If one enters savings and loans associations in English as an internet search term (Estonian: Hoiu-laenuühistu), one will most likely be presented with texts covering crises hitting such institutions, particularly the crisis in the US, 40 years ago, which absorbed over US$100 million in taxpayers' money. The crisis was linked to inadequate risk management.

The solution to that crisis was found in legislative amendments adopted by the US Congress, which improved the financial supervision of such savings and loan associations, and extended the scope of deposit insurance in a similar way to that of banks.

In Estonia, two particular savings and loan associations have run into difficulties in recent years, with those who have invested money in them standing to lose their savings.

Although several experts, including at the Bank of Estonia, have already drawn attention to the possible issues, these cases represent a serious alarm call as to the fact that one aspect of the financial sector in Estonia is weakly regulated, and is essentially not subject to financial supervision and lacks deposit insurance.

This renders plans on the part of the Minister of Finance to clean up this sector as highly correct, to ensure that even more customers do not lose their deposits.

Savings and loan associations have been operating in Estonia since the restoration of independence (in 1991-ed.). They were originally made up of community-based financial institutions operating in a small area or areas, where the members knew one another, and there was joint control over the risks taken by the cooperative.

Over the last ten years, however, cooperatives have grown too large for such safeguards to be effective. And whereas in the past, savings and loan associations attracted deposits from just the one region, now essentially they do so from the whole of the country. In other words, they do not comply with the principle of territoriality, actually established by legislation.

To recapitulate this, a requirement whose basis meant, it could be argued, that these associations did not represent a simple taking of deposits from the public.

In developed countries, financial institutions which raise money from the public are subject to financial supervision.

For example, insurance undertakings and investment funds are also supervised for this very purpose. The principle in the EU is that companies which take deposits from, and issue loans to, the public, must apply for a license to operate as a credit institution, i.e. a bank, and comply with prudential regulation,* all while their activities are supervised.

The purpose of this supervision is, in particular, to assess whether a financial institution has sufficient equity capital to its name, in order to cover the risks inherent in lending. This type of financial supervision is referred to as capital supervision, and in Estonia it is carried out by the Financial Supervisory Authority (Finantsinspektsioon).

Since equity can be used to cover potential loan losses a financial institution might incur, the objective of capital requirements and supervision to ensure compliance include one to reduce the likelihood that deposit-taking financial institutions might go bankrupt, hence investors losing their deposits.

For as long as capital supervision is functioning, developed countries have introduced deposit guarantee schemes to compensate, in particular, the deposits of small savers in the event that equity is still insufficient, and the supervised credit institution does end up going bankrupt.

In Estonia, deposit insurance has been in force with banks in Estonia since 1998 and has earned its keep, since on two occasions, depositors have received compensation, after a bank collapsed.

Effective capital supervision is a prerequisite for the introduction of a deposit guarantee scheme similar to savings and loan associations, as it helps to reduce the need to reimburse deposits.

Deposit compensation is, however, very costly, both for the market participants, who make the payments to the guarantee scheme, and for the economy as a whole.

There are currently 22 savings and loan associations operating in Estonia, with a total volume of assets of over €150 million. By size, these cooperatives can be divided into three categories:

• First, cooperatives with a balance sheet total of less than €1 million, and with an average of around 80 members. These cooperatives can be considered the group which was in mind when the law on savings and loan associations was developed, in the 1990s.
• The second group consists of cooperatives with a balance sheet totaling between €1 million and €10 million. In these cases, there can no longer be any talk of the functioning of community surveillance, so it is largely a matter of taking deposits from the public.
• The largest savings and loan associations have a balance sheet total of more than €10 million and are similar in nature to the smaller banks. This raises the question of fair competition, if a large savings and loan association and a small bank operate in the same market and earn income from similar services. While banks are subject to trust requirements and capital supervision, savings and loan associations have but a few general requirements relating to lending and liquidity, while there is currently no state capital supervision as such.

All-in-all, the proposal from the Ministry of Finance for the organization of the market of savings and loan associations is based on the right aim – to protect the depositor.

Under their proposal, savings and loan associations, as financial institutions that take deposits from the public, will have to apply for credit institution authorization, which means that they will be subject to the same requirements and capital supervision as banks, nd will be covered by deposit insurance too.

If a savings and loan association is too small in size to be licensed as a standalone, cooperatives have the opportunity to merge. For example, as a result of a similar reform carried out in Lithuania five years ago, several savings and loan associations applied for operating licenses, with the smaller outfits merging into two institutions.

*Prudential regulation is a legal framework focused on the financial safety and stability of institutions and the broader financial system. They require banks to maintain sufficient capital reserves and liquidity at all times.

The above piece was originally published in Estonian, on the Bank of Estonia blog.

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