Cyprus banks recover from loan crisis, but borrowers still suffer

Banks clear non-performing loans but private debt remains a problem, CBC analyst says Cyprus has largely cleaned up its banking sector’s non-performing loans (NPLs), but a substantial private debt problem remains outside bank balance sheets, according to Xenios Socratous of the Central Bank of Cyprus’ (CBC) risk analysis section. In a piece of analysis published on the central bank’s website, Socratous argued that Cyprus had undergone one of the most dramatic transformations in European banking, moving from having NPL levels approaching half of total lending to a banking system whose asset-quality indicators are now broadly aligned with the European Union average. However, he stressed that the improvement in bank balance sheets did not mean the underlying debt problem had disappeared. “The problem of NPLs was never simply a banking ratio. It was a macroeconomic constraint,” Socratous stated. He explained that large volumes of NPLs had tied up bank capital, consumed administrative resources and restricted banks’ ability to finance the economy, while heavily indebted households and businesses also tended to postpone investment and consumption. The roots of the crisis, he said, stretched well before 2013, with rapid credit growth, rising deposits and a major expansion in property and housing finance following Cyprus’ accession to the EU and adoption of the euro. This left banks heavily exposed to property developers, households and businesses linked to the construction and real estate sectors, while the banking system itself had become disproportionately large relative to the economy and significantly exposed to Greece. Socratous also pointed to lending practices that placed excessive weight on the value of property collateral rather than borrowers’ actual repayment capacity. During the boom years, he said, this created a false sense of security, while inadequate provisioning meant that loans could remain apparently sound even after borrowers’ financial positions had deteriorated. The widespread use of so-called “extend and pretend” restructuring practices further concealed weaknesses, as repayment periods were extended and additional collateral was sometimes obtained despite evidence that borrowers could no longer service their debt sustainably. When property values, incomes and confidence subsequently fell together, the protection provided by collateral proved much weaker than expected. The weaknesses were compounded by lengthy judicial procedures for foreclosures, insolvency and debt enforcement, which reduced creditors’ incentives to pursue legal action and allowed some payment arrears to persist for years. The crisis intensified between 2012 and 2014 as the recession, eurozone crisis and exposure to Greece were followed by the 2013 banking crisis, the deposit bail-in, capital controls and a sharp loss of confidence. Household wealth and incomes fell, unemployment rose and businesses faced a sudden deterioration in demand and liquidity. Socratous said the sense of injustice created by losses to deposits and other financial assets also weakened borrowers’ willingness to co-operate with banks over restructuring. At the same time, banks were poorly equipped to handle arrears on such a scale, with systems, data and specialised restructuring capabilities having to be developed while the crisis was already unfolding. The subsequent surge in NPLs, however, reflected not only new defaults but also a more accurate recognition of existing problems. In 2014, the European Banking Authority introduced a harmonised reporting framework for NPLs and forbearance exposures across the EU, shifting attention towards borrowers’ actual credit risk rather than simply the existence of collateral. A loan could therefore be classified as non-performing not only after more than 90 days of arrears but also when the borrower was considered unlikely to repay the full obligation. “The basic principle was simple and clear. Financial distress should be recognised on the basis of the borrower’s actual ability to repay, rather than being postponed because collateral exists,” Socratous said. By the peak of the crisis, roughly half of the banking sector’s loan portfolio had been classified as non-performing, making Cyprus an extreme European outlier. Between 2015 and 2018, banks developed specialised units for managing arrears, improved borrower information, strengthened collateral valuations and increased restructuring efforts. Debt-for-asset swaps also reduced NPLs, although they left banks holding substantial property portfolios that subsequently required dedicated management. Legal reforms to foreclosure and insolvency procedures strengthened creditors’ negotiating position, while European measures increased supervisory pressure to recognise losses, improve provisioning and actively manage bad loans. Socratous stressed that foreclosures and restructuring should not be viewed as opposing approaches, arguing that a credible enforcement framework was necessary to make meaningful restructuring possible. From 2018 onwards, the clean-up accelerated as banks began dealing with NPLs as portfolios that could be valued, grouped and transferred rather than solely as individual loans. The Bank of Cyprus’ Project Helix was a key turning point, followed by further portfolio transactions across the banking sector. The co-operative banking sector followed a different route, with its healthy operations transferred to Hellenic Bank while the majority of its problematic loans were moved outside the banking system. Socratous said the decline in NPLs resulted from several factors working together, including economic recovery, stronger profitability, higher provisions, improved capital buffers, supervisory pressure and stricter lending standards. The COVID-19 pandemic provided a major test of the reformed banking system in 2020, when about half of performing bank loans were subject to payment moratoria at the peak of the crisis. Yet the feared new wave of NPLs did not materialise, which Socratous attributed to stronger capital, healthier balance sheets, higher provisions and more prudent lending practices developed after the earlier crisis. Despite the dramatic improvement, he argued that the problem had partly moved rather than disappeared. Credit-acquiring companies now hold the majority of problematic loans, with most of those loans remaining non-performing, meaning they have left bank balance sheets but not the wider economy. Borrowers continue to face unresolved obligations, restructuring negotiations and debt recovery procedures, while outstanding NPLs can still affect property markets through collateral sales and property portfolios accumulated by credit-acquiring companies. Socratous also warned that the size of the remaining debt stock needs careful interpretation because contractual balances and accounting values are not the same thing. The contractual balance represents what the borrower owes under the loan agreement, including accumulated interest, while the accounting value reflects what the creditor realistically expects to recover after taking account of estimated recoveries, future cash flows and impairments. A lower accounting value therefore does not mean that the borrower’s obligation has disappeared. He argued that both measures remain important, particularly for credit-acquiring companies whose portfolios consist predominantly of legacy NPLs. The broader lesson from Cyprus, Socratous said, was that accurate recognition of losses, credible insolvency and foreclosure frameworks, adequate provisioning, sustainable restructuring, effective secondary markets and a strong repayment culture all form part of the same system. “Selling NPLs improves banks’ balance sheets, strengthens investor confidence and releases capital for new lending. The underlying credit risk, however, does not disappear. It is transferred to another creditor,” he said. Socratous further stated that Cyprus had largely resolved the banking dimension of its NPL crisis, but had not yet fully resolved the wider private debt problem. “The banks appear to have closed their own chapter of the crisis,” he said. “For many borrowers, however, that chapter is still being written,” Socratous concluded.