Keynote speech by the Governor of the Central Bank of Cyprus, Chrystalla Georghadji, at the event organised by the Representation of the European Commission in Cyprus and the Central Bank of Cyprus on the “Achievements and Challenges of the Banking Sector in Cyprus: the European Perspective”
Nicosia, 30 October 2017
Good morning ladies and gentlemen.
It’s a pleasure for me to address this event. My speech today will focus on the high levels of non – performing loans (NPLs), which unquestionably affect both the financial sector and the real economy. Although significant reforms have taken place, the current level of NPLs still presents a major challenge.
I will begin by explaining the drivers behind the high level of NPLs in Cyprus. I will then briefly highlight the impact of these NPLs on banks, the economy and financial stability. Following that, I will explain our NPL resolution strategy, what we have achieved so far and the lessons learned. Lastly, I will present the way forward and in particular our expectations about the key enablers and challenges in the NPL resolution process.
Gross NPLs for all banks operating in Cyprus, and which relate to households and non-financial corporations, currently stand at €21,9 billion or 44% of total loans and 120% of GDP. Net NPLs amount to €11,7 billion, which corresponds to 65% of GDP. Around half of the NPLs relate to terminated accounts (denounced loans).
The main factors driving the surge in NPLs in Cyprus before the 2013 crisis were the following:
Following the Eurogroup decision in March 2013 on Cyprus’ financial assistance programme and the unprecedented measures implemented to resolve and recapitalise the two largest banks, including a bail-in of uninsured depositors, the asset quality of banks deteriorated rapidly. Specifically, NPLs to legal entities and private individuals in the period June - December 2013 increased by 24% (from €21 billion in June 2013 to €26 billion in December 2013) and the respective NPLs increased from 31% in June 2013 to 42% in December 2013. This surge in NPLs was driven by the resulting negative macroeconomic developments following the resolution of the two systemic banks and the bail-in of €7,8 billion of uninsured deposits, which included the working capital of non-financial corporations and household deposits.
What is the impact of NPLs on banks, the economy and financial stability?
NPLs have a negative impact on banks’ profitability by requiring an increase in impairment provisions and by increasing the costs of managing distressed loans. At the same time, NPLs consume more capital due to the implied higher risk weights. In this regard, NPLs are a significant threat to bank viability and solvency. Similarly, banks with high NPLs are more vulnerable to future shocks.
High NPLs increase the risk perceived by creditors and Investors and weakens access to capital and funding, both from wholesale and customer deposits, and increases the risk premium that is translated into higher funding costs.
Inevitably, the increasing cost of risk and the capital constraints, lead to higher lending rates and tighter credit standards and, therefore, to less available credit.
The Cyprus banking system has faced all of the above. The doubts about the banks’ solvency and viability resulted in a crisis of confidence, whereby deposit outflows threatened financial stability. As a result, besides the recapitalisation measures, capital controls were imposed from 2013 to 2015 in order to safeguard financial stability.
Cyprus’s NPL resolution strategy.
As a result of the financial crisis of 2013, the Government requested financial assistance through the EFSF/ESM, and the IMF. The key objectives of the programme were the structural reforms and the fiscal adjustment measures aimed at restoring the macroeconomic imbalances and creating conditions for sustainable growth, full employment and the restoration of market confidence. The banking sector was the third main area of focus of the programme.
The NPLs and their drivers that I mentioned earlier were not the only reason for the unprecedented banking crisis in Cyprus. The crystallisation of sizeable losses as a result of the Greek economic crisis and later from the purchase of Greek government bonds by our banks were also catalytic.
As a result, a number of unprecedented resolution, recapitalisation and restructuring measures were implemented, aimed at addressing the challenges facing the banking system. In addition, decisive steps were taken to strengthen the supervisory and regulatory framework in order to lay the foundations for a healthy, more resilient and stable banking sector in the medium and long term. For example, the regulatory framework was amended in the areas of internal and corporate governance.
The Cyprus authorities, in cooperation with our international partners under the financial assistance programme, have taken comprehensive action for NPL resolution. This has involved the early identification of all impediments and the creation of a comprehensive strategy, giving due consideration to the micro-prudential, macro-prudential and social aspects. In view of the limited fiscal space, the NPL resolution strategy has focused on a private sector approach under three pillars:
Strengthened regulation and supervision of banks
Under the first pillar of strengthening regulation and supervision of banks, the first step was an asset quality exercise to ensure appropriate recapitalisation followed by numerous actions in the regulatory and supervisory context as well as market transparency. The regulatory framework was reinforced through new directives in the areas of NPL recognition, provisioning, loan origination and arrears management. At the same time, the supervision of banks was strengthened through enhanced supervisory reporting on arrears management, specific attention to the banks’ arrears management capabilities and restructuring activity, using internal and external expertise, and the introduction of restructuring targets. Additionally, the establishment and utilisation of a credit register has proved very useful to banks in their NPL management.
In September 2013, the Central Bank of Cyprus issued a revised directive on NPLs with regard to the identification of and reporting on NPLs, including definitions of NPLs and forbearance consistent with the European Banking Authority’s (EBA) definitions ahead of their implementation across the European Union in September 2014. The directive was later replaced by the EBA Implementing Technical Standards (ITS).
In addition, a new directive on loan impairment and provisioning procedures was issued in 2014, aiming to ensure the prudent application of the relevant International Financial Reporting Standards. Specifically, banks are required to have in place adequate provisioning policies and procedures, including collateral valuation, based on conservative assumptions. In this regard, banks are required to identify and monitor an extensive list of trigger events ensuring that all credit facilities requiring provision are correctly and timely identified, and adequate provisions are recognized. Moreover, in the case of a collective impairment process, appropriate probabilities of default and loss given default should be used.
In addition to the above, a new directive on loan origination processes and processes of reviewing existing loans was issued in December 2013, prescribing how lending origination and renewal should be assessed, and requiring banks to consider affordability as the primary criterion in their lending decisions.
Lastly, the existing loan to value ratio at origination was maintained as a macro-prudential measure and supplemented by a debt service to income ratio to promote prudent borrowing and lending behaviour.
A key step in this long journey of regulatory and supervisory reforms was the directive on arrears management, originally issued in 2013 and revised in 2015 to reflect experience from its application. It requires banks to apply efficient and effective strategies, policies, structures, procedures and mechanisms for the management of arrears and the attainment of fair and sustainable restructuring of credit facilities of borrowers with financial difficulties.
In order to be able to closely monitor banks’ restructuring progress, both in terms of volume and quality, banks complete and submit to the Central Bank of Cyprus on a monthly basis detailed templates. In particular, among other things, banks are completing migration matrices and provide information on NPL and restructuring flows, type of restructuring solutions and their performance, cash collection rates, cure rates, default rates and key performance indicators on restructurings and foreclosures.
During 2014, on-site inspections to review the quality of restructuring solutions were conducted by our supervisory teams.
Another important step was the establishment of a credit register, which is an important tool for off-site and on-site supervision. At the same time, it facilitates more effective management of credit and other related risks from the banks. The credit register has been operational since September 2014. However, the development of the credit register for supervisory, financial stability and statistical purposes is still ongoing.
In September 2015, the Central Bank of Cyprus implemented a loan restructuring target framework in an effort to further incentivise banks to increase the volume and improve the quality of restructurings for loans presenting arrears of over 90 days, but also to take proactive action for the loans presenting arrears of over 30 days and to prevent them from becoming non-performing.
Each quarter the Central Bank of Cyprus agrees with banks specific targets for the various phases of the restructuring process for two quarters ahead. In case of failure to achieve any of the targets, banks are required to provide detailed explanations and take corrective measures.
The Central Bank of Cyprus publishes these targets, on an aggregate basis, together with the past performance of the banks and an explanation for any possible discrepancy between targets and actual performance. If need be, targets are revised.
The introduction of the loan restructuring target framework has managed to push banks to increase the pace and sustainability of their restructuring activity However, our analysis reveals that the sustainability of some restructurings depends on the ability to realise the collateral held within the timeframe agreed, which is challenging. Despite the various constraints, banks continue to take measures to improve their restructuring performance.
Notwithstanding the above, given the current improvement of the real economy, as indicated by the positive growth rates in real GDP, the CBC is considering revising the current targets by setting targets and key performance indicators for the level of NPLs rather than for the restructuring activity.
Reform of the legal framework
The second pillar of our strategy was a reform of the legal framework. Under this initiative, the Cyprus authorities have modernised the personal and corporate insolvency framework to make it more efficient and give to borrowers and lenders the right incentives to restructure.
Equally important has been the establishment of a new foreclosure framework so as to minimize the time and cost of recovery from assets pledged as collateral. Another supportive initiative was the suspension of tax on real estate transfers agreed under debt restructuring, so as to accelerate foreclosure through encouraging voluntary debt for asset swaps.
We also established a voluntary mediation process for restructuring solutions under the Financial Ombudsman.
Last but not least, an important area of focus is the efficiency of the judicial system, where efforts are ongoing in enhancing capacity, specialisation and speed.
Market for distressed assets
The third pillar of our strategy relates to reducing barriers to entry and encouraging a market for distressed assets. A law enabling the sale of loans was enacted while a draft securitisation law is being prepared so as to facilitate the issuance of securities by securitization vehicles.
What have we achieved?
In a systemic NPL crisis such as the one Cyprus experienced, neither the banks nor the operational environment are ready to deal with NPLs. Initially, our banks were reluctant to admit the lack of capabilities and the need to utilise external expertise. However, since 2013 the banks have gone through complex changes to shift attention from lending to collecting. They have set up centralised and independent arrears management units, including call centres with proactive customer contact strategies to manage early arrears. Supervisory push was catalytic in this process. The extent of the operational changes that were necessary in developing internal NPL management capabilities was unprecedented and have started to produce results.
Equally important, but more difficult to achieve, has been the cultural change. Moving away from extend and pretend restructuring such as interest only and grace periods to sustainable restructuring solutions has been a lengthy and challenging process. Staff training, the introduction of restructuring toolkits and performance management systems as well as the introduction of the supervisory loan restructuring target framework supported this process. In 2016 there was a gradually increasing use of sustainable restructuring solutions, such as debt for asset swaps, write offs, split and freeze and interest rate reduction.
The reform of the legal framework, although lengthy and not yet fully tested, has succeeded in targeting strategic defaulters, encouraging a repayment culture and incentivising borrowers to negotiate a restructuring.
In 2015 the Cyprus economy returned to modest economic growth after three years of contraction, reflecting the progress in implementing the economic adjustment programme.
The stock of NPLs in households and non-financial corporates peaked in 2014Q4 at €28 billion and has been gradually declining ever since. It is currently at €21,9 billion. Added to this has been the increase in provisions and write-offs.
However, we still have a long way ahead of us before NPLs are no longer a threat to the banks, the economy and financial stability.
In our NPL resolution journey we have learned that:
The last part of my remarks will focus on the way forward and in particular our expectations about the key enablers and challenges in the NPL resolution process.
Cyprus is faced with an extraordinary level of NPLs across all sectors and addressing this will take time. There is no magic bullet.
NPLs can decrease through a combination of actions, namely restructuring of viable borrowers and liquidation of the collateral/assets of non-viable borrowers, generous concessions from banks and write - offs, sales of NPLs as well as natural cure.
However, the accomplishment of our NPL resolution goal is highly dependent on progress in a number of other areas. Specifically:
Economic recovery is important as it will facilitate an improvement in debt servicing capacity and will reduce the probability of default. However, economic recovery on its own will not suffice. Given the magnitude of the problem, further intensification of sustainable restructuring activity for viable borrowers, along with the effective implementation of the refined insolvency and foreclosure frameworks and streamlining of the judicial system will be key drivers.
Last but not least, a strong supervisory and regulatory focus with due consideration of the macro-prudential aspect of NPLs rather than focusing solely on NPLs as a micro-supervisory problem should be a key enabler in this process. Supervisory emphasis on sustainable restructuring, liquidation, write offs and disposition of foreclosed assets as well as on the appropriateness of provisioning and collateral valuation practices is warranted. In this regard, the Central Bank of Cyprus welcomes and supports the SSM guidance to banks on NPLs that was published for consultation in September 2016 and the European Council conclusions on the action plan to tackle NPLs in Europe.
The journey to NPL resolution is not and will not be easy.
The systemic nature of the NPL problem in Cyprus requires a coordinated strategy and completion of the reform agenda.
Macroeconomic conditions are gradually improving, although vulnerabilities still exist. Geopolitical events and/or slowdown of global economic growth and/or BREXIT may affect the economic recovery in Cyprus and especially the tourist industry, which is has been a key driver of GDP growth in the last two years. Unemployment remains high, although it is expected to fall in the coming years. There has been a small increase in new lending but credit growth remains constrained amid continuing efforts of the private and banking sector to deleverage and repair their balance sheets.
The efficiency of the new foreclosure and insolvency legal framework has not yet been tested and possible unpredicted delays in the effective implementation of the refined foreclosure framework could result in further inefficiencies.
The increased efficiency of the judicial system, despite ongoing efforts, is complex and needs time before it is effective.
Although significant progress has been made in the operational capacity and expertise of the banks, there is still room for improvement. Banks need to remain focused and committed to their NPL strategies.
Ensuring sustainable restructuring solutions could be challenging amid the high level of indebtedness in households and non-financial corporations and their weak debt servicing capacity. Efficient implementation of the insolvency framework could be a silver lining.
In addition, let’s not forget that the level of defaults is a function of the economic environment, the use of short-term restructuring solutions as well as the option of strategic default if the incentives are not balanced.
Recovery of the real estate sector is not expected to be easy both due to internal and external factors, whereas possible mass disposals could result in sharp reductions in real estate prices, creating feedback loops between the real economy and the banking sector.
The banks’ capital buffers and internal capital generation cannot support aggressive provisioning or write-offs or capital destructive NPL sales. On the other hand, pre – impairment profitability should remain positive in the medium and long term so that the building up of additional provisions is feasible. In this regard, banks should pay particular attention to viable business models.
A secondary market for distressed assets in Cyprus might at this stage be shallow due to the small size of portfolios and the perceived illiquidity of the real estate market. In addition, transactions may require high haircuts on net book value due to uncertainties over the recovery value. However, the recent collaborations of two significant banks with foreign servicing platforms for the management of NPLs, the gradual recovery of the real estate sector and the continuous increase of NPLs provisioning can potentially support distressed assets transactions.
We acknowledge that tackling NPLs is not an easy task, but it is necessary for improving the soundness of our banking system and economic recovery. We remain committed to the effort bearing in mind the words of the ancient Greek philosopher Lucius Mestrius Plutarchos “Τα χαλεπά ταις επιμελείαις αλίσκεται”, which means that difficult situations can only be overcome through diligent effort.
Thank you for your attention.
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