By Erol Riza
In the aftermath of the Eurogroup’s decision last March, Cyprus was forced to accept the harshest conditions imposed on the financial sector of any programme country. This included the forcible closure of the second largest bank, the transfer of EUR9.5bln in ELA financing to Bank of Cyprus, the assets which provided the collateral and a bail in of the largest bank of Cyprus with a final bail in number of 47.5% per cent of depositor’s funds.
The mandate of the interim board of Bank of Cyprus last spring was primarily to keep the bank solvent and to prepare a restructuring plan which the new shareholders of the Bank of Cyprus would implement. This was the correct decision since the new owners of the bank should have the first say on how the bank was to be managed.
As part of the restructuring plan, one of the options was to implement a solution akin to what was used in Ireland and Spain i.e. an Asset Management Company (AMC). The essence of the decision which the Ministry of Finance, the troika and the Central Bank agreed in August 2013 and asked the management of the Bank of Cyprus to study was the viability of a Real Estate Investment Bank. The decision was to look at a real estate investment bank since an AMC was not able to take ELA. I believe the decision to explore the option of selling the Non-Performing Loans (NPLs) was the right one and a solution of this nature should be urgently considered.
The statement by the CEO of the Bank of Cyprus John Hourican to Reuters this week is thus welcomed because the restructuring plan agreed with the troika seems to be failing and the progressive worsening of the NPLs within the Bank of Cyprus concern all the stakeholders of the financial sector which are the Bank of Cyprus, the Central Bank of Cyprus and the Ministry of Finance. The Bank of Cyprus, albeit a private company, is the largest bank on the island and its fortunes go hand in hand with the economy whether we like to admit it or not.
The term used to implement a solution where NPLs are sold to another entity has been coined as “bad bank” as it assumes the recovery/asset management loans which may be considered as bad or unlikely to perform so that the bank has no continued issues of provisions and hits on its capital. This is not a good term and not correct in terms of recovery of loans. The asset management company may be a better description of the type of company that buys the NPLs but I believe that an even better term would be a Loan Rehabilitation Fund. The choice of rehabilitation is purposeful in that the borrowers, given time and support from an asset manager with experience in real estate, will have a better opportunity of maximising recovery than if these loans are held within a bank. The sale of the loans to a separate company which has a different funding base (longer term view) and has no capital adequacy issues will provide the Bank of Cyprus with a huge relief in terms of additional provisions and a Core Tier 1 capital just above the minimum required.
I agree that an advisor should be appointed to review the success or not of the restructuring plan and consider what would be best for the Bank of Cyprus, its shareholders and the economy at large. For how can trust return to the bank if there is a handicap of NPLs rising and all that means for provisions and capital. An experienced investment banker like Hourican must have realised that the six month “grace period” is more than enough to judge the next move. In the IMF report on the Cyprus financial sector published last December it was clear to those that read it that the implementation risk was the main concern of the IMF. The implementation risk, having in mind the nature of the NPLs, and the lack of a creditor friendly bankruptcy law has if anything increased in the last few weeks as Parliament has sought to interfere making the restructuring of loans ever more difficult; in fact the proposal to force banks to use the original valuation of the security instead of current market is one step that any sensible banker would never accept. Hence in the light of the NPLs climbing to above 50 per cent it is high time another solution is considered and in this the CEO deserves credit.
If one considers the costs of not doing anything I would list the following:
1. A high level of interest rates to make profit to cover losses of NPLs which penalises those good borrowers who meet their obligations;
2. NPL dynamics are such that in a recession they continue to increase long before they stabilise which puts pressure on provisions and capital;
3. The bank is unable to lend to businesses desperate for credit and a credit crunch develops causing more pain to the economy; in such an environment the risk premium of lending goes up and a bank under distress seeks to minimise risky lending;
4. The trust required to get depositors back to the bank takes longer and hence the capital restrictions may have to stay longer;
5. High NPLs and interest rates and a weak economy are a disincentive to foreign investors;
6. While ELA may not be the issue it was last summer the creditors would expect to have a roadmap on how they will repaid which places the bank under pressure since any asset disposal does not enrich the banks liquidity since the first claim on sale proceeds of assets pledged as ELA collateral will be used to repay ELA. This deprives the bank of much needed liquidity to provide new loans and improve profitability.
In my opinion the benefits of following the examples of Spain and Ireland and sell off the NPLs to a separate entity (call it what you like) are the following:
1. The bank will halve its NPLs by selling EUR6-7bln distressed real estate loans thereby improving the provisions outlook and thus capital;
2. The bank will focus on its core business strategy with a sounder business plan to attract a strategic investor. I believe that it would not be the best time to sell the 18 per cent shareholding of the former Laiki before a solution to the NPLs is found.
3. Interest rates could be significantly reduced;
4. Capital restrictions could be lifted earlier
5. The bank would have reduced legacy problem and would be better placed to regain the trust of depositors
6. Investment in the real estate sector could pick up once prices are deemed to have bottomed out with overseas investors taking advantage to invest as we have seen both in Ireland ad Spain.
7. Investment in real estate can lead to the recovery of real estate values much quicker and will improve the collateral value of the whole banking system;
8. The Bank of Cyprus asset portfolio could benefit from the general improvement in economic activity which lower interest rates and foreign capital will bring.
The troika should revisit the creation of an AMC or Loan Rehabilitation Fund for the NPLs linked to real estate for the Bank of Cyprus. There is no other alternative which offers the same promise to the Government of Cyprus which has been used as a model of how bank resolution will be done in the Eurozone. Although there is a cost to be assumed from the large discount at which the NPLs will be sold, and thus the loss to be crystallised upfront, the European Stability Mechanism (ESM) can provide the recapitalisation required via a loan to the Cyprus Government. It may that this recapitalisation can be done direct with the Bank of Cyprus, but this will only be possible when the European Central Bank becomes the Single Supervisory Mechanism which is likely to be at the end of 2014 and Bank of Cyprus qualifies for such support following the asset quality review being conducted. The ECB President has referred to the proactive cleansing of bank balance sheets before the final decision of the ECB and this comes at a time when many Eurozone banks are having their asset quality reviews.
The solution to the NPLs is a complex one and there is a need to aim for the least damage to the economy and the bank itself. While the borrowers may be concerned about their businesses and real estate, I believe that a Spanish type of AMC which has a life of 15 years and aims for maximum recovery provides ample time for real estate prices to recover thus giving borrowers an opportunity to buy back their land at face/near face value and pay off their loan. The AMC or Bank Rehabilitation Fund may actually offer the borrowers the best opportunity to rehabilitate themselves and this can be best done outside a bank.
Borrowers should have an option to buy their property at agreed recovery levels with the Bank of Cyprus having some revenue sharing agreement with the AMC/Fund whereby above a recovery threshold the Bank of Cyprus shares in the revenue. These issues and other matters of funding the AMC (be that with shares, bonds sub debt or mezzanine) the bank will require are best left to advisors such as HSBC who are better placed to advise.
The solution requires political support from fellow member states such as Germany and France. It was the Eurogroup that imposed on Cyprus the harsh terms and it is these key member states in the Eurozone that can provide the political support required to get the ESM to support for the Bank of Cyprus. It is hard to believe that the Irish closed Anglo Irish bank and converted ELA into 40 year bonds without political support. I am not suggesting Cyprus does the same but instead propose that the Cyprus government wins political support to have the Bank of Cyprus be recapitalised by the ESM. Cyprus deserves solidarity from its Eurozone partners.
Erol Riza is a former senior investment banker with experience in major banks in London. Between 2002/07 he was Managing Director of DEPFA Investment in Cyprus. Last year he served on the interim board of the Bank of Cyprus