A. Scope of the Note¹

1. This Technical Note analyzes the bank failure mitigation and resolution regime in Malta, as well as arrangements for preparing for and managing a financial crisis. It summarizes the findings of the FSAP mission undertaken during the period September 1 0 –26, 2018. The Not e addresses the supervision of recovery planning by banks, early intervention in banks by the authorities when problems are identified, resolution planning by the resolution authorities, the institutional and legal framework for bank resolution and financial safety nets, and the authorities’ preparedness to deal with a potential system-wide crisis. It also considers recovery and resolution planning for significant insurers with links to banks. The assessment presented in this Note is based on an analysis of the legal framework and documentation relating to policies and procedures, and on discussions with and representations made by the authorities and the private sector. The Note does not represent an assessment of adherence to relevant international standards, especially the Key Attributes of Effective Resolution Regimes for Financial Institutions and the Core Principles for Effective Deposit Insurance Systems,² though those standards serve as a frame of reference for certain recommendations cited in this Note.

B. Financial Sector Landscape

2. Three banks in Malta are designated as SIs by the ECB ³,⁴

• Bank of Valletta, the largest bank in the country, with 44 percent of total deposits, is 25 percent owned by the government, and it is sole shareholder of an asset management subsidiary and investment management subsidiary, as well as a minority shareholder in a local insurer ⁵ and a 50 percent owner of one of the two dominant life insurers in Malta.⁶

• HSBC Bank Malta, with a 21 percent share of total deposits, is an indirect subsidiary ⁷ of HSBC Bank Plc, based in the United Kingdom, and is sole shareholder of the other major life insurance subsidiary and of an asset management subsidiary.

• MeDirect Bank is owned by a Malta registered holding company that is ultimately owned by a hedge fund based in the United Kingdom. MeDirect is a largely internet-based bank⁸ with an 8 percent market share of total deposits in Malta. The bank owns another internet-based bank in Belgium of comparable size.

3. Other banks are also of domestic importance . Among the six banks classified as core banks by the CBM, in that they mainly service the domestic market, are BNF Bank, Lombard Bank, and APS Bank. BNF Bank is owned by Qatari investors. Lombard Bank is 49 percent owned by the National Development and Social Fund. APS Bank is majority-owned by the Archdiocese of Malta and Gozo.⁹ Five other banks serving the domestic market are classified by the CBM as noncore. Some 80 percent of the assets of these five are concentrated in FIM Bank and Sparkasse Bank. FIM Bank, Malta’s fourth largest bank, is owned by investors in Kuwait and Bahrain. Sparkasse Bank is part of the Austrian group of the same name. Three of the banks are designated as HP-LSIs.

4. There are 14 other banks operating in the market which do business largely with nonresidents and are classified as inter national banks by the CBM. These include two branches of Turkish banks with balance sheets comparable in size to that of the Bank of Vallett a.¹⁰ The others are small banks, including a branch and a subsidiary of EU banks. The MFSA has intervened into the operations of two banks previously classified as international banks, Nemea Bank and Pilatus Bank. In both cases, the MFSA requested the ECB to withdraw the banks’ license. ¹¹ The deposits of the banks are eligible for Malta DCS coverage, whereas the deposits of the two Turkish branches are not.¹²

5. The two large life insurers are potentially systemic. Together, HSBC Life and MSV Life (Bank of Valletta) have a 95 percent share of the life insurance market in Malta.¹³ Both are fully dependent on their associated banks to distribute their products.

C. Legal Framework

6. Multiple laws and regulations govern the management of problem and failing banks in Malta. The legal framework was amended and enhanced with the transposition of the EU Bank Recovery and Resolution Directive (BRRD) and Deposit Guarantee Scheme Directive in 2015. The BRRD was transposed by means of the issuance of the Recovery and Resolution Regulations under the MFSA Act, along with relevant amendments to the MFSA Act itself. The Deposit Guarantee Scheme Directive was transposed by means of the DCS Regulations under the MFSA Act. The legal framework relevant for this Note also includes the Banking Act, the Central Bank of Malta Act, the Companies Act, the Controlled Companies Act, and the Bank Reorganization and Winding-up Regulations issued under the Banking Act.

7. The Insurance Business Act provides the legal framework of managing failing insurers. The Act also addresses early intervention measures to deal with problems insurers.

D. Recent Crisis Experience

8. There have been two recent instances of bank failure . These are the first two bank failures in Malta since the 1970s and were managed by the Bank Supervision Unit (BSU), SC, and the MFSA Board in its supervisory capacity. The legal framework underlying these cases, and the legal, policy, and procedural issues they give rise to, are explained and discussed in subsequent sections of this Note. These brief descriptions of the two cases are drawn from information in the public domain.

9. The MFSA appointed a CP to Nemea Bank in April 2016 and its license was withdrawn by the ECB in March 2017. The appointment of the CP followed a joint MFSA/ECB onsite inspection.

• On April 20, 2016, subsequent to conducting an analysis to determine if it would be in the public interest to put Nemea Bank into resolution, the RC decided that normal insolvency proceedings were the best course of action. The MFSA as competent authority was informed accordingly.

• On April 2 7 , 2016, t he M F SA appointed a CP to take charge of the bank’s assets and assume control of its business. It also announced that the bank had been issued a Directive regarding accepting new deposits and deposit withdrawals. The public notice cited a number of serious regulatory shortcomings that were identified during the inspection. By way of separate public notice on the same day, the MFSA restricted depositor withdrawals to €250 per day and prohibited acceptance of new deposits.

• On July 18, 2016, the M FSA incr eased t he daily wit h drawal limit t o €2,500 per day and maintained the prohibition on accepting new deposits. This easing was subject to the condition that the present maturities of deposits are maintained and that no term deposits be withdrawn before their stated maturity dates. The MFSA also confirmed ongoing discussions with shareholders on ensuring necessary actions to address regulatory shortcomings.

• On January 20, 2017, the MFSA issued a public notice stating that it had asked the ECB to initiate the process to withdraw the bank’s license on the grounds of lack of tangible progress in fulfilling regulatory requirements. The notice stated that the MFSA had issued a Directive to the bank to block further deposit withdrawals. After following its internal procedures, the ECB with drew the license on March 23, 2017.

• On March 30, 2017, the MFSA triggered a deposit pay out by the DCS.

• At time of writing (October 2018), the CP remains in place and the bank has not been placed in liquidation pending an appeal of the ECB’s decision to the Court of Justice of the European Union by bank shareholders.

10. A CP was appointed to Pilatus Bank in March 2018 and a request to withdraw its license submitted to the ECB in June 2018.

• On March 20, 2018, the bank ‘s ultimate beneficial owner , chair man , and chief executive officer (CEO) was indicted in the United States.¹⁴

• On March 21 , 2018, the MFSA issued public notices stating that it had issued a Directive to the bank to cease all transactions, and that it had removed the bank’s CEO and suspended his voting rights.

• On March 22, 2018, the MFSA appoint ed a CP to take charge of the bank’s assets and assume control of its business.

• On May 3, 2018, the RC, following discussions with the MFSA as competent authority, made a Public Interest Assessment to determine the preferred strategy for Pilatus Bank. The decision of the RC was that normal insolvency proceedings were the best strategy as they would meet the resolution objectives at least to the same extent as a resolution under the BRRD. This decision was communicated to the MFSA as competent authority.

• On June 30, 2018, the M FSA submitted a draft decision to the ECB requesting withdrawal of the bank’s license on the grounds of unsuitability of the ultimate beneficial owner and breach of regulatory liquidity coverage.¹⁵

• At time of writing (October 2018), the ECB had not yet decided on this request.¹⁶ Should the license be withdrawn, it is not anticipated there will be any cost to the DCS. The bank’s covered deposits, which represent only a small proportion of total deposits, are fully matched by a contingency contribution in favor of the DCS by Pilatus Bank, held in cash at the CBM. This arrangement was a condition of the bank’s license (granted in January 2014).

A. Institutional Framework, Operational Capabilities, and Legal Protections

11. Like other members of the Banking Union, the ECB and the SRB play a significant role in bank supervision and resolution in Malta. The roles of the ECB under the Single Supervision Mechanism and the SRB under the Single Resolution Mechanism mainly fall into three categories: (i) the exercise of direct supervision powers by the ECB and resolution planning and resolution decision-making powers by the SRB over the institutions under their respective remits;¹⁷ (ii) the oversight of the National Competent (Supervisory) Authorities by the ECB and National Resolution Authorities by the SRB; and (iii) if deemed necessary to ensure consistent application of supervisory and resolution standards, the direct exercise by the ECB and SRB of their respective powers for institutions under the purview of the National Competent Authorities and National Regulatory Authorities.

12. The domestic financial authorities nonetheless continue to play critical roles. The domestic authorities relevant to this Note are the MFSA, the CBM, and the MFIN. The MFSA is both Malta’s National Competent Authority and National Resolution Authority. As the national resolution authority it is responsible for the resolution planning arrangements, including the Malta component of the Single Resolution Fund (SRF).¹⁸ The DCS is responsible for its funding arrangements.¹⁹ The MFSA contributes substantially to the work of the ECB and the SRB with respect to Maltese banks by participating in ECB Joint Supervisory Teams and SRB Internal Resolution Teams, and is responsible for all banks/groups not under the remit of those two institutions. The MFSA as the national resolution authority also is responsible for conducting a Public Interest Assessment to determine whether a bank goes into normal insolvency proceedings or resolution; for executing all resolution actions, including those decided upon by the SRB; and for participating in SRB governance by means of its representation in SRB Extended Executive Sessions and Plenary Sessions.

13. The MFSA Board of Governors serves as the Resolution Authority for banks but does not take resolution decisions, which under the MFSA Act are taken by the RC . The RC has all the powers assigned to a Resolution Authority under the BRRD and is supported by the RU (see paragraph 14). The RC is composed of three persons, only one of which appointed by the MFSA, with the other two appointed by the CBM and the MFIN (the latter is currently the chair).²⁰ Members are appointed for three-year terms and can be reappointed once. The presence of MFIN and the relatively short term of the RC member’ mandate does not support the perception of operational in dependence from political influence. ²¹ The operational independence of the de facto Resolution Authority should be strengthened by changing the RC´s composition to all independent members²² and prescribing terms for its members that are longer than the national election cycle. The RC should only consult with the MFIN for decisions entailing the use of public funds (or potential use of public funds). The RC and RU functions are sufficiently separated from MFSA’s supervisory functions, vested ultimately with the SC. The RC reports directly to the MFSA Board (acting as the Resolution Authority) and takes resolution decisions based upon the recommendations of the RU. It communicates resolution decisions to the Board/RA and implements those decisions. It must notify the Minister of Finance regarding its resolution decisions (ex post) and must seek the minister’s written approval prior to taking any decisions that may have a direct fiscal impact or which have systemic implications. The RC administers the Malta component of the SRF, issued the Recovery and Resolution Regulations, which transposed the BRRD, and may issue binding and timebound directives to individuals. While the law does not formally designate it as such, the MFSA Board also is the authority for the resolution of insurers.

14. The RU carries out the functions assigned to it by the RC. The RU is responsible for resolution planning, undertaking resolvability assessments, and executing resolution actions as determined by the SRB or RC. The RU may also assess whether an institution is failing or is likely to fail and make a recommendation to the RC.²³ The RU is led by the RU Head and currently has nine staff and two additional as yet unfilled positions.²⁴ The unit’s budget is proposed by the RU Head, and, as with all MFSA units’ budgets, is discussed with the Chief Operations Officer and ultimately approved by the MFSA Board. The RU Head represents the MFSA in SRB governing bodies. The RU may draw upon other MFSA staff and contract with external consultants in time of need. Currently, there is no framework specifically governing the resolution of insurers, and the RU plays no direct role in resolution work related to insurers. However, it does engage with the MFSA’s Insurance and Pensions Supervision Unit (IPSU) regarding consultation papers, etc., issued at European level on the subject.²⁵

15. In summary , at present the Board/RA serves mainly as a policy-making body, the RC as the resolution decision maker, and the RU as the operational body undertaking planning and analysis, making recommendations on decisions, and executing decisions. The RU Director (and staff) meet periodically with the RC to report on activities and developments. In 2017, five such meetings were held and in 2016 six meetings were held. SI resolution plans and matters associated with the two recent bank failures have been the primary focus. The RU prepares a quarterly report on its activities, which is endorsed by the RC and provided to the Board (acting as the Resolution Authority). The RU also makes periodic reports to the Domestic Standing Committee.²⁶

16. Approved RU staffing levels appear inadequate. The unit’s work program currently includes significant engagement with the SRB and its Internal Resolution Teams to formulate resolution strategies and develop resolution implementation plans for SIs, assessing and deciding on resolution strategies, and implementation plans for HP-LSIs, and for weak LSIs. It also contributes to SRB policy development and participates in SRB governing bodies, prepares Handbooks of policies and procedures for implementing resolution tools, and participates in Crisis Management Task Force efforts to develop an interagency crisis preparedness framework. This Note makes recommendations regarding a number of matters that imply additional work for the RU, including (i) supporting decision making regarding bank insolvency cases; (ii) undertaking legal analysis to support a revision of the bank insolvency regime; (iii) the development of additional written policies and procedures; and (iv) accelerating resolution planning. ²⁷ Furthermore, commencing work on resolution plans for systemic insurers will require additional qualified staff. A review of the adequacy of RU staffing levels should be commissioned by the MFSA Board and its resources increased accordingly.

17. Legal protections are afforded MFSA staff but not contracted third parties such as CPs appointed by the MFSA as part of an intervention in a bank. The MFSA Act provides the Board, management, and staff with adequate legal protections.²⁸ The Act does not provide for indemnification of legal expenses incurred by staff when defending themselves and does not cover third parties. Indemnification of staff legal expenses, however, is outlined in the staff handbook, which forms part of the contractual relationship between the MFSA and its employees. Reportedly, it is the intent to consolidate various sectoral legislative provisions extending legal protections to MFSA staff into a single provision in the MFSA Act. As part of this effort, the authorities should extend legal protections to third parties, such as CPs, and to make explicit the provision to indemnify legal costs. Operational arrangements to make legal protection effective should also be introduced, covering such issues as the choice and (timing of) payment of legal representation and liability, and legal aide insurance covering realistic monetary amounts.

18. The DCS is a “paybox” within the MFSA. The DCS is administered by a Management Committee comprised of seven members (who also make up the Investor Compensation Scheme).²⁹ The administration of the DCS vests with a secretariat housed within the MFSA, including a senior manager, lawyer, statistician, and two analysts. The RU Head serves as the secretary to the Management Committee. The members of the Management Committee are legally protected in the same manner as the members of the RC and staff of the RU by virtue of provisions of the Investor Compensation Scheme Regulations.³⁰ While operationally independent, the DCS is exposed to potential inaction by the MFSA Board in its supervisory capacity, a matter addressed in Part F of this Section of the Note.

19. RU staff are appropriately engaged in existing resolution colleges. Staff participate with the SRB in the Bank of England Crisis Management Group (resolution college) for the HSBC group.³¹ The RU communicates its views through the SRB. The RU has only limited involvement in the resolution college for a euro area bank, which has a small subsidiary in Malta that is classified as an LSI and is deemed not to have critical functions in Malta. The participation in the resolution college mainly involves collecting certain data that is forwarded to the college and providing comments on draft resolution plan.

20. Summary of Recommendations:

• Strengthen the RC´s independence by changing its composition to all independent members and prescribing terms for its members that are longer than the national election cycle;

• Amend law such that the requirement for the Minister’s prior written approval for decisions that have systemic impact is limited to those which have potential fiscal implications;

• Undertake a review of the adequacy of RU staffing levels and increase its resources accordingly;

• Extend legal protections to third parties and make explicit in law the provision to indemnify legal costs.

• Introduce operational arrangements to make legal protection effective, covering such issues as the choice and (timing of) payment of legal representation and liability, and legal aid insurance covering realistic monetary amounts.

B. Recovery Planning and Early Intervention

21. As noted , the supervision of Malta banks, including recovery planning and early intervention, is a joint exercise between the ECB and the MFSA. The ECB-led Joint Supervisory Teams are responsible for supervision of Sis, whereas BSU staff supervise HP-LSIs and LSIs. The Joint Supervisory Teams are led by ECB coordinators, with a sub-coordinator and staff from MFSA. In the assessment of SI recovery plans the joint teams are supported by ECB experts from different departments.³²

C. Insolvency and Special Resolution

33. Multiple laws and regulations may govern the failure of banks. Besides the Companies Act, which may apply, bank failure is addressed in the Banking Act, the Controlled Companies (Procedure for Liquidation) Act, the Credit Institutions (Bank) Reorganization and Winding Up Regulations, and the Recovery and Resolution Regulations. ⁵¹ This part of the Note assesses the legal regimes for banks that are non-systemic and for those that are potentially systemic in failure.

D. Resolution Planning, Strategies, and Impediments

49. The SRB and RU lead resolution planning. For the four banks under the authority of the SRB, ⁶⁹ resolution plans are prepared by the SRB Internal Resolution Teams supported by staff from the RU in consultation with BSU staff.⁷⁰ For other banks, the plans are being prepared by the RU and will be endorsed by the RC and sent for comment to the SRB and the MFSA Board (as the Resolution Authority). The inter-agency DSC ⁷¹ is kept informed of the status and any significant issues arising in the course of resolution planning.

50. Resolution planning remains a work in progress. Resolution plans for two of Malta’s three SIs were prepared starting in 2016 and are now undergoing their third annual iteration. The resolution plan for the third SI is the responsibility of the Bank of England-led Crisis Management Group,⁷² and the SRB and the RC are working to ensure more explicit and complete treatment of the Malta subsidiary in that plan . In late 2017, t h e RU initiated resolution planning for banks designated as HP-LSIs. Initial resolution plans for two of the HP-LSIs is expected to be completed in 2018, and for the third in early 2019. Resolution plans for certain problem banks have also been developed. Initial plans for other banks are expected to be completed by end-2020. In general, resolution plans in most cases have not yet achieved the ultimate goal that they be credible⁷³ and feasible.⁷⁴ Continued effort in resolution planning is necessary and efforts should be made to accelerate the timetable for any particularly weak small banks.

51. Formal resolution planning by the authorities for the two dominant life insurers has not yet been initiated. As noted, the feedback provided by the MFSA’s Insurance and Pensions Supervision Unit on the insurers’ internal Own Risk and Solvency Assessment appropriately addresses recovery and resolution planning by the firms. There is scope for the MFSA, including the RU, to consider possible resolution measures for the insurers, and the consequences for the insurers of resolution of the banks with which they are associated, and vice versa. Responsibility for resolution planning for significant insurers should be assigned within the MFSA and work initiated, ensuring integration into the plans of the relevant banks.

52. A key component of resolution planning is to decide on the preferred resolution strategy (P RS) for each bank. The PRS for a bank could specify the use of one or more of the resolution tools or, alternatively, the use of insolvency proceedings.⁷⁵ The PRS for one SI has been agreed with the SRB and the PRS for the other two SIs are likely to be agreed soon. Further analysis is required to determine fallback resolution strategies for the three SIs in the event the PRS is deemed not feasible at the time of resolution, and this should be pursued. In principle, the default PRS for all banks is use of insolvency proceedings. As noted, the use of resolution tools must meet a series of tests, including that of being in the public interest.

53. Upon agreement on the PRS for each bank, a minimum requirement for eligible liabilities (MREL requirement) is determined. The MREL requirement aims to ensure banks have adequate loss-absorbing capacity and recapitalization funds to support the effective implementation of the chosen resolution tool.⁷⁶ The SRB specified indicative MREL targets for all SIs in 2017, and thus far in 2018 has set a binding external target for the SI for which a PRS has been agreed. Binding external targets for the two other SIs are anticipated soon.⁷⁷ Specific MREL requirements for other banks have not been set either by the RU, though adequate progress is being made.⁷⁸

54. Through the process of resolution planning, impediments to resolution are being identified. The RU is working with the SRB and the banks to resolve potential impediments. Key potential impediments include:

• Ensuring the ability to provide adequate liquidity for a bank in resolution. The t wo las t -resort sources of liquidity funding in resolution are emergency liquidity assistance (ELA) from the CBM and use of the SRF.⁷⁹ The SRB, however, precludes the consideration of either in formal resolution planning.⁸⁰ The RU therefore will need to consider other planning approaches. In particular, the RU (and banks) should be as cognizant as possible of CBM’s ELA framework,⁸¹ to ensure that a bank in resolution is able to meet the CBM’s requirements should it be deemed eligible for ELA at the time of resolution. ⁸²

• The lack of practically “bail-in a bl e “ liabilities in Malta. Potentially bail-inable instruments generally include total own funds, subordinated debt, senior debt, and, prospectively, senior nonpreferred debt.⁸³ Other potentially bail-inable instruments include uncovered (uninsured) corporate deposits. The market structure and demand in Malta are such that banks’ debt instruments, including subordinated debt, are purchased in significant volume by retail customers, even where the minimum denomination is relatively high (e.g., €25,000). Moreover, a large proportion of Malta’s corporate depositors are qualified as “small and medium enterprises” under the EU definition. Issuing sufficient MREL may therefore prove challenging for banks, considering the limited domestic professional investor market and issuance sizes that may be small for potential external investors. These market realities have been conveyed to the SRB. The banks, the SRB, and the RU will need to work collaboratively to ensure MREL requirements are able to be met with instruments that can be bailed-in in practice.

55. The feasibility and credibility of the bail-in tool can be constrained by compensation claims that can arise when departing from pari passu treatment of creditors. In bail-in, the RC can depart from pari passu treatment of creditors in the same class under certain circumstances. ⁸⁴ Under the creditor hierarchy,⁸⁵ uninsured depositors (with the exception of uninsured household and “small and medium enterprise” depositors) and senior unsecured bondholders⁸⁶ rank in the same creditor class. With pari passu treatment in imposing losses in resolution, uninsured depositors would incur the same loss as would senior unsecured bondholders. Alternatively, protecting uninsured depositors but not senior unsecured bondholders would potentially give rise to valid “no-creditor-worse-off” claims on the part of bondholders, who may be left worse off in resolution than they would have been had the bank been put into insolvency proceedings. “No-creditor-worse-off” claims must be paid by the SRF, and SRF access criteria give rise to yet additional challenges that must be taken into consideration.⁸⁷ Also, without a departure from pari passu treatment , use of bail-in potentially would convert uninsured depositors to shareholders.

56. The lack of flexibility to depart from the pari passu principle may constrain the effective implementation of sale of business (and bridge bank) tools. As noted, Maltese legis lat ion explicit ly allows for departures from the principle of pari passu when using the bail-in tool.⁸⁸ The ability to depart from the pari passu treatment of creditors with in a class should also be explicitly available for the application of the sale of business tool and the bridge institution tool. For example, this may be necessary to allow for the transfer of certain liabilities (e.g., uncovered corporate deposit liabilities), but not the other liabilities within the same ranking (e.g., senior unsecured bonds). While it may be possible to read such flexibility into the Recovery and Resolution Regulations, consideration should be given to making explicit in law the power to depart from pari passu treatment of creditors when using the sale of business and bridge institution tools to reduce the potential of legal challenges arising from the lack of express authority.

57. The use of a bridge institution can serve as an effective fallback solution where a suitable arrangement with a private sector acquirer under a sale of business tool transaction cannot be achieved. For example, where the RU/SRB are unable to conclude a private sale within the required timeframe or on acceptable terms, critical functions could be transferred to a bridge bank and subsequently sold to the private sector. Under the Recovery and Resolution Regulations, any bridge institution is to be controlled by the RC but can be owned in whole or part by one or more public authorities. Following SRB guidance and policies, the RU began to prepare a handbook for operationalizing a bridge institution. A priority in this effort should be to define which entity will own a possible bridge institution and how the ownership function will be organized, how the institution’s governance structures will be rapidly put in place in time of need, and how the bridge institution will be returned to the private sector in a timely manner. Collaboration with the MFSA Authorizations Unit will be important and is encouraged.

58. Preparations are also being made to operationalize an AMC to enable use of the asset transfer tool. Based on guidance available from the SRB, the RU has prepared a first draft of a regulation. As with bridge institutions, the regulation should define which entity will own a possible AMC and how its governance structures can be rapidly established in time of need.

59. As noted, prior to taking a decision to initiate resolution, or to write down and/or convert capital instruments, the RC must arrange for a third-party valuation. Contracting for this purpose is subject to government procurement rules. The RU has held initial discussions with MFSA’s Procurement Office but will seek SRB guidance on valuations before proceeding with procurement. Consideration should be given to contracting with at least two firms that can commence required valuations on short notice (e.g., within five days). (A single firm is impractical because of a possible conflict of interest arising from its business relationships with the bank in resolution.)

60. The RU intends to prepare handbooks to guide implementation of each of the resolution tools as its disposal. As noted, the SRB is providing guidance for this exercise. The handbooks should contain policies and procedures relevant to each tool. This will require substantial effort and is among the key tasks facing the RU. The handbooks should be developed as soon as possible.

61. Summary of recommendations:

• Continue efforts in resolution planning and consider means to accelerate resolution planning for any particularly weak small banks;

• Assign responsibility for development of formal resolution plans for significant insurers within the MFSA and initiate the work, ensuring integration with the plans of the relevant banks;

• Consider approaches to mitigating the potential that lack of access to sufficient liquidity funding proves an impediment to effective implementation of resolution tools;

• Continue collaboration with the SRB to ensure MREL requirements are able to be met with instruments that can be bailed-in in practice under Malta’s market circumstances;

• Consider making explicit in law t he power to depart from pari passu treatment of credit or s when using the sale of business and bridge institution tools;

• Develop plans to establish a bridge institution and an AMC, including defining which entity will own the legal entities, how the ownership function will be organized, how their governance structures can be rapidly established in time of need, and how the institution or assets will be returned to the private sector in a timely manner;

• Contract with at least two firms that can, on short notice, commence valuations required to support use of resolution tools; and

• Develop handbooks to guide implementation of each of the resolution tools.

E. Resolution Funding

62. There are several sources of funding for implementing resolution measures. Subsequent to the write-down and/or conversion of capital instruments and other liabilities eligible for bail-in, financing may be required for recapitalization of a resolved bank and for maintaining adequate liquidity prior to, during, and subsequent to executing resolution measures.⁸⁹ The sources are the SRF, ELA, and public financing subject to conformity with EU state aid rules.

F. Deposit Protection and Payout

74. The Deposit Guarantee Scheme Directive created a common EU framework. It introduced harmonized coverage of deposits at €100,000, a requirement for faster payout (seven days), and ex ante funding arrangements. The scheme requires that premiums be risk-based and that by July 3, 2024, each national scheme shall reach a target level of at least 0.8 percent of covered deposits.

75. The Malta DCS was established in 2003 and its legal foundations were amended in late 2015 with the transposition of the Deposit Guarantee Scheme Directive. The DCS covers resident and nonresident depositors in banks licensed in Malta and their branches in the EU. It does not cover depositors in branches in Malta of banks licensed outside the EU, nor does it cover deposits by other banks or investment firms, deposits by collective investment schemes or other investment funds, and most deposits by pension and retirement funds.¹⁰⁰ Covered deposits as of June 30, 2018, were €11.6 billion, representing 62 percent of the €18.8 billion in eligible deposits¹⁰¹ and 54 percent of the €21.6 billion in total deposits. DCS assets are kept in accounts at the CBM, which also serves as investment manager for the fund.

76. The DCS targets a fund balance of 1.3 percent of covered deposits. This level was reached in 2016. The target fund balance for 2017 was €141 million, though a deposit payout of €35 million that year reduced the fund balance by about 25 percent. At the 1.3 percent target fund size, the DCS has insufficient resources for a full payout of the SIs and five individual LSIs, the smallest of which has roughly a 2 percent market share in total deposits. The DCS has the authority to enter into agreements with third parties to obtain additional financing to increase its resources or to raise cash. In one instance, the DCS explored obtaining a loan from commercial banks but was unsuccessful and entered into a repo transaction with the CBM to raise cash.¹⁰² No backstop funding arrangements are in place. The DCS should continue to pursue additional funding sources in times of need, including secured with future premiums, ideally from commercial banks, but, as a last resort, from the government.¹⁰³

77. In 2012 the MFSA adopted a policy with respect to new entrants designed to protect the DCS. In February 2012, it adopted the policy setting out a general expectation that new entrants should have a bank of established repute in their shareholding and/or management structure. In May 2012, the MFSA adopted a policy that would take into consideration in its authorization process the means of funding by new entrants that would not be covered by the DCS, particularly for those potential entrants that do not have a bank of established repute in the shareholding or management structure. Subsequently, licenses have been granted to eight banks under the condition that they agree to maintain blocked funds in their account at the CBM in favor of the DCS, with six banks required to maintain blocked funds equivalent to 100 percent of their covered deposits, and two banks required to maintain blocked funds of 15 percent of their covered deposits.¹⁰⁴

78. The DCS is financed through ex ante contributions imposed on banks. The risk-based premiums are determined by the DCS Management Committee. Regular annual premiums take the form of payment commitments and cash contributions. At present, the payment commitment represents 63.5 percent of the total annual premium but must be reduced to 30 percent by 2024. Of the current fund balance of €111 million, 86 percent is comprised of payment commitments.¹⁰⁵ The DCS can require banks to make extraordinary contributions in an amount of up to 0.5 percent of covered deposits each year if its resources are deemed insufficient.

79. The DCS is seeking an amendment to the DCS Regulation to mitigate the 2017 depletion of the fund. As noted, the DCS paid out €35 million in covered deposits, representing 25 percent of its €141 million fund. At the time of writing of this note, Parliament was expected to consider an amendment to enable the DCS to require banks to issue additional payment commitments of €35 million, an amount equal to the recent payout. Banks would have to fulfill the commitment in four annual contributions, unless the DCS recoups its outlays during that period. This legal amendment should continue to be pursued.

80. At present, the DCS is required to make payouts within 20 days. Under the Deposit Guarantee Scheme Directive this period must be reduced to seven days by 2024. The DCS is implementing an automated system in which banks would send data files to the DCS to enable payouts within the seven-day period. The system is envisaged to be operational by end-2018. The system enables payouts to depositors either by means of checks issued by the CBM or by transfer of covered deposit amounts to a pre-specified deposit account at another bank. Over time, consideration could be given to complementary payout methods. One option involves creating a portal where covered depositors can designate an account at another bank to which to transfer the paid-out funds. This would be more flexible than the existing pre-designated account approach. Another option is to use an agent bank to make payouts, which might be more convenient for depositors than receiving a CBM check.

81. The DCS has the power to finance the transfer of assets and liabilities in the context of insolvency proceedings.¹⁰⁶ This power to finance P&A transaction, is subject to a provision that the costs borne by the DCS in such transfers do not exceed the net amount of paying out covered depositors. However, the apparent lack of MFSA or DCS power to transfer assets and liabilities to a third party under bank insolvency proceedings noted in Part C of this Section of the Note would seem to preclude the use of this financing option. Moreover, as noted, uncertainties regarding the insolvency regime extend to a lack of clarity as to the creditor hierarchy in insolvency and thus the status of the DCS’s claim in subrogation of covered depositors. Consequently, it is unclear how to determine the net amount the DCS would incur in paying out covered deposits. The DCS should clarify in writing its interpretations of current law and its policies in this regard.

82. The DCS has the power to finance resolution actions in certain cases. Specifically, in the context of bail-in, the DCS is liable for the amount by which covered deposits would have been written down to absorb the losses in the bank, had covered deposits been included within the scope of a bail-in and been written down to the same extent as creditors in the same level of the creditor hierarchy.¹⁰⁷ If resolution tools other than bail-in are employed, the DCS is liable for the amount of losses that covered depositors would have suffered in proportion to the losses suffered by creditors in the same level of the creditor hierarchy. That said, the DCS’s liability cannot exceed the net losses that would result under insolvency proceedings. Again, however, there is no certainty as to the status of the DCS’s claim in subrogation of covered depositors, which renders it unclear what net loss it might incur in insolvency. In any case, here too the DCS should clarify in writing its interpretations of current law and its policies. An interpretation allowing the DCS to finance resolution measures up to the amount it otherwise would have paid out to depositors under insolvency--providing that it is reasonably expected to recover those funds to the same degree as in liquidation--would increase resolution funding options.¹⁰⁸

83. The MFSA determines when the DCS is triggered. Should the ECB withdraw a bank’s license (which, as noted, would occur upon the recommendation of the MFSA Board acting as the supervisory authority), the MFSA notifies the DCS, which triggers a deposit payout.¹⁰⁹

84. The DCS does not have explicit legal power to put a bank into liquidation.¹¹⁰ This limits the ability of the DCS to protect its interests. As noted, license withdrawal by the ECB triggers a notification by the MFSA Board to the DCS, triggering a deposit payout. Should the MFSA Board not place the bank into liquidation, as in the current Nemea Bank case, the DCS may not be able to recoup its paid-out funds, because it is conceivable that the cost of maintaining the former bank in abeyance of liquidation will deplete its available assets. This situation will affect the recovery by other creditors as well. These concerns should be remedied in any amendments to current law or in the broader update and streamlining of the bank insolvency framework to create an administrative regime for the orderly closure and liquidation of a failing bank.¹¹¹ In the meantime, the MFSA should adopt a policy to place a bank into liquidation when a deposit payout is made.

85. The DCS needs to be prepared to play a lead role in creditor-led insolvency proceedings. Notwithstanding the significant uncertainties regarding the legal regime for bank insolvency, it is likely that the DCS, in subrogation of paid-out covered depositors, will be the largest claimant on most, if not all, bank liquidation estates. This may place certain duties upon the DCS in the context of any creditor-driven liquidation process; for example, as is provided for in the Companies Act.¹¹²

86. Summary of recommendations:

• Continue to pursue efforts to obtain additional funding sources, ideally from commercial banks but, as a last resort, from the government, in compliance with state aid rules;

• Continue to pursue an amendment to the DCS Regulation to allow a replenishment of the fund;

• Consider eventually adopting additional payout mechanisms;

• The DCS should clarify in writing its interpretations of current law and its policies on its ability to finance the transfer of assets and liabilities in insolvency, and to finance the use of resolution measures;

• The MFSA should adopt a policy to put a bank into liquidation when a deposit payout is made; and

• The DCS should be prepared to take a leading role in any creditor-led liquidation process.

G. Contingency Planning and Crisis Management

87. The authorities have well-defined institutional arrangements for interagency coordination in the context of threats to financial stability and financial crisis. These are the Joint Financial Stability Board, which serves as coordinating body for the CBM and the MFSA in matters potentially affecting financial stability,¹¹³ and the DSC—with its broad membership, including the MFIN—with responsibility for financial crisis preparedness and management.

88. The Joint Financial Stability Board is a statutory body under the Central Bank of Malta Act. Chaired by the governor, it is also comprised of the two CMB deputy governors and the MFSA Chairman and CEO. The minister normally attends as a non-voting member. The board’s decisions routinely are taken by consensus. The board meets quarterly and plays essentially an advisory role— its recommendations, advice, or assessments are to be taken into consideration by the relevant authority, and the authorities are to seek the opinion of the board prior to taking action that may impact on financial stability.

89. The DSC is a body established by agreement of the members. It is chaired by the CBM deputy governor responsible for financial stability and is comprised in addition by the CBM Chief Officer responsible for financial stability, the CBM Financial Stability Department Head, the MFIN Budget and Finance Permanent Secretary, the MFSA Director General, and the MFSA RU Head. The DSC often invites the Financial Intelligence Analysis Unit,¹¹⁴ and occasionally the Attorney General and the Malta Stock Exchange, to participate as observers at the DSC meetings. The DSC mandate is both to enhance crisis preparedness in normal circumstances and to facilitate the management and resolution of an actual crisis. It serves as a forum to exchange views, evaluate, and consult on matters of mutual interest.

90. The Crisis Management Task Force serves as the permanent operational arm of the DSC. It is chaired by the MFSA RU Head and is comprised of technical personnel from the CBM, the MFSA, and the MFIN. Its primary objectives are to maintain and update the interagency Framework for the Management of Domestic Financial Crises (Interagency Crisis Management Framework), to organize simulation exercises to test parts of the framework as directed by the DSC, and to make recommendations to enhance the regimes for recovery, insolvency, and resolution. At present, the Task Force is focused on updating the Interagency Crisis Management Framework to reflect changes in responsibilities associated with the introduction of the Single Supervision Mechanism and the Single Resolution Mechanism, guidance provided by the ECB and the SRB, and the findings of a recent crisis simulation exercise (see paragraph 91).

91. The authorities engaged in a crisis simulation exercise in 2016. The participants included the senior management of the CBM, the BSU, the RU, and the MFIN. The objectives were to assess reporting lines, escalation processes, response prioritization, collaboration, and decision making in line with policies and procedures.¹¹⁵ As noted, one key outcome was to identify the need to update the Interagency Crisis Management Framework. The exercise also highlighted the need to be better prepared to take decisions on whether to use the insolvency regime or resolution measures in individual banks,¹¹⁶ and the need to improve the ELA framework.¹¹⁷

92. In conjunction with work to upgrade the Interagency Crisis Management Framework, the authorities should ensure their own internal crisis management plans are adequate. While the CBM’s well-elaborated ELA framework largely serves that purpose, the MFSA and the MFIN at present do not have well-documented crisis management plans in place. Internal contingency plans are an important complement to a comprehensive interagency plan. Efforts to put them in place should begin. In the case of the MFSA, this would complement the work of the RU to prepare handbooks for using various resolution tools. Many of the recommendations in this Note call for the authorities to adopt formal written policies and procedures. These would best be reflected in their internal crisis management plans. The completed plans should be shared with the other agencies.¹¹⁸ The agency-specific plans should be reviewed and updated periodically, with relevant updates and then incorporated into the interagency framework.

93. The institutional architecture for the Banking Union was largely designed with resolution of individual banks and banking groups in mind. The specified interactions between the MFSA, the RC, the SRB, the EC, and the Council on the adoption of a resolution scheme contemplate the failure of an individual institution or group. However, a system-wide crisis involving simultaneous distress and potential failure of multiple banks and other financial institutions would involve additional participants (e.g., the CBM, the MFIN) and require a more comprehensive strategy. At present, there can be ambiguity as to which authorities would be responsible for the design, implementation, and public communication of such a strategy and how the various authorities would coordinate their activities. As an eventual part of their efforts to update the Interagency Crisis Management Framework, the Crisis Management Task Force and the DSC should consider how the domestic agencies would interact with European authorities in the event of a system-wide crisis, potentially involving other euro area jurisdictions, and have in place appropriate contingency plans to ensure financial stability in Malta.

94. Summary of recommendations:

• The MFSA and the MFIN should develop formal internal crisis management plans as a complement and input to the Interagency Crisis Management Framework.

• The Interagency Crisis Management Framework should eventually address how the domestic agencies would interact with European authorities in the event of a system-wide crisis, potentially involving other euro area jurisdictions, to ensure financial stability in Malta.