Cyprus Banking Crisis: Causes and Consequences - Cyprus Profile

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Articles | 10 July 2014

Cyprus Banking Crisis: Causes and Consequences

After securing a financial bailout from international lenders in 2013, Cyprus is now on a steady path to recovery. The tough terms of the bailout have hit the economy hard, but the country has beat estimates and is projected to return to growth in 2015.

The Cyprus bailout captured the attention of the world, as it was the first and only bailout worldwide with a condition to impose a bail-in of bank deposits – a measure considered inconceivable until then.

At the height of the eurozone sovereign debt crisis, 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. One of the smallest nations in the EU, Cyprus fought hard to bounce back from the brink of bankruptcy through intense negotiations with its lenders, while at the same time undergoing presidential elections and a change of government.

As part of the terms of the €10 billion bailout agreement, which was approved in April 2013, Cyprus was bound by a Eurogroup decision to set the controversial eurozone precedent of imposing losses on large depositors in two of its major banks, Bank of Cyprus and Laiki Bank. This was immediately followed by a closure of the entire banking sector for nearly two weeks with the imposition of capital controls in a bid to prevent a bank run. Cypriots and the local banking sector were 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.

Deposits exceeding €100,000 were turned into equity to recapitalise the Bank of Cyprus, which was also lumped with most of Laiki’s assets and debts, including €9.2 billion in emergency liquidity assistance. The measures were severe and there was – and still is – much justified anger over these events. Yet unlike other EU countries undergoing bailout programmes, Cyprus did not see a run on the banks or violent riots, but a defiant show of resilience and solidarity among the Cypriots.

Causes

A number of factors contributed to the 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, with Cypriot banks already grappling with 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 grosslyunderestimated 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.

Consequences

Several EU countries developed significantly larger banking systems compared to their economies to promote themselves as international financial centres, and Cyprus was 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. Adopting a national financial services strategy and boosting supervision of the banks are high on the agenda today, and Cyprus has already made good headway in establishing a smaller, stronger and safer banking sector.

Following the bailout, many predicted the country’s financial centre would be destroyed and a loss of investor confidence would signal the end of Cyprus as a successful international business centre. Cypriots braced themselves for a mass exodus of foreign business, but as anxious investors looked to other jurisdictions they quickly discovered the reasons that first brought them to Cyprus remained as valid as ever. The country’s status as a financial centre has certainly been severely wounded, but what remains intact is Cyprus’ solid experience in corporate structuring and offering blue chip companies and tax planners preferential access to high-growth markets like Europe, Russia, China and India. With close to 50 double tax treaties, Cyprus continues to provide international businesses an attractive base for their operations, a fully EU-harmonised tax and legal framework and one of the lowest and most competitive corporate tax rates in Europe at 12.5%. Following these events, many investors are in fact viewing Cyprus with renewed interest with its expanding investment opportunities in the tourism, real estate and oil and gas sectors.

Every evaluation Cyprus has undergone so far has garnered positive results from its lenders, who praise the country for meeting all its targets with significant margin. Although still facing challenges, Cyprus’ return to international markets and the progress it has made over the last year has sparked cautious optimism. The small Eastern Mediterranean island is determined to succeed, and if there ever was one, Cyprus could be held up as a bail-out success story at the end of this painful three-year economic reform process.

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