By Erol Riza
THE RECENT observations by the Central Bank governor and the new CEO of the Bank of Cyprus about the clear and present danger of the growing size of non performing loans (NPLs) which the banking system in Cyprus faces provides all the stakeholders with a unique opportunity to address this important issue.
NPLs are the opposite side of the coin with distressed borrowers on the other side. The government has a vested interest in seeing that the banks manage their NPLs in a manner that is likely to allow the banking system in Cyprus to restart lending to SMEs, thereby reigniting economic recovery. This is a simplistic approach about the driver of economic growth and merits further analysis since economic growth, and the capital investment required, will not be supported by the banking system.
In this article I will seek to outline the immediate risks of inaction with regards to NPLs, the opportunities to deal with the problem and what the stakeholders can contribute.
I believe there is no short term fix for NPLs and the work out period of NPLs could take up to five years. The principal problem of NPLs in Cyprus is their concentration in the real estate sector. It is important to understand how this may be managed by recalling the reasons for the problem: credit expansion, hence liquidity, was excessive during the period 2006-08 and at the height of the credit expansion it reached 36 per cent growth on an annual basis.
All real estate bubbles are driven by liquidity and Cyprus is no exception. Credit expansion of double digit figures is out of the question once the ECB is in charge and hence real estate prices will remain fairly subdued in the future as prices correct to levels which will attract buyers.
The outlook for real estate prices matters to the banks and the borrowers alike. Borrowers need to get a reality check about the value of their collateral and banks cannot sit back and do nothing as provisions will have to be increased if prices continue to fall. The forthcoming asset quality review to be conducted by the European Banking Authority is something bankers and borrowers alike need to have in mind.
The banks in Cyprus have to address the question of NPLs soon as inaction would mean further provisions and worsening profitability leading to lower capital adequacy and thus reducing funds available for lending.
Increasing NPLs would also harm the restoration of depositor trust that is vital to stem the deposit outflow. Without trust in the banking system the capital controls may have to remain in place for longer and the uncertainty of capital controls may deter inward foreign direct invest (FDI) that is badly needed for economic growth. In the meantime borrowers’ financial position and the value of their collateral will deteriorate further making restructuring of loans even more difficult.
The above scenario is pretty much what one is witnessing at the moment and the banks have to act swiftly with the process that has been implemented in many other countries.
In times of financial distress corporate debt restructuring is what is recommended and in this the banks have been prompted by the updated MoU programme which has been agreed between the government and troika officials. There is no reason to talk about bank fire sales of real estate as this is excluded in the MoU and the process would be self defeating in Cyprus as the whole banking system is dependent on real estate collateral.
Banks have the guidelines of the Central Bank to use with regards to Treatment of Arrears, and the Conduct of Banks is laid out in a separate directive. Corporate debt restructuring is not a panacea in itself but it is the best starting point and most of the recent experience, as documented by various international approaches such as the Vienna Initiative, suggests that restructuring is the desirable solution. The most useful guide to corporate debt restructuring though is the IMF paper on such measures in the wake of a financial crisis.
The upshot of all these studies is that banks should seek out of court settlements in a consensual manner. The Central Bank adds to consensual restructuring the term “sustainable restructuring” which means more than extending the repayment period and reducing interest rates.
The banks, working with the distressed borrowers, need to introduce work out teams with adequately experienced staff that can look at the borrowers’ business models and discuss the roadmap for repaying their debt in a constructive and prudent manner. It may mean that on occasion banks will have, in order to attract FDI, swap debt for equity and the issue here is how much equity in their corporate customers can banks take on their balance sheet.
According to the Central Bank directives there is a limit to how much equity can be held and banks should look at repackaging such equity into securities that can be sold to institutional investors, both local and overseas. In this the government may assist by providing tax incentives to such investors.
For corporate debt restructuring to be successful and efficient it will require the recalibration of borrowers as a lot of the problems have to do with the projects that are not viable or that will not attract FDI. Borrowers need to work on business plans that have robust revenue models and are credible to overseas investors. Projects which were probably focused on residential developments alone cannot be the projects that will today attract investors as buyers have a choice and Cyprus is not a core market for institutional investors. The FDI that will matter is institutional investment given the funds at their disposal.
The recent discussion about how to deal with the NPLs of the Bank of Cyprus will probably show the way since an internal bad bank, or a specialist division within the bank, will be the preferred approach to managing the NPLs and would constitute part of the restructuring plan agreed with the Central Bank. The importance of getting the right management of the impaired assets with the expertise that is required is what will make the difference for bank sustainable recovery and restoring confidence.
Borrowers will have to understand that the banks in Cyprus have no option but to deal with NPLs by way of restructuring and that their collaboration would be very positive. Non co-operation is not an option as banks will, within two years, be able to foreclose and hence there is every reason for borrowers to be seeking the best solutions for repaying their debts.
At the same time banks will have to provide flexibility over the conditions of restructuring and not limit these to the grace period for principal repayments or extension of maturities but instead consider innovative solutions such as two tier interest rate structures for real estate developers.
The problem of developers whose land is owned by banks is simple to understand. The plot of land is non revenue generating and hence a loan secured on land alone cannot be serviced and nor will an overseas investor like to invest in a project that is charged 7-8 per cent when euro rates in other countries are quite low.
The stakeholders include the government, the banks, the borrowers and the Central Bank. It must be in the interest of all to co-operate in good faith and work out the best way forward.
Erol Riza was a member of the Bank of Cyprus’ interim board of directors