New capital as well as other regulatory requirements that are expected to go into effect from January 2007 are perhaps one of the key challenges facing Cyprus banks, but the Governor of the Central Bank of Cyprus, Christodoulos Christodoulou is confident that Cyprus based banks will rise to the challenge.
During a speech at 6th Interbalkan Forum of Banking Associations on the issue of “Contemporary Trends in Regulation and Supervision in the Banking System: the Cypriot experience”, Christodoulou talked about the Cyprus experience and the challenges facing the banks.
Herebelow are extracts from his speech secured by the Financial Mirror.
Until as recently as May 2004, when Cyprus became a member of the European Union, banks in Cyprus enjoyed a privileged franchise as entry to the industry was restricted, being based on the “economic need criterion”, a relatively undefined and general term, which effectively gave adequate discretionary power to the Central Bank of Cyprus to regulate entry to the Cypriot banking sector.
Equally, as recently as the end of 2000, the cost of deposits as well as loans was strictly regulated, a situation which afforded and preserved comfortable profit margins for all banks and effectively eliminated the potential interest rate risk. Banking assets consisted mainly of advances and loans to customers secured, as a rule, by mortgages on property. The existence of an exchange control regime which, although gradually liberalised over the years as regards current and capital transactions, was not fully abolished until Cyprus’s entry to the European Union afforded banks the special status of “authorised dealers in foreign currency”.
The above, coupled with restrictions on the holding of foreign assets and the extension of credit facilities to non-residents or in foreign currencies, effectively minimised the foreign exchange and country risks faced by banks. The only exceptions to the above overprotected situation were: Firstly, the overseas activities of domestic banks i.e. their operations through branches or subsidiaries which were established in countries, such as Greece and the United Kingdom, which had liberalised their banking systems long before Cyprus and, secondly, the operations of those foreign banks operating in Cyprus under the special category of “offshore banks” or “International Banking Units” which, however, were completely “ring fenced” i.e. they were not allowed to deal with the permanent residents of Cyprus or in the local currency.
Cyprus’s decision to join the European Union acted as a catalyst in liberalising the country’s banking system. Interest rates were liberalised in 2001 while capital / exchange controls were completely abolished on Cyprus’s accession to the European Union on 1st May, 2004. The above developments meant that Cyprus’s banking supervisory and regulatory regime had to be completely harmonised with the European Union requirements.
Thus, in a relatively short period of time, banking supervision has been transformed in Cyprus in line with the best practices dictated by the relevant EU Directives and the principles of the Basle Committee on Banking Supervision, Christodoulou said.
Capital requirements
Perhaps, the most fundamental change in the history of banking supervision which is already having a profound effect on the way banks are operating and which, in the case of EU banks and investment firms, is the new Capital Requirements Directive (“CRD”) which will be put into effect on 1st January, 2007, while in the case on non-EU internationally active banks, is the New Capital Accord of the Basle Committee on Banking Supervision, known as “Basle II”, Christodoulou said.
The new Capital Requirements Directive aims at ensuring the closest possible alignment between regulatory and economic capital, reinforcing financial stability and promoting the competitiveness of the EU’s financial sector. Banks with healthy credit portfolios and effective risk management systems are rewarded, in terms of risk weights attached to the various classes of risk assets, and the above acts as a very strong incentive to modernise and upgrade their risk management systems. In contrast to the present capital framework (“Basle I”), which does not take into account the specific risk profile of each bank, the CRD allows the use of three alternative approaches for the calculation of capital requirements against both credit as well as operational risks, which escalate from the most simple to the most advanced.
Within the framework of the new Capital Requirements Directive, the specific requirement which is going to fundamentally change the hitherto mentality of banks as well as their modus operandi is the need for a clear organisational structure with consistent lines of reporting and a responsibility for an effective risk identification, management, monitoring and reporting procedures for all the risks that a bank is exposed to or may, potentially, be exposed to, as well as satisfactory internal control mechanisms. In line with the requirements of the CRD, the Central Bank of Cyprus has, therefore, issued a separate Directive, under the title “Framework of Principles of Operation and Criteria of Assessment of Banks’ Organisational Structure, Internal Governance and Internal Control Systems”, which is going to be put into effect on 1st January, 2007, at the same time as the CRD, and which aims at, firstly, strengthening the overall framework of organisational structure and internal governance of banks and, secondly, upgrading the three basic functions of banks’ internal control systems: Internal Audit, Risk Management and Compliance.
The provisions of the above Directive concern and directly affect the composition as well as operation of Boards of Directors, Boards of Directors’ Committees, Senior Executive Management and specific operational units of banks, such as the Internal Audit Unit, the Risk Management Unit, the Compliance Unit, the Information Technology Unit and the Internal Legal Service. More specifically, the Directive outlines the best internal governance principles to be followed by banks, specifies criteria for determining the “fitness and properness” of persons to be appointed as Directors and describes the roles of the Chairman of the Board of Directors as well as that of non-executive and independent directors. Moreover, the provisions of the Directive concern the banks’ external auditors. It is important to note that banks in Cyprus have been asked to demonstrate to the Central Bank of Cyprus, by the end of September, 2006, the latest, their operational readiness to implement in time the provisions of the Directive.
“In conclusion, let me just observe that the recent changes in the composition of the Board of Directors of domestic banks in Cyprus as well as the on-going upgrading of their risk management systems are clear indications that banks in Cyprus are prepared and ready to face successfully the new risks as well as challenges posed by the new global competitive environment,” Christodoulou said.
