In addition, on account of the high liquidity levels prevailing in the banking system, reserve requirements were introduced. The capital structure of the banks was also strengthened through new share issues and an augmentation of internal reserves, while a capital market, in the form of the Malta Stock Exchange, was set up. Supporting economic reforms included a relaxation of the extensive system of import controls, the partial lifting of wage-price controls and an overhaul of the income tax system. The introduction of reserve requirements and of open market operations by the Central Bank of Malta in 1994 opened the way for the removal of administered interest rates. At the same time, the Bank encouraged banks to manage their liquid assets more actively, setting the stage for the development of an interbank market. The Central Bank of Malta’s engagement in open market operations was followed by the establishment of a market-driven interest rate structure, which is, of course, of paramount importance for the transmission of monetary policy signals. The Bank began to use weekly auctions to influence the size of the monetary base, while gaining control over the excess liquidity in the banking system. Maximum interest rates on bank loans and advances were linked to the Central Bank’s discount rate, injecting some flexibility into the interest rate structure. Soon after, preferential lending rates were abolished, with a margin of three percentage points above the discount rate being permitted for almost  BIS Review 31/2004  1  all categories of lending.
By the end of 2003 for example, the domestic banks’ assets amounted to over 277% of GDP, compared with a euro area average of 273%, while the ratio of domestic bank credit to GDP stood at 155%, as against 143% in the euro area. More significantly, spreads between short-term lending and deposit rates in Malta, at 2.41 percentage points in 2003, were even narrower than the euro area average of 3.48 points. This suggests that the local banks compare favourably in terms of efficiency with banks elsewhere in the European Union. Furthermore, despite the global economic slowdown and the recent weak performance of the Maltese economy, the profitability of banks in Malta, as evidenced by the return on assets, has been fairly stable at around 0.8%. This compares with an average return of 0.6% recorded by European banks in 2001. At the same time, bank liquidity remains very high, with the domestic banks’ holdings of liquid assets as a share of short-term liabilities, just under 50% at the end of 2003, consistently exceeding the 30% prudential requirement. Maltese banks are also strongly capitalized. Their aggregate capital adequacy ratio, defined as the ratio of own funds to risk-weighted assets, stood at 16.7%. On the other hand, the banks’ loan portfolio still tends to be concentrated on a few sectors, reflecting the structure and small size of the Maltese economy. Furthermore, they still rely too heavily on property as collateral.