Sigrún Davíðsdóttir's Icelog

The Memorandum of Understanding for Cyprus seems to indicate that restructuring of banks (though possibly only a timid one) should precede any financial aid to them. If this is the case, the Cyprus bailout will be a changing course in the story European bailouts.

With every Eurozone bailout, some new lessons are learnt – but so far, not the only sensible lesson: letting banks fail if needed, aggressively writing down debt and restructuring. That is a pie in the sky for European taxpayers, until the planned banking union, with not only a banking supervision but also a unified resolution structure will come into being. Until that rosy future dawns, banks are bailed out, bondholders and the official sector paid – though, as Greece shows, not always in full now.

But the Cyprus Memorandum of Understanding, the basis of its bailout, indicates that for the first time, restructuring failing banks might be a prerequisite for the bailout. If that is the case, the Cyprus bailout might help the EU turning a page – though the MoU raises the question if the restructuring is tough enough.

How much does Cyprus need?

How much is needed from the troika this time? The first numbers I heard floated earlier this year from a Cypriot source was something like €5-6bn to recapitalise the banks and slightly less for the sovereign, in total around €11bn. The number now mentioned is €17bn. Pimco, having been called in to do an independent estimate of the need, landed on €9.1-9.6bn – while others think it’s too low and €13bn would be more likely.

Much was made of the impact of the Greek writedown in March on Cypriot banks. No doubt, the effect was a serious one but the Greek writedown was only the last straw, not the real reason for the Cypriot failure. Already in the latest available IMF report, from 2011, on Cyprus there were ominous indications (emphasis mine):

The large banking sector, with assets totaling over 8 times GDP by the broadest measure, and with significant exposure to Greece, is a significant vulnerability. Banks face significant capital needs to reflect mark to market valuations on their sovereign bond holdings and to achieve a
9 percent core tier one capital ratio, as mandated by the European Banking Authority. Non-performing loans are increasing, and further loan deterioration could add to recapitalization needs. Meanwhile, the system is also vulnerable to an outflow of deposits in the event of adverse circumstances. Cypriot banks receive significant liquidity support from the European Central Bank.

With all these significant issues further to the significant numbers:

A large banking system with heavy exposure to Greece is a major vulnerability of the Cypriot economy. Bank assets total €152 billion (835 percent of GDP), while assets of commercial banks with Cypriot parents are €92 billion (500 percent of GDP). Exposure of these banks to Greece totals €29 billion, or 160 percent of GDP, including both Greek government bonds and loans to Greek residents. They also hold €1.6 billion of Cypriot government bonds but minimal amounts of sovereign debt of other peripheral euro area countries.

And as to the Greek writedown being the lethal hit to the Cypriot banks the IMF 2011 report puts that in perspective:

Commercial banks with Cypriot parents hold €92 billion (505 percent of GDP) in assets, dominated by three large banks (Bank of Cyprus, Marfin Popular Bank, and Hellenic Bank) which together account for 97 percent of total assets of this group. They have large foreign operations through branches and subsidiaries, primarily through the Marfin and Bank of Cyprus branches in Greece. They hold €23 billion (130 percent of GDP) in loans to Greek residents and €5 billion of Greek government bonds.

Did a 50% writedown of nominal value of €5bn in total assets of €152bn cause the collapse of the Cypriot banking system? Hardly. It was, as the 2011 IMF report shows, already a system about to collapse.

To say that loans are now being negotiated with the troika makes it seem as if Cyprus is still functioning on its own. That is not the case. As the IMF report mentions already last year Cypriot banks were receiving significant support from the ECB. Last May, FT Alphaville wrote on the ECB Emergency Liquidity Assistance Cypriot banks were making use of, gauging the banks had already had €3.8bn shot, which might well be an underestimate since this had probably been going on for a good part of 2011.

Restructuring – or tinkering?

Ever since it became clear that the troika aid to Ireland was a poisonous chalice – it saved Ireland from bankruptcy there and then but burdened the sovereign with private debt – the challenge has been how to avoid this debt migration from the private to the public sector. As is always the case under these circumstances, there are only two options for Cyprus: restructuring – or to borrow to pay its creditors in full.

During the Trichet aera at the ECB the word “restructuring” was unmentionable within the bank.

Cypriot media has published the Memorandum of Understanding between the troika and Cyprus (or at least a draft of it; in a Word version, fresh with “track changes”). Interestingly, key programme objective number 1 is:

to restore the soundness of the Cypriot banking sector by thoroughly restructuring, resolving and downsizing financial institutions, strengthening of supervision, addressing expected capital shortfall and improving liquidity management;

At least the word “restructuring” is now part of the bailout vocabulary.

Then there is this paragraph:

With the goal of minimising the cost to tax payers, bank shareholders and junior debt holders will take losses before state-aid measures are granted. Before any state recapitalisation is granted, the Central Bank of Cyprus will require a conversion of any outstanding junior debt instruments into equity for the purpose of protecting the public interest in financial stability, including by implementing voluntary or, if necessary, mandatory subordinated liability exercises (SLE). In order to facilitate a voluntary SLE, a small premium can be offered in line with state aid rules. To this end, the necessary legislation will be introduced no later than [January 2013]. The Central Bank of Cyprus together with the EC, the ECB and the IMF will monitor any operation converting junior debt instruments into equity.

As far as I understand the EU is not entirely against restructuring. But so far, the ECB cannot bring itself to go further than to junior debt – which is pretty useless in terms of solving the problem once and for all and not in painful steps over many years, à la Greece.

However, compared to the Greek MoU from February, there is a significant change in the Cyprus MoU: in Cyprus, it seems that restructuring will – or should – precede any financial assistance. In the Greek one, this was not the case. How this Cypriot restructuring will be carried out is a key thing. If it is just junior debt and not something more forceful this will be a tinkering and not the really necessary cleaning up, so lacking i.a. in Ireland.

Bailing out Cyprus – (in)directly helping the Russian Mafia?

Cyprus poses a particular problem: it is awash with Russian money. The historic ties go back before the collapse of the Soviet Union, strengthened by the Orthodox church. Later, Cyprus was the predilected offshore haven for Russian oligarchs and they actually followed the money. Limassol has the nickname Limassolgrad for a reason.

According to Spiegel, the German secret service, Bundesnachrichtendienst, BND, has warned that financial assistance to Cyprus amounts to assisting the Russian Mafia. A bailout for Cyprus is bound to raise not just the usual questions of why and how and who is paying more than others – but also how it will affect the shadowy side of the Cypriot banking system.

A year ago Cyprus got a loan of €2.5bn from Russia. This autumn, it hoped to negotiate another €5bn but the loan never materialized. The existing loan apparently has a tenor of 4 ½ years, meaning it would most likely come due during the time Cyprus is under the troika’s intensive care. The troika has to ask itself how it feels about paying back the Russian loan.

Cyprus is not only a haven for Russians. The island has all the attributes of an offshore haven, including a huge flow of money of uncertain origin. It is an international finance centre, allegedly with 40.000 companies registered on the island. Active companies pay a levy of €350 but dormant companies don’t pay anything. One of the possible revenue streams now under preparation is to let all companies, active or not, pay the levy.

My feeling has been that Cyprus was mini-Greece, i.e. unclear as to the real size of the problem though with much lower numbers in a much smaller economy. My Cypriot source tells my I’m completely wrong – 17bn is the max number sought but most likely the island will use €15bn. I am not entirely convinced, given the huge and fast-growing, ballooning banks – I’ve seen too much of the Icelandic banks – not to mention the offshore environment. Qui vivra verra.

*For those who want to see an overview of the structure of the Cypriot banking system, i.e. types of banks and business areas, with thought-provoking numbers, take a look at the very informative Box 4 in the IMF 2011 report (ah, where would we be without the deliciously juicy IMF reports… and, since I’m mentioning names, enticing Eurostat data)

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