TWELFTH FINANCIAL STABILITY REPORT 2019...Chart 4.5: Gross written premium of the domestic non-life insurance sector by line of business 85 Chart 4.6: Composition of assets held by

TWELFTH FINANCIAL STABILITY REPORT

2019

© Central Bank of Malta, 2020

AddressPjazza KastiljaValletta VLT 1060Malta

Telephone(+356) 2550 0000

Fax(+356) 2550 2500

Website www.centralbankmalta.org

E-mail [email protected]

Photo creditsShutterstock

All rights reserved. Reproduction is permitted provided that the source is acknowledged.

The cut-off date for information relating to banking, insurance and investment funds is 28 February 2020 unless otherwise specified. The source of data in tables and charts is the Central Bank of Malta unless otherwise indicated.

ISSN 2312-5918 (print)ISSN 2074-2231 (online)

CONTENTS

PREFACE 11

1. MACROPRUDENTIAL RISK ASSESSMENT 13

2. DEVELOPMENTS IN THE BANKING SECTOR 21 2.1 Core Domestic Banks 22 2.1.1 Profitability 23 2.1.2 AssetQuality 24 Box1: BankLendingSurveyResults 25 2.1.3 FundingandLiquidity 33 2.1.4 Capital and Leverage 35 2.2 Non-core Domestic Banks 36 2.2.1 Profitability 36 2.2.2 AssetQuality 37 2.2.3 FundingandLiquidity 39 2.2.4 Capital and Leverage 39 2.3 International Banks 40 2.3.1 Branches of Foreign Banks 40 2.3.1.1 Profitability 40 2.3.1.2 AssetQuality 41 2.3.1.3 FundingandLiquidity 42 2.3.2 Subsidiaries of Foreign Banks and Stand-alone Banks 43 2.3.2.1 Profitability 43 2.3.2.2 AssetQuality 43 2.3.2.3 FundingandLiquidity 44 2.3.2.4 Capital and Leverage 45

3. STRESS TESTS 47 3.1 Macro Stress Testing Framework 48 3.2 Interest Rate Risk in the Banking Book 54 SPECIAL FEATURE: COVID-19 – Aspects of Financial Sector Resilience 58

4. INSURANCE COMPANIES AND INVESTMENT FUNDS 81 4.1 Domestic Insurance Companies 82 4.1.1 The Domestic Life Insurance Companies 82 4.1.1.1 Asset Composition 82 4.1.1.2 Profitability 84 4.1.1.3 CapitalAdequacy 84 4.1.2 The Domestic Non-life Insurance Companies 85 4.1.2.1 Asset Composition 85 4.1.2.2 Profitability 86 4.1.2.3 CapitalAdequacy 87 4.1.3 Domestic Insurance Risk Outlook 87 4.2 Domestic Investment Funds 87 4.2.1 AssetCompositionbyFundType 88 4.2.2 AssetCompositionbyInstrument 89 4.2.3 TypeofInvestors 90 4.2.4 Risk Assessment 90 4.2.5 Risk Outlook 92

5. THE POLICY RESPONSE 93Box2: O-SIIRevisedMethodology 96

APPENDICES AND GLOSSARY 107

CHARTS & TABLES

Chart1.1: ECBdepositfacilityrateandyieldcurveonAAAeuroareagovernmentbonds 14Chart1.2: Keyriskindicators 16Chart 2.1: Distribution of assets – core domestic banks 22Chart 2.2: Contribution to balance sheet growth – core domestic banks 22Chart2.3: Profitabilityratios−coredomesticbanks 23Chart2.4: Maincomponentsofprofits–coredomesticbanks 23Chart2.5: Annualgrowthrateofresidentloans−coredomesticbanks 24Chart2.6: ResidentloansbyNACE–coredomesticbanks 25Chart2.7: SectoralallocationofloansandadvancesandNPLs−coredomesticbanks 31Chart 2.8: NPL ratios – core domestic banks 31Chart2.9: Growthinassetsandtotalriskexposure−coredomesticbanks 32Chart2.10: Coverageratio−coredomesticbanks 32Chart 2.11: Bond portfolio – core domestic banks 33Chart2.12: Bondholdingsbyrating–coredomesticbanks 33Chart 2.13: Contribution to growth in customer deposits – core domestic banks 33Chart 2.14: Banks’ liabilities components – core domestic banks (2019) 34Chart2.15: LiquidityCoverageRatio–coredomesticbanks 35Chart2.16: Changesintotalownfunds,capitalandleverageratios−coredomesticbanks 35Chart2.17: Maincomponentsofprofits−non-coredomesticbanks 36Chart2.18: Customerloansbysector–non-coredomesticbanks 37Chart2.19: Customerloansbyresidency–non-coredomesticbanks 37Chart 2.20: Bond portfolio – non-core domestic banks 38Chart 2.21: Capital and leverage ratios – non-core domestic banks 40Chart2.22: Profitability–branchesofforeignbanks 40Chart2.23: Customerloansbysector−branchesofforeignbanks 41Chart 2.24: Bond portfolio – branches of foreign banks 42Chart 2.25: Distribution of liabilities – branches of foreign banks 42Chart2.26: Profitability–subsidiariesofforeignbanksandstand-alonebanks 43Chart2.27: Customerloansbysector–subsidiariesofforeignbanksandstand-alonebanks 43Chart 2.28: Bond portfolio – subsidiaries of foreign banks and stand-alone banks 44Chart 2.29: Capital and leverage ratios – subsidiaries of international banks 45Chart 3.1: Stress test results – macro stress test baseline scenario – relative contribution of the impact on core domestic banks’ Tier 1 capital ratio 52Chart 3.2: Stress test results – macro stress test baseline scenario – relative contribution of the impact on non-core domestic banks’ Tier 1 capital ratio 52Chart 3.3: Stress test results – macro stress test adverse scenario – relative contribution of the impact on core domestic banks’ Tier 1 capital ratio 52Chart 3.4: Stress test results – macro stress test adverse scenario – relative contribution of the impact on non-core domestic banks’ Tier 1 capital ratio 53Chart 3.5: Stress test results – impact of a drop in house prices on core domestic banks’ Tier 1 capital ratio 54Chart 3.6: Stress test results – change in the euro term structure of interest rates under the six BCBS scenarios 55Chart 3.7: Stress test results – impact of changes in NII on Tier 1 capital ratio of core domestic banks 55Chart 3.8: Stress test results – impact of changes in NII on Tier 1 capital ratio of non-core domestic banks 56Chart 3.9: Stress test results – impact of changes in NII on Tier 1 capital ratio of international banks (excluding branches) 56Chart4.1: Compositionofassetsheldbythedomesticlifeinsurancesector 83Chart 4.2: Corporate bond portfolio – investment ratings – life insurance sector 83

Chart4.3: Maincomponentsofprofits–domesticlifeinsurancesector 84Chart 4.4: Liquid asset ratio of the domestic life insurance sector 84Chart4.5: Grosswrittenpremiumofthedomesticnon-lifeinsurancesectorbyline of business 85Chart4.6: Compositionofassetsheldbythedomesticnon-lifeinsurancesector 85Chart4.7: Maincomponentsofprofits–domesticnon-lifeinsurancesector 86Chart 4.8: Liquid asset ratio of the domestic non-life insurance sector 86Chart4.9: Domesticinvestmentfundsbymainstrategy 87Chart4.10: Numberofdomesticinvestmentfundsbylicenceandasashareofassets 88Chart4.11: Compositionofassetsbytypeofdomesticinvestmentfunds 89Chart4.12: Compositionofassetsheldbythedomesticinvestmentfunds 89Chart4.13: Domesticinvestmentfunds’NAVbyinvestortype 90Chart4.14: Liquidassetsratioofthedomesticinvestmentfundsbylicence 90Chart 4.15: Ratio of AUM-to-NAV of the domestic investment funds 91Chart4.16: Countryexposureofthesecuritiesportfolioofdomesticinvestmentfunds 92

Table1.1: Summaryofrisks 19

Figure 3.1: Schematic overview of the MST framework 50Figure5.1: OverviewofsupervisoryandregulatoryapproachestoNPEcoverage 105

BOX CHARTS & TABLES

Box 1 Chart 1: Credit standards 26 Chart 2: Credit terms and conditions 26 Chart 3: Corporate credit demand 28 Chart 4: Mortgage credit demand 28 Chart 5: Consumer credit and other lending demand 29

Box2 Table1:Featuresofthe2016O-SIIidentificationmethodology(step1) 97 Table2:RevisedscoringmethodologyfordomesticO-SIIidentification 98 Table3:2016O-SIImethodologybucketingapproach 100 Table4:RevisedO-SIIbucketingmethodology 100 Table 5: Designated O-SIIs scores and corresponding capital buffer rates 100 Table6:Comparisonbetweenthe2016O-SIImethodologyandthe revisedO-SIImethodology 101

SPECIAL FEATURE

PanelA: Thefinancialsector’sexposurestohard-hitsectors Chart 1: Change in resident deposits of productive sensitive sectors – firstfivemonthsoftheyear 60 Chart 2: Change in resident loans of productive sensitive sectors – firstfivemonthsoftheyear 61 Chart3:Loansofproductivesensitivesectors–May2020 62 Chart4:Loanconcentrationtoproductivesensitivesector–May2020 62 Chart 5: Non-performing loans of productive sensitive sectors – March 2020 62 Chart 6: Resident loans and NPL ratios – March 2020 63 Chart 7: Insurance exposures to productive sensitive sectors – December 2020 64 Chart 8: Investment funds’ exposures to productive sensitive sectors – December 2020 65

PanelB: Stresstestsonbanks’liquidityandsolvencypositions Table 1: Stress test results – impact of persistent deposit withdrawals – scenario 1, restrictedECBfunding,excessliquiditytototalcounterbalancingcapacity 67 Table 2: Stress test results – impact of persistent deposit withdrawals – scenario 2, unrestrictedECBfunding,excessliquiditytototalcounterbalancingcapacity 68 Table 3: Description of baseline and adverse scenarios 68 Chart 9: Stress test results – LCR results for all banks 69 Chart 10: Stress test results – Impact of deterioration in debt securities portfolio on Tier 1 capital ratio 70 Chart 11: Stress test results – Impact of an increase in NPLs in sensitive sectors and mortgages on Tier 1 capital ratio 71 Chart 12: Stress test results – Impact of deterioration in debt securities portfolio and increase in NPLs in sensitive sectors and mortgages on Tier 1 capital ratio 71

PanelC: TheCBM’spolicyresponsetotheCOVID-19outbreak Table4:Residentexposuressubjecttomoratorium–asatendMay2020 77 Chart13:Households’acquisitionofCOVID-19moratoria–May2020 78 Chart14:TopsectorsbenefittingfromCOVID-19moratoria–May2020 78

APPENDICES

AppendixA: Implementedpolicymeasures 109Appendix B: Financial soundness indicators 111

ABBREVIATIONS

AIF Alternative Investment Funds AMC amortised cost (accounting treatment)AML/CFT anti-moneylaundering/combatingthefinancingofterrorismAPP Asset Purchase ProgrammeAUM Assets under ManagementBBM Borrower-based MeasuresBCBS Basel Committee on Banking SupervisionBIA Basel’s Basic Indicator Approach (for calculating operational risk capital requirements)BLS BankLendingSurveyBR Banking RuleBRRD BankRecoveryandResolutionDirectiveCBC counterbalancingcapacityCBM Central Bank of MaltaCCB Capital Conservation BufferCCyB CountercyclicalCapitalBufferCET1 CommonEquityTier1CFIML captivefinancialinstitutionsandmoneylendersCIU Collective Investment UndertakingsCQD CreditQualityDeteriorationCRD Capital Requirements Directive CRR Capital Requirements RegulationDCS Depositor Compensation SchemeDFR depositfacilityrateDSTI debt-service-to-incomeEBA EuropeanBankingAuthorityESAs EuropeanSupervisoryAuthoritiesECB European Central BankEIOPA EuropeanInsuranceandOccupationalPensionsAuthorityEU European UnionESRB EuropeanSystemicRiskBoardFA financialauxiliariesFATF Financial Action Task forceFIAU FinancialIntelligenceAnalysisUnit FSAP Financial Sector Assessment ProgrammeFSR FinancialStabilityReportFSSA FinancialSystemStabilityAssessmentFV fair valueFVOCI fair value through other comprehensive income (accounting treatment)FVTPL fairvaluethroughprofitandloss(accountingtreatment)FX foreign exchangeGBP British Pound Sterling GDP gross domestic productG-SII globallysystemicallyimportantinstitutionsGVA gross value addedHQLA high-qualityliquidassetsIFR/IFD Investment Firms Regulation and Directive IFRS International Financial Reporting StandardsIMF InternationalMonetaryFundIRRBB interest rate risk in the banking book ICPF insurance corporations and pension fundsLCR liquiditycoverageratio

LHS left-hand scaleLGD loss given defaultLiST SSM’s2019LiquidityStressTestexerciseLSTI loan-service-to-incomeLTI loan-to-incomeLTV loan-to-valueLTV-O loan-to-value at originationMiFID Markets in Financial Instruments DirectiveMFI monetaryfinancialinstitutionMFSA MaltaFinancialServicesAuthorityMGS Malta Government Stocks MMF moneymarketfundsMREL minimum requirements for own funds and eligible liabilitiesMSE Malta Stock ExchangeMST macro stress testingNACE nomenclature statistique des activités économiques dans la communauté européenneNAIF notifiedalternativeinvestmentfundNAV net asset valueNFC non-financialcorporationsNII net interest incomeNIM net interest marginNNII net non-interest incomeNPE non-performing exposuresNPISH non-profitinstitutionsservinghouseholdsNPL non-performing loansNSFR Net Stable Funding RatioNTI net trading incomeO-SIIs othersystemicallyimportantinstitutionsOCI other comprehensive incomeOCR overall capital requirementOFI otherfinancialintermediariesP&L ProfitandLossaccountPDW persistent deposit withdrawalsPEPP pandemicemergencypurchaseprogrammePIF Professional Investor FundP2G Pillar 2 GuidanceRHS right-hand scaleRI relevant indicator (for calculating operational risk capital requirements)ROA return on assets ROE returnonequityRRE residential real estateRRM risk reduction measuresRWA risk-weighted assets SBS securitybysecuritySCTS SEPA credit transfersSDD SEPA direct debitsSDW Statistical Data Warehouse SRMR Single Resolution Mechanism RegulationSREP SupervisoryReviewandEvaluationProcessSSM SingleSupervisoryMechanism STREAM StructuralMacro-EconometricModeloftheMalteseEconomyTLAC TotalLoss-AbsorbingCapacityTLTRO targetedlonger-termrefinancingoperations

TSCR total SREP capital requirementUCITS Undertakings of the Collective Investment in Transferable SecuritiesUK United Kingdom US United States of AmericaUSD United States dollar

THE DOMESTIC FINANCIAL SECTORBanksCore Domestic Banks Non-Core Domestic Banks International BanksAPS Bank plc FCM Bank Limited AgriBank plcBank of Valletta plc FIMBank plc Akbank T.A.S. (Branch)BNF Bank plc IIG Bank (Malta) Limited CommBank Europe LimitedHSBC Bank Malta plc Izola Bank plc Credit Europe Bank NV (Branch)Lombard Bank Malta plc Sparkasse Bank Malta plc Credorax Bank LimitedMeDirect Bank (Malta) plc European Depositary Bank SA (Malta Branch)(1)

ECCM plcFerratum Bank LimitedMerkanti Bank LimitedNBG Bank Malta LimitedNovum Bank LimitedSatabank plc(2)

Turkiye Garanti Bankasi A S (Branch)Yapi Kredi Bank Malta Limited

Domestic Investment FundsAltinum Funds SICAV plc EOS Sicav Plc Sunshine Fund (Malta) SICAV Limited

Altinum Fund Emerging Market Trade Finance Fund Alba FundAmalgamated Investments SICAV p.l.c. Futura Funds Sicav plc The Multi-Asset Fund

Amalgamated Growth and Income Fund Futura Real Estate Fund TEE Market Fund SICAV plcAPS Funds SICAV plc Global Funds SICAV p.l.c. TEE Market A Fund

APS Diversified Bond Fund Global Bond Fund Plus VENTURA SICAV PLC.APS Income Fund Malta Privatisation and Equity Fund Digital Opportunities 1 FundAPS Regular Income Ethical Fund Melita International Equity Fund Vilhena Funds SICAV p.l.c.

Arco SICAV plc HSBC Malta Funds SICAV p.l.c. Global Balanced Multi-Manager FundA and G Fund Equity Growth Fund Vilhena Broad Opportunities FundCS Fund HSBC Property Investment Fund Vilhena Euro Income FundCT Fund International Bond Fund Vilhena European Multi Manager FundJB Fund Malta Bond Fund Vilhena Far East OpportunitiesNS Fund Malta Government Bond Fund Vilhena Global Themed FundQV Fund Maltese Assets Fund Vilhena High Yield Fund

Audentia Capital SICAV II plc Integra Private Wealth SICAV Plc Vilhena Malta Bond FundAudentia Top Talent Fund IPW Alternatives Fund Vilhena Malta FundBarlei Fund Merill SICAV plc Vilhena Malta Government Bond FundPDT One Fund Merill Global Equity Income Fund Vilhena Maltese Equity Focus FundSeptentrium Rates Oriented Fund Merill High Income Fund Vilhena Maltese Opportunities Fund

Audentia Capital SICAV plc Merill Total Return Income Fund Vilhena Sterling Income FundFilfla Fund Northern Cross SICAV plc

Bianco SICAV plc Resonor Gold FundBianco SICAV plc Novium Opportunity Umbrella SICAV plc

BOV Asset Management Limited Personal Care Fund(3)

BOV Balanced Portfolio Fund Special Situations Fund(3)

BOV Conservative Portfolio Fund Priveq Funds Sicav PlcBOV Growth Portfolio Fund Equivest Fund

Calamatta Cuschieri Funds SICAV plc Logivest FundEmerging Market Bond Fund Privest FundEuro Equity Fund Southern Cross SICAV plcGlobal Balanced Income Fund Avalon Tech FundHigh Income Bond Fund- EUR Strategica Funds SICAV plcGlobal High Income Bond Fund Zattere FundMalta Balanced Income FundMalta Government Bond Fund

Domestic Insurance CompaniesLife Insurance Companies Non-Life Insurance CompaniesGlobalCapital Life Insurance Limited Atlas Insurance PCC LimitedHSBC Life Assurance (Malta) Limited Citadel Insurance plcMAPFRE MSV Life plc Elmo Insurance Limited

GasanMamo Insurance LimitedMAPFRE Middlesea plc

This edition of the Financial Stability Report is based on the above categorisation of banks, domestically-relevant insurance companies and investment funds.

(3) Personal Care and Special Situation Funds are in the process of being liquidated.

(2) In October 2018, the MFSA appointed Ernst and Young Ltd as a competent person in terms of Article 29(1)(c) and (d) of the Banking Act to take charge of the bank. Satabank's licence was withdrawn on 30 June 2020.

(1) European Depositary Bank SA (Malta Branch) is a branch of the European Depositary Bank SA (LX) and is licensed to offer custody services.

11

CENTRAL BANK OF MALTA Financial Stability Report 2019

PREFACE

Asoundandrobustfinancialsystemisthecornerstoneofthenationaleconomicinfrastructureasitfosterstheeconomicgrowthpotential of a countrybyallocating financial resourcesefficiently.Without financialstability,broadereconomicandpricestabilityareunlikelytomaterialise.ItisthereforenotbycoincidencethatfinancialstabilityisatthecoreoftheCentralBankofMalta’smandate.TheCOVID-19pandemicposesthebiggesttesttotheresilienceoftheMaltesefinancialsystemsincetheGreatFinancialCrisis.PromptresponsesbytheMalteseGovernment,theregulatoryandsupervisoryauthorities–includingtheECB,theCentralBankofMaltaandcredit institutionsthemselvesweretargetedtoprovidetherequiredliquiditytoensurethecontinuationoffinancialstability,andsupporttotherealeconomy.

This edition of the Financial Stability Report,assessesthecurrentandpotentialfinancialstabilityrisksinthefinancialsystem,thepolicyactionsimplementedduringtheyear,andputsforwardrecommendationstostakeholdersinabidtofurtherbolstertheresilienceofthefinancialsystem.

Typically,theReportcoversthedevelopmentsinthefinancialsectorofthepreviouscalendaryear.Giventhecurrent unprecedented events, this edition also includes a special feature on the channels through which the COVID-19contagionisimpactingthedomesticfinancialsystem.TheReport also carries a number of other boxed articles, including a discussion of the latest macroprudential measures.

The Financial Stability Report ispreparedbytheFinancialStabilityDepartmentoftheCentralBankofMaltaandisreviewedandendorsedbytheFinancialStabilityCommittee,whichisaninternalstructuremandatedtooverseetheriskassessmentandpolicymeasuresrelatedtofinancialstabilityandthemacroprudentialframework.

1. Macroprudential risk assessment

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ECB Deposit facility ̶ date of changes (raw data) ̶ LevelYield curve spot rate, 10-year maturity ̶ Government bond triple A rating ̶ Euro area

Source: SDW.

Chart 1.1ECB DEPOSIT FACILITY RATE AND YIELD CURVE ON AAA EURO AREA GOVERNMENT BONDS

1. MACROPRUDENTIAL RISK ASSESSMENT

In2019,thefinancialstabilityenvironmentinEuroperemainedchallengingasdownsideriskshaveincreased.Theultra-low interest rateenvironment,weak international tradespurredby trade tensionsbetween theUnited States of America and China, and the looming Brexit deadline were some of the main threats faced bytheglobalfinancialsystem.Indeed,growthinEurope’seconomysloweddownto1.5%inrealtermsfromthe2.0%registeredin2018.1Eventhoughglobalgrowthweakened,stockmarketsrosesignificantlydur-ing 2019 with major indices, including the Euro Stoxx 50 index, reaching their highest level since the 2008 globalfinancialcrisis.2ThismarketrallywaspartlydrivenbytheUKelectionresultsinDecember2019,andtheUS-Chinaphase-onetradedealcoupledwiththeinterestratedecisionsbytheFederalReserve,whichalleviated some of investors’ concerns. Notwithstanding these international challenges and the softening of the macro environment, the Maltese economycontinuedtogrowrobustly,albeitataslowerrate,andcontinuedtopostoneofthehighestgrowthrates in Europe.3 Looking ahead, the spread of COVID-19 will be a critical challenge for the European financialsystemasthepandemic isdisruptingeconomicactivitybringingaboutasharpglobaleconomicdownturn, with governments taking unprecedented measures to limit this fall out. International Developments2019wasadecisiveyearfortheUnitedKingdom,asnegotiationsonitsexitfromtheEuropeanUniongath-eredmomentum.ThesepreparationshadconsequencesontheoperationalstructureofcreditandfinancialinstitutionsthatoperatedorhadthemajorityoftheirbusinessintheUnitedKingdom.Globalbanksthatactas intermediaries in capital and derivatives markets made plans to transfer some activities from the United Kingdom to continue servicing their counterparties in the euro area.4Contingencyplansforahard-Brexitscenariocontinuedtobedevelopedduringtheyear.Inaddition,marketuncertaintyonBrexitdevelopmentspersisted as UK elections were called that were to determine the future of the United Kingdom in the Euro-peanUnion.However,theconfirmationofgovernmentwitharesoundingmajorityinDecember2019easeduncertainty,withthePoundSterlinggaininggroundagainsttheeuro,risingfromits lowest levelof1.077inAugust 2019 to end the year at1.175.5 Brexit officially took placeon 31 January 2020. Going for-ward, uncertainties will persist as discussions on future agreements, whichwereinpartdisruptedbythepandemic, continue during the tran-sition period which is scheduled to end on 31 December 2020. After more than three years ofunchanged policy interest rates,in September 2019, the European Central Bank (ECB) cut its deposit facility rate by 10 basis points to-0.5%(seeChart1.1).6 This accom-modative monetary policy stancewas also accompanied with a fresh stimulus package, which came into place with the approval of a new 1 Source: https://ec.europa.eu/eurostat/databrowser/view/tec00115/default/table?lang=en2 Source: https://www.stoxx.com/index-details?symbol=SX5E3 Source: https://ec.europa.eu/info/business-economy-euro/economic-performance-and-forecasts/economic-performance-country/malta/economic-forecast-malta_en4 Source: https://www.ecb.europa.eu/pub/fie/article/html/ecb.fieart202003_01~690a86d168.en.html#toc15 Source: https://www.ecb.europa.eu/stats/policy_and_exchange_rates/euro_reference_exchange_rates/html/eurofxref-graph-gbp.en.html#6 Source: ECB Statistical Data Warehouse (SDW)

https://ec.europa.eu/eurostat/databrowser/view/tec00115/default/table?lang=en

https://www.stoxx.com/index-details?symbol=SX5E

https://ec.europa.eu/info/business-economy-euro/economic-performance-and-forecasts/economic-performance-country/malta/economic-forecast-malta_en

https://ec.europa.eu/info/business-economy-euro/economic-performance-and-forecasts/economic-performance-country/malta/economic-forecast-malta_en

https://www.ecb.europa.eu/pub/fie/article/html/ecb.fieart202003_01~690a86d168.en.html#toc1

https://www.ecb.europa.eu/stats/policy_and_exchange_rates/euro_reference_exchange_rates/html/eurofxref-graph-gbp.en.html#

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roundofbondpurchasestoshoreupgrowthintheeuroareaandhaltthedropininflationexpectations.Atthesametime,theECBeasedthetermsofitstargetedlonger-termrefinancingoperations(TLTRO)tostimu-latelendingandintroducedatwo-tiersystemforreserveremunerationtomitigatepossibleside-effectsoftheultra-expansionarymonetarypolicy.Thelatterexemptspartofthebanks’excessliquidityfromnegativeremunerationwiththeaimofsupportingfurtherthebank-basedtransmissionofmonetarypolicy.7

Despitesuchmeasures,profitabilityremainschallengingfortheeuroareabankingsystem,withthepro-longedultra-lowinterestrateenvironmentcontinuingtoexertitstoll.Thereturnonequity(ROE)andreturnonassets (ROA)ofbanks in theEuropeanUniondeclined from5.9%and0.42% in2018 to5.2%and0.37%,respectivelybythefourthquarterof2019.8Inaddition,overallcredittotherealeconomystayedbroadlyunchangedin2019.AccordingtotheECB’sBankLendingSurvey,creditstandardsonloanstoenterprisesandmortgages remained relativelyunchanged in2019.However, credit standards for con-sumercreditandotherlendingweretightenedduring2019.Furthermore,yieldsoneuroareagovernmentbondsdeclinedtoalowof-0.68%inAugust2019from0.32%in2018torecoversomewhatbyyearendat-0.14%,makingitcostlyforinvestorstoholdhighly-ratedgovernmentpaper(seeChart1.1).9 Investors were motivated to take on higher risk, with potential negative repercussions should sentiment change caus-ing a repricing of risk premia.

High public and private sector indebtedness continued to be a matter for attention. Euro area sovereign debt asashareofGDPstoodat84.2%bythefourthquarterof2019,downby1.7percentagepointscomparedtothepreviousyear.Theshareofdebtmaturingwithinoneyearstoodataround12%ofeuroareaGDP,withsomecountriesreportingashighas20%.10 Public debt levels are anticipated to rise further owing to theextraordinarymeasuresbyGovernmentstocombatthepandemic.Moreover,householdindebtednessvariedacrosseuroareacountries,rangingfromaround23%toover100%ofGDP,withtheoverallaveragefortheyearstandingat57.9%.

Cyber-attacksonfinancialinstitutionscontinuedtoposeachallengetoglobalfinancialstabilityassuchriskscouldpotentiallymaterialiseasfinancialandreputationallossesand–dependingontheirseverity–couldalsoimpairthefunctioningofthefinancialsystem.Inaddition,discussionsonthepotentialimplicationsofcli-matechangeonfinancialinstitutionsaregaininggroundasfailuretoaddressclimateriskthroughthebanks’exposurestohigh-carbonsectorscouldprovokefinancialdisruption,affectingtheirprofitabilitythroughlowerassetvaluesanddepletedrepaymentcapacity.Thedistributionofeuroareabankexposurestonon-financialcorporations (NFCs) and their respective emission intensities has been gradually improving,minimisingsomewhat the risk of an abrupt transition period.11 However, in line with the European Commission’s action planforsustainablegrowth,workonaharmonisedtaxonomyisnecessaryandshouldbespeededupfurthercoupledwiththeneedtodevelopmoreharmonisedreportingrequirementsthatcouldmeasurefirm-levelexposures to climate-related risks.12 Insurance companies are more vulnerable to climate change risk since naturaldisasters,globalwarmingandrisingsealevelscreatepotentialriskofpropertydamagesandlossoflife, with potential implications on rising claims.

Domestic DevelopmentsDespitegrowingataslowerpacethanin2018,theMalteseeconomyregisteredarealgrowthrateof4.4%in 2019.Economic activitywasmostly driven by private and public consumption,which contributed 3.1percentagepointstogrowth,whilegrossfixedcapitalformationaddedafurther1.5percentagepoints.Netexports shaved 0.2 percentage point off real GDP growth in 2019. Service-oriented sectors continued to be the engine of economic growth.

7 https://www.ecb.europa.eu/mopo/two-tier/html/index.en.html8 Source: ECB SDW9 Source: ECB SDW10 Source: ECB SDW 11 Source:ECB,FinancialStabilityReview,November201912 EuropeanCommission,EUTaxonomyforSustainableActivities

https://www.ecb.europa.eu/mopo/two-tier/html/index.en.html

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GovernmentdebtasashareofGDPdecreasedfrom45.6%inDecember2018to43.1%inthelastquarterof2019,whileafiscalsurplusof0.5%wasregistered.Householdindebtednessstoodataround50%ofGDPbytheendof2019,upby1.3percentagepointsoverayearago.Furthermore,corporateindebtednessinMaltaincreasedmarginallyinrelationtoGDP,standingat80.5%in2019Q4,upby0.4percentagepointcomparedtothesameperiodlastyear.Nonetheless,corporateleverage–measuredastheoverallconsoli-datedNFCdebtasashareoffirms’assets–declinedby1.5percentagepointsto31.5%,justslightlybelowtheaveragefortheeuroareawhichstoodat31.8%.13 In fact, corporate leverage has been on a declining pathsince2008,whereitstoodat64.5%.Domesticfirmscontinuedtofundtheiroperationsfromrelatedcompanies,thoughasashareofGDPthishasbeendecliningandstoodaround59%byend2019,slightlyhigherthantheeuroareaaverageofaround57%.14

At6.1%, the increase inrealestateprices in2019exceededsomewhat thatof2018,mainlyasaresultofdevelopments in thefirsthalfof theyear,withgrowthdecelerating in the latterhalf.15Housingsupplyadjusted following fouryearsofdouble-digitgrowth,with thenumberofpermitteddwellingsdecliningbyaround3%in2019,indicatingthatapossibleplateauwasreached.

Whileresidentcreditgrowthremainedoverallstableat6.8%,thiscontinuedtobelargelydrivenbygrowthinmortgages, which picked up further momentum in 2019. In contrast, growth in lending to NFCs decelerated to2.8%,notwithstandingthatgrossvalueadded(GVA)expandedby7.5%in2019.TheslowdowninNFCcreditmainlyreflectedadropinlendingtothewholesaleandretail,andthemanufacturingsectors.Thiswassomewhatoffsetbyhigherlendingintheprofessional,scientificandtechnicalactivities,andconstructionandrealestatesectors,whichallreportedsignificantgrowthintheGVAofaround10%.

Creditriskcontinuedtoimproveasnon-performingloans(NPLs)declinedby6.7%in2019.Thiswasmainlydue to improved creditworthiness of borrowers within construction, real estate as well as manufacturing, transportationandstoragecoupledwithagrowingeconomyandatargetedstrategybydomesticbankstoreducetheamountofNPLs.AsseeninChart1.2,themedianNPLratiostoodat2.5%in2019.

Maltesebankscontinuedtooperateonthebackofsubstantialliquiditywiththemedianliquiditycoverageratio(LCR)standingat441.5%foralltheMaltesebanks,butthismaskedsignificantheterogeneityamongbanks, with a few banks reporting relatively weaker ratios. Chart 1.2shows that 90%ofMaltesebankshave a Common Equity Tier 1(CET1) ratio of above 15% and aleverageratioabove4.5%.

Off-balance sheet contingent liabili-ties stood at around 14% of theiroverall balance sheet, down from 17.4% in the previous year. Suchcontingentliabilitiesmainlytaketheform of commitments to make loans or to extend credit.

Maltese banks’ post-tax return-on-assets decreased by 0.1 percent-agepointto0.8%,withthedropinprofitslargelyreportedbybranches

13 Source: ECB SDW14 Source: ECB SDW15 Source: Eurostat

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Chart 1.2 KEY RISK INDICATORS(per cent)

Source: Central Bank of Malta.

17


generallyoffsetbyaconsolidationinbusinessbythesamebranches.Indeed,excludingsuchbranches,theROEincreasedfrom5.6%to6.8%indicatinghigherprofitability.

Turning to the insurance sector, risks stemming from the domestically-relevant insurance companiesremainedcontainedastheycontinuedtooperateonthebasisofampleliquidityandstrongcapitalbuffers,withanoverallsolvencyratioof227.8%inDecember2019.Aprolongedlowyieldenvironmentremainsakeychallengefortheinsurancesectorandthiswillcontinuetoexertpressureontheirprofitability. Similarly,thedomestically-relevantinvestmentfundsremainedprudentreflectingtheirconservativeinvest-mentstrategies.Thekeyriskexposurefordomestic investmentfundsisthepotentialre-pricinginglobalriskpremiaowingtoheightenedvolatilityinfinancialmarketsanduncertaintydrivenbygeopoliticaleventsincludingtheuncertaintyrelatedtotradeprotectionism.Sucheventscouldleadtohigherredemptionrates,whichcouldpotentiallycoincidewithlessliquidityinthemarkets,henceexacerbatingtherisksinthissector.

Maltesebankscontinuedtostrengthentheirdigitalsecurityinfrastructuretocounterpotentialcyber-attacks,whichcouldresultinadversefinancialandreputationallosses.In2019,oneMaltesebankfacedacyber-attack,whichforcedittotemporarilyshutdownallitsoperations.Theimpactwascontainedandthebanktookthenecessaryactionstorestoreitsbusinessintheshortesttimepossible,whileatthesametimerein-forcingitscybersecurityforitsinfrastructure. Themountingpressureoncorrespondentbankingisaninternationalphenomenon,largelyreflectingthede-riskingstrategiesofinternationalbanksduetohigherregulatorystandardsandanincreaseintheassociatedcostsforcompliancewithAML/CFTlegalrequirements.Facedwiththethreatoflargefinesanduncertainregulatoryexpectations,internationalbanksaredownsizingtheircorrespondentbankingservicesbytermi-natingbusinessrelationshipsacross jurisdictions,particularlysmallonesgiven their limitedvolumesandhencelowerreturnsvis-à-vistherisksposed.Malta,beingasmalljurisdictionisaffectedbythisglobaltrend,togetherwithitsowndomestic legacyissues.Thisnotwithstanding,Maltesecredit institutionshaveman-agedtomaintainadequatechannelsforforeigncurrencytransactionsincludingthosedenominatedinUSdollars. Indeed, local banks have de-risked and are adjusting their business models to provide the neces-saryreassurancesforthiskindofbusinessrelationship.Furthermore,theCentralBankofMaltaiscurrentlyinvestinginapaymentshubtoofferindirectparticipationtolocalinstitutionsauthorisedandlicensedbytheMaltaFinancialServicesAuthority(MFSA)fortheclearingofSEPACreditTransfers(SCTs)andSEPADirectDebits(SDDs),andlaterininstantpayments.

InSeptember2019,MONEYVALgrantedaperiodofoneyearforMaltatoaddressidentifiedshortcomingsrelatedtoAML/CFTsupervisionandmoneylaunderingframework.TheFinancialIntelligenceAnalysisUnit(FIAU) is on course to address all MONEYVAL recommendations in time for the follow-up assessment, which is due to take place in October 2020.16 In addition, Malta’s AML/CFT regime was updated in line with theFifthAnti-MoneyLaunderingDirectiveand takes intoconsideration the recommendationsmadebyMONEYVALandtheVeniceCommission.Furthermore,theFIAUsignedMemorandaofUnderstandingwiththeCentralBankofMalta,theAccountancyBoardandtheMaltaGamingAuthoritytostrengthenfurthercoordinationefforts incombattingmoney launderingandfinancialcrime,andwasgivenadditionalfinan-cialresourcesforfurthercapacitybuilding.InJune2020,MaltalaunchedtheInter-AgencyCommitteeonCounteringFundingofTerrorism(ICOFT)followingoneoftherecommendationsbyMONEYVALand,goingforward,aCentralisedBankAccountRegistry(CBAR)willbelaunched.ThiswillaidAuthoritiestoaccessfinancialinformationoncompaniesandindividualsinatimelymanner.TheCentralBankofMaltaiscloselyfollowingtheprogressmadebytheAuthoritiestoaddresstheMONEYVALrecommendations.ItisimportantthattheAuthoritiescontinuetostrivetoensurethatalltheMONEYVALrecommendationsaresatisfiedandimplemented within the targeted timeframe. Looking forward, a number of downside risks exist which could reinforce financial stability risks. Keyeconomic sectors are expected to weaken in 2020 as a result of the COVID-19 spread, with adverse

16 https://fiaumalta.org/wp-content/uploads/2020/06/Annual-Report-2019.pdf

https://fiaumalta.org/wp-content/uploads/2020/06/Annual-Report-2019.pdf

18


repercussionsontherevenuegenerationofvariouscompanies.Somefirmsoperatinginthosesectorshitbythepandemictrimmedtheirworkweekandevenlaidoffanumberofemployees,furtherimpactingtheeconomicgrowthpotential.Theeconomicshockcausedby theCOVID-19pandemic is likely toweakenfurtherbanks’profitabilityasthepositivetrendinassetqualityobservedsince2015islikelytobereversed,with banks needing to step up further their provisioning levels. The prolonged low interest rate environment, coupled with lower fees and commission income, as well as possible higher market funding costs amid slowdownincredit,areallexpectedtoimpacttheprofitabilityofcreditinstitutions.Atthesametime,NFCleverageislikelytoincreaseasfirmswillincreasinglyresorttoborrowingfrombanksorthecapitalmarketastheirinternalfundsdryup.

Property pricegrowth inMalta,whichwasmoderating towards the latter half of 2019, could slowdownfurtherastherealestatemarketwasimpactedbythepandemic.Asignificantriseinlossofjobsforforeignnationals, ifprolonged,couldhavenegative implicationsontherentalmarketandthebuy-to-letpropertysegment.Atthesametime,someresidentscouldhavedifficultiestorepaytheirmortgages,albeitthemora-toriainplaceshouldmitigatethisimpactifsuchincomelossesaretemporary.Allthesefactorscouldleadtodownwardpressureonpropertyprices,withpotentialimplicationsonbanks’balancesheetsintermsoflowercollateralvalues.Concurrently,creditforhousepurchasesisexpectedtoslowdownin2020.However,suchsofteningcouldbemitigatedbyincreasedworkingcapitallendingthroughthevariousmeasuresimple-mentedviatheMaltaDevelopmentBank,whichcouldsupportemployment.Meanwhile,adeteriorationinassetquality–ifthepost-pandemicrecoveryturnsouttobeslowerthanexpected–couldtriggeranuptickin the NPL ratio. While the implementation of Central Bank of Malta Directive No. 18 on moratoria helps to givebreathingspacetohouseholdsandbusinesses,aslowrecoverycouldgiverisetoinsolvencyofsomenon-financialcorporatefirms. In turn,globalequitymarketshaveadjustedquickly,ashavecertainpartsof thehigh-yieldfixed incomemarkets.Thereassessmentofriskpremia,whichmaterialisedinthefirstquarterof2020,isstillprevalentowing to the increaseduncertainty behind the fundamental valueof underlying securities,with potentialfurtherdropsgoingforward.Domestically,attheonsetofthepandemic,theMaltaStockExchange(MSE)index declined somewhat as investors’ sentiment changed, though these losses recovered somewhat in the secondquarter.Maltesebanks’equitypriceshaddraggedtheindexlowerinthefirsthalfof2020,butsomebankequitypriceshaveeitherstabilisedorrecoveredsomeoftheearlierlosses.GovernmentsimplementedextraordinarycontainmentmeasurestorestrainthespreadofCOVID-19,thusbringinganumberofsectors,mostnotablytourism,toahalt.TheyalsoimplementedextraordinaryaidpackagestoshoreupandfighttheadverseimpactoftheCOVID-19pandemicontheireconomies.Similarly,fromadomesticperspective,sup-port measures were also implemented, with the Maltese Government presenting a €1.8 billion aid package, which included wage supplements, tax deferrals, loan guarantees and increased spending to support the economy.TheGovernmentwillbeservicingthispackagethroughborrowinglocallyfromthepublicandthefinancialinstitutions,thoughGovernment’sdebtlevelisexpectedtoremainbelow60%ofGDP.

As a response to the COVID-19 outbreak, the Central Bank of Malta issued two directives. Directive No. 17 enablesvulnerablebankcustomerstodeposit“only”chequesthroughtrustedthirdparties,andspelledoutminimumserviceexpectationstobeprovidedbycommercialbanksandfinancialinstitutions,particularlyinwithdrawals and deposit of cash and cheques. Directive No. 18 outlines the provisions governing the legal moratoria on credit facilities. The Central Bank of Malta further amended Directive No. 16 on borrower-based measuresbyallowingmoreflexibleconditionsforresidentialrealestate(RRE)loanstobeprovidedwhileitalso amended Directive No. 8 to allow for more favourable collateral requirements.

TheECBhasalsotakenseveraldecisions,whichincludedtheimplementationofanewtemporaryassetpurchase programme (APP) covering private and public sector securities to the tune of €1,350 billion as well asmicro-prudentialcapitalandoperationalreliefmeasures,throughthereleaseofcapitalandliquiditybuf-ferssetasidebythebanks.ThemeasuresundertakenbytheECBalsoincludesupervisoryflexibilityforthetreatmentofNPLs,guidanceonapplyingtheInternationalFinancialReportingStandards(IFRS)9standard

19


inawaythatavoidsprocyclicaleffects,restrictionsindividendsdistributions,andtemporaryeasingincol-lateral requirements.

Formoreinformation,refertotheSpecialFeatureontheCOVID-19spreadanditsimplicationsonthefinan-cial sector’s resilience.

TheaboveisalsoreflectedinTable1.1,whichsummarisestheintensityanddirectionofthemainsystemicrisksfortheMaltesefinancialsystem.

Table 1.1SUMMARY OF RISKS

Credit Cyclical/ Structural ↔ ↑

Credit Structural ↑ ↔Credit Cyclical/

Structural ↔ ↑Contagion Structural ↔ ↔

Contagion/Profitability Structural ↑ ↔Liquidity/Solvency/

ProfitabilityCyclical/

Structural ↑ ↑Credit/Solvency/

ProfitabilityCyclical/

Structural ↔ ↑

Credit/Profitability Cyclical ↔ ↑Credit/Contagion Cyclical ↔ ↑

Profitability Structural ↔ ↑Credit/Profitability Cyclical ↑ ↑

Contagion Structural ↔ ↔Profitability Cyclical ↑ ↑Profitability Cyclical ↔ ↑

↑↔↓

Moderate Increased risk

Medium Stable risk

Elevated Decreased risk

Direction of risk

Domestically-relevant Investment funds

Vulnerabilities outside the financial system

Domestic macroeconomic developments

Real estate market developments

Exposures of the financial sector to domestic sovereign securities Economic conditions in the euro area and public debt sustainability

Geopolitical uncertainties

Prolonged low interest rate environment

Reassessment in risk premia

Risk position

Risk assessment for 2020

Vulnerabilities within the financial system

Domestically-relevant Insurances

Main vulnerabilities and risks for the financial system

Type of risk

Nature of risk

Change in risk level since FSR 2018

The level of non-performing loans

Concentration in sectoral lending

Developments in bank credit

Interlinkages between banks and the non-bank financial sector

Operational risk

2. Developments in the Banking sector

22


2. DEVELOPMENTS IN THE BANKING SECTOR

2.1 Core Domestic Banks The balance sheet of the core domestic banks grew by 2.3%,with assets reaching 186.7% ofGDP. This ratio was 8.3 percentage points lower compared to a yearago, primarily since Malta’s GDPexpanded at a faster pace than these banks’ assets (see Chart 2.1). This group of banks became even more focused on domestic business activities, as their foreign assets declined to just over a quar-ter of their balance sheet. More than half of the latter were invested in debt securities, mainly foreigngovernment paper and bank bonds. Anotherfifthofforeignassetscon-sisted of placements with other foreignMFIswiththerestmainlyinnon-resident customer loans.

In line with previous years,placements with the central bank were again one of the main contributors behind the growth in assets, reflecting the abundanceof liquidity in the banking system.These increased by 12.7% toaround 17% of assets (see Chart2.2). At around 48% of assets,customer loans remained the largest asset component on these banks’ balance sheet. The expansion in the loan book was largely driven by resident loans,mainly mortgages, as otherwisegrowth in resident consumer loans and lending to NFCs was weak.

Althoughgrossvalueaddedgrewbyaround7.5%,largelyinservice-orientedsectors,lendingtoresidentcorporateswasmoremute,inlinewiththeslowdownreportedintheBankLendingSurveys(BLS)carriedoutin2019(seeBox1).Thiscaninpartbeexplainedbythecontinuedincreaseincorporatebondissuancewhichroseby21.3%to€1.6billionin2019from€1.3billionthepreviousyear,andinsomeinstancesthroughthedrawdownofdepositsbysomesectors.1 In fact, overall borrowing including bond issues increased over thepreviousyear.Inaddition,intragroupfundingroseby8.0%.Allthesefactorssuggestthatsomecorpo-rateswereinpartsubstitutingbankfundingwithalternativefinancingresources.At31.5%,corporatelever-agecontinuedtodeclinewiththeconsolidateddebttofirms’financialassetsstandingslightlybelowtheeuro

1 During 2019, the gross issue of corporate and bonds issued on Prospects MTF amounted to €309 million, of which 12 new issues were ofcorporatebonds(€266.1million)and10newissuesofProspectsbonds(€42.9million).Consideringalsotheredemptionsandbuy-backsthatoccurredduring2019,thenetincreaseamountedto€279.7million(21.3%)whencomparedto2018.

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2015 2016 2017 2018 2019Loans to households Loans to non-financial corporatesLoans to other financial entities Placements with banksGovernment debt securities Other securitiesClaims with the Eurosystem Other assetsAssets as a % of GDP (RHS)

Chart 2.1 DISTRIBUTION OF ASSETS − CORE DOMESTIC BANKS (EUR billions; per cent)


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Chart 2.2 CONTRIBUTION TO BALANCE SHEET GROWTH − CORE DOMESTIC BANKS (percentage points)


23


area average (see Chapter 1). The weakening in non-resident lending persisted as some banks continued with their de-risking strategies.

Intermsofthebanks’investmentportfolio,afterdecliningforfourconsecutiveyears,holdingsofdebtsecuri-tiesincreasedmarginally,mainlyowingtohigherholdingsofforeignsovereignpaper.Ontheotherhand,interbankclaimsdeclinedbyalmostafifthin2019tojust6.2%oftotalassets.Otherassets,includingfixedandintangibleassets,grewby23.7%,butstillaccountedforarelativelyminorshareofthebalancesheet.

2.1.1 Profitability Theprofitabilityofcoredomesticbanksimprovedin2019,withpre-taxprofitsrisingbyjustover20%to€200million.Consequently,thepost-taxROEandROAincreasedby0.15and0.03percentagepointto6.7%and0.6%,respectively,surpassingtheEUaveragesof5.2%and0.4%(seeChart2.3).2 However, this improve-mentmasked theeffectofonebank’sprovisions in2018 tocover legal risks,whichwerecomparativelylowerin2019.Adjustingfortheseprovisions,pre-taxROAwouldhaveremainedstableat0.9%whilepre-taxROEwouldhavenarrowedby1.6percentagepointsto10.8%.

Growth in net interest income (NII) accelerated in2019,upbyaround2% to account for almost two-thirds of gross income (see Chart 2.4). This was entirely attributableto greater intermediation activi-ties as otherwise interest margins narrowed. The weighted average interest rate on loans fell by 0.2percentage point to 3.6% whilethatofdepositsremainedrelativelyunchanged at 0.3%. Thus banksweresupportedbygreatervolumesresulting from the buoyant eco-nomic activity noted earlier, whichcompletelyoffset thedrop in inter-est rate margins.

OtherNIIcontractedby16.7%,pre-dominantly due to lesser incomefrom securities which more than off-set the decline in interest payableon outstanding bonds.

During 2019, core domestic banks reportedasignificantdeclineinnetimpairment losses, which dropped from €56.1 million in 2018 to €0.8 million in 2019, mainly reflectinglower bad debts written off and a corresponding reversal of provi-sions related to these bad debts. Taking into account this reversal, non-interest income would have increasedbyaround20%in2019.

2 Source: ECB SDW.

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Chart 2.4 MAIN COMPONENTS OF PROFITS − CORE DOMESTIC BANKS (EUR millions)

Source: Central Bank of Malta. Note: Grey bars indicate pre-tax profits in absolute amounts. Teal (positive) and red (negative) bars indicate yearly changes in profit components. NII stands for net interest income.

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Chart 2.3PROFITABILITY RATIOS − CORE DOMESTIC BANKS(per cent)

Sources: Central Bank of Malta; ECB SDW.

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Tradingprofitscontributedpositivelytogrowthinnon-interestincome,reflectingfavourablefairvalue(FV)movementsontheirfinancialassets.Atthesametime,banksreportedhigherdividendincomefromsub-sidiaries.Meanwhile, income from feesandcommissions remainedgenerally stable,butat53.3%,stillaccounted for the bulk of non-interest income.

Non-interestexpensesroseby4.9%duetohigherstaffexpensesandotheroperatingexpensesmainlyrelatedtotheupgradingofsomebanks’ITcoresystemscoupledwithadditionaloutlaystostrengthentheirriskmanagementandAnti-MoneyLaundering(AML)frameworks.

Theoperationalcost-to-incomeratiodeterioratedto66.1%in2019asoperatingexpensesincreasedwhilegrossincomedeclinedmarginally.ThisratioisbroadlyinlinewiththeEUaverageof64%.

2.1.2 Asset Quality

The loan portfolioInlinewiththeirprudentbusinessmodels,coredomesticbanksengagedprimarilyinintermediation,withalmost90%oftheirloanbookchannelledtowardsresidents.Meanwhile,non-residentcustomerloansfellby28.2%in2019duetolowerparticipationinsyndicatelending.

Growth in resident credit gatheredmomentum, driven by resident household lendingwhich grew by9.4%.Theupwardtrendinmortgagelendingpersistedin2019,risingby10.3%comparedto8.8%inthepreviousyear(seeChart2.5).Consequently,theshareofresidentmortgagesincreasedbyafurther1.8percentagepoints to51.3%of resident loans.Suchdevelopmentsmirrored thebenigndomesticeconomicenvironmentaccompaniedbyfavourablehousingmarketprospects.Despitethehighexpo-sure towards resident mortgages, banks continued to adopt prudent lending practices. Indeed, although themedianloan-to-value(LTV)ratioforRRElendingroseby2.7percentagepoints,thisstillremainedcontainedataround80%.Similarly,themedianloan-service-to-income(LSTI)andtheloan-to-income(LTI)ratiosstoodat22.7%and4.4timestheannualincome,respectivelywithamedianmaturitytermof30years.3

Meanwhile,residentconsumercreditexpandedby1.0%in2019,followingacontractionof3.1%reportedin 2018.

Lending to resident NFCs continued to grow, yet at a moremoderate pace than in 2019. Such credit went up by 3.0% in 2019compared to 3.7% a year earlier.Lending to private NFCs also grewby3.0%,compared to3.7%in 2018, while lending to public sector NFCs grew by 2.4%, 0.6percentage point lower than in thepreviousyear.Theincreaseinlending was channelled towards the professional, scientific andtechnical activities, construction and real estate sectors, and administrative and support services activities. Resident

3 DataarebasedonasampleofnewloansforhousepurchasesfromaquarterlysurveycarriedoutbytheCentralBankofMalta.

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Total loans Non-financial corporate loansMortgages Consumer credit and other lending

Chart 2.5ANNUAL GROWTH RATE OF RESIDENT LOANS − CORE DOMESTIC BANKS(per cent)

Source: Central Bank of Malta.Note: A break in series was reported in May 2017 with regards to household consumer credit and other lending due to a reclassification exercise.

25


lending towards the former sector rose by 56.3%, mainly driven byone core domestic bank’s lending towardsheadoffices,businessandother management consultancyactivities. Nevertheless, the share of resident professional, scientificand technical activities in overall resident lending remained limited to2.9%(seeChart2.6).Althoughlending to construction and real estate grew by 7.6%, its sharein resident lending increased marginally to 13.3%. Conversely,resident lending to the wholesale and retail trade, and manufacturing sectors declined.

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Financial and insurance activities

Households - mortgages

Households - consumer creditand other lending

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Chart 2.6RESIDENT LOANS BY NACE − CORE DOMESTIC BANKS(per cent)

BOX 1: BANK LENDING SURVEY RESULTS1

ThequarterlyBLScarriedoutbytheESCBprovidesqualitativeinformationonbanks’lendingcondi-tions,developmentsinthepastthreemonths,andexpectationsofbanksinrelationtoloansupplyand demand for enterprises and households.2Inthe2019edition,thesurveysalsoaskedanumberof ad hoc questions relating to the banks’ access to retail and wholesale funding, the impact of new regulatoryorsupervisoryrequirements,theeffectoftheECB’sexpandedassetpurchaseprogramme(APP),theECB’snegativedepositfacilityrateandtheeffectofNPLsonthebanks’lendingpolicies.Acrosstheeuroarea,144banksparticipatedinthe2019surveyrounds,ofwhichfourwereMaltesebanks,whichtogetheraccountedforabout91%oftotalresidentbankcredit.3

TheBoxcoversbanklendingdevelopmentsthatoccurredduring2019.ThesurveyswererunpriortotheintensificationofCOVID-19’sspread,andhencerepliesreflectperceptionspriortotheonsetof the pandemic. Meanwhile, the latest round of the BLS that was carried out during April 2020 sheds some light on the lending developments during the coronavirus outbreak.

Credit supply conditionsAsinpreviousyears,domesticparticipantbanksreportedthattheymaintainedtheircreditstandardson loans toenterprisesunchangedat tight levelsduring2019(seeChart1).Similarlysuchcreditstandardswerekeptstableinthefirstquarterof2020,withthemajorityofthedomesticBLSbanksexpecting them to remain unchanged over the second quarter of 2020. In the euro area, although competition from banks continued to have an easing impact on lending standards, overall corporate creditstandardstightenedmarginallyduring2019asaresultofhigherriskperceptionsrelatedtothegeneraleconomicoutlookandindustryorfirm-specificsituationsandtoa lowerextentduetotheimpact of euro area banks’ capital position.

1 ThisBoxwaspreparedbyArianaBartolo,anEconomicsOfficerwithin theFinancialStabilitySurveillanceandResearchDepartmentoftheCentralBankofMalta.Anyerrorsandviewsexpressedinthisboxaretheauthor’ssoleresponsibility.2 Supplyconditionsincludecreditstandardsandtermsandconditions.Creditstandardsrefertothebank’sinternalguidelinesorloanapprovalcriteria,establishedpriortotheactualloannegotiation.Thesespecifytherequiredborrowercharacteristicssuchasincomelevels,ageandemploymentstatuswhichbanksconsiderintheircreditscoringmethods.Credittermsandconditionsrefertotheconditionsofaloanthatabankiswillingtogrant,namelytheinterestrate,loansize,fees,collateralrequirements,maturitytermsandotherconditions.3 The BLS data for all euro area countries are published on the ECB’s SDW.

26


In 2019, domestic BLS banks kept their overall cor-porate credit terms and con-ditions stable (see Chart 2). Nonetheless, the margins on average loans to enter-prises narrowed further, particularly due to pres-sures from competition. All the domestic participating banks kept their corporate credit terms and conditions unchanged during the firstquarter of 2020.

On the other hand, euro area banks reported some tightening of the overall cor-porate terms and conditions due to increased banks’ funding costs, balance sheet constraints and heightened risk perceptions, which also resulted in wider margins for riskier loans. However, some factors such as com-petitive pressures continued to have an easing impact attenuating somewhat the tightening effect and result-ing in some narrowing of margins on average loans to enterprises throughout theyear.

Mortgage credit standards as reported by domesticparticipating banks tight-ened during the second and third quarters of 2019, owing to the introduction of the Central Bank of Malta (CBM) Directive No. 16 on regulation of Borrower-Based Measures (BBM) (see Chart 1).4 Thesethereafterremainedunchangedinthelastquarterof2019andinthefirstquarterof2020,withexpectations that domestic banks will maintain these unchanged also in the second quarter of 2020. Similarly,overall credit termsandconditions formortgages tightened in2019,drivenbydevelop-ments reported during the third quarter of 2019 as half of the domestic respondents tightened their LTVratio,loansizelimitsandtheterm-to-maturitytobringtheminlinewiththerecently-introducedBBM(seeChart2).Thistighteningwaspartlyoffsetbyeasinginthemarginsforbothaverageandriskier loans. Yet, domestic lending rates for mortgages remained higher than those of the euro area, ataround3%and2%,respectively.5 Some easing effect was also reported in the second quarter as

4 https://www.centralbankmalta.org/centralbankofmaltadirectives5 Source:ThefigureforMalta’smortgageinterestrateisfromBR06data.TheeuroareafigureisfromtheECB’sSDW.Figuresare reported as at March 2020.

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Sources: ECB; Central Bank of Malta calculations.

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Sources: ECB; Central Bank of Malta calculations.


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one bank eased its mortgage credit terms and conditions due to higher competitive pressures and higherrisktolerance.Duringthefirstquarterof2020,themajorityofdomesticrespondentskepttheirtermsandconditionsformortgagesstable,withonlyonebankreportingsomeeasingonthebackofnarrower loan margins on average loans owing to higher competitive pressures.

Euro area banks reported some offsetting developments in mortgage credit standards resulting in an overall stable position (see Chart 1). Although pressures from competition continued to be the mainfactorcontributingtotheeasingofmortgagecreditstandards–particularlyinthesecondandthirdquartersof2019– thiswasoffsetbysome tighteningarising fromfundingcostsandbanks’risktoleranceparticularlyinthefirstandlastquartersof2019.Mortgagecredittermsandconditionsmeanwhiletightenedslightlyin2019,partlyrevertingtheeasingreportedinthepreviousyear(seeChart2).Thiswasmainlyduetopressuresfromfundingcosts,balancesheetconstraintsandbanks’risk tolerance, together with a tightening of margins for riskier loans. Euro area banks’ margins on averageloansmeanwhileeasedslightly,partlyoffsettingthetighteningeffectonriskierloans.

After two years of stable credit standards for consumer credit and other lending to households,domestic banks eased such standards during the second and – to a much higher extent – in the third quarterof2019(seeChart1).Thelatter,however,reflectedincreasedlimitsonunsecuredlendingbyone domestic participant bank. Such standards remained stable in the last quarter of 2019. During thefirstthreemonthsof2020,onedomesticBLSbankreportedsometighteningasitreducedthelim-its on unsecured lending in response to the economic impact of the COVID-19 pandemic. Meanwhile, another domestic BLS bank was expecting to ease its credit standards for consumer credit in 2020 Q2tosupportitscustomersmostlyaffectedbytheCOVID-19pandemic.Meanwhile,thetighteningreportedbyeuroareabankspersistedin2019,mainlyowingtoalowerrisktolerancebybanksinlinewith higher risk perceptions related to the general economic environment.

Domestic banks’ credit terms and conditions on consumer credit and other household lending were on average kept unchanged during 2019, with one domestic surveyed bank reporting offsettingresultsinthesecondandthirdquartersoftheyear(seeChart2).Thehighercreditlimitsreportedduring the second quarter of 2019 – on the back of increased competitive pressures and higher risk tolerance – were later tightened owing to the introduction of Central Bank of Malta Directive No. 16 in thethirdquarterof2019,whichimpactedthesizeofloansandterm-to-maturity.6 Meanwhile, during thefirstquarterof2020,alldomesticparticipatingbankskepttheirconsumercredittermsandcondi-tions unchanged.

On the other hand, euro area banks eased their overall terms and conditions on new consumer credit andotherhouseholdlending,mainlyonthebackofcompetitivepressureswhichresultedinnarrowerspreads on average loan margins.

Credit demand conditionsDomestically,adrop incorporatecreditdemandwasobservedduring2019,reflecting lowerfixedinvestment and working capital requirements coupled with competitive pressures from other banks (seeChart3).Meanwhile,inthefirstquarterof2020,twodomesticBLSbanksreportedoffsettingreplies as a result of the COVID-19 outbreak. One domestic BLS bank indicated an increase in cor-porate credit demand as enterprises experienced higher working capital requirements, while another reportedafallinsuchdemandduetolowerfixedinvestmentonthebackofheighteneduncertaintiesand market disruptions. Nonetheless, all domestic participant banks expect their demand for corporate

6 CentralBankofMaltaDirectiveNo.16mayhavetosomeextentimpactedtheprovisionofconsumercreditandotherhouse-hold lending since in some instances additional loans, such as for example to purchase furnishings, were granted in combination with mortgage loans, having the same conditions. These are now granted as a personal loan.

28


loans to increase during the second quarter of 2020 to finance higher workingcapital requirements.

In the euro area, although overall corporate credit demand for the first threequarters of the yearremained positive on the back of the general level of interest rates, mergers and acquisitions and fixedinvestment, a downward trend was observed in the last quarter of 2019 for both large, and small and medium size enterprises. This was due to lower financingneeds,especiallydue to the availability offirms’ internal funds anddebt securities issuance.

After reporting higher demand for mortgages during the first quarter of2019, domestic BLS banks reported a significant dropin demand in the second half of 2019 (see Chart 4). This reflected the stricterregulatoryandfiscalregimeincluding the newly-intro-duced regulatory BBMs.Housing market prospects, competitive pressures and – to a lower extent – con-sumerconfidencealsocontributedtolowerdemandforhousingloansinthesecondhalfof2019.Furthermore,duringthefirstthreemonthsof2020,themajorityofdomesticBLSbanksreportedafall in demand for loans for house purchases owing to uncertain housing market prospects and lower consumerconfidenceowingtothepandemic.Expectationsforthesecondquarterof2020showthatall the domestic BLS banks are anticipating a further decline in the demand for mortgages, as a result of ongoing repercussions from the COVID-19 spread.

Onapan-Europeanfront,similartopreviousyears,euroareabanks’netdemandforhousingloansstrengthenedfurthermainlyonthebackofthelowlevelofinterestrates,favourablehousingmarketprospectsandconsumerconfidence.Otherfinancingneedsincludingdebtrefinancing/restructuringandtheregulatoryandfiscalhousingmarketregimealsohadapositiveimpact.

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Chart 3CORPORATE CREDIT DEMAND(+ indicates increase/ - indicates decrease)

Corporate credit demand Fixed investment

Inventories and working capital

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Sources: ECB; Central Bank of Malta calculations.Note:Theimpactoffactorsrelatesolelytothedomesticcorporatecreditdemand.

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Chart 4MORTGAGE CREDIT DEMAND(+ indicates increase/ - indicates decrease)

Mortgage credit demand Housing market prospects

Regulatory and fiscal regime


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Sources: ECB; Central Bank of Malta calculations.Note: The impact of factors relate solely to the domestic mortgage credit demand.

Consumerconfidence

29


Domestic BLS banks have reported largelyunchangedoverall demand for con-sumer credit and other lend-ing to households during 2019, with the exception of two banks which reported lower demand in the third and fourth quarters (see Chart 5). This was mainlyowing to competitive pres-sures and the use of alter-native finances particularlyvia internal savings. During thefirstquarterof2020,halfof the respondents reported a fall in the demand for con-sumer credit due to a drop inconsumerconfidenceandlower spending on durable consumer goods in response to the COVID-19 pandemic. Although this fall was expected to continue over the second quarter of 2020, one domestic BLS bank reported an expectedrecoveryinitsdemandforconsumercreditandotherlending,linkedwithitsintentiontoease related credit standards.

In contrast, demand for consumer credit and other household lending in the euro area increased throughouttheyear,thoughstillbelowthelevelreportedin2018.Thelowlevelofinterestrates,con-sumerconfidenceandincreasedspendingondurablegoodsallhadapositiveimpactonconsumercredit demand in the euro area.

Ad hoc questionsDuring 2019, Maltese participant banks reported increased access to retail funding largely fromhigher inflowsof short-termdeposits and to a lesser extent from long-termdeposits.Meanwhile,accesstowholesalefundingremainedgenerallystableforthemajorityofdomesticbanks.WhiletheCOVID-19pandemicdidnotimpactdomesticbanks’retailfundingduringthefirstquarterof2020,twodomesticparticipantbanksreportedadeteriorationintheirveryshort-termmoneymarket,withoneofthesebanksanticipatingafurtherdeteriorationinitsinterbankunsecuredmoneymarketinthesecond quarter of 2020.

On their part, euro area banks indicated that their access to wholesale funding improved during 2019, predominantlyonthebackofhigherissuanceofmedium-tolong-termbonds.Accesstosecuritisation,retailfundingandunsecuredinterbankmoneymarketallimprovedforeuroareabanksduring2019.

Withregardstotheimpactofthenewregulationondomesticbanks’lendingbehaviour,inthefirsthalfoftheyearonedomesticBLSbankreportedanincreaseinitsrisk-weightedassetsonaccountof both average and riskier loans as a result of the Capital Requirements Regulation (CRR).

Meanwhile, euro area banks reported that new regulatory or supervisory requirements led to astrengthening of their capital position, and an increase in total assets and liquid assets. Euro area banks’risk-weightedassetsalsorose–drivenentirelybyincreasedlending.Moreover,whilefundingconditionseasedslightly,theeuroareabanks’creditstandardsandcreditmarginstightenedacrossall loan categories in 2019.

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Chart 5CONSUMER CREDIT AND OTHER LENDING DEMAND(+ indicates increase/ - indicates decrease)

Factors


Sources: ECB; Central Bank of Malta calculations.Note: The impact of factors relate solely to the domestic consumer credit demand.

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consumer goods

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30


Surveyresultscoveringtheperiodfromthelastquarterof2018uptothethirdquarterof2019showthattheECB’sexpandedAPPdidnotimpactthedomesticparticipantbanks’assets,liquiditybuffers,marketfinancingconditions,profitabilityandcapitalposition.TheirlendingpoliciesandvolumeswerealsonotaffectedbytheimpactoftheAPP.Meanwhile,duringthelastquarterof2019andfirstquarterof2020,onedomesticparticipantbankreportedthattheAPPandthePandemicEmergencyPur-chaseProgramme(PEPP)contributedtolowertotalassets,wherebythevolumeofeuroareasover-eign bond holdings fell. This bank anticipated a further decline in its total assets but an improvement initsliquiditypositionduringthesecondandthirdquartersof2020,whilethemajorityofthedomesticBLSbanksanticipatednochangesinrelationtotheirassets,liquidityposition,profitabilityandcapitalposition.7 Meanwhile, euro area banks reported that the APP contributed to an improvement in their marketfinancingconditionsandliquiditypositions,butledtoadeteriorationintheirprofitabilityasnetinterest margins narrowed. Furthermore, the APP continued to have a net easing impact on credit standardsparticularlyonhouseholdloansandtermsandconditionsofallloancategories.Euroareabanks indicated a positive impact on their lending volumes for both enterprises and housing loans.

TheECB’snegativedepositfacilityrate(DFR)contributedsomewhattoadeclineintheprofitabilityofmostdomesticrespondents,asreflectedbylowerNII.However,thisdeclinewasattenuatedfol-lowingtheECB’sintroductionofatwo-tiersysteminOctober2019,withthemajorityofthedomesticparticipatingbanksindicatingthatsuchsystemwasbeneficialfortheirprofitability.Meanwhile,oneofthedomesticBLSbanksnotedadeclineinitsprofitabilityduetolowerNIIandmarketfinancingconditions. One of the domestic BLS banks reported a drop in its lending rates for all loan categories resulting in narrower interest rate margins but higher lending volumes owing to the negative DFR. Furthermore, during the April 2020 round, covering developments during the last quarter of 2019 and firstquarterof2020,somedomesticBLSbanksalsoreportedadeclineintheirretaildepositrates.8

Similarly,euroareabanks’NIIfell,togetherwithadecreaseintheirlendingratesandloanmarginsforbothenterprisesandhouseholdloans.Thiswaspartlyoffsetthroughapositiveimpactontheirnon-interestratechargesandlendingvolumesforallthetypesofloans.IntheApril2020BLSround,euroareabanksreportedanegativeimpactoftheDFRondepositrates,withsomerespondentstry-ing to compensate for the negative rates via higher non-interest rate charges on deposits. Euro area banksindicatedthatthetwo-tiersystemhadapositiveimpactontheirprofitabilityand–toamuchlowerextent–ontheirliquiditypositionandmarketfinancingconditions.Inaddition,euroareabanksreported that lending rates across loan categories declined, while deposit rates for both enterprises andhouseholdsrosefollowingtheintroductionofthetwo-tiersystem.

Withregardstotheimpactofnon-performingloans,themajorityofthedomesticBLSbanksdidnotreportanychangesrelatedtotheir lendingpolicies,althoughoneofthereportingdomesticbanksreportedsomeeasingofcreditstandardsformortgagesduringthefirsthalfof2019onthebackofstrong economic growth. Throughout 2019, euro area banks meanwhile reported a tightening of their creditstandardsforall loancategories,andtermsandconditions–particularlyforcorporatesandconsumer credit and other lending to households when considering the impact on their NPL ratio.

7 DuringtheApril2020round,thesurveyquestionontheimpactof theECB’sAPPwasamendedto includethedirectandindirect effects of both the APP and the PEPP, following the COVID-19 pandemic.8 IntheApril2020round,bankswereaskedforthefirsttimetoindicatetheDFRimpactondepositsheldbycorporatesandhouseholds.Also,BLSbankswereaskedtoassessthe impactof theECB’stwo-tiersystemontheirprofitability, lendinganddeposits,comparedwiththesituationwithoutatwo-tiersystem.

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Non-performing loansNPLs declined by 2.5% in 2019,entirelyattributedtoimprovementsin the resident loan portfolio. Resi-dent NPLs accounted for 82.1%of overall NPLs with non-resident NPLs accounting for the remainder (see Chart 2.7). Resident corporate NPLs fellbyabout13%,mainly inthe construction and real estate sector. In light of this, their share dropped by 6.1 percentage pointsto26.4%ofoverallNPLs in2019.Meanwhile, resident household NPLs dropped by 4.8% reflectingdeclines in both non-performing mortgages and consumer credit, down by 4.0% and 7.5%, respec-tivelytorepresent28.5%ofoverallNPLs.

The drop in NPLs was in part due to legacy loans,withNPLs thathavebeen non-performing for more than 90 days declining, including thoseofover fiveyears.Meanwhile, theincrease in non-resident NPLs mainly reflected those loans thatareunlikelytopaybutpastdueforlessthan90days.

The core domestic banks’ overall NPL ratio improved marginally to3.2%in2019(seeChart2.8).4 The resident NPL ratio narrowed by0.7percentagepointto3.1%,withimprovementsprimarilyreflectedintheNPLratioforresidentNFCloans,whichdroppedby1.6percentagepointsto8.2%in2019.TheNPLratioforresidenthouseholdlendingimprovedby0.4percentagepointto2.6%,indicatingpositivedevelopmentsinbothresidentmortgagesandconsumercredit,withtheirNPLratiodecliningto2.2%and5.2%in2019,downfrom2.5%and5.4%ayearearlier,respectively.Incontrast,thenon-residentNPLratiorosefrom1.7%in2018to3.7%in2019,onthebackofhigheroutstandingnon-residentNPLsandadeclineinthevolumeof non-resident loans.

Thecoredomesticbanksmanagedtoexpandtheirbalancesheetwhilealsoimprovingtheirriskprofile.Inthisregard,theshareoftotalrisk-weightedassets(RWA)tototalassetsdeclinedfrom48.5%in2018to46.1%in2019(seeChart2.9).RWAdeclinedby2.9%whilethebanks’balancesheetgrewfurther.CreditriskimprovedonthebackoflowerRWAattributedtoloanssecuredbymortgagesonimmovableproperty,as well as credit risk related to institutions and other exposures. Nevertheless, credit risk exposures still accountedforthebulkofRWA.Risksarisingfromcreditvaluationadjustmentsalsocontributedpositivelytolower RWA, however to a much lower extent, remaining negligible as a share of total RWA. On the other hand,

4 TheNPLratiostoodabovetheEUbanks’averageNPLratioof2.7%(asat2019Q4).Source:EuropeanBankingAuthority(EBA)RiskDashboard.

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Chart 2.8NPL RATIOS − CORE DOMESTIC BANKS(per cent)


Chart 2.8NPL RATIOS − CORE DOMESTIC BANKS(per cent)


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Chart 2.7SECTORAL ALLOCATION OF LOANS AND ADVANCES AND NPLs −CORE DOMESTIC BANKS (per cent)


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RWA allocated for operational risk roseby3.9%toaccountfor8.6%oftotal RWA, while foreign exchange and commodities risks, and other risk types, also increased whileremaining minimal in the composi-tion of RWA.

Loan loss provisionsThe core domestic banks’ coverage ratio narrowed by 0.9 percentagepoint to 43.7%mainly on thebackof lower specific provisions whichpusheddownthespecificcoverageratio to 29.0% in 2019 (see Chart2.10). Moreover, collective provi-sions covering non-performing loans also declined, contributing to around 11 percentage points of the total cov-erage ratio. The “Reserve for Gen-eralBankingRisks”,asperBankingRule09/2019,roseby2.2%,addinganother 3.6 percentage points to the overall coverage ratio. Meanwhile, core domestic banks continued to relyoncollateralasacreditriskmiti-gating mechanism, with real estate representing87.0%ofcollateral. In2019, the amount of collateral back-ing NPLs dropped by around 20%with the ratio of collateral backing total NPLs narrowing by 11.3 per-centage points to around 53%.Asa result, when considering collateral together with provisions, NPLs are almostcompletelycovered. The securities portfolioAt €5.8 billion, the securities portfolio accounted for almost a quarter of the banks’ balance sheet. The expan-sionintheinvestmentportfolioemanatedfrombothhigherbondandequityholdings,whichroseby0.3%and2.2%,respectively.Furthermore,coredomesticbanks’allocationbetweenbondsandequityremainedverysimilartothatofthepreviousyear,withbondsaccountingforabout92%oftheoverallsecuritiesport-folio.Theincreaseinequitieswasdrivenprimarilybyonebankwhichinvestedmoreheavilyinequitiesofresident public sector NFCs.

Holdings of domestic debt securities rose by 2.2%, reflecting increased holdings of Malta GovernmentStocks (MGS) which accounted for just over a quarter of debt securities (see Chart 2.11). Holdings of domes-ticcorporateandbankbondsalsorosebutremainedlimitedto1.6%and0.2%oftheoveralldebtsecuritiesportfolio,respectively. Meanwhile,holdingsofforeigndebtsecuritiescontractedby0.5%butneverthelessaccountedforaround71%ofthedebtsecuritiesportfolio.CoredomesticbanksshedsomeoftheirholdingsinUKbanks,butat23.8%foreignbankbondsstillremainedanimportantelementinthebondportfolio.Holdingsofforeignsov-ereigndebt,mainlyofeuroareagovernments,increasedbyaroundafifthto€1.7billionpushingtheirshare

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Chart 2.10COVERAGE RATIO − CORE DOMESTIC BANKS(EUR millions; per cent)


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inthebondportfolioby5.0percent-agepointsto30.7%.

Bonds booked at fair value through other comprehensive income (FVOCI) increasedbyalmost15%torepresent35.3%ofdebtsecuri-ties. Despite decreasing by 6.0%,debt securities listed at amortised cost (AMC) still continued to repre-sent the largest share accounting for64.1%ofalldebtsecurities.Theremaining bonds were designated atfairvaluethroughprofitandloss(FVTPL)whichdeclinedby13.7%during 2019.

Securities’ asset quality The ratings composition of the bond portfolio improved in 2019 as holdings of high-rated bonds rose byaround16% toaccount for justabove 43% of the bond portfolio(see Chart 2.12). Meanwhile the share of medium-rated bonds fell by2.2percentagepointsto43.9%,but continued to account for the largest portion of the bond portfolio. Low-rated and unrated investment gradebondsalsofell,by14.3%and25.0%,respectively.Asaresult,theshare of low-rated bonds of total securities dropped from 4.4% in2018to3.8%,whilethatofunratedinvestment grade bonds fell from 12.4%in2018to9.3%.Moreover,core domestic banks did not record anynon-performing securities andconsequently their non-performingexposures (NPE) ratio improved slightlyto2.5%.5

2.1.3 Funding and Liquidity

Customer deposits Customer deposits remained the preferred funding source for core domesticbanks,financingjustover80% of assets in 2019. Althoughslowing down somewhat compared to the previous year, customerdeposits rose by 3.6%exclusivelyfrom residents (see Chart 2.13). This increase in resident depos-its was mainly driven by house-5 Non-performing exposures include defaulted loans and securities as a share of total loans and securities.

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Chart 2.12 BOND HOLDINGS BY RATING − CORE DOMESTIC BANKS


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Chart 2.13 CONTRIBUTION TO GROWTH IN CUSTOMER DEPOSITS − CORE DOMESTIC BANKS (percentage points; per cent)


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hold depositswhich rose by 7.3%and accounted for more than half of the balance sheet size, and almost two-thirds of the overall customer deposits, despite the marginal decline in the weighted average interest rate (see Chart 2.14). Otherwise, deposits from resident private NFCs declined for the second consecutive year,down by 2.9% to 13.6% of theoverall customer deposits. This dropwas,however,bankspecificasgenerally residentdepositsbyprivateNFCscontinuedtoflowin.Meanwhile, other resident cus-tomerdepositsgrewby10.2% torepresentalmost12%ofcustomerdeposits, reflectinghigher inflowsfromotherfinancialinstitutions(OFIs)andfinancialauxiliaries(FAs),captivefinancialinstitutionsandmoneylenders(CFIML),thegeneralgovernment,insurancecorporationsandpensionfunds(ICPFs),and public NFCs.6

Althoughsomebanks started to tapnon-resident customerdeposits, overall thesedeclinedby14.5%overthepreviousyearduetolowerdepositsfromOFIsandFAs,CFIML,followedbyprivateNFCsandhouseholds to a lower extent. As a result, the share of non-resident customer deposits contracted from 11.5%in2018to9.5%in2019oftotalcustomerdeposits,financinglessthan8%ofthecoredomesticbanks’ assets.

Retail customers’ preference for short-term liquid assets persisted as demand depositswent up by 1.6percentagepointstoaround78%ofthetotaldeposits.Meanwhile,theshareoffixed-termdepositswithamaturityofupto12monthsdeclinedby1.3percentagepointsto14.3%ofdepositswhilethosewithaterm-to-maturityexceedingoneyearremainedstableat7.8%ofallcustomerdepositsin2019.Euro-denominateddeposits remained themostpopular, representing90.9%ofall customerdeposits in2019,while foreigncurrencydenominateddeposits remained limitedandweremostlydenominated inUSdollarandPoundSterling.

Eurosystem and wholesale funding Bytheendof2019,coredomesticbanksdidnothaveanyoutstandingmonetarypolicyoperations,followingtherepaymentofaTLTROIIbyonebank.

Thecentralbank-eligibleCounterBalancingCapacity(CBC),definedasthestockofunencumberedassetsorotherfundingsourceswhichareavailabletocoverpotentialfundinggaps,roseby3.2%to€3billion.Thisrepresented12.4%ofthebalancesheet,upfrom12.2%inthepreviousyear.Thisisindicativeofthefundingspaceavailableintimesofliquiditystress,withthecentralbank-eligibleshareofCBCamountingto1.4timesthetotalLCRnetcashoutflows,suggestingthatthesebankscanonaggregatesurvivearound40daysofnetcashoutflowsinastressedscenario.Inaddition,centralbank-eligibleCBCasashareoftotalcovereddepositsundertheDepositorCompensationScheme(DCS)narrowedby1percentagepointto25.8%byend2019.Atbanklevel,therearewidedivergenceswiththeratiospanningfromalowof6%toalmost60%.

6 ‘Otherresidentcustomerdeposits’includedepositsfromthegeneralgovernment,ICPFs,monetaryfinancialinstitutions(MFIs),non-MMF investment funds, OFIs, FAs, CFIML, and public NFCs.

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Chart 2.14BANKS' LIABILITIES COMPONENTS − CORE DOMESTIC BANKS (2019)(per cent)

Source: Central Bank of Malta.Note:Totalcustomerdepositspiechartrepresentsthe80.7%inthetotalliabilitespiechart.Thisaddsupto100%.

Total liabilities Total customer deposits

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Meanwhile,interbankexposures(excludingrepos)asashareofliabilitiesfellby1.5percentagepointsto3.8%in2019,mainlyreflectinglowernon-residentintragrouplendingandfundingfromotherunrelatedcreditinstitutions.Debtsecuritiesissuedalsodeclinedby15.3%in2019toaccountforjustover1%ofthetotalliabilitiesasmaturingbondsoftwocoredomesticbankswerenotfullyrolled-over.Incontrast,fundingfromreposand‘otherliabilities’roseby11.5%and10.1%,respectively,butstillfinancedamorelimitedshareoftotalassets,at1.0%and4.5%,respectively.

Liquidity Inlinewithpreviousyears,coredomesticbankscontinuedtooperateonthebackofampleliquiditybuffers,withtheLCRimprovingto341.6%in2019from316.1%in2018(seeChart2.15).Thisimprovementreflectedhigherliquidassetswhichroseatafasterpacethannetliquidityoutflows.Liquidassetsroseby12.2%asa result of higher withdrawable central bank reserves, central government assets, and multilateral develop-ment bank and international organ-isations assets while net liquidityoutflowswentupby3.8%.Inaddi-tion, the customer loan-to-deposit ratio for core domestic banks declined by 1.3 percentage pointsto59.6%in2019,remainingsignifi-cantlybelowtheeuroareaaverageofabout102%.7

2.1.4 Capital and Leverage Core domestic banks expanded further their Tier 1 capital base, although at a slower pace when compared to recent years. Asa result, the Tier 1 capital ratio strengthened by 1.4 percentagepoints to 17.4% as at end-2019(see Chart 2.16). All banks reported higher Tier 1 capital ratios while continuing to report some level of voluntary buffers above the mini-mumregulatoryrequirements.Thisincludes extra capital add-ons high-lighted under the Capital Require-ments Directive (CRD) IV such as the capital conservation buffer (CCB), which stood at 2.5 percent-age points on Tier 1 capital ratio for 2019. Furthermore, as at end 2019, some of these banks were required to hold additional capital in line with the Other Systemically ImportantInstitutions (O-SIIs) buffer and Pil-lar II requirements (see Chapter 5).8 Atthesametime,theCountercycli-calCapitalBuffer(CCyB)remainedunchangedat0%.9

7 Source: ECB SDW8 PillarIIrequirementsincludethecapitalbufferarisingfromtheSupervisoryReviewandEvaluationProcess(SREP)andguidancelevels.9 Refer to https://www.centralbankmalta.org/countercyclical-capital-buffer.

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Chart 2.15 LIQUIDITY COVERAGE RATIO − CORE DOMESTIC BANKS (EUR millions; per cent)


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Chart 2.16 CHANGE IN TOTAL OWN FUNDS, CAPITAL AND LEVERAGE RATIOS − CORE DOMESTIC BANKS (EUR millions; per cent)


https://www.centralbankmalta.org/countercyclical-capital-buffer

36


Furthermore,Tier2capitalalsoimprovedforthesecondconsecutiveyear,upby15.3%onthebackofhighereligiblesubordinatedloansreportedbytwocoredomesticbanks.Inlightofthesedevelopments,totalownfundsforcoredomesticbanksroseby6.8%toreach€2.2billionbyend2019.This,coupledwithlowerRWAs,ledtoanincreaseintheTotalCapitalRatioto19.9%from18.1%in2018.Theenhancedcapitalbufferswerealsosupportedbyanimprovementintheleverageratiowhichtrendedupwardstoreach7.7%bytheendof2019,exceedingthe3%minimumrequirementstipulatedintheCRR.

Goingforward,challengestothecoredomesticbanks’profitabilityarehighlylikelytoincreaseasaresultof the COVID-19 pandemic. As banks anticipate increased expected credit losses, higher provisioning is expectedtotakeplace.At thesametime,the introductionofmoratoriaonloanrepaymentsshouldeasetheburdenonborrowersand limit tosomeextent immediateadverseconsequencesonassetquality. Incontrast,thetemporaryrestrictionsimposedbyGovernmenttopreservepublichealthhavehaltedeconomicactivity,whichinturn,affectedthebanks’bottomlineintermsoflowerincomefromfeesandcommissionsreceivable, foreign exchange and other non-interest income activities. Furthermore, lower demand for house purchases could result in a slowdown in this kind of credit, leading to lower income from intermediation activities.Ontheupside,banksareexpectinghighershort-termdemandforcorporateloanstofinancework-ingcapital,whichshouldpartlyoffsettheexpectedslowdowninloans.

2.2 Non-core Domestic BanksIn 2019, the number of non-core domestic banks remained unchanged at five.However, their activitiesexpandedby9.3%withoverallassetsaccountingfor22.2%ofGDP.Growthwasmainlydrivenbyhigherplacements with the Central Bank of Malta and loans to both residents and non-residents, with resident loans picking up momentum as these banks continued to penetrate the domestic market. Yet, resident loans stillaccountedforjust2.4%ofallresidentcustomerloansinthebankingsector.Inturn,elevatedlendingactivitywasprimarilyfundedbyincreasednon-residentcustomerdepositsassomebanksalsoventuredintoonline deposit platforms to widen their funding sources.

2.2.1 ProfitabilityTheoverallprofitabilityofthisgroupofbanksimprovedsubstantiallybutmainlyonthebackofonebankwhich received pronounced dividends from one of its subsidiaries. When the latter is taken into consider-ation,pre-taxprofitssurgedfromaround€5millionin2018to€37.8millionayearlater,pushingthepost-taxROEandROAto11.5%and1.3%from1.5%and0.2%ayearearlier.Excludingthesedividends,theprofitablilityofthesebankswouldstillhaveimproved,largelyduetoanincreaseinNIIfromintermediationand lower net impairment charges.

The notable increase in dividends received by one bank drove upoverall non-interest income bymorethan50%torepresentaroundtwo-thirds of gross income (see Chart 2.17). Yet, when excluding the effect of these dividends, other non-interest income declined on the back of lower fees and commissions,whichfellbyafifthin2019,inpartreflectingthede-riskingmeasures on some portfolios. Nevertheless, since the operations ofthesebanksarelargelyfocusedon international trade finance,documentary collection andcustody services among others,

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Chart 2.17 MAIN COMPONENTS OF PROFITS − NON-CORE DOMESTIC BANKS (EUR millions)

Source: Central Bank of Malta. Note: Grey bars indicate pre-tax profits in absolute amounts. Teal (positive) and red (negative) bars indicate yearly changes in profit components. NII stands for net interest income.

37


feesandcommissionincomeremainedanimportantsourceofrevenue,representingaround70%ofnon-interest income excluding dividends.

NIIrosebyalmostathirdoverthepreviousyearandwasentirelydrivenbyhigherlendingvolumesasother-wisetheinterestratespreadfellby0.3percentagepointowingtoafasterdropintheweightedaveragerateon loans than that on deposits. Other NII also increased, however, it still accounted for just over a quarter oftotalinterestincome.Profitabilityofthesebankswaspartiallyaffectedbyhighernon-interestexpenses,mainlyintheformofstaffwagesandhigherinvestmentsinITinfrastructureas,otherwise,netimpairmentcharges decreased during 2019.

Despiteregisteringanincreaseinnon-interestexpenses,thecost-to-incomeratioimprovedbyaconsider-able16percentagepointsto45.6%,boostedbytheriseindividendsmentionedearlier.Shouldtheeffectofthesedividendsbeexcludedforboth2018and2019,thecost-to-incomeratiowoulddeteriorateby1.6percentagepointsto73.8%.

2.2.2 Asset Quality

The loan portfolioLendingby thenon-coredomesticbanks increasedby10.4% to sur-pass the €1 billion mark, account-ing for 37.0% of their overall bal-ance sheet. The expansion in the loan book originated primarilyfromthenon-bankfinancialsector,mainlyfromtrusts,followedbytheconstruction and real estate sec-tor,andhouseholdsandnon-profitinstitutions serving households (NPISH).At39.3%ofthecustomerloan book, loans to the non-bank financial sector represented thelargest share. These grew by justover 7 percentage points from 2018 (see Chart 2.18). Loans to the wholesale and retail trade sector fellbyjustoverafifth,butremainedthe second most important sec-tor,accountingforalmostafifthofcustomer loans. Although loans to households almost doubled, these representedjustabove6%ofthesebanks’ loan book as at end 2019.

While both resident and non-res-ident loans increased, the geo-graphical allocation changed some-what. Loans to European countries other than the euro area grew byalmost 60% to represent around24%ofcustomerloans(seeChart2.19). Meanwhile, loans towards euro area countries increased mar-ginally,yet theirshare in the retail

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Chart 2.18 CUSTOMER LOANS BY SECTOR – NON-CORE DOMESTIC BANKS

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Chart 2.19 CUSTOMER LOANS BY RESIDENCY ̶̶ NON-CORE DOMESTIC BANKS (shares in per cent)

Source: Central Bank of Malta. Note: Data for euro area excludes Malta.

38


loanbookfellby1.6percentagepoints to16.9%.Lendingtowardsnon-EUcountries fellbyalmost10%toaroundathirdof the loanbook.Overall,non-residentcustomer loans increasedby7.6%torepresentaroundthree-quartersofthecustomerloansportfolio.Thesewerelargelyconcentratedinthefinancialandinsurance activities sector and, to a lesser extent, in the wholesale and retail trade sector, construction, real estateandmanufacturing.Residentcustomerlendingincreasedbyjustoverafifthtoaccountforaquarterofthe customer loan book. The penetration of these banks in the resident retail market was most pronounced in thehouseholdsector,mainlyconsumercredit,withsuchbankscateringfor11.5%oftheoverallresidentcon-sumercreditinthesystem.Loanstotheresidentconstructionandrealestate,andfinancialandinsurancesectorsalsogrew.Nevertheless, excluding consumer credit, linkswith thedomestic economy remainedlimited, with the share of resident customer loans in overall resident lending of the banking sector standing atjust2.4%.

Interbankexposuresdeclinedbyjustoverathirdtoalmost13%oftotalassetsin2019.Thiscontractionwasdrivenbybothlowerresidentandnon-residentplacementswithunrelatedcreditinstitutions.

TheoverallNPLratioofthiscategoryofbanksincreasedby1.9percentagepointsto5.5%mainlyonthebackofhigherNPLsbyonebank.Excludingthisbank,theoverallNPLratiowouldhavestoodatjust0.5%,upfrom0.1%inthepreviousyear.Thenon-residentNPLratioroseto8.8%from4.5%ayearearlier,withthebulkoftheincreasestemmingfromthewholesaleandretailtradesector.Accordingly,theshareofthissector’s non-resident NPLs grew to almost two-thirds of all non-resident NPLs. Resident NPLs also rose, up by13.8%buttheresidentNPLratioremainedcontainedatjust1.9%.TheseNPLsweremainlyconcentratedin the OFIs sector and corporates operating in the administrative and support services activities and in the wholesale and retail trade. As these banks expanded their retail loan book, credit risk rose commensu-rately,withriskexposuresaccountingforaround87%ofRWAs.Meanwhile,inlinewiththesurgeinNPLs,provisionsalsorose–albeitataslowerpace–upby9.1%.Around41%ofoverallNPLsarecoveredbyprovisions. Taking into consideration the collateral backing NPLs together with the provisions, coverage will increaseto59%,althoughstillleavingsomeNPLsexposedtocreditrisk.

The securities portfolioTheinvestmentportfoliocontractedby3.4%to€711.8milliontostandatalmostaquarteroftotalassetsin2019.

Thebondportfoliocontractedby9.2% to represent13.4%of totalassets.Thesebankschangedsome-what their portfolio allocation, as theyincreasedinvestmentsinbothdomestic and foreign sovereign paper, while shedding a signifi-cant amount of their foreign bank bonds (see Chart 2.20). As a result, investments in foreign sovereign paper accounted for a large share ofthebondportfolio.Thesemainlyreflected holdings of euro areagovernment paper, and to a lower extent non-EU government bonds. Domestic sovereign paper became the second most preferred invest-ment type for thisgroupofbanks,followedby investments in foreignnon-bank corporate bonds. The lat-tercontractedbyjustoverafifthtoaround11%oftheirbondportfolio.As a result of these developments,

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Chart 2.20 BOND PORTFOLIO − NON-CORE DOMESTIC BANKS (EUR millions)


39


eventhegeographicalbondallocationchangedsomewhat,withthedomesticbondportfolioexpandingbyjustover50%,albeitstillaccountingforaroundafifthofthebondportfolio.

Althoughhigh-ratedbondscontractedby8.1%,theirshareinthebondportfolioincreasedby0.7percentagepointtoalmosttwo-thirds.Meanwhile,unratedandspeculativebondsfellsignificantlybyjustoverathird,pushingdowntheirshareinthebondportfolioby6percentagepointsto15.4%.Conversely,theshareoflow-andmedium-ratedbondsroseto8.6%and12.9%,respectively.Consequently,thequalityoftheirbondportfolioimprovedoverayearago.

Equityholdingsincreasedbyalmost5%annually,reflectinghighernon-residentequityholdingsinnon-bankfinancialintermediariesandmoneymarketfunds(MMF),asotherwisethesebankssoldaround30%oftheirunits indomesticnon-moneymarket investment fund.Asaresult, theshareofdomesticequityholdingsaccountedforarounda thirdof totalequityholdings.Followingthesedevelopments, theassetallocationratio of bonds and stocks became more balanced from 60:40 in 2018 to 55:45 in 2019.

2.2.3 Funding and LiquidityThe upward trend in customer deposits observed in recent years persisted. These grew by 12.1% tofinance just over 70% of these banks’ business activities.Against this backdrop, the level of covereddepositsundertheDCSroseby16%.Similartopreviousyears,non-coredomesticbanks’preferenceintargetingnon-residentcustomerspersisted,asthesesurgedby16.2%toaccountforaround77%oftotalcustomerdepositsandaround55%oftheirbalancesheetsize.Thesebanksobtainedthemajorityoftheirretailfundingfromnon-residenthouseholdsandOFIswhichrosebyaround12%and40%,respectively.Incontrast,non-residentcorporatedepositsfellbyjustoverafifthtoaccountfor8.0%ofoverallcustomerdeposits.Residentcustomerdepositsrosebyamarginal0.3%tofinance16.3%oftotalassets.Duringtheyear,thesebankssubstitutedsomewhattheirdomesticfundingsourcesasfundingfromresidentOFIsincreased, to become the most preferred domestic funding source while funding from resident households declinedbyaquarter.Meanwhile,residentcorporatedepositsalsoretreatedbyaroundafifth,whichwaspartiallycompensatedforbyhigherdepositsfromdomesticnon-MMFinvestmentfunds.

Despitebeinganother importantsourceof funds, interbank funding fellby12.6%tofinancealmost11%of totalassets.Theseweremainly in the formofdeposits fromunrelatednon-residentcredit institutionsreceivedbyonebank.Residentinterbankfundingremainedlimitedtojust4.6%oftotalinterbankexposuresbythiscategoryofbanks.Bytheendoftheyear,Eurosystemfundingmorethandoubledto€45.7millionparticularlythroughthebanks’participationinTLTROIII,andthetappingoftheone-weekUSdollarfundingoperations.Duringtheyear,thecentralbank-eligibleCBC,definedasthestockofunencumberedassetsorotherfundingsourceswhicharelegallyandeffectivelyavailableto institutionstocoverpotential fund-inggaps,rosebyalmost40%to€663.7million,representing23.5%ofthebalancesheetposition,upfrom18.4%inthepreviousyear.Thisisindicativeofthefundingspaceavailableintimesofliquiditystress,withthecentralbank-eligibleshareofCBCamountingto2.6timesthetotalLCRnetcashoutflows,suggestingthatthesebankscanonaggregatesurvivearound75daysofnetcashoutflowsinastressedscenario.Inaddition,centralbank-eligibleCBCasashareoftotalcovereddepositsundertheDCSstoodat62.3%byend 2019.

TheliquiditypositionofthesebanksremainedhealthyasevidencedalsobythehighLCRof381.7%.AllbanksreportedanLCRsignificantlyabovethe100%regulatorythreshold,signallingthatthesebankshaveampleliquiditybuffers.Liquidassetsarelargelyintheformofcentralbankandgovernmentassets.

2.2.4 Capital and Leverage Similartopreviousyears,thecapitalpositionofthesebanksremainedadequate,withthetotalandTier1capital ratiosbothstandingat17.1%(seeChart2.21).During2019, the increase in riskweightedexpo-suresof4.2%wasmorethancompensatedbyasimultaneousincreaseintotalownfundsof3.5%.Atthesametime,theriskprofileofthesebankswasreducedslightly,astheratioRWAstototalassetsdeclined

40


by3.2percentagepointsto60.7%.The expansion in total own funds wasentirelyunderpinnedbyhigherTier 1 capital, as Tier 2 capital fell as one bank shed off completelyitsownTier2capital.Themajorityof riskexposuresaremainly com-posed of credit exposures derived from corporates, and to a much lower extent, in operational risk exposures and foreign exchange risk exposures.

Similarly,at9.4%thenon-risk-basedleverage ratio remained healthy,with all banks exceeding the mini-mumregulatorythresholdof3%.

2.3 International BanksThenumberofinstitutionsclassifiedasinternationalbanksincreasedto14in2019.Fouroperatedasbranchesof foreign banks, with the remainder operating as subsidiaries or stand-alone banks. The business model ofthesebanksfocusesalmostentirelyonnon-residents,henceexhibitingnegligiblelinkswiththedomesticeconomy.Thecoreactivitiesofthisgroupisvaried,rangingfromtradefinancingandfactoring,paymentsandsettlements, to wealth management and lending to both retail and wholesale customers. Wholesale funding is thepreferredavenueoffunding,thoughsomebanksalsorelyonretailcustomerdeposits.

Duringtheyear,totalassetsofthiscategoryofbankscontractedby21.1%tostandat102.1%ofGDP.Thiscontractionwasmainlydrivenbythetwolargestbranchesofforeignbanks,whichhavecontinuedtodown-size their operations. Should all branches be excluded, the balance sheet size of the remaining banks would havestillcontracted,albeitataslowerrateof4.7%.

2.3.1 Branches of Foreign Banks

2.3.1.1 Profitability Pre-taxprofitsofthefourbranchesofforeignbanksmorethanhalvedto€111.4millionin2019,withthepost-tax ROA contracting from 1.4% in2018 to0.8%ayear later(see Chart 2.22). The deteriora-tioninprofitswasmainlydrivenbylower NII which was partly offsetbyhighernon-interest incomeanddeclines in net impairment charges and operating expenses.

NIIdroppedbyasignificant72.7%,as the fall in interest income outpaced reductions in interest expenses. Indeed, interest income declinedby38.6%,almostentirelydue to lower income from invest-ments as branches continued to shed holdings of foreign non-euro government paper. Interest income from intermediation also fell by

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Chart 2.21 CAPITAL AND LEVERAGE RATIOS − NON-CORE DOMESTIC BANKS (per cent)

Source: Central Bank of Malta. Note: The leverage ratio using a fully phased-in definition of Tier 1 is based on COREP figures.

41


0.5%duetolowerincomeearnedoneuro-denominatedloanstoforeignNFCsandonplacementswithpar-entbanks.Suchweakeningreflectedlowervolumesofapprovedloans,asotherwisetheweightedaverageinterestrateontheseloansstoodrelativelyunchangedat3.6%in2019.Meanwhile,interestexpensefellbyaroundonefifthoverthepreviousyear,onaccountofbothlowercustomerdepositsandinterestratescharged on such deposits.

Profits fromnon-interestbearingactivities tripled to represent40.8%of totalgross income in2019.Thisrecovery from previous years’ reported losseswasmainly attributed to higher income earned from for-eignexchangerevaluationsandlowernon-tradinglossesfromthedisposaloffinancialassetsclassifiedatFVOCI.

Netimpairmentchargesalsocontributedpositivelytoprofitability,fallingbyjustunderathirdin2019fol-lowingsignificantincreasesin2018.Similarly,non-interestexpensescontractedbyalmostathirdoverthepreviousyearonaccountofreductionsinoperatingexpenses.Branchescontinuedtoreportmodestoperat-ingcosts,whichasashareoftotalassetsstoodatjust0.1%.Intermsofcost-efficiency,thecost-to-incomeratioincreasedby1.4percentagepointsover2018,thoughitremainslowat5.7%,mirroringlowoperatingcostsgiventheirstrongrelianceontheirheadofficeforoperationalsupport.

2.3.1.2 Asset Quality

The loan portfolio Customerloansissuedalmostexclusivelytonon-residentsdeclinedby11.8%,yetasashareoftotalassetstheseincreasedby5.3percentagepointsto38.0%in2019.Corporateloansdeclinedby15.6%,butstillaccounted formore than three-quarters of the customer loanportfolio andweremainly concentrated inthetransportationandstoragesector,construction,energy,manufacturingandadministrativeandsupportservicesactivities(seeChart2.23).Meanwhile,loanstonon-residentOFIsincreasedby3.8%over2018,representingjustunderaquarteroftheloanbookandaround9%ofthebalancesheetsizein2019.Loansissued towards resident customers remained negligible.

Interbankexposuresfellby8.7%in2019,buttheirshareintotalassetsroseby2.3percentagepointsto13.9%.10 Although interbank placements with unrelated non-resident banks declined, these still accounted formorethantwo-thirdsoftheoverallinterbankexposuresandaround9.5%oftotalassets.Ontheotherhand,interbankexposuresofbrancheswiththeirparentandsubsidiarycompaniesincreasedby2.7%over2018, and accounted for 4.4% oftotal assets. Placements with the CentralBankofMaltafellbymorethan half compared with the same period last year, accounting for4.0%oftotalassetsin2019.

Theassetqualityof the loanport-folio of these branches improved, with theNPL ratio easing to 1.2%in2019 from1.4% in thepreviousyear. The level of non-perform-ing loans declined by more thana quarter over 2018, stemming mainlyfromnon-residentOFIsand,to a lower extent, foreign NFCs specialised in the manufacturing and construction sector. Compared to 2018, provisions halved to €21.2

10 Interbank exposures include loans and deposits reported on the assets side and exclude interbank repos and securities.

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Chart 2.23 CUSTOMER LOANS BY SECTOR – BRANCHES OF FOREIGN BANKS


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million in 2019. Consequently, thecoverageratiodroppedby12.9per-centagepointsto27.7%in2019,asthe drop in provisions outpaced the drop in NPLs.11 While the collateral underlying non-performing loansmitigates somewhat credit risk, NPLs are not fully covered, withprovisions and collateral amounting toabout63.6%ofNPLs.

The securities portfolioThe contraction in the balance sheetofthebrancheswasprimarilydriven by a reduction in the secu-ritiesportfolio,whichfellbyalmosta third. Thus, their share in total assetsdroppedto31.4%in2019–3.1 percentage points lower than in thepreviousyear.Holdingsofforeignsovereignbonds,largelynon-euroareagovernmentpaper,stillrepre-sented the bulk of the securities portfolio (see Chart 2.24). At the same time, investments in MFI bonds more thanhalvedtoaccountfor10.4%ofthesecuritiesportfolio.Giventhepredominanceofnon-euroareapaperintheportfolioofthesebranches,whichreflectsthelocationoftheirrespectiveheadoffice,suchportfoliosfeature a low investment rating.

2.3.1.3 Funding and Liquidity Wholesalefundingforthebranchescontractedby13.3%,mainlyduetolowerplacementsfromtheirrespec-tiveheadoffices.Nevertheless, it remained themostpreferredsourceof funding,upby9.0percentagepointsover2018,andfinancing73%ofthebalancesheet(seeChart2.25).12 Meanwhile, lower interbank placementsbyunrelatedcreditinstitutionswerealsoreported.Similarly,reposwithunrelatedcreditinstitu-tionsfellby16.5%,fundinganother10.6%oftotalassets.

Customer deposits fell by morethan two thirds over 2018, pushing downtheshareintotalliabilitiesby9.5percentagepoints to just6.8%in 2019. While deposits remained mostly sourced from foreign pri-vateNFCs–accounting for73.7%of total customer deposits – with-drawals were reported from pri-vateNFCsoperatingmainly in thewholesale and retail trade and man-ufacturing sector. Deposits from non-resident OFIs and households also fell, thoughbya lowerextent,andaccountedfor13.4%and0.4%of total customer deposits, respec-tively. Meanwhile, deposits frominsurance companies and pen-sionfundsincreasedbymorethan

11 ProvisionsfortwobrancheswhodonotreportanyNPLsareexcludedfromthecalculationofthecoverageratio.12 Wholesale funding includes interbank deposits and loans reported on the liabilities side, but excludes repurchase agreements.

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threefoldto12.5%ofthecustomerportfolioin2019fromjust1.2%ayearearlier.Internalfundingintheformofcapitalandreservesrepresentedanother1.2%oftotalliabilitiesin2019.Fundingfromresidents,largelyhouseholds, remained negligible and shrank further to just €0.6 million in 2019 from €1.7 million in 2018.

2.3.2 Subsidiaries of Foreign Banks and Stand-alone Banks

2.3.2.1 Profitability Pre-taxprofitsgeneratedby thesebanks improvedby30.1%during2019,drivenpredominantlybyonebank,asaresultoflowernetimpairmentchargesand,toalowerextent,byotherbanksinvolvedinmicrolending.Againstthisbackdrop,thiscategoryofbanks’post-taxROAandROEimprovedby0.8percentagepointand1.4percentagepointsto2.7%and6.6%,respectively(seeChart2.26).

NIIgrewstronglyby23.8%over2018,withitsshareontotalgrossincomerisingfrom50.4%in2018to52.8%in2019.TheexpansioninNIImainlystemmedfromhigherinterestincomeearnedfromintermediationwhichwentupby18.7%over2018,reflectingtheincreaseinvolumesofmicro-loanstonon-residenthouseholds.Interestexpensesfellby5.0%,supportingtheincreaseinNIIonthebackofthelowerweightedaverageinter-estrateondeposits,whichdroppedto1.5%in2019,asotherwisethecustomerdepositbasegrew.Incomefromnon-interestbearingactivitiesstrengthenedby12.2%over2018,supportingfurthertheimprovementinprofitsmainlyonthebackofhigherfees and commissions as well as tradingprofits.

Non-interest expenses expanded by 13.3% over 2018, owing tohigher fees and commission charges incurred by one bank aswell as staff expenses which rose by 12.7% over a year ago. Over-all net impairment charges grew by almost a fifth in view of higherwrite-downs on collective provi-sions. Notwithstanding, the cost efficiency of this banking groupimproved, with the cost-to-income ratio narrowing by 2.3 percentagepoints to 53.9% in 2019, as oper-ating income rose at a faster pace than operating expenses.

2.3.2.2 Asset Quality

The loan portfolioAlthoughcustomerloansfellby1.1%over 2018, driven by lower loansissued towards foreign NFCs spe-cialised in energy-related sectors,the lending portfolio still accounted for two thirds of these banks’ assets. The sectoral composition of the loan bookremainedrelativelystable,withthe majority of NFC loans issuedtowards manufacturing, transporta-tion and storage as well as in the construction and real estate sectors (see Chart 2.27). Consumer loans to

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Chart 2.27 CUSTOMER LOANS BY SECTOR – SUBSIDIARIES OF FOREIGN BANKS AND STAND-ALONE BANKS


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non-residenthouseholdsincreasedbyasignificant39.1%,drivenmainlybymicro-lendingactivity.Loanstonon-residentOFIsroseby5.8%overthepreviousyeartorepresent6.7%oftotalcustomerportfolio.Residentloans,mainlytowardscorporatesinthetransportationandstoragesector,declinedmarginallyover2018tojust1.0%ofthetotalcustomerloanportfolio,accountingforjust0.2%ofallresidentcustomerloansintheMaltesebankingsystem.

Atthesametime,interbankplacementscontractedbyaroundaquarterto12.2%oftotalassets,owingtolowerplacementsbyparentandsubsidiarycompanies,asotherwiseinterbankplacementsfromunrelatedforeigncreditinstitutionsroseby38.4%.Meanwhile,placementsfromunrelatedresidentcreditinstitutionsalmosthalvedtofinancejust1%ofassetsin2019.

During2019, theassetqualityof thesebanks improved,with theNPL ratiodroppingby2.4percentagepoints to3.5% in2019.NPLsalmosthalvedon thebackof lowerNPLsrelated to foreignNFCs,mainlyoperating in the transportation and storage sector and real estate activities and to a lower extent, in manu-facturing,accommodationand foodservicesactivities,energy-related,humanhealthservicesandsocialworkactivities,andthewholesaleandretailtradesector.Meanwhile,householdNPLsincreasedby1.9%over2018,stemmingexclusivelyfrommicrolendingactivity.Totalprovisionsfellby5.8%overthepreviousyear.Nonetheless,thecoverageratiostrengthenedfrom62.2%in2018,to109.6%ayearlater,asthedropin NPLs outpaced the decline in provisions. Collateral as a means of credit risk mitigation measure was, however,limited,yetNPLsremainfullycoveredevenwhenexcludingcollateralbackingNPLs. The securities portfolio Thesecuritiesportfolioheldbythesebanksexpandedby51.2%over2018,pushingupitsshareofassetsto6.7%in2019,from4.2%ayearearlier.Theincreasewasmainlydrivenbyhigherbondholdings,whichroseby85.7%,representingaroundtwo-thirdsofthesecuritiesportfolio.Thiswasunderpinnedbyhighersover-eign securities, which accounted for more than half of bond holdings (see Chart 2.28). Investments in foreign sovereignpaperincreasedsignificantly,largelycomprisingofeuroareasovereignbonds.Meanwhile,MGSholdingsfellbymorethanathird,toaccountforaround9%ofthebondportfolio.ThesebanksalsoinvestedinMFIandNFCbonds,mostlyforeign,withtheirshareaccountingfor32.8%and1.8%ofthebondportfolioin2019,respectively.Asaresultofthesedevelopmentstherewasashiftinthequality,withtheshareofmedium-ratedbondsincreasingfrom52.1%in2018to78.1%in2019,whereastheshareofhigh-qualitybondsdroppedby25percentagepointsto15.5%in2019,indicatingsomesearch-for-yieldbehaviour.Fur-thermore, theremaining6.4%were invested in low-ratedandunratedbonds.Although theoverallcreditqualityofthesecuritiesportfolioweakened,thesebanksdonothaveanynon-performingsecurities.Mean-while, the remaining third of secu-rities is invested in equities, which rosebyover10%andaremainlyofGerman NFCs.

2.3.2.3 Funding and Liquidity This category of banks reliedlargely on capital and reservesincluding retained earnings to finance their operations, account-ing for two-fifths of the balancesheet. Reliance on wholesale fund-ing weakened further in 2019 and is being substituted by retail fundingwith customer deposits increasing by13.4%,pushinguptheshareintotal liabilities by 5.2 percentagepoints to around a third in 2019. Themajority of customer deposits

€0.3

€0.6

€1.1

€56.0

-€6.4

-25 0 25 50 75

Foreign bank bonds

Domestic bank bonds





Chart 2.28 BOND PORTFOLIO − SUBSIDIARIES OF FOREIGN BANKS AND STAND-ALONE BANKS (EUR millions)


45


aresourcedfromnon-residents,largelyfromhouseholdswhichincreasedbyalmostaquartertoaccountfor43.9%oftotalcustomerdepositsandfinancedaround14%ofthebalancesheet.Similarly,depositsofnon-residentprivateNFCsincreasedby12.0%,whereasdepositsfromnon-residentOFIsfellby4.2%,toaccount for15.3%and34.7%ofcustomerdeposits, respectively.Although thebusinessmodelof thesebanksremainedinternationally-oriented,residentcustomerdepositsmorethandoubled,drivenbyhigherdepositsfromresidentOFIs.Yet,theseaccountedforlessthan2%oftotalliabilitiesofthiscategoryofbanksandjust0.3%oftotalresidentcustomerdepositsheldintheMaltesebankingsystemin2019.

Wholesalefundingfellby30.7%over2018,financing16%oftotalassetsin2019.Thisreflectedaretrench-ingfromintragroupfunding,whichcontractedbymorethanathird,thoughfundingfromunrelatedforeignbanksincreasedby3.5%tofinancejust2.1%oftotalassetsin2019.AlthoughsomebanksareeligibletoparticipateinEurosystemfundingoperations,bytheendoftheyear,nobanktappedsuchsourcereflectingtheirampleliquiditybuffers.Meanwhile,althoughdeclining,theLCRstoodat396%in2019,remainingwell-abovetheminimumregulatoryrequirement.

2.3.2.4 Capital and Leverage The capital position of these banks remained strong in 2019, with the total capital and Tier 1 capital ratios standingat48.4%and48.1%respec-tively(seeChart2.29).Despitethesestrong capital positions, both the Tier 1 and the Total capital ratio declined slightly over 2018. The drop wasmotivated by lower own funds asone bank is winding down its opera-tionsona voluntarybasis, coupledwith an increase of 1.4% in RWA.As a result, the RWA on total assets increased from 79.6% in 2018 to84.9% in 2019, reflecting also thecontraction in total assets. Mean-while, the leverage ratio improved by3.0percentagepointsto38.3%in2019, the highest level in these last fiveyears.

0

10

20

30

40

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2015 2016 2017 2018 2019

Tier 1 capital ratio Total capital ratio Leverage ratio

Chart 2.29CAPITAL AND LEVERAGE RATIOS − SUBSIDIARIES OF INTERNATIONAL BANKS(per cent)

Source: Central Bank of Malta.Note:Theleverageratiousingafully-phased-in definition of Tier 1 is based on COREP figures.

3. Stress tests

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3. STRESS TESTS

TheCentralBankofMaltaconductsregularstresstestsandscenarioanalysestoassesstheresilienceofthedomesticfinancialsystemtoextreme–yetplausible–shocks,underdifferenthypotheticalscenarios.InresponsetotheCOVID-19pandemic,theCentralBankofMaltahasmodifieditsstresstestingframe-workstoassesstheimpactofthepandemiconbanks’solvencyandliquiditypositions.Whiletheresultsofthese stress tests are presented in Panel B of the Special Feature on COVID-19, this chapter focuses on the results of the Macro Stress Testing (MST) and the interest rate risk in the banking book (IRRBB) frame-works. In particular, section 3.1 describes the MST framework which is run under a baseline and an adverse scenario, which consider the June 2020 projections to take into account the impact of the pandemic. The MSTframeworkiscomplementedbyasensitivityanalysisrelatingtotheimpactoncoredomesticbanksunder a house price correction scenario. Section 3.2 presents the results of the IRRBB framework which assesses banks’ NII under prescribed scenarios for changes in interest rates.

Thestresstestspresentedinthefollowingsectionshavebeentailoredtoaddressspecificrisksandmayexclude certain banks that fall out of scope of the exercise being conducted.1 The results are benchmarked againsttheapplicableminimumrequirementsforsolvencyandliquidity,anddonotconsiderthetemporarycapital relief measuresannouncedbytheECBCommunicationof12March2020.2,3 Moreover, the purpose ofthestresstestingframeworksistocapturetheeffectofsystemicriskratherthanidiosyncraticrisk;thusbanksaresubjectedtosimilarassumptionsandmethodologysothattheyarebenchmarkedagainstacom-monscenario.Thisobjectivemayrestricttheframeworks’capacitytodelveintoidiosyncrasiesofindividualinstitutions, such that certain weaknesses inherent to the business model or balance sheet structure of particularbanksarenotdirectlyorspecificallycaptured.Whiletheaggregatestresstestresultspresentedin this chapter as well as in Panel B of the Special Feature, show overall resilience of the banking sector to a pandemic-induced stress impact, capital depletion under the MST’s adverse scenario is more substantial at individual bank level.

3.1 Macro Stress Testing FrameworkThe MST framework assesses the impact on banks’ balance sheets from changes in the domestic and inter-nationalmacroeconomicandfinancialenvironment.ItwasfirstintroducedintheFinancial Stability Report 2015,andperiodicallyrefinedintermsofscenariodesignandmethodology.Theframeworkisdesignedtocapturethecoreandnon-coredomesticbanksduetotheirdirectlinkswiththedomesticeconomy,albeitlimited in the case of non-core domestic banks.

2020-2022 Scenario DesignThe scenarios have been tailored to the current economic outlook amid the COVID-19 pandemic and feature a baseline and an adverse scenario. All scenarios are based on the June 2020 economic projections pub-lishedbytheCentralBankofMaltaaspartoftheEurosystemstaffmacroeconomicprojections.Specifically,the MST’s baseline scenario refers to the baseline of the said macroeconomic projections while the adverse scenario draws from the severe scenario published in June 2020, with additional shocks to capture potential systemicriskstothedomesticeconomy.AsimilarapproachwasadoptedbytheECBfortheCOVID-related

1 Specifically,branchesfromforeignbanksareexcludedfromthestresstestingsamplegiventhatthesebranchesdonotholdcapitallocally.Stresstestingexercisesarecarriedoutwiththeintentionofassessingbanks’capitaladequacy.2 ThisCommunicationinformsbanksthatthe“ECBwillallowbankstooperatetemporarilybelowthelevelofcapitaldefinedbythePillar2Guidance(P2G),theCCBandtheLCR.TheECBconsidersthatthesetemporarymeasureswillbeenhancedbytheappropri-aterelaxationoftheCCyBbythenationalmacroprudentialauthorities.BankswillalsobeallowedtopartiallyusecapitalinstrumentsthatdonotqualifyasCET1capital, forexampleAdditionalTier1orTier2instruments,tomeetthePillar2Requirements(P2R).”Instead, the benchmarks considered in the tests consist of the capital requirements as applicable in December 2019.3 For illustrative purposes, results in the Financial Stability Reportarebenchmarkedagainstacommon6%minimumTier1capitalratio;however,theresultsarealsoassessedintermsofthe4.5%CET1capitalratioaswellastherespectiveTotalSREPCapitalRequirement(TSCR) and Overall Capital Requirement (OCR) as communicated to banks prior to the revisions addressing the COVID-19 outbreak. The benchmarkappliedfortheTSCRincludesthe8%minimumtotalcapitalrequirementandthebank-specificPillar2requirements,whiletheOCR consists of the TSCR and all the combined capital buffers.

https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200312~45417d8643.en.html


https://www.centralbankmalta.org/file.aspx?f=31445


https://www.centralbankmalta.org/economic-projections

https://www.ecb.europa.eu/pub/projections/html/index.en.html

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scenarios used in its VulnerabilityAssessmentpublishedon28July2020.4 This exercise was conducted on 86SignificantInstitutions(SIs)acrosstheeuroareatoassesstheimpactofCOVID-19followingthepost-ponement of the EBA 2020 EU-wide stress test to 2021.

UndertheMST’sbaselinescenario,domesticGDPisexpectedtodeclineby-4.8%in2020duetoadeclineinforeignanddomesticdemand.Foreigndemanddropsmainlyduetorestrictionsontravel-relatedactivitiesanddisruptionstotheglobalsupplychain.ProjectedoilpricesincludeasignificantdropinordertoreflecttherecentdipinpriceswhichwasobservedbetweenFebruaryandMarch2020.Thedropindomesticdemandarises from a reduction in private consumption and investment as a consequence of the shutdown of various activitiesandelevateduncertainty.Theunemploymentrateisexpectedtopeakat5.5%in2020.Thedomes-ticeconomyisexpectedtorecoverthereaftermainlydrivenbyaresurgenceofdomesticdemandwithGDPgrowthstandingat5.8%in2021and4.1%in2022.Theunemploymentratereducesto4.6%in2021and4.5%in2022.SimilartotheECB’sVulnerabilityAssessment,thisscenarioisaugmentedbyanexogenousV-shapedshocktoequitypriceswhichwoulddropby12%inthefirstyearandpartiallyrecoverthroughoutthetesthorizon.Moreover,underthisscenario,itisassumedthatdividendincomeonbanks’equityholdingswoulddropby50%in2020and,similartoequityprices,partiallyrecoverthroughoutthetesthorizon.

Undertheadversescenario,GDPisexpectedtodeclineby8.3%in2020followingaseveredropintouristexpenditureduetothetravelban,globalsupply-chaindisruptionsandloweremploymenthourstoavoidlay-offs.Oilpricesremainlowasprojectedunderthebaselinescenario.Theunemploymentratepeaksat6.1%in2020.Theimpactoftheadversescenarioisalsoaugmentedbyexogenousshockstoequitypriceswhichwoulddropinstantaneouslybyamaximumof24%whiledividendincomereceivedbybanksfromsharehold-ingcompanieswouldnotbereceivedin2020(100%haircut),withbothpartiallyrecoveringtoapproachthe2019levelsthereafter.Realestatepricesareshockedtodropbyaround5%ineachyearcomparedtothebaseline scenario to account for the mild overvaluation observed at the reference date and to cancel the baseline growth.

Giventhatthescenariostakeintoaccountathree-yearhorizon,theeffectsofmoratoriagrantedunderthetermsdefinedinCentral Bank of Malta’s Directive No. 18 are not being considered.

MethodologyThe current framework draws from the methodologies developed for the EBA EU-wide stress testing exer-cisesandthetop-downmodeladoptedbytheInternationalMonetaryFund(IMF)duringtheir2018MaltaFinancial Sector Assessment Program. The MST framework runs over a three-year time horizon andassumesastaticbalancesheetwherebythesamestructureisretainedthroughoutthetesthorizon,toallowforeaseofcomparisonacrosstheresultsofbanksinscope.Tosatisfythisrequirement,assetsandliabilitieswhichmaturebetween2020and2022arereplacedwithsimilarfinancialinstrumentsintermsoftype,creditqualityanddateofmaturityasatthestartoftheexercise.Moreover,itisassumedthatbanksregisteringprofitspayoutdividendsat30%ofpre-taxprofits,wherethelatteraresubjecttotheofficialcorporatetaxrateof35%.5,6 However, in the case of losses, banks are not allowed to create deferred tax assets and, in linewiththecommunicationbyboththeECB and MFSA on dividend distribution, dividends are not paid out whenever banks breach the respective OCR.

Totransposethechangesinthemacroeconomicscenariosontobanks,theframeworkemploysanum-berofriskmodulestoquantifytheimpactfromcreditrisk,marketrisk,NII(costoffunding),nettrading

4 TheECBVulnerabilityAssessmentisbasedonthreescenarios:apre-COVIDscenariobasedontheEBA2020EU-widestresstestbaselinescenarioandtwoCOVID-relatedscenarios,namelytheCOVID-MID scenario and the COVID-SEVERE scenario, which are based on the baseline and severeEurosystemstaffmacroeconomicprojectionsasatJune2020.5 While the ECB has issued Recommendation ECB/2020/19tobandividendpay-outsforfinancialyear2019and2020,whichhasbeenextendedbytheMFSAtoalllicensedcreditinstitutionsdirectlysupervisedbyitviaacircular, the MST allows banks that still manage to registerprofitsduringthehorizontopayoutdividendsfromaccumulatedprofits,ifany.Tonotethatifadividendbanweretobeappliedinthe test, the results under the baseline scenario would be more positive. 6 Even though banks are still allowed to pay dividends, dividend income received from shareholding companies is assumed to behinderedbytheevolutionofthepandemic,droppingby50%and100%in2020,underthebaselineandadversescenarios,respectively.Dividendincomeisexpectedtopartiallyrecoverin2021and2022toapproachthe2019levels.

https://www.bankingsupervision.europa.eu/press/pr/date/2020/html/ssm.pr200728_annex~d36d893ca2.en.pdf?731039993a2a10392e3b7679d1669fb5


https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52017HB0044&from=EN

https://www.mfsa.com.mt/wp-content/uploads/2019/01/16_1739236274_20181127Circularondividenddistribution.pdf

https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52020HB0019&from=EN

https://www.mfsa.mt/wp-content/uploads/2020/04/Circular-to-Credit-Institutions-on-Dividend-Distributions-or-Share-Buybacks.pdf

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income(NTI)andoperationalrisk.Theframeworkisflexibleinawaythatspecificmodulescanberunonastand-alonebasis,additionalmodulescanbeincorporated,andthemagnitudeofshockscanbeeasilymodifiedtosuitthescenariosbeingtested.Figure3.1presentsaschematicoverviewoftheeffectsofthescenarioasquantifiedbytherespectiveriskmoduleonthebanks’statementofprofitandloss(P&L)andbalance sheet.

Overview of Risk ModulesThe Credit Risk Module assesses credit risk arising from the loan book via panel regression which projects theNPLratioatbanklevelforcorporateandhouseholdloansusingthemainmacroeconomicandfinancialvariablesdefinedintherespectivescenario(moredetailsinBox3oftheFinancial Stability Report 2018). Loan loss impairments are estimated on the unsecured portion of the projected new NPLs and are charged directlytotheP&L.

For debt securities accounted for at AMC, impairments are estimated on the basis of a three-notch down-gradeintheofficialcreditrating,pairedwithalossgivendefault(LGD)of35%forcoveredbondsand40%for all other securities. The calculation of impairments also takes into account whether banks record a book value below par (which can be released to absorb expected losses) or if the booked value is above par (requiring higher impairments to erase the unrealised gains). Debt securities accounted for at FV are repriced on the basis of valuation haircuts sourced from EBA EU-wide stress testing exercises in the case of sovereign bonds, or via the widening of credit spreads for non-sovereign FV securities.7 The changes in

7 The widening of credit spreads is calibrated on the basis of the iTraxx European Senior Financial Index.

Statement of Profit & Loss

Loan

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wholesale funding

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EBA 2016 Market Risk Simplified Approach

NTI module

Forgone income from defaulted

assets

Other Comprehensive

Income

Retained Earnings

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NII module

Figure 3.1SCHEMATIC OVERVIEW OF THE MST FRAMEWORK



51


thepriceofsecuritiesaccountedforatFVthroughprofitandloss(FVTPL)are recognised as impairments in the P&L and thus are subject to taxation, while gains and losses on FV through other comprehensive income(FVOCI)securitiesarereflectedinthebalancesheet,havingadirectimpactoncapital.

The Market Risk Modulequantifiesthelossesthatwouldpotentiallybeincurredfollowingchangesinthetermstructureofinterestrates.Underboththebaselineandadversescenarios,theprofileoftheyieldcurvechangesasaresultoftheassumedincreasesinboththeshort-term(overnight)andlong-term(10-year)interest rates. The changes to the term structure of interest rates would have a two-fold impact. FV bonds wouldexperiencevaluationgainsorlossesowingtotheinverserelationshipbetweenpricesandyieldswhileequitypriceswoulddropby12%inthefirstyearofthebaselinescenarioandby24%inthefirstyearoftheadversescenario.InlinewiththeexpectedrecoveryinGDP,equitypricesareassumedtopartiallyrecoverthereafter. The changes in valuation of FVTPL and FVOCI debt securities are recorded in the P&L and balancesheet,respectively.Atthesametime,NIImightmitigatetheformereffectduetorevisedcouponsearnedonfloatingratenotesanddebtsecuritieswhichmatureduringthetime-horizonwhicharerolledoverat the new prevailing interest rates.

The NII Module affects income and expenses from interest-bearing assets (loans and debt securities) and liabilities (mainlydeposits)by theshock to interest rates.Theassumedshift in theyieldcurve isonly inpart translated onto the banks’ interest income and expenses through the application of the respective pass-through rates which are sourced from Micallef, Rapa and Gauci (2016). These rates are estimated asymmetricallytoreflectdifferentresponsesbybanksdependingonwhetherinterestrateshaveincreasedordecreased.Anyinterest-bearingassetsandliabilitieswhichmatureduringthetimehorizonarereplacedwith similar instruments that charge the new prevailing rates. In addition, most of the components of net non-interest income (NNII), such as administrative expenses and staff wages, are assumed to remain con-stantoverthetesthorizon.However,dividendincomereceivedbybanksfromtheirshareholdingcompaniesfor2020isassumedtodropby50%underthebaselineand100%undertheadversescenarioandpar-tiallyrecoverthereafter,inlinewiththeshocktoequityprices.Moreover,feesandcommissionincomeareassumedtodeclineby10%underthebaselineand15%undertheadversescenarios.Theimpactarisingfrom NNII is added to the outcome of the NII module and charged to the P&L.

The NTI ModulequantifiesmarketriskonsecuritiesaccountedforatFVTPL,whichincludederivativesandeconomichedges.ThehistoricalvariationofNTIobtainedfromthesepositionsisusedasaproxyforthebanks’sensitivitiestoadversemarketriskconditions.Themoduleisbasedonthesimplifiedapproachofthemarketriskmethodologyadoptedinthe2016EBAEU-WideStressTest(describedinSection3.6ofthe2016 methodological note). The estimated changes in NTI are included in the P&L account.

The Operational Risk Module quantifies operational risk on the basis of theCRD IV’sBasic IndicatorApproach(BIA)whichcalculatesacapitalrequirementforoperationalriskas15%oftheaverageoverthreeyearsoftherelevantindicator(RI).TheRIiscomposedofseveralP&Litems,thesumofwhichisequivalenttothenetprofitbeforetaxfigure.AspertheEBA2018stresstestmethodology,thismodulecalculatesamaterialisationoflossesarisingfromoperationalriskequalto6%oftheRIunderthebaselinescenarioand15%undertheadversescenario.Moreover,themoduleaccountsforprojectedlossesfrompendingcourtcaseswhichareequallydistributedoverthethree-yearstresstesthorizonundertheadversescenarioasper paragraph 423 of the EBA 2020 methodological note.

ResultsCharts 3.1 and 3.2 present the contributions from the various risk modules (as a fraction of risk weighted assets)totheevolutionoftheTier1capitalratioforcoreandnon-coredomesticbanks,respectively,underthebaselinescenario.Inthecaseofcoredomesticbanks,thechangeinthecapitalratioismainlydrivenbycreditriskontheAMCdebtsecuritiesandtheloanportfolioduetotheeconomicslowdown.Banksalsoneed to set aside additional impairments for revaluation losses on FV debt securities following the change in thetermstructureofinterestrates.Itisalsoassumedthatbanksfaceareductionindividendincome(50%

https://journals.aserspublishing.eu/jasf/article/view/494

https://eba.europa.eu/file/60886/download?token=9A5XDA3P

https://eba.europa.eu/sites/default/documents/files/document_library/2020%20EU-wide%20stress%20test%20-%20Methodological%20Note.pdf

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in 2020 with a partial recovery toapproach the 2019 level thereaf-ter), and in fees and commission income of 10%. Nonetheless,after absorbing these losses, core domestic banks increase capital with their Tier 1 capital ratio improv-ing by 0.60 percentage point.Conversely, profitability of non-core domestic banks is negativelyaffectedbycreditriskonloansandmarket risk. The latter represents unrealised losses from the repric-ing of FV securities and the shock toequitypriceswhichdropby12%inthefirstyearofthetesthorizon.The scenario, however, assumes that equity prices partially recoverinthesubsequentyears.TheTier1capitalratiodropsby2.81percent-age points below the 2019 starting level, but remains well above the regulatoryrequirementof6%.

Charts 3.3 and 3.4 show that under the adverse scenario, the aggre-gate Tier 1 capital ratios would drop as banks within both bank categories would register losses that would need to be offset bythe release of capital. In this case, most banks would not be able to distribute dividends. The Tier 1 capital ratio for core domestic banks falls by 3.29 percentagepoints to reach 14.11%while thatof non-core domestic banks falls by7.63percentagepointstoreach8.89%.Underthisscenario,losseswouldmainlyoriginatefromhigherlevels of NPLs and defaulted bonds that reduce the stream of interest income via missed loan repay-ments and forgone coupon pay-ments. This reduction in interest income is reflected ina lessposi-tive NII & NNII contribution when compared to the baseline sce-nario. Moreover, the higher share ofdefaultedassetsisalsoreflectedin the larger impact from credit risk requiring additional impair-ments charged to the P&L and the application of higher risk weights

18.00

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Taxes and dividends

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Market risk

Credit risk

NII & NNII

T1 capital ratio 2019

Chart 3.1 STRESS TEST RESULTS – MACRO STRESS TEST BASELINE SCENARIO – RELATIVE CONTRIBUTION OF THE IMPACT ON CORE DOMESTIC BANKS' TIER 1 CAPITAL RATIO(per cent)

Source: Central Bank of Malta calculations.

13.71

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Chart 3.2 STRESS TEST RESULTS – MACRO STRESS TEST BASELINE SCENARIO – RELATIVE CONTRIBUTION OF THE IMPACT ON NON-CORE DOMESTIC BANKS' TIER 1 CAPITAL RATIO(per cent)


14.11

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NII & NNII


Chart 3.3 STRESS TEST RESULTS – MACRO STRESS TEST ADVERSE SCENARIO – RELATIVE CONTRIBUTION OF THE IMPACT ON CORE DOMESTIC BANKS' TIER 1 CAPITAL RATIO(per cent)


53


against these assets. In addition to losses in interest income aris-ing as a consequence of credit risk, NNII is also reduced as a result of the assumed decline in dividend income(100%in2020withapar-tialrecoverytoapproachthe2019level thereafter) and in fees and commissionincome(15%overthetest horizon).

Core domestic banks would also experience losses arising from operational risk while non-core domestic banks experience losses arising from realisation of market risk, mainly from high unrealisedlosses on equities given that these make up a higher share of banks’ securities portfolios when compared to the core domestic banks’ securities portfolio. Under this scenario, equitypricesareassumedtodropbyamaximumof24%.Theseresultsdonotconsiderthepotentialinter-ventionofpolicymakerstomitigatetheoutcomeoftheadversescenariobyprovidingsupplementarysupportmeasures.

TheTier1capitalratioforbothbankcategoriesremainswellabovethe6%minimumrequirement.Moreover,at the individual bank level, all banks are assessed against their respective TSCR, which is the applicable benchmarkforanadversescenarioundertheSREPguidelinesandconsistsofthecommon6%Pillar1andindividualbankPillar2requirementsetbythesupervisorforDecember2019.Althoughbanksingeneralexhibit resilience under the adverse scenario, weaknesses are observed in a few small banks.

TheresultsoftheadversescenariocorroboratethefindingsoftheECB’sVulnerabilityAssessmentwhichconcludes that: “Overall, the results show that the banking sector is well positioned to take on the pandemic-inducedstressimpact,butcapitaldepletionintheseverescenariocouldbematerial.”

Sensitivity analysis: Impact following house price correctionTocomplementtheMSTframework,thefollowingsectionpresentstheresultsofasensitivityanalysiswhichfeatures an exogenous shock to house prices on the core domestic banks’ balance sheets, given that these banksarethemainprovidersofmortgages,overaone-yearhorizon.ThemagnitudeoftheshocksappliedaredifferentfromthoseusedintheMSTframeworkasthesensitivityanalysisassumesaninstantaneousandmoresevereshocktohouseprices.Thedropinhousepricestranslatesfullyintoadropinproperty-relatedcollateralvalues,whichforcoredomesticbanksisthepredominanttypeofcollateralbackingloans.The magnitude of the assumed shocks to house prices is determined on the basis of the historical standard deviationsofthehousepriceindex.Whilenon-realestaterelatedloansarenotdirectlyhitbythisshock,the test applies a simultaneous increase in NPLs in the remaining sectors owing to the negative wealth effect (as explained below). The relationship between the shock to house prices and the increase in NPLs is determined via STREAM, the Bank’s macroeconomic model, for both households and NFCs. While the MST framework adopts shocks to house prices of a magnitude consistent with the macro-scenario, this sensitiv-ityanalysisconsiderstwoadversescenarios.Thefirstappliesanexogenousshockof7.5%,approximatelyequaltoonehistoricalstandarddeviationofthehousepriceindex,pairedwithanincreaseinNPLsof4%.Thesecondmoresevereadversescenarioappliesa30%dropinhouseprices,equivalenttoaroundfourhistoricalstandarddeviations,pairedwithan18%increaseinNPLs.Notethattheshocktopropertypricesisratherextremegiventhatitisappliedtocollateralvaluesthatarealreadydiscountedbyhaircutsthatbanksnormallyapplywhenapprovingloans.

8.89

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Market risk

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NII & NNII


Chart 3.4 STRESS TEST RESULTS – MACRO STRESS TEST ADVERSE SCENARIO – RELATIVE CONTRIBUTION OF THE IMPACT ON NON-CORE DOMESTIC BANKS' TIER 1 CAPITAL RATIO(per cent)


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The test considers that as collateral values decline, loan loss provisions would have to increase to satisfythe requirement of full coverage of property-related NPLs. Further-more, the additional NPLs arising from negative wealth affects would also lead to an increase in loan loss provisions for the other loans. While the increase in provisions is charged to capital, the higher risk-weightsapplicabletonewlyclassi-fied NPLs affect the risk-weightedassets. Thus, the assumed shocks underthistestwouldinfluenceboththe numerator (capital) and denom-inator (risk-weighted assets) of the Tier 1 capital ratio.

Results show that at theaggregate level, coredomestic bankswould comfortablywithstand the severeshocks applied under both adverse scenarios. The core domestic banks’ Tier 1 capital ratio would drop from 17.40%to16.95%and16.11%underadversescenarios1and2,respectively(seeChart3.5).Thepost-shockTier1capitalratioattheaggregateremainswellabovetheregulatoryminimumof6%,evenunderthe more severe adverse scenario. In fact, all core domestic banks would be able to absorb the impact and have a total capital ratio which exceeds their respective OCR.

TheimpactofthistestisslightlyhigherwhencomparedtotheresultspublishedinFinancial Stability Report 2018 due to a reported decrease in loan collateralisation for NPLs and – to a lesser extent – a decrease in loanlossprovisions.WhiletheoverallstockofNPLshasdecreased,theshareofNPLsto‘otherfinancialinstitutions’hasincreasedrelativetothedeclineinNPLsfromloanstohouseholdsandnon-financialcor-porations when compared to December 2018. This shift in sectoral composition of NPLs originates from thebusinessmodelofaspecificbankwhichinturndrivestheaggregatedecreaseinloancollateralisationasloanstootherfinancialinstitutionstendtohavealowercollateralcoverageratiocomparedtotheothertwo sectors. Thus, even though NPLs decline, the test results in a higher need for provisions to cover the unsecured portion of the loans. Nonetheless, all banks have ample capital buffers to withstand this assumed increase in provisions – even more so when considering the recent capital injections, with all core domestic banks reporting a higher Tier 1 capital when compared to the Financial Stability Report 2018.

3.2 Interest Rate Risk in the Banking BookIRRBBreferstothepotentialriskarisingfromchangesintheshapeoftheyieldcurveonthebanks’interestbearingassetsandliabilities,impactingthebanks’earningcapacityintheimmediateterm,andconsequentlytheircapital.Theextentoftheimpactresultingfromchangesininterestratesisinfluenced,amongothers,bytheinterestratetype(fixed,variableoracombinationofboth),thecurrencydenominationandtheresetdate of the interest-bearing assets and liabilities. While both effects complement each other and need to be taken into account, this framework assesses the impact of changes in interest rates under different scenarios in terms of the banks’ NII and capital.

Duetothecurrentlowinterestrateenvironment,anumberofinternationalandnationalsupervisoryauthori-tieshavedefinedregulatoryrequirements for themeasurementandmanagementof interestraterisk. In2016, the Basel Committee on Banking Supervision (BCBS) issued standards for IRRBB, while in 2018, theEuropeanBankingAuthority(EBA)publishedguidelines ‘on the management of interest rate risk arising from non-trading book activities’.8Inearly2020,theEBAlaunchedthe2020EU-widestresstestexercise,

8 In its 2017sensitivityanalysis of interest rate changes on the banks’ banking books as part of its annual SREP, the ECB also based its hypotheticalshocksontheBCBSstandards.

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Chart 3.5STRESS TEST RESULTS – IMPACT OF A DROP IN HOUSE PRICES ON CORE DOMESTIC BANKS' TIER 1 CAPITAL RATIO(per cent)


https://www.bis.org/bcbs/publ/d368.pdf

https://eba.europa.eu/sites/default/documents/files/document_library/Guidelines%20on%20the%20management%20of%20interest%20rate%20risk%20arising%20from%20non-trading%20activities%20%28EBA-GL-2018-02%29.pdf

https://www.bankingsupervision.europa.eu/press/pr/date/2017/html/sr170228.en.html

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which for the first time included a‘low-for-long’ interest rate environ-ment, involving a recession with low or negative interest rates for a pro-longed period. However, following the outbreak of COVID-19, the EBA has decided to postpone the EU-wide stress test exercise to 2021.

This test quantifies the impact ofsix different interest rate shocks as prescribed in Annex 2 of the BCBS standards. These scenarios con-sist of a parallel shift upwards and downwardsoftheyieldcurveasatthe reference date, an increase and a decrease in the short rate end of the curve and two composite shifts in the short- and long-term rates referred to as the steepener and flattenerscenarios.Allsixscenariosaffectthetermstructureoftheyieldcurveanddifferintermsofthecurrencyinwhichtheinstrumentsaredenominated.ThesescenariosarecomprehensiveenoughinassessinganypotentialmovementsininterestratesalsoasaresponsetotheCOVID-19pandemic.Onlyeuro,PoundSterling(GBP)andUSdollar(USD)arebeingconsideredasthematerial currencies in which the banking book is denominated, the latter two being the most relevant cur-rencies,otherthaneuro,forallthreebankingcategories.Indeed,99%ofthebankingbookofcoredomesticandnon-coredomesticbanksand92%ofthebankingbookofinternationalbanksisdenominatedinthesethreecurrencies,witheurobeingthemostrelevantcurrencyrepresenting90%,69%and71%ofthebankingbookofthesethreebankcategories,respectively.Chart3.6showstheshiftintheeurotermstructureunderthesixdifferenttestedscenariosasatDecember2019.TheGBPandUSDyieldcurveswouldexperiencesimilar shifts under the respective scenarios.

The framework tests the impact of IRRBB on NII over a 12-month horizon and assumes a static balance sheet,soanyinstrumentsthatmaturewithinthehorizonarerolledoverwithsimilarinstrumentsatthepre-vailing interest rates in the respec-tive scenarios. Charts 3.7 to 3.9 present the impact of the six sce-narios on the Tier 1 capital ratio for core domestic, non-core domestic and international banks, respec-tively, following the application ofthecorporatetaxrateof35%.9

As illustrated in these charts, the short rate down would have the largest negative impact on the core domestic and international bank categories, while the parallel down scenario would have most impact on the non-core domestic banks. Under the short rate down sce-nario, the Tier 1 capital ratio would drop from 17.40% to 15.30% and

9 Banksmayapplyalowertaxrateifinpreviousyearstheyhaveaccumulateddeferredtaxassets.

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Chart 3.7 STRESS TEST RESULTS – IMPACT OF CHANGES IN NII ON TIER 1 CAPITAL RATIO OF CORE DOMESTIC BANKS (per cent)


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from48.40%to47.23%forthecoredomestic and international banks, respectively,whileundertheparal-lel down scenario the Tier 1 capi-tal ratio for the non-core domes-tic banks drops from 16.52% to15.16%.Thepost-shockTier1cap-ital ratios at the aggregate remain well-abovetheregulatoryminimumof6%,evenunderthemostseverescenarios that would hit banks the most. In fact, all banks would be able to absorb the impact and have a total capital ratio which exceeds the respective OCR following the largest negative impact.

Given that most banks hold the majority of their interest-bearingassets in loans and advances which arerepricedimmediately,andfundtheir business mainly via openmaturitydeposits,shiftsintheshortendof the yield curvewould influ-ence banks the most. In addition, the banks’ current balance sheet structure would allow them to gain from potential increases in inter-est rates. While loans are repriced immediately,alargeshareofdepos-itsarewithanopen-endedmaturityand, to a lesser extent, maturing within the year, which attract 0%or very low interest rates. Indeed,84%,87%and68%ofdepositsofcore domestic, non-core domestic and international banks, respec-tively,maturewithinoneyear.

The impact of changes in the interest rates was also measured in terms of the movements in the net inter-estmargin(NIM),definedasthedifferencebetweeninterestincomeandinterestexpensedividedbytotalinterest-bearing assets. For the NIM, the impact of changes in interest rates is taken at pre-tax as these scenariosaffectthetotalNIIinfull,whiletaxesareonlydeductedpriortochargingtheresultingimpactonthe Tier 1 capital. Under the most severe scenario for each of the three bank categories, the NIM would dropfrom1.84%to0.22%,from1.38%to-0.39%andfrom9.95%to8.32%forthecoredomestic,non-coredomesticandinternationalbanks,respectively.Theseresultshavetobeseenwithinthecontextoftheseverityoftheyieldcurveshocksbeingassumedwhichpushesthecurrentlowinterestratesconsiderablyfurtherintonegativeterritory.

Conversely,themajorpositiveimpactwouldbefromtheshort rate up for the core domestic and interna-tional banks and the parallel up scenario for the non-core domestic banks. Under these scenarios, the Tier 1capitalratiowouldincreasefrom17.40%to19.93%,from16.52%to17.93%andfrom48.40%to49.83%for thecoredomestic,non-coredomesticand internationalbanks, respectively. In thescenarioswith the

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Chart 3.9 STRESS TEST RESULTS – IMPACT OF CHANGES IN NII ON TIER 1 CAPITAL RATIO OF INTERNATIONAL BANKS (EXCLUDING BRANCHES) (per cent)


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largestpositiveimpactforeachofthethreebankcategories,theNIMwouldincreasefrom1.84%to3.80%,from1.38%to3.16%andfrom9.95%to11.93%forthecoredomestic,non-coredomesticandinternationalbanks,respectively.Owingtotheassumptionofasymmetricpass-throughforincreasesanddecreasesininterest rate assumptions (as applied in the MST), banks are assumed to react sooner to a positive shift in theyieldcurvewhencomparedtodownwardinterestrateshocks.

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SPECIAL FEATURE: COVID-19 – ASPECTS OF FINANCIAL SECTOR RESILIENCE

Introduction1

The global economic impact from the spread of the coronavirus (COVID-19) is pushing economies into reces-sionsofuncertainmagnitudeanddurationunseeninrecenthistory.InJune2020,theIMFestimatedthattheworldeconomyislikelytoshrinkbyastark4.9%,whichisbyfarworsethanthepeakoftheGlobalFinancialCrisis.2

Theimpactontheeuroarea’seconomyismuchmorepronouncedwitheconomicactivityforecastedtocon-tractby10.2%.Manycountriestookthemeasuresnecessarytocontainthespreadofthepandemicbyclosingborders, schools and non-essential services. Health authorities in some countries advocated other measures to contain the spread such as social distancing and a complete lockdown in some countries, while others advocatedisolationforvulnerablepeople,inabidtoflattentheepidemiologicalcurveandavoidoverburdeninghealthcaresystems.COVID-19tookitstollonthe‘normal’socialandeconomiclifeacrosstheglobe. Maltawasnotimmunetothispandemic.Whenithitourshores,Maltatookthenecessarymeasurestocon-tain as much as possible the virus spread, while limiting its social and economic implications. Being a small openeconomy,Maltaisdirectlyaffectedbyforeigndemandshocks–particularlyintheservicessector,espe-ciallywithintourism.Apartfromthedirectimpactfollowingtheclosureoftheseaandairports,theensuingfall in tourism demand had repercussions on most catering establishments, restaurants and bars – which had alreadyreportedasignificantdropinsalespriortobeingshutdownonGovernment’sorders.Variousactivi-ties were cancelled resulting in additional loss of revenue for the entertainment segment. The manufacturing industrywasalsohardhit,particularlyduetosupply-chaindisruptionsinsourcemarkets,butalsoduetoadecline in world demand.

Theeconomiceffectofthepandemicismoreaptlyvisibleinconsumption.Whileconsumerdemandforarange of essential goods trended upwards, demand for a number of other goods and services suffered. Locally-orientedbusinessesreactedtothisfallingdemandandrisinguncertaintybycancellingorpostpon-ing investment, while others embarked on a labour rationing response such as implementing a shorter work weekschedule,aswellasoutrightlay-offs.ThemeasurestakenbytheGovernmenttomitigatetheimpactonthelabourmarkethelpedtocontaintheincreaseintheunemploymentratebyjust0.7percentagepointbetweenFebruaryandApril2020,upto4.1%.

Apartfromthedirectimpactonanumberofeconomicsectors,COVID-19islikelytohavesignificantsecond-roundeffectsonvariousothersectorsoftheeconomy.Thepandemicisalsotestingthefinancialstabilityofcountriesworldwideasanumberofriskscouldmaterialise,simultaneously.TheECB’sMay 2020 Financial Stability Reporthighlightedthatthepandemichaseffectivelyimpactedvariousaspectsofeconomicactiv-ity,andat times interactedwithpre-existingvulnerabilitiessuchasovervaluedassetprices,weakprofit-ability, still-high sovereign indebtednessand increased liquidity and credit risks in thenon-bank sector.3

Whilethesealready-presentvulnerabilitieshadamplifiedthepandemicshock,thefinancialsystemprovedtobebroadlyresilientinpartduetotheregulatoryreformsinstitutedsincethegreatfinancialcrisis.Height-enedriskaversioncoupledwithabroadeconomicfallouthasalsoledtoincreasingdemandsonthefinan-cialsystemforfundingandliquidity.Yet,thelossofincomeforborrowersandmarketuncertaintywillalsoimpingeonbanks’assetqualityandhencetheirprofitabilitygoingforward.

ThisSpecialFeatureprovidesanindicationofsomeoftheinitialdirectimpactsonMalta’sfinancialservicessectorastheoutbreakcontinuedtospreadbothlocallyandglobally.PanelAattemptstoshedlightontheexposuresofthefinancialservicesindustrytoCOVID-19-sensitivesectors,whilePanelBdelvesintotheCentralBankofMalta’sscenarioanalysistoassessbanks’liquidityandsolvencypositions.PanelCshedslightonthemeasurestheCentralBankofMalta,asthemacroprudentialauthority,hasputinplacetoeasetheburdenandlimitthefalloutfromthepandemic.ThisSpecialFeaturereflectstheCentralBankofMalta’s(CBM) perspective as of 20 June 2020.

1 PreparedbyWendyZammit,HeadFinancialStabilitySurveillanceandResearch,andAndrewSpiteri,ManagerwithinFinancialStabilityandSurveillanceandResearch.TheauthorswouldliketothankAlanCassar,ChiefOfficerFinancialStabilityforhisvaluablesuggestions.2 IMF, June World Economic Outlook. https://www.imf.org/en/Publications/WEO/Issues/2020/06/24/WEOUpdateJune20203 https://www.ecb.europa.eu/pub/financial-stability/fsr/html/ecb.fsr202005~1b75555f66.en.html

https://www.imf.org/en/Publications/WEO/Issues/2020/06/24/WEOUpdateJune2020

https://www.ecb.europa.eu/pub/financial-stability/fsr/html/ecb.fsr202005~1b75555f66.en.html

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Panel A: The Financial Sector’s Exposures to Hard-hit Sectors4

Some economic sectors are more prone to direct effects from the COVID-19 pandemic and hence are con-sideredtobemoresensitive,withtheirbusinessmodelsdentedbylowcashflows,whichinturnaffectedtheirprofitabilityanddebt repaymentcapabilities.For thepurposeof thisSpecialFeature theproductivesectorsoftheeconomymostsensitivetoCOVID-19aredeemedtobe:

• NACE C: Manufacturing• NACE F: Construction• NACEG:WholesaleandRetailTrade;RepairofMotorVehiclesandMotorcycles• NACE H: Transportation and Storage• NACE I: Accommodation and Food Services Activities • NACE J: Information and Communication• NACE L: Real estate• NACEM:Professional,scientificandtechnicalactivities• NACE N: Administrative and Support Service Activities• NACE P: Education• NACE R: Arts, Entertainment and Recreation• NACE S: Other Service Activities.

The ECB’s Financial Stability Report identifiedmanufacturing,wholesaleand retail trade, transportation,accommodation and food services, as well as arts and entertainment as COVID-19 sensitive sectors. The abovelistwas,however,furtheraugmentedbythosesectorsidentifiedinMaltaEnterprise’swagesupple-mentscheme,aswellasthosesectorswhichresortedmoreprominentlytomoratoriaontheirlendingfollow-ing the introduction of the Central Bank of Malta Directive No. 18.

The Financial Sector Environment: Strengths and Weaknesses The Maltesebankingsectorisfacingthisunprecedentedshockfromarelativelystrongfinancialstanding.Sincethefinancialcrisis,bankshavestrengthenedfurthertheircapitalbuffersandcontinuedtooperateonthebackofampleliquiditybuffers,ascustomerdepositscontinuedtoflowinevenduringthepeakofthepandemic.ThisisfurtherreaffirmedbystresstestscarriedoutbytheCentralBankofMaltainthecourseofitswork,showingthat–overall–banksremainedresilientandcapitallevelsaboveregulatoryminimawithonlyafewbanksshowingsomevulnerabilities(refertoChapter3).Owingtothedisruptionscausedbythespreadofthevirus,theECB’sSingleSupervisoryMechanism(SSM)hasprovidedtemporaryrelieftosig-nificantinstitutionsfromcapitalandliquidityrequirements,toprovideevenmoreroomforbankstooperatein case of need.

Whileat thecurrent juncture liquidity isample, if thepandemicpersistsand thepath to recovery ispro-longed,theliquiditypositionofsomebankscouldbesomewhataffectedaspotentiallysomeborrowerscouldsuspendrepaymentsandstartexercisingdrawdownsofalready-committedcreditlines.Aslowdownintherealeconomycanleadtorepercussionsonthebanks’assetqualityasprovisioninglevelswouldneedtobesteppedup–coupledwithpotentiallywrite-downsofloans–goingforward.Creditriskinthebankingsectorhadbeenabatingforanumberofyears,supportedbyimprovedcreditworthinessofborrowersonthebackofagrowingeconomy,targetedsupervisorymeasuresandduetoactiveeffortsbybankstode-risktheirbalancesheets.Asaresult,theNPLratioofthecoredomesticbanksfellto3.2%in2019,downfrom7.2%in 2015. Banks are therefore in a much better position and more resilient to deal with this exogenous shock. Nonetheless,incaseofaprolongeddragontheoveralleconomy,NPLsarelikelytoincreaseinsomesec-tors,althoughthemeasurestakenbythebankingsector(suchasmoratoria),thesupervisoryauthoritiesand Government, including the COVID-19 Guarantee Scheme, should help in cushioning the effect to some extent, even though most measures are for a limited period.5

4 PreparedbyWendyZammit,HeadFinancialStabilitySurveillanceandResearch,andAndrewSpiteri,ManagerFinancialStabilityandSurveillanceandResearch.TheauthorswouldliketothankAlanCassar,ChiefOfficerFinancialStabilityforhisvaluablesuggestions.5 TheCOVID-19GuaranteeSchemewasputinplacebytheMaltaDevelopmentBanktoprovideguaranteestocommercialbanksfortheprovisionoffinancingforworkingcapitalrequirementsandshouldalsohelpineasingtheburdenonbanks.

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Meanwhile, in termsofprofitability,domesticbankshavehistoricallyoutperformed theirEuropeanpeers.However, in recent times, profitability has been waning on the back of the prolonged low interest rateenvironment,coupledwithincreasingregulatorycosts, investmentinITsystemsandotheradministrativeexpenses.TheadditionalchallengesfromtheCOVID-19implicationsontheeconomywillundoubtedlyputadditionalstrainonprofitability,particularlythroughlowerrevenues.Theincreaseduncertaintysurroundingthepandemicandlackofclarityonhowlongthisisgoingtotakecouldtriggeracreditcrunch,particularlyfortheproductivesectorsmostsensitivetotheCOVID-19spreadmentionedearlier.Fromasupplypointofview,thisisdependentonthecapacityaffordedonbanks’balancesheetandtheirabilitytoabsorbanyassetqualitydeteriorationwithouthavingtolimitcredittotherealeconomy.Monthsofsocialdistancinghavealsodisruptedthecapitalformationprocessand,ultimately,labourparticipationandproductivitygrowth,withimplicationsoncreditdemand.Indeed,whilecreditlinesforNFCsmayincreaseintheshorttermforworkingcapitalpurposestooffsettheshortfallincashflows,otherformsofcorporatecreditmaybepostponedinviewofpossiblelowerfixedinvestment.Moreover,mortgagelending–whichforanumberofyearswasthemaindriverofcreditgrowth–isexpectedtoslowdownasthepropertymarketcametoavirtualstandstillduring theperiodof containmentmeasures,exacerbating further theslowdown thathadalreadystartedtowardstheendof2019.Indeed,BankLendingSurveyresultshaveshownthatmostoftherespondentsobservedadropindemandforloansforhousepurchasesinthefirsthalfoftheyear,whichisalsocorrobo-ratedbythemonth-on-monthdropsinoutstandingmortgagesforAprilandMay2020.

Furthermore,adversedevelopmentsinfinancialmarketscouldalsoresultinlowerprofitabilitydrivenbylossinvalueforthebanks’portfoliosespeciallyonthemarked-to-marketsegmentoftheirsecuritiesholdings.

TherestofthisPanelwill takeastaticapproachtothedatagatheredsofartobeabletoinferthelikelyexposureofthelocalfinancialsectortotheaforementionedpotentialvulnerabilities.

Domestic Exposure to Vulnerable Sectors of the Economy

BanksBanks’ deposit funding from the productive sectors most sensitive to COVID-19 contagion mentioned earlier amountedto€5.1billioninDecember2019.Thisdroppedto€4.7billionbyMay2020,equivalentto16.6%ofoverall deposits. The largest share of these deposits pertained to Maltese entities, which amounted to €3.9 billioninMay2020,almostentirely(94.5%)heldwiththecoredomesticbanks.Thelatterfinancedalmostafifthofoverallresidentlending.

Despite the COVID-19 pandemic, resident deposits from the produc-tive sectors most sensitive to the spread continued to flow in, andincreased by 2.6% in the first fivemonths of 2020 (see Chart 1). At a sectoral level, there are wide diver-gences with the manufacturing sec-torrecordingaround23%growthindeposits while the accommodation and food services sector recorded a drop of 21.2%. This divergencereflected,albeitpartially,theasym-metric impact in both timing and intensity of the pandemic acrosseconomic sectors. Deposits from resident households have also con-tinuedtoflowinthedomesticbank-ing system, as the postponement

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Accommodation & food service activities (I)

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Chart 1 CHANGE IN RESIDENT DEPOSITS OF PRODUCTIVE SENSITIVE SECTORS ̶ FIRST FIVE MONTHS OF THE YEAR (per cent)


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ofbothspendingondurablegoodsamidlowerconsumerconfidence,andlowerspendingonrecreationalactivities and other consumer goods given the partial lockdown, resulted in higher savings. Between Janu-aryandMay2020,residenthouseholddepositsrosebyalmost€500million(+4.0%),mainlyreportedinthemonthsofMarchandApril,wheredepositsrosebyaround€420million.Inthefirstfivemonthsof2019,depositshadincreasedby€231.1million(2.0%).

Thebanks’liquidityandfundingpositionisstrong.Indeed,shouldanextremesituationbeconsideredwherealldepositsoftheproductivesectorsmostsensitivetoCOVID-19bewithdrawn,thisshouldnotcauseanyfund-ingconstraintsonthecoredomesticbanks,withtheloan-to-depositratioforcoredomesticbanksincreasingbyaround13percentagepointstoabout73%,stillbelowthe100%mark.TheaggregateampleliquiditypositionisconfirmedbytheliquiditystresstestsdescribedinPanelB,however,vulnerabilitiesaredetectedforsomebanksduetotheseverityofthescenarioswhicharedesignedtoassesssystemicrisk.

Loan portfolioThebankingsystem’screditexposuretoCOVID-19sensitiveproductivesectorsamountedto€8.5billionbytheendof2019,accountingforaround44%ofallloansgranted,andequivalenttojustaboveafifthoftotalassets,remainingrelativelyunchangedasattheendofMay2020.Around60%oftheseexposuresarerelatedtonon-residentlendinglargelybyinternationalbanks,whichhavelimitedornolinkswiththeMalteseeconomy.

Residentlendingtothesameproductivesectorswaslowerandpertainedmostlytothecoredomesticbanks.Ataround€3.6billion,thisstoodatalmostathirdoftheoverallresidentlendingandjust8.7%oftheover-all assets of the banking sector in 2019, which amounted to €41.4 billion. At €3.4 billion, the bulk of these exposuresweregrantedbythecoredomesticbanks.Thesewereequivalentto13.8%ofthecoredomesticbanks’assets,andalmostathirdoftheirloanbook.Inthefirstfivemonthsoftheyear,residentexposurestothesesectorsgrewby2.4%to€3.7billion,whichwasalmostentirelydrivenbyhigherlendingtowardstheaccommodationandfoodserviceactivitiessector,whichroseby12.7%(seeChart2).Residentlendingtothehouseholdsectortotalled€6.1billioninDecember2019,andislargelywithcoredomesticbanks.Dur-ingthefirstfivemonthsoftheyear,itgrewby1.1%.Yet,lessthan10%ofhouseholdloansaresubjecttomoratoria as per Panel C. The resilience of banks against an increase in NPLs from loans to the productive sensitivesectorsandmortgagesgrantedamoratoriumistestedseparatelyinPanelB.

Lendingtonon-residentproductivesensitivesectorsislargelyconcentratedinthetransportandstoragesec-tor,accountingforalmost45%oftotalnon-residentlendingtoproductivesensitivesectors,mainlydrivenbya non-EU branch. Non-resident lending is also prevalent in manufacturing and construction sectors. Mean-while, resident lending is concen-trated in the real estate sector and represented just above a quarter of resident lending to sensitive sectors (seeChart3).Thiswasfollowedbylending towards the wholesale and retail trade sector, construction and accommodation and food services sectors.

International banks are the most exposed to COVID-19 sensitive productive sectors, which on aggregate accounted for around 65%oftheirloanportfolio.However,significant heterogeneity existsamong this group of banks, with some reporting no loans to these sectors, while others are entirely

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Chart 2 CHANGE IN RESIDENT LOANS OF PRODUCTIVE SENSITIVE SECTORS ̶ FIRST FIVE MONTHS OF THE YEAR (per cent)


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exposed, also in view of their limited loan portfolio. The median international bank reported an exposure of 56.3% of their loanportfolio (see Chart 4). Non-core domestic banks’ aggregate exposure stood at 48%, rangingfromalmostniltoaround88%,withamedian level of just above 63%.Meanwhile, core domestic banks are the least exposed with the aggregate exposure standing at 32.8%, closeto the median of 34.2%, with therangespanningbetween21.2%and60.0%.Thisrelativelylowexposure,aswell as the heterogeneitywithinthe group, reflected the significantbut diverging exposure to household lending which on average represents around half of the loan portfolio.

The level of NPLs could shed light on the vulnerability of each sec-tor prior to the pandemic. Some of the sectors prone to the pandemic shock also exhibited elevated NPLs, presenting a riskier exposure to banks going forward. NPLs in these sensitive sectors amounted to around €470 million in March 2020with around38%beingnon-residentNPLs.Around60%of thenon-resident NPLs pertained to the wholesale and retail trade sector (see Chart 5).

Focusing on the resident element, in absolute terms, resident NPLs weremainlyintheconstructionsec-tor, followedby thewholesaleandretail, real estate and manufacturing sectors. The average resident NPL ratio for COVID-19 sensitive sec-tors stood at 8.2% inMarch 2020compared to the overall resident NPL ratio of 7.7%. Nevertheless,throughout the years, significantimprovements were reported by anumber of sectors, with the average NPL ratio for the sensitive sectors droppingfrom9.9%in2018,mainlydrivenby the real estateand con-struction, with the manufacturing

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and accommodation sectors also reporting noticeable drops in NPLs. Chart 6 combines the size of the loan portfolio with the correspond-ing NPL ratio for each vulnerable sector, to shed light on the magni-tude of domestic banks’ exposures at risk from the pandemic. As can be seen in the chart the construc-tion and manufacturing sectors and to a lower extent wholesale and retail sector, among others exhibit an elevated NPL ratio, with local banksalsohavingsignificantexpo-sure in terms of their loan portfolio.

Going forward, as the economic slowdown by the COVID-19 pan-demicissettohaveafurtherimpact,assetqualitymaydeteriorateforanumberofsectors,withtheriskofreversingtheimprovingtrendrecordedinthepastfewyears.

Investment portfolioBanks are also exposed to these productive sensitive sectors through their securities portfolios. The rapid spreadofCOVID-19 tookmarketsbysurpriseand left itsmark,althoughstockmarketshave recoveredsomewhatsincethestartofthepandemic.Volatility,asdeterminedbytheVIXindex,reachedall-timehighsasinvestorsfledtosafety.Assetvaluationsplungedbuttheextentoftheimpactonthebanks’portfoliosislargelydependentontheirpositioningandtheextenttowhichtheyarevaluedatAMCoratFVthroughothercomprehensiveincome.Althoughglobalequitymarketshaverecoveredsomewhat,aidedbycentralbanks’timelyactionsaswellasfiscalsupport,highuncertaintystilllingersasthepandemiccontinues.

Domestic banks held €8.5 billion in debt securities as at the end of March 2020, equivalent to around a fifth of theoverall assets.Of these, almost 40%aremarkedasavailable for sale, andhence suscep-tible to affect theirP&L throughmarket fluctuations.Direct exposures to theproductive sensitive sectorsare limited, as around 70% are invested in government bonds or supranational organisations, whereasaround27%areinvestedinfinancialsector-relatedbonds.Theremaining3.4%areinvestedinnon-finan-cial private sectors, of which around 3 percentage points pertain to productive sensitive sectors, largelyin theprofessional, scientificand technicalactivities,and transportationandstoragesectors.Aroundhalfof such holdings are rated as low or sub-investment grade bonds, with around a third rated as medium, whileabout15%arehigh-investment-gradebonds,mainly reflectingbondholdingsofnon-EUbranches.6

Debtsecuritiesofthecoredomesticbanksrepresented21.1%oftheirtotalassets.Exposureisalsopredomi-nantlyheldingovernmentbonds(around60%oftotaldebtsecurities),followedbyfinancialsector-relatedbonds (approximately35%).Non-financial corporatebondsaccounted for the remaining5%of total debtsecuritiesholdings,ofwhicharoundfourfifthspertainedtoCOVID-19sensitivesectors.Thelatterarelargelymedium-orhigh-ratedbonds,representingaround55%and20%respectively,withtherestheldasloworsub-investment grade bonds.

Yet, while the direct effects of holding securities in sensitive sectors are limited in terms of volumes, market movementscouldaffectthebanks’entireportfolio,forexamplethroughincreasedvolatilityinthemarkets,more so for those securities which are booked at FV rather than at original purchase cost.

6 Investment-gradebondscarryingaratingofAA-oraboveareregardedas‘high-ratedbonds’.‘Medium-ratedbonds’arethoseratedbetween A- and A+, whereas ‘low-rated bonds’ are those rated between BBB- and BBB+. Sub-investment grade bonds are rated lower than BBB.

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Note: Bubble size refers to the loan book, y-axis to the NPL ratio.Source: Central Bank of Malta.

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Domestically-oriented Insurance CompaniesThe pandemic is also leaving its imprint on the insurance sector. While insuring against catastrophic events such as harsh weather con-ditions and other natural disasters has become the norm, insuring against a pandemic is less com-mon. Businesses are inclined to insure against interruption of their activities, but such policies tend to exclude pandemic coverage, high-lightingabusiness linewhichmaygrow in the future. Yet, the COVID-19 era has made it harder for insur-erstoassessandaccuratelymodeltherisksthattheytakeon,coupledwith potential valuation losses on their securities portfolios. In the three months of social distancing, evidence showed that claims for road accidentshalved,aidingthebottomlineofinsurersbutontheotherhandcashflowsforotherbusinesslinescouldbeaffectedduetodelaysinreceiptofpremiaastheeconomycametoavirtualhalt,andincreasedclaims for business interruption.

Exposuresbydomestically-orientedcompaniestotheproductivesensitivesectorsamountedtoalmost€563millionasatDecember2019,equivalenttoalmost15%oftheiroverallassets.Ofthese,around€102millionpertainedtoresidententities,aroundfour-fifthsofwhichwereheldinequitieswiththemajorityoftherestheldasdebtsecurities.Ofthedebtsecurities,around45%arelow-investment-grade,withapproximatelyanother30%medium-rated.Around8%arehigh-investment-gradewiththeremaindereithersub-investmentor unrated. At a sectoral level, the largest exposure is towards the manufacturing sector, amounting to €252.5million,followedbytheinformationandcommunicationsector(seeChart7).

Overall exposures are mainly concentrated within the life undertakings. At around €522 million, theseaccountedforabout16%ofassets.Exposuresbynon-lifeundertakingsweremorelimited,amountingto€40.2million,equivalentto8.7%oftotalassets.

Initialestimatesindicatethatinthefirstquarterof2020,theprevailingmarketconditionsresultedinvalua-tionlossesforanumberofinsurancecompanies,inrelationtosecuritiesholdings,althoughthismayhaveimprovedasmarketsrecoveredinthesecondquarteroftheyear.

Domestically-oriented Investment FirmsTheFinancialStabilityBoardhighlightedthattheCOVID-19pandemichasunearthedanumberofvulner-abilitiesinthefundsindustryasfinancialmarketswentintoafreefallwithdramaticfallsinassetprices.7

Somemarketreactionswereamplifiedbytheneedforinvestmentfundstosellassetstomeetlargeoutflowsas investors tried to realise their gains.

Domestically, based on security-by-security (SBS) data, debt securities of the productive sensi-tive sectors held by the domestically-oriented investment funds amounted to just above €100 million.8

Theseamountedto7.6%ofoveralldebtsecurities,equivalentto3.9%ofassets.Suchsecuritiesmainlyper-tained to the manufacturing and administrative sectors (see Chart 8). Meanwhile, equities of COVID-19 sensitive sectorsamountedto€137.5million,equivalentto14.7%ofallequityholdings,andjustaround5.4%ofassets.9

7 https://www.fsb.org/wp-content/uploads/P150420.pdf8 SBSdatafordebtsecuritiesrepresent94.0%oftotaldebtsecuritiesholdings.9 SBSdataforequityholdingsrepresent66.1%oftotalequityholdings.

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https://www.fsb.org/wp-content/uploads/P150420.pdf

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Such equitiesweremainly relatedto the information and communica-tion sector, manufacturing, trans-port, and retail and wholesale trade sectors. As a result, total exposures to the productive sensitive sectors addupto9.3%ofassets.

From discussions held with local fund managers, it appears that there were no abnormal redemp-tionsduring thefirstquarterof theyear.

ConclusionThe global economic impact from the COVID-19 related disruptions isexpectedtobesignificant.How-ever, policymakers in the fiscal,monetary,micro-andmacroprudentialspherestookimmediateactionstolimitasmuchaspossibletheeco-nomicfalloutfromthepandemicwhileatthesametimesupportingeconomicrecovery.Thepolicyresponsesalsohelpedthefinancialsystemtowithstandtheimpactoftheeconomicdownturn.

The Maltesebankingsectorisfacingthisshockfromastrongfinancialstanding.Itoperatesonthebackofample liquiditybuffersand isgenerallywell-capitalised.Theresilienceof thebankingsector is furtherreaffirmedbystresstestscarriedoutbytheCentralBankofMalta,whichshowthatinasevereadversescenario,overall,banksremainedresilientwithcapitallevelsaboveregulatoryminima,andonlyafewsmallbanks showed some vulnerabilities.

Priortothepandemic,overallbankliquiditywasampleandthiscontinuedtorisegiventhatsavingscontin-uedtoincreaseduringthepandemic.IfthespreadofCOVID-19persistsandrecoveryisprolonged,certainbankingmodelscouldcomeunderpressureforliquidityowingtosuspendedrepaymentsanddrawdownsofalreadycommittedcreditlines.COVID-19willhaveanimpactontheextentofnewcreditandbanks’assetqualitywithapotentialincreaseinprovisioninglevelsandwrite-downs.Thelattertogetherwithaprolongedlow-interestrateenvironmentwouldaffectnegativelybanks’futureprofitability.

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Panel B: Stress Tests on Banks’ Liquidity and Solvency Positions10

Thispanelaimstoassessthebanks’liquidityandsolvencypositionsfollowingthepotentialmaterialisationof specific adverse scenarios emanating from the COVID-19 pandemic. This panel also complementsthe stress tests featured in Chapter 3, particularly the MST framework. Indeed, in order to have amore comprehensive picture of the impact from the evolution of the COVID-19 pandemic over a three-year horizon, the MST framework was run to assess the impact of changes in the macroeconomicand financial environment on banks’ balance sheets under a baseline and an adverse scenario.

ThisPanelfeaturesanumberofsensitivitytestsbasedonMarch2020dataaimedatassessingresilienceagainsthypotheticaladverseoutcomesintheshortterm.Thebanks’liquiditypositionistestedagainst(i)abank-runtypescenario,(ii)thestandardadversescenariossimulatinghigheroutflowsduringthe30-dayhorizon of the LCR framework, and (iii) the impact of additional scenarios testing partial or full withdrawal ofcommitmentsundertheLCRframework.Furthermore,thebanks’solvencypositionistestedagainstapotentialdeteriorationinthecreditqualityofbanks’debtsecuritiesportfolio,andahypotheticalsensitivityanalysisinwhichNPLsinthenon-financialcorporatesectorsmostvulnerabletothepandemicandmort-gages would increase, tested in isolation as well as combined together.

Scenario analyses: Banks’ Liquidity StanceWhileatthereferencedatethepublicwasurgedtomakepaymentsusingcontactlessdebitorcreditcards,andtoengage insocialdistancingasapreventivemeasure, theuncertaintycouldhavetriggeredhigherdepositoutflows.Moreover,thedisruptionoftheperformanceintheproductivesensitivesectorsidentifiedinPanelAandthepossibilityofothersectorsbeingaffectedcouldhavecausedastrainonbanks’liquiditypro-file.Inthisregard,theCentralBankofMaltaassessesbanks’liquiditypositiononaregularbasisbymeansof two frameworks which have been extended to account for COVID-19 adverse repercussions. Persistent deposit withdrawalsThepersistentdepositwithdrawals(PDW)frameworkassesseswhetherindividualbanks’ liquiditybuffersofthehighestqualityaresufficienttomeettheassumedliquidityoutflowsarisingfromabank-runtypesce-nario.TheframeworkusesMarch2020dataandconsidersextremeshockstothedepositoutflowsoveraperiodoffivedaysandthesubsequentthreeweeks,andtestswhethertheshockedbanks’counterbalancingcapacity(CBC)issufficienttomeettheoutflows.TheCBCisdefinedasthequantityoffundsatthebanks’disposaltomeetliquidityrequirements,andiscomposedof,inter alia: cash, excess on their reserve require-ment with the Central Bank of Malta, and funds raised following the sale of marketable securities. Under this test,abankwouldfallshortiftheoutflowsonaspecificday/weekwouldexceedtheavailableCBC.

The framework sources data from prudential reporting templates and makes use of granular information on banks’bondholdingscomplementedbymarket information toassess individualbanks’counterbalancingcapacity.

Twoscenariosareconsidered.Underthefirstscenario,banksareallowedtoobtainfundingfromstandardEurosystemmonetarypolicyoperationsonlyagainstsecuritiesthatwerepledgedwiththeECBasatthereference date.11,12Underthisscenario,bankswouldhavetosell theremainingFVsecuritiesatfiresaleprices.13

10 PreparedbyDavidStephenLaw,SeniorQuantitativeAnalystwithinPolicyCrisisManagementandStressTestingDepartment,andKirstenAbela,QuantitativeAnalystwithinPolicyCrisisManagementandStressTestingDepartment.TheauthorswouldliketothankChris-tineBarbara,ManagerwithinPolicyCrisisManagementandStressTestingDepartment,andAlanCassar,ChiefOfficerFinancialStability,for their valuable suggestions. 11 EligiblesecuritiesrefertosecuritiesthatsatisfytherequirementstobepledgedascollateralforEurosystemmonetaryoperations.12 SecuritiespledgedwiththeECBaresubjecttoaliquidityhaircutaspertheGuideline(EU)2019/1033onthevaluationhaircutsappliedin the implementation of the Eurosystemmonetarypolicyframework(ECB/2019/12).Thehaircutsintheframeworkareregularlyupdatedin line with revisions to the ECB framework.13 Firesalepriceshavebeencalibratedonthebasisofmarketpricesobservedduringthe2008financialcrisis.

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Under the second scenario, banks can pledge all eligible securities with the ECB and sell the remaining FV secu-ritiesatfiresaleprices.Thisdiffersfromthefirstscenariobyalsoincludingotherdebtsecuritieswhichareeligibleandunencumbered.GiventhatthehaircutsassumedforfiresalepricesarehigherthanthevaluationhaircutsthatwouldbeappliedbytheECB,thisscenarioresultsinbankshavingahigherCBCcomparedtothefirstscenario.14

Moreover,inviewoftheECB’songoingcommitmenttoprovideliquidityassistance,thisscenarioisdeemedmore plausible.

Under scenarios one and two, it is assumed that banks do not make use of their AMC securities to raise funds,unless thesearepledgedoreligible forEurosystemmonetarypolicyoperations.BankspurchaseAMC instruments to receivea regular streamof couponpayments and the final principal uponmaturityrather than with the intention ofmaking capital gains by selling themwhen prices increase.While thisaccounting treatment insulates thesefinancial instruments frommarket risk,bankswouldbeatadisad-vantagegiventhat–bywayofextremeassumptioninthistest–thesesecuritiescannotbeusedtoobtainliquidity.Theframeworkconsidersathirdscenariothatwouldgenerateadditionalcounterbalancingcapac-ity for thebanks thatholdAMCsecurities,boosting further theexcess liquiditypresented inscenario2.Under this scenario, banks are assumed to taint their AMC portfolio and convert all securities held at AMC to FV through other comprehensive income (FVOCI) to be able to sell these securities. Core domestic banks had a small decline in the share of securities accounted for as AMC, while for non-core domestic banks, shifts were noted in a few banks from holding securities at FV to those accounted for as AMC.15

Furthermore, under both scenarios it is assumed that the intragroup funding and interbank funding would be suspended and withdrawn for the duration of the stress period.

Intermsofoutflows,theextentofliquidityoutflowsfromdepositsisdeterminedaccordingtotheterm-to-maturity,aswellascustomercategory.TheshocksarecomparabletothecumulativeoutflowratesappliedintheSSM2019LiquidityStressTest(LiST)overafive-dayperiodandafour-weekperiod,andaremoresevere than the adverse scenario and closer to the magnitudes applied in the extreme scenario.16

Tables 1 and 2 present the results of the PDW framework under both scenarios as at March 2020 and reveal thatthethreebankcategoriesmanagetosurvivethetestwithampleexcessliquiditythroughoutthestresstesthorizon.Inthemoreseverescenario(scenario1),excessCBCdropsto56%,52%and71%forcoredomestic,non-coredomesticandinternationalbanks,respectively.Nonetheless,despitetheoverallpositiveresult,afewweaknessescanbeobservedinindividualbanksbydesignoftheframeworkwhichsimulatesseveredepositoutflowstoassesssystemicriskandappliessignificanthaircutstotheavailableCBC.

14 See Box 2 in the Financial Stability Report2015forfurtherdetailonthemethodologyandhaircutsappliedinthePDWstresstest.ThehaircutsforECBeligiblesecuritieshavesincebeenupdatedinlinewiththecurrentguidelinesissuedbytheECBwhichalsoincludehair-cutsforassetswithafloatingcoupon.Previouslytheguidelineprescribedthesamehaircutsasassetswithafixedcoupontype.15 Whilethisscenarioisrelevantforafewbanks,theimpactatbankcategorylevelisonlymarginallydifferentfromscenario2andthusthe results are not being presented. 16 The methodologyoftheLiSTwaspublishedontheSSMwebsiteon6February2019andwasrunbytheECBonasampleofthebanksitdirectlysupervises,includingthreedomesticbanks.

Scenario Day 1 Day 2 Day 3 Day 4 Day 5 Week 2 Week 3 Week 4Core domestic banks 85% 81% 77% 73% 69% 65% 61% 56%Non-core domestic banks 84% 79% 74% 69% 65% 60% 56% 52%International banks 89% 87% 85% 83% 81% 78% 74% 71%

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STRESS TEST RESULTS ̶ IMPACT OF PERSISTENT DEPOSIT WITHDRAWALS ̶ SCENARIO 1, RESTRICTED ECB FUNDING, EXCESS LIQUIDITY TO TOTAL COUNTERBALANCING CAPACITY

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LCR-based liquidity stress testThesecondframeworkistheLCRframeworkwhichassessesthebanks’ratioofhighqualityliquidassets(HQLA)tonetcashoutflowsagainstathresholdof100%.

The framework as introduced in the Financial Stability Report 2018, is run on a baseline and four adverse scenarios.Thebaselinescenarioappliesthebenchmarkhaircutsandinflow/outflowratesasprescribedbythe European Commission (EC) Delegated Regulation (EU) 2015/61 (hereafter, LCR Delegated Regula-tion)andactsasamonitoringtoolfortheLCRasreportedbybanks.Theadversescenariostargethigheroutflowswhileassuming that theHQLAbuffer remainsunchanged.Thefirst adversescenarioassumeshigheroutflowratesthanthoseappliedinthebaselinescenario(approximately1.5timeshigherexceptforcategoriesforwhichtheLCRDelegatedRegulationalreadyappliesa100%outflowrateandhencecan-notbeincreasedfurther).Theremainingthreeadversescenarioscombinethesehigheroutflowrateswithadditionalwithdrawalsoffixed-termdepositswhichhaveacontractualmaturityexceedingthe30-dayperiodcoveredbytheLCRDelegatedRegulation.Thesescenariostargetdepositsplacedbyeitherresidents,non-residentsorboth,respectively,andweredesignedtoassumethatcustomerswouldbewillingtoforfeitanyaccrued interest to access their funds.17

InadditiontothesestandardLCRscenarios,theframeworkisflexibleinawaythatitallowsnewscenariostobedesigned.InthemidstoftheuncertaintycreatedbyCOVID-19,bothintermsoftheimpactandthedurationofthepandemic,considerationisgiventotheliquiditystanceofbanksshouldstrugglingNFCsandhouseholds(theretailsector)availthemselvesofanyapprovedbutunutilisedcredit,beitonexistingloans,overdraftsorcreditcards.Inthisregard,fouradditionalscenarioswereconsideredwherebybanksexperi-ence a partial or full withdrawal of commitments to NFCs and the retail sector. Table 3 provides a description of these scenarios.

17 See Box 4 in the Financial Stability Report2018forfurtherdetailonthemethodologyandhaircutsappliedintheLCRstresstest.

Scenario Day 1 Day 2 Day 3 Day 4 Day 5 Week 2 Week 3 Week 4Core domestic banks 88% 85% 82% 78% 75% 72% 69% 66%Non-core domestic banks 86% 82% 78% 74% 70% 66% 62% 59%International banks 90% 88% 87% 85% 84% 80% 77% 75%

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STRESS TEST RESULTS ̶ IMPACT OF PERSISTENT DEPOSIT WITHDRAWALS ̶ SCENARIO 2, UNRESTRICTED ECB FUNDING, EXCESS LIQUIDITY TO TOTAL COUNTERBALANCING CAPACITY

Scenario DescriptionBaseline Haircuts and outflow/inflow rates as prescribed by the LCR Delegated RegulationAdverse:Scenario 1 Higher outflows compared to the LCR Delegated Regulation Scenario 2 Scenario 1 with additional withdrawals of resident time deposits (>30 days) Scenario 3 Scenario 1 with additional withdrawals of non-resident time deposits (>30 days)Scenario 4 Scenario 1 with additional withdrawals from both resident and non-resident time deposits Scenario 5 Baseline scenario with 50% withdrawal of committed facilities to NFCsScenario 6 Baseline scenario with 100% withdrawal of committed facilities to NFCs Scenario 7 Baseline scenario with 100% withdrawal of committed facilities to retail, including mortgagesScenario 8 Baseline scenario with 100% withdrawal of committed facilities to retail and NFCs

Table 3DESCRIPTION OF BASELINE AND ADVERSE SCENARIOS


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AsatMarch2020, theLCRunder thebaselinescenariostoodat351%forcoredomesticbanks,352%fornon-coredomesticbanksand315%forinternationalbanks.Underadversescenario4,whichconsid-ershigheroutflowratesforallresidentandnon-residenttimedeposits,theLCRfallsto172%,216%and85%forcoredomestic,non-coredomesticandinternationalbanks,respectively.Ontheotherhand,underadversescenario8,whichconsidersa100%withdrawalofcommittedfacilitiesforboththeNFCsandretailsector,theLCRfallsto130%,337%and297%forthecoredomestic,non-coredomesticandinternationalbanks,respectively.

Bydesignoftheadversescenariosandtheseverityoftheshocksapplied,weaknessesareidentifiedatanaggregate bank level for the international banks (under adverse scenarios 3 and 4) as well as at an individual banklevelforalleightadversescenarios,withsomebanksexperiencinganLCRbelow100%.Itshouldbenotedthatintimesofstress,banksareallowedtobreachtheLCRrequirementaslongastheyprovideaplanoutliningwaysinwhichtheLCRwouldberestored. Thisisespeciallythecasenow,asECBBankingSupervisionhasannouncedthatitwillallowbankstooperatetemporarilybelowtheLCRaspartofthetem-porarycapital,liquidityandoperationalreliefinreactiontoCOVID-19 via a press release published on the 12 March 2020. Moreover, the MFSA has also issued a Circular to extend these same relief measures to all credit institutions under its direct supervision. Therefore, these vulnerabilities have to be seen in the context inwhichthesupervisorshaveannouncedthattheywilltemporarilytoleratedipsintheLCRrequirements,inviewofthecurrentextraordinarycircumstances.

Chart 9 shows the results for the three bank categories under the baseline and adverse scenarios. Byfocusingonthefirstfouradversescenarios,thelargestdropisobservedunderscenario1duetoageneraltendencyforrelianceonshort-termfunding.Indeed,scenario2isonlyminimallydifferentfromscenario1,mostlyaffectingcoredomesticbanksgiventheirhighershareofresidentdeposits.Underscenario3thereisafurthersignificantimpactontheLCRofinternationalbanksduetotheirrelianceonnon-residenttermdepositsasasourceof funding. Indeed, the internationalbankscategory fallsbelow the100% require-mentunderboththeadversescenarios3and4duetotheadditionaloutflowsappliedtonon-residenttermdeposits. With regard to additional scenarios targeting the withdrawal of committed facilities, the largest impact is observed for core domestic banks being the main providers of mortgages and loans to domestic NFCs. While the data distinguish between the NFCs and retail sectors, it is not possible to determine the extent of com-mitmentswhichcouldberevokedbythebanks.Inaddition,thefullwithdrawalfromcommittedcreditlinesto retail customers includes also mortgages for which a sanction let-ter was issued. While prospective clients could have more than one sanction letter from multiple banks after shopping around for the best rates and loan conditions, no new property sale contracts could besigned in the immediate months following the reference date due to COVID-19-related measures. Nonetheless, the adverse scenar-ios assume that these temporarymeasures are not in place and all committed funds are available for withdrawal and show that all three bank categories remain well above the100%LCRrequirement.

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Chart 9STRESS TEST RESULTS – LCR RESULTS FOR ALL BANKS(per cent)




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Scenario analyses: Banks’ SolvencyTheuncertaintyduetoCOVID-19couldaffecttheeconomicperformanceofanumberoffirmsresultinginanincreasedriskofdefaultonloansanddebtsecuritiesissuedbythesefirms.Asaresponse,governmentsandpolicymakershave issuedanumberoffiscal,macroeconomicandfinancialmeasureswith theaimof mitigating this risk, improving resilience of various sectors as well as economic agents and bolstering economicactivity (refer toPanelC for furtherdetailon the implementationofpolicymeasures).For thepurposesofstresstestingexercises,eventhoughfirmsmightnotdefault,theuncertaintysurroundingtheunfolding of COVID-19 could affect the pricing of their debt securities. Inthisregard,theCBMhasalsoconductedsensitivityteststoassesstheimpactoncapitalfromadeteriora-tioninthequalityofthebanks’holdingsofdebtsecuritiesaswellasdefaultonloansgrantedtotheproduc-tivesensitivesectorsasidentifiedinPanelAandmortgages.Thetestsarecarriedoutbothtoassesstheeffect on the portfolios in isolation as well as combined, as described below.

Credit quality deterioration in the debt securities portfolioInordertoassesstheimpactofadeteriorationinthecreditqualityandvaluationofdebtsecuritiesfromcom-paniesoperatingwithintheidentifiedsensitivesectors,thetraditionalcreditqualitydeterioration(CQD)sen-sitivityanalysisasreportedinpreviousFinancial Stability Reportscouldbemodifiedtofocusontheperfor-manceofthesesectors.However,thetraditionalsensitivitytestalreadytakesintoaccountpossiblecontagionacrossallsectorsandquantifiescreditriskfordebtsecuritiesheldatAMCagainstathree-notchdowngradeintheirofficialrating,whileawideningofcreditspreadsandvaluationhaircutsareappliedfornon-sovereignandsovereignnon-AMCdebtsecurities,respectively.Thus,thetestisrunonallholdingsofdebtsecuritiesasatMarch2020,ratherthanonlyonthoseconsideredassensitivesectorsasdescribedinPanelA.

AsatMarch2020,followingthecreditqualitydeteriorationofbanks’debtsecuritiesportfolio,theresultingTier1capitalratiosremaincomfortablyabovethe6%regulatoryrequirementforallbanks.Chart10showsthatinsuchascenario,Tier1capitalratioswouldfallfrom17.26%to16.43%,from18.05%to16.91%andfrom67.53%to66.96%forcoredomestic,non-coredomesticandinternationalbanks,respectively.

Credit quality deterioration in the loan portfolioThis sensitivity analysis has beendesigned to assess the impact on solvency from a hypothetical situ-ation in which performing loans to the identified productive sensitivesectors (refer to Panel A of this Spe-cial Feature) and mortgages, which have been granted a moratorium (up to May 2020), would becomenon-performing.18 This test excludes the effect on remaining sectors not identified as sensitive, given thatthese represent a negligible portion of the NFC portfolio and would not significantly influence the results.Bankswhichhavenotgrantedanymoratoriaonloanstotheidentifiedsensitive sectors and mortgages

18 WhilethetestreferstobankdataasatMarch2020,theuptakeofmoratoriahasbeencalibratedatMay2020tocapturebothmora-toriagrantedbybanksattheonsetofthepandemic,aswellasaftertheCentralBankofMaltaissuedDirective No. 18 on 13 April 2020 to regulate moratoria granted to credit facilities in exceptional circumstances.

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Chart 10STRESS TEST RESULTS ̶ IMPACT OF DETERIORATION IN DEBT SECURITIES PORTFOLIO ON TIER 1 CAPITAL RATIO(per cent)



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are excluded from the analysis.19

Upon classification of NPLs, thebanks would need to increase their loan loss provisions based on the uncollateralised part of the loans. These provisions are charged to the P&L and in the case that operat-ingprofitsprovideonlypartial lossabsorption, banks would need to release capital to offset the residual losses.

As at March 2020, the assumed increase in NPLs would have an impacton10banks,asonlythesebanks have granted moratoria to the identified productive sensitivesectors and mortgages. Chart 11 shows that in such a scenario, Tier 1capitalratioswouldfallfrom17.26%to15.07%,from18.04%to17.58%andfrom43.10%to39.02%forcoredomestic,non-coredomesticandinternationalbanks,respectively–butremainingwellabovetheregu-latoryTier1capitalratiorequirementof6%.TheimpactontheTier1capitalratioofthe10banksinscoperanges between 0.08 and 7.37 percentage points, and is a worst case scenario assuming that none of the borrowers that were granted a moratorium would be in a position to honour their obligations.

Credit quality deterioration in the debt securities and loan portfolioTo further assess the banks’ solvency positions, the previous two sensitivity analyses are combined toconsideradeteriorationinthecreditqualityofboththedebtsecuritiesportfolioaswellasanincreaseinNPLs from the loans granted to the productive sensitive sectors (identified inPanelA) andmortgages.Fifteenbanksfallwithinscopeofthistest,withthesame14banksincludedinthesensitivityanalysisontheirdebt securities portfolio plus another bank which does not hold debt securities but has granted moratoria to loansintheidentifiedproductivesensitivesectors.

Thequantificationof the impactofthe combined scenario would result in a drop in the Tier 1 capital ratio of 3.02, 1.52 and 2.78 percentage points for core domestic, non-core domestic and international banks, respectively. Chart 12 shows thattheir Tier 1 capital ratio would drop from 17.26% to 14.24%,from 18.05% to 16.53% and from63.75% to 60.97%, respectively.The materialisation of the assumed shocks would therefore leave all three bank categories in a comfort-able position to absorb potential losses when compared to the regu-latoryminimumTier1capital ratioof 6%.These results are corrobo-

19 For this reason, the starting Tier 1 capital ratio of non-core domestic and international banks varies from that presented in the previous section and Chapter 3 due to the different sample of banks considered.

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Chart 11 STRESS TEST RESULTS ̶ IMPACT OF AN INCREASE IN NPLS IN SENSITIVE SECTORS AND MORTGAGES ON TIER 1 CAPITAL RATIO (per cent)


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Chart 12STRESS TEST RESULTS ̶ IMPACT OF DETERIORATION IN DEBT SECURITIES PORTFOLIO AND INCREASE IN NPLS IN SENSITIVE SECTORS AND MORTGAGES ON TIER 1 CAPITAL RATIO(per cent)


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ratedbythefindingsoftheMSTframeworkwhichbytheendofthethree-yeartesthorizonshowthatcoreand non-core domestic banks would remain resilient to the pandemic-related scenario. Credit risk would be amajorcontributortotheoveralllossesexperiencedundertheslowerpacedeconomicrecoveryassumedunder the adverse scenario.

ConclusionAs part of the stress testing frameworks presented in Chapter 3, the CBM has run its MST framework based onscenariostailoredtotheCOVID-19pandemic.Thepurposeofthesescenariosistofocusonsystem-widerisks–thus idiosyncrasies,whicharespecificto individual institutions,maynotbedirectlyorspecificallycaptured.

The scenarios applied in the MST consist of a baseline to account for the – at least partial – success of the containment measures introduced, and an adverse scenario assuming the implementation of additional measurestocontainasecondwaveofinfectionsthatwouldfurtheradverselyinfluencethemacroeconomicenvironment. Under the baseline scenario, it is observed that the overall losses experienced following the unfoldingofthepandemic,whicharecharacterisedprimarilybyhighercreditrisklossesfromboththehold-ings of debt securities and the loan portfolio (including mortgages), would affect non-core domestic banks morethancoredomesticbanksduetotheirinternationally-orientedbusinessmodels.Moreover,evenunderthe adverse scenario, core and non-core domestic banksmanage to absorb the losses and satisfy theapplicable capital requirements. The stress test results show overall resilience of the banking sector to the COVID-19-related scenarios, with capital depletion under the adverse scenario being more substantial for small individualbanks.TheresultsoftheadversescenariocorroboratethefindingsoftheECB’sVulner-abilityAssessmentforasampleofEurosystembanks,whichconcludesthat:“overall,theresultsshowthatthe banking sector is well positioned to take on the pandemic-induced stress impact, but capital depletion in theseverescenariocouldbematerial.”

Panel B of this Special Feature complements the stress test results presented in Chapter 3 with additional stresstestsandsensitivityanalysesrunspecificallytotestresilienceintermsoftheliquidityandsolvencypositionusingdataasatMarch2020.WhilethesedatareflectatbesttheonsetofCOVID-19and–inthemeantime – banks are expected to be facing more dire conditions, a number of mitigation measures have been put in place to counteract the impact of the pandemic. Further detail on mitigation measures is provided in the next panel of this Special Feature.

WithreferencetotheliquiditystresstestspresentedinthisPanel,theirresultsshowbroadresilienceunderboth the adverse deposit withdrawals scenario (PDW framework) as well as the eight LCR adverse sce-narios followingan impact of higher outflowsandapartial or fullwithdrawal of commitments.However,weaknessescanbeobservedinafewbanksgiventhesevereoutflowratesappliedtotestforsystemicrisk.Thisisespeciallyrelevantforthosebanksthatarereliantonshort-termfundingandfurtherexacerbatedforthecategoryofinternationalbankswhentheseoutflowsarepairedwithwithdrawalsfromnon-residenttermdeposits. Whenconsidering thePDWstress test,mostbankswouldbeable tosurviveanadversebank-run typescenarioforaprotractedperiodextendingbeyondtheone-monthhorizon.VulnerabilitiescanbeobservedinsomebankswithregardtotheLCRstresstest.Thesevulnerabilitiesaretobeexpectedgiventheseverityoftheassumedshocksintherespectivescenarios,whicharedesignedtoassesssystemicrisk.Further-more,thesemustbeseeninthecontextofthecurrentextraordinarycircumstancesandthebanks’businessmodelsasaresultofwhichitisexpectedthatafewlocalbankswoulddipintoanLCRlowerthan100%.Suchshortcomingsarebeingtoleratedduringthecrisisbythesupervisors.

Ontheotherhand,thesolvencysensitivityanalysesbasedonadeteriorationinthecreditqualityofboththebanks’ debt securities portfolio and the increase in NPLs from moratoria granted on loans in the productive sensitivesectorsandmortgages(testedindividuallyandsimultaneously)showanoverallresilienceinthebanks’ capital positions. The tests cover the entire debt securities portfolio and the loan portfolio (mortgages



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andvirtuallyalloftheNFCloansportfolioastheproductivesensitivesectorsrepresentthemaineconomicactivitiesofNFCborrowers),respectively,andcomplementthefindingsoftheMSTbyfocusingontheshort-termimpactofspecificassetclasses.

Althoughthebankingsystemingeneralappearstoberesilientagainstthecontemplatedscenarios,stresstestsarenot tobeconstruedas forecastsas theyattempt tocapture theeffectsofacontemplatedsce-narioonbanks’financialsituationatapointintime.Thedurationandextentofthepandemicalsoremainsunknownandthusanypotentialfurtherdeteriorationinthemacroeconomicenvironmentwouldlikelyexac-erbate the adverse impact on the results.

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Panel C: The CBM’s Policy Response to the COVID-19 Outbreak20

TheCOVID-19outbreakandthehealthmeasurestakentocontainthepandemicpresentedasignificantand unforeseen economic shock to businesses, as well as individual workers and households. Business disruptionshaveledtosignificantstrainsoncashflowsandincome,withsomebusinessesexperiencingacompletehaltincashinflows. Ifleftunaddressed,thistemporaryliquiditystraincouldleadtoaforcedfiresaleofassetsandresultintheundueclosureofotherwisesolventbusinesses.Indeed,asaresultofbusinessdisruptions,somefirmshavefoundthemselvesinapositionoftemporaryinabilitytoservicetheirbanklending,whileothersneededfur-therfinancingforcontinuedworkingcapitalneeds.Persistentliquiditystrainscouldalsoexacerbatetheinitialeconomicshock,andleadtoanegativefeedbackloop.Intheabsenceofadequatepolicyresponse,borrow-ers who were unable to continue servicing their debts would have otherwise defaulted, in accordance with the90-days-pastduecriterionasspecifiedinArticle178(1)(b)ofCRR,orbecomeforborne.Consequently,bankswouldberequiredtosubstantiallyincreaseprudentialprovisionstocoversuchlosses,placingfurtherstrainon theirprofitability.Moreover, capital levelswouldbenegatively impacted, therebypresentinganobstacletothecurrentlymuchneededbanklendingcapacitytocontinuefinancingeconomicactivities inordertostimulateeconomicrecovery.Atthesametime,affectedborrowersseekingtoobtainamortgageonthebackofthetemporaryreducedincomewillfinditincreasinglymoredifficulttomeetthecriteriastipulatedin CBM Directive No. 16 ‘Regulation on Borrower-Based Measures.’

TheongoingworkandpolicymeasuresthatwereintroducedbytheCentralBankofMalta,theECB,Euro-peanSupervisoryAuthorities,theMFSAandGovernmentwiththeonsetoftheCOVID-19outbreak,playedacrucialroleinsafeguardingfinancialstabilityinsuchcircumstances.Inexercisingitsmacroprudentialman-date, the Central Bank of Malta enacted a new Central Bank of Malta Directive No. 18 on Moratoria on Credit FacilitiesinExceptionalCircumstances,andalsoissuedaNoticeonthetemporaryeasingofcertainrequire-ments of Central Bank of Malta Directive No. 16. Furthermore, the CBM issued Directive No. 17 on Business ContinuityMeasuresconcerningdepositandwithdrawalofcash,depositandencashmentofpaper-basedinstrumentsandprovisionofservicesthroughalternativedeliverychannels,andamendedCentralBankofMaltaDirectiveNo.8onMonetaryPolicyInstrumentsandProcedures.

Measures adopted by the Central Bank of Malta

Amendments to Central Bank of Malta Directive No. 8 on ‘Monetary Policy Instruments and Procedures’TheCentral Bank ofMalta initially amendedCBMDirectiveNo. 8 onMonetary Policy Instruments andProcedures on 20 April 2020 to implement Guidelines ECB/2020/20 and ECB/2020/21.21,22,23 The changes includedcollateraleasingmeasurestofacilitateEurosystemcounterpartiesinmaintainingsufficientcollat-eralinordertobeabletoparticipateinallliquidity-providingoperations.Furthermore,theGoverningCounciloftheECBdecidedtotemporarilyincreaseitswillingnesstotakeonriskstosupporttheprovisionofcreditvia itsrefinancingoperations. Inparticular, thevaluationhaircutsappliedtocollateralwerereducedbyafixedfactor.Furthermore,nationalcentralbankscouldacceptascollateralforEurosystemcreditoperationsmarketabledebtinstrumentsissuedbythecentralgovernmentoftheHellenicRepublic.

20 PreparedbyBrendonCassar,EconomistwithinPolicyCrisisManagementandStressTestingDepartment,andJoanneCiantar,AnalystwithinPolicyCrisisManagementandStressTestingDepartment.TheauthorswouldliketothankStephenAttard,HeadwithinPolicyCrisisManagementandStressTestingDepartment,andAlanCassar,ChiefOfficerFinancialStabilityfortheirvaluablesuggestions.21 CentralBankofMaltaDirectiveNo.8onMonetaryPolicyInstrumentsandProcedures.Source:https://www.centralbankmalta.org/file.aspx?f=437 22 Guideline(EU)2020/515oftheECBof7April2020amendingGuidelineECB/2014/31onadditionaltemporarymeasuresrelatingtoEurosystemrefinancingoperationsandeligibilityofcollateral(ECB/2020/21).Source:https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32020O0515&from=EN23 Decision(EU)2020/506oftheECBof7April2020amendingGuideline(EU)2015/510ontheimplementationoftheEurosystemmon-etarypolicyframeworkandGuideline(EU)2016/65onthevaluationhaircutsappliedintheimplementationoftheEurosystemmonetarypolicyframework(ECB/2020/20).Source:https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32020D0506&from=EN



https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32020O0515&from=EN


https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32020D0506&from=EN

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TheDirectivewasfurtheramendedon27April2020toreflecttheCBM’sdecisiontoreducetheminimumsize threshold of domestic credit claims to €25,000 from €500,000. TheDirectivewasalsoamendedon18May2020,toimplementGuidelineECB/2020/29.24 The measures wereaimedatmitigatingtheadverseimpactonEurosystemcollateralavailabilityofpotentialratingdown-grades resulting from the economic fallout of the COVID-19 outbreak.

TogetherwiththemeasuresadoptedinApril2020,thesenewmeasuresaimedatensuringthatEurosystemcounterpartiesremainabletomaintainandmobilisesufficientcollateralinordertobeabletoparticipateinEurosystemliquidity-providingoperationsandthatthereforetheEurosystemisinapositiontosupporttheprovisionofcredittotheeuroareaeconomy.

Notice on the amendments to Directive No. 16 ‘Regulation on Borrower-Based Measures’TheCBMalsodeemeditnecessarytotakeadditionalmeasurestosafeguardborrowerswhohavebeennegativelyimpactedbytheCOVID-19pandemicandwhomaythereforebeinatemporarilyweakerfinancialposition toobtainfinancing forpurchasingRREproperty.Furthermore, theCOVID-19pandemiccausedseriousdisruptionsineconomicactivity,includingintherealestatemarket,particularlyarisingasaresultofdisruptionsinbankingandnotarialservices,increaseindemandforcashbuffersinsuchextraordinarytimes,and social distancing restrictions which had a negative impact on the search and negotiation processes betweenbuyersandsellers.

As a result, on 1 June 2020, the CBM issued a Notice to amend Directive No. 16 on Borrower-Based Mea-sures, which sets limits on the LTV ratio at origination (LTV-O), Debt-Service-to-Income (DSTI-O) ratio at origination,andtermtomaturityforRREloans.25,26,27

Inlightofpotentialtemporaryshocksonborrowers’incomeasaresultoftheCOVID-19pandemic,borrow-erspurchasingasecondpropertymightfinditmoredifficulttomeetthe25%depositrequirementapplicableasfrom30June2020andmightthereforebeunabletoobtainthenecessaryfinancing,therebyreducingmortgagecreditavailabilityfornewpropertybuyers.Asaresult,inordertoprovidethenecessaryrelieftoprospectiveCategoryIIborrowers,theCBMgrantedanextensionofoneyearintheapplicableLTV-Oratioforsuchborrowers,whichcurrentlystandsat85percent,upuntil30June2021.Thiswouldenablesuchborrowerstodisbursealoweramountofcash,namelytocontinuewithadown-paymentof15%ratherthanthe25%asthatoriginallyanticipatedbytheDirectiveasfromJuly2020. Inlightoftheabove-mentionedtemporaryincomeshocksufferedbyborrowers,theCentralBankofMaltaprovidedforatemporaryeasingintheapplicablestressedDSTI-OratioforbothCategoryIandCategoryIIborrowers. Lenders can, at their own discretion and provided that a number of conditions are met, grant new RREloanswithastressedDSTI-OratiohigherthanthelimitsetintheDirectiveof40%.Asaresult,lenderswouldbetemporarilyabletoprovidenewmortgageloanswherestresseddebtservicingcouldamounttomorethan40%oftheirincome,subjecttocertainconditions.

The Central Bank of Malta granted the concession on the stressed DSTI-O ratio for a period of six months, until 1 December 2020, and indicated that it is to be applied on a forward-looking basis over the whole life cycleoftherespectiveRREloan.

24 Guideline(EU)2020/634oftheECBof7May2020amendingGuidelineECB/2014/31onadditionaltemporarymeasuresrelatingtoEurosystemrefinancingoperationsandeligibilityofcollateral(ECB/2020/29).Source:https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32020O0634&from=EN25 Notice – Directive No.16 ‘Regulation on Borrower-Based Measures’ – COVID-19 Related Measures. Source: https://www.centralbank-malta.org/en/news/79/2020/8823 26 Central Bank of Malta Directive No. 16 in terms of the Central Bank of Mala Act (Cap.204) – Regulation on Borrower-Based Measures. Source: https://www.centralbankmalta.org/file.aspx?f=72401 27 DirectiveNo.16distinguishesbetweentwocategoriesofborrowers–CategoryIandCategoryIIBorrowers.CategoryIborrowersrefersmainlytoborrowerspurchasingtheirprimaryresidencewhileCategoryIIborrowsreferstoborrowerspurchasingRREpropertyforsecondaryresidencepurposesorforbuy-to-let.DetailsonthefulldefinitionsofbothCategoriescanbereferredtoinparagraph6oftheDirective available in the link as per preceding footnote.



https://www.centralbankmalta.org/en/news/79/2020/8823



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Central Bank of Malta Directive No. 17 on ‘Business Continuity Measures concerning deposit and withdrawal of cash, deposit and encashment of paper based instruments and provision of services through alternative delivery channels’Following the advice of national health authorities for persons to remain indoors as much as possible, on 25 March 2020, the CBM issued Directive No. 17 on important measures concerning encashment of cheques to enablepersonstoavoidasmuchaspossiblevisitingbankbranchesandotherfinancialserviceproviders,bydepositing them through trusted third parties.28 The measures were introduced after consultation with com-mercialbanksasatemporarymeasureduringthepandemicrestrictions,andcameintoforceon26March2020.TheDirectivemaintainsbankingservicesessentialtothelifeofthecommunitybysettingminimumservicestobeprovidedbycommercialbanksandfinancialinstitutions,concerning:

• deposit, encashment and clearing of cheques, bank drafts and similar instruments;• provisionofservicesthroughalternativedeliverychannels;• chequesmarkedas“only”forusebythebeneficiarycanbedepositedbyatrustedthirdparty,subject

toendorsementbyboththepayeeandthethirdparty;• over-the-countercashwithdrawalsfromadepositaccountassociatedwithapaymentcardshallonly

beentertainedifinexcessoffivehundredeuro(€500).

Central Bank of Malta Directive No. 18 on Moratoria on Credit Facilities in Exceptional CircumstancesOn 13 April 2020, the Minister responsible for public health, with the concurrence of and after consultation with the Minister for Finance and Financial Services, the Superintendent of Public Health, the CBM and the MFSA, and following consultation with the Malta Bankers’ Association, published Legal Notice 142 on Moratorium on Credit Facilities in Exceptional Circumstances Regulation. The Legal Notice gave the right tothoseborrowerswhoweremateriallyaffectedbytheCOVID-19outbreaktoapplyforamoratoriumofsixmonthsontheirloans,subjecttothefulfilmentoftheeligibilitycriteria.SuchcriteriawereregulatedviatheCBM Directive No. 18, which is also aligned with the guidelines on legislative and non-legislative moratoria onloanrepaymentsappliedinthelightoftheCOVID-19crisis,issuedbytheEBA.29

Features of Directive No. 18 DirectiveNo.18determinestheeligibilitycriteriaofapplicantswiththefirstconsiderationbeingthatthedebtservicingcapabilityofvariousborrowersfromawidevarietyofeconomicsectorswouldhavebeennega-tivelyimpactedbytheCOVID-19outbreakinaheterogeneousmanner.Moreover,themoratoriumisopentoallretailandnon-retailclientsincludingnon-financialcorporates,micro,smallandmediumsizedenterprises,self-employed,personsinemploymentandhouseholds,whowerenotinarrearsandweremeetingfullytheircommitments prior to 1 March 2020.

Loansgrantedpriorto14April2020canbeinscopeoftheDirectiveandtheaccompanyingLegalNotice142.30TheeffectsofCOVID-19werematerialisinginMaltainMarch2020withthefirstcasereportedonthe7ofMarch.Thus,anydifficultiesinrepaymentordefaultswhichwerespecificallyasaresultofCOVID-19shouldhavemanifestedonlyafterMarchandnotbefore. Applicationsforamoratoriumaretobemadeonavoluntarybasis,whichapplicationdeadlinewasoriginallyplanned to expire on 30 June 2020, but was later extended to 30 September 2020.31 Together with this appli-cation,obligorsmustpresentsufficientevidencetoprovethattheirinabilitytocontinueservicingtheirdebtis

28 CentralBankofMaltaDirectiveNo.17intermsoftheCentralBankofMaltaAct(Cap.204oftheLawsofMalta)–BusinessContinuityMeasures concerning deposit and withdrawal of cash, deposit and encashment of paper based instruments and provision of services through alternativedeliverychannels.Source:https://www.centralbankmalta.org/file.aspx?f=92791 29 EBAGuidelinesonlegislativeandnon-legislativemoratoriaonloanrepaymentsappliedinlightoftheCOVID-19crisis.Source:https://eba.europa.eu/sites/default/documents/files/document_library/Publications/Guidelines/2020/Guidelines%20on%20legislative%20and%20non-legislative%20moratoria%20on%20loan%20repayments%20applied%20in%20the%20light%20of%20the%20COVID-19%20c-risis/882537/EBA-GL-2020-02%20Guidelines%20on%20payment%20moratoria.pdf 30 L.N. 142 of 2020 Moratorium on Credit Facilities in Exceptional Circumstances Regulations, 2020: https://legislation.mt/eli/ln/2020/142/eng/pdf31 See related press release on the following link: https://www.centralbankmalta.org/en/news/14/2020/8832


https://eba.europa.eu/sites/default/documents/files/document_library/Publications/Guidelines/2020/Guidelines%20on%20legislative%20and%20non-legislative%20moratoria%20on%20loan%20repayments%20applied%20in%20the%20light%20of%20the%20COVID-19%20crisis/882537/EBA-GL-2020-02%20Guidelines%20on%20payment%20moratoria.pdf




https://legislation.mt/eli/ln/2020/142/eng/pdf

https://legislation.mt/eli/ln/2020/142/eng/pdf


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temporaryandrelatedtoCOVID-19.TheevidencesubmittedisimportantfordeterminingwhethertheissueisoftemporaryilliquidityandisaconsequenceofCOVID-19oranissueoflonger-terminsolvency. TheDirectivealsoprovidesfullflexibilitytotheborrowertobeabletopostponetemporarilyinterestsand/orprincipalrepayments,inpartorinfull.Thus,theborrowerisabletoadjusttherepaymentstoitsspecificneedsandcanexitthemoratoriumbeforeitsexpiry.Duringtheperiodofthemoratorium,interestcontinuestoaccrue.Inlinewiththis,inthe23AprilCBMCommunication,theCBMclarifiedthatduringthecourseofthe moratorium, interest is to be accrued but not capitalised; in other words no interest compounding is to occur during this period.32

Themoratoriumallowsadegreeofcertaintyforbusinessesandindividualsaliketobeabletoplantheircashflowmanagement,whichuptonowhasbeenextendedto12monthsforthoseborrowersthathadappliedupto30June2020,andbysixmonthsfornewapplicantsfollowingJune2020. Take-up of Moratoria up to May 202033

BytheendofMay2020,thetotalvalueofloanssubjecttomoratoriastoodat€1.9billion.Ofthese,81%weregrantedtoresidents,largelybythecoredomesticbanksandaccountedfor10.2%ofoutstandingloansinthebankingsystem. Credit registerdataon the take-upofmoratoriasheds lightalsoonspecificeconomicsectors thatwerehardest-hitbytheCOVID-19pandemic.Table4ranksthesectorsthatweregrantedmoratoriabythevalueof outstanding resident loans. The household sector attracted the lion’s share of moratoria but these repre-sented9.8%ofoutstandinghouseholdloans.

Around6,921household loansweresubject toamoratorium,ofwhich79%weremortgages to residenthouseholds.Non-residentmortgagessubjecttoamoratoriumwerelimitedtojust1%.Therestweremora-toria on consumer facilities, the bulk of which were to resident households (see Chart 13).

32 https://www.centralbankmalta.org/en/news/79/2020/880533 PreparedbyWendyZammit,HeadFinancialStabilitySurveillanceandResearchDepartment,andDenisCecchiniButsugan,InspectorCreditReferenceAgencieswithintheStatisticsDepartment.TheauthorswouldliketothankAlanCassar,ChiefOfficerFinancialStabilityfor his valuable suggestions.

(number of loans; EUR million; percentage)Volume of

loans(1)Outstanding

amounts(2)Share in sector`s

outstanding loans(3)

Households 6,847 593.2 9.8%Construction and real estate 487 293.3 19.4%Accommodation and food service activities 370 194.4 45.7%Financial and insurance activities 64 91.3 11.2%Wholesale and retail trade; repair of motor vehicles and motor cycles 462 76.1 12.2%Administrative and support service activities 72 76.1 23.0%Professional, scientific and technical activities 81 62.6 20.2%Manufacturing 148 44.7 21.3%Information and communication 26 33.4 54.6%Others 291 73.9 8.5%Total 8,847 1,538.9 13.7%Source: Central Bank of Malta.(1) Number of loans subject to moratorium.(2) Outstanding amount of loans subject to moratorium as at end month, in EUR million.(3) The percentage of loans subject to moratorium in total outstanding loans held by the sector as at end of month.

RESIDENT EXPOSURES SUBJECT TO MORATORIUM ̶ AS AT END MAY 2020Table 4


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The real estate sector came to a virtual halt during the peak of the pandemic.Inrecentyears,thissec-tor has grown in importance with its share in overall gross value added standingatapproximately5%(seeChart 14).Up untilMay 2020, therelated exposures subject to mor-atoria amounted to €258.7 mil-lion, accounting for some 28.3%of outstanding loans to the sector. Similarly, owing to social distanc-ing, some of the projects suffered delays.Asurveyconductedby theMalta Association of Credit Man-agement in May 2020 shows that55%ofrespondentsfromthebuild-ingandconstructionindustryexpe-rienced no negative impacts from COVID-19 on their cash collection and cash flow to date.34 However, 20% of the effected respondentsnotedthattheyfailedtocollect40%– 60% of income that they usedto collect in pre-COVID-19 times. Another20%ofrespondentsnotedthat they collected between 80%– 100% less than they used to.Indeed,5.7%ofoutstanding loansto the resident construction sector were subject to moratoria.

The accommodation sector also suffered the brunt of the pandemic as airplanes were grounded, ports were closed, and hotels were shut down. Around €194 million of loans towards the accommodation sector weresubjecttomoratoriawhichaccountedfor46%ofoutstandingloanstowardsthissector.Thewholesaleandretailtradesectorwasalsoaffectedwith12.2%ofloanstothissectorsubjecttoamoratorium.

Theprofessional, scientific and technical sector captures a variety of industries that offer expertise andprovide services to other companies and even households. While some of these subsectors could continue providingtheirservicesremotely,theirbusinesswasstillaffectednegativelyduetoreducedcashflowanddemand for their services, as other sectors were closed down. Some 81 loans were subject to a moratorium, equivalentto20.2%ofloanstowardsthissector.

The‘Others’categorygroupsanumberofsectorswhichintotalhaveabout€74millionofloanssubjecttoa moratorium. Of these, the transportation and storage sector has about €28 million which accounted for around10%ofalltheloanstothissector.Inaddition,theeducationsectorwhichalsocaptureschildcarecentres,hadatotalof€20millionofloanssubjecttoamoratorium.Thisequatestoabout68%oftheout-standingloanspertainingtothisactivity.Thearts,entertainmentandrecreationwasalsoadverselyhitas

34 https://www.macm.org.mt//media/articles/MACM%20Survey%20Covid19%20Construction%20May%202020.pdf

Property ̶ Maltese residents

Property ̶ non-residents

Consumer loans ̶ Maltese residentsConsumer loans ̶ non-residents

Chart 13HOUSEHOLDS' ACQUISITION OF COVID-19 MORATORIA ̶ MAY 2020(per cent)

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Chart 14TOP SECTORS BENEFITTING FROM COVID-19 MORATORIA ̶ MAY 2020(per cent)

Source: Central Bank of Malta.Note: Y-axis refers to the share of resident of Malta moratoria taken by the top sectors, as a per cent of their respective overall resident of Malta loans. Bubble size refers to the GVA.

https://www.macm.org.mt//media/articles/MACM%20Survey%20Covid19%20Construction%20May%202020.pdf

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majorpubliceventswereeithercancelledorpostponedandvenueswereeventuallycloseddownaspartofthecontainmentmeasuresinstitutedfollowingrecommendationsbythenationalhealthauthorities.Around40%ofloansrelatedtothissectorweresubjecttoamoratorium.

ConclusionAsCOVID-19continuestospreadacrosssomecountries,includingMalta,consumers,firmsandgovern-ments are rising to the challenge with response measures to minimise the medium- and long-term impacts ontheeconomy.Inparticular,businessesandhouseholdsaffectedbythecrisismayfaceliquidityshortagesandmaybeunabletoaffecttimelypaymentsontheirfinancialcommitments.Thiscouldinturnhavenega-tive repercussions on banks as it can lead to a larger number of defaults and increased own funds require-mentsforcreditinstitutions.ThepolicymeasuresintroducedbytheCentralBankofMalta,thesupervisoryauthorities, international bodies and the Government to support credit institutions from the unprecedented economicshockinthewakeoftheCOVID-19pandemichelptoavoidpotentialsystemicfinancialcrisis,andatthesametimepromoteeconomicrecovery.

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4. insurance companies and investment Funds

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4. INSURANCE COMPANIES AND INVESTMENT FUNDS

Insurancecompaniesand investment funds continued toplayan important role in theMaltese financialsystem.Asatend2019, therewere68 licensed insurancecompanieswithassets totalling€13.8billion,equivalentto104.3%ofGDP.Ofthese,eightinsurersunderwriteriskssituatedinMalta.Meanwhile,therewerearound500licensedandreportinginvestmentfunds,ofwhich67areconsideredtobedomesticallyrelevantwithassetsof€2.6billion,correspondingto19.3%ofGDP.

4.1 Domestic Insurance CompaniesOutoftheeightdomestically-relevant insurancecompanies,threearelifeandfivearenon-life insurancecompanies.Twoofthelatterarereferredtoascompositeinsurerssincetheyarealsolicensedtoprovidelifeinsuranceproducts.Lifeinsuranceisamarginalelementoftheirbusinessaccountingfor2.1%ofgrosswrit-tenpremia.In2019,theoverallassetsroseby10.9%to€3.8billion,equivalentto28.6%ofGDP.Domesticinsurers remained resilient with adequate capital levels and positive performance in spite of the persistent lowinterestrateenvironment,thoughsomesearch-for-yieldbehaviourwasobserved.

Domesticinsurancecompaniesareintrinsicallyinterconnectedwiththecoredomesticbanks,butasinsur-ancefirmsaresetupasseparatelegalentitieswiththeirownspecificcapitalrequirements,contagionriskis reduced.

Insurancecompaniesarealsolinkedtootherinsurersincaseswhensuchfirmstakeonbusinesswhosecoveragewouldbetooburdensomeforonecompanytohandleonitsown,therebyreducingunderwritingriskwhileobtainingcapitalrelief.However,contagionriskisattenuatedbythegenerallyhighratingofthereinsurance companies and the fact that such business is spread across a number of reinsurance compa-nies.Domesticinsurancecompaniesreinsuredamedianof17.0%oftheirpremiawithforeignreinsurancecompaniescomparedto15.1%in2018,andhigherthantheEUmedianof5.7%asatDecember2019.1 Goingforward,theprolongedlow-yieldenvironment,togetherwiththedirectandsecondroundeffectsofcovid-19pandemic,willcontinuetochallengetheinsurancesectorpotentiallyapplyingfurtherpressureonprofitability.Thesecouldgiverisetohigherclaimscoupledwithadversemarketmovementsontheirportfo-lioswhichinturncouldtriggeranincreaseinsearchforyieldbehaviour.

4.1.1 The Domestic Life Insurance CompaniesThebalancesheetofdomesticlifeinsurersexpandedby10.7%to€3.3billion,equivalentto25.1%ofGDP,largelydominatedbytwolifeinsurancecompanies,whichtogethertakeup96.6%ofgrosspremiawrittenbythelifeinsurancesector.

Themostdominantlineofbusinessremained‘insurancewithprofitparticipation’–asavingsproductwhereattheendofeachyeartheinsurancecompanymaydeclareabonusratewhichformspartoftheannualinvestmentreturn.Suchbusinesscharacterisedaround80%ofthetotalgrosswrittenpremiarepresentinga rise of 3.1 percentage points over December 2018. ‘Index and unit-linked’ products – where the obliga-tionforthelifeinsurancecompanyisrepresentedbythevalueoftheunderlyingunit–contractedby4.7percentagepointstoaround12%ofgrosswrittenpremia.Technicalprovisionssetasideforsuchindexandunit-linkedproductsremainedlimitedto17.7%ofthetotallifeinsurers’technicalprovisions,withtherestofthe technical provisions set aside for non-unit linked products. Meanwhile, the remaining line of business is classifiedas‘otherlifeinsurance’andconstitutedabout8%ofthetotalpremiawritten,upby1.6percentagepointsoverayearago.

4.1.1.1 Asset CompositionThebondportfolioofdomesticlifeinsurersgrewby6.3%to€1.2billion.2 However, while these remained the largestsinglebalancesheetcomponentasapercentageoftotalassets,theydeclinedby1.5percentage

1 Themedianreinsurancepartofpremiaforthelifeandnon-lifesectorsin2019stoodat8.5%and34.9%,respectively.Source:EIOPARisk Dashboard April 2020.2 The bond portfolio is made up of government bonds, corporate bonds and collateralised securities. Collateralised securities are cap-tured under ‘other assets’ in Chart 4.1.

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points to 37.4% owing to a faster increase in the balance sheet size (see Chart 4.1).

Almost three-fourths of the bond portfolio was composed of sover-eign bonds, ofwhich around46%were invested in MGS with the remainder mainly spread acrosssovereign bonds of euro area countries.

Holdingsofcorporatebondsroseby11.2%,buttheirshareintotalassetsremained unchanged at 9.3%.However, noticeable changes were reported in their credit ratings with holdings of sub-investment grade or unrated corporate bonds contract-ing bymore thanhalf to represent18.2%ofbondsholdings(seeChart4.2).3 Meanwhile holdings of low-rated bonds increased by 54.2%to around 41% of total corporatebond portfolio while medium-rated bond holdings more than doubled to37.4%ofcorporatebonds.Hold-ings of high-rated corporate bonds alsoincreased,upby6.5%buttheirsharedecreasedmarginallyto3.9%of the corporate bond portfolio. Thus, although the incentive for searching-for-yieldremains,thelife insurancesector seems to be adopting a more conservative riskstrategy. In2019,more than half of these bonds were issuedineuroareacountriesmainlybyNFCs,banks,CFIMLsandOFI.4 Another32.0%wereissuedintheUSandrelatedtoNFCs,OFIsandbanks.Asaresult,foreigncorporatebondsincreasedby1.1percentagepointstoalmost23%ofthebondportfolio.Theremainderweredomesticcorporatebonds,largelyissuedbyCFIMLs,banksandNFCs. Collateralisedsecuritiesrefertothesecuritieswhosevalueandpaymentsarederivedfromaportfolioofunderlyingassets.Theirshareintotalassetsremainedlowandstoodat0.2%,increasingby0.1percentagepointfrom2018.Around29%ofcollateralisedsecuritiesarecollateralisedbyrealestate.

Equities roseby16.6%,mainly reflecting the rise inmarketprices toaccount for17.4%of life insurers’assetsasatendof2019.SuchholdingsweremainlyconcentratedinNFCslocatedintheUnitedStatesand

3 Investment-gradebondscarryingaratingofAA-oraboveareregardedas‘high-ratedbonds’.‘Medium-ratedbonds’arethoseratedbetween A- and A+, whereas ‘low-rated bonds’ are those rated between BBB- and BBB+. Sub-investment grade bonds are rated lower than BBB-.4 TheCFIMLalsoconsistofholdingcompaniesthathavecontrollinglevelsofequityofagroupofsubsidiarycorporationsandwhoseprincipalactivityisofowningthegroupwithoutprovidinganyotherservicetothebusinessesinwhichtheequityisheld.

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Chart 4.1COMPOSITION OF ASSETS HELD BY THE DOMESTIC LIFE INSURANCE SECTOR(per cent of total assets)

Source: Central Bank of Malta.Note: Other assets mainly include deferred tax, property, recoverables and receivables, collateralised securities, mortgages and loans.

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Chart 4.2 CORPORATE BOND PORTFOLIO − INVESTMENT RATINGS − LIFE INSURANCE SECTOR (EUR millions)


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predominantlyineuroareacountries.Around14.1%ofequitiespertainedtodomesticNFCs,withmorethanafifthrelatedtorealestate.

Participation in collective investment undertakings (CIU) increased by almost 17% spread across debt,equity,moneymarketandassetallocationfunds,predominately ineuroareacountriesother thanMalta.Suchholdingsaccountedforaround30%ofthelifeinsurers’assets.

The domestic life insurers’ participation in non-traditional non-insurance activities remained negligible with loanschannelledtorelatedNFCsaccountingforjust0.6%oftheirassets.Meanwhile,domesticlifeinsurershaveexposurestotangiblerealestate,whichstoodat4.0%oftotallifeinsurers’assets,thebulkofwhichwas held for investment purposes.

4.1.1.2 ProfitabilityLife insurers’ pre-tax profitsimproved by 23.1% to reach€19.8 million (see Chart 4.3). This increase in profitability was drivenby higher gains from revaluationoffinancialassetsfollowinglossesregisteredin2018.Thiswaspartlyoffsetbyadropinnetwrittenpremiacoupled with higher net claims and a rise in provisions against claims. Pre-tax ROE rose from 6.1% in2018to7.8%in2019,withthepre-taxROAalsoincreasingfrom0.4%to0.6%.Pre-taxreturnonnetpre-miastoodat5.7%,upfrom4.2%in2018,whichwasdrivenbyafasterincreaseinprofitbeforetaxthaninnet premia.

The domestic life insurance sector remainedhighlyliquidwithaliquidassetratioof78.9%,althoughthisnarrowedslightlywhencomparedwith the levels observed in 2018 (see Chart 4.4).5 Such high liquid-ity reflected significant holdingsof government bonds and listed equities.

4.1.1.3 Capital AdequacyThe overall solvency position ofthe domestic life insurers remained noticeablyabove theminimumsetbyregulatoryrequirementswithanoverall solvency ratio of 209.1%,upby5percentagepointsoverthepreviousyear.Thismainlyreflecteda faster decline in the Solvency5 The liquid assets ratio shows the proportion of liquid assets to total assets (excluding assets held for unit-linked). The ratio is calculated byapplyingdifferentweights(rangingfrom100%forcashto0%forintangibleassets)tothedifferentassets,accordingtotheirliquidityprofile.

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Chart 4.4 LIQUID ASSETS RATIO OF THE DOMESTIC LIFE INSURANCE SECTOR (per cent)


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Chart 4.3 MAIN COMPONENTS OF PROFITS − DOMESTIC LIFE INSURANCE SECTOR (EUR millions)

Source: Central Bank of Malta. Note: Grey bars indicate pre-tax profits in absolute amounts. Teal (positive) and red (negative) bars indicate yearly changes in profit components. These figures are based on management accounts.

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Capital Requirements – which fell by 9.5% – than the 7.3% drop intotal eligible own funds. The capital compositionremainedofveryhighquality – almost entirely in Tier 1own funds.

4.1.2 The Domestic Non-life Insurance CompaniesAssets held by the domestic non-lifeinsurancesectorroseby12.6%to €462.3 million in 2019, equiva-lentto3.5%ofGDP.Theirbusinessis mainly concentrated in motorvehicle-related business, which in total accounted for 43.1% of thetotalpremiawritten,followedbyfireand other property damage whichrepresented a further 25.9% (seeChart 4.5).

4.1.2.1 Asset CompositionAlthough a number of insurers shed some of their equities, these still remained the largest asset component ofnon-lifeinsurersrepresenting26.6%oftheirassets.Around86%ofequityholdingspertainedtodomesticfirms,thebulkofwhichwereinrelatedinsurancecompanies,implyingahighlevelofinterconnectednessdue to cross ownership. The rest of the domestic holdings were spread among equities in captives, MFIs, financialinstitutionsandalsoNFCslargelywithintherealestate,informationandcommunication,transportandstorage,andwholesaleandretailsectors.ThelargemajorityofforeignequitieswereinvestedinNFCswithin the information and communication, manufacturing, wholesale and retail trade as well as in mining andquarrying sectors.Participations inCIUs–whicharemainly debt funds, equity fundsandMMFs–declinedby8.4%to8.0%ofthenon-lifeinsurers’assets(seeChart4.6).

Recoverableandreceivablesroseby3.5percentagepointsto21.0%ofnon-lifeinsurers’assets.Theseweremainlycomposedofrecoveriesoflossesfromclaimsthatarerecoupedfromthereinsurersandreceivablesinterms of pending premia.

Bondholdingsaccountedfor10.7%of their balance sheet, three fourths of which consisted of corporate bonds. Around two thirds of the lat-ter related to foreign corporates in EU countries (other than Malta) and the United States, with the remain-ing invested in Maltese companies. Most of the corporate bond hold-ings are either unrated – which rose by3.1percentagepointsto38.7%of corporate bond holdings – or else have a low rating. The latter increasedby1.2percentagepointsto31.9%,indicatingsomepotentialsearch-for-yield behaviour.6 Mean-while, medium- and high-rated 6 See footnote 3.

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Chart 4.6COMPOSITION OF ASSETS HELD BY THE DOMESTIC NON-LIFE INSURANCE SECTOR(per cent of total assets)

Source: Central Bank of Malta.Note: Other assets mainly include mortgages and loans.

25.9%

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1.7% Fire and other damage topropertyMotor vehicle liability

Other motor

Medical expense insurance

General liability

Other insurance products

Marine, aviation and transport

Assistance

Miscellaneous financial loss

Chart 4.5 GROSS WRITTEN PREMIUM OF THE DOMESTIC NON-LIFE INSURANCE SECTOR BY LINE OF BUSINESS (per cent of total gross written premia)

Source: Central Bank of Malta. Note: Solvency II Reporting. Other insurance products include workers' compensation, income protection, other life insurance and profit participation, index-linked and unit-linked insurance.

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bonds stood at 25.1%and 4.3%of the corporate bond portfolio, respectively. Foreign sovereign bondsamountedto10.1%oftheinsurers’bondportfolio,fallingby2.1percentagepointssince2018,whileanother11.6%wereMGS,whichnarrowedby8.0percentagepoints.

Non-lifeinsurerswerenotinvolvedincreditintermediation,withuncollateralisedloanstodomestically-relevant insurancecompaniesaccounting for0.2%ofassets.Furthermore,by2019,non-life insurerscontinued to increase their exposure towards the domestic real estate market as tangible real estate exposuresroseto17.4%ofassetsfrom14.5%inDecember2018.Morethanhalfoftheseassetswereintheformofofficeandcommercialbuildingsheldforinvestmentpurposes,withtherestmainlyheldforown use.

4.1.2.2 ProfitabilityCompared to 2018, pre-tax profits increasedby 107.5% to €51.2million (seeChart 4.7).The rise inprofitswasmainlydrivenbyinvestmentandotherincomeascapitalmarketsrecovered.A7.3%increasein netwritten premia, equivalent to €162.5million, also contributed to profit growth, though thiswaspartly offset by higher net claimspaid which increased by 7.4% to€79.2 million reflecting growthin the insurance market, as well as higher claims on the back of unfavourable weather conditions, which caused significant damageinthefirstquarterof2019.Aspre-mia earned outpaced the extent of claims incurred, the loss ratio fell slightly to 51.3%, represent-ing positive underwriting perfor-mance. However, as net operat-ing expenses grew, the combined ratio went up by 1.2 percentagepoints to around 85% in 2019,though still pointing to the abilityof non-life insurers to generate positive underwriting results. This is also evidenced by the overallnet expense ratio, which rose by2.8percentagepointsto33.2%inDecember 2019. Consequently,thepre-taxROErosefrom15.1%in 2018 to 28.9% in 2019, whilethepre-taxROArosefrom5.7%to10.7%.Similarly,thepre-taxreturnonnetpremiastoodat31.5%,upfrom16.3%in2018.

Compared to end 2018, liquiditynarrowedslightly to38.9% reflect-ing the share of intragroup equityholdings and recoverables and receivables held by non-life insur-ers which are deemed to be less liquid (see Chart 4.8).7

7 Intragroupequityholdingsaccountedfor20.5%ofassetsandreceivables,whilerecoverablesrepresentedanother21.0%ofassets.Thesecarryazeroweightingwhendeterminingtheextentofliquidity.

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Chart 4.8 LIQUID ASSETS RATIO OF THE DOMESTIC NON-LIFE INSURANCE SECTOR (per cent)


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Chart 4.7MAIN COMPONENTS OF PROFITS − DOMESTIC NON-LIFE INSURANCESECTOR (EUR millions)

Source: Central Bank of Malta.Note: Grey bars indicate pre-tax profits in absolute amounts. Teal (positive) and red (negative) bars indicate yearly changes in profit components. These figures are based on management accounts.

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4.1.2.3 Capital AdequacyThenon-lifeinsurers’capitalremainedwelloverthesupervisoryrequirementswithanoverallsolvencyratioof256.5%,surpassingtheminimumregulatorythresholdof100%.Thisratiostrengthenedby15.0percent-age points when compared to December 2018 due to a stronger increase in total eligible own funds. The majorityoftotalownfundswasheldintheformofTier1ownfunds.

4.1.3 Domestic Insurance Risk Outlook Goingforward,thelow-yieldenvironmentinconjunctionwiththeCOVID-19pandemiccouldaffectnegativelytheprofitabilityofinsurancecompanies,particularlyifthespreadisprolongedfurther.Whileadirectimpactofthecoronavirusfromclaimsisexpectedtobelesssignificant,asepidemicsareusuallyexcludedfrom(non-life) insurance cover, in other instances such as in the case of trade credit and business interruption insurance,significantclaimscouldposesomesolvencyrisksfortheinsurerandultimatelythreatenpolicy-holder protection.8Cashflowsforalllinesofbusinessesofferedbyinsurancecompaniescanbeatriskasnewbusinessmayaffecttherenewalofpoliciesaswellaspaymentsofpremiacouldbedisrupted.Somebusinesslines–likemotorinsurancewhichformsalargeshareofnon-lifepremia–may,however,experi-ence lower claims.9Thatsaid,itisfartooearlytopredicttheimpactofthepandemicasitsdurationisstillunclear,whileanumberofpolicymeasuresthatwereintroducedcouldmitigatetosomeextenttheadverseeffectsontheeconomy.

Therecentwideninginriskpremiaandequitypricedropsmighthaveanadverseeffectonsolvencyratios,asanycorporatedebtdowngradecouldresultinassetvaluationlossesandinturnrequirehighercapitalcharges.10Nevertheless,thedomestically-focusedinsurancesectorendedtheyearwithhealthycapitallev-elsandliquiditybufferswhichprovideresiliencetotheirbusiness.

4.2 Domestic Investment FundsBytheendof2019,67sub-fundswereconsideredtobedomestically-relevantgiventheirtieswiththeMal-teseeconomy.11Overtheyear,twosub-fundswerewounddown,whileonesub-fundstartedoperating.Theassetsofthesedomesticfundsgrewby5.1%to€2.6billionandstoodat19.3%ofGDP.

The distribution by type of thesedomestically-relevant investmentfundsremainedvirtuallyunchangedwhen compared to a year earlier.Just above a quarter of the sub-funds were bond funds, with their shareoftotalassetsincreasingby2.9percentagepointsto51.4%(seeChart 4.9). This, in part, reflecteda strong performance of the bond market as investors increasinglyturned to bonds owing to their per-ceived safe-haven characteristics, on the back of weaker economic growthandfurthermonetarypolicyeasing by various central banks.As a result, bonds acted more like equities with the bulk of the return resulting from price movements as yieldsslumped.

8 Tradecreditinsuranceismainlypurchasedbycompaniesandpaysoutagainstdefaultofthedebtor.9 Source: European Central Bank Financial Stability Review(May2020).10 See footnote 9.11 Thenumberofdomestically-relevantsub-fundsasatDecember2018wasrevisedto68,withtotalassetsamountingto€2.4billion.Asat December 2019, two sub-funds were in the process of being liquidated.

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Chart 4.9 DOMESTIC INVESTMENT FUNDS BY MAIN STRATEGY (per cent of total number of funds and per cent of total assets)


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Almostafourthofthesub-fundswereclassifiedasequityfundsgiventheirfocusoninvestinginequities.Theseaccountedfor22.1%ofoverallassetsundermanagement(AUM),representingadropof1.0percent-age point from December 2018.

Meanwhile,morethanathirdofthedomestically-relevantsub-fundswereclassifiedas‘otherassetalloca-tionfunds’withtheirassetsincreasingbymorethan€2millionto21.2%oftotalassets.12 In turn, the number ofsub-fundsclassifiedasmixedfundsremainedunchangedoverayearago,accountingforsome5%ofassetsand7.5%ofthenumberofentitiesunderscope.13Theassetsofrealestatefundsfellbymorethan65%torepresent0.5%ofoverallassetsand4.5%ofthenumberofsub-funds.Assetsofprivateequityfundsincreasedby7.5%to0.2%totalassets,butsuchentitiesonlyaccountedfor3%oftheoverallamount.

4.2.1 Asset Composition by Fund TypeJustoverhalfofthedomestically-relevantsub-fundswerelicensedasretailUndertakingsfortheCollectiveInvestment inTransferableSecurities (UCITS) representing 59.0%of the domestically-relevant sub-funds’assets. Of the remaining sub-funds, 17 were licensed as Professional Investor Funds (PIFs) accounting for 19.4%ofassets,11wereAlternativeInvestmentFunds(AIFs)representing21.4%ofassetsandthreewereretailnon-UCITS,representingjust0.1%oftotalassets.Lastly,therewasonlyoneNotifiedAIF,accountingfor0.2%oftotalassets(seeChart4.10).

Thefunds’assetcompositionshedslightontheinvestmentstrategyofthedifferentinvestmentfunds.Tra-ditionallyfavouringliquidity,morethantwothirdsofretailUCITS’assetsconsistedofbonds,whileequitiesaccountedforaround30%oftheirassets,whichremainedstableoverthepastthreeyears.RetailUCITSalsohelddepositsandloanclaimstothetuneof7.5%oftheirbalancesheet,whichdroppedby4.1percent-age points from December 2018.

In contrast, PIFs – which aremarketed tomore professional and experienced investors – were highlyinvestedinequities,representingmorethan80%oftheirassets.Theserosebyaround5percentagepointsfromthepreviousyear,probablyreflectingtheirdrivetotapintopotentialhigherreturnsasthestockmarketrallycontinuedin2019.Overtheyears,thisconcentrationofequitieshasbeentrendingupwards,increasingby25.5percentagepointssinceDecember2016.Meanwhile,morethan15%ofPIFs’assetswereinvestedin bonds in 2019, narrowing some-whatsincethepreviousyear.

AIFs invested predominantly indebtsecurities(56.1%oftheirbal-ance sheet), followed by depos-its and claims on loans (21.2%)and equities (16.3%).Additionally,AIFs also held 6.1% of their bal-ance sheet in cash. Although cash holdingswerealreadyobserved in2018, the share increased further in 2019,possiblyreflectingAIFs’pre-paredness to get back in the market when favourable investment oppor-tunities arose. Meanwhile, in 2019, AIFs invested in higher holdings of debt securities and equities which were offset by lower deposits andloan claims.

12 Fundsareclassifiedas‘otherassetallocationfunds’iftheycannotbeclassifiedasanyoftheotherfunds.Forexample,aninvestmentfundinvestingincommoditiesisclassifiedas‘otherassetallocationfund’.13 Investmentfundsareclassifiedas‘mixedfunds’iftheyinvestinbothbondsandequitywithnogeneralpolicyinfavourofeitheroneor the other.

Retail UCITS, 59.0%

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Chart 4.10NUMBER OF DOMESTIC INVESTMENT FUNDS BY LICENCE AND AS A SHARE OF ASSETS

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Almost 70% of retail non-UCITS’balance sheet is made up of cash (see Chart 4.11). Such holdings increased significantly when com-pared to end 2018, as these sub-funds shed most of their equities and bonds in 2019.

4.2.2 Asset Composition by InstrumentDebt securities represented the largest asset component of domes-tically-relevant investment funds.Thesegrewby11.4%toreach€1.3billion,accountingfor51.8%oftotalassets. Around half of these bonds were in sovereign bonds, of which almost 90% pertained to theMal-tesegovernment.Meanwhile,almostaquarterwereinvestedinbondsissuedbyOFIs,FAsandCFIMLs,while12.2%wasinvestedinnon-financialcorporatebonds.Ofthelatter,around30%wereinvestedinMal-tesefirmswhilearound27%wereineuroareacorporatebonds.Domestically-relevantsub-fundsalsoheldbankbonds,representing8.0%oftheoverallbondportfolio,witharoundathirdpertainingtolocalbanksfollowedbyothereuroareaandUSbanks.Investmentsinotherinstitutionsincludeinsurancecorporationsandnon-MMFinvestmentfunds,which–however–weremorecontainedrepresenting1.0%and0.1%ofthebondportfolio,respectively.

Holdingsofequitiesincreasedby11.3%toalmost€940millionandwereequivalentto36.7%ofassets.Thegrowth inequitieswasprimarilydrivenbyhigherparticipations innon-MMFinvestmentfundswhichroseby30.9%toaccountformorethanathird(37.3%)oftheoverallequityportfolio.Theselargelyrepresentedinvestmentsinnon-MMFinvestmentfundsdomiciledintheeuroarea(78.7%).MMFholdingsrosefivefold,butatalmost€0.5million,theystillrepresentedonly0.1%oftheequityportfolio.

Meanwhile,directequityholdingsincreasedby5.5%andwerelargelydrivenbyhigherinvestmentsinNFCs torepresentalmosthalfoftheoverallequityportfolio.14SuchholdingsweremainlyinothereuroareaNFCs,followed by Maltese NFCs andholdings inUS firms.On the otherhand, domestic investment funds decreased their holdings of bank equitiesbyaround21% to6.7%ofthe overall equity portfolio – withmore than 90% of such holdingspertaining to Maltese banks. Hold-ingsinOFIs,financialauxiliariesandcaptivesamountedto4.5%ofover-allequities,withtheremaining1.4%invested in insurance corporations, themajorityofwhichweredomiciledin Malta.

During 2019, the share of depos-its and loan claims decreased by5.0 percentage points to 9.2% of

14 DirectequityholdingsincludeinvestmentsinMFIs,OFIs,financialauxiliariesandcaptives,insurancecorporationsandNFCs.

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Chart 4.11COMPOSITION OF ASSETS BY TYPE OF DOMESTIC INVESTMENT FUNDS (per cent of total assets)


0%

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Dec. 2016 Dec. 2017 Dec. 2018 Dec. 2019

Bonds Equities Deposits Loans Cash OtherSource: Central Bank of Malta.Note: The 'Other' category consists of other financial assets, non-financial assets (including fixed assets) and, to a lesser extent, financial derivatives.

Chart 4.12COMPOSITION OF ASSETS HELD BY THE DOMESTIC INVESTMENT FUNDS (per cent of assets)

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assets,whilecashholdingsgrewby0.3percentagepointto1.5%oftotalassets.Financialderivativesandotherfinancialassetscapturedunder‘other’inChart4.12stoodat0.7%oftotalassets,downfrom1.0%inDecember2018,whilenon-financialassets(includingfixedassets)accountedforamarginal0.01%oftotalassets.15

4.2.3 Type of Investors At55.4%ofthetotalnetassetvalue(NAV),Maltesehouseholdscontinuedtobetheprincipalinvestorsindomestically-relevantsub-funds,whileMalteseNFCsrepresented23.7%oftheoverallNAV.ThesewerefollowedbydomesticMFIsaccountingforanother11.4%.Meanwhile,participationbynon-residentinvestorswaslimitedto4.5%.

HouseholdsarelargelyinvestedinretailUCITS,holdingabout70%oftheirNAV,whileMalteseNFCsanddomesticbanksheld13.3%and12.5%,respectively.Meanwhile,themajorityoftheunits(80.3%)inPIFswereheldbydomesticNFCswhileanother10.4%washeldbyMaltesehouseholds.Furthermore,Maltesehouseholds also held a significantamount of units (58.2%) in AIFs,while domestic MFIs and insur-ance companies held 18.7% and16.0%,respectively.Lastly,Maltesehouseholds were also the main shareholders in retail non-UCITS, accounting for 82.2%of their totalNAV, followed by resident insur-ancecompanieswith17.8%ofthetotal NAV (see Chart 4.13).

Overall, domestically-relevantinvestments funds represented 4.7% and 1.8% of the Maltesehouseholds’ and the NFCs’ finan-cialwealth,respectively.

4.2.4 Risk Assessment

Liquidity profileThe marketability of the invest-ment funds’ assets determines their ability tomeet thedaily regulatoryrequirements and also redemption requests from investors. Most of the domestically-relevant invest-ment funds are UCITS, which are globally recognised as highly liq-uidproducts.Toqualify as suchafund, capital is raised from the pub-lic in transferable securities and in other liquid financial assets. TheUCITS Directive and the Alternative Investment Fund Managers Direc-tive have provisions to ensure that adequate liquidity levels are kept

15 The‘Other’categoryconsistsofotherfinancialassets,non-financialassets(includingfixedassets)andfinancialderivatives.

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Chart 4.13 DOMESTIC INVESTMENT FUNDS' NAV BY INVESTOR TYPE (% of NAV)


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Chart 4.14LIQUID ASSETS RATIO OF THE DOMESTIC INVESTMENT FUNDS BY LICENCE(per cent of assets)

Source: Central Bank of Malta.Note: Liquid assets include deposits with banks, debt securities issued by MFIs, sovereign bonds,equity and investment fund shares and cash.

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forUCITSandAIFs.Domesticretailnon-UCITSremainedthemostliquidtypeoffundsovertheyear,withaliquidassetsratioamountingto100%.16ThesewerefollowedbyPIFs,whichalsoheldasignificantshareofliquidassets,withtheirliquidassetsratiostandingat82.6%,upby1.9percentagepointsfrom2018.Inaddi-tion,themajorityofretailUCITSandAIFs’assetswerealsohighlyliquidaccountingfor73.3%and71.5%oftheirassets,respectively.

Asa result, the overall liquid assets ratio of thedomestically-relevant investment funds stoodat 74.6%inDecember2019,upby2.4percentagepointsfromthepreviousyear.Thisshowsthatoverall,domes-ticinvestmentfundshaveenhancedtheircapacitytoabsorbliquidityshockswithliquidassetsincreasingthroughhigherequityandsovereignbondholdings(seeChart4.14).

LeverageFinancialleverageisdefinedasanymethodutilisedbyinvestmentfundstoincreasetheirexposuresoverandabovetheirassetstofinancetheiroperations,whichcanbedonethroughtheborrowingofcash,securi-tiesorleverageembeddedinderivatives,amongothers.Whilethiscanamplifyinvestorreturns,itcanalsoresultinsignificantlossesincaseofadversemarketmovements,potentiallyrequiringtheneedtoquicklyliquidateassetstomeetmargincallsparticularlywhencashbuffersareverylow.

UndertheUCITSDirective,UCITShaveinbuiltlimitsontheexposurescreatedbytheuseoffinancialderiva-tives.Thesefundsareallowedtoleverage–providedthatsuchborrowingisonatemporarybasisanddoesnotexceed15%ofassets.Meanwhile,PIFsmarketedtoexperiencedinvestorscanleverageupto100%ofNAVthroughtheuseoffinancialderivativesbuttherearenorestrictionsforPIFspromotedtoqualifyingandextraordinaryinvestors.17

During2019,theAUM-to-NAVratioofthedomestically-relevantinvestmentfundsincreasedmarginallyto101.2%(seeChart4.15).

Apart from retail non-UCITS, which in 2019 reported higher leverage due to liquidation and redemption of investments, other investment funds’ leverage remained contained, with AIFs’ AUM-to-NAV ratio standing at 102.7%, followed by PIFs, witha ratio amounting to 101.5% andlastly,retailUCITSwith100.4%.

Concentration riskConcentration riskmay arise fromconcentration to a single country,sector or instrument, which can eventuallybeathreattothehealthof the investment portfolio. The securitiesportfolioofdomestically-relevantinvestmentfundsishighlyconcentrated in Malta, standing at 46.0% of the whole securitiesportfolioat theendof2019,upby0.6 percentage point over a yearago. This is closely followed bysecurities of euro area sovereigns, with40.2%oftheoverallsecurities

16 Liquidassets includecashanddepositswithbanks,debtsecurities issuedbyMFIs,sovereignbonds,equityand investmentfundshares.17 TherearethreetypesofPIFs,includingPIFspromotedtoexperiencedinvestors,whichhaveanentrylevelof€10,000;PIFspromotedtoqualifyinginvestors,havinganentrylevelof€75,000;andfinallyPIFspromotedtoextraordinaryinvestors,whichhavethehighestentrylevel of €750,000.

100.0% 100.5% 101.0% 101.5% 102.0% 102.5%

Dec. 2016

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AUM-to-NAV ratioSource: Central Bank of Malta.

Chart 4.15RATIO OF AUM-TO-NAV OF THE DOMESTIC INVESTMENT FUNDS

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portfolio, down by 0.2 percentagepointoverayearago.Theremaining13.8%oftheportfoliowasspreadincountries from the rest of the world (see Chart 4.16). The bond portfolio is highly concentrated in domesticsovereign paper, accounting for just under a quarter of assets. The concentration in local sovereign holdings mainly arises from therelatively high domestic yieldswhen compared to other countries in the euro area.

4.2.5 Risk Outlook Compared to the previous year,assets of domestically-relevantinvestmentfundsgrewmoderately.However,theoverallinvestmentstrategyremainedunchanged.

Structural risk Potential group contagion risk is still present in the investment funds sector since some asset management companiesareownedbythecoredomesticbanks,responsible formanagingalmost60%of theNAVofthedomestically-relevantsub-funds.Tosafeguardagainstanypotentialstep-inrisks,investmentfundsareset up as separate legal entities, and are subject to the provisions of the Maltese Companies Act and the InvestmentServicesAct.Additionally,fundsemployseveralliquiditymanagementtoolssuchasredemptiongates and redemption fees to mitigate the risks emanating from potential destabilising liquidation requests.

Cyclical riskWhileatthecurrentjuncturefundmanagersdidnotappeartohaveembarkedonexcessivesearch-for-yieldbehaviour,goingforwardfundmanagersmaystepupthisbehaviourtocompensateforvaluationlossespar-ticularlyduetotheequitypricedropsexperiencedduringthefirstquarterof2020.Investmentfunds’expo-suretoCOVID-19sensitivesectorsamountedto9.3%ofassets(refertoSpecialFeature,PanelA),withanypotentialimplicationsfrominvestmentsnegativelyhitbytheshockinassetpricescontained.18 Furthermore, localinvestmentfundsdidnotexperiencetheoutflowsfacedbyfundsdomiciledinothereuroareacountriesasthesituationremainedincheckandnosignificantredemptionswereaffected.

18 TheshareofinvestmentfundsexposedtoCOVID-19sensitivesectorsisbasedonSBSdataonly.SBSdatafordebtsecuritiesrepre-sent94.2%oftotaldebtsecuritiesholdingsandSBSdataforequityholdingsrepresent66.1%oftotalequityholdings.

40.4%

45.4%

14.1%

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Euro area Malta Rest of the world


2018

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Chart 4.16COUNTRY EXPOSURE OF THE SECURITIES PORTFOLIO OF DOMESTIC INVESTMENT FUNDS(per cent of securities portfolio)

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5. the policy response

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5. THE POLICY RESPONSE

Malta – IMF Financial Sector Assessment Program (FSAP)Theyear2019markedtheconclusionoftheIMFFinancialSectorAssessmentProgram(FSAP),whichwasinitiatedduringthefirsthalfof2018,followingarequestbytheMalteseGovernmentbackin2017.TheFSAPwas carried out during 2018 through a Scoping Mission and a Main Mission, following which a Financial SystemStabilityAssessment (FSSA) reportwaspublishedon27February2019.1 The FSSA concluded thattheMaltesefinancialsectorisrelativelylargecomparedtotheeconomyandthatthefinancialsystem–comprisedofbanks,insurancecompanies,investmentfundsaswellasaresidualcategoryofotherfinancialinstitutions (OFIs) – hold a large amount of assets and liabilities with the rest of the world. Despite the fact thatthedomesticbankingsystemisingoodhealth,challengesremainaccordingtokeymetrics,especiallyconsidering the core domestic banks’ high exposure to property-related loans.Notwithstanding this, theFSSAemphasisedthatdomesticbankswerewellcapitalised,liquiditywasample,andprofitabilityhealthy.

A number of technical notes were also published on 21 November 2019.2 These covered a number of areasincluding,bankingsupervision,riskanalysis,domesticinitiativesaimedatanti-moneylaunderingandcombatingthefinancingofterrorism(AML/CFT),thedomesticmacroprudentialpolicyframeworkandtoolsimplemented, the supervision of the insurance and securities sector, bank resolution and crisis management.

The IMF put forth a set of recommendations for the MT authorities, including the Central Bank of Malta. During 2019, the Bank endeavoured to implement the Recommendations which were also published in theFSSA.TherecommendationsdirectedtotheBankrelatedto:enhancementstoliquiditystresstesting,performanceofregularsensitivityanalyses,datamanagementimprovements(includingclosingremainingdatagaps),enhancements toanalytical tools,andrefinements to theborrower-basedmeasures.FurtherdetailsontherefinementstothestresstestingandriskquantificationtoolkitcanbereferredtoinChapter3 of Financial Stability Report 2018. With reference to the borrower-based measures, as explained above and as stipulated in Directive No. 16, the Bank reserves the right to amend the conditions stipulated in the Directive subject to prevailing market developments.

Borrower-based measuresTheCentralBankofMaltapre-emptivelyintroducedbindingmeasureswithrespecttotheprovisionofRREloans for all lenders granting domestic RRE loans through the publication of Directive No. 16.3 Directive No. 16provideslimitsontheLTV-Oratio,theDSTI-OratioandmaturityonRREloanssanctionedfromJuly2019onwards. The aim is to strengthen the resilience of lenders and borrowers against the potential build-up of vulnerabilities,whichcouldresultinfinanciallossestobothlendersandborrowersstemmingfrompotentialunfavourable economic developments. The limits imposed act as a minimum standard and are therefore complementarytolenders’existinginternalcreditriskassessmentpolicies.

DirectiveNo.16differentiatesbetweentwotypesofborrowers,namely:CategoryIborrowerswhichincludethosepurchasingtheirprimaryresidence;andCategoryIIborrowerswhichprimarilyincludeborrowerspur-chasingsecondaryresidencesorbuy-to-letproperty.CategoryIborrowersaresubjecttoaterm-to-maturitylimitofupto40yearsandacorrespondingLTV-Olimitof90%.ThelimitsstipulatedinDirectiveNo.16arebydesignmorestringentforCategoryIIborrowerswithamaturitylimitof25years,andaphasing-inLTV-Olimitof85%,applicableinthefirstyearofthecomingintoforceoftheDirectiveinJuly2019,followedbyafullyphased,morestringentLTV-Olimitof75%fromJuly2020onwards.InresponsetotheCOVID-19pandemic,theBankissuedaNoticeon1June2020topostponethefullyphasedLTV-Olimitof75%to1July2021.4 Further detail is provided in the COVID-19 special feature.

1 IMFMaltaFinancialSystemStabilityAssessment(7February2019).Source:https://www.imf.org/en/Publications/CR/Issues/2019/02/27/Malta-Financial-System-Stability-Assessment-466362 IMF FSAP Technical Notes. Source: https://www.imf.org/en/Countries/MLT3 Central Bank of Malta Directive No. 16 in terms of the Central Bank of Malta Act (Cap. 204) Regulation on Borrower-Based Measures (29 March 2019). Source: https://www.centralbankmalta.org/file.aspx?f=724014 https://www.centralbankmalta.org/en/news/14/2020/8823

https://www.imf.org/en/Publications/CR/Issues/2019/02/27/Malta-Financial-System-Stability-Assessment-46636

https://www.imf.org/en/Publications/CR/Issues/2019/02/27/Malta-Financial-System-Stability-Assessment-46636

https://www.imf.org/en/Countries/MLT



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Countercyclical Capital Buffer (CCyB)TheCentralBankofMalta’snotificationrelatingtothedecisionontheapplicableCCyBrateforthesecondquarterof2020showsthatnochangesweredetectedinthelevelofcyclicalsystemicrisksinMalta.5 Quanti-tative and qualitative information show that credit developments remained contained, with the relevant bank credit-to-GDPratiorecordedat74.7%anditsdeviationfromthelong-termtrendremaininginnegativeter-ritoryat-17.1percentagepoints(asatDecember2019).ThissupportstheCentralBankofMalta’sdecisiontomaintaintheCCyBrateat0%.

Identification of material third countriesOnthebasisofEuropeanSystemicRiskBoard(ESRB)Recommendation2015/1onrecognisingandsettingofCCyBratesforexposurestothirdcountries,aswellasthroughthemacroprudentialpowersconferredtoitbyArticle17AoftheCentralBankofMaltaAct(Cap.204),theBankcarriesoutanannualexercisefortheidentificationofmaterialthirdcountriestotheMaltesebankingsystem.6,7 In accordance with the methodol-ogyprescribedinArticle4ofESRBDecision2015/3,thethirdcountrieswhichhavebeenidentifiedbytheCentralBankofMaltaasmaterialfortheMaltesebankingsystemfortheperiodQ22019uptoQ22020,aretheUnitedArabEmirates,theRussianFederation,theRepublicofTurkeyandtheUnitedStatesofAmerica.8 ThisindicatesthatthelistofmaterialthirdcountriesfortheMaltesebankingsystemremainunchangedfromthatofthepreviousyear.Furthermore,in2019,theCentralBankofMaltaconcludedthattheCCyBrateof0%setbyalltheAuthoritiesoftheaforementionedthirdcountrieswasappropriate.

Voluntary reciprocation of macroprudential measures During2019,inlinewithitsinternalpolicyframework,theCentralBankofMaltaanalysedtheSwedish,theBelgian,theFinnishandFrenchmeasures,whichwereallrecommendedforreciprocationbytheESRB.9 It was decided not to reciprocate the Belgian, Finnish and Swedish measures on grounds that these measures wereintendedforinstitutions,whichoperateaninternalrating-basedmodelforthequantificationofcapitalthatisdistinctfromthestandardisedmodelusedbyMaltesebanks.10 Furthermore, domestic credit institu-tions have no material exposures towards these countries’ respective markets. With respect to the French measure, the Central Bank of Malta conducted thorough assessments throughout 2019 to determine the relevanceofthemeasureinthelocalcontext.Adecisionnottoreciprocatethemeasurewastakeninearly2020,followingwhichtheESRBwasnotifiedofnon-reciprocationoftheFrenchmeasure.

Identification of Other Systemically Important Institutions (O-SIIs)In the course of 2019, the Central Bank of Malta, in consultation with the MFSA, revised the domestic O-SII methodology(seeBox2).CreditinstitutionsthatwerepreviouslyidentifiedasO-SIIsfortheyear2019havebeenreconfirmed,namely:BankofVallettaGroup;HSBCBankMaltaplc;andMDBGroupLtd.Duringthelatestidentificationexercise,APSBankplcexceededthe425bpsidentificationthreshold,thusbecominganewlyidentifiedO-SIIforMalta,andthefourthdomesticbanksubjecttoanO-SIIbuffer.11

FurtherdetailsonthedesignandrationaleofthenewO-SIImethodologyisprovidedinBox2.

5 Refer to: https://www.centralbankmalta.org/countercyclical-capital-buffer6 ESRB2015/1:RecommendationoftheESRBof11December2015onrecognisingandsettingcountercyclicalbufferratesforexpo-sures to third countries. Source: https://www.esrb.europa.eu/pub/pdf/recommendations/ESRB_2015_1.en.pdf?f368460c8363b65bdd866 58d608b7bec7 Justice Services (1968): Central Bank of Malta Act (Chapter 204). Source: http://www.justiceservices.gov.mt/DownloadDocument.x?app=lom&itemid=8713&l=18 ESRB Decision 2015/3: Decision of the ESRB of 11 December 2015 on the assessment of materiality of third coun-tries for the Union’s banking system in relation to the recognition and setting of countercyclical buffer rates. Source: https://www.esrb.europa.eu/pub/pdf/other/Decision_ESRB_2015_3.pdf?ee1fea534a8a9319f4fcaa4ab065d4a49 https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32020Y0701(01)&from=EN10 https://www.centralbankmalta.org/reciprocity11Thisthresholdincludesthemaximum75bpsleewaywhichisallowedundertheEBAGuidelinesoncriteriatoassessothersystemicallyimportant institutions (O-SIIs) (EBA/GL/2014/10).

https://www.centralbankmalta.org/countercyclical-capital-buffer

https://www.esrb.europa.eu/pub/pdf/recommendations/ESRB_2015_1.en.pdf?f368460c8363b65bdd866 58d608b7

https://www.esrb.europa.eu/pub/pdf/recommendations/ESRB_2015_1.en.pdf?f368460c8363b65bdd866 58d608b7

http://www.justiceservices.gov.mt/DownloadDocument.aspx?app=lom&itemid=8713&l=1

http://www.justiceservices.gov.mt/DownloadDocument.aspx?app=lom&itemid=8713&l=1

https://www.esrb.europa.eu/pub/pdf/other/Decision_ESRB_2015_3.pdf?ee1fea534a8a9319f4fcaa4ab065d4a4

https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32020Y0701(01)&from=EN

https://www.centralbankmalta.org/reciprocity

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BOX 2: O-SII REVISED METHODOLOGY1

Thesize,businessmodelcomplexityandlackofsubstitutesforcreditinstitutionsdetermineswhethersuchinstitutionsareclassifiedas‘too-big-to-fail’,orintechnicalterms,systemicallyimportant.Thefailureorimpairmentofsuchinstitutions,particularlyincaseswheretheyarehighlyinterconnectedwith other financial institutionsand themacroeconomy,wouldhaveadominoeffect and severeadverserepercussionsonthesamemacroeconomicandfinancialenvironment.Theriskthatthesesystemicallyimportantinstitutionsexertisreferredtoassystemicrisk.

On1January2016,theCBMjointlywiththeMFSA(‘theAuthorities’)introducedforthefirsttimeaPolicyDocumentontheidentificationoftheO-SIIsandthecalibrationoftherelatedcapitalbuffer.2

TheO-SIIframeworkcomprisesoftwostages,namelytheidentificationstageandthebuffercalibra-tionstage.Intheidentificationstage,O-SIIsareidentifiedbasedonacoresetofcriteria,indicatorsandweights,wherebythosecreditinstitutionswhichsurpassanestablishedthresholdwillbeclassi-fiedasO-SIIs.Subsequently,thebuffercalibrationstageinvolvesthesettingofanadditionalCET1capitalbuffertoenhanceagivenO-SII’sresilienceandlossabsorbingcapacity,therebyensuringthatsuchinstitutionposeslessrisktothedomesticeconomyandinsodoing,minimisingthe‘toobigtofail’ problem. This box will discuss the revised joint CBM-MFSA O-SII framework, highlighting the rationale for such changes as well as explaining the major differences.

Changes to the Identification MethodologyFollowing a review of the 2016 O-SII framework, the Authorities in 2019 decided to revise their meth-odology.Therationalebehindthisrevision,whichbecameeffectiveasfromJanuary2020,istobetterreflectdevelopmentsinthedomesticfinancialsectorandtofurtheralignthedomesticO-SIImethod-ologywiththeEBAGuidelinesontheassessmentofO-SIIs.3Therevisedmethodologyisdeemedtoprovide a better representation of the developments observed in the domestic banking sector while concurrentlydepartingfromtheconceptofrelativeimportanceagainstan‘average’referenceinstitu-tion,andmovingtoaconceptofathreshold-basedapproachasprescribedbytheEBAGuidelines. As highlighted in Table 1, the 2016 O-SII identification methodology was based on a two-stepapproach.Asafirststep,theAuthoritiesassessedsystemicallyimportantinstitutionsonthebasisoftheirrelevancewithinthedomesticfinancialsectortakingintoaccountthefollowingfourcategories:(i)‘size’,(ii)‘substitutability’,(iii)‘cross-borderactivity’and(iv)‘residentinterconnectedness’.Thesecategorieswereweightedat20%,40%,20%and20%respectively.

The‘Size’criterionwasentirelybasedonthevalueoftotalassetswhereasthe‘Substitutability’crite-rionwasbasedonthreeequallyweighted(13.33%)indicatorsnamely:(i)‘Residentcustomerloans’,(ii) ‘Resident customer deposits’ and (iii) ‘Holdings of Government debt’. Meanwhile, the ‘Cross-BorderActivity’criterionfeaturedtwoequally-weighted(10%)indicators:‘Cross-BorderAssets’and

1 PreparedbyBrendonCassar,EconomistwithinPolicyCrisisManagementandStressTestingDepartment;andJurgenGrima,AnalystwithinPolicyCrisisManagementandStressTestingDepartment.TheauthorswouldliketothankChristineBarbara,Man-agerwithinPolicyCrisisManagementandStressTestingDepartment,andStephenAttard,HeadwithinPolicyCrisisManagementand Stress Testing Department, for their valuable suggestions.2 CBM-MFSAPolicyDocumentonthemethodologyfortheidentificationofothersystemicallyimportantinstitutions(O-SIIs)andthe related capital buffer calibration3 Criteria to determine the conditions of application of Article 131(3) of Directive 2013/36/EU (CRD) in relation to the assessment of other systemically important institutions (O-SIIs) https://eba.europa.eu/sites/default/documents/files/documents/10180/930752/964fa8c7-6f7c-431a-8c34-82d42d112d91/EBA-GL-2014-10%20(Guidelines%20on%20O-SIIs%20As-sessment).pdf.


https://eba.europa.eu/sites/default/documents/files/documents/10180/930752/964fa8c7-6f7c-431a-8c34-82d42d112d91/EBA-GL-2014-10%20(Guidelines%20on%20O-SIIs%20Assessment).pdf



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‘Cross-Border Liabilities’. Lastly, the ‘Resident Interconnectedness’ criterion included two equallyweighted(10%)indicators,namely‘ResidentInterbankAssets’and‘ResidentInterbankLiabilities’. Under the2016O-SIImethodology, the identificationstageusedasystemof relative importanceagainstthemeanbyemployingaz-scoringmethodology.Institutionswithanoverallresultexceedingthevalueof1,i.e.beyondonestandarddeviationfromthemean,wereclassifiedasO-SIIsbasedonthe above-mentioned criteria. The2016O-SII identificationmethodologyalso includedasecondsteptoassesswhether furtherinstitutions should be designated as O-SIIs based on the following two additional indicators:

(i) Size≥25%ofGDP;and(ii) CoveredDeposits≥2.5timesthedomesticDCSfunding.

Irrespectiveofthefirststep,aninstitutionthatmeetsbothindicatorslistedinpoints1and2abovewould still be subject to an O-SII capital buffer.

Under the revisedO-SII identificationmethodology, the definition of the ‘Size’ criterion remainedunchangedwhilethedefinitionofthe‘Substitutability’criterionwasreplacedbythe‘Importance’cri-terion,‘Cross-BorderActivity’wasreplacedby‘Complexity’and‘ResidentInterconnectedness’wasreplacedby thebroader ‘Interconnectedness’criterion.Althoughusingdifferent terminologies, theeconomicrationaleremainedrelativelyunchanged.

In termsof the identification stage,while the2016methodology reliedona systemof z-scoring,therevisedmethodologyisbasedonmarketconcentrations.Indeed,therevisedO-SIIidentificationmethodologymeasurestheweighted-averagemarketshareofacreditinstitutionwithintheindustry,with market shares being expressed in basis points and determined as proportions of the various chosen indicators. Thus, the score of bank can be expressed through the following formula:

Criterion IndicatorsSize Total Assets 20.00% 20%

Resident customer loans 13.33%Resident customer deposits 13.33%Holdings of Government debt 13.33%Cross-border assets 10.00%Cross-border liabilities 10.00%Resident Interbank assets 10.00%Resident Interbank liabilities 10.00%


Table 1

2016 O-SII MethodologyWeight

Substitutability 40%

Cross-Border Activity 20%

Resident Interconnectedness 20%

FEATURES OF THE 2016 O-SII IDENTIFICATION METHODOLOGY (STEP 1)

𝑆𝑆𝑗𝑗 =∑𝑥𝑥𝑖𝑖𝑗𝑗. 𝑎𝑎𝑖𝑖. 𝑏𝑏𝑖𝑖∑ 𝑥𝑥𝑖𝑖𝑗𝑗23𝑗𝑗=1

12

𝑖𝑖=1. 10,000

𝑆𝑆𝑗𝑗 𝑥𝑥𝑖𝑖𝑗𝑗 𝑎𝑎𝑖𝑖 𝑏𝑏𝑖𝑖

𝑗𝑗 𝑖𝑖 𝑎𝑎𝑖𝑖

𝑏𝑏𝑖𝑖

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Where: • refers to the O-SII score of bank • is the value of indicator for bank • is the weight of indicator as a proportion of the weight of the criterion to which it belongs • is the weight of the criterion to which indicator belongs

In other words, the obtained score for a credit institution in a given indicator can range from 0 to 10,000,with10,000indicatinga100%marketshareinthegivenindicator.Thescoreineachindica-toristhenweightedaccordingtotherespectiveweightoftherespectivecriteriontoproduceafinaloverall O-SII score.

TheweightshavebeencalibratedtosomewhatdepartfromasystemofequalweightingasappliedintheEBAGuidelinesandasalsoappliedinthe2016identificationmethodology.ThisnewweightingsystemusedintherevisedmethodologyputsmoreweightonthosechannelswhichposegreatersystemicrisktotheMalteseeconomyandfinancialsystem.Indeed,therevisedidentificationmethod-ologyhasbeendesignedtoreflecttheMaltesebankingsectorwhichispredominantlybasedonthetraditional banking business model (i.e. resident deposit taking and loan provisions) and dominated byasmallnumberofrelativelylargecreditinstitutions.Thisisevidencedthroughtheallocationofhigher weights to the ‘Importance’ and the ‘Size’ categories (see Table 2).

Comparedwiththe2016methodology,theweightassignedtothe‘Size’criterionunderthenewmeth-odologywasincreasedfrom20%to22%,whilethetotalweightassignedtothe‘Importance’criterionremainedunchanged(at40%)butcomposedoffiveindicatorsbasedonthoseoutlinedintheEBAGuidelines–threemandatoryandtwooptional.Theoptional(andadditional)indicators–,namely‘Pri-vate sector deposits from Maltese residents’ and ‘Private sector loans to Maltese residents’ – capture thespecificitiesoftheMaltesefinancialsector,inparticular,thestrongorientationtowardsdomesticdepositsand loans.Theremaining three indicators (i.e. ‘Valueofdomesticpayment transactions’,‘Private sector loans to recipients in the EU’ and ‘Private sector deposits from depositors in the EU’), apartfrombeingmandatoryintheEBAGuidelines,alsoreflectothersourcesofsystemicimportance.

Criterion Indicators Indicator weight

Criterion weights

Size Total Assets 22.00% 22.00%Value of domestic payment transactions 8.00%

Private sector deposits from depositors in the EU(1)5.50%

Private sector loans to recipients in the EU(2)5.50%

Private sector deposits from Maltese residents 10.50%Private sector loans to Maltese residents 10.50%Value of OTC derivatives (notional) 4.00%Cross-jurisdictional liabilities 7.00%Cross-jurisdictional claims 7.00%Intra-financial system liabilities 9.00%Intra-financial system assets 9.00%Debt securities outstanding 2.00%


Table 2

Importance

(1) MT deposits are incorporated in ‘private sector deposits from depositors in the EU’ indicator.(2) MT loans are incorporated in ‘private sector loans to recipients in the EU’ indicator.

40.00%

Complexity 18.00%

Interconnectedness 20.00%

REVISED SCORING METHODOLOGY FOR DOMESTIC O-SII IDENTIFICATION



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Theclearingoftransactionsisveryimportantforaproperlyfunctioningfinancialmarketsinfrastructureandanyinterruptionstopaymentsystemsareconsideredasasourceofsystemicrisk.Asaresult,the‘Valueofdomesticpaymenttransactions’indicatorhasbeenassignedarelativelyhigherweightof8%.

The‘PrivatesectorloanstorecipientsintheEU’indicatorreflectsadomesticinstitution’sexposuretoforeigneconomies,whichmayposeanelementofimportedsystemicrisk.Hence,loanstowardsMalteseandEUresidentsreflectamorecompleteassessmentoftheexposureofanO-SIItotheeconomies which it transacts with. On the other hand, the inclusion of ‘Private sector deposits from depositors in the EU’ represents a more complete assessment of the impact on the domestic DCS, giventhatEUdepositorsarealsocoveredbythescheme.4Thus,thedegreeofsystemicriskposedthrough the DCS is more complete when one accounts for both domestic and EU covered depositors. It is worth noting, however, that domestic private sector deposits and loans indicators were given a greaterweightof10.5%,toreflectthegreaterrelevanceoftheirsystemic impactonthedomesticrealeconomycomparedtotheEU-levelindicatorswhichwereassignedalowerweightof5.5%.Itis also worth highlighting that the EU-level indicators also include values for Malta in order to further reinforcetheimpacttowardstheMalteseeconomy.

Thelowerweightassignedtothe‘Complexity’criterion(18%)reflectsthetypicalMaltesecreditinstitu-tion which operates under the simple, traditional banking business model. This criterion includes the threeEBA-mandatoryindicators;‘Cross-jurisdictionalliabilities’,‘Cross-jurisdictionalclaims’and‘ValueofOTCderivatives’,withthelatterbeinganadditionwhencomparedtothe2016O-SIImethodology.

‘Interconnectedness’reflectsthedegreeofinterconnectivityacrosscreditinstitutionsandtherestofthebankingandfinancialsectorasawhole.Inthisway,onecangaugethedegreeofsystemicriskasaresultofcontagion.Unlikethe2016O-SIImethodology,therevisedidentificationmethodologydoesnotsolelyrelyon‘Residentinterbankassetsandliabilities’butalsoincorporatesexposurestowardsnon-residentfinancialsystems,whichisanimportantindicatorforassessingtheriskofcontagion.Indeed,adomesticO-SIImaybeexposedtoforeignfinancialsystemstoanextentthatanyproblemsinthesefinancialsystemsmayleadtoimportedsystemicriskinMalta.Furthermore,whilethe2016O-SIImethodologyfocusedonlyonintra-bankexposures,therevisedmethodologyconsidersexpo-surestothefinancialsystemasawholetocaptureamoreholisticapproachtowardsthechannelsofcontagion.Theindicator‘Debtsecuritiesoutstanding’hasbeenassigneda2%weighttoreflectthefactthatdebtsecuritiesrepresentarelativelysmallsourceoffinancefordomesticcreditinstitutions,which are more reliant on deposit taking.

Lastly,therevisedidentificationmethodologymakesfulluseofthemaximum+/-75bpsleewayonthe350bpsidentificationthresholdspecifiedintheEBAGuidelines,toreflectMalta’srelativelysmallandhighlyconcentratedfinancialsector.Thus,thosecreditinstitutionswhoseO-SIIscoreexceedsthe425bps cut-off threshold point would be considered as O-SII.

Changes to the Buffer Calibration MethodologyCredit institutionsthatareidentifiedasO-SIIsarerequiredtomaintainanapplicableO-SIIcapitalbuffer,whichconsistsof–andissupplementaryto–CET1capital,andisexpressedasapercentageof the total risk exposure amount.

Asper2016O-SIImethodology,anidentifiedO-SIIwouldfallwithinoneoffourbucketsasperTable3.

Conversely,under the revised2019methodology, identifiedO-SIIswouldbeclassified intooneoffivebuckets,dependingon theO-SIIscoreobtainedduring the revised identificationstageasperTable4.TheuseoffivebucketsallowsforamoreproportionateandcommensurateO-SIIsurcharge.4 Covered deposits are the part of eligible deposits that do not exceed the coverage level laid down in Regulation 10 of the Depositor Compensation Scheme Regulations, 2015 (S.L. 371.09).

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Furthermore,thereisabetterdelineationbetweenthoseO-SIIswhichmarginallyexceedthe425bpsidentificationthreshold(i.e.fallingunderbucket1)andotherO-SIIswithhigherO-SIIscore,whoseO-SIIidentificationismorelikelytoremainpermanent.Thehighestandlowestbucketsapplya2%and0.25%capitalsurchargerespectively;thehigherthesystemicriskposedbytherespectiveO-SII,the higher the capital buffer rate applied.

BasedontherevisedO-SIImethodology,theAuthoritiesfollowingtherecommendationoftheJointFinancialStabilityBoardand,followingconsultationwiththeEuropeanCentralBank,identifiedfourinstitutions as O-SIIs. Table 5 below lists these institutions together with their obtained O-SII scores and the corresponding capital buffer rates:5

Table6providesageneralcomparisonoftheoverallfeaturesofthe2016O-SIImethodologyandtherevisedmethodologyincludingindicatorschosen,thescoringsystememployedandrespectivebuck-ets used for calibration purposes.

5 The Authorities recognise the impact that certain provisions of the measure could have on a credit institution’s capital planning. Inviewofthis,theAuthoritiesdecidedtograntatransitoryperiodforthebuild-upoftheO-SIIbufferfornewlyidentifiedO-SIIs.ThetransitoryperiodisspecifiedintheapplicableyearlyStatement of Decision, available on both the Authorities’ websites.

Table 3

Buckets Capital Buffer Rate

Criterion for each bucket

3 2.00%High risk due to most of the criteria and/or score equal to or above 1.75

2 1.50%Risk due to most of the criteria and/or score equal to or above 1.25 and below 1.75

1 1.00% Some risk due to some criteria and/or score equal to or above 1and below 1.25

Step 2 0.50% Step 2 (additional indicators)


Step 1

2016 O-SII METHODOLOGY BUCKETING APPROACH

Table 5DESIGNATED O-SIIS SCORES AND CORRESPONDING CAPITAL BUFFER RATESCredit Institution Scores (bps) Buffer RateBank of Valletta Group (BOV) 2,739 2.00%HSBC Bank Malta plc (HSBC) 1,362 1.50%MDB Group Ltd (MED) 662 0.50%APS Bank plc (APS) 472 0.25%Source: Central Bank of Malta.

Buckets Capital Buffer Rate Score range for each bucket (bps)5 2.00% 1700 ≤ Score4 1.50% 1200 ≤ Score < 17003 1.00% 830 ≤ Score < 12002 0.50% 580 ≤ Score < 8301 0.25% 425 ≤ Score < 580


Table 4REVISED O-SII BUCKETING METHODOLOGY


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102


ConclusionThisboxhascomparedandhighlightedthemainchanges,implementedasfromJanuary2020,ofthejointCBM-MFSAO-SIImethodologywhencomparedtothe2016O-SIImethodology.ThemainobjectiveofthechangeswastobringthedomesticmethodologymoreinlinewiththeEBAGuide-lines.Thesechangesalsoaimtoprovidemoreconsistentandcomparableresults,whichreflectthesystem-wideimplicationsofthedomesticsystemicallyimportantbanks.

Ingeneral,thechangesrelatingtotheidentificationstageincluded(i)ashiftfromasystemofz-scor-ing toasystembasedonweightedaveragesandmarket sharesand (ii) the introductionofnewindicators coupled with a redistribution of the indicator weightings. The main change relating to the calibrationstagewastheincreaseinthenumberofbucketsfromfourtofive,thusprovidingarela-tivelymoreproportionateapproachtotheO-SIIbuffercalibration.

TheAuthoritieswillcontinuetoactivelymonitortheappropriatenessoftheO-SIImethodologyand,following thenecessaryconsultationprocedures,willaffectanychangesasnecessary.TheO-SIIidentificationandcalibrationmethodologiesareundertakenonanannualbasis,andtheresultsarepublished in the Statement of Decision.6The listofO-SIIs ispubliclyavailableon theCBM’sandMFSA’s websites.

6 2020 Statement of Decision available on the following link.


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Main MFSA Circulars

Circular to credit institutions on Banking Rule BR/09The MFSA issued two annexes to Banking Rule BR/09 on the “Measures addressing credit risks arising fromtheassessmentof thequalityofassetportfoliosofCredit Institutionsauthorisedunder theBankingAct”.Annex1implementsEBAGuidelinesonconnectedclients(EBA/GL/2017/15),clarifyingthetreatmentofconnectedclientsunderArticle4(1)(39)oftheRegulation(EU)575/2013(‘theCRR’).Thisannexspecifiestheapproachrequiredbycreditinstitutionsinapplyingtherequirementtogroupoftwoormoreclientsintoa“groupofconnectedclients”sincetheyconstituteasingleriskasdefinedinArticle4(1)(39)oftheCRR.Also, in accordance with Article 4(1)(39)(b) of the CRR, the annex establishes interconnectedness based on economicdependencyandalsocontrolandmanagementprocedurestobeestablishedbycreditinstitutionsforidentifyingconnectedclients.

Annex2relates to theEBAGuidelineson“Limitsonexposures toshadowbankingentities”whichcarryout banking activities outside a regulated framework, under Article 395(2) of Regulation (EU) No 575/2013 (EBA/GL/2015/20).Thisannexsetsoutthecreditinstitutions’provisionofspecificlimitsforappropriateindi-vidual and aggregate limits for such exposures. Indeed, credit institutions shall establish an internal frame-worktoidentify,manage,controlandmitigatetherisksarisingfromexposurestoshadowbankingentities,whichframeworkisoverseenbytheBoardofDirectorsoftherespectivecreditinstitutions.

Circular to credit institutions on Banking Rule BR/14TheMFSAissuedanannextoBankingRuleBR/14onthe“OutsourcingbyCreditInstitutionsauthorisedundertheBankingAct1994”.ThisanneximplementsEBA’srecommendationsonoutsourcingtocloudser-viceproviders(EBA/REC/2017/03)andstipulatesthesupervisoryrequirementsandprocessesthatapplywhencreditinstitutionsoutsourcetocloudserviceproviders.Italsosetsoutthemannerinwhichmaterialityof cloud outsourcing is assessed and reported to the MFSA. Furthermore, the annex provides guidance on thesecurityofthedataandsystemsusedwhileaddressingthetreatmentofdataanddataprocessingloca-tions in the context of cloud outsourcing. The annex includes requirements for credit institutions to mitigate the risks associated with ‘chain’ outsourcing, where the cloud service provider subcontracts elements of the servicetootherproviders.Finally,theannexguidescreditinstitutionsonthecontractualandorganisationalarrangementsforcontingencyplansandexitstrategiesthatshallbeinplaceinrelationtocloudoutsourcing.

Issuance of a new Banking Rule BR/21 on “Remuneration Policies and Practices”This new rule governs sound remuneration policies for all credit institutions’ staff and for staff whose profes-sionalactivitieshaveamaterial impactonacredit institution’sriskprofileincompliancewiththerequire-mentssetoutinArticles92to95ofDirective2013/36/EU(CRD)onaccesstotheactivityofcreditinstitutionsandtheprudentialsupervisionofcreditinstitutionsandinvestmentfirms.

ThisrulealsoimplementstherequirementsspecifiedintheEBAGuidelinesonSoundRemunerationPoli-cies under Articles 74(3) and 75(2) of Directive 2013/36/EU and disclosures under Articles 450 of the Regu-lation (EU)575/2013 (EBA/GL/2015/22) as well as providing guidance on disclosures under Article 96 of Directive 2013/36/EU as transposed into paragraph 32 of BR/07.

Finally,thisrulegovernstheremunerationpoliciesandpracticesrelatedtothesaleandprovisionofretailbanking products and services implementing the EBA Guidelines on Remuneration Policies and Practices related to the Sale and Provision of Retail Banking Products and Services EBA/GL/2016/06). These guide-linesmainlyspecifytherequirementsforthedesignandimplementationofremunerationpoliciesandprac-tices,inrelationtotheofferingorprovisionofbankingproductsandservicestoconsumersbycreditinstitu-tions, with a view to protecting consumers from undesirable detriment arising from the remuneration of sales staff.

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Main European Regulatory Policies

Risk reduction measures (RRM) package The RRM package amends rules on capital requirements under the CRD V and the CRR II as well as resolutionundertherevisedBankRecoveryandResolutionDirective(BRRDII)andtheSingleResolutionMechanism Regulation (SRMR II).12

CRR II and CRD V entered into force on 27 June 2019 where most provisions in CRR II will become appli-cable as of 28 June 2021 whereas the national transposition for most provisions in CRD V is 28 December 2020.TheCRRIIimposesabindingleverageratioofatleast3%andintroducesanadditionalleverageratiobuffertoglobalsystemicallyimportantinstitutions(G-SIIs).Furthermore,CRRIIimposesanetstablefund-ingratio(NSFR)designedtocomplementtheLiquidityCoverageRatio(LCR)toensurefundingresilienceoveralongertimehorizon,andintroducesasimplifiedNSFRtoallowsmallandnon-complexinstitutionstouseasimplifiedandlessgranularversionofsuchratio.

TheCRRIIandCRDVeliminatethemacroprudentialuseofPillar2suchthatPillar2requirementswillonlybeusedtoaddressrisksofamicroprudentialnature.Additionally,theCRDVprovidesincreasedflexibilityintheuseofmacroprudentialinstrumentssuchastheSystemicRiskBufferwhiletheCRRIIprovidesforfurtherclarificationofrolesandresponsibilitiesofdesignatedandcompetentauthoritieswhenapplyingmea-sures to real estate exposures on the basis of Articles 124 and 164 of the CRR.

TheCentralBankofMaltaiscurrentlyintheprocessofamendingDirectiveNo.11onMacroprudentialPolicytoeffectivelytransposetheelements,inparticularofCRDV,inlinewiththetranspositiondateprovidedbyEU law.

The BRRD II and SRMR II entered into force on 27 June 2019 and will be applicable as from 28 December 2020. The BRRD II includes a new framework for minimum requirements for own funds and eligible liabilities (MREL)whichwillbring theEUrules in linewith theFinancialStabilityBoard’s (FSB) internationalTotalLoss-AbsorbingCapacity(TLAC)standardforG-SIIsinresolution.ThisnewMRELregimeintroducesfixedminimumlevelsofMRELandminimumsubordinationrequirementsforEUG-SIIs,top-tierbanks(definedasthosebankswithassetsgreaterthan€100billion)andothersystemicentitiesthatqualifyneitherasG-SIIsnortop-tierbanksbutwhichresolutionauthoritiesassessasposingsystemicriskintheeventoffailure.

TheMRELrequirementsshouldbemetbybanksby1January2024butresolutionauthoritiescansetlongertransitionperiodsonacase-by-casebasis.ResolutionauthoritiesalsohavetosetanintermediatetargetforMRELrequirementthatbanksshouldmeetby1January2022.

Investment Firms Regulation and Directive (IFR and IFD)TheIFR/IFDframeworkintroducesmoreproportionatelawsforinvestmentfirmsandhencedifferentiatesbetweenthreeclassesofinvestmentfirms:Class1includeslargeinvestmentfirms;Class2includesotherinvestmentfirmsexceedingthecategorisationthresholdsforsmallandnon-interconnectedinvestmentfirms;andClass3includessmallandnon-interconnectedinvestmentfirms.13

InvestmentfirmsclassifiedasClass1whichdealonownaccountand/orunderwritefinancialinstrumentsand/orplacefinancialinstrumentsonafirmcommitmentbasis(MiFIDregulatedactivities),andhavetotalconsolidated assets equal to or in excess of €15 billion, will remain subject to the current CRR/CRD framework astheirriskprofilesareconsideredsimilartothoseofsignificantcreditinstitutions.14Similarly,authorised

12 ThelegislativetextsrelatedtotheRRMpackagewereadoptedbytheCounciloftheEuropeanUnionandtheEuropeanParliamenton20May2019andpublishedintheOfficialJournaloftheEuropeanUnionon7June2019:OfficialJournaloftheEuropeanUnionL150,Volume 62 (7 June 2019). Source: https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=OJ:L:2019:150:FULL&from=END13 ThenewInvestmentFirmsRegulation(IFR)andInvestmentFirmsDirective(IFD)werepublishedintheOfficialJournaloftheEuro-peanUnionon5December2019andenteredintoforceon25December2019:OfficialJournaloftheEuropeanUnionL314,Volume62(5December 2019). Source: http://publications.europa.eu/resource/cellar/ceb0d926-1745-11ea-8c1f-01aa75ed71a1.0006.03/DOC_114 MFSACircular(6February2020):ChangeinthePrudentialRegulationofInvestmentFirms–TheInvestmentFirmRegulationandDirective. Source: https://www.mfsa.mt/wp-content/uploads/2020/02/2020206-Change-in-the-Prudential-Regulation-of-Investment-Firms-%E2%80%93-The-Investment-Firm-Regulation-and-Directive.pdf

https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=OJ:L:2019:150:FULL&from=END

http://publications.europa.eu/resource/cellar/ceb0d926-1745-11ea-8c1f-01aa75ed71a1.0006.03/DOC_1

https://www.mfsa.mt/wp-content/uploads/2020/02/2020206-Change-in-the-Prudential-Regulation-of-Investment-Firms-%E2%80%93-The-Investment-Firm-Regulation-and-Directive.pdf

https://www.mfsa.mt/wp-content/uploads/2020/02/2020206-Change-in-the-Prudential-Regulation-of-Investment-Firms-%E2%80%93-The-Investment-Firm-Regulation-and-Directive.pdf

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investmentfirmsthatcarryoutMiFIDregulatedactivities,andwhicharepartofagroupcontainingacreditinstitution,willalsobetreatedasinstitutionssubjecttotheCRR/CRDframeworkandregulatoryapproval.Ontheotherhand,investmentfirmswhichareneithersystemic,norbank-like,norofasignificantsizewillbeclassifiedasClass2andClass3andwillbesubjecttotheIFR/IFDregime.

Non-performing loansOn22August2019,theECBissuedacommunicationonsupervisoryapproachesforNPEs,clearlyhigh-lightingthepurposeandapplicationofthemainpolicyinitiativestakenbyEUinstitutionswithspecificrefer-encetothesupervisorycoverageexpectationsforNPEs.15 These consist of:

(i) The Addendum to the ECB NPL Guidance, which was published in March 2018.16 The addendum sets outsupervisoryexpectationsforprudentialprovisioningfornewNPEs.

(ii) SupervisoryexpectationsfortheprovisioningofNPEstock,ascommunicatedinapressreleaseissuedon11July2018.17

(iii) Regulation (EU) 2019/630 amending the CRR (Regulation (EU)575/2013) as regards minimum loss coveragefornon-performingexposures,publishedontheOfficialJournaloftheEUon25April2019–CRR Pillar 1 NPE treatment.18

AspertheECBCommunication,theabovemeasuresshallapplyinthefollowingorder:

(i) Supervisoryexpectations for theprovisioningofNPEstock: this applies to those loans issuedandbecoming non-performing before 1 April 2018;

(ii) Addendum to the ECB Guidance: this applies to those loans issued before 26 April 2019 and becoming non-performing after 1 April 2018;

(iii) CRR Pillar 1 NPE treatment: this applies to those loans issued after 26 April 2019 and becoming non-performingatanydatethereafter(seeFigure5.1).

ThescopeoftheECB’ssupervisoryexpectationsfornewNPEsisaformofPillar2measure.Theapproachas communicated in the addendum will be limited to exposures not subject to Pillar 1 treatment – i.e. to NPEs

15 ECBCommunicationonsupervisorycoverageexpectationsforNPEs.Source:https://www.bankingsupervision.europa.eu/press/let-terstobanks/shared/pdf/2019/ssm.supervisory_coverage_expectations_for_NPEs_201908.en.pdf16 Addendum to theECBGuidance tobanksonnon-performing loans:Supervisoryexpectations for prudential provisioningof non-performing exposures. Source: https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.npl_addendum_201803.en.pdf17 ECBPressrelease:“ECBannouncesfurtherstepsinsupervisoryapproachtostockofNPLs”.Source:https://www.bankingsupervision.europa.eu/press/pr/date/2018/html/ssm.pr180711.en.html18 Regulation (EU) 2019/630 of the European Parliament and of the Council of 17 April 2019 amending Regulation (EU) No 575/2013 as regards minimum loss coverage for non-performing exposures. Source: https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019R0630&from=EN

Figure 5.1OVERVIEW OF SUPERVISORY AND REGULATORY APPROACHES TO NPE COVERAGE

1 April 2018

NPE Stock

ECB supervisory approach for addressing the stock of NPEs

– 2/7 calendarNo progressive path

Addendum exceptions 26 April 2019

Exposure origination date

NPE Flow

NPE FlowECB Addendum – 3/7/9

calendar Progressive path to 100% Addendum

exemptions

CRR Pillar 1 NPE treatment – 3/7/9Calendar

Progressive path to 100 % CRR


https://www.bankingsupervision.europa.eu/press/letterstobanks/shared/pdf/2019/ssm.supervisory_coverage_expectations_for_NPEs_201908.en.pdf

https://www.bankingsupervision.europa.eu/press/letterstobanks/shared/pdf/2019/ssm.supervisory_coverage_expectations_for_NPEs_201908.en.pdf

https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.npl_addendum_201803.en.pdf

https://www.bankingsupervision.europa.eu/press/pr/date/2018/html/ssm.pr180711.en.html

https://www.bankingsupervision.europa.eu/press/pr/date/2018/html/ssm.pr180711.en.html



106


arising from loans, which originated before 26 April 2019. NPEs arising from loans, which originated from 26 April2019onwards,willbesubjectsolelytoPillar1asperCRR.

In order to make the two approaches (i.e. ECB Addendum and CRR) more consistent, the relevant time frames for NPEs arising from loans which originated between 1 April 2018 and 26 April 2019 (i.e. subject to theECBAddendum)waschangedfrom2/7yearsto3/7/9yearstoalignthesetimeframeswiththeCRR.19

EBA Guidelines on management of non-performing exposuresInaddition to thedevelopmentscarriedoutbyEU legislatorsand theECB, theEBAhasalsopublishedguidelines on the management of non-performing and forborne exposures, aimed at ensuring that banks haveadequatetoolsandframeworksinplacetomanageeffectivelytheirNPEsandtoachieveasustainablereduction on their balance sheets.20

The guidelines set the qualitative elements that banks should have in place in order to manage their levels of NPEsbyintroducinga5%grossNPEratiothresholdasatriggerfordevelopingNPEstrategiesandapplyingassociatedgovernanceandoperationalarrangementsasstipulatedintheGuidelines.Thus,anybankwithanNPEratioof5%orhigheratanyonepointintimeisrequiredtodrawupatime-boundNPEstrategyanda corresponding operational plan in order to lower its NPE ratio.

With regards to the application date, the EBA Guidelines entered into effect as from 30 June 2019, based on NPE ratios as at 31 December 2018 reference date.

Update from the European Commission on AMLInrecentyears,theEUhasbeenworkingintenselyonstrengtheningitslegalframeworkinitsfightagainstmoneylaunderingandterroristfinancing, in linewiththestandardsadoptedbytheFinancialActionTaskForce(FATF).Indeed,followingtheadoptionofvariousdirectivesrelatingtoAMLduringthepastyears,inJuly2019,theCommissionadoptedacommunicationtotheEuropeanParliamentandEuropeanCounciltowardsbetterimplementationoftheEU’santi-moneylaunderingandcounteringthefinancingofterrorismframework.ThecommunicationwasaccompaniedbyfourreportsrelatingtotheUnion’slegalframeworkforpreventingmoneylaunderingandterroristfinancinganditsimplementation. ThefirstreportrelatestothebiennialSupranationalRiskAssessmentReport.ItpresentsanassessmentofthemoneylaunderingandterroristfinancingrisksthatcouldpotentiallyimpacttheEU.Inthissecondreport,sevennewproductsandservicesareidentifiedasbeingpotentiallyvulnerabletomoneylaundering/ter-roristfinancingrisks,namely:theuseofnewtechnologies(FinTech);virtualcurrencyexchangeplatforms;custodianwalletproviders;privatelyownedautomatedtellermachines;professionalfootball;freeports;andinvestor citizenship and residence schemes (‘golden passports/visas’). The second report assesses the recentallegedmoney-launderingcasesinvolvingEUcreditinstitutions.Itprovidesa“post-mortemreview”of alleged publicly-known cases of EU credit institutions being involved inmoney laundering. The thirdreport assesses the framework for cooperation between Financial Intelligence Units (FIUs) in the EU with thirdcountriesandlooksatwaysofimprovingcooperationwiththepossibilityofsettingupacoordinationandsupportprocedures.ThefindingsrevealthatFIUsadoptdifferentapproachesforSuspiciousTransac-tion Reports and there is lack of regulation on information exchange between FIUs in different EU Member States and FIUs in third countries. In this regard, the Commission will continue to work on improving the cur-rentpracticesinplacetoaddresstheidentifiedshortcomings,especiallyabouttheimprovementofcoordina-tionandsupportincross-bordercooperationandanalysis.Finally,thefourthreportassessestheconditionsandthetechnicalspecificationsandproceduresforensuringsecureandefficientinterconnectionofcentralbankaccountregistersanddataretrievalsysteminlinewithArticle32aofDirective2015/849/EU.

19 3/7/9refertothenumberofyearsbywhenanexposureistobe100%coveredbycollateral.20 Final Report on the EBA Guidelines on management of non-performing and forborne exposures. Source: https://eba.europa.eu/sites/default/documents/files/documents/10180/2425705/371ff4ba-d7db-4fa9-a3c7-231cb9c2a26a/Final%20Guidelines%20on%20manage-ment%20of%20non-performing%20and%20forborne%20exposures.pdf

https://eba.europa.eu/sites/default/documents/files/documents/10180/2425705/371ff4ba-d7db-4fa9-a3c7-



107


Appendices and glossary

109


Appendix A IMPLEMENTED POLICY MEASURES

Capital Buffer for Other Systemically Important Institutions (O-SII)

2016 2017 2018 2019 2020 Implementation date

Medirect 0.125% 0.250% 0.375% 0.500% 0.500% 1 Jan. 2016 Revised on 1 Jan.

2020 HSBC Group Malta 0.375% 0.750% 1.125% 1.500% 1.500% Bank of Valletta Group 0.500% 1.000% 1.500% 2.000% 2.000% APS Bank Plc - - - - 0.0625% *APS Bank Plc is currently subject to a transitory period for the build-up of its fully-loaded O-SII buffer rate as follows: 2020 – 0.0625%; 2021 – 0.125%; 2022 – 0.1875%; 2023 – 0.25%

Countercyclical Capital Buffer (CCyB)

2018 2019 2020 Implementation date

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 All credit institutions 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 1 Jan. 2016

Macroprudential policy: Reciprocity

2018 2019 2020 Implementation/ Withdrawal date

Reciprocity of the Systemic Risk Buffer implemented by Estonia

1.0% for risk exposures exceeding

€200 million

1.0% for risk exposures exceeding

€200 million

Withdrawn by Estonia as of 1

May 2020 in response to the

COVID-19 pandemic

24 Oct. 2016/1 May 2020

Macroprudential policy: Material Third Countries


Identification of Material Third Countries

United States of America, Republic

of Turkey, Russian

Federation, United Arab Emirates

United States of America, Republic

of Turkey, Russian

Federation, United Arab Emirates

United States of America, Republic of Turkey, Russian Federation, United

Arab Emirates

June 2016

Measures Addressing Credit Risk


Borrower-based measures

Launch of public consultation with

stakeholders

Publication of feedback

statement on outcome of the

public consultation, and Directive No.16

Issuance of Notice to amend

Directive No.16 in response to the

COVID-19 pandemic

1 July 2019 (amended 1 June

2020)

All credit institutions (BR/09/2019)

Implementation of NPL Reduction Plan for banks

which exceed the 6% NPL ratio

threshold



threshold



threshold

2 Jan. 2017

Moratoria on Credit Facilities in Exceptional Circumstances

Publication of Directive No.18 in response to the

COVID-19 pandemic

13 April 2020 (amended 23 April and 30 June 2020)

111


App

endi

x B

FIN

AN

CIA

L SO

UN

DN

ESS

IND

ICA

TOR

S

2015

2016

2017

2018

2019

2015

2016

2017

2018

2019

2015

2016

2017

2018

2019

2015

2016

2017

2018

2019

Cor

e FS

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l to

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t sec

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l ass

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9.30

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1.27

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113


Glossary

Alternative Investment Fund (AIFs): a Collective Investment Scheme (CIS) that raises capital from sev-eralinvestorsandinvestsitinlinewithadefinedpolicyforthebenefitofitsinvestors,andwhichdoesnotqualifyundertheUndertakingforCollectiveInvestmentinTransferableSecurities(UCITS)Directive.

Alternative Investment Funds Managers Directive (AIFMD): a European Union (EU) Directive seeking to regulate the managers of funds other than Undertaking for Collective Investment in Transferable Securities (UCITS).

Amortised cost (AMC): instrumentsheldwiththeintentionofcollectingcontractualcashflowswhicharevaluedatthediscountedfuturepayments(principalandinterest)overthelifeoftheinstrument.

Asset Purchase Programmes (APP): includes all purchase programmes under which private sector and publicsectorsecuritiesarepurchasedtoaddresstherisksofatooprolongedperiodoflowinflation.

Assets-Under-Management (AUM) to net-asset-value (NAV) ratio:calculatedbydividingtheassetsbythe NAV.

Borrower-based measures:acombinationof instruments thatset limits to theamountofmoney thatanaturaloralegalpersoncanborrowtopurchasearesidentialproperty.ThemeasuresintroducedbytheCentralBankofMaltainJuly2019includelimitsontheloan-to-valueratioatorigination(LTV-O),limitsonthedebt-service-to-incomeratioatorigination(DSTI-O)wherethedebtservicingisstressedby150bps,andlimitsontheterm-to-maturityoftheresidentialrealestateloan.

Captive financial institutions and money lenders (CFIML):thissectortypicallyconsistsofholdingcom-paniesthathavecontrollinglevelsofequityofagroupofsubsidiarycorporationsandwhoseprincipalactivityisofowningthegroupwithoutprovidinganyotherservicetothebusinessesinwhichtheequityisheld.

Combined ratio:calculatedasthesumofnetclaimsandexpensesincurreddividedbynetpremiaearned.

Countercyclical Capital Buffer (CCyB): credit institutions are required to set aside additional Common EquityTier1capitalduringperiodsofexcessivecreditgrowth.TheaimoftheCCyBistoincreasebanks’resilience in good times to be able to absorb potential losses that could arise in a downturn, enabling the continuedsupplyofcredittotherealeconomy.

Collective Investment Undertakings (CIU): undertakings that raise capital from investors (fund holders) to carryoutcollectiveinvestmentsintransferablesecuritiesand/orinotherfinancialassets.

Cost-to-income ratio:definedasoperatingexpenses(netofamortisationbut includesintangibleassetsother than goodwill) to gross income (net interest income and non-interest income).

Coverage ratio: the ratio of overall provisions and interest in suspense to total non-performing loans (NPLs). Covered bonds:debtsecuritiesissuedbyaninstitutionwhicharecollateralisedagainstapoolofassets.Intheeventthattheissuinginstitutionbecomesinsolvent,thebondiscoveredbytheseassets.

Credit standards:banks’ internalguidelines for loanapprovals.Thesespecify theborrower’scharacter-isticssuchashis/herincomelevels,ageandemploymentstatus,whichthebanksconsiderintheircreditscoring methods.

Credit terms and conditions:theconditionsofaspecificloan.Theseconsistoftheinterestrate,loansize,fees,collateralrequirements,maturityandotherconditions.

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Customer deposits:depositsof(i)moneymarketfunds(ii)centralgovernment(iii)othergeneralgovern-ment, and (iv) other remaining economic sectors, including households and corporates, but excluding the financialintermediationsector.

Customer loans: loansto(i)moneymarketfunds(ii)centralgovernment(iii)othergeneralgovernment,and(iv)otherremainingeconomicsectors,includinghouseholdsandcorporates,butexcludingthefinancialintermediation sector.

Debt-service-to-income ratio (DSTI): the annual total debt service relative to the total annual gross income of the borrower/s.

Eurosystem funding: credit provided to eligible counterparties (banks) on a collateralised basis. The ECB coordinatestheoperationsandthenationalcentralbankscarryoutthesetransactions.

Expected credit loss (ECL): under IFRS 9, lifetime ECL is the expected present value of losses that arise ifborrowersdefaultontheirobligationsatsometimeduringthelifeofthefinancialasset.Foraportfolio,ECListheweightedaveragecreditlosses(loss-given-default)withtheprobabilityofdefaultastheweight.

Fair value through profit and loss (FVTPL): instruments measured at fair value whose gains and losses arerecognisedentirelyintheprofitandlossaccount.

Fair value through other comprehensive income (FVOCI): instruments measured at fair value whose gainsandlossesarerecogniseddirectlyinthebalancesheetaspartofothercomprehensiveincome.

Financial Sector Assessment Programme (FSAP):acomprehensiveandin-depthanalysisofacountry’sfinancialsectorrunbytheInternationalMonetaryFund.

Haircuts:riskcontrolmeasuresappliedtounderlyingassetswherebythevalueofsuchassetsiscalculatedasthemarketvaluelessapercentage(the“haircut”).Thesizeofthehaircutreflectstheperceivedriskofholding such an asset.

High-Quality Liquid Assets (HQLA): comprises Level 1, Level 2A and Level 2B assets. Level 1 assets includecash,centralbankreserves,andcertainmarketablesecuritiesbackedbysovereignsandcentralbanks, among others. Level 2A assets include, for example, certain government securities, covered bonds and corporate debt securities. Level 2B assets include lower-rated corporate bonds, residential mortgage-backed securities and equities that meet certain conditions.

Impairment charges: costs incurred as a result of the decline in the value of assets. These include write-downofloans,investmentsandnon-financialassets,netofrecoveriesandreversalsfromanimpairedstate.

Insurance with profit participation:asavingsproductwhereattheendofeachyeartheinsurancecom-panymaydeclareabonusratewhichformspartoftheannualinvestmentreturn.

Index and unit-linked products: products that offer both insurance coverage and investment exposure inasingleproduct.Thepremiapaidbypolicyholdersare inpartutilisedfor insurancecoveragewiththeremainingportionpooledwithassetsfromotherpolicyholdersandinvestedinequityanddebtinstruments.

Internal rating-based (IRB) approach:bymeansofthisapproach,aspartoftheBaselIIguidelinesandsubjecttosupervisoryapproval,banksareallowedtousetheirownestimatedriskparametersforthepur-poseofcalculatingregulatorycapitalforcreditrisk.

iTraxx European Senior Financial index: an index composed of credit default swaps covering senior Europeanfinancials.

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Leverage ratio:calculatedbydividingTier1capitalbythebank’saveragetotalconsolidatedassets(sumof the exposures of all assets and non-balance sheet items). Credit institutions are required to maintain a minimumleverageratioof3%.

Liquid asset ratio for insurance corporations: shows the proportion of liquid assets on total assets (excludingassetsheld forunit-linked).Theratio iscalculatedbyapplyingdifferentweights(ranging from100%forcashto0%forintangibleassets)tothedifferentassets,accordingtotheirliquidityprofile.

Liquid assets ratio for investment funds: calculated as the liquid assets (i.e. cash and deposits with banks,debtsecuritiesissuedbyMFIs,sovereignbonds,equityandinvestmentfundshares)dividedbytotalassets. Liquidity coverage ratio (LCR):promotestheshort-termresilienceofabank’sliquidityriskprofilebyensur-ingthatabankhasanadequatestockofunencumberedHQLAthatcanbeeasilyandimmediatelyconvertedintocashtomeetabank’sliquidityneedsfora30-calendardayliquiditystressscenario.

Liquidity Coverage Ratio (LCR) Regulation: the European Commission Delegated Regulation which supplements the (EU)No575/2013of theEuropeanParliamentand theCouncilwith regard to liquiditycoveragerequirementforcreditinstitutions.Itlaysdowndetailedrulesoftheliquiditycoveragerequirement.ItincludesdetailsoftheassetsthatcanbeconsideredasHQLAandtheestimationoftotalnetcashflowsovera30-calendardayperiod.

Loan loss provisions: an amount set aside to cover for non-performing loans.

Loss ratio: the total incurred losses in relation to the total collected insurance premia.

Loan-service-to-income ratio (LSTI):theannualloanpaymentsrelativetotheannualgrossincomeoftheborrower/s.

Loan-to-deposit ratio:theratioforassessingabank’sliquiditybydividingthebank’stotalloansbyitstotaldeposits.Iftheratioistoohigh,itmeansthatbanksmightnothaveenoughliquiditytocoveranyunforeseenfundingrequirements;iftheratioistoolow,banksmaynotbeearningasmuchastheycouldbepotentiallyearning.

Loan-to-income ratio (LTI): the amount of funds borrowed relative to the annual gross income of the borrower/s.

Loan-to-value ratio (LTV): theamount lent for thepurchaseofaproperty,expressedasashareof themarketvalueofthepropertypurchased.

Loss given default (LGD):theratioofthelossonanexposureduetothedefaultofacounterpartytotheamount outstanding at default.

Minimum requirement for own funds and eligible liabilities (MREL): banks’ minimum requirement for own funds and eligible liabilities so as to be able to absorb losses and restore their capital position.

Mixed funds:investmentfundsthatinvestinbothbondsandequitywithnogeneralpolicyinfavourofeitherone or the other instrument.

Net asset value (NAV): represents the net value of a fund and is calculated as the value of its assets less the value of its liabilities.

Net expense ratio:thelevelofexpensesincurredbyinsurancecompaniesasashareofnetpremiaearned.

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Net interest income (NII):thedifferencebetweentherevenue/interestgeneratedbyabankfromassetsand the expenses/interest paid on its liabilities.

Net interest margin (NIM): expressed as a percentage of the difference between interest income and inter-est expense to interest-bearing assets.

Net stable funding ratio (NSFR): the amount of available stable funding relative to required stable funding. Thisratioshouldbeequaltoatleast100%onanongoingbasis.Itaimstopromoteresilienceoveralongerperiodbycreatingincentivesforbankstofundtheiractivitieswithmorestablesourcesoffunding.

Non-performing exposures (NPEs): credit facilities and debt securitieswhich are classified as non-performing.

Non-performing loans (NPLs):creditfacilitieswithpaymentsofinterestand/orcapitalwhichareoverdueby90daysormore,aswellasthosefacilitiesaboutwhichacreditinstitutionhasreasonabledoubtontheeventualrecoverabilityof funds.Thenon-performing loansratio iscalculatedbytakingthevalueofnon-performingloansasashareofthetotalloanfacilitiesheldbythebank.

Own funds:thesummationofCommonEquityTier1(CET1)capital,AdditionalTier1capital,Tier2capitalaswellasdeductionsfromthedifferenttypesofcapital,andtransitionalprovisionsforownfundsintermsof grandfathering.

Other asset allocation funds: those funds which invest in a mix of asset classes such as investing in com-modities. Other Systemically Important Institutions (O-SII):institutionsthat,duetotheirsystemicimportance,aremorelikelytocreateriskstofinancialstability.Whilemaximisingprivatebenefitsthroughrationaldecisions,theseinstitutionsmaybringnegativeexternalitiesintothesystemandcontributetomarketdistortions.

Overall capital requirement (OCR): the sum of the total SREP capital requirement (TSCR), capital buffer requirements and macroprudential requirements, expressed as own funds requirements.

Professional Investor Funds (PIFs): a special class of collective investment schemes anticipated for spe-cificcategoriesofmoreprofessionalandexperiencedinvestorsandwhichfallwithintheprovisionsoftheInvestment Services Act, 1994.

Return-on-assets (post-tax):annualpost-taxprofits/lossesdividedbya12-monthmovingaverageoftotalassets.

Return-on-equity (post-tax): annual post-tax profits/losses divided by a 12-month moving average ofshareholders’ funds.

Risk reduction measures (RRM):theRiskReductionMeasuresPackagewasadoptedbytheCounciloftheEuropeanUnionandtheEuropeanParliamenton20May2019andmainlyrelatetotherevisedCapitalRequirementsDirective(CRDV),CapitalRequirementsRegulation(CRRII),BankRecoveryandResolu-tion Directive (BRRD II), and Single Resolution Mechanism Regulation (SRMR II) in order to complete the Single Rulebook.

Risk-weighted assets (RWA):assetsmultipliedbytheirrespectiveriskweightsasspecifiedintheCapitalRequirements Directive.

Solvency capital requirement (SCR): the capital required for insurers to meet their obligations over the next12monthswithaprobabilityofatleast99.5%.

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Supervisory Review and Evaluation Process (SREP):acorefunctionof thesupervisoryauthorities inassessingbanks’resilienceintermsofcapitalandliquidityrequirements.Italsoconsiderstheviabilityofbanks’ business models and overall risk management.

STREAM:theCentralBankofMalta’sStructuralMacro-EconometricModeloftheMalteseeconomy,whichisatraditionalstructuralmodelbuiltaroundtheneo-classicalsynthesis.

Systemic Risk Buffer:aimstoaddresssystemicrisksofalong-term,non-cyclicalnaturethatarenotcov-eredbytheCapitalRequirementsRegulation.Thebufferlevelmayvaryacrossinstitutionsorsetsofinsti-tutions. There is no maximum limit on the rate applicable for this buffer, but depending on its level and the impactonotherMemberStates,authorisationfromtheEuropeanCommissionmayberequired.

Tier 1 Capital:mainlycomposedofequityandretainedearnings.

Tier 1 Capital Ratio: Tier 1 capital expressed as a percentage of risk-weighted assets.

Tier 2 Capital: includes, inter alia, undisclosed reserves, revaluation reserves, general provisions, and subordinated term debt.

Total Capital Ratio: own funds (Tier 1 and Tier 2 capital) expressed as a percentage of risk-weighted assets.

Total SREP capital requirement (TSCR):thesumofownfundsrequirementsasspecifiedinArticle92ofRegulation (EU)575/2013 and additional own funds requirements determined in accordance with the criteria specifiedintheEBASREPguidelines.

Undertakings for Collective Investment in Transferable Securities (UCITS):aregulatoryframeworkbythe European Commission that creates a harmonised regime for the management and sale of mutual funds. The objective was to create a single European market for retail investment funds, while at the same time ensuring a high level of investor protection. This framework allows such funds to seek a single authorisation in one EU Member State, and to register for sale and market across EU Member States.

Documents

TWELFTH FINANCIAL STABILITY REPORT 2019...Chart 4.5: Gross written premium of the domestic non-life insurance sector by line of business 85 Chart 4.6: Composition of assets held by