The financial position of the Estonian banking sector is strong: the level of own funds of the banks is high, the quality of the loan portfolio of the banks is very good, and loan losses are small, the Bank of Estonia said in a press release on Wednesday.

The biggest risk to banking in Estonia, meanwhile, continues to come from the Nordic countries. The sources of risk there are the high indebtedness of households and high dependence of banks on market-based financing of large household debt. If developments were to turn bad, the ability of Estonia to export could be reduced and the funding conditions for Estonian companies could be tightened.

The departure of some foreign banks has reduced the relations between the Estonian banking sector and the Nordic countries, but this introduces a new danger to financial stability in Estonia. Once Luminor has become a pan-Baltic bank with a head office in Estonia and branches in the other Baltic states, financial stability in Estonia will start to be directly affected by everything that happens in Latvia and Lithuania.

The role of Nordic parent banks in funding the banks will decline in future, and they will begin increasingly accessing funding from international financial markets. Banks operating in Estonia largely fund themselves with client deposits and loans from their parent banks, but financial markets are a more volatile source of funding. The overall trustworthiness of the Estonian financial sector, which has been shaken of late by the recent money laundering scandal, will also become more important.

The impact of the money laundering scandal on the Estonian financial sector overall remains small, as Danske Bank, which has been at the centre of suspicions of money laundering, has ended its business with non-residents in Estonia and Versobank was closed. As already noted, the lion's share of funding for the Estonian banking sector comes from resident client deposits, and the share of non-resident deposits has fallen over the years to the current 7%. Companies from outside of the EU, which may be considered the riskiest clients, now account for less than 1% of all clients.

Rapid real estate growth likewise risky

Another risk to financial stability alongside the risk from the Nordic countries is the rapid growth in the real estate and construction sector in Estonia, as it is taking up labour, investment and funding. Although loans to those sectors have not increased as a share of banks' loan portfolios, that share remains large. Rising real estate prices are being driven further by demand for new apartments, as household incomes are rising and confidence about the future is strong, and this may make people more inclined to take risks.

To dampen the risks from growth in lending to households, the Bank of Estonia approved requirements for housing loans from banks in 2014. Should company and household debt grow faster, the central bank can also set a countercyclical capital buffer for the banks as well. The Bank of Estonia has also introduced a systemic risk buffer requirement to strengthen the banks' capital partly due to lending to the real estate and construction sectors.

The additional capital requirements that the central bank has set for banks in Estonia are higher than those in most other EU member states. This would allow the banks to continue funding companies and households even if the economic environment should deteriorate.

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