Annual Report 1994. Banking Supervision

The trends of 1993, especially the more realistic risk assessments of banks and increasingly conservative credit policy, promised a further internal and external improvement of the Estonian banking system in 1994. In general terms, this was true. However, looking back, it is evident that the stability of the banking sector was somewhat overestimated at the end of last year. It was premature to speak about the probability of banking crises being smaller. The moratorium imposed in August 1994 on the largest commercial bank as of the end of 1993 - Eesti Sotsiaalpank (Estonian Social Bank) - offered a warning of the possible consequences of a bank's orientation to one single type of customer (Government in this instance), or in other words, the consequences of excess concentration of the bank's liabilities. The risks are multiplied in case the management and shareholders act carelessly and only keep the near future in mind. The moratorium imposed on the Social Bank and the internal changes anticipated in the banking system during the first half of 1995 allow us to say that 1994 was a year of quests and increasing consciousness of one's market possibilities for the banks.

THE CRISIS OF EESTI SOTSIAALPANK AND EESTI TÖÖSTUSE ARENGU PANK

The crisis of Eesti Sotsiaalpank (ESP) and Eesti Tööstuse Arengu Pank (ETAP) had a significant influence on the development of the Estonian banking system in 1994. The uncertainties continuing practically through the whole year created problems for bank customers and had a negative influence on the development of the interbank market.

The main reason for the problems of ESP can be found in the unfortunate choice of strategy by its owners that was reflected in weak management policies. That, in turn, resulted in low quality of the bank's assets and vulnerability to internal risks. The risks were aggravated by an unwarranted high concentration of the bank's sources of financing (that was not taken into account in asset management). The problems can be followed on the structure of the balance sheet of ESP and its changes: as of 1 January 1994 the share of Government deposits of the balance sheet total was 45%, it was 55,9% in February. Emergence of a crisis situation can be traced back to February 15 when a very rapid withdrawal of government budget funds from the bank started after a Government decree to that purpose.

The difficulties of ETAP also arose from choosing an aggressive strategy of expansive development inconsistent with the bank's real possibilities.

Dealing with the crisis reached its final stages by 9 March 1995 when the third phase of the restructuring programme was launched. That meant liquidation of the parts of the bank's branch network that had been kept so far. ESP will be reorganised into a bank for collecting problem loans.

Before that various measures traditionally used by central banks and well known in international banking practice had been taken. There had been directives by the banking supervisors on reinvesting the bank's profits, limitations set on the extention of credits by the bank; the bank had been restructured and its management had been changed; there had been a moratorium and assistance had been granted to keep the bank liquid and solvent.

The following objectives were kept in mind when dealing with the crisis:

• avoiding a possible systemic crisis in the banking sector,
• protecting the funds of depositors in a situation where Estonia lacks a deposit insurance scheme,
• rising the the bank owners' consciousness of investment risk and the responsibility of the investor.

All in all, the way the crisis was dealt with was relatively effective. But the success could have been even greater if there had been more effective cooperation between the Government and Eesti Pank.

ORGANISATION OF BANKING SUPERVISION

A relatively rapid growth of banks and the expansion of their activities into practically all areas of modern banking necessitated an increasing emphasis on systematic supervision capable of anticipating possible risks. To this end, methodical as well as organisational changes were carried out in the activities of supervision.

Stricter requirements

In assessing a bank's situation, complex criteria taking into account several aspects of its activities were adopted, following the example of countries with a developed banking sector. At the end of 1994 new methods were adopted in supervising the credit institutions. That means a complex assessment of the quality of the bank's assets, stability and strengh of its capital base, profitability, management of assets and liabilities and the effectiveness of administration (including internal supervision). Adopting an integrated approach makes comparisons between different credit institutions significantly more reliable and leads to more accurate assessment of their capability to react in an adequate way to changes in the legal and economic environment.

Assessments of the quality of assets are based on the quality of the loan portfolio of the credit institution, the structure of its investments and the quality of off-balance-sheet items. The concentration of assets by sectors of industry as well as the existence of reserves adequate for the needs of the individual bank are watched. The reserves must be sufficient to cover possible losses without endangering the effects of the bank's creditors. Special attention is paid to the dangers inherent in concentration of loans to parties connected to each other.

It is most important that the supervisors keep track of the way the loan and investment policies of a credit institution are interrelated with the quality of its assets.

Analysing the earnings of a credit institution helps determine its capability for absorbing losses without weakening its capital base and its ability to maintain a sufficient level of profit to attract additional capital. On the other hand, that is also one of the criteria used for assessing the professionalism of the management in optimising risks and profits.

The comprehensiveness of internal procedures and the existence of effective risk management and monitoring systems are included in the supervisors' analysis of a bank's management. The availability of regular and systematic information backup for management decisions is also checked as well as the effectiveness of the follow-up control by internal supervision.

It is important that methods adopted in 1994 make it possible to enhance the role of anticipatory inspection in banking supervision and diminish the need for the more labour-consuming on-site inspections. Preventive control was strengthened on the stages of issuing licences to credit institutions and approving the members of management as well. Besides that, requirements for banks' on-site inspections have been made stricter. These activities have become more systematic and better planned.

Organisational changes

The changed priorities in supervisory activities necessitated some organisational changes. In fact, the changes were initiated in 1993 already when the Bank Supervisory Committee was founded as an advisory body of Eesti Pank. The Committee coordinates and directs the activities of separate units engaged in supervision, and discusses strategies.

In November, some changes were made in the way work was organised in the Banking Supervision Department, and working groups headed by experienced inspectors were formed. Certain banks were assigned to each working group and thus, the principles of collective and systematic on-site inspection were strengthened. In order to widen the organisational structure of the banking supervision, the feasibility of tightening co-operation with the internal and external auditors of banks is being considered. To this end, some legal and ethical problems concerning bank confidentiality have to be solved, first of all.

LEGISLATION AND NORMS

During the whole post monetary reform period underdeveloped legislative environment has been one of the most serious problems faced by Estonian banking supervisors. Up to the end of 1994 Estonia lacked both a modern accounting law and business legislation covering several fundamental issues. (The Accounting Law entered into force on 1 January 1995; the Business Law was signed by the President of the Republic of Estonia on 8 March 1995). The necessary regulatory minimum for supervising investment funds was created by directives of the Ministry of Finance only in the second half of 1994.

The slower development of the general business legislation compared to the banking regulations set limits to the legal authority of the banking supervisers in demanding that the banks follow modern risk management principles. Accounting principles inconsistent with modern requirements created additional difficulties in objective assessment of the data reported by the banks.

Law on Credit Institutions

An important step was the passage of the Law on Credit Institutions by the Riigikogu in December 1994 and its entry into force in January 1995.

The law was compiled on the basis of the legal acts regulating banking in the member countries of the European Union, always taking into account the development level of Estonian banking. The more important articles of the Law deal with the foundation, reorganisation and termination of a credit institution, its management, share capital, norms established for ensuring the reliability of credit institutions and safeguarding the interests of their customers, accounting and reporting, money laundering, banking supervision regulations and possible sanctions. The new credit institutions' law enhances the legal basis of practically all areas of the banking supervision.

Improving the banking regulations

The normative framework regulating the activities of credit institutions has been constantly improved through practical steps.

At the beginning of January, adjustments were made to the procedure of writing off non-performing loans, according to which the loans overdue for 150 days have to be written off on account of the loan risk reserve. In case the reserves are not adequate for writing off such loans, the appropriate amount has to be accounted for under revaluation losses. In principle, this was the first step obligating the banks to revalue their assets. Without underestimating the above decision and keeping in mind its positive influence on the more realistic valuation of the banks' assets, it still has to be admitted that it did not solve all the problems. A more thorough solution will be provided by the full-scale implementation of the Law on Credit Institutions and the Accounting Law in 1995.

The most important part of the changes made in the rules for calculating the net foreign currency position in February was the approval of an unlimited German mark position. This is a logical step, in conformance with the Eesti Pank monetary and exchange rate policy.

The changes made in the rules for calculation and usage of the required reserves in July 1994 gave the banks a possibility to take their Estonian kroon cash into account as part of the reserve. However, the share of Estonian kroon cash should not exceed 50% of the total reserve requirement. In essence, this meant that the amount of reserves held with Eesti Pank decreased and additional liquidity was inserted into the banking system in the form of approximately 160-170 million kroons.

In September 1994 the Board of Eesti Pank made a number of decisions dictated by the necessity to reinforce the financial positions of banks, to avoid excess risk concentration and to decrease the possibilities for conflict of interests occurring in a bank.

Deadlines for reaching required minimum levels of own funds were set up for banks that have already obtained licences: 50 million kroons by 1 January 1996; 60 million kroons by 1 January 1997; 75 million kroons by 1 January 1998. The idea of this decision was to reinforce the banks' capital base and to promote internal consolidation within the system which, in turn, makes the banks better able to fulfil the role of financial intermediaries.

The maximum allowed ratio of commitments of one client or a group of connected clients to the credit institution's own funds was lowered from 50% to 25%. Additional ratios were established for monitoring the "internal" interest groups: the commitments of credit institution's subsidiaries, parent enterprise and other subsidiaries of the parent enterprise should not exceed 20% of the credit institution's own funds and the total commitments of management members, other employees, shareholders representing 5% or more of paid-in capital or votes as well as commitments of entities connected to them should not exceed 20% of the credit institution's own funds. The banks have to comply with the above norms by 1 January 1996 as regards the already existing commitments.

In addition to the changes mentioned above, the Law on Credit Institutions brought along the need for further changes in the prudential ratios and reports connected with them. Much-needed help was rendered in this area by the IMF and the Working Group on Accounting of the Republic of Estonia. The new prudential ratios as well as the accounting and reporting regulations that nearly fully correspond to the respective directives of the European Union and international accounting standards (IAS) are going to be implemented in full in the first half of 1995; the consolidated supervision during 1995. During 1994 practically all the prudential ratios were changed or adjusted.

In order to better control the adaption process, the banking supervision initiated joint efforts with the banks at the end of 1994 in order to solve the problems connected with implementing the new requirements.

Institutional subordination of the banking supervision

At the end of 1994 the question of subordination of the banking supervision came to the forfront. A Banking Supervision Department subordinated to Eesti Pank was criticised for vested interests as shares in commercial banks were held by Eesti Pank (in Savings Bank, Investment Bank, Social Bank). There were fears of possible conflict of interests arising from that. Admittedly, a certain theoretical irregularity exists here, for Eesti Pank performs the roles of both the supervisor and the supervisee. However, such an approach is highly simplistic and also erroneous in the present circumstances. There are two reasons: the central bank holds shares of commercial banks due to extraordinary circumstances (monetary reform, banking crisis) and Eesti Pank has clearly declared its wish to liquidate its shareholdings, which is not possible within a short period of time. Making such an important step too rapidly and without thorough contemplation would inevitably negatively influence the institutions which have caused the questions to be raised and, through them, the financial system and the trustworthyness of the state as a whole. Thus, we cannot speak of the economic interests of Eesti Pank in maintaining the above shares and, hence, of a potential conflict of interests. The activities of Eesti Pank so far and its clearly pronounced wish to give up, step-by-step, all shares in credit institutions can rather be considered an integral part of fulfilling the supervision function conferred upon it by the constitution. During 1994 the participation of Eesti Pank in Eesti Investeerimispank (Estonian Investment Bank) decreased from 66 2/3% to 40%. Negotiations held with the EBRD on further development of Hoiupank (Savings Bank) are nearing finish.

In addition, effective supervision requires the economic and political independence of the authority performing it. Taking into account the present-day Estonian legislation, one can in all truth claim that of the public institutions, the above two conditions are best fulfilled by Eesti Pank.

The experience of other countries confirms that the institutional subordination of the banking supervision that is in force in Estonia today is well-grounded. Empirical data[1] show that nearly 3/4 of the world's countries have banking supervision performed by the central bank. Of countries where banking supervision is subordinated to either the Ministry of Finance or some other public institution: a) 1/4 do not have a central bank at all, and b) in half of the remaining countries, the role played by the central bank in practical supervision is rather noteworthy. The role of the central bank in banking supervision is not worth mentioning or is totally missing in only 10 per cent of the observed countries.

INTERNATIONAL COOPERATION IN BANKING SUPERVISION

The intergration of the Estonian banking with the world's financial markets, foreign banks coming into Estonian banking market and the growth of the share of foreign transactions in local banks demands that cooperation in banking supervision be carried out on an international level. The Banking Supervision Department has working contacts with the Basle Banking Supervision Committee as well as with the Banking Supervision Contact Group of the Central and East-European Countries founded within the framework of the former. In 1994 Estonia participated in the annual meeting of the above contact group for the first time. Estonia was also represented at the 8th International Banking Supervision Conference.

On the level of regional co-operation, contacts with the Latvian and Lithuanian respective authorities were tightened. The banking supervision working group of the Baltic Seminar that was held in Tallinn was an important event in this context. Granting licences to Kansallis-Osake-Pankki and Suomen Yhdyspankki for opening branch offices in Tallinn created a basis for preparing a cooperation agreement between Estonian and Finnish supervisory authorities. The signing of this document should take place in March 1995.

It can be presumed that the integration of Estonia with the world's financial markets will continue. Hence, the higher demands to be faced by the banking supervision and the banks are, in turn, a prerequisite for the development of Estonian financial system and its stability in the long run.

[1] By BIS Supervision Committee