The Effect of the Stress Tests for the Cyprus Banking Sector

The announcement of the European Banking Authority’s (EBA) Stress Test results triggered various responses within the European financial industry.  Many viewed the results as an important albeit initialmove towards a safer European banking sector under the supervision of the European Central Bank’s Single Supervisory Mechanism (SSM). On the other hand, many argued that similar stress tests had been performed by EBA and the European Central Bank (ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB) in the past without being able to identify the capital shortfalls of European banks.

The ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB and EBA explain that the traditional stress test which is part of the Comprehensive Assessment is similar to the ones in the past with mixed success. However, in the current assessment there was a new element. Using external auditors, the ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB has also simultaneously carried out a comprehensive audit of the participating banks’ assets, called the Asset Quality Review (AQR), in order to identify cases where their assets have not been appropriately valued.  In the case of banks the most important asset class is their loan book, the value of which depends on the borrower’s ability to repay the loan and/or on the value of the collateral securing the loan.

Through the AQR, the EBA and ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB aimed to reveal problematic loans which were previously hidden in the banks’ balance sheets before performing the stress tests.

Most important is to understand what the objectives of the ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB are and what the importance is of achieving those objectives to the various stakeholders of the banking sector in Cyprus.

The major objectives of the ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB appear to be the following:

• Enhancing the harmonization of the European banking sector and providing a better visibility of European banks’ credit quality;
• Cleaning up the system before taking over as a supervisor;
• Ensuring that the European banking sector is ready to work as a transmission mechanism for ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB’s monetary policy;
• Strengthening the perception of ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB as the most credible financial institution in Europe.

These objectives are key pre-requisites, which will allow the establishment of the Single Supervisory Mechanism that in turn is a key step towards the creation of a banking union.

The question that follows is how the achievement of these objectives and the subsequent establishment of the SSM can potentially be an advantage to the different stakeholders of the Cypriot banking sector.

The primary groups of stakeholders who are likely to benefit from the new regime are the depositors, and the benefit for them is twofold, first,through the improved visibility of each bank’s credit quality resulting from the Comprehensive Assessment and second,the fact that Cypriot Banks will now be under the direct supervision of the ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB. These factors will increase confidence amongst depositors who will be in a better position to make informed decisions as to where to deposit their funds.

The borrowers also stand to benefit from the results of the Comprehensive Assessment and the subsequent supervision of Cypriot banks under the SSM.  First, the improved liquidity that will result from the improvement in depositor confidence will allow banks to increase liquidity through the provision of more loans.  Inevitably, this should speed up the recovery of the real economy. Second, reduced liquidity pressure from deposit outflows will lead to a reduction in banks’ deposit interest rates and in turn a reduction in lending interest rates, thus reducing the cost for borrowers.  Finally, regulations such as “Non Performing” loans and the direct supervision by the SSN will strengthen the quality of the loan acceptance, thus protecting borrowers from unsustainable levels of debt.

Further, the direct benefit for the Cypriot taxpayers is that the Comprehensive Assessment has not resulted in any additional capital needs for the Cypriot banking system needed to be covered by the government.

In the future, failing banks supervised by the SSM will be managed by the Single Resolution Mechanism (SRM) of the ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB, which will be financed by the banking sector and will aim to ensure their orderly resolution with minimal costs for taxpayers and to the real economy.

Finally, shareholders and investors are likely to benefit from the improved financial information and better visibility on the credit quality of Cypriot banks resulting from the Comprehensive Assessment, as this will allow them to make better informed decisions and more effectively monitor the performance of the bank’s management.

The results of the stress tests were generally perceived as one of few positive notes involving the Cypriot Banking Sector in the last three years. In order for the Cypriot Banking Sector to regain its appeal towards foreign and domestic investors, it is required to take bold steps forward and ensure that the benefits to the many stakeholders are maximized.