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.

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.