15 Jan 2017 Bank of Cyprus and the long road back

Next week Bank of Cyprus (BoC) will start trading on the London Stock Exchange. This follows an announcement last week that it had fully repaid all Emergency Liquidity Assistance (ELA) to the Central Bank of Cyprus.

ELA, as its name implies, is the last resort for a bank. When a bank has lent out more than it has on deposit, which is often the case in modern banking, it normally fills the gap with interbank lending. When other banks lose faith in you, your next recourse as a eurozone bank is the European Central Bank (ECB).

But the conditions are tough, and the worse your situation gets, the less likely you will be to qualify for ECB lending.

The final recourse is your national central bank. And if you can’t pay the national central bank back, then the debt ends up “with the sovereign”.

In other words, it ends up as the debt of the government, which ultimately has to be repaid by the taxpayer.

BoC’s repayment of ELA is a remarkable achievement. As part of the bailout (and bail-in) deal in March 2013, BoC was forced to absorb more than €9bn in ELA, built up by another bank, the now-defunct Laiki, under circumstances that remain contentious to this day.

Inferring from Central Bank of Cyprus data, Laiki’s ELA leapt from €650,000 in September 2011 to €2.7bn in October 2011. ELA was allowed to carry on climbing on the basis that Laiki would eventually be solvent when the bailout came.

But by the time the bailout came, it certainly was not solvent and had not been for quite some time.


A precarious few months

Thanks to the general run on deposits as the situation at Laiki worsened, BoC already had more than €2bn of its own ELA by March 2013, which meant that it was suddenly saddled with a €11.4bn debt to the Central Bank of Cyprus.

At the time I thought this ran a high risk of finishing off the bank. Certainly the dumping of ELA on BoC put it in a very tricky position for the first few months. This is because, in order to receive ELA, banks must put up assets (loans) as collateral.

But a large chunk of the loans which Laiki had used as collateral had disappeared overnight with the fire-sale of the Greek branches.

While there were no official figures on how much of Laiki’s ELA was created by the funding gap in the Greek branches, I inferred at the time from financial statements that it must have been around €4.5bn. BoC therefore had to find collateral for this amount from its own resources.
Moreover, other loans which BoC might have been able to use as collateral were rapidly turning sour. This meant that for every €1bn in ELA, the Central Bank would have to demand even more collateral.

I estimated that BoC would have had to put up at least 40% of its assets at the time in order to receive €11bn in ELA. After the Laiki fiasco, the ECB was also more cautious about allowing the Centtal Bank of Cyprus to pump more ELA to BoC.

We know that the situation was pretty precarious because of a letter sent by the president, Nicos Anastasiades, to the troika of international lenders in June 2013, complaining that an earlier letter about ELA from the finance minister, Harris Georgiades, had gone unanswered.

Despite a rather terse reply from the Eurogroup president, Jeroen Dijsselbloem, one can infer from historical data that BoC was shunted another €100m ELA in July.

This was probably enough to keep it going until the decision on the haircut percentage was announced at the end of the same month. The final haircut on deposits over €100,000 was 47.5% – lower than the expected 60%. This would also have helped BoC’s liquidity position.
From then on, ELA started to fall, dropping by €1.2bn alone in August 2013. The next significant drop came in September 2014, when ELA fell by more than €1bn immediately after BoC raised €1bn in new capital from the private sector.

As deposits started to return, ELA continued dropping, until it was all paid off at the beginning of this month.


The bad loan problem

At the same time as dealing with a difficult liquidity problem, BoC, like other banks in Cyprus, also had to deal with a mounting non-performing loan (NPLs) problem.

Loans past due for more than 90 days (NPLs on a 90+ DPD basis) soared from 17% at the end of 2011 to 47% by September 2013.

Moreover, thanks to long delays by opposition members of parliament (MP), banks had to wait until the final quarter of 2015 before a legal framework for tackling bad loans was put in place. BoC’s NPL ratio carried on rising, therefore, peaking at 53.2% in December 2014.

Since the legislation was passed, the ratio has started to drop, reaching 42.6% in September 2016, according to the latest data. The performance is more impressive when looked at in absolute terms.

NPLs on a 90+ DPD basis have fallen by around one-third, from €13bn in December 2013 to €8.8bn in September 2016.

The reason this does not make a huge difference to the ratios is because total loans also fall as bad loans are repaid.

While BoC’s liquidity problems are behind it, and it is currently well capitalised with a common equity core Tier 1 ratio of 14.6%, it still has a long way to go to record decent net profits.

At the moment, it has to divert most of its operating profits to raising provisions against bad loans. Moreover, it is hard to second-guess what the eurozone authorities will demand next in terms of provisions.

But once the provisioning is over, operating profits suggest it should be making in the region of €500m to €600m per year.