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Financial stability

STABLE BANKING IS ESSENTIAL TO MONETARY POLICY

Financial stability means that banking – important banks, savings and loan associations, investment companies, security markets, insurance companies and paying authorities, i.e. the entire financial sector – operates smoothly under both normal and adverse circumstances. To this end, people must trust the financial sector and use its services: those who want to pay with bank cards can do so, those who want to save money can entrust their earnings to a bank, and those who want to take out a loan can apply for one from a bank.

Ensuring financial stability is a function of the central bank, because the central bank needs stable banking to implement monetary policy. In a way, commercial banks constitute the circulatory system of the economy, through which the cost and availability of money can be influenced. To implement monetary policy, the central bank lends money to commercial banks more or less expensively and in greater or smaller amounts. Thereby, the central bank controls inflation, i.e. implements monetary policy. When commercial banks encounter difficulties, the central bank cannot perform this function.

BANKING MUST RETAIN RESERVES AND HEDGE RISKS

As large bank groups operate in several states, countries must also cooperate in ensuring supervision. It is important for Estonia that all of the bigger banks located here belong to the Nordic bank groups. This means that in terms of financial stability it is crucial for Estonia to cooperate with states where the parent banks of the banks operating in Estonia are located, i.e. Sweden, Finland and Denmark.

Estonia cooperates closely with the supervisory authorities of the Nordic countries and other Baltic States. This communication network is one of the most progressive in Europe. International cooperation in the field of regulations and supervision is consistent. To prevent and overcome financial crises, the Nordic-Baltic Stability Group – consisting of representatives of the central banks, financial supervision authorities and Ministries of Finance of the Nordic countries and Baltic States – was established in 2011. Eesti Pank participates in the activities of the Group.

During the recession which unfolded in 2008, the Member States of the European Union significantly changed the manner of addressing joint issues within the framework of public finance and financial stability. Prior to the crisis, the ensuring of financial stability was the task of each country; the regional groups of the Nordic countries and Baltic States were an exception. At present, a separate unit is being created under the European Central Bank that will directly inspect banks that have a crucial role to play in the entire banking of a country. More central and uniform supervision will help to ensure that analyses and judgments are made in the same manner for everybody and, as a result, risk assessments will also be based on uniform fundamentals. This will make the assessment and supervision of banking in the European Union clearer and more reliable.

BANKING SUPERVISION IS INTERNATIONAL

As large bank groups operate in several states, countries must also cooperate in ensuring supervision. It is important for Estonia that all of the bigger banks located here belong to the Nordic bank groups. This means that in terms of financial stability it is crucial for Estonia to cooperate with states where the parent banks of the banks operating in Estonia are located, i.e. Sweden, Finland and Denmark.

Estonia cooperates closely with the supervisory authorities of the Nordic countries and other Baltic States. This communication network is one of the most progressive in Europe. International cooperation in the field of regulations and supervision is consistent. To prevent and overcome financial crises, the Nordic-Baltic Stability Group – consisting of representatives of the central banks, financial supervision authorities and Ministries of Finance of the Nordic countries and Baltic States – was established in 2011. Eesti Pank participates in the activities of the Group.

During the recession which unfolded in 2008, the Member States of the European Union significantly changed the manner of addressing joint issues within the framework of public finance and financial stability. Prior to the crisis, the ensuring of financial stability was the task of each country; the regional groups of the Nordic countries and Baltic States were an exception. At present, a separate unit is being created under the European Central Bank that will directly inspect banks that have a crucial role to play in the entire banking of a country. More central and uniform supervision will help to ensure that analyses and judgments are made in the same manner for everybody and, as a result, risk assessments will also be based on uniform fundamentals. This will make the assessment and supervision of banking in the European Union clearer and more reliable.

FINANCIAL SYSTEM: BORROWING AND SAVING

BORROWING

Borrowing is the use of somebody else’s – a lender or saver’s – money with the obligation to pay it back by an agreed date. Upon borrowing, both the borrower and lender must assess the ability of the borrower to repay the loan.

Well-considered borrowing contributes to the growth of the economy. A loan raised to start a business project may later produce more money than was borrowed. Private individuals can acquire or renovate their homes via loans without the need to put these plans back until the distant future. In other words, with the help of a loan people can pay for big purchases over a long period.

Is the loan a concern of the lender?
The risk that may occur upon lending money is the borrower’s failure to pay it back. This usually happens if cash flow (what is earned) is smaller than expected, e.g. if a person loses their job or a company does not succeed in its business. If there are many such borrowers, this can cause problems in the economy and primarily in the financial system (banking), because banks may encounter payment difficulties due to large debts. Thus, banks must assess the solvency of borrowers and risks that could jeopardise the repayment of a loan. Lenders as well as borrowers must adhere to the principles of responsible lending and borrowing and consider worst case scenarios (decline in earnings, loss of job et al.).

How is the cost of a loan determined?

The cost of a loan or the interest rate consists of two components: the cost of the money, i.e. the price (interest rate) at which banks receive funds for lending; and the solvency and payment behaviour of the borrower. In other words, the cost of a loan is established on the basis of the general risk-free interest rate effective in the economy and a risk premium dependent on the borrower.

The risk-free interest rate is paid by all borrowers – this does not depend on the borrower and is the same for everybody. The risk-free rate is usually the interest rate at which countries receive loan money.

Did you know that if a relative lends you money and asks you to pay back the same amount given to you, this does not mean that the loan has no cost or risk? It simply means that the relative has borne it themselves.

The amount of the risk premium depends on the borrower. The term ‘risk premium’ stems from the lender taking a risk when lending money because the borrower may not be able to pay it back. This risk varies by borrower – depending, for example, on whether the borrower has prior debts before a bank, which is the amount of the borrower’s income and value of assets. The bigger the risk of not getting the money back (a risky project or borrower), the greater the compensation (fee or risk premium) of the lender. Thus, the risk premium and the cost of a loan, i.e. the interest rate, may vary significantly from one borrower to the next. The amount of the risk premium is also influenced by the collateral the bank demands when granting a loan. In the event of more valuable collateral, the loan interest rate may be lower, because collateral is one way of hedging a risk for the bank: if payment difficulties occur, the collateral can be sold to compensate for the loan amount.

Did you know that if you have had payment difficulties in the past the bank may grant you a loan on more expensive terms than others or refuse to grant you the loan?

SAVING

Saving or collecting money is the opposite of borrowing. The saver decides to put aside money for the future or waive current consumption for future consumption. Money is usually saved to buy something expensive or for a time when income may decrease. It is possible to save in different ways – for example, placing money between the pages of a book, or depositing it in a bank.

Depositing funds in banks is safe, and banks pay interest to savers, because it can use their savings to lend other people money.

Where should savings be deposited?

As soon as you have begun to save money, you need to think about the most expedient place to deposit your savings. The aim is to earn as much as possible at the lowest risk. The two main factors to consider are rate of return and risk.

Money can be saved in several ways, from biscuit tins to deposits and investments. Depending on where you have decided to deposit your money, you can earn income in different manners – but better earning options tend to be accompanied by a higher risk of losing part or all of your funds.

By collecting cash, you will have as much in the future as you manage to save in the intervening period. However, as the purchasing power of money (the quantity of goods received for the same amount of money) mostly diminishes over time due to price increases (for more details see the “Inflation” section), the value of cash decreases over time. There is also a risk that cash may be physically destroyed for some reason.

By depositing money in a bank or by investing, your money earns you more money. Money is loaned to investors or borrowers who will pay it back in the future with interest. A bank deposit is one of the easiest ways to save money. Money invested as a deposit is generally secured by a guarantee, and when saving in this manner the value of the money should not decrease over time. The risks are relatively low, as well.

Depositing money with a bank usually generates low income. If things go well, the interest rate of a long-term deposit equals the inflation rate, but it is often lower. Therefore, it is recommended that money be invested in other, riskier assets (securities, funds or real estate), but investors must be aware of the risks accompanying them.

When choosing where to invest your savings, another three significant aspects must be taken into account: your expertise, your risk tolerance and the purpose of your saving. Risk tolerance (i.e. how high the risk is you are prepared to take or how much money you will risk losing) primarily plays an important role in investing in riskier assets. When choosing how to save, you should also consider what you are saving for, because some possibilities are more suitable for short-term and others for long-term saving.

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