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«Cyprus Economic Policy Review, Vol. 5, No. 1, pp. 3-21 (2011) 1450-4561 Big Banks In Small Countries: The Case Of Cyprus† Constantinos Stephanou∗ ...»

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Cyprus Economic Policy Review, Vol. 5, No. 1, pp. 3-21 (2011) 1450-4561

Big Banks In Small Countries: The Case Of Cyprus†

Constantinos Stephanou∗

World Bank

Abstract

A large banking system has served Cyprus well to date. It has supported the

country’s outward-oriented, services-driven economic model and has significantly

contributed to output and employment. The question going forward is whether

banking system growth can continue indefinitely and at what cost. This paper

argues that systemic risks are important for Cyprus given its banking system size and structure - in particular, the presence of big domestically-owned banks. It recommends that the authorities take a more macroprudential approach to financial sector oversight, that they engage in an immediate and significant fiscal consolidation effort, and that they introduce a set of prudential measures for systemically important banks that are customized to the needs of Cyprus.

Keywords: financial stability, systemic risk, banking, Cyprus, financial system, systemically important financial institutions, too big to fail.

1. Introduction The objective of this paper is to review the systemic risks from the presence of big banks in small countries and to identify policy measures to address them, using Cyprus as an example. This topic has acquired prominence recently as a result of the global financial crisis and its impact on banking systems worldwide. Although Cyprus has not been as affected by the crisis as some other European Union (EU) member states, the crisis has provided useful country experiences and policy lessons about the vulnerabilities from having a large banking system in general and big domestic banks in particular.

† Prepared by Constantinos Stephanou, Senior Financial Economist at the World Bank, and currently on secondment at the Financial Stability Board.

Email:(cstephanou@worldbank.org).

∗ The author would like to thank Charis Charalambous, Marios Clerides, Nigel Jenkinson, Zenon Kontolemis, Michael Sarris, Nicos Stephanou, George Syrichas, Martin Vasquez Suarez, Dimitri Vittas and an anonymous referee for their useful comments and suggestions. The views expressed in this paper are solely those of the author.

The paper is not intended to capture all aspects of this topic or to undertake an in-depth analysis of Cyprus’ specific context. The topic is multi-faceted and particularly complex since it involves important policy trade-offs, especially for countries (such as Cyprus) that are heavily reliant on international business services (including finance) as an engine of growth. However, the paper does raise some key issues and provides leads for future research and analysis on this topic.

The paper is structured as follows:

• Section 2 compares the size and structure of Cyprus’ banking system to a peer group drawn from EU member states;

• Section 3 describes the systemic risks from having big banks, drawing on the experience of selected countries during the crisis;

• Section 4 outlines policy measures that can mitigate these risks and relevant initiatives at national and international levels;

• Section 5 derives policy implications for Cyprus; and

• Section 6 summarizes the main findings and recommendations.

2. Banking system size and structure

Cyprus has a large banking system compared to its economy (total assets of 896% of Gross Domestic Product or GDP in 2010), relative to the average for the EU and the Eurozone (357% and 334% respectively in 2009). Even if one excludes the overseas operations of domestically-owned banks, the size of the banking system is still large and exceeds 7 times GDP.

However, Cyprus is not unique in that respect: several other EU countries have similar or even larger banking systems (Graph 1). For example, Luxembourg’s banking system is more than 21 times its GDP, while Ireland’s and Malta’s systems are similar in size to Cyprus. These systems grew significantly over the past decade (Graph 2) as a result of an accommodating global environment and policy measures by national authorities to promote them as international financial centers. It is only recently that financial crisis-induced deleveraging of internationally active banks and slowdown in cross-border capital flows have halted that trend.

Two factors distinguish Cyprus from some other countries with large banking systems. First, domestically-owned credit institutions - in the form of both cooperatives and commercial banks - play an important role, accounting for 63% of total banking system assets in 2009. The subsidiaries of foreign - mostly Greek - banks have also expanded rapidly in recent years (one-third of total assets in 2009), particularly following the entry of

–  –  –

Source: ECB (October 2006 and September 2010).

Note: These figures include the overseas assets of domestically-owned banks. The size of Luxembourg’s banking system has remained above 20 times GDP over this period, and it is not shown here in order to more clearly illustrate the evolution of size in other countries.

Second, even though the biggest domestically-owned credit institutions in Cyprus are small in absolute terms, their large size as a proportion of GDP sets them apart from those of other countries (Graph 3). Very few other European countries (Switzerland and Netherlands are exceptions) have domestically-owned banks that are so big compared to the economy. This feature is also reflected in high concentration levels, with the three biggest Cypriot banks - Bank of Cyprus, Marfin Popular Bank, and Hellenic Bank controlling 55.6% of domestic deposits and 48% of domestic loans as of March 2011. These banks sit at the centre of financial groups that provide a broad range of other financial services. In addition, they have significantly expanded their operations abroad (particularly Greece) in recent years.1 FIGURE 3 Size of Selected Credit Institutions to GDP (end-2009) 300% Total Assets (% of Home Country GDP) 250% 200% 150% 100% 50% 0% Source: The Banker, World Bank.





Note: These figures represent a bank’s total assets at group level, including from overseas

operations. The acronyms in brackets indicate the country where the bank is based:

CY=Cyprus, GR=Greece, FR=France, GER=Germany, ITA=Italy, IRE=Ireland, MLT=Malta, LUX=Luxembourg, NL=Netherlands, ESP=Spain, SWI=Switzerland, SWE=Sweden, UK=United Kingdom.

1 According to the Central Bank of Cyprus (CBC, December 2010), at end-June 2010, the overseas operations of the big 3 domestically-owned banking groups represented around 40% of their total consolidated assets, three-quarters of which were in Greece.

The significant expansion of the Cypriot banking system in general, and of the big domestically-owned banks in particular, has been part of the broader push to promote the island as an international business centre.

The Cypriot economy is open and relatively undiversified, traditionally relying on tourism and international business services. The latter type of activity has been driven by various factors2, which also help to explain the size of the banking system. The strategy has undoubtedly paid off, and the contribution of the financial services sector - both directly and indirectly to employment and GDP in Cyprus have been substantial (Graph 4).

–  –  –

7% 6% 5% 4% 3% 2% 1% 0%

–  –  –

Source: Cystat.

Note: GVA is Gross Value Added. Employment refers to full-time equivalent number of working persons; figures for 2008-09 are provisional.

3. The systemic risks of big banks The current size of the Cypriot banking system, and particularly of the two biggest banks, raises the issue of whether growth has unequivocally been a good thing that should continue indefinitely. In particular, against the 2 These include economic and institutional stability, a favorable tax environment (low corporate tax rate and an extensive network of double taxation treaties), relatively low levels of corruption and bureaucracy, a highly educated and low-cost employee work force, a well-established legal system based on British standards, good geographical location and communications infrastructure, and a relatively sound prudential framework for banks.

benefits previously mentioned are risks that need to be taken into account.

The most important of them is systemic risk - namely, the “risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences for the economy” (IMF, BIS and FSB, October 2009).

According to this definition, systemic risk materializes when the collapse of a financial institution causes both a disruption to the flow of financial services (i.e. certain financial services become temporarily unavailable and/or their cost is sharply increased) and significant negative spillovers to the real economy.

Assessing systemic importance is a challenging exercise because it is timevarying and it depends on both the specific context (e.g. economic environment and financial sector conditions) and the purpose of the assessment (e.g. calibration of regulatory framework vs. crisis management). However, three key criteria are helpful in assessing the

systemic importance of a financial institution:

• size - the volume, and hence importance, of financial services that it provides relative to the financial system and the economy at-large;

• (lack of) substitutability - the extent to which other financial institutions can provide the same or similar services on a timely basis in the event of its failure; and

• interconnectedness - its direct and indirect linkages with other financial system participants, so that its failure would have broader repercussions and knock-on effects.

An assessment based on these criteria needs to be complemented with an analysis of other contributing factors, such as institution-specific financial vulnerabilities (e.g. leverage, liquidity and maturity mismatches etc.) and other characteristics (e.g. complexity in organizational and legal structure), as well as the robustness of the institutional framework to deal with systemic risk (e.g. effectiveness of failure resolution arrangements).

Based on these criteria, some financial institutions can be labeled as systemically important (SIFIs). Systemic risk created by SIFIs is a negative externality that may lead to significant contagion effects for the broader financial system and spillovers on the overall economy. The absence of policy measures to adequately monitor and control such risk contributes to the expectation by market participants of government support in case of SIFI trouble - the so-called ‘too-big-to-fail’ problem. As a result of the lack of market and supervisory discipline, SIFIs are therefore able to borrow at preferential rates, operate with higher levels of leverage, and engage in excessively risky activities. This type of behavior has adverse implications for competition (unfair advantage) and for financial stability (increased risk-taking beyond a socially optimal level).

The financial crisis has illustrated that big and highly interconnected financial institutions, most notably banks, are significant sources of systemic risk and that their failure can have wider fiscal, economic and social costs from the damage to the economy at-large. While the costs of the crisis cannot be attributed solely to systemically important banks, these banks have contributed greatly to the scale of the crisis and have been disproportionate beneficiaries of rescue packages.3 The crisis has therefore not only confirmed the risks posed by SIFIs and their support by governments in case of trouble, but also significantly expanded the subsidies that such institutions receive.4 The implicit support provided by the authorities to the banking sector is also reflected in the ratings that are assigned by credit rating agencies to banks. A credit rating of a bank, which is meant to capture its safety and soundness, encompasses both an assessment of the bank’s stand-alone default risk as well as a judgment on the expected government support.

Credit rating agencies often notch up the ratings of big banks to account for the probability of sovereign support that such banks would receive in case of financial distress. This ratings uplift represents an implicit subsidy from the government to the banks, since it allows them to borrow at a lower cost and to attract clients on the basis of greater perceived creditworthiness.5 Prior to the crisis, the balance sheets of banking systems in some international financial centers - such as Iceland, Ireland, Switzerland, and the UK - expanded rapidly. This can be attributed primarily to the growth of their biggest banks as a result of a variety of domestic and cross-border strategies that they pursued (IMF, April 2010). Their growth was supported by an accommodating macroeconomic environment and by the 3 In addition to industry-wide support measures, several countries adopted rescue packages for certain troubled SIFIs (e.g. Citigroup and Bank of America for the US, RBS and Lloyds for the UK, Hypo for Germany, ING for the Netherlands, and UBS for Switzerland).

See, for example, IMF (May 2011b) and chart 5.9 on page 51 in the Bank of England’s Financial Stability Report (December 2010) on the estimated implicit funding subsidy to UK credit institutions by size of institution.

See chart 3.41 on page 43 of the Bank of England’s Financial Stability Report (June 2010), which shows the extent of government support embedded in the ratings of different countries’ banking systems. It is possible to convert the ratings uplift into a monetary measure of support by mapping the different ratings to yields paid on bank bonds, and by then scaling the yield difference by the value of each bank’s ratings-sensitive liabilities; see Haldane (March 2010) for an example.



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