The persistent NPL issue

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Since 2013, when the economic crisis was at its peak (GDP contracted by c6%), Cyprus economic growth and fiscal performance continuously surpassed expectations, while macro-economic projections have constantly been revised favourably.

The Cyprus economy exhibited positive GDP growth as early as 2015, just 2 years following the peak of the economic crisis. The upward trend was maintained in 2016, following the earlier than scheduled exit from the financial assistance program (having utilized €7,3bn out of the €10bn made available).

GDP growth accelerated further in 2017, placing the island amongst the highest accelerating economies in Europe (2017 expected growth of 3,4%). According to IMF forecasts, the Cyprus economy will sustain a positive outlook with projected GDP growth of c2,6% in 2018 and c2,4% in 2019.

The economic recovery, however, is still challenged by the high level of Non-performing loans (NPLs) which delay the recovery of the banking sector and the return of Cypriot banks to profitability. There has been considerable improvement and undoubted progress regarding the NPLs and the NPL provision coverage since 2014. The NPL ratio in the Cypriot banking sector stood at 43% as of 30 September 2017, which translates to €21bn loans and c.110% of Cyprus’ GDP.

NPLs mainly comprise Households and Non-financial corporations, with NPL ratios of 53% and 49% respectively. The Construction industry, which represents 32% of Non-financial corporations’ NPLs, has the highest NPL ratio of all industries (64%).

Although some reforms towards assisting on the restructuring and/or resolution of loans have been implemented to date, such as the set-up of Personal Repayment Plans, debt relief orders to qualifying borrowers and creation of Arrears Management Units, the problem appears to be persistent.

The continuation of the NPL issue recently turned banks towards expert, third party NPL servicers for more effective management and resolution of the problematic loan portfolios. In 2017, Hellenic Bank and Cyprus Cooperative Bank signed servicing contracts with APS and Altamira respectively. However, given that both contracts have been in effect only for a few months, it will take some time before results can be witnessed.

Despite undoubted progress achieved over the last years and the significant deleveraging carried out by banks, the NPL issue appears to be deep-rooted in the Cypriot banking sector and requires more determined and perhaps even radical system-wide measures.

It is imperative to revise the legislation package around NPLs, introducing changes to the Insolvency framework for enabling more efficient and effective out-of-court collateral enforcement/foreclosures. The judicial system could also be an area where improvements may be implemented; under the current judicial system, court procedures are lengthy with no time restriction in resolving insolvency issues, while courts appear to lack relevant specialisation in settling such cases. Strategic defaulters, borrowers who have the capacity to repay their loans but refrain from doing so, take advantage of the deficiencies and ineffectiveness of the surrounding legal framework.

The laws for the securitisation and the sale of loans could further facilitate the development of the distressed asset market. Transactions involving sale of loan portfolios have been considerably low, with the most recent one being the sale of €145m (gross value) non-retail secured and unsecured loans by Hellenic Bank to a listed Norwegian corporation specialising in debt purchasing. Until recently, banks appeared unable to bear the losses from selling these loans at a large discount due to the banks’ thin capital buffers. Increased provisions booked over the last years, especially in respect of unsecured loans, could make the sale of such loans more feasible.

The largely untested loan disposal legislation, along with the relatively low data quality around Cypriot NPLs, also prevent interested investors from making informed / fairer pricing decisions in respect of such loans.

The high level of NPLs creates interest from investors specifically in distressed assets; such investors have different risk appetites (and required return targets) compared to investors interested in traditional banking operations. Removing the NPLs from banks’ balance sheets (e.g. via disposals) could become the basis for the rapid redemption of the NPL’s from the Cypriot banks’ balance sheet, whilst enabling banks to attract fresh capital for their operations. Although such a split would create significant losses for banks if NPLs were to be carved out / disposed of at prices below their book value (closer to investor ask prices), these losses could be covered by fresh capital injections from private investors looking to invest in traditional banking operations in Cyprus.

Overall, despite the growth and promising economic prospects for the Cyprus economy, the high level of NPLs remains a problem for the economy and the banking sector in particular. Growth alone is not sufficient to reduce NPLs. A systemic strategy/solution involving more effective legislation with regard to insolvency and sale of loans as well as restructuring solution with willing/cooperative delinquent borrowers is necessary to be implemented. Separating traditional banking operations from non-core assets, hence diversifying the investment offering based on different risk appetites, could also create a more appealing proposition to investors and attract fresh capital in the Cypriot banking sector.

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Constantinos Constantinou
Partner - Advisory, PwC Cyprus
Tel: +357-22555245
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