Presentation by the chairman of the management board of the Financial Supervision Authority regarding the Financial Supervision Authority’s 2013 annual report
Distinguished President of the Riigikogu, honourable members of the Riigikogu!
In the following, I will give an overview of the key events, trends and achievements in 2013 in the Estonian financial market and financial supervision.
What is the financial market founded on? I believe it starts with and consists of three components: law, mathematics and trust.
Law is the behavioural framework and foundation on which the financial market is based. It is the mortar that binds the different parts and guarantees that they interoperate as required.
Mathematics imbues financial services with content, determines how risks are taken, transferred and priced.
Trust is the basis of a well-functioning financial market. Without trust in financial service providers, no voluntary distribution of financial resources could take place from those who have a surplus to those who need them the most at a given time and place. The same goes for redistribution of risks.
1. Law – i.e. the most important legislation passed in 2013 with regard to the financial market
The legal framework of the Estonian financial market is shaped largely at the European Union level. This is needed to deepen the single market for financial services. Considering the number and volume of new legal acts, I will focus on the most important topic in 2013 with regard to the regulation of the EU financial market – Banking Union.
Banking Union is the greatest change on the financial market since the euro was introduced and the greatest delegation of sovereignty in connection with the financial market. The first pillar of Banking Union is the Single Supervisory Mechanism (SSM). Under the mechanism, participating countries give the European Central Bank the right to decide on allowing banks to enter the market or revoke permission, and the right to perform oversight on whether the key risks assumed by the banks are covered by capital.
Whereas executive decision making on certain matters will move from Tallinn to Frankfurt next autumn, oversight will remain largely centred in Tallinn and is even expected to intensify. The European Union regulations that form the basis for the activities of SSM consist of a total of 187 articles on over 100 pages. This is merely a framework that is updated, including the supervision manual, which is some 1,000 pages thick. It is common to all supervisory institutions taking part in the SSM.
SSM doesn’t pertain to supervision of financial services, nor does it pertain to capital supervision of smaller banks or capital supervision conducted with regard to all other financial service providers.
Financial supervision operates on the basis of legislation and implements legislation. The Financial Supervision Authority and SSM will begin to implement the new regulation on bank capital requirements as well as the corresponding directive transposed into national legislation. The package of legal acts – the CRD IV – will be used to raise the level and quality of banks’ capital, with minimum requirements set forth for banks’ liquidity as well. The banks must establish additional buffers for the purpose of forestalling negative future developments and banks critical to the system must establish even more buffers to mitigate risks stemming from their size.
The CRD IV package is massive: 165 articles of the framework directive, plus the directly applicable European Union regulation with 521 articles. They contain over 100 provisions delegating authority to the European Banking Authority to develop compulsory, universal, directly applicable regulations for implementing the package. Fifty-seven of the implementing regulations were drafted in 2013 and 30 of them were published in the Official Journal of the European Union that same year.
The second pillar of Banking Union will harmonize the restructuring of banks. Restructuring of banks will start to be financed primarily by shareholders and certain types of creditors. This will not affect the deposits secured by the Guarantee Fund. The Single Resolution Fund comes into play only last, financed by contributions made by the banks themselves.
The Single Resolution Mechanism (SRM) will encompass at least the credit institutions that are under SSM supervision. As an institution, the SRM will be based at the Commission in Brussels and in essence it will decide on matters of restructuring of banks by competent institutions belonging to the SRM. The challenging and nuanced work of implementing the SRM will remain in place, in our case in Tallinn. Estonia will have to establish its own bank resolution institution, something that the Financial Supervision Authority is intensively working toward.
The basis of the SRM operations is a Single Rulebook on bank resolution. SRM rulebook will consist of 220 articles in legal acts taking up over 500 pages. Besides this, tens of provisions delegating authority to the European Banking Authority to develop compulsory regulations of direct and general application. Figuratively speaking, SSM is a coach who watches over and helps strengthen physical condition, SRM is an emergency medic who resuscitates or pronounces patients dead.
More and more fields in the financial services market will start to be regulated by the Commission. The law of the Estonian financial market stems 95% from directives, to which directly applicable EU legal acts can be added.
To sum up, two conclusions:
1) The mass and level of detail of the regulations allows for better protection of consumer interests, but on the other hand it is a burden on small and medium-sized enterprises, a category that encompasses all Estonian financial service providers as seen from the European perspective. It is in our interests to have less stringent regulations in place for SMEs as they are the engine of private enterprise and job creation.
2) In the field of regulating the financial market, it must be emphasized that the European Parliament plays a major role here. Most of the important financial market legal acts are adopted in co-decision-making procedure between Parliament and the Council of the European Union. It is in Europe’s interests and our own that Estonian MPs be active in Parliament.
2. Mathematics – i.e. the most important developments on Estonia's regulated financial market in 2013
In terms of asset volumes, Estonia’s regulated financial market is controlled by banking groups. Asset management and insurance are also important segments.
Twenty credit institutions operated on the Estonian market in 2013, of which eight had an Estonian activity licence. There were 12 branches, of which five were in liquidation. The branches are primarily under the supervision of the supervisory authority of their country of origin. The Financial Supervision Authority has functions here that focus mainly on the supervision of provision of service.
Credit institutions are mainly engaged in lending money and drawing deposits. The banks’ loan portfolio grew 2.5 percent compared to 2012. The contraction of loan portfolios that occurred in 2009 has slowed and marginal growth can again be seen starting in 2012.
Supervisory authorities were pleased to see the quality of the loan portfolio improve. The share of loans past 90 days overdue among companies dropped to 1.84 percent and, among natural persons, to 2.6 percent of the entire loan portfolio. For example, in 2010, it approached 10 percent in the business segment, while in the case of individuals, it was 5 percent.
The volume of accepted deposits grew, and the financing of banks became more balanced. The total volume of deposits in 2013 was 13.7 billion euros. The share of term deposits has grown each year, to make up approx. 50% of all deposits. Interest rates continue to be low. This is due, among other things, to the general interest climate, where the European Central Bank has gone so far as to establish a negative interest rate. A negative interest rate means that the bank has to be paid money for depositing funds. According to our rules, Estonian banks cannot charge negative interest rate on people's deposits.
In 2013, the banking market was characterized by a trend of smaller banks seeking new markets and opportunities for growth. The larger banks tended to be cautious in taking on risks. In the case of larger banks as well, we could see pressure for saving on costs, which occasionally manifested itself as a reputational and operational risk. Still, there is a clear limit to saving on costs, and this is the expense of enforcing the law. Banks are well capitalized, they have capital buffers in place to cover risks and fiduciary norms are met with room to spare.
Numerous subjects of the Financial Supervision Authority’s supervision operate on the asset management market, especially management companies. A total of 18 management companies have received an activity licence from Estonia. The management companies manage investment funds. The latter’s volumes have constantly been growing. By the end of 2013, funds had 2.5 billion euros in assets. The last time similar levels were attained was in late 2007. But the structure of the funds has changed since that time: in 2013, the second pillar funds managed 1.77 billion euros, while the figure in 2006 was 0.5 billion.
The yield on the investment funds was generally positive in 2013. Based on the numbers of market participants, it can be concluded that there is competition, but less of it in the case of second pillar funds. The latter are characterized by very thorough regulations, which on one hand ensure greater protection for unit holders – the future pensioners – but not, of course, from fluctuations of market prices. On the other hand, it means a barrier for entry to a given market – smaller competition. The issue of the optimum fees for second pillar funds will or should remain a topic for analysis as the fund volumes are showing more of a growing trend.
Insurance is above all associated for us with compulsory motor TPL insurance and the requirement that loan collateral be insured. There are 14 non-life insurance companies on the Estonian market and five life insurance companies. Six of these are branches. There are also 35 insurance brokerages that should be mentioned, plus six branches of foreign insurance brokers.
Premiums amassed from non-life and life insurance grew in comparison to 2012. Motor TPL and motor own damage insurance still made up the main share of non-life insurance products. A drop in the share of auto insurance could be seen, though. Loss and expense ratios have risen.
On the insurance market – in particular true of non-life insurance – 2013 saw the decline in profitability and the control of the market by foreign branches sowing tensions between Estonia insurers and insurance brokers. The latter have come up with consumer-friendly solutions that allow branches of foreign insurers to relatively easily enter the Estonian market, and allow consumers to buy insurance quite economically. This increases competition, which in turn has an effect on the economic results of Estonian insurers.
On the other hand, concentration can be seen on the insurance brokerage market, which in the long term may start working against the advantages of competition.
To sum up, three conclusions:
1) The keywords for Estonian banking in 2013 were “stability” and “stabilization”.
2) In asset management, it was a year of growth, led and propelled by the second pillar compulsory pension funds.
3) In the insurance sector, shrinking margins and increasing competition put strain on the market.
3. Confidence – the activities of national supervision authority in 2013
The Financial Supervision Authority is a joint institution of the Estonian state and central bank. The Financial Supervision Authority’s decisions are made collegially by at least a three-member management board.
Decisive and visible activity on the part of the Financial Supervision Authority is of vital importance for establishing and maintaining confidence. In 2013, we issued 62 administrative acts at 52 meetings, and gave out three activity licences. In comparison, this year three activity licence proceedings have already gone into motion, which does not necessarily mean that the activity licence will be granted. These are complex and time-consuming processes, where the applicant’s financial capability, the organization and individuals are assessed one by one. We don’t want to see low-quality financial service providers on the financial market.
Notionally, day-to-day supervisory activity falls into on-the-spot checks and analytical and investigative activities that are different in character from the former. In the case of the investigations and analysis, various proceedings should not necessarily be seen as separate; the activities are continuous, ongoing. For example, monitoring transactions and supply on the stock exchange, if we are speaking of preventing market abuses.
The organizations and activities of the financial service providers can be bigger, smaller, complicated or simple. The issues facing them often reveal their true nature on the spot. On-the-spot checks were conducted at 11 subjects of supervision in 2013. We have been putting more emphasis on the local work, as for market participants it is a clear sign of our presence. For instance, this year 22 on-the-spot checks are ongoing or in progress. Money laundering prevention and other aspects of provision of financial service are certainly under scrutiny for us.
The central proceedings of banking supervision concern the passing of a judgment by the supervisory institution on the taking of risks, management, capitalization and organization – in other words, the SREP, or Supervisory Review and Evaluation Process. This goes on practically year-round, requires going through very voluminous documentation, intense communication with employees on various levels of banks etc. In the framework of SREP, we evaluated all credit institution in 2013, and pinpointed 159 million euros in additional capital for covering risks.
Sometimes there are differences of opinion with regard to financial supervision and the final truth and justice has to be settled in court. The Financial Supervision Authority has proceedings ongoing in administrative court, part of which have to do with fundamental issues of financial supervision: whether and to what extent a person has the right to learn about financial supervision proceedings implemented with regard to a third party, does that party have the right to file action against administrative acts issued with regard to the third person, does financial supervision act in the public or private interests?
As a general trend, it should be noted that more and more complicated issues make it to the courts from the financial sector. The Supreme Court has handed down yet another ruling with regard to loan interest rates that it considers unethical. A market abuse criminal case was decided, with sizeable fines meted out. The court of the first instance made a decision in a case concerning investment fraud and sentence included real prison time (2014).
From the point of view of financial supervision, a positive area with regard to implementation of penal law is that heavy fines and/or real prison time are becoming the new normal. These are topics I have advocated for over 10 years and they clearly increase liability of those who disregard the rules in the financial sector. After all, the financial market operates with a significant amount of other people’s money. Violations result in losses being incurred to other people’s assets and worst of all, trust in the honesty and transparency of the financial market is abused. The course toward the new normal is supported by more recent European Union legal acts.
The Financial Supervision Authority is one of the state institutions that is the most integrated with the European Union. Pursuant to European Union legal acts, we along with financial supervision authorities from other member states vote in the highest executive bodies of the European Banking Authority, the European Securities and Markets Authority and the European Insurance and Occupational Pensions Authority. These European Union institutions draft directly applicable legal acts for implementing directives and regulations. These institutions, headquartered in London, Paris and Frankfurt, take care of the uniform and correct application of the Single Rulebook and resolve disagreements that rise between supervisory authorities. This work largely takes place through and with the support of the member states’ supervisory institutions. The Financial Supervision Authority is a part of SSM. As one among many, we decide in Frankfurt on matters that are in the remit of the SSM on the banking market. As part of SSM, our staff makes a contribution to everyday banking supervision in Tallinn. Depending on the decisions made in the future, the Financial Supervision Authority may start taking part in the work of the SRM as a resolution authority.
1) In 2013, the Financial Supervision Authority fulfilled its tasks imposed on it by law. We will put more of an emphasis on certain aspects in the future, such as on the spot work, as we want a little more visibility for the financial market;
2) A development welcomed by the Financial Supervision Authority is the “reawakening” of penal law, as it increases the liability of service providers and trust in the market;
3) The integration of the Financial Supervision Authority with the supervisory system of the European Union is deepening and encompassing new fields, as the European Commission wants to establish a functioning single financial market.
Distinguished members of the Riigikogu!
A central function of the Financial Supervision Authority is to maintain financial stability and to ensure the honest and transparent functioning of the financial markets. The 2013 yearbook of the Financial Supervision Authority now available to you describes how the authority discharged these central functions in the 2013 reporting year, in the 11th year of operation of the Financial Supervision Authority.
Thank you for your attention!