A brief debate on the local capital market

Last week, I attended the half-day capital markets conference organised by Camilleri Preziosi Advocates with the support of the Malta Stock Exchange.

One of the key note speeches was delivered by the former chairman of Bank of Valletta, Roderick Chalmers, who was always regarded as being a fantastic speaker. His delivery at the Camilleri Preziosi conference was again enlightening, very well researched and provided some important considerations for debate.

At the end of 2014, the European Central Bank took over the responsibility for the supervision of 129 systemically important banks across the eurozone, including Bank of Valletta plc HSBC Bank Malta plc and Mediterranean Bank plc. Chalmers touched upon three main decisions which he believes will have a direct bearing on the local capital market, which could have important repercussions for retail investors who may not be aware of these facts.

Firstly, Chalmers pointed out that the ECB believes that many banks across the eurozone remain undercapitalised and therefore it is determined to push banks to increase their Tier 1 capital levels. Many local investors should already be aware of this from comments by the current chairman of BOV John Cassar White. In its 2015 Annual Report, BOV publicly stated that the bank’s first priority was to strengthen its capital bases. Furthermore, in its latest interim results BOV confirmed that the bank is planning to reduce the dividend payout ratio and raise new equity capital while de-risking its business model.

Chalmers believes that the ECB’s decision on banks’ capital requirements will also need to be implemented in Malta. This could not only imply rights issues or new offerings by some of the banks already listed on the MSE but, in my opinion, this could also mean that some of the banks not listed on the MSE may seek the public equity route as a means of increasing their capital base.

Secondly, the ECB wants to sever the link between governments and the banking sector. Chalmers explained the reasoning of the ECB by mentioning the developments over recent years in Greece, Cyprus and Italy (where inappropriate government policies contaminated the banking sector through high holdings of domestic sovereign bonds) and also in the cases of Ireland, Portugal and the UK where trouble in the banking sector affected government finances.

The ECB is insisting that banks gradually reduce their holding of domestic government paper and Chalmers indicated that a number of eurozone countries are not accepting this proposal. In fact, Malta’s Minister of Finance was recently quoted as having said that: “Malta is completely against this idea of sovereign debt exposure, for the simple reason that Europe is seemingly aiming at creating problems where there have not even been during the worst of the financial crisis, and there aren’t today.”

This is especially important in the case of Malta since the banks are major holders of Malta Government Stocks and Chalmers presented an interesting graph revealing that as a percentage of total assets, the holdings of MGS across the three systemically important banks in Malta (BOV, HSBC and Mediterranean Bank) represent a higher proportion compared to the EU average.

Chalmers then refered to the dynamics of the local MGS market and the strong level of support shown by retail investors as well as financial institutions to any of the various MGS offerings placed on the market on an annual basis. In my view, he correctly questioned whether demand from retail investors would continue to be sufficiently robust to absorb all the new issuance in the next couple of years if the ECB insists on not allowing banks to subscribe in a material manner.

Europe is seemingly aiming at creating problems

The graph above shows that over the next six years, MGS redemptions will reach €2.84 billion. It could be a major challenge for the Treasury to ensure that new MGS issuance in the future is also met with strong demand. One must also not forget that apart from refinancing the maturing bonds in issue, the Treasury must also finance the budget deficit on an annual basis, unless the government can manage to move to a surplus. However, given present circumstances, this can only happen a few years down the road.

Chalmers also debated whether in view of these possible dynamics, the Treasury may, for the first time, consider seeking international investor demand for new MGS issuance. This has been happening indirectly in a small manner in recent years and in fact recent statistics indicate that 8.8 per cent of total MGS is presently held by foreign institutions. The present Governor of the Central Bank of Malta has publicly aired his views on this matter in recent years and was deliberating seeking support from Middle Eastern sovereign wealth funds. In my view, the fact that retail investors and local financial institutions have been the largest takers of MGS was positive both for the banks and the country in general as this insulated the MGS market from the severe volatility that was experienced by other sovereign bond markets since the international financial crisis. As such, this should only be considered once there is concrete evidence that the local banks will be forced to implement the ECB decision.

The third regulatory decision mentioned by Chalmers relates to lending to the property market where the ECB appears to be insisting that banks reduce their exposure to property development since they believe that this is one of the major factors that caused damage to banks internationally during the recent crisis.

Chalmers explained that historically in Malta, the banks have been the main providers of finance to the property sector. He argued that if increased pressure were placed on the banks to limit future financing to property development projects, then such developers would be forced to seek alternative methods of finance also involving the capital markets.

This is where increased vigilance is required in the words of Chalmers. He argued that when developers ask for bank funding, apart from the initial assessment and due-diligence by the banks, annual reviews are also carried out, which helps instill a degree of discipline and control on the borrowers. On the other hand, Chalmers said that the bond market was less demanding and “little control or oversight is imposed on the borrower following the initial prospectus”. While I agree with this comparison, it is also fair to say that the recent policies for borrowers to publish a Financial Analysis Summary on an annual basis is a step in the right direction and helps analysts and investors understand a company’s performance from one year to the next as well as their projections for the current financial year.

The concluding remarks on the property sector were also an eye-opener and he referred to cases where some developers who are unwilling to go to the bond market “are resorting to unorthodox schemes for the raising of finance”.

In the current environment of very low interest rates, which Chalmers believes will remain so for a while longer, retail investors are invariably taking on greater risk in order to ensure that they obtain a higher rate of interest when compared to traditional bank deposits. While this is a natural development all across the world, this is where in my view, there needs to be greater responsibility on the part of financial services practitioners to try to educate investors on a continuous basis.

This is one of my main objectives for my weekly contributions in the press and why I felt it was important to ask Chalmers to replicate the views he presented at last week’s conference for the benefit of the wider investor audience.

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.

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

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