Coops to remain the budget’s perpetual black hole

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By Alexander Michaelides*

It is hard to imagine how Cyprus can get out of the mess it got itself into when it decided to bail out the co-ops yet again.

finance ministryToday, the government, which has a 99 per cent stake after injecting almost €1.7bn over the past two years, wants to reduce its stake in these lenders, which since their birth have been accustomed to political meddling and – because of their mismanagement – addicted to taxpayer’s money. This however is unlikely to succeed and any attempt to prolong their life will imply additional cost for the taxpayer.

It will be hard to find an investor who will put in money to save the co-ops. They have been unable to develop a proper corporate culture even after Cyprus’ international creditors insisted on them being supervised by the Central Bank of Cyprus (CBC). Since 2014, they have also been supervised by the European Central Bank’s Single Supervisory Mechanism.
But let us start the story from the beginning.

In April 2011, I wrote an article about the risks and potential costs emanating from the way co-operatives were being run and supervised in Cyprus.

“Co-ops revitalise competition in the local market but this unfortunately may come at a cost. Their shareholders are at the same time the depositors.

COOP LOGOTherefore, the moral hazard of state deposit insurance is even higher than in banks,” I said. “A bank’s shareholders have a high probability of losing their money from risky decisions, and thus have an incentive to pay attention to how the bank manages deposits. Instead, co-ops do not have this additional safeguard, as depositors and shareholders are the same people. As a result, the moral hazard for taking risky decisions based on the (justified) expectation that the state cannot let depositors lose money is even greater in co-ops than in the rest of the banking system.”

I also pointed out other reasons for concern back then: a bailout in 1980-1981, and the ubiquitous sense of political party interference in the co-ops.

My article was published on Sunday (03/04/2011) and on Friday that week the Cooperative Societies’ Supervision and Development Authority (CSSDA) sent me a response electronically, which was also posted on the internet, where it can still be found.

At that moment I realised that the problem was much bigger than I had originally thought. I had made a theoretical argument why co-op supervision needed to be done differently (basically performed directly by the CBC). Five days later I was receiving a letter from an authority that had in its own title an obvious conflict of interest (at the same time responsible for supervision and development) that all was well and reassuring me that the CSSDA was the competent supervisory authority for the co-ops. The CSSDA said there was close cooperation between the CSSDA and CBC and that the supervisory practices and standards were the same for both the co-ops and banks.

Of course, since the banking crisis that ended with the bail-in in March 2013, the CSSDA is no longer the competent authority of the co-ops. This was at the troika’s insistence and not down to local political decisions. However, this externally enforced change on supervision does not necessarily mean that political involvement has vanished from co-op operations, or changed the co-op culture.

Cooperative Central BankThe question posed to the state by the taxpayer is what will happen in the future with the state enterprise called co-ops?

Let’s start from the beginning. What are co-ops? As the CSSDA rightly pointed out in their response to me in 2011, co-ops are associations of persons voluntarily associated in order to serve their economic, social and cultural needs and aspirations through a participatory and democratically controlled company.

No member holds a significant stake in the share capital of the co-ops, while by law each member has only one vote at the general meeting regardless of capital held. Also, the co-op reserves may not be distributed to the members and profit maximisation is not the main purpose of their operation.

The question to be answered in 2016 is whether this description still holds. Do the co-ops continue to be non-profit organisations? Or are they profit-making banking institutions that should be privatised? The current co-op leadership gives the impression that co-ops are profit-making banking institutions like other private banks and therefore should be treated as such.

The government, as the main shareholder, should take a stand and explain what the future role of the co-ops in the country’s economic life will be, after discussing this with the co-op membership (still probably under the impression that co-ops are non-profit). The question eventually needs to be addressed: are co-ops for-profit or non-profit institutions?

The second question that must concern us is whether the co-ops, now under direct CBC supervision, are completely safe. At this stage, it might be useful to go back to the (2011) CSSDA argument: “Unlike companies that aim to maximise the wealth of shareholders, i.e. capital associations, there is no incentive for taking risky decisions and hence no moral hazard arising from the state guaranteeing deposits”.

We now know that this argument has been empirically rejected in view of the Cypriot experience of 2013. Therefore, whether you see the co-ops as for profit or non-profit organisations, the temptation to make risky decisions (e.g. based on political criteria) continues to exist.

The third question that should concern all relevant state authorities is the exit strategy from co-op ownership. My personal view is that it will prove hard to privatise the co-ops (why not start a new bank without any obligations?). But even if a privatisation takes place, due to possible state subsidies, who can guarantee that the state will never need to bail out this organisation again in the future?

Cooperative BankAnother possible solution is to enable the members to buy back the co-ops. This would be the best solution, but this should be done with the members’ own money, as was done when the co-ops were originally created. But even if the members have the money and want to invest in this direction, why should they decide to follow this route rather than start a second co-operative movement?

Why would they not consider starting a brand-new co-op movement, having learned from past mistakes, but without the debt overhang from past decisions? And if the state cannot sell the co-ops, what is the long-term role of the organisation? Is it intended to be a new state bank where administrations and decisions will change with each government and thus with strong political involvement?

Unfortunately, I have no answers on how the state will extricate itself from the co-ops, and it is for this reason that they look like a black hole to me. Do they have a future and if so, what does it look like? Are the co-ops non-profit or for-profit organisations? I believe that, as events have unfolded, these are difficult questions both in theory and in political practice, but must be answered by the competent authorities (or those prepared to put their own capital in the co-ops).

This task involves the government (as almost the sole shareholder), the parliament (as guardian of taxpayer money), the Central Bank (as supervisor) and all state agencies that are responsible for taxpayers’ wealth management.

(*) Alexander Michaelides is professor of finance at Imperial College Business School.

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About Author

Stelios Orphanides is a journalist at CyprusBusinessMail.com. To contact Stelios Orphanides: [email protected]

  • Jeremy Rigg

    As far as I can see, the sooner we get to meltdown and the countries apocalypse, the sooner they can bring in expert foreign help and sort the job out once and for all.

    • John Henry

      Its hard to argue with your statement as desperation seems to be the only motivation for corrective action.

  • John Henry

    The start of a 2nd co-op movement, while well intended, in my experience would only be replacing one form of insanity with another. It seems quite obvious that perhaps a slight majority of the population do not realize, and/or even care, that money does not grow on trees and there is not an endless supply of it. When we first moved here decades ago anytime anyone wanted anything (a car, a house etc) all I ever heard was “go to the bank.” I never realized what that actually really meant until March 2013.

  • alexander reutersward

    In general it is better to let businesses go bankrupt than having the government save it.

    It should have been done with CO-OP and it should have been done with laiki.

    This message would have made all other business understand that they don’t get external help and must be efficient.

    • Erol Riza

      Alexander
      In the midst of the biggest financial crisis witness by the world tell us how many systemic banks we re allowed to go bankrupt, especially in Germany. The government was right to bail out the Co Op societies. The mistake was the supervision which was non existent. The Co Op is now a state owned bank like any other bank and any thought of anything else is hot air. The answer to Prof Michaelides is that it is a profit making institution for sure otherwise it will never build the capital to sustain its business model and become attractive for external investors. The problem with banking in Cyprus is that there are too many many banks and the requirements of banking as an industry is such that returns are likely to be in single figures and this is not very attractive.
      However for as long as the government’s subsidise banks with guaranteed depoists there will be investors who will seek to take advantage. In my vie the guarantee of deposits is a state subsidy which has to be abandoned in order to have the strong banks stand out based on their good corporate governance and risk management. The governments of the EU, unless a development bank, have no reason to own banks. The sooner the government manages to sell the better.

    • Disenchanted

      Laiki was the second largest systemic bank in Europe (assets relative to GDP). If it was allowed to fail, the consequences would have been catastrophic. All deposits in the bank would be frozen until the assets would be liquidated, thus even insured depositors would have no access to their funds for years. The government itself would go bankrupt because it wouldn’t be able to honour its deposit insurance commitments. Borrowers would be asked to pay back their loans, causing massive fire sales. It would be economic and financial Armageddon. That’s why no systemic bank in Europe has been allowed to fail. Systemic banks are not corner shops, they are, unfortunately, too big to be allowed to fail. The onus is upon regulators and supervisors toprevent them from taking on excessive risk in the first place.

  • Gui Jun An

    On CM homepage there’s an ad by Hellenic Bank, ‘Want a new car, come to see us.’
    All banks are in business to make money. The co-op gives it away. I hope depositors amounts of 100,000 euros or less are guaranteed by government. If so, the Co-op should say so.

  • Erol Riza

    Some of the ex pats who are quick to criticise should look at their house and check out what happened with Northern Rock and several of the Building Societies and of course the Co Op Bank in the UK which was bailed in as well; the creditors took the hit and the bail in did not touch the depositors. Thus before you start throwing stones in a gas house check to the facts. I am not saying that the British banking system was rotten but look at how much much money in terms of penalty fees has RBS been paying and will pay. What about the tax payer in the UK????