By Erol Riza
One may be forgiven for wondering why there is a sudden interest by various stakeholders and economists in the persistent problem of non-performing loans (NPLs).
Gross NPLs are in excess of €20 billion, or more than 100 per cent of gross domestic product, the highest in the EU. The politicians who claim they have the answer to the NPLs are the same ones who refused to consider a solution in 2013 and made sure that the laws they passed made it very difficult for banks to efficiently manage their NPL portfolios.
The NPL resolution, in accordance with the governor of the central bank, will take time as the excesses since 2008 must be unwound and banks must seek innovative solutions.
The serious voices of concern, however, come not from domestic politicians but from the chairman of the Single Supervisory Mechanism and the European Commission who have all reminded the Cypriot authorities that the high level of NPLs was deleterious. This week the ECB chairman also added his voice to the need for reducing NPLs.
These concerns should be distinguished from the new-found interest of politicians who have thought that there is an easy solution according to their populist announcements. It may be too late for a bad bank and an asset management company since banks are private companies and cannot be coerced into accepting government decisions. However, there are new ideas about financial tools that can be used to address some of the NPLs and this is the purpose of this article.
In Cyprus the NPL problem dates back to 2008. Financial crises do not happen overnight and one should look at history to understand the problem and how to address it. The lending by banks which ended up being imprudent and their gamble on Greek bonds dates back to Cyprus’ entry into the euro. Before joining the euro, Cypriot banks taking on non-resident deposits in foreign currencies had to keep 70 per cent of these deposits in six-month investments and could only term lend 30 per cent.
After the adoption of the euro the currency became local currency and hence banks were free to lend without restriction, subject to large exposure rules set by the central bank. Huge inflows took place into the two large Cyprus banks because of the high interest rates paid (encouraged by those promoting Cyprus’ status as a business centre). As Charles Kindleberger, in his book Manias, Panics and Crashes explains this feeds credit expansion. At its peak, credit expansion in Cyprus reached 25-30 per cent per annum. Thereafter we had a property bubble and ultimately, when developers could not be tapped for lending, the banks took a bet on Greek bonds, even though the bond market at the time gave Greece a 50 per cent chance of default!
The banks were not the only party that went on a lending binge. The borrowers also did the same. In this regards we must not forget that everyone in Cyprus partook of the generosity of banks (‘Think of it and it will happen’ was the Bank of Cyprus’ slogan to attract borrowers), hence the huge levels of private indebtedness we now witness.
Borrowers and lenders enjoyed the party until the Greek crisis worsened and the two big banks in Cyprus were found to be exposed in a big way (€6-7 billion in bonds and €25 billion in loans to Greek borrowers) which were not adequately provided for losses. The rest is history.
How the banks resolve this problem will depend on the next steps taken by government and the banks. The banks face challenges both from regulatory issues (International Accounting Standard 9 application in 2018, provisions for future NPLs as suggested by the ECB and Minimum Requirement for Eligible Liabilities) whilst at the same time there is a legal environment that is riddled with structural inefficiencies and hostile to creditors.
The sale of loans and foreclosure laws have made it very difficult for banks to recover their collateral in a timely manner and borrowers knows this. Moreover, the primary residence is an issue for banks because banks will be hard pressed to repossess homes as they do in the UK and USA; even in Ireland it was very difficult for NAMA to foreclose.
The answer all along has been to get rid of the NPLs as banks are not the best place to park these loans. Whereas until recently banks could not take the losses from selling these loans at a large discount, the increased provisions which have been made make the sale of loans easier. The sale though cannot be made as the law in Cyprus ensures that the central bank has a tight grip on who can buy these assets. Also, the law allows the defaulted borrower to make a bid at the same price as the one the bank choses to sell within a deadline. How a defaulted borrower can find the funds to purchase a loan with a discount is beyond reason but maybe other banks may take on the defaulted borrowers as a new client. Perish the thought that a borrower who has appeared in the borrowers’ defaulted registry as defaulting on his obligations would a good client!
The problem is intractable without some new structure which banks may be able to use to reduce their NPLs. The two fundamental difficulties are the price at which banks may wish to sell is higher than what buyers may want to pay and the lack institutional buyers of such assets. One financial tool is securitisation, but securitisation is difficult for performing loans and doubly difficult when the asset pool is non-performing. The rating agencies in their modelling of such transactions attribute time to recovery and amount of recovery as two very significant negatives for some assets such as retail borrowers and SMEs.
Notwithstanding the difficulties of conventional securitisation, the innovation suggested by ECB advisers is feasible for large corporate and commercial property. Briefly, the government should participate and co invest (indirectly) in a securitisation transaction, undertaken at market prices, by guaranteeing a significant portion of the risky tranche of the transaction, the junior tranche as it is called. The innovation is the aligning of the interest of private investors with the government which can be done in accordance with state aid regulations so long as some minimum conditions are met. A derivative transaction known as total return swap will allow the government to protect investors in exchange for the upside in terms of better recovery over time.
The key problem remains which assets will be sold (only a true sale will count for bank capital relief) and herein lies the Cypriot dimension. Laws introduced to protect primary residences of households and SMEs, which have their primary residence as collateral, have made the timeliness and rate of recovery from these loans difficult to predict. Hence, it will complicate the securitisation unless the government also agrees to take these loans into an agency to asset manage over say 15-20 years.
To summarise, the government and banks, with central bank support, should discuss the role of government and should seek to implement solutions which are innovative and consistent with ECB guidelines. Other solutions to please ill-informed citizens could be a waste of time and mere pre-election promises.
Erol Riza is the managing director of a UK based financial advisory firm and a former non-executive vice-chairman of the interim board of the Bank of Cyprus and former managing director of DEPFA Investment Bank.