fifth financial stability report 2012

FIFTH FINANCIAL STABILITY REPORT

2012

© Central Bank of Malta, 2013

AddressPjazza KastiljaValletta VLT 1060Malta

Telephone(+356) 2550 0000

Fax(+356) 2550 2500

Website http://www.centralbankmalta.org

E-mail [email protected]

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The cut-off date for information relating to banking, insurance and investment funds is 11 March 2013. The source of data in tables and charts is the Central Bank of Malta unless otherwise indicated.

ISSN 2074-2231

CONTENTS PREFACE 7

1. OVERVIEW 9

2. THE MACRO-FINANCIAL ENVIRONMENT 11 2.1 The external environment 11 Box 1 Single Supervisory Mechanism 14 2.2 The domestic environment 16

3. FINANCIAL STABILITY CONDITIONS 19 3.1 Credit risk 19 3.1.1 The corporate sector 19 Box 2 Bank Lending Survey results 23 3.1.2 The household sector 24 3.1.3 Quality of bank loans 25 3.2 Other asset holdings 26 3.2.1 Foreign asset holdings 26 3.2.2 Domestic government paper 27 3.3 Funding 28 3.3.1 Customer deposits 28 3.3.2 Eurosystem and wholesale funding 29

4. RESILIENCE OF CORE DOMESTIC BANKS 31 4.1 Balance sheet developments 31 4.2 Profitability 33 4.3 Loan loss provisions 34 4.4 Liquidity 35 4.5 Capital and leverage 35 4.6 Stress tests 37

5. THE OTHER COMPONENTS OF THE FINANCIAL SYSTEM 40 5.1 Non-core and international banks 40 5.1.1 Non-core domestic banks 40 5.1.2 International banks 43 5.2 Insurance and investment funds sector 45 5.2.1 Domestic insurance companies 45 5.2.2 Domestic investment funds 47

6. RISK OUTLOOK AND RECOMMENDATIONS 49

APPENDIX 55

GLOSSARY 57

CHARTS & TABLES

Chart 2.1: Euro area GDP growth rate 11Chart 2.2: DJ STOXX 600 (Europe) 12Chart 2.3: Volatility Index - VDAX 12Chart 2.4: Dispersion of euro area ten-year sovereign bond yields 12Chart 2.5: Composite indicator of systemic stress (CISS) 13Chart 2.6: Contribution to GDP growth 16Chart 2.7: Debt-to-GDP ratio of euro area countries (2012) 17Chart 2.8: Yield curves 17Chart 2.9: Unemployment rates 18Chart 2.10: Malta Stock Exchange Index 18Chart 3.1: Contribution to growth in gross value added 19Chart 3.2: Change in nominal residential property prices 19Chart 3.3: Valuation perceptions of residential and commercial properties 20Chart3.4: Profitabilityoflistednon-financialcompanies 21Chart 3.5: Bank lending to selected corporate sectors - core domestic banks 21Chart3.6: Indebtednessofnon-financialcorporates 22Chart 3.7: Concentration in resident corporate lending - core domestic banks (2012) 22Chart 3.8: Weighted average interest rates on resident household loans - core domestic banks 24Chart3.9: Nethouseholdfinancialwealth 25Chart 3.10: Distribution of household loans backed by residential property by income bracket - core domestic banks 25Chart 3.11: NPL ratios - core domestic banks 25Chart 3.12: Change in NPL ratio (2012 compared to 2011) - core domestic banks 26Chart 3.13: Sectoral allocation of loans and NPLs - core domestic banks (2012) 26Chart 3.14: Asset holdings of selected countries - core domestic banks (2012) 27Chart 3.15: Euro area holdings - core domestic banks 27Chart 3.16: Outstanding MGS by ownership and redemption date (2012) 28Chart 3.17: Growth in customer deposits - core domestic banks 28Chart 3.18: Banks’ liability components - core domestic banks (2012) 29Chart 4.1: Growth in total assets of MFIs - selected euro area countries 31Chart 4.2: Contribution to balance sheet growth - core domestic banks 31Chart 4.3: Distribution of bank assets - core domestic banks 32Chart 4.4: Securities portfolio - core domestic banks 32Chart 4.5: Customer loan-to-deposit ratio - core domestic banks 32Chart 4.6: Return on equity - core domestic banks 33Chart 4.7: Return on assets - core domestic banks 33Chart 4.8: Coverage ratio - core domestic banks 35Chart 4.9: Liquid assets to short-term liabilities - core domestic banks 35Chart 4.10: Growth in Tier 1 capital and risk-weighted assets - core domestic banks 36Chart 4.11: Solvency ratios - core domestic banks 36Chart 4.12: Leverage ratio - core domestic banks 36Chart 4.13: Stress test results - impact of deterioration in securities portfolio on Tier 1 capital 37Chart 4.14: Stress test results - impact of an increase in NPLs in key economic sectors on Tier 1 capital 38Chart 4.15: Stress test results - impact of an increase in NPLs by sector on Tier 1 capital (2012) 38Chart 4.16: Stress test results - impact of a drop in house prices on Tier 1 capital (2012) 39Chart 4.17: Stress test results - impact of persistent deposit withdrawals on liquid assets (2012) 39

Chart 5.1: Asset structure - non-core domestic banks 40Chart 5.2: Customer loans by residency - non-core domestic banks 41Chart 5.3: Investment securities by residency - non-core domestic banks 41Chart 5.4: Liabilities structure - non-core domestic banks 41Chart5.5: Profitability-non-coredomesticbanks 42Chart 5.6: Solvency ratios - non-core domestic banks 42Chart 5.7: Asset structure - international banks 43Chart 5.8: Customer loans by residency - international banks 43Chart 5.9: Investment securities by residency - international banks 44Chart 5.10: Liabilities structure - international banks 44Chart5.11: Profitability-internationalbanks 44Chart 5.12: Solvency ratios - international banks 45Chart 5.13: Investment assets of the insurance sector (2012) 45Chart5.14: Profitcomponentsoftheinsurancesector 46Chart5.15: Profitabilityoftheinsurancesector 46Chart 5.16: Risk retention ratio 47Chart 5.17: Net asset value of the investment funds sector 47Chart 5.18: Asset allocation of the investment funds sector (2012) 48Chart 5.19: Holdings in investment funds (2012) 48

Table 1.1: Summary of risks 10Table4.1: Maincomponentsoftheprofitandlossaccount-coredomesticbanks 34Table6.1: Measurestoaddresskeyrisksinthefinancialsystem 51

BOX CHARTS

Box 2 Chart 1: Credit standards 23 Chart 2: Credit demand 23

APPENDIX

Table 1: Financial soundness indicators 55

ABBREVIATIONS

BLS Bank Lending SurveyBR Banking RuleCAR Capital adequacy ratioCDS Credit default swapsCIS Collective investment schemeCISS Composite indicator of systemic stressCRD Capital Requirements Directive CT1 Core Tier 1EBA European Banking AuthorityEC European CommissionECB European Central BankECOFIN Economic and Financial Affairs CouncilEFSF European Financial Stability FacilityESM European Stability MechanismESRB European Systemic Risk BoardEU European UnionGDP Gross domestic productGVA Gross value addedHCI Harmonised competitiveness indicatorsICT Information and communications technologyIMF International Monetary FundLCR Liquidity Coverage RatioMFI MonetaryfinancialinstitutionMGS Malta Government Stocks MSE Malta Stock ExchangeNCA National Competent AuthoritiesNPL Non-performing loanNSO NationalStatisticsOfficeOMT Outright Monetary TransactionsPD Probability of defaultROA Return on assets ROE Return on equitySSM Single Supervisory MechanismUK United Kingdom US United States

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CENTRAL BANK OF MALTA Financial Stability Report 2012

PREFACE

Financialstabilityreflectstheabilityofthefinancialsystem,comprisinginstitutions,marketsandinfrastruc-tures,toefficientlysupplythenecessarycreditintermediationandpaymentservicestotherealeconomytoenableittoachievesustainablegrowth,tobeabletoallocatesavingsintoinvestmentopportunitiesandtofacilitatetheefficientsettlementofpayments.Financialstabilityalsoallowsthesystemtoabsorbshocksandthusmanagerisksthatmayharmitsperformanceand,consequently,thatoftheeconomy.

The Financial Stability Report, hereinafter referred to as theReport, reviews and assesses themacro-financialconditionsanddevelopmentsof thefinancialsystem inMalta. Itevaluates the resilienceof thesystemandidentifiessourcesofpotentialsystemicrisk.Italsomakesrecommendationstopreserveand,wherenecessary,improvetherobustnessofthefinancialsystem.Furthermore,theReport seeks to promote awarenessoftheworkingsofthefinancialsysteminMaltaandofrelatedfinancialstabilityissues.

The analysis and information contained in the main text of the Report is based on activities of those institu-tions,banks,insurancecompaniesandinvestmentfundswhichplayasignificantroleintheeconomy.Themain analysis in the Report focusesonactivitiesof thosebanksclassifiedascoredomesticbanks.1 To ensureacomprehensivecoverageofallsystemicriskaspects,theReport includes an additional analysis ontherestofthefinancialsysteminaseparatesection.FinancialsoundnessindicatorsareshowninanAppendix.

The Report is prepared by the Financial Stability Department of the Bank and is subsequently reviewed and endorsedbytheFinancialStabilityCommittee.TheCommitteeischairedbytheGovernor,andincludesasmemberstheDeputyGovernor, theDirectorGeneral,FinancialPolicyandSpecialProjects, theDirector,MarketOperations,theDirector,FinancialStability&InformationSystems,andtheAdvisortotheGovernor.

1 ThecoredomesticbanksareAPSBankLtd,BanifBank(Malta)plc,BankofVallettaplc,HSBCBankMaltaplc,andLombardBankMalta plc. The list of institutions forming part of the non-core and international banks remained the same as in 2011 (refer to Financial Stability Report 2011).

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1. OVERVIEW1

Thedomesticfinancialsectorcontinuedtodemonstraterobustnessthroughout2012,whileitfacedchalleng-esfromanuncertainexternalenvironmentcharacterisedbyfragileconditionsinfinancialmarkets.However,the agreement by European Union authorities on policy actions and other measures aimed at strengthening thesupervisoryregime,andthetimelyinterventioninfinancialmarkets,contributedtomitigaterisksassenti-mentintheinternationalfinancialmarketsimprovednoticeablyinthesecondhalfoftheyear.

Against thisuncertainbackdrop, theMalteseeconomyregisteredpositivegrowthunderpinnedby furtherexpansion in specific high value added sectors, such as information and communications technology,financeandtourism.TherelativelybuoyantdomesticeconomyandthelowrateofunemploymentinMaltawere important factors supporting the stability of the banking system.

Thebalancesheetsofcoredomesticbanksexpandedby3.5%during2012reflecting, toa largeextent,growth in their lendingportfolios,whichroseby1.8%andrepresentedalmost60%of theirassets.As inrecentyears,mortgagelendingremainedthemaindriverofcreditactivity.Thisroseby6.8%,whereascor-poratelendingcontractedby1.1%.Customerdepositsremainedthebanks’mainsourceoffunding,growingby5.6%duringtheyear.Theseaccountedforaround82%oftheaggregatebalancesheetvalue.Asaresult,theloan-to-depositratioacrosscoredomesticbanksatabout70%remainedataprudentlevel,wellbelowtheaverageratioofeuroareabanks,whichstoodataround110%.Wholesalefundingremainedminimal.Core domestic banks’ exposure to fragmented markets in the euro area and possible contagion effects were substantiallylimited.Similarly,bankswerefairlyinactiveintheEurosystemweeklyauctions,owingtoamplelevelsofliquidityavailableinthedomesticfinancialmarket.

During2012therisksandthreatsfacedbythelocalfinancialsectorremainedbroadlystable,withnonewchallenges emerging since the last edition of the Financial Stability Report and its Update. With respect tocreditrisk,thecoredomesticbanks’exposuretospecificsectors,particularlytheconstructionandrealestatesector,oncemorecontinuedtoposeconcentrationrisksatatimewhenthissectorwasexperiencingsubduedactivity.Thus,duringtheyearthelevelofnon-performingloansincreasedfurther,particularlyinrespecttolendingwhichinvolvedimmovableproperty.Toaddresstheserisks,in2012bankssubstantiallyincreasedtheirprovisioninglevels,whilstapplyingrelativelyhighhaircutsoncollateralvalues.Meanwhile,supervisory authorities encouraged banks to continue monitoring their loan books and to periodically assess theircustomers’creditworthiness.Furthermore,bankswerealsourgedtomaintainhaircutsathighlevelson immovable property offered as collateral. With regard to their holdings of securities issued by stressed euroareacountries,bankscontinuedtodisposeofsuchassetswhileincreasingtheholdingsofhigherratedsovereign securities.

Throughout2012coredomesticbanks’capitaladequacyratiosremainedwellabovetheregulatoryminima,standingat14.3%forthecapitaladequacyratioandat10.3%fortheTier1capitalratio.Furthermore,thequalityofcapitalremainedhigh,underpinnedbytheaccumulationofreservesbywayofretainedearnings.

In2012theprofitsofcoredomesticbanksrosebymorethanathird,reflectingasteadyincomestreamfromtheirtraditionalbankingbusinessoperations.Thebanks’liquidityrisksalsoremainedcontained,owingtotheirreliance on stable funding sources in the form of customer deposits. Ahead of the deadline to meet regula-toryrequirements,inparticulartheCapitalRequirementsDirectiveIV,theCentralBankofMaltaencouragedbankstofurtherstrengthentheircapitalthroughhigherlevelsofretainedearnings.Thus,whileingeneralthebusinessoutlookforcoredomesticbanksappearstobepositive,ahighlevelofprofitscannotbeassuredgiven the low interest environment and the need to meet new supervisory and regulatory requirements.

Risksemanatingfromothercomponentsofthefinancialsectors’balancesheet(i.e.excludingcoredomes-tic banks) remained broadly low and unchanged. Both non-core and international banks maintained high

1 All quoted ratios are based on weighted averages unless otherwise stated.

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solvency and liquidity levels and mainly focused on transactions with non-residents. The size of interna-tional banks remainedrelativelyhighasaproportionofthetotalbankingsector.However,linkageswiththedomestic economy remained minimal so that any negative systemic risks are remote. Although the non-bank financialsectorwasoncemorehighlyinterlinkedwithcoredomesticbanks,suchlinksposelittlerisktothefinancialsector.Theperformanceofsuchinstitutionsremainedsatisfactorythroughout2012.

Table 1.1 SUMMARY OF RISKS

Moderate Medium Elevated

Vulnerabilities within the financial system

Increasing non-performing loans and the low level of provisioning Credit ↔ ● ↔Concentration of bank lending and collateral towards property Credit ↔ ● ↔

High proportion of short-term funding Liquidity ↔ ● ↔

Subdued credit demand Profitability ↑ ● ↔Interlinkages between bank and non-bank financial institutions Contagion ↔ ● ↔

Vulnerabilities outside the financial system

Subdued economic conditions Credit,Profitability ↑ ● ↔

Weak activity within the construction sector and low property market turnover Credit ↔ ● ↔

Feedback loop between the public and financial sectors Profitability ↔ ● ↔

EU sovereign debt crisis Contagion,Profitability ↓ ● ↔

Government re-financing needs Liquidity ↔ ● ↔

Main vulnerabilities and risks for the financial system Type of risk

Change in risk level

since 2011 FSR

Risk position as at 2012 Risk outlook for 2013

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2. THE MACRO-FINANCIAL ENVIRONMENT

Throughout 2012 the economic and financial environment remained fragile, as global growth prospectswereagainweakandeuroareafinancialmarketsremainedfragmented.Overall,theeuroareaeconomycontracted,butheterogeneityacrossMemberStatesresultedinawidedivergenceinkeyindicators.Duringthefirsthalfoftheyear,internationalfinancialmarketswereoncemoreinfluencedbytheunfoldingeuroareasovereigndebtcrisis,whichincreaseduncertaintyandcontinuedtofragmentmarketconditions.However,duringthesecondhalfoftheyear,tensionsinEuropeanfinancialmarketseasedconsiderably,underpinnedby a number of complementary policy actions by the European Central Bank (ECB) and the European Com-mission (EC). These measures contributed to the reduction of high impact events and strengthened the supervisoryregimethroughthecreationofasinglebankingsupervisorfortheeuroarea,whichinturn,ledto a general decline in sovereign debt yields and to receding trends in systemic risk indicators.

Lookingahead,intheshorttomediumterm,anumberofdownsideriskspersistintheeuroarea.Theseemergefromseveralchallenges,including:theneedforfurtherfiscalconsolidationandstructuralreformsatthenationallevel,thehighlevelofunemploymentandtheprevailingtightcreditconditions.InMay2013theECB,takingintoconsiderationthesefactorsandtheabsenceofthreatstopriceinflationinthemediumterm,reduceditsmainrefinancingrateto0.50%.

TheMalteseeconomyremainedresilient inthisscenario,supportedbyrelatively lowunemploymentandsustainedgrowthinspecifichighvalueaddedsectors,suchasinformationandcommunicationstechnology,financeaswellastourism.However,downsiderisksshouldnotbeoverlooked,particularlyifgrowthintheeuro area decelerates further than anticipated.

2.1 The external environment

Worldeconomicgrowthdeceleratedfurther,withtheglobalgrossdomesticproduct(GDP)growingby3.1%inrealterms,downfrom4.2%in2011.TheUSeconomygrewby1.3%,whereaseconomicgrowthintheUKstoodat0.3%.Meanwhile,theeuroareaeconomycontractedby0.6%in2012,fallingshortoftheEC’sforecastof-0.3%.Moreover,theeuroareacontinuedtoregistersignificantcross-countryheterogeneity,withreal GDP growth ranging from -6.4% to 3.2% among Member States (see Chart 2.1). A similar dispersion was evident in the labourmarket,with unemployment rates ranging between 4.4% and 25%, resultingin an average of 11.4% for the euro area as a whole.

Commodity prices increased fur-ther during the year, with oil pric-es (in US dollars) rising by 2.2%,whereas the price of gold went up by 7.1%. Moreover, pressuresin the equity market appeared to have abated, particularly dur-ing the second half of 2012, withthe DJ STOXX Europe 600 Index recovering by 14.4%, althoughremaining significantly below pre-crisis levels1. The banking compo-nent of the index recorded a larger

1 The DJ STOXX Europe 600 index is derived from the STOXX Europe total market index and is a subset of the STOXX Global 1800 index.Withafixednumberof600components,theSTOXXEurope600indexrepresentslarge,mid-andsmallcapitalisationcompaniesacross 18 countries in Europe.

-15

-10

-5

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5

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2008 2009 2010 2011 2012 2013

Max-Min Range euro area

Chart 2.1EURO AREA GDP GROWTH RATE(per cent)

Source: European Commission.

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improvement, rising by 23.1% (seeChart 2.2). Meanwhile, standard volatility benchmarks also declined,reaching the lowest levels since the outbreak of the sovereign debt crisis in 2007 (see Chart 2.3).2

Tensions in the euro area sovereign debt market continued throughout 2012. Heightened risk aversion,particularly in the first half of theyear, contributed to a widening ofthe divergence in government bond yields(seeChart2.4).However,dur-ing the latter half of 2012, financialconditions improved, with risks tofinancial stability abating followingvarious policy responses by authori-ties. These led to a general drop in sovereign bond yields and to a decline in sovereign credit default swaps (CDS) from their peak levels. Furthermore, the risk of joint sover-eign defaults (represented by co-movements in the sovereign CDS) also declined, aided by the ECB’snon-standard measures and by the adjustment programmes undertaken by highly indebted countries.

This improvement was reflectedin several systemic risk indicators,including the Composite Indicator of Systemic Stress, which fell steadilyduring the year, although remain-ing slightly above pre-crisis levels (see Chart 2.5).3 Nevertheless, inearly 2013, challenges across theeuro area re-surfaced, with Cyprusbeing the fifth country to request aEuropean Union/International Mon-etary Fund (EU/IMF) programme. Contagion to other euro area mar-kets was largely contained as the exposure of euro area banks to Cypruswas limited,with theexcep-tionofGreece,wheretheoperationsof Cypriot banks located in Greece were ring-fenced.

During the year credit standards in the euro area remained rather tight,2 VDAXisameasureoftheimpliedvolatilityoftheDAX,whichisabluechipstockmarketindexconsistingofthe30majorGermancompanies trading on the Frankfurt Stock Exchange.3 TheCISSisanindicatorcomposedof15financialstressmeasuressplitequallyinfivecategories,includingthefinancialintermediariessector,moneymarkets,equitymarkets,bondmarketsandforeignexchangemarkets.

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All companies Banks

Chart 2.2DJ STOXX 600 (EUROPE)

Source: Reuters.

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Chart 2.3VOLATILITY INDEX - VDAX

Source: Reuters.

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Minimum Maximum

Chart 2.4DISPERSION OF EURO AREA TEN-YEAR SOVEREIGN BOND YIELDS (per cent)

Source: Reuters.

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constraining credit supply. Bank profitability was on the low side,partly affected by banks’ asset qual-ity. The latter persisted as a key con-cern in view of weak economic activ-ity, togetherwith declining propertyprices in several Member States.

Throughout 2012 the ECB and EU Member States took various steps to manage and mitigate risks aris-ing from the sovereign debt crisis and from the negative feedback loops to the banking sector. Apart from further lowering its key policy interestrate,theECBimplementeda number of additional non-standard measures. In September it launched theOutrightMonetaryTransactions,involving the purchase of sovereign bonds in secondary markets by the ECB. This measure was aimed atrepairingthemonetarytransmissionmechanismindysfunctionalfinancialmarkets,particularlythoseinstressed euro area countries.4Furthermore,inordertocontinuesupportingliquidity,theECBwidenedtheeligibility criteria for collateral and extended the list of eligible marketable debt instruments for the Eurosys-tem’s monetary operations. In September 2012 the EC proposed a single supervisory mechanism (SSM) for European banks. This is the initial step towards an integrated banking union with the ultimate objective of stabilisingthefinancialsystem.Otherobjectivesofthebankingunionareabreakinthelinkbetweenbanksandsovereignsandareductioninfinancialmarketfragmentation.InDecembertheEconomicandFinancialAffairsCouncil(ECOFIN)reachedanagreementontheSSM,givingtheECBbankingsupervisorypowersover all credit institutions in the euro area and in other participating non-euro area Member States (see Box 1).WhiletheSSMisexpectedtorestoreconfidenceintheeuroareabankingsector,itisenvisagedthatitwill eventually be complemented with a single resolution mechanism and a common deposit insurance fund.

Towardstheendof2012, theeuroareafinanceministersandtheIMFreachedanagreement toreduceGreekdebt,atwhichpointEuropeanauthoritiesreleasedmorethan€34billioninbail-outfunds(€23.8billiontobanksand€10.6billioninbudgetassistance).Anadditional€9.3billionwastobepaidinthreetranchesbytheIMF.Throughthesemeasures,Greececompletedadebtbuybacktoreduceitsoutstandingdebtlevel.Oncompletion,StandardandPoor’supgradedGreece’screditratingtoB-.5Until5July2013,Europeanauthoritieshaddisbursedmorethan€130billioninbail-outfunds.

InJune2012SpainrequestedafacilityfromtheEUtofinancetherecapitalisationofbanks,followinglargelosses incurred on the collapse of the real estate market. This assistance was provided by the European FinancialStabilityFund(EFSF)intheformofloanswithanagreedmaximumof€100billion.Bytheendof2012,around€40billionwereinjectedintofourSpanishbanks.During2012Spainwasdowngradedgradu-ally from AA- as at end-2011 to BBB- in October 2012 by Standard and Poor’s.

Inthefirsthalfof2011,PortugalrequestedanEU/IMFprogrammeamountingto€78billion,whichshouldrun until June 2014. Since then several measures have been undertaken by the Portuguese Government to restoresustainabilityinpublicfinances.Byend-2012,Portugalregainedaccesstofinancialmarketsfollow-ingasuccessfulbondexchangeplan.Duringlate2012andearly2013,thePortugueseGovernmentinjectedalmost€7billiontorecapitalisethreebanks.

4 StressedcountriesincludeCyprus,Greece,Italy,Ireland,PortugalandSpain.5 FollowingtheannouncementbyGreeceofitsintentiontoconductabondbuyback,S&PdowngradedGreecetoSelectiveDefaultfromCCC.Thisdowngradewasreversedshortlyafterthecompletionoftheprogramme,withthenewB-ratingbeingthestrongestratingsinceJune 2011.

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Chart 2.5COMPOSITE INDICATOR OF SYSTEMIC STRESS (CISS)

Sources: Reuters; ECB and ECB calculations.

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Throughout2013theeuroareaeconomyisexpectedtocontractby0.4%,considerablybelowpreviousestimates which had forecast a growth rate of 1%. Labour market conditions are projected to deterio-rate,withtheunemploymentratereaching12.2%in2013.6 Cross-country heterogeneity is expected to persist,withproblemsinstressedcountriescontinuingtoplaceconstraintsontheoverallrecoveryoftheeuro area.

6 Source:EuropeanEconomicForecastSpring2012,EuropeanEconomicForecastWinter2013.

BOX 1: SINGLE SUPERVISORY MECHANISM The process towards a banking union

Attheeuroareasummitof29June2012,theHeadsofStateorGovernmentdecidedtoestablishasinglebankingsupervisorymechanism runby theECB, followingwhich theEuropeanStabilityMechanism (ESM) would be enabled to inject funds directly into distressed banks.1 On 12 September 2012,theECadoptedapackageofproposalstosetupaSSMforbanks.

The proposed package is set on three pillars:

(i) alegislativeproposalforaCouncilRegulationtoassignspecifictaskstotheECB;(ii) a legislative proposal for a regulation designed to align the existing European Banking Authority

(EBA)Regulationtothemodifiedframeworkforbankingsupervision;(iii) a communication on a roadmap for completing a banking union (which would incorporate a

SSM,aSingleResolutionMechanismandaSingleDepositInsuranceMechanism).

AgreementonthesethreepillarswasreachedbyEUfinanceministersataspecialECOFINmeetingon 12-13 December 2012.2 This process is expected to break the negative feedback loop between governmentsandbanks,andtorestoreconfidenceinthesoundnessofthebankingsystem.

ThisboxexplainsthemainfeaturesoftheproposedSSM,liststhetasksoftheECBandthenationalcompetentauthorities(NCA)withinthisframework,andbroadlydescribesthebenefitsoftheSSM.

Role of the ECB within the SSM

InlinewithArticle127(6)oftheTreatyoftheFunctioningoftheEuropeanUnion,theproposedregu-lationconferson theECBspecific tasksconcerningpolicies relating to theprudentialsupervisionof credit institutions. The objective of the regulation is to contribute to the safety and soundness of creditinstitutions,andtothestabilityofthefinancialsystemwithintheEUandineachMemberState.Besides theECB, theSSMwill involveNCAs in thesupervisionofbanksestablished inMemberStates participating in the Mechanism. The ECB shall be responsible for the overall effective function-ing of the SSM and shall assume all the tasks conferred on it by the proposed Regulation 12 months afteritsentryintoforce.TheNCAsshallassisttheECB,includingintheon-goingday-to-dayassess-mentofabank’ssituationand relatedon-siteverifications.TheECBshallcooperatecloselywiththe EFSF and with relevant resolution authorities and other mechanisms providing direct or indirect publicfinancialassistance.

1 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131359.pdf2 http://register.consilium.europa.eu/pdf/en/12/st17/st17812.en12.pdf

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The SSM framework shall cover all credit institutions established in euro area countries and in other EUparticipatingMemberStates (estimatedatmore than6,000banks).3 The ECB shall carry out directsupervision,inconjunctionwithNCAs,ofthosebanksthataredeemedsignificant,specificallyaround 130 banks.4Lesssignificantbanksshall continue tobesupervisedbyNCAs,whichshallabidebyECBregulations,guidelinesorgeneralinstruction.TheECBshallhaveaccesstodatacon-cerning all credit institutions and may opt to exercise direct supervisory powers on any credit institu-tion,eitheronitsowninitiativeoruponrequestbyNCAs.

TheECBshallconducton-sitesupervisionofsignificantbanksthroughthedeploymentofjointteamswith respective competent authorities, whilst off-site supervision shall be carried out through theassessmentofkeyindicatorsfortheentirebankingsystem.AssetoutinArticle5(4)oftheregulation,abankisdeemedtobesignificantif:

(i) thetotalvalueofitsassetsexceeds€30billion;or(ii) the ratio of total assets to GDP of the participating Member State of establishment exceeds

20%,unlessthetotalvalueofassetsisbelow€5billion;or(iii) following a notification by the NCA to consider an institution of significant relevance in the

domesticeconomy, theECB takesadecisionconfirmingsuchsignificance following itsowncomprehensivereview,includingabalancesheetassessment.

TheECBmayalso,onitsowninitiative,consideraninstitutiontobeofsignificantrelevancewhenit has established banking subsidiaries in more than one participating Member State and its cross-borderassetsorliabilitiesrepresentasignificantpartofitstotalassetsorliabilities.ThosebanksforwhichpublicfinancialassistancehasbeenrequestedorreceiveddirectlyfromtheEFSFortheESMshallbeautomaticallyconsideredassignificant.Asaminimum,theECBshallcarryout thetasksconferredonitbythisregulationforthethreemostsignificantcreditinstitutionsineachofthepartici-patingMemberState,unlessjustifiedbyparticularcircumstances.BranchesinEUcountriesnotpartof the SSM but originating from participating Member States are subject to supervision by the SSM.

Supervisory tasks of the ECB

The following are the tasks conferred on the ECB by the proposed regulation:

(i) to authorise and to withdraw authorisation of credit institutions;(ii) to assess applications for the acquisition and disposal of qualifying holdings in credit institutions;(iii) to ensure compliance with prudential requirements on credit institutions in the areas of own

fundsrequirements,securitisation,largeexposurelimits,liquidity,leverage,andreportingandpublic disclosure of information on those matters;

(iv) to ensure compliance with Union acts requiring credit institutions to have in place robust gover-nance arrangements;

(v) tocarryoutsupervisoryreviews,includingstresstestsandtheirpossiblepublication;(vi) to carry out supervision on a consolidated basis of credit institutions’ parents established in one

of the participating Member States;(vii) toparticipateinsupplementarysupervisionofafinancialconglomerate;(viii) to carry out supervisory tasks in relation to recovery plans and early intervention.

Withregardtomacro-prudentialpolicy,theECBshallalsobeempoweredtoapplyhigherrequire-mentsforcapitalbuffersandotherprudentialmeasuresspecificallysetoutinrelevantUnionlaw,if

3 The regulation allows non-euro area EU Member States to participate through the setting up of close cooperation. 4 InArticle5,paragraph4,significant relevance isdeterminedaccording tosize, importance for theeconomyandcross-border activities.

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2.2 The domestic environment

During 2012 Malta’s economic activityremainedgenerallyresilient,outperforming the euro area. Eco-nomicgrowthin2012wasat0.8%,lower than the 1.7% registered in 2011. This slowdown was largely driven by a decline in domestic demand, primarily contractions inboth gross capital formation and household consumption. On the otherhand,governmentconsump-tion expenditure increased during theyear,whilenetexportscontrib-uted positively to GDP growth add-ing just under 1 percentage point (see Chart 2.6). At 5.2%, exportsgrewatafasterpacethanimports,which rose by 4.4% during 2012.

deemed necessary to address systemic or macro-prudential risks.5 Tasks not listed in the regulation shall be carried out by NCAs.

Tocarryoutthetaskslistedabove,theECBhasbeenallocatedanarrayofpowers,whichincludeinvestigatorypowers,authorisation,supervisorypowersandsanctioning.Toavoidconflictofinterestbetweensupervisionandmonetarypolicy,theproposedregulationestablishesasupervisoryboardto carry out preparatory work and propose to the Governing Council of the ECB draft decisions for its adoption. Unless an objection is made by the Governing Council within a period not exceeding a maximumoftenworkingdays,adraftdecisionwillbedeemedadopted.Tosupportitsactivities,asteering committee will be appointed by the Supervisory Board.

The proposed regulation requires the ECB to be accountable to the European Parliament and to the EuropeanCouncil.TheECBshallsubmiteachyear to theEuropeanParliament, theCouncil, theCommission,theEurogroupandthenationalparliamentsofparticipatingMemberStates,areportonthe execution of the tasks.

Benefits of the SSM

TheSSMoffersanumberofbenefits.First,theESMcanprovidedirectrecapitalisationtotroubledbanksunderauniformframework,thusaddressingtheissueofthefeedbackloopbetweensover-eignsandbanks.Second,theSSMisexpectedtoenhancebankingsupervision,thusfacilitatingamoreeffectiveidentificationandmitigationofrisks.Third,theSSMwillcontributetotheharmonisa-tionofsupervisorypracticesacrossMemberStates,thuslimitingregulatoryarbitrageandensuringgreatertransparencyandcomparability.Fourth,theECBshallhaveaccesstosupervisoryskillsandexpertisefromallparticipatingMemberStates.Finally,theSSMisexpectedtocontributesignificantlyinreversingfragmentationwithinthefinancialmarketandtorestoreconfidenceinthebankingsector.

5 Article4aoftheProposalforaCouncilRegulationconferringspecifictasksontheECBconcerningpoliciesrelatingtotheprudential supervision of credit institutions (Regulation EU No. 17812/12).

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Chart 2.6CONTRIBUTION TO GDP GROWTH(percentage points; per cent)

Source: NSO.

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Asobserved in the last fewyears,some economic sectors continued to register rapidgrowth,whileoth-ers lagged behind. Activity within the construction sector remained subdued,decelerating furtheroverthe previous year. Lower invest-ment by the private sector in con-struction may imply some contain-ment of supply conditions in the real estate market. According to the Real Estate Market Survey of the CentralBankofMalta,demandforreal estate remained subdued. Dur-ingtheyear,theBank’sadvertisedresidential property price index registered an average marginal increase of 0.5% and is projected to rise further by 1.8% in 2013. In2012thepublicdebt-to-GDPratioincreasedto72.1%from70.3%ayearearlier,whilethedeficitstoodat3.3%ofGDP.Althoughexceedingthe60%benchmarksetbytheMaastrichtcriteria,thepublicdebt-to-GDPratio remains lower than the euro area average (see Chart 2.7).

Malta’s sovereign debt credit rating was downgraded by two credit rating agencies but was kept unchanged by another rating agency.7Ontheotherhand,theyieldcurveforMaltagovernmentsecuritiesshifteddown-wardscomparedwith2011(seeChart2.8).Meanwhile,thespreadontheten-yeargovernmentbondvis-à-vistheGermanbundnarrowed.Strongdemandcontinuedfordomesticsovereigndebt,whichismostlyheldby residents, and benefitted fromthe domestic economy’s resilience to international turmoil.

In terms of external competitive-ness, Malta’s Harmonised Com-petitiveness Indicators (HCI) based on consumer price indices declined by0.6%over theprevious year, alower extent than the drop of the euro area average, which fell by2.3% annually.8 The unit labour cost index for Malta continued to rise, up by 3.7% during 2012, afaster rate than in the euro area where the index rose by 1.5%. In 2012 the country’s current account turned into a surplus of €24.2mil-lion,comparedwithanaveragedef-icitof€266.5millionintheprevious

7 InFebruary2012Moody’sadjustedtheratingsofnineEuropeansovereigns,includingMalta,tocapturedownsiderisks.Asaresult,Malta’sgovernmentbond ratingwasdowngraded toA3 fromA2,with theoutlook remainingnegative.StandardandPoor’s loweredMalta’screditratinganotchtoA-inJanuary2012andthentoBBB+inJanuary2013,alsowithastableoutlook.Fitchkeptitscreditrat-ing stable at A+.8 The HCI produced by the ECB provides a comparable measure of euro area countries’ price and cost competitiveness that are also consistent with the real effective exchange rates of the euro.

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Chart 2.7DEBT-TO-GDP RATIO OF EURO AREA COUNTRIES (2012)(per cent)


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Chart 2.8YIELD CURVES(per cent)

Sources: ECB and Central Bank of Malta.

18


fiveyears.Theunemploymentrateincreased slightly to 6.5% by end-2012, remaining amongst the low-est across euro area countries (see Chart 2.9).

Meanwhile, the financial sector, inparticular the banking sector, sup-portedfinancialstabilitywithaposi-tive flow of credit supply, despitetight credit standards. The domes-tic banks’ business model togeth-er with their limited exposure to stressed countries enabled banks to maintain their already high prof-itability levels. Furthermore, suchprofits continued to support thebuild-up of capital buffers.

The financial infrastructure pro-vided further effective support to the domestic economy. Throughout the year, payment and securitiessettlement systems maintained a high levelofefficiency,ensuringasmooth transfer of funds and clear-ance of securities.

Meanwhile, the Malta StockExchangeIndexroseby3.8%,mir-roring the higher share prices of listed banks, which constitute thebulk of stock market capitalisation (see Chart 2.10).

In early 2013, the EC’s consumerand industry confidence indicatorsfor Malta showed signs of further improvement,despiteremainingnegativethroughout2012.Thesetrendscontrastwiththeeuroareaaver-age,whichworsenedduring2012.

Lookingahead,theMalteseeconomyisprojectedbytheCentralBankofMaltatogrowby1.4%in2013,withasubduedoutlook,giventheslowdownintheworldeconomicgrowthandthenegativeoutlookintheEuropeanUnion.TheinflationratebasedontheHarmonisedIndexofConsumerPricesisanticipatedtodeclineto1.4%in2013,andisexpectedtodropfurtherintheforthcomingyears.Theunemploymentrateisforecast to remain stable at 6.5% in 2013.

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Chart 2.9UNEMPLOYMENT RATES(per cent)

The shaded area shows the max-min range of unemployment rates within the euro area.


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Chart 2.10MALTA STOCK EXCHANGE INDEX

Sources: MSE and Central Bank of Malta calculations.

19


3. FINANCIAL STABILITY CONDITIONS

During2012risksfacedbythefinancialsectorremainedbroadlyunchangedfromthoseidentifiedayearearlier.Modesteconomicgrowth,aswellasslackconditions in theconstructionand realestatesectorscontributedtoanincreaseincreditrisk,althoughthiswaspartiallyaddressedbyahigherlevelofprovisionsbybanks.Incontrast,sovereignriskremainedinsignificant,owingtobanks’limitedholdingsofdebtissuedbycountriesundergoinganadjustmentprogramme.Meanwhile,liquidityremainedample,particularlyastheflowofresidentdepositswaspositive,supportingbanks’operations.

3.1 Credit risk

In 2012 credit risk increased marginally from 2011. In light of continued weaknesses in certain sectors of theeconomy,thelevelofnon-performingloans(NPL)inthecorporatesectoredgedup.Creditriskfromthehouseholdsector,however,remainedlow,supportedbyhighemploymentlevelsandfurtheraccumulationoffinancialwealth.

3.1.1 The corporate sector

The performance of non-financialcorporations in aggregate improved during 2012, with their operatingsurplus increasing by 3.8% year-on-year. However, at a sectorallevel, results were mixed. Somecorporations, particularly thoseinvolved in financial services, ICT,gaming and the high value added industries operating in the manu-facturing sector, maintained theirmomentum.Ontheotherhand,theperformance of enterprises within the construction sector continued to be affected negatively by the weak local property market. Chart 3.1 illustrates the varying contribu-tions of economic sectors to gross domestic product (GDP) growth.

Construction and real estateDespite the slowdown in business activities, the performance of boththe construction and real estate sectors was positive during 2012. The operating surplus of the con-struction sector rose by 4.5% over the previous year, whilst that ofthe real estate sector went up by 4.9%.1 However, these sectors’contribution to gross value added (GVA) was negligible since com-pensationofemployees, theother

1 Source: NSO.

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2008 2009 2010 2011 2012Construction and real estateManufacturingProfessionalservices,informationandcommunicationFinancial and insurance activitiesWholesale,retail,transportandaccommodationOthersTotal gross value added

Chart 3.1CONTRIBUTION TO GROWTH IN GROSS VALUE ADDED(per cent)

Source: NSO.

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Chart 3.2CHANGE IN NOMINAL RESIDENTIAL PROPERTY PRICES(Q3 2012; per cent)

3-year change

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20


majorcomponentofGVA,declinedby2.1%.Atthesametime,indica-tive property prices as calculated by the Central Bank of Malta’s Advertised Property Price Index increased slightly during the year,up by an average of 0.5% in 2012. The generally stable situation in the Maltese property market contrasted sharply with continuous depressed conditions in real estate markets in several euro area countries, nota-blyIreland,SpainandGreece(seeChart 3.2). The rise in domestic property priceswas, however, notsufficient to offset the downwardmovement in prices that occurred inrecentyears,particularlyin2008and 2009.

Despitestablepropertypricesandthepositiveperformanceofthesector,theRealEstateMarketSurveyconductedbytheBankrevealedthatduring2012thevolumeofpropertysales,bothforresidentialandcom-mercialpurposes,declined.Propertypricesarestillperceivedtobesomewhatoverpricedforbothcatego-ries,despitesomeimprovementinexpectations,particularlyinthecommercialpropertymarket(seeChart3.3). Inaddition, theConstructionConfidence Index forMalta (publishedby theEuropeanCommission)remainedinnegativeterritorythroughout2012,asdidtheindicesofothereuroareacountries.

The number of units for which permits were issued by the Malta Environment and Planning Authority declined byaround22%in2012,whencomparedwiththesameperiodayearearlier.Theslowdownintheissueofsuchpermitsmayreflecttheoversupplyofpropertyintherealestatemarket.Thismaycontinuetopersist,in viewof slowergrowth inmortgagecredit and theuncertaineconomicoutlookoverseas,whichhasanegative impact on foreign demand at the high end of the market. On the positive side is the government’s re-launchofarevisedpermanentresidenceschemeinJune2013,withtheobjectiveofattractingmorefor-eigners to buy property in Malta.

The generally subdued sentiment in the Maltese property market induced banks to maintain their cautious approach when lending to the construction and real estate sectors. The exposure to the construction sector accountedfor21.5%ofcorporateloans,whilelendingtotherealestatesectoramountedtoaround8%.

Other non-financial corporate sectorsTheperformanceacrosstherestofthecorporatesectorvaried.Overall,theweaknessesofspecificsec-tors were compensated by improved results in others. Firms involved in transportation recorded a drop in theiractivity,whilethoseengagedinmanufacturing,wholesale&retailandaccommodationregisteredanimprovement. The 2.1% increase in the operating surplus of the manufacturing industry was supported by theexpansioninoutput,asreflectedintheIndexofIndustrialProduction,whichroseby10.2%in2012.2 Withregardtoaccommodationactivities,resultsfromtheMaltaHotelsandRestaurantAssociationSurveyindicatedthatin2012thegrossoperatingprofitincreased,despitehigheroverheadsfacedbytheindustry.Thisimprovementwasrecordedamongthethree,fourandfive-starhotelcategories,mainlydrivenbyhigherturnover levels as tourism remained buoyant.

2 TheIndexofIndustrialProduction,whichiscompiledbytheNationalStatisticsOffice,describestheeconomiccyclesofthemanufactur-ing industry.

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Over-priced Correctly priced Under-priced

Chart 3.3VALUATION PERCEPTIONS OF RESIDENTIAL AND COMMERCIAL PROPERTIES(per cent)

Source: Central Bank of Malta Real Estate Market Surveys(Dec2011,Dec2012).

Residential Commercial

21


Listed non-financial companies Compared with 2011, the perfor-mance of business groups, whichacquired funding from the domes-ticcapitalmarket, improvedduring2012.3 The overall return on equity and return on assets turned posi-tive,estimatedat6.2%and1.9%,respectively (see Chart 3.4).4

The overall sales of listed compa-nies increased by 2% in 2012 com-pared with a 10.2% rise a year ear-lier. This increase was registered in different sectors. At the same time, the ratioofcurrentassets tocurrent liabilities stood at 123.1%,suggesting a sound liquidity posi-tion,althoughthiswaslowerby17percentagepointsonayearearlier.Thisfallwaspartlytheresultofanumberofearlybondredemptions,someofwhichwerefinancedbyinternalfunds.Meanwhile,theproportionalincreaseincapitalandreservesand total assets kept the leverage ratio broadly stable at 41.2%.

Corporate indebtedness and concentrationDuring2012lendingbycoredomesticbankstotheresidentcorporatesectordeceleratedfurther,contractingby 1.1% as investment activity in the domestic economy remained subdued.5 Results of the Bank Lending Surveyshowthatthisslowdownwasprimarilydemanddriven,althoughthebanksremainedriskaverse.Indeed,corebanksmaintainedtightcreditstandards,bothinrespectofsmallandmedium-sizedcompaniesandoflargecorporates,particularlyin relation to companies involved in the property market (refer to Box 2). The contraction in corporate credit was mainly accounted for by the construction sector. Lending to thewholesale, retail and trans-port sectors also declined, whilstcredit to the manufacturing and accommodation sectors somewhat increased (see Chart 3.5). Mean-while,at5.3%, theweightedaver-age interest rate on lending to the resident corporate sector remained in line with 2011.

External funding through the capi-tal market by the resident corpo-ratesectoralsofell,withthevalue

3 This group includes those companies which have issued bonds or shares on the Malta Stock Exchange.4 Sincethefullyearresultsforsomecompanieswerenotyetavailable,theestimatesfor2011werecalculatedusingtailoredannualisa-tionmethods:inthecaseoffirmswhoseperformancesareseasonal,themid-yeargrowthrateswerereplicatedinthesecondhalfofthefirms’fiscalyear,whilefortherest,thesecondhalfwasassumedtobeidenticaltothefirsthalf.Theperformanceforeachspecificyearreflectstheyearinwhichthefinalaccountsarepublished,irrespectiveofthemonth.5 Asimilarpatternwasobservedinthetotalbankingsystem,whichregisteredadropof1.3%during2012.

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Chart 3.4PROFITABILITY OF LISTED NON-FINANCIAL COMPANIES(per cent)


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Chart 3.5BANK LENDING TO SELECTED CORPORATE SECTORS - CORE DOMESTIC BANKS(EUR millions)

Source: Central Bank of Malta.

22


of quoted and unquoted bonds declining by 10.4% in 2012 com-pared with a year earlier. With regard to bonds issued on the Mal-ta Stock Exchange, two corpora-tions operating in the hotel indus-try launched new bonds totalling €27.5millionduring theyear.Thenew issues were, however, morethan offset by redemptions and buy-backs by other companies mainly operating in the construc-tion sector.

However,overall corporate indebt-edness (which includes bonds,bank credit and funding from non-financial and other stakeholders)increased to 151.6% of GDP in 2012 from 145.9% in 2011 (see Chart 3.6). When considering out-standing quoted bonds and loans granted to the corporate sector by core domestic banks, corporateindebtedness dropped to 73% of GDP compared with 76.3% a year earlier. Loans granted by non-core domestic banks to the resident cor-porate sector amounted to 3.3% of GDP,whilelendingbyinternationalbanks to the resident corporate sector was negligible.

The sectoral allocation of loans remained generally stable, withsome concentration resulting from bank credit being extended to a number of large borrowers oper-ating within specific industries.6 Theseborrowers,whichincludefirmsinconstruction,transportandtheenergy-relatedsectors,accountedfor over 40% of total corporate credit (see Chart 3.7).

6 Aloanisclassifiedasa“largeexposure”whenitaccountsformore10%ofTier1capitalofaparticularbank.

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Chart 3.6INDEBTEDNESS OF NON-FINANCIAL CORPORATES(EUR billions; per cent)

Sources: MSE and Central Bank of Malta.

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Electricity,gas,steam&airconditioningsupplyConstructionTransportation and storageFood services and accommodationOther

Chart 3.7CONCENTRATION IN RESIDENT CORPORATE LENDING - CORE DOMESTIC BANKS (2012)(per cent)


Other lendingLargeexposures

23


BOX 2: BANK LENDING SURVEY RESULTS

Credit Supply Conditions

Results of the Bank Lend-ing Survey (BLS) show that banks have tightened their credit standards on corpo-rate loans during the firstquarter of 2012 while main-taining them unchanged throughout the rest of the year (see Chart 1).1

The tightening stance was prompted by adverse per-ceptions on the general economy and specificallythe outlook on the construc-tion sector, aswell as sub-dued property prices. It was transmitted through stricter controlsonthesizeofloans,collateral requirements and loan repayment periods.

Incontrastwiththeeuroarea,creditstandardsinMaltawerekeptunchangedduringthelastthreequartersof2012.Negativeeconomicandindustry-specificperceptionsledsomebankstotightentheircreditstandardsonallthreeloancategories(corporate,mortgageandconsumercredit),buttheimpactof this tightening was offset by some easing of controls by certain banks as they faced competitive pressures from others. During the first quarter of 2013, creditstandards were maintained stable across the three loan categories and no changes are anticipated for the sec-ond quarter of the year.

Credit Demand Conditions

During 2012 credit demand in Malta remained gener-ally subdued (see Chart 2).

1 The BLS is the Central Bank of Malta’s contribution to the European Central Bank’s euro area BLS. This quarterly survey in which all euro area national central banks participate is designed to provide qualitative data on bank lending behaviour in the euro area. Participating banks are asked to express their views on developments in credit conditions in the previous quarter and their expectationsforthesubsequentquarter.FourofthefivecoredomesticbanksinMaltaparticipateinthissurvey.

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Chart 1 CREDIT STANDARDS(+ indicates net tightening / - indicates net easing)

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Sources: ECB and Central Bank of Malta calculations.

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Chart 2CREDIT DEMAND(+ indicates increase / - indicates decrease)

Sources: ECB and Central Bank of Malta calculations.

24


In the first half of 2012, corporate credit demanddeclined, but stabilised towards theendof theyear. This development reflected lower fixed investment, inventories andworking capital. Highercompetitive pressures from banks which do not participate in the BLS also contributed to the fall in creditdemandofparticipatingbanks.Ontheotherhand,lendinginresponsetodebtrestructuringneedspartlyoffsetthisdecline.Duringthefirstquarterof2013,corporatecreditdemandremainedunchanged,withnochangesbeinganticipatedforthesecondquarteroftheyear.

Inthecaseofmortgages,respondentsreportedlowerdemandduringtheearlymonthsof2012,ascompetitivepressures,subduedhousingmarketprospectsanddeterioratingconsumerconfidencehadanegative impacton themortgagecreditmarket.However,aslight improvement inhousingmarketprospectstowardstheendoftheyearledtohigherdemand.Meanwhile,demandforcon-sumercredit,whichisconsideredassensitivetohouseholds’perceptionsoneconomicconditions,remainedsluggishthroughouttheyear.Lowerspendingondurablegoods,dropsinconsumercon-fidenceandcompetitivepressuresweredownsidefactorsaffectingsuchdemand.Inthefirstquarterof2013,banksreportedsomeimprovementindemandforhomeloans,whereasinthecaseofcon-sumercredit,demanddroppedfurther.Respondentbanksexpectdemandtoremainstableforbothloan categories during the second quarter of 2013.

3.1.2 The household sector

Household indebtednessDuring2012thegrowthrateofhouseholds’residentloansstoodat5.2%,downfrom7%ayearearlier.Thedecelerationinhouseholdcreditgrowthwasconsistentwiththeslowdownineconomicactivity,particularlyprivateconsumption,whichremainedsubdued.Thus,consumercredit,whichismoreresponsivetoeconomicdevelopments,contractedby1.2%.However,mortgagelendingremainedbuoyant,growingby6.8%in2012.Viewedoverthelonger-termhorizon,suchgrowthratesarenoticeablylowerthantheirfive-yearaverages,withconsumercreditandmortgagelendingaveraging7.9%and10.3%,respectively.Sincehouseholdbor-rowing grew at a faster pace than GDP, the household debt-to-GDPratio rose by 1 percentage point to 55.7% by end-2012. Household indebtedness, however, remainedlower than the average for the euro area,whichstoodat66%.7

The cost of borrowing for house-holdsincreasedmarginally,withtheweighted average interest rate on household loans standing at 4.1% by end-2012. The average interest rate of mortgage loans edged up to 3.7%, while that for consumercredit was almost unchanged at 5.6% (see Chart 3.8).8 With house-hold outstanding debt rising in 2012,theinterestburdenremained

7 Refer to ECB Financial Stability Report, May 2013.8 Theweightedaverageinterestrateonconsumercreditalsoincludescreditcarddebt.However,sincethelatterisequivalenttojustaround14%oftotalconsumercredit,theimpactontheoverallweightedaverageinterestrateislimited.

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Chart 3.8WEIGHTED AVERAGE INTEREST RATES ON RESIDENT HOUSEHOLD LOANS - CORE DOMESTIC BANKS(per cent)

25


relatively low and stable at around 5%ofhouseholdincome,asthelat-ter was boosted by a rise in com-pensation of employees.

The credit worthiness of resident households was also supported by an increase in their net finan-cialwealth,whichroseby6.4%in2012, significantly higher than the0.1% growth rate reported a year earlier.Thisimprovementreflectedhigher holdings of deposits and other financial assets, particularlydomestic quoted securities (see Chart 3.9).

The distribution of household loans by income bracket implies a low level of credit risk for banks. Dur-ing 2012 around 46% of bank loans was channelled to households with an annual income exceed-ing €30,000 per annum, whereasloans granted to households with anincomeoflessthan€10,000perannumremained low,at just3.7%of the total (see Chart 3.10).

3.1.3 Quality of bank loans

At the end of 2012 the NPL ratio of core banks was 8.1%, up from7.3% in 2011 (see Chart 3.11). The increase was mainly attributable to the corporate sector. However,around a third of this increase was underpinned by better statistical classification across the loan per-formance categories. Almost all NPLs pertained to residents, withthe share of non-residents in the total standing at less than 1%.

Resident corporate NPLs as a pro-portion of total corporate lending increased to 12.7% by end-2012 from11.1%in2011.Thisreflectedarise in corporate NPLs and a slight contraction in the level of over-all corporate lending, which bothcontributed to the deterioration in the NPL ratio. Higher NPLs were

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Chart 3.9NET HOUSEHOLD FINANCIAL WEALTH(EUR billions)

Sources: MSE and Central Bank of Malta.

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Chart 3.10DISTRIBUTION OF HOUSEHOLD LOANS BACKED BY RESIDENTIAL PROPERTY BY INCOME BRACKET - CORE DOMESTIC BANKS(per cent)


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Chart 3.11NPL RATIOS - CORE DOMESTIC BANKS(per cent)


26


reported by most core domestic banks and were spread across all maineconomicsectors,particularlytheconstruction&realestatesector(see Chart 3.12). The elevated level of NPLs in this sector remains a source of risk to the banking sector. In2012,incontrasttothecorporatesector,theresidenthouseholdloanportfolio retained a higher level of quality despite a slight increase in theNPLratio,from3.0%in2011to3.2% a year later. This rise resulted largely from some weakening in the qualityofconsumerloans,withtherelated NPL ratio increasing by 0.7 percentage point to 5.7% by the end of 2012. In the case of mort-gageloans,theNPLratioremainedunchanged at 2.6%. The household loan portfolio represents 44.4% of total loans, but accounts for only17.4% of total NPLs, reflecting ahigher quality (see Chart 3.13). Factors contributing to the favour-able asset quality of household loans are the high employment lev-el in Malta and the increase in net financial wealth of the householdsector. Furthermore, the tendencyof households to give priority to their debt servicing obligations con-tributes positively to the high quality of mortgage loans.

3.2 Other asset holdings

Despite thepersistentnegative impactof theeuroareasovereigndebtcrisisonfinancialmarkets, coredomestic banks continued to adopt a prudent approach to their asset management during 2012. Their hold-ings of assets from stressed euro area countries declined further while those from higher rated euro area sovereignstatesincreased.Thebanksalsocontinuedtoholdsignificantinvestmentsinhighqualityfinancialassetsofnon-euroareacountries.Meanwhile,thebanks’holdingsoflocalgovernmentsecuritiesremainedpredominant,thepricesofwhichwereunaffectedbytheeuroareacrisis.

3.2.1 Foreign asset holdings

At theendof2012, the foreignassetholdingsof coredomesticbanksamounted toalmost€2.9billion,equivalentto19.4%oftotalassets.Euroareaassetholdingsamountedto€1.1billionor7.2%oftotalassets,slightly lower than the 8.0% reported in 2011.9During2012suchholdingsdeclinedby6.5%,withthebulkinvestedinfinancialassetsofstrongeconomies.Holdingsofassetsbyeuroareacountriesunderstress

9 Euro area asset holdings include securities and placements with banks but exclude Maltese assets and any holdings with the Central Bank of Malta.

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Chart 3.12CHANGE IN NPL RATIO (2012 COMPARED TO 2011) - CORE DOMESTIC BANKS(1)

(percentage points)

(1) About one-third of the increase in NPLs is attributed to better statistical classification across loan categories.Source: Central Bank of Malta.

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Chart 3.13SECTORAL ALLOCATION OF LOANS AND NPLs - CORE DOMESTIC BANKS

Note: The inner circle represents the sectoral allocation of NPLs while the outer circle shows the sectoral allocation of loans.Source: Central Bank of Malta.

NPLs

Chart 3.13SECTORAL ALLOCATION OF LOANS AND NPLs - CORE DOMESTIC BANKS (2012)

LOANS

NPL

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accounted for 12.9% of the total aggregate of euro area asset hold-ings, down from about 31.4% ayear earlier. Meanwhile, non-euroarea asset holdings amounted to €1.8billion,equivalentto12.2%oftotal assets at the end of 2012. The largest holdings were allocated in the UK and consisted predominant-ly of placements with banks (see Chart 3.14).

AsobservedinChart3.15,securi-ties accounted for almost two-thirds of total euro area holdings of core banks. In this regard, monetaryfinancial institutions (MFI) werethemostsignificantcounterparties,notwithstanding the fact that banks’ holdings of such securities and placements (loans and deposits) werelowerin2012.Similarly,banksalso reported reduced holdings of assets issued by non-MFI private companies,buttheyincreasedtheirholdings of sovereign bonds.

Although sovereign bond hold-ings increased by 22.0% during the year, these still amounted tojust 1.1% of total assets, up from0.9% in 2011, mainly reflectinghigherholdingsofsovereigndebt,which continued to be relatively insulated from the sovereign cri-sis in the euro area. Around 75% of euro area sovereign bonds held by core domestic banks are rated AAorbetter.Meanwhile,sovereignbonds issued by stressed countries accounted for just 0.23% of total assets and represented 21.5% of the totaleuroareasovereignbondportfolio.WhencomparedwiththeirTier1capital,suchholdingsdeclinedfrom4.7%to4.4%.Thislowexposure,togetherwiththegradualnarrowingofthespreadbetweenmosteuroareasovereignbondsandtheGermanbund,hascontributedtoaneasingofcontagionriskforcoredomestic banks.

3.2.2 Domestic government paper

Throughout 2012 domestic government paper remained an attractive investment asset for core domestic banks.Infact,despitea2.9%dropinholdingsofdomesticgovernmentpaper,thesestillaccountedforhalfofthebanks’investmentportfolio,amountingtoalmost€1.7billionandcorrespondingto11.3%oftheir totalbalancesheet.At theendof2012, thebanks’holdingsofMaltaGovernmentStocks(MGS)increasedmarginallyoverthatprevailingin2011,whereastreasurybillholdingsdeclined.Themajorityofsuchholdingswillberedeemedby2018,withbanksholding the largestproportionof thesestocks

0.00.40.71.11.41.82.12.52.83.23.53.94.24.64.9

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Chart 3.14ASSET HOLDINGS OF SELECTED COUNTRIES - CORE DOMESTIC BANKS (2012)(EUR millions; per cent)


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Chart 3.15EURO AREA HOLDINGS - CORE DOMESTIC BANKS(EUR millions; per cent)


Note: Data excludes Maltese assets and holdings with the Central Bank of Malta.Data on placements includes loans to and deposits with MFIs.''Other'' includes private companies excluding MFIs.

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(see Chart 3.16). It is expected that during 2013 the Government will implement the third stage of the MGS Switch Auctions Pro-gramme,whichisaimedatlength-ening and smoothening the inter-est and redemption profile of theexisting MGS debt portfolio.

The relatively smooth trend in MGS yields and prices throughout 2012 wasreflectedinthestabilityofthespread of the ten-year MGS vis-à-vis the German bund of similartenor. Both sovereign securities experienced a drop in their respec-tive long-term interest rates, thuslowering their debt servicing costs. The limited participation of non-residentfinancialinvestorscontributedtothesustainedstabilityintheMGSmarket.10ThisisconfirmedbytheconsistentandstrongdemandfornewlyissuedMGSin2012.Consequently,governmentexposuretorolloverriskremainsremote,especiallyinthelightofrecentdevelopmentsinthelocalcapitalmarket,wheretheGovernmentwasabletocovermorethanhalfofitsrefinancingneedsfor2013initsfirstbondauctionlistedinMarch2013.Inaddition,thismarketislargelycharacterisedbyabuy-to-holdapproach,withlim-itedsecondarymarketturnover,reinforcingthelowroll-overrisk.Indeed,theaveragedailytradinginMGSamountedto€2.2millionin2012,equivalenttoaround0.05%oftheaverageoutstandingMGSsfortheyear.

3.3 Funding

Thebanks’fundingandliquiditysituationremainedstableduring2012.Bankscontinuedtofinancethebulkoftheirassetsthroughcustomerdeposits,withthelatteracceleratingin2012whencomparedwith2011.Wholesale and Eurosystem funding remained a minor source of funding for core domestic banks.

3.3.1 Customer deposits

During 2012 the banks’ customer deposit base expanded further and was equivalent to 82% of total liabilities, 1.6 percentage pointshigher thanayearearlier. Indeed,customer deposits grew at a fast-erpace than in2011,upby5.6%year-on-year compared with 1.4% in 2011 (see Chart 3.17). Resi-dentdeposits roseby3.6%,whilenon-resident deposits registered significant gains,with an increaseof 16.5% more than offsetting the contraction of 12.8% a year earlier. This notwithstanding, non-residentdeposits continued to follow an

10 At the end of 2012 MGS holdings of non-residents accounted for only 3% of the outstanding amount.

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Chart 3.16OUTSTANDING MGS BY OWNERSHIP AND REDEMPTION DATE (2012)(EUR millions)


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Chart 3.17GROWTH IN CUSTOMER DEPOSITS - CORE DOMESTIC BANKS(per cent)


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erratic trend as a result of volatile movements in corporate deposits.

Resident customer deposits increasedataslowerpacein2012,by 3.6% compared with 4.6% a year earlier. This rise was largely driven by household deposits,which cumulatively accounted for 59.5% of total customer depos-its and almost half of total liabili-ties (see Chart 3.18). Household deposits, which are regarded asless volatile than corporate depos-its, rose by 3.2%, in line with theexpansion registered a year ear-lier. Growth in deposits occurred despite the strong private invest-ment in new MGS issues and their continuousoversubscriptions.Householddepositsareprojectedtomaintainanupwardtrendin2013,giventheexpectationsoflowerinflationduringtheyearandafurtherriseinemploymentincome.Ontheotherhand,thesepositivefactorsmaybesomewhatoffsetbyGDPprojectionsshowingariseinprivateconsump-tion.Meanwhile,residentcorporatedepositsdeceleratedoverthepreviousyear,growingby3.1%in2012(12.4% in 2011).

Fromacurrencystructureperspective,theaccelerationinresidentcustomerdepositgrowthwasdrivenbyeurodenominateddeposits,whereasinthecaseofnon-residentdepositsthereboundinthegrowthrateresulted from both euro and other European Union currency-denominated deposits.

Fromamaturityviewpoint,overtheyearsanumberofbanksofferedfixed-termdepositproductswithlongermaturities,someofwhichatvariablerates(linkedtodevelopmentsinpre-setinternationalindices).Theseproductscontributedtomaintainasomewhathighershareoflonger-termdeposits,whichstoodataround9%inboth2011and2012,comparedwith7.3%in2010.

Theflowofdepositsreportedbycoredomesticbanksremainedpositiveovertheyear,despiteslowereco-nomicgrowth,theattractionofanumberofbondissuesinthecapitalmarketandthecompetitionfordepos-its from non-core domestic banks. The weighted average interest rate paid on resident deposits excluding MFIsbycorebanksstoodat1.2%atend-2012,lowerthanthatpaidbynon-coredomesticbanks,whichstoodat3.5%.Thisnotwithstanding,corebankshadamplelevelsofliquidityasreflectedinloan-to-depositratios,whichremainedconsistentlylowacrossallbanks,hoveringataround70%onaggregateandconsid-erablylowerthantheeuroareaaverageof111%(refertoChapter4,Section4.1,Chart4.5).

3.3.2 Eurosystem and wholesale funding

Inlinewithpreviousyears,coredomesticbanksonlymadelimiteduseofEurosystemfunding.Indeed,attheendof2012,onlyaround14%oftheireligiblesecuritieswerepledgedwiththeCentralBankofMaltaascollateralformonetarypolicyoperations.Furthermore,sincemostofthecollateralplacedwiththeBankbycoredomesticbanksconsistsofgoodqualityassets,thecollateralpoolofbanksisgenerallyshieldedfromnegative implications of sudden price movements that affected securities of relatively inferior quality.

Atend-2012,Eurosystemfundingamountedto1.7%oftotalliabilities,slightlyhigherthanthelevelof1.5%registeredayearearlier.This fundingmostly reflected theparticipationbysomebanks in the three-yearlong-termrefinancingoperationsconductedbytheEuropeanCentralBank(ECB)inDecember2011and

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Chart 3.18BANKS' LIABILITY COMPONENTS - CORE DOMESTIC BANKS (2012)(per cent)


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February2012.Whereasthisnon-standardformoffinancingwasintroducedbytheECBprimarilytoallevi-ateliquiditypressuresfacingbanks,thelocalbanks’interestinthefacilitywasmainlyduetoitslowcost,implyingopportunitiesformoreremunerativeinvestmentofsuchfunds.Intheearlymonthsof2013,mostofthesefundswererepaid,bringingdowntheproportionofEurosystemfundingintotalliabilitiestojust0.6%.

Core banks continued to make little use of interbank funding. Their exposure amounted to only 2.1% of total liabilitiesattheendof2012,ofwhichaboutone-seventhwasintheformofinterbankdeposits.Afurther2.1%oftotalliabilitieswerefinancedthroughtheuseofdebtsecuritiesissuedbybanks,whichincreasedby 15.2% during the year.

31


4. RESILIENCE OF CORE DOMESTIC BANKS

Thebankingsectorremainedresilientinthefaceofchallengesposedbythemacro-financialenvironment.Banks continued to expand their balance sheet and to strengthen their capital buffers. The latter was pos-sibleowingtoacontinuingpositiveperformance.Furthermore,bankfundingsourcespatternsremainedsus-tainable,supportedbyfurthergrowthincustomerdeposits.Thebanks’underlyingstrengthwasconfirmedbyresultsofstresstestsconductedbytheCentralBankofMalta,notablytheTier1capitalratiowhichremainedabovetheregulatoryminimaunderextreme,butplausiblescenarios.

4.1 Balance sheet developments

During2012thetotalassetsofcoredomesticbankscontinuedtoexpand,althoughataslowerpacethaninthepreviousyear.Thesegrewbyanannual3.5%,comparedwith5.2%in2011.AsindicatedinChart4.1,totalassetsofcoredomesticbanksroseconsistentlyoverthefiveyearsto2012.Inthisregard,thedomestic banks’ performance con-trasted sharply with banks in sev-eraleuroareacountries,asthefor-mer downsized their balance sheet to improve their solvency ratios.

Loan portfolios contributed around 30% of the expansion in banks’ total assets during 2012 (see Chart 4.2). This occurred despite the slowdown in credit growth to 1.8% from 4.5% in 2011. Lending to households, specifically mort-gages,grewby5.3%whereascor-porate lending contracted by 1.1% (see Chart 4.3). As a result, thebanks’ loan portfolio accounted for 57.5% of total assets.

Higher claims on theEurosystem,predominantly deposits with the CentralBankofMalta,wastheoth-er major driver of the expansion in totalassets.Thisreflectedprimarilyone bank’s regular participation in theEurosystem’sfixed-termdepos-it auction. The expansion in these asset classes was partly offset by a fall in interbank claims and hold-ings of securities, which declinedby4.4%and3.5%,respectively.

During the year core domestic banks disposed part of their fixedincome securities holdings, whichthus contracted to around 23% of banks’ total assets at the end of the year compared with 24.5% in the previous year. The share of

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Chart 4.1 GROWTH IN TOTAL ASSETS OF MFIs - SELECTED EURO AREA COUNTRIES(2007 = 100)

Note: Data for Malta refers to the core domestic banks only.Sources: ECB and Central Bank of Malta.

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Chart 4.2CONTRIBUTION TO BALANCE SHEET GROWTH - CORE DOMESTIC BANKS(percentage points)


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securities held for trading purposes remainedatalowlevel,accountingfor only 0.7% of the total securities portfolio. Securities “designatedat inception at fair value through profit and loss” made up 16.6%,while the rest of the portfolio was classified either as “available forsale” (45.6%)oras “held tomatu-rity” (37.1%). The latter has nodirectimpactontheprofitandlossaccounts of the banks.

Domestic securities accounted for 52.7% of the total securities portfo-lio (see Chart 4.4). These consisted almost entirely of Malta Govern-ment Securities (MGS), reflectingtheir attraction as a secure invest-ment and an eligible asset for col-lateral purposes in connection with refinancing operations undertakenwith the Eurosystem. However,during 2012 banks reduced their holdings of MGS and also lowered their exposure to foreign sovereign bonds. The decline in the banks’ holdings of sovereign securities was partly compensated by a rise in their holdings of foreign private sector securities. These rose to almost 40% of the banks’ secu-rities portfolio and were spread out across a number of countries. This switch in investment strategy reflectedthebanks’effortstoobtainbetter yields on their investments,given the prevalent low interest rate environment.

Throughout 2012 banks contin-ued to fund themselves mainly through customer deposits. These increased by 5.6% and accounted for 82% of total liabilities. The faster growth in customer deposits when compared with loans contributed to the prudent level of the loan-to-depositratiowhich,at70.1%,wassignificantly lower than the aver-age of the euro area. The latter,although declining steadily over thepastyear,remainedwellabove100% (see Chart 4.5).

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Chart 4.3DISTRIBUTION OF BANK ASSETS - CORE DOMESTIC BANKS(EUR billions)


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Chart 4.4SECURITIES PORTFOLIO - CORE DOMESTIC BANKS(EUR millions)


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Chart 4.5CUSTOMER LOAN-TO-DEPOSIT RATIO - CORE DOMESTIC BANKS(per cent)


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Interbankfundingdecreasedbyhalfmainlyowingtolowerintragroupfinancing.However,giventhebanks’lowrelianceonsuchfunding,thisdeclinehadnosignificantimpactonbanks’coreoperationsandliquidityposition.Debtsecuritiesissuedbybanksincreasedduringtheyear,butremainedamarginalsourceoffund-ing,accountingfor2.1%oftotalliabilities.

During2012Eurosystemfundingincreasedby17.2%but,overall,italsoremainedalowsourceoffunding,accounting for just 1.7% of total liabilities. The rise in such funding was due to the rolling over of maturing short-termfundsandthesubscriptiontolong-termfinancingatalowcost.However,intheearlymonthsof2013,asignificantpartofthethree-yearlonger-termrefinancingoperationswaspaidback,reducingsuchfunding to just about 0.6% of total liabilities.

4.2 Profitability

Onaggregate,corebanksreportedhigher profits for the financial year2012. These were up by 34.5% on a year earlier and were mainly driven bybuoyanttradingprofitsand,toalesser extent, by increased returnsfrom intermediation activities.1 This notwithstanding,notallbanksreport-edariseintheirprofitsalthoughthedispersion between them in terms of their performance narrowed dur-ing the year. The banks’ return on equity(ROE),increasedfrom19.5%in 2011 to 23.9% in 2012 (see Chart 4.6) while their return on assets (ROA) improved by 0.3 percent-age point to 1.6% (see Chart 4.7). Compared with small banks in the EU (with an average ROE and ROA standingat1.3%and0.1%,respec-tively)theoverallprofitabilityofcoredomestic banks remained higher.2

As in previous years, the mainsource of bank profits was netinterest income, which during2012 accounted for 66.8% of gross income, down from 72.5% a yearearlier. During the year net interest incomeincreasedby4.5%,reflect-ing returns from financial interme-diation activities (see Table 4.1). Although deposits grew faster than loans,thebanks’extensiverelianceon short-term deposits paying very low rates of interest kept funding costs at low levels.

1 Tradingprofitsincludegainsorlossesondisposaloffinancialassetsandfairvaluemovements.2 SmallbanksintheEUaredefinedasthosewhosetotalassetsarelessthan0.005%ofthetotalEUconsolidatedassets.

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Chart 4.6RETURN ON EQUITY - CORE DOMESTIC BANKS(per cent)


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Chart 4.7RETURN ON ASSETS - CORE DOMESTIC BANKS(per cent)


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Non-interest income also increased notably over the year as banks recorded substantial fair value gains on theirsecuritiesportfolio.Theseamountedtoover€21million.Meanwhile,earningsfromothernon-interestsourcesdeclinedslightly,mainlyasaresultofabaseeffectrelatedtothesaleofabusinesslinebyamajorbank in2011.Lowerdividend income fromsubsidiarycompaniesalso impactedonnon-interest income,whereas net fees and commissions (which account for the bulk of non-interest income) remained stable during the year.

Withregardtonon-interestexpenses,thesewerebroadlyunchangedfromthepreviousyear.Thus,whilebanksdidnotincurextraordinarycostsasinthepreviousyear,theyfacedhighernetimpairmentcharges(write-offs,write-backs,provisionsandrecoveries),whichincreasedbyalmost€8millionwhencomparedwith 2011.3 In thecaseofnetspecificandcollectiveprovisioncharges, thesewereupby€24.3million,despiteafallof€16.4millioninbaddebtwrite-offs.

Thebanks’robustprofitperformancecontinuedtobeunderpinnedbytheirtraditionalbusinessmodelsandbytheirstableincomeandfundingsources.Nevertheless,thepersistentweaknessindomesticdemandandthelowinterestenvironmentmayputprofitmarginsunderpressure.Inparticular,thedecelerationincreditdemandandtherisingtrendinnon-performingloans(NPL)couldimpactnegativelyonprofitperformance.Inthisrespect,andgiventheregulatorychangesthatwillcomeintoforceby2019,thecorebankswereencouraged to adopt prudent dividend policies to build up their capital buffers in line with international regula-tory obligations and thus strengthen their core capital base.

4.3 Loan loss provisions

During2012bankstookstepstoboosttheirloanlossprovisions.Thesewereraisedby25.7%,exceedingtheincreaseof12.5%inthelevelofNPLs.Theoverallexpansionintotalprovisionsreflectedbothhigherspecificandcollectiveprovisions,whichwereaugmentedby24.5%and27.3%,respectively.Specificprovi-sions were increased mainly to cover NPLs in the construction and the household sectors. The remaining increase was spread more broadly over other major economic sectors.

Thehigherlevelofloanlossprovisionscontributedtoariseinthecoverageratio(definedastotalprovisionsto total NPLs) which increased by 2.3 percentage points to 22.1% in 2012 (see Chart 4.8). An alternative coverage ratio based on International Financial Reporting Standards also improved from 26.1% in 2011 to 32.1% in 2012.

3 The extraordinary costs incurred in 2011 relate to an out-of-court settlement and early retirement schemes.

EUR millions

2008 2009 2010 2011 2012Total net interest income 276,611 250,988 292,916 314,414 328,571

Net interest income on intermediation 74,866 126,181 206,759 223,487 238,645 Other net interest income 201,745 124,807 86,157 90,927 89,925

Non interest income 24,190 151,033 121,619 119,479 163,316 Trading profits(1) (80,707) 30,057 1,575 (27,770) 21,573 Other non-interest income 104,897 120,976 120,044 147,248 141,742

Non interest expense (199,661) (203,024) (227,438) (260,032) (258,107)Net profit before tax 101,141 198,998 187,097 173,861 233,779 (1) Trading profits (fair valuation movements and gains/losses on traded securities).

Table 4.1MAIN COMPONENTS OF THE PROFIT AND LOSS ACCOUNT - CORE DOMESTIC BANKS

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The ratio of specific provisions tototal NPLs improved by over 1 per-centage point, reaching 11.8% bytheendof2012.Thespecificpro-visions-to-NPL ratio with respect to the household sector stood at 12.6%,whileforthecorporatesec-tor,thisstoodat11.7%.Meanwhile,it was estimated that bank collat-eral covered 75.4% of total NPLs.4 In case of immovable property as collateral, banks apply substan-tial haircuts, often in the regionbetween 20% and 30%.

4.4 Liquidity

During 2012 the banks’ liquid-ity position improved further. The liquidity ratio, defined as liquidassets to short-term liabilities,increased by 5 percentage points to 49.1% in 2012 (see Chart 4.9). The liquidity ratio among core banks varied froma lowof39.8%,whichis still well above the 30% regula-tory threshold to a high of 75.2%. The banks’ strong liquidity posi-tion is supported by marketable debt securities, which account formore than half of liquid assets. The remainder are almost equally split between balances held with other credit institutions and the Central Bank of Malta.

Ontheliabilitiesside,about55%oftotal deposits consisted of savings and current deposits. Although such deposits have in a historical context registered low volatility despite their liquidnature,theyhavethepotentialtobeasourceofinstabilityifbanks’balancesheetscomeunderstress.The provisions governing the liquidity coverage ratio (LCR) under the new Basel III framework will require bankstomaintainenoughliquidassetstomeetthenotionalamountofcashoutflowsoccurringovera30-dayperiod.ThefullregulatoryrequirementsoftheLCRwillbegraduallyphasedin,withafullimplementationbyJanuary2019.Thefirstmilestone,however,istobemetbyJanuary2015withaminimumLCRof60%.Overthe past years banks began restructuring their balance sheets to meet new regulations and it is expected that they will meet the new requirements before the deadline.

4.5 Capital and leverage

Throughout 2012 the capital position of core domestic banks improved further as evidenced by the level oftheCapitalAdequacyRatio(CAR),whichroseby0.8percentagepointto14.3%bytheendof2012.This is well above the 8% statutory requirement. This improvement was recorded across almost all core

4 Allcollateral,includingproperty-backedcollateral,isincludedinthisratio.

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Chart 4.8COVERAGE RATIO - CORE DOMESTIC BANKS(EUR millions; per cent)


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Chart 4.9LIQUID ASSETS TO SHORT-TERM LIABILITIES - CORE DOMESTICBANKS(per cent)


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domestic banks. The higher CAR resulted from further accumulation of totalownfunds,whichexpand-edby7.6%onayearearlier,andmore than compensated for the increase in risk-weighted assets,which rose by 1.7% in 2012 (see Chart 4.10). Risk-weighted assets also grew at a slower pace than totalassets,owingtothestrongeraccumulation of assets with lower risk weights by banks, includ-ing mortgage loans.5 As a result,the overall risk profile of banks,defined as risk-weighted assetstototalassets,declinedslightlyto51.0% from 51.9% in 2011.

Tier 1 capital increased by 9.5% and contributed €67.2 million tothe overall rise of €75.8million intotal own funds. The increase in Tier 1 capital was driven mainly byretainedearnings,whichinturnwas partly converted into a new share issue. This improved the qualityofbanks’Tier1capitaland,asa result, theTier1capital ratiorose by 0.7 percentage point to 10.3%at theendof theyear, sig-nificantlyhigherthanthethresholdof 4.0% required under local regu-lations (see Chart 4.11). The level of this ratio differed substantially among core domestic banks, withthe lowest ratio standing at 6.5% while the highest one stood at 18.2%. The increase in Tier 2 capi-talwasmorecontained,upby2.9%or€8.6million.Thiswasachievedmainly through the augmentation of collective provisions.

Atthesametimetheleverageratio,definedascapitaland reserves tototalassets, improvedbya further0.4 percentage point to 6.9% (see Chart 4.12).6 Almost all banks reg-istered a modest rise in this ratio.

The improvement in banks’ capital buffers observed over the years is 5 Thecoredomesticbanksfollowthe“standardisedapproach”forcapitaladequacy,meaningthatthecalculationofrisk-weightedassetsis based on pre-set weighting for various asset categories.6 Thecomputationdoesnot,however,consideroff-balance-sheetexposures.Theseareincludedinthecalculationoftheforthcomingleverage ratio requirement under the CRD IV framework.

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Chart 4.10GROWTH IN TIER 1 CAPITAL AND RISK-WEIGHTED ASSETS - CORE DOMESTIC BANKS


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Chart 4.11SOLVENCY RATIOS - CORE DOMESTIC BANKS(per cent)


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Chart 4.12LEVERAGE RATIO - CORE DOMESTIC BANKS(per cent)


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a positive development against a backdrop of increasing credit risk and relatively subdued economic activ-ity.Furthermore,thestrengtheningofcapitalenablesbankstomeettherequirementsoftheforthcomingCRD IV framework,which isexpected tobe implemented in2014.This frameworkwillallowagradualbuild-upofcapitalandwillalsointroducenewvariablecapitalbuffers,suchassystemicriskbuffersandcounter-cyclical buffers.

4.6 Stress tests

Stress testing exercises continued to be conducted by the Central Bank of Malta during 2012 to assess thefinancialsystem’sresiliencetoextremeyetplausibleevents.Thesestresstestsbroadlycapturedtheelementsofcreditrisk,sovereignriskandliquidityrisk.Overthelastyear,themethodologyofstresstestswas further improved although the scenarios considered are the same as those presented in the previous Report,namely: (i) credit quality deterioration; (ii) a drop in property prices; (iii) an increase in NPLs owing to adverse macroeconomic conditions; (iv) persistent deposit withdrawals.

TheBankconsiderstheprobabilityoftheoccurrenceofthefirstthreescenariostobelow,whileadepositrunmaterialisingisdeemedtoberemote.Resultsofstresstestsaretobeconsideredasindicative,giventhat these tests are univariate in nature and do not capture second-round effects.

Scenario 1: Credit quality deterioration in the securities portfolio

This stress test assesses the impact on core banks’ balance sheets of a deterioration in the credit quality of the securities portfolios. The test assumes a credit grade downgrade of two to three notches.7

At the end of 2012 approximate-ly 90% of banks’ total securities attracted a credit rating aboveA-,and almost 99% of securities were classified as investment grade.Moreover, the securities portfo-lio only represents around 23% of core banks’ balance sheets. Banks could comfortably withstand a two to three-notch downgrade in their securities portfolio, wheretheir aggregate Tier 1 capital ratio remains significantly higher thanthe regulatory threshold. In fact,even under a three-notch down-grade,theaggregateTier1capitalratio would remain around the 10% level (see Chart 4.13).8

7 Intheeventofdeteriorationincreditquality,assetsaredowngradedandassociatedprobabilitiesofdefault(PD)increaseinlinewiththeunderlyingrisk.Securitiesarecategorisedbycreditratingasassignedbytheofficialratingagencies,wherebytheassociatedPD is applied to determine the expected loss. A distinction is made between assets that are held to maturity (HTM) and those which arenot,sincesuchaclassificationallowsfordifferentaccountingtreatmentonbanks’books.Risk-weightedassetsareassumedtoremain constant.8 The results of tests are not comparable with those published in the previous Report since the PDs applied have been updated and the currenttest,unlikethepreviousone,excludestheloanportfolio.

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Chart 4.13STRESS TEST RESULTS - IMPACT OF DETERIORATION IN SECURITIES PORTFOLIO ON TIER 1 CAPITAL(per cent)

Source: Central Bank of Malta calculations.

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Scenario 2: An increase in NPLs owing to adverse macroeconomic conditions

This scenario assumes that, fol-lowing an adverse macroeconomic shock, NPLs in a number of keyeconomic sectors increase within a range of 5% and 15%. The sectors includedinthetestarehouseholds,manufacturing, construction andreal estate, wholesale and retailtrade,andtransportandaccommo-dation. As a result of the assumed increaseinNPLs,thelevelofprovi-sions risesaccordingly, translatinginto a drop in retained earnings and deterioration in the solvency state of the banks. Banks’ capital ratios are also negatively influenced bythis rise in NPLs, given that suchloans attract a higher risk weight and hence require higher capital allocation.

Stresstestresultsrevealthat,evenunder the most extreme scenario (i.e. a 15% increase in NPLs in keyeconomic sectors), thebanks’aggregate Tier 1 capital ratio drops to 9.9%, i.e. remains comfortablyabove the regulatory threshold (see Chart 4.14).9

Atasectorallevel,thedeteriorationin the NPLs in the construction and real estate sector is the main cause ofthefallintheTier1capitalratio(seeChart4.15),reflectingthestrongershareofNPLsinthesesectors(refer to Chart 3.13).

Scenario 3: A drop in property prices

Thisscenarioconsidersadropinpropertypricestovaryingdegrees,whichinturnhasanegativeimpacton loancollateralvalues.Theassumedfall inpropertyprices isappliedonthevalueofcollateral,whichis already subjected to haircuts by banks.10 This ensures that a worst case scenario is applied in this test sincehaircutsonpropertyvaluesareappliedbybankswhensanctioningloanfacilities.Moreover,thetestassumesthat,ascollateralvaluesdecline,provisionsforexistingNPLswouldneedtobereplenishedandraisedaccordingly.ThisscenariofurtherpenalisesbanksasitassumesasignificantincreaseinNPLsowingtothenegativewealtheffectofthedropinpropertyprices,whichinturnleadstoafurtherriseinprovision-ing levels.

9 The test is only broadly comparable with results produced in the previous Report,sincethemethodologywasslightlymodified.10 Around 90% of banks’ collateral consists of immovable property.

8.5

9.0

9.5

10.0

10.5

Tier 1 ratio(end 2012)

Tier 1 ratio(5% shock)



Chart 4.14STRESS TEST RESULTS - IMPACT OF AN INCREASE IN NPLs IN KEY ECONOMIC SECTORS ON TIER 1 CAPITAL(per cent)


-0.45

-0.40

-0.35

-0.30

-0.25

-0.20

-0.15

-0.10

-0.05

0.005% shock 10% shock 15% shock

Manufacturing Households

Wholesale,transportandaccommodation Construction and Real Estate

Chart 4.15STRESS TEST RESULTS - IMPACT OF AN INCREASE IN NPLs BY SECTOR ON TIER 1 CAPITAL (2012)(percentage points)


39


Resultsindicatethat,onaggregate,banks would be able to withstand a 30% fall in collateral values and a concurrent increase in NPLs of 10%, before their Tier 1 capitalratios drop below the regulatory threshold (see Chart 4.16).11

Scenario 4: P e r s i s t e n t deposit withdrawals

Under this scenario the banks’ liquidity position is subject to per-sistent deposit withdrawals in the rangeof10%to15%forfivecon-secutive days. During this period,as counter-balancing capacity,banks were assumed to only utilise the range of highly liquid assets stipulated in the Banking Rules.12 The test is therefore based on the extent of in-house liquidity and ignores anysparecapacity,whichcanbetappedtofurtherincreasethepoolofliquidassets.Resultsindicatethatfollowingpersistentdepositwithdrawalsof15%,banksonaggregatewouldremainliquid.Onabank-by-bankbasis,oneparticularbankwouldrequiretotapintootherfundingsourcestowithstandtheassumedfive-daypersistentdepositwithdrawalperiod(refertoChart4.17).

Aspartofitsfinancialstabilityassessment,duringtheyeartheBankalsorepeatedandextendedtheEuro-pean Banking Authority (EBA) European Union-wide stress testing exercise on a number of relevant core and non-core banks. The exercise was carried out using the same methodology as that applied in the 2011 stresstest,wherebybanksweretestedagainsta5%CoreTier1(CT1)capitalratiobenchmark.However,anumberofrefinementsweremadetotheoriginalmethodologyusedintheEBAexercisetoreflectrecentdevelopments in both the interna-tional macroeconomic environment and financial markets. The testsought to quantify credit risk in both the loansandsecuritiesportfolios,market risk in the securities portfo-lios,aswellasthecostoffunding.

Overall,thestresstestingexercisedemonstrated that the financialsystem as a whole is resilient to the scenario proposed by the EBA in its stress test. Even under the most extreme scenario, only one bankachieved a result below the estab-lished 5% CT1 threshold. This bank increaseditsCT1ratioduring2012,and has plans to increase further its CT1 ratio during 2013.

11 Results published in the Financial Stability Review 2011 are not comparable with results published in this edition since the simulated increase in NPLs ranged from 10% to 20% in 2011 and from 5% to 10% in 2012. 12 Mostliquidassetsheldbydomesticbanksconsistofmarketabledebtsecurities,namelyMGS.

0%

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5%

6%

7%

5% 7% 10% 5% 7% 10% 5% 7% 10%

Chart 4.16STRESS TEST RESULTS - IMPACT OF A DROP IN HOUSE PRICES ON TIER 1 CAPITAL (2012)(per cent; x-axis = increase in NPLs)

Scenario 1 - 20% decline in house prices




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Chart 4.17STRESS TEST RESULTS - IMPACT OF PERSISTENT DEPOSIT WITHDRAWALS ON LIQUID ASSETS (2012)(1 = liquidity index prior to shock)


40


5. THE OTHER COMPONENTS OF THE FINANCIAL SYSTEM

Risksfromothercomponentsofthefinancialsector,namely,non-coredomesticbanks,internationalbanks,insurancecompaniesand investment funds,continue tobedeemedas low.Theoperationsofnon-coredomesticand internationalbanksremainskewedtowardsnon-residents,withvery few interlinkageswiththedomesticeconomy.Meanwhile,theirperformanceandfinancialconditionsareconsideredsatisfactory.Similarly,theperformanceoftheinvestmentandinsurancecompaniesareseenaspositive,supportedbyimproved international market conditions.

5.1 Non-core and international banks

5.1.1 Non-core domestic banks

Eightbanksare classifiedasnon-core, ofwhich fourare foreign-owned, threeare subsidiariesof otherEuropean Union (EU) banks and one is a branch of an EU bank.1 The total assets of these banks are equiva-lentto77%ofgrossdomesticproduct(GDP),withtheiroperationsmainlyorientedtowardsnon-residents.Indeed,residentassetsaccountedforonly9.2%,whereasresidentliabilitiesamountedto16.4%.

Asset structure During2012thegrowthrateintotalassetsofnon-coredomesticbanks,whichreached€5.2billion,acceler-atedto5.1%,upfrom1.2%in2011.Whiletheincreaseintotalassetswaslargelyconcentratedinonebank,no signs of deleveraging were recorded in the other non-core domestic banks. The expansion in total assets waslargelydrivenbyhigherholdingsofsecuritiesissuedbynon-residentbanks,whiletheassetstructureof the non-core group showed modest changes. The share of the non-resident loan portfolio contracted to 40.3%oftheoverallbalancesheetvaluefrom43.4%in2011,whereasthesecuritiesportfolio,consistingmainlyofdebtissuedbymonetaryfinancialinstitutions(MFI),grewto38.3%oftotalassetsfrom36.1%ayear earlier (see Chart 5.1).

Total lending decreased by 1.7% in 2012 and remained predominantly channelled to the non-resident corpo-ratesector.Lendingtothefinancialsectordroppedby28.9%.Thiscontractionreflectedmovementsininter-banklending,whichmorethanhalved,mainlyinrespectofintragroupfunds.Meanwhile,lendingtohouse-holds and corporates increased by almost 10%.

From a geographical perspec-tive, customer lending to non-EUresidents remained prominent,although the proportion decreased from 53.4% in 2011 to 42.4% of total customer loans (see Chart 5.2). This was compensated by higher lending to residents in EU countries, representing 44% oftotal customer loans in 2012, upfrom 31.9% a year earlier. Resident customer loans remained relatively subdued,downfrom14.8%oftheirtotal lending to 13.6% and equiva-lent to just 2.8% of total resident loans in Malta.

1 Refer to Financial Stability Review 2011fortheclassificationofbanks.

9.4%

14.8%

28.6%22.6%

13.5%

11.1%

9.2%

11.1%

29.2%26.6%

11.6%

12.3% Resident assets

MFIs-loans&deposits

Othersectors-loans&deposits

MFIs - securities issued

Other sectors - securitiesissued

Other assets

2012

Chart 5.1ASSET STRUCTURE - NON-CORE DOMESTIC BANKS

2011

Note: The inner circle refers to the asset structure in 2011 while the outer circle refers to the asset structure in 2012.


41


Total non-performing loans (NPL) of non-core domestic banks declined throughout 2012 with the NPL ratio endingtheyearat4.1%,downfrom4.5% in 2011.

Geographically, the investmentportfolio of non-core banks consists mainly of securities issued in EU countries, accounting for around70% of total securities (see Chart 5.3). During the year these banks sharply reduced their holdings of securities issued in stressed coun-tries in the euro area from 41% of total securities in 2011 to 20% by end-2012,adropwhichwaswide-spread, but particularly in Ireland,Spain, Greece and Portugal. Themajority of these bonds consisted ofdebtissuedbyMFIs.Meanwhile,domestic securities accounted for only7%of total securities, slightlyhigher than the 5.8% in 2011. These were practically all channelled into domesticgovernmentpaper,which,nevertheless, only accounted forabout 3% of outstanding domestic government paper.

Funding structureNon-core domestic banks obtained their funding primarily from the wholesale market, accounting for50% of their total liabilities.2 While no signs of parent bank funding pressureswereobserved,thefund-ing composition of these banks shifted from intragroup funding to funding from other unrelated credit institutions. Meanwhile, financ-ing obtained from the Eurosystem slightly decreased to 2.2% of total assets, down from 2.6% in 2011(see Chart 5.4). Resident interbank liabilities of non-core domestic banks remained negligible at 0.22% oftheirtotalliabilities,indicatingthelack of interconnectedness to the localfinancialsystem.

Customer deposits fund almost 25% of these banks’ balance sheet.

2 ThisincludessalesandrepurchaseagreementswithbothotherMFIsandfinancialintermediaries.

14.8%

13.5%

18.3%

53.4%

13.6%

21.4%

22.5%

42.4%

Malta

euro area

Other EU

Rest of theworld

0% 10% 20% 30% 40% 50% 60%

2012 2011

Chart 5.2CUSTOMER LOANS BY RESIDENCY - NON-CORE DOMESTIC BANKS


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2011 2012Malta Peripheral countries Other euro area Other EU Rest of the world

Chart 5.3INVESTMENT SECURITIES BY RESIDENCY - NON-CORE DOMESTIC BANKS(per cent)


12.6%

2.6%

41.5%10.2%

11.0%

20.8%

1.3%16.4%

2.2%

37.3%10.8%

12.3%

18.9%

2.0%Resident liabilities

Eurosystem funding

MFIs - placements withbanks


Other sectors -sales/repurchaseagreementsCapital and reserves

Other liabilities

2012

Chart 5.4LIABILITIES STRUCTURE - NON-CORE DOMESTIC BANKS

2011

Note: The inner circle refers to the liabilities structure in 2011 while the outer circle refers to the liabilities structure in 2012.Source: Central Bank of Malta.

42


Duringtheyearresidentcustomerdeposits,whichrepresent12.4%oftotalliabilities,increasedby53.2%,bringingtheirproportiontooverhalfoftotalcustomerdeposits.Despitethefastgrowthrate,residentcus-tomerdepositsheldbythesebanksstillrepresentedjustover6%oftotalresidentcustomerdeposits,upfrom 4.2% a year earlier. The expansion in these banks’ customer deposit base led to an increase in the amount of deposits covered by Malta’s Depositor Compensation Scheme from 3.8% in 2011 to 6.2% of total covereddepositsintheMaltesefinancialsystem.

The total value of securities issued on the Malta Stock Exchange (MSE) by three of the non-core domestic banksslightlyincreasedthroughouttheyeartoaround€100million,equivalenttoabout11%ofthetotalvalueoflistedprivatesectorbondsontheExchange.Thesesecuritiesarealmostentirelyheldbyresidents,primar-ilyhouseholds.Meanwhile,nodevelopmentswerereportedduringtheyearforquotedsharesissuedbynon-coredomesticbanks.Indeed,onlyonebankhadresortedtothistypeoffundinganditsproportionamountedto around 3% of total listed private sector equities. The bulk of these shares are held by non-residents.

ProfitabilityDuring2012pre-taxprofitsofnon-coredomesticbankssurgedbymorethan200%.Thiswaslargelyattrib-utabletoonebank,whichreportedrevaluationgains.Ontheotherhand,anotherbankreportedanotice-able contraction in profits mainlyresulting from lower net interest income. Excluding these two par-ticular banks,which reported con-siderable swings in their returns,the profits of the remaining non-core domestic banks increased by 27.3%. Apart from higher trading profits, non-core domestic banksalso reported gains on the disposal of financial assets and lower netimpairment charges. As a result of thesedevelopments, thereturnonequity (ROE) increased from 1.4% in 2011 to6.5% in2012,whereasthe return on assets (ROA) rose to 1.4% from 0.5% over the same period (see Chart 5.5).

Solvency and liquidity The non-core domestic banks’ sol-vency ratios remained positive and relatively stable with the capital adequacy ratio (CAR) and Tier 1 capitalratiosat29.1%and25.9%,respectively (see Chart 5.6). The leverage ratio (capital and reserves toassets)remainedhealthy,stand-ing at 20.4% compared with 23.7% in2011.Similarly,theliquidityratiodefined as liquid assets to short-term liabilities, continued to showhigh liquidity levels, standing at82.4% at the end of 2012, whichis well above the 30% regulatory requirement.

-20

-15

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15

2008 2009 2010 2011 2012

ROE ROA

Chart 5.5PROFITABILITY - NON-CORE DOMESTIC BANKS(per cent)


15

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35

2008 2009 2010 2011 2012

Tier 1 capital ratio Leverage ratio CAR

Chart 5.6SOLVENCY RATIOS - NON-CORE DOMESTIC BANKS(per cent)


43


5.1.2 International banks

Atotalof13bankswhichoperateinMaltaareclassifiedasinternationalbanks,ofwhichthreeareforeign-owned,sixareEUsubsidiaries,twoarenon-EUsubsidiariesandtwoarenon-EUbranches.3Attheendof2012,total assets of these banks were equivalent to 493.7% of GDP. The operations of international banks remained almostexclusivelyorientedtowardsnon-residents,largelyinfluencedbythetwonon-EUbranchesowingtotheircomparativelylargebalancesheets.Indeed,thesetwobranchesrepresentalmost66%oftheaggregatedtotalassets of international banks. Resident assets and liabilities continued to account for a very small proportion ofallinternationalbanks’balancesheetitems,equivalenttoonly1.9%and1.4%oftotalassets,respectively.

Asset structure During2012thetotalassetsofinternationalbanksexpandedby4.4%,comparedwithanincreaseof1.5%in2011,reaching€33.4billion.However,atbanklevel,developmentsweremixed,withsomebanksreportingacontraction.ThegrowthintotalassetswasmainlydrivenbyhigherholdingsofTurkishgovernmentsecurities,reflectingthepredominanceofthetwoTurkishbankbranches.Theassetstructureofinternationalbanksreg-isteredsomemodestshifts,withtheshare of the loan portfolio shedding over 3 percentage points to 59.6% of the balance sheet. The securi-ties portfolio expanded from 32.4% of total liabilities in 2011 to 36.8% a year later (see Chart 5.7).

Total lending decreased by 10.3% in2012,largelyasaresultoflowercorporate sector loans,which nowaccount for 54.1% of total lend-ing compared with 56.4% in 2011. Lending to the financial sector,which accounts for around 46% of totalloans,declinedprimarilyowingto lower interbank lending to related banksandaffiliates. From a geographical perspective,customer lending remained highly biased towards non-EU countries,reflecting the operations of the twolargeTurkishbranches.Indeed,thelatter loans accounted for 58.5% of total customer loans. Lending to EU countries amounted to 32.2% of total customerlending,whereasresidentlending totalled to less than 0.03% (see Chart 5.8).4 From an asset quality perspective, the NPL ratioremainedgenerallylow,atjust0.5%.

Asinthecaseoftheloanportfolio,the banks’ investment portfolio con-sisted mainly of securities issued in non-EUcountries,which accounted

3 Refer to Financial Stability Review 2011fortheclassificationofbanks.Twoadditionalbanks,AgribankLtdandFerratumBank(Malta)Ltd were licenced in 2012 but were not yet operational before the end of 2012.4 ShouldlendingtotheTurkishbranchesbeexcluded,lendingtoEUcountrieswouldaccountfor68.5%ofthebanks’totalcustomerlending.

2.3%

36.3%

27.0%

3.8%

28.6%

1.9%1.9%

36.0%

23.6%

3.4%

33.4%

1.7%

Resident assets

MFIs-loans&deposits


MFIs - securities issued

Other sectors - securitiesissued

Other assets

2012

Chart 5.7ASSET STRUCTURE - INTERNATIONAL BANKS

2011

Note: The inner circle refers to the asset structure in 2011 while the outer circle refers to the asset structure in 2012.


0.1%

17.4%

8.9%

73.6%

0.0%

19.5%

12.7%

67.7%

Malta

euro area

Other EU

Rest of the world

0% 10% 20% 30% 40% 50% 60% 70% 80%

2012 2011

Chart 5.8CUSTOMER LOANS BY RESIDENCY - INTERNATIONAL BANKS


44


for 83.3% of total securities. These holdings largely reflect the opera-tions of the two Turkish bank branch-es. When excluding these two branches, themajorityofsecurities(80.6% of the total) constituted debt issued in EU countries. The majority of these bonds were privately issued bonds,whereasnodomesticsecu-rities were held by this category of banks (see Chart 5.9).

Funding structureOn the liabilities side, internation-al banks primarily obtained their funding from the wholesale mar-ket, which accounted for almost55% of total liabilities (see Chart 5.10).5 The interconnectedness to thedomesticfinancialsystemalsoremainednon-existent,withpracti-cally no resident interbank liabili-ties.Meanwhile,Eurosystemfund-ing remained low at just 0.3% of total assets.

Customer deposits, which arealmost entirely obtained from the non-residentmarket,financealmost18% of the international banks’ balance sheet. Resident deposits remained minimal, amounting toalmost €12 million and equivalentto just 0.1% of total resident depos-its in Malta. The amount of deposits covered by Malta’s Depositor Com-pensation Scheme represented just 0.5% of the total covered deposits intheMaltesefinancialsystem.

ProfitabilityDuring 2012 international banks reported a 14.7% increase in their pre-tax profits. This improvementwas entirely attributable to opera-tions of the branches. Higher net interest income contributed to the improved performance, althoughthis was partly offset by lower non-interest income. The latter resulted from trading losses on foreign exchange dealings. Excluding the performance of the two branches,

5 Wholesalefundingrelatestodeposits,loansandrepoagreementswithotherMFIs.

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2011 2012 2011 2012

Periheral countries Other euro area Other EU Rest of the world

Chart 5.9INVESTMENT SECURITIES BY RESIDENCY - INTERNATIONAL BANKS(per cent)


Including Branches Excluding Branches

1.3%0.5%

53.6%

19.4%

24.6% 0.6%

1.4%0.3%

54.7%

17.9%

25.1%

0.7%

Resident liabilities

Eurosystem funding

MFIs - placements withbanks


Capital and reserves

Other liabilities

2012

Chart 5.10LIABILITIES STRUCTURE - INTERNATIONAL BANKS

2011

Note: The inner circle refers to the liabilities structure in 2011 while the outer circle refers to the liabilities structure in 2012.


0

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4

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12

2008 2009 2010 2011 2012

ROE ROA

Chart 5.11PROFITABILITY - INTERNATIONAL BANKS(per cent)


45


theprofitsfortheotherinternationalbanks contracted by 4.9%. In 2012 the ROE and ROA stood at 3.6% and 1.3%, respectively, comparedwith 3.9% and 1.2% a year earlier (see Chart 5.11).6

Solvency and liquidity levelsInternational banks’ solvency ratios remained positive and at elevated levels.Asatendof2012, theCARstood at 102.7%, whereas the Tier1 capital ratio was at 102.2% (see Chart 5.12). Such high ratios are largely attributable to one particular bank, which operates with a largedeposit base and a corresponding low risk-weighted asset portfolio.7 Similarly, the leverage ratio (capitalandreservestoassets)alsoremainedhealthy,standingat68.8%.Theliquidityratio,definedasliquidassetstoshort-termliabilities,comfortablyexceededtheminimumrequirementof30%,reaching146.3%asatend-2012.

5.2 Insurance and investment funds sector

5.2.1 Domestic insurance companies

Thedomesticinsurancesectorcomprisesthreelifeandfivenon-lifeinsurancecompanies.Somedomesticinsurancecompaniesarecloselyinterconnectedwiththebankingsector,particularlywithcoredomesticbanks,asthelatterholdasignificantshareholdinginthreeoftheeightdomesticinsurancecompanies(twolifeinsur-ance companies and one non-life insurance company).8Intermsofaggregateassetsofthefinancialsector,thedomesticinsurancesectorremainedsmall,equivalenttoonly15.3%ofcorebanks’assets.Thehighlevelofconcentrationcontinuedtopersistdespitecross-bordercompetition,withoneinsurancecompanyaccount-ing for more than half of the sector’s total assets and almost one third of gross premium written. In fact,the gross premium written for risks in Malta by insurance companies established abroad was minimal.

Theinvestmentprofileoftheinsur-ance sector remained prudent,despite the high level of con-centration in the asset structure. Asset allocations were broadly unchanged compared with 2011. The investment portfolio represent-ed 73.2% of the balance sheet val-ue,withdomesticsovereignbondsaccounting for almost a third of the total investment portfolio (see Chart 5.13). The sector’s holding of euro

6 The ROE excludes the branches given that these banks do not hold any capital.7 Excludingthisparticularbank,theTier1capitalratiooftheinternationalbankswouldstandataround50%.8 Refer to Financial Stability Review 2011 for the categorisation of domestic insurance companies.

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2008 2009 2010 2011 2012

Tier 1 capital ratio Leverage ratio CAR

Chart 5.12SOLVENCY RATIOS - INTERNATIONAL BANKS(per cent)


0 10 20 30 40

Othersecurities and

financialderivatives

Shares andother equity

Euro areasovereign

bonds

MaltaGovernment

Stocks


Chart 5.13INVESTMENT ASSETS OF THE INSURANCE SECTOR (2012)(per cent)

46


areasovereigndebt,excludingMaltaGovernmentStocks(MGS),represented9.7%ofthetotalinvestmentportfolioanddidnotincludeanysecuritiesfromstressedcountries.Meanwhile,theproportionofsharesandotherequity(themajorityofwhichwereissuedbyforeignentities)amountedto38.7%.Apartfromthesignifi-cantshareholdingofcoredomesticbanksinthreeofthedomesticinsurancecompanies,theseinterlinkagesare also evidenced by the fact that around 8.0% of the insurances’ total assets consist of deposits held with the banking sector in Malta.

Theresilienceoftheinsurancesectorcontinuedtobereflectedinitsprofitabilityfigures.During2012profitsaftertaxamountedto€37.8million,morethandoublethanthosereportedayearearlier(seeChart5.14).Theincreasewaslargelydrivenbythelifeinsurancesector,althoughthenon-lifesegmentalsorecordedstrongresults.Thelifesector,infact,reportedaconsiderableimprovementininvestmentincomeowingtopositivemarketdevelopments,reversingthebleakmarketconditionsof2011.Ontheotherhand,netpremi-umwritten declined,mainly owingtoa specific large insurance com-pany which reported lower sales of single premium written products. In thecaseofthenon-lifesector,bothinvestment income and net pre-mium rose, although the changeswere smaller than in the life sector. For most of the non-life insurers,the strong investment returns were reinforced by profitable underwrit-ing activity. This was reflected bythe combined ratio of the non-life insurance sector, which stoodbelow 100% at 93.4%.9

During 2012 insurance compa-nies reported a general rise in net claims,somewhatdampeningprof-its. This resulted from a greater number of maturity payments dur-ing the year compared with 2011,owing to the maturity profile of atranche of investment-type policies which matured in 2012.

Higherprofitspushedup theROAand ROE to 2.2% and 14.6%,respectively, in December 2012,up from 1.1% and 7.4% a year earlier (see Chart 5.15). The ROE ratio was higher than the average in a sample of large EU insurance groups in the first half of 2012,which hovered around 7%.10 Such groups reported positive under-writing business and investment income,butwereadverselyaffect-ed by catastrophic events.

9 Thecombinedratioisdefinedasthesumofnetclaimsincurredandthenetoperatingexpensesoverthenetearnedpremia.Acombinedratiolessthan100%signalsunderwritingprofit,asinsurersaretakinginmoreinpremiathanpayingoutinclaimsandotherexpenses.10 Source: ESRB Risk Dashboard, March 2013.

(150)

(100)

(50)

0

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150

2009 2010 2011 2012

Underwriting business Investment income/lossesOther income net of other expenses Profit after tax

Chart 5.14PROFIT COMPONENTS OF THE INSURANCE SECTOR(EUR millions)


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2008 2009 2010 2011 2012 2008 2009 2010 2011 2012

ROA total ROA life ROA non-lifeROE total (RHS) ROE life (RHS) ROE non-life (RHS)

Chart 5.15PROFITABILITY OF THE INSURANCE SECTOR(per cent)


ROA ROE

47


Thecapitalpositionoftheinsurancesectorremainedbroadlystable,supportedbyprudentdistributionpoli-cies.Attheendof2012,theratioofcapitaltototalassetsstoodat15.2%,comparablewiththemedianoflarge insurance companies in the euro area.11 Solvency levels remained higher among the non-life insurers whose business is generally associated with higher risks. The solvency levels of the non-life sector rose to 41.6%,upfrom40.9%in2011,whereasthatforlifeinsurersremainedstableat11.5%.Technicalreserves,whicharesetasidebyinsurancecompaniestocoverfutureclaims,increasedby8.5%onayearearlier.

The risk retention ratio was estimated at 70.3% for the non-life segment and at 95.2% for the life segment.12 Themedianriskretentionratiooftheaggregatedomesticinsurancesectorstoodat81.1%,relativelylow-er than the median in a sample of largeEU insurancegroups,whichstood at 93.2% at the end of 2012 (see Chart 5.16).13 The insurance sector views the risk of huge claims resulting from catastrophic events as remaining low, as such claimsare mitigated through the appli-cation of clearly stated exclusion clauses.Theseexclusions,howev-er, transfer the risk topolicyhold-ers and may thus have a potential negative implication for financialstability through the adverse effect on net wealth.14Suchfinancialsta-bility implications are, however,deemed marginal.

5.2.2 Domestic investment funds

At the end of 2012, the domesticinvestment funds sector was com-posed of 14 funds (ten collective investment schemes [CIS] and four hedge funds).15,16 This sector contin-ued to be dominated by core domes-ticbanks,whichmanagethemajorityofthesefunds,oraround98%ofthetotal net asset value. The drop in the net asset value of investment funds reported in 2011 was reversed with an13.7%risein2012,withCISreg-isteringanincreaseof15.2%,whilethe hedge fund category grew mar-ginally (see Chart 5.17). CIS made 11 Source: ECB Financial Stability Review December 2012.12 The risk retention ratio describes the extent to which gross premia and risk are being retained by the company by netting out premia which are seeded out to re-insurers. 13 Source: ESRB Risk Dashboard, March 2013.14 The United Nation’s Institute for Environment and Human Security rates the risk of becoming a victim of a natural disaster in Malta at only0.72%(thereportisbasedonanindexrelatedtotheexposureofcountriestonaturalhazardsandclimatechange,aswellassocialvulnerability). Source: World Risk Report 2011.15 The InvestmentServicesAct (1994)specifies thatCISareorganisationswith theaimofcollectively investing“capitalacquiredbymeansofanofferofunitsforsubscription,saleorexchange”.HedgefundsareaspecialclassofCIS,attractingpersonsorcompanieswitharelativelyhigherinitiallevelofcapital.Astheirnatureisnon-retail,hedgefundsaresubjecttolimitedregulationandoversight.16 Refer to Financial Stability Review 2011 for the categorisation of domestic investment funds.

70

75

80

85

90

95

100

H2 H1 H2 H1 H2 H1 H2

Median - Malta Median - EU

Chart 5.16RISK RETENTION RATIO(per cent)

Note: Data for the European Union is based on a sample of large insurance companies. Sources: Central Bank of Malta and ECB.

2009 2010 2011 2012

0

100

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500

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2009 2010 2011 2012

Thou

sand

s

CIS Hedge funds Total

Chart 5.17NET ASSET VALUE OF THE INVESTMENT FUNDS SECTOR(EUR millions)


48


up the bulk, or 90.8%, of the netasset value of the investment funds sector,withhedgefundsaccountingfor just 9.2%.

The expansion in the net asset value was primarily attributable to improvedasset valuations, reflect-ing to a certain degree improve-ments in international financialmarkets and the stronger perfor-mance of the domestic sovereign securities. The latter accounted for over 37% of the sector’s invest-ment assets (see Chart 5.18). The proportion of domestic sovereign debt is more prominent in the case ofCIS,equivalent to40.8%of thesector’s investmentportfolio,whilehedge funds had no holdings in MGS.Inturn,theshareofholdingsof sovereign euro area bonds was limitedtoonly1.6%forCIS,where-as hedge funds’ holdings were almost negligible.

Equity holdings dominated the asset portfolio of hedge funds. These remained skewed towards shares quoted on the MSE, withthe latter accounting for some 56% of the hedge funds’ total investment assets. Bank equity represented thebulkof such shares, highlight-ing the strong interconnectedness between the investment funds sec-tor and the banking system. CIS’ equity holdings amounted to 21.9% oftheirportfolio,equallymadeupofbothbankandnon-bankdomesticequities.Ontheotherhand,directexposure to commercial property by the investment funds sector was negligible.

During 2012 there were no particular changes in the interlinkages between the investment funds sector and thebankingsysteminMalta,althoughtheseremainedhigh.Nevertheless,thesystemicrelevanceofthedomesticinvestmentfundssectorwaslimited,particularlyasCISaccountforjust5.8%ofhouseholdfinan-cialwealth,despitehouseholdsbeingthemajorfundholders(seeChart5.19).Inthecaseofbanks,theseheld an average of 4.8% of domestic investment funds (constituted of 1.7% of CIS and of 35.6% in hedge funds). Such fund holdings are equivalent to merely 0.1% of the banking sector’s aggregate assets.

41%

1%

36%

12% 3%

7%

5%

56%14%

25%37%

2%33%

16%

4%8%

MGS Other euro area sovereign bondsOther bonds Domestic equitiesOther euro area equities Other non-euro area equities

Collective Investment Schemes

Hedge funds

Total

Chart 5.18ASSET ALLOCATION OF THE INVESTMENT FUNDS SECTOR (2012)(per cent)


0 10 20 30 40 50 60 70 80 90 100

CIS

Hedge funds

Households Non-financial corporates Banks Other financial institutions

Chart 5.19HOLDINGS IN INVESTMENT FUNDS (2012)(per cent)


49


6. RISK OUTLOOK AND RECOMMENDATIONS

Despitethedifficultexternalenvironment,theMalteseeconomycontinuedtoshowahighdegreeofresil-ience,whichwasreflectedinapositiverateofgrowthduring2012.Thefinancialsystemtoomaintaineditsstabilityinchallengingconditions,asriskshighlightedinthepreviouseditionoftheFinancial Stability Report and its Update remained contained. Challenges from the international environmentThroughouttheyearglobaleconomicconditionsremainedweak,amidsignsofaneasingofpressuresininternationalfinancialmarketstowardstheendoftheyear.Theuncertaintyacrosstheeuroareapersisted,with the economy in this region contracting by a larger extent than anticipated. The negative feedback loops betweensovereignsandthebankingsectoremergedintheearlypartof2012;however,thesestabilisedtowardstheendoftheyear.Strainsinfinancialmarketsre-appearedbrieflyinthefirstquarterof2013inresponsetothebankingcrisisinCyprus.Asaresult,thefocusofmarketattentionturnedonsmallcountrieswithrelativelylargebankingsectors.Inthisregard,therefore,itisrelevanttohighlightsomefigureswhichthrow further light on Malta’s banking structure. Atend-2012,thebankingsectorinMaltaconsistedof26creditinstitutionswithtotalassetsamountingtoalmost 800% of gross domestic product (GDP).1However,assetsbelongingtothefivecoredomesticbanks,whichareextensively integratedwith thedomesticeconomy,accounted for218%ofGDP,whileassetsbelongingtotheeightnon-corebanks,whichundertakeaverylowvolumeofbusinesswiththedomesticeconomy,accountedfor77%ofGDP.TherestofMalta’sbankingsectorismadeupof13internationalbankswithvery limited linkstothedomesticeconomyandtotherestof thefinancialsector.Thesebanksholdassets totalling 494% of GDP.

Furthermore,core,non-core,and internationalbanksareallwell-capitalised,highly liquidandprofitable.Thecorebanks’capitaladequacyratiosincreasedfrom13.5%in2011to14.3%in2012,wellabovethe8%threshold.TheTier1capitalratioalsoimprovedfrom9.6%in2011to10.3%in2012,againwellabovetheregulatoryminimumof4%.Inthecaseofnon-coreandinternationalbanks,thecapitaladequacyratioswerealsosignificantlyinexcessoftheregulatoryrequirementsat29.1%and102.7%,respectively.In2012banksreportedhealthyprofitswiththereturnonequityremainingatahighlevel,withthatforcoredomesticbanksstanding at 23.9% while for non-core banks at 6.5% and 3.6% for international banks. All banks had ample liquiditylevelswellabovethe30%requirementasliquidassetstoshort-termliabilitiesalsostoodat49.1%,82.4%and146.3%forcore,non-coreandinternationalbanks,respectively,in2012.

AnotheraspectofthebankingsectorinMaltaisthatasignificantproportionofassetsareheldbyforeign-controlledsubsidiariesandbranches, reflectingefficient cross-border specialisation.Assetsbelonging tosubsidiariesandbranchesofEuropeanUnion(EU)banksamountedtomorethan250%ofGDP,ofwhichabout 155% belonged to subsidiaries of globally systemic institutions. A further 363% consisted of subsidiar-ies and branches of non-EU banks.

Challenges within the financial sector in MaltaAgainsttheprevailingbackgroundofuncertaintyininternationalfinancialmarkets,thedomesticbankingsec-torremainedsoundandrobustduring2012,supportedbyitsprudentbusinessmodels.Thisnotwithstanding,thebankscontinue to faceanumberof challenges,particularly theirexposure tospecificeconomicsec-tors,primarilytheconstructionsector,whichstillfacesdifficultbusinessconditions.Lookingahead,modesteconomicgrowthmayimpingeontheperformanceofcreditors,particularlycorporates,whichcould,inturn,adverselyaffecttheassociatedcreditriskofbanks.Inthisregard,bankswereurgedtocontinuetomaintainmoderate loan-to-value ratios,particularlywith respect to lendingsecuredby realestate.Theywerealsoencouraged to furtherstrengthen theirprovisioning levels,moderate their forbearancepracticesand takethe necessary steps to reduce the amount of non-performing loans (NPL). The continued adoption of con-servativecollateralvaluationsthroughtheallocationofappropriatehaircutswasalsoadvocated,particularly

1 Two additional banks were licensed in 2012 but were not yet operational till the end of 2012.

50


where loans were covered by commercial real estate since these are more susceptible to general economic orindustry-specificshocks.Asapolicymeasure,theJointFinancialStabilityBoard,whichwasestablishedinJanuary2013,startedtoconsiderpossibleenhancementstotheMaltaFinancialServicesAuthorityBankingRules,particularlyBR/09/2008-CreditandCountryRiskProvisioningbyCreditInstitutionsAuthorisedUnderTheBankingAct1994,andBR/12/2013-TheSupervisoryReviewProcessOfCreditInstitutionsAuthorisedUnderTheBankingAct1994,withaviewtostrengtheningbanks’provisioninglevelsandenhancingcapitalbuffers.

Banksremainedhighlyliquidduring2012,withliquidityratioswellabovetheregulatoryrequirements.Thus,liquidity risks are expected to remain contained as banks continue to rely on customer deposits as the main sourceoffunding.Depositscontinuedtogrowduring2012reflectinghouseholds’highpropensitytosave.Ontheotherhand,giventheshort-termmaturityprofileofcustomerdeposits,bankscouldfacesomechal-lengesinmeetingthenewrequirementsundertheCRDIV,astheseplacegreateremphasisonstablelong-term funding. Banks will therefore be obliged to adjust their liability maturity structure to comply with the new framework.2Inthisregard,however,thebanksarealreadytakingstepstosatisfythenewregulationsanditis anticipated that they will be in line with the new requirements before the target date.

Whilebanksareexpectedtoremainprofitable,underpinnedbygenerallystablelevelsofnetinterestincome,the general interest rate environment and regulatory requirements to lengthen deposit maturity structures mayhaveslightlynegativeimplicationsforthebanks’short-termprofitability.Furthermore,creditdemandmay be expected to expand at a decelerating rate in response to modest economic growth. With regard to non-interestincome,thiswaslargelyaffectedbyinternationalfinancialconditions,resultinginassetpricefluctuations,andhencevaluationgainsandlosses.Giventhemorestableconditionsininternationalfinan-cialmarkets,itisexpectedthatfluctuationsintradingprofitswillbemorerestrained.

The banks maintain capital adequacy ratios well above the required regulatory minimum and have been successfulinraisingcapitalfromexternalsources.However,afurtherstrengtheningofthebanks’capitalbase may be necessary to buttress capital buffers. This could be generated through internal sources. Con-sequently,bankswereencouragedtomaintainprudentdividendpolicies.

Risksfromothercategoriesofthebankingsector,thatisthenon-coreandinternationalbanks,areantici-pated to remain low. The operations of these institutions are expected to remain broadly unchanged over the mediumterm.Whilesomeofthenon-coredomesticbankshaveincreasedtheirresidentdepositbase,suchdeposits still constitute only around 6% of total resident deposits in Malta. Non-core domestic and interna-tionalbankdepositscoveredbytheDepositorCompensationSchemestoodat6.2%and0.5%respectively,of total eligible deposits.3

Othersub-sectorsof thefinancial sector,namely, the insuranceand investment fundsectors,appear toposelimitedrisktothefinancialsystemasawhole,althoughcloselinkagesexistbetweencoredomesticbanksandindividualinstitutionsinthesesub-sectors.Thegenerallystrongprofitperformanceofinsurancecompanies and investment funds and the adoption of prudent business practices are important elements contributingtotheresilienceofthefinancialsector.

Challenges outside the financial sector in MaltaTherecentcrisiswithintheeuroarearevealedthepotentialadverselinkbetweensovereignsandthefinan-cialsector,highlighting theneedforsoundfiscalpoliciesasaprecondition forfinancialstability.Lookingahead,closeadherencetofiscaltargetsbytheGovernmentremainsanimportantconditionforstabilitybothinthedomesticeconomyandinthefinancialsector.

2 ThenewCRDIVregulatoryframeworkintroducestwoliquidityratios,namelytheLiquidityCoverageRatio(LCR),whichcomesintoforcein2015,andtheNetStableFundingRatio(NSFR),whichcomesintoforcein2018.3 ByvirtueofLegalNoticesNumber159and340of2012,allbankswereobligedtoincreasetheircontributiontotheDCSfromthecurrentlevel of 0.77% of eligible deposits to 0.846% in 2012; to 0.89% in 2013; to 0.966% in 2014 and 1% by 2015. The Supplementary Contribu-tion (cash contribution) was raised from 0.1% to 0.2% while the Special Contribution (pledged assets) was increased from 0.67% to 0.8%.

51


An important development in the coming year will be the introduction of the Single Supervisory Mechanism. Thus,asfrom2014,thebankingsectorwillstartoperatingunderanewregulatorylandscape,withtheEuro-pean Central Bank (ECB) taking on increased responsibilities to supervise banks in the euro area. The ECB shallcarryoutitstasks,subjecttoandincompliancewiththerelevantlegislationandthecommonrulesandregulations applying to all Member States. While this new regulatory framework is not expected to change theoperationsofbanksinMalta,banksmayfaceincreasedreportingobligationsandmoredemandingeuroarea-wide supervisory practices.

The Financial Stability Report 2012 has emphasised that the external environment continues to be charac-terisedbyweakeconomicconditionsandfragilityininternationalfinancialmarkets.Inalocalcontextitviewsthemacro-financialenvironmentaschallengingandthusrecommendsthatcorebankscontinuetoadoptprudentlendingpolicies,especiallyaseconomicgrowthisprojectedtoremainmodest.TheReport’s main policyrecommendationsthereforefocusoncreditrisk,concentrationriskandtheneedtorestructurebal-ancesheetssoastofulfilthenewregulatoryrequirements(SeeTable6.1).TheReportnotesthatmeasuresin line with these recommendations are being gradually implemented by the respective authorities and by the industry participants themselves.

Table 6.1MEASURES TO ADDRESS KEY RISKS IN THE FINANCIAL SYSTEMRisks Measures required Time horizon

Credit risk Improve coverage of NPLs Short term

Concentration risk Increase capital buffers Medium term

Regulatory changes (CRD IV) Lengthen the maturity structure of deposit liabilities Short termEnhance capital buffers through increased profit retention Medium term

APPENDIXAND

GLOSSARY

55


Appe

ndix

: Fin

anci

al S

ound

ness

Indi

cato

rs

2010

2011

2012

2010

2011

2012

2010

2011

2012

2010

2011

2012

Cor

e FS

IsR

egul

ator

y ca

pita

l to

risk

wei

ghte

d as

sets

12.8

913

.53

14.3

129

.77

29.0

829

.06

104.

7011

5.53

102.

6754

.64

56.7

853

.35

Reg

ulat

ory

Tier

1 c

apita

l to

risk-

wei

ghte

d as

sets

9.17

9.55

10.2

827

.93

27.3

525

.91

103.

1211

4.38

102.

1852

.06

54.2

250

.93

Non

-per

form

ing

loan

s ne

t of p

rovi

sion

s to

cap

ital

55.8

654

.45

56.1

99.

818.

928.

000.

430.

080.

166.

926.

767.

47N

on-p

erfo

rmin

g lo

ans

to to

tal g

ross

loan

s7.

457.

338.

093.

594.

474.

120.

610.

450.

493.

043.

253.

74Se

ctor

al d

istri

butio

n of

loan

s to

tota

l loa

nsAg

ricul

ture

0.31

0.30

0.29

0.06

0.07

0.07

0.00

0.00

0.00

0.11

0.11

0.12

Fish

ing

0.13

0.12

0.12

0.00

0.00

0.00

0.00

0.00

0.00

0.04

0.04

0.05

Min

ing

and

quar

ryin

g0.

100.

080.

080.

070.

010.

010.

000.

000.

000.

040.

030.

03M

anuf

actu

ring

3.48

3.30

3.86

0.29

0.34

0.36

0.00

0.00

0.00

1.13

1.21

1.52

Electricity,gas,S

team

andAirConditioningSupply

5.50

5.70

5.37

0.09

0.10

0.11

0.00

0.00

0.00

1.76

2.06

2.09

Wat

er S

uppl

y; S

ewer

age

was

te m

anag

emen

t and

rem

edia

tion

activ

ities

0.78

0.76

0.79

0.00

0.00

0.00

0.00

0.00

0.00

0.25

0.27

0.30

Con

stru

ctio

n12

.92

12.0

911

.17

3.96

4.57

4.17

0.00

0.00

0.00

4.46

4.72

4.67

Who

lesa

le a

nd re

tail

trade

; Rep

air o

f mot

or v

ehic

les

and

mot

or c

ycle

s10

.19

9.91

9.40

0.64

1.22

1.79

0.00

0.00

0.00

3.30

3.67

3.79

Tran

spor

tatio

n an

d st

orag

e4.

604.

634.

361.

051.

080.

950.

040.

050.

001.

581.

781.

77Ac

com

mod

atio

n an

d fo

od s

ervi

ce a

ctiv

ities

5.54

5.50

5.50

0.23

0.10

0.12

0.00

0.00

0.00

1.79

1.99

2.14

Info

rmat

ion

and

com

mun

icat

ion

1.45

1.37

1.33

0.04

0.06

0.09

0.00

0.00

0.00

0.47

0.50

0.52

Fina

ncia

l and

insu

ranc

e ac

tiviti

es2.

212.

122.

110.

190.

390.

230.

000.

000.

000.

720.

800.

84R

eal e

stat

e ac

tiviti

es [i

nclu

des

inpu

ted

rent

s of

ow

ner-

occu

pied

dw

ellin

gs]

4.17

4.05

4.03

2.80

3.13

3.04

0.00

0.00

0.00

1.57

1.71

1.82

Professional,scientificandtechnicalactivities

0.85

1.05

0.69

0.05

0.06

0.04

0.00

0.00

0.00

0.28

0.38

0.27

Adm

inis

trativ

e an

d su

ppor

t ser

vice

act

iviti

es1.

111.

131.

080.

460.

520.

510.

000.

010.

010.

390.

450.

46Pu

blic

adm

inis

tratio

n an

d de

fenc

e; C

ompu

lsor

y so

cial

sec

urity

1.49

1.47

1.49

0.00

0.00

0.01

0.00

0.00

0.00

0.47

0.53

0.58

Educ

atio

n0.

310.

410.

430.

000.

000.

000.

000.

000.

000.

100.

150.

17H

uman

hea

lth a

nd s

ocia

l wor

k ac

tiviti

es0.

470.

540.

640.

000.

280.

270.

000.

000.

000.

150.

220.

27Arts,entertainmentandre

creation

0.48

0.51

0.73

0.34

0.36

0.32

0.00

0.00

0.00

0.18

0.21

0.31

Oth

er S

ervi

ces

activ

ities

0.34

0.36

0.38

0.02

0.03

0.03

0.00

0.00

0.00

0.11

0.13

0.15

Hou

seho

lds

and

indi

vidu

als

(exc

l. So

le P

ropr

ieto

rs)

41.9

442

.95

44.3

90.

670.

750.

810.

000.

010.

0113

.42

15.5

217

.23

Activ

ities

of e

xtra

terr

itoria

l org

anis

atio

ns a

nd b

odie

s0.

000.

000.

000.

000.

000.

000.

000.

000.

000.

000.

000.

00N

on-r

esid

ent

1.63

1.65

1.76

89.0

286

.94

87.0

999

.95

99.9

499

.98

67.6

963

.51

60.9

1R

etur

n on

ass

ets

1.40

1.27

1.63

1.33

0.48

1.51

1.10

1.16

1.25

1.20

1.12

1.38

Ret

urn

on e

quity

22.3

819

.46

23.9

34.

351.

377.

013.

083.

893.

615.

005.

095.

95In

tere

st m

argi

n to

gro

ss in

com

e70

.66

72.4

666

.80

63.3

969

.96

28.5

262

.05

89.0

012

4.61

66.0

179

.11

83.0

5N

on-in

tere

st e

xpen

se to

gro

ss in

com

e49

.66

54.0

745

.52

35.4

545

.53

28.8

58.

188.

877.

0830

.02

34.1

027

.48

Non

-inte

rest

inco

me

to g

ross

inco

me

29.3

427

.54

33.2

036

.61

30.0

471

.48

37.9

511

.00

-24.

6133

.99

20.8

916

.95

Liqu

id a

sset

s to

tota

l ass

ets

24.9

324

.09

28.8

310

.86

14.7

414

.41

5.76

7.39

9.94

15.0

916

.11

19.6

7Li

quid

ass

ets

to s

hort-

term

liab

ilitie

s42

.85

44.1

049

.09

82.8

690

.40

82.4

386

.13

111.

0214

6.27

47.8

349

.59

55.6

3

Oth

er F

SIs

Cov

erag

e ra

tio19

.83

19.7

622

.10

31.7

342

.84

40.9

376

.00

107.

6796

.41

27.7

229

.16

29.0

4D

omes

tic in

vest

men

t sec

uriti

es to

tota

l ass

ets

12.2

812

.76

11.9

52.

232.

232.

880.

000.

000.

003.

553.

773.

59Fo

reig

n in

vest

men

t sec

uriti

es to

tota

l ass

ets

11.9

011

.46

10.7

335

.13

36.1

038

.27

28.7

531

.50

36.5

224

.81

26.3

729

.56

Uns

ecur

ed lo

ans

to to

tal l

endi

ng20

.02

19.7

922

.42

54.6

939

.48

50.7

456

.05

54.2

457

.80

44.4

640

.64

43.5

2As

sets

to to

tal c

apita

l and

rese

rves

(*)

15.7

815

.48

14.5

54.

124.

214.

891.

601.

561.

453.

133.

133.

14La

rge

expo

sure

to c

apita

l14

4.86

138.

4812

2.44

72.8

613

1.21

111.

676.

4310

.25

10.9

525

.45

32.2

231

.54

Gro

ss a

sset

pos

ition

in fi

nanc

ial d

eriv

ativ

es to

cap

ital

2.18

4.89

3.20

0.68

1.51

0.55

0.00

0.42

0.55

0.68

0.99

0.87

Gro

ss li

abilit

y po

sitio

n in

fina

ncia

l der

ivat

ives

to c

apita

l7.

8811

.56

10.7

61.

062.

452.

660.

100.

120.

070.

991.

551.

54Pe

rson

nel e

xpen

ses

to n

on-in

tere

st e

xpen

ses

55.6

152

.44

53.9

834

.52

36.2

437

.23

19.4

121

.24

26.7

048

.09

46.5

048

.19

Cus

tom

er d

epos

its to

cus

tom

er lo

ans

141.

7413

7.51

142.

6638

.16

55.7

068

.82

81.9

471

.93

76.1

010

2.58

99.7

868

.82

Net

ope

n po

sitio

n in

equ

ities

to c

apita

l16

.07

17.7

417

.31

80.3

879

.71

75.4

30.

890.

890.

067.

497.

687.

51(*

) exp

ress

ed a

s a

ratio

.

Tota

l ban

ksIn

tern

atio

nal b

anks

Non

-cor

e do

mes

tic b

anks

CO

MPA

RAT

IVE

IND

ICAT

OR

S 20

09 -

2011

- (A

LL F

IGU

RES

IN %

)C

ore

dom

estic

ban

ks

57


Glossary

Capital adequacy ratio: the bank’s regulatory capital expressed as a percentage of its risk-weighted assets.

Collective provisions: the amount of provisions allocated for the estimated losses incurred on a collective basis,butwhichhaveyettobeindividuallyidentified.

Combined ratio: as the sum of net claims incurred and the net operating expenses over the net earned premia.Acombinedratiolessthan100%signalsunderwritingprofit,asinsurersaretakinginmoreinpremiathan paying out in claims and other expenses.

Core Tier 1 capital ratio: Tier1capitalisthecoremeasureofabank’sfinancialstrengthfromaregula-tor’spointofview.Itiscomposedofcorecapital,whichconsistsprimarilyofcommonstockanddisclosedreserves(orretainedearnings),butmayalsoincludenon-redeemablenon-cumulativepreferredstock.TheBasel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital.

Coverage ratio:thestockofspecificandcollectiveprovisionsexpressedasaproportionofnon-performingloans.

Credit default swap: aswapdesignedtotransferthecreditexposureoffixedincomeproductsbetweenparties.Thebuyerofacreditswapreceivescreditprotection,whereastheselleroftheswapguaranteesthecreditworthinessoftheproduct.Thus,theriskofdefaultistransferredfromtheholderofthefixed-incomesecurity to the seller of the swap.

Customer deposits: all currency deposits of (i) money market funds (ii) central government (iii) other gen-eralgovernmentand(iv)otherremainingeconomicsectors,excludingthefinancialintermediationsector.

Customer loans: all currency loans of (i) money market funds (ii) central government (iii) other general gov-ernmentand(iv)otherremainingeconomicsectors,excludingthefinancialintermediationsector.

Depositor Compensation Scheme: a rescue fund for depositors of failed banks which are licensed by the Malta Financial Services Authority.

Interest burden: all interest payments excluding repayment of principal.

Leverage ratio: the proportion of capital and reserves/shareholders’ funds to balance sheet assets. Capital and reserves/shareholders’ funds includeordinary shares, sharepremium,perpetual preferenceshares,reserves and capital contributions.

Liquid assets:consistmainlyofcashandbalancesheldwiththeCentralBankofMalta,Treasurybillsandsimilarsecurities,othereligiblebills,depositsheldwithothercredit institutions,debtsecurities,goldandotherbullion,andinvestmentfunds.

Liquidity ratio: the value of liquid assets to short-term liabilities. In terms of Banking Rule BR/05/2007 issuedbytheMFSA,creditinstitutionsarerequiredtoholdaminimumliquidityratioof30%.

Loan loss provisions:collectiveprovisionsandspecificprovisions.

Loan-to-deposit ratio: the statistic for assessing a bank’s liquidity by dividing the banks total loans by its totaldeposits.Thisnumber,alsoknownastheLTDratio,isexpressedasapercentage.Iftheratioistoohigh,itmeansthatbanksmightnothaveenoughliquiditytocoveranyunforseenfundrequirements;iftheratioistoolow,banksmaynotbeearningasmuchastheycouldbe.

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Loan-to-value ratio: the amount lent for the purchase of a property expressed as a proportion of the value of the property purchased.

Net impairment charges: costs incurred as a result of the decline in the value of assets. These include write-downofloans,investmentsandnon-financialassets,netofrecoveriesandreversals.

Non-performing loans: credit facilities with payments of interest and/or capital overdue by 90 days or more,aswellasthosefacilitiesaboutwhichacreditinstitutionhasreasontodoubttheeventualrecover-ability of funds.

Non-performing loans ratio: non-performing loans expressed as a percentage of total loans outstanding.

Probability of default: the likelihood that a debt will not be paid on time.

Repurchase agreement (repo): contract of sale of securities accompanied by an agreement authorising the seller to buy back the securities at a later date.

Return on assets: annual net income before tax divided by a 12-month average value of total assets.

Return on equity: annual net income before tax divided by a 12-month average value of shareholders’ funds.

Risk retention ratio: theproportionofriskwhichisretainedwithininsurancecompaniesandisdefinedaspremiawritten,netofreinsurance,asaproportionofgrosspremia.

Risk-weighted assets:assetsmultipliedbytheirrespectiveriskweightsasspecifiedintheCapitalRequire-ments Directive.

Short-term liabilities: include the amounts owed to banks and customers, which arewithdrawable ondemandoratshortnoticewitharemainingtimetomaturityofthreemonthsorless,orwhichcanbewith-drawn at any time against a penalty; they also include any other borrowing which is repayable either on demand or with a remaining term to maturity of seven days or less but exclude intragroup borrowings.

Specific provisions:provisionssetasidefordoubtful/lossfacilities.Specificprovisionsshouldatleastbeequal to the loss not covered by collateral in the event of default.

Systemic risk: “theriskofdisruptioninthefinancialsystemwiththepotentialtohaveseriousnegativecon-sequencesfortheinternalmarketandtherealeconomy”,asdefinedbytheESRB.

Switch Auction Programme: a voluntary programme launched by the Maltese Government late in 2011 to convert MGS maturing in the short-term into securities with longer maturities.

Technical reserves:thefundssetasidebyinsurancecompaniesfromprofitstocoverclaims.

Tier 1 capital: the bank’s core capital mainly composed of equity capital and disclosed reserves.

Tier 1 capital ratio: Tier 1 capital as expressed as a percentage of risk-weighted assets.

Tier 2 capital:includes,inter alia,undisclosedreserves,revaluationreserves,generalprovisionsandsub-ordinated term debt.

Weighted average interest rate: the interest rate charged to each economic sector multiplied by the latter’s share of total outstanding loans.

fifth financial stability report 2012

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