Financial Stability Review

23.04.2014

Key points

• Development and current state of the Estonian Financial

Sector

• Additional topics covered in the Review: savings and loan

associations, instant loans, real estate prices

• An assessment of the main risks affecting Estonian

financial stability

2

Economic activity in the euro area has increased, but growth remains modest

Source: Eurostat

-15%

-10%

-5%

0%

5%

-3%

-2%

-1%

0%

1%

2005 2006 2007 2008 2009 2010 2011 2012 2013

GDP real quarterly growth in the euro area and Estonia

euroala (vasak telg) Eesti (parem telg)

Uneven development in emerging markets could raise tension

in financial markets and weaken the outlook for growth

3

euro area (left scale) Estonia (right scale)

Sources: Finnish customs board, national statistical offices

Any worsening of the Ukraine crisis poses a serious risk of deterioration in the external environment for Estonia

Trade with Russia is also important for our main trading partners

4

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Share of exports going to Russia in 2013

Estonia Latvia Lithuania Finland Sweden

The slowing of Estonian economic growth reduced the profitability of companies, but payment behaviour and finances continued to improve

Sources: Krediidiinfo, Eesti Pank 5

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Q1-2 Q3-4 Q1-2 Q3-4 Q1-2 Q3-4 Q1-2 Q3-4 Q1-2 Q3-4 Q1-2 Q3-4 Q1-2 Q3-4

2007 2008 2009 2010 2011 2012 2013

Payment behaviour of companies

overdue loans as a share of the portfolio

share of companies with tax debts

share of companies with payment difficulties

Wage pressures may start to affect the ability of companies to repay loans

6

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

Annual growth in corporate profits and gross monthly wages

average gross monthly wages (left scale) company profits (right scale)

Overdue loans are forecast to continue falling as a share of the loan portfolio

If the external environment were to deteriorate, overdue loans would grow less than during the last downturn

7

0%

1%

2%

3%

4%

5%

6%

7%

8%

2008 2009 2010 2011 2012 2013 2014 2015

Loans overdue by more than 60 days as a ratio of the loan portfolio

actual base scenario 5 pp 10 pp 15 pp

Household indebtedness and housing prices have continued to rise in Sweden

Sources: statistical offices, Valueguard

Swedish banks are largely funded through financial markets, and so their funding can be rather fragile

8

100

120

140

160

180

200

220

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

Indices of house prices in Sweden (January 2005=100)

Sweden Stockholm flats Stockholm houses

Capital indicators for parent banking groups have been supported by good profitability and low volumes of problem loans

Source: public reports of banks

* based on Basel III

9

0%

5%

10%

15%

20%

25%

20

10

20

11

20

12

20

13

20

10

20

11

20

12

20

13

20

10

20

11

20

12

20

13

*

20

10

20

11

20

12

20

13

*

Danske Nordea SEB Swedbank

Capital adequacy of Nordic parent banking groups

total capital ratio Tier 1 Core Tier 1 Tier I Basel II according to transition rules

Banks operating in Estonia are using fewer funds from parent banks to finance lending

Parent banks play an important role in centralised liquidity and capital

management

10

0

5

10

15

20

0%

50%

100%

150%

200%1

99

7

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

EU

R b

illi

on

Loans and deposits

loan to deposit ratio (left scale) volume of loans (right scale)

volume of deposits (right scale)

The profitability of the banks has been helped by low funding costs, by the recording of earlier loan write-downs as profit and by dividends from subsidiaries

11

-4%

-3%

-2%

-1%

0%

1%

2%

3%

-1 500

-1 000

-500

0

500

1 000

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

EU

R m

illi

on

Components of bank profitability

write-downs expenses

other income income from fees and services

net interest income return on assets (right scale)

Loan and deposit interest rates in Estonia are lower than in most European countries

Source: European Central Bank12

0%

1%

2%

3%

4%

5%

6%

CY

PT

SK

FR IT SI

BE

NL

MT

LV ES IE GR EE

DE

AT FI

LU

eu

ro a

rea LT SE

DK

Average interest rates for loans and deposits for households in February 2014

housing loans household deposits of up to one year

-3%

-2%

-1%

0%

1%

CY

PT

SK

FR IT SI

BE

NL

MT

LV ES IE GR EE

DE

AT FI

LU

eu

ro a

rea LT SE

DK

Net write-downs by banks as a ratio to total assets in Q1-Q2 2013

The level and quality of capitalisation in the Estonian banking sector are very good

13

5%

10%

15%

20%

25%

2008 2009 2010 2011 2012 2013

Capital and leverage ratios

common equity tier 1 capital ratio capital adequacy ratio leverage ratio

There are more problems with loan repayments in the instant loan market than with the much larger volume of bank loans

Sources: Eesti Pank, commercial register, Ministry of Economic Affairs and Communications14

0

100

200

300

400

500

600

700

800

2010 2011 2012

EU

R m

illi

on

Consumer loans issued by instant loan

companies and banks

assets of instant loan companies consumer loans issued by banks

0

10

20

30

40

50

60

70

80

90

100

estimated volume

of problem loans

at instant loan

companies (2012)

instant loan assets

passed on to debt

collection

companies or

subject to court

proceedings (2013)

household

consumer loans

from commercial

banks overdue by

more than 60 days

(2013)

household

mortgage loans

from commercial

banks overdue by

more than 60 days

(2013)

EU

R m

illi

on

Instant loans subject to claims by debt collection

companies or to court proceedings

Low interest rates meant that household deposits with savings and loan associations increased

• Unlike bank deposits, deposits in SLAs are not covered by the deposit guarantee scheme

and income tax must be paid on the deposit interest earned

• There is no supervision of SLAs, the members themselves are responsible for the sound

operation of SLAs

Deposits in SLAs are equal to 0.1% of deposits in banks

15

2

4

6

8

10

12

14

2

4

6

8

10

12

2009 2010 2011 2012 2013 2014

EU

R m

illi

on

EU

R m

illi

on

Deposits with banks and savings and loan associations

savings and loan associations (right scale) banks (left scale)

Prices for housing have increased significantly faster than incomes since the second half of 2013

Sources: Estonian Land Board, Statistics Estonia

16

0,0

0,5

1,0

1,5

2,0

2,5

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Ratio of median price per square metre of an apartment to

average gross monthly wages

Tallinn Estonia

Housing prices have risen faster in bigger cities and in the Tallinn districts with larger populations

Source: Estonian Land Board

80

90

100

110

120

130

140

150

160

170

180

2009 2010 2011 2012 2013

Real estate prices in largest Estonian towns

Q3 2009 = 100

Tartu Pärnu Narva

Kuressaare Tallinn

90

110

130

150

170

190

210

2009 2010 2011 2012 2013

Real estate prices in Tallinn districts

Q3 2009 = 100

Haabersti Kesklinn LasnamäeMustamäe Põhja-Tallinn

17

Banks have a smaller role in the housing market than during the boom

Sources: Estonian Land Board, Eesti Pank18

0%

20%

40%

60%

80%

100%

120%

140%

0

500

1 000

1 500

2 000

2 500

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

EU

R m

illi

on

Volume of mortgage loans issued in the year and value of real estate

transactions for residential space

volume of new housing loans value of real estate transactions by private people

mortgage turnover / transaction value (right scale)

The banks have not run lending campaigns, which would have boosted demand for housing further

Lending standards and conditions have not changed greatly

19

0%

1%

2%

3%

4%

5%

6%

7%

8%

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

Interest rate on new housing loans by components

6m EURIBOR interest margin

Main risks and conclusions

Risks to Estonian financial stability from the external environment have increased

The main risks to Estonian financial stability

A worsening of risk assessments for Nordic economies and banks could increase the funding and liquidity

risks of parent banking groups

A deterioration in the external environment could worsen the outlook for economic growth in Estonia and

lower the loan quality of the banks

The rapid rise in Estonian real estate prices may affect the financial behaviour of households and companies

and lead risks to the financial system to build up

minor risk major risk

arrow indicates changes in the risk level from the previous assessment of October 2013

21

Any worsening of the risk assessment for the Nordic countries will increase the funding and liquidity risks of the parent banking groups

• The banks have largely funded the growth in household indebtedness using funds

from the financial markets. A funding model which is excessively based on market

confidence can be rather fragile

• As Nordic bank groups have over 90% of the Estonian banking market, and Swedish

banks have around 80%, then there would be a significant weakening of Estonian

financial stability if this risk were to be realised

– Realisation of this risk would damage the Estonian economy through external

trade links and the funding and liquidity risk to local banks that would come

through the banking groups

• The Swedish central bank and financial supervisory authority have tightened

requirements for liquidity and capital. Although this is necessary to ensure financial

stability, it may not have enough effect to prevent risks building up further

22

Any deterioration in the external environment could damage the outlook for economic growth in Estonia and worsen the loan quality of banks

• The Estonian economy is dependent on a recovery in external demand and on

confidence

– Wage pressure could restrict the competitiveness of companies in export

markets

– Events in Ukraine could raise uncertainty for Estonian companies and for

our main trading partners

• The banking sector has good buffers

– The direct exposures of the Estonian financial sector in Ukraine and Russia

are small and so the immediate systemic risk is limited

– The Estonian economy and banking sector are more resilient now to any

deterioration in the external environment than they were before the

Russian crisis in 1998 or the global financial crisis in 2008

23

The rapid rise in Estonian real estate prices could lead to risky behaviour and a build-up of risks to the financial system

• The build-up of risk comes from unreasonable expectations for real estate prices

and for the continuation of rapid wage growth

• There is a greater chance risks will be underestimated when interest rates are low

A cautious housing loan market is helping keep risks under control

• The role of the banks in financing residential real estate transactions is smaller than

in the past and lending conditions (interest margins and loan maturities) have not

been loosened

• Banks need to continue to follow responsible lending principles when assessing the

loan repayment ability of borrowers and requiring them to make sufficient down

payments

• Eesti Pank is prepared to impose requirements for stricter lending conditions if

necessary

24

Eesti Pank has been granted responsibility for macroprudential supervision

• One week ago the Riigikogu changed the law to give Eesti Pank the right to act

as a macroprudential authority

• Eesti Pank has the right to set additional capital and liquidity requirements for

banks when necessary

– Banks in the European Union are subject to a single set of minimum

requirements, but additional capital and liquidity requirements can be

imposed in response to the condition of the local economy or financial

sector or the credit cycle

• Eesti Pank also has the right to set stricter requirements for lending standards,

such as limits on the loan to value ratio and the ratio of a borrower’s monthly

repayments and income

25

Capital requirements in Estonia from 2014

The systemic risk buffer requirement will come in under a decree of the Governor of Eesti Pank

Core Equity Tier 1 (CET1)

requirementTotal equity requirement

Base requirement 4.5% 8%

Buffer requirement

Systemic risk buffer 2%

Capital conservation buffer 2.5%

Counter-cyclical buffer 0%

Total capital requirement 9% 12.5%

26

The risks to the Estonian financial sector are small, but have increased in the past six months

• Estonian financial stability is still supported by

– increased economic activity in the euro area

– market confidence in the Nordic countries

– the strengthened financial position of Estonian companies and

households, and the high capitalisation of the local banking sector

• Risks have increased since the autumn

– The conflict between Ukraine and Russia has increased uncertainty

about the external environment

– Real estate price rises have accelerated, which risks creating imbalances

in the Estonian economy

27

Risks to Estonian financial stability from the external environment have increased

The main risks to Estonian financial stability

A worsening of risk assessments for Nordic economies and banks could increase the funding and liquidity

risks of parent banking groups

A deterioration in the external environment could worsen the outlook for economic growth in Estonia and

lower the loan quality of the banks

The rapid rise in Estonian real estate prices may affect the financial behaviour of households and companies

and lead risks to the financial system to build up

minor risk major risk

arrow indicates changes in the risk level from the previous assessment of October 2013

28