Central Bank report recommends vigilance for potential adverse developments impacting financial stability

The post-pandemic global economic recovery was somewhat hindered by the war in Ukraine, causing further supply chain disruptions and aggravating inflationary pressures.

This emerges from an in-depth assessment of the domestic and international developments that could impact the stability of the financial system carried in the Central Bank of Malta's 15th edition of the Financial Stability Report. This analysis is supplemented by top-down stress tests and sensitivity analyses, to determine the resilience of the financial system.

Central banks across the globe tightened their monetary policy stance to rein in inflation. In the euro area, key interest rates increased rapidly, whilst the European Central Bank also discontinued its Asset Purchase Programmes, ending a long era of cheap funding. These economic shocks led to high volatility in financial markets with both equity and bond prices declining significantly, wiping away previous gains.

Amid such challenges, the profitability of domestic banks improved. Income from intermediation activities rose on the back of sustained lending and wider margins. In addition, the ECB started to remunerate bank deposits, while income from the bond portfolios also rose. At the same time, asset quality also improved considerably on the back of lower NPLs, with the NPL ratio trending downwards since the height of the pandemic.

Credit growth remained mainly spurred by resident mortgages, although resident corporate lending also recovered. This was mainly driven by the real estate sector as demand picked up after the slowdown reported during the pandemic. Concentration in the banks' loan book intensified further, while the build-up of cyclical risks persisted.

Domestically-relevant insurance companies and investment funds were adversely impacted by the volatility in financial markets, affecting their investment income and balance sheet composition. Nonetheless, both insurances and investment funds continued to operate on the back of strong capital and liquidity buffers, which should enable them to withstand potential shocks from the ongoing macroeconomic uncertainty and inflationary pressures.

The report recommends vigilance for potential adverse developments impacting financial stability going forward. The slowdown in global economic growth coupled with inflationary pressures could potentially negatively impact the repayment capabilities of borrowers with consequences on banks’ asset quality.

Furthermore, banks’ income from intermediation could be adversely affected if loan demand weakens significantly. Against this backdrop, banks should continue to adopt conservative lending practices and maintain healthy liquidity and capital buffers and monitor emerging financial stability risks, such as cyber and climate-change related risks.

The publication features a number of boxed articles on diverse topics. One of these articles introduces a domestic cyclical systemic risk indicator which is another tool in the Bank’s framework in guiding its domestic macroprudential policy decisions.

Another explains the rationale behind the introduction in 2023 of the sectoral systemic risk buffer (sSyRB) for domestic banks, specially aimed at targeting domestic mortgage exposures.

A third article relates to the main results of the Bank Lending Survey where respondents pointed to an increasingly challenging environment as cost of funding is on the rise, including through higher interest rates on retail deposits for some banks during 2022.

Another article presents details on a new framework quantifying expected credit losses of banks to both hypothetical inflationary pressures and interest rate increases.

Other articles tackle the accounting treatment of debt securities holdings under IFRS 9, and the second run of the household stress testing framework with a focus on assessing the resilience of indebted households to inflationary pressures and interest rate shocks.

The analysis identifies some vulnerabilities in low-income households but concludes that overall, Maltese indebted households are resilient to adverse economic shocks.

This edition of the report also highlights experimental indicators on climate change for Malta, following the publication of harmonised euro area indicators by the ECB as part of its broader climate action plan.

The Financial Stability Report can be downloaded from www.centralbankmalta.org or obtained in printed form from the Central Bank of Malta.