Welcome address by Panicos Demetriades, Governor of the Central Bank of Cyprus at the conference organised by the Central Bank of Cyprus
Nicosia, 27-28 January 2014
Good morning ladies and gentlemen.
It is my pleasure to welcome you to the Conference on Arrears Management and Loan Restructurings organised by the Central Bank of Cyprus. Arrears management and loan restructuring is one of the most challenging issues currently facing the banking sector in Cyprus in its path to the restoration of financial soundness. The cleaning up of the banks’ balance sheets will help improve the functioning of the monetary transmission mechanism. More specifically, a reduction in the level of NPLs will result in lower provisioning requirements and this will contribute to the decline in interest rates in the long run, to the benefit of households and businesses. At the same time, adequate capital buffers will be created thus strengthening the resilience of banks. The organisation of this conference highlights the importance placed on this issue by the Central Bank.
I would like to take this opportunity to extend a warm welcome and express my gratitude to all our presenters who have taken time away from their busy schedules to share with us their expertise and experiences, especially our guests from the international banking community who have travelled from abroad.
As you all know, the issue of problematic debt servicing and repayment has been a significant factor in the global financial crisis. In Cyprus, significant correction measures have been taken to address such issues and restore the soundness of the Cypriot banking sector, following the Eurogroup decisions in March 2013 and the MoU between Cyprus and the ECB, IMF and the European Commission.
Cyprus has embarked on an economic adjustment programme aimed at restoring the health of the financial sector, continuing the on-going process of fiscal consolidation and implementing appropriate structural reforms that will support competitiveness and a sustainable and balanced growth. The two largest domestic banks have been resolved, restructured and recapitalised with shareholders, bond holders and depositors of over €100.000 bailed-in to restore adequate capital buffers. The banks have started deleveraging and will focus their operations on domestic core banking products. However, while there were a number of reasons that contributed to the need for such decisive actions, one cannot discount the severe effect that problematic loans, largely due to imprudent loan origination standards and practices, have had on the banks' liquidity, profitability, and ultimately capital positions.
Unfortunately, for many years the banking sector in Cyprus, in common with some other countries, adopted poor risk and credit management practices, dominated by asset based lending, and an overexpansion of the real estate market. The consequences of such practices can be disguised in periods of an expanding booming economy, even appearing as successful while real estate prices are rising, demand remains strong, and income growth targets supersede the basic principles that should govern any basic business or lending transaction – the ability of borrowers to repay their debts.
Many developed economies, including Cyprus, discovered that such recipes lead to a significant increase in arrears, particularly as they strive to overcome the ripple effects of the global financial crisis. With falling demand, the economy in recession and rising inability to meet repayments as well as decreasing real estate and other asset prices, the banks find themselves not only with liquidity concerns but also with rising security shortfalls and an increasing need for the provisions.
This is a very pressing issue in Cyprus, with arrears and non-performing loans rising to unprecedented levels. The IMF December 2013 Cyprus Second Review provides valuable lessons from Ireland and Iceland. As in the case of Cyprus, these countries entered the crisis with large private sector indebtedness accumulated in the decade preceding the crisis. Private sector indebtedness peaked at over 500% of GDP in Iceland, and 300% in Ireland. By comparison, private sector indebtedness stands at 300% in Cyprus. When the crisis arrived, non-performing loans rose dramatically as they did in Cyprus. One should however place this in context and recognise that while the numbers are high, the problem can be addressed and defused once appropriate and targeted measures are taken, such as a targeted case-by-case approach to debt restructuring, an effective arrears management framework, and the strengthening of the legal framework.
The Central Bank of Cyprus has issued a number of directives to assist the banks in addressing the current situation, and thus reducing the risk of this being repeated in the future.
A new loan origination directive was issued by the Central Bank, providing guidance as to how origination and review applications for lending should be assessed. This new directive aims to shift lending from asset based criteria to assessing the ability to repay. Indeed, asset based lending is no longer acceptable and ability to repay should be the main criterion that governs a credit approval decision. Collateral should be just that, an added layer of security in case things do not evolve as expected, and should not be expected to be the primary source of repayment.
In September 2013, an Arrears Management Framework and a Code of Conduct for borrowers and creditors was issued designed to manage the increasing number of borrowers in financial difficulties and enhance the framework for private-sector-debt restructuring. Credit institutions operating in Cyprus are now required to establish an appropriate framework for the effective management of arrears and loan restructurings of borrowers in financial difficulties. Credit institutions are currently revising their strategies, policies and procedures and designing appropriate action plans for the full implementation of the requirements of the Central Bank’s directive.
The Central Bank expects that our banks will play a significant role in the efforts made to establish the right environment for arrears management, by placing the utmost importance on the correct application of the above directives. An assessment of the credit institutions internal effectiveness, operational capacity, and arrears management policies, procedures and practices for the different sectors in the market will be conducted in the first half of 2014.
It should be noted that at this critical phase of the economic cycle, and while the banking system strives to restore confidence and leave the bad practices of the past behind, a focus on the human factor, especially in cases of home owners, should remain. The emphasis remains on restructuring loans on the basis of fair pricing in order to achieve a viable repayment schedule which will assist the borrowers' business and financial condition, contribute to economic recovery and safeguard the interests of banks. A loan restructuring provides an opportunity for banks to strengthen their liquidity and profitability where an improvement in debt servicing performance can be achieved. Steps taken to address arrears should at all times adhere to the Code of Conduct for borrowers and creditors, with a case by case approach. A distinction should be made by banks between those borrowers who are cooperative and willing to meet repayments in line with their financial capacity, and those who are able to repay but are unwilling. The treatment between these two groups should be appropriate and values should be maximised where possible with decisive recovery measures deployed for able but unwilling clients.
The road ahead is not easy. The shareholders and management of banks will have to deal with the legacy issues of poor risk management and credit assessment and badly managed asset based lending that led to the historic expansion of the loan portfolios which have resulted in the growth in non-performing loans and arrears. Banks should and are continuing to reorganise themselves internally to prioritise the management of arrears and become well equipped organisations in risk management. It is expected that the focus on this area will continue.
Restructuring and cleaning up a bank’s balance sheet is not easy, and market conditions remain challenging. A change of culture and thinking is needed to improve things in the short term, and ensure the effective functioning of the system in the medium and long run.
Concluding remarks
This remains a challenging juncture for Cyprus and its banking system. The Central Bank is fully committed to the implementation of the programme agreed with the international lenders. I remain positive that the Cyprus economy will come out stronger from the current crisis. Cyprus retains its European Union member status, a strategic location between three continents, well performing industries such as tourism and shipping, while significant investment is expected in the energy sector. In addition, it maintains a strong financial services sector infrastructure, experience, and know-how.
An efficient and well operating arrears management function across banks will assist in once again creating healthy bank balance sheets as well as improving liquidity, profitability, and capital. It will also have a key role in restoring confidence in the sector and in the wider economy. Effective arrears management should be expedited and form part of the immediate implementation strategy and plan at every credit institution.
Creating dedicated arrears management units and managing NPLs will require deploying the appropriate resources and developing the appropriate level of expertise. This is where the contributions during the course of this conference may prove most valuable. I look forward to hearing the presenters’ views and to a discussion over the course of the conference and in the coming months, as we continue our efforts to create a strong and robust banking sector.