By Andreas Charalambous and Omiros Pissarides
The well-known economist Rüdiger Dornbusch argued that a crisis takes a long time to materialise but it then happens faster than expected. This statement fits the events that we have been experiencing in recent years in the banking and the broader financial sector, which is being tested through a combination of adverse factors, including the recent coronavirus induced crisis.
In this context, it is worth examining the role served by the banks and the challenges they face.
The main functions performed by banks include facilitating payments, accepting deposits, as well as channeling liquidity into the economy. In countries such as Cyprus, where small and medium-sized enterprises constitute the main pillar of the economy, these functions are crucial. Effectively banks act as intermediaries, converting mostly deposits of short-term nature into loans while earning the difference between the credit and the deposit interest rate, provided the loan is properly repaid. Otherwise, if loans are not repaid and banks accumulate non–performing exposures on their balance sheet, the cost-benefit ratio turns negative, even if banks possess sufficient real estate collateral, as is the case in Cyprus.
The underlying challenges of the banking business model are reflected in the significant number of banks that are driven to bankruptcy at a global level. Many banks have attempted to alleviate the problem by extending their activities to seemingly profitable sectors such as investment banking, cash flow management and investment, etc., but they are often not successful, considering that such activities involve an elevated business risk.
In recent years, the challenges for banks have widened – intensified levels of supervision, including the important issue of money laundering and terrorist financing, time-consuming customer account opening procedures, weak quality of assets manifested in low earnings, enhanced capital adequacy and liquidity requirements and increasing competition. The business environment for banks is becoming unequivocally more difficult, especially for banks operating in small markets, such as Cyprus, which do not offer the necessary size to absorb the required adjustment costs. At the same time, the absence of a sizeable liquid capital market as an alternative financing mechanism constitutes an additional challenge for the economy as whole.
The situation is not likely to change substantially in the coming years. On the contrary, the challenges are expected to intensify due to the significant costs of adopting new technological standards, the growing burden of supervision, the limited ability to align banking wages with productivity, as well as due to competition from new entrants, such as electronic money institutions which possess comparative advantages with respect to cost, utilisation of technology and customer service. Considering further the prolonged period of low interest rates, which limits banking profitability but is otherwise necessary to address the impact of Covid-19, the future does not appear bright, especially for banks’ shareholders who demand quick and high returns.
In conclusion, the current crisis poses enormous challenges for the entire economy and the financial sector, especially for banking institutions due to the culmination of endogenous and accumulated long-term weaknesses and problems. Difficult decisions are required based on a long-term horizon and a clear strategy that aims to support sectors with appealing prospects in the modern era. Artificial intelligence, new forms of tourism, e-commerce, green energy, telecommunications, healthcare and modern methods of education and training offer prominent opportunities for banking institutions. This is especially true in Cyprus, where banks remain focused on traditional sectors, such as construction and trade. Without this adjustment, banks in their current form are in danger of being overtaken by developments.
Andreas Charalambous is an economist and former director of the finance ministry. Omiros Pissarides is the Managing Director of PricewaterhouseCoopers Investment Services