FINANCIAL SECTOR ASSESSMENT MALTA APRIL 2004 MIDDLE EAST AND NORTH AFRICA REGION VICE PRESIDENCY FINANCIAL SECTOR VICE PRESIDENCY BASED ON A JOINT IMF - WORLD BANK FSAP

1. The Financial Sector AsSessment (FSA) summarizes the findings o f the joint IMF/World Bank missions that visited in October 2002 and January 2003’. The preliminary findings o f the mission were discussed in a wrap-up session with the Malta Financial Services Authority (MFSA) and the Central Bank o f Malta (CBM) in January 2003; the final FSAP report was delivered to the authorities in May 2003.

I. MACROECONOMIC ENVIRONMENT AND RISKS

2. Potential macroeconomic factors affecting Malta’s economy are: (i) the narrow economic base o f the economy that i s heavily dependent on external developments and has implications for the financial sector’s ability to diversify its risks; (ii) the commitment to continue the trend o f fiscal consolidation; (iii) the buildup o f a liquidity overhang and the potential for capital outflows; and (iv) concerns about the competitiveness o f parastatals following EU accession.

3. manufacturing, and is, thus, heavily influenced b y external developments. Malta i s a small island economy with a population o f about 394,000 and a GDP per capita o f about USD 9,200 (one o f the highest among the EU accession countries). Tourism and manufacturing are the dominant sectors accounting for more than 50 percent of GDP.

Malta’s economy i s highly dependent on a few sectors, such as tourism and

The mission was led by Mr. Piero Ugolini (IMFMD) and Ms. Paula Perttunen (World Bank, OPD). Other mission members included Messrs./Mmes. Laura Ard, Luc Cardinal (both Wl3, OPD), Peter Kyle (WB, LEG), and Elisabeth Sherwood (WB, MNA), Margarita Aguilar (administrative assistant), Terry Donovan, Sandra Marcelino, Andrea Schaechter, and Mark Zelmer (all MF/MFD), and Karsten Biltoft (Danmarks Nationalbank) and Paolo Corradino (Banca d’Italia). The W C F T assessment benefited from the participation o f Giulio Sanarighi (Maggiore o f the Italian Guardia di Finanza). The FSAP team gratefully recognizes the warm hospitality and the outstanding and open cooperation by the authorities and the technical counterparts.

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Electronic products make up three quarters o f manufactured exports. The government’s involvement in the economy remains high, notwithstanding the ongoing reform strategy of reducing i t s stake in enterprises. Public administration and state-owned enterprises account for about one-fourth of GDP and employ about one-third of Malta’s labor force.

4. growth. The slowdown in the economy also has raised somewhat the levels o f N P L s , although it i s difficult to quantify the exact level since stricter credit risk management and regrading o f loan facilities following on-site examinations occurred at the same time. Real GDP growth recovered somewhat to 1 per cent in 2002 comparing favorably to the 1.2 percent drop of GDP in 2001, but lying considerably below the Maltese economy’s growth rates between 1997 and 2000, which exceeded 4 percent annually. The slowdown of the economy has affected the trend o f fiscal consolidation that Malta has embarked upon since 1998 and raised the fiscal deficit to 5.9 percent o f GDP in 2002. This compares with 5.2 percent in 2001 and 5.5 percent in 2000.

The weak performance of Malta’s economy in 2001 and 2002 has slowed credit

5. Strong growth in deposits combined with a slowdown in credit demand has led to a rapid buildup of liquidity in the banking system over the past two years. Interest rates, which are now fully liberalized, have gradually fallen. Inflationary pressures from the buildup o f liquidity have been modest. Price developments are mostly determined externally due to Malta’s exchange rate peg and the openness o f i t s economy. Moreover, the level o f economic activity i s s t i l l below potential. However, housing prices are rising rapidly because o f strong demand. At the same time, balance o f payments surpluses have enabled the CBM to build up i t s reserves and strengthen i t s position to maintain the peg ahead o f EU accession. The CBM’s level o f foreign reserves stood at about 50 percent o f GDP or about 8.5 months o f imports o f goods and services at end-2002.

6. joining the European Union. A number o f capital account restrictions have already been lifted or loosened over the past five years. Banks and insurance companies are no longer subject to any capital account restrictions, and the ceilings on portfolio investments were substantially increased. Remaining restrictions on short-term capital flows (in particular loans with a maturity o f less than six months) are to be phased out before Malta joins the EU. Levies and subsidies are also being l ifted and there are expectations that Malta’s economy wi l l remain competitive. One area o f concern, however, i s the competitiveness o f many parastatals, which w i l l have to cope with reduced subsidies.

The private sector seems well placed to cope with the macroeconomic effects of

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11. SOUNDNESS AND VULNERABILITIES OF THE FINANCIAL SYSTEM

A. Banks

7. that account for 90 percent o f the sector’s assets. The government has a 25 percent stake in one o f them, Bank o f Valletta; i t s 70 percent stake in the other, Mid-Med Bank, was sold to HSBC in 1999. There i s also an onshore international banking segment, which mainly consists of branches and subsidiaries o f Austrian and Turlush banks that deal wi th non- residents and were established in Malta for tax purposes. The offshore banking segment has gradually come onshore. There are no significant links between the domestic and international segments o f the banking system. External and onshore foreign currency borrowing by the private non-bank sector i s limited (less than 20 percent o f total borrowing).

The domestic banking sector, which comprises four banks, i s dominated by two banks

Domestic banks and stress testing

8. economic base. Financial soundness indicators indicate that the domestic banks are profitable, liquid, and well capitalized. Banks also can readily manage their r i s k s to individual borrowers. However, the soundness of the banking system i s highly dependent on the financial condition of the two largest institutions and could be undermined in the event of a major systemic economic shock given the high concentration o f banks’ loan portfolios and their strong reliance on domestic real estate properties as security in lending operations. Loolung forward, a major challenge for the banks w i l l be EU accession in 2004, and the associated restructuring o f the Maltese economy, including the privatization o f many state- owned enterprises.

The Maltese banking system i s healthy but exposed to the country’s narrow

9. recent years at around 0.8 percent2 The growth o f non-interest revenues and expenses has slightly lagged that o f total assets. Banks’ loan portfolios are highly concentrated, notably in loans to the tourism, retail trade, manufacturing, ship repaidshipbuilding, and construction sectors. Banks reported that domestic real estate properties represent almost three fourth of the collateral used as security in lending operations. Lending to non-residents i s insignificant, and more than 95 percent of lending to residents i s denominated in Maltese liri.

Bank profitability, as evidenced by return on assets, has been fairly stable in

10. Domestic banks are currently very liquid. All four banks’ holdings o f liquid assets as a share of short-term liabilities comfortably exceed the 30 percent prudential requirement. In light o f the significant structural excess liquidity in the banlung system, banks do not have a strong need for wholesale money market funding. For funding, domestic banks rely heavily on Maltese lira deposits from residents. Resident foreign currency deposits are not significant.

This compares with an average 0.6 percent return recorded by European Banks in 2001 - Central Bank’s EU Banking Stability Report (February 2003).

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11. Maltese banks also show strong capital levels that are well in excess of capital adequacy requirements. Provisions mainly cover the unsecured element o f NPLs, since banks rely heavily on supporting collateral, mostly real estate property. Whi le the banks’ discounts on the value o f collateral are prudent from the standpoint o f dealing with individual problem loans, experience in other countries indicates that they may not fully reflect the low liquidation values that could ensue if the banks had to quickly liquidate collateral for a wide range o f borrowers in the middle o f a systemic economic crisis.

12. The C B M introduced a quarterly stress testing exercise in 2002 to assess the four domestic banks’ ability to cope with various economic and financial shocks. The mission relied on these stress tests, and supplemented them with an examination o f the banks’ ability to absorb changes in the average credit quality o f their domestic loan portfolio and securities holdings.

13. condition i s significantly influenced by Malta’s narrow economic base. While banks can readily manage their exposures to individual borrowers, they might have difficulty in coping with shocks that are more systemic in nature due to the limited diversification o f their loan portfolios and their reliance on real estate property as collateral in lending operations. The banks also need to continue improving their credit risk management system so that they can monitor exposures and set provisions in a more proactive fashion. A close monitoring o f the NPLs and asset quality of the banks w i l l be essential to ensure the soundness o f the banking sector.

Stress tests for credit r i s k clearly illustrate how the domestic banks’ financial

14. shocks to interest rates, foreign exchange rates, and equity prices.

Stress tests for market r i s k suggest that banks are well positioned to cope with

International banks

15. The international banks operating in Malta have no significant linkages to the domestic financial system and therefore do not pose any systemic risks. Most of them rely on funding provided by deposits from foreign banks (notably parentdaffiliates) and non- resident deposits obtained in part through parent banhng groups. Their assets are primarily invested in deposits o f foreign banking institutions (in many cases related affiliates), foreign securities, and loans to non-residents (especially those sourced through the global banhng networks o f the parent banks). As per agreement wi th the Maltese authorities, weak loans do not remain on the books o f the Maltese entities, but are transferred back to the foreign parent. None of these banks has encountered any difficulties.

B. Non-Bank Financial Institutions and Markets

16. development. The largest institutions in both markets are affiliated with the two large domestic banks. Although these sectors are fairly small, i t i s important to emphasize that

The insurance and capital market segments are small and at an early stage of

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Maltese residents have significant investments offshore, and a long history of accessing foreign financial institutions to manage their savings.

17. Registration of off-shore financial and non-financial business ceased at end of 1996 following revision o f the legislation.

All existing non-bank offshore business will be phased out by September 2004.

Insurance Companies

18. sector. One local group o f insurance companies (Middlesea), which i s affiliated with Bank of Valletta and owned in part b y the Maltese government, dominates the insurance market, and i t s failure would pose a risk for the systemic stability o f the insurance sector. However, the direct links between the insurance and banking industries are limited.

The insurance sector i s very concentrated and indirectly linked to the banking

19. margin requirements even though profitability ratios are on the decline. The sector i s also very conservative in i t s provisioning, and reinsurance i s kept to a reasonable level.

The insurance sector i s profitable and insurers are complying with solvency

Capital Markets

20. The Maltese domestic capital market i s small, the number of available investment vehicles i s limited, and the secondary market i s currently very thin. While some improvements are recommended in the infrastructure, major development of the market i s likely only through integration with European financial markets. The Malta Stock Exchange commenced operation in 1992. Share prices rose in tandem with the global demand for equities until 2000, and since then have fallen in line with international developments. Government bonds, which are often held to maturity, have historically represented an important savings vehicle for Maltese residents in the absence o f private pension schemes and in view of the single-pillar, pay-as-you-go pension system. Corporate bond issuance has been low, but picked up in 2002.

21. liquidity in the banking system and the small number of banks. The money market consists of an unsecured cash market and a T-bi l l market. T-bills, almost all of which are held by banks, are not dematerialized, and trading i s on an unregulated over-the-counter basis. Due to the high excess liquidity in the banking system, currently there are almost no interbank transactions - either in T-bills or in unsecured bank claims.

Trading activity in the Maltese l ira money market i s very low due to the excess

22. government securities market. Given the absence of private market-malung facilities, the CBM quotes daily bid and offer prices to guarantee liquidity to holders o f Maltese government securities and to stimulate trading in this market. The CBM’s pricing policy seeks to be market-driven and i s entirely independent o f the monetary operations framework. Still, the C B M has been encouraged b y the FSAP team to consider reducing i t s presence in the market once a system o f primary dealers has been implemented.

An important issue revolves around the role of the CBM as market-maker in the

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23. While the present operational arrangements for the Central Securities Depository (CSD) and the Central System of Securities Settlement (CSS) functions in the MSE are appropriate for the nature and size of the domestic market, some uncertainties surround the role, regulation, and supervision of the CSD and CSS. Being an integral part o f the MSE, it i s difficult to separate the function o f the CSD/CSS from those of the MSE. Explicit supervision o f the CSD i s not mandated in the legislation. Ensuring that the CSD and CSS have a well-founded legal basis, including finality o f securities transactions, and properly mandated supervision should be given priority attention.

24. The Maltese authorities should ensure that the planned steps to introduce Delivery Versus Payment in the Maltese securities settlement system are implemented as soon as possible. Presently, securities are transferred on the day o f trade, while the funds are transferred three days later.

C. The Supervisory and Regulatory Framework

Banking supervision and regulation

25. good. The following supervisory issues were identified as needing further attention:

Compliance with the Basel Core Principles for Effective Banking Supervision i s

The internal governance process o f the Malta Financial Services Authority (MFSA) should be more explicit and further developed.

No legal provision requires the supervisor to take prompt corrective action based on certain evolving and existing conditions. A provision requiring the supervisor to take gradually increasing remedial action when certain conditions exist should be considered. Also, the supervisor should impose some form o f formal written agreements or memoranda o f understanding in the case o f significant problems, not necessarily based exclusively on capital impairment. An amendment to the Banking Act or other legislation may be necessary to ensure the enforceability o f such regulatory directions.

MFSA should give increased emphasis to i t s overall assessment o f banks’ internal risk management systems, and the methods (accuracy and effectiveness) o f risk measurement, monitoring, control and reporting.

Additional focus i s also needed on collateral valuation and the subsequent credit given to it in the classification and provisioning process.

Capital adequacy figures reflecting examination classifications and provisioning results should be presented in the reports o f examination and be included in the supervisor’s monitoring systems and documentation. Material misstatements o f financial position made b y a bank or any pertinent violations o f law should trigger supervisory actions.

While the appropriate legal provisions are in place to allow information sharing and reciprocal cooperative agreements wi th foreign supervisors, no MoUs are yet in

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place. The supervisor should continue to pursue fluid communications with foreign supervisors in order to further establish i t s reputation as an effective and transparent regulator, thereby enhancing the reputation of the Malta banking system. Efforts to formalize cooperative agreements with the pertinent authorities should continue.

Insurance supervision and regulation

26. supervisory framework and comply with most IAIS Core Principles, but some areas need further strengthening. In particular, the MFSA should formalize insurance company corporate governance procedures. Similarly, work i s needed to move to a more formal risk- based approach to supervision and to develop a consistent approach with respect to the exchange of information with foreign insurance supervisory authorities.

The authorities have made significant progress in creating an effective insurance

Securities markets supervision and regulation

27. However, given the extent of recent legislative reform, it i s too early to assess the enforcement track record under the new regime. The MFSA’s new supervisory and regulatory responsibilities are l ikely to place strains on staff resources given i t s expanded responsibilities and the mismatch between the large number of regulatory subjects - largely comprising secondary listings o f funds - and the number of staff in the Investment Services Unit. The enforcement powers are appropriate and well established in law, and the established enforcement practices also seem appropriate. The statutory capital requirements of the stock-broking and investment services f i r m s should be risk-adjusted.

Observance of IOSCO Objectives and Principles for Securities Regulation i s good.

111. LEGAL FRAMEWORK AND JUDICIAL SYSTEM

28. Malta has a sound and well-established legal system that i s based upon a combination of civil and common law provisions and principles. Respect for the ru le o f law, the judiciary and the legal profession i s high. The courts are regarded as responsive to the needs o f the people, although delays in the resolution o f commercial cases are widely regarded as excessive.

29. drafted and consistent with international best practices. Following the decision to move to a single regulator, the financial sector reforms that were introduced between 1994 and 1998 have been substantially revamped in the last two years and brought into line wi th EU norms and directives and international standards. Accounting and audit standards are high.

The financial sector laws and regulations are comprehensive in scope, well

30. The collateral /debt enforcement provisions are satisfactory but implementation tends to be more problematic. The land registration system appears to work well, although significant areas o f Malta are s t i l l not subject to individual title. The company register i s

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highly efficient and accessible on-line. The only significant area o f concern relates to what i s widely regarded as excessive delays in resolving court cases. The insolvency regime i s comprehensive, although i t lacks a corporate restructuring, Le., chapter 1 1-type, facility. This reform i s under consideration.

Iv. ANTI-MONEY LAUNDERING AND COMBATING THE FINANCING OF TERRORISM

3 1. AML/CFT regime and have demonstrated a strong commitment to fulfilling their international obligations in this area. Malta has put in place a legal framework which i s comprehensive, well established and broadly consistent with international standards. I t has signed, ratified, and adopted most of the key international conventions, treaties, and United Nations (UN) Resolutions relevant to AML/CFT and i s committed to achieving full compliance. No major legislative or regulatory gaps have been identified.

The authorities in Malta have long recognized the importance o f an effective

32. regime are in place, fo l lowing the establishment o f the Financial Intelligence Analysis Unit (FIAU), which became fully operational in October 2002. I t i s not feasible at this early stage o f i t s operation to assess in detail the effectiveness o f the FIAU. However, i t i s expected to be in a position during 2003 to satisfy the requirements for membership of the Egmont Group o f financial intelligence units.

Al l o f the institutional elements necessary to support an effective AML/CFT

33. The implementation o f the AMWCFT regime has been integrated in to the ongoing supervision o f all regulated institutions. While the FIAU i s the designated competent authority for A W C F T , the MFSA, as single regulatory authority for banks, securities f i rms, insurance businesses, and foreign exchange bureaus, carries out a program o f onsite and offsite supervision into which AMLICFT i s incorporated. A high standard of awareness, acceptance, and implementation of the A W C F T provisions was observed in the course o f the mission in a range o f regulated institutions.

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