Radical reform of Cyprus banking

The Risk Watch Column: By Dr Alan Waring

Much has been written and spoken already about the causes, processes and effects of the Cyprus banking crisis, especially since the collapse of Popular/Laiki Bank and near collapse of Bank of Cyprus in March 2013. Now at last the final report on these matters by the Independent Commission on the Future of the Cyprus Banking Sector, commissioned by the Central Bank of Cyprus, has been published. Some 118 pages long, the report examines the systemic failures that led to the crisis as the basis for detailing a viable formula for the road to recovery and a sustainable future. That formula involves a radical reform of the entire banking system and banking culture in Cyprus and, in particular, attitudes towards risk, risk management and corporate governance.
The report is a sobering account of what happened and why, in refreshingly blunt language, thanks perhaps to the multinational make-up and independence of the Commission’s membership. By pulling all the material information together in a coherent manner, the report will be, or ought to be, the touchstone reference on the future of Cyprus banking. The report is not without debatable weaknesses. For example, in discussing the external causes of the crisis, the report appears to place equal emphasis on external and internal causes and does not offer any guidance or opinion on which and what proportion of causes (external and internal) were most significant. If there had been no external causes, for example, would the crisis have still occurred? Probably yes, but some time later. The report implies but does not state explicitly that external causes, such as exposure to the Greek bonds and the Cyprus property market bubble, were the triggers and accelerants whereas the internal causes, such as poor management and an archaic, corrupt banking culture, were the ‘conflagration waiting to happen’.

A ‘What Can We Get Away With?’ Culture
The report condemns what it calls a ‘culture of deference’ in the Cyprus banking sector, whereby strong-willed CEOs with their own agendas dominated deferential boards and often against the interests of shareholders and customers. There were, says the report, strong conflicts of interest that many bank directors ignored and, for example, it was not uncommon for individual directors to grant themselves huge personal loans (with or without the normal bank checks and approvals) or to receive supply contracts. In addition, personal and political relationships between board members and outside interests were far too influential, to the extent that corruption or the risk of it was difficult to avoid. As the report notes, and as Risk Watch observed in The Banks and Due Diligence (Financial Mirror 22-28 May 2013), the very familiarity of personal and political relationships with customers or other outsiders, at whatever level in a bank, is a double-edged sword. Without sufficient vigilance and strict procedures, otherwise beneficial relationships may result not only in by-passing or watering down of vital due diligence controls but also, in some cases, encourage fraud and corruption.
The dysfunctional culture and parochial attitudes (the report refers to them as ‘inbred’) were self-serving within such a closed banking community, where non-Cypriots were barred at almost every level and on boards individuals having any significant international banking experience were as rare as hen’s teeth.

Governance? What Governance?
The report states that the effectiveness of corporate governance in Cyprus banking, including the Central Bank, was ‘close to non-existent in practice,’ whatever formal compliance procedures may have been evident. A ‘risk management culture was missing at all levels’ and the value of corporate governance was not even accepted as being of prime importance, if not essential, to the proper running of any bank. Board risk committees were treated as window dressing and their proper protection function was frequently thwarted by boards and individual members. The culture of deference was never challenged effectively and independent Non-Executive Directors who did raise objections were by-passed, e.g. decisions were deliberately taken in their absence or they were not informed of decisions to which they might have objected.
Loans were given to property developers by Cyprus banks against real estate collateral regardless of a developer’s cash flow and his ability to repay the loan. The banks sought over a number of years to treat NPLs (non-performing loans) as ‘good’ and failed to pursue debtors, especially where asset collateral had been secured on paper as in the case of property developers. As the Troika Memorandum identified, while exposure to Greece’s debt problems had been instrumental in the crisis for Cyprus banks, many of the latter’s problems were home grown and related to over-expansion in the property sector as a consequence of the banks’ poor risk management. As is now evident from recent CBC data which includes collateralised debts, the actual scale of NPLs at the end of 2012 totalled €15.4bn or some 88% of GDP. A large part of this will be the liability of developers. It is reported that many developers, including the major ones, have been veering towards insolvency for some time and restructuring of their debts by the post-crisis banks may not always be possible.
As the report notes, the persistence of these accumulated NPL bad debts years after they arose may well dog the recovery of Cyprus banks, just as it has done in Iceland. The report advocates a swift and thorough clean-up of the NPL debacle so as to restore trust and confidence in the banks and allow them to operate efficiently and effectively unfettered by the NPL millstone.

Labour Malpractice
The report cites the stranglehold of trade unions in the banks as an important factor in the latter’s general inefficiency and high operating costs, compared to modern banking in the rest of the EU. Labour costs still account for two-thirds of operating costs in Cyprus banks. Once the unions had asserted their dominance over a cowed management, the culture of deference ensured that it stayed that way. Swaggering union leaders became used to issuing public statements about bank policy and actions as if they and not the board were in charge of the bank. The report is clear that labour reform will be essential so that unwarranted union interference in the management of the banks is removed.

Recommended Reforms
The following are paraphrased highlights of the report’s recommended reforms:
• Creation of a national strategy for financial services.
• Culture change to one of personal accountability, code of ethics, objective decision-making, objective recruitment and selection, declaration of interests and relationships, rejection of cronyism and nepotism.
• Raise the standard of corporate governance and board oversight in the banks, especially of internal audit and risk management.
• Strengthen the role of external audits.
• Strengthen the banks’ skill base and culture by introduction of experienced personnel from other countries who are familiar with objective processes.
• Each bank to transfer all NPLs into a separate entity incorporated within the bank and owned by the bank’s shareholders.
• The CBC supervisory function should be under a rigorous risk framework to meet international Basel Committee benchmarks and should also itself be subject to internal audit.
The report recognises that whereas policy, structural and procedural changes are capable of being introduced fairly quickly, the massive cultural change required to make it all work effectively may take considerably longer and maybe up to a generation. However, it is clear that if Cyprus wishes its banking sector to recover from its current drubbing and very low ebb then it really has no alternative but to implement such changes with determination and commitment for however long it takes.

Wider Implications
This report focusses entirely on the banking sector. However, almost identical issues arise for the other sectors of the economy, such as civil service, local authorities, state-owned companies such as EAC, CYTA and Cyprus Airways. The ‘what can we get away with?’ culture, undue influence of vested interests, lack of corporate governance, weak risk management, operational inefficiency, high labour costs, and union interference and intransigence that have afflicted the banks also afflict these other sectors. Analogous or similar reforms are therefore needed.
The reforms needed across the broad spectrum of the economy are exactly what the ‘New Governance for a New Cyprus’ initiative seeks to achieve ultimately, based on a ‘Governance Charter’, as outlined in various articles in the Financial Mirror in recent months. More information on this is available from Petros Florides ([email protected] ), who will be contributing a further article on the Independent Commission’s banking report in a forthcoming issue of the Financial Mirror.