Background
The importance of the banking sector to the wellbeing of the Cyprus economy is high relative to that of its European neighbours. In 2020 it accounted for 6.6% of national Gross Value Added, a figure which contrasted sharply with the Eurozone average of 2.8%. Cyprus’ Banking sector has been transformed in the years following the 2009-2013 economic crisis and subsequent EU bail out. The economic crisis was largely precipitated by over exposure to the Greek economy and sovereign debt and, a severely overleveraged property sector; all factors which resulted in Cyprus banks portfolios containing an unacceptably high proportion of non- performing loans (NPL) some in excess of 50%. Since then enormous strides have been taken to successfully correct the fundamental supervisory and structural weaknesses of the system and to deal effectively with the NPL issue. In January 2023 the level of NPL within the system had reduced to 9.6%, the capital bases of the individual banks were strong and liquidity levels high. This significant turnaround was acknowledged by the President of the ECB’s Supervisory Council early in 2023 when he noted that Cypriot banks enter the cycle of uncertainty created by the war in Ukraine in a strong position and suggested that there was a real possibility of them being allowed to pay shareholder dividends for the first time since the crash.[1] It also helped the sector to retain a sense of calm when problems emerged with some European banks early in 2023. Despite these positive changes, however, many challenges remain which must be overcome if the sector is to thrive and service the Cypriot economy into the future.
The Challenges
Changing the business model. Historically the banking sector has been one of the biggest employers within the Cypriot economy. It has also been one of the best payers with an average salary level 80% higher than the national average. It is a workforce which was structured to operate large networks of local bank branches. The rise of technology and cultural shifts towards a preference for online transactions and cashless payment have, however, made such networks largely redundant. Compared with their new FinTech rivals the banks have been saddled with a cost base that requires significant reduction if they are to remain viable businesses. This necessarily means bank mergers, branch closures and staff reductions via redundancies, early retirements and general attrition. It also means that banks must embrace digitalisation, mobile banking, personalised banking etc. in order to attract and retain the younger customer whilst at the same time finding a way to satisfy older and possibly less tech savvy customers. This requires significant investment in staff training and retraining as well as in infrastructure. It also means introducing new product lines and revenue streams whilst maintaining sensible risk assessment procedures. The challenge is not unique to Cyprus but relative to its European and UK counterparts the Cyprus banking sector was slow to recognise it and begin implementing the necessary changes. It also exists in a country where its main rivals, Fintech companies, have been actively promoted by the government as a key player of the future.Regulatory and Sanctions Compliance. Again this is not a challenge unique to the Cypriot banking sector, but it is a significant cost burden and the complexities involved again underline the need for the banking sector to invest in the technology which will assist it in ensuring that it meets its international obligations. Most recently the country’s historic and modern-day ties with Russia coupled with its geographic position and EU membership have placed it firmly in the headlights of US and UK sanctions agencies. Whilst not legally obliged to impose UK and US sanctions, the reality is that in order to continue to function as a respected financial centre Cyprus has no viable alternative other than to fall in line with both countries as well as the EU. Outside of this, the island’s position as a conduit for investment between the EU, Eastern Europe, Africa and the Middle East means that the sector is involved in a high number of complex cross border transactions relative to its size and consequently the scrutiny level required is also raised.Excess liquidity. Currently Cyprus has the highest ratio of bank deposits to loans in Europe. Whilst it has been argued that this represents a return of confidence in the banks following the 2013 ‘haircut’ the reality is that the situation is reflective of a combination of factors. Specifically, the sector has been accused of being overly risk averse when considering loan applications, overly bureaucratic and lacking in vision as regards alternate investment possibilities. Whilst it is currently making profits on the differential between interest received on its large deposits held with the European Central Bank (‘ECB’) and the low levels paid to its depositors this is a temporary aberration and not a sustainable long-term position. The banks need to find new income streams and provide a commercial service suited to the needs of the Cypriot economy.Non-performing loans. Much of the historic NPL problem has been resolved by the offloading of problem debt portfolios to asset management companies and a more robust approach to debt enforcement. However, the overall level of non-performing debt within the economy remains high and measures put in place as a ‘temporary relief’ during the Covid pandemic such as bans on foreclosures involving residential properties remain in force. There are concerns that the situation between Ukraine and Russia and the sanctions related to them may, if they persist for the long term, result in a new wave of economic hardship and consequential increases in commercial and domestic loan defaults.Cybersecurity risks. Increasing the use of technology within the sector means increasing the risk of security breaches. Cyber breaches, when they occur, tend to be high profile and costly – both in terms of financial and reputational damage. Investment in the latest security driven measures such as Address Verification Services, End to End Encryption and a variety of authentication procedures is essential and continuous. So too is the need to ensure that staff are aware of the risks and appropriately trained to help counter them.The Response
The past few years have witnessed a significant level of consolidation within the Cypriot banking sector coupled with large scale reductions in branch networks and staffing levels. In a three-year period the number of branches has reduced by 30% whilst the number of ‘online’ customers has increased by 70%.[2] The associated one-off costs were high, but they have resulted in a far more cost-effective streamlined structure moving forward. Moody’s estimate that the sectors cost to income ratio will move far closer to that of their European peers from 2024 onwards. The managed closure of Russian Commercial Bank (RCB) removed one of the most significant banks from the market leaving Hellenic Bank (which acquired the RCB performing loan portfolio) and the Bank of Cyprus as the two dominant market players. Further consolidation may still occur since Eurobank is attempting to increase its stake in Hellenic to 30%.
Work on removing NPLs from the balance sheet continues to progress with the reduction to an overall level of 9.6% from 11% at the end of 2021 attributed to a combination of loan repayment, debt restructurings and debt write offs. On 31 March 2023 Hellenic Bank announced the completion of its ‘Starlight Project’ which concerned the sale of a NPL portfolio and of APS Debt Service Provider Ltd to Themis Portfolio Management Ltd. It also announced that it had entered into a long-term contract to manage its remaining NPL and any future ones that may arise. Against these positive moves, however, sanctions against Russia have resulted in record inflation of energy bills due to a heavy dependency on imported energy. This is expected to challenge the ability of private and commercial borrowers to repay their debts as originally scheduled.
Profitability levels in the sector also remain low due to an almost exclusive reliance on interest rate differentials to generate profit. A temporary uplift in ECB rates in 2023 has been beneficial but in order to constantly achieve the ECB viability target of 6-10% a new strategy is required.
In January 2023, in cooperation with the Association of Cyprus Banks, Ernst & Young produced a report on the future of the banking sector in Cyprus. The report underlined the importance of the sector to the Cyprus economy and suggested that in order to gain the ‘buy in’ of all stakeholders, future strategy for the sector should focus on developing banking which conformed to four pillars. The sector should be:
‘Purpose Led’ – A comprehensive ESG strategy should be developed and implemented which will help drive the economy forward and ensure that the country meets its EU climate obligations. This should be linked to a culture of integrity and professionalism with a goal of restoring trust in the sector which was lost as a result of the 2013 ‘haircut’.‘Viable’ – Steps should be taken to develop a sector which demonstrates sustainable profitability and provides a ROCE in line with, at a minimum, the EU average. There needs to be a move towards developing new income streams (including possible alliances with fintech rivals and, developing sector specific products), accelerating the digitalisation of operations and further reducing the cost base and most notably staffing costs.‘Safe and Stable’ – There must be no repeat of the events of 2013. The banks must maintain capital adequacy, keep NPL at an acceptable level, employ stringent corporate governance policies, exhibit ESG compliance including with EU Taxonomy, the newly agreed Corporate Sustainability Reporting Directive, the Sustainable Financial Disclosure Regulation and the upcoming Pillar 3 ESG disclosures and they must prioritise cyber security.‘Progressive’ - The banks must harness technology to ensure that they can continue to compete with their Fintech rivals. This will also mean ensuring that staff are adequately trained, and the right skill sets recruited. However, the banks must also be viewed as accessible by all their customers – this may mean having some form of physical presence in remote areas to assist those who are not at ease with modern technologies and also ensuring that the digital platforms utilised are easy to understand and operate.The public response by major players, Bank of Cyprus and Hellenic Bank, to the report has been swift and supportive. Early in April, Bank of Cyprus affirmed that assisting the country to transition to a more sustainable basis is one of its strategic priorities and consequently it was establishing a ‘Sustainable Finance Framework’. The Framework is supported by a second party opinion given by Moody’s and will allow Bank of Cyprus to issue Green, Social and Sustainable Bonds. The proceeds from issuing the bonds will be used to finance sustainable projects including those linked to renewable energy, energy efficiency, clean transportation, green buildings, access to essential services including healthcare and, employment generation and SME financing. This was followed in May by Hellenic Bank announcing that having set customer as well as staff satisfaction as its top priority, it was investing in upgrading its banking services, focusing on a new service model to transition to the digital age fully and effectively. Hellenic’s aim is to progress on three simultaneous tracks – digital customer service, internal processes, and optimising workplace culture[3].
The challenge now for the sector is take advantage of its return to profitability as a result of a ‘one off’ interest boost. The major banks must ensure that they follow through on their promises as regards modernisation, sustainable development, and diversification whilst continuing to adhere to strong and prudent corporate governance policies. Failure on any front may well see them fall by the wayside as the Fintech sector continues to rise.
Footnotes:
[1] Interview with Cyprus News Agency 19 January 2023
[2] The Future of Banking in Cyprus – Report prepared by Ernst & Young with the support of the Association of Cyprus Banks
[3] Cyrus Mail, 23 May 30, 2023
