Domestic banks should continue to operate along the lines of their traditional business model, Central Bank Governor Josef Bonnici told the Institute of Financial Services Malta’s annual dinner on Friday.
The Central Bank expects such institutions to look primarily to the markets for their funding requirements
“This method of doing business has certainly protected them from the vagaries of the wholesale funding market. In this context, I would like to emphasise once again that the Central Bank will not be supportive of banking institutions that operate in Malta and seek central bank liquidity as their primary source of funding their loan and investment activities,” Prof. Bonnici said in his first speech as Central Bank Governor.
The Governor said that when a banking institution funds its purchase of high yielding assets from short term sources, it is not only exposing itself to losses on the asset side but also to adverse changes in its funding costs, particularly at a time when historically low interest rates are in effect.
“For this reason, the Central Bank expects such institutions to look primarily to the markets for their funding requirements,” he added.
Prof. Bonnici said he was pleased to note that the domestic banking system continues to be characterised by relatively high liquidity levels.
“Furthermore, a major strength of the domestic banking system is its prudent approach towards credit, where loans are fully covered by deposits, while loan-to-value ratios, which were already at relatively prudent levels at the time of the global financial crisis, declined further to around 70 per cent.
“Another major strength of the domestic banking sector is its strong capital base. Capital adequacy ratios improved further from already healthy levels, with the core capital adequacy ratio rising to 12.4 per cent. This ratio is significantly higher than the present statutory requirement of four per cent.
“The debt crisis has highlighted the importance of risk diversification. Encouragingly, the investment portfolio of the domestic banks has limited exposure to securities issued by countries in financial distress,” the Governor said.
Prof. Bonnici said it is equally important for the banks to diversify risk in their loan portfolio.
“Most of the troubles of banking systems overseas, particularly in Ireland and Spain, stemmed from their relatively large exposure to the construction sector, especially the housing market. While the latest update of the Central Bank of Malta’s Financial Stability Report provides a generally favourable assessment of the situation in the domestic banking sector, it notes that credit and concentration risks remain elevated, mainly due to corporate borrowers in construction and real estate activities,” he said.
Prof. Bonnici added: “However, on the positive side, the share of lending to these sectors has now eased slightly since before the crisis to around 10.5 per cent of total assets as at September 2011, and domestic banks are encouraged to continue on this path to reduce concentration risk.
“In the same vein, I would also like to stress that the sovereign debt crisis has also highlighted the importance of prudent credit standards and for banks to improve the institutional capacity to appraise risk, not only as it relates to the individual borrower but also from a sectoral and economy-wide perspective.
“The Central Bank of Malta also continues to urge banks to expand loan loss provisioning levels, especially related to the construction sector, and also to strengthen further the capital buffers through the adoption of prudent dividend policies. Such measures are also needed for banks to eventually implement the stringent Basel III regulatory requirements.”
The Governor stressed that there is never room for complacency, especially at a time of uncertainty in the global financial system, and also because economic growth in Malta’s main trading partners is expected to slow down appreciably during 2012.
Prof. Bonnici said there is no doubt that the impact of the sovereign debt crisis highlights the importance of ensuring a stable domestic financial system pointing out that the case of Ireland shows us that imprudent bank policies can have devastating effects on the economy.
He said the domestic banking system played a crucial role in preventing a more severe downturn in economic activity after 2008, and in averting a sharper deterioration in public finances, because of prudent behaviour on the part of the banks in both asset and liability management.
“The reliance on retail deposits has been a major source of funding for the domestic banks. These remained stable during the period of financial turmoil. In other countries, banks that relied heavily on wholesale funding sources came under severe stress as interbank markets dried up and the cost of funding increased significantly,” he said.
Prof. Bonnici said the challenges faced by the Maltese economy today are not so dissimilar from those of the past.
“It is true that the setting has changed considerably but as a small open economy these relate mainly to competitiveness aspects and the capacity to deal with external shocks. It must be stressed that competiveness is not exclusively a concern for the export-oriented part of the private sector, but also for those who focus their business activity on the domestic market.
“Non-competitive practices and inefficiency in that part of the economy that is not directly exposed to foreign competition tends to spill over into the tradable sectors thus threatening the overall competitiveness of the whole economy. We must avoid this as much as possible. I am cautiously optimistic about the future and feel sure that despite the persistence of the sovereign debt crisis and the prospect of a weaker global economy, Malta will overcome the challenges that lie ahead, if all stakeholders remain focused on meeting the country’s economic objectives in a prudent and effective manner,” he said.