Weak Performance of Cyprus Banks

Data provided by the European Central Bank[1] reveals that the systematically important banks in Cyprus are performing poorly relative to their counterparts in other EU countries. In recent years the profitability of Cyprus banks has been diminished by their failure to build a portfolio of interest-bearing loans. Rather banks have just piled-up cash both through accumulating depositors’ money and by selling NPLs and related property collateral. Cyprus banks have largely not followed the traditional model of intermediating private savings and converting such funds into loans to finance investments and consumption, and in turn contribute to real economic growth. But in contrast to the more traditional behavior of European banks, Cyprus banks have been pre-occupied with removing impaired property-secured loans from their balance sheets and selling these loans to third parties. Such activity by Cyprus banks results merely in a transfer of wealth and keeps the private sector heavily indebted.

Key Developments

The reckless lending of Cyprus banks reflected in a huge amount of non-performing loans (NPLs) was the main cause of the 2012/13 financial crisis. Following the conducting of an adjustment program agreed with the troika of international institutions, namely the IMF, the European Commission, and the ECB, Cyprus exited the program in March 2016, with claims that financial stability had been restored. Furthermore, with banks seen to be possessing adequate liquidity and capital it was argued that the stage was set for banks to productively restructure and extend loans to support economic growth.

However, by early 2016 Cyprus banks remained lumbered with an immense volume of NPLs estimated at around 26 billion euro or 43 per cent of total loans.  Conversely, private sector entities comprising non-financial corporations (NFCs) and households were still heavily burdened with debt, that in turn inhibited their ability to support domestic demand and create investment opportunities. This situation led to bankers complaining that they had few creditworthy customers to lend to and worthwhile projects to finance. In response bankers became pre-occupied increasingly with getting impaired loans off their balance sheets with write-offs, property exchanges, and sales to third parties, rather than trying to productively restructure existing loans and extend new credits.

Despite the accumulation of loanable funds from deposits of households, this preoccupation contributed to banks giving little focus to expanding their portfolio of interest-bearing new loans. In fact, after deducting NPLs held by banks, such loans outstanding on their balance sheets declined by over 12 billion euro or 34 per cent between end-2015 and June 2022.

Over the same six and one-half years the cash and cash balances at central banks held by Cyprus banks, “earning” negative interest in recent years, rose spectacularly by 12.8 billion euro or over 100 per cent. Indeed, by June 30, 2022 this cash component at systematically important Cyprus banks of 17.9 billion euro exceeded loans and advances totaling 17.6 billion euro and accounted for 39.1 per cent of their assets. In 17 other EU countries the ratio of cash to total assets of systematically important banks on the same date was less than half of that of Cyprus banks at 15.6 per cent. Undeniably, banks in most other European countries have been able to use their funds more productively than Cyprus banks through expanding steadily their portfolio of interest-bearing loans. Whereas loans and advances of Cyprus banks accounted for 38.6 per cent of total assets on June 30 2022, the proportion for banks in 17 other EU countries was a much greater 58.6 per cent.

Given the inability of systematically important Cyprus banks to adequately utilize funds derived from deposits in income-yielding loans, their loans to deposits ratio had reached a very low 54.1 per cent at end-June 2022, being well below the average of banks in 17 other EU countries of 105.3 per cent.

The extremely small proportion of loans actually earning interest in the asset portfolio of Cyprus banks has contributed most importantly to their relatively low profitability compared with European banks. In the first half of 2022 the returns on equity and assets for Cyprus banks averaged 2.18 per cent and 0.17 per cent, respectively, while such returns on equity and assets for banks in 17 other EU countries averaged 6.83 per cent and 0.42 per cent, respectively.

Unproductive Bank Operations

Questions are asked as to why banks continue to operate in a way that at best yields very low profits and contributes little to supporting economic growth. Prima facie the answer would seem to reflect the inability or even an unwillingness of bankers to identify and, restructure and extend, productive loans on the basis of the economic viability of the project of the borrowing client. Unfortunately, banks in Cyprus still cling to the practice of extending longer-term credits only if the loan is secured by collateral, because in large part bankers do not have the ability to conduct competent risk analysis in appraising loan applications. However, with the repayment capability of bank clients not properly assessed or even considered in some cases many secured loans become impaired.

Thus, banks receive relatively little income from interest not only because very few productive loans are given, but also owing to a large number of secured loans becoming non-performing. But, why do the Cyprus authorities, banks and their shareholders tolerate this situation? Bankers have discovered that rather than expanding their balance sheets with new loans it is advantageous for banks, at least for politically-connected large shareholders and top executives, to call-in impaired loans and sell the related collateral to a third party, thus removing distressed assets from their balance sheets. And banks, most inequitably, more than facilitate often the sale of NPLs to predator funds at around 15 to 20 per cent of the book value, with third parties enjoying practically full collaterals and guarantees.

As a result of the selling of NPLs and related collateral to third parties there is a transfer of wealth, but no change in the overwhelming indebtedness of the private sector, that in turn constrains economic growth through, among other things, a reluctance of banks to lend to uncreditworthy customers. This vicious circle would not have arisen if banks had productively restructured loans and/or written off debt where the borrower had been extended a loan, which he or she had little prospect of repaying. Indeed, it is the failure of the Cyprus authorities and banks to deal effectively with the problem of a prolonged and huge private debt overhang that has impeded the inclusive and equitable growth of the Cyprus economy. In fact, private sector debt according to the latest revised data of the Central Bank of Cyprus amounted to 6O.3 billion euro or over 240 per cent of estimated 2022 GDP at end-June 2022, this being the highest ratio in the EU apart from that of Luxembourg, and was only 2.0 billion euro below its near-peak level at end-2015.

In Cyprus it appears that major banks prefer to engage in transactions with NPLs both on and often controlled off their balance sheets rather than in arranging new loans. And considerable bank credit has been given to companies for the purchase of NPLs from banks. Indeed, what are the financial and personnel relations between Cyprus banks and credit acquiring companies registered by the Central Bank of Cyprus? Do the Cyprus authorities have accurate information on the operations and balance sheets of credit acquiring companies, such as their capital to risk assets ratios, or are banks essentially responsible for the questionable operations and financial protection of these companies?

Recommendations

Institutional changes must be made so that the very large amount of idle cash in banks and tax payer’s money can be put to more productive use. As recommended repeatedly an independent Development Finance Agency needs to be established with competent staff tasked with identifying and arranging the financing of large scale economically viable projects, including those involving Public Private Partnerships.

And the practices of banks and other financial institutions need to be better regulated and supervised. Original borrowers should be given the first right to accept an offer made by a bank to a third party to sell collateral at a discounted price so as to prevent profiteering at the expense of initial bank client. In addition, consideration should be given to passing legislation along the lines of the “Law of Fraudulent Conveyance” of New York State, whereby it is considered illegal if a lender has given a loan without first assessing the ability of the borrower to repay, allowing the borrower not to lose the asset that was put up as collateral.

Furthermore, to contribute to an efficient and prudent use of financial resources there is a  need for strengthening the regulation and supervision of non-bank financial institutions including credit acquiring companies in terms of their capital requirements, borrowings from banks, and use of funds, with the requirement that these institutions provide punctually audited bi-annual income statements and balance sheets.