Cypriot Banking Crisis Issues - Essay Example

?Cypriot Banking Crisis Introduction In 2002, the late mortgage payments recorded the highest value in the recent history of Europe. In August 2007, BNP Paribas SA which is the largest bank in France, froze three investment funds of approximately 1.6 billion euros worth, as the “U.S. subprime mortgage losses roiled the credit markets” (Boyd, 2007). Consequently, the European stock index declined by 1.9 percentage proportion. This is marked as the first sign of a financial crisis appeared in the EU zone. This alarmed the policy makers and called for an urgent European crisis management framework. Nevertheless even by the end of year 2009 formulating of such an effective crisis management framework had been inadequately progressed (Ferry and Sapir, 2009). The currently unfolding banking crisis in Cyprus can be considered as the latest stage of EU zone banking crisis. Literature Review Fragility of the Cypriot Banking System: Situation before the Bailout The following chapter presents existing literature regarding the problems of banking system in Cyprus. Gunsel, 2007, defined bank failure as “a situation in which banks were closed because of financial difficulties.” Accordingly during the period of 1999-2002 the rate of banking failure in North Cyprus had been as high as 32.4 percentage proportion of the total banks in the country. The number of total banks in North Cyprus declined from 37 in 1999 to 25 towards end of 2002. Example: the Cyprus Credit Bank Ltd., Cyprus Liberal Bank Ltd., Everest Bank Ltd., Kibris Yurtbank Ltd. and Cyprus Finance Bank Ltd., were closed due to bankruptcy in 2001. Moreover, the Cyprus Commercial Bank Ltd., Yasa Bank Ltd., Tilmo Bank Ltd., Asia Bank Ltd., and Cyprus Industrial Bank Ltd. were taken over by the Saving Deposit Insurance Fund (SDIF) of the country during the same time period. Estimated cost of banking failure in year 2000, amounted approximately 200 trillion TL, (almost 50 percentage proportion of the national GNP of previous year) in the Turkish Republic of Northern Cyprus. Banking sector comprised of 6.3 percentage proportion (568.4 million TL, in 1977 prices) of the country’s GDP in 1999. It steadily declined reaching 4.8 percentage proportion (416.1 million TL, in 1977 prices) by 2002. The global economic crisis is recognized as the leading cause of this deteriorating. In 1999 the banking sector provided employments to approximately 3.5 percentage proportion of the total working population in Northern Cyprus. Contribution of the financial for providing employments to the Cypriot economy severely dropped after closing of the banks. In 2002 only 2.6 percentage proportion of the country’s employments were provided by the financial institutions. Further, the other sectors in the economy showed slight recovery from the economic crisis towards the end of year 2002 however, financial sector remained unrecovered. The failure of the system was evident in the revoking of banks from operation and taking over by other banks (Safakli, 2003). Failure of the Banking System: Root Causes Gunsel, 2007, revealed that inadequate capital, poor asset quality, high interest expenses, low profitability, low liquidity and small asset size are significant variables that determine the likelihood of bank failure in North Cyprus. Black, 1995, revealed that poor risk analysis by the banks especially during the expansion phase of the business cycle can trigger banking crises. Inefficient internal credit control systems may fail to monitor the amount and quality of bank loans. Hoenig, 1999, revealed that connected lending or lending to the companies or development projects connected with the bank owners or managers despite their limited profitability as a major cause of bankruptcy in the region. Banks which lack capital assets are more susceptible to the shock of an economic downturn. According to the Bank for International Settlements (BIS) a minimum of 8 percentage proportion capital to risk weighted assets ratio is required for all international banks. High leverage can affect the profitability of any business venture. If the bank is operating below the minimum of 8 percentage proportion of the capital to risk weighted assets ratio, such capital can lose value by slight changes in the interest rate. Similarly if the borrowers are relying mainly on bank loans for financing businesses such may experience sever financial losses due to a small rise in interest rate (Huang ve Vajid, 2002). According to Demirguc-Kunt and Detragiache, 1998, low GDP growth, high real interest rates and inflation also can increase the likelihood of systemic banking crises. Crisis Management Framework in the EU zone Financial and banking system in the European Union largely collapsed since 2007. It is widely believed that the EU was ill-prepared to manage the upcoming challenges of integration process that the countries’ financial systems were undergoing during this period. There was limited transparency regarding the motives of main financial institutes & the public across the zone. The ad hoc coordination between the financial institutes when managing the 2007-2009 financial crisis worsened the instability of the EU zone banking system. “Banking Crisis Management In The Eu: An Interim Assessment” by Ferry and Sapir, 2009, revealed that key components of financial stability and crisis management are; national banking supervisory bodies, central banks, treasuries and deposit insurance schemes within the countries of EU. The above interim assessment is an optimistic forecast regarding the financial crisis management in the EU zone. Cyprus is the 5th country in the Euro zone followed by Greece, Ireland, Portugal and Spain to receive 10-billion euros bailout from the International Monetary Fund. The main objectives of the crisis management framework which is currently adopted by the EU zone can be listed as; (1) protecting the stability of the financial system in all EU countries (2) Management of a cross-border crisis is based on the common interest for all member states affected. If public resources are involved, direct budgetary net costs are shared among affected member states on the basis of “equitable and balanced criteria” (3) Full participation in management and resolution of a crisis will be ensured at an early stage for those member states that may be affected through individual institutions or Infrastructures and (4) Policy actions in the context of crisis management must comply with EU competition and state-aid rules (Ferry and Sapir, 2009). IMF Rescue Package to Cyprus Cyprus officially requested a rescue package from IMF in June 2012. Negotiations regarding the terms of the rescue package proceeded until March 2013 between the Euro-group and the Cypriot government. Eventually both parties agreed to the following; downsizing of the financial sector (with the domestic banking sector reaching the EU average by 2018), strategic fiscal consolidation, structural reforms and privatization in the banking sector. In order to achieve the above, “Laiki Bank of Cyprus” which is the second biggest bank in the country will be closed, rate of tax on withholding capital income and the statutory corporate income will be increased, Bank of Cyprus will be re-capitalized through a deposit/equity conversion of uninsured deposits with full contribution of equity shareholders & bond holders and the country will receive 10-billion euros bailout from the International Monetary Fund (Cyprus MoU, 2013). Currently a maximum withdrawal limit is being formulated for the depositors. To prevent funds going abroad, a restriction has been imposed upon the travelers leaving the country as 3,000 euros maximum. Implications of the Cypriot Bailout to the World Economy Clearly, IMF rescue package for Cyprus is not aimed at re-establishing the country’s banking sector stability. It is formulated based on the common interests of the EU countries. The above rescue package cannot be viewed as a profitable deal to the country. Financial sector comprises a significant proportion of country’s GDP and employments. Closure of large banks and discouraging of national and international depositors will further affect the viability of the Cypriot banking sector. Example: approximately 40percentage proportion of the total large depositors in the country can lose due to the proposed package (Reuters, 2013). Structural reformation of the banks which is aimed at integrating and strengthening the financial system across the EU zone can favorably contribute to the economic growth of EU countries. References Black, F. “Hedging Speculation, and Systemic Risk.” Journal of Derivatives 2 (1995). Web. 25 April 2013 Boyd, Sebastian. “BNP Paribas Freezes Funds as Loan Losses Roil Markets.” Bloomberg L.P.4. N.p. 9 August, 2007. Web. 25 April 2013 Demirguc-Kunt, A. and Detragiache, E. “The Determinants of Banking Crises in Developing and Developed Counties.” IMF Staff Papers (1998): pp.83. Ferry, J.P. and Sapir, A. Banking Crisis Management in the EU: An Interim Assessment. Tilburg University, 23-24 Oct. 2009. Web. 25 April 2013 Gunsel, Nil. “Financial Ratios and the Probabilistic Prediction of Bank Failure in North Cyprus.” European Journal of Scientific Research 18.2 (2007): 191-200. Web. 25 April 2013 Hoenig, Thomas. “Financial Regulation, Prudential Supervision, and Market Discipline: Striking a Balance.” Conference on the Lessons from RecentGlobal Financial Crises. Federal Reserve Bank of Chicago, 1 October 1999 Huang, H. Ve Wajid, S. K. “Financial Stability in the World of Global Finance.” Finance & Development (2002): 13-16. Reuters, James Saft. “Managing Wealth: What all investors can learn from Cyprus.” Financial Post. National Post, Postmedia Network Inc. 25 March 2013. Web. 25 April 2013 Safakli Okan. “Basic Problems of the Banking Sector in the TRNC with Partial Emphasis on the Proactive And Reactive Strategies Applied.” Dogus Universitesi Dergisi 4.2 (2003): 217-232. Web. 25 April 2013 The Eurogroup Statement on Cyprus. 25 March 2013. Web. 25 April 2013 Read More