By Rennos Ioannides*
The level of accumulated non-performing loans (NPLs) along with the other challenges facing banks are so critical 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.
It’s no wonder; these are worrying times for local banks which find themselves operating in truly hostile surroundings.
Banks do not have sufficient or, in certain cases, expert enough 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 insofar as the issuance of separate property title deeds is concerned and the heavy concentration in a saturated real estate sector, which presently lacks financing liquidity (other than the impetus created as a result of the Cyprus Citizenship and Permanent Residence scheme), 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 are further 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 at December 2016 as per the European Banking Authority). This limits 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, 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.
(*) Rennos Ioannides is a financial analyst