The deal negotiated for the Hellenic Bank to acquire the “good part” of the Cyprus Cooperative Bank (Co-Op Bank) and for the Government to take over the “bad part” has generally been viewed as very favorable for Hellenic Bank, but bad for the Cyprus tax-payer. Although the fine details of these arrangements have yet to be published and related legislation passed it is still possible to explore in more depth some of the issues and consequences that would most likely arise from a Hellenic Bank-Co-Op Bank deal. In particular how are the balance sheets and policies of Hellenic Bank and the Central Government likely to be affected? And what could be the expectedrepercussions of the deal on the overall financial system, on the behavior of the non-financial private sector, and more broadly on the macro-economy?
Questions on Competence and Biased Behavior of the Government
The first issue that should be stressed is that the deal has been put together in a shambolic, partly illegal, non-transparent, uncompetitive and inequitable manner following the failure of Minister Georgiades and his advisors to privatize the Co-Op Bank. The issue of Development bonds of 2.35 billion euro announced on April 10, 2018 and a later issue of one billion euro placed on the balance sheet of the Co-Op Bank and to be transferred subsequently to Hellenic Bank as a key element of the deal violated public debt management laws in that the Houseof Representatives was not informed about these bond issues. Furthermore, a bill that would enable the Government to extend guarantees to Hellenic Bank for possible impairment of certain assets acquired from the Co-Op Bank was not presented to the Attorney General. Moreover, the proposed agreement between Hellenic Bank and the Co-Op Bank was not vetted by the Attorney General. Indeed, the stealthy and unprofessional way in which the deal has been prepared and managed not only raises questions about the legality of the deal, but poses the issue of whether the Government was acting in the best interests of the public at large or was just engineering things to especially favor the acquisition of the “good part” of the CCB by Hellenic Bank, leaving the “bad” part of the CCB to be a heavy financial burden on the law-abiding tax-payer for generations to come.Moreover, the Government is paying to give a package of risk-free assets to Hellenic Bank, a company whose major shareholders are connected closely with the ruling political party and whose record in managingand productively deploying financial assets has been poor.
Impact on Hellenic Bank
As a result of the acquisition of deposit liabilities of 9.7 billion euro and certain assets (Government bonds of 4.1 billion euro, performing loans of 4.6 billion euro, and cash of 1.6 billion euro) from the Co-Op Bank the size of Hellenic Bank’s balance sheet nearly trebles to over 17 billion euro. This purchase improves the quality of Hellenic Bank’s asset portfolio in the sense that its NPLs are reduced from 53 % to approximately 20% of its gross loans.In addition the balance sheet comprises 4.6 billion euro of “protected” Government bonds which should provide a steady interest income stream of around 115 million euro per annum. It isdebatable whether this income together with revenue from performing loans will be sufficient to more than offset the costs associated with a greatly increased number of employees and with theprovisioning related to newloans (IFRS 9 regulatory requirements) and impairment of existing loans as well as interest expenses on deposits to yield satisfactory profits for Hellenic Bank. Much will depend on whether the bank can reduce substantiallyits NPLs and can extend new loans for economically viable projects.
According to Hellenic Bank and Central Bank personnel, if a deposit of a Co-Op Bank customer is moved to Hellenic Bank as a result of the deal and the total of his/her deposits at the bank then is above 100,000 euro the excess will not be insured for protection. But depositors in the three months following the deal becoming effective will have the right to remove fixed deposits prematurely without penalty.If enacted these proposed regulations for depositors could induce a considerable outflow of funds from Hellenic Bank with deposits of individual customers moved to other banks to keep below the 100,000 euro limit and also into cash. This loss of deposits and cash if quite large (above 2 billion euro) could harm Hellenic Bank’s liquidity position, but at the same time reduce its interest expenses on deposits and on the holding of cash at the Central Bank.
There has been the misleading viewpoint propounded by politicians, media commentators and even managers of the Central Bank of Cyprus that your insured deposits of up to 100,000 euro would be safer or at less risk if held at Hellenic Bank rather than remaining at the Co-Op Bank. However, for each bank it is the Government that takes the risk in providing protection if a bank cannot fund its insured deposits in the event of its collapse. So in truth the deposit risk remains with the Government and ultimately with the tax-payer.
Impact on Government
The deal could prove to be very expensive for the Central Government and ultimately for the law-abiding tax-payer. The Government has had to issue Development Bonds totaling 3.35 billion euro to bolster the “good part” of the Co-Op Bank, raising its debt to GDP ratio from 97.5% at end-2017 to currently between 115% and 120%. In addition, the Government has agreed to protect the assets of the Hellenic Bank by providing guarantees which could eventually be very costly if exercised. Moreover, the deal between the Government and Hellenic Bank is imbalanced and one-sided with built-in incentives for one party, that is, the Hellenic Bank, to call in the Government’s undertakings and guarantees if certain conditions are not satisfied.
Furthermore, the Government has agreed to take over the “bad part” of the Co-Op Bank comprising mainly NPLs of 8.3 billion euro, with the latter assets in turn to be managed by a Loan Management Companyset up by the Government.In this connection the Government will incur considerable costs associated with the capital required for the setting up of this company and of provisioning for the impairment of loans and for losses on loans sold to third parties at a discount. Considerable costs also are likely to be associated with the implementation of Estia, a scheme aimed at helping vulnerable households and possibly businesses repay their loans by subsidizing their monthly instalments. Furthermore, the Government has agreed to make redundancy payments to the 1000 plus employees of the Co-Op Bank who are expected to be laid off as a result of the deal.
All these costs and additional debt obligationswill have to be met ultimately bylaw-abiding Cyprus tax-payers. And with the surge in public debt arising mainly from efforts to prop up the banks the Government will have difficulty in borrowing in international markets and will be forced to rely on tax revenue and/or cutting back on traditional outlays to meet its new expenditure and debt servicing obligations. It will have to raise tax rates and/or undertake real serious efforts to combat tax evasion and aggressive tax avoidance in order to substantially increase tax revenue. And with the Government finances likely to be severely strained, scope for outlaying funds for urgently needed improvements to the health and education services and for environmental protection as well as for productive infrastructure investments will be greatly limited.
It is noted that at a time when collecting tax income is and will be at a premium the Chairman of the House Finance Committee is submitting bills to provide tax relief to persons who begin to service their non-performing loans. But it can be argued that such measuresare most likely to be counter-productive in encouraging and providing incentives for more debt defaulting and tax evasion over the medium-term.
Impact on the real economy
From the expenditure side the main driver of the recent fast growth of the Cyprus economy has been private consumption. Buoyant consumption expenditures have been facilitated in part by households and business entities not paying their debts, income taxes and other obligations such as car insurance. However, if as a result of the Hellenic Bank-Co-Op Bank deal there is a substantial and necessary increase in tax collections from the private sectorand if new related legislation on foreclosures and insolvencies as well as greater political will to combat strategic debt defaulting prevail, then the growth of private consumption will be curtailed significantly. In addition with a return to fiscal austerity as a consequence of the strains on public finances and excessive adherence to EU fiscal rules domestic demand will be further reduced. And with a considerable decrease in the growth of domestic demand entrepreneurs will be more starved of private investment opportunities and are likely to lower their capital expenditures. Accordingly, Cyprus is likely to enter a recession in the coming years, the severity of which will depend importantly on the extent of external demand stemming mainly from foreign tourists and property buyers in offsetting the decline in domestic demand.
The providing of private credit to finance economically viable projects is integral for healthy and sustained economic growth. In the Cyprus context it is critical that its banks have secure funding sources mainly in the form of deposits to finance such projects. Thus, it is of concern that as a result of the gross mismanagement of the large pool of funds of the Co-Op Bank and the shambolic and failing efforts to privatize the Co-Op Bank that its deposits have been seriously run down in recent months, with a considerable part of the deposit withdrawals being kept as cash or deposited abroad, that is outside the domestic banking system. And as mentioned above the proposed deal could lead to further outflow of funds from the banking system as entities reduce their deposits with Hellenic Bank to 100,000 or less in the wake of the transfer of their deposits from the Co-Op Bank to their Hellenic Bank accounts.
And with the private sector holding more cash the large underground economy of Cyprus involving more untaxed cash transactions will be fueled and fostered. Such a development would run counter to the need for the Government to substantially raise tax revenue to finance the costly and extremely over-generous deal involving the acquisition of the good part of the Co-Op Bank by Hellenic Bank and the transfer of the bad part to the Government.
Is there an alternative?
Is there an alternative to the Hellenic Bank-Co-Op Bank deal that would be less costly to the tax-payer, contribute better to financial stability, and provide an improved and sound basis for productively using bank funds to generate economic growth?Given these objectives and the questionable motives of the main shareholders of Hellenic Bank in wanting to acquire the cherry-picked assets and deposit liabilities of the Co-Op Bank on very favorable terms it is recommended that the Government take over the balance sheet of the good part of the Co-Op Bank that was headed to Hellenic Bankand in due course establish a new Bank. While retaining its retail operations with households the mission and role of this new bank would be to intermediate and utilize financial savings including its access to equity funding to promote economic development.The managers of the new Bank should be competent professionals who should be supported by a staff of lawyers, accountants, debt restructuring experts, financial analysts, economists and other talented personnel selected on the basis of their capabilities rather than their loyalty and connections with Ministers and politicians. When in place management and staff should begin directing the Bank toward specializing in development banking activities somewhat along lines suggested by SavvakisSavvides in his recent paper “The Alternative Way to Deal with the Cyprus Co-Op Bank” available at SSRN.
As this bank would be Government-owned with possible contributions to capital from international organizations such as the European Investment Bank there wouldbe little need for costly guarantees andprotection schemes aimed at making assets risk-free.
Deposits of Co-Op Bank customers would be automatically moved to the new Bank upon its activation with those up to 100,000 euro insured for protection by the Government. Problems as described above relating to financial outflows from banks arisingfrom the transfer of depositsof Co-Op Bank customers to the Hellenic Bank that cause their total individual deposits at a bank to exceed the 100,000 euro insurance limit would thus be avoided.
Financial instability reflected in runs on deposits usually emanate from the wasteful use and abuse of bank funds by bankers in extending numerous loans to customers who do not have the ability to repay and to those who are unwilling to repay as was the case in Cyprus in the run-up to the 2012/13 crisis. Similarly, the run on the deposits of the Co-Op Bank during 2018 reflects the strong perception that the funds of the Bank are being mismanaged and abused, a view supported by the Bank’s prevailing extremely high level of NPLs and certain dubious lending of late. In this connection it is this writer’s opinion that the management of a new bank comprising competent professionals will be able to use the balance sheet of the good part of the Co-Op Bank that was headed to Hellenic Bank much more prudently and productively than the influential and politically-connected shareholders and management of Hellenic Bank.And this greater competence of the new Bank in deploying its loanable funds would in turn help to restore some semblance of financial stability and provide a stronger basis for bringing about the healthy and sustained recovery of the Cyprus economy. That is a recovery after the inevitable economic slowdown associated with the substantial increase in private savings required to effect the large repayments of the huge amounts of household and business debt and tax liabilities.
Partly reflecting the very large extent of tax evasion in Cyprus tax arrears to the Central Government amounted to 1.99 billion euro, over 10% of GDP, at end-2017 according to the Financial Report of the Government. However, this is only “the tip of the iceberg” in that a great many professionals, teachers (for private lessons), tradesmen/women and others do not report all their income and, accordingly, no tax arrears are calculated on their unreported income.