MEASURES FOR ENSURING SUSTAINABILITY OF THE BANKING SECTOR DEVELOPMENT

The orientation of the economic policy to the macro-economic stability and the efficient implementation of market mechanisms, has created a reliable basis for the continuation of rapid economic development in Estonia. The more smoothly we are able to adjust ourselves to the changes, the more fully the development potential of the Estonian economy is utilised and the more rapidly increases the welfare of the society as a whole.

Characteristic to the present stage of development is the necessity of external savings for the additional capitalisation needed for the efficient operation of the Estonian economy. The so-far relatively low level of domestic savings will not necessarily cover the investment demand, arising from rapid economic growth, in the nearest future yet. The earlier overwhelming predominance of direct investments and less institutionalised capital flows have been replaced by a situation where in the intermediation of external savings a bigger role is played by various domestic and foreign financial institutions among which Estonian credit institutions and businesses directly related to them have a significant role.

The more banks are connected with the intermediation of capital inflow, the more they are open to risks accompanying the volatility of foreign capital and the possible overheating of the Estonian economy. Fully supporting the increased risk awareness and prudence of banks as well as considering the impact of competition and difficulties in evaluating macro-economic risks, Eesti Pank finds it necessary to take additional measures for ensuring the sustainability of the development of the banking system.

The most important measure for that is: Eesti Pank will rise the capital adequacy requirement for credit institutions, i.e. the minimum ratio of the own funds to risk weighted assets and certain off-balance sheet items, from 8% to 10%. The decision will take effect after it is approved by the Board of Eesti Pank and it will come into force on 1 October 1997. The establishment of a capital adequacy requirement higher than the international minimum is in line with the practice of several other transition economies. The above measure decreases the banks incentive to achieve competitive advantage through taking additional risks and increases the protection of creditors.

Furthermore, since July this year, a few amendments will be applied to the methods of calculating capital adequacy and reserve requirement. Although the main aim of those measures is to correct structural distortions arising from regulations, they have a tightening effect on the expansionary behaviour of the banking sector.

When calculating capital adequacy, the risk weight of loans to local governments is increased from 50% to 100%. The same risk weight is established for loans granted to businesses, for example. The borrowing of local governments often being excessive and uncontrolled within the general fiscal policy framework indicates that favourable treatment of local government borrowing is unjustified.

Due to the decline in the importance of cash as a means of payment, the eligibility of vault cash when meeting the reserve requirement will be reduced from the present 40% to 30%. The decrease in the eligibility of cash increases the liquidity cushions of the payment system, reduces the security risks and the incentive in the formation of the so called reporting cycles.

Due to the distinctive features of foreign capital inflow in Estonia, the reserve requirements will be extended to the net borrowing from foreign credit institutions by the Estonian banks. The structural position of the Estonian credit institutions vis-a-vis foreign banks has started to diverge from the usual framework of liquidity management, due to which the respective net position can be considered as a form of capital inflow. In the reserve requirement calculation the latter should be treated similarly to the other liabilities of banks to non-residents.

Within the overall macroeconomic framework, the abovementioned measures taken by Eesti Pank should be considered in the context of present government policies, aimed at general fiscal consolidation. The budgetary imbalances together with the current account deficit, may undermine the sustainability of the economic development. Therefore, Eesti Pank fully supports the Government plans to continue prudent fiscal policy and strengthen the budget discipline of local governments.