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    Taking the Bull by the Horns

    Banking

    Strong economic growth and continuous credit rating upgrades have boosted market and investor confidence, while fresh investment through acquisitions is reshaping the Cyprus banking sector into a more agile industry ready to compete in a new reality of increased regulatory pressure.

    The Cyprus banking sector has seen interesting developments in the last year with fresh investment and acquisitions shaking up the landscape, specialised units taking over non-performing loan management and new international players vying to snap up distressed asset portfolios from local banks’ balance sheets. Following the infamous 2013 bail-in, Cyprus banks achieved rapid stabilisation and recapitalisation, and the sooner-than-expected turnaround was hailed a modern success story. Continuous credit rating upgrades have boosted investor confidence, as has the country’s robust economic growth of nearly 4% and the flow of foreign direct investment into a wide range of sectors.

    In addition, further reforms in the country’s legal and judicial framework have given banks more avenues to reduce the burden of problematic assets and economic imbalances, which are a legacy of the crisis. It is no secret that the single biggest challenge for the sector continues to be the volume of non-performing exposures (NPEs), however international rating agencies project that Cypriot banks should be able to reach an NPE ratio of about 25% by the end of 2020, from more than 50% at the end of 2017 – a goal that the sector is determined to achieve with mounting pressure from the European Central Bank.

    At the same time, the banking sector is implementing new investments to address technology demands of the market, with the aim to introduce new products and facilities to companies, start-ups and new ventures that will add value. The core banking focus in Cyprus continues to be providing increased lending to both households and key economic sectors such as shipping, tourism, real estate and professional services – which are the growth drivers of the economy.

    Sustainable Development

    Today, the Cyprus banking sector is on solid ground, it has shrunk and reorganised, developed its capital strength and invested in corporate governance. All core banks in Cyprus have passed successive and rigorous European Central Bank (ECB) stress tests and have strong foundations to move toward sustainable development. Capital ratios are around the EU average of 12%, according to ECB’s requirements of capital levels, and with the number of non- performing loans (NPLs) on a steady downward trajectory the future outlook is positive. Liquidity and solvency in the banking system have improved significantly, with deposits increasing by more than €3 billion in 2016-17, allowing the full repayment of Emergency Liquidity Assistance (ELA). In addition, proactive measures combined with insolvency and foreclosure legislation have led to a reduction of more than €6.5 billion in non-performing exposures between 2015 and 2017.

    Total deposits in the Cypriot banking sector reached €50.2 billion in June 2018, while total loans stood at €46.7 billion, according to the Central Bank of Cyprus (CBC). Net loan demand by both enterprises and households in Cyprus increased further in 2017Q4, in line with strong domestic economic activity, the small increase in wages as well as the increased supply of new loan contracts, according to the January 2018 Bank Lending Survey of the Central Bank of Cyprus, which covers approximately 85% of the lending market. The key developments for the same period according to the survey was the easing in credit standards for loans to households for consumption and other lending purposes for the first time since the beginning of the survey in 2008. The easing reflects positive developments in the banking sector, such as banks’ efforts to clean-up their balance sheets and the gradual reduction in the level of NPEs. Also, the vigorous domestic economic environment has had a positive impact on the solvency of prospective borrowers and the reduction of risk undertaken by banks. Net loan demand is projected to increase further in 2018, which is a development that is expected to have a positive impact on domestic activity and to be mainly supported by the historically low level of lending interest rates as well as the increase in consumer confidence and investments.

    Sector Structure and Regulation

    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 the country as a launch pad into high-growth markets. The list of banks of foreign origin in Cyprus consists of over 30 institutions, which mainly carry out international banking business and have limited interaction with the domestic economy. Banking in Cyprus is regulated by the Central Bank of Cyprus and is fully harmonised with EU legislation and directives, while commercial banking arrangements and practices follow the British model. However, changes introduced by the EU’s Single Supervisory Mechanism (SSM) saw the transfer of supervision of all the eurozone’s largest banks to the European Central Bank (ECB) in 2014, harmonising the landscape for all big banks in Europe.

    Key Players

    Key players in the Cyprus banking landscape are Bank of Cyprus, Hellenic Bank and RCB Bank, with the rest of the market made up of smaller banks and foreign subsidiaries such as Greek Alpha Bank and Eurobank. The Cyprus Cooperative Bank (CCB) was one of the top three banks, until the healthy assets of the state-owned lender were acquired by Hellenic Bank in June 2018. As part of the deal, Hellenic Bank (HB) acquired CCBs total deposits amounting to €9.7 billion and took on €10.3 billion in assets consisting of performing loans, bonds and cash, and around €500 million in non-performing loans. Assets worth approximately €8.3 billion were transferred to the state, with the so-called bad assets set to be managed by a special government-controlled entity.

    CCB made slow progress compared to its rivals in reducing its non-performing loans stock, and also had to comply with additional capital requirements which crushed its plans for a Cyprus Stock Exchange listing that would have allowed it to reduce the government’s stake to 25%. According to Finance Minister Harris Georgiades the decision to break up the bank was necessary after it saw €2 billion in deposit out flows in the first three months of the year due to lack of depositor confidence. The European Commission made the approval of the transaction conditional to Cyprus making its foreclosure and insolvency framework more effective, a move which industry experts say could encourage borrowers to pay more towards their loans and allow banks to speed up clearing NPLs off their balance sheets.

    The acquisition has bolstered Hellenic Bank’s status as a major player in the market. Following the 2013 financial crisis, Hellenic Bank was successfully recapitalised through private funds, with New York based hedge fund Third Point LLC, international online gaming developer Wargaming, and local in- vestment house Demetra together taking the majority of the share capital, and the European Bank for Reconstruction and Development (EBRD) securing a minority stake in the bank. Hellenic Bank also led the way in 2017 in becoming the first financial institution to join forces with an asset management company, APS Holdings, to manage its NPEs. The agreement with the Czech debt- servicing specialist, whose clients include Merrill Lynch, Bank of America, Unicredit, Fortis Bank, Banco Populari and Deutsche Bank, is of strategic importance for HB and is part of the group’s strategy of reorganising and transforming its business model. The bank had another coup in reducing its troubled assets in June 2018, when it sold off non-retail secured and unsecured exposures worth €145 million to B2Holding, a Norwegian firm specialising in distressed bank loans.

    The island’s largest lender Bank of Cyprus (BoC) has come a long way since 2013, and for the second year in a row won the ‘Best Bank for Private Banking’ in 2017, an award by international magazine Euromoney. Another milestone was listing on the London Stock Exchange (LSE) in 2017 in a bid to increase the visibility of BoC shares and to expose the bank to a broader base of investors. The dual listing is also meant to draw attention to Cyprus’ well performing economy and the opportunities offered by the Cyprus Stock Exchange. More recently, the bank sold o its UK subsidiary to Cynergy Capital, a group of British retail and property entrepreneurs, in a €117 million deal expected to be concluded by the end of 2018. The decision to sell the UK o shoot was in line with BoC’s strategy to principally focus on supporting the growth of the Cypriot economy, according to CEO John Hourican.

    In July 2018, rating agency Standard & Poor’s affirmed its B/B rating of the bank, stating that BoC was lagging behind its peers in improving its business and financial profile despite an impressive 44% decline in its NPE stock from its peak in 2014. However, the lender may get a boost as a number of funds are said to be keen on buying a part of its problematic stockpile worth €5 billion, according to reports by Bloomberg.

    For some time now, US and other international funds have been keeping a close eye on southern European distressed bank assets, and at the time of writing Apollo Global Management, Pacific Investment Management Co and Lone Star – as well as B2Holding – are being touted as potential buyers of BoC NPL portfolios.

    RCB Bank has been active in Cyprus for over 20 years and has big plans to carve out a bigger share of the local market. In 2016 RCB joined forces with the European Investment Bank (EIB) and the Cypriot government along with BoC and HB, to drive more funding into the local economy and to support SMEs through competitive lending solutions. In 2018, the bank renewed its commitment with a new €30 million tranche signed with EIB backing to provide Cypriot companies with longer term loans and favourable rates. RCB previously also signed a €10 million loan agreement with the European Investment Fund, the first agreement of its kind to be signed in Cyprus in the context of the European Fund for Strategic Investments, a basic pillar of the Investment Plan for Europe, to provide more funding to innovative small and medium-sized enterprises (SMEs).

    Over the last few years, the sector has also seen investment from new players such as Swedish Ancoria Bank, who with an initial capital of €50 million offers personal and business banking products from its branches in Nicosia, Larnaca and Limassol. Strategic new investment also came in 2017 when a group of international investors led by Lebanese banker Maurice Sehnaoui acquired the majority stake of the Cyprus subsidiary of Greece’s largest lender Piraeus Bank. Now rebranded AstroBank, the lender, who cites growth as a top priority in its strategy, is set to grow even further with the August 2018 agreement to acquire the operations and staff of USB Bank. The deal was financed by AstroBank’s own resources and supported by a capital raise primarily from its existing shareholders. The acquisition will increase the bank’s balance sheet by 55% and total assets to €2 billion, including gross loans of €1.2 billion – and build up its customer deposits to €1.9 billion and equity to €160 million. The deal is expected to be completed by the end of the year after approval from regulatory authorities and will certainly contribute to the further consolidation of the Cyprus banking sector and highlight potential investment opportunities in Cyprus.

    Regulatory Pressures and NPL Burden

    Although the banking sector is on a more solid footing today and Cyprus’ economic growth is ranked as one of the fastest in the EU, challenges and vulnerabilities remain. NPLs in the banking system stood at €20 billion in March 2018 constituting around 43% of the total – which is the second highest in Europe after Greece – compared to the EU average of 4.2%. It will be no easy feat to tackle this issue, especially following the intro- duction of IFRS 9 and new stricter ECB guidelines to rapidly reduce the number of delinquent loans. Granted, much has already been achieved with banks managing to reduce NPLs by more than €6 billion in less than three years, mainly through loan restructurings and debt-to-asset swaps. According to Finance Minister Harris Georgiades the drop in NPLs in Cyprus is proportionately the fastest in the EU despite intense supervisory pressure, although he concedes that speed to tackle the problem is of the essence.

    There is always a trade-off on how strict banking regulation should be in order to safeguard financial stability, but also to ensure that economic growth is not stifled. Banks must balance the need of devoting resources into complying with the increasingly strict regulatory framework, together with the need to invest in new technology to enhance their profitability and prospects. The consequences of the recent liquidation of the Cyprus Cooperative Bank and amendments to the foreclosure framework have given impetus for more progress, and the introduction of the new securitisation law in July 2018 will make it easier for banks to securitise or sell loans, allowing the creation of a secondary market which can ultimately help them reduce their stock of non-performing loans.

    Banking Transformation

    Cyprus is going through the growing pains of rebuilding its banking sector, a process that if carried out meticulously will reap rewards in the future. The country has received much praise from its international partners for taking firm steps to strengthen its financial institutions and assessments have proved Cyprus has a high level of compliance across the banking sector, with some statutory requirements even more demanding than in other EU member states. GDP growth is supporting efforts and recent Moody’s reports say Cyprus’ banking sector is expected to see profits for 2018.

    Creating more innovative banking solutions and integrated products will support the industry and its competitiveness and bring many opportunities in its wake to support sustainable development in a time of tough competition and rising costs. Cyprus has also placed strong focus on going digital and bringing more innovation to services and activities. Investment opportunities that could be tapped into are distressed assets and loan portfolios, mergers and acquisitions, private equity and venture capital projects, as well as financing of infrastructure projects, such as tourism development and oil and gas projects.

    A steadily growing investment fund industry is set to further strengthen activity in the banking sector, especially after the introduction of the new framework for Registered Alternative Investment Funds (RAIFs). Brexit could also foster new business for Cyprus with UK-based companies seeking alternative operational and business locations within the EU. Cyprus is a compelling alternative thanks to the excellent relations and long shared history between the two countries and the fact that Cyprus’ legal system is based on UK Common Law.

    Cyprus has already demonstrated resilience in the face of adversity and most industry professionals believe the current transformation and increased European supervision has produced a more sound and agile banking sector for the future. Continuous legislation updates and coordination between all stakeholders are necessary for the interest of the banks and the economy, as well as for improving the prospects of society and the country at large. Provided the country sticks to its reforms and takes the delinquent NPL bull by the horns, it will overcome today’s challenges and emerge stronger and ready to unleash its true potential as a vibrant financial centre on the international scene.

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    September 2018

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