Photographer: Simon Dawson/Bloomberg

ECB Glimpse of Cyprus Debt Shows Limits of Bank Cleanup

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There was a time when a Cypriot on a moderate income could take a gamble on foreign real-estate worth more than his life savings.

One banking crash, 3 1/2 years of recession and an international bailout later, 58-year-old Stelios Charalambous is among the Mediterranean island nation’s many debtors who realize that time has passed.

“I took a 70,000-euro loan six years ago from a cooperative bank in the days when no one asked you many questions, and I bought six plots of land in Romania,” the Nicosia-based chiropractor said in an interview. “Now I’m earning half what I was and no one wants to buy my Romanian land. I realized I could afford to pay my children’s university expenses or my loan. I chose my kids and no one can blame me.”

The European Central Bank, which holds a policy meeting in the euro area’s easternmost capital on Thursday, cares about such cases as they add up to almost 900 billion euros ($1 trillion) of soured credit in the region and hobble lenders’ ability to serve the economy. Yet Cyprus, where non-performing exposures account for more than half the country’s loan-book, also shows how politics can get in the way of a cleanup.

The nation made euro-era history in March 2013 when it imposed capital controls for the first, and so far only, time in the single currency’s existence. The measures came alongside a 10 billion-euro rescue led by the euro area, the merger of the country’s two largest lenders, and the seizure of almost half the savings of some 21,000 customers.

Political Opposition

The crisis gave birth to a new class of individuals and small businesses that could not, or would not, service their debt, turning Cyprus into the country with the highest bad-debt ratio in the currency bloc. That meant banks had to tie up large chunks of their capital in loss provisions instead of making fresh loans to companies and households.

To relieve the blockage, a new foreclosure law enabling banks to seize property from defaulters was introduced in 2014, only to be held up repeatedly by opposition politicians nervous of the impact on businesses and families. Implementation -- and the disbursement of further bailout funding which is contingent on the law -- is still pending.

The economic slump and legal uncertainty created a “perfect storm” for the banks, Euan Hamilton, head of restructuring and recoveries for Bank of Cyprus Pcl, said in an interview.

‘Pretty Stuck’

“I sometimes say the national sport of Cyprus is not repaying your bank,” said the former Royal Bank of Scotland Group Plc executive. “We aren’t interested in mass foreclosure; there’s no benefit for the bank. What we don’t want is people saying ‘I’m not paying my mortgage and you can’t do anything about that.’ We’re pretty stuck until something is done.”

The political sensitivity of non-performing loans can also be seen in other bailed-out nations. In Ireland, which suffered a property collapse forcing it to accept an aid program in 2010, moves by the banks to foreclose have unleashed popular protests. The new Greek government plans to change its law to make foreclosure more difficult.

More than a third of loans by Irish banks are judged as non-performing, and in Greece the number is at least 42 percent. ECB data show that euro-area bank lending has contracted for more than 2 1/2 years amid the drag of bad debt and pressure to shrink balance sheets.

‘Wait-And-See’

“A large amount of NPLs diverts management attention from its primary role, which is to give loans,” said Marios Clerides, general manager of Cyprus’ Cooperative Central Bank Ltd. “The political debate over foreclosure has created a lot of wait-and-see attitudes.”

That standoff threatens to undermine the ECB’s plans to revive the euro-area economy and inflation through massive monetary stimulus. When policy makers meet in Nicosia, they should put the finishing touches to a 1.1 trillion-euro bond-buying program that’s scheduled to start this month.

Purchasing managers indexes published on Wednesday showed the euro-area recovery remaining fragile even as the outlook brightens.

The challenge for the ECB is that the primacy of local law limits its influence over how lenders and borrowers resolve their differences.

Its yearlong bank asset review through last October helped establish a new European definition of non-performing loans as being any credit more than 90 days overdue. Beyond that, supervisors can only gradually work down the level of bad debt on a bank-by-bank basis. A single European solution lies beyond their scope.

Bad Banks

The ECB has encouraged banks to negotiate with debtors as best they can, split the assets off into a “bad bank,” or package the debt and attempt to sell it in Europe’s infant distressed-debt markets.

“It would be better for the banks to sell these loans, one way or another,” ECB Executive Board member Peter Praet said last month. “It can be through asset-management companies, as they do in Spain very successfully. They can try by asset-backed securities, or any other way, but they have to find a way.”

As individual debt sales can be slow and complex, in Cyprus as in Italy some bank executives are holding out for the creation of a bad bank, which could remove problem assets from lenders and eventually wind them down. Spain, Ireland and Slovenia have already set up such an entity.

“Banks end up being part of whatever political strategy there is in the country,” said Bridget Gandy, managing director for financial institutions at Fitch Ratings in London. “You can’t tackle the issue of bad debt in isolation from what’s happening in the economy and in politics. It’s a very slow-burn process.”

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