Most important developments in Estonian financial sector in 2017
The Estonian financial sector is stable and market participants are well capitalised and with adequate financial buffers, states the 2017 financial sector overview published by the Financial Supervision Authority. However, the risks threatening the sector cannot be ignored.
Technological risks in banking have increased
The liquidity and capitalisation of the Estonian banking sector have remained strong. Approximately a quarter of the assets of credit institutions are liquid and the liquidity buffer is larger than required. Estonian banks have adequate funds for covering risks and their capitalisation indicators are among the strongest in Europe.
Should the risks related to the Swedish real estate sector materialise, the impact of this may carry over to the Estonian banking market as well. However, the carryover of risks across the border should certainly be reduced by the adequate capital and liquidity buffers of Estonian credit institutions.
The loan growth of banks has been relatively fast, which is supported by the favourable economic environment. The loan quality may start deteriorating as the economic growth slows down, which is why it’s important that credit institution stick with the current conservative approach to lending and maintain adequate capital buffers.
Compliance risk and technological risks have also increased in relation to the large number of new legal provisions and the digitalisation of banking. The risks existing in the area of money laundering and terrorist financing prevention and compliance with international financial sanctions are decreasing rather than increasing.
Number of fund management companies has increased
The number of fund management companies operating in Estonia increased and their number as at the end of 2017 was 16. A fund management company that only started offering pension funds that invest passively in other index funds entered the market. This increased the price competition of fund management companies.
The Investment Funds Act that entered into force early in the year required fund management companies to inform the Financial Supervision Authority about the activities they were going to continue with. This led to a clearer division of the fund management sector on the basis of the permissibility of public offerings of the managed funds. The new act allows fund management companies to manage non-public funds on the basis of the authorisation of a small fund management company and four fund management companies chose the authorisation of a small fund management company.
The volume of the assets managed by fund management companies increased by 12% over the year and amounted to 6.1 billion euros. The profit of the sector increased to 19.6 million euros over the year.
Liquid assets form a large share of the aggregated balance sheet of fund management companies. The biggest risk, market risk, is associated with investments made in the companies’ own funds. The second significant risk is operational risk and the key role in the management of this risk is performed by internal control mechanisms.
New capital regulation demands additional capability from insurance companies
Three authorised life insurance companies and foreign branches, and seven non-life insurance companies and six foreign branches operated in Estonia in the end of 2017. The life insurance and non-life insurance sectors are both well capitalised and all insurance undertakings complied with the capital requirement.
Compliance with the new, complex and risk-sensitive capital regulation requires additional capability from the organisations of insurance undertakings. Compliance with the new provisions is problematic at times.
40% of the insurance premiums of Estonian insurance undertakings were mediated by insurance brokers. Considering the importance of insurance brokers in the marketing of insurance and the fact that Estonian law permits insurance undertakings to pay the brokerage commission on behalf of the customer, it is important to prevent conflicts of interest between the customer, and the insurance undertaking and broker. The activity of an insurance broker is primarily related to the risk concerning the nature of their representative relationship: an insurance broker has a duty of loyalty to the policyholder, not the insurance undertaking.
Several payment institutions are changing their business models
The overall capitalisation of the payment institutions operating in Estonia is good. The volume of payments made via payment institutions in 2017 was 386 million euros.
The sales revenue of payment institutions increased times and a half over the year, but only less than one-fifth of the total sales revenue of the sector comes from the provision of payment services. The biggest income type of payment institutions is the interest income related to lending.
Many payment institutions are about to change their business models due to the insufficient volume and low profitability of payments. New possible services are analysed and the provision of new services is considered in the course of this.
Non-compliance with responsible lending requirements by creditors is a risk
The balance of the loan portfolio of creditors increased by 15% over the year, amounting to 851 million euros. The majority, i.e. 79% of the loan portfolio of creditors belongs to creditors operating on the basis of exemption authorisations, i.e. subsidiaries of credit institutions. Their consumer credit balance is still considerably larger than that of the creditors operating in Estonia on the basis of an authorisation.
The greatest risk for creditors' activity is the capability of companies to comply with the requirements of responsible lending, especially in assessing the solvency of their customers, and the suitability of their managers in this.
The quality of the loan portfolio of the creditors operating on the basis of an authorisation is a risk on the consumer credit market. Thus, continuing efficient supervision over creditors and credit intermediaries is a significant risk management tool.
Profitability of investment firms remains high
Investment firms were adequately capitalised at the end of the year and similar to 2016, their profitability remained relatively high. The total profit earned amounted to 6.1 million euros and the return on equity reached to 15%.
The main risks of investment firms arise from the business model built on taking higher market risk. Due to high leverage, a small shock on the financial markets may generate remarkable losses in a short time, which is why active risk management is very important.
The purpose of the high additional capital requirements established by the Financial Supervision Authority for investment firms is to guarantee that investment firms maintain adequate capital for covering risks.
The risk of compliance with regulations must also be considered a risk factor. Providing services to non-residents may also expose investment firms to money laundering risks.
* The financial sector overview is a part of the yearbook of the Financial Supervision Authority. Yearbook 2017 can be found here.