The future of Cypriot Banking - Is there life after Troika?

18 December, 2013 | Posted By: Jim Leontiades

By Dr. Jim Leontiades
Cyprus International Institute of Management

Have you ever wondered why so many small countries rely on banking as their primary industry? A partial list of these would include: Monaco, Malta, Luxembourg, Cayman Islands, Bahamas, Bermuda, Guernsey, Liechtenstein, Isle of Man, Jersey, British Virgin Islands. All of these have a population of less than 1 mln. Their other common feature is that they are all international financial centres. Also, they are all relatively prosperous. They all enjoy per capita incomes which place them among the most affluent countries in the world. Luxembourg has the highest income per capita of any country in the European Union. At least two of the above listed country’s are even wealthier than Luxembourg.
Although some of the countries also have tourist industries, none of them could have reached their present level of affluence based on tourism alone. They could not have reached this level of economic success without an international banking industry. The plain fact is that small countries, particularly small island states, have few options as to which industries they can compete in effectively. Small countries are seldom able to compete in the manufacturing industry of automobiles, home appliances, electronics, machine tools, etc.
In an increasingly globalised world, small countries import virtually all their manufactured goods from larger countries which enjoy the benefits of a domestic market offering the necessary economies of large scale. To pay for these imports, smaller countries must produce goods and/or services that find an international market and can offer employment to their people. Banking and associated financial services are one of the few industries which fill this need. Small countries which have not succeeded in this industry are virtually all on a lower income level.

Cyprus used to be included in this list of prosperous financial centres, but no more. The Eurogroup decisions of March 2013 have seen to that. Cypriot banking was considered to be too large for Cyprus and was downsized, some would say purposely destroyed, as an international centre.
Furthermore, it is clear that tourism alone will not bring Cyprus to its former level of prosperity. Tourism cannot provide more than a fraction of jobs needed by the island’s well educated workforce. Cypriot oil and gas prospects provide some hope but let’s not jump to the conclusion that this can solve the employment problem. Even if such resources prove to be substantial (still a big “if”) this industry provides few of the sort of managerial positions which are associated with banking and finance.

Given its current indebtedness, this country has no choice but to abide by the decisions of the Eurogroup which downsized its banking and finance industry. But, Cyprus will one day pay off its debts to the Eurogroup and will have the opportunity to consider the future of its financial sector without the current constraints. There is every reason to believe that Cypriot banking can once again become the focus of an international financial sector.
Research carried out by Harvard Professor Michael Porter across a wide number of countries shows that international competitiveness depends on a combination of factors. These include a country’s institutions and skills, supporting industries, as well as the presence of positive government and national environmental conditions.
The factors that contributed to the success of Cyprus as an international financial centre before the current crisis, including managerial and technical skills, tax treaties, stable democratic government, geographic position, transport and communication facilities, relative safety and living conditions, are still present and still provide the basis for an attractive banking environment. Perhaps that is why, even after the catastrophic March MOU, foreign banks did not flee the island but have maintained their presence here.
Another positive indication of future potential is the recent rise in Cypriot bank deposits of non-European nationals. Once Cyprus is free from its debt to the Troika it will again be free to develop its banking and finance more in line with its own needs and opportunities. Of course, the pre-MOU model will not do, there will have to be significant changes.

What should the future model for the Cypriot banking and financial services industry look like? Luxembourg and its banking industry contain some potentially useful lessons. With a population smaller than that of Cyprus, Luxembourg hosts a banking and finance industry several times bigger than our own, both in absolute terms and in relation to national GDP. Yet, the Eurogroup does not consider it too large. Nor has it exposed the country to the sort of risks witnessed here.
Luxembourg’s banks have total assets amounting to 735 bln euros, compared to some 47 bln in Cypriot bank deposits recently (over 65 bln euros before the MOU). Luxembourg’s bank assets, however, are spread over a larger number of individual banks (140 compared to 40 in Cyprus) with a large foreign ownership content.
More significantly, Luxembourg avoids the problem that has proved so damaging for Cyprus of concentrating bank assets in a few “too big to fail” banks. The largest Luxembourg bank accounts for only 13% of total bank assets compared to the 27% which is held even now by the Bank of Cyprus. This spreading of financial risk is greatly reinforced by Luxembourg’s heavy participation in the management of investment funds, something Cyprus has been slow to develop. Luxembourg is second only to the U.S. in this respect. Investment funds in the tiny country manage an astonishing 2.4 trln euros of investments.