Interview with Kathimerini Cyprus

Interview with Andrea Enria, Chair of the Supervisory Board of the ECB, conducted by Panagiotis Rougkalas and published on 7 July 2019

How do you assess the situation of Cypriot banks following the implementation of a vast array of economic reforms in Cyprus since 2013?

Significant progress has been made in recent years in stabilising the banking sector in Cyprus. This stabilisation has also benefited from the very favourable development of the Cypriot economy. Moreover, the sale of the “good” assets of the Cyprus Cooperative Bank (CCB) to Hellenic Bank and the transfer of CCB’s “bad” assets to the state-owned asset management company (KEDIPES) in 2018 have clearly reduced uncertainty in the sector.

Another important component of the stabilisation was the Cypriot Parliament’s adoption in 2018 of amendments to the insolvency and foreclosure frameworks. The reform package also comprised legislation on the sale of loans and the adoption of the securitisation law. On this basis, Cypriot banks are now participating in the market for trading non-performing loan (NPL) portfolios, which has resulted in a remarkable acceleration of NPL resolution.

Notwithstanding these achievements, we should bear in mind that the high NPL ratio (31.1% as of February 2019, against a euro area average of 3.8%) is still the main challenge that Cypriot banks must overcome. Sustained progress in NPL resolution has to be achieved while the macroeconomic environment is favourable. This crucially hinges on the effective implementation of the revised legal framework and also requires further measures to improve the effectiveness and efficiency of the judiciary.

You mentioned the foreclosures law that was passed in July 2018. There are some efforts under way to amend it and the banks have been reacting to this. What do you think about these efforts?

We must not forget that, despite the recent progress, the NPL ratio in the Cypriot banking sector remains the second highest in the euro area. Against this background, if there are any amendments to the insolvency and foreclosure frameworks they must not undermine the effectiveness of those frameworks, as this would significantly complicate, and even impede, the ongoing NPL resolution efforts. It is also essential to ensure that any amendments do not further weaken payment discipline by strengthening incentives for strategic defaults. It is worth noting that the ECB has not been consulted regarding the efforts to amend the foreclosure framework or other components of the legislative package adopted by the Cypriot Parliament in 2018.

What are the main challenges for Cypriot banks over the next five years in your view?

Beyond the continued reduction of distressed assets that I previously mentioned, the main challenges for Cypriot banks are: strengthening their profitability, ensuring sustainable business models and improving corporate governance.

Banking sector profitability in Europe remains persistently low, and Cyprus is no exception. As a result, most European banks are trading at price-to-book ratios that are lower than those of their international peers.

Profitability is under continuous pressure on account of a number of factors, such as low interest income, high operating costs, increased competition in certain market segments and the potential need for additional provisions in an environment of high NPL ratios.

While Cypriot banks have already made significant efforts to reduce overstaffing and the size of their branch networks, further efforts are needed to address the remaining excess capacity. Relieving the pressure on profit margins will require continued cost reduction (including by adjusting business models), a review of organisational structures and the swift adoption of new technologies.

I would like to emphasise that the most profitable banks in Europe have two common features: high cost-efficiency and intensive use of modern technology. Although there is no one-size-fits-all strategy, this is an indication of the catalysts for change.

At the same time, strengthening risk management, compliance and internal audit functions, together with an enhanced risk culture, are essential to pave the way for improved bank performance.

Are you, as a supervisor, satisfied by the mergers carried out so far in the Cypriot banking system? Do you believe that more mergers should take place? Would you favour cross-border mergers?

Excess capacity in the banking sector is one of the legacies of the crisis, and maybe the only one which has not yet been effectively addressed. Consolidation would help reduce excess capacity and make banks more efficient and profitable. But this is a decision for banks’ managers and shareholders to make – not supervisors. We must also not forget that healthy competition between banks is desirable because it benefits their customers.

As far as cross-border mergers in Europe are concerned, they are now a more feasible option thanks to the European banking union, which has the ultimate goal of creating a more transparent, unified and safer market for banks. Any obstacles should be removed, to help banks diversify their portfolios and become more resilient. This would also alleviate the link between banks and sovereigns so that the banking sector could help smooth shocks that hit a single Member State.

In Cyprus, although 50% of NPLs have been removed from the banking system and transferred to loan managers, they still remain in the economy. Is this a problem? How can it be dealt with? How and when do you believe that NPLs will actually be eliminated in Cyprus?

Indeed, half of the NPLs were recently removed from the Cypriot banking sector. However, it is important to note that this mostly reflects two one-off transactions. First, the transfer of CCB’s “bad” assets to the state-owned asset management company KEDIPES. And second, the sale of the “Helix” portfolio by the Bank of Cyprus. Beyond this, the speed of NPL resolution has not been very impressive recently, particularly if we consider the very favourable economic environment in Cyprus.

And you are right – the NPLs that left the banking system continue to weigh on the economy, as servicing the corresponding debt constrains the capacity of firms and households to invest. But the transfer of assets and the pooling in asset management companies could help restructure the debt and alleviate the burden for households and companies. It’s also important to note that the large amount of NPLs being transferred to credit-acquiring companies, be they state-owned or private, highlights the need to ensure a sound framework for the supervision of such companies.

As for when NPLs will be actually eliminated in Cyprus, this is something that will require persistent effort, time and growth-friendly economic policies.

Does the sale of large loan packages pose any risks to banks and their profitability? What should banks look out for?

The sale of packages of distressed loans has two main positive effects for the banks. First, these sales reduce the economic uncertainty resulting from holding these assets. And second, instead of locking up capital and employing resources to manage these loans, banks can use them for carrying out new business. Distressed loans are costly, as they imply the need to allocate provisions, have high management costs and face problems regarding the recoverability of interest.

While the sale of distressed assets usually has an immediate impact on capital and profitability, in the medium term this is generally compensated by lower funding costs and the ability to pursue new business opportunities. The positive effect is also visible in the positive reaction of stock markets to sales of bad loans portfolios.

Do you believe that the digitalisation of banks, although a challenge, will be an opportunity for profitability?

In my view, the digitalisation of banking is an opportunity to improve profitability. If banks do not keep pace with the digitalisation in the sector, they risk losing market share, as they are challenged by other more efficient banks and by new fintech competitors.

Also in Cyprus, digitalisation could make an important contribution to enhancing the efficiency of banks, and thus their profitability, and to reducing excess capacity. Investment in IT and digitalisation is also essential to improve internal processes and customer interaction.

Do you think that the citizenship by investment programme could negatively affect the country’s economy and, consequently, its banking system?

The citizenship by investment programme (CIP) has had a non-negligible impact on the Cypriot economy. Even though the programme has recently been amended to reduce the links to the construction sector, there is some evidence that the scheme has contributed to an overreliance on construction investment and has had negative implications for housing affordability in certain regions. Risks to financial stability may emerge if the CIP-driven component of the expansion in the construction and property sectors turns out to be unsustainable.

There is also a broader dimension of the CIP, linked to the implied risks of money laundering and tax evasion. It is therefore important that foreign investment related to the scheme is subject to strict due diligence procedures to ensure compatibility with standards for anti-money laundering and combating the financing of terrorism.