Financial Stability Report June 2012

7/30/2019 Financial Stability Report June 2012

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RESERVE BANK OF MALAWI

FINANCIAL STABILITY

JUNE 2012


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Table of Contents

FOREWORD AND SUMMARY OF FINANCIAL STABILITY ASSESSMENT iii

1.0 MACROECONOMIC AND FINANCIAL ENVIRONMENT 1

1.1 GLOBALDEVELOPMENTS ............................................................................................................................. 11.1.1 Global Financial Stability........................................................................................................11.1.2 Risks to Global Financial Stability.........................................................................................21.1.3 Potential Global Financial Stability Policy Responses ........................................................3

1.2 REGIONALDEVELOPMENTS.......................................................................................................................... 51.2.1 Macroeconomic Developments ...............................................................................................51.2.2 Regional Financial Stability....................................................................................................51.2.3 Key Downside Risks to the Regional Macroeconomic and Financial Environment ........61.2.4

Regional Policy Options in the Period Ahead......................................................................7

1.3 DOMESTICDEVELOPMENTS ......................................................................................................................... 81.3.1 Performance of the Malawian Economy...............................................................................81.3.2 The Financial Sector................................................................................................................91.3.3 Potential Risks to Domestic Financial Stability Ahead.................................................... 111.3.4 Remedial Options ................................................................................................................... 12

2.0 FINANCIAL INSTITUTIONS 15

2.1 THEBANKINGSECTOR................................................................................................................................. 152.1.1 The Banking Sector in Malawi .............................................................................................. 152.1.2 Assessment of Financial Soundness Conditions ................................................................. 152.1.3 Banking Sector Risks and Remedial Measures ................................................................... 16

2.2 BANKLENDINGSURVEY .............................................................................................................................. 212.2.1 Objectives of the Survey....................................................................................................... 212.2.2 Response Rate ......................................................................................................................... 212.2.3 Credit Developments October 2011 March 2012 ............................................................ 212.2.4 Developments in Credit Standards ...................................................................................... 222.2.5 Developments in Demand For Loans ................................................................................... 232.2.6 Prospects for April 2012 September 2012 ....................................................................... 23

2.3 STRESSTESTING.............................................................................................................................................. 242.3.1 Large Exposure Concentration Risk ..................................................................................... 262.3.2 Liquidity Risk ........................................................................................................................... 262.3.3 Foreign Exchange Risk............................................................................................................ 262.3.4 Interest Rate Risk ................................................................................................................... 27


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2.3.5 Equity Risk ............................................................................................................................... 272.3.6 Shock to Net Interest Income ............................................................................................... 282.3.7 Shock to Net Foreign Exchange Income .............................................................................. 282.3.8 Combination of Agricultural Shock and Other Shocks...................................................... 28

2.4THEINSURANCESECTOR.............................................................................................................................. 32

2.4.1 Assessment of Financial Soundness Conditions .................................................................. 322.4.2 Insurance Sector Risks and Remedial Measures .................................................................. 33

2.5 THECAPITALMARKET................................................................................................................................. 342.5.1 Overview of the Malawi Stock Exchange ............................................................................ 342.5.2 Legislation and Oversight of the Capital Market.............................................................. 342.5.3 Recent Trends.......................................................................................................................... 342.5.4 Risks to the Growth of the Capital Market ........................................................................ 352.5.5 Remedial Options For the Capital Market ......................................................................... 35

3.0 FINANCIAL INFRASTRUCTURE AND REGULATION 37

3.1 ROLE OF PAYMENT SYSTEMS IN FINANCIAL STABILITY .................................................................................... 37

3.2 MANAGEMENT AND MITIGATION OF FINANCIAL AND OPERATIONAL RISKS ..................................................... 373.2.1 Role of MITASS ........................................................................................................................ 373.2.2 Composition of MITASS Throughput .................................................................................... 38

3.3 MITASSAND OPERATIONAL RISKS................................................................................................................. 393.3.1 Availability and Reliability of MITASS ................................................................................ 39

3.4 LEGISLATION AND OVERSIGHT OF NATIONAL PAYMENT INFRASTRUCTURE .................................................... 393.4.1 Legislation ............................................................................................................................... 393.4.2 Oversight of National Payment System .............................................................................. 40

3.5 CURRENT NPSREFORM PROJECTS.................................................................................................................... 40


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iii

FOREWORD AND SUMMARY OF FINANCIAL STABILITY ASSESSMENT

The Reserve Bank of Malawi considers financial stability as a condition represented by a strong financial

system capable of withstanding shocks to the economy, one that is able to allocate savings into investment

opportunities, facilitate the settlement of payments efficiently and manage risks in a satisfactory manner.

The global economy has not improved since the previous Financial Stability Report. Potential threats to

global financial stability persist and have heightened owing to financial distress in the euro area, and

unfavourable macroeconomic prospects in developed and emerging markets. In Sub-Saharan Africa region

economic activity remained buoyant despite unfavourable global macroeconomic developments. Economic

growth in Malawi has been estimated at 4.3 percent in 2012, down from 6.7 percent as earlier envisaged.

That notwithstanding, Malawis banking sector remains well capitalized, and therefore properly cushioned

against shocks to its balance sheet. This has been verified by the results of a number of stress testing

scenarios. The insurance sector is also adequately capitalized, while the payments and settlement system

also remains robust, ably mitigating financial and operational risks. Financial markets are also generally

sound and well equipped to withstand any shocks to the system. The overall assessment of financialstability in Malawi, presented in this report therefore, broadly did not find major threats to systemic

stability.

A number of fragilities and vulnerabilities continue to loom on the horizon, nonetheless. High levels of

public and private debt in developed countries pose a significant risk. Furthermore, emerging markets and

other open economies face the challenge of cushioning their financial systems against potential spillovers

from the euro area. Meanwhile economic growth in the emerging and developing economies is projected to

slowdown in 2012 on account of the deteriorating sovereign and banking sector developments in the euro

area. Regionally, the spillover effects of the drought in the western and eastern parts of Africa are likely to

cause a surge in inflation. On the domestic front, the persistent fuel and foreign exchange shortages, and the

unrelenting increase in inflation continue to pose a significant threat to the domestic financial system. In

the banking sector, credit risk is on the increase, while the insurance sector remains susceptible to

reinsurance risk.

The Reserve Bank of Malawi will therefore continue to monitor these and any other potential systemic

vulnerabilites closely and tackle any threats to stability which might emerge in the future.

C.S.R. Chuka

GOVERNOR


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Global Financial Stability Map

Note: Closer to centre signifies less risk, tighter monetary and

financial conditions, or reduced risk appetite.

Source: Global Financial Stability Report (GFSR)April 2012

Chart 1.1 Macroeconomic Risks

Source: Global Financial Stability April 2012

1.0 MACROECONOMIC AND FINANCIAL ENVIRONMENT

1.1 GLOBAL DEVELOPMENTS1

The global financial system remained at risk over the periodSeptember 2011 to April 2012 as potential threats to financialstability persisted. The risks largely emanated from stresses inthe euro areas banking and government bond markets.

Unfavourable macroeconomic prospects in both developed andemerging markets have also induced an increase in the level ofrisks to the global financial stability. Growth in emerging anddeveloping economies is expected to continue to be sluggish dueto spill-over effects from the euro area.

1.1.1 Global Financial Stability

Over the seven months period from September 2011 to April2012, the global financial system stability hardly improved. Asdepicted by the IMFs Global Financial Stability map in Figure1.1, the global financial system exhibited an acute deteriorationin January 2012.

Notably, macroeconomic risks escalated from the September2011 level, on account of weak economic performance and theprevailing debt burden within the euro region, which has beenaggravated by unfavourable growth prospects in the euro zoneand the divergence between the core and the peripheraleconomies2. According to the World Economic Outlook (WEO)April 2012, therefore, economic baseline projections ofSeptember 2011 have been revised downwards as the euroeconomy is anticipated to suffer a mild recession.

Similarly, credit and market and liquidity risks worsened due to

the prevalence of sovereign default and bank failures.Notwithstanding this, between January and April 2012, in a bidto address market and liquidity conditions, the ECB increasedinjection of liquidity to the banking system. This was done byremoving the restriction on the amount of collateralised liquidityto banks and by widening the range of eligible collateral foraccess to liquidity facilities by banks. Furthermore it providedofficial funding, which relieved refinancing pressures.

Consequently, in April 2012 the global financial systemrebounded to the levels of September 2011 as depicted by theGlobal Financial Stability Map, (figure 1.1). The map shows a

significant shift in macroeconomic and credit risks as they movedinwards from January 2012 back to the September 2011 levels. Amore pronounced improvement is observed in the inwardmovement of the market and liquidity risks, as they settle below

1Analysis complemented with that from GFSR (IMF) April 2012

2Core Eurozone countries; Germany, France, UK, Netherlands, Belgium

Periphery economies: Mainly consist of countries lying to the south, east and

west of the EU

Main MessageRisks to global financial stabilityremained elevated owing tostresses in the euro areasbanking and government bondmarkets, unfavourable macro-economic prospects in bothdeveloped and emergingmarkets; as well as large fiscaldeficits in advanced economies.However, sound macroeconomicand financial policies helped toease the intensity of the risks.Consequently, global financialstability indicators moved backto the levels recorded in

September 2011.


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Chart 1.2 Market and Liquidity Risks


Chart 1.3 Risk Appetite


Source: World Economic Outlook April 2012

the September 2011 levels.

On the other hand, the monetary and financial conditionsremained fairly stable following the strong interventions by theECB. The ECB cut the policy rate in December 2011 to 1.0percent and also reduced the reserve requirements in order toreduce the deleveraging pressures and weakening growth,thereby easing the global monetary conditions. However, overthe period of seven months to April 2012, bank lending standardstightened and financial conditions deteriorated. Thus offsettingimprovements in the monetary conditions and leaving themonetary and financial conditions stable.

Emerging market risks to global financial stability hardly changedfrom the levels recorded in September 2011 due to the ability ofthe markets to absorb external shocks. These markets havesubstantial buffers and policy room to remain resilient toexternal shocks, thereby reducing default risks.

Improvements in liquidity availability in the financial systeminduced an increase in risk appetite as the price of risky financialassets strengthened. In addition, the resilience and growth inemerging markets provided motivation for investment indiversified financial assets.

1.1.2 Risks to Global Financial Stability

Assessment of potential threats to global financial stabilityreveals that the global financial system remains vulnerable tosome significant risks.

The global financial system faces a risk emanating from highfiscal deficits in developed countries. High levels of public andprivate debt in the euro zone pose a risk to efforts in repairingfinancial institutions balance sheets. The countries of Japan andUnited States are also experiencing huge fiscal deficits.However, their policy response has been weak compared to theeuro region as they have not put in place mitigation measures.Such a weak policy response to high levels of fiscal debtsexacerbates the risks to global financial stability, consideringthat strategies of addressing high levels of fiscal debt take timeto develop. Job creation in advanced economies is also likely toremain sluggish in 2012.

Policymakers in emerging markets and other exposed economiesface a challenge of cushioning their financial systems againstpotential spillovers from the euro area. Open economies with asignificant number of European owned banks are likely to sufferfrom high levels of retrenchment leading to high levels ofunemployment. High levels of unemployment increase the levelof credit risk and cause deterioration in books of banks.

Table 1.1 Selected Global Economic Indicators

Projections

2010 2011 2012 2013

Real Output

Growth

5.3 3.9 3.5 4.1

Consumer PriceAdvanced

Economies

1.5 2.7 1.9 1.7

Emerging and

Developing

Economies

6.1 7.1 6.2 5.6

Interest Rates

Real Six Months -0.6 -1.6 -0.1 0.1

World Real Long

Term Interest

Rate

1.6 0.2 0.7 1.3

Current Account

% of GDP

Advances

Economies

-0.2 -0.2 -0.4 -0.2

Emerging and

Developing

Economies

1.9 1.9 1.7 1.3

External Debt

Emerging and

Developing

Economies

25.2 23.8 23.7 23.6

Debt Service

Emerging and

Developing

Economies

8.2 8.4 8.9 9.1


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The WEO April 2012 projects that the euro area will go into amild recession in 2012. Growth in emerging and developingeconomies is also projected to slowdown in 2012 mainly onaccount of the damage done by deteriorating sovereign andbanking sector developments in the euro area.

1.1.3Potential Global Financial Stability Policy Responses

Policy makers in advanced economies need to put in placecomprehensive strategies to deal with sources of global financialmarket turbulences. These economies need to adopt policies,which will encourage tightening of sovereign spreads, gradualrebuilding of investor base and improvement in the banking andfiscal sectors.

Individual advanced economies need to implement strong fiscalconsolidation policies supported by sufficiently accommodativemonetary policy and structural reforms. Fiscal consolidation isvery instrumental in cushioning the impact of adjustment.However, this should be consistent with the objective of price

stability. Effective structural reforms enhance productivity andcompetitiveness, thereby strengthening the foundation forgrowth and more balanced external accounts in deficit countries.In the cases of Japan and the United States, both countries needto put in place long term plans for deficit reduction that willpromote short-term growth but also enhance debt sustainabilityand financial markets stability.

Efforts by advanced economies need to be supported bycomplementary positive developments in both the emerging anddeveloping economies.

To sustain financial stability of emerging markets, authorities inemerging markets need to enhance effective policy mechanismsto cushion negative external shocks. Such policies will controlpotential spillovers from advanced economies into emergingmarkets and other open economies. Thus emerging marketsshould consider implementation of countercyclical policiestogether with deployment of targeted facilities and instrumentsas these can be effective in sustaining growth amidst foreignshocks.


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BOX 1.1: TRANSMISSION CHANNELS OF AND THE LIKELY IMPACT OF THE EUROZONE DEBT CRISIS ONDEVELOPING COUNTRIES LIKE MALAWI

The magnitude of effects of the EU debt crisis on developing economies has varied depending on thecountry's level of integration. In Malawi, the effects have been relatively less severe due to the low

level of financial integration of the local economy to the international financial system. Nevertheless,Malawi like a number of other African countries has experienced spillover effects from the EU debtcrisis indirectly mainly through; Overseas Developments Aid (ODA) flows, FDI, Trade, exchange rateeffects and remittances.

The full impact of the crisis on Malawi cannot be assessed due to various reasons, chief of which is thefact that substantive data is lacking that can be significantly linked to the transmission channels. Inaddition, the crisis is still raging and cannot therefore be fully assessed. Nevertheless, the box belowpresents the likely transmission channels through which the Euro zone debt crisis may have indirectlyimpacted on developing countries like Malawi.

CHANNELS OFTRANSMISSION

IMPACT ON DOMESTIC ECONOMY

ODA The requirement by EU banks to hold more capital and tighten creditconditions is likely to have reduced the amount of loanable funds /aidto aid dependant developing countries like Malawi.

Attempts to reduce EU debt likely to affect aid volumes to developingcountries.

FDI Changes in market sentiment have prompted delayed or reducedinvestments and portfolio flows into developing countries like Malawi.

Loss in confidence has reduced consumption and investment, leading toa decline in real EU activity, thereby negatively affecting levels of FDI

flowing to developing countries. Sell-off in EU equity markets has led to withdrawals of funds in

developing countries, thus causing adjustment problems.Trade andTourism

Fiscal consolidation through deleveraging reduced growth in EU. Thisaffected developing countries through trade and investment.

Reduced consumption and investment has caused a decline in EUs tradewith other countries including, Malawi.

Trade in services has declined due to a weaker euro. Furthermore,European tourists are experiencing declining purchasing power. This islikely to have adversely impacted the performance of tourism sector ofdeveloping countries.

Exchange rateeffects Loss of confidence in euro has implied a depreciation of euro againstdollar. Countries like Malawi, whose exports are dollar based are likely

to suffer from an appreciation of the dollar against the euro.Remittances The prevailing increase in unemployment in EU countries has translated

into fewer remittances to developing countries as immigrants struggleto maintain or find new jobs.

A weaker euro has reduced value of remittances originating in Europeand flowing towards developing countries.

FinancialContagion

The prevailing global liquidity constraints are likely to have caused acurtail in credit lines to banks in developing countries like Malawi bycorrespondent banks abroad, leading to a reduction in letters of creditand foreign exchange business in general, thereby affecting theprofitability of banks.


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Table 1.2 Sub Saharan Africa: Real GDPGrowth (Percentage Change)

Source: REO April 2012

1.2 REGIONAL DEVELOPMENTS3

1.2.1 Macroeconomic Developments

Sub Saharan Africa (SSA) economic activities remainedbuoyant despite unfavourable global macroeconomicdevelopments. The regional economy is expected to

register a more robust growth of 5.4 percent in 2012compared to a growth of 5.2 percent in 2011. At 5.4percent, the growth in SSA is stronger compared to majorregions in the rest of the world.

The expected growth in 2012 will be spurred by variousfactors. First, the discovery of new natural resources inseveral oil producing countries like Angola, Niger, andSierra Leone. Analysis has revealed that there is a steadydemand for these resources in emerging and developedeconomies. Second, the eastern African economies areexpected to rebound from drought, which was at thecentre of rising inflation in this region. In December2011, SSA regional inflation surged to 9.75 percent fromthe December 2010 level of 7.0 percent. Between theperiods, inflation in eastern Africa increased by 16.0 basispoints to 20.0 percent. Consequently, authoritiesimplemented tight monetary policies aimed at addressingthe rising inflation. Third, the western African economieswill likely register favourable macroeconomicdevelopments following the strong post-conflict recoveryin Cte dIvoire.

On the other hand, most countries in the region areexperiencing weaker fiscal positions than prior to theglobal economic turmoil of 2008/2009. As such, theexpected economic expansion in 2012 will provideresources for fiscal consolidation over time.

1.2.2 Regional Financial Stability

Financial systems in SSA remained resilient to bothexternal and internal shocks.

Regional financial conditions continued to withstand theglobal financial stresses caused by the 2008-2009 financial

crisis and the recent European debt crisis. Overall,banking systems within the region remained sound, withonly a banking crisis experienced in Nigeria mainly due tocorporate governance issues.

Open financial markets within the region also remainedrelatively insulated to the world financial turmoil.However, the South African equity and deep, liquid bondmarkets, which attract significant foreign portfolioinvestment, experienced some decreases in stock prices.The resilience of the SSA financial systems to external

3

Main MessageThe financial systems in SSAremained resilient to bothexternal and internal shocks.Major drivers of the resilienceinclude sound macroeconomic and

financial policies coupled withlimited financial integration withthe rest of the world. However,major risks still persist. Theregion continues to faceunfavourable macroeconomicprospects arising from bothspillover effects of the globalcrises and also the economicfundamentals within the region.In addition, financial system

supervisory capacity has beenoutpaced by the rapid growth ofpan African banks, which hascome with the introduction ofnew financial products. Policymakers therefore need to carryout ongoing financial systemsurveillance in order to safeguard

the regional financial stability.


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Table 1.3 Sub Saharan Africa:Other MacroeconomicIndicators


Chart 1.4 Sub Saharan Africa:Inflation


Chart 1.5 Sub Saharan Africa: RealGDP Growth by Country Group


shocks was supported by limited exposure of regionalbanks to the global financial system.

1.2.3 Key Downside Risks to the Regional Macroeconomicand Financial Environment

Although there has been continued resilience of the SSAregional financial system to external and internal shocks,potential threats to regional financial stability stillremain.

The spillover effects of drought in western and easternAfrica are likely to cause a surge in food, hence overallinflation thereby undermining the loan books of thebanking system and causing a risk on the performance ofthe financial sector within the region. Further, the overallcurrent account and fiscal deficits of the affectedcountries are likely to widen.

Indirect threats from the global financial stress to regionalfinancial stability are likely to come through a decrease inworld growth and trade; as external demand for theregions exports would contract. In turn this will causeunfavourable economic activity and worsen externaldemand for exports from the SSA. This is likely to squeezethe loan books of the banking system within the region.Secondly, banks that have their origins in the euro regionare likely to face retrenchment as a way of cutting cost.Increasing levels of unemployment are likely to cause a

decrease in economic growth within the region and lateron a decrease in borrowers ability to repay the loans.Furthermore, few banks in SSA, which have asset-sideexposures to Euro zone financial systems, will experiencesome stress on foreign assets.

The rapid rise in credit to the private sector in various SSAeconomies may be an indicator of financial sectordeepening. However, high growth rates of lending to theprivate sector may result into poor quality of creditextension that is likely to result into an increase innonperforming loans.

The banking systems within the region have recentlyexperienced an increase in inter linkages throughexpansion in pan African banking groups. This hasenhanced competition and financial innovation. However,rapid growth in competition and more advanced products,pose an additional threat to the financial system withinthe region. Furthermore, in most countries within theregion, financial innovation has outpaced supervisorycapabilities. If supervisory authorities do not catch upwith the innovation, the results may be unfavorable.Rapid growth of financial innovation that accompanied


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outdated levels of supervision contributed to the globalfinancial crisis that started in 2007. In addition, rapidgrowth in pan African banks can be a source of crossborder contagion.

1.2.4 Regional Policy Options in the Period Ahead

Despite the resilience of the financial systems within theSSA to external shocks, the authorities in the region needto carry out ongoing financial system surveillance aimedat putting in place preventive measures.

First, countries in the SSA region need to improve theirprudential regulation and supervision. The RegionalEconomic Outlook (REO) April 2012 reports that although16 SSA countries have registered an encouragingimplementation process of Basel Core Principles, they arefacing some challenges in the implementation of theprinciples.

The increased regional integration reflected in the rapidgrowth of pan-African banking groups, necessitates theneed for common supervisory arrangements across thecountries within the region. This will ensure that bankingsystems in the region are subjected to consolidatedsupervision. Consequently, authorities will be able toeffectively reduce the impact of systemic risks across theborders.

Both commercial and central banks, which have some of

their assets in the financially stressed euro zone shouldreview their investment strategies. They should considerplacing some of their assets in markets deemed less risky.

Countries which are experiencing rapid increases in creditto private sector should ensure that the credit facilitiesare in support of financial stability within the region.

Lastly, major financial systems within the region shouldengage in dialogue with relevant authorities in order toimprove the assessment of possible systemic risks.International financial institutions can play a key role in

facilitating this task.


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Table 1.4: Selected EconomicIndicators

Source: Reserve Bank of Malawi

1.3 DOMESTIC DEVELOPMENTS

Macroeconomic activities remained sluggish largely owingto poor performance in the manufacturing, construction,transportation and agriculture sectors. Inflationarypressures continued to mount rising to a double digitfigure of 11.4 percent in March 2012 from 7.7 percent in

September 2011. Foreign exchange reserves continued tocontract on account of high demand compared to supply.Financial sector conditions also hardly improved asevidenced by a slow decline in nonperforming loans as apercentage of GDP coupled with a decrease in the ratio ofcredit to private sector as a percentage of GDP.Notwithstanding the unfavourable macro-financialdevelopments, the domestic financial system remainedresilient.

1.3.1 Performance of the Malawian Economy

After averaging 7.5 percent between 2007 and 2010, realGDP growth has been estimated at 4.3 percent in 2012 aswas recorded in 2011. Impetus for growth in 2012 is likelyto emanate from the mining and quarrying (13.9 percent)and accommodation and food services sectors(6.0percent) from respective growths of -4.5 percent and 0.4percent in 2011. Though registering relatively highergrowths of 2.0 percent, 4.2 percent, 4.2 percent and 5.0percent in 2012, from respective growths of 1.7percent,2.4 percent, 2.7 percent and 3.5percent in 2011; themanufacturing, construction, transport, and wholesaleand retail trade sectors have been the most adversely

affected in recent years. This is because these sectorsare heavily dependent on imported raw and intermediateinputs that require foreign exchange, which has beenproblematic during the last couple of years. This hasbeen compounded by intermittent power supply asevidenced by the slowdown expected in the growth of theutilities sector to 2.0 percent in 2012 from 4.4 percent in2011. Slower growth is also expected in agricultureproduction, the countrys mainstay, and is estimated at4.1 percent in 2012, down from 6.4 percent in 2011. Theslowdown is largely attributed to a significant drop inproduction of tobacco and a marginal decline in maize

output. The financial sector is estimated to grow by 8.7percent in 2012, down from 10.0 percent in 2011, onaccount of a slowing down of business in the year.

2009 2010 2011 Sep-11

Mar-12

Real OutputGrowth (%)

8.9 6.7 4.5 4.3 4.3

GrossOfficial

127.4 279.6 190.2 266 137.9

Reserves(US$)

GovernmentBorrowing

11.8 90.6 133.1 132 154.2

from banks(Kbn)Inflation(%)

8.4 7.4 7.6 7.7 11.4

Main MessageThe domestic financial systemremained vulnerable to risksemanating from unfavourablemacro-financial developmentsin the global, regional anddomestic economic arenas.However, the impact of theglobal and regional financialshocks was less severe owing tothe limited financialintegration of the localeconomy into the globalsystem. Domestically,unfavourable macroeconomicprospects in the form of a poorperformance in the agriculture

sector, intermittent powersupply and fuel shortages arelikely to have a negativeimpact on real output therebyworsening the financialconditions of both the financialand non financial entities.Policy makers should thereforeimplement effective policiesaimed at addressing theongoing macroeconomic and

financial fragilities.


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Chart 3: Nonperforming Loansas a Percentage of GDP


Chart 4: Credit to the Private Sectoras a Percentage of GDP


Chart 5: Growth Rate of Credit tothe Private Sector


Inflationary pressures intensified as headline inflationescalated to 11.4 percent in March 2012 from 7.7 percentin September 2011. The rise in inflation was triggered byrising food prices particularly maize and hightransportation costs, resulting from an increase in fuelpump prices in the latter part of 2011.

Fiscal performance during the period was expansionary asthe budget deficit worsened to K10.6 billion in March 2012compared to K6.8 billion in September 2011. The outturnwas mainly on account of low realisation of revenuescompared to what was projected in the budget.Consequently, the stock of government borrowing fromthe banking system increased to K154.2 billion in March2012 from K132.0 billion in September 2011.

Gross official reserves contracted to US$137.9 million inMarch 2012 from US$266.0 million recorded in September

2012. This was largely explained by the increase indemand for foreign exchange that outweighed supplyduring the review period. Consequently, the officialimport cover decreased to 1.1 months in March 2012.

1.3.2 The Financial Sector

i. Credit RisksCredit risks have remained significantly high as economicagents continue to face debt repayment pressures mainlydue to unfavourable macroeconomic developments.

Over the six months period to March 2012 the ratio ofnonperforming loans as a percentage of GDP improvedmarginally from 0.77 percent to 0.70 percent. Theminimal improvement is likely to undermine the balancesheets of lending institutions, thereby posing a threat tothe domestic financial system. In addition, total credit tothe private sector as a percentage of GDP contractedfrom 17.46 percent in September 2011 to 14.06 percent inMarch 2012. Private sector credit as a ratio of GDP is aconventional indicator of banking sector development asit measures the intermediary role of the banking systemand also the efficiency of the financial system. The

decrease in credit to the private sector as a percentage ofGDP is a reflection of tight credit conditions prevailing inthe local financial markets as financial intermediariesimplement a responsive solution to the persisting defaultrisks. Thus the decrease in credit to the private sector asa percentage of GDP signifies the potential vulnerabilityof the local financial system to default risks.


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ii. Liquidity RisksBanking system liquidity risks eased as banks continued tohold significantly high total reserves compared to requiredreserves. In March 2012 excess reserves stood at K10.93billion compared to K4.40 billion in September 2011. Thehigh liquidity in the system was also evidenced by the

decreasing Discount Window accommodation from K0.70billion in September 2011 to K0.45 billion in March 2012.The increase in liquidity was on account of expansionaryfiscal operations. This was exacerbated by inadequatecontractionary monetary operations mainly due todecreasing foreign exchange reserves on the part of theauthorities. However, the significantly high levels ofliquidity that prevailed in the financial system are likelyto have induced an increase in risk appetite andinflationary pressures in the economy.

iii. Monetary ConditionsMonetary conditions largely remained unchanged over thereview period as the policy rate remained constant at13.0 percent. Consequently, the commercial bankslending and savings rates remained static at 17.75 percentand 3.75 percent, respectively. In addition, the All TypeTreasury bill rate maintained an upward trend to 7.7percent in March 2012 from 6.64 percent in September2011.

However, money market operations in March 2012worsened mainly on account of an unfavourablemacroeconomic environment, notably the hike in inflationfrom 7.7 percent in September 2011 to 11.4 percent inMarch 2012. Investors continued to earn a negative realrate of return on money market instruments, as inflationremained higher than savings and Treasury bills rates. Thisis likely to cause a potential threat to the domesticfinancial system by discouraging investors in the moneymarket, thereby undermining the balance sheets of thefinancial intermediaries.

iv. Financial Conditions of the Non Financial SectorThe robust performance of financial systems largelydepends on the financial condition of their customers.There is a positive correlation between the level offinancial stability and the vulnerabilities to changes in theeconomic environment of financial systems clients. Majorcustomers of the financial intermediaries are the nonfinancial sector, namely the household and the corporatesector. In addition to providing deposits, the householdand corporate sectors also form a significant part ofdemand for financial services and products. In the questfor financial stability, it is therefore vital that the


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Chart 6: Personal Loans as aPercentage of GDP


Chart 7: Growth Rate of PersonalLoans


Chart 8: Corporate Loans as aPercentage of GDP


financial conditions of the non financial sectors arecritically assessed.

a) Corporate and Household Debt RatiosThe ratio of personal loans, as measured by loans to

households, as a percentage of GDP trended downwardsto 2.6 percent in March 2012 from 3.1 percent inSeptember 2011. Similarly, loans to the corporate sector,as narrowly measured by the loans extended to thecommercial and industrial subsector for businesspurposes, as a percentage of GDP declined to 6.5 percentin March 2012 from 8.4 percent in September 2011. Thedecreasing trend in both loans to households and businessenterprises as a percentage of GDP was mainly on accountof banks unwillingness to lend to the non financial sector.The tight credit conditions were adopted by most lendingbanks in the domestic market in order to hedge against

the prevailing default risk of borrowers, largely emanatingfrom the deteriorating macroeconomic and businessconditions in the country.

v. Resilience of Domestic Financial System toExternal Macro-financial Developments

The domestic economy remained vulnerable to global andregional shocks due to its links with the rest of the worldthrough aid and trade. Malawi has aid and tradedependence relationships with the currently financiallystressed euro zone. Malawis exports to the Euro regionare estimated at 21.0. Furthermore, it is estimated thatdevelopment partners fund a significant portion ofMalawis budget, with the euro region contributing asubstantial amount. In addition, Malawi is a net importerof commodities such as fertiliser and fuel. Consequently,inflationary pressures and exchange rate developments incountries that supply strategic commodities including oilto Malawi are likely to have spill-over effects into thelocal economy. However, the Malawi economy is a smallopen economy, and its financial system is not reallyinterconnected with foreign markets. As such, thedomestic financial system remained resilient to externally

generated shocks.

1.3.3 Potential Risks to Domestic Financial StabilityAhead

Risks to the domestic financial system are likely to persistowing to the projected sluggish domestic economic andfinancial activities.

The persisting increase in inflation poses a threat to thedomestic financial system. High levels of inflationundermine the real earnings of investors in the financial


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markets. This is likely to cause financial disintermediationas investors in the money market will be demotivated andforced to withdraw their funds from financialintermediaries.

Unfavourable projected macroeconomic developments are

also likely to exert a negative impact on production ofvarious sectors of the economy and real output at large.This will amplify default risk by undermining the loanrepayment ability of borrowers in the financial system,thus in turn worsening the financial positions of thelending institutions.

The long outstanding speculation about the exchange rateadjustment has exacerbated the prevailing shortage offoreign exchange as economic agents have preferredholding foreign currency. Therefore, if the currentspeculation continues, it is likely to worsen the operations

of the domestic financial system.

Furthermore, fuel shortages arising from theunavailability of foreign exchange as well as poweroutages continue to be a cause for concern.

1.3.4 Remedial Options

The prevailing shortage in foreign exchange has beencaused by increased demand for imports which has usuallyoutpaced the available sources of foreign exchange. Thus

authorities need to emphasise on the implementation ofpolicies deliberately aimed at increasing exports andenhancing import substitution. This can be achievedthrough various ways including the correction of themisalignment in the exchange rate to restore equilibrium,imposing high levies on locally substitutable imports andencouraging local production of substitutes for someimports.

Despite limited exposure of the domestic financial systemto the rest of the world, external shocks are likely to hitthe domestic financial system through contagion and cross

border systemic risks. It is essential that the financialsystem supervisors put in place measures aimed athedging against the impact of foreign threats on the localfinancial system. Therefore prudential and risk basedsupervision should be emphasized in order to ensure thatfinancial system fragilities and vulnerabilities areminimised.

High level of inflation is detrimental to the operations ofboth the financial and non financial sectors. Thus if thecurrent rise in inflation is not addressed, the Malawi


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economy and its financial system are likely to continuefacing unfavourable developments. It is thereforenecessary that monetary authorities should implementtight monetary policies aimed at curbing rising inflation.Upward adjustment of the policy and interest rates istherefore not only important for contracting levels of

inflationary liquidity in the financial system but also forthe improvement of the real rate of return to investors inthe financial market. There is a positive correlationbetween the real rate of return in the money markets andwillingness of economic agents to invest in the moneymarket, thereby strengthening the financial positions offinancial intermediaries.

In order to maintain financial system liquidity withinfinancially healthy levels over the long term, authoritiesshould consider issuing more long term instruments. Inaddition, the Government as a major cause of excess

liquidity should ensure that it implements policies aimedat enhancing fiscal prudence. The Government shouldtherefore also consider issuing more long-term Treasurybonds in order to reduce the frequency of borrowing fromthe central bank to finance maturing securities.


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BOX 2.1: MALAWIS FINANCIAL INSTITUTIONSBANKING INSTITUTIONS

1 National Bank of Malawi

2 Standard Bank of Malawi3 FMB Bank4 NBS Bank5 IndeBank Malawi6 Nedbank Malawi7 Malawi Savings Bank8 Opportunity Bank of Malawi9 Ecobank

10 FDH Bank11 International Commercial Bank12 Leasing and Finance

Company13 CDH Bank Investment BankINSURANCE COMPANIESNon-life InsuranceCompanies

1 Charter Insurance Co Ltd2 General Alliance Insurance Co Ltd3 NICO General Insurance Co Ltd4 Prime Insurance Co Ltd5 REAL Insurance Company of Mw Ltd6 Reunion Insurance Company Ltd7 United General Insurance Co Ltd

Life AssuranceCompanies

8 NICO Life Insurance Co Ltd9 Old Mutual Life Assurance Co Mw Ltd

10 Smile Life Assurance Company Limited11 Vanguard Life Assurance Co Ltd

THE CAPITAL MARKET1 Malawi Stock Exchange (MSE)

i. Stockbrokers Malawi Limitedii. FDH Stockbrokersiii. African Alliance Securities Ltdiv. CDH Stockbrokers


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Chart 2.1 Banking Industry TotalAssets


2.0 FINANCIAL INSTITUTIONS

2.1 THE BANKING SECTOR

Malawis banking sector remains relatively stable. This isevident from the performance indicators such as capitaladequacy, profitability, quality of assets and liquidity

which have revealed satisfactory performance over the sixmonths period to March 2012. The performance is likely toremain stable in the ensuing months.

2.1.1 The Banking Sector in Malawi

As depicted in Box 2.1, the banking sector in Malawicomprises 13 banking institutions (except the RBM) thatare mainly engaged in financial intermediation. Examplesof these institutional units include commercial banks,merchant banks, and a leasing company. Two largebanks, National Bank of Malawi and Standard Bank ofMalawi, dominate the sector with a combined assets anddeposits account of 46.0 percent relative to the entiresector. This position is slightly lower than in September2011, when their dominance stood at 48.0 percent.

2.1.2 Assessment of Financial Soundness Conditions

The consolidated balance sheet of the banking industryexpanded by 9.8 percent over the six months to March2012. This was lower than the 16.7 percent growthrecorded over the six months to September 2011. The

small growth in the banking industrys asset size can beexplained by the relatively smaller growth in the depositbase, being the major source of funding. The consolidateddeposit base and capital account grew by 10.2 percentand 17.7 percent respectively. All banks loan books areestimated to have grown by over 9.2 percent over the last6 months. While this is a positive development for theeconomy, the increased lending has also led to anincrease in credit risk for commercial banks (the risk thatarises from counter party defaults on agreements).

An analysis of the sectoral distribution of credit byregistered banks in Malawi revealed that as at March2012, a major portion of the banking sectors credit wasextended to private corporations (46.6 percent) and toindividuals and households (18.5 percent). Compared withthe year before, concentration of banks exposures to thevarious sectors remained largely unchanged.

Main Message

The banking sector remains stablethough highly concentrated.Although growth of theconsolidated balance sheet in thesix months period (September2011 to March 2012) is relativelysmaller, the performance of thesector remains satisfactory. Twoof the largest banks hold almosthalf of the sectors total assetsand deposits. Apart from thedominance of the two largestbanks, the main risk remainscredit concentration in thecommercial and industrial sector

which essentially exposescommercial banks to negativedevelopments in the sector.


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Chart 2.2 Banking Industry AssetStructure


Chart 2.3 Banking IndustryCapital Adequacy


Chart 2.4 Banking IndustryCredit Conditions


2.1.2.1 Capital AdequacyBanks in Malawi are required to maintain a minimum corecapital ratio4 of 6.0 percent and minimum total capitalratio of 10.0 percent. In the six months to March 2012,the core capital of the banking sector at 19.7 percentincreased by 3.6 percentage points. The increase can be

attributed to 26.9 percent growth in core capital against3.6 percent growth in risk weighted adjusted assets overthe same period. The banks capital positions imply thatthe banking sector has sufficient cushion to cover lossesthat may arise in the normal course of business to avoidinsolvency.

2.1.2.2 EarningsThe capital position of the banks is constantly enhancedby the profitability of the sector. On account of a stableinterest rates environment, the profitability of thebanking industry improved thereby building up capital in

the process.

These developments are reflected in the increase in thereturn on equity (ROE) ratio to 34.7 percent in March 2012from 28.3 percent in September 2011. ROE ratio reflectsthe banking institutions efficiency in using capital and,over time, it provides information on the sustainability ofdeposit-takers capital positions. Similarly, return onassets (ROA), which is a measure of deposit-takersefficiency in using assets of the banking institutions,increased to 5.0 percent in March 2012 from 3.9 percentin September 2011.

2.1.2.3 LiquidityLiquidity is critical to the survival of the banking sector asbanks need to settle any claims that depositors and othercreditors make on their investments. The Reserve Bank ofMalawis Policy Statement on Prudential Aspects of BanksLiquidity requires banks to maintain a minimum liquidityratio of 30.0 percent. This ratio presents liquid assets as aproportion of deposits and short term liabilities5. Theliquidity of the banking industry was at 42.8 percent,which was above the regulatory requirement.

2.1.3 Banking Sector Risks and Remedial Measures

A large concentration of credit in a specific economicsector or activity could increase the vulnerability of thebanking sector to adverse developments in that sector oractivity. Many financial crises in the past were partly

4 Core capital ratio is a measure of the equity readily available for the absorption of lossesas a percentage of risk based assets.5 Liquid assets as a percentage of total assets referred to as the liquid-asset ratio), is an

asset-based financial soundness indicator that reflects the liquidity available to meet


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Chart 2.5 Banking IndustryProfitability


Chart 2.6 Banking IndustryLiquidity


caused or amplified by downturns in particular sectors ofthe economy spilling over into the financial system.Evidently, loan concentrations in the corporations, andindividual and household sectors, merit close monitoring.Authorities need to monitor the disproportionately hugedependence of the commercial and industrial sector on

commercial banks credit with the surveillance focusingon repayment capabilities. Higher repayment burdensincrease the vulnerability of the private sector to adverseeconomic shocks.

Another risk relates to availability of foreign exchange.The prevailing global liquidity constraints could curtailcredit lines by correspondent banks leading to reductionin letters of credit and foreign exchange business ingeneral. Consequently, the profitability of banks would benegatively affected. Similarly, low foreign exchange

reserves for Malawi could effectively deny commercialbanks an important source of funding, thereby affectingtheir profitability. Unavailability of foreign exchange canalso be attributed to poor performance of tobacco sales atthe auction floors. As at 31st March 2012 a total amount of1,174,800.00 Kg (US$1,204,700.00) of tobacco was sold atthe auction floors compared to a total amount of4,908,000.00 (US$3,716,200.00) sold as at 31st March2011. To counter this challenge, the Malawi Governmenthas established the Export Development Fund (EDF) whichis geared towards raising foreign exchange for the countrythrough the financing of non-traditional exports.


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BOX 2.2: REGULATIONS PERTAINING TO THE BANKING SECTOR

Recently, two bills were enacted into law, namely the Banking Bill and the Financial Services Bill(FSB). Whereas the Financial Services Act 2010 is an umbrella Law for the whole financial sector,the Banking Act 2010 has the following implications on the banking sector:

Enhancement of Fit and Proper requirements;The Act extends fit and proper requirements beyond the board and executivemanagement to include shareholders who are the ultimate drivers of banking entities. Inaddition, the Act also requires that fit and proper requirements should applycontinuously when an individual is in office to ensure proper conduct of office bearers.This is unlike in the previous Act where such requirements were only applied when theindividual is being appointed into office.

Enforcement and Corrective Action;The previous Act did not adequately provide for enforcement and corrective action when abank violated provisions of the Act. The current Act seeks to enhance corrective action soas to encourage compliance among players in the market by imposing both administrativeand monetary penalties to a non compliant player.

Problem Bank Resolution and Statutory Management;The current Act addresses problem bank resolution and statutory management. Statutorymanagement involves assessing a bank that is experiencing problems to establish whetherit can be salvaged and restored to normal operations before any receivership andliquidation considerations can be made. The inclusion of the statutory management

requirement will ensure that banks that can be restored to normality at a reasonable costare not placed under receivership.

Additional Duties of External Auditors;The Act provides the Registrar with regulatory powers to require external auditors topresent their findings, especially adequacy of provisions for bad debts, prior to publishingthe annual accounts. The incorporation of this requirement is important as it will enablethe Registrar to review and assess the adequacy of the provisions for bad debts before theaccounts are published with the objective of preventing overstatement of the financialcondition of a banking entity.

Submission of Periodical Returns;An essential element of banking supervision is the ability of the Supervisor to supervise thebanking group on a consolidated basis, adequately monitor and apply prudential norms toall aspects of the business conducted by the group. This requires that the Registrarmonitors the performance of banks subsidiary, affiliate, associate or holding company.Unlike the previous Act, the current Act gives power to the Registrar to call for periodicreturns of banks groups companies. This is in line with Basle Core Principles for EffectiveBanking Supervision.

Transfer of Responsibilities;Under the previous Act, decision-making in terms of operational activities of the Registrarsuch as endorsing new licences, replacement of the same due to change of name, loss or

change of trading premises had been referred to the Minister of Finance. The current Acthas transferred such operational responsibility to the Registrar, thus allowing the Ministerto concentrate on determining the sectoral policy.


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BOX 2.3: BASEL II AND FINANCIAL STABILITY

The Reserve Bank of Malawi took a policy position in 2005 to adopt Basel II in its supervisorywork. Currently, Malawi is under Basel 1 and preparations are under way to adopt Basel IIby 2014. It is believed that adoption of Basel II will promote financial stability since underBasel II regulation of bank capital plays a key role in banks soundness, risk -taking

incentives and corporate governance. This is because poorly capitalized banks are likely tospur systemic risk and hence threaten financial stability.

What is Basel II?

Basel II is a revision to the 1988 Basel Capital Accord (commonly known as Basel 1)produced by the Bank for International Settlements (BIS) headquartered in Basel,Switzerland. Basel 1 was intended to provide a framework within which internationallyactive banks mainly in G10 countries could compete on a level playing field with regards toregulation. However, due to regulatory arbitrage the Basel Committee on BankingSupervision (BCBS) proposed a revised capital framework in 1999 which was approved in

June 2004. The new framework aims to reduce the scope of regulatory arbitrage byimproving the measurement of risk and better aligning risk weights with the underlyingrisks. Whereas the structure of Basel 1 was premised on one pillar (i.e. minimum capitalrequirements), Basel II is premised on three pillars as follows;

Pillar 1of the new capital framework revises the 1988 Accords guidelines by aligningthe minimum capital requirements more closely to each banks actual risk of economicloss.

Pillar 2 of the new capital framework recognises the necessity of conducting effectivesupervisory reviewof banks internal assessments of their overall risks to ensure that bankmanagement is exercising sound judgement and has set aside adequate capital for these

risks.

Pillar 3 leverages the ability of market discipline to motivate prudent management byenhancing the degree of transparency in banks public reporting. It sets out the publicdisclosures that banks must make that lend greater insight into the adequacy of theircapitalisation.

The New Basel Capital Accord envisages a greater role for supervisory judgment indetermining capital adequacy and increased use of rules of disclosure to impose marketdiscipline on bank behaviour; thereby addressing many standard criticisms of the original1988 Accord. Further, it is argued that the New Basel Capital Accord has the potential of

significantly improving risk management practices in banking systems around the world,and that it would eventually increase the efficiency of the financial system.

The overarching goal for the Basel II Framework is to promote the adequate capitalizationof banks and to encourage improvements in risk management, thereby strengthening thestability of the financial system. This goal will be accomplished through the introduction ofthe three pillars that reinforce each other and that create incentives for banks toenhance the quality of their control processes.


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BOX 2.4: RISK BASED SUPERVISION MALAWIS EXPERIENCE AND STAGE OF IMPLEMENTATION

The Reserve Bank of Malawi (RBM) formally adopted a risk based approach to supervision (RBS) ofbanks in 2009 with technical assistance from the IMF East Afritac. This was a departure from thetraditional CAMEL approach. The CAMEL approach was first adopted in 1979 in the United States ofAmerica and ever since, Central banks world-wide have employed this approach to assess the

financial soundness of banks. The approach involves analysis of capital adequacy, asset compositionand quality, management, earnings and liquidity.

The two approaches are different as illustrated in the following table:

CAMELs Approach Risk-Based Approach

1. Transaction based Process or system oriented

2. Point in time assessment Continuous assessment

3. Employs standard procedures Employs risk driven procedures

4. Focuses on historicalperformance

Forward looking and futuristic perspective

5. Focuses on historical riskquantification and future avoidance

Focuses on risk management

The major focus of RBS approach has been on all the risks assumed by banks in the course of theirbusiness such as credit risk, operational risk, liquidity risk, market risk and legal and reputational

risk.

After implementing the RBS for 2 years, the RBM had an independent assessment from the IMF EastAfritac (in January 2012) to review the implementation of its RBS framework.

The review mission found that RBM had made progress in moving from compliance based supervisionto RBS and that a number of RBS tools and practices were in place. However, the mission identifiedconcerns about the use and maintenance of some RBS tools such as institutional profiles, riskmatrices and scope memoranda. It also noted in some instances the need to strengthen the qualityof financial analysis in quarterly offsite reports.

To address these shortfalls, the IMF East Afritac conducted a training program from May 28 toJune1, 2012.


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2.2 BANK LENDING SURVEY

2.2.1 Objectives of the Survey

The lending survey is undertaken by the ResearchDepartment of the Reserve Bank of Malawi bi-annually, inApril and October. The main objectives of the survey are

to: Supplement statistics on credit market conditions

derived regularly from the monthly balance sheets ofthe commercial banks in order to broaden theassessment of monetary and economic developmentsas an input into monetary policy decisions.

Enhance RBMs assessment of the usage of privatesector credit in order to ascertain whether the bulkof the credit is being channelled to productiveavenues i.e. consumption or production.

Facilitate the preparation of economic forecasts asinformation regarding expected changes in creditconditions could enhance the precision of economicprojections.

Bolster the assessment of systemic risks throughacquisition of information regarding the commercialbanks pricing of risk.

2.2.2 Response Rate

Questionnaires were sent to twelve commercial banks andten of the commercial banks responded, yielding anoverall response rate of 83 percent. The systemicimportance of every institution notwithstanding the Banksthat did not respond accounted for 3.9 percent of thetotal assets of the banking sector in March 2012.

2.2.3 Credit Developments October 2011 March 2012

During the survey period, gross extensions of creditamounted to K12.8 billion against recoveries of K0.9billion yielding a net extension of K11.9 billion. This wasslightly lower compared to the K13.1 billion extended

between March and September 2011. Overall, 8 out of the10 banks recorded net extensions whilst net recoverieswere registered at only 2 of the banks. In terms ofsectoral allocation, the commercial and industrial sectoraccessed 46.0 percent of the resources whilst theindividuals and households benefited about 18.5 percentof the commercial banks resources. Mortgage loansaccounted for about 12 percent of the credit, typifyinggrowth despite challenging economic circumstances.Notably the participating banks accounted for 89.6percent of the resources availed during the survey period.


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Table 2.1: Growth By Sector

GDP GROWTH BY SECTOR2008 2009 2010 2011 2012

Agr iculture, forestry and f ishing 4.2 13.1 2.0 6.4 4.1

Mining and quarrying 35.8 4.9 80.2 (4.5) 13.9

Manufacturing 19.5 4.8 2.2 1.7 2.0

E lect ricit y, ga s & water supply 5 .0 6.6 4.0 4.4 2.0

Construction 2.7 7.4 16.1 (2.4) 4.2

Wholesale and retail trade 19.2 6.6 8.0 3.5 5.0

Transportation and storage 16.3 8.9 4.2 2.7 4.2

Accommodation and food services 7.6 13.2 8.4 0.4 6.0

Information and communication 58.1 10.5 10.0 6.5 7.5

Financial and insurance activities (14.7) 7.8 10.6 10.0 8.7

Real estate activities 19.7 12.1 11.0 2.6 2.6

Public administration and defense 7.4 4.9 5.8 -1.8 1.1

GDP at constant market prices 8.3 8.9 6.7 4.3 4.3

Source: Ministry of Economic Planning and Development

Chart 2.7 Changes in FactorsContributing to Credit Standardsas applied to Approval of Loans orCredit to Enterprises

-100

-80

-60

-40

-20

0

20

40

60

80

Capital Liquidity Securit ies Competit ion Perception of

risk

Apr-11 Dec-11 Apr-12

The positive value refers to creditstandards easing or that the factor hasimpacted the easing of credit standardswhile the negative balance refers tocredit standards tightening or that the

factor has affected the tightening ofcredit standards

2.2.4 Developments in Credit Standards

According to the April 2012 bank lending survey, nettightening of credit standards was upheld as bank expertsreported a broadly neutral stance. This development wasalong the lines of expectations reported in the September2011 bank lending survey. The tightening of standards was

applied to both households and corporations. In netterms, the tight credit standards were sustained for Smalland Medium Enterprises (SMEs) with a further gripreported at 50 percent of the Banks. Aversion towardslong-term loans was also noticeable whilst standardsremained the same for short-term loans. With respect tohouseholds, tightening of standards surged at 70 percentof the banks especially on consumer credit and otherlending.

Participating banks reiterated that the surge in the nettightening of credit standards was attributed to theadverse combination of a weakening economic andindustry outlook. Evidently, after averaging over 7.5percent a year during 2007-10, real GDP slowed down to4.3 percent in 2011. The worsening economic activityoutlook was on account of the effects of the foreignexchange shortages which impacted the manufacturing,transportation, construction and wholesale and retailsectors as tabulated in table 2.1:

The weaker expectations concerning economic outlookcontributed to the banks maintaining the tightening of

standards. Subsequent risk assessments on collateraldemanded also led to further tightening as reported at 80percent of the banks, up from 63.4 percent in thepreceding survey. Aligned with the deterioratingsentiments, perception regarding the creditworthiness ofconsumers worsened at 70 percent of the participatingbanks, up from 63.4 percent in the December 2011survey. Concurrently, the economic environment had abearing on cost of funds and balance sheet constraints asmanifested in capital position considerations at 60percent of the institutions. Further, the contribution inrelation to liquidity conditions as well as investment in

securities also contributed to the tightening of standardsshored up largely by structural balances held inanticipation of foreign exchange availability and thesearch for a yield, respectively.

In contrast, counterbalancing factors like pressure fromcompetition, which generally works in the direction ofeasing of credit standards, was reported to havecontributed to some ease at 40 percent of the banks, adeparture from the previous round when they remainedbroadly neutral.


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Chart 2.8 Factors Affecting DemandFor Loans by Corporations

-60

-40

-20

0

20

40

60

80

100

120

Fixed investments Inventories &

working Ca pital

Mergers &

Acquisition

Use of alternative

finance

Ap r-11 Dec-11 Apr-1 2

The positive balance shows an increaseof the demand or that the factorhas contributed to increased demand,while the negative balance reveals afall in demand or that the factorhas contributed to decreased

credit demand.

2.2.5 Developments in Demand For Loans

In terms of demand, Malawian banks reported a highincrease in net demand for loans at 70 percent in April2012, albeit slightly lower than the 81.8 percent ofDecember 2011. Demand by large firms surged to 70percent in April 2012 from 63.8 percent in December 2011

whilst SMEs demand stagnated at about 80 percent. Therewas a marked shift away from long-term loans into short-term as concerns regarding the trajectory of inflation andservicing costs came to the fore. Reflective of thisdevelopment, demand for short term loans soared at 80percent of the banks.

The worsening economic environment led to increasedrecourse to commercial banks resources principallydriven by inventories and working capital needs whosecontribution remained high at 80 percent of the banks.Financing needs for fixed investments were lesspronounced (30 percent in April 2012 and lower than 45percent in December 2011) whilst mergers andacquisitions remained non-aligned to demand.

In terms of households, demand for loans for consumptionincreased as well as for consumer credit whilst demandfor mortgage loans actually declined. It is noteworthy,however, that over recent quarters, both realised andexpected figures on the demand for mortgage loans havebeen particularly volatile from one quarter to the next,possibly pointing to a large degree of uncertainty with

respect to this category of loans.

2.2.6 Prospects for April 2012 September 2012

The expectations regarding loan demand weredichotomised into a no policy change scenario as well as apossible devaluation of the kwacha. In the event thatpolicies did not change significantly, banks anticipate thatdemand will increase somewhat on the strength of therelevant survey period which is normally earmarked formarketing of agricultural produce but moderated by fueland foreign exchange shortages. But with the new

Government, most experts were optimistic that creditconditions will normalise. The net percentage of banksassessing a drastic increase in credit demand stood at 90percent and the assessment was premised on improvedeconomic sentiment, relations with donors and pricesfetched at the tobacco auction which were deemed inturn to propel activity hence higher demand for banksfinancing at both households and corporations.

The banks experts assess that credit standards applied onloans to households and corporations shall remain

basically unchanged in the six months to September 2012based on the fact that in the short-term, benefits of any


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foreseeable adjustment should be transmitted into thesystem with a lag. In the meantime, banks shall bemaking assessment regarding credit and liquidity risks andfurther loosen standards in the medium term.

2.3 STRESS TESTING

Stress testing represents a risk management tool used toevaluate the potential impact on a banking institution (ora group of entities) of a specific event and/or movementin a set of financial variables. Stress testing generally isused as a generic term for the assessment of thevulnerability of individual banking institutions or thebanking/financial system to shocks. At its most basiclevel, stress testing involves the application of what ifscenarios. The difficult identification of low frequency but

high severity events is of particular interest in thiscontext. It focuses on capturing the impact ofexceptional, but still plausible, events and theunderstanding of the overall risk profile of the bank in acoherent and consistent framework. Stress testing canalso involve more sophisticated techniques that provideinformation on the major vulnerabilities of a country'sfinancial system. In this case, the techniques are usuallyreferred to as macro, or aggregate, stress tests. Thisapproach can use a bottom-up or a top-down approach orthe combination of both.

The two key words used to define a stress event are'exceptional' and 'plausible'. Although stress events shouldbe low-probability events, they should not be so far-fetched as to stretch the limits of plausibility. This isbecause lack of plausibility can limit the importance givento the results of stress tests, i.e. the event might bedeemed so unrealistic that nobody believes it will everhappen and hence no importance will be assigned to thestress tests. Stress testing involves testing beyond normaloperational capacity, often to a breaking point, in orderto observe the results.

Stress testing permits a forward-looking analysis and auniform approach to identifying potential risks generatedby exceptional but plausible shocks to individualinstitutions and/or the financial system as a whole. It alsoexamines potential vulnerabilities faced by institutionsthat may not be revealed by quantitative riskmanagement models. Stress testing supplements theoutput of quantitative risk management models such asValue at Risk (VAR), and have the advantage over VAR ofexplicitly linking potential large losses with specificevents. Stress testing also enables management to better

understand the nature of risks embedded in business linesand may also help to initiate dialogue in order to quantify


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the effects of exceptional events on various risk types inisolation and on combinations ofrisks. Finally, stress testscan assist banks in conducting appropriate contingencyplanning for periods of stress and contribute to theprocess of allocating capital within the bankinginstitution.

The Reserve Bank of Malawi is currently conducting stresstests for banking institutions on a biannual basis. Data for11 banking institutions as at end December 2011 wasshocked. Emphasis was put on trying to establish relevantlinks between the macro shocks and the variables in thestress testing spread sheet. In addition to shocks affectingsingle risk types (e.g. credit risk and foreign exchangerisk), shocks were combined in order to look at thecombined effects on the banks financial positions, mainlytheir Tier 1 ratios. Both the results for individual banksand the whole banking sector were analyzed and are

discussed below.

A range of macro shocks and combination of shocks wereused. The results indicated that, in general, the singlebiggest risk of most of the banks stems fromconcentration risk related to large borrowers. Shock tothe agricultural sector is also likely to affect the bankscredit risk to a considerable extent. This shock might alsoaffect the banks income, in particular income fromforeign exchange trading. The agricultural shock assumedin this exercise, showed that three banks would have anegative Tier 1 ratio while four other banks would haveTier 1 ratios around or below the minimum regulatoryratio of 6 percent set by RBM.

The effect of shocks to the banks net interest income andincome from foreign exchange trading activities on theirreturn on assets (ROA) were also analyzed and discussed.The results indicated that the shocks have a large effecton most of the banks ROA. Four banks would have anegative ROA owing to their high dependence on incomefrom foreign exchange trading.

The results further indicated that some banks areconsiderably more exposed to liquidity risk than others.For example, if there was a sudden withdrawal of 20percent of the banks domestic demand deposits and a 5percent withdrawal of their foreign currency demanddeposits, two banks would be illiquid already after twodays1.

More detailed results of the stress tests are providedbelow. However, the exact identities of the bankinginstitutions have been intentionally ommitted. Fordiscussion of weaknesses/limitations of the model and

1 This result may have been influenced by the starting date, the last

b ki d f h


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Chart 2.9 Largest ExposureConcentration Risk


Chart 2.10 Number of BanksAfter Liquid Shocks


Chart 2.11 Direct and IndirectEffect of 50 Percent Depreciation


data used in the stress tests please refer to Boxes 2.5 and2.6.

2.3.1 Large Exposure Concentration Risk

Risk concentration towards large loan exposures isprobably the single largest risk exposure of the banks of

Malawi. As per chart 2.9, there is a considerable decreasein the Tier 1 ratio even if only the largest exposure ineach bank becomes NPL and the loan loss provision is 50percent. The results highlight the considerably largeexposure concentration risk the banks are subject to.

The following assumptions were made:i. The 1st largest borrower fails.ii. The 1st and 2nd largest borrowers fail.iii.The 1st, 2nd and 3rd largest borrowers fail.iv. The 1st, 2nd, 3rd and 4th largest borrowers fail.v. The 1st, 2nd, 3rd, 4th and 5th largest borrowers fail.vi. The 1st, 2nd, 3rd, 4th, 5th and 6th largest borrowers

fail.vii.The 1st, 2nd, 3rd, 4th, 5th, 6th and 7th largest

borrowers fail.viii.All the eight largest borrowers fail.

2.3.2 Liquidity Risk

As per chart 2.10, the results show that two banks will beilliquid, i.e. the net cash outflow from the assumptions islarger than the cash available from the assumptions,already after day 2. After day 3, another two banks will

be illiquid. By the end of day 5, only five banks remainliquid.

The following assumptions were made:i. A withdrawal of 20.0 percent of both domestic

demand and time deposits each day for five daysii. That only 5.0 percent of the foreign currency

deposits are withdrawn as a result of the shock.iii.90.0 percent of the liquid assets and 1.0 percent

of the non-liquid assets were assumed to beavailable each day.

iv. That the banks do not use the discount windowor other funding alternatives to compensate forthe lost deposits.

2.3.3 Foreign Exchange Risk

A bank might be exposed to both direct and indirectforeign exchange risk. The direct risk reflects the net


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Chart 2.12 Tier 1 Ratio AfterIncrease In Interest Rate


Chart 2.13 Tier Ratio AfterEquity Shock


Chart 2.14 Effects of IncomeShocks on Tier 1 Ratio


open exposure of all foreign currency positions, while theindirect risk reflects the risk a bank faces from loancustomers who have borrowed in a foreign currency. Chart2.11 below shows the direct and indirect effects of theshock on all banks. As seen, banks in total will actually

benefit slightly even if the NPL on foreign exchange loansis 30 percent and the loan loss provision is 50 percent.

The following assumptions were made:i. Banks are exposed to both direct and indirect

foreign exchange rate risk.ii. The direct risk reflects the net open exposure of

all foreign currency positions, while the indirectrisk reflects the risk a bank faces from loancustomers who have borrowed in a foreigncurrency.

iii.A 50.0 percent depreciation of the MK.iv. That 30.0 percent of the banks foreign exchange

loans become NPLs and that the loan loss provisionon these loans is 50.0 percent.

2.3.4 Interest Rate Risk

The results indicate that only four banks will experience adrop in tier 1 ratio as a direct result of an increase ininterest rates of 4.0 percentage points. Nevertheless, thedrop is only marginal. The results for all banks are shownin chart 2.12 below.

The following assumptions were made:i. An increase in the RBM interest rate of 4

percentage points.ii. That there is a parallel increase in the interest

rates of banks, i.e. a given increase is identical forall interest bearing assets and liabilities.

2.3.5 Equity Risk

The banks holdings of shares listed on the MSE and othernon-listed securities are rather small. On average theyconstitute only 1.7 percent of the banks total assets. For

only two banks, the holding of local stocks is larger than 2percent (8.5 and 2.1 percent, respectively). This impliesthat even large shocks to the value of locally held stockwill not affect the banks Tier 1 ratio to a critical extent,although the banks profits will deteriorate to someextent. Only one bank will experience a substantial dropof its tier 1 ratio as a result of this shock i.e. from 17.1percent to 11.0 percent. Chart 2.13 shows the effect of a50.0 percent decline in the value of locally held stocks.The assumption of a reduction of 50.0 percent in thevalue of domestic stocks is employed.


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Chart 2.15 Effects of IncomeShocks on ROA


Chart 2.16 Tier 1 Ratio AfterCombination of Shocks


2.3.6 Shock to Net Interest Income

The banks net interest income would be reduced by a fallin the interest margin and/or a reduction in lendingvolume. The interest margin could be affected byincreased competition between the banks, for example asa result of foreign banks entering the market or the

domestic banks stepping up their fight for market shares.The interest margin could also be affected by a generaldecrease in the interest rates, for example if the depositrates decrease less than the lending rates.

The results indicate that the tier 1 ratio of all banksindividually will not be considerably affected by a 10percent decrease in net interest income. Two mostaffected banks will have their tier 1 ratios drop from 31.3percent and 17.6 percent to 25.6 percent and 12.3percent, respectively. The effects of the shock to netinterest income on all banks are shown in chart 2.13below.

Assumes decrease in the banks the return on assets (ROA)as a result of decrease in net interest income of 10percent.

2.3.7 Shock to Net Foreign Exchange Income

Chart 2.14 below shows the effects on the banks ROA ofdecreases in net foreign exchange income of 50.0percent. All other things being equal, all banks will stillhave a positive ROA if their net foreign exchange income

decreases by up to 50.0 percent; whilst the ROA of fourbanks will become negative. The results show that thebanks vulnerability to decreases in net foreign exchangeincome varies considerably. Four banks will retain arelatively healthy level of ROA even if their net foreignexchange income decreases by 50.0 percent.

2.3.8 Combination of Agricultural Shock and Other Shocks

In the stress tests above, it is assumed that the effects ofthe shocks are deducted directly from the Tier 1 capital,keeping all other factors constant. This is a staticapproach, in which it is assumed that the banks do notcarry on with their activities during the stress testingperiod.

The effect of combined shocks is that three banks areparticularly hard hit with their tier 1 ratios turningnegative. Three banks also have their tier 1 ratios belowthe regulatory minimum. Interestingly, two banks recordan increase in their tier 1 ratios.

The effects of the combined shocks on all banks are

shown in Chart 2.15 below.


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Box 2.5: ASSUMPTIONS (MACRO SHOCKS AND CREDIT RISK)

Agricultural shock

The following assumptions were made:- As a result of a serious drought, the agricultural output decreases by 50.0 percent

compared to last years output.- This is assumed to affect all producers of agricultural products (both individualsand companies) to some extent. Some are likely to be seriously affected, as alarge part of their income will disappear while the production cost may remain atalmost the same levels. Hence, it is not unreasonable to assume that a relativelylarge part of the loans to companies and individuals directly engaged inagriculture will become NPL.

- The recorded overall high of NPL of 21 percent in 2002 was to a large extent aresult of a serious drought. Although a sector break-down of the NPL data was notavailable at that time, it is not unreasonable to assume that the NPL of theagricultural sector was well above 21 percent as this was the sector most severelyaffected.

- Sectors more or less indirectly involved in agriculture are also likely to beaffected, in particular trade, which to a large extent depends on agriculturalproducts. Manufacturing is also likely to be relatively seriously affected both as aresult of a loss of agricultural input and/or higher prices of agricultural rawmaterials as demand might outstrip supply.

- The indirect effect of lower foreign exchange earnings as a result of the decreasein agricultural products may also spill over to other sectors includingmanufacturing.

The following new levels of NPL were discussed and agreed upon:o Agriculture: 50.0 percent, up from existing level of 0.9 percento Trade: 50.0 percent, up from existing level of 7.6 percento Other: 30.0 percent, up from existing level of 10.2 percento Manufacturing: 30.0 percent, up from existing level of 0.4 percento Construction: 30.0 percent, up from existing level of 10.4 percento Tourism: 28.0 percent, up from existing level of 23.7 percento Non-bank financial institutions: 2.0 percent, up from existing level of 0.1

percent

- That loan loss provisions would increase to 50.0 percent, up from the existingtotal average of 5.0 percent. This reflects among other things that the value ofthe banks collateral is likely to decrease in a crisis situation. It may also takelonger for the banks to realize the collateral, and hence may lead to higher

operating costs.


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Box 2.6: MODEL ISSUES

For the purpose of this stress testing project it was decided to use the stress testing modeldeveloped by Mr. Martin Cihk of the IMF as a starting point. The model has been modifiedand adapted at various stages in order to incorporate the particular aspects of theeconomy and banks of Malawi. The modified version includes a function for stress testingequity risk and shocks to the banks net income from foreign exchange trading. A functionfor combining shocks to the banks net interest income and/or net foreign exchangeincome with other shocks is also included in the modified version. In its present form, thestress testing spreadsheet only allows analysis of the effect of the various stress testingscenarios on one measure of capital adequacy. For the purpose of this project, the Tier 1capital ratio is chosen. However, other types of capital adequacy may be selected, e.g.Tier 1 and 2 ratio, Total equity/Risk weighted assets or Total equity / Total assets.

Furthermore, it is also worth mentioning that stress testing results based on the current

spreadsheet might miss the next shock or crisis situation as it is based on the last(relevant) available h

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Financial Stability Report June 2012

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