Could Brexit impact the capital efficiency of the Maltese banks?

Malta among most exposed countries to Brexit

The Brexit Sensitivity Index (BSI) issued by Standard & Poors (S&P), ranks Malta in second place out of the 20 countries most exposed to a potential UK exit from the EU: the so-called Brexit. Malta, along with Ireland, Luxembourg and Cyprus are in the frontline of economies susceptible to trade and migratory aftershocks from a decision by the UK to leave.

The survey measures sensitivity along four data points: exports, financial sector exposure, Foreign Direct Investment (FDI) and migration.

Malta's historical connections with the UK enables vigorous trade and substantial migratory flows between the two countries. According to S&P, Maltese exports to the UK amount to 7.1% of Malta GDP while the sum of Maltese residents in the UK and vice versa totals 7.5% of Malta’s population. In particular, Malta's attractive climate has drawn a large population of UK pensioners, on top of the annual tourist receipts.

Financial claims on the UK are substantial at 58% of Malta GDP, measured on an ultimate risk basis (including derivatives and guarantees). Furthermore, inward FDI from the UK amounts to 6.3% of Malta GDP.

How Brexit can impact the credit rating of Maltese sovereign debt

The general uncertainty following a Brexit vote would hit confidence across the EU and could weigh on economic growth. In particular, Malta's deep trade ties and strong financial sector links to the UK increases its vulnerability to any economic impacts caused by Brexit.

If there is a slowdown in the Maltese economy due to Brexit, the outlook for Malta may be lowered to negative and sovereign debt for Malta may be downgraded by international rating houses.

How Brexit can impact Malta’s banking sector through sovereign debt exposure

According to data collected by the EBA as part of the 2015 EU-wide transparency exercise, Maltese banks ranked fifth in Europe in terms of highest exposure to home sovereign debt as at 30 June 2015, with an average of 8.5% of total assets. Domestic sovereign bias for Malta (for a sample of core domestic banks) amounts to 70%, which equals the bias in Irish banks and exceeds the EU average of 65%.

The key impacts of Brexit on the local banking sector given the high domestic sovereign debt bias are the following:

1. Fair value loss leading to capital shortfall. An increase in yield following a credit rating downgrade on Maltese sovereign debt due to Brexit would reduce the market value of sovereign debt measured at fair value on banks’ balance sheets. In such cases, there would be a hit on capital.

2. Regulatory developments on treatment of sovereign debt. The largest impact on capital requirements is expected from the potential regulatory developments in the sphere of sovereign debt exposures. European regulators are considering enforcing two measures on sovereign debt exposures:

a)   Apply positive risk weights (currently sovereign debt is treated as risk free and risk weighted at zero); and

b)   Set exposure limits (currently sovereign debt is exempt from the large exposures framework)

Should these measures be implemented, a credit rating downgrade following Brexit would result in a higher risk weight for Maltese sovereign debt and thus higher capital requirements.

3. Pillar 2 capital requirements. The key tool of the Single Supervisory Mechanism (SSM) to address bank-specific risks is the Supervisory Review and Evaluation Process (SREP). Through SREP, banks may be required to increase the capital they hold against risks driven by their business model and risk profile. In this new reality, banks may be required to hold additional capital against sovereign risk. According to Daniele Nouy, chair of the SSM, banks may face added scrutiny and supervisory measures if they do not follow Pillar 2 capital guidance.

As part of SREP, banks will also be assessed on how well they can handle expected market events, such as Brexit, and whether their internal stress testing frameworks adequately model such events.

Conclusion

Should European regulators move ahead in implementing the new measures on sovereign debt, the implications on local banks may be multiplied by the risk of Brexit.

Each lender exposed to Maltese sovereign debt should consider conducting two critical exercises:

1. A sensitivity analysis on your investment portfolio to be able to quantify capital premiums that may be required if the sovereign risk weight is increased; and
2. A re-balancing exercise of your investment portfolio to better match risk, return and capital requirements.

Our experienced team of banking experts can assist you with the above. We can also produce a capital agenda for your bank including transaction support to divest investments or non-core portfolios, and capital raise planning.