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The interest rate conundrum

In recent months we heard calls for commercial banks to lower the interest rates they charge on lending. This thread started when at the annual dinner of the Institute of Financial Services – which is the high-profile annual gathering of Malta’s financial sector players (a sort of Davos gathering made in Malta) – the governor of the Central Bank stated that “in terms of interest rates, Malta needs to further align with its peers”.

Naturally, this observation must not have been so well received by the banks as it could be seen as a threat to their high profitability. However, the rules of the game have changed since the commercial banks were the silent followers of the Central Bank’s interest rate decisions. In a liberalised market, banks are free to set interest rates and, with the adoption of the euro, their actions are driven to a large extent by profit motives and financial conditions in the euro area.

The plain truth is that the interest rate announcements by the European Central Bank only offer guidance as ultimately the setting of bank rates is a commercial decision. When banks set their lending interest rates, they focus on two main factors: the cost at which banks can borrow; and the perceived riskiness of the borrower.

The consecutive interest rate cuts, announced by the European Central Bank since the onset of the global financial crisis means that, in theory, Maltese banks can benefit from extremely cheap financing. However, as indicated in the latest ‘Financial stability report’ published by the Central Bank, “core domestic banks still make limited use of wholesale funding, despite the availability of such channel” with the share of Eurosystem funding remaining modest.

Furthermore, the ratio of customer deposits to customer loans amounts to around 144 per cent, which is rather high when compared to the banks abroad. These figures indicate that the traditional Maltese banks lack the incentives to tap into Eurosystem money since they benefit from a stable source of short-term deposits. As a result, changes in the ECB rates exert a lower impact on Maltese banks than their foreign counterparts.

It would be interesting to understand why banks in Malta are generally not so keen to reconsider their funding strategy to align it more with their European counterparts. Maltese old-style bankers might quickly argue that the strength of Maltese banks lies in the fact that they focus on the long term, not being tempted by cheap ECB money, preferring to focus on more stable (and more expensive) customer deposit funding. A higher cost of funding would inevitably keep lending rates high.

If commercial banks lose out from a regular flow of income from their lending to government entities, they would be forced to become more active in lending to the other sectors

Some banks may also be moderating the drop in their lending rates in order to avoid unsustainable borrowing, that is borrowing which is only feasible when the interest rates are very low, and which under a higher interest rate scenario could experience repayment difficulties.

A less upbeat view would point to the fact that competition by domestic banks may be below what one would hope for. A striking fact is that there is greater competition in deposit-taking activities between the traditional Maltese banks and the newly established banks than in lending.

Indeed, the latest Central Bank of Malta data indicates that the lending by non-core domestic banks amounted to below three per cent of resident lending. It would be worthwhile to explore why newly established banks do not seem to be interested in providing domestic loans. On one hand, the costs associated with lending activities may be considered to be high, but equally important may be the fact that with a resident corporate non-performing loans ratio which as at June 2013 stood at 15.4 per cent, the domestic credit market does not look so attractive.

If this were the case, the ‘high’ price charged to borrowers would represent the correct pricing of risk, something which should be lauded.

One solution which has been put forward by the Central Bank governor is to establish a development bank. Admittedly, such bank would probably focus on the larger state projects, but if commercial banks lose out from a regular flow of income from their lending to government entities, they would be forced to become more active in lending to the other sectors.

However, this idea is not without its downside. Indeed, the International Monetary Fund – the international keepers of sound economic doctrine – highlighted in the 2013 (latest) Article IV Consultation on Malta that “the international experience with development banks has been mixed, as these banks have sometimes been subject to undue political pressure and weak supervision, which resulted in substantial losses to taxpayers”.

If authorities want lending rates in Malta to become cheaper, banks must be encouraged to become more creative and sophisticated in their practices. One option would be to consider whether securitisation of bank loans could be feasible in Malta. If successful, such strategy could achieve cost savings on lending activities. The difficulty is striking the right balance between innovation and prudent behaviour.

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