Cyprus deserves a revisit as to how the financial sector will be rehabilitated
The German newspaper Der Spiegel has reported that German Finance Ministry officials are quite pleased with the progress of Cyprus and the model of severe and harsh measures upfront coupled with implementation monitoring may be the way forward in the Eurozone. This comes also at a time when a further bail out of Greece is being considered on top of the debt haircut of billions and the EUR40bln fund for Greek bank recapitalization. In Cyprus the financial sector is expected to address the problems of non-performing loans (NPLs) via the creation of three internal bad banks/special units and with hardly any financial assistance to the two private banks (Bank of Cyprus and Hellenic) and with little assistance for the Co Operative Central Bank. In my opinion the current state of affairs in the financial sector of Cyprus, albeit better than 6 months ago, is highly damaging and as the IMF has highlighted in its December report on Cyprus is fraught with risks of implementation. In the view of the author the experiment yet again attempted on Cyprus has not been tested anywhere else and that the real economy and Cyprus’ ability to restore confidence is hampered by the financial sector distress which is continuing.
It begs the question why the Troika would accept that the resolution of the financial distress in Ireland and Spain, as well as Slovenia, be addressed via the creation of Asset Management Companies (AMC) where the results hitherto have been positive, while in the case of Cyprus the issue of debt sustainability has been at the core of the unwillingness of the Troika to offer additional assistance to Cyprus. In the case of Greece the IMF debt sustainability report produced by the IMF prior to the debt haircut contained quite a few assumptions which did not meet the test of time and yet Greece was on the receiving end of significant financial assistance. Despite the slow progress in Greece’s program the German government has announced they contemplate additional assistance of EUR10-20bln! The debt to GDP ratio cannot be the sole determining factor and there is a need to have a more open discussion about additional assistance for the financial sector in Cyprus.
The current situation of maintaining high interest rates to cover the losses of the NPLs, thereby penalizing the performing loan debtors, is unfair, highly damaging and will probably lead to more NPLs. I would like to challenge the Troika to show one example where an economy experiencing such economic dislocation and financial distress can recover from the recession with banks having a Net Interest Margin of 4-5%; In a normal economy the interest margin is 2-3%. If anything in the IMF paper of corporate debt restructuring in the wake of the financial distress the IMF have a different view and even suggest standstill in debt payments. The implementation risks which the IMF refers to in its report are made even more difficult by the high level of interest rates in Cyprus. The Cyprus economy, and borrowers, require a sharp fall in interest rates to stimulate investment and growth.
If we are to accept that the only way forward is that proposed in the reports produced by various external advisors and accepted by the Central Bank of Cyprus/MOF and the Troika, all these reports are plans for restructuring and as such are prone to error. The real experience is that advisors’ plans are designed without taking into consideration the economic reality especially the resolution of NPLs in the courts. Ask any distressed loan expert advisor in the EU and they will say to you that the courts and legal systems are very critical to quick resolution and better still consensual restructuring is best; this in fact is one of the conditions which the Central Bank of Cyprus requires in its Arrears Management Directive. The demand by the Troika that the Government of Cyprus take no measures to impede the banks attempts to foreclose on distressed debtors who are in default is evidence that they are concerned about recovery of NPLs. Hence there is an issue of implementation of restructuring or recovery, as raised by the IMF, and also a possibility that delays in foreclosure may not get the result that the Troika wishes, especially the ECB which would want to know how the Bank of Cyprus will repay the ELA.
In the opinion of the author the Troika should revisit the creation of an AMC for the NPLs linked to real estate for all the financial sector and if this is not desirable for the three banks which all have over 40% in NPLs to at least ensure that the Bank of Cyprus is afforded a different approach. The real question to be answered is how much upfront loss will have to be crystallized as a result of the sale/transfer of the NPLs to the AMC. Typically when real estate linked loans are sold/transferred to an AMC this takes place at a significant discount of the loans in relation to their face value i.e., 45-55%. Hence if the bank which sells the loans has NPL coverage from its provisions less than the discount it would suffer an upfront loss which may be significant and as such impacts the capital base of the bank. The examples of Ireland and Spain are a good guide of the discounts of distressed real estate loans which in some cases exceeded the range indicated above. In the case of Cyprus the reported amount of EUR6bln owed by 30 borrowers makes management and recovery easier while in Ireland and Spain the borrowers numbered thousands. In the case of Spain the setup of SAREB (the asset management company established to deal with NPLs)“ the overall objective of AMC set up was to manage and orderly divest of the portfolio of assets received, maximizing their recovery, over a maximum time horizon of 15 years. In pursuing its activity, SAREB will have to contribute to the restructuring of the financial system, while minimizing the use of public funds and any market distortions it may cause”. The short description of SAREB’s aim provides an example of the type of an AMC Cyprus should also seek; it will provide the necessary relief of longer term restructuring and management which an AMC in Cyprus may facilitate.
The current focus of recovering distressed loans within a short time because of the pressure on the core tier 1 capital of the Bank of Cyprus places an unrealistic assumption that there are business plans that developers can produce to attract foreign direct investment and hence enable borrowers to repay their loans by restructuring the distressed loans; is this realistic? The real question the Troika should ask is what if their planned NPL management within a bank in the current environment fail? Should the Cyprus real economy be subjected to further financial punishment because of the reckless lending that took place before? If an AMC can be designed that will allow the private sector to restructure, have lower debt service payments which may secure overseas investment, together with some support from the Troika, it may be the best reward the government of Cyprus deserves for its compliance and success with the implementation of the MOU with the Troika.
The author would like to propose that an AMC be set up for the EUR6bln NPLs of the Bank of Cyprus and the sale/transfer price of these loans be considered to see what would be the amount of the upfront loss. In parallel the Bank of Cyprus would invite private investor interest from the international markets to see at what final price the transfer/sale take place. The loss that will be incurred would necessitate financial assistance in the form of recapitalization and in the view of the author this may be provided by the European Stability Mechanism (ESM). Under the ESM’s Guidelines on Financial Assistance for the Recapitalization of Financial Institutions in Article 2 “Aim of a loan for the purpose of recapitalization” (1) the loan granted to an ESM Member State under this form of stability support shall be restricted for the specific purpose of supporting financial institutions, including through schemes to support asset separation and disposal……”. This article should be considered as an alternative support mechanism for Cyprus in order to get out of the economic and financial distress much earlier. This support scheme in the form of a loan from the ESM would be one that is decided at the political level and the Eurogroup. If a loan were to be made it would have to be a loan granted to the Member State since under the current rules no direct bank recapitalization can be made. The additional debt burden which the government of Cyprus is not one that cannot be accommodated if the terms of the loan where designed in such a way to give Cyprus the breathing space in the first 10 years; Ireland was afforded more generosity by the ECB!
The benefits of enabling the Bank of Cyprus to create an AMC would be quite a few; it will allow the bank to restart lending and hence boost recovery of the economy, it would reduce the human suffering of young unemployed as more jobs will be created, it would improve tax revenues as the economy comes out of recession faster, it would encourage Foreign Direct Investment, it would hasten the lifting of capital restrictions etc. In fact it begs the question what is the counter argument for not being a bit more generous to Cyprus which has been subjected to a violent reduction of its banking system, a bail in of 47.5% of depositors at Bank of Cyprus and caused severe hardship to human beings as a result of unintended consequences of the Eurogroup’s actions. Cyprus deserves more financial assistance to get the island out of the economic and financial distress quickly so that the road to economic revival is not long and winding. On the occasion of the third appraisal of the Cyprus economy, and the discussions which surely will take place on how to deal with the growing problem of NPLs of the financial sector, it is timely for the Troika to consider an alternative that is open to them via the European Stability Mechanism. After all the ESM was set up to protect the Eurozone and provide solidarity to its members. Cyprus deserves this solidarity.