International Monetary Fund audit on Estonian financial stability, in both the conducting of risk-based supervision and in international cooperation, and by Moneyval's audit on efficiency of impeding money laundering.
The third important priority for the Financial Supervision Authority is the reinforcement of the crisis management framework. We have made a deal with the Bank of Estonia and the Ministry of Finance, which stipulates the exact role of every institution and the cooperation mechanisms for prevention, and, if necessary, also for management of the crisis situations. In the framework of this cooperation agreement we are currently dealing with the implementation of different policy papers and procedures, at the operating level. The Financial Supervision Authority, in cooperation with the Bank of Estonia and the Ministry of Finance, has also signed a pan-European memorandum on crisis management. Consequently, the Scandinavian countries and the Baltic States have started to prepare a common regional memorandum on crisis management, which includes the governments of all countries, central banks and supervisory institutions. According to the plan, the document should be concluded this year. As the recent events on the US market have shown, your potential role in crisis management cannot be underestimated. I count on your multifaceted operational cooperation, when necessary, believing, however, that this will to cooperate won't need to be tested in real life.
All these steps suggest some confidence about our maturity to face potential crises and their consequences together, and to guarantee the operational stability and sustainability of the Estonian financial sector.
Fourthly, the Financial Supervision Authority continually considers improvement of consumer awareness and financial literacy to be its main work directions. In 2007, we started publishing the joint review reports, the meaning of which stands first and foremost in the enhancement of market transparency. We supplement our consumer portal www.minuraha.ee daily, with the objective of bringing often complicated questions in the finance domain closer to people and to make them clearer. Additionally, we have translated this consumer education portal into Russian, in order to offer balanced and objective information in the mother tongue of those whose native language is not Estonian. The frequency of visits to the Minuraha website has doubled over the year, thereby indicating the existence of considerable interest among consumers. In addition to the contribution of the Financial Supervision Authority, the domain of consumer education should also receive financial support from the state. In order to reach out to the less insured and socially uninformed social classes, we are about to launch a respective project in cooperation with Ministry of Social Affairs. It is planned to promote social workers' training in the introduction of financial services ABC as well as in counselling SMS-loan debtors.
Finally, I would like to call your attention to the need for changes in legislation we consider to be of crucial importance.
First of all, for consumers it is important that their disputes with the bidders of financial services be concluded quickly and competently at minimal cost. This is important, first of all, for the reason that in such disputes the client is clearly the weaker party in both knowledge and resources. The settlement of disputes by way of judicial proceedings should not necessarily be optimal when being guided by the interests of consumers. We have frequently offered the help of the Financial Supervision Authority for creating a settlement mechanism for extra-judicial disputes in the field of financial services, regrettably enough, the state has so far not been interested in serious treatment of this subject.
Secondly, you are about to receive a copy of the changes to the legislation pertaining to the mandatory funded pension system. The Ministry of Finance has performed a comprehensive analytical work on the development of draft legislation, for that end involving in relevant and opened way all the market parties.
The Financial Supervision Authority has previously called attention to the fact that, in the mandatory pension funds system, serious market failures exist. During the years, the volume of pension funds and profitability of management companies has increased, but basically, the service prices have remained the same. The fund-related charges remain static, being sometimes even higher than those of optional pension funds offered by the same management company.
The Financial Supervision Authority, in its relevant analysis, has pointed out several reasons eliciting such a situation. The most significant of those to be mentioned are state provided constant money inflow into funds, strong bank channels of commerce, low awareness level of compulsory service consumers, the restricted rights of unit-holders, and complicated compensation structure. Some of them are quintessential and inevitable but others are convertible, when to invest a lot of energy in eliciting the change.
I am glad to realize, that in the draft legislation there are many proposals from the Financial Supervision Authority taken into account - the structure of pension funds has become more delimited, state plans to intervene gradually into the restriction of charge amounts, imposing on management companies lower marginal rates of charges. This way the state, conventionally purchasing from management companies the vast amount of services for administering finances of social security, intervenes increasingly into the forming of service prices.
Nevertheless, the draft legislation does not comply with the Financial Supervision Authority expectations in the question that concerns the need to broaden the rights of unit holders. More important than direct interference into the service prices is the need to broaden the rights of unit-holders. I disapprove of the restrictions set, according to which persons that have joined the second pension pillar can change the mandatory pension fund or can start making contributions to new funds only once a year. Such a restriction does not let the unit-holders to properly and duly intervene in the development of demand and public offer, failing to allow real competition to evolve. Our position is that those failures should be eliminated in the framework of legislation.
In conclusion, I would like to underline the regressive effect of the external environment, especially that of the financial crisis on the opportunity to reverse the Estonian economic cycle. Via the mediation of journalism, we have heard the minor tunes about "excessive" integration of Estonian financing sector with the financing sector of the Nordic Countries, and about our apparently small influence in the supervisory perspective. Therefore, I would like to stress, that in the environment of complex financial crisis, the Swedish parent banks, however, operate rather as stabilizers of the Estonian financial system than as the primary source of our problems. To be honest, our banks would be more vulnerable to the risks of world financial market than the banks forming part of the Scandinavian Bank Group. At the same time, in constantly changing markets, it is impossible to offer indulgence to Swedish banks. When the problems arise, it is not solely our problem, but a problem shared with the Swedish government, the central bank, and also with the Financial Supervision Authority. I can assure you that the Financial Supervision Authority has done everything possible to guarantee the stability and reliability of the Estonian financial sector in a rapidly changing environment. Both in respect of what we can do here in Estonia, but also at the cross-border level, in close cooperation with our colleagues.
Thank You for listening!