The banks may need to reassess their dividend policies in view of an upward trend in non-performing loans which is likely to call for an increase in loan loss provisioning, the Governor of the Central Bank, Michael C. Bonello said.

"Combined with the probable introduction of more stringent capital and liquidity requirements in the period ahead and the likely pressure on profitability deriving from an unfavourable economic conjuncture, the expected increase in credit risk suggests that the banks may need to reassess their dividend policies in order to be able to support a commensurate amount of capital."

Mr Bonello made his comment in the introduction to the Financial Stability Report 2009, published today by the Central Bank of Malta.

He said that during 2009 and the early part of 2010, Malta’s financial sector exhibited a high degree of resilience. As expected, the contraction in economic activity put some pressure on the debt-servicing capacity of households and corporates alike, which was reflected in somewhat higher levels of non-performing loans and an increased incidence of loan rescheduling.

On the other hand, capital adequacy and liquidity ratios remained robust and well above the regulatory minima, while stress test results confirmed that the banks were able to withstand extreme but plausible shocks.

"While the risk outlook for financial stability in Malta does not, therefore, give rise to concern at this time, its future evolution remains uncertain in a global scenario characterised by the prospect of weak growth, fiscal retrenchment and market volatility," Mr Bonello said.

These factors, he pointed out, were reflected in the Bank’s latest forecasts for the Maltese economy, which pointed to relatively modest growth up to 2011.

"This suggests that the upward trend in non-performing loans evident in 2009 is likely to persist, a development which would, in turn, call for an increase in loan loss provisioning. Combined with the probable introduction of more stringent capital and liquidity requirements in the period ahead and the likely pressure on profitability deriving from an unfavourable economic conjuncture, the expected increase in credit risk suggests that the banks may need to reassess their dividend policies in order to be able to support a commensurate amount of capital."

The financial system

The report says that the observed system-wide deterioration in the quality of bank assets, reflected in the significant rise in both household and corporate non-performing loan ratios and the number of rescheduled loans, was not matched by a similar increase in loan loss provisioning by banks.

"This factor may exacerbate the negative impact on banks should credit risks materialise, particularly in view of the high concentration in propertyrelated loans.

"A deceleration in both household and corporate credit growth resulted in a slower aggregate bank balance sheet expansion."

This, the Central Bank said, reflected both demand and supply factors: the uncertain economic prospects and an increased resort to alternative sources of funding by the corporate sector on the one hand, and tighter credit conditions imposed by the banks on the other.

Indeed, throughout the year bond issues were heavily oversubscribed, indicating a strong search for yield among households amidst an environment of low deposit interest rates.

During 2009 the banks did not depart significantly from their traditional business model, continuing to rely strongly on retail deposits to finance their lending activities while diverting excess liquidity into high quality securities. An increase in corporate sector deposits more than offset a marginal decline in household deposits.

Moreover, the share of longer-dated time deposits increased as banks launched a series of special deposit products to benefit from the relatively flat yield curve. The aggregate profitability of the banking sector improved during the year, driven largely by the reversal of valuation losses incurred during 2008. This more than compensated for the decline in interest income, which nevertheless remained the banks’ main source of revenue.

The drop reflected, to a large extent, the lagged re-pricing of deposits when compared to loans and the generally lower interest rates earned on securities and holdings of required reserves.

Profitability was further boosted by lower charges for specific and general provisions and bad debts written off, despite the recession. Banks remained well capitalised, with regulatory ratios above the minima. Indeed, capital adequacy ratios improved, albeit through a reduction in risk-weighted assets. The latter reflected a rebalancing towards lower risk assets, as well as subdued lending growth.

"Despite the adoption of tighter lending standards, however, there is no evidence to suggest that banks undertook, or intended to undertake, any significant de-leveraging. At the same time, stress test results confirmed the banks’ ability to withstand extreme yet plausible shocks. Indeed, the indications are that the banks should be able to withstand all the hypothetical strong adverse shocks which were modelled - namely, a deterioration in asset quality, a strong economic downturn, a generalised adverse house price correction and a severe deposit run," the report said.

"Nevertheless, banks should continue to strengthen their capital buffers to be able to withstand possible further challenges.

The full report can be seen on pdf below: