michael c bonello : the challenges facing malta's banking system speech by mr michael c bonello, governor of the central bank of malta, at the second annual conference of finance malta, valletta, 29 may 2009. * * * introduction this conference about malta ’ s financial services industry is being held in the midst of the most severe global financial crisis since the great depression and whose consequences for the real economy in terms of output and employment losses are proving to be the most devastating in living memory. it is a crisis, therefore, which cannot but have repercussions on a small, open economy like malta ’ s that is highly integrated with the world economy through trade and finance. these circumstances present challenges for the domestic banking system, and in addressing them it is important to recognise the implications for the economy at large. a sound, adaptable and innovative banking system is a prerequisite for sustainable development. the birth of a modern banking system malta ’ s recent banking history has indeed tended to mirror policy shifts in the broader economy. the nationalisation of the major banks in the 1970s was itself recognition that the centralisation of economic activity could not be achieved without state control of financial resources, including credit flows. lending rates were set by the minister of finance while the central bank controlled deposit rates. nominal interest rates were kept artificially low, often resulting in negative real interest rates. unable to adjust lending rates according to the creditworthiness of borrowers, banks resorted to significant collateral requirements and to credit rationing. the heavy reliance on real estate as collateral, the insufficient importance attached to the viability of project proposals, along with the absence of a capital market meant than savings were often not channelled efficiently into productive investment. the resulting misallocation of resources served to compound the distortions that would proliferate in the rest of the economy. a sea change in economic strategy occurred in the late eighties with the introduction of policies to reduce the overbearing state presence. these included a gradual reorientation towards a more market - oriented banking system and a monetary policy that operated more through incentives and less through command. a first reduction in the government ’ s shareholdings in banks took place during 1990 / 1991, and this was accompanied by a strengthening of the regulatory framework, including measures to enhance the capital base of banks through profit retention and the issue of new stock. a capital market, in the form of the malta stock exchange, was also created. supporting economic reforms included a relaxation

of the extensive system of import controls, the partial lifting of wage - price controls and an overhaul of the income tax regime. while reforms were incremental, a number of landmarks stand out. in 1994, for example, a comprehensive package of legislation was enacted as part of a strategy to further develop malta as an international financial centre. the thrust of this initiative was to promote competition by opening up the licensing process and removing administrative controls on lending, while stressing the importance of maintaining adequate capital and managing risk appropriately. at the same time, the malta financial services centre was established as the regulator for financial services other than banking, which remained the responsibility of the central bank of malta. also in 1994, responsibility for monetary policy was moved to the central bank of malta. the introduction of reserve requirements and the bank ’ s engagement in open market operations paved the way for the establishment of a market - driven interest rate structure, which is of paramount importance for the transmission of monetary policy. to promote activity in the money market and bolster its own ability to steer interest rates, the bank initiated weekly auctions to influence the size of the monetary base, while gaining control over the excess liquidity of the banking system. further steps were subsequently taken to create an independent regulatory framework in line with international standards. in 2002 the renamed malta financial services authority took over from the central bank of malta the responsibility for supervising the banks and the stock exchange, becoming the single regulator. at the same time, the bank was given formal independence in the conduct of monetary policy, in the oversight of payment systems and in safeguarding the stability of the financial system. to complement the institutional framework, a financial intelligence analysis unit was established to strengthen the anti - money laundering regime and to combat the financing of terrorism. as part of the authorities ’ efforts to create a reputable financial centre, in late 2002 the imf / world bank were requested to conduct a financial sector assessment programme ( fsap ). the assessment concluded that malta ’ s financial system appeared to be healthy and well supervised, with a comprehensive legal framework and strong adherence to most international standards and codes. at the same time, the report also noted that, mainly because of the predominance of two large banks, the system was highly concentrated and exposed to the country ’ s narrow economic base. malta as an international financial centre eu membership in 2004 proved to be an important catalyst in the further development of the financial services industry. malta now benefits from the greater credibility conferred by