By George Markides
IN LESS THAN one and a half years after Bank of Cyprus seized deposits to recapitalise itself, it is seeking at least €1.0 billion to boost its Core Tier 1 capital at the behest of the Central Bank (CBC). The question in everyone’s mind is why?
First of all we need to define Core Tier 1 capital, it’s the buffer capital held by the bank to cover against risks arising from its assets, it is usually expressed as a percentage ratio (capital buffer divided by the bank’s total equity), and this ratio must not fall below 8.0 per cent.
To demonstrate: assume bank A with a total equity of €10 that has set aside €1.0 as a capital buffer (Core Tier 1 capital ratio 10 per cent).
Person B wants a €5.0 housing loan with guarantees and Person C wants a €4.0 consumer loan with no guarantees. The bank assesses the risk of the loans and assigns a risk weight to each loan.
For this exercise let’s assume that for the housing loan the risk weight is 10 per cent and for the consumer loan it is 15 per cent.
To determine how much capital the bank needs to have in place to cover for B and C’s risk we first multiply the risk weight 10 per cent by the asset €4.0 (Person B’s loan), and 15 per cent by €5.0 (for Person C’s loan).
For loan B the capital that must be set aside is €0.40 and for loan C it is €0.75 or €1.15 in total, but the bank has only €1.0 set aside. From a regulatory standpoint the bank still meets the 8.0 per cent minimum requirement; however risks may increase if the economic condition of either C or B deteriorates forcing the bank to beef up its capital buffers to 1.15 or above.
Back to Bank of Cyprus. The bank has a rather shaky loan portfolio close to 50 per cent of total loans are non performing meaning they are over 90 days in arrears and the bank is brutally exposed to the real estate sector.
There was much talk after John Hourican was appointed as CEO that he wanted to create a bad bank to handle risky non performing loans (NPLs).
A bad bank has the sole purpose of liquidating all of its assets and then ceases to exist, so far no bad bank has ever made a profit or broke even and BoC would need to sustain its Bad Bank operations with money.
However, a bad bank would have given the chance to BoC to offload its bad loans and improve its capital position.
From our example, if bank A offloads loan C onto a bad bank then automatically bank A’s capital position has greatly increased without the need for additional capital because, as we have mentioned, loan B is less risky, therefore better quality.
Additionally, the bank no longer needs to keep capital to protect against loan C therefore €1.0 capital buffer is more than enough to cover for loan B risks (calculated at €0.4).
The decision to create a bad bank was never adopted by the BoC’s current board of directors. There were rumours circulating in the press that some BoD members bowed to pressure from real estate developers.
This spring BoC commissioned HSBC “to help us look at our overall corporate finance agenda including the entire structure of how the group is organised,” as Hourican told Reuters.
HSBC stated the obvious and recommended that BoC create a bad bank. To this day HSBC recommendations have not been heeded by the board of directors and there were media reports that Hourican wanted to resign over this issue.
The Central Bank of Cyprus (CBC) has threatened to remove some board members and instructed BoC to proceed immediately with a capital increase of at least a €1.0 billion – the group’s total equity stood at €2.7 billion at the end of March 2014.
Moreover, the CBC gave clear instructions to limit the number of new shares to existing shareholders to less than 20 per cent. The new shares will be sold at a discount as yet unknown, but BoC will definitely be forced to cut the price at well below the €1.0 mark (the rate applied when deposits were converted to shares), so with less money new shareholders will get more shares.
Even without a discount, existing shareholders will see their holdings diluted/reduced by 21.6 per cent after the capital increase. When the exercise is finished, BoC will host a new shareholders meeting and some of the existing board of directors members will be shown the door as new shareholders seek board representation.
The bad bank issue comes into play here. As we have discussed, if assets had been offloaded onto a bad bank then it is reasonable to suggest that the capital requirements would be much less than €1.0 billion.
It appears then that some board members have inflicted damage on shareholders (80 per cent of whom were depositors) because by refusing to create a bad bank they have pushed up the capital requirements.
In October, the European Banking Authority (EBA) and the European Central Bank (ECB) are expected to announce the results of the Asset Quality Review (AQR) and the Stress Tests. Upon publishing the results, banks will have less than a year to plug any capital shortfalls.
If banks fail, then the newly voted pan-EU framework for bank rescue kicks in. Any bank that fails to raise capital from the private sector will be subjected to a liabilities haircut (meaning debt, deposits etc) of up to 8.0 per cent.
If that is not enough, the bank’s domicile country will have to bail it out from state coffers. If the country is flat broke then the EU’s European Stability Mechanism will recapitalise the bank but the sovereign will be liable to pay back the money.
Understandably, Cyprus banks cannot afford a second bail-in nor can the government afford to bail out any of its banks or, take on board more ESM debt to recapitalise them.
Personally I have little doubt the CBC is trying to kill two birds with one stone.
First they want to increase BoC’s capital buffers in order to pre-empt the ECB-EBA stress test-AQR, and second, they want to get rid of some of the existing board members that are dragging their feet on the NPL issue.
George Markides, BSc and MBA, is an economics researcher
*Disclosure: I and persons related to me, have no positions in any of the stocks/securities mentioned and no plans to initiate any such positions in the foreseeable future. Opinions expressed here are my own and do not constitute advice for readers to buy/sell any securities mentioned therein. I and persons related to me, have no business relationship with the business mentioned or with any competing business in Cyprus or abroad.