Cyprus' banks reduce their Non-Performing Loans. See how it is done, and weep.

There was an lol for me today, thanks to an article in the Cyprus Business Mail announcing that Non-performing loans (“NPLs”) in the Cypriot banking system had fallen in March 2018 by almost €2.1bn to €19.9bn compared to February’s figure, and that this was the lowest figure for NPLs since December 2014, according to figures issued by the Central Bank of Cyprus (“CBC”).

The NPLs ratio in the system fell in March from 45.3% in February 2018 and 46% in March 2017, to 43% – i.e. 43% of all loans extended by Cyprus’ banks are NPLs.

A bank should now have Tier 1 capital in the order of 9% of its loans, which should all be Performing bar a few, perhaps 1-2% of NPLs out of total loans. It should have Tier 1 capital of anything between 25% and 100% of its NPLs, depending on how bad they are. Cyprus’ banks may have 9% Tier 1 capital but only of total loans, without the extra capital to reflect the risk of loss on NPLs. There is glaring black hole where that extra capital should be and this absence renders Cyprus’ banks insolvent: unable to meet their liabilities as they fall due from the proceeds of their assets.

Cyprus’ banks are locked into a form of continuous bailout in this mode with rolling lines of credit from CBC and the other Eurozone central banks, until every now and again a bank does go over the edge, as Cyprus CoOperative Bank did recently, in which case another Cyprus bank (in this case Hellenic) was wheeled in to acquire its deposits and its Performing loans, and the Cyprus taxpayer was awarded the NPLs.

CBC tells us that the implementation of international financial reporting standard (IFRS) 9 in January led then to an increase in banks’ NPLs, but now a new classification methodology is in place which “provides for a minimum 12-month probation period for restructured facilities”.

We read that as meaning that when an NPL has been “restructured” – meaning things like the unpaid interest has been capitalised, the repayments have been stretched out and other forbearance actions taken - the NPL is then counted as Performing. It is backed out of NPLs, which reduce, and the loan cannot fall back into NPLs whatever happens for a year.

That is very bad, not very good; it means that Cyprus’ banks can enjoy a reduction in NPLs that will last at least a year by basically letting the borrower off the hook.

CBC’s further statements reinforce this unease: “The downward trend in NPFs (non-performing facilities) can be attributed to write-offs, increased restructurings successfully completed by the end of the observance period and reclassified as performing facilities, repayments as well as settlement of debt through swaps with immovable property that is expected to be sold with the aim of a faster cash collection”.

The point about “immovable property” is that any hope of the loan being repaid via the borrower’s cashflow is replaced by reliance on mortgage security, no doubt with suitably lax conditions around the Loan-to-Value, the size of the re-sale market for the asset if repossessed, the length of the legal process for repossession and so on. Nevertheless, the loan can then be classified back into Performing due to this new security, even if the security does not get sold. This sort of chicanery is what the ECB's Mme Nouy recently recommended for adoption across the entire Eurozone banking system.

CBC admits that loan restructurings do involve write-offs but adds, emolliently, that the write-offs are “amounts that already form part of credit institutions’ loan loss provisions,” which fell by €2.2bn in a month to €9.7bn in March.

It may well be that Cyprus’ banks had either built up a Loan Loss Provision on the liability side of their balance sheets to account for the impairment of the value of these loans on the Asset side, or that they had written off part of the value of the asset by taking a charge through the P&L account, and were now valuing the loans at a “carrying value” below face value.

It seems far-fetched to imagine that Cyprus’ banks can afford to put new write-offs through their P&L accounts, or that their loan loss provisions were already adequate to cushion the realisation of losses on the 43% of their loan book that had gone bad.

No, it is more plausible that the main factors that have reduced NPLs are restructurings involving forbearance techniques and the pledging of mortgage security of whatever quality.

The factor that normally reduces NPLs is not even mentioned: the ability of borrowers to meet their commitments when they could not do so before.

NPLs have been reduced thanks to accounting policies and the watering-down of borrowers' commitments, not thanks to a recovery of the economy or of the creditworthiness of borrowers.

That this should be recorded as some form of success is measure of the depth of the difficulties in which the Cyprus banking system remains mired, and the Cyprus banking system can be taken as a proxy for the Eurozone banking system as a whole.