4  BIS Review 65/2009  Macro considerations relate to the pro-cyclical nature of the current accounting framework. The micro dimension relates to absence of depth in some financial markets, particularly in times of stress when liquidity problems arising from valuation adjustments are quickly transmitted to an institution’s capital base. The presumption in the current valuation rules that a market value for a financial instrument exists does not necessarily hold during a crisis. The reclassification of assets in such circumstances would help financial institutions mitigate the problems arising from the inability to discover prices. Another concept that is gathering support internationally is that of dynamic provisioning, which seeks to avoid the pro-cyclical impact of current accounting rules by recognising portfolio losses over the cycle. As a result, loss provisions are measured against the expected losses over the life of an asset rather than when losses are actually incurred. The losses made during a downturn can then be met from the accumulated buffer built up during the economic upswing. Risk management practices and stress testing Let me now turn to some risk management issues. Another lesson that has been learned from the financial turmoil is that proper liquidity management is of paramount importance to satisfy the banks’ funding needs, and heightens their resilience against idiosyncratic or systemic risks. Although existing EU legislation on liquidity risk is highly fragmented, in part reflecting the various national approaches, adherence to a set of common principles such as those provided by the Basel Committee on Banking Supervision should prove fruitful.

For this purpose, it will be important for the banks to build on their strengths and minimise their weaknesses. With regard to the former, our banks start from a relatively strong position since their fundamentals have not been weakened by the financial crisis. The existence of a sound regulatory system, effective risk management practices and prudent lending policies have combined to minimise the banks’ exposure to bad or dubiously-valued assets. Investment portfolios are in fact highly diversified, with minimal holdings of asset-backed securities, while the domestically-oriented banks’ measured approach to credit is reflected in loan-to-deposit and residential loan-to-value ratios that average around 79% and 73%, respectively. One of the lessons learned from the crisis is that a bank’s funding model is crucial. The reliance by a number of international banks on wholesale funding proved to be a major source of weakness in time of stress. In contrast, Maltese banks have traditionally relied on retail deposits to fund their lending operations, a source of liquidity that has proved more reliable. This explains the banks’ high liquidity ratios, currently averaging 46%. The steady supply of liquidity, combined with a sustained demand, have permitted the credit channel to remain intact, despite the ongoing global turmoil. As a matter of fact, bank lending to the private sector grew by 9.7% in the twelve months to April 2009, compared with 8.7% in the preceding twelve months. Another lesson concerns the importance of a strong capital base.