Michael C Bonello: The Central Bank of Malta and financial stability
Speech by Mr Michael C Bonello, Governor of the Central Bank of Malta, at the conference "Onshore
Europe", organised by the Malta Financial Services Authority, St Julians, 13 September 2004.
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The title chosen for this conference is as significant as it is brief. The two words "Onshore Europe"
neatly capture Malta's current reality, that of a financial centre with solid credentials which affords its
players both the guarantees and the opportunities to be offered by the Single European Market for
Financial Services.
As we commemorate Malta's first ten years as an international financial centre, it is appropriate to
record that if we are able to look back with satisfaction at past achievements, it is only because our
legislators had the political vision to adopt a consensual approach to the task at hand in 1994. This
involved a radical overhaul of existing laws and the drafting of new ones to lay the foundations of a
modern financial centre governed by the highest standards and yet flexible enough to allow new
opportunities for growth and development to be seized to the country's economic advantage. I would,
therefore, like to pay tribute to all those who saw the project through to a successful conclusion.
An analysis of Malta's track record leads to another important conclusion, which is that having in place
an appropriate legislative and institutional framework is a necessary, but not a sufficient condition for
success. Recent experience around the world suggests that the potential of a financial centre cannot
be maximized unless it possesses another essential attribute. That other ingredient is stability and it is
this aspect that I propose to explore today.
Ensuring financial stability is a statutory responsibility of the Central Bank of Malta. The Bank is thus
obliged to participate actively in the maintenance of a stable and efficient financial system and to
contribute towards its development. This applies not only to the payment and settlement system, of
which the Bank is the regulator, but to the entire financial system. The Bank has an on-going role to
play in assessing the robustness of the system. It must draw attention to any problems and ensure
that these do not in any way impede the functioning of the financial markets as efficient providers of
capital for companies and households. The Bank's approach is therefore to consider the general risks
to the system rather than the situation of individual credit and financial institutions. The latter is the
task of the Malta Financial Services Authority (MFSA), which has successfully assumed, over the last
ten years, full responsibility for the supervision of institutions providing financial services.
Why central banks promote financial stability
There are several reasons why the maintenance of a healthy financial sector is an essential function of
central banks, and this irrespective of their involvement or otherwise in regulation and supervision.
First, by virtue of their role as providers of liquidity to the banking system and their involvement in
payment systems, central banks have a vested interest in the quality of their counterparties. Any
developments that could affect the financial health of their counterparties are of direct interest to a
central bank, not least because the inability of the former to honour their commitments would have
negative financial implications for the central bank. Furthermore, instability in the financial system
could hinder central banks from successfully pursuing their other objectives, particularly the
achievement of price stability through monetary policy measures.
Indeed, monetary policy can only be implemented effectively if the financial system is stable, for only
then can financial intermediaries respond to changes in interest rates and in liquidity conditions
engineered by the central bank, and thus transmit these impulses on to non-financial intermediaries.
At the same time, by pursuing price stability central banks contribute directly to financial stability, since
a stable price environment reduces volatility in financial variables and ensures the smooth functioning
of markets.
From a central bank perspective, it is also evident that a healthy financial system contributes to
stability in the exchange rate particularly where, in countries like Malta, a fixed exchange regime
coexists with the absence of capital controls. Thus, in a situation where there are concerns about the
robustness of the financial infrastructure, the regulatory framework or the integrity of financial
intermediaries, the external account may be undermined through sizeable outflows of capital. In other
words, what starts off as a crisis in an individual institution could easily develop into a balance of
payments and currency crisis, which may, in turn, trigger off secondary effects throughout the rest of
the financial sector, disrupting other sectors of the economy in the process and thus resulting in a
fullblown financial crisis.
In the case of the Central Bank of Malta, these considerations assume even greater importance given
the Maltese economy's small size, openness and lack of natural resources, which make it highly
dependent on foreign markets. The small size of the domestic market, moreover, also has implications
for savings and investment. Thus a limited pool of savings is in turn reflected in a low volume of
internally generated resources for investment purposes, making the country highly dependent on
external financing. This dependence is evidenced by the private savings ratio, which is not only low by
international standards, at around 22% of GDP, but has also been falling in recent years as public
sector imbalances have widened to unsustainable proportions.
The Central Bank of Malta's approach to financial stability
Against this economic background, therefore, price and exchange rate stability assume particular
importance and the need for a stable financial environment becomes all the more crucial. The
maintenance of financial stability was accordingly recognized in the legislation setting up the Central
Bank of Malta in 1968, but it was only pursuant to the 2002 amendments to this legislation that the
Bank's responsibility was made more explicit.1 These amendments also recognized the Bank's role in
preserving a sound and efficient payment system.
The Bank's efforts to strengthen its capacity in the area of financial stability commenced before its
responsibility for banking regulation and supervision was transferred to the Malta Financial Services
Authority (MFSA) in January 2002. In fact in 2000, a Financial Stability Office was set up to identify
and analyse potential systemic threats not only in banks, but also in other parts of the financial system,
such as the insurance and investment sectors, the securities markets and also selected large
corporations in the non-financial sector.
The Office has since developed a set of financial soundness indicators and a model which detects and
assesses the impact of different types of risks. It has also introduced shock scenario techniques to
stress-test the resilience of the banking system. This year the Bank has also started to conduct a
bi-annual financial stability review whereby developments abroad as well as in the domestic
macroeconomic, regulatory and operational environment are assessed in one analytical framework
designed to detect potential weaknesses and to devise appropriate remedial measures.
These activities are supplemented by the work of the Bank's Payment Systems Office, which is
responsible for the maintenance and oversight of the payment system. This is an important function
because modern electronic payment systems have the potential to serve as channels of contagion by
transmitting the payment difficulties of one, or a few, large financial intermediaries to others in the
system.
In 2002 a Retail Gross Settlement System based on the Bank for International Settlements' ten core
principles2 was introduced in Malta through which inter-bank domestic payment orders are now
transmitted, cleared and settled with greater efficiency than previously. The Bank has also issued a
number of directives which seek to provide participating banks with an adequate degree of protection
against legal and systemic risks associated with participation in such systems. Other directives seek to
ensure that the rights of banks' clients to adequate information concerning retail payments are upheld
by the intermediaries rendering payment services. In this way, credibility in the integrity of the
infrastructure used for the settlement of payments is preserved at both wholesale and retail level.
The Bank's role in financial stability has more recently been enhanced by membership of the
European System of Central Banks (ESCB) from May 2004. It has started to participate in the ESCB
committee dealing with financial stability, the Banking Supervision Committee, and at the EU level the
Bank also participates in the Economic and Finance Committee and in its Financial Stability Table.
The importance of two-way cooperation with the MFSA
The initiatives I have described have strengthened the Bank's ability to monitor and analyse
developments in the financial system in a wider context. It is nevertheless becoming increasingly clear
that to carry out this role effectively, the Bank's efforts in this area need to be supported by the
activities of the overall supervisor in the financial field, that is the MFSA.
It is, therefore, reassuring to note that good co-operation already exists between the Bank and the
Authority. More specifically, the Authority's focus on the health of individual service providers
complements the Bank's macroprudential analysis of the financial system as a whole and its oversight
of the payment and settlement systems.
In undertaking their respective tasks, both these institutions have access to information that may not
be readily available to the other. Thus, for example, through its involvement with payment systems and
the daily monitoring of the banks' foreign exchange exposures, the Central Bank of Malta has daily
information on the amount of liquidity and the extent of foreign exchange risk prevalent in the
inter-bank market. Similar information, however, only becomes available to the Authority with a delay,
through the monthly statistical reports submitted by the individual financial intermediaries.
Furthermore, the Bank's macro perspective assessment of financial developments may identify
general risks to the system that may not be apparent when the prudential supervision of individual
financial institutions is undertaken. This may occur, for example, if the risk profiles of the institutions in
question show a high degree of similarity, making the system especially vulnerable to a particular type
of shock. Supervision at the micro level, therefore, has to be complemented with a macro analysis of
the interlinkages between different segments of the domestic financial sector and its links with the
payment system, the rest of the economy and its counterparts abroad.
On the other hand, it is also true that the Bank's macroprudential analysis may not provide precise
information on individual institutions, particularly those that may be on the brink of insolvency. Here,
the Authority, through regular inspections of individual service providers will have a more in-depth
knowledge of the health of single intermediaries and market segments, including those which play a
peripheral role in the monetary policy transmission process and with which the Bank's relationship is,
at least on a one-to-one basis, rather distant. In this sense, the Authority also contributes to the
soundness of the Bank's counterparties. It is also the Authority which ensures that only sound
institutions are licensed to enter the Maltese market. Furthermore, confidential supervisory information
available to the Authority could be useful to the Bank as an input into its overall analysis of the
financial system, enabling it to respond to liquidity and related constraints that could set off negative
ripple effects.
The potential for synergies between the two institutions prompted them to sign two Memoranda of
Understanding in 2002 to provide for enhanced co-operation, including through the establishment of a
Standing Committee.
This cooperation framework has contributed to the general soundness and stability of the financial
system. The profitability of our banks, for example, has remained stable with an average return on
assets after tax of 0.8% in 2003, the same level as that recorded by European banks. Furthermore,
bank liquidity and capitalization levels have both remained strong. Liquid asset holdings as a
percentage of short-term liabilities were close to 53% at the end of 2003, compared to a minimum
threshold of 30%. Meanwhile, the banks' aggregate capital adequacy ratio, defined as the ratio of own
funds to risk-weighted assets, currently stands at 23%, compared to a minimum of 8%. In the
insurance sector and collective investment schemes steady growth continues to be registered.
This positive performance notwithstanding, there remains scope for further improvement in the
framework through which the Bank and the Authority seek to safeguard the health of the domestic
financial system. It is becoming increasingly evident, for example, that a proper analysis of the
system's robustness requires detailed statistics about entities for which data are currently either not
available or are fragmented. This is particularly the case of the non-bank financial sector, and also of
the corporate and household sectors, although in this latter area some progress is being made
through the joint efforts of the Bank, the Authority and the National Statistics Office.
Another aspect warranting particular attention is that of financial crisis management. While the current
institutional and regulatory framework has been successful in keeping at bay any major systemic
disturbance, further progress is required, for example by defining the specific roles and responsibilities
of the Bank, the Authority and the Government. In this respect, the Joint Contingency Plan for
systemically important banks drawn-up by the Bank and the Authority already takes into account the
involvement of the Ministry of Finance with respect to the possible use of public funds and the Bank's
lender of last resort function. This framework is currently in the process of being refined further.
The need for improved cross-border cooperation
On the other hand, it is a matter of some concern that whereas modalities for crisis management have
been, or are in the process of being formalised effectively in most jurisdictions, including Malta, the
way forward for the resolution of crises of a cross-border nature, and requiring the prompt intervention
of central banks and supervisors that operate in different time zones and with different day-to-day
practices, is not yet clearly defined.
Some progress in this respect has been made at the EU level through the formalisation of the
Memoranda of Understanding of the ESCB on high-level principles of co-operation in crisis
management situations and between payment systems overseers and banking supervisors. However,
these agreements, to which the Central Bank of Malta and the MFSA are also a party, do not go far
enough. The implications of systemic crises whose resolution would, for example, require some form
of fiscal input and possibly also the contribution of other entities spanning different jurisdictions are not
yet articulated. This issue will hopefully be addressed during the forthcoming review of the EU Banking
Codified Directive of March 2000.
As the two key institutions with financial stability responsibilities, the Bank and the Authority have a
direct interest in the future evolution of international co-operative arrangements. Such arrangements,
moreover, will also impact on the way in which the two institutions seek to co-operate with each other
and with similar authorities based abroad. In particular, the activities and institutions which the Bank
and the Authority will be expected to monitor will become more complex as the number of financial
intermediaries with a presence both in Malta and in other countries, either directly through the
establishment of branches or subsidiaries, or indirectly through the provision of cross-border services
via the internet or otherwise, continues to grow in the light of the incorporation of EU passporting rights
in Maltese legislation. The coming into effect of Basle II and, at the EU level, CAD III will be significant
factors in this regard. At the same time, the tendency of companies to seek multiple listings in different
securities markets means that interest rates and stock market valuations in one country will
increasingly mirror those in other countries, even though the underlying economic fundamentals of that
country might warrant some divergence in such variables.
Indeed, as has been the experience of other countries, the trend towards consolidation and merger
activity in the various segments of the market, from banking and the selling of insurance and
investment funds to the provision of payment services and trading facilities, will lead to a situation
where the institutions to be supervised will vastly exceed the financial resources and technical
expertise available to supervisors and central banks. This will be further accentuated by the current
trends whereby financial intermediaries outsource activities both on a domestic and cross-border level,
while the introduction of the European Union Directive on the European Single Company Statute, the
so called Societas Europea, will present new regulatory and financial stability challenges on a regional
level.
The implications of international developments for Malta
These observations are particularly relevant for Malta. First, whereas the size and complexity of
financial intermediaries, and that of corporate entities to which they are exposed, has grown
disproportionately relative to the resources available to regulators and liquidity providers across the
globe, this divergence is magnified further in a small jurisdiction such as ours.
Second, because the characteristics of the Maltese economy make it vulnerable to developments
abroad, the financial sector is especially exposed to changes in the perceptions of foreign investors
about the sustainability of prevailing economic policies and the capacity of the financial sector to
absorb external shocks.
Given the ease with which funds can now move in and out of the country, moreover, and the scope for
disparity between the size of the economy and that of foreign institutional investors, the need to
maintain confidence in the domestic financial sector assumes particular importance. This risk is further
accentuated by the fact that while most sectors of the economy operate in a competitive environment,
in many sectors business remains concentrated among a small set of market players. The financial
sector is no exception in this regard.
Furthermore, while the structure of the domestic financial sector has evolved considerably over time,
its level of development still falls short of that of the more advanced EU Member States. Thus, for
example, although in the past few years the number of players in the non-bank sector has increased in
terms of both number and variety, financial intermediation in Malta remains largely bank-based. Within
the domestic banking sector, moreover, two banks together account for around 90% of total loans and
deposits. A similar picture emerges in the capital market where the degree of capitalisation, the
number of market participants and the volume of turnover are still relatively low. In 2003, for example,
the ratio of stock market capitalisation to GDP stood at 37%. While this was higher than in most of the
other new Member States, it was only around half of the euro area average. Annual turnover was even
lower, hovering around 4% of GDP and 12% of stock market capitalization.
Where, as in Malta, the performance of the financial sector hinges crucially on the fate of a small
number of players and where the lack of depth and liquidity in capital markets often causes the market
value of a particular debt instrument to deviate from underlying fundamentals, the risk of contagion
within the system, as well as, from other systems is accentuated.3
This latter aspect might become less relevant as financial services providers in Malta and in the EU
respond to the introduction of the Financial Services Action Plan and the eventual establishment of a
single market in financial services. On the positive side, such initiatives provide better income-earning
and liquidity management opportunities, improve the efficiency with which the sector operates and
enhance its capacity to weather sector-specific shocks.
On the other hand, the advent of liberalisation and heightened levels of competition could well spur
service providers domiciled in Malta to take on new risks and venture into non-traditional lines of
business. Furthermore, as a result of passporting rights, competition is likely to become more acute.
The ensuing interdependence between different sectors and countries could well expose the domestic
system to new vulnerabilities, including possible contagion from systemic shocks.
This will be especially the case upon Malta's entry in the euro area as such a move would provide
further momentum to the pace of financial market integration. Moreover, the eventual linkage of the
domestic payment system with TARGET will also facilitate the transmission of certain risks, not least
those of an operational nature.
Conclusion
There are clearly several good reasons why sound regulatory and oversight practices remain vital for
the stability of our financial system and why, therefore, the Central Bank of Malta and the MFSA must
work more effectively together. It is also evident, however, that on their own these two institutions
cannot provide full protection against systemic disturbances, and that the modalities for co-operation
which are in place locally need to be strengthened further and extended to other bodies with
comparable responsibilities at the international, and particularly at the EU level.