Financial Crisis - Back to basics
Prudent policies shelter Malta's insurers and banks from worst of financial storm
Malta and the eurozone, along with the rest of the world, are currently facing a bleak economic outlook. Many of Europe's biggest economies are now in recession. Malta has managed to avoid that outcome itself: growth slowed to 0.7 per cent in the second quarter of the year to the end of June. A recession is not yet on the cards: the definition is two consecutive quarters of negative growth and none have been registered so far.
On one other indicator, there is more cause for concern. While inflation across Europe seems to be contained, in Malta it reached 5.8 per cent last month. In addition, the slowdown across Europe is likely to impact Malta; after all, our fellow EU member states are by far our largest trading partners.
In the opinion of a number of economists consulted for this article, the recession is not a direct result of the current turmoil on the financial markets. "After a number of years of growth, a slowdown is only to be expected," they said, adding that "the financial turmoil has, however, added to the problems."
Among the people in the financial services industry the consensus seems to be that economic slowdown is the real risk to Malta and its financial sector, not the financial turmoil itself. And the influence is not evenly spread: while the bankers spoken to admit that a slowdown will affect their business, the insurers seem more confident for the future.
"Historically, insurers have not been affected as badly as other sectors by recession," Mark Salmon, general manager at AON Insurance Managers (Malta) said. The reason is unclear; he suggested that during a period of uncertainty, people seek to cover the risks they know about to be able to handle unexpected problems more easily.
The financial turmoil has caused problems for the international banking sector, with reputed institutions collapsing and many others turning to state-sponsored rescue plans. The domestic sector, however, remains robust and continues to grow both deposits and loan books. Liquidity remains strong, and capitalisation is not compromised.
While many people refer to the current turmoil as a credit crisis, this diagnosis is disputed by Jean-Claude Trichet, President of the European Central Bank. During the last press conference following the Governing Council's rate-setting meeting on November 6 at which the ECB cut its rates by 0.5 per cent for the second month in a row, Mr Trichet said clearly: "I cannot say we are observing a credit crunch now."
Mr Trichet was talking about the European situation. His comments do not reflect on developments elsewhere, but are backed up by the Euro-Area Bank Lending Survey for October, published by the ECB on November 7. This shows tightening of credit standards, especially for advances to large corporations; SMEs and individuals do not seem to be facing this to the same degree.
"We have been facing a financial turmoil that was triggered by a liquidity shortage. The storm intensified very significantly in mid-September 2008, when some large failures of financial institutions led to a general loss of confidence. This transformed the turmoil into crisis, and the liquidity shortage became a massive threat to solvency for many financial institutions in a large set of countries," Mr Trichet explained at the Fifth ECB Central Baking Conference on November 13.
"When Bears Sterns was in difficulties early this year, it was rescued which led the market to believe that no bank, or at any rate no major bank would be allowed to fail by the US government," Charles Borg, chief officer, financial markets and investments at Bank of Valletta said. "But Lehmann Brothers was not rescued in September."
The result was that banks, already a little wary of lending to each other, suddenly refused almost completely to provide funds on the interbank market, reflected in the spreads between interest rates on the interbank market (in Europe, the Euribor rate) and the rate at which governments borrow. In calmer times, the two rates are almost identical. But following the Lehmann Brothers' collapse, that spread grew to enormous proportions.
The interbank market is of vital importance to most banks. Across Europe and the US, banks tend to lend substantially more than the value of customer deposits they hold. "Northern Rock maintained a loans to deposits ratio of 170 per cent," Mr Borg pointed out. "HBOS's ratio was 150 per cent, while at BOV the ratio is under 70 per cent."
This means these banks could not rely on their own internal resources to supply the liquidity they required. They borrow it on the interbank market, against collateral in the form of the investments the bank has made. This leverage is, under normal circumstances, not a problem. But if the interbank market stops functioning, then the banks are in trouble.
This matters because, as Mr Borg put it, the liquidity flowing through the banking system is like the lifeblood of the economy as a whole.
This is why governments and central banks around the world are willing to spend large sums rescuing the banking system. Actions so far have focused on two areas: first, rebuilding confidence and ensuring that the markets maintained the liquidity they need, and, secondly assistance in shoring up damaged bank balance sheets.
"The crisis began about 15 months ago in the US, but only hit Europe seriously in March and April this year," Armin Eckermann, FIMBank's head of banking and deputy president said. He emphasised that the root of the problem is liquidity, and the lack of confidence comes at least partly from the uncertainty in the markets.
Mr Borg compared the current crisis to the perfect storm: After years of a very tranquil market with small interest rate spreads, a number of separate crises seem to be coming together to create a new, almost unavoidable crisis.
It started with defaults in the US sub-prime mortgages (and, as Joseph Bugelli, senior credit manager at Volksbank Malta pointed out, Prime and Alt-A mortgages as well). These should have remained the problem of the banks that issued the credit in the first place. But, as Mr Borg pointed out, banks were looking for a way to generate better profits during an extended period of low interest rate spreads. Many of the loans were accepted, and then sold on to other banks and institutions, packaged into new and opaque financial instruments.
And these instruments were sold aggressively. Mr Borg said that the rating agencies often told BoV that it could achieve a greater return on its portfolio by investing in different securities - at the same or even better risk. These included, he explained, these sub-prime mortgage-backed securities.
"But as I understand it, greater returns only come with greater risk," he continued.
Faced with this uncertainty, banks became increasingly reluctant to take various securities as collateral on the interbank market, making liquidity scarce. This sent interbank rates up, and eventually spread to the rest of the bond market, leading to dropping prices. As Mr Borg explained it, the markets stopped working properly. Few people were buying; at the same time, banks squeezed for cash were looking to sell their holdings. The result was clear: prices collapsed.
"This is a real imbalance which needs to be corrected!" he said. "Essentially, the market was not providing a real measure of value: that only comes when the buyer and seller agree a price, not when the seller has to take whatever price is offered!"
This is the background to BOV performance reported on 31 October 31. The reduction in profits from €101.8 million for the group last year to €40.6 million is the result of unrealised losses on the bank's investment portfolio. Its core operations continue to look robust.
Deposits and the bank's loan book have continued to grow. The turmoil has not impacted the bank directly through the lack of liquidity in the interbank market because, with a conservative loan to deposit ratio of under 70 per cent, it is able to fund its lending entirely from its deposits.
With strong capital and liquidity ratios at 11.5 per cent and more than 50 per cent respectively, its prudent investment strategy has definitely proved itself.
The bank has a prudent, conservative investment strategy. "We invest in high investment grade paper," Mr Borg explained. "We have not put anything into high risk securities like Collateralised Debt Obligations (CDO's), Asset Back Securities (ABS') and other similar structured products. Our investments are in sovereign paper, or in reputable institutions."
Volksbank Malta is a local subsidiary, but there again it is weathering the storm well. It does not hold any US mortgage-based assets at all, Mr Bugelli said.
"The bank's risk strategy is to maintain a low risk appetite and cautious lending policies," Mr Bugelli explained, taking the opportunity to add that Volksbank Malta rates every one of its borrowing customers using Volksbank internal rating systems, rather than relying exclusively on external sources.
Mr Bugelli said that with a strong solvency ratio well above 25 per cent, the bank is well capitalised, and has the support of its parent in Vienna, which in turn has a strong customer deposit base in its Austrian clients, meaning that Volksbank Malta does not expect to experience any shortage of liquidity.
This does not mean that the Austrian Volksbank group has not been affected by the crisis. One of its subsidiaries, Kommunalkredit Austria AG, a specialist lender to local authorities and government agencies, was a partnership with Dexia, a Belgian bank that had to resort to support from the governments of Belgium, France and Luxembourg.
Kommunalkredit began facing difficulties, and Volksbank essentially surrendered its stake in Kommunalkredit to maintain public trust and distance itself from the troubles. Volksbank AG also decided to increase its core capital by €1 billion because, as Franz Pinkl, CEO, put it: "Today's capital base is tomorrow's success."
FIMBank focuses on trade finance, not retail banking or long-term lending. "Our credit is typically very short term, which has allowed us to maintain a liquidity ratio almost double the regulatory minimum and capital ratios more than double," Dr Eckermann said. "Our specialisation in trade finance has protected us from the downturn in the global economy: international trade continues even in times of crisis. People still need to eat, to dress and so on."
He pointed out that FIMBank is most active in African countries, which have only been marginally affected by the global crisis due to their international isolation. And he sees the potential silver lining to this cloud.
"Going forward, we see the credit squeeze more as an opportunity rather than as a threat," he said. "As credit for international trade becomes scarce, the need for short-term structured trade financing of the sort offered the FIMBank is poised to grow," Dr Eckermann said.
Malta's insurance sector, both the domestic and the lucrative managed and captive insurance business that has been developing well for the past few years, also look well placed to weather the storm.
"Insurers may take a hit on their balance sheets as a result of the losses on the financial markets," AON's Mark Salmon explained. "But most take a conservative approach to their investment policy, not wanting to take on investment risk as well as the insurance risk they carry."
He added that more businesses may actually be attracted to captive insurance. "In a situation of uncertainty, companies may prefer to retain their risk and keep their premiums in-house rather than 'trusting the market'," he said, pointing out that few people would have imagined that AIG, the world's largest insurer, would have ever gone down.
"The White Rock PCC we have moved to Malta a few weeks ago is well placed to provide quality insurance to a shocked market!" he said.
Peter Grima, managing director at FirstUnited Insurance Brokers, explained that the downturn in the markets is only likely to produce problems in the solvency requirements of Maltese insurers, if at all. "If an insurer has put capital into property or equities, then when the value falls they may face a problem maintaining adequate capital," he said.
"Maltese insurers are overcapitalised compared to the regulatory minima," he continued. "This means that they have a comfortable buffer against the effects of the crisis, like Malta's banks."
The outcome is that the insurers will probably report a lower profit as a result of the loss in value of investments - but that profit on operations will probably be unaffected, or at worst marginally below the previous year's figures.
On one other indicator, there is more cause for concern. While inflation across Europe seems to be contained, in Malta it reached 5.8 per cent last month. In addition, the slowdown across Europe is likely to impact Malta; after all, our fellow EU member states are by far our largest trading partners.
In the opinion of a number of economists consulted for this article, the recession is not a direct result of the current turmoil on the financial markets. "After a number of years of growth, a slowdown is only to be expected," they said, adding that "the financial turmoil has, however, added to the problems."
Among the people in the financial services industry the consensus seems to be that economic slowdown is the real risk to Malta and its financial sector, not the financial turmoil itself. And the influence is not evenly spread: while the bankers spoken to admit that a slowdown will affect their business, the insurers seem more confident for the future.
"Historically, insurers have not been affected as badly as other sectors by recession," Mark Salmon, general manager at AON Insurance Managers (Malta) said. The reason is unclear; he suggested that during a period of uncertainty, people seek to cover the risks they know about to be able to handle unexpected problems more easily.
The financial turmoil has caused problems for the international banking sector, with reputed institutions collapsing and many others turning to state-sponsored rescue plans. The domestic sector, however, remains robust and continues to grow both deposits and loan books. Liquidity remains strong, and capitalisation is not compromised.
While many people refer to the current turmoil as a credit crisis, this diagnosis is disputed by Jean-Claude Trichet, President of the European Central Bank. During the last press conference following the Governing Council's rate-setting meeting on November 6 at which the ECB cut its rates by 0.5 per cent for the second month in a row, Mr Trichet said clearly: "I cannot say we are observing a credit crunch now."
Mr Trichet was talking about the European situation. His comments do not reflect on developments elsewhere, but are backed up by the Euro-Area Bank Lending Survey for October, published by the ECB on November 7. This shows tightening of credit standards, especially for advances to large corporations; SMEs and individuals do not seem to be facing this to the same degree.
"We have been facing a financial turmoil that was triggered by a liquidity shortage. The storm intensified very significantly in mid-September 2008, when some large failures of financial institutions led to a general loss of confidence. This transformed the turmoil into crisis, and the liquidity shortage became a massive threat to solvency for many financial institutions in a large set of countries," Mr Trichet explained at the Fifth ECB Central Baking Conference on November 13.
"When Bears Sterns was in difficulties early this year, it was rescued which led the market to believe that no bank, or at any rate no major bank would be allowed to fail by the US government," Charles Borg, chief officer, financial markets and investments at Bank of Valletta said. "But Lehmann Brothers was not rescued in September."
The result was that banks, already a little wary of lending to each other, suddenly refused almost completely to provide funds on the interbank market, reflected in the spreads between interest rates on the interbank market (in Europe, the Euribor rate) and the rate at which governments borrow. In calmer times, the two rates are almost identical. But following the Lehmann Brothers' collapse, that spread grew to enormous proportions.
The interbank market is of vital importance to most banks. Across Europe and the US, banks tend to lend substantially more than the value of customer deposits they hold. "Northern Rock maintained a loans to deposits ratio of 170 per cent," Mr Borg pointed out. "HBOS's ratio was 150 per cent, while at BOV the ratio is under 70 per cent."
This means these banks could not rely on their own internal resources to supply the liquidity they required. They borrow it on the interbank market, against collateral in the form of the investments the bank has made. This leverage is, under normal circumstances, not a problem. But if the interbank market stops functioning, then the banks are in trouble.
This matters because, as Mr Borg put it, the liquidity flowing through the banking system is like the lifeblood of the economy as a whole.
This is why governments and central banks around the world are willing to spend large sums rescuing the banking system. Actions so far have focused on two areas: first, rebuilding confidence and ensuring that the markets maintained the liquidity they need, and, secondly assistance in shoring up damaged bank balance sheets.
"The crisis began about 15 months ago in the US, but only hit Europe seriously in March and April this year," Armin Eckermann, FIMBank's head of banking and deputy president said. He emphasised that the root of the problem is liquidity, and the lack of confidence comes at least partly from the uncertainty in the markets.
Mr Borg compared the current crisis to the perfect storm: After years of a very tranquil market with small interest rate spreads, a number of separate crises seem to be coming together to create a new, almost unavoidable crisis.
It started with defaults in the US sub-prime mortgages (and, as Joseph Bugelli, senior credit manager at Volksbank Malta pointed out, Prime and Alt-A mortgages as well). These should have remained the problem of the banks that issued the credit in the first place. But, as Mr Borg pointed out, banks were looking for a way to generate better profits during an extended period of low interest rate spreads. Many of the loans were accepted, and then sold on to other banks and institutions, packaged into new and opaque financial instruments.
And these instruments were sold aggressively. Mr Borg said that the rating agencies often told BoV that it could achieve a greater return on its portfolio by investing in different securities - at the same or even better risk. These included, he explained, these sub-prime mortgage-backed securities.
"But as I understand it, greater returns only come with greater risk," he continued.
Faced with this uncertainty, banks became increasingly reluctant to take various securities as collateral on the interbank market, making liquidity scarce. This sent interbank rates up, and eventually spread to the rest of the bond market, leading to dropping prices. As Mr Borg explained it, the markets stopped working properly. Few people were buying; at the same time, banks squeezed for cash were looking to sell their holdings. The result was clear: prices collapsed.
"This is a real imbalance which needs to be corrected!" he said. "Essentially, the market was not providing a real measure of value: that only comes when the buyer and seller agree a price, not when the seller has to take whatever price is offered!"
This is the background to BOV performance reported on 31 October 31. The reduction in profits from €101.8 million for the group last year to €40.6 million is the result of unrealised losses on the bank's investment portfolio. Its core operations continue to look robust.
Deposits and the bank's loan book have continued to grow. The turmoil has not impacted the bank directly through the lack of liquidity in the interbank market because, with a conservative loan to deposit ratio of under 70 per cent, it is able to fund its lending entirely from its deposits.
With strong capital and liquidity ratios at 11.5 per cent and more than 50 per cent respectively, its prudent investment strategy has definitely proved itself.
The bank has a prudent, conservative investment strategy. "We invest in high investment grade paper," Mr Borg explained. "We have not put anything into high risk securities like Collateralised Debt Obligations (CDO's), Asset Back Securities (ABS') and other similar structured products. Our investments are in sovereign paper, or in reputable institutions."
Volksbank Malta is a local subsidiary, but there again it is weathering the storm well. It does not hold any US mortgage-based assets at all, Mr Bugelli said.
"The bank's risk strategy is to maintain a low risk appetite and cautious lending policies," Mr Bugelli explained, taking the opportunity to add that Volksbank Malta rates every one of its borrowing customers using Volksbank internal rating systems, rather than relying exclusively on external sources.
Mr Bugelli said that with a strong solvency ratio well above 25 per cent, the bank is well capitalised, and has the support of its parent in Vienna, which in turn has a strong customer deposit base in its Austrian clients, meaning that Volksbank Malta does not expect to experience any shortage of liquidity.
This does not mean that the Austrian Volksbank group has not been affected by the crisis. One of its subsidiaries, Kommunalkredit Austria AG, a specialist lender to local authorities and government agencies, was a partnership with Dexia, a Belgian bank that had to resort to support from the governments of Belgium, France and Luxembourg.
Kommunalkredit began facing difficulties, and Volksbank essentially surrendered its stake in Kommunalkredit to maintain public trust and distance itself from the troubles. Volksbank AG also decided to increase its core capital by €1 billion because, as Franz Pinkl, CEO, put it: "Today's capital base is tomorrow's success."
FIMBank focuses on trade finance, not retail banking or long-term lending. "Our credit is typically very short term, which has allowed us to maintain a liquidity ratio almost double the regulatory minimum and capital ratios more than double," Dr Eckermann said. "Our specialisation in trade finance has protected us from the downturn in the global economy: international trade continues even in times of crisis. People still need to eat, to dress and so on."
He pointed out that FIMBank is most active in African countries, which have only been marginally affected by the global crisis due to their international isolation. And he sees the potential silver lining to this cloud.
"Going forward, we see the credit squeeze more as an opportunity rather than as a threat," he said. "As credit for international trade becomes scarce, the need for short-term structured trade financing of the sort offered the FIMBank is poised to grow," Dr Eckermann said.
Malta's insurance sector, both the domestic and the lucrative managed and captive insurance business that has been developing well for the past few years, also look well placed to weather the storm.
"Insurers may take a hit on their balance sheets as a result of the losses on the financial markets," AON's Mark Salmon explained. "But most take a conservative approach to their investment policy, not wanting to take on investment risk as well as the insurance risk they carry."
He added that more businesses may actually be attracted to captive insurance. "In a situation of uncertainty, companies may prefer to retain their risk and keep their premiums in-house rather than 'trusting the market'," he said, pointing out that few people would have imagined that AIG, the world's largest insurer, would have ever gone down.
"The White Rock PCC we have moved to Malta a few weeks ago is well placed to provide quality insurance to a shocked market!" he said.
Peter Grima, managing director at FirstUnited Insurance Brokers, explained that the downturn in the markets is only likely to produce problems in the solvency requirements of Maltese insurers, if at all. "If an insurer has put capital into property or equities, then when the value falls they may face a problem maintaining adequate capital," he said.
"Maltese insurers are overcapitalised compared to the regulatory minima," he continued. "This means that they have a comfortable buffer against the effects of the crisis, like Malta's banks."
The outcome is that the insurers will probably report a lower profit as a result of the loss in value of investments - but that profit on operations will probably be unaffected, or at worst marginally below the previous year's figures.