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It cannot escaped many people’s attention that Cyprus was the latest Eurozone country to require a bailout from the “troika” of lenders earlier this year as its banks, heavily exposed to Greece, succumbed to the debt crisis. Nevertheless, while this has necessitated some painful short-term fiscal and monetary policy measures, the banking sector, and the economy in general, is expected to emerge from the crisis relatively unscathed.
Despite the fact that people in Cyprus, in common with those in Greece (along with other Mediterranean countries) have a regrettable habit of not paying all the tax they should, the economy grew lustily until 2008 and barely shrank in 2009 (one of the best performances in the EU) – a year which many thought was the depth of the financial crisis. However, following a weaker-than-expected recovery in 2010, the Cypriot economy flat-lined in 2011, and shrank by 2.3% in 2012. 2013 growth forecasts are at the moment make fairly depressing reading: optimistic predictions suggest that GDP will contract by 5% in 2013, but some analysts are more pessimistic, expecting the economy to reverse by up to 15%.
“The Cypriot economy faces strong headwinds and downside risks due to financial turbulence in the euro area, the large exposure of Cypriot banks to Greece, and the need for substantial fiscal consolidation to stabilize public finances,” the IMF observed in its annual review of the Cypriot economy in November 2012.
The IMF also harboured strong concerns about the health of the jurisdiction’s banking sector, which, with assets totalling over 8 times GDP by the broadest measure, and with significant exposure to Greece, represents, in the Fund’s words, a “significant vulnerability”.
“Banks face significant capital needs to reflect mark to market valuations on their sovereign bond holdings and to achieve a 9% core tier one capital ratio, as mandated by the European Banking Authority. Non-performing loans are increasing, and further loan deterioration could add to recapitalization needs. Meanwhile, the system is also vulnerable to an outflow of deposits in the event of adverse circumstances. Cypriot banks receive significant liquidity support from the European Central Bank,” said the IMF.
In the summer of 2012, Cyprus Popular Bank became one of the first victims of the Greek crisis. In August 2012, it emerged that the island’s second-largest bank was working on a substantial restructuring plan to be put into effect in September to significantly cut its size, involving substantial staff lay-offs and the closure of 60 branches in Cyprus and Greece. However, on September 13, the European Commission announced that it had “temporarily” approved a rescue recapitalisation worth EUR1.8bn that the Cypriot government granted to Cyprus Popular Bank under state aid rules for reasons of “financial stability”. The public support measure was approved for a period of six months and the Cypriot authorities committed to submit a restructuring plan for the bank within that period. The Commission would then take a final decision on the basis of the restructuring plan. To meet capital requirements from the European Banking Authority, Cyprus Popular Bank issued new shares for EUR1.8bn, which Cyprus underwrote in May 2012. Cyprus committed to acquire any new shares not purchased by the general public or existing shareholders. Because private investors had subscribed only to negligible amounts of the offered shares by the end of June 2012, the Cypriot government acquired them and thereby became the majority shareholder of the bank. The government paid the bank by transferring to it a 12-month sovereign bond, which will be rolled over during five years.
The nation's largest bank, the Bank of Cyprus had proved more resilient to the Greece crisis; despite substantial write-offs, the lender had required just EUR500m in state support to meet Tier 1 capital requirements. However, in the summer of 2012, Cyprus began discussions with the Troika group of lenders comprising the European Central Bank, the IMF, and the EU regarding a bailout both to prop up the banking sector, and service the country's deficit.
In April 2013, IMF Managing Director Christine Lagarde confirmed the terms of a bail-out jointly funded by the IMF, the EU and the European Central Bank. A combined financing package of EUR10 billion is designed to help Cyprus cover its financing needs, including to service debt obligations, while it implements the policies needed to restore the health of the economy and regain access to capital market financing.
“The program ahead rests on two pillars,” Lagarde said. “The first pillar aims to restore the health of the financial system and minimize the contingent liabilities from the banks to the state. Recent actions have already resulted in a substantial reduction in the size of the banking system in relation to the economy as well as in restructuring and recapitalization of one of the banks. Going forward, efforts will focus on completing the financial sector recapitalization process, gradually restoring normal financial flows, and facilitating the restructuring of banks’ impaired loans. To prevent the build-up of risks in the future, the program seeks to reform banking supervision and regulation and to enhance transparency.”
The Central Bank of Cyprus confirmed shortly before Lagarde’s statement that as part of the plan to restructure the Bank of Cyprus, deposit amounts that were above EUR100,000 on March 26 would be 37.5% converted into bank shares, and that a further 22.5% might be subjected to the same measure within 90 days of a valuation of the Bank of Cyprus by an independent valuer. The statement also confirmed that a depositor's total loans and credit facilities would be taken into account in determining whether they had reached the EUR100,000 threshold, and that deposits in joint accounts would be divided by the number of individual depositors. The extra 22.5% that may or may not become shares was to be frozen and unable to accrue interest, although the amount that is not finally converted will be eligible for retrospective interest, and a small increment will be added. Deposits made after March 26, 2013 are not affected by any of these measures.
The bail-out plan was narrowly approved by the Cypriot parliament on April 30, 2013, and on September 16, Lagarde said that the Cypriot authorities had made “commendable progress in implementing near-term stabilization policies.”
“Important policy actions were taken to advance the banking sector strategy, including the recapitalization of the two largest banks without the use of public support,” she observed. “Steps are being taken to recapitalize and restructure remaining solvent banks and the cooperative credit sector. Payment restrictions that were earlier introduced to safeguard financial stability will be eased gradually to boost confidence and support economic activity.”
As of September, 2013, the final outcome of the banking restructuring programme remains unclear. The Popular Bank is to be wound up and its balance sheet merged with that of Bank Of Cyprus, which will also take on the very large liquidity support loans that Popular Bank had received from the ECB. What this means for the capital adequacy of the Bank of Cyprus remains to be determined, along with the final details of the depositors’ “bail-in”. Anecdotally, and perhaps surprisingly, major foreign depositors and international businesses do not seem to have deserted Cyprus. Perhaps a case of “lightning doesn’t strike twice in the same place”.
The second pillar to the rescue programme is what the IMF describes as “an ambitious and well-paced fiscal adjustment that balances short-run cyclical concerns and long-run sustainability objectives.” Therefore, the government has taken some painful and necessary steps towards greater fiscal rectitude which are designed to return the deficit, which reached 7% of gross domestic product (GDP) in 2011m to Maastricht levels (3% of GDP) by 2014 and a 4% surplus by 2018. In April, parliament voted to raise corporation tax by 2.5%, to 12.5%, to increase the bank levy on transactions by credit institutions by 0.04%, creating a new rate of 0.15%, and to double the tax rate collected via the Special Defence Contribution on bank deposit interest and dividends to 30%. These measures followed previous waves of austerity measures which included raising the rate of value-added tax, introducing a EUR350 annual company fee and increasing revenues from property taxation. According to the IMF, Cyprus remains on track to meet its fiscal targets.
The Cypriot banking sector has also suffered as a result of the downturn of the real estate market, which, for the previous two decades, was one of the country’s star economic performers. After peaking in 2008, house prices fell by 12% over the next three years, mainly attributable to lower demand from foreign buyers, particularly the British. Nonetheless, the Cypriot real estate market has not experienced the sort of declines witnessed elsewhere; house prices in Ireland for example have fallen well over 50% since hitting their 2007 peak. And the fundamentals remain unchanged: Cyprus was, and will again be, a highly attractive destination for international real estate buyers, both English-speaking and otherwise. There are significant Russian and Middle-Eastern communities which will attract new entrants in due course. What’s more, underlying Cypriot real estate prices are still well below those in comparable locations around the Mediterranean.
Moreover, despite the recent increases in taxation, Cyprus is still very competitive from a tax perspective, despite rumblings of discontent over the banking levy and the government’s decision to raise corporate income tax; companies - including banks - need to establish a headquarters somewhere in the EU, and with its near absence of withholding taxes and still-low corporate taxation Cyprus remains in a good position to attract investment. If the government helps with other business-friendly measures, the island will surely attract a good flow of incoming financial services operators, who can then provide their services throughout the EU under the passporting directive. The Central Bank certainly has this as one of its objectives, and pursues policies which are very welcoming to foreign banks. Even if the domestic sector could be said to be adequately, if not over-banked, there are plenty of international opportunities both in the financial services sector itself and also in the support of non-domestic activity, notably including the maritime sector, where Cyprus has a well-established regime and very tax-friendly policies.
The days are long gone in which Cyprus, followed by Malta, was somehow involved in Russian capital flight. The Prevention and Suppression of Money Laundering Law of 1996 has been largely successful: in April 1998 a Select Committee of Experts from the Council of Europe reported enthusiastically about the island's measures to control money laundering. On December 13, 2007, the House of Representatives enacted an updated Prevention and Suppression of Money Laundering Activities Law, which consolidated, revised and repealed the 1996 law. Under the current Law, which came into force on January 1, 2008, the Cyprus legislation has been harmonised with the Third European Union Directive on the prevention of the use of the financial system for the purpose of money laundering and terrorist financing (Directive 2005/60/C).
The present Law, as the previous one, designates the Central Bank of Cyprus as the competent supervisory authority for persons engaged in banking activities and money transfer business. Under this framework, the Central Bank of Cyprus has the responsibility of supervising and monitoring the compliance of banks and money transfer businesses with the provisions of the Law for the purpose of preventing the use of the financial system for money laundering and terrorist financing activities.
The Central Bank's list of financial institutions under its sway currently includes 42 entities, including six local banks, eight subsidiaries of foreign banks (most of which are from EU member states), 27 branches of foreign banks (11 of which are from the EU), and one representative office.
In April 2008, the Central Bank of Cyprus issued a revised Directive to the banks, in accordance with the provisions of the Law of 2007, requiring the introduction of new revised policies and procedures, as well as the upgrading and enhancement of the measures and systems for the effective prevention of money laundering and terrorist financing in line with the FATF standards and the Directives of the European Union in this sector. It is emphasized that the Law explicitly states that Central Bank of Cyprus Directives are binding and compulsory for all persons to whom they are addressed.
Since 1997, a special Unit for Combating Money Laundering has existed at the Attorney General’s Office which is responsible for the receipt and analysis of suspicious transaction reports and money laundering investigations. In the course of money laundering investigations, this Unit may apply to the Court and obtain an order for the disclosure of information addressed to any person, including banks, who may be in possession of information related to the investigation as well as orders for the freezing and confiscation of funds and property suspected to be derived from money laundering.
In March, 2009, Cyprus ratified the Council of Europe Convention on Money Laundering, Search, Seizure and Confiscation of the Proceeds from Crime and on the Financing of Terrorism (CETS No. 198). The convention opened for signature to the member states of the Council of Europe, the non-member states which have participated in its elaboration, and the European Community, in Warsaw, on May 16, 2005. It entered into force on May 1, 2008. The latest convention replaces the Council of Europe’s 1990 convention, providing legislation to take into account the fact that not only could terrorism be financed through money laundering from criminal activity, but also through legitimate activities.
The Central Bank has always stoutly denied culpability for the events of the early '90s, and it is certainly true by now that the banking sector is super-clean, with tight local and EU regulation and supervision, which is due to become even more stringent (as in all EU countries) with new prudential directives emanating from Brussels.
For the offshore investor, Cyprus banking law provides a reasonable but not outstanding level of non-disclosure. Offshore entities must disclose beneficial ownership to the Central Bank on formation, but Central Bank employees are bound to secrecy by Section 3 of the Central Bank Law 37 of 1975 (now Section 29 of the Banking Laws 1997 to 2013). Normally speaking, local banks apply about the same standards of confidentiality as apply in English law. In December, 2003, the Government announced plans to breach banking confidentiality, allowing the tax authorities access to residents' bank accounts. This made it possible for the government to run a tax amnesty scheme targetting those with undeclared bank accounts.
The rules for exchange of information with foreign states are a complex mixture of the local taxation laws, the network of double-tax treaties, and international agreements for mutual legal assistance and the exchange of information to which Cyprus is a signatory, now further complicated by the EU acquis communitaire which substantially worsens the position of individuals and corporations as regards secrecy. However Cyprus law does provide for normal judicial appeal procedures against treaty requests for information and cooperation.
As part of its support for international banking, the Central Bank has followed a policy of entering Memoranda of Understanding with other countries' financial regulators. Typically, such Memoranda define a general framework of mutual cooperation and exchange of information between the two supervisory Authorities, with a view to facilitating the consolidated supervision of cross-border establishments, and ensuring the safe functioning of credit institutions in their respective countries, in accordance with their national laws and regulations. Such Memoranda have been signed with Austria, The Dubai Financial Services Authority, the Central Bank of the Russian Federation, the Bulgarian National Bank, the National Bank of Ukraine, the National Bank of the Republic of Belarus, the National Bank of Serbia, the National Bank of Romania, the Financial and Capital Market Commission of the Republic of Latvia, the National Bank of Slovakia, the Bank of Tanzania, the Central Bank of Jordan, the Bank of Greece, the Banque du Liban, the Central Bank of Armenia, De Nederlandsche Bank N.V. and the Jersey Financial Services Commission, all of these being countries with financial interests in Cyprus. A number of further Memoranda are under negotiation.
Also not to be forgotten in assessing the attractions of Cyprus as a financial centre is its network of double tax treaties, particularly with the ex-member countries of the USSR. Cyprus figures high up on the list of 'conduit' countries for FDI into Russia and other Eastern European countries, and the flows of investment in one direction and tax-privileged dividends in the other must of necessity pass through Cyprus-resident banks.
So, while the short-term outlook for the Cypriot banking sector, and the economy in general, looks turbulent, the country’s long-term economic fundamentals remain in good shape.
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