13 April 2011 Are Cypriot banks ready for the EU stress tests?

Note: This article first appeared in the Financial Mirror newspaper on 13 April 2011. It is no longer available online so is reproduced in full here, along with the update dated 15 April 2011. The table below is based on the updated article

Cypriot banks would stay the right side of Basel II even with a 50% haircut of Greek sovereign debt but would drop below the stricter level set for the EU-wide stress tests, according to our analysis.

Cypriot banks have been under the spotlight lately, with Moody’s downgrading the three major banks on March 2nd and the Economist Intelligence Unit (EIU) rating them as the second riskiest in the eurozone, in a report released last week entitled, “State of the Union: Can the euro zone survive its debt crisis?”

Standard & Poor’s downgraded the Republic of Cyprus for the second time six months on March 30th, which means the banks are likely to follow, since bank ratings are always affected by the “sovereign ceiling”. Only Fitch has remained more or less on the sidelines, with Cyprus on a negative watch but not yet downgraded.

There are two main reasons for the downgrades: the banking sector and the public finances. Once upon a time, a domestic deposit base of EUR 45 bln, or nearly EUR 70 bln when non-residents are included, in an economy that was only EUR 17 bln would be seen as a sign of strength. Today it is seen as a potential risk, especially given local banks’ exposure to Greece.

Expectations of a Greek default, negotiated or otherwise, are now growing. The EIU’s baseline forecast is a 42% haircut by 2013, Reuters last week cited an academic expecting a haircut of 50% and Standard and Poor’s mentioned a haircut of 50%-70%. While analysts worry what that will mean for the banks’ bottom line, they also lack of faith in the Cypriot government’s deficit-cutting programme.

Why does this affect the banks? Because if a Greek default led local banks to need capital injections to keep them solvent, a deficit-ridden government might not have the funds, or the access to financial markets, to prop them up.

In the next few weeks, the newly created London-based European Banking Authority (EBA) will be running an EU-wide stress test similar to the one conducted last year by the Committee of European Banking Supervisors (CEBS).However, this time the test will be tougher. Banks will be required to keep their Core Tier 1 ratios above 5% (the Basel II minimum is 4%).

However, the results will not be known until June, which might be too long to wait if you expect a Greek default any time now. The Financial Mirror, in cooperation with Sapienta Economics, has therefore decided to run its own basic test, based on published data of the three banks, as well as additional information kindly provided to us.



How much have the banks lent to Greece?

The first question to answer is how much the banks have lent to Greece – both the Greek sovereign (Greek government debt) and the Greek corporate and private sector. At the end of last year Bank of Cyprus, Cyprus’ largest bank, had lent EUR 2 bln to the Greek government according to its investor relations presentation. In addition, it had lent EUR 10.1 bln to Greek corporations and individuals. Total loans to Greece are therefore EUR 12.1 bln, out of total group loans of EUR 27.7 bln.

At the same time, the Core Tier 1 capital of Bank of Cyprus is reported at EUR 2.12 bln, with a ratio of 8.1%, compared with a Basel II minimum of 4%. Its Tier 1 is EUR 3.346 bln, with a ratio of 12.7%, compared with the Basel II minimum of 8%. Total risk weighted assets are reported at EUR 26.277 bln.

These ratios are after adding the EUR 1.3 bln in “CoCo” convertible bonds that will be issued in the coming weeks. These bonds convert into shares if either Core Tier 1 drops below 5% or if the Central Bank of Cyprus declares that Bank of Cyprus is not compliant with capital adequacy rules.

Constandinos Pittaris of Bank of Cyprus says that some of the CoCo issue will be used to replace existing hybrids that will not qualify under the forthcoming Basel III rules. Net new capital, therefore, will amount to around EUR 500 mln.

Marfin Laiki, the second largest bank, has lent EUR 3 bln to the Greek government and has another EUR 12.5 bln in corporate and individual loans. Its Core Tier 1 level is EUR 2.547 bln and its Core Tier 1 ratio is 9.3%. Its general Tier 1 capital is EUR 3.285 bln and its overall ratio 12.0%. Inferring from these figures, we can assume that its total risk weighted assets are EUR 27.4 bln.

Its ratios are also after adding a convertible capital issue of EUR 660 mln in the coming weeks. These will also be convertible if triggered by an event that will be defined closer to the issue date.

Hellenic Bank, the third largest bank, is the least exposed, with loans to the government of Greece amounting to just EUR 110m with additional loans to corporations and individuals amounting to just under EUR 1 bln. Hellenic does not publish its Core Tier 1 levels but its overall Tier 1 is EUR 157,587,000 (EUR 0.16 bln) and its Tier 1 ratio is 12.3%. Our estimate, based on the Core Tier 1 to Tier 1 ratios for the other banks, is that Core Tier 1 is probably EUR 0.11 bln, giving it a Core Tier 1 ratio of 8.3% [see updated article below]


The impact of a 50% haircut

With this data, we can examine what the impact would be of a 50% haircut of Greek debt. Here we assume that brotherly love means that Cypriot banks, despite their smaller size, would not be hit any harder than, say, German banks, so that the 50% haircut is evenly spread across the eurozone.

If a bank suddenly faces a default on its loans, it has to raise provisions. Provisions have an impact on the profit and loss account, which in turn have an impact on Tier 1 capital. Therefore a 50% haircut would have a direct impact on Tier 1. We are also assuming for the purposes of this survey that it would have an immediate impact on Core Tier 1, although we have not confirmed if this is the case.

If 50% of the EUR 2 bln in Bank of Cyprus loans to the Greek government suddenly disappeared, this would reduce its Core Tier 1 to EUR 1.1 bln, bringing its Core Tier 1 ratio down from 8.1% to 4.3%. Under these circumstances, it would remain within the Basel II rules but would not pass the new EU-wide test. On the other hand, if the haircut were only 40%, it would pass the test with a Core Tier 1 ratio of exactly 5.0%.

If 50% of the Marfin Laiki loans to the Greek government defaulted, its Core Tier 1 ratio would drop from 9.3% to an estimated 4.3%. It would keep within Basel II but it would fail the test based on our own estimate for total risk weighted assets (EUR 27.4 bln). On the other hand, if the haircut were 40%, it would come close to passing the EBA test. And given that we have estimated the weighted assets, it is probably within the margin of error.

Finally if 50% of the Hellenic loans to the Greek government disappeared, its Core Tier 1 would drop from our estimated 8.3% to an estimated 4.4%. Again, it would remain the right side of Basel II but would not pass the EBA test [see update below]. As with the other two banks, it would pass if the haircut were only 40%.


Probably scope for more capital issues

We can conclude from this analysis that all three banks would remain on the right side of Basel II rules even with a 50% haircut but would fail the more stringent EBA test. Only in the case of a 40% haircut would they pass an EBA test.

However, a Greek government default would no doubt create distress in the Greek real sector and have an impact on other lending to Greece. Moreover, Basel II will soon be replaced by Basel III, which is likely to raise the ratios by as much as 2.5 percentage points.

For this reason, we can expect the banks to continue shoring up their capital for some time to come.


UPDATE 15 April 2011:

EU-wide stress tests: update based on new data

Hellenic Bank passes with flying colours

Last Wednesday we published the results of our own basic stress test devised by Sapienta Economics in conjunction with the Financial Mirror for the three main Cypriot banks, using baseline assumptions of a 50% and 40% haircut on Greek sovereign debt. Our pass/fail threshold was the Core Tier 1 ratio remaining at or above 5% (compared with the Basel II requirement of 4%).

At the time, we only had to access the preliminary financial statements of Hellenic Bank, which had less complete data than the (Greek) Audited Financial Statement, which we have now seen.

The Audited Financial Statement gives a figure for risk weighted assets (EUR 5.4 bln) and also enough data on capital to make a better estimate for Core Tier 1. Inferring from Tier 1 loan capital, we can confidently say that Hellenic’s Core Tier 1 is around EUR 0.5 bln, which would yield a Core Tier 1 ratio of around 9%.

Hellenic has lent only EUR 110 mln to the Greek government. Therefore, a 50% haircut of Greek sovereign debt would reduce Hellenic’s Core Tier 1 capital by only one percentage point to 8%, while a 40% haircut would reduce it to 8.3%.In other words, Hellenic Bank passes our test with flying colours under both scenarios.

The EU-wide stress tests will be more complex than the one we used, taking into account the maturity of the loans, bank  profitability and a range of risks over a two-year period. All European banks are currently under a gagging order by their regulators, who have asked them not to disclose sensitive information before the stress tests have been completed.