Are banks learning to swim in cash?

The latest liquidity statistics released by the Single Supervisory Mechanism revealed that Cypriot banks are swimming in cash.

They have more cash than they know what to do with, according to the official liquidity coverage ratio (LCR), which is almost twice as high as that of the EU average.

Cypriot banks have 311.61% LCR, the third-highest in the banking union, which compares unfavourably with the EU’s average of 171.78%, far exceeding the minimum regulatory requirement set at 100%.

The LCR essentially refers to the proportion of highly liquid assets held by banks to ensure their ongoing ability to meet short-term obligations.

According to professor Panicos Demetriades, who served two years as Central Bank of Cyprus governor: “Liquidity coverage ratio is a relatively new regulatory requirement that was put in place through Basel III, which took on board the lessons learnt from the freezing of money markets during the Global Financial Crisis.

“It requires banks to have enough liquid funds to withstand a 30-day stress scenario, agreed with supervisors.

“It seems the supervisory interpretation being utilised relates to withdrawals in the last month (which doesn’t correspond to a stress scenario) during the current conditions.

“The fact that Cyprus is currently ranked third in the euro area in terms of the LCR, albeit seemingly positive, should not be over-interpreted.

“It is merely a reflection of the lack of profitable lending opportunities in the banking system, which itself is because of the legacy of an over-indebted private sector.

“Indeed, other indicators such as the leverage ratio are consistent with the same picture: relative to their equity, Cypriot banks are not lending as much as banks in other eurozone countries.”

Challenges for banks

Limited lending opportunities combined with excess liquidity suggests there are challenges not just for the banks but also for the economy.

People prefer to stash money anywhere that is considered safe, and they don’t want to take any risk, even if that means their purchasing power is eroding.

On the other hand, the financial services sector has a potential market to tap into if they can access these depositors and convince them that they have products that can address their investment needs.

One glimmer of hope is banks will be able to lend more as businesses reassess the post-Covid-19 situation and renew their plans.

But that might prove to be a long shot.

Many companies are still recovering from weak demand, and access to new lending may prove difficult unless the government steps in with its plan to provide state guarantees.

However, countries like Germany, with a much stronger economy and diversified industry, enjoy the lowest LCR at 158.62%.

Cypriot banks will have to work harder and smarter to deal with their excess cash and turn it into profit.

Resorting to consumer lending is not the answer.

On the flip side, the excess liquidity shows that Cypriot banks went a long way since 2013 to restore trust.

Although local depositors have few choices regarding depositing their money, the single market offers a good menu of products for those who put safety above returns, such as money market funds, sovereign debt instruments and the list increases as the risk tolerance grows. Capital & liquidity buffers

According to the ECB, “Capital and liquidity buffers have been designed with a view to allowing banks to withstand stressed situations like the current one.”

The European banking sector has built up a significant amount of these buffers.

The ECB said it “will allow banks to operate temporarily below the level of capital defined by the Pillar 2 Guidance (P2G), the capital conservation buffer (CCB) and the liquidity coverage ratio (LCR).

The ECB considers these temporary measures will be enhanced by the appropriate relaxation of the countercyclical capital buffer (CCyB) by the national macroprudential authorities.”

Banks will also be allowed to partially use capital instruments that do not qualify as Common Equity Tier 1 (CET1) capital, for example, Additional Tier 1 or Tier 2 instruments, to meet the Pillar 2 Requirements (P2R).

It brings forward a measure initially scheduled to come into effect in January 2021 as part of the latest revision of the Capital Requirements Directive (CRD V).

The above measures “provide significant capital relief to banks in support of the economy.

Banks are expected to use the positive effects coming from these measures to support the economy and not to increase dividend distributions or variable remuneration,” the ECB said.