The Central Bank of Malta has published its annual Financial Stability Report, where it says that the domestic banking sector in 2010 remained resilient throughout 2010 as a result of its robust capital and liquidity buffers, however challenges remain.

In its report, the Central Bank said risks stem from a possible weakening in global macroeconomic conditions and the resulting adverse knock-on effects. Any protracted weakness in the construction and real estate sector, which may propagate to other economic sectors, could add further pressure. The Report identifies two main vulnerabilities, namely heightened credit risk and persistently high concentration risk on both side of banks’ balance sheets, owing to large exposures to the real estate sector and the relatively high proportion of short-term, and therefore potentially volatile, deposits in total deposit liabilities. Other risks and vulnerabilities identified in the Report include a possible upward shift in interest rates, the effects of prolonged political turmoil in North Africa and the Middle East and possible valuation losses as a result of the ongoing sovereign debt crisis. Maintaining public debt dynamics under control is also important, as experience from other countries clearly indicate that sustainable public finances are a pre-condition for financial stability. Other risks stem from structural illiquidity and lack of depth in the domestic market. In the case of the insurance sector, risks relate mainly to the lack of re-insurance practices within the sector.

The financial system appears to be resilient to a number of stress events. Univariate stress tests confirm that the banking sector is largely resilient to a reversal in economic conditions, deterioration in credit quality and a significant fall in house prices. However, since the risk outlook suggests that financial stability conditions will remain challenging, strong vigilance is required, supported by robust risk mitigation practices. Banks are called on expand their provisioning levels commensurate with the heightened credit risk and to reduce concentration risks by further strengthening capital buffers. This could be achieved either through a review of dividend policies or through fresh issue of equity. Banks should endeavour to reduce further any maturity mismatches. Financial institutions are also encouraged to take on board the proposals on the Basel Committee and the future CRD IV capital and liquidity requirements and to take steps to ensure a smooth transition to the tighter regulatory regime.

The Financial Stability Report can be downloaded from www.centralbankmalta.org.