The evolution of commercial banking in Estonia.

Krishnan, V. Sivarama ; Listra, Enn ; Shetty, Shekar 等

INTRODUCTION

Estonia regained its independence and emerged from the shackles of the Soviet rule in 1991. Estonia was an independent country from 1918 to 1941 and was under Soviet rule from 1941 to 1991. The smallest of the former Soviet Union Republics, it developed into a thriving free market economy in the remarkably short time since then. An important part of this economic revolution is the story of the evolution of the Estonian commercial banking industry that has developed into one of the most modern and competitive in the region. The first commercial bank in Estonia was actually licensed in 1988 and the early period was one of turbulence and financial crises. Despite this, the banking industry evolved and emerged as healthy, highly competitive institutions providing a range of consumer and commercial banking services on par with the best in the industrialized world. While the overall market size is small, the banks have modernized to a level seen in few countries and offer totally paperless banking.

The primary factor behind this healthy evolution of the banks was the unique regulatory approach pursued by the central bank, Bank of Estonia (BOE), which served as the main regulatory authority during the first decade of the newly independent Estonia. The early years saw easy entry with very low share capital requirements and very limited regulations. The approach included some missteps, hand-holding, and over time a sound free market approach where errant banks with unsound policies and balance sheets were allowed to fail. BOE was able to assert its leadership after the currency reform and reintroduction of the kroon backed by a currency board arrangement. BOE appeared to quickly find its regulatory bearings and was able to guide the Estonian banking industry to develop into a healthy and efficient one. This paper provides a historic and critical overview of the industry's evolution and attempts to draw key lessons from the Estonian experience. The paper is organized as follows. The first section gives a summary history of the Estonian banking industry. The following section describes the regulatory and legal framework of the period. The next section summarizes the current structure and features of the Estonian banking industry. The last section attempts to draw key lessons offered by the Estonian experience and offers concluding comments.

A SUMMARY HISTORY OF ESTONIAN BANKING

Zirnask (2002) provides a very colorful and insightful view of the history of commercial banking in Estonia. Vensel (2001) chronicles the developments in the industry with a more critical and academic view and reviews the performance of the industry players using financial ratio analysis. Sorg (2003) and Sorg and Tuusis (2008) describe the reform and reconstruction of banking system in Estonia that brought down the number of commercial banks from more than 50 when the country became independent from USSR in 1991 to mere 7 in 2000. Probably by a lucky coincidence or perhaps because of its small size and distance from Moscow, Estonia happened to be in the forefront of the early and hesitant attempts at economic reform in the Soviet Union. These reforms began in 1987 with decontrol of many state enterprises as well as permission given to run co-operatives in some sectors of the economy. The banking system was reorganized with the creation of five specialized sector banks separate from the Soviet central bank (Gosbank). This was the beginning of the two-tier banking system--a central bank to manage the monetary policy aspects and commercial banks to handle business and individual credits and deposits. The very first licenses for independent commercial banks were issued in September, 1988 and some Estonians proudly cite that the first commercial bank to be licensed in the Soviet Union was an Estonian Bank--Tartu Commercial Bank (TCB). This sure was coincidence. The same day another bank was licensed in Latvia and the license number for TCB happened to be 1 and for the Latvian bank it was 2. Before the end of the year more than 10 different banks were licensed in the different republics of the Union. The shareholders of TCB were Estonian public sector enterprises. TCB had a difficult time at first attracting customers, as the specialized state-owned banks were reluctant to let go of their customers (Jumpponnen et al, 2004)).

In December 1989, the Estonian Republic passed the Estonian Banking Act and reestablished the Bank of Estonia (BOE). These were rather symbolic acts as Estonia still remained a part of the Soviet Union and used the ruble as its currency. During 1990, BOE assumed control or ownership of the Estonian branches and divisions of the specialized public sector banks. These banks remained key players in the banking industry for several years and were at the center of the financial crisis later. In retrospect it could be viewed that these early acts gave the Estonian banking industry a head start and prepared them for ensuing economic and political freedom of Estonia, which came on August 20, 1991. This was soon followed by BOE establishing its independence from the Soviet central bank.

The early years of economic reforms saw the Estonian economy experience both very high inflation and a steep fall in GDP. Annual inflation ranged from 17 percent in 1989 to 954 percent in 1992. The cumulative decline in GDP between 1989 and 1992 was over 30 percent. The high inflation made it very easy for potential bankers to meet the share capital requirements of 5 million rubles (equivalent to 0.5 million kroons when the kroon was reintroduced) needed to get a banking license. Entry barriers were practically non-existent and there was a boom in new banking licenses issued. The number of banks nearly doubled during 1992 though many of these banks were very small and had very few shareholders (Jumpponnen, et al, 2004)). The high inflation and reallocation of public assets gave venturesome businessmen and banks willing to finance them opportunities for some very easy profits. Currency exchange was also an extremely profitable business. The economy was transitioning between completely controlled or administered prices and free-market prices for a number of essential commodities and industrial raw materials. It was fairly easy to arbitrage between the administered prices and the market prices, if one knew the right persons like the people running the state-run enterprises that produced the commodities and products that they were required to sell for controlled prices. Under these circumstances, banks found it fairly easy to make money through very short-term loans financing these transactions without having to engage in serious banking and lending operations. Zirnask (2002, p.46) provides examples. Many banks did not realize that these conditions were to change very drastically soon.

The foundation for lasting economic reforms for the new nation was laid in June 1992 with the re-launching of the Estonian kroon. The kroon was the currency of Estonia between 1918 and 1941. This could be considered the beginning of the economic and financial sector reforms for the country. The currency was launched at a fixed-exchange rate of 8 kroons to 1 German Mark and was backed by a currency board arrangement. Even though inflation continued at a high rate for the first couple of years after the launch of national currency, BOE's willingness to stick to the fixed exchange rate and the currency board arrangement boosted the credibility of BOE and the kroon. Currency exchange market became less profitable and banks, which did not develop skills of credit management, found themselves victims of the changed market. A number of these banks failed and the BOE let them. There was no deposit insurance and many depositors paid a heavy price.

The period 1992 to 1994 were watershed years--some cite these as the crisis years--for Estonian banking industry as the industry faced a wrenching shakeout. In October 1992, BOE made the first of its many moves to strengthen the banking industry by raising the equity capital requirement from 0.5 million kroons to 6 million kroons. A month later BOE declared moratorium on three leading banks, which had a combined market share of over 50 percent of banking assets, and were facing serious liquidity and asset quality problems. The moratorium involved suspension of all banking activities and take-over of effective control by a BOE appointed administrator. One of the three banks was TCB, perhaps the best known bank at that time. BOE ultimately forced the liquidation of TCB and merger of the other two banks. Another five banks lost their licenses in early 1993 and eleven other banks were combined to form a new bank (Estonian Union Bank). The number of banks came down from 41 at the beginning of 1992 to 24 in early 1993. The first banking crisis of Estonia would soon be over and the economy was about to take a turn for the better.

The Estonian parliament passed the Bank of Estonia Act in May 1993. The BOE now had more formal powers and had clearly emerged as a credible central bank. BOE, as part of its new banking policy, announced that no new bank will be licensed for at least a year. Actually, no new license was issued till 1999 and probably no one felt the need for it. BOE also decided to raise the share capital requirements to 15 million kroons by April 1, 1995 and further to 25 million kroons by April 1, 1996, and to 35 million kroons by April 1, 1997. BOE was sending a clear signal that it would encourage larger size (Zirnask, 2002, p 96). Estonia had removed all restrictions on capital flows in 1994. The year 1994 also saw the first public share offering by an Estonian company and this happened to be Hansa Bank (now known as Swedbank), which later became the most profitable and largest Estonian bank. The bank also expanded successfully into neighboring Latvia and Lithuania. There were some serious problems with two major banks during the period between 1994 and 1996 involving the largest bank at the time (Sotsiaalpank) and the third largest bank (Pohja-Eesti Pank (PEP)). Government deposits were about 60 percent of the assets of Sotsiaalpank and when the government decided to withdraw this business from the bank, the bank faced a crisis of loss of customer confidence. The bank's deposits came down sharply (by more than 70 percent). The bank could not survive this disruption. PEP, which was a successor to a Soviet-era bank and under the effective ownership of BOE, got a $10 million dollar loan to that was used to fund a scam perpetrated by some criminal operators. Zirnask (2002) provides detailed account of these unfortunate episodes of early Estonian banking history. The period, in general turned out to be one during which the Estonian economy and the banking industry stabilized (See Table 1 and Cavalcanti & Oks, 1998). The Credit Institutions Act was in place and formed a better basis for banking regulations (Zirnask, 2002, p.121-2). Inflation, while still high, was declining and was 23 percent in 1996. The period saw large increases in bank deposits as well as increased commercial bank lending to private sector (Cavalcanti & Oks, 1998).

Cottarelli et al. (2003) identify Estonia as one of the "early birds" among the transition economies of Central and Eastern Europe, which showed a very healthy increase in commercial banking credit to private sector. By the mid 1990s, the Estonian banking industry had clearly established itself as one of the healthiest ones among the transition economies of central Europe (Cottarelli, 2003; Cavalcanti & Oks, 1998). The period also saw further consolidation in the industry, which continued till 1998 (see Table 1). The industry consolidation was driven by both the existing market conditions as well as BOE's push to raise capital requirements (Sorg & Tuusis, 2008). BOE raised equity capital requirements to 50 million Estonian Kroons (EEK) by January 1996, 60 million EEK by January 1997, and 75 million EEK by 1998. The period also saw increasing foreign investment in the industry.

The Estonian stock market represented by the Tallinn stock exchange started trading in the summer of 1996. After a quiet start, the market took off to a boom in 1997. The number of issues traded increased from 11 (including six bond issues) to 41 (including nine bond issues and 3 investment funds) by the end of 1997. The Tallinn stock index rose by a whopping 380 percent in the first 8 months of 1997. Shares of several banks rose three or four fold. The boom, or bubble as it was characterized later, was partly fueled by a number of positive factors. The economy grew by over 10 percent in 1997 and foreign capital was flooding in. The crowning glory for Estonia was that the European Commission included it, ahead of its larger neighbors, in the list of countries invited to start negotiations to join the European Union. The stock market peaked in August 1997 and then started a sharp downward spiral and by March of 1998 the market had lost most of the gains. The bursting of the bubble had serious consequences on several banks that were direct or indirect participants in the stock market boom. Sorg and Tuusis (2008) call this period as characterized by naive optimism. Banks with poor risk management paid a high price. The crisis caused bankruptcy of three small banks and investment by foreign banks in the largest of the Estonian Banks. Again, BOE stepped in and acted quickly and the banks in financial distress were forced to merge with healthier banks. BOE had reacted proactively to the stock market boom as well as the budding Asian crisis of 1997 with more stringent capital adequacy requirements as well as tighter approach to computing the reserve requirements.

Overall and in retrospect, Estonian banking industry weathered the bursting of the bubble in 1998 and the Russian crisis, which followed, reasonably well (See Sorg & Tuusis, 2008). The Russian crisis claimed a few banks as its victims, but its impact on the economy and the banking industry was limited. The industry was more or less fully consolidated by the end of 1998 and there were six banks standing. It was a remarkable journey that in about 7 years the number of banks had fallen from 41 to 7 by a fairly rapid process involving a combination of attrition, forced closures and mergers. Another change in the industry was that two Swedish banks ended up as majority owners of the two largest banks of Estonia. This was followed by a Finnish acquisition of the third largest bank in 2000 resulting in foreign ownership level of over 87 percent. Today the foreign ownership is over 90 percent (Sorg & Tuusis, 2008).

REGULATORY REGIME

Estonian banking industry's development took place over a remarkably short period of less than 15 years. During most of this period, BOE was essentially the sole regulatory authority. BOE often followed its "seat of the pants" instinct as the country had very limited formal laws and little legal tradition relating to commercial banking. It could be said that the laws were evolving slower than the pace of the industry. The early banking could easily be described as free banking in the best sense of the phrase, where BOE was content to let the market forces determine the winners and losers. While BOE was sometimes criticized as arbitrary for its actions, at no time, BOE allowed the TBTF (too-big-to-fail) syndrome affect its decisions. BOE used minimum capital requirements and prudent ratios to force the banks to conform to its standards. BOE has systematically increased capital requirements and capital adequacy ratios over time. BOE also required banks to satisfy a number of ratios to minimum standards. These ratios include:

* Equity to liabilities--10 percent,

* Liquid assets, defined as net assets redeemable in 30 days or less, to demand deposits--35 percent,

* Size of loans granted to one borrower--equal to or less than bank's equity, and

* otal of big loans, defined as loans of more than 10 percent of bank's equity--not to exceed 800 percent of bank's equity.

BOE also regulated a bank's relationship with its subsidiaries and loans to the management, shareholders and employees. Table 2 gives an overview of the regulatory framework, which developed over time and governed the Estonian banking industry's evolution during the last two decades.

ESTONIAN BANKING TODAY

Table 3 gives the details of banks, which operate in Estonia today. The Estonian banks operate as universal banking institutions and offer a range of services offered to the consumer include, besides the usual choice of checking and savings accounts, accounts in different foreign currencies, online and inter-bank payment options. The commercial banking services include, besides loans, checking accounts, and payment services, a range of leasing and factoring services. The banks or their subsidiaries also offer a full array of insurance and investment services.

These figures are as of the end of 2008. Besides the above banks, eleven foreign credit institutions have branches in Estonia. The market share indicated above is for the total financial sector including leasing and factoring services. The total assets of banks as of the end of 2008 are estimated at about 320 billion kroons (approximately $30 billion). It is interesting to note that external or foreign borrowing, as reported in the annual report of BOE, ranged from 65 to 75 percent of the liabilities for the 4 largest banks. The total foreign ownership of the banking industry is about 90 percent. This was 55 percent in 1998. Despite the market share picture, the competition has intensified in recent years and smaller banks have gained market share at the cost of leaders, as reported in the Financial Stability Review (2009). The Review also highlights the fact that the industry is very competitive as reflected by tight net interest and profit margins. The commercial banks listed above account most of the leasing operations, investment funds market, and pension funds. While the dominance of the commercial banks in financial sector and the high concentration of market share might be a cause for concern, it is not unusual in small markets.

A number of recent research papers attempt to evaluate the operating performance (Vensel, 2001), range of services as well quality of services (Lutsoja & Lutsoja, 2004; Aarma & Vensel, 2001; and Listra, 2001). For an industry, which was only about 15 years old, the performance is really creditable. Sorg and Tuusis (2008) cite a European Central Bank study that showed several performance measures--net cost to income, return on assets, and net interest margin--for the Estonian banks are as good or better compared to Euro area banks. Jumpponnen et al. (2004) and Sorg and Uiboupin (2001) evaluate the motivation and rationale of internationalization of banking in Estonia as well as Estonian banks' attempts at overseas expansion. The primary rationale appeared to be driven by pursuit of following the customer into foreign markets. Estonian banks did well in both Latvia and Lithuania. Among the most remarkable features of Estonian banking today is the use of technology, Internet and E-banking to the point over 95 percent of the total volume of payment transactions are carried out through electronic banking (Lustisik, 2003). Estonian banking had the advantage of avoiding paper-oriented banking using checks, drafts and other instruments and encouraged customers to use electronic banking for all transactions. The high level of e-banking usage has enabled the Estonian banks to extremely productive. Forrester Research in 2000 ranked Hansa Bank's Internet banking as one of the best in Europe (Lustisik, 2003). According to the Financial Stability Review of BOE (2009 and 2010), the relative strength of Estonian banking industry has helped them withstand the financial crisis of 2007-2009 relatively well, even though the industry has suffered heavy losses. There was no need for government bail-outs. While the assets of the banking industry have fallen sharply and profitability has been affected, the four leading banks have maintained their investment grade bond ratings.

SUMMARY AND CONCLUSION

The paper chronicles the remarkable story of the evolution of banking industry in Estonia, the smallest of the former Soviet Union countries. Through a combination of market-oriented policies, currency reforms and vigilant, but not excessive banking regulations the Estonian central bank facilitated the emergence of a very healthy and competitive banking industry. This successful and very rapid evolution of Estonian banking industry has received general acclaim (Cottarelli et al, 2003; Schipke et al, 2004). The key questions relate to the lessons to be learned for banking industry outside Estonia. Can the success factors be replicated in other countries and other banking industries?

It should be noted that some factors that played a significant part in the industry's evolution may be unique to Estonia. Estonia is a very small country with a compact geography. The early political leadership wanted to break away from the shackles of socialism as fast as possible. BOE did a very good job of managing the currency reforms as well as the several crises that the country had to face. The hands-off approach to licensing and control of the emerging phases of the industry with neither deposit insurance nor any implied TBTF policy definitely introduced a "free-banking" atmosphere. This made the errant banks with poor credit management and high risk policies pay the price for their inadequacies and weaknesses. The fact that foreign entry was permitted from very early days, even though major foreign presence did not materialize till much later, made the market "contestable" and extremely competitive. Either by design or by chance, deposit insurance was introduced only in 1998, when the industry has stabilized and consolidated to a handful of strong players. This reduced the incidence of moral hazard in the early years. The deposit insurance still covers only 90 percent of the deposit, thus providing enough incentives for the depositor to be vigilant.

Consistent market-oriented policies from the very beginning enabled the stronger and better managed banks to survive and succeed. Sound credit management, investment in modern and productive technology, and innovative product and services were the hallmarks of the successful banks. These are worthy lessons for bankers, banking regulators, and the political leadership, which craft the legal framework for regulations.

REFERENCES

Aarma, A. & V. Vensel (2001). Banks' Retail Customer Satisfaction and Development of Bank Customer Relationships. Published in the Estonia on the Threshold of the European Union: Financial Sector and Enterprise Restructuring in the Changing Economic Environment; Collection of Papers; Ed. V. Vensel and C. Wihloborg.

Bank of Estonia (2008)--Report on Estonian and Non-Financial Sector, from http://www.eestipank.info/frontpage/en/

Cavalcanti, C. & D. Oks (1998). Estonia: The Challenge of Financial Integration, The World Bank Policy Research working paper.

Cottarelli, C., G. Della'Ariccia & I. Vladkova-Hollar. (2003). Early Birds, Late Risers, and Sleeping Beauties: Bank Credit Growth to the Private Sector in Central and Eastern Europe and the Balkans, International Monetary Fund Working Paper.

Jumpponnen, J., K. Liuhto, M. Sorg & V. Vensel (2004). Banks' Internationalization: Estonian and Russian Banks' Expansion to Foreign Markets. Working Papers in Economics, Tallinn Technical University-TUTWPE No.04/109.

Listra, E. (2001). Development of Financial Sector and Banking Services, Published in the Estonia on the Threshold of the European Union: Financial Sector and Enterprise Restructuring in the Changing Economic Environment; Collection of Papers; Ed. V. Vensel and C. Wihloborg.

Lustsik, O. (2003). E-banking in Estonia: Reasons and Benefits of Rapid Growth, Kroons and Economy3/2003.

Lutsoja, K. & M. Lutsoja (2004). The Main Changes in Financial Behavior of Firms in Transition: An Estonian Case." Working Papers in Economics, Tallinn Technical University-TUTWPE No.04/1113.

Schipke, A., C. Beddies, S. M. George & N. Sheridan (2004). Capital Markets and Financial Intermediation in the Baltics. International Monetary Fund Occasional Paper 228.

Sorg, M & J. Uiboupin (2001). Internationalization and the Entry of Foreign Banks into Estonian Market, Published in the Estonia on the Threshold of the European Union: Financial Sector and Enterprise Restructuring in the Changing Economic Environment; Collection of Papers; Ed. V. Vensel and C. Wihlborg.

Sorg, M. (2003). Reformation of the Estonian Banking System. Discussion Paper, University of Greifswald, Germany.

Sorg, M. & D. Tuusis (2008). Foreign Banks Increase the Social Orientation of Estonian Financial Sector, Discussion Paper, University of Greifswald, Germany.

Vensel, V. (2001). Estonian Banking System Performance, 1994-2000. Published in the Estonia on the Threshold of the European Union: Financial Sector and Enterprise Restructuring in the Changing Economic Environment; Collection of Papers; Ed. V. Vensel and C. Wihlborg.

Uiboupin, J. & V. Vensel (2001). Motives and Impact of Foreign Banks Entry into Estonia. Published in the Estonia on the Threshold of the European Union: Financial Sector and Enterprise Restructuring in the Changing Economic Environment; Collection of Papers; Ed. V. Vensel and C. Wihlborg.

Zirnask, V. (2002). 15 years of New Estonian Banking. Published by the Bank of Estonia.

V. Sivarama Krishnan, University of Central Oklahoma

Enn Listra, Tallinn University of Technology

Shekar Shetty, Gulf University for Science & Technology, Kuwait

Table 1: The Economy and Banking

Year    GDP growth   Inflation    Number        Assets
         rate (%)     rate %)    of Banks    (billion EEK)

1992      -15.0         954         41            5.2
1993       -6.0        89.8         22            6.4
1994       -2.0        47.7         24           10.4
1995        4.3        29.0         18           15.5
1996        3.9        23.1         13           22.9
1997       10.6        11.2         11           40.6
1998        4.7         8.2          6           41.0
1999       -1.1         3.3          7           47.1
2000        6.4         4.0          7           57.8
2001        7.1         5.6          7           68.4
2002        7.5         3.6          7           81.7
2003        9.2         1.4          7           98.6
2004       10.4         3.0          9          133.6
2005        6.3         4.1         12          185.1
2006       -3.6         4.4         12          239.5
2007      -10.3         6.7         13          320.6
2008       -0.8        10.6         15           N/A

Source: Zirnask (2002) and Bank of Estonia (2008)

Table 2: Regulatory Framework

    Laws/Key          Action        Key Elements          Comments
   regulations      Initiated
                     in Year

Banking Act            1991      Licensing of banks    Included
                                 Liquidation of        provisions
                                 credit institutions   relating to
                                                       BOE

Currency law of        1992      Currency board
the Republic of                  system
Estonia

Law of the             1992      Backing the kroon
Republic of                      under currency
Estonia on the                   board
security for
Estonian kroon

Bank of Estonia        1993      Additional powers     Revision and
Act                              for BOE to            separate act
                                 liquidate banks
                                 and remove
                                 management

Capital adequacy       1993      Set at 8 percent in
ratio                            1993; increased to
                                 10 percent in 1996
                                 in response to
                                 Asian crisis and
                                 stock market boom

Maximum exposure       1993      Set at 50 percent
to a single                      of net own funds,
borrower                         lowered to 25
                                 percent in 1994

Credit                 1995      More powers for BOE   Replaced
Institutions Act                                       Banking Act

Deposit Guarantee      1998      Deposits guaranteed
Fund Act                         up to 20,000
                                 kroons; covers 90
                                 percent of the
                                 deposit. The
                                 maximum coverage
                                 increases to
                                 313,000 by 2010.

Money Laundering       1999      Regulations in line
and Terrorist                    with those of
Financing                        European Union
Prevention Act

Savings and Loan       1999      Act determines the
Associations Act                 legal status, the
                                 bases of the
                                 activities and the
                                 procedure for
                                 foundation and
                                 dissolution of
                                 savings and loan
                                 associations

Financial              2001      Separate agency       Reform of
Supervision                      within BOE with its   financial
Authority Act                    own budget and with   supervision in
                                 regulatory powers     Estonia
                                 over all financial
                                 institutions

Securities Market      2001      Act regulates the
Act                              public offer of
                                 securities, the
                                 activities of
                                 investment firms,
                                 the provision of
                                 investment
                                 services, the
                                 operations of
                                 securities markets
                                 as well as the
                                 exercising of
                                 supervision

Table 3: Estonian Banking Industry Today

        Bank            Market share--%   Majority Ownership

Swedbank AS                   48          Swedbank (Sweden)
SEB Pank                      25          SEB (Sweden)
Nordea Bank                    7          Finland
Danske Bank                   15          Denmark
Estonian Credit Bank           3          Latvian
Tallinn Business Bank          1
Bigbank                       <1          Estonian
LHV Pank                      <1          Estonian
Marfin Pank Estonia           <1          Cyprus, Greece

Source: Bank of Estonia Report (2008)