Challenges Facing Governor of the Central Bank of Cyprus

The major challenge for the new Governor of the Central Bank of Cyprus in his leadership is to induce Cyprus banks to return to a situation where their activities are contributing more positively to the real economy and society of Cyprus. In essence, Cyprus banks should be enticed to do a much better job in serving the needs of their customers and the economy in general.

While Cyprus bankers have long contended that their activities, particularly in providing credit, have been the lifeblood of the Cyprus economy, data on the operations of Cyprus banks since 2015 reveal that they are doing little to positively support economic progress and the welfare of citizens. In truth, Cyprus banks have moved away from their traditional and intermediation role of taking-in funds, mainly deposits, from those with money and lending them to those who need the money, including businesses that can buy capital equipment and hire workers and support the development of the real economy in the process.  

While the main objective of banks is to produce profits and provide good returns to their shareholders, Cyprus bankers appear to show minimal concern on how their activities in making profits may be impacting adversely on the economy and society.

Ever since Cyprus banks returned to stability by strengthening their key capital and liquidity ratios they have just piled-up cash and displayed little interest in longer-term project financing to enhance the economy’s productive capacity outside that of the property sector. And by accumulating cash and moving away from the traditional model of banks intermediating between longer-term savers and investors, the ability of Cyprus banks to exploit short-term profit opportunities has been greatly facilitated.

And in this connection, Cyprus banks have over the last 18 months used their large cash holdings, exceeding 35% of their assets, to reap immense profits by depositing their very ample reserves in deposits at the ECB earning up to interest up to 4% per annum. Instead, Cyprus banks have largely failed in deploying more of their plentiful surplus liquidity and human resources in extending productive loans to support the real economy of Cyprus and its citizens. In sharp contrast, systemically important banks in Europe on average held a much lower proportion of their assets in cash and cash balances with Central Banks of just 13% in 2023, and used over 62% of their assets in loans and advances compared with a pitiful 36% for the four largest Cyprus banks[1].

Central bank data reveals that Cyprus banks increased their interest income by 1.3 billion euro in 2023, while approximate estimates based on financial statements of the Bank of Cyprus and the Hellenic Bank indicate that Cyprus banks received an increase of around 660 million euro in interest income from the ECB in 2023, that is, equivalent to 60% of the 1.1 billion euro rise in their profits (Table 1). Indeed, with the ECB offering banks up to 4% interest on their overnight deposits there has been a strong incentive for banks to extract such easy risk-free money, rather than extending riskier loans to businesses and households at higher interest rates.

The selfish and anti-social behavior of Cyprus banks is reflected in their failure to pass on the high deposit rates they receive from the ECB onto the deposits of their customers, with most banks still suppressing rates on fixed-term deposits to well below the current rate of inflation.

But, even before ECB deposit rates became attractive as a short-term parking spot for bank funds, Cyprus banks have showed a reluctance to engage in longer-term lending and keep impaired loans on their balance sheet with productive restructurings. In fact, in common with banks in many modern economies, Cyprus banks have shifted toward a “originate-to-distribute” model, whereby the banks that originate loans pass them onto others, who bear the risk of bad lending. And, undeniably, the prolific selling of non-performing loans (NPLs) by Cyprus banks to credit acquiring agencies has been a salient feature of the Cyprus financial landscape in recent years. This has meant that banks increasingly made income from fees charged and capital gains in off-loading their loans, rather than from the spread between the rate borrowers paid them and the rate they paid depositors under the traditional bank model.

Dealing with Challenges

A key challenge for the Cyprus authorities is induce the banks to extend a greater amount of loans to support the real economy with financing for economically viable projects as against holding a huge pile of cash balances. This not an easy task, but the Governor of the Central Bank as a member of the Governing Council of the ECB needs to argue that a significant reduction in the ECB overnight deposit rate below 4% should encourage banks with considerable surplus liquidity to deploy their excess reserves more in extending interesting-bearing loans to finance real economic activity.

In addition, moral suasion should be used by the Cyprus authorities to entice banks to extend longer-term loans to finance priority investment projects, particularly for those arranged under the Recovery and Resilience Plan agreed with the EU. And if bankers continue to show a limited interest and a lack of competence in seeking and appraising economically viable projects to finance, serious consideration should be given to setting-up an independent Development Bank that would be tasked with evaluating and financing large-scale investment projects as repeatedly advocated by this author and Savvakis Savvides[2]

Furthermore, if Cyprus banks continue to earn very high profits from activities that hardly support the real economy, then such profits should be subject to greater taxation so that part of the income of banks can be returned to the economy and society.  Notably, governments in countries such as Italy, Spain, Latvia and Estonia in the Eurozone, which had much lower rates of profitability than Cyprus banks in 2023[3], and where banks derived more of their profits from contributing to real economic activity, have instituted taxes or levies on the higher profits of banks.

Bank deposits are the main means for saving by Cyprus households. And through raising competition between banks and moral suasion, Cyprus banks should be pressured to raise deposit rates above the ongoing inflation rate so that holders of fixed-term deposits do not suffer erosion of the real value of their savings. And in this respect, the government could help by lowering the defense tax rate on interest income from the current 17% to say 5%.

Banks have predominantly cleaned their balance sheets by selling very large amounts of NPLs and related property collateral to “credit acquiring companies”, in effect transferring risk to these entities. There are questions on how well such companies are managing these NPLs and related property collateral and whether they will continue to be a festering problem for the economy.

And are credit acquiring companies adequately regulated and supervised? Do these companies have sufficient capital and provisions to cover losses from the possible impairment of the large amounts of loans and property on their balance sheets? To what extent are these companies indebted to the banks and would any significant deterioration in their finances such as from a substantial decline in property prices owing to an over-supplied market pose problems for the financial sector?