Interview with Kathimerini Cyprus
Interview with Elizabeth McCaul, Member of the Supervisory Board of the ECB, conducted by Panagiotis Rougkalas
12 November 2023
How do you assess the progress of the Cypriot banking sector over the last decade?
First, let me thank the Central Bank of Cyprus for the excellent cooperation we have always had. Its role has been instrumental in reinforcing financial stability in the country. Cypriot banks have made tremendous progress since the inception of European banking supervision ten years ago. And this is particularly evident on the asset quality side, where non-performing loans (NPLs) are steadily returning to more sustainable levels. Recently completed large-scale NPL deleveraging transactions have driven ratios down. The average NPL ratio of Cypriot banks is now below 9%, down from over 50% only a few years ago. At the same time, increased efficiencies, in some cases via voluntary redundancy schemes, ultimately improved the sustainability of the banks’ cost base. Finally, Cypriot banks have made notable progress in building up their MREL capacity (minimum requirement for own funds and eligible liabilities) with Tier 2 issuances in 2022 and 2023. The MREL targets set by the Single Resolution Board are now within reach. In a nutshell, the situation has improved dramatically since the dark days of 2013, and the future looks even more promising.
More needs to be done as NPLs in Cyprus are still above the euro area average. While most banks have succeeded in substantially reducing NPLs, some are still lagging behind in offloading sizeable stocks of increasingly ageing foreclosed assets. Policy initiatives play a crucial role in helping banks make progress towards reducing these legacy assets. These include an efficient foreclosure framework. We monitor and remain concerned about national legislative proposals which may hamper a bank’s ability to recover the value of both the remaining real estate it owns and of NPLs.
Furthermore, the recent increase in interest rates has certainly boosted the Cypriot banking sector’s profitability. At the same time, higher rates are having a negative impact on domestic credit demand in both the corporate and household segments. Indeed, the long-term sustainability of banks’ business models still depends on the successful implementation of cost reduction measures, which need to be completed.
Let me say here that higher interest rates increase the credit risk of existing and new loans. Improving credit underwriting standards is essential to avoid a renewed build-up of NPLs. At the same time, we expect Cypriot banks to reinforce risk management practices to detect expected credit losses in their banking book in a timely manner. Such measures will pay off, reducing the procyclicality of a possible economic slowdown.
What are the key challenges for banking supervision? Does the failure of Credit Suisse change the way you see things?
The European banking system remains resilient overall. Banks under our supervision have generally comfortable capital and liquidity ratios. The average Common Equity Tier 1 ratio of significant banks was 15.7% in the second quarter of 2023, while the average liquidity coverage ratio stood at 158% during the same period. Bank profitability has strengthened further, with the annualised return on equity of significant banks at 10% now, compared with 7.6% one year ago. This is primarily due to rising net interest margins that offset declining bank lending volumes. From a financial stability point of view, this increase is a welcome normalisation, reversing the trend of declining margins seen during the low interest rate environment of recent years. At the same time, banks need to remain vigilant and to continually monitor and adapt their approach to potential new risks and vulnerabilities. The fast-paced monetary policy normalisation is also posing challenges. For example, as households’ and firms’ savings decrease, market competition for funding might continue to increase.
Since you mentioned Credit Suisse, let me say that I think it has reminded the supervisory community that sound internal controls and risk management, good governance and sustainable business models are absolutely key. Also, looking at the events in the United States, the turmoil in March this year illustrated the changing and more volatile nature of depositors’ behaviour. Social media may be used to mobilise people to withdraw deposits, and new trends in digitalisation can have a greater impact on depositors’ behaviour and thus on the stability of banks’ liquidity and funding sources. So we are looking carefully at the level of diversification of banks’ funding sources and the adequacy of their funding plans.
Do you think European banks have an appropriate business model to produce sustainable profits in the medium term and attract investors’ interest in a way that will boost market valuations?
Supervisors are not meant to provide investment advice, but to ensure that banks are resilient, safe and sound. Banks must have a robust and sustainable business model over the entire economic cycle. Today, monetary policy conditions favour banks’ profitability. They should take advantage of this opportunity to become more cost-effective and innovate and invest in IT and digitalisation. They must also strengthen their corporate governance. We have seen how banks with management and a board that have a better grip on strategic steering are capable of exiting unprofitable business segments and upscaling sufficiently in those business areas where they have a competitive advantage.
Do you see any risks ahead? Anything that causes supervisors anxiety?
The risks stemming from non-bank financial institutions (NBFIs) require a closer look. There is a massive shift of historically traditional banking services to sectors outside the remit of banking supervision, like credit intermediation, leading to exponential growth in the non-bank financial intermediation sector. We need to close the data gaps and strengthen the regulatory and supervisory oversight of the NBFI sector, especially in a cross-border context. The numbers are truly staggering. By one measure, in the euro area, the sector has doubled since the global financial crisis, up from €15 trillion in 2008 to €31 trillion today. It now accounts for half the financial sector. I can briefly mention three risks originating from that situation. First, the build-up of financial and synthetic leverage which can propagate risks across the entire financial system and lead to major disruptions. The second risk concerns liquidity. As we saw in the United Kingdom in September 2022, liquidity stress in the NBFI sector can easily spill into the broader financial sector. Investment and pension funds using liability-driven investment strategies faced large collateral requests in repo transactions and margin calls in interest rate derivatives, resulting in fire sales until the Bank of England intervened. Third, we have counterparty risks created by banks’ derivative exposures to NBFIs. There is a lot of room for improvement in order to reduce these risks.