Grant Stein discusses the banking crisis in Cyprus, which unfolded this year, leaving banks in Cyprus greatly exposed to systemic risk with a combination of bad lending and large holdings of Greek sovereign debt.
The nightmare scenario of the Cyprus banking crisis unfolded one morning in March of this year. Depositors awoke to the news that the EU bailout of the Eastern Mediterranean republic would mean losses of around 40 per cent of their cash balances, as savings were swapped for shares in a domestic banking sector already on its knees.
As the sovereign debt crisis enveloped Europe, banks in Cyprus were greatly exposed to systemic risk with a combination of bad lending decisions and particularly large holdings of Greek sovereign debt. These bonds saw yields as high as 30 per cent last year, before a debt restructure, a huge EU bailout and likely decades of austerity to follow. The lightly regulated banking sector in Cyprus also attracted huge deposits from Russia and other states in the CIS.
Impacting hard-working savers, wealthy depositors and the ubiquitous Russian oligarchs without favour, Germany reluctantly voted on the €23 billion EU bailout package. The German Finance Minister, Wolfgang Schaeuble, said that those seeking out the higher interest rates on offer in Cyprus would have to accept the greater risks associated with investing in a banking system with lighter regulation.
A harsh lesson perhaps, but with other EU banking centres similarly exposed to the European sovereign debt crisis, it remains to be seen what action would follow should other indebted nations, such as Slovenia, require an EU rescue.
While the Cyprus bail out could be a blueprint for the future, it is clear that the EU considers that country's banking sector to be too large, at around eight times GDP, and would like to see that figure halved, to fall into line with the EU average. Luxembourg, with the biggest banking sector relative to GDP in the Euro Zone at more than 20 times according to studies by both the ECB and Lombard Street Research, has been similarly in the spotlight
More significantly for the leading small IFCs around the world, it has been claimed that such a blow-up in the Cayman Islands would make the Cyprus crisis look like ‘child's play’, given the huge disparity between its large banking sector and by comparison, a miniscule population. For an island with a population of less than 57,000, finger pointing at Cayman focused on its banking and financial sector, which is worth around 750 times GDP.
Professor Jeffrey Sachs of Columbia University's Earth Institute in New York attempted the math, calculating that Cayman's approximate US$1.4 trillion of banking assets and liabilities equates to some US$24 million per resident. Sachs described the situation as a "house of cards providing a mortal threat to the world economy", which is far beyond the capacity of regulators in Cayman to control. However, what he demonstrates here is a complete failure to understand the nature of the banking system in the Cayman Islands and, significantly, how it differs to Cyprus.
Structurally, the Cayman Islands' banking sector differs greatly from Cyprus and other troubled economies in Europe. The key difference is that a major proportion of the banking assets registered in Cayman are US banks - and banks from all over the world - placing overnight deposits in their own branch or subsidiary, which is registered in the Cayman Islands. They are not lending and certainly not lending on the back of a real estate bubble, as has taken place across Europe as well as in the US. This means the money is effectively being transferred between accounts in New York and other financial centres and would not be exposed to the investment ideas or whims of any banker or asset manager based in the Cayman Islands.
According to the Cayman Islands Monetary Authority, over 80 per cent of more than US$1 trillion on deposit and booked through the Cayman Islands represents inter-bank bookings between onshore banks and their Cayman branches or subsidiaries and these type of institutions represent a very low risk profile for systemic risk or money laundering. The long and short of the debate is that banks in Cayman are very conservative when it comes to opening accounts and lending money and the system is certainly not characterised by local banks lending out funds they have on deposit.
The Cayman Islands Monetary Authority said this year that the fundamentals of its banking sector remain sound and the industry in general has been relatively resilient in a very challenging market environment. Banks continue to consolidate and restructure in search of cost efficiencies, and improvements in operational risk management and governance. As of December 2012, banking assets in Cayman stood at US$1.409 trillion, which was down from US$1.543 trillion at the same time in the previous year where total assets stood at US$1.75 trillion, according to the Bank for International Settlements.
There have also been no significant changes to banking regulation in the Cayman Islands in recent years. The banking sector in the Cayman Islands is already well regulated and Cayman’s regulatory framework has been positively appraised by the International Monetary Fund and the Financial Action Task Force. Additionally, the financial industry in the Cayman Islands is extremely diversified, so the arguments being used in relation to what happened in Cyprus are simply not applicable.
As no primarily Cayman based financial institution was significantly affected by the global financial crisis, we have not seen any major Cayman based banking litigation taking place. The banking litigation we have seen in Cayman has been peripheral to wider issues related to onshore matters. At the same time, the banking system in pockets of Europe continues to struggle under the weight of bad loans, with Slovenia and its primarily state run banking system seen as the next likely candidate for a bail out. Relatively oversized banking systems in Malta and Luxembourg are also in the firing line, albeit to a lesser extent with a greater proportion of foreign owned lenders.
There has also been no suggestion of any possible government intervention in the private sector and no suggestion of any measures in any shape or form that may involve bank account confiscation. A high level view of the global outlook for the Cayman Islands economy and financial system produces further clear blue water compared with Cyprus and other struggling nations. In February 2013, Moody's affirmed the Cayman Islands' Aa3 Sovereign Rating, maintaining its Stable Outlook. Moody's said: “Cayman's stable outlook balances the very high levels of economic development and still low debt metrics with the potential risk of recently rising debt burdens. While debt at less than 25 per cent of GDP remains low by international standards, the debt rose rapidly between 2007 and 2011. Since then the government has stabilised the debt burden and the projection of small deficits going forward support the current outlook.”
Grant Stein is the Global Managing Partner for Walkers, the global offshore law firm of choice for investment banks, international law firms, collateral managers, and other financial institutions. Based in the Cayman Islands with offices in the British Virgin Islands, Dubai, Hong Kong, Jersey, London, and Singapore, Walkers provides clear, concise and practical advice based on an in-depth knowledge of the legal, regulatory and commercial environment in the Cayman Islands, the BVI, and Jersey.
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