Prospects for Malta’s retail banking industry

Over recent weeks, two of the three retail banks listed on the Malta Stock Exchange (namely HSBC Bank Malta plc and Lombard Bank Malta plc), published their respective 2015 Annual Reports.

The statements contained in these Annual Reports give a clear indication of the status of the local banking sector and an insight into what changes are expected going forward.

Since many retail investors are exposed to the three retail banks (there are around 20,000 shareholders in Bank of Valletta plc, 10,000 in HSBC Bank Malta plc and 1,500 in Lombard Bank Malta plc), I thought it would be useful to highlight a number of the issues raised in these reports which clearly portray the challenges being faced by the banking industry.

The low interest rate environment and the increasing regulatory pressures are the main factors leading to a generally bleak outlook for retail banks. This has been well documented over recent months, both locally as well as internationally.

In the current interest rate environment, the core business of retail banks (i.e. interest income) is being impacted by the lower interest earned on loans as well as lower returns being generated by a bank’s investment portfolio. With respect to the idle liquidity not loaned out or re-invested, the continued easing of monetary policy by the European Central Bank (ECB) resulted in negative rates on short-term government securities (namely Treasury Bills) and money market placements at the Central Bank of Malta. The latter continued to be exacerbated following the ECB meeting on 10 March 2016 when the deposit facility rate was further reduced to -0.40% from -0.30%.

On the other hand, retail banks benefit from lower interest payments as interest rates on customer deposits are also reduced. The two larger retail banks (HSBC Malta and BOV) both introduced lower rates on savings accounts during the course of 2015. This helped the financial performances of both banks as BOV registered a 14.9% growth in net interest income during the 2014/15 financial year which ended on 30 September 2015 and HSBC Malta experienced an improvement in net interest income for the first time since 2012, albeit at only +3.7%. However, the growth in HSBC’s interest income was also due to a change in accounting methodology for suspended interest which results in a higher level of interest income but also higher impairment charges. On the other hand, Lombard Bank suffered a decline of 8.2% in net interest income during 2015.

“… These challenging conditions for banks are not anticipated to abate in the near term …”

Notwithstanding the decline in interest rates on deposits, all three banks reported a continued inflow of deposits. In view of the slow growth in loans (also hindered by regulatory pressure on banks) and limited investment opportunities, deposit-taking is posing a stiff challenge for banks given the negative interest rate environment due to the cost of placing such additional funds with the Central Bank of Malta as well as the ECB. This has been exacerbated by the decline in interest rates on 10 March 2016 deeper into negative territory. The alternative being resorted to by a few large banks in the Eurozone is a charge placed on customers for holding deposits. However, there is no evidence as yet that such a measure will also be adopted by the local retail banks, at least in the short-term. This is a very topical discussion across the international media and one international journal commented a few days ago that “more rate cuts would threaten to crush the banking system unless banks pass on the cost to ordinary consumers. That could lead to people withdrawing money from their banks en masse and hoarding it”. This would surely not be a desirable outcome for the ECB.

On the regulatory front, in the 2015 Annual Report, the Chairman of HSBC Malta Mr Sonny Portelli listed several projects which the bank worked upon during 2015. Few investors would appreciate the numerous pieces of regulation that need to be complied with.

Moreover, as from November 2014, the ECB assumed a new supervisory role for systemically important banks operating in the Eurozone. Two of the retail banks listed on the MSE (BOV and HSBC) have been classified as systemically important for Malta and have been under the direct responsibility of the ECB’s Joint Supervisory Team for the purposes of banking supervision since November 2014. BOV’s Chairman Mr John Cassar White had commented that such regulation is becoming “intrusive”.

Although Lombard Bank does not fall under the ECB’s Joint Supervisory Team, it still needs to be compliant with the Single Supervisory Mechanism (SSM). The statement in the 2015 Annual Report by the Chairman of Lombank Bank Malta plc, Mr Michael Bonello, provides a concise overview of the regulatory challenges in this respect. Mr Bonello remarked that “the SSM does not seem to allow any measure of discretion to national authorities to take account of different country circumstances”.

On his part, the CEO of Lombard Bank Mr Joseph Said refers to this as a “one-size-fits-all approach” and Mr Bonello claims that “a strict application of the new rules on lending may be warranted in a context of economic stagnation, undercapitalised banks and bailouts”. The Chairman of Lombard rightly argues that during the international financial crisis from 2007 onwards, “Malta’s core domestic banks displayed financial soundness indicators that demonstrated a high degree of resilience”. In fact, none of the local banks required any bailout.

The international credit rating agencies had made reference to Malta’s strong financial system in their regular reports on Malta and the Central Bank of Malta also performed regular assessments on local banks which continued to show ample capital and liquidity ratios, declining non-performing exposures, strong coverage ratios and loan to deposit ratios considerably lower than the euro area average. This was again confirmed in the 2015 Annual Report of the Central Bank of Malta. The Governor also made reference to the ranking of Malta in the World Economic Forum among the top 15 countries in terms of the soundness of the banking system. The Governor noted that the balance sheet growth was mainly “fuelled by the flow of customer deposits, which resulted in abundant liquidity levels for banks. Indeed, the average loan-to-deposit ratio trended further downwards, to reach 58.2% in December 2015, substantially lower than the EU average of 101.3%”.

Lombard’s Chairman opined that the “results of the time-tested model of relationship banking in Malta would seem to merit greater recognition from a regulatory standpoint”. Mr Bonello also warns that this “new regime impinges increasingly on profitability… particularly in the case of the smaller banks which do not benefit from economies of scale”.

So where does all this regulation leave Maltese banks, also at a time when the Central Bank of Malta is also continuing to pressure the banks to reduce the present lending rates to small and medium-sized enterprises (SME)? Moreover, the news of the creation of the Malta Development Bank expected by the end of this year could also pose additional competition for the retail banks flushed with liquidity although the Government is claiming that this new institution will not compete with local banks. However, last week, the Government also indicated that the Malta Development Bank is aiming to assist in “investment in the infrastructure, both by the government and the private sector, including through public private partnerships” - possibly a lucrative new area for retail banks given their abundant liquidity positions.

Another challenge for the banking sector is the Quantitative Easing (QE) programme which is reducing the investment options available for banks who continue to hold excess levels of liquidity.

In the meantime, the ECB is also proposing that banks reduce their exposure to sovereign bonds of their own country. In a recent meeting with the European Commission, the local media indicated that Malta’s Finance Minister argued against this idea. The European Commission has now reportedly asked the International Monetary Fund for advice regarding the way forward. Should this be implemented in due course, it would be another blow especially for local banks who hold high levels of liquidity.

These challenging conditions for banks are not anticipated to abate in the near term as the President of the ECB last week again indicated that interest rates are expected “to remain at present or lower levels for an extended period of time”.

Furthermore, in addition to the prevailing interest rate scenario and the increased regulatory costs, banks are also being requested to hold higher capital levels thereby leaving a marked impact on profitability ratios such as the return on equity.

One way for banks to increase their capital levels is to reduce distributions to shareholders. Local regulation to this effect was implemented a few years ago and banks were forced to set aside additional reserves and reduce dividend payments to shareholders.

Investors need to be cognisant of this changing reality and the likelihood of lower dividend income from banks as confirmed by BOV’s Chairman when presenting the financial statements to analysts over the past two years and also during the last few Annual General Meetings.

Coupled with this, the possible changes in shareholdings expected across some of the banks makes it a very interesting, albeit challenging time ahead for investors exposed to bank shares.

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