## EXECUTIVE SUMMARY (Content unit: 1mltea2019003)

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### MACROFINANCIAL BACKGROUND
- Malta’s economy is highly open and strongly connected to the rest of the world; after joining the EU in 2004 and the EA in 2008, Malta harmonized its financial sector legislation with that of the EU.
- Annual GDP growth averaged 6.8 percent in 2013–17.
- Credit developments:
  - Credit grew at 3½ percent per annum in 2015–17, mostly supported by mortgage lending.
  - Bank credit to the private sector declined to about 80 percent of GDP by end-2017.
  - Bank credit to nonfinancial corporates (NFC) declined; NFCs increased intercompany borrowing.
- NFCs’ leverage is high compared to European peers, with construction and real estate exhibiting the highest leverage.
- Household sector:
  - Household debt stood at 108 percent of gross disposable income in 2017.
  - Home ownership ratio was 82 percent.
  - Debt-to-financial-wealth ratio was stable at 23 percent.
  - New mortgages’ averages in 2017: LTV 77 percent and DSTI 21 percent.
- Housing and property:
  - Mortgage lending grew by 8½ percent annually since 2013.
  - Residential property prices rose by 33 percent in 2010–17.
  - Construction investment has recently picked up.
- Banks’ sovereign exposure:
  - Banks held 29 percent of total government debt (3.3 percent of assets) in 2017.
  - 90 percent of these holdings were concentrated in core banks (6.6 percent of their assets).
- AML/CFT context:
  - Malta has experienced high-profile ML/TF-related incidents in the banking sector; in July 2018 the EBA established that the FIAU had breached the Third EU Directive on AML/CFT in the case of Pilatus Bank.

### FINANCIAL SYSTEM RESILIENCE — KEY FINDINGS
- Overall system strength:
  - Banking system is well capitalized, liquidity is ample, and profitability is healthy.
  - NPLs remain below the euro area (EA) average, though pockets of distressed corporate loans persist.
- Concentration and vulnerabilities:
  - Core domestic banks have high exposure to property-related loans amid rapid house price appreciation.
  - Nonresident deposits are a significant share of international and noncore domestic banks, raising vulnerability despite limited exposure to the domestic economy.
- Stress and contagion:
  - Banking system remains resilient under a severe scenario; weaknesses are limited to a few small banks.
  - Large withdrawals of wholesale and nonresident deposits under a stress event can put some banks under pressure.
  - Contagion risk is limited overall, but distress could affect smaller banks via cross-border and cross-sectoral linkages.
- Surveillance and capacity needs:
  - Need to closely monitor evolving business models for shifts in systemic risk.
  - Strengthen stress test approaches and enhance data quality and management.

### FINANCIAL STABILITY POLICY FRAMEWORK — ASSESSMENTS & RECOMMENDATIONS
- Macroprudential policy and monitoring:
  - Recent strengthening of systemic risk monitoring is commendable.
  - Gaps: legal framework enhancements needed, data gaps to be closed, and nonbank risk assessment should be strengthened.
  - Planned borrower-based measures (LTV and DSTI limits) to address housing/household vulnerabilities are welcome; refine by reducing exemptions for loans against secondary and buy-to-let properties.
- MFSA resources and independence:
  - The MFSA is substantially understaffed; this undermines effectiveness and operational independence.
  - Recommendations:
    - Upgrade MFSA’s operational capacity and grant it full autonomy over recruitment.
    - Develop a five-year plan to ensure sustained budgetary resources for the MFSA.
    - Maintain a dedicated statutory committee on supervisory issues to preserve checks and balances.
- Bank supervision shortcomings:
  - Urgent actions: take timelier supervisory actions, increase frequency and scope of onsite inspections, make more use of monetary fines, and ensure supervisory action is not delayed through judicial appeal.
  - Supervision should focus on credit, liquidity, compliance, and adequacy of risk classification and provisioning.
  - Related-parties framework needs alignment with the Basel Core Principles (BCP).
  - Improve oversight of non-EU branches.
- Early intervention and resolution, insolvency:
  - Develop policies and procedures for MFSA’s early intervention and resolution powers to mitigate legal risks.
  - Adopt an administrative bank insolvency framework and clarify creditor hierarchy.
  - Shift responsibility for decisions on bank liquidation and insolvency post-license withdrawal from MFSA’s supervisory function to its resolution function.
  - MFSA and the Ministry for Finance (MFIN) should develop internal crisis management plans.

### FINANCIAL SAFETY NET AND CRISIS MANAGEMENT — PRIORITY ACTIONS
- Adopt an administrative bank insolvency regime with explicit powers to transfer assets/liabilities and clarify creditor hierarchy (Timing: I — Responsibility: Government) (¶41).
- Shift responsibility for decisions on bank insolvency and liquidation, post-license revocation, from MFSA’s supervisory function to its resolution function (Timing: I — Responsibility: MFSA) (¶42).
- Review adequacy of the Resolution Unit’s staffing and increase its resources accordingly (Timing: I — Responsibility: MFSA) (¶40).
- Develop MFSA and MFIN internal crisis management plans (implicit in discussion above) (¶42).

### FINANCIAL INTEGRITY (AML/CFT) — RISKS & STRATEGY
- Systemic ML/TF risks:
  - Cross-border linkages create significant ML/TF risks, notably from foreign proceeds of crimes, increasing reputational risks and pressure on correspondent banking relationships (CBR) and compliance costs.
  - Fast-growing remote gaming activity, virtual-assets intermediation, high demand for real estate, and the Individual Investment Program (IIP) elevate financial integrity risks.
- Recommended multi-prong strategy:
  - Ensure banks appropriately apply preventive measures, including customer due diligence with efficient verification of beneficial ownership (BO), especially for higher risk activities and significant nonresident sector.
  - Fully implement risk-based AML/CFT supervision.
  - Apply timely, dissuasive, and proportionate sanctions and effective fit-and-proper tests.
  - Additional supervisory resources needed for FIAU and MFSA to bolster risk-based AML/CFT supervision.
  - Support establishment of an EU-level arrangement responsible for AML/CFT supervision to facilitate consistent and comprehensive approach and minimize regulatory arbitrage.

### STRESS TESTS — DESIGN, RESULTS, AND SENSITIVITIES
- Coverage and design:
  - Top-down solvency stress tests for 2018–20; baseline aligned with April 2018 World Economic Outlook; adverse scenario from IMF Flexible System of Global Models with cumulative GDP deviation of 15.4 percent (2.07 standard deviations) over three years.
  - Sample covers 93 percent of bank assets (excluding foreign branches).
- Solvency (quasi-static, adverse, Year 2020):
  - CET1 would decline by 329 bps to 14.5 percent compared to end-2017.
  - Total capital ratio would decline by 390 bps to 16 percent.
  - Three small banks would see at least one capital ratio decline below regulatory thresholds; total recapitalization needs estimated at 0.14 percent of GDP.
  - No bank would see its leverage ratio fall below the 3 percent threshold, with one bank just above it.
- Sensitivity tests:
  - Simultaneous default of five largest exposures would cause four banks’ CET1 to fall under the regulatory 4.5 percent threshold.
  - Interest rate sensitivity and single-factor funding cost shock show low direct interest rate risk exposure due partly to prevalence of variable rate loans.
- Liquidity stress tests:
  - Aggregate resilience to short-term liquidity pressures due to high liquidity buffers.
  - Some small banks would fail to meet LCR requirement under stress because of heavy reliance on wholesale and nonresident deposits.
  - NSFR-based test: most banks do not face structural long-term liquidity risks; a few small banks struggle due to high share of mortgage and long-term corporate loans.
  - Cashflow-based maturity-ladder tests show funding gaps in some small banks over five-day, one-month, and three-month horizons; withdrawals of five largest depositors caused LCR of three banks to fall below the 80 percent threshold.

### STRUCTURE, SIZE, AND CROSS-SECTOR LINKAGES
- Financial system composition:
  - Financial institutions total (millions of euro): 42,190 (2004), 184,720 (2010), 257,860 (2017).
  - Nominal GDP (millions of euro): 4,852 (2004), 6,600 (2010), 11,295 (2017).
- Banking sector:
  - 25 banks in Malta.
  - Six banks account for about half of system assets, 95 percent of resident deposits, and 98 percent of loans to residents.
  - Two non-EU bank branches hold 39 percent of system assets but have no exposure to Maltese residents.
- Key banking ratios and metrics (end-2017 unless stated):
  - Total capital adequacy ratio: 21.2 percent of RWA.
  - Tier 1 Capital ratio: 19 percent.
  - Banks’ NPL ratio (excluding non-EU branches): declined from 6.6 percent in 2014 to 4.1 percent by end-2017.
  - NPLs of NFCs: declined from 11.8 percent in 2014 to 9 percent in 2017.
  - Sectoral NPLs persist: construction 27.8 percent; corporate real estate 13.9 percent.
  - Loan loss provisions (LLP): 34 percent of NPLs in core domestic and international banks; 57 percent in noncore domestic banks.
  - Bank profitability supported by stable NIM; risks to sustainability include contracting corporate loan books, exposure to low-yield bonds, increased regulatory compliance costs, higher LLP requirements, and implementation of MREL.
- Nonbank sectors:
  - Domestic insurers’ assets amounted to 37 percent of GDP at end-2017.
  - Domestic investment funds’ assets amounted to 16.8 percent of GDP at end-2017.
  - Malta Stock Exchange market capitalization of 1.1 times GDP at end-2017; market turnover is thin.
- OFIs:
  - OFIs’ total assets amounted to 16¾ times GDP at end-2017; 98 percent of OFIs’ assets were invested abroad; 65 percent of assets were unlisted shares; OFIs held deposits with 11 Maltese banks amounting to 4.5 percent of banking sector deposits.

### RISK ASSESSMENT MATRIX — MAJOR RISKS (likelihood and impact summaries)
- Weaker-than-expected global growth: Overall Level of Concern: Medium; Likelihood: Medium; impact via exports (about 150 percent of GDP in 2017), FDI, employment, housing prices, NPLs.
- Rising protectionism and retreat from multilateralism: Overall Level of Concern: High; Likelihood: Medium; impact on passporting, trade, investment, and financial interlinkages.
- A sharp tightening of global financial conditions: Overall Level of Concern: High; Likelihood: Medium/Low; impact via asset price declines, higher funding costs, and credit stress.
- A sharp correction in historically high housing prices: Overall Level of Concern: Medium; Likelihood: Medium; impact concentrated on domestically oriented banks via collateral and NPL deterioration.
- Possible changes in international taxation: Overall Level of Concern: Medium/Low; Likelihood: High/Medium; impact on corporate tax base, IIP, remote gaming, and potential deposit outflows.
- Slow progress in effectively implementing the AML/CFT framework: Overall Level of Concern: Medium; Likelihood: Medium; impact via reputational risk, withdrawals of wholesale and nonresident deposits, and higher funding costs.

### VIRTUAL-ASSET REGULATION AND IMPLEMENTATION RISKS
- Legal developments:
  - In July 2018, parliament passed three acts to provide a legal status and regulatory framework for virtual assets.
  - Framework requires a financial group to establish a separate entity within the group before operating VFA-related operations.
- Implementation risks and capacity needs:
  - Financial Instrument Test may leave interpretation/implementation uncertainties.
  - DIA will have enforcement powers but cannot access source code protected by cryptographic keys.
  - Authorities face reputational and cross-border enforcement challenges.
  - AML/CFT coverage needs completion; current coverage falls slightly short of the FATF definition by excluding virtual tokens.
  - Effective implementation requires cyber, technology, and legal expertise; suggested gradual implementation with strict Sandbox conditions.

### SELECTED KEY RECOMMENDATIONS (selected from Table 1 and text)
- Strengthen risk analysis: incorporate new liquidity stress-testing dimensions, conduct regular sensitivity analysis on selected vulnerabilities, and enhance data management (¶18) — Timing: NT — Responsibility: CBM, MFSA.
- Consider granting the CBM powers to recommend actions to public authorities with a “comply or explain” mechanism; amend MFSA Act to add a financial stability objective (¶29) — Timing: NT — Responsibility: Government, MFSA.
- Close remaining data gaps and enhance analytical tools (¶30) — Timing: NT/MT — Responsibility: CBM, NSO, MFSA.
- Refine and introduce planned borrower-based instruments to address housing/household vulnerabilities (¶31) — Timing: I — Responsibility: CBM.
- Ensure stable funding for the MFSA, grant full autonomy over recruitment, and maintain a dedicated statutory committee on supervisory issues (¶34) — Timing: I — Responsibility: MFSA, Government.
- Address supervisory and enforcement capacity gap by increasing staff and broadening skill set (¶33) — Timing: I — Responsibility: MFSA.
- Increase number and risk orientation of onsite inspections of LSIs; enhance supervision of third country branches (¶37) — Timing: ST — Responsibility: MFSA.
- Take timely supervisory actions (including for ML/TF), increase use of monetary fines, and ensure supervisory action is not delayed through judicial appeal (¶36) — Timing: ST — Responsibility: MFSA, FIAU, Government.
- Improve authorities’ assessment and understanding of ML/TF risks and strengthen national coordination (¶46, 47) — Timing: I — Responsibility: NCC.
- Adopt multi-prong AML/CFT strategy focusing on preventive measures, risk-based supervision, sanctions, and fit-and-proper tests (¶48) — Timing: I — Responsibility: MFSA, FIAU, ROC, Government.
- Support establishing an EU-level arrangement responsible for AML/CFT supervision (¶46) — Timing: MT — Responsibility: Government.
- Adopt an administrative bank insolvency regime with explicit powers to transfer assets/liabilities and clarify creditor hierarchy (¶41) — Timing: I — Responsibility: Government.
- Shift responsibility for decisions on bank insolvency and liquidation post-license revocation from MFSA’s supervisory function to its resolution function (¶42) — Timing: I — Responsibility: MFSA.
- Review adequacy of Resolution Unit staffing and increase resources accordingly (¶40) — Timing: I — Responsibility: MFSA.

*International Monetary Fund — Malta: Financial Sector Assessment (selected chapter content, content unit 1mltea2019003).*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 6

### EXECUTIVE SUMMARY

### MACROFINANCIAL BACKGROUND
- Malta’s economy is highly open and strongly connected to the rest of the world; after joining the EU in 2004 and the EA in 2008, Malta harmonized its financial sector legislation with that of the EU.  
- Annual GDP growth averaged 6.8 percent in 2013–17.  
- Credit developments:
  - Credit grew at 3½ percent per annum in 2015–17, mostly supported by mortgage lending.
  - Bank credit to the private sector declined to about 80 percent of GDP by end-2017.
  - Bank credit to nonfinancial corporates (NFC) declined; NFCs increased intercompany borrowing.
- NFCs’ leverage is high compared to European peers, with construction and real estate exhibiting the highest leverage.
- Household sector:
  - Household debt stood at 108 percent of gross disposable income in 2017.
  - Home ownership ratio was 82 percent.
  - Debt-to-financial-wealth ratio was stable at 23 percent.
  - New mortgages’ averages in 2017: LTV 77 percent and DSTI 21 percent.
- Housing and property:
  - Mortgage lending grew by 8½ percent annually since 2013.
  - Residential property prices rose by 33 percent in 2010–17.
  - Construction investment has recently picked up.
- Banks’ sovereign exposure:
  - Banks held 29 percent of total government debt (3.3 percent of assets) in 2017.
  - 90 percent of these holdings were concentrated in core banks (6.6 percent of their assets).
- AML/CFT context:
  - Malta has experienced high-profile ML/TF-related incidents in the banking sector; in July 2018 the EBA established that the FIAU had breached the Third EU Directive on AML/CFT in the case of Pilatus Bank.

### FINANCIAL SYSTEM RESILIENCE
- Overall system strength:
  - Key metrics indicate the banking system is well capitalized, liquidity is ample, and profitability is healthy.
  - NPLs remain below the euro area (EA) average, though pockets of distressed corporate loans persist.
- Concentration and vulnerabilities:
  - Core domestic banks have high exposure to property-related loans amid rapid house price appreciation.
  - Nonresident deposits are a significant share of international and noncore domestic banks, increasing their vulnerability despite limited exposure to the domestic economy.
- Stress and contagion:
  - The banking system remains resilient under a severe scenario; weaknesses are limited to a few small banks.
  - Large withdrawals of wholesale and nonresident deposits under a stress event can put some banks under pressure.
  - Contagion risk is estimated to be limited, but distress could affect smaller banks due to cross-border and cross-sectoral linkages.
- Surveillance and capacity needs:
  - Need to closely monitor evolving business models for shifts in systemic risk.
  - Strengthen stress test approaches and enhance data quality and management.

### FINANCIAL STABILITY POLICY FRAMEWORK
- Macroprudential policy and monitoring:
  - Recent strengthening of systemic risk monitoring is commendable.
  - Gaps: legal framework enhancements needed, data gaps to be closed, and nonbank risk assessment should be strengthened.
  - Planned borrower-based measures to address vulnerabilities in housing and household sectors are welcome.
- MFSA resources and independence:
  - The MFSA is substantially understaffed; this undermines effectiveness and operational independence.
  - Authorities should upgrade the MFSA’s operational capacity and grant it full autonomy over recruitment.
  - A five-year plan should be developed to ensure sustained budgetary resources for the MFSA.
  - Further steps should enhance checks and balances in MFSA decision-making.
- Bank supervision shortcomings:
  - Urgent action needed: take timelier supervisory actions, increase frequency of onsite inspections, make more use of monetary fines, and ensure supervisory action is not delayed through judicial appeal.
  - Supervision should focus on credit, liquidity, compliance, and adequacy of risk classification and provisioning.
  - Related-parties framework needs alignment with the Basel Core Principles (BCP).
  - Improve oversight of non-EU branches.
- Early intervention and resolution, insolvency:
  - Develop policies and procedures for MFSA’s early intervention and resolution powers to mitigate legal risks.
  - Adopt an administrative bank insolvency framework and clarify creditor hierarchy.
  - Shift responsibility for decisions on bank liquidation and insolvency post-license withdrawal from MFSA’s supervisory function to its resolution function.
  - MFSA and the Ministry for Finance (MFIN) should develop internal crisis management plans.

### FINANCIAL SAFETY NET AND CRISIS MANAGEMENT
- Recommendation highlights (from Table 1):
  - Adopt an administrative bank insolvency regime with explicit powers to transfer assets/liabilities. Clarify the creditor hierarchy (¶41) — Timing: I — Responsibility: Government.
  - Shift responsibility for decisions on bank insolvency and liquidation, post-license revocation, from the MFSA’s supervisory function to its resolution function (¶42) — Timing: I — Responsibility: MFSA.
  - Review the adequacy of the Resolution Unit’s staffing and increase its resources accordingly (¶40) — Timing: I — Responsibility: MFSA.
  - Develop MFSA and MFIN internal crisis management plans (¶42) (MFSA, MFIN) — implicit in discussion above.

### FINANCIAL INTEGRITY (AML/CFT)
- Systemic ML/TF risks:
  - Cross-border linkages create significant ML/TF risks, notably from foreign proceeds of crimes, increasing reputational risks and pressure on correspondent banking relationships (CBR) and compliance costs.
  - Fast-growing remote gaming activity, virtual-assets intermediation, high demand for real estate, and the Individual Investment Program (IIP) elevate financial integrity risks.
- Recommended multi-prong strategy:
  - Ensure banks appropriately apply preventive measures, including customer due diligence with efficient verification of beneficial ownership (BO), especially for higher risk activities and significant nonresident sector.
  - Fully implement risk-based AML/CFT supervision.
  - Apply timely, dissuasive, and proportionate sanctions and effective fit-and-proper tests.
  - Additional supervisory resources needed for FIAU and MFSA to bolster risk-based AML/CFT supervision.
  - Support establishment of an EU-level arrangement responsible for AML/CFT supervision to facilitate consistent and comprehensive approach and minimize regulatory arbitrage.

### KEY RECOMMENDATIONS (selected from Table 1)
- Strengthen risk analysis by incorporating new liquidity stress-testing dimensions, conducting regular sensitivity analysis on selected vulnerabilities, and enhancing data management (¶18) — Timing: NT — Responsibility: CBM, MFSA.
- Consider providing the CBM powers to recommend actions to public authorities with a “comply or explain” mechanism; amend MFSA Act to add a financial stability objective (¶29) — Timing: NT — Responsibility: Government, MFSA.
- Close remaining data gaps and enhance analytical tools (¶30) — Timing: NT/MT — Responsibility: CBM, NSO, MFSA.
- Refine and introduce planned borrower-based instruments to address housing/household vulnerabilities (¶31) — Timing: I — Responsibility: CBM.
- Ensure stable funding for the MFSA, grant full autonomy over recruitment, and maintain a dedicated statutory committee on supervisory issues (¶34) — Timing: I — Responsibility: MFSA, Government.
- Address supervisory and enforcement capacity gap by increasing staff and broadening skill set (¶33) — Timing: I — Responsibility: MFSA.
- Increase number and risk orientation of onsite inspections of LSIs; enhance supervision of third country branches (¶37) — Timing: ST — Responsibility: MFSA.
- Take timely supervisory actions (including for ML/TF), increase use of monetary fines, and ensure supervisory action is not delayed through judicial appeal (¶36) — Timing: ST — Responsibility: MFSA, FIAU, Government.
- Strengthen conduct supervision and enhance sectoral risk-based supervision framework (¶39) — Timing: MT — Responsibility: MFSA.
- Improve authorities’ assessment and understanding of ML/TF risks and strengthen national coordination (¶46, 47) — Timing: I — Responsibility: NCC.
- Adopt multi-prong AML/CFT strategy focusing on preventive measures, risk-based supervision, sanctions, and fit-and-proper tests (¶48) — Timing: I — Responsibility: MFSA, FIAU, ROC, Government.
- Support establishing an EU-level arrangement responsible for AML/CFT supervision (¶46) — Timing: MT — Responsibility: Government.
- Adopt an administrative bank insolvency regime with explicit powers to transfer assets/liabilities and clarify creditor hierarchy (¶41) — Timing: I — Responsibility: Government.
- Shift responsibility for decisions on bank insolvency and liquidation post-license revocation from MFSA’s supervisory function to its resolution function (¶42) — Timing: I — Responsibility: MFSA.
- Review adequacy of Resolution Unit staffing and increase resources accordingly (¶40) — Timing: I — Responsibility: MFSA.

*MALTA — INTERNATIONAL MONETARY FUND, EXECUTIVE SUMMARY.*

### 10.      Malta’s financial system is large compared to its economy and is strongly linked with

### 10.      Malta’s financial system is large compared to its economy and is strongly linked with

### Structure and size of the financial system
- Financial system comprises banks, insurance companies, investment funds, and a large residual category of “other financial institutions” (OFIs).
- Cross-sectoral linkages: part of the banking sector and OFIs hold large assets and liabilities mostly vis-à-vis the rest of the world.
- Financial institutions total (millions of euro): 42,190 (2004), 184,720 (2010), 257,860 (2017).
- Nominal GDP (millions of euro): 4,852 (2004), 6,600 (2010), 11,295 (2017).
- Other financial institutions: sector 127 (Captive Institutions and Money Lenders) of ESA 2010; at end-2017, OFIs’ total assets amounted to 16¾ times GDP, 98 percent of OFIs’ assets were invested abroad, 65 percent of assets were unlisted shares; OFIs held deposits with 11 Maltese banks amounting to 4.5 percent of banking sector deposits.

### Banking sector: market structure and orientation
- 25 banks in Malta.
- Six banks account for about half of system assets, 95 percent of resident deposits, and 98 percent of loans to residents.
- Two non-EU bank branches hold 39 percent of system assets but have no exposure to Maltese residents.
- Most banks orient business models either domestically or internationally; strong segmentation remains across geographical concentration of funding sources and assets.

### Banking system health: capital, liquidity, and asset quality
- Capital adequacy and liquidity:
  - Total capital adequacy ratio: 21.2 percent of risk-weighted-assets (RWA) in 2017.
  - Tier 1 Capital ratio: 19 percent in 2017.
- Asset quality:
  - Banks’ NPL ratio declined from 6.6 percent in 2014 to 4.1 percent by end-2017 (excluding non-EU branches).
  - NPLs of NFCs declined from 11.8 percent in 2014 to 9 percent in 2017.
  - NPLs remained persistently high in construction (27.8 percent) and corporate real estate (13.9 percent).
  - Loan loss provisions (LLP) stood at 34 percent of NPLs in core domestic and international banks, and 57 percent in noncore domestic banks.
  - In 2016 authorities mandated banks to reduce their NPL ratio below 6 percent over five years.
- Profitability:
  - Bank profitability remains good supported by stable net interest margins (NIM) and operating costs for core domestic banks; however, risks to sustainability include contracting corporate loan books, weakening property market, large exposure to low-yield bonds, increased regulatory compliance costs, higher LLP requirements, and implementation of MREL which will likely raise funding costs.
- Funding:
  - Loan-to-deposit ratios generally low and liquidity high.
  - High and growing reliance on nonresident deposits (especially by smaller banks) and high share of sight deposits raise concerns about funding stability under adverse shocks.
- Correspondent banking relationships (CBRs):
  - Some banks’ CBRs are subject to pressures and restrictions, particularly when they provide correspondent banking services and channel flows from high-risk jurisdictions or deal with high-risk clients (e.g., nonresidents, e-gaming, virtual-asset operators, IIP, politically exposed persons).

### Nonbank sectors: insurance, funds, OFIs, capital markets
- Insurance:
  - Except for eight domestic insurers, the insurance sector writes predominantly non-Maltese risks.
  - Domestic insurers’ assets amounted to 37 percent of GDP at end-2017; they have large exposures to core domestic banks and underwrite a negligible amount of foreign risk.
  - Market features: presence of professional reinsurers, captive insurers, protected cell companies (PCC), and one reinsurance special purpose vehicle.
- Investment funds and services:
  - Domestic investment funds’ assets amounted to 16.8 percent of GDP at end-2017.
  - Top three domiciles for UCITS passporting into Malta: Luxembourg, Ireland, United Kingdom.
  - Top three jurisdictions where Maltese investment service licensees passported services: Italy, Germany, United Kingdom.
- Malta Stock Exchange:
  - Market capitalization of 1.1 times GDP at end-2017, but market turnover is thin.
- OFIs:
  - OFIs typically tax-minimizing Maltese entities transacting with foreign affiliates; not engaged in shadow banking.
  - About half of entities estimated owned by natural or legal persons from Germany, Netherlands, Ireland, Canada, and the UK.
  - Authorities launched a survey to supplement Inland Revenue Office data to improve statistics.

### Financial system resilience — key risks
- Main systemic risks (Risk Assessment Matrix):
  - Reputational risks including ML/TF, loss of CBRs, sanctions, changes in international corporate taxation could negatively affect Malta’s attractiveness.
  - Sharp correction in housing prices would trigger adverse wealth effects and deterioration of NPLs for domestically oriented banks.
  - Weaker external demand, given Malta’s openness, would adversely affect domestic confidence and growth.
  - Sharp tightening of global financial conditions would lead to declines in asset prices, valuation losses, and higher funding costs.

### Stress testing and resilience assessment
- Stress test design:
  - Top-down solvency stress tests conducted using baseline and adverse scenarios for 2018–20.
  - Baseline aligned with April 2018 World Economic Outlook.
  - Adverse scenario based on IMF Flexible System of Global Models; envisaged a cumulative deviation of GDP from the baseline of 15.4 percent (2.07 standard deviations) over three years.
  - Sample accounts for 93 percent of bank assets (excluding foreign branches).
- Solvency results:
  - Baseline: banking system remains resilient; total capital ratio stabilizes at 19.4 percent and leverage ratio (Tier 1 to total assets) at 9.1 percent for the sample.
  - Adverse scenario aggregate results:
    - CET1 would decline by 329 bps to 14.5 percent compared to end-2017.
    - Total capital ratio would decline by 390 bps to 16 percent.
    - Drivers: loan loss provisions, increased RWA, and valuation losses.
    - Three small banks would see at least one capital ratio decline below regulatory thresholds; total recapitalization needs estimated at 0.14 percent of GDP.
    - No bank would see its leverage ratio fall below the 3 percent threshold, with one bank just above it.
- Sensitivity tests:
  - Simultaneous default of five largest exposures would cause four banks’ CET1 to fall under the regulatory 4.5 percent threshold.
  - Interest rate sensitivity and single-factor funding cost shock show low direct interest rate risk exposure due partly to prevalence of variable rate loans.
- Liquidity stress tests:
  - Aggregate resilience to short-term liquidity pressures due to high liquidity buffers.
  - Some small banks would fail to meet LCR requirement under stress because of heavy reliance on wholesale and nonresident deposits.
  - NSFR-based test: most banks do not face structural long-term liquidity risks; a few small banks struggle due to high share of mortgage and long-term corporate loans.
  - Cashflow-based maturity-ladder tests show funding gaps in some small banks over five-day, one-month, and three-month horizons; some banks experience negative cash balances after utilizing counterbalancing capacity.
  - Withdrawals of five largest depositors caused LCR of three banks to fall below the 80 percent threshold; similarly, three banks failed under large withdrawals of depositors from certain economic sectors.
- Contagion and interconnectedness:
  - Contagion risk via domestic intersectoral linkages is higher than via cross-border interbank exposures due to cross-ownership and deposit concentration.
  - Potential cascade effects and spillovers mainly from core banks to insurers, and to a lesser degree, funds.
  - Cross-border interbank exposures show strong interconnectivity with the EA and other European banks; overall contagion losses are limited and concentrated in a few smaller banks.

### Financial stability policy framework: assessments and recommendations
- Macroprudential framework:
  - Institutional framework broadly in line with IMF guidance.
  - CBM empowered with statutory macroprudential functions; Joint Financial Stability Board ensures coordination with relevant agencies.
  - Recommendations:
    - Strengthen legal backing of interagency coordination: CBM should be empowered to recommend actions to a public authority or institution with a “comply or explain” mechanism and to issue warnings and opinions.
    - Provide MFSA with a financial stability objective while keeping powers and functions distinct from CBM to raise accountability and reduce conflicts between macroprudential and microprudential policies.
    - Strengthen systemic risk monitoring: develop commercial real estate price indexes and collect granular loan data including intercompany loans; strengthen risk assessment of the nonbank financial sector, including OFIs.
    - Planned introduction of borrower-based measures welcomed: authorities preparing to introduce LTV and DSTI limits and restrict maturities for residential real estate bank loans; refine measures by reducing exemptions from LTV limits for loans against secondary and buy-to-let properties.
- Supervisory resources and operational independence (MFSA):
  - MFSA mandate covers banks, insurance, securities, and other regulated entities; tasked to assist FIAU in supervising subject persons; developed regulatory framework for VFA.
  - Resource constraints:
    - Resources stretched and insufficient for scope of tasks; issues with planning and timely execution of supervision actions and maintaining contacts with less significant institutions (LSI).
    - MFSA steps: staff remuneration improved; plans to (i) increase number of staff by 50 percent over next three years; (ii) formalize a new human resources strategy; launched Business Process Reengineering exercise.
    - MFSA urgently needs to increase staff and quantify resources necessary for more intrusive risk-based supervision, mapping required skills (credit and IT risk experience, statistics and VFA knowledge).
  - Operational independence concerns and recommendations:
    - Funding stability: separation of Registry of Companies (ROC) in April 2018 redirected significant part of MFSA funding to the government; government to cover MFSA funding gaps going forward. Recommendation: develop a five-year plan to increase budgetary resources with strong public commitment from government; revisit policy for license fees and basis for other regulatory charges to enhance funding stability.
    - Recruitment autonomy: MFIN endorses human resources budget yearly and Office of Permanent Secretary approves recruitments case-by-case; MFSA should have full autonomy over recruitment.
    - Decision-making and checks and balances: supervisory powers currently vested in MFSA’s Supervisory Council (SC) are planned to be transferred to an executive committee chaired by the CEO. Recommendation: maintain a dedicated statutory committee tasked with supervisory and enforcement powers to ensure sufficient attention, time, and resources devoted to supervisory actions.

*International Monetary Fund — Malta: Financial Sector Assessment (selected chapter content).*

### 35.      Bank supervision has been upgraded in recent years. The implementation of EU

### 1mltea2019003 - 35.      Bank supervision has been upgraded in recent years. The implementation of EU

### Bank supervision — recent upgrades and scope
- Implementation of EU directives and regulations helped close several gaps identified in the 2003 FSAP and in an independent assessment in 2011.
- Key legal and supervisory changes:
  - The definition of related parties has been broadened.
  - Administrative penalties and measures have been set out.
  - The MFSA has been empowered to issue binding regulations (e.g., requiring banks to submit NPL reduction plans).
  - The ECB’s Banking Supervision has raised the level of supervisory intensity and intrusiveness of three significant institutions (SI).
- Supervisory coverage and reporting arrangements:
  - MFSA is responsible for supervision of 18 LSIs, subject to ECB oversight, and two non-EU branches.
  - For three High-Priority LSIs (HPLSI), the ECB receives mandatory reporting and ex-ante notifications on certain supervisory actions by the MFSA.
- FSAP focus: Primarily on the supervision of LSIs.

### Shortcomings in supervisory implementation and enforcement
- Timeliness and effectiveness issues:
  - Significant delays exist between the end of onsite inspections and the date on which decisions were taken by the SC.
  - Judicial appeals against monetary sanctions have suspensive effects, undermining the sanctions policy (e.g., MFSA has 27 pending appeals with some dating back to 2009).
  - The low and limited number of monetary sanctions has little deterrent effect.
- Onsite inspection scope and frequency:
  - Limited scope of onsite inspections (low frequency and key risks insufficiently covered) impair detection of problems, including in the ML/TF area.
- Recommendation:
  - Authorities should eliminate delays in supervisory actions (including by amending the law if needed) and take full advantage of the broad enforcement powers.

### Needed improvements in supervisory practices
- MFSA actions required:
  - Complete the rollout of its supervision strategy, including the completion of the Supervisory Review and Evaluation Process for all HPLSIs.
  - Address the low frequency of onsite inspections at LSIs.
  - Adopt a more intrusive approach to assess banks’ risk-management processes, including for asset recovery, related-party transactions, forbearance measures, and collateral valuation.
  - Focus supervision on main risks: credit, liquidity, and compliance; adequacy of risk classification and provisioning; and stronger follow-up on remediation progress.
- Related-party framework gaps:
  - Legal amendments are needed to increase MFSA’s powers and banks’ obligations related to:
    - (i) the change of legal structures;
    - (ii) major acquisitions;
    - (iii) the review of the activities of companies affiliated with banks’ parent companies; and
    - (iv) the communication of materially adverse developments.
  - Authorities should improve the supervision of non-EU branches.

### Insurance and securities market supervision
- Ongoing priorities:
  - MFSA should continue efforts to strengthen supervision as the insurance and securities markets evolve.
  - The complexity, high exposure to EU countries, and high concentration of life insurance and reinsurance industries call for continued close monitoring of evolving business models.
- Risk-based supervision frameworks (RBSF):
  - The RBSF for insurance and investment firms assesses licensees based on risk impact and probability, driving the annual supervisory plan.
  - Scope for improvement: monitoring of macro-risks and business model analysis in the RBSF.
  - The supervisory program for conduct supervision should be expanded to include banks acting as distributors of insurance and securities products.

### Financial safety net and crisis management
- Institutional arrangements and staffing:
  - A Domestic Standing Committee comprising relevant staff from the CBM, MFSA, and MFIN has a mandate to enhance crisis preparedness and to facilitate crisis management.
  - Supervisory and resolution functions within MFSA are adequately separated; the Depositor Compensation Scheme (DCS) has its own Management Committee.
  - Given current workload, a review of the adequacy of MFSA’s Resolution Unit staffing should be undertaken, and its resources increased.
- Insolvency regime and creditor hierarchy:
  - Multiple laws and regulations govern bank failures, creating uncertainties in application, including regarding the creditor hierarchy.
  - The MFIN should initiate reform of the bank insolvency framework in line with international standards, including providing explicit powers to transfer assets and liabilities of failing banks.
  - In the meantime:
    - The DCS should clarify its legal interpretation of and policies under the current framework.
    - The MFSA should adopt a policy to place a bank into liquidation when a deposit payout is made.
- Strengthening supervisory and early intervention procedures:
  - MFSA should assess recent bank failures and strengthen supervisory and early intervention procedures, including to mitigate legal risks.
  - This should include reducing the time in office for the competent person appointed to manage the affairs of a bank.
  - Responsibility for decisions on bank insolvency and liquidation of banks whose license is withdrawn needs to shift from MFSA’s supervisory function to its resolution function.
- Operationalizing BRRD resolution tools and MREL:
  - Preparations to operationalize the BRRD resolution tools should be accelerated and internal crisis management plans developed.
  - Ensuring the availability of sufficient MREL is critical, as the resolution regime mandates the bail-in of creditors.
  - Issuing sufficient MREL may prove challenging given the limited domestic professional investor market and small issuance sizes for potential external investors.
  - The Resolution Unit should prepare the use of the business transfer and the bridge bank tools, including ownership and governance structure of the latter.
  - The MFSA and the MFIN should develop internal crisis management plans to supplement the Interagency Crisis Management Framework currently under review by the Domestic Standing Committee.

### Financial integrity (AML/CFT)
- Vulnerabilities and legal framework:
  - Malta’s openness to financial flows makes it vulnerable to ML/TF risks.
  - Increasing inflows, including from countries generally considered to pose greater ML/TF risks, may exploit vulnerabilities in the banking sector, real estate, remote gaming, virtual assets, and the IIP.
  - A new legislative AML/CFT framework entered into force in 2018, but according to the opinion of the European Commission (July 2018), the transposition of the EU’s Fourth AML Directive is not complete and recent bank intervention cases exposed serious shortfalls in the framework.
  - Malta is currently undergoing an assessment against the Financial Action Task Force 2012 standard.
- Strategy, NRA, and implementation:
  - The National Risk Assessment (NRA) of ML/TF risks was updated in 2017 but was not published.
  - Authorities published an ambitious national AML/CFT strategy and a comprehensive AML/CFT action plan; implementation is at the initial phase.
- Cooperation and supervision:
  - Cooperation among FIAU, MFSA, and law enforcement must be strengthened.
  - Recent efforts to step up joint FIAU and MFSA AML/CFT supervision are welcome, but further operational cooperation improvements are needed.
  - Authorities should consider supporting the establishment of an EU-level arrangement directly responsible for AML/CFT supervision to enhance convergence and minimize regulatory arbitrage.
- Risk understanding and data gaps:
  - The NRA noted the threat posed by the foreign proceeds of crime to Malta is high, but there are no measurable estimates of the amount of proceeds of crime possibly laundered through and in Malta.
  - Authorities lack comprehensive understanding of ML/TF risks affecting Malta as an international financial center heavily relying on nonresident clients and significant cross-border financial flows.
- Multi-prong strategy and preventive measures (recommendations):
  - Strengthen banks’ verification of BO information and ongoing monitoring of risk-sensitive accounts, especially applying enhanced measures for nonresident clients (including opaque companies), new technologies (e.g., virtual assets and e-gaming), and IIP-related funds.
  - Fortify customer due diligence for domestic and foreign politically exposed persons, their family members, and close associates, and improve reporting of suspicious transactions.
  - Continue addressing ML/TF risks related to expanding blockchain technologies and virtual assets:
    - Close any related gaps in the AML/CFT framework.
    - Ensure the definition and AML/CFT oversight of a “subject person” are in line with the requirements of the Financial Action Task Force regarding virtual asset service providers.
    - Immediate action is needed to strengthen resources for AML/CFT oversight of virtual asset service providers.
  - Fully implement a risk-based AML/CFT supervision of banks, evaluate banks’ risk mitigation models more stringently, and develop more effective AML/CFT enforcement, including by applying dissuasive and proportionate sanctions and eliminating delays in their application.
  - Apply more vigilant fit-and-proper requirements, including assessment of the reputation of bank owners and managers, to improve bank governance.
  - The ROC should be adequately resourced and required to properly verify and update the BO information.

*IMF staff summary of content unit 1mltea2019003 - 35.*

### 2.3 percent of total new bank mortgage loans in 2017.

### 1mltea2019003 - 2.3 percent of total new bank mortgage loans in 2017.

### Mortgage lending and housing exposures
- Bank’s exposure to the housing market has been increasing.
- About 70 percent of new mortgages are taken for purchases of primary residence.
- At end-2017, total property-based lending (i.e., to residents and nonresidents) was 40 percent of total loans to customers. For core domestic banks, the ratio was 56 percent.
- Median LTV of new loans is around 80 percent; median DSTI of new loans is around 20 percent.
- LTV and DSTI ratios have become more prudent for loans for secondary residence and buy-to-let properties.
- Share of new mortgage loans by type (2016–2017) shown for:
  - Primary residence: first-time buyer
  - Primary residence: other
  - Secondary residence
  - Buy-to-let

### Household debt and vulnerability
- "2.3 percent of total new bank mortgage loans in 2017."
- Debt varies significantly across income deciles.
- A balance sheet stress test shows that low-income households are more vulnerable to drop in income and house prices and a rise in financing costs.
- Household leverage includes non-profit institutions serving the household sector.
- Debt consists of outstanding amounts of mortgages and on credit cards, credit lines/bank overdrafts, and outstanding amounts of other, non-collateralized, loans (including loans from commercial providers and private loans).
- Distribution metrics presented by income decile (pre-stress and under stress scenarios) with PDs for 2016 and projections for Initial (2016), 2018, 2019, 2020.

### Housing prices and valuation
- House prices have been increasing since 2014 and at a higher rate than the EA average.
- Price ratios are picking up; econometric analysis suggests some overvaluation.
- Two different house price indexes used: CBM index based on advertised prices, and NSO index based on reported market transactions.

### Bank–sovereign nexus
- Malta’s sovereign bonds are mostly held by residents.
- The banking sector holds 29 percent of the total stock of Maltese government bonds, concentrated in core domestic banks.
- Sovereign bond investor base shown over time (millions of euro) for Resident MFIs, Resident non-MFIs, and Non Residents.

### Banking sector structure and performance
- The banking sector is large but declined recently as international banks consolidated operations.
- Sample banks (11 banks) cover 93 percent of total assets (foreign branches excluded) for several indicators.
- Banks are well capitalized and liquidity is ample.
- The share of nonresident deposits is relatively small in core domestic banks but large and volatile in other banks.
- Profitability is declining, albeit still healthy.
- Liquidity Coverage Ratio (percent) presented across 2016Q3–2017Q4 for All banks and Core banks.
- NPLs are decreasing for all groups of banks; provision coverage is stable for core domestic banks but decreasing for non-core and international banks.
- NPL ratios are high for consumer and NFC loans; NFC NPLs concentrated in construction, real estate, and administrative and support services.

### Financial system structure and cross-sectoral linkages
- Cross-sectoral linkages and gross exposures presented for 2017 with network maps (including Rest of the World and without).
- Cross-sectoral network comprises 24 banks (red), 8 insurers (blue) and 8 funds (green).
- OFIs include captive financial institutions and money lenders.

### Cross-border exposures and contagion
- Cross-border banking network comprises 21 Maltese banks and 58 non-Maltese banks.
- Cross-border contagion mapping based on a sample of 21 Maltese banks with large exposures to a total of 58 banks outside.
- Hypothetical default of the most contagious bank results in average losses to Maltese banks of close to 5 percent of their capital buffer; the most vulnerable Maltese bank incurs average losses of about 13 percent of its capital buffer.

### FSAP stress test scenarios and macro projections
- Scenario severity from historic perspective and Real GDP Growth (percent) comparisons presented.
- Baseline aligned with the April 2018 World Economic Outlook.
- FSAP Macroeconomic Projections include:
  - Real GDP index (Baseline and Adverse)
  - Consumer Price Inflation (percent)
  - Unemployment Rate (percent)
  - Nominal House Prices (Index)
  - 10-year Government Bond Yield (percent)
  - 3-month EURIBOR Rate (Index)
- Example projection points shown:
  - Real GDP growth series: 4.0, 5.0, 5.8, 6.1, 4.2, 4.4, 4.6 (presented in figure labels)
  - Consumer Price Inflation series: 1.3, 2.4, 2.9, 3.1, 1.4, 1.7, 1.9 (presented in figure labels)

### Solvency and liquidity stress test results
- Top-down solvency stress test—quasi-static approach results presented for all sample banks, core domestic banks, and other banks.
- Contribution breakdowns to solvency results shown.
- Top-down liquidity stress test results presented for sample banks.
- Table 7: Solvency stress test results (selected figures)
  - Before Stress (end-2017) Bank CET1 ratio: All 11 banks 17.8, Core-domestic banks 15.1, Other banks 29.9
  - Quasi-static approach, Adverse (Year 2020) Bank CET1 ratio: All 11 banks 14.5, Core-domestic banks 12.4, Other banks 24.3
  - Static approach, Adverse (Year 2020) Bank CET1 ratio: All 11 banks 15.5, Core-domestic banks 13.3, Other banks 26.4
  - Banking sector leverage ratio and Max capital shortfall in terms of CAR (as percent of GDP), plus numbers of banks breaching CET1 <4.5%, T1 <6%, CAR <8% are reported in table format.

### Key macro and financial statistics (selected, as presented)
- Population (millions):0.524,538
- Quota (as of Dec. 31, 2018; millions of SDRs):168.316.8
- Real GDP growth (2016–2024 series in Table 2): 5.7, 6.6, 6.4 (2016–2018 Est.), 5.2 (2019), 4.4 (2020), 3.8 (2021), 3.5 (2022), 3.3 (2023), 3.2 (2024)
- HICP (period average) (2017–2020 sample): 0.9, 1.3, 1.7, 2.0, 2.1, 2.1, 2.0, 2.0, 2.0 (across years)
- General government debt (percent of GDP) (2016–2024 series): 55.4, 50.2, 45.4, 42.4, 39.0, 35.6, 32.1, 30.0, 28.1
- Current account balance (percent of GDP) (2016–2024 series): 3.4, 10.4, 10.1, 9.3, 8.8, 8.5, 8.3, 8.1, 8.0
- Nominal GDP (millions of euros) (2016–2024): 10,343; 11,295; 12,277; 13,203; 14,106; 14,965; 15,830; 16,710; 17,608
- Credit to the private sector (percent of GDP) noted as: 84.4 79.4 (table entry as presented)
- Table 4 (Gross Written Premiums in 2017, € million):
  - Non-life sub-total: Domestic 153, Foreign 1,499, Total 1,652 (Market share percent 100)
  - Life sub-total: Domestic 390, Foreign 279, Total 669 (Market share percent 100)
  - Total: 543 Domestic, 1,778 Foreign, 2,321 Total

*Source: Maltese Authorities; 2017 Eurosystem Household Finance and Consumption Survey; IMF staff calculations; figures and tables as presented in the source content.*

### Appendix I. Risk Assessment Matrix (RAM)

### Appendix I. Risk Assessment Matrix (RAM)

### Risk assessment overview
- The RAM shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff).
- Relative likelihood categories: "low" = probability below 10 percent; "medium" = probability between 10 percent and 30 percent; "high" = probability between 30 percent and 50 percent.
- The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

### Major risks, likelihoods, and expected impacts on financial stability

- Weaker-than-expected global growth
  - Overall Level of Concern: Medium
  - Likelihood of severe realization in 1–3 years: Medium
  - Expected impact on financial stability:
    - The Maltese economy is highly open with exports standing at about 150 percent of GDP in 2017.
    - A secular weak external demand would have an adverse effect on domestic confidence and growth prospects.
    - Cross border spillovers could impact growth and employment through FDI channel, an important source of funding to nonfinancial corporates.
    - Rising unemployment among residents and outflow of foreign workers could amplify the housing price correction, worsening the downward spiral.
    - Transmission channels: adverse impact on exports and GDP growth and financial channels including banks’ foreign exposures.
    - Slower growth and higher unemployment could increase NPLs and lead to higher loan loss impairment impacting bank profitability.
    - Erosion in corporate profits may increase distress due to large share of intercompany lending, potentially leading to cascading defaults among NFCs and spreading into the banking system.
    - Internationally active banks could suffer credit losses on cross-border exposures.
    - Mitigant: Higher-than-envisaged gains from recent large-scale infrastructure projects and labor market reforms may mitigate the impact.

- Rising protectionism and retreat from multilateralism
  - Overall Level of Concern: High
  - Likelihood of severe realization in 1–3 years: Medium
  - Expected impact on financial stability:
    - Heightened uncertainty regarding Brexit, trade tensions, and policymaking in the US may weigh on confidence and adversely affect growth prospects through lower investment and trade.
    - Disruption to passporting arrangements into the UK for insurance and investment firms could be costly.
    - Weaker GDP growth and higher unemployment in EA and UK would adversely impact export and GDP growth.
    - Brexit impacts on financial sector participants (loss of business or direct exposures) could spread via interlinkages and cross-holding relationships.
    - Mitigants: Malta’s trade diversification, excess demand in tourism sector, and possible relocation of firms servicing the EU from the UK to Malta.
    - Loss of market confidence and reduction in market prices of securities held by banks could negatively affect banks’ balance sheets and capital.

- A sharp tightening of global financial conditions
  - Overall Level of Concern: High
  - Likelihood of severe realization in 1–3 years: Medium/Low
  - Expected impact on financial stability:
    - Despite relative insulation from contagion, Malta is vulnerable to weak external demand and lower FDI inflows.
    - Continued monetary policy normalization and stretched valuations increase risk of abrupt change in global risk appetite leading to sudden, sharp increases in interest rates as term premia decompress.
    - Financial stress from continuous confidence shocks would exacerbate fall in asset prices and could result in a credit crunch.
    - Higher debt service and refinancing risks could stress households and firms.
    - Loss of market confidence and increases in risk premia would lead to declines in asset prices, valuation losses, higher funding cost for banks, and affect insurers/funds.
    - A global financial cycle downturn could trigger further reduction in housing prices due to interest rate increases and a drop-in income growth.

- A sharp correction in historically high housing prices
  - Overall Level of Concern: Medium
  - Likelihood of severe realization in 1–3 years: Medium
  - Expected impact on financial stability:
    - After price increases and strong mortgage lending in a low interest rate environment, a downturn poses significant risks to domestically oriented banks given high and rising exposure to property-related loans.
    - Currently strong household balance sheets could provide cushion, but pressure intensifies if accompanied by broader economic slowdown—an increase in unemployment and/or interest rates, limiting recovery.
    - Significant drop in housing prices would reduce collateral values and lower recoveries in default cases.
    - Erosion in profits and capital adequacy at core banks could cause widespread distress with tightening in lending conditions.
    - Credit crunch could trigger negative spiral of low investment and adverse effects on financial stability and growth via wealth and income channels.

- Possible changes in international taxation
  - Overall Level of Concern: Medium/Low
  - Likelihood of severe realization in 1–3 years: High/Medium
  - Expected impact on financial stability:
    - About half of corporate tax base is reliant on foreign-owned companies.
    - Changes in Malta’s comparative tax advantage could impact corporates and demand for its IIP and result in shrinkage of the international sector, including within the financial system.
    - Financial sector contribution (together with ancillary professions) is about 10 percent of Malta’s GDP.
    - Remote gaming sector generates an estimated 10 percent gross value added to the economy.
    - Business exits would erode tax base, increase unemployment, suppress economic growth, and stress public finances spilling into the banking system given strong home bias.
    - Deposit outflows from retrenchment could reduce banks’ liquidity, raise funding costs, and subsequently lending rates.

- Slow progress in effectively implementing the AML/CFT framework
  - Overall Level of Concern: Medium
  - Likelihood of severe realization in 1–3 years: Medium
  - Expected impact on financial stability:
    - Banking sector has large exposures to nonresident customers, internationally-oriented resident companies, new technologies (e.g., VFA, e-gaming), and investments from the IIP, posing ML/TF risks and reputational challenges.
    - Heightened risks could lead to outflows from financial and remote gaming sectors.
    - Materialization of reputational risks could trigger large withdrawals of wholesale and nonresident deposits, as well as deposits of internationally oriented resident companies.
    - Deposit outflows from retrenchment could reduce banks’ liquidity and raise funding costs.
    - High liquidity of banks is a mitigating factor.
    - Exit of domestically oriented banks and de-risking would reduce system capacity to support financial intermediation.

---

### Appendix II. Financial System Features

### Structure and segmentation
- Financial institutions were previously licensed under an offshore regulatory regime restricted from doing business with residents; a unified licensing regime now applies, but strong segmentation persists (geographical concentration of funding sources and assets).
- Authorities group institutions into domestic and international based on exposures to residents and perceived potential effect on financial stability.

### Banking system categories and key metrics
- Authorities' bank classification and features:
  - Core domestic banks:
    - Mainly operate in domestic economy, attract household and corporate deposits, lend domestically.
    - Account for 99 percent of mortgages to residents.
    - Sovereign debt securities account for a quarter of their total assets.
    - Claims on the Eurosystem are high, reflecting excess liquidity.
    - Two core domestic banks each own a large domestic insurer.
  - Non-core domestic banks:
    - Small, foreign owned, funded from wholesale markets and nonresident deposits, limited exposure to residents.
    - Some focus on syndication, factoring and finance; others on private banking and conventional lending.
    - Two banks account for about 80 percent of this category’s assets.
  - International banks:
    - Foreign-owned with insignificant domestic exposures.
    - Account for over 80 percent of the banking system’s total nonresident deposits and 77 percent of lending to nonresidents.
    - Rely mostly on wholesale (including intragroup) funding of relatively long maturities; focus on group custodian services, trade finance, and investment banking.
    - Two branches of Turkish banks account for 83 percent of this category’s assets (€19 billion).

- Supervisory classification:
  - Three largest core domestic banks are classified as SIs.
  - SIs hold 86 percent of category assets (42 percent of total bank assets) and account for 81 percent of all mortgages.
  - Remaining banks are classified as LSIs (18 banks), a subsidiary and a branch of banks of other EA countries (one parent entity is an LSI and one is a SI), and non-EU branches.
  - Non-EU branches are not subject to ECB oversight.

### Banking system statistics (end-2017, extracted figures)
- Exports standing at about 150 percent of GDP in 2017.
- Two branches of Turkish banks account for 83 percent of international banks' assets (€19 billion).
- Core domestic banks account for 99 percent of mortgages to residents.
- Domestic insurers: eight identified; assets totaled 37 percent of GDP at end-2017.
- Domestic investment funds: 46 funds at end-2017 with assets under management amounting to 16.8 percent of GDP.
  - More than 60 percent of domestic investment funds were UCITS funds.
  - Domestic investment funds invest mainly in bonds, accounting for 67 percent of assets under management as of end-2017.
  - About 80 percent of assets under management is managed by banks’ subsidiary fund management companies.

### Branches of two large Turkish banks
- The Turkish branches:
  - Have no direct exposures to the Maltese economy; operate mostly with Turkish counterparties.
  - Do not source deposits locally and do not extend loans to residents.
  - Deposits are not covered by the DCS in Malta (but are subject to deposit insurance in Turkey).
  - About half of their assets are invested in sovereign papers, of which 60 percent is denominated in US dollars.
  - Entire sovereign portfolio is invested in Turkish sovereign bonds.
  - Assets declined from about 300 percent in 2012 to about 140 percent of GDP by mid-2018.
  - Have general banking licenses in Malta without passporting rights into the EU.
  - Special licensing agreements exempt the branches from all prudential rules in Malta, prohibit them from having NPLs on their books, and prescribe NPLs transfer to their head offices’ books.
  - Deal exclusively with customers introduced by the parent bank.

### CBM Methodology to Categorize Institutions for Financial Stability Purposes

- Banking Sector (weights)
  - (i) Credit to residents (30 percent): credit to residents by bank “I” to total resident loans;
  - (ii) Resident deposits (30 percent): resident deposits of bank “I” to total resident deposits;
  - (iii) Holdings of domestic bonds (13.3 percent): domestic bonds held by bank “I” to total outstanding domestic bonds;
  - (iv) Resident contingent liabilities (13.3 percent): resident contingent liabilities of bank “I” to total resident contingent liabilities of the banking sector;
  - (v) Market capitalization (13.3 percent): market values of equities or bonds of bank “I” to total market capitalization of banks in Malta.

- Insurance Sector (equal weights)
  - (i) Shareholding by core domestic banks;
  - (ii) The amount of domestic investment assets held;
  - (iii) The total gross premia written for risks situated in Malta;
  - (iv) The total gross claims paid for risks situated in Malta;

- Investment Funds (equal weights)
  - (i) The extent to which the fund was managed by a core domestic bank;
  - (ii) The amount of resident assets that it held;
  - (iii) The proportion of resident shareholder units in each fund.

Source: CBM.

### Appendix III. Stress Test Matrix (STeM) — Banking Sector: Solvency Risk

### Exercise design and coverage
- Institutional Perimeter
  - Top-down by FSAP team.
  - Institutions included: the top 11 banks by share of assets.
  - Market share covered: 93 percent of total assets in the banking system (excluding foreign bank branches).
  - Data and baseline date:
    - Latest data: December 2017.
    - Supervisory data: balance sheet information, COREP and FINREP, and large exposure (LE) templates provided by the authorities.
    - Additional supervisory information provided (nonperforming loans by portfolio, details of funding by type of depositor).
    - Market and publicly available data used.
    - Scope of consolidation: banking activities of the consolidated banking group for banks headquartered in Malta and subconsolidated level data for subsidiaries of foreign banks.
    - Coverage of sovereign and non-sovereign securities exposures: held to maturity, available for sale, and fair value accounts, valued respectively at amortized cost, MTM, or fair-value at starting point.

### Methodology and channels of propagation
- Methodology
  - Solvency stress test based on International Accounting Standard (IAS) 39 principles (e.g., provisioning approach).
  - FSAP team satellite models and methodologies.
  - Balance-sheet regulatory approach.
  - Market data–based approach.
- Satellite models and approximations
  - FSAP team models and expert judgment for balance-sheet and credit growth, pre-impairment net income as sum of net interest income and noninterest income. No accrued income on NPL loans.
  - Credit loss model for lending portfolios; consumer (nonmortgage) credit risk estimated by benchmark PD and LGD provided by ECB due to unavailability of consistent NPL data series.
  - Credit estimation of loan to credit and financial institutions proxied by Moody’s Expected Default Frequency (EDF).
  - Losses from sovereign debt holdings: haircuts calculated based on a modified duration approach and historical distributions of changes in yield.
  - Losses from bonds and money market instruments: haircuts calculated based on a modified duration approach and historical distributions of changes in yield.
  - Losses from HTM portfolios: credit-rating migration approach.

- Stress test horizon: 2017Q4–2020Q4 (three years)

### Scenarios and sensitivities
- Scenario analysis:
  - Macrofinancial scenario analysis agreed with the authorities.
  - Baseline scenario based on April 2018 World Economic Outlook projections, CBM, and ECB projections.
  - Adverse macro scenario informed by IMF’s Flexible System of Global Models (FSGM).
- Sensitivity analysis:
  - Concentration and interest risks.
  - Interest rate increase and decrease by 200 and 100 bps respectively.
  - Failure of the largest 1, 3, and 5 non-financial corporate exposures.

### Risks, behavioral assumptions, and calibration
- Risks/factors assessed:
  - Credit losses for lending and investment exposures, including indirect risk from foreign exchange book.
  - Losses from debt instruments (sovereign and other issuers) in trading and banking books.
  - Market risk, including foreign exchange risk.
  - Interest rate risk on banking book.
  - Counterparty concentration risk.
- Behavioral adjustments (quasi-static and static balance sheet assumptions):
  - Quasi-static assumptions:
    - (i) Balance sheet growth in line with nominal GDP, with a floor set at zero, accounting for foreign exchange movements and triggered off-balance sheet items (credit lines and guarantees);
    - (ii) Risk weighted assets change due to newly nonperforming loans, triggered off-balance sheet items, and new loans granted during the stress test horizon;
    - (iii) Balance sheet composition/structure remain constant throughout the stress test horizon;
    - (iv) Banks build capital only through retained earnings;
    - (v) Maturing capital instruments (AT1 and Tier 2) are not renewed.
  - Static balance sheet for comparison:
    - (i) Balance sheet growth assumed to be zero;
    - (ii) Maturing assets replaced by exposures of the same type and risk.
  - Dividends can only be paid by banks that remain adequately capitalized and have positive profits.

- Calibration of risk parameters: based on credit models estimated by IMF staff.

*Source: IMF staff compilation from the provided appendices.*

### 5. Regulatory and

### 5. Regulatory and Market-Based Standards and Parameters

### Credit Risk Modeling and Regulatory Framework
- The stress test used satellite models to project credit risk by sector.
- Because all sample banks are under standardized regulatory framework, Probability of Default (PD) and Loss Given Default (LGD) calculations are not readily available.
- NPL ratios were projected using panel regression techniques for two exposure classes: corporate and household mortgages.
- Credit risk estimation of loans to credit and financial institutions is proxied by Moody’s Expected Default Frequency (EDF) series and projected using panel regression model.
- Credit risk for consumer loans (non-mortgage) was estimated by benchmark PD and LGD provided by ECB due to unavailability of consistent NPL data series.

- Regulatory/Accounting and Market-Based Standards:
  - National regulatory framework.
  - Capital metrics: Basel II standardized approach and fully loaded Basel III definition.
  - The hurdle rate based on capital requirements for CET1, T1, Total Capital, and Leverage ratio.
  - Capital conservation buffer is allowed to be used under adverse scenario.

### Reporting Format for Results (Credit)
- Output presentation:
  - Capital ratio decline of the banking system.
  - Number of banks and the percentage of banking assets (or GDP) in the system that falls below a hurdle rate.

### Banking Sector: Liquidity Risk

### Institutional Perimeter and Data
- Exercise: Top-down by FSAP team.
- Institutions included: The top 11 banks by share of assets.
- Market share: 93 percent of total assets in the banking system (excluding foreign bank branches).
- Debt and baseline date:
  - Latest data:
    - December 2017 (LCR and NSFR approaches); and
    - March 2018 (cashflow-based liquidity stress test approach).
  - Source: supervisory data (COREP: LCR, NSFR and ALMM Maturity Ladder template).
  - Scope of consolidation: consolidated banking group.

### Channels of Risk Propagation and Methodology
- Methodology:
  - Basel III LCR and NSFR type proxies, cashflow-based liquidity stress test using maturity buckets by banks, incorporating both contractual and behavioral (where available), with assumption about combined interaction of funding and market liquidity and difference level of the central bank support.
  - Liquidity test in total currency and major foreign currencies.
  - Liquidity test for large depositors’ withdrawals.
  - Liquidity test for certain industry concentration risk for funding.

### Risks and Buffers
- Risks:
  - Funding liquidity.
  - Market liquidity.
  - Counterparty/depositor concentration risk, i.e., withdrawal of top 1, 3, and 5 depositors.
  - Industry concentration risk, i.e., withdrawal of depositor for certain industries, i.e., namely financial and insurance activities sector, accommodation and food service activities, and arts, entertainment, and recreation (including gaming).
  - ECB haircuts for Eurosystem monetary policy implementation as applicable at the reference date.
- Buffer:
  - The counterbalancing capacity, including liquidity obtained from markets and/or the central bank’s facilities.
  - Expected cash inflows are also included in the cashflow-based and LCR-based analysis.

### Tail Shocks and Calibration
- Size of the shock:
  - The run-off rates are calibrated to reflect scenarios of system-wide deposit runs and dry-up unsecured wholesale and retail funding, with additional run-off for nonresident deposits on top of the retail and wholesale run-off, which is calibrated following historic events and IMF expert judgment.
  - For LCR-based liquidity stress test, total run-off rate of nonresident deposits ranged from 33 to 46 percent, depending on the type of deposits (current, saving, and time).
  - The scenario will provide a combination of assumed deposits run-off and approaches to CBC:
    - Withdrawal of unsecured wholesale deposits, with CBC valuation at market price.
    - Withdrawal of unsecured wholesale and retail deposits. Market liquidity shock will reduce the CBC value and will incorporate the central bank haircut.
    - Withdrawal of unsecured wholesale and retail deposits, with additional run-off for nonresident deposits. Market liquidity shock will reduce the CBC value and will incorporate the central bank haircut.
  - The liquidity shocks will be simulated for one month for both LCR and cashflow-based approaches, and five days and three months for cashflow-based approach.
  - The haircut of high-quality liquid assets (HQLA) is calibrated consistent with market shock for investment securities and money market instruments in solvency stress test.

### Regulatory and Market-Based Standards and Parameters (Liquidity)
- Regulatory standards:
  - Consistent with Basel III regulatory framework (LCR and NSFR).
- Standards and Parameters:
  - Liquidity shortfall by bank.

### Reporting Format for Results (Liquidity)
- Output presentation:
  - Liquidity ratio or shortfall by groups of banks and aggregated (system wide).
  - Number of banks that still can meet their obligations.

### Financial Sector: Contagion Risk

### Institutional Perimeter and Data
- Exercise: Top-down by FSAP team.
- Institutions included: Three networks:
  - Cross-border: 21 Maltese banks and 58 non-Maltese banks.
  - Cross-sectoral (domestic): 24 banks, 8 insurers, and 8 funds.
  - Market-based global: 4 listed Maltese banks, 34 global banks.
- Market share:
  - Cross-border: 99 percent of banking system excluding branches.
  - Cross-sectoral: 99 percent of total assets in the banking system, including foreign bank branches, 35 percent of total assets of the insurance industry (100 percent of domestic insurers), 17 percent of total Net Asset Value of investment funds (100 percent of domestic funds).
  - Market-based global: 70 percent of banking system excluding branches (100 percent of market capitalization of listed banks).
- Data and baseline date:
  - December 2017 for cross-border, June 2017 for cross-sectoral, 2005-2018 for market-based.
  - Source: supervisory data (COREP, LE, AMM, AE, LCR, FINREP) for cross-border, proprietary MFSA dataset from various supervisory reports for cross-sectoral, Bloomberg for market-based.
  - Scope of consolidation: consolidated (sub-consolidated for subsidiaries) only within own sector.

### Channels of Risk Propagation and Methodology
- Methodology:
  - Cross-border and cross-sectoral: Espinosa-Vega and Sole Bank Network Model (2010) framework and calibrated based on Covi, Gorpe, and Kok (2018) CoMap methodology.

### Tail Shocks
- Size of the shock:
  - Pure contagion: hypothetical default of institutions.

### Reporting Format for Results (Contagion)
- Output presentation:
  - Number of undercapitalized institutions in distress;
  - Capital shortfall systemwide, by bank and by group: contagion and vulnerability scores.
  - Amplification and cascade effects, direction and size of spillovers within the network.
  - Net spillovers due to interconnectivity (market based).

### Appendix IV. Development of Virtual-Asset Regulations

### Legal and Institutional Developments
- Malta actively embraces blockchain technologies and virtual assets and seeks a financial innovation-friendly regulatory approach.
- In July 2018, the parliament passed three acts that seek to provide a legal status and regulatory framework for virtual assets.
- The framework determines that a financial group will not be allowed to operate VFA-related operations until it establishes a separate entity within the group.

### Financial Instrument Test and Implementation Risks
- A financial instrument test is used to determine regulatory requirements for a VFA under distributed ledger technology. It seeks to provide clear guidance to issuers, exchanges, or other service providers as to whether they are subject to:
  - (i) the existing EU legislation and corresponding national legislation;
  - (ii) the proposed VFA Act; or
  - (iii) exemption from any financial regulation.
- A guidance note provides more details of the criteria, but it is uncertain how some criteria would be interpreted, assessed, and implemented.
- Although all innovative technology arrangements need an opinion issued by a system’s auditor, the authorities could face the risk of manipulation or misrepresentation from the issuer, partly due to the limitation of their access to relevant information, such as the source code.

### Digital Innovation Authority (DIA) Powers and Limitations
- The Digital Innovation Authority (DIA) is tasked with promoting and enforcing ethical and legitimate criteria in the design and use of innovative technologies. It will have enforcement powers to investigate technology applications and take regulatory actions, including suspension and revocation of the certification.
- Limitations and risks:
  - The authority will not be able to access the source code and other information protected by the cryptographic keys.
  - It would face the reputational risk of endorsing unsuccessful technologies.
  - Separation of powers between the MFSA and DIA would help prevent reputational contagion to the financial regulator, but public reputation could be affected in case of material investment loss among retail investors.

### Cross-Border Enforcement and Reputational Risks
- Challenges from cross-border nature of the business model:
  - Innovative Technology Arrangements and Services Act requires agents to be located in Malta and gives the authorities some enforcement powers against these agents, but authorities may not have the same level of suasion as over traditional financial institutions.
  - Cooperation with foreign authorities may be limited to mutual legal assistance in criminal cases as some foreign authorities may not have the necessary regulatory and enforcement powers with regard to these activities.
  - Reputational risk from the use of the “Malta DIA technology certification” brand by firms offering products and services outside Malta.

### AML/CFT and Implementation Recommendations
- Authorities are encouraged to continue addressing ML/TF risks related to virtual currencies.
- Authorities are working on amendments to introduce AML/CFT obligations related to virtual currencies, including issuance of a legal notice by the FIAU and relevant guidelines.
- Changes to the AML/CFT regulations will expand the definition of “subject person” to include issuers, VFA agents, and license holders.
- The coverage falls slightly short of the Financial Action Task Force definition of VFA by excluding virtual tokens.
- It is important for the authorities to complete any updates to the legal framework in an expeditious manner to avoid ML/TF and reputational risks that may arise from any (temporary) gaps in the AML/CFT framework.

### Implementation Pace and Capacity Considerations
- While the establishment of a legal framework is welcome, the high risk of virtual-asset investments warrants cautious implementation.
- Effective implementation will require significant resources with appropriate expertise, such as cyber risk experts, technology experts and lawyers specialized in technology, creating additional challenges for financial authorities to build and retain expertise.
- Future technological developments may pose new challenges.
- Authorities are strongly encouraged to implement the relevant laws and regulations gradually.
- Suggested safeguards include adopting strict Sandbox conditions, such as periodic renewal of any license, allowing licensing requirements to be amended in line with evolving international practices.

*Prepared by Nobuyasu Sugimoto (MCM), with contributions from staff from MCM and the Legal Department, IMF.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1mltea2019003.pdf_