Speech by Panicos Demetriades, Governor of the Central Bank of Cyprus, at the 3rd Luncheon Event in 2012, Association of International Banks Cyprus
Nicosia, 22 October 2012
Ladies and gentlemen,
I would first like to thank the Association of International Banks for the invitation to address the international banking community of Cyprus. Today I will take advantage of this opportunity to discuss broadly the role of the banking sector in economic growth and, more specifically, the reforms necessary to create a more stable and competitive banking system at the European level and in Cyprus.
The banking sector is an integral part of the broader financial system and constitutes a key provider of finance to business. A well functioning banking system facilitates the exchange of goods and services provides incentives for savings and efficiently channels them to productive investments. As such it supports and promotes a more efficient allocation of resources in the economy. In general, a healthy, robust and stable banking sector plays a crucial role in supporting economic activity, promoting economic growth and ensuring financial stability.
It is interesting to note that, although financial markets now play an enhanced role, the process of saving and investment still remains largely in the hands of the banking system, thus giving it one of the most important roles in an economy.
The relationship between banks and economic growth has been one of the most popular topics in financial economics over the past two decades at least. It is also a subject which I began researching as an academic from the early years of my academic career.
Regardless of whether the financial system drives or simply follows economic growth, most of the academic literature on this subject confirms the existence of a positive relationship between these two. That is to say, greater financial development is associated with higher long-run economic growth (Rousseau and Wachtel, 2011).
The literature also suggests that when the financial system is sick so is the rest of the economy. For example, when bank balance sheets are heavily burdened with non-performing loans banks may not be able to provide new loans to companies, even to those that have good investment opportunities. Lack of finance, of course, reduces investment and economic activity and, ultimately, economic growth. In the extreme, a credit crunch impacts adversely even on trade finance and can grind all economic activity to a halt.
More broadly, it is now widely accepted that a fragile financial system can impair long-run growth. Recent research, for example, shows that the combination of lax prudential regulation and supervision with inadequate corporate governance practices in banks can have disastrous consequences for the rest of the economy (Andrianova et al., 2012). It has also been found that the combination of imperfect information with loose supervision and/or regulation and weak corporate governance may be lethal, as it frequently leads to bank "looting" (for example through connected lending, dubious or reckless investments and other forms of extraction).
With the experiences we have had recently, especially after the financial crisis that erupted in the US in 2007 and spread to other developed countries, it is apparent that economic growth is not linked in a simple fashion to the size of the financial system, but more likely to the quality of prudential regulation and supervision. Recent studies have shown that when the financial system is under strict supervision, the growth rate can be up to 2% higher per year compared with a regime of lax supervision (Demetriades and Rousseau, 2011a). It has also been observed that the quality of supervision determines whether financial reforms increase or reduce real economic growth. For example, measures that lead to increased competition in the banking system – which, at first sight, may sound appropriate – can actually lead to a fall in the growth rate of up to 0,4% per year when banking supervision is weak (Demetriades and Rousseau, 2011b). This is not surprising: as greater competition drives up deposit rates the role of supervision in preventing excessive risk taking by banks becomes more important. When supervision is weak, more competition can lead to reckless risk taking (casino banking).
EU banking sector reforms
Vickers and Liikanen
The recent global financial crisis and the lessons learned have been the subject of serious debate in many countries and have led to the establishment of special committees to review the facts and events, draw conclusions and issue policy recommendations to competent authorities with a view to enhancing the stability and resilience of the financial system. For example, in the UK, the final report of the Independent Commission on Banking (Independent Commission on Banking, 2011) led by Professor Sir John Vickers, aimed at recommending reforms that would create a more stable and competitive banking system, which could cope with future financial crises without transferring risks from banks to public finances.
The Vickers report argues that the right policy approach for banking stability requires greater capital and other loss-absorbing capacity as well as structural reform. As regards loss absorbency, the report highlights that it is inappropriate for the taxpayer to bear the risks associated with the banking system. Neither do ordinary depositors have the incentive (given deposit insurance to guard against runs) nor do they normally have the ability to monitor those risks. For the future then, the risk should be borne by the owners of the bank whose debt must be capable of absorbing losses on failure. Any government intervention, if still needed, should involve resolution, not financial rescue.
With respect to structural reform, the most important recommendation of the report is the need to ring-fence retail banking activities from wholesale/investment operations. The current unstructured combination of the two sets of activities gives rise to public policy concerns, which their separation seeks to address. First, structural separation should make it easier and less costly to resolve banks that get into trouble. Second, separation should help insulate retail banking from external financial shocks, including by diminishing problems arising from global interconnectedness. Third, separation would help make the banking system more resilient. Moreover, separation accompanied by appropriate transparency should assist the monitoring of banking activities by both market participants and the authorities.
In its final report published in October of this year, the High-level Expert Group on reforming the structure of the EU banking sector (High-level Expert Group on reforming the structure of the EU banking sector, 2012), established by the Commission and chaired by Bank of Finland Governor Erkki Liikanen, has also made several proposals with the objective of establishing a stable and efficient EU banking system serving the needs of citizens, the economy and the internal market.
First, proprietary trading and other significant trading activities should be assigned to a separate legal entity if the activities to be separated amount to a significant share of a bank's business. This would ensure that trading activities beyond an acceptable threshold are carried out on a stand-alone basis and separate from the deposit bank.
Second, the Group emphasises the need for banks to draw up and maintain effective and realistic recovery and resolution plans, as set out in the Commission's recent proposals for bank recovery and resolution.
Third, the Group strongly supports the use of designated bail-in instruments. Banks should build up a sufficiently large layer of "bail-inable" debt that should be clearly defined, so that its position within the hierarchy of debt commitments in a bank's balance sheet is clear and investors understand the eventual treatment in case of resolution. Such debt should be held outside the banking system.
Fourth, the Group proposes to apply more robust risk weights in the determination of minimum capital standards and more consistent treatment of risk in internal models. Also, the treatment of real estate lending within the capital requirements framework should be reconsidered, and maximum loan-to-value (and/or loan-to-income) ratios included in the instruments available for micro- and macro-prudential supervision.
Finally, the Group considers that it is necessary to augment existing corporate governance reforms by specific measures to strengthen boards and management, promote the risk management function, rein in compensation for bank management and staff, improve risk disclosure and strengthen sanctioning powers.
Bank recovery and resolution
The financial crisis has shown that public authorities are ill-equipped to deal with ailing banks operating in today's global markets. In particular, in the EU, the need has been highlighted for more robust crisis management arrangements at the national level and for mechanisms better able to cater for cross-border banking failures. During the crisis there were several high profile failures of EU banks (e.g. Fortis, Anglo Irish Bank, Dexia), which have revealed serious shortcomings in the existing arrangements. In the absence of mechanisms to organise an orderly wind down, member states had no choice other than to bail out their banking sector.
In order to maintain essential financial services for private individuals and businesses, governments were forced to inject public money into banks and issue guarantees on an unprecedented scale. Specifically, from October 2008 until October 2011, the European Commission approved €4,5 trillion (equivalent to 37% of EU GDP) of state aid measures to financial institutions. This averted massive banking failures and economic disruption, but burdened taxpayers with deteriorating public finances and failed to resolve the issue of how to deal with large cross-border banks facing financial difficulties.
In light of the above, in June of this year the European Commission adopted proposals for EU-wide rules for bank recovery and resolution (European Commission, 2012b) which ensure that in the future authorities will have the means to intervene decisively both before problems occur and early on in the process if they do. Furthermore, if the financial situation of a bank deteriorates beyond repair, the proposal ensures that a bank's critical functions can be rescued while the costs of restructuring and resolving failing banks fall upon the bank's owners and creditors and not on taxpayers. To be effective, the resolution tools will require a certain amount of funding. If market funding is not available and in order to avoid resolution actions from being funded by the state, supplementary funding will be provided by resolution funds, which will raise contributions from banks proportionate to their liabilities and risk profiles. The funds will be used exclusively for supporting orderly reorganisation and resolution, and never to bail out a bank.
European banking union
A European banking union is envisaged to be one of the main drivers towards strengthening the Economic and Monetary Union (EMU) and fostering deeper financial integration. It will also help break the link between sovereigns and banks. In the future, bank losses should no longer become the taxpayers' debt, putting into doubt the financial stability of whole countries.
The banking union rests on the completion of the single rulebook, i.e. a single set of rules to impose more uniform supervision of banks across the whole EU. Such a union should have three crucial elements: a single supervisory mechanism (SSM), a common resolution framework and a unified deposit guarantee scheme. The Commission proposals for a SSM for banks in the euro area published in June of this year (European Commission, 2012a) are an important first step in creating a banking union that will help restore confidence in the supervision of all banks in the euro area, while reinforced supervision within the new system will help improve the robustness of banks. If a crisis does occur it is necessary to ensure that institutions can be resolved in an orderly manner and that depositors are assured their savings are safe. Against this background, a banking union should also include a more centralised management of banking crises. Therefore, a single resolution mechanism, which would govern the resolution of banks and coordinate the application of resolution tools to banks within the banking union, is needed. In addition, a unified deposit insurance scheme should also be established.
Reforming the Cyprus banking sector
Let me now focus on the challenges facing the Cyprus banking sector, and explain why, although these are serious, I remain confident that we will be able to overcome them in the near future. In fact, although history teaches us that every crisis is different one general lesson that can be drawn is that a crisis is normally a rare opportunity to fix long-standing problems.
As is well known, the two largest Cypriot banks have requested state aid, partly due to the capital shortfalls emanating directly from the losses incurred on their sovereign debt holdings as a result of the Greek PSI. In addition, the quality of both banks’ assets has been adversely affected by their substantial exposure to the Greek economy and, to a lesser extent, by deteriorating domestic economic conditions. This is reflected in rising non-performing loans and the need for increased provisions, thus putting additional pressure on bank profitability. It should be noted, however, that both banks have recently shown a more determined effort to clean up their balance sheets through a sharp rise in provisions and to contain their operating expenses.
The Central Bank of Cyprus (CBC), in its banking supervisory role, is taking important steps to strengthen corporate governance and risk management within both banks. The two banks now have new leaderships with whom we are working very closely in order to ensure that they emerge stronger from the current crisis.
We have also appointed a leading international company to carry out an independent investigation into the circumstances that led to the two banks applying for state aid. This inquiry will provide clarity and comprehension regarding the current financial stress in the country and will guide remediation to strengthen the stability of the banking sector.
The Government’s application for financial support from the EFSF/ESM was triggered by the need to recapitalise the banking system. This, of course, also provides an opportunity to restructure and reform the banking sector, and I can assure you that every effort will made in this direction. The aim is to restore confidence in the system and enhance financial stability.
It is imperative, for example, to seek to strengthen corporate governance as well as risk management practices within banks. Moreover, we need our banks to focus on core business, which may involve, among other things, withdrawing from some retail operations overseas, while at the same time improving the domestic services offered to their international clients on the island. We want the Cyprus banking sector to become healthier, more resilient and more competitive. I can assure you that the reforms that are currently taking place or are in the pipeline all aim towards achieving this objective.
In addition, the supervisory framework should be enhanced and steps are already being taken in this direction by the CBC, not least based on the lessons learned from the crisis. Much more emphasis should also be placed on the macro-prudential aspect of supervision to identify, monitor and assess risks to financial stability and implement policies to strengthen the resilience of the financial system and decrease the build-up of systemic risk.
We also need to tighten supervision not only of banks but also of cooperative credit institutions (CCIs). It is true that, unlike commercial banks, CCIs, with their own business practices focusing on the domestic economy, enhance diversity in the financial system and thus help to strengthen its resilience. Examples of other countries such as the Netherlands (Rabobank) and the UK (Building Societies) reinforce this finding. There is, however, a need to continuously improve the effectiveness of the supervision of the cooperative credit sector, in line with efforts to strengthen the supervision of commercial banks. In this regard, in order to satisfy the need for institutional reform with respect to the supervision of CCIs, alternative models need to be considered for adoption that might involve the CBC as the ultimate supervisory authority but at the same time provide some degree of relative autonomy for the cooperative credit movement. Perhaps the Dutch model, in which the central bank is responsible for the exercise of supervision of the Rabobank Group on a consolidated basis, could provide a good example of how to restructure the supervision of CCIs in Cyprus.
In the next few years I also expect to see shrinkage in the overall size of the Cyprus banking sector relative to GDP, while at the same time a leaner and more competitive banking system emerges. The market is expected to have new entrants as well as room for both large and small players, and for different types of ownership, i.e. domestic, foreign, shareholder-based or mutual. Such diversity in any system is a source of resilience. Moreover, more competition will result in lower cost of capital for non-financial corporations, which will help stimulate private investment and growth. The CBC’s aim is to end up with a healthy, resilient, stable and competitive banking sector that can underpin sustainable economic growth.
I would like now to clarify two inter-related issues regarding Cyprus’s participation in the EFSF/ESM programme that I consider particularly important, namely (a) the extent to which capital ratios in banks should be restored and (b) the sustainability of public debt.
Some, including the ratings agencies, have suggested that, as a result of the EFSF loan, Cyprus’s public debt may rise to levels that raise concerns about its sustainability. Others have suggested we should not capitalise banks fully in order to alley such concerns. Both views are not well founded. Let me explain why.
First, strengthening the capital position of banks by increasing their capital levels should be seen as the best way to restore confidence in the banking sector and hence create the foundation for future economic growth. In my opinion, the sooner we proceed with bank recapitalisation and raising capital ratios to the levels that apply internationally the better chance we stand to fix banking problems in a timely and effective manner, boost confidence and make a fresh start going forward.
Second, despite their gradual deterioration, the public finances of Cyprus are still in better shape than in a number of other EU member states. Specifically, the government debt to GDP ratio in Cyprus amounted to 74,6% in the first quarter of 2012 compared with 88,2% in the euro area. The aforementioned ratio in Cyprus is lower than that in Greece, Ireland and Portugal (132,4%, 108,5% and 111,7%, respectively), marginally higher than in Spain (72,1%) and even lower than the ratio in some of the strongest EU economies, such as Germany (81,6%) and France (89,2%). Similarly, the government deficit to GDP ratio in Cyprus stood at 6,3% in 2011, compared with 4,1% in the euro area, but this lower than the ratio in Greece, Ireland and Spain (9,1%, 13,1% and 8,5%, respectively).
Those who claim that public debt may become unsustainable have, of course, added to the current figures an amount of 60% of GDP or so, representing the new EFSF loan.
Even if this number is the true figure – and we have no way of knowing until the Pimco exercise is completed - there are at least three reasons why in my mind public debt will remain sustainable, even after adding a new loan amounting to 60% of GDP, all of which emanate from the observation that the loan is primarily intended to recapitalise the banking system.
1. Direct recapitalisation of Cyprus banks from the ESM will be possible when this facility becomes available. This will happen when the Single Supervisory Mechanism is in place, which may be as late as 1 January 2014. That, however, does not prevent replacing part of the EFSF loan with a direct capital injection into the banks from the ESM. Such an act can easily reduce the public debt to a level below 100% of GDP, alleviating if not removing altogether concerns about debt sustainability. There is good reason why this should happen. First and foremost, Cyprus should not be treated less favourably than other countries. Second, financial stability is not only a domestic public good for Cyprus but also, most importantly, a European public good. Cypriot banks operate in a number of other EU member states (e.g. Greece, UK, Romania, Malta), with particularly strong presence in the Greek market. Specifically, around 34% and 47% of the operations of the two largest Cypriot banks, respectively, that have requested state aid are in Greece. The Cyprus banking sector has indeed suffered from contagion from Greece, especially with regard to the heavy losses imposed by the Greek PSI, which cost banks an amount equivalent to around 25% of Cyprus’s GDP. It should be remembered that the Cyprus government provided its agreement on the Greek PSI in order to assist our fellow member state Greece and our EU partners in the spirit of solidarity. Domestic banks have also been adversely affected as a result of the significant asset quality deterioration of the banks’ Greek loan portfolio and, therefore, recapitalisation will need to cover for the losses arising from the banks’ Greek operations too. Thus, by Cypriot banks receiving capital support directly from the ESM, not only is the stability of the domestic financial system safeguarded but financial stability in the EU is enhanced as well.
2. The privatisation of banks that have been bailed out could be feasible within a horizon of three years. In effect, public funds injected in banks that got into trouble will not be wasted but rather, under the right conditions, the government could make a return on such an investment. For example, to date, US taxpayers have recovered almost $266 billion from the Treasury’s TARP bank programs through repayments, dividends, interest and other income, approximately $21 billion more than the $245 billion invested in banks (US Department of the Treasury, 2012). The role of the CBC in this endeavour is to seek to restructure banks that have received public support by improving management and ensuring proper corporate governance in order to facilitate the selling of the banks at an appropriate time with a view of maximising return on the investment.
3. The existence of large natural gas reserves in the Cyprus Exclusive Economic Zone is an important new development which is expected to substantially enhance public finances, as well as increasing GDP and the ability of the government to service its debt. In particular, the exploitation of natural gas requires the construction of pipelines from the reserves, liquefaction facilities, expansion of ports, an internal network and infrastructure for transportation and distribution, etc. These projects are multi-billion Euro investments in the fields of construction, energy, infrastructure and technology that can lead to an upward economic cycle with significant multiplier effects on the country’s GDP and tax revenues. In this new future development, the Cyprus banking sector has of course an important role to play since it will be asked to finance many of the necessary investments. This could inevitably lead to a quicker recovery for the country’s banking institutions.
There is an additional, very important, reason that makes me confident about the future of the Cyprus banking sector and the economy as a whole. Recent decisions and actions at the EU level with the aim of tackling the crisis demonstrate strong eagerness on behalf of the EU leaders and institutions and are reinforcing our efforts to overhaul the domestic banking system. Recent examples of policies aimed at enhancing financial and economic stability include the bank recovery and resolution as well as the single supervisory mechanism proposals on behalf of the Commission, while at the ECB level we had the enhancement of collateral requirements and the new Outright Market Transactions (OMT) programme. The significant progress made in creating a banking union in the EU is particularly important for countries like Cyprus with large banking systems relative to the size of the economy since it will help decouple sovereign risk from banking risk.
In conclusion, I have no doubt that, with appropriate policies and with the help of our European partners, the Cyprus banking sector and the economy as a whole will recover and will emerge stronger from the current crisis. The EFSF/ESM programme should be regarded as a catalyst that will reinforce macroeconomic and financial stability in Cyprus. In my capacity as Governor of the CBC, I will do my best to promote the conditions for a healthier, more resilient and more competitive domestic banking system that can help spur sustainable economic growth and employment creation.
Andrianova, S., P. Demetriades, A. Shortland (2012) "Government ownership of banks, institutions and economic growth", Economica, 79: 449-469.
Demetriades, P. and P. L. Rousseau (2011a) "Government, openness and finance: past and present", The Manchester School, Supplement 2: 98-115.
Demetriades, P. and P. L. Rousseau (2011b) "The changing face of financial development", paper presented at the MMF Conference, University of Birmingham.
European Commission (2012a) Proposal for a Council Regulation conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions, September.
European Commission (2012b) Proposal for a Directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directives 77/91/EEC and 82/891/EC, Directives 2001/24/EC, 2002/47/EC, 2004/25/EC,2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No 1093/2010, June.
High-level Expert Group on Reforming the Structure of the EU Banking Sector (2012) Final Report, October.
Independent Commission in Banking (2011) Final Report: Recommendations, September.
Rousseau, P. L. and P. Wachtel (2011) "What is happening to the impact of financial deepening on economic growth?", Economic Inquiry, 49(1): 276-288.
US Department of the Treasury (2012) Troubled Asset Relief Program (TARP): Monthly Report to Congress – July 2012, 10 August.