Below is an excerpt of the written statement, submitted by the former governor of the Central Bank Athanasios Orphanides to the investigative committee for the economy last month, in which he gives a chronological account of how the actions and decisions of the AKEL government and the Central Bank led to haircut of deposits and destruction of the banking sector.
The second half of 2012 was an unpleasant surprise. Even though I was away from Cyprus most of the time, I was monitoring the unpleasant developments quite closely.
After I left the Central Bank in May 2012, AKEL secured simultaneously complete control of both the government and the supervisory authority of the banking system. I was concerned about the deliberate harm AKEL could do to the banking system, working with the Central Bank, in order to serve party and other interests. With the presidential election less than a year away, it was convenient to target the banks. Banks are an easy target for populism. It was convenient for the party to argue that the banks were exclusively to blame for all Cyprus’ ills.
Of course this strategy was destroying confidence in the banking system. In an open letter I addressed to President Christofias, I warned that this would harm our children’s futures and that the scale of damage could be enormous.
Unfortunately, the relentless attack by AKEL through the Central Bank proved more damaging than I had expected. It also proved very well prepared. The first unpleasant surprise was that from the first day, the Central Bank’s new leadership changed the responsibilities of key technocrats at important posts.
Soon after, it became clear that the target was the banking system in general and more specifically the Bank of Cyprus (BoC). One of the first moves was to change the methodology for calculating bank provisions with the excuse that Cyprus was not following international practice. However practices vary from country to country to reflect local conditions, even within the generally harmonised environment of Europe. The real reason for this change was to force banks to book accounting losses immediately so that their capital position would appear worse than it was in reality.
The reason for impeding BoC from completing its recapitalisation before June 2012 also became evident. By forcing the bank to apply for state aid, the Central Bank could justify including BoC in an investigation by Alvarez & Marsal, a firm that was hired in order to investigate, supposedly, why the two big banks suffered losses and needed state support. It soon became apparent that the real aim was to damage the BoC. Systematic, selective leaks to the press, unprecedented in the history of the supervisory authority, targeted the bank.
Curiously, Laiki which indeed needed state support was essentially left out of the investigation, upon instructions from the Central Bank which were kept secret even from the House of Representatives, which had asked to be briefed on the matter in October 2012. Serious cases which had been pending and concerned certain problematic loans in Greece e.g. to the family of Michalis Sallas, Andreas Vgenopoulos and his associates were left outside the scope of the investigation.
I was aware of these pending cases because the said loans had come to the CBC’s attention following a prudential inspection before my term had ended. I had asked the then, new president of Laiki, Michalis Sarris, to pursue these cases even in court in order for the bank to be compensated. This was under way. Curiously, upon the removal of Sarris from Laiki, after my term ended, it seems that many of these investigations essentially froze. Only some of these resurfaced later, and this only happened after the March 2013 sale by the Central Bank of the Greek operations of Laiki to Bank of Piraeus, the bank controlled by Michalis Sallas.
On June 26, 2012, Cyprus became the first country in history whose Central Bank (the ECB, in other words) systematically did not accept its bonds as collateral for the provision of liquidity; the first and only country, because the ECB deemed the government completely untrustworthy. Greece, Ireland and Portugal did not experience anything similar. After this, the government was forced to call the troika for help.
It was already known that to meet the fiscal needs of the government Cyprus needed to borrow around 7-8 billion euros. AKEL faced a big dilemma – accept some political cost and properly negotiate a programme with the troika, or make every effort to reduce the political cost, regardless of the negative implications for the country. It was known, for example, that a long delay would be disastrous for the country.
The choice that was made is known. A challenge for AKEL was how to convince people that the banks were to blame for all ills of the country once it became known that the government needed 7-8 billion euros for its fiscal needs, whereas until April 2012 about €2 billion was sufficient for the capital needs of the banks. To achieve this AKEL needed help from the CBC. With its help, AKEL could at least claim that the capital “needs” of the banking system were bigger, perhaps as much as €10bn. The Central Bank could ensure that the calculations for the capital needs of the banks leading to the conclusion of the Memorandum of Understanding were suitably inflated.
Indeed, from the end of June onwards, even before any analysis was made, the number “10 billion” became a target. Leaks, when the troika arrived in Cyprus, made headline news on July 4, 2012 in daily Phileleftheros – the capital needs of the banks supposedly reached 10 billion. A simple addition of the fiscal and banking needs would suggest that the government would have to ask for support in the region of 17 to 18 billion euros. Basic knowledge of the IMF methodology for calculating debt sustainability suggested that this would make Cyprus’ debt unsustainable. And when the IMF considers the debt of a country seeking support as unsustainable, a haircut is imposed before approval of assistance. In this way, AKEL and the CBC introduced the haircut into bailout negotiations.
On that day I called Finance Minister Vassos Shiarly to make sure he knew the consequences. He immediately understood the issue and seemed to be concerned. Although he acknowledged that what the CBC was doing could lead to a haircut, he did not know whether he could influence developments, as the Central Bank was in direct consultation with AKEL and the presidential palace.
The inflated PIMCO numbers
Indeed, the Central Bank continued to implement its plan to inflate the apparent capital needs of the banking sector. In accordance with standard practice, the CBC hired an outside consultant to carry out the exercise. Guidance on the terms of reference of the audit would be given by a steering committee with members from the Central Bank, the finance ministry, other Cypriots and members of the troika. The committee would take decisions by consensus. Of key importance was the fact that the CBC would be chairing the committee. As long as decisions would be taken by consensus and the CBC was chairing the committee, this essentially meant that no decision could be taken if the CBC expressed strong disagreement. Since it is known that decisions on the methodology may alter the result by several billion euros, the work of this inconspicuous committee could in effect decide the future of the country. In other countries, the governor and top banking-supervision officials were personally involved in this work using the chairmanship of the committee to safeguard the interests of the country. In Cyprus, where an exaggeration of the capital needs would be catastrophic, only lower level officers from the CBC participated in the meetings, whereas the appointed chairman of the committee rarely attended the sessions due to other obligations.
In this manner, PIMCO, hired by the CBC and following the guidance of the steering committee that was chaired by the CBC, reached the inflated numbers. In order to inflate these sufficiently, it was necessary to change the methodology for the worse compared to similar audits that took place in other countries. One example is enough. The valuation of immovable property used as collateral for many loans are among the determining factors for the outcome. First there was an impairment based on a forecast on property prices’ decline over the next few years. In other countries, these discounted prices were used for the calculations. Perhaps because this did not sufficiently reduce the value of collateral (and thus did not inflate sufficiently the numbers for the capital needs of the banks) in the case of Cyprus a further 25 per cent of this value was deducted, automatically adding an extra 25 per cent in the relevant capital “needs”. The excuse given was that if someone were forced to make a forced sale the price would be lower than the value. An excuse that is contrary to international practice.
With its actions and guidance, the CBC added billions of euros to the calculations for the banks’ capital needs, but achieved the outcome AKEL wanted. The needs of the banks exceeded the fiscal needs of the government.
From PIMCO’s inflated numbers to the haircut of deposits
The coordinated propaganda by the AKEL government and the CBC managed to harm the image of Cyprus internationally. Cyprus is a very small country for a foreign investor to give much time or attention to. Since the government and the central bank, the two authorities which officially communicate with foreign governments, international organisations and others, suggested that Cyprus was facing a huge problem with insolvent banks, they had no reason to look into it. Inevitably, investors simply left.
Statements made in New York in December 2012 by the Central Bank governor, that banks in Cyprus engaged in “casino banking” had an impact. International newspapers adopted that position. For example, on 23 February, Wall Street Journal wrote: “The euro zone’s debt crises have come in two stripes. The problems of Greece and Portugal arose out of troubled government finances while those of Ireland and Spain derived from struggling banks. Cyprus falls into the latter category.”
The success of the AKEL-CBC strategy had another consequence: It convinced some of the stakeholders in the bailout negotiations that the best solution was to relieve the country of its “casino banks”. This solution politically suited EU governments which did not want to incur any political cost from being seen as helping suspicious banks or suspicious depositors. For the German government, in particular, the delay in the Cypriot programme brought it very close to the German elections with the chancellor facing terrible problems if she agreed to a loan that would finance Cypriot banks as happened in other countries, particularly after the publication of allegations about Russian money laundering in Cyprus.
In this environment, it was preferable for the recapitalisation of banks in Cyprus to also include “internal measures” i.e. haircut of deposits, bonds and securities. And the CBC showed that it agreed with this. It was understood that the implementation of these plans would effectively destroy the banking system in Cyprus, with a huge cost to the country. Other stakeholders could justify this outcome by adopting the position of the Cypriot authorities that the root of the problems in Cyprus was “casino banking”.
Since the Cypriot authorities had ‘proved’ that the debt of the Republic was unsustainable, a haircut became necessary. Since the authorities of Cyprus had ‘proved’ that Cyprus’ banking model was unsustainable, the best solution was a haircut of deposits. In this way, AKEL and the CBC managed to bring a haircut of deposits into the bailout discussions.
The matter was essentially settled before the presidential elections in February. A report by the Dutch ministry of finance on the Eurogroup of January 21, 2013, noted that the analysis for the financing of Cyprus had reached the final stage. It was at this meeting that it was also agreed that the final signature for the MoU negotiated by the AKEL government and the CBC would take place in March, immediately after the elections in Cyprus, since – due to delays by the AKEL government and the CBC – those elections were now just a few weeks away.
Leaks about the haircut on deposits occurred frequently in the international press. On January 24, according to the Wall Street Journal “Rescue loans could be reduced and the Cypriot debt left more sustainable if some depositors were bailed in … in other words, some depositors wouldn’t get all their money back.” On February 21, the Financial Times took the view that “Writing down senior creditors — even uninsured deposits — is the best way to go.”
It had become clear by then that the government and the CBC had ensured a programme for Cyprus that included some kind of deposit haircut and subsequent destruction of the banking system. What was left was to decide on the exact type of haircut.
In Cyprus, the first official reference to the haircut which was to be imposed was made by AKEL’s general secretary on February 8, 2013. In a TV interview Andros Kyprianou, noted that the Cypriot side is under pressure to agree that depositors also contribute to meet the banks’ capital needs. Even then, the concern for AKEL was to avoid the political cost.
Consequences of the inflated PIMCO numbers
The consequences of the inflated PIMCO numbers were clear before the end of the year. This was the reason behind public interventions I made in Cyprus in December 2012. At a meeting arranged by Sarris with Minister of Finance Vassos Shiarly on December 30, I explained to Shiarly that as a consequence of the exaggerated capital needs that the CBC had achieved through PIMCO, a haircut of deposits had already become the preferred solution of some other governments.
I urged him to intervene so that the CBC would insist on a correction of the methodology which had added billions in the calculations and created the problem, irrespective of whether this suited AKEL.
The CBC should have had a leading role in protecting, not damaging, the financial sector in Cyprus. The CBC was in control of the procedure of giving guidance to PIMCO and could have the influenced the results. Only the CBC could intervene at that point to stop the crime against the country.
Unfortunately the correction did not take place. Instead, in light of the fact that the consequences for the country were becoming clear, there was an attempt by the CBC to deny its huge responsibilities. The crucial role of the CBC (through the steering committee) for the methodology and assumptions used by PIMCO was revealed in a letter sent by PIMCO to the CBC, responding to an attempt by the latter to blame the inflated numbers on PIMCO. As noted in the introductory paragraph: “PIMCO has prepared responses to the 16 points you raised in your letter dated 1 February 2013. We also note where assumptions that have been described as PIMCO inputs in your letter were, in fact, direct inputs from the Steering Committee.”
Accepting the PIMCO outcome created a remarkable inconsistency, also for the CBC itself. Acceptance of the PIMCO results by the CBC rendered Laiki Bank clearly insolvent. At least since the end of November when PIMCO delivered its analysis, if not earlier, Laiki should have been deemed insolvent. At the same time, as it was later confirmed, the CBC was granting ELA (Emergency Liquidity Assistance) to Laiki. But the provision of ELA to an insolvent credit institution constitutes a serious breach of the legal framework of central banks within the eurozone. How can this be explained? Was Laiki both solvent and insolvent according to expediency? Was this inconsistency necessary so that the CBC could at the same time achieve the exaggerated capital needs for the banking sector, but also avoid creating election problems for AKEL by taking the necessary actions to deal with an insolvent bank?
The inflation of the PIMCO numbers had many predictable negative consequences. Together with the excessive powers which were, improperly in my view, given by Parliament to the CBC on March 22, 2013, the inflated PIMCO numbers were used for the diversion of wealth worth billions of euros from the legal owners in Cyprus to interests outside Cyprus. The inflated numbers essentially determined how much property the CBC could transfer from the rightful owners to others via a “sale” of the assets of the banks.
In particular, for the shareholders, bond holders and depositors of Bank of Cyprus, in my view the sale of the branches in Greece, which was agreed and signed by the CBC without the consent of the legal owners is problematic and amounts to theft. A theft of billions of euro. A statement, in an action now pending before the courts, that the CBC decided that Bank of Cyprus was a credit institution which had to be resolved on the basis of the PIMCO results, before these results were even disclosed to Bank of Cyprus or its board of directors, raises many questions.
The PIMCO-inflated numbers led also to the destruction of the co-operative sector. The CBC could not opt for significantly different methodologies for the banks and the co-ops in order to avoid inflating the needs of the co-op sector. As a result, the war against the banks, especially against Bank of Cyprus, had as collateral damage the co-op sector.
More broadly, however, the inflated-PIMCO results have essentially led to the destruction of the country’s economic model. It will take many years to rebuild the economy after the tsunami of the last five years. This is what leads to my pessimistic prediction that the blow to the economy may prove worse than the one suffered in 1974.
I hope that this time subsequent facts prove me wrong.