By George Theocharides
The banking sector in Cyprus has gone through radical transformation in the last few years following the disastrous events of March 2013. To a large extent, the sector has regained confidence from both its domestic customers and the international community. However, major problems still exist and the level of non-performing loans (NPLs) in fact worsening since 2013, with the problem threatening the overall stability of the banking sector. It is imperative that the interested parties find a permanent solution before it escalates further.
The latest data by the Central Bank of Cyprus (CBC) from July 2015 shows that the NPLs now stand at €27.4 billion, or 47.4 per cent of the €57.8 billion domestic loan portfolio. The banks have made provisions for these problematic loans, but only for €8.9 billion, with only 24.4 per cent of the total currently restructured. For households and corporations, the size of the NPL portfolio is greater than 55 per cent of the total loan portfolio, again highlighting the need to find a solution.
A driving force behind the size of the NPL portfolio has been the on-going economic crisis Cyprus is experiencing, with many citizens simply unable to repay back their loans because their salary has shrunk substantially during the crisis or they are no longer in employment.
However, strategic defaulters, i.e. borrowers that are taking advantage of the system and the cumbersome processes used to pursue them, are refusing to honor their obligations and therefore adding fuel to the fire. Parliaments recent passage of the foreclosure law and the insolvency bill framework could help prompt these rogue borrowers into action.
Thanks to the new framework, if all attempts at restructuring the loan have failed, the bank has the right to seize the collateral assets of the loan holder and auction them, within a reasonable timeframe. It remains to be seen if the foreclosure law and the insolvency bill will help to substantially reduce the size of the problem, as the financial sector sees these frameworks as yet another tool in their arsenal to combat NPLs, not the silver bullet.
Creation of a ‘Bad’ Bank
Another proposed solution that has not yet materialised is the ‘bad’ bank, or as it is less commonly known, the Cyprus Asset Management Company (CAMC), which will take over the NPLs. The aim is to maximise the recovery value of the assets (loans) within a medium- to long-term horizon. If done properly and with good planning, then the banking institutions will be left with the ‘good’ loans on their balance sheet, increasing the likelihood of attracting new investors and depositors.
It should be noted that this was part of the first draft of the Memorandum of Understanding (MoU), but not of the signed document of April 2013. The proposal was to create an institution that would acquire loans and other claims, including foreign exposure – especially Greek assets – from credit institutions that would then receive state-aid. The transfer price would be the long-term economic value of the assets, decided after a thorough asset quality review process.
For funding purposes, CAMC would have been able to issue bonds guaranteed by the state. In exchange for the assets, the banks would receive an equity participation in CAMC, in the form of bonds issued by CAMC, as well as cash and/or other high quality securities. The reason this proposal did not made it to the MoU of April 2013 was thanks to the events of March 2013, and the decisions taken during those specific Eurogroup meetings.
It important to point out that the creation of a bad bank was a solution utilised in other countries that experienced banking problems, such as Ireland and Spain. In Ireland, following an economic crisis and the real estate bubble which burst after many years of uncontrolled lending to the property market, a National Asset Management Agency (NAMA) – or ‘bad’ bank – was created in late 2009, to take the bad loans from the main financial institutions of the country, with the banks receiving government-guaranteed bonds in exchange.
In 2010 Ireland was forced to seek a bailout package from the EU-IMF, and managed to exit the accompanying MoU in 2013. The country now has the highest growth rate in Europe, estimated at 6.2 per cent for 2015. In Spain, the creation of the ‘bad’ bank helped tackle the crisis, with SAREB created in 2012 to take over, for the exchange of government bonds, a number of problematic loans from four nationalised financial institutions.
The creation of a ‘bad’ bank was a condition set by the EU in exchange for a financial package of €100 billion for the Spanish banking sector, with SAREB allotted a period of 15 years to sell its assets. Although Spain is still suffering from a high unemployment rate of more than 20 per cent, the country’s economy is improving and is expected to grow at a healthy rate of 2.4 per cent in 2015, with the property market picking up accordingly.
Why not Cyprus?
The initial discussion relating to the creation of a bad bank to tackle the NPLs problem was mooted, but quickly faded away, with one major reason for this a lack of funding for such an entity. Cyprus had already been provided with up to €10 billion for the period 2013-2016 under the MoU to cover fiscal obligations, as well as for the recapitalisation of the co-ops. There was simply no room for any further funding, as public debt would have reached unsustainable levels.
Another way could have been to transfer liabilities and not just assets (loans) to the ‘bad’ bank. However, as a large proportion of the Bank of Cyprus’ liability came from the Emergency Liquidity Assistance (ELA) provided by the ECB, it seems as though there were too many complications for such a transfer, as the ELA is meant for short-term funding, rather than long-term obligations.
Overall, and in spite of the challenges in setting up such an entity, the experiences of both Ireland and Spain show that it remains a viable option. With the right structure a ‘bad’ bank could be the long-term lasting solution to the major banking problem of Cyprus, the NPLs.
The writer is an associate professor of finance at Cyprus International Institute of Management (CIIM) and the director of the MSc in financial services. This article first appeared in the InFocus magazine.