Reports on Observance of Standards and
1. An assessment of Estonia's observance of and consistency with relevant international standards and core principles in the financial sector, was undertaken under the auspices of the Bank-Fund Financial Sector Assessment Program (FSAP). This has helped to place the standards assessments in a broader institutional and macroprudential context, and identify the extent to which the supervisory and regulatory framework has been adequate to address the potential risks in the financial system. The assessment has also provided a source of good practices in financial regulation and supervision in various areas.
2. The assessment covered (i) the Basel Core Principles for Effective Banking Supervision; (ii) the International Association of Insurance Supervisors' (IAIS) Supervisory Principles; (iii) the International Organization of Securities Commissions' (IOSCO) Objectives and Principles of Securities Regulation; (iv) the Committee on Payment and Settlement Systems' (CPSS) Draft Core Principles for Systemically Important Payment Systems; and (v) the IMF's Code of Good Practices on Transparency in Monetary and Financial Policies. This comprehensive coverage of standards was carried out at the request of the Estonian authorities, in light of the rapid development of the financial sector, including nonbank financial institutions. It should be noted that some of the standards are still in draft form, and some do not yet have a complete methodology to systematically assess compliance or consistency.1
3. The assessment of standards and codes draws on the self-assessments by the Estonian authorities and on field work undertaken by a joint IMF-World Bank mission which visited Estonia during February 1–11, and February 29—March 14, 2000. The assessments were based on a peer review process by Stefan Niessner (Deutsche Bundesbank), M. Srinivasan (Reserve Bank of India) and Richard Abrams (IMF) on the Basel Core Principles, Martin Halvorsen (Kredittilsynet, Norway) on the IAIS Insurance Supervisory Principles, Melinda Roth Alexandrowicz (World Bank) on the IOSCO Objectives and Principles of Securities Regulation, and Charlie Garrigues (World Bank) on the Draft CPSS Core Principles for Systemically Important Payment Systems. Jingqing Chai (IMF) prepared the Code of Good Practices on Transparency in Monetary and Financial Policies, with inputs from the sectoral experts. The expert team was coordinated by the IMF-World Bank FSAP mission led by Alexander Fleming (World Bank, mission chief) and Richard Abrams (IMF, deputy mission chief).
4. The assessment, which was based on information available through March 2000, showed that Estonia has made great strides in strengthening its supervisory framework. Progress has been particularly strong in the area of banking supervision. Supervision of insurance firms is also improving, although some concerns remain. On the other hand, oversight in the securities sector is weak. While the payment system itself is viewed as relatively strong, payment system oversight could be improved.
5. The findings regarding transparency practices were quite favorable. No significant weaknesses were identified with respect to either monetary policy or the deposit guarantee scheme, while the shortcomings in banking and insurance supervision and on the payment system were relatively minor. Transparency practices in securities supervision were assessed as somewhat weaker than the others, although the flaws were not serious.
G. Background and Overview
6. The following is an assessment of observance of the CPSS Draft Core Principles. It was carried out against the existing payment system, although changes envisaged in the new Interbank Payment System (IBPS), which is expected to begin its first phase of operation in end-2000, were also noted.
7. The clearing and settlement system in Estonia has been run by the BoE since 1992. There is no clearinghouse for paper instruments and all interbank transactions have been sent in electronic form. The system processes about 40,000 low- and large-value transactions each day. However, these transactions represent only one third of the total volume of all Estonian payment transactions, with the remainder cleared as intrabank transactions by Estonia's two large banks. In addition, about 500 securities transactions per day are cleared by the ECDS. After three days (at T+3), the ECDS sends bilateral balances to ECDS participants, who initiate interbank credit orders to cover their obligations. Transactions are settled on a gross basis with payment made in central bank deposits.
8. Card payments (around 30,000/day) are cleared by a Card Center, which is owned by the three major banks. The Card Center is a service provider without any financial responsibility. Every day, bilateral balances calculated by the Card Center are sent to participants that initiate corresponding credit orders settled in the BoE system. Even though the Center is bank-owned, the BoE has not inspected its operations.
9. The existing payment system has three limitations. First, it can handle only credit orders and not debit transactions such as direct debit, debit, or credit card transactions. Second, upgrading the system to achieve compliance with the Lamfalussy standards for risk and liquidity management is not relevant because the Estonian system is not a net settlement system. Third, there is no Real-Time Gross Settlement (RTGS) process, nor can the existing system be linked to TARGET (the EU RTGS infrastructure necessary for participation in the euro zone) for cross-border transactions. However, a new system, called IBPS, has been designed to fully observe international standards and is under implementation.
H. Main Findings
Principle 1: The system should have a well-founded legal basis under all relevant jurisdictions.
10. Payment and settlement activities are regulated by the Law of the Central Bank of the Republic of Estonia (May 18, 1993, amended April 5, 1994), the Law on Credit Institutions (December 15, 1994, amended July 1, 1999) and relevant decrees of the President of the BoE. Under Article 87 of the Credit Institutions Act, payments of credit institutions must be settled through a payment system pursuant to the procedure established by the BoE. Several decrees issued by the BoE establish the time for settlement of payments, the rules for sending and receiving payment orders, and common account statements.
11. There is no special legislation governing different payment instruments (such as checks, payment cards, and direct debits). The payment practices are determined by agreements between banks, service providers and customers. Specific legislation on payment instruments is needed including, inter alia, a description of instruments, customer identification methods, customer's obligation, issuing bank obligation, receiving banks obligations, irrevocability rules, and transfer of value rules.
Assessment: Broadly observed. Legislation governing different types of payment instruments is needed.
Principle 2: The system's rules and procedures should enable participants to have a clear understanding of the system's impact on each of the financial risks they incur through participation in it.
12. There is no explanatory document describing financial risks that participants could incur. However, participants are of the view that in practice their participation does not pose any significant risks. In addition, the new IBPS framework will include specific regulations and contracts that will cover this issue in a manner that is in observance of EU directives and ECB recommendations.
Assessment: Broadly observed. The financial risks that participants could incur are not described in explanatory documents. However the new IBPS framework will cover this issue.
Principle 3: The system should have clearly defined procedures for the management of credit risk and liquidity risks, which specify the respective responsibilities of the system operator and the participants and which provide appropriate incentive to manage and contain those risks.
13. In the existing system, credit and liquidity risks cannot be transferred from the issuing financial institution to the BoE (the operator) or any other financial institution, since any transactions that cannot be covered by the paying bank are rejected at the end of the day by the central settlement system, while clears on a FIFO basis. In the new IBPS system, credit risk and liquidity management are expected to be addressed according to international best practices.
Assessment: Fully observed.
Principle 4: The system should provide prompt final settlement on the day of value, preferably during the day and at a minimum at the end of day.
14. The existing payment system is based on end of day final settlement taking place on a gross basis. But this is at the end of the day, and no final settlement can takes place during the day. However, the IBPS system plans envisage that its RTGS system will begin operation by end-2001.
Assessment: Fully observed.
Principle 5: A system in which multilateral netting takes place should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation.
15. At present there is no netting system. However, in the new IBPS net settlement system, limits will be fully collateralized in order to guarantee end-of-day settlement in case of failure of the largest single participant.
Assessment: Not applicable.
Principle 6: Assets used for settlement should preferably be a claim on the central bank; where other assets are used, they should carry little or no credit risk.
16. The current system only allows the use of reserve deposits at the BoE for settlement. The required reserve ratio is currently 13 percent. Since required reserves deposits are calculated as the average daily level of reserves during a given month, required reserves deposits may be drawn down to settle payment transactions. The IBPS system is envisaged as having rules consistent with the CPSS Core Principles.
Assessment: Fully observed.
Principle 7: The system should ensure a high degree of security and operational reliability and should have contingency arrangements for timely completion on a daily processing.
17. The security and reliability of the existing system have been upgraded regularly. An audit of the system was conducted in 1999 and concluded that all security and contingency arrangements were satisfactory. The security, reliability and contingency specifications of the new IBPS system were fully laid out, and a project team is putting them in place.
Assessment: Fully observed.
Principle 8: The system should provide a means of making payments that is practical for its users and efficient for the economy.
18. The system offers settlement only for credit orders; no debit transactions are processed.
19. The current system is efficient, with same-day settlement, and economical, with a first settlement account free of charge and a transaction fee of only EEK 0.10. However, the system does not cover all of its costs.
20. The new IBPS system is envisaged as being more efficient than the existing system. However, the cost for users is not yet fixed and the distribution of development and operating costs between the BoE and the commercial banks is under discussion.
Assessment: Broadly observed. The current system does not cover its costs and the BoE must bear a share of these costs. The new IBPS System will be more efficient and the cost-sharing burden for the BoE is currently under discussion.
Principle 9: The system should have objective and publicly disclosed criteria for participation, which permit fair and open access.
21. The current system is open to credit institutions licensed by the BoE, which are required to open a settlement account at the BoE. In the future IBPS system other financial institutions may be permitted to participate, but the rules are yet to be finalized.
Assessment: Fully observed.
Principle 10: The system's governance arrangements should be effective, accountable, and transparent.
22. The BoE is fully in charge of and responsible for the interbank system. The BoE's organization chart is published in its annual report, which is also available on the BoE's web site. The BoE's two payment system departments, policy and operations, are under the direct responsibility of one deputy governor. The BoE's Payment Committee also meets regularly, in principle once a week, to make decisions and coordinate payment system activity and policy. Other BoE departments that perform payment-related work—IT, accounting, and banking supervision—are also represented on this committee. However, a system of ongoing oversight of the payment system has not yet been developed. The system has been audited and inspected by both internal and external auditors.
23. A Payment Council was created in 1998 to involve all stakeholders, but it has not met since its opening session. However, at the operational level, a subcommittee dealing with payment systems meets regularly with the IBPS project group, which also includes payment system and IT specialists from both the BoE and the commercial banks.
Assessment: Broadly observed. A system of ongoing oversight of the payment system should be established.
Priorities for further action
24. The findings of the CPSS Core Principles assessment are summarized in Table 4. In brief, the existing payment system operates cheaply and efficiently, with minimal systemic risk. However, it is only capable of processing credit payments and it does so on a gross basis. The priorities for improving the payment system primarily relate to ensuring the prompt and successful implementation of the new, more flexible IBPS. Areas deserving special note include establishing clear rules dealing with participants' financial risks (principle 2), and developing limits and guarantees to ensure that the failure of one participant will not lead to a systemic failure of the payment system (principle 5). The Estonian authorities should also strengthen the legal basis for payment instruments (principle 1) in line with the new EU directive on electronic payments. They should also begin to conduct oversight of the private card payment organization.
Table 4. Estonia: Observance of CPSS Draft Core Principles for Systemically Important Payment Systems
Source: Mission's assessment.
1 The Basel Core Principles were issued in September 1997; a Core Principles Methodology was released in October 1999 by the Basel Committee on Banking Supervision. The Code of Good Practices on Transparency was adopted by the Interim Committee in September 1999; work on a supporting document is in progress. The IOSCO Objectives and Principles were issued in September 1998, and a detailed self-assessment methodology is being developed. A draft of the Core Principles for Systemically Important Payment Systems was issued for public comment in December 1999. The IAIS Insurance Supervisory Principles were issued in September 1997; a self-assessment program has been developed to assist member countries in evaluating compliance.