The role of banking in the development of Estonian economy

The main advantages of the formation of a stable banking sector in Estonia, integrated into international economic life, were private property and liberal movement of capital. The emergence of the new monetary system was primarily influenced by the development of private banking that became, despite some setbacks and crises, the backbone of Estonian economy. Stable, transparent and consistent policy framework has also been of utmost importance – the laws and regulations governing the work of credit institutions were fully harmonised with the relevant requirements of the currency board arrangement. Today’s state of the financial sector in Estonia has been taking shape according to the continuous development within the framework of the currency board arrangement.

The early days of Estonian banking date back to 1992, when prior to the reform of the financial sector and the introduction of the currency board the number of the commercial banks had reached 42. Given the Estonian population of only 1.5 million, the banking market was clearly over-banked. The Bank of Estonia (BoE) quickened the space of consolidation through increasing minimum capital requirements in an attempt to restructure and build confidence in the banking system. As a result, the banking sector went through two crises in 1992 and 1994, which caused the weaker banks to seek alliance with healthier institutions, or collapse. Due to the transparency of the process and the decisive actions by BoE the general confidence in the banking sector was not shaken.

The golden era of the banking sector dates back to 1996-1997 when during a period of rapid economic expansion, the sector recorded explosive growth rates. The bulk of the growth was financed by low cost foreign borrowing and equity issues, hence the economy witnessed a surge in money supply, which in turn fuelled domestic demand. The abundance of funds resulted in fierce competition between banks and often clouded rational credit judgement. Disproportionate amounts of funds went to finance economically not viable projects, private consumption and leveraged positions in the stock market.

The situation started to deteriorate in the second half of 1997 along with the escalating crisis in Asia. Despite the mounting problems, the banking sector still posted amazingly good results for 1997 – 77 % growth in assets, 73 % in lending and 54 % in client deposits. At the time banks believed their credit quality to be excellent while the non-performing loans and respective provisions constituted only around 1 % of the total loans.

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