Interview with Panicos Demetriades, Governor of the Central Bank of Cyprus, conducted on 10 September 2012 by Natalia Kardash
Q. What is your estimation of the current situation in the banking sphere of Cyprus? What measures should be taken immediately? What will help to the banks to become healthier and have more public trust?
It is well known that the two largest Cypriot banks have requested state aid because of capital shortfalls emanating directly from the Greek PSI, which resulted in losses amounting to over €4 billion. The banks were able to absorb a significant portion of these losses because, prior to the Greek PSI, they had substantial capital buffers. These, however, were not sufficient to absorb all the losses. Moreover, the capital shortfalls were exacerbated by the need to raise additional regulatory capital by the end of June 2012, to satisfy tighter capital standards required by the European Banking Authority.
In addition, as is also well known, the quality of both banks’ assets has been affected by their substantial exposure to Greece, a country that has been in recession for four consecutive years and the deterioration of the Cypriot economy, which is now in recession. These adverse developments have put additional pressure on bank balance sheets, reflected in rising NPLs. However, both banks continue to make positive profits from their operations and their latest results show a more determined effort to clean up their balance sheets through a sharp increase in provisions, and to contain their operating expenses. Both banks are also making significant efforts to restructure their operations, with the help of reputable international companies, so as to minimise risk and strengthen their ability to create profits.
I should add here that the Central Bank of Cyprus (CBC), in its supervisory role, is taking important steps to strengthen corporate governance within both banks. Both banks have new leaderships, with which we are working very closely in order to ensure that the Cypriot banking system emerges stronger from the current crisis.
To this end, we have appointed a leading international company to carry out an independent investigation into the circumstances that led the two banks to apply for state aid. This investigation will provide clarity and comprehension regarding the current financial stress in the Republic and guide remediation to strengthen the stability of the banking sector.
Finally, as you know, the Cyprus government has applied for financial support from the EFSF/ESM and the IMF to help recapitalise the banking system.
I am therefore confident that Cypriot banks will emerge substantially stronger from the current crisis and, partly as a result, so will the country’s economy.
Q. What are the expected changes in treatment of the real estate that is collateral for loans? Is it true that now the banks can do nothing if the loans are not paid but still consider this kind of loans as not risky? And what do you think on the system of risk estimation in the banks based in Cyprus? Does it need any clarification or improvement?
It is true that the legal system in Cyprus is such that there are long delays in cases where a bank has to resort to legal proceedings in order to recover dues on loans through liquidation of the underlying collateral. These delays impede the functioning of the housing market and weaken the usefulness of collateral in terms of its ability to mitigate risk. Having said this, collateralised loans remain less risky compared to non-collateralised loans, not least because collateral aligns the incentives of the borrower with those of the lender to protect the underlying asset. Moreover, it normally acts as an effective pressure mechanism for the borrower to make every possible effort to service their debt or to cooperate with the lender in terms of efforts to sell the property in settlement of their debt. As regards risk estimation, banks assess non-performing loans and, depending on the level of risk, make appropriate provisions against expected losses.
Q. What is the role of the Central Bank in terms of liquidity control? Does the CB control the level of liquidity in the local banks?
The CBC monitors liquidity for the local banks on a daily basis and can promptly identify any trends requiring action by itself or the relevant bank. It stands by to provide Emergency Liquidity Assistance as needed and as justified, subject to certain conditions. The actual level of liquidity in the local banks is not controlled by the CBC, in the sense that it is governed by market factors, such as the level of deposits, the level of liquidity made available in interbank markets, etc. However, the CBC requires banks to hold minimum liquidity buffers.
Q. What do you expect in the near future? Do you think there will be (or should be) any mergers, acquisitions or disposals?
In the near future, I expect that banks will be focusing more strongly on core business, that they will be cutting down on operating expenses and that they will be making every effort to ring fence their Greek operations. Moreover, I expect that they will be reviewing their international operations with a view to reducing their presence in countries where having a retail operation is not warranted by risk-return considerations.
As a result, I expect to see a shrinkage in the overall size of the Cypriot banking system relative to the size of the economy and I also expect to see that the domestic banking system will become more competitive not least because of new entrants in the market. A smaller, leaner and more competitive banking system will naturally have room for large and small players, and for different types of ownership, domestic, shareholder-based or mutual, as well as foreign. Diversity in any system is a source of resilience. Moreover, a more competitive banking sector will result in a lower cost of capital for non-financial businesses, which will help stimulate private investment and growth. The CBC’s aim is to maintain a healthy, stable and robust banking sector that can underpin sustainable growth.
Q. What is the destiny of capital securities in today's situation?
Bearing in mind the current difficult economic environment, it is difficult for banks to raise any capital through new issuance. We expect that as soon as the current economic climate is reversed, banks will again be able to raise capital from the markets.
Q. You have published articles on the economy of Cyprus. You have studied the measures taken by the Cyprus government in different times and in different situations. And you know well the theory and history of financial crisis. Having all this in mind, what is your opinion on today's situation? What kind of policies can visibly improve Cyprus’s economy in a short period of time? Can you also share with us your opinion how to make the country strong in the medium term?
Indeed, I have published many articles in the popular press about Cyprus and Europe prior to taking up my new role as Governor on 3 May 2012. I have also published numerous articles in academic journals about financial crises, financial development and growth. One can certainly draw on that experience as well as on economic theory and economic history to comment on the current situation both in Cyprus and in Europe. Having said this, every crisis is different and the current one in Cyprus cannot be seen in isolation of what is going on in the euro area. Of course the euro crisis is both unique and extraordinary, thus making predictions of what lies ahead rather difficult.
What is, however, reassuring is to see that the ECB – which is perhaps the only institution in the euro area that has the capacity to make a difference in the short run – is determined to act to safeguard the monetary union from market distortions which threaten its viability. The ECB can give sufficient time for politicians to take all necessary steps to enhance and strengthen economic integration in Europe. In my few months on the ECB Governing Council, I have witnessed increased determination by the ECB, under the leadership of Mario Draghi, to safeguard the future of the currency union. Recent examples of policies aimed at enhancing economic and financial stability, include the enhancement of collateral requirements, the new Outright Market Transactions (OMT) programme and the significant progress made in creating a banking union in the euro area.
When it comes to Cyprus, I believe that with the assistance of our European partners, the Cyprus economy will soon be on track to recovery and on a path that will lead it to stronger and more sustainable economic growth.
The CBC will work to ensure that the mix of policies that will be agreed upon between the government and the troika will help to deliver the required fiscal consolidation while at the same time minimising any adverse short-term effects on output and employment. Regrettably, significant sacrifices will be needed, primarily but not exclusively by public sector employees. Expenditure cuts and new taxes will reduce domestic demand and, as such, they will have negative effects on output and employment. It is important for everyone to be realistic about the magnitude of these effects so that both the depth and the pace of fiscal consolidation that will be agreed upon is one that will not plunge the economy into a deep recession. A stabilisation programme can be derailed if one is not realistic when estimating these effects at the outset.
What also needs to be emphasised – and this cannot be emphasised enough – is the importance of taking steps to boost external demand and to protect productive public sector expenditures. In fact, academic research suggests that public sector investment in transport and telecommunications, R&D, etc, raises the productivity of private investment and has substantially positive effects on long run growth. It is, therefore, critical to keep an eye on the fiscal policy mix during a stabilisation programme.
Last but not least, it is important to note that Cyprus’s medium and long term prospects remain very good. Besides excellent human capital, institutions and infrastructure, the recent discovery of natural gas resources with the associated investments that are envisaged has substantially improved the medium and longer-term growth potential of our economy.
Q. What did you think about while taking a decision to accept or refuse the offer to take this position? Why did you accept it?
Before taking up the post, I had served as an academic at various UK universities for 22 years. My last post was Professor of Financial Economics at the University of Leicester, a post which I held for over 12 years.
The opportunity to take on the role of CBC Governor, when it came up, represented a new challenge for me, in light of the current circumstances. Although I must add that I felt well prepared for it, in light of my research and teaching interests as an academic. From that point of view, I felt ready for the professional challenges that the role entails. However, being a central bank governor certainly requires a lifestyle shift compared to being a jeans-wearing, freely talking academic. It also entails many new challenges for one’s family, including the transition from the quiet rural lifestyle of Leicestershire.
Q. Is it difficult to combine theoretical knowledge with practical daily work? Do they differ much? What is the most dramatic difference between being an academic and being the Governor of the Central Bank?
Not at all. I find that my academic background helps me in terms of evaluating policy choices that present themselves from time to time at a deeper level than is usually the case for policymakers without such a background. I am sometimes disturbed by the ease with which some policymakers come to conclusions without being familiar with the evidence on a specific topic. Good policy needs to be evidence-based.
The most dramatic difference between being an academic and being a central bank governor is the speed with which decisions frequently need to be made. This is in fact why having prior knowledge of the issues surrounding a decision helps one to make better informed choices, when time is of the essence.
Q. What is your personal target? What needs to be done before you can say: “I did everything I could”
My personal goal as Governor of the CBC is to succeed in strengthening Cyprus’s banking system. In five years time, when my term ends, I would like to deliver a more competitive, more resilient, more innovative and more stable banking system. I have no doubt that with the help of my colleagues at the CBC – and I must add that I am very fortunate to be working with some very talented people here – this goal will be achieved, hopefully before the end of my term.