Speech by Panicos Demetriades, Governor of the Central Bank of Cyprus, at the 3rd Nicosia Economic Congress organised by the Institute of Certified Public Accountants of Cyprus in cooperation with Gold magazine(1)
Nicosia, 22 May 2013
Ladies and gentlemen,
I would first like to thank the organisers of this event for their kind invitation to present the Bank’s views on the challenges facing the Cyprus banking sector, the financial system reforms underway and the outlook for the future.
Introduction
In recent months, Cyprus has faced an unprecedented and deepening crisis that has necessitated drastic measures to resolve it. To address the short- and medium-term financial, fiscal and structural challenges, the country has agreed to an ambitious reform programme, backed by substantial financing from international organisations, aimed at restoring financial stability and achieving sustainable public finances to support the recovery of economic activity.
More specifically, the key objectives of the economic adjustment programme are to:
· restore the soundness of the Cypriot banking sector and rebuild depositors' and market confidence by thoroughly restructuring and downsizing financial institutions, strengthening supervision and addressing expected capital shortfalls, in line with the political agreement of the Eurogroup on 25 March 2013;
· continue the on-going process of fiscal consolidation in order to correct the excessive general government deficit as soon as possible, in particular through measures to reduce current primary expenditure, and maintain fiscal consolidation in the medium-term, specifically through measures to increase the efficiency of public spending within a medium term budgetary framework, enhance revenue collection and improve the functioning of the public sector; and
· implement structural reforms to support competitiveness and sustainable and balanced growth, allowing for the unwinding of macroeconomic imbalances, in particular by reforming the wage indexation system and removing obstacles to the smooth functioning of services markets.
Progress to date
Major steps have already been taken to address these challenges. In the banking sector, these include:
· divestment of the Greek operations of the three largest domestic banks. This allowed the ring-fencing of Greece and the elimination of the risk of any further losses from the banks’ Greek loan portfolios, thus helping to safeguard financial stability in both Cyprus and Greece;
· resolution of the Cyprus Popular Bank by transferring assets, insured deposits, interbank liabilities and Emergency Liquidity Assistance (ELA) to Bank of Cyprus;
· recapitalisation of Bank of Cyprus with the participation of bank creditors in the order of seniority (i.e. shareholders, bank debt holders and partial conversion of uninsured deposits into equity, while fully protecting insured depositors); and
· imposition of temporary and proportionate restrictions on financial flows to preserve financial stability.
Main financial system reforms
The resolution, restructuring and recapitalisation of the two largest domestic banks have averted a collapse of the system and a disorderly default of the sovereign. They have also reduced contingent liabilities on the sovereign, with the domestically-owned sector already downsized significantly. Upfront action has addressed immediate concerns but restoring the health of the banking system will require additional measures. Under the proposed programme, a comprehensive strategy will be implemented to restore the viability of the banking sector and strengthen the supervisory and regulatory framework.
Further steps are needed to complete the restructuring and recapitalisation process so as to rebuild confidence in the banking system, normalise financial flows and set the conditions for sustainable economic growth. Restructuring is also expected to further reduce the size of the banking sector. Moreover, measures will be needed to facilitate private debt restructuring, enhance banking supervision and regulation and strengthen anti-money laundering (AML) practices.
Restructuring and recapitalising the banking sector
Firstly, the restructuring of Bank of Cyprus needs to be completed. According to the new bank resolution law, an independent fair value assessment of the assets and liabilities of Bank of Cyprus and the Cyprus Popular Bank will be conducted by end-June 2013. This will help to finalise the new balance sheet based on most recent information and determine whether additional capital is required to ensure a Core Tier 1 (CT1) ratio of 9 percent by the end of the programme. To this end, in addition to the 37,5 percent of Bank of Cyprus uninsured deposits converted into equity, a further 22,5 percent will remain frozen and subject to potential conversion after completion of the valuation process.
Under the recapitalisation strategy, all insured depositors have been protected. However, in the two banks in which intervention was necessary, part of the uninsured deposits has been converted into shares to ensure adequate capitalisation, in line with the new bank resolution law. Looking forward, to address potential additional capital needs following an independent asset valuation in Bank of Cyprus, an additional uninsured deposit buffer has been set aside and could be used if needed. In the rest of the commercial banks and co-operative credit institutions (co-ops), uninsured depositors are not expected to participate in the recapitalisation of their institutions. Such recapitalisation will be done through private or public funds.
The recapitalisation of the rest of the commercial banks will be guided by the capital needs identified under the due diligence exercise conducted by PIMCO. Time will be allowed for viable but undercapitalised institutions to raise capital and preserve private ownership. However, if new capital is not forthcoming, viable banks will receive government support according to state aid rules involving dilution of existing shareholdings and junior debt holdings, but without contributions by depositors. Banks recapitalised with public funds will also be asked to submit business plans with clear downsizing targets, including divestiture of non-core activities and reduction of operational costs.
The co-operative credit sector will also be restructured and recapitalised. Any weaknesses identified will be addressed as follows:
· An assessment of the capital needs for individual co-ops not covered by the due diligence exercise will be finalised by end-June 2013;
· Co-ops will be given an opportunity to raise capital in the market;
· All co-ops which cannot access sufficient private capital will be orderly and gradually restructured and recapitalised with public funds, without contribution by depositors. Public funds will be made available subject to compliance with minimum governance and operational criteria to guarantee the viability of the sector.
· To maintain confidence in the sector, sufficient official funds to cover recapitalisation and restructuring costs will be disbursed in a special account at the time of the first review, to be drawn on over time as the co-ops are being restructured.
Normalising financial flows
As regards the lifting of temporary capital controls and restrictions on deposit withdrawals, it is important to consider the tradeoff between freeing payment flows and preserving financial stability. Obviously, there are significant costs to economic activity posed by the restrictive measures, relating to the ability of working capital to flow freely not only within the economy but also outside, as Cyprus is heavily dependent on imports. Nevertheless, it must be recognised that eliminating restrictions too abruptly can lead to disruptive outflows and liquidity problems in the banking sector.
These controls will be relaxed gradually, based on close monitoring of trends and of banks’ liquidity buffers. The overall strategy focuses on lifting restrictions on domestic transactions before lifting those on international payments as conditions continue to ameliorate. Completing the restructuring process is expected to lead to a resumption of confidence and a gradual stabilisation of funding.
Enhancing preparedness to deal with troubled borrowers
The framework for debt workouts will be enhanced to facilitate the clean-up of banks’ portfolios. Given already high and likely rising non-performing loans (NPLs), having in place tools to address past due loans expeditiously helps both the banks and their borrowers. The CBC is already in the process of revising the existing framework with the aim to facilitate the development of strategies by banks to deal with NPLs of viable, but temporarily troubled borrowers, while minimising moral hazard. These would need to be carefully monitored. An ombudsman-type institution to mediate between borrowers and banks will also be established.
Strengthening banking supervision and regulation
The supervisory and regulatory framework for credit institutions needs to be strengthened. A number of deficiencies in the existing framework have allowed the rapid expansion of the banking sector and the build-up of risks and vulnerabilities that led to the recent crisis. These pertained, inter alia, to the monitoring of credit quality (including use of non-standard NPL definitions excluding fully collateralised loans), lack of an early intervention framework for banks and heterogeneous supervisory standards and responsibilities related to banks and co-ops. In this context, to prevent risks from materialising in the future, the regulatory framework will be strengthened along the following dimensions:
· Credit quality monitoring. Going forward the banks will: (i) report NPLs timely and adequately, based on internationally-recognised definitions incorporated in revised CBC regulations that have already been prepared and will soon be finalised; (ii) comply with materially enhanced risk management practices, including proper underwriting and loan collection standards, as well as appropriate collateral valuation and provisioning practices; and (iii) be able to obtain credit information from individuals and corporates from a credit register that will be established to effectively monitor large exposures and troubled borrowers.
· Early corrective actions. Measures will be taken empower the CBC with sufficient supervisory tools (including the ability to impose penalties, remove bank managers, and suspend dividend payments) to timely address bank vulnerabilities or misconduct before they become a threat to financial stability.
· Supervision and regulation of co-ops. The lack of a common supervisory approach to banks and co-ops has contributed to the accumulation of balance sheet and governance issues among the latter. The aim is to: (i) transfer supervisory and regulatory powers of the sector to the CBC and harmonise standards with those of the commercial banks; (ii) prohibit co-ops from lending to independent board members and remove all board members in arrears on existing loans; and (iii) require an annual audit performed by a recognised and independent auditing firm for the largest co-ops.
Enhancing the anti-money laundering (AML) framework
The AML legal framework was amended in December 2012 to incorporate tax and other fiscal-related elements. An independent audit of the implementation of the AML framework by credit institutions has also been carried out by Moneyval and Deloitte Italy in April 2013. The two assessment reports, as well as identifying some risks and areas for improvement, also revealed a number of significant strengths in the existing AML framework but also in its implementation by the credit institutions. Going forward, additional measures to improve transparency and enhance the effectiveness of the AML framework will be taken by: (i) further revising the legal framework to rectify any possible remaining weaknesses, (ii) ensuring that the transparency of legal persons and trusts is properly implemented and (iii) strengthening the CBC AML supervision of financial institutions by the further implementation of a risk-based approach.
Main risks ahead
Risks to the outlook are substantial and tilted to the downside. Notably, macroeconomic risks remain unusually high, given the uncertain impact of the banking crisis and fiscal consolidation on economic activity and the adaptation of the business model. On the domestic side, given the size of the banks having been resolved, the losses faced by uninsured resident depositors, temporarily frozen corporate accounts and the need to impose payment restrictions, there are concerns that recession could prove to be deeper than anticipated, with negative feedback loops on public finances, including government debt.
Banking sector risks also remain high, including funding liquidity pressures, rising non-performing loans, litigation risks, the future impact of administrative restrictions as well as the potential consequences of their premature lifting and the likelihood of not implementing the programme reforms fully or in a timely manner.
On the upside, as soon as the banking system is seen as having stabilised, confidence could return sooner, allowing for the earlier removal of controls and a faster recovery of economic activity. In addition, some support may come from large investments in the energy sector, which could prove beneficial to both banks and the economy.
Concluding remarks
Looking forward, Cyprus is confronted with an extremely challenging road ahead. However, after a long period of uncertainty, there is now at last a paved path towards financial stability and economic recovery. Time is needed to allow the economy to address its imbalances, adjust to the deep structural changes in the banking sector and adapt the business model that will set the conditions for sustainable and balanced growth.
The CBC is fully committed to ensure the resolute implementation of the programme agreed with the international partners so as to rebuild confidence in the viability of the banking system and put public finances on a sustainable footing. Completing the necessary banking sector reforms will help restore the health and soundness of credit institutions and reinforce their resilience, thus allowing credit flows to the real economy to resume and hence contribute to the revival of private sector activity. It is important to keep in mind that the raison d'être of banks is, ultimately, to serve the needs of the domestic economy. Restoring financial stability will in turn help to spur economic growth and job creation.
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ENDNOTE:
(1) The speech was delivered by Yiangos Demetriou, Director of the Central Bank’s Supervision, Regulation and Licensing.