One of the main functions of banks is to act as intermediary between those people and businesses that have excess cash (depositors) and those that require cash to finance their economic activities (borrowers). Banks make a margin by charging higher rates to borrowers than they pay to depositors.
This margin must be sufficient to cover three requirements. Firstly, the margin must be adequate to make up for credit losses, which arise when borrowers find themselves in financial difficulties that prevent them from repaying their borrowing.
We must remember such losses have to be made good for from the bank’s own funds and not from depositors’ money.
Secondly, the margin must cover the administrative costs of maintaining the infrastructure necessary to receive deposits and give out loans.
Thirdly, it must also include a fair return to shareholders, who are risking their capital by investing in banks.
It is critically important, as the Governor of the Central Bank, Josef Bonnici, points out, that margins made by banks are equitable. Overcharging on bank lending may burden businesses with undue costs, rendering the local economy uncompetitive.
Other entrepreneurs will simply be discouraged from investing, with the result that economic growth is stifled.
Let us consider the local situation. Are local banks overcharging businesses for their loans and is this discouraging borrowing? Statistical evidence suggests that this is not the case. A recent article in The Economist commented on the high level of Maltese private debt which, at 220 per cent of GDP, is among the highest in Europe.
This invites two observations: that the flow of credit from the banks to the private sector is abundant and unimpeded; and that Maltese businesses are borrowing relatively more than their European counterparts – which means Maltese banks are lending relatively more.
Local businesses are relying more on bank finance and therefore less on shareholder capital. This situation, which is described in financial terms as ‘high gearing’, increases the risk of credit losses for the lending banks.
Concentration risk is another risk faced by local banks, to a far greater extent than their European peers. This is the inevitable result of exposure to a tiny island economy and a relatively small base of borrowing customers.
The level of interconnectedness between firms, coupled with the high reliance on property as collateral, poses the danger of a ‘domino effect’; a downturn experienced by one sector or group of customers could easily spread to others, thereby magnifying the risk to the lending banks.
The level of interconnectedness between firms, coupled with the high reliance on property as collateral, poses the danger of a ‘domino effect’; a downturn experienced by one sector or group of customers could easily spread to others, thereby magnifying the risk to the lending banks
Another relevant observation was recently made in the European Commission’s 2013 SBA (Small Business Act for Europe) Fact Sheet, which showed that applications for loans made by SMEs, which were rejected by the banks, is lower for Malta than for the EU average. The willingness of Maltese banks to provide loans to SMEs is higher. The Commission commented that “while obtaining a bank loan is not a foregone conclusion – very much like anywhere in the EU – the situation for SMEs in Malta seems to be much less difficult than for that of their peers in many other member states. To begin with, far fewer loan applications are rejected… and far fewer SMEs in Malta report any deterioration in access to public financial support or in the willingness to provide loans.”
This is the context within which the governor’s observation on local banks’ margins must be considered. The level of margin depends on the level of risk being taken on.
Higher risk demands higher margins, so that this additional risk can safely be absorbed, while depositors are protected.
Malta is one of the few European countries not to experience a credit crunch in the wake of the financial crisis. The supply of credit remains and banks do not shy away from lending to businesses, which may be perceived elsewhere as highly-geared.
The Governor is right to indicate that over-charging is an unacceptable hindrance to economic efficiency. Higher margins are only acceptable if they can be justified in terms of the level of risk being taken on by the banks.
Despite our belief that the interest margins made by Maltese banks are not wide off the mark, Bank of Valletta recently reduced its business lending base rate by 15 basis points. At the same time, the rates payable on deposits were calibrated to encourage longer-term savings – this was done by increasing rates payable on deposits with a maturity longer than one year by up to 50 basis points.
John Cassar White is the chairman of Bank of Valletta.