The evolution of commercial banking in Estonia.

Author:Krishnan, V. Sivarama


Estonia regained its independence and emerged from the shackles of the Soviet rule in 1991. Estonia was an independent country from 1918 to 1941 and was under Soviet rule from 1941 to 1991. The smallest of the former Soviet Union Republics, it developed into a thriving free market economy in the remarkably short time since then. An important part of this economic revolution is the story of the evolution of the Estonian commercial banking industry that has developed into one of the most modern and competitive in the region. The first commercial bank in Estonia was actually licensed in 1988 and the early period was one of turbulence and financial crises. Despite this, the banking industry evolved and emerged as healthy, highly competitive institutions providing a range of consumer and commercial banking services on par with the best in the industrialized world. While the overall market size is small, the banks have modernized to a level seen in few countries and offer totally paperless banking.

The primary factor behind this healthy evolution of the banks was the unique regulatory approach pursued by the central bank, Bank of Estonia (BOE), which served as the main regulatory authority during the first decade of the newly independent Estonia. The early years saw easy entry with very low share capital requirements and very limited regulations. The approach included some missteps, hand-holding, and over time a sound free market approach where errant banks with unsound policies and balance sheets were allowed to fail. BOE was able to assert its leadership after the currency reform and reintroduction of the kroon backed by a currency board arrangement. BOE appeared to quickly find its regulatory bearings and was able to guide the Estonian banking industry to develop into a healthy and efficient one. This paper provides a historic and critical overview of the industry's evolution and attempts to draw key lessons from the Estonian experience. The paper is organized as follows. The first section gives a summary history of the Estonian banking industry. The following section describes the regulatory and legal framework of the period. The next section summarizes the current structure and features of the Estonian banking industry. The last section attempts to draw key lessons offered by the Estonian experience and offers concluding comments.


Zirnask (2002) provides a very colorful and insightful view of the history of commercial banking in Estonia. Vensel (2001) chronicles the developments in the industry with a more critical and academic view and reviews the performance of the industry players using financial ratio analysis. Sorg (2003) and Sorg and Tuusis (2008) describe the reform and reconstruction of banking system in Estonia that brought down the number of commercial banks from more than 50 when the country became independent from USSR in 1991 to mere 7 in 2000. Probably by a lucky coincidence or perhaps because of its small size and distance from Moscow, Estonia happened to be in the forefront of the early and hesitant attempts at economic reform in the Soviet Union. These reforms began in 1987 with decontrol of many state enterprises as well as permission given to run co-operatives in some sectors of the economy. The banking system was reorganized with the creation of five specialized sector banks separate from the Soviet central bank (Gosbank). This was the beginning of the two-tier banking system--a central bank to manage the monetary policy aspects and commercial banks to handle business and individual credits and deposits. The very first licenses for independent commercial banks were issued in September, 1988 and some Estonians proudly cite that the first commercial bank to be licensed in the Soviet Union was an Estonian Bank--Tartu Commercial Bank (TCB). This sure was coincidence. The same day another bank was licensed in Latvia and the license number for TCB happened to be 1 and for the Latvian bank it was 2. Before the end of the year more than 10 different banks were licensed in the different republics of the Union. The shareholders of TCB were Estonian public sector enterprises. TCB had a difficult time at first attracting customers, as the specialized state-owned banks were reluctant to let go of their customers (Jumpponnen et al, 2004)).

In December 1989, the Estonian Republic passed the Estonian Banking Act and reestablished the Bank of Estonia (BOE). These were rather symbolic acts as Estonia still remained a part of the Soviet Union and used the ruble as its currency. During 1990, BOE assumed control or ownership of the Estonian branches and divisions of the specialized public sector banks. These banks remained key players in the banking industry for several years and were at the center of the financial crisis later. In retrospect it could be viewed that these early acts gave the Estonian banking industry a head start and prepared them for ensuing economic and political freedom of Estonia, which came on August 20, 1991. This was soon followed by BOE establishing its independence from the Soviet central bank.

The early years of economic reforms saw the Estonian economy experience both very high inflation and a steep fall in GDP. Annual inflation ranged from 17 percent in 1989 to 954 percent in 1992. The cumulative decline in GDP between 1989 and 1992 was over 30 percent. The high inflation made it very easy for potential bankers to meet the share capital requirements of 5 million rubles (equivalent to 0.5 million kroons when the kroon was reintroduced) needed to get a banking license. Entry barriers were practically non-existent and there was a boom in new banking licenses issued. The number of banks nearly doubled during 1992 though many of these banks were very small and had very few shareholders (Jumpponnen...

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