A development bank fit for managing NPLs can succeed with EU support

The outcome of the recent meeting between the President of the Republic and his Minister with the Board and CEO of the Bank of Cyprus is a very welcome development.  After the meeting it was announced by the Chairman of the Bank of Cyprus that a development bank could be set to manage distressed real estate loans. The Bank of Cyprus as the major financial institution and the key systemic bank was not purely a matter for the shareholders.  The state of the financial sector must concern the government and surely the President's hard efforts to attract foreign direct investment could have been made easier if there were no uncertainties about the financial system and in particular the Bank of Cyprus. The need to deal with the NPLs that have troubled the management of the Bank of Cyprus for more than 6 months has been made more urgent due to the stress tests the banks will have in the context of the Asset Quality Review which the European Central Bank insists upon before taking over as the Single Supervisory Mechanism. In this article the author will attempt to explain the importance of the capital structure which a development bank should have in order to be the entity best suited to handle such distressed real estate loans and possibly play a role in the project financing of future infrastructure projects which require long term financing. In this the key role will be the manner and type of funding of such a development bank since in the absence of the optimal mix of funding it may be that an alternative entity/agency may offer a better structure for the asset management of the NPLs for the benefit of the borrowers, the investors, the lenders and the economy at large. Development banks in general have relied on state support for their funding of lending, be they international development banks or national development banks. The World Bank had set the example for many years but the reliance on paid in capital and callable capital from governments was over the years supplemented by development banks borrowing from international capital markets via the issuance of bonds with medium to long term maturities. The investors effectively took the risk of the support of governments which would be implicit. In the case of the World Bank the major shareholders were the OECD countries which included the richest countries in the world and naturally the AAA rating of the World Bank enabled it to borrow at very attractive interest rates. The European Bank for Reconstruction and Development, set up to finance the transition of the East European countries departed from the lending practice of the World Bank in that it limited the lending to the public sector and focused on the private sector. It's majority equity funding was pretty much from rich industrialized countries and debt funding from the international capital markets. Hence the two key ingredients of development banks are paid in and subscribed equity from government/s and access to long term funding via the international capital markets; in all cases the amount of lending and guarantees are linked to the equity position of the development banks. Multilateral Development banks also by their very nature are not regulated by central banks and hence do not have the capital requirements that regulators impose on other financial institutions such as commercial and investment banks. In fact private sector banks in general are the most regulated firms and have to comply with national and international standards; the latter being the Basel framework for financial institutions which many countries adopt. It is thus very important that a development bank that will be set up in Cyprus as a local bank have the paid up and subscribed equity that will be sufficient to comply with EU Directives and meet the capital requirements of the ECB; who will provide this equity? Will it be the government or a mix of government and multilateral development banks such as the EIB and IFC? In the view of the author the latter would be the preferred equity capital structure since the Cyprus government is unable to provide the equity. The proposed development bank will also have to seek non deposit liabilities that will be consistent with its aim to asset manage the NPLs over a medium to long term period and, if it is to be the source of funding for long term project financing, it would have to issue medium to long term bonds to have the right mix of funding otherwise it would be left exposed to refinancing risk. One can see immediately the difficulties an unrated development bank will have in terms of its cost of funding if it were to seek to source long term funding from the markets; such as international institutional bond holders, private equity and real estate funds. Patient long term capital, such as EIB loans, could be willing to take Cyprus country risk as well as the risk of an unrated development bank! However, this will have to be complemented by more expensive private sector borrowing. There is thus a need to consider how the EBRD, EU Institutions or even the IFC can support the activity of the development bank in its funding otherwise the private sector sources will want to be rewarded for their risk taking by charging high interest rates on the bonds the development bank will have to issue. The official sources of funding (IFC, EBRD, EIB, EU) would be best suited as their interest rates would be lower and herein is the challenge of the development bank success.  Another issue which a development bank, that is not fully supported by the public sector, will face is the amount of leverage it will be allowed to have since this is increasingly being seen as a measure of the risk that a bank takes. A development bank that does not have retail deposits but relies on non deposit liabilities has high leverage and there is a need to see how the ELA financing that may be transferred to the development bank can be converted to a long term deposit. From the point of view of the asset management of real estate NPLs, which require medium to long term work out periods, for a development bank to be fit for purpose there are clearly a lot of issues regarding its funding sources and its regulatory status which need to be addressed from the start and this will require Central Bank support and EU participation. It certainly is within the ability and scope of the EU, and the EIB in particular, to provide funding and the credit support the development bank will require. Moreover the EU can support the set up in respect of the governance of the development, so critical for the credibility of the development bank. The Central Bank and the Ministry of Finance have thus an important stake in making sure that if the preferred solution is the development bank it is adequately funded and has the support of the EU. These issues are by their very nature political. If, however, the government does not or cannot secure a development bank that is fit for purpose then it may be that the asset management company solution is one that is more likely to appeal to the investors for equity and debt, albeit more costly. An asset management company is not a bank and hence is not restricted to comply with bank regulatory capital which, given the risks it handles, does not have to provide for Pillar I and II minimum capital requirements. An asset management company will have the flexibility in what type of equity, quasi equity and debt instruments it issues to fund itself; this flexibility must not be ignored. In Spain private banks and insurance companies provided the bulk of funding and there is scope to be innovative with instruments that will reduce the cost of funding which may not be possible to do so if the issuer is a bank. Whilst it may argued that the patient capital from development banks such as the EBRD and IFC may not be forthcoming it is not unheard of to see these institutions lend to non bank entities where NPLs asset management is critical for economic recovery and rehabilitation of the financial sector. The advantage of a flexible capital structure that is designed to enhance the asset management of NPLs, together with the absence of regulatory compliance which a bank has to have, are important enough to consider before the final decision is made. In the view of the author the flexibility an asset management company may offer can achieve a funding mix that is consistent with recovery in real estate values as a result of work outs to be undertaken by the AMC. If such NPLs are bought by a development bank it will still mean that capital and provisions are an issue given the implications that such loans have on the balance should the asset quality continue to deteriorate. At the end of the day the option must rest on what is best for the asset management of the NPLs and the economy at large. This is very clearly linked to the access, cost and length of loan capital and thus the challenge would be for the government to seek the collaboration of the EU, the EIB, IFC and the EBRD so that a development bank is set up that will have the best prospects of success. These sources of patient and lower cost of capital could provide the best support of the development bank given their expertise in rehabilitating financial sectors and access to the international capital markets with their AAA rating.