Cyprus, The Bank of Cyprus and Banking Union

by George Hatjoullis

The Bank of Cyprus has finally emerged from resolution. For every 100k of uninsured deposits 47.5k will now be converted to equity. Quite how many shares this constitutes and how long this shareholding will take to once again be worth 47.5k remains to be seen. An additional 5k will be returned as cash, on top of the 10k already returned. The balance of 37.5k will be kept back as fixed term deposits, albeit at above market interest rates. The central bank reserves the option to roll over the deposits. In short, for every 100k of uninsured deposits, the depositors get 15k, some shares and some fixed term deposits which will accrue interest but cannot be spent until the central bank says . It could be worse but is hardly a matter for rejoicing.

The resolution gives Bank of Cyprus a Tier one capital ratio of 12%. This was, it seems, a matter of dispute because the memorandum of understanding only requires 9%. However, this 9%, it was explained to the hapless Cypriots, is a target tier one ratio for 2016. Evidently, the troika expect some further significant deterioration in the BoC loan book and have built-in a capital buffer. Good call. The 12% ratio is based on current data and one would not be wholly surprised to discover, over the fullness of time, that current data overestimate the quality of the loan book. The next step for BoC is to work through the non-performing loans and judging from the PIMCO report on Cyprus banks, the first step might be to correctly classify loans as non-performing or otherwise. We shall see.

The optimistic scenario is that the resolution will restore some faith in the Cyprus banking system and stop the slow haemorrhage of deposits. This would be a prelude to removing capital controls without all deposits instantly fleeing the system. However, the extent to which this scenario will unfold is very uncertain. Confidence in Cyprus banking is at a low ebb and the longer the controls remain the lower the confidence falls. It is Catch 22. In addition, the co-operative movement needs to be consolidated and this may further damage confidence. The exit of BoC from resolution is a good start but there is a treacherous road ahead.

The exit also does little for lending in the near term. The BoC must first tidy up its balance sheet and this will almost certainly involving shrinking. It cannot embark on new loans until it fully understands and provisions for the extent of non-performing loans. This may take a while. In the meantime, credit growth will be non-existent.

The pessimistic scenario is that the extent of non-performing loans quickly erodes the newly restored Tier one capital. The potential problems can all be discerned from the PIMCO report. Many loans were made against collateral or cross-guarantees. The value of the collateral and guarantees is being severely depressed by the present economic situation. If the banks try to resolve bad loans by foreclosure or charges against guarantors the result will be to depress the value of collateral further and boost bankruptcies. In the meantime, debt service will remain a challenge for borrowers and interest will accrue. Catch 22 again. The risk that the BoC will need another capital injection is non-zero.

This is the shape of banking union to come. A non-national body will determine the fate of banks that are unwise enough to make bad investments. The body will work its way through all the banks creditors, culminating in the uninsured depositors, in order to recapitalize the bank. If the bank is small relative to the economy in question this process may work out. However, if the bank is large then the knock-on effects to the economy may be quite devastating. The Bank of Cyprus and Laiki bank were huge relative to the Cyprus economy. This may not end well.