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«FINANCIAL STABILITY REPORT 30 SEPTEMBER 2015 NICOSIA - CYPRUS Prepared and published Financial Stability Report Executive Summary In 2015 the Cyprus ...»

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Prepared and published

Financial Stability Report

Executive Summary

In 2015 the Cyprus economy returned to modest economic growth after three years of contraction and is finally in a

path of gradual recovery. Economic activity has turned out better than expected, with Gross Domestic Product (GDP)

forecast to increase by 1,6% in 2015 and by 2,0% in 2016. Cyprus has made considerable progress in implementing its

economic adjustment programme. New insolvency and foreclosure legislation has now been adopted. Access to market financing has improved, as reflected in the successful government debt issuance on international capital markets in April this year. The financial situation of the banks is gradually recovering, liquidity and solvency in the banking system has improved and it is encouraging to note that the slow pace of debt restructuring is picking up.

Overall, a gradual economic recovery is envisaged.

While sentiment is improving, challenges still remain. The banking system has unprecedented levels of impaired loans – among the highest in Europe - and addressing these loans will take time; new lending is at a low level; households and non-financial corporations (NFCs) are characterised by elevated debt levels, unemployment – albeit falling – remains high and public debt as a percentage of GDP has improved significantly but remains high. Along with these financial risks, some delays are also observed in the passing of legislation such as legislation allowing the securitisation of loans by banks. Moreover, despite the reduced real and financial links between Greece and Cyprus, adverse developments in Greece could cause confidence effects. We are also observing many geopolitical developments in and around the European Union. Any of these could impact the financial stability of Cyprus.

Contents I. Main risks and vulnerabilities

II. Overview of financial sector developments and outlook

III. The new additional responsibilities of the Central Bank of Cyprus with respect to financial stability and macroprudential policy

IV. Macroeconomic environment

V. Non-financial corporations and household sector

VI. Banking sector

VII. Insurance sector

VIII. Investment funds and investment firms sector

I. Main risks and vulnerabilities The following vulnerabilities have been identified as representing the main sources of risk for the Cyprus financial system. The analysis to this can be found in the report.

–  –  –

II. Overview of financial sector developments and outlook During the past year, strong policy action has been taken and the economic adjustment programme has been followed through - which has been an important factor to mitigate the impact of the high level of indebtedness and the vulnerabilities being faced in the financial sector. Cypriot banks are making headway in restructuring their nonperforming loan portfolios. Recent improvements in the legal tools governing foreclosures may support the banks' loans restructuring, complemented by a modernised personal and corporate insolvency regime which should facilitate debt restructuring. Further, the country’s return to modest economic growth after three years of real GDP contraction also helps the banks' restructuring efforts and reduces the risk of further increases in the level of non-performing loans.

Continued efforts are being made, such as the new legislation to expedite the transfer of title deeds which came into force in September 2015. Legislation to facilitate securitisation and the sale of loans is planned to be tabled in 2015Q4.

Recent developments

A key priority on the reform agenda has been addressing the high level of non-performing loans in the banking system and policy action has been taken to deal with this. The high level of NPLs reflects the severe recession. It also reflects the increasing number of strategic defaults according to anecdotal evidence from banks, especially given the positive asset position of households. However, latest available data indicate that NPLs may be reaching their peak.

While bank deposit outflows have slowed, non-performing loans have continued to rise, and credit remains impaired.

Some signs of recovery have started to appear.

The new package of insolvency laws has been designed to help borrowers restructure their debt and should make it easier for banks to demand payment or seize assets. A debt-restructuring framework has been put in place, banks have put in place restructuring units, legislation to facilitate foreclosures was adopted in April 2015 and this has been complemented by a new modernised insolvency regime. More time is required to make a proper assessment as to whether there has been an improvement in the restructuring process due to the new legislation, however, the situation is being monitored. Implementing the measures effectively is a necessary condition for a sustainable stabilisation of the banking system.

The Central Bank of Cyprus (CBC) published an arrears-management framework (AMF) and the Code of Conduct in April 2015 to guide the loan restructuring process and developed a supervisory framework to monitor banks’ capacity and progress against operational and restructuring indicators. The AMF requires banks to implement efficient and effective structures, processes and tools to support arrears management and execute fair, adequate and sustainable debt restructurings. Incentives are now in place for banks to handle the excessive NPLs. Through this process, the pace of debt restructuring is expected to pick up.

Macroeconomic environment and public finances The Cypriot economy has seen positive growth since the beginning of the year after almost four years of recession and economic performance continues to exceed expectations. Public finances remain on the upside exceeding initial expectations and there are some encouraging signs regarding the still very high level of non-performing loans in the banking system. Sovereign debt yields have declined, benefitting from purchases by the European Central Bank’s bondbuying programme that started in July. However, economic growth is still weak and high indebtedness levels remain a drag on economic activity. The unemployment rate remains elevated, but has stabilised at around 16% over the first half of 2015 and is forecast to steadily reduce.

Households and non-financial corporations sector Domestic households and non-financial corporations (NFCs) continue to be highly indebted, with bank credit to the domestic private sector reaching the level of 280,2% of GDP at end-March 2015 and is significantly higher than the euro-area average. At high levels of indebtedness households and corporates are more likely to encounter payment difficulties in the face of shock to incomes. Households’ and NFCs’ debt-servicing capacity continues to be weak as reflected in the high aggregate debt service ratio and high non-performing bank loan ratios, especially in the case of loans to the broader real estate sector to which banks are highly exposed.

Despite the difficult outlook - the high levels of unemployment, declining household income as well as the very difficult operating environment for enterprises against a background of weak macroeconomic conditions - considerable progress has been made. Latest data indicate that NPLs may be reaching their peak, a modest recovery is beginning to appear and since 2014Q4 we observe a stabilisation in households’ and NFCs’ financial position. It is important that the new insolvency framework is efficiently implemented to help improve the high levels of indebtedness in the private sector.

Real estate sector Regarding the housing market, prices may be bottoming out and could modestly increase in the medium-term, given emerging signs of renewed domestic and foreign demand. However, the prospects for recovery of the property market are difficult to predict with certainty. Close monitoring of property sector is necessary owing to its importance both for the asset position of households and for banks’ loan portfolios. Particular attention to the sector will need to be given, by closely monitoring the evolution of house prices as well as the risk profile of banks’ mortgage portfolios.

Banking sector Following the escalation of the financial and banking crisis in Cyprus at the end of 2013Q1, following the bail-in of unsecured depositors, depositors’ confidence deteriorated rapidly. The three largest banks continue on the path to normalisation. A range of challenges remain for domestic banks. While profit levels remain low (see Chart 28, p. 18), the return to profitability is a necessary step in the development of a sustainable and resilient banking sector capable of supporting an increase in lending to finance the real economy.

The overall level of non-performing loans (at over 47% of the loan book – see Chart 34, p. 20) remains very high. A large portion of impaired loans are to the real estate sector to which banks are highly exposed and a significant amount of impaired loans arises in the non-mortgage loan book. While bank deposit outflows have slowed, non-performing loans have continued to rise, and credit remains impaired.

Low levels of new lending and the limited scope to increase lending margins, are expected to constrain the ability of domestic banks to increase their income. Tackling non-performing loans remains a critical issue.

Some signs of recovery have started to appear. Confidence is in the process of being repaired and there has been an increase in shorter-term deposits. Progress has been made with the setting up of restructuring units at the banks following the enactment of the new insolvency legislation. The maturity profile of funding remains weighted heavily to the short term. Customer deposits are among those short-term funds and are a stable funding source. Nevertheless, the general funding profile leaves domestic banks susceptible to volatile foreign funding sources.

Insurance sector Although the insurance sector has fared better than the banking sector, the weak macro-financial climate remains a key concern. Profitability is constrained by weak premium growth. Persistently low interest rates could pose a risk to the life sector in particular, due to the impact on profitability and the difficulties in generating adequate investment income, especially as insurers are diversifying their investments. Regulatory changes are looming, with Solvency II coming into force on 1 January 2016, whereby insurance companies will be required to operate in a new environment with more effective governance and increased compliance requirements. Insurers will be required to value their insurance liabilities on a market-consistent basis, to re-examine their risks and raise any additional capital to stand against these risks. All in all, the sector stands relatively well prepared for the impending changes, with no major recapitalisation needs in sight.

Investment funds and investment firms sector Cyprus has recently modernised its regulatory framework for investment funds. This, along with an increasing appetite of investors and fund service providers for EU-regulated jurisdictions, has seen a significant increase in the size of the investment funds sector. Overall, while the industry is susceptible to external developments and changing investor preferences, it does not pose a significant risk to the domestic financial environment given its small relative size.

However, as the sector is growing rapidly and links to both the economy and the financial sector exist, developments are being monitored closely. With respect to Cyprus investment firms, their operations are to a large extent outside Cyprus. Even though the domestic operations of these investment firms are fairly limited, due to the growing importance of their operations, close oversight is warranted with regard to risk mitigation measures, governance and internal controls.

Capital Markets Union The European Commission’s Capital Markets Union (CMU) is a growth initiative proposed in 2014, to create deeper and more integrated capital markets in the 28 member states. Almost 80 % of credit in Europe is intermediated through the banking system therefore policymakers are now focusing on capital markets as a way to improve access to financing in Europe, particularly for SMEs. The aim of the CMU is to increase and diversify funding channels with a view to maximising the benefits of capital markets and non-bank financial institutions to the real economy. Non-bank financial institutions operate in areas such as venture capital, private equity investment, public equity issuance, corporate bond issuance, corporate debt securitisation, and captures activities such as loan origination by investment funds.

The CMU though raises a number of potential financial stability issues. Increased credit intermediation through nonbank channels will require oversight and monitoring in order to assess fully the potential vulnerabilities of this sector.

The sector’s interconnectedness with the traditional banking system will also need to be examined further. From a monitoring perspective, a fairly large number of investment funds are registered in Cyprus.

Regulators are hindered both by data gaps in the European shadow banking sector and by the lack of regulatory tools for some non-bank financial institutions that are engaged in credit intermediation. Sufficient attention should therefore be devoted in the CMU to safeguarding financial stability, such as in the area of shadow banking. An assessment of the financial stability impact of the CMU should require an action plan for the collection and analysis of all relevant capital markets data across the EU from which macroprudential policy conclusions would then be drawn.

The Commission’s Action Plan on the Capital Markets Union that was published on 30 September 2015 will have to be critically assessed to ensure the safeguarding of financial stability.

Summary The domestic economic outlook has improved since 2013, while there have also been some positive developments in the banking sector. Despite a challenging external environment, economic recovery continues. There is positive evidence that loan restructuring is proceeding at a faster pace. The macroeconomic environment has been improving and progress has been made in reforming the insolvency and foreclosure laws which will further support banks’ efforts to tackle the high level of NPLs.

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