By Rennos Ioannides*
There is a well-known axiom in the financial world which stipulates that no banking system, and as a matter of fact, no economy, can survive with non-performing loan (NPL) figures over fifty percent, as is the case in Cyprus; yes, they are stubbornly well over 50 per cent when governmental and non-financial corporations are excluded!
And there is another well-known axiom which says that “as you sow, so shall you reap”. And local banks are reaping, for the past few years now, the rotten fruit of the loan seeds they sowed ‘en masse’ a decade ago.
As no juggler in the world can actually juggle with so many “air-borne balls” at the same time, no banker can actually handle so many problem loans, despite the valiant efforts that have taken place to date. Much like the Lernaean Hydra, no matter how many loans are resolved, even more spring up. And, heaven forbid, banks are not, cannot and should not become real estate clearing houses. This is not their role in the modern economy! Their role is none other than to diligently and rigorously assess new investment and financing propositions with a view to funding with caution the productive capacity of the economy, thus propelling real economic growth.
Juggling with so many balls, using only conventional ways, is simply “an accident waiting to happen”. A potential “nuclear” accident to be honest. The rationalised and conventional way of going about resolving the sizeable NPLs stock is not making sufficient inroads.
The process is slow and painful and banks possibly lack sufficient specialised resources. In addition, banks may also carry embedded legacy structures, cultures, policies and procedures which give rise to decision-making cautiousness or hesitancy and operational capacity bottlenecks or even inertia. All these constraints stifle efforts to swiftly and determinedly deal with the problem, which is exactly what is required in crisis situations.
Borrowers, on the other hand, may lack sufficient resolve to efficiently deal with the problem, whereas the local corporate world and households alike are excessively indebted and cannot sustainably service their debts at their present levels.
To complete the picture, the legal and enforcement frameworks for debt recovery and for the liquidation of collaterals is not yet mature or effective enough.
Banks’ ability to fund new investments and economic growth is, as a result, severely curtailed, prolonging the return of sustainable economic recovery. And our banks are in for yet more challenges:
- IFRS 9 which comes in force in 2018 and will most likely lead to additional and/or faster provision requirements,
- the new pan-European stress tests which are anticipated to take place in the second quarter of 2018,
- the newly published guidance to banks by the European Central Bank on non-performing loans, the requirements of which will form an integral part of the annual Supervisory Review and Evaluation Process and may reasonably feed through to Pillar 2 capital requirements. Detailed reporting requirements have been set down where the NPL strategy, plans and performance of high NPL banks will be diligently scrutinised by supervisors at frequent intervals.
Threat of crisis reignition
The level of accumulated NPLs along with the other challenges facing banks are so critical to the extent that they make local banks extremely vulnerable to any sort of downturn or adverse development. The risk of reigniting a 2013-like crisis cannot be completely overlooked.
No wonder these are worrying times for local banks which find themselves operating in truly hostile surroundings:
As already touched upon, banks do not have sufficient or, in certain cases, enough expert resource capacity to deal with and subsequently manage the NPL avalanche arising from the sheer number of cases at hand.
To top it up, banks’ attempts to offer swift, long-term and truly sustainable solutions may be deterred because of inflexible internal processes and corporate governance issues.
As a result, trying to work out all the non-performing loans inside the bank only prolongs the healing process in the organisation. Recent insolvency law reforms have yet to mature and it will typically take time to build capacity, develop uniform processes and test the rules in court. Structural impediments, on the other hand, such as the slow progress in terms of the issuance of separate property title deeds is concerned and the heavy concentration in a saturated real estate sector, which presently lacks financing liquidity, are further factors which do not bode well for the future of the banking sector.
On another front, the local banking system is profoundly crowded both in terms of the number of commercial banks operating in this small economy and in terms of the number of bank branches per capita.
All financial institutions are in effect juggling with the same “balls” (or, chasing the same distressed, and healthy, borrowers) which leads to intense competition to get a bite of the small ‘healthy borrower’ pie against a backdrop of low net interest spreads and a largely inflexible cost base. The already stressful business pressures facing banks arefurther exacerbated by the heavy load of supervisory, compliance and reporting requirements and resultant costs.
This low profitability environment, which is driven by all the above factors, may well call into question the viability and sustainability of certain banks’ business models. Daniele Nouy, chair of the Single Supervisory Mechanism, has repeatedly stated that “low profitability is a concern for supervisors because it may impact the medium-term sustainability of some business models. Certain institutions might struggle to generate capital while having limited access to financial markets. The European Central Bank will carefully assess the sustainability of banks’ business models in the coming quarters, with a view to ensuring that they are able to withstand cyclical developments and structural challenges”.
Local businesses and households are typically multi-banked and excessively indebted, therefore many of the distressed borrowers are common to more than one banks, either as principal debtors or as guarantors. Arguably, there is not much benefit in resolving some of these distressed borrowers’ loans with one or two banks whilst leaving borrowings with other banks unresolved.
Likewise, resolving these loans without actually adjusting the debt level to the amount which can be reasonably sustained by the borrower in the long-term is not of great help either.
The unresolved borrowings will one way or the other come back to haunt the resolved loans; it will only be a matter of time before the cleaned up loans get contaminated by the diseased loans. Similarly, it will not be long before the unsustainable restructured debts re-default.
In conclusion then,
- a joint bank effort for the restructuring of multiple creditor loans and
- assertive action for the re-adjustment of the level of debt,
are called for on a number of occasions; neither action is, however, typical of the existing banking culture in Cyprus.The distressed asset market for the sale of NPLs is anything but developed in Europe yet, exhibiting a steep bid-ask pricing gap between buyers – sellers that is making the sale of distressed debt unaffordable for banks and is thus blocking the NPLs secondary market across Europe.
Alarmingly, when we turn to the local market we find that the provisioning coverage of local NPL loans is still below the European Union average (39.7 per cent coverage for Cyprus vs 44.6 per cent weighted average for all EU countries, as of December 2016 as per the European Banking Authority), thereby limiting even further the potential for distressed debt sales which shall maintain banks in a capital-neutral position. Even more worryingly though, the higher NPL countries in the EU (with ratios over 10 per cent) are mostly much better covered, with coverage ratios closer to 50 per cent or even higher.
What’s more, the local market is so small and hampered by so many structural constraints that one would not reasonably expect a flood of interest from international investors to buy a chunk of Cyprus’ problem loans. Interestingly, the first move to dispose of a portion of their NPL portfolio, which has been very recently publicised, relates to the sale of a very small fraction of a local bank’s portfolio to another local bank.
To sum up this first part of our analysis, it is only fair to say that traditional banking rationalism in the form of the conventional management of NPLs may not be the wisest choice in times of turbulence and business pressures on a number of fronts.
Doing business in crisis conditions requires, by its very nature, thinking outside the box in conjunction with pace and determination.
(*) Renos Ioannides is a financial analyst ([email protected])