From the perspective of economic development, we should ask whether the profitability of banks supports financial stability — specifically, whether it helps ensure the functioning of the financial sector under both normal and adverse conditions, prevents banks from encountering difficulties during economic downturns and supports the sustainable financing of the economy. Experience shows that banks with stronger profit-making ability tend to be more beneficial to society in terms of maintaining financial stability and financing the economy.

Over the past two years, the profits of Estonian banks have reached the billion-euro mark, which has sparked a sense of injustice in society and fueled debate over the possibility of imposing additional taxes on banks. The question is whether this level of profit is something extraordinary or simply the result of a few good years.

To answer this, we can compare banks' recent profits to their historical profitability levels (see Figure 1).* At the end of 2024, the total assets of Estonian banks stood at €45 billion, with equity totaling €5 billion. Based on that, bank profits could reasonably reach several hundred million euros. Using the Nordic [parent] banks' target — 15 percent return on equity — as a benchmark, Estonian banks' profits should average around €750 million. In better years, profits might reach €1 billion, while in weaker years they may fall slightly below that.

Several banks operating in Estonia are listed on the local stock exchange, and in the event they need to raise capital, it is important to compare their profitability to that of other publicly traded companies. While banks listed on the Nasdaq Tallinn exchange are not the most profitable compared to other firms, they typically rank between second and fifth place depending on the year.

Against this backdrop, it is notable that there is no public debate about taxing other companies with above-average profitability. It is unclear why there is a push to impose additional taxes on a single sector based solely on its higher profit figures, without taking into account that this is inherently a multibillion-euro industry. From the standpoint of economic development, the more appropriate question would be whether bank profitability supports financial stability and the sustainable financing of the economy.

Since the restoration of independence, Estonian banks have posted losses during three major episodes: the banking crisis that followed the currency reform and culminated in 1994, the Russian crisis and the preceding stock market collapse of 1997-1998 and the aftermath of the global financial crisis in 2009. In the first two crises, banks went bankrupt and the banking sector as a whole faced serious difficulties. However, following the global financial crisis, Estonia's banking sector, unlike that of many other countries, remained operational. This created a strong foundation for economic recovery and renewed credit growth.

Banks' ability to withstand loan losses depends both on their capital levels and their capacity to generate profits. Notably, the primary source for covering loan losses is banks' ongoing earnings, with shareholder capital serving as a secondary buffer.

During the global financial crisis, the countries that fared best were those where banks had higher profitability and stronger capital positions. At the same time, new capital adequacy rules were introduced and existing capital requirements significantly relaxed. Between 2007 and 2011, Estonian banks' capital-to-assets ratio was historically low — averaging 7 percent (see Figure 2). Nevertheless, this was still higher than in many other countries and sufficient to provide an additional cushion against rising loan losses.

One of the lessons from the global financial crisis was the decision — both internationally and at the European Union level — to enhance capital requirements for banks. In addition to the previously existing rules, new so-called softer requirements were introduced, including various macroprudential buffers aimed at mitigating systemic risks. Because of their softer nature, failing to meet these requirements does not trigger supervisory intervention in a bank's operations but instead results in restrictions on dividend payments.

Along with the introduction of new capital buffers, macroprudential supervision was adopted as part of national economic policy. Its goal is to assess risks that threaten the functioning of the financial system and to establish requirements for banks to ensure financial stability. When imposing or increasing capital buffers, two principles are followed: first, to strengthen banks' resilience in the event of an economic crisis, and second, to mitigate the effects of the financial cycle.

The financial cycle is often confused with the business cycle. The financial cycle primarily reflects the development of household and corporate debt levels, whereas the business cycle describes the overall health of the economy. Evaluating the financial cycle thus focuses on the pace of lending growth among businesses and households, as excessively rapid loan growth can increase the risk of loan losses and, in turn, deepen a subsequent economic downturn. For example, during the global financial crisis, Estonia's economic contraction was exacerbated by the rapid rise in debt that had preceded it.

In conclusion, bank profits are essential for supporting economic development and providing protection during potential financial crises — both for banks and their clients — while also ensuring the continued functioning of economic financing. One of the key lessons from the global financial crisis was the increase in capital requirements for banks, along with added flexibility in how those requirements are met. One expression of this is the capital buffers set by macroprudential supervisory authorities — represented in Estonia by the central bank.

* From 2016 to 2022, banks' equity levels were unusually high because foreign-owned banks, due to tax regulations, preferred to reinvest their profits rather than distribute them. As a result, return on equity during this period was likely about 40 percent higher than reported — meaning that if the chart shows a range of 8-13 percent, the actual figure was more likely between 11 and 18 percent.

The comment was originally published in the Bank of Estonia blog.

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