BANKS lend approximately €0.90 of every €1.00 they take in deposits. The remaining €0.10 they hold as ‘liquidity’. Liquidity is a financial term that means the amount of capital that is available as cash at the request of the financial institution. Today, most of this capital is tied up in investments such as equities and bonds, which (theoretically) can be sold and converted into cash at the discretion of the bank.
For Cypriot banks, a part of this €0.10 is held in Greek government bonds which are effectively bank loans to Greece. How much of this €0.10 is in Greek government bonds varies from bank to bank, but the significance of the recently agreed 50% ‘haircut’ in Greek bonds is virtually identical for them all.
The ‘haircut’ reduces the amount that banks will receive from Greece when they redeem these bonds and the interest they receive from them in the meantime. If Greece has borrowed €0.04, the 50% haircut means that it will only have to pay the banks €0.02 – and the banks will lose the other €0.02.
Banks have a number of options open to them to increase/restore their liquidity from €0.08 to €0.10.
Their first is to issue their own bonds, i.e. borrow money from someone else. But this option is inappropriate because, as a result of the market’s low assessment of the Island’s economy and rising bad debts on existing loans, the banks will have to offer bonds at high interest rates.
Their second option is to attract new deposits through higher interest rates; this is already happening. However the increase in deposit rates will also increase the cost of borrowing and will lead to further damage.
The third option available to the banks is to increase their share capital by issuing more shares. For existing shareholders, in order for their investment not to be ‘diluted’, it means that they will have to give more money to a bank to receive the same level of dividend they are receiving on their current shares. But what shareholder, be they new or existing, would want to invest in a bank in Cyprus in the current environment? Cypriot banks are not profitable and are unable to pay dividends – so what is the point of investing in them?
As a consequence of the Greek bond ‘haircut’:
- Firstly, the cost of borrowing on new and existing loans will increase as the banks try to recover losses from their investment in Greek bonds.
- Secondly, there will be a further reduction in lending by banks and stricter criteria for those wishing to borrow money.
- Thirdly, the reduction in loans is likely to reduce growth in the economy and lead to a significant increase in financial pressure on households.
- Finally, the knock-on effect will be an increase in non-performing loans which will increase further the pressure on financial institutions and the Island’s economy.
And what about real estate?
In this article we have not discussed the real estate market, even though the sector has caused a significant part of the problem in which we find ourselves and holds part of the solution. However, as a society, we have yet to recognise that ‘the problem’ will not go away any-time soon. Slowly slowly – and when it’s probably too late – we will then move on and try to solve it.
About the author
Pavlos Loizou MRICS is the lead consultant at Leaf Research
Leaf Research carries out real estate market research and financial modelling for development projects and for properties that are used as part of a business. The company specialises in development, tourism & leisure, health & wellness, the education industry, and ‘green energy’.
(Originally published in Greek, this article first appeared in the Simerini Business Weekly supplement published on 28th October, 2011)