Nonbank Sources of Corporate Financing in Malta1
Maltese corporates’ access to bank lending remains limited, with high costs of borrowing and loans concentrated in the large companies’ segment, while the banking system focuses on balance sheet repair from legacy nonperforming loans (NPLs). At the same time, alternative funding channels to bank credit have developed, with intercompany lending taking the most prominent share of financing.2 In addition, direct issuance of debt securities and credit from nonbank financial institutions (NBFIs) have been growing rapidly, albeit from a low base.3 This calls for close monitoring and consideration of supervisory and macroprudential measures to this part of the financial sector while its size is still small and vulnerabilities have not materialized.
1. Since 2011, traditional bank lending to nonfinancial corporations (NFCs) has been on a declining trend in Malta. Against a background of increasing regulation, increased risk aversion, and an elevated share of legacy corporate NPLs, banks have shifted their lending activity from NFCs to households, particularly mortgages. Loans to NFCs have contracted from approximately 62 percent of GDP (53 percent of total bank loans) in 2009 to 31 percent of GDP (35 percent of total bank loans) in the first half of 2017, owing to both demand and supply side factors (Darmanin, 2017). The largest part of the contraction has been driven by the construction sector, followed by retail and transport. Meanwhile, NFCs’ nonbank financing increased significantly from 59 percent of GDP in 2009 to 95 percent of GDP in the first half of 2017, representing mainly an increase in inter-company loans, but also loans from nonbank financial institutions.
Malta: Corporate Sector Financing
Sources: Central Bank of Malta and IMF staff.
2. At the same time, private investment has increased considerably across sectors in recent years. Despite the decline in bank loans, and pointing to a shift to alternative financing sources, investment in Malta remained strong, with private sector’s gross fixed capital formation (GFCF) increasing substantially to around 25 percent of GDP in 2015 and 2016, from 17 percent of GDP in 2014. The largest sectoral contributors to the increases in GFCF have been the energy and aviation sectors.
Malta: Private Sector Investment
3. Against this background, this paper examines recent trends for sources of corporate financing other than bank loans in Malta. In particular, the paper discusses (i) the causes for the shift out of bank loans; (ii) the large role played by intercompany loans in corporate funding; (iii) the growing role of market funding through debt securities and of NBFIs corporate loans; and concludes with (iv) policy implications.
B. Disintermediation and Nonbanks: Trends for Corporate Financing in Malta
4. The cost of bank borrowing for corporates in Malta is among the highest in the euro area. The average interest rate paid by Maltese companies in the first half of 2017 stood at approximately 200 basis points above the euro area average, with the spread widening in recent years as euro area average rates registered a faster decline than those in Malta. Among euro area peer countries, only Greece and Cyprus have higher average interest rates for corporate loans. The high lending rates reflect several factors, including the limited competition in the NFC lending market,4 and an elevated level of legacy impaired loans, which—although declining—continue to weigh heavily on bank balance sheets. Additionally, Maltese corporates remain quite indebted compared with peer countries, reflecting in part many family-owned firms that have low equity. Finally, the shift of corporate activity towards services may also imply less availability of collateral for securing corporate loans and, with a less capital-intensive production, a decreasing financing need.
Malta: Declining Bank Loans and High Interest Rates
Sources: Central Bank of Malta, European Central Bank, and IMF Staff.
Malta: New Bank Loans to Corporates by Size of Loan
Sources: European Central Bank and IMF Staff
1/ Spread calculated as average from December 2007 to date of Interest rate charged for loans above 1 EUR million and below EUR 1 million.
5. New business volumes for corporate loans are both declining and concentrated in the large companies’ segment. New bank lending to NFCs has declined significantly across all categories of firm size. Nonetheless, the credit supply constraints in Malta affect disproportionately small and medium-sized enterprises (SMEs), with the volume of bank loans extended to SMEs—proxied by the smaller loan sizes—taking a tiny share of new loans. In a further sign of credit rationing for SMEs, the interest rate spread for small loans over larger loans has been increasing significantly.
Malta: Persistently High Debt-to-Equity Ratio
Sources: European Central Bank and IMF staff
6. Strong profitability in the past few years may have supported firms’ overall financing needs. The 2016 EU Survey on the Access to Finance of Enterprises (SAFE and Zerafa, 2017) showed that only seven percent of respondents highlighted access to finance as the most important concern. While this share has increased over time, the relatively low percentage may reflect the emergence of alternative financing sources, including the recent increase in firms retained earnings, which is well above levels seen in the euro area. Indeed, about a quarter of Maltese firms surveyed reported that retained earnings has become a significant source of financing for investment and working capital.
Profit Share in Euro Area Countries
Sources: Central Bank of Malta, Eurostat, and IMF Staff.
7. Maltese corporates changed their financing mix considerably in the past decade. Corporates have so far succeeded in diversifying their financing out of bank lending by developing a significant domestic intercompany loan market, which has replaced bank lending as the main source of financing. Between 2007 and 2017, loans have remained the primary source of corporate funding amounting to 80 percent of overall non-equity liabilities. However, in the same period, banks’ share in overall corporate loans fell from 49 to 25 percent, while intercompany loans increased from 25 to 45 percent. In addition to the increase in intercompany lending between domestic NFCs, external borrowing continues to provide approximately a fifth of loan financing, including direct investment financing from parent corporates. Therefore, while the bulk of intercompany lending is between resident corporates, loan financing includes a significant foreign component in the context of direct investment relationships with a foreign parent corporation. Although still small at two percent of corporate loans, credit from NBFIs—albeit partially reflecting SPE-channeled FDI—is growing fast and the sector is expanding both in terms of size and in terms of variety of operating institutions.
8. Debt securities issuance resumed after a few subdued years, and the households’ sector purchased most of the debt securities issued by Maltese corporates. Households financing of corporates increased marginally between 2007 and 2017, but the composition of this financing shifted to include a larger amount of debt securities. In the same period, holdings of corporate debt securities by households increased approximately fourfold. The change is significant, as households’ loans to corporates usually represent lending to family-owned enterprises, while the holding of corporate debt securities is a new lending channel for the entire corporate sector. Issues of debt securities are sold by Maltese firms to households through financial brokerages. Although most of these issues are not rated, the current low interest rate environment and the search for yield contributed to an increase in demand for these instruments by savers.
Malta: Corporate Debt Securities Issued by Holding Sector
Sources: Central Bank of Malta, European Central Bank, and IMF Staff.
C. Large Intercompany Lending: A Stabilizer for Corporate Funding?
9. Intercompany lending has become the largest source of corporate funding in Malta. Following the decline in bank credit, intercompany loans between domestic corporates have grown considerably to represent approximately 30 percent of corporate non-equity liabilities in 2017, from 15 percent in 2007. Loans between corporates have provided a stable source of funding mostly for Maltese firms, but their systemic importance raises macrofinancial questions regarding a possible buildup of vulnerabilities within the corporate sector. When compared to peer countries, the share of intercompany loans in Malta is the largest in the euro area.
Malta: Highest Intercompany Loans in the Euro Area
Sources: European Central Bank and IMF Staff.
10. Intercompany lending remains subject to a lower macrofinancial scrutiny, despite common characteristics with financial intermediation. Although some of the short-term lending between domestic corporates may help them to manage surplus liquidity, around half of intercompany loans are long-term (above one year of maturity), potentially raising credit risk concerns for lending NFCs. These large illiquid claims within the corporate sector may pose financial stability issues, as a negative shock to profitability in a corporate could spread to its creditors and eventually lead to increasing corporate defaults. Vulnerabilities could possibly spillover to the banking system, if the corporate that provided the loan ultimately financed its activities using bank loans.
Malta: Intercompany Loans and Direct Investment1
Sources: National statistics Office, Central Bank of Malta and IMF staff.
1/ Inward direct investment in nonfinancial sectors.
11. An additional important source of funding is direct investment from foreign corporates. Malta’s business-friendly environment continued to attract FDI flows and nonfinancial corporate liabilities to foreign parent corporations stand at approximately 30 percent of GDP. Although this type of funding is generally stable and does not pose financial stability issues in the case of Malta, it may provide a channel for cross border spillovers with possible effects on growth and employment, as well as on fiscal and external positions.
D. Nonbank Financial Institutions Lending: Small but Fast Growing
12. Corporate loans by domestic NBFIs are small, but growing fast. Domestic NBFIs provide credit to corporates mainly in the form of long-term loans and trade credit. Although still relatively small (about 2 percent of GDP in 2017Q2) and possibly reflecting some FDI funding channeled through domestic SPEs, corporate loans issued by NBFIs have quadrupled since 2007 and could emerge as an important funding source for NFCs. On the other hand, domestic institutional investors (insurers and investment funds) do not play a significant role in financing of corporates.
13. NBFI loans are concentrated in the SME segment, but available data do not distinguish the types of institutions involved in lending. Among NBFIs that can lend to the corporate sector, loan funds are a newly established category of NBFI, which invest in loans to unlisted companies and SMEs and are not permitted to lend to financial institutions or individuals. Loan funds are established as “professional investor funds” and their liabilities cannot be sold to retail investors. At present, they do not originate loans but invest in existing loan portfolios and their size is currently small. Factoring companies are NBFIs whose business is to provide credit to corporates by buying invoices and other accounts receivable at a discount. Loans to corporates by other NBFIs, though possible per Maltese financial sector law, is at present not significant.
Malta: Loans to Nonfinancial Corporations
Sources: Central Bank of Malta, European Central Bank, and IMF Staff.
14. Finally, trade credit also plays a significant role in corporate financing by NBFIs. According to the SAFE 2016 survey, over 80 percent of Maltese firms responded that trade credit is a relevant source of financing. NBFIs hold approximately a quarter of this type of claim on corporates, with some significant amounts representing claims by holding companies on local subsidiaries.
E. Policy Implications
15. Restoring the bank lending channel for corporates. The diversification of funding has supported the operations and investment activity of Maltese corporates in recent years. While overall this is a welcome development, it partly reflects the impairment of bank lending to SMEs. Advancing the resolution of distressed legacy loans would help restore the bank lending channel for corporates and support a better functioning of the monetary policy transmission mechanism. The recently introduced Banking Rule requiring banks to reduce their NPL ratio to below six percent is a welcome step and will help banks to free up resources and reduce the cost of corporate lending. As lengthy insolvency proceedings remain a key impediment for the resolution of distressed loans, further improvements in the insolvency process in addition to the recent amendments to the Companies Act, remain critical.
16. SME lending by the Malta Development Bank (MDB) should be managed prudently. The MDB is a public financial institution that was established in May 2017 with the MDB Act, following which the Board of Directors and Supervisory Board were recently appointed. The MDB is expected to commence operations in 2018, and provide SME loans via commercial banks. Although this is expected to improve SMEs access to bank credit, the MDB structure should ensure adequate checks and well-designed origination rules to avoid evergreening or guaranteeing existing bad loans.5 This is particularly important in view of the government’s already large contingent liabilities.
17. Potential financial stability implications of intercompany lending should be closely monitored. Intercompany lending in Malta has replaced bank lending in becoming the most prominent funding source for corporates. While this development seems to have served well the corporate sector’s financing needs and may be evidence of cross-ownership relations between firms in Malta, the unusually large size of lending among domestic corporates may create contagion risk. Moreover, given that a significant amount of these loans is long-term, they provide a stable source of funding for borrowing corporates, but are a riskier asset for creditor corporates, which could be more difficult to liquidate in case of financial stress. In addition, intercompany lending is not subject to diversification principles, with the result that concentrated exposures to specific borrowers or sectors may emerge. Although lending between unrelated entities is in principle subject to licensing by the Malta Financial Services Authority (MFSA), the intercompany lending phenomenon has not been fully assessed by the authorities due to lack of granular data and assumption that most of these loans reflect intra-group activity. Stepping up efforts to better monitor intercompany liabilities would help mitigate financial stability risks.
18. The regulation and macroprudential oversight of NBFIs engaged in lending should be strengthened. Better monitoring NBFI activity would help ensure that credit provision by these institutions does not lead to excessive buildup of corporate leverage or large indirect exposures of banks to corporates, particularly if concentrated in specific sectors. Moreover, disclosure and reporting frameworks for NBFIs must be improved. Although some NBFIs report data to satisfy the requirements of the ECB’s statistical regulations and of other EU regulations (e.g. Solvency II for insurance), sectoral balance sheets are not available for all types of NBFIs, making it hard to understand linkages between NBFIs and other sectors in detail. This task is especially important given the increasing, albeit still small, role of “shadow banking” institutions in the provision of credit intermediation. The CBM and the MFSA are currently in the process of pooling resources to improve the statistical and balance sheet coverage of NBFIs.
Prepared by Giovanni Ugazio. The author is grateful to participants of a workshop hosted by the Ministry of Finance for their useful comments and suggestions.
Intercompany lending in this paper is defined as lending between domestic nonfinancial corporations (NFCs), including unrelated NFCs and intra-group lending. The two concepts cannot be disentangled due to data availability.
In this paper, NBFIs include all financial institutions excluding monetary financial institutions (MFIs).
Two domestic banks provide about 80 percent of the bank loans to the NFC sector.
The MDB is designed to complement other initiatives to promote SME lending such as the Joint Assistance Initiative for Maltese Enterprises (JAIME).