Cyprus Profile

Banking

Rebuilding the Cypriot Banking Sector

Securing financial assistance from international lenders and the ambitious overhaul of the banking sector marks an end to prolonged uncertainty in Cyprus. Currently undergoing robust restructuring, the key priorities of the banking sector are to ensure financial stability and to boost confidence.

After securing a €10-billion bailout deal from international lenders in April 2013, Cyprus is working overtime to restructure and downsize its local banking sector. Today the situation is stable and the country’s two largest banks, Laiki Bank and Bank of Cyprus, have been merged and recapitalised. The second largest bank, Hellenic Bank, has also been successfully recapitalised through private funds, the co-operative sector is being restructured with a capital injection of €1.5 billion and significant improvements are being made to strengthen the supervisory system.

The local banking sector has faced major challenges over the last few years, especially following the write-down of Greek debt, which resulted in heavy economic losses. Confidence in the banks has been severely damaged and is a setback the country will need time to recover from. Temporary capital controls remain in place to safeguard the banking system, but have been eased gradually  Although the sector is undergoing a complete overhaul, the majority of banks on the island have been relatively unaffected, as out of more than 40 banks operating in Cyprus only two local banks were forced to undergo restructuring. However, the on-going eurozone financial crisis has made all banking institutions well aware of how delicate the economic situation continues to be.

The current restructuring is also opening up new opportunities in the banking sector, encouraging healthy competition and a wider range of services. With the current lack of liquidity, the Cypriot market is thirsty for funding providing exciting prospects for new players to enter into the market.

The Development of the Cyprus Banking Sector

Enjoying decades of uninterrupted growth before the global financial crisis, Cyprus was considered an ‘economic miracle’ turning its economy around with strict austerity measures following the 1974 Turkish invasion and the subsequent division of the island. The collapse of the Soviet Union and wars in Lebanon and the former Yugoslavia provided the island’s economy with a boost of funds as fleeing businesses and individuals set up in Cyprus, attracted by the country’s stability, efficient infrastructure and straightforward procedures. These events played a significant role in the development of the banking sector and the transformation of the country into both a business and financial centre. After Cyprus’ accession to the EU in 2004, the island established itself as a gateway to Europe and attracted increasing business from both Eastern European and Arab investors looking to expand into European markets.

Cyprus’ banking sector is comprised of two tiers: domestically-oriented banks and international banks. International banks have long been attracted to the island for its fiscal regime and to use Cyprus as a launch pad into high-growth markets. The success of Cyprus as a holding and finance company jurisdiction and the increasing number of established foreign trading companies and regional headquarters, led to the growing demand for banking services and increased the number of foreign banks setting up operations in Cyprus.

Over the years, Cypriot banks also expanded into Russian and Eastern European markets and sought growth opportunities in China and India. The list of banks of foreign origin in Cyprus consists of around 30 institutions, which mainly carry out international banking business and have limited interaction with the domestic Cypriot economy – thus being largely unaffected by current developments.

The Banking Crisis

A number of factors contributed to the current bank crisis in Cyprus. The country’s accession to the EU and the adoption of the euro sparked a rapid liberalisation of a previously tightly controlled banking system and restraining credit growth with traditional monetary levers became a challenge for Cyprus. Another factor was the global financial crisis, the effects of which Cyprus began to feel in 2010 as the construction and real estate sector suffered a severe blow with falling property prices and a decrease in overseas buyers.

As the economic climate deteriorated further, concerns increased over the rising number of non-performing loans Cypriot banks were grappling with and the over exposure to Greece. Risky expansion strategies, imprudent lending and weak bank governance all contributed to the downfall of the banks. However, the most significant internal cause was the failure on a national policy level to recognise potential shocks and the risk of running a large bank industry with low supervision. The government’s mismanagement of the budget was another major failure, which led to a lack of resources when the banks needed rescuing.

The collapse of the Greek economy and Cyprus’ significant exposure to Greek government bonds was the last straw for the sector, destroying the banks’ balance sheets. Although domestic funds were running out, Cyprus banks made the fatal decision to expand further by investing €5.7 billion in Greek bonds. The risk was grossly underestimated as was the outcome of the Greek bailout, which imposed staggering losses of around €4.5 billion on Cypriot banks following the EU/IMF debt haircut on Greece.

At the height of the sovereign debt crisis in eurozone economies, Cyprus became the fifth EU member state to request a financial assistance package from the European Commission (EC), the European Central Bank (ECB) and the International Monetary Fund (IMF) – collectively known as the Troika. The debated €10-billion bailout package was finally approved in April 2013, with the controversial and unprecedented condition that Cyprus impose losses on large depositors in two of its major banks and enforce temporary capital controls on its banking system. Cypriots and the local banking sector have been severely hit by the closing of Laiki Bank and the restructuring of the Bank of Cyprus, which entailed a haircut of 47.5% imposed on depositors with cash exceeding €100,000 turned into equity to recapitalise the bank and being lumped with most of Laiki’s assets, including €9.2 billion in emergency liquidity assistance.

Current Situation and Challenges

Many EU countries have developed significantly larger banking systems compared to their economies to promote themselves as international financial centres, and Cyprus is no different in this respect. At its height in 2009 the Cypriot banking sector was equivalent to nine times the country’s GDP, today the sector is being radically downsized closer to the EU average of 3.5 times GDP. The challenge is to find the optimal size, which will eventually be determined by the availability of capital, scale of opportunities and Cyprus’ capacity to supervise the sector.

Today, the Bank of Cyprus is the largest lender with around 50% of the market, the co-operative sector is the second largest with 93 co-ops now merged into 18, Hellenic Bank is the third largest lender and the rest of the market is made up of smaller banks and subsidiaries of foreign banks. Bank of Cyprus has officially exited administration status and the Central Bank has approved all the directors elected to the new board of the bank. The new board appointed former RBS executive John Patrick Hourican as the new CEO, starting a new chapter in the history of the bank. Hellenic Bank avoided a state bailout by successfully completing its recapitalisation through private funds. New York-based hedge fund Third Point LLC, Belarus-owned online gaming developer Wargaming.net and local investment house Demetra pumped €100 million into the bank taking 75% of the share capital.

Adopting a national financial services strategy and boosting supervision of the banking sector are high on the agenda today. Changes introduced by the EU’s Single Supervisory Mechanism (SSM) are scheduled to start in November 2014 and will transfer the supervision of the eurozone’s largest banks to the European Central Bank (ECB) in Frankfurt. For Cyprus, this means that Bank of Cyprus, the Co-Operative Central Bank, Hellenic Bank and Russian Commercial Bank will be transferred from the supervision of the Central Bank of Cyprus to the ECB.

Cyprus is working hard to restore stability and public finance sustainability, but challenges remain. Adopting a new mentality in the banking industry is crucial, as is the introduction of fresh ideas and new people to provide sound advice and international expertise. Cyprus needs to reduce the number of bank branches and personnel, tackle its non-performing loans and lift capital restrictions as soon as possible for a speedy recovery. There has also been a call for a state guarantee of all deposits in Cyprus’ banks to reduce the risk of deposit flight, a move that could help restore confidence in the banking sector.  

A Stronger Future and New Opportunities

New opportunities are also springing up in the wake of rebuilding the Cypriot banking sector. With the current lack of liquidity, the market is thirsty for funding providing opportunities for new players to enter into the market. The new structure is encouraging healthy competition and a wider scope of services, such as online and telephone banking, microfinance and Islamic banking. Niche services such as asset management, ship financing and custodian services could also be areas of interest. Other investment opportunities that can be tapped into by international banks and financial groups are mergers and acquisitions, private equity and venture capital projects as well as financing of large infrastructure projects in the oil and gas industry, casino and resort development and other large scale projects. To reduce its bank dependence, Cyprus may look to alternative sources of finance such as bond markets and investment funds, peer-to-peer lending and crowd funding are also emerging as new finance models.

Despite the short-term pains of temporary capital controls, the rapid downsizing of the banking sector and the economic programme agreement ensure the public debt of Cyprus will be sustainable. Cypriot banks have already demonstrated resilience in the face of adversity and most industry professionals believe the current overhaul of the sector and increased supervision will produce a more efficient banking sector to boost the economy. The transition period will be tough, but Cyprus is making sure every cent counts to build a stronger future.

Updated March 2014