Over recent weeks, two of the three retail banks listed on the Malta Stock Exchange (namely HSBC Bank Malta plc and Lombard Bank Malta plc), published their respective 2015 annual reports.

The statements contained in these annual reports give a clear indication of the status of the local banking sector and an insight into what changes are expected going forward.

Since many retail investors are exposed to the three retail banks (there are around 20,000 shareholders in Bank of Valletta plc, 10,000 in HSBC Bank Malta and 1,500 in Lombard Bank Malta), I thought it would be useful to highlight a number of the issues raised in these reports which clearly portray the challenges being faced by the banking industry.

The low interest rate environment and the increasing regulatory pressures are the main factors leading to a generally bleak outlook for retail banks. This has been well documented over recent months, both locally as well as internationally.

In the current interest rate environment, the core business of retail banks (i.e. interest income) is being impacted by the lower interest earned on loans as well as lower returns being generated by a bank’s investment portfolio. With respect to the idle liquidity not loaned out or re-invested, the continued easing of monetary policy by the European Central Bank (ECB) resulted in negative rates on short-term government securities (namely Treasury Bills) and money market placements at the Central Bank of Malta.

On the other hand, retail banks benefit from lower interest payments as interest rates on customer deposits are also reduced. The two larger retail banks (HSBC Malta and BOV) both introduced lower rates on savings accounts in 2015. This helped the financial performances of both banks as BOV registered a 14.9 per cent growth in net interest income during the 2014/15 financial year which ended on September 30, 2015 and HSBC Malta experienced an improvement in net interest income for the first time since 2012, albeit at only +3.7 per cent.

However, the growth in HSBC’s interest income was also due to a change in accounting methodology for suspended interest which results in a higher level of interest income but also higher impairment charges. On the other hand, Lombard Bank suffered a decline of 8.2 per cent in net interest income during 2015.

All three banks reported a continued inflow of deposits. In view of the slow growth in loans (also hindered by regulatory pressure on banks) and limited investment opportunities, deposit-taking is posing a stiff challenge for banks.

The alternative being resorted to by a few large banks in the eurozone is a charge placed on customers for holding deposits. However, there is no evidence as yet that such a measure will also be adopted by the local retail banks, at least in the short-term. That could lead to people withdrawing money from their banks and hoarding it – surely not a desirable outcome for the ECB.

On the regulatory front, in the 2015 annual report, the chairman of HSBC Malta Sonny Portelli listed several projects which the bank worked upon during 2015. Few investors would appreciate the numerous pieces of regulation that need to be complied with.

Moreover, as from November 2014, the ECB assumed a new supervisory role for systemically important banks operating in the eurozone. Two of the retail banks listed on the MSE (BOV and HSBC) have been classified as systemically important for Malta and have been under the direct responsibility of the ECB’s Joint Supervisory Team for the purposes of banking supervision since November 2014. BOV’s chairman John Cassar White had commented that such regulation is becoming “intrusive”.

A very interesting, albeit challenging time ahead for investors exposed to bank shares

Although Lombard Bank does not fall under the ECB’s Joint Supervisory Team, it still needs to be compliant with the Single Supervisory Mechanism (SSM). The statement in the 2015 annual report by the chairman of Lombank Bank Malta, Michael Bonello, provides a concise overview of the regulatory challenges in this respect.

Bonello remarked that “the SSM does not seem to allow any measure of discretion to national authorities to take account of different country circumstances”. On his part, the CEO of Lombard Bank Joseph Said refers to this as a “one-size-fits-all approach” and Mr Bonello claims that “a strict application of the new rules on lending may be warranted in a context of economic stagnation, undercapitalised banks and bailouts”.

The chairman of Lombard rightly argued that during the international financial crisis from 2007 onwards, “Malta’s core domestic banks displayed financial soundness indicators that demonstrated a high degree of resilience”. In fact, none of the local banks required any bailout.

The international credit rating agencies had made reference to Malta’s strong financial system in their regular reports on Malta and the Central Bank of Malta also performed regular assessments on local banks which continued to show ample capital and liquidity ratios, declining non-performing exposures, strong coverage ratios and loan to deposit ratios considerably lower than the eurozone average.

This was again confirmed in the 2015 annual report of the Central Bank of Malta. The governor noted that the balance sheet growth was mainly “fuelled by the flow of customer deposits, which resulted in abundant liquidity levels for banks. Indeed, the average loan-to-deposit ratio trended further downwards, to reach 58.2 per cent in December 2015, substantially lower than the EU average of 101.3 per cent”.

Lombard’s chairman opined that the “results of the time-tested model of relationship banking in Malta would seem to merit greater recognition from a regulatory standpoint”. Bonello also warns that this “new regime impinges increasingly on profitability … particularly in the case of the smaller banks which do not benefit from economies of scale”.

So where does all this regulation leave Maltese banks, also at a time when the Central Bank of Malta is also continuing to pressure the banks to reduce the present lending rates to small and medium-sized enterprises (SME)? Moreover, the creation of the Malta Development Bank, expected by the end of this year, could also pose additional competition for the retail banks. Although the government is claiming that this new institution will not compete with local banks, last week it indicated that it would assist in “investment in the infrastructure, both by the government and the private sector, including through public, private partnerships” – possibly a lucrative new area for retail banks given their abundant liquidity positions.

Another challenge for the banking sector is the Quantitative Easing (QE) programme which is reducing the investment options available for banks that continue to hold excess levels of liquidity.

In the meantime, the ECB is also proposing that banks reduce their exposure to sovereign bonds of their own country, something Malta’s Finance Minister has argued against.

The Commission has now reportedly asked the International Monetary Fund for advice regarding the way forward. Should this be implemented in due course, it would be another blow, especially for local banks who hold high levels of liquidity.

These challenging conditions for banks are not anticipated to abate in the near term as the president of the ECB last week again indicated that interest rates are expected “to remain at present or lower levels for an extended period of time”.

Furthermore, in addition to the prevailing interest rate scenario and the increased regulatory costs, banks are also being requested to hold higher capital levels thereby leaving a marked impact on profitability ratios such as the return on equity.

One way for banks to increase their capital levels is to reduce distributions to shareholders. Local regulation to this effect was implemented a few years ago and banks were forced to set aside additional reserves and reduce dividend payments to shareholders.

Investors need to be cognisant of this changing reality and the likelihood of lower dividend income from banks as confirmed by BOV’s chairman when presenting the financial statements to analysts over the past two years and also during the last few annual general meetings.

Coupled with this, the possible changes in shareholdings expected across some of the banks makes it a very interesting, albeit challenging time ahead for investors exposed to bank shares.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd (RFC) is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the company/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent, and may also have other business relationships with the company/s. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.

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Edward Rizzo is a director at Rizzo, Farrugia & Co. (Stockbrokers) Ltd.