A CBC financial stability report for 2015 comes as Cyprus nears the exit of its three-year economic adjustment programme on March 31, 2016.

“While sentiment is improving, challenges still remain,” the report notes citing the unprecedented levels of impaired loans, which are among the highest in Europe, the low level of credit demand, the high indebtedness of households and corporations which corresponds to 280% of Cyprus` GDP and the, albeit falling, high unemployment rate.

The baking watchdog also warns that adverse developments in Greece could cause confidence effects, whereas the geopolitical developments in and around the European Union “could impact the financial stability of Cyprus.”

According to the CBC projections, GDP, after almost four years of contraction will grow by 1.6% in 2015 followed by a 2.0% growth in 2016.

According to the CBC, the first source of vulnerability is associated with concerns over asset quality due to excessive exposure to non-performing loans which amounted to 47% of total loans.

“Addressing the high level of NPLs remains the key priority to restore credit and support growth,” the report notes.

Low levels of new lending and the limited scope to increase lending margins are expected to constrain the ability of domestic banks to increase their income. Tackling non-performing loans remains a critical issue.

However it points out that the risk outlook is expected to improve, adding that “decisive and efficient implementation of the newly enacted insolvency framework is expected to be conducive to resolution of non-performing assets,” the report notes.

The island’s households and corporations over-indebtedness is the second source of vulnerability, as “at high levels of indebtedness households and corporates are more likely to encounter payment difficulties in the face of shock to incomes.”

The CBC notes that the risk outlook is expected to improve, adding “decisive implementation of the newly enacted insolvency framework should reduce the overall level of indebtedness and may bring about an acceleration of private debt restructuring.”

The CBC warns over increased vulnerability concerning the banks’ and insurance companies’ weak profitability in a low interest rate and low growth environment, which should be offset by new lending.

“Bank profitability might therefore be squeezed further if banks cannot compensate for this by increasing loan volumes and/or reducing credit risk, which is quite challenging in the current climate,” the CBC says.

Noting that the domestic insurance sector has been subject to a period of weak premium income growth due to the operating conditions associated with a weak economy and low interest rates, the CBC points out that “while recent moderate improvements in the economic climate, if maintained, should serve to support the sector, the persistence of the low yield environment continues to present challenges to the profitability of both the domestic life and non-life sectors.”

The CBC also underlines that the implementation of the Cyprus General Health Scheme without the participation of insurance companies would lead to a major reduction in their business.

On real estate prices, the CBC notes that risks are stable, as “prices may be bottoming out and could modestly increase in the medium-term, given emerging signs of renewed domestic and foreign demand.”

It notes however the prospects for the recovery of the property market are difficult toestimate with certainty. “Close monitoring of property sector is required owing to its importance both for the asset position of households and for banks’ loan portfolios,” it adds.

The CBC assigns stable outlook on the banking system’s funding risks. Three years after the bail-in of unsecured deposits, “access to medium-and longer-term funding at sustainable cost remains a challenge as Central Bank funding remains a significant proportion of the funding base.”

Pointing out that as the reliance on ECB emergency liquidity has been reduced from a peak of €11.4 billion in March 2013 to €4.9 billion in September 2015, the CBC notes that “maintaining confidence is essential for financial stability.”

Furthermore, the CBC points out that depositor confidence still remains vulnerable, although deposit outflows have slowed considerably, noting the risk outlook is expected to improve.

The CBC notes that “inevitably, credit institutions have no option but to actively manage loan arrears, including the sale of loan collateral if needed,” highlighting that “the sale of loan collateral should be undertaken with care as mass disposals would result in sharp reductions in real estate prices, creating feedback loops between the real economy and the financial sector.”

Source: Famagusta Gazette