High Level Conference organised by the National Bank of Belgium on “Bank Restructuring”
Speech by the Governor of the Central Bank of Cyprus, Mrs Chrystalla Georghadji
Belgium, 23-24 February 2017
Distinguished guests, dear participants,
1. Introduction
Let me begin by thanking my dear friend Jan Smets for his kind invitation to speak at this high level conference on the very interesting topic of “Bank Restructuring”. It is an honour to address such a prominent audience and to share our experiences and lessons from the financial crisis in Cyprus and in particular of the banking crisis in March 2013, which led to a wide restructuring of the banking sector.
During the last decade, the world has witnessed a financial crisis of an unprecedented nature, in terms of duration and impact, on the global economy. To preserve and restore confidence in the banking system, state authorities channelled considerable public funds to credit institutions to prevent systemic failures, protect depositors and maintain financial stability. In the EU, substantial state aid was granted in the form of capital and guarantees to restore the solvency and liquidity of banks. This varied from 5% of GDP in Belgium and Spain to 20% of GDP in Cyprus and Ireland. The consequences of such interventions were increased fiscal deficits and a threat to the sustainability of public debt.
International standard setters such as the Basle Committee and the Financial Stability Board responded by issuing a series of new standards aimed at strengthening preventive measures and ensuring that, should the worst happen, banks can be resolved or liquidated without use of taxpayers’ funds and with a minimum impact on the real economy.
The Financial Stability Board Key Attributes of Effective Resolution Regimes for Financial Institutions and the European Commission’s Proposal for the Recovery and Resolution Directive served as the basis of the Resolution Law, enacted in Cyprus in March 2013, used to restructure Cyprus’ two largest banks, as one of the conditions for obtaining an EU-IMF financial assistance programme for Cyprus.
In the next part of my presentation, I will briefly describe the internal and external causes of the banking crisis in Cyprus as part of the financial crisis which peaked in March 2013. I will then outline the efforts by the Central Bank and other policy makers in Cyprus to address those causes and mitigate their impact on financial stability and the real economy. I will conclude with remarks on the restructuring tools currently available to regulatory authorities in the EU, drawing from the lessons learned and the European Commission’s recently submitted risk reduction proposals.
2. The Cyprus crisis and the role of public authorities in bank restructuring
For many years, banks in Cyprus operated in a growing economy with a flourishing real estate sector. This, unfortunately, led to banks adopting risk and credit management practices dominated by asset based lending. The consequences of such practices can be disguised in periods of an expanding economy, even appearing as successful as long as property prices continue to rise and demand remains at strong levels. However, in periods of economic recession, practices such as this may lead to a significant increase in arrears and non-performing loans and, as a consequence, a rapid impairment of the capital position of banks. Hence, securing what may appear to be adequate collateral, should never supersede the basic principle governing any lending transaction: the borrower’s ability to fully repay their debt from future cash flows.
In addition, the two largest Cypriot banks pursued aggressive expansion overseas since early 2000 by extending their banking presence in Greece, followed by a wider expansion in South East Europe, Ukraine and Russia. These expansions added greatly to the size of their balance sheets, which exceeded 400% of the country’s GDP, and raised questions about their ability to manage such ambitious strategies. As Greece’s sovereign debt crisis deepened, the Cypriot banks suffered a higher level of bad debts from their operations in Greece than their domestic business. The banks also experienced a massive flight of deposits from their operations in Greece of nearly €10billion between 2008 and 2012, forcing them to transfer funds from Cyprus to Greece in order to meet their liquidity requirements. The largest losses, however, resulted from the write-down of their large Greek sovereign bond holdings following the Greek debt restructuring programme in late 2011 early 2012, which cost the two largest Cypriot banks nearly 25% of Cyprus’ GDP.
In 2011, most of the international rating agencies downgraded the Cyprus government’s long-term debt rating to below investment grade for a number of reasons. In May 2011, the government of Cyprus lost access to international markets, while a year later the two largest Cypriot banks, unable to find private funds for their recapitalisation, requested state aid. By early July 2012, the Government had injected €1,8billion into one of its systemic banks and was faced with additional requests for capital injection from the other major systemic bank. A few days before, in June 2012, the Government had formally applied to the Eurogroup and the IMF for financial assistance.
The agreement reached between Cyprus and its lenders in March 2013 provided that Cyprus would embark on an economic adjustment programme aimed inter-alia at restoring the health of its financial sector. By using the Resolution Law that was passed a few days before the resolution action, the two largest Cypriot banks were resolved and merged with a full write down of shareholders and bond holders as well as a bail-in of uninsured depositors, including pension funds and small businesses. The total amount of deposits that suffered a ‘haircut’ either to absorb losses in one of the banks or recapitalise the other bank before the merger by conversion of deposits into equity, amounted to approximately €8billion or almost 50% of the country’s GDP. Cyprus was the first country in the EU – and still the only one – in which the bail-in of depositors was used to absorb losses and recapitalise its banks. A third systemic bank was recapitalised with the injection by the state of initially €1.5billion raised from the €10billion EU/IMF financial assistance programme (Cyprus actually utilised €7,25billion out of the €10billion). The Eurogroup agreement also provided for the immediate sale of the Cypriot bank branches in Greece to protect financial stability in both countries. The resolution actions on the two largest Cypriot banks, which controlled more than 40% of the domestic retail banking market, was a massive shock for confidence in banks. In light of the emergency situation, and to avoid the collapse of the banking system, the Government adopted capital controls, both internally and externally, i.e. it imposed limits on deposit withdrawals and also it limited the transfer of funds, so as to protect the liquidity of banks. The resolution of the two systemic banks and the introduction of restrictive measures in banking transactions had a disruptive effect on the real economy intensifying the ongoing recession. Economic activity decreased significantly during the period 2012-2014 which, in turn, led to the deterioration of the financial position of borrowers and the consequent sharp increase in non-performing loans. Since then, and following a series of economic reforms and the restructuring of credit institutions, public confidence in banks has gradually been restored. The capital controls were gradually lifted and eventually abolished, less than two years after they were introduced. Public finances were substantially improved and the economy returned to growth in 2015. In March 2016, Cyprus exited the financial adjustment programme with a positive GDP growth and sustainable public finances.
In parallel, the Central Bank of Cyprus worked to improve the regulatory and supervisory legal framework and introduced changes to provide banks with debt restructuring tools to deal effectively with the problem of NPLs. Stricter requirements on loan origination as well as on bank governance issues were introduced. Robust foreclosure and arrear management frameworks were adopted to ensure viable restructurings of loans. Finally, a bill is currently being discussed that will provide the legal and taxation framework for loan securitisation. Dealing with NPLs remains the top priority and challenge of both the Cypriot authorities and credit institutions.
3. Lessons learned and policy issues going forward
Experience in Cyprus shows that bailing-in of uninsured retail depositors and SMEs can have a big impact on the real economy, financial stability and society in general. The BRRD has acknowledged the importance of protecting these groups of depositors, first by giving priority to their claims compared to other uninsured creditors in the event of liquidation and, second, by excluding them from the bail-inable liabilities that banks are required to maintain to ensure their resolvability, a requirement known as MREL (Minimum Requirements for own funds and Eligible Liabilities).
The flexibility by which resolution authorities will approach their task of determining the amount and setup of MREL as well as the period that banks will have to comply with these requirements, will effectively reshape the structure, not only of individual banks within the EU, but also the EU banking sector as a whole. Banks that pursue a traditional deposit-funded model or are still recovering from the crisis with none or limited access to capital markets will be the ones that will struggle to comply. Some of these banks may be forced to change their business model or, if the cost of compliance threatens their viability, to merge with larger banks that are able to meet MREL requirements without a burden in terms of time and cost. Another group of institutions that may be affected by MREL are the relatively small institutions which, in the event of failure, would be subject to insolvency proceedings. These banks may benefit in the short term from not having to meet an MREL requirement, at least not as stringent as that applicable to significant banks. But in the long-run, they will be at a disadvantage in attracting uninsured depositors and creditors that are exempted from bail-in or with claims that rank higher than MREL eligible liabilities. As such, I expect that a number of these banks will find it difficult to operate in the long run and will eventually be acquired by larger banks.
The use of public funds in bank restructuring is also an issue that needs to be addressed, particularly in cases of systemic crises. We all agree with the principle that shareholders and creditors are the first to bear the costs of a bank failure, without the need to resort to the use of public funds. However, one needs to assess the feasibility and credibility of resolution actions in significant banks in the event of systemic banking crises. Some argue that if a bailout had occurred in Cyprus, the real economy and banking sector would have been in a better shape than they currently are and the banking sector would have been able to recover quicker. However, there is the counter argument that a bailout rather than a bail-in would have resulted in greater austerity, Greece is an example. Although these questions will most definitely be the subject of future academic studies, my suggestion would be to consider giving Member States the discretionary power to step in, in extraordinary cases of systemic banking crises where resolution measures might have a severe adverse impact on financial stability and the real economy.
Moreover, as I mentioned above, the ability to apply a moratorium on the transfer of funds and the withdrawal of deposits was essential for the successful implementation of the resolution measures both before and after the resolution action under the Treaty of the Functioning of the European Union. Member States reserve the right to adopt capital controls in case of systemic crises for safeguarding public order and public security. Nevertheless, supervisors and resolution authorities should also have the discretionary power to suspend payments and deposit withdrawals to prepare for the implementation of resolution action and stabilise the bank following the resolution action. The recent European Commission proposals are moving in the right direction by introducing moratorium powers for both supervisors and resolution authorities. Limiting the moratorium prior to resolution for a short period of time of no more than five working days may be appropriate. However, from our experience, a moratorium of payments following resolution action may need to last longer.
Bank restructurings as part of an open bank bail-in need careful and thorough preparation so as to identify promptly and accurately the priority of liabilities, good and bad assets and ensure that adequate systems are in place that safeguard the continuation of provision of critical services after resolution. Furthermore, the rationale of resolution action should be communicated to all those affected and the public at large in a timely manner so as to maintain confidence in the bank. A final issue which needs close attention is litigation that one should expect to be initiated by persons affected by the resolution measures. The Central Bank of Cyprus and the Republic of Cyprus are faced with hundreds of law suits in local courts and international arbitration tribunals from shareholders, bondholders and depositors of the two banks that were placed in resolution in March 2013. In this regard, resolution authorities should ensure that their decisions and actions are legally sound and are thus able to stand up to challenges in the courts. On the other hand, Treaties for the protection of investments in member states should be reassessed in light of the new EU regulatory framework for financial services and the powers given to regulatory authorities over financial institutions and credit institutions in particular.
4. Concluding remarks
Concluding, I would like to stress the overriding principle that prevention is better than cure. In this regard, it is imperative that banks operate with sound policies and practices in line with a robust regulatory framework and have in place feasible and credible recovery plans whose implementation would promptly restore solvency and liquidity. In addition, supervisors should have the necessary early intervention powers to restructure banks in a credible way so as to prevent the worst from happening.
Thank you for your attention.