Important findings from the CBM’s Financial Stability Report

One of the functions of a central bank is to ensure financial stability within its jurisdiction. In this respect, the Central Bank of Malta (CBM) published its analysis and findings in an annual publication referred to as the Financial Stability Report (FSR) which is also supplemented by an interim report. On 28 August 2019, the Central Bank of Malta published the eleventh edition of the FSR.

The FSR reviews and assesses the macro-financial conditions and developments of the Maltese financial system. It also evaluates the resilience of the system and identifies sources of potential systemic risk. In the FSR, the CBM also makes the necessary recommendations to preserve and also enhance the resilience of the financial system.

The latest FSR is based on data as at the end of 2018 and the Central Bank of Malta once again confirmed that the 6 core domestic banks that remain the most systematically-relevant credit institutions for the Maltese economy are APS Bank Limited, Banif Bank (Malta) plc, Bank of Valetta plc, HSBC Bank Malta plc, Lombard Bank Malta plc and MeDirect Bank (Malta) plc. It is also important to highlight that Bank of Valletta plc, HSBC Bank Malta plc and MDB Group Ltd (which is the parent company of MeDirect Bank (Malta) plc) are also classified as Other Systematically Important Institutions (O-SII) in terms of the European Banking Authority guidelines and as such are also directly scrutinised by the European Central Bank.

The FSR is a lengthy publication which most investors are unlikely to read in detail. As such, today’s article is intended to highlight the main findings of this report which should be given due consideration.

The FSR notes that 2018 was characterised by a challenging external environment in contrast to buoyant economic activity in Malta. In fact, whilst international economies were adversely impacted by geopolitical uncertainties, escalating trade conflicts as well as instability across emerging economies, Malta’s economy continued to thrive on the back of higher consumption expenditure and growth in net exports driven by the expansion in the services sector.

Going forward, this trend is expected to persist with vulnerabilities from within the local financial system perceived to remain much lower than external risks. In fact, although economic growth in Malta is expected to moderate, it is still expected to exceed the average for the whole of the eurozone. The latest forecasts by the European Commission indicate that Malta is expected to register a 5.3% growth in gross domestic product (GDP) in 2019 and growth of 4.8% in 2020. This is less than the 6.7% GDP growth achieved in 2018 but significantly better than the anticipated growth of 1.2% in 2019 and 1.4% in 2020 for the whole of the euro area. Furthermore, the Central Bank of Malta notes that this strong economic momentum of the local economy is somewhat shielding Malta from external risks especially those related to international geopolitical uncertainties (which the Central Bank of Malta is classifying as posing elevated risks) and the increasing risks related to the weak economic conditions in the euro area and public debt sustainability issues across some euro area countries including Italy.

The FSR also delves into the local banking system, which is split into three categories, namely the core domestic banks, non-core domestic banks (having limited operational exposure to the domestic market) and international banks which almost exclusively deal with non-residents. With respect to core domestic banks, the aggregate profitability weakened during 2018 which resulted in a post-tax return on equity of just 6.2%. This reflects some one-off provisions (including the €75 million litigation provision that BOV set aside in the first six months of the year) but is also due to waning net interest income as well as rising operational expenses. The latter is a recurring theme across the European banking industry and various analysts have indicated in recent months the need for European banks to step-up their efforts in restructuring their business model in order to be able to withstand the ‘lower for longer’ interest rate scenario, sustain the increasingly demanding regulatory requirements as well as implement a digital transformation strategy whilst also ensuring an adequate and sustainable profit. This is very challenging indeed as even the European Banking Authority (EBA) has recently added business model sustainability as one of its key supervisory priorities for 2020. Locally, HSBC Bank Malta plc has already taken the lead. Following the significant restructuring undertaken over the past few years, HSBC Bank Malta plc recently announced its plans for the modernisation and downsizing of its branch network supported by the additional focus on digitalisation with the aim “to maximise the opportunities from the rapidly changing way customers are using banks”.

On the other hand, the FSR positively notes that the local core domestic banks still hold ample liquidity and could also withstand an extreme set of conditions as designed under the stress tests conducted in 2018 and in early 2019. In fact, under such hypothetical scenarios, the levels of liquidity remained comfortably above minimum regulatory requirements. It is also reassuring to note that core domestic banks continue to be largely funded through customer deposits. Moreover, 90 per cent of total customer deposits are resident deposits.

Core domestic banks also have adequate capital ratios which should also enable banks to withstand adverse conditions as evidenced through the aforementioned stress tests. Moreover, the FSR confirmed that the local banks classified as O-SII continued to comply with the build-up of an O-SII capital buffer. In fact, as from 2016, MeDirect Bank (Malta) plc, HSBC Bank Malta plc and Bank of Valletta plc started building this capital buffer to reach the required level of 0.5 per cent, 1.5 per cent and 2 per cent respectively. It is also noteworthy to highlight that in contrast to earlier FSRs, the CBM has not emphasised the importance for banks to maintain a prudent dividend policy possibly in view of the close regulatory supervision to which banks are being subjected in this respect. In fact, national supervisory authorities can withhold dividend payments if banks do not meet their respective capital requirements and buffers.

Meanwhile, the latest FSR focuses on the lending trends within local core domestic banks. The Central Bank of Malta noted that during 2018 the growth in assets across core domestic banks was almost entirely driven by an increase in customer loans which, in turn, was mostly related to mortgages for resident households. As a result, by the end of 2018, mortgages accounted for 49.5% of resident loans compared to 48.2% in 2017. Likewise, in view of the buoyant local property market, the number of loans granted to the construction and real-estate sector also increased albeit at a slower pace. Collectively, property-related loans accounted for around 63% of all core domestic bank loans compared to just above 52% in 2008. This concentration in sectoral lending has been highlighted by the Central Bank of Malta as one of the growing risks for local banks emanating from within the local financial system.

Given this growth in property-related lending, possibly fuelled by the low interest rate scenario amongst other factors, the Central Bank of Malta undertook a special study on the trends in the local property market and related financing. The FSR notes that a well-functioning property market is important for economic and financial stability. The study indicates that in view of the rising property prices, the monthly average repayments on property-related loans have surged and surpassed the record levels seen in 2007. Furthermore, whilst the FSR acknowledges that ratios of property prices and average repayments to income have not increased as much, it also stated that there are increasing pockets of vulnerability. Particularly, the FSR explains that whilst the prevailing low interest scenario may act as an incentive for higher leverage, a less accommodative monetary policy stance in the future (considering that mortgages usually carry a very long repayment period) may accelerate debt servicing and credit risks especially in the local context whereby the majority of mortgage credit is granted at variable interest rates.

Nonetheless, the FSR states that the strong momentum in the local economy also led to a contraction in the level of non-performing loans particularly in the construction and real-estate sector which now account for 33.2% of total non-performing loans of core domestic banks compared to 36.2% in 2017. Meanwhile, loan loss provisions increased during 2018 following the introduction of more cautious policy measures. The authorities also introduced other measures to ensure that local banks maintain a prudent approach to lending.

Overall, the FSR gives a positive view of the local banking sector on the back of the economic growth being registered which is also mitigating the risks emanating from abroad. Nonetheless, all stakeholders must remain vigilant as vulnerabilities do exist, including jurisdictional reputation risks, whilst the local economy progresses through cycles that may also include less buoyant times in the future.

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