The Restructuring of the Banking Sector in Cyprus and its Impact

Ladies and gentlemen, The Restructuring of the Banking Sector in Cyprus and its Impact I would first like to thank the organizers of the event for giving me the opportunity to present here and express some of my thoughts and ideas. My speech today will concentrate on the restructuring efforts currently under way for the banking sector in Cyprus, as well as the possible impact/opportunities/threats that could create for the professional services sector in Cyprus. I will begin by documenting the current situation with our banking sector, highlighting the underlying problems that led to the massive troubles that our banks are facing, and continuing with the current restructuring efforts that are being made. I will then draw some lessons learned from previous important banking crises, highlighting the regulators response to the crisis and the impact of those responses. The remainder of my talk will focus on possible opportunities (or threats) that could arise from these structural changes happening in the banking sector. Current Situation As we all know, our banking sector is facing considerable challenges with our two largest Cypriot banks seeking state aid to achieve the desired Core Tier 1 capital ratio, set by the European Banking Authority (EBA). The main problems started late last year with the infamous Greek PSI and the overnight loss of about 4 billion from the sector and our economy. Furthermore, because of the banks huge exposure to the Greek economy (estimated at around 25 billion) as well as to the real estate sector here in Cyprus, led to a substantial climb in their non-performing loans following the rapid deterioration in the economies of both countries. Someone could also argue that the expansion in foreign markets (mainly the Balkans and Eastern Europe) as well as in non-traditional commercial banking activities (insurance, brokerage, asset management, investment banking), although profitable in the boom years, proved risky and expensive for them in the late recession years. As a result to all these problems that the banks were facing, the banks have continuously been downgraded by the credit rating agencies, which automatically implies loss of confidence from investors and increase in the cost of borrowing. I need to point out though here that the reasons for the banks or sovereign downgrades (as expressed in the rating agencies reports) is not solely a result of the banking crisis, but also due to the fiscal problems faced by our government and the structural problems that our economy is facing and need to be resolved. But why did the banking sector ended up in this unfortunate situation? What are the underlying reasons? One factor is certainly a rather loose regulatory supervision that allowed individual banks, as well as the overall banking sector, to increase to such a large extent that it dwarfs the GDP of the country (is approximately eight times its size), and take excessive risks without properly diversifying their portfolio. Unfortunately, we created institutions that are too big to fail, but also too big to save! It s ironic that people kept praising the regulatory authorities for protecting the banking sector from toxic products (asset/mortgage-backed securities, 1

collateralized debt obligations (CDO), credit default swaps (CDS)) at the height of the global banking crisis of 2007-2009, products that led to the collapse of banking and insurance giants all over the globe, such as Lehman Brothers, AIG, or Bear Sterns. Then, in a few years, we find out that the simplest of the securities and supposedly the least risky (sovereign bonds) were to prove so fatal that brought our banking sector to its knees. Another underlying reason for the crisis is certainly the excessive risks that banks have taken, either in the form of cheap credit given out to real estate developers without properly assessing the risks involved, or the overexposure to the Greek economy and Greek government debt, without properly diversifying their investment portfolio. Buying risky securities (even from the secondary market) is acceptable, given that the organization properly assessed the risk and hedged the exposure (using credit default swaps was certainly one way). Here of course is the classic example of moral hazard, i.e. bank executives taking risky investments knowing that in case of a negative outcome the burden would not fall on their shoulders. Obviously in case of a positive outcome, they would be the ones to reap the rewards with big bonuses. One could also argue that the lack of proper and effective corporate governance practices was also a prime determinant for the crisis. Good corporate governance practices can create shareholder value through transparent disclosure of the organization s activities to its shareholders, holding directors accountable, and creating an effective two-way communication between the board and the shareholders. There are internal and external mechanisms that organizations can utilize to achieve these objectives. Internal mechanisms include the establishment of independent board of directors with non-executive directors and the establishment of specialist committees (audit, risk, and compensation). External mechanisms can include legal duties imposed on directors, listing rules of exchanges that have to be adhered to, honest reporting of financial performance, and external audit of financial and other statements. Unfortunately corporate governance has failed in this situation, and this should prove an important and useful lesson not only for the two main banks, but for a number of other organizations in Cyprus. Finally, the global financial crisis that started from the US in 2007 and eventually spread to Europe in the form of a sovereign debt crisis is certainly a major underlying reason behind our country s problems. This highlights the impact of globalization and how contagion effects can propagate financial crises from one region or country to another. The Response In late June, and after attempts to recapitalize the two main banks through private investors have failed, the government applied for financial support from the EFSF/ESM. The proposed memorandum from troika (as well as the proposals from our government) focuses on three areas: fixing fiscal issues related to the government expenses/revenues, fixing long-standing structural issues of the economy, but also reforming the banking sector. As the Governor of the Central 2

Bank of Cyprus has recently pointed out in one of his speeches, a crisis gives you an opportunity to fix long-standing issues. I couldn t agree more with that, not only for the banking sector but for the rest of the economy. The recommendations of troika as it relates to the banking sector deals with the following issues: - Maintaining and improving the liquidity in the banking sector - Restoring the capital adequacy buffers, with an increase in the Core Tier 1 capital ratio from the existing 8% to 10% by the end of 2013 - A due diligence review of the credit portfolios of the main banking institutions as well as a representative sample of cooperative credit institutions (currently under way by PIMCO) - Stronger supervision and regulation both for the banks as well as the cooperative credit institutions - Introduction of new legislation as it relates to the bank resolution methods - Creation of the Cyprus Asset Management Company that would take over the bad loans from the banks, both from Cyprus and Greece - Close monitoring of corporate and household indebtedness - Better financial transparency Apart from these recommendations, we are also now seeing an attempt in Europe for bank unionization under the European Central Bank (ECB), with a single supervisory mechanism, a common resolution framework, and a unified deposit guarantee scheme. All of these measures and attempts will inevitably create a more efficient and transparent banking system, with improved supervision, corporate governance and risk management practices. Consequently, the banking sector can regain some of its lost confidence from investors and depositors, and money can start flowing into the banks. As the Governor has recently pointed out, we should expect to see in the near future shrinkage of the overall size of the banking sector relative to GDP, as well as shrinkage of the size of individual banks. This shrinkage can come from selling foreign operations (already under way), reducing their domestic deposit and loan portfolios, or selling non-traditional commercial banking departments (such as insurance, or asset management). Looking at the latest data, we are seeing a movement of deposits away from the main domestic banks to smaller or foreign banks that do not face the same problems related to the exposure to Greece and the real-estate market in Cyprus. In particular, Bank of Cyprus and Laiki Bank have suffered a reduction in their percentage share of the market of 5% and 18% on an annual basis (for the period September 2011 September 2012), respectively. On the contrary, in the same period, Cyprus Development Bank had a 38% increase in market share, while foreign banks had a 22.6% increase. 3

Lessons from Previous Banking Crises Before analyzing likely opportunities that can arise in the financial and services sector from the banking reforms, I would like to briefly discuss some important previous financial crises and the lessons that we can draw from such events. The Great Depression of the 1930s is obviously one such example. There are many stories regarding the causes of this crisis, ranging from demand-driven to monetary theories. Major bank failures were certainly instrumental to the stock market crash in October 1929 and the subsequent depression. The response to the crisis was the Banking Act of 1933 and the Glass- Steagall Act, which limited the activities of commercial banks (restrictions on speculative actions), the competition for interest rates on deposits through rate controls, and branch banking. The Act also provided a separation between commercial and investment banking, and limited and enforced a federal system of bank deposit insurance. The instigators of this Act claimed that big commercial banks were marketing high-risky securities to their clients, unsophisticated bank depositors ( naïve investors) and other, smaller banks. Opponents of this Act argued that a government-enforced cartel was therefore formed limiting competition and producing an inefficient banking system. Supporters of this Act though argued that it was the reason for a prolonged period of stability in the US banking system. The limitation on interest rate for time deposits (Regulation Q) was put into effect for the first time in the 1960s when the market interest rates exceeded the limits. This led to a series of credit crunches as depositors withdrew their funds from the banks in order to invest in the capital markets at higher interest rates. Thus, the regulation of commercial banks imposed by the banking reforms of the 1930s, failed with the emergence of nonbank institutions that replaced traditional commercial banks for providing loan and deposit schemes. Multiple efforts were then made to repeal the provisions under the Glass-Steagall Act, with the successful signing of the Gramm-Leach-Bliley Act (GLBA) in 1999 by President Clinton. This Act repealed the Glass- Steagall Act and the provision for separation between commercial and investment banking. Many argue that the above repeal was an important factor for the recent global banking crisis. It allowed commercial banks to provide the same kind of risky products similar to the capital markets, and created institutions that grew to such a large extent, that now were too big to fail. That was the case with the collapse of Lehman Brothers in September 2008 that rocked capital markets, propagated the shock to the real economy, as well as markets around the globe. Many stories and theories have been written about the crisis and its causes real estate bubble, lack of the necessary supervision of financial markets, failure of corporate governance, creation of highly complex but very risky securities, cheap credit, excessive leverage by institutions, deregulation of financial markets, among others. Governments around the world responded to the crisis with large fiscal stimulus packages, lowering of interest rates, and expansion of money supply through quantitative easing (QE) programmes (the US is right now is in the third programme). Furthermore, the US has proposed and passed a law known as the Dodd-Frank 4

Wall Street Reform and Consumer Protection Act in 2010 (that included the Volcker rule). The main proposals of this Act are the following: - Better oversight and regulation of financial markets - Increased transparency (for example, over-the-counter derivatives going through organized exchanges) - Better protection for investors - Improved accounting practices and stricter regulation of credit rating agencies - Prohibition of commercial banks from proprietary trading - Restriction of banks in owning hedge funds and private equity funds Some have described these proposals as a light version of Glass-Steagall Act. Several influential individuals as well as organizations argued in favor of this law, expressing the need for an improved financial system. However, opponents of this Act have been arguing against that it will diminish the profitability of financial institutions, reduce liquidity in the market leaving small businesses with no credit, hinder economic growth, and thus exacerbate the unemployment. Results thus far are mixed, and even the U.S. Fed Chairman Ben Bernanke has pointed out that the government is not capable in measuring the costs/rewards that this law has placed on the U.S. economy. Two more crises that are important to mention since they have similarities to our case is Ireland and Iceland. Ireland went through a prolonged period of prosperity and growth from mid-1990s to 2007 (known as the Celtic Tiger years). Oversupply of credit, especially to the real estate sector, created asset bubbles and eventually in 2007, (and partly due to the deteriorating worldwide economic conditions), the bubble burst, causing massive losses for the Irish banking sector. The Irish banking case is also an example of an asset-liability mismatch, where short-term borrowing was used in order to fund long-term projects. When those long-term projects though could not be sold, lead to oversupply, causing a mismatch between the duration of assets and liabilities. The government intervened in early 20009 by bailing out or nationalizing the country s largest banks. A National Asset Management Agency (NAMA) was also formed to take over the bad loans, enabling the banks to return to normal operations. However, banks bailouts pushed the government debt out of control and eventually had to seek a bailout package of 85 billion, mainly from EU and IMF. The Icelandic banking crisis stems from the huge debts incurred by the country s largest banks (that dwarfed the GDP of the country). The result was a collapse of three of the country s major commercial banks and a run on deposits in the Netherlands and the UK. In November 2008, the country received an IMF-led package of 4.6 billion. Banking reforms were put in place to ring-fence the operations of the banks, to continue servicing the Icelandic people, whereas the foreign operations went into receivership. Since the crisis erupted in 2008, the reforms as the measures imposed by the outside creditors (led by IMF) helped the country s economic situation and Iceland is on its way to recovery. 5

Impact of Restructuring Reforms My first reaction is that the restructuring effort that is being made in the banking sector will be beneficial for the fiduciary and corporate service industry. For Cyprus to be a financial and service provider center, it needs to have a healthy and efficient banking system. One concern of tighter capital requirements imposed on the banks in order to meet their Core Tier 1 capital ratios imposed by EBA is the problem of deleveraging. This is actually a concern by IMF for countries in Europe with fiscal problems (periphery countries), estimating that European banks could dump $2.8 trillion of assets (more than 7 percent of their balance sheet) by the end of next year (according to the IMF s global financial stability report). Liquidity would be severely affected in the market, deteriorating the already negative economic situation, leading to a rise in unemployment and crippling growth. We can already see this deleveraging trend occurring reports on Cyprus data indicate that in the month of September 2012, there was a reduction of loan amount of 137 million from August. At the end of September, the total amount of loans stood at 72.7 billion. Thus, the need for liquidity in the market can create the emergence of opportunities for new players to fill this void left by the stricter capital requirements imposed on the traditional banking sector. These new players could then use the services provided by fiduciaries and other corporate service providers. This is similar to the shadow banking system that emerged in a number of countries, following restructuring efforts of the banking sector. A shadow banking system provides bank-like activities through non-bank financial intermediaries, such as hedge funds, money market mutual funds, and securitization vehicles. These entities receive funding through short-term borrowing (by issuing commercial paper, asset-backed securities, or using repo transactions) and use these sources to provide leverage for corporations, or for securities trading. They have the benefit that they are not subject to the same strict regulations imposed on the traditional banking system. However, the emergence of this system comes with its risks. In fact, there are people that argue that the real reason behind the global crisis of 2007-2009 was the failure of these institutions to refinance their short-term liabilities coupled with the fact that they were highly leveraged (and not so from the traditional commercial banking sector). Thus, if we see the emergence of such entities to provide funding in the market, we need to put into place appropriate laws and regulations, with supervision from the regulatory bodies. As I stressed earlier in my talk, the banks will probably shrink in size perhaps by selling foreign operations or other non-traditional commercial banking departments (such as insurance, brokerage services, fund management, or investment banking). Again, this could lead to the emergence of opportunities for other players (domestic or foreign) to enter these markets that can use the services provided by the fiduciary industry. 6

I also believe that, unfortunately given the size of the non-performing loan portfolio of the banking sector and based on troika s recommendation for seizure and sale of loan collateral in a short-period of time, will inevitably create more opportunities for law offices that will need to deal with such disputes. Finally, the discovery of natural gas reserves in the Cyprus Exclusive Economic Zone is an exciting development with a potential to create lots of job opportunities in the field of energy, construction, technology, but also finance in the near future. The extraction and processing of natural gas will entail large and expensive projects that will need to be funded either by the banking sector, or other financial institutions such as venture capital firms. All of these firms that will take part in these projects will also need the services and support of the fiduciary industry. Conclusion Despite the negative situation that we are experiencing right now, in the long run I am optimistic about the prospects of our banking sector, which inevitably affects other industries such as the fiduciaries and corporate service providers. I will stress again Governor Demetriades remarks, that a crisis is a unique opportunity to fix long-standing problems. I agree with this view, and I see a number of the reforms that are being put in place are in the right direction in achieving this goal. The banking sector needs to regain back the confidence from investors, creditors, and depositors. Transparency, stricter supervision, and good corporate governance and risk management practices will help in this way. A healthy banking sector is essential for the economy so we should make every effort to achieve this as soon as possible. 7