Cypriot banking sector is in the best position it has been over the last decade, experts said at the 19th Annual Economist Summit, on the session regarding the response of the banking sector in an environment of elevated interest rates. The experts highlighted, however, the importance of implementing the foreclosure framework to combat NPLs.

Representatives of ECB’s SSM, ESM and Moody’s stressed that the European banking sector shows resilience, despite the hike of interest rates and the many challenges of the last few years, like the pandemic, the war in Ukraine, high inflation, an energy crisis and the recent developments in the Middle East.

Resilient EU banking sector

Elizabeth McCaul, member of the supervisory board of the European Central Bank, noted that, overall, the European banking system remains resilient. The banks under ECB’s supervision have comfortable capital and liquidity ratios. The average CET1 ratio of significant institutions stood at 15.7% in 2023Q2, she noted.

She added that bank profitability is also up, with an annualized return on equity up by 10%, compared to 7.6% a year ago, primarily due to the rising of net interest rate margins. “From a financial stability point of view, these increases are very much welcome,” she said.

McCaul added that the results of recent stress tests of the European banking sector show that the banking system could withstand even a severe economic downturn.

However, she highlighted that this is not a moment of complacency. “Banks need to remain vigilant and continuously monitoring and adapting their risk scenarios, they have to be open, to be able to have a clear line of sight into vulnerabilities of the overall economy and understand that it’s a fast-moving macroeconomic environment that they are operating in.”

She also added that the monetary policy normalisation has been faster and stronger than expected. Households and firms’ savings decreased, market competition for funding might continue to increase and assets’ prices decrease. These have to be taken into account in the banks’ risk scenarios, she noted.

McCaul pointed out that in the bottom-line, the banking sector remains resilient in the current environment of elevated interest rates, “but we also know that there is weaker lending growth and we see rising funding costs and we see asset quality deterioration as areas that might pose outside risk to banks profitability going forward,” she said.

Asked if lessons have been learnt both by supervisors and banks since the 2010 crisis, she said that lessons learnt have been built into the regulatory framework. “The key is to not forget those lessons. It’s important to keep following through on delivery of the requirements,” she noted.

Cypriot banking sector stronger in a decade

Wim Van Aken, senior adviser to the chief economist of the European Stability Mechanism, and mission chief for ESM’s post programme surveillance activities in Cyprus, said that most economic outlook projections were done before the recent developments, that add pressure to inflation, weigh on the economic outlook and could have an impact to growth, noting that projections have been revised downward so far.

Despite this growing economic uncertainty, the economy has shown resilience, Van Aken said, noting that this is true for the euro area and for Cyprus.

He said that Cyprus has enjoyed a strong economic performance and the economic projections for Cyprus remain relatively robust. They are higher in terms of growth than euro area average and average inflation is projected to drop significantly in 2023 and to go lower than in euro area.

Cyprus has also been fiscally prudent and able to create fiscal space, Van Aken noted, adding that this is the result of cautious use of energy measures to support households, while also noting that public debt in Cyprus continues to decline. He stressed that one reason for Cyprus being in such good position relates to the reform efforts that have been taken over the last decade.

He underlined that in Cyprus, the banking sector reported the strongest position in a decade. Higher rates have boosted earnings, they drive solvency ratios above the euro area average and, so far, assets’ quality has remained resilient, he said.

“Since the financial crisis, Cypriot banks have significantly de-risked their balance sheets”, he noted, adding that rating agencies have upgraded Cypriot banks.

However, he stressed that while the reduction of legacy NPLs in Cyprus has been significant on banks’ balance sheets, they still stay high compared to the EU average. Moreover, he said that NPLs outside the banking system remain very high and they weigh on banks new lending opportunities and profitability, as borrowers are not able to return to banks as viable clients.

“NPLs resolution in Cyprus critically depends on the effectiveness of the foreclosure framework. Numerous legislative proposals that could undermine the effectiveness of the foreclosure framework and the lack of its implementation are concerning,” he noted.

On the other hand, he pointed out as positive news Cyprus returning to an investment grade by all major rating agencies. “This is a major achievement and a moment of celebration for the country, because it has meant many efforts of the people of Cyprus to get here,” he said, adding that for EMS this is a reflection of the efforts that have been made and is a great step forward.

He noted, though, that positive momentum is only the first step. It means that Cyprus’ governments need to continue using this space in order to keep the positive momentum. That means continued efforts of fiscal responsibility, a stable financial sector and reform implementation under the country’s reform plan.

Overall, Van Aken said that in the mid-term, Cyprus can continue focusing on the fiscal prudence and show fiscal buffers and that could mitigate the expected slowdown of the economy in the current uncertainty. In the long-term, investing in modernizing the economy, through investments to digital technologies and innovations is essential. Finally, to preserve future economic growth in Cyprus, early adaptation actions regarding climate change are important for the economy’s resilience, he concluded.

Cyprus’ banking sector saturated, profitability will not last

Simon Ainsworth, an associate managing director co-responsible for Moody’s EMEA Insurance ratings, said that elevated core inflation means that central banks cannot yet be certain that they have achieved their mandate and so “we expect restrictive policy stunt to be maintained throughout next year”. He noted that so far ECB’s monetary policy has been effective, with deposits and lending rates leading banks to tighten their lending criteria. High interest rates are expected to result in a fallen loan demand, he said.

He agreed that Cypriot economy remains resilient, despite external shocks. “Moody’s expects a GDP growth of 2.8% next year”. However, he noted that Cyprus’ small and saturated banking sector, the banks’ small loan book and low fee income component will limit their long-term business and profit growth opportunities in the domestic market.

On the upside, he said that in Cyprus, where residual assets remain high, initial indications are of a limited impact on Cypriot banks’ assets quality.

He noted that banks are protected by strong capital buffers, which rose after the reforms following the global financial crisis. More importantly, he said, this capital is now predominantly comprised of very high-quality common equity.

He noted that Bank of Cyprus posted a common equity tier 1 ratio of 16% and a leverage ratio of 7.2%, well above the minimum and the euro average. Hellenic Bank has even more respectable ratios of 20% and 10% respectively, he said.

“An improved profitability, which we think is likely to peak next year, will fade away over time”, he said, pointing out that conservative loan appetite may limit the role the banks have to play in facilitating growth.