MAJOR reforms to the definition of non-performing loans have been announced in a draft directive issued by the Central Bank of Cyprus (CBC) to banks and financial institutions domiciled in Cyprus.
As a result of these new preliminary instructions from the CBC there are significant concerns about soaring non-performing loans, since from now on what will matter will be the repayment ability of borrowers and not the actual value of the tangible real estate which is used as collateral.
In the Memorandum of Understanding (MoU) signed by the Cyprus government, it is clearly stated that the Central Bank of Cyprus will provide guidance on the classification of loans as non-performing (NPLs).
The NPL definition will be amended to include all loans due by more than +90 days, which will comply with the European and IFRS accounting standards. Note that by changing the NPL definition this will automatically imply a huge financial hit on the banks in terms of capital requirements.
The major amendment will be that where the value of the collateral (real estate) is greater than the amount of the loan outstanding, then even in those cases the loan will be classified as being non-performing (until now it was not) and the bank will need to make a provision for the difference between the amount of the loan and the value of the collateral. For instance, if a customer has a loan of €300,000 with a property (collateral) market value at €500,000 and this loan is not repaid normally, i.e. on a monthly basis (depending on the loan repayment schedule), then this loan will be classified as non-performing despite the fact that the value of the collateral is higher than the loan amount.
Furthermore, the underlining philosophy of monitoring existing and, importantly, granting new loans will be heavily focused on the repayment ability of borrowers and not so much on the value of the collateral as bankers practiced in recent years.
In summary, and as per the preliminary instructions drafted by the CBC, a non performing loan will be considered:
- Any loan with arrears exceeding 90 days. That is, if a customer of a specific bank during a loan left unpaid three instalments.
- Loans with adequate collateral, but with a delay of 90 days.
- If 20% of the total debt of a borrower is not served (i.e. becomes non-performing), then all of the loans and other facilities will be categorised as non-performing in the bank’s books.
- All restructured loans (e.g. extension of repayment terms, etc) will be made non-performing for a year. Also, the extension/lengthening loan twice in a year will require classification of the loan as non-performing. It is worth noting that the extension of a loan once in a year does not necessarily mean that the loan will be is classified as non-performing. Under the preliminary instructions from the CBC, the restructuring/rescheduling of loans will include:
- Interest rate reduction. Previously, banks restructured the loan of a customer but at a premium: the increase of the current interest rate (‘re-pricing’), many times achieving an increase of 2-4% on interest income. This will now change, affecting banks’ profitability but helping struggling households and businesses to repay off the loans.
- Concession of a grace period for paying only the interest (interest only period), and granting a grace period for a full freeze of instalments. Any loans which were non-performing and after restructuring become performing will remain in the non-performing loans category for a year.
Based on the new guidelines drafted by the CBC, apart from loans, current accounts and credit cards will also be classified non-performing. Also, overdraft accounts will be considered as non-performing if they exceed a 5% limit for 90 days.
To clarify, once a loan is “classified” as a non-performing, this action does not automatically initiate the foreclosure/forced-sale procedure of properties (collateral). The troika indicated that the administrative hurdles and the legislative framework currently constraining the foreclosure and sale of loan collateral will have be amended so that the property pledged as collateral can be foreclosed within a maximum time-span of 1.5 years from the initiation of legal proceedings. In the case of primary residences, this time-span could be extended up to 2 to 2.5 years.
In the MoU it is stated that the necessary legislative changes will be implemented by 2014, macroeconomic conditions permitting. We believe that the time span for the eviction from primary and secondary residences will be subject to a significant debate as there are significant social and financial implications associated with it.
Also, we believe that given the present economic conditions in Europe, and specifically in Cyprus, it is not in the banks’ interest to repossess such assets as property prices have significantly decreased, something which will impact capital levels and profitability, and most assets are illiquid. However, we believe that new ‘mortgage rescue schemes’, such as the ones applied in the UK, should be used and should be strongly supported by the government.
All these reforms are in the right direction to create a reliable and dynamic financial system. With the above reforms, banks in Cyprus will be forced to make higher provisions which will have a direct impact on capital and profitability, consequently affecting households and businesses. All these guidelines are necessary however in order to regain credibility as a regional financial hub, creating banks with solid foundations that can serve the real economy of our country.