How many does it really take to tango?

 I was appointed on the Board of Bank of Cyprus (BOC) in April 2011 as an independent director about three months before the first PSI agreement and all the events that followed.  My personal view on the events of the recent few weeks, that have basically, treated BOC as insolvent, is that certainly BOC’s decisions to invest in the Greek sovereign bonds took its toll. My main goal here is to demonstrate that BOC’s current financial position is the result of a series of events, some more important than others, which nevertheless, together contributed to the current situation.   The first part of the article discusses BOC’s decision to invest in the Greek sovereign bonds and its implications. The second part discusses the role of other exogenous factors that contributed to BOC’s troubles and the third part sets forth a number of suggestions that could help alleviate the adverse effects of the financial crisis on BOC.  Setting the puzzle: Investing in Greek Bonds The first and perhaps critical event behind BOC’s financial troubles was the decision to (re)-acquire Greek sovereign bonds in the amount of about €2 billion.  The amount invested was approximately around 70 % of capital and 35 % of the bank’s total investment portfolio in bonds.  Certainly BOC’s decision ignored concentration risks and overexposed the company to the Greek economy.   The second important event was the political decision to write-down Greek debt, known as the private sector involvement, (PSI), a decision that imposed all of Greece’s financial troubles on the shoulders of the private sector. As a result BOC was “voluntarily” forced to write down its Greek sovereign investment by 53.5% in nominal value and approximately 75% in fair value leading to an overall hit of €1.3 billion on BOC’s profitability and equity.  Given the significant amount in firm value that vanished in a blink of an eye, it is important to examine whether this decision entails criminal or even illegal elements.  My personal take on this is that it doesn’t.  It rather seems to me that the decision to acquire the Greek bonds was a poor decision but one that falls under the so-called “business judgment rule”.  Under the business judgment rule officers, directors, managers, and other agents of a corporation are immune from liability to the corporation for loss incurred in corporate transactions that are within their authority and power to make when sufficient evidence demonstrates that the transactions are made in good faith. Board decisions are usually not second-guessed by the courts, even if a reasonable person would have acted differently under the same circumstances.  So was this a bad decision that falls under the auspices of a poor judgment call that was, nevertheless, made having in mind the interests of the shareholders? The findings of the Alvarez and Marsal investigation, partly support this conjecture as they fail to document that the purchase of Greek bonds was in fact in breach of any regulatory or internally-set limits, nor has there been any evidence regarding personal gains by the people involved in that decision. In addition, the last time BOC purchased Greek bonds these were rated at investment grade (with the lowest one still being A3), and considered by ECB as 0-risk.  (In contrast, the purchase of Cyprus bonds in the last year, when these were rated as below investment grade (i.e., ‘junk’), was justified, by the same people who find the investment in Greek bonds as criminal,  as necessary to support our Government’s needs.  The Cyprus COOP system also currently holds a significant amount of Cyprus bonds.  Why there is so much outcry for the purchase of the Greek bonds by BOC and not for the Cyprus bonds is still a puzzle to me).  Is buying the Greek bonds on the secondary market an act of “bad” faith? Not really. Secondary markets exist for this specific reason. To allow investors balance their portfolios as they see fit. In fact, a number of financial institutions across the world trade in secondary markets not only in sovereign bonds, but also in much riskier instruments like equities and derivatives.  BOC did not have an active trading book and did not trade in equities nor derivatives. The decision to invest in Greek bonds was partly a political decision to show BOC’s support to the Greek government after a public communication to the contrary.  Was it also an attempt to increase profits? Of course it was.  Is seeking profits a crime?  Not if the bank is acting within its risk appetite and not taking excessive risks.    Obviously the bank underestimated the risks involved with such decision. This includes concentration risk, market risk and political risk. The latter mostly relates to BOC’s assessment that a PSI, or any other form of bond haircut wasn’t plausible given that at the time of the purchase both ECB and our own CBC were against any such measures.  Therefore, the decision, at least in my view, can be, sadly, a classic textbook case of a business judgment that went awfully wrong.  Completing the puzzle:  A bad business decision by BOC, along with the political decision for the PSI and the political ignorance to demand same treatment for the recapitalization of Cyprus banks as for Greek banks, created a bank with numerous financial troubles.  Was BOC an insolvent bank after the PSI? As part of a policy to restore confidence in the EU banking sector, EBA (the European Banking Authority) issued a recommendation to national authorities to raise their Core Tier 1 ratios to 9%, to ensure sufficient capital against unexpected losses if the economic situation deteriorated further (EBA, October 2012).  Even though BOC was short of the 9% EBA threshold at the end of June of 2012, it was certainly not insolvent.  How important was meeting the threshold? According to the financial news, the local regulator would decide on the steps to be taken if a bank did not meet the ratio, with the expectation that for a bank which fell short of the ratio by a small amount the local regulator would be sympathetic.  “If the ratio is very low, that’s when the regulator will step in with forced recapitalisation.” (Financial News, 20 Feb. 2012).  Unfortunately, the regulator showed no sympathy to BOC’s inability to reach the threshold even though the amount at the time was not large, and BOC was in the process of selling its insurance companies.  So why a solvent bank falling short of the 9% EBA threshold by a relatively low amount, has been considered insolvent, as often, and perhaps indirectly, portrayed by the press, reflected in the statements of government officials and the draft MoU between the government and troika, and expressed by public opinion?   My take is that there were two different forces, each serving its own interests, but which happened to converge on their strategy to focus on, and even accentuate the poor financial picture of BOC. The end result was a badly injured BOC whose reputation was deeply (and possibly irreversibly) hurt.   The first was an insider attempt to convince public opinion that for BOC’s trouble only one person should be blamed; the ex-CEO.  In their attempt to personally harm the ex-CEO however, much greater harm has been inflicted upon BOC.  The attempt to harm Eliades, led the forces behind this to leak documents to both CBC and the press pointing, among others, to his negligent or even “criminal” decision to invest in Greek bonds.  The personal war against Eliades was fed to the press and ended up being a war against BOC. From the exploitation of innocent depositors and their investment in the bank’s CoCos, to Eliades low interest rate loan and the payment of his provident fund (which by the way was portrayed by the press as a  “bonus” payment, hinting that this was a voluntary payment by BOC and hiding the fact that this was actually a contractual obligation).  The second was an attempt by the government to blame all of its financial troubles on the banking sector, a myopic and dangerous strategy that undermined what keeps a banking sector strong and flourishing: investor and depositor confidence and trust.  I find the Government’s insistence on publicizing the troubles of the banking system grossly negligent, to say the least. Governments should protect their banking sectors as even the slightest possibility of trouble can not only bring a bank down but also take with it the whole economy. The most typical example is probably that of the US where the Federal Reserve fought for more than two years to keep details of the largest bailout in U.S. history a secret.  Why? As the Fed itself revealed, identifying borrower details would create a stigma -- investors and counterparties would shun firms that used the central bank as lender of last resort (Bloomberg, “Secret Fed Loans gave banks $13billion undisclosed to Congress”, 28/11/2011).  Unfortunately, the government’s strategy was backed by CBC’s new governing team, for reasons that I cannot really infer.  I suspect that part of the reason was an attempt to change the Cyprus banking system and redirect it towards what the new governor and his team thought was the best way forward. It seems that the Governor of the Central bank had a clearly laid out plan on what had to be done to restructure the banking system long before his appointment. His academic activity and his article contributions indicate that his plan was to significantly reduce the role of the two big banks in the Cyprus economy, break them into bad and good banks, and strip them of their foreign assets, long before these issues were finally addressed by the MoU between the government of Cyprus and Troika.  Mr. Demetriades has long been an advocate of breaking troubled banks into a bad and a good part. In his article published on stockwatch on February 7^th, 2012, entitled “Bad Banks”, he makes the case that if toxic assets are not overvalued, the creation of a bad bank should benefit the taxpayer, as without any losses incurred, the economy can start moving again, decreasing unemployment and enhancing public finances. When, in 2012, the Finance Ministry announced measures to boost economic growth Mr. Demetriades noted the absence of any measures for bank consolidation. “But what really worries me is that no measure promoting the consolidation of the banking system has been announced yet”, he added. According to Mr. Demetriades, consolidation may be achieved via the creation of a bad bank according to international standards to absorb the “toxic” data in the balance sheets of the two largest Cypriot banks. (Stockwatch, Cyprus Economy, Doubts on growth measures, 07/02/2012) He had often voiced his concerns regarding the size of the local banking system: In his article entitled “wake up call”, published on stockwatch on September 5^th, 2011, he states that the big losses incurred by the Cypriot banks due to the Greek PSI program for the first time show the real picture of how great their exposure to the Greek Economy is. He goes on to say that these losses should be the wake up call for further measures to reduce the dependence of the local economy on foreign markets due to the banks’ decisions to expand… He concludes by saying that Cyprus banks should prepare restructuring plans to reduce significantly the risks incurred by the Cyprus taxpayers due to the banks’ large size and their exposures not only in Greece but in other countries as well.  It is quite natural then to wonder, whether the MoU’s banking clauses were indeed imposed to the CBC or, more disconcertingly, whether it was our own CB that influenced the decisions by ECB and Troika.  I find it extremely worrisome that the new version of the MoU refers to both Cyprus banks as being insolvent. “The accounting and economic value assessment already mentioned revealed that the two largest banks of Cyprus were insolvent.” (MoU draft, 9 April, 2013. paragraph 1.23). Is the assumption that BOC is insolvent based on Troika’s own assessment or has it communicated by our local regulator, and when? The MoU explicitly assigns the responsibility of setting bank capital needs to CBC.  “The Central Bank of Cyprus in consultation with the EC, the IMF and the EBA, and in liaison with the ECB, will establish the specific capital needs of each participating bank by [31 January 2013] with a view to recapitalisation or resolution, if necessary.” Under the MoU of 9/4/2013 the “bank-by-bank stress tests” were conducted by CBC. Does CBC then consider BOC insolvent? As an ex-director of BOC I can state that during the past two years, the only time the equity value of BOC turned negative was right after the sale of the Greek operations to Piraeus Bank due to the detrimental terms of the sale, which were imposed by the CBC and which were NEVER ratified by BOC’s board. Was this decision really a genuine Troika’s suggestion or has it been again influenced by the governor’s own views on this? Are there any written statements by Troika requesting, for example, the sale of BOC assets at any price, any loss, and without the need for its board’s consent?  This discussion brings me to the last part of the article.  If BOC is not insolvent (even if it has been treated as one), are there any measures that we can still take to increase the probability that Cyprus’ largest bank, has a fair chance to survive?  Suggestions to reverse the damage inflicted on BOC    As a solvent bank the appointment of a bank administrator, even under the auspices of overseeing the merger with Laiki and implementing the haircut on deposits, is illegal. Therefore: a.    The administrator’s appointment should be revoked with immediate effect. A new board should be appointed with full powers to oversee the above. b.    The new board should renegotiate, to the degree possible, the terms of sale of the bank’s Greek operations to Piraeus to ensure that these are at least not harming shareholder interests. I would like to remind the readers here that the terms were negotiated by CBC, had no positive impact on the bank’s capital (the impact is in fact currently negative and can only be mitigated over time as projected NPLs materialize), and even required a substantial cash injection from BOC to Piraeus.  c. The empowered board should also properly evaluate the merger with Laiki to ensure

1. that NO part of ELA assumed by BOC is not adequately collateralized.
2.  Laiki’s “good” loan portfolio is assumed by BOC at fair and not at face value (allow me to also draw the comparison here with the sale of  BOC’s Greek portfolio which in contrast was “given away” to Piraeus fully collateralized).

 d. Seek alternative ways to recapitalize the bank. My suggestion is to allow BOC to first make a new capital issue before imposing the haircut on deposits.  I propose a voluntary conversion of deposits to ordinary shares (same class as the one currently in issue), and by offering pre-emptive rights to existing shareholders. The advantages of this solution are clear.  First, there will only be one class of shares, without harming the interests of BOC’s existing shareholders who invested in a solvent bank. Second, uninsured depositors will choose whether they want to convert part of their deposits to capital, realizing of course that if not enough of them do, they will have to incur the mandatory conversion.  I expect that under this proposal the needed amount from deposit conversion will be lower than the one under the mandatory scheme for two reasons.  First, under the voluntary conversion, existing shareholders might also choose to invest in order to secure their interests in an investment already made.  Second, by raising its own capital BOC will only need to raise as much as to reach or adequately beat the 9% EBA threshold. If this is achieved, ELA can continue to provide emergency assistance and BOC will be adequately capitalized without draining liquidity. Finding the right balance between capital adequacy and liquidity is extremely important as a strongly capitalized bank with poor reputation can still face bankruptcy.  Irene Karamanou Associate Professor of Accounting Department of Accounting and Finance University of Cyprus (Board member of BOC: April 2011 – March 2013)