Cyprus’s banks keep calm and carry on

The Cypriot banking sector has had to weather plenty of crises over the years. But in many ways, the country’s banks entered the coronavirus pandemic in pretty good shape from the reforms and steps taken since the global financial crash (2007-2009) and the 2013 Cypriot banking crisis, such as reducing the size of its banking sector and stock of non-performing exposures (NPEs), as well as improving compliance and regulatory standards.

But coming into the pandemic, the biggest challenge facing Cyprus’s banks was whether they could continue on the road of recovery, particularly in offloading their NPEs at a decent pace. That test was passed with flying colours.

“Banks demonstrated their ability to continue completing market sales of NPEs during the pandemic despite uncertain market conditions, which in our view contributed to easing the pressure related to the economic shock and placed banks better to deal with potential new asset quality deterioration,” says Miriam Fernandez, an associate director in the Europe, Middle East and Africa banking team at S&P Global Ratings. “Despite being one of the largest in Europe in relative terms, the portfolio of loans with payment deferrals has so far proved resilient. Hence, we think that asset quality deterioration that is yet to come should be manageable for banks.

“We view positively the fact that banks have been able to preserve their capitalisation throughout the various transactions, with common equity Tier 1 ratios above 16%, on average,” says Ms Fernandez. “That said, banks continue to have some stock of foreclosed real estate assets on their balance sheets — we estimate it at 6-8% of gross loans — that we expect will only be disposed of gradually.”

NPE disposal progress

Bank of Cyprus and Hellenic Bank — the two largest banks in Cyprus — have made particularly significant progress in NPE disposals, reducing their impaired loans ratios from 30% and 24.9% from the end of 2019 to 8.6% and 14.5% to the end of September 2021, respectively.

Hellenic Bank’s planned €700m disposal of its ‘Starlight’ NPE portfolio is expected to bring its impaired loans ratio down to mid-single digits, with a target to reach a target of 3% in three to five years. Meanwhile, Bank of Cyprus is planning to reach a target of below 10% by the end of 2022.

“At the start of the pandemic, we identified significant downside risks on Bank of Cyprus and Hellenic Bank’s ratings, which could come under pressure from a surge in new impaired loans,” says Julien Grandjean, director, financial institutions at Fitch Ratings. As a result, the agency had both banks on a negative outlook until recently.

“However, in the end these two banks’ asset quality proved more resilient than initially expected, helped by the generous moratorium schemes during the pandemic,” continues Mr Grandjean. “This, combined with the banks’ recent, more active stance on balance sheet clean-up through large-scale portfolio sales of problem loans by domestic standards, changed our views on these two banks’ future prospects and signalled a revision of their rating from negative outlook to positive in December 2021.”

“Over the last few years, the asset quality of Cyprus’s banks has been improving quite significantly,” says Christos Theofilou, a banking analyst at Moody’s Investors Service. “We’ve seen an improvement even during the pandemic with banks continuing to sell and transfer NPEs out of the banking sector to asset management companies. Now that NPEs are coming down, banks are focusing on profitability.”

Cyprus is looking to accelerate the sales of its NPEs with the creation of a state-owned ‘bad bank’. Speaking to The Banker, Cyprus’s minister of finance, Constantinos Petrides, said the government is in discussions with the EU to transform the Cyprus Asset Management Company into a bad bank to directly buy non-performing loans from banks with a total portfolio size of €1bn to €1.5bn.

Improved compliance standards

Cyprus’s banks have also made strong progress in improving compliance and regulatory standards since the 2013 banking crisis.

“The banking sector went through an enormous remediation and revamping of its compliance function and an enhancement of its governance framework,” says Marios Skandalis, head of compliance at Bank of Cyprus Group.

“We have not focused merely on regulatory conformity, but rather set benchmarks of international excellence in order to develop a much higher level of resilience to prevent a situation like in 2013 happening again,” says Mr Skandalis. “We realised the hard way that this was the only way to effectively reverse the old perceptions of the past. Our strategy has not been across the board, but focused on de-risking from high-risk jurisdictions and refraining from unethical practices.

“Having clients with high-risk profiles was not only causing friction with key stakeholders, such as our correspondent banks and our international shareholders, but it was also not in line with our new risk-management framework and the new culture that is currently in place,” he continues. “We have been successful in setting the Cyprus banking sector as a benchmark of excellence and regaining the credibility of our stakeholders, not because of what we are saying, but simply by allowing the results of our actions to do the talking.”

George Theocharides, chairman of the Cyprus Securities and Exchange Commission (CySEC), who took over the role in September 2021, says: “An unprecedented wave of new financial regulations has been adopted in Europe, affecting everything from market structure and intermediaries to capital standards.

Significant changes have taken place in the Cypriot regulatory framework as well, which have led to a stronger and healthier investment sector, he explains. “CySEC, in its role as a regulator, has helped Cyprus to become widely considered as a promising and emerging jurisdiction. Among other things, CySEC has been at the centre of a process to overhaul and modernise the Investment Funds Regulatory Framework, in order to enhance the appeal of Cyprus to fund managers and associated undertakings for collective investments, without sacrificing investor protection and corporate governance in the process.”

Mr Theocharides says the other big challenges for CySEC include the digitalisation of financial services and the increasing use of online and mobile trading platforms, as well as artificial intelligence and blockchain technology.

These trends bring many opportunities, but at the same time, they come with risks, he notes. “These risks relate to the protection of the investors, to cases of money laundering and terrorist financing, and risks around cyber security. As regulators, we need to be proactive in understanding these new technologies and how they impact financial services in order to mitigate the risks and protect investors.

“It is essential that we, as regulators, help investors to understand these risks so they are not lured into unsuitable investments based on inaccurate or incomplete information. To address this, we are increasing the level and the frequency of supervision, particularly of online trading platforms, by expanding our internal resources and, because the activities of Cyprus investment firms are international and largely web-based, CySEC has acquired a supervisory system for monitoring supervised entities’ online marketing activities and materials.”

As a research fellow at the UCL Centre Blockchain Technologies and a former chairman of the board of Cyprus Blockchain Technologies, Mr Theocharides has strong views on the increasing use of blockchain and its importance in finance. He believes that distributed ledger technology is here to stay and will have myriad applications not only in investment, but in many areas of economic activity. Recent developments in crypto are raising questions about increased risk-taking behaviour and possible market exuberance, he posits, suggesting that money laundering, hacking and the operational weaknesses of the various crypto exchanges are all risks that must be taken seriously.

“Against these risks, our work has focused on applying legal principles that curb the use of new technology for the potential circumvention of established rules,” continues Mr Theocharides. “Recently, CySEC issued a policy statement on the registration and operations of crypto-asset service providers and we expect that these kinds of initiatives to alleviate some, but not all, of the risks involved in crypto-asset investment, and we welcome developments at EU level, under the proposed Regulation on Markets in Crypto-assets.”

Bank consolidations

Along with a heavy burden of NPEs and a weak corporate, governance and regulatory framework, another major contributing factor to the 2013 Cypriot banking crisis was a banking sector that was huge relative to the size of its economy.

“At the time of the banking crisis, the sector was excessively large — more than eight times the gross domestic product (GDP) of the country, so you can understand why this had such a huge impact on the economy of the island,” says Mr Skandalis.

Since then, the size of Cyprus’s banking sector has been significantly reduced to less than three times the size of the country’s GDP; but many believe the country is still over-banked and requires further consolidation.

“For the Bank of Cyprus and to a lesser extent for Hellenic Bank, as they are already dominant players on the island with large market shares, they could be constrained by the competition authorities to participate in large consolidation moves in Cyprus, although small players remain and could be potential targets,” says Mr Grandjean. “For both banks, we believe it is more of a question of buying specific performing loans portfolios or fee-generating businesses, which are attractive as they increase scale without negatively impacting costs and improve balance sheet structural viability.”

Ms Fernandez says that any potential consolidation will most likely happen between the smaller banks: “Given the already quite concentrated market among the top-two players, additional consolidation moves are more likely to take place among smaller institutions. While consolidation of such players could favour further efficiency and business model gains, the overall benefit at system level should be limited.”

Looking ahead, Cyprus’s banks must continue offloading their NPEs, particularly in real estate. This will improve the asset quality of the banks, which remains weak. The other big issue is tackling the low profitability of the country’s lenders.

“We think the banks’ low profitability prospects remain their main weakness, given the ultra-low interest rate environment and the need to continue investing in digital transformation,” says Ms Fernandez. “Overall, we also think that the payment culture in Cyprus remains weak, evidenced by the poor results of the Estia [debt relief] scheme and high rates of re-defaulted restructured loans.”