The domestic financial sector showed strong resilience in 2021 despite challenges for certain sectors, according to a central bank report published on Monday.

In its fourteenth edition of the financial stability report, the CBM assesses developments in 2021 that are relevant for domestic financial stability.

The bank remarks, in its report, that the macroeconomic environment in the EU improved over a year ago as vaccination programmes aided the reopening of economic activity. However, recovery was uneven across sectors, partly due to supply bottlenecks, coupled with the emergence of new COVID variants which led to the reintroduction of containment measures.

Geopolitical risk rose further exacerbated by the Russia-Ukraine war and its compounding effect on the already-rising inflationary pressures particularly for energy and commodity prices with potential ramifications on growth prospects, going forward.

As pandemic-related government support measures were maintained in 2021, government debt levels continued to increase with potential debt sustainability concerns for some jurisdictions, particularly due to the strengthening of links between governments, banks, and corporates.

The domestic front

On the domestic front, despite the high uncertainty surrounding the global economic climate, banks reported improved asset quality owing to both reduced Non-performing Loans (NPLs) and higher loan volumes.

The latter was largely driven by increased mortgages as lending to corporates was solely driven by the Malta Development Bank’s COVID-19 Guarantee Scheme, the bank notes.

Its report highlights increased concentration toward property-related loans.

Such developments, according to the CBM, reaffirm the need for continuous monitoring of increasing concentration risk in the banks’ loan portfolios for the timely adoption of targeted policy measures if the need arises.

"The profitability of banks recovered strongly reflecting lower provision charges and, to a lower extent, higher fees and commission income.

"Yet, the banks’ main source of income remained related to net interest income. The overall solid performance of financial markets in 2021 had a positive impact on domestically-relevant investment funds as their holdings of equities rose, which were partly offset by lower bond holdings amidst increasing inflationary pressures.

"Similarly, domestically-relevant insurance companies also benefitted from the general upswing in financial markets as they raised their exposures in equities and investment funds. As a result, the profitability of this sector also improved, coupled with a general increase in premia, supported, in turn, by the overall economic recovery."

Overall, the report finds that the domestic financial sector showed strong resilience in 2021 despite challenges for certain sectors.

The findings are corroborated by the results of the liquidity and solvency stress test exercises, which reveal an overall resilient financial system.

"Nevertheless, going forward, financial stability risks remain, mainly due to the war between Russia and Ukraine, largely through second-round effects, as the direct exposure to these two countries is limited.

"Furthermore, inflationary pressures and downside risks to economic growth could possibly impact debt servicing capabilities, which in turn, could test the resilience of the domestic financial sector. This highlights the importance for credit institutions not to engage in excessive risk-taking and set aside adequate provisions whilst maintaining healthy liquidity and capital buffers," it warns.

And with the cybersecurity landscape continuously shifting with more sophisticated threats emerging, financial institutions should remain at the forefront for the adoption of the latest technological advancements to safeguard themselves against cybersecurity risks, it adds.

Climate risk-related adverse scenario

The report also features, for the first time, a climate risk-related adverse scenario for the macro stress testing framework.

The scenario seeks to assess the impact on banks’ capital from heightened transitional risks following oil price hikes to disincentivise its use and reach net zero emissions by 2050.

The impact of the climate-related test on the banks' overall capital is not low, but does not indicate any specific needs for recapitalisations.

The significance of the test is to shed light on banks’ preparedness under such a scenario and therefore, on the importance of assessing risks related to exposures linked to high CO2 emissions and associated climate-related costs.

"The impact of repercussions surrounding climate change is increasingly on institutions’ agenda as a source of risk for financial stability that could materialise not only in the longer-term but also in the short-to-medium term.

"With increasing evidence of physical effects and accelerating impacts of the effort to transition to a low-carbon economy, financial regulators are rapidly integrating climate-related and environmental risks into their supervisory frameworks," the report notes.

The report also refers to the launch of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), two years after the adoption of the Paris Agreement in 2015.

The NGFS currently consists of around 130 central banks and supervisors, which aim at improving the role of the financial system in risk management and capital mobilisation for green and low-carbon investments.

In one of its most recent publications, the NGFS last year released a set of scenarios consisting of six pathways for global changes in policy, the energy system and climate.

These six long-term scenarios (with projections up to 2050) are grouped into three categories: the orderly, disorderly and hot house world scenarios.

They vary in terms of the extent of physical risks as a consequence of environmental events such as floods, or transition risks associated with new policies and technologies.

The orderly scenarios, called Below 2°C and Net Zero 2050, assume that climate policies are enacted in a timely manner and gradually become more stringent to smoothly limit climate change to below 2°C compared to pre-industrial levels (a more ambitious target of 1.5°C under Net Zero 2050).

The two disorderly scenarios, consisting of the Delayed Transition and the Divergent Net Zero scenarios, include higher transition risk due to policies that are delayed or diverge across different countries and industries.

Under the former scenario, carbon prices are assumed to rise quickly after a 10-year delay to allow for a fossil-fuel-based economic recovery after COVID-19.

The Divergent Net Zero scenario instead still reaches the net-zero emissions target by 2050 but with divergent policies and a faster phase-out of fossil fuels.

Both disorderly scenarios lead to higher transition costs compared to the orderly scenarios.

Finally, the two hot house world scenarios, called Current Policies and Nationally Determined Contributions, assume that some climate regulations are enacted in some jurisdictions, but global efforts are unsuccessful in preventing major global warming.

This results in significant physical risk, such as irreversible impacts like a sea-level rise.