Cyprus
Assessment of Financial Sector Supervision and Regulation, including Reports on the Observance of Standards and Codes on the following topics: Banking Supervision, Insurance Supervision, and Securities Regulation

The report summarizes the assessment of Financial Sector Supervision and Regulation on Reports on the Observance of Standards and Codes (ROSC) on banking supervision, insurance supervision, and securities regulation of Cyprus. The report assesses that the financial system in Cyprus is in a process of reform generated by liberalization and regulation owing to accession to the European Union. The paper analyzes competency in the banking sector and technical supervisory rules, and assesses its strengths and vulnerabilities in the implementation of financial standards mainly in cross-border cooperation, information exchange, and consolidated supervision.

Abstract

The report summarizes the assessment of Financial Sector Supervision and Regulation on Reports on the Observance of Standards and Codes (ROSC) on banking supervision, insurance supervision, and securities regulation of Cyprus. The report assesses that the financial system in Cyprus is in a process of reform generated by liberalization and regulation owing to accession to the European Union. The paper analyzes competency in the banking sector and technical supervisory rules, and assesses its strengths and vulnerabilities in the implementation of financial standards mainly in cross-border cooperation, information exchange, and consolidated supervision.

I. Financial System Overview

A. Background

1. The Republic of Cyprus joined the EU in May 2004, signaling a major change in its institutional and regulatory structure which is expected to benefit the financial sector and economy significantly.1 The government-controlled area of the Republic had a population of 796,000 and per capita income of $16,602 in 2003.2 The single most important industry is tourism, but financial intermediation contributed 5.7 percent to real GDP in 2003, and the group “real estate, rentals and business activities,” which reflects international business services, was 14.1 percent of total output and was an important contributor to real growth in 2003.

2. Following a relatively weak performance in 2002–03, the economy recovered with real growth expected to average 3.5 percent in 2004–05. Recovery has been led by consumption fed by fiscal easing and, possibly, a confidence effect from entry to the EU, though sluggish tourist spending lowered the contribution of expanded arrivals.3 Unemployment remains low by European standards, while inflation has crept up modestly on rising energy prices. The Cypriot pound is pegged to the Euro with a formal fluctuation margin of ±15 percent, but with a de facto narrow band around the central parity of €1.7086: £C 1; adoption of the Euro is targeted.

3. Low corporate tax rates for international companies serving nonresidents were the major attraction of locating in the international or offshore sector in Cyprus up to end-2001. In addition, geographical location and political stability since the late 1970s attracted to Cyprus companies from areas with political and civil disturbances. Thus, the civil war in Lebanon, formerly an important business center in the Middle East, the dissolution of the former Soviet Union, and East European conflicts attracted business from these areas to Cyprus.

4. It is expected that international companies will continue to be attracted to the island despite the increase in taxes and tightened regulations resulting from EU accession. Continuing stability, prosperity represented by EU membership, an extensive network of over 30 double taxation treaties, and a rate of corporate tax (10 percent) that remains low relative to others in Europe, as well as the skills available on the island are expected to provide the necessary incentives.

5. The legal provisions and supervisory arrangements for AML/CFT were found to be quite satisfactory by a 2005 MONEYVAL mutual evaluation of the AML/CFT regime, based on the 2003 FATF Forty Recommendations and the Nine Special Recommendations on Terrorist Financing (both revised in 2004). Nevertheless, the mutual evaluation indicated areas for improvement.

B. Financial Institutions and Markets

6. Cyprus has three classes of credit institution, an active insurance market, and a developing securities market (see Table 2). Before the EU-propelled reforms (see Box 1), institutions operating in the offshore or international financial center, including international banking units (IBUs) were distinguished from domestic institutions by their status as foreign-owned entities restricted to doing business with nonresidents in foreign currency and paying the preferential tax rate. Credit cooperatives were, however, lightly regulated relative to the domestic banks. The market is dominated by three groups4 which are active in all three sectors—banking, insurance, and securities. However, their banking retail operations are subject to effective competition from the traditional cooperative sector that, not only had looser regulation but has lower operating costs and nonprofit goals.

Table 2.

Financial System

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Sources: Central Bank of Cyprus, Cyprus Securities and Exchange Commission, Insurance Companies’ Control Service

Number of institutions with 75 percent of total assets.

Number of institutions with 75 percent of total deposits.

Data for 2005 is provisional.

Composite insurance companies and EU branches are not included.

Data prior to 2003 are not available because data files were relocated.

Firms licensed by CySEC under the 2002 investment firms laws.

From 2003 international financial companies refer to financial advisory firms plus international trustee services companies.

Data for 2004 is at June.

Summary of Changes Resulting from European Union Membership

In May 1, 2004, Cyprus joined the European Union, as the culmination of a series of policy reforms which harmonized its regulations with the acquis communautaire. Changes related to capital account liberalization, financial regulation, and taxes have removed official differences between the international and domestic financial sectors, ending their segmentation. Following is a summary of several key changes affecting the financial sector.

Capital account liberalization

December 1999–May 1, 2004: Gradual relaxation of restrictions on inward and outward capital flow together with a simplification of administrative procedures applicable to current transactions. With EU entry on May 1, 2004, the abolition of the Exchange Control Law came into effect through the Capital Movement Law of 2003, removing all restrictions on capital movements and payments, and ending the distinction between residents and nonresidents exercised under the Exchange Control Law.

Financial regulation

January 2001: Legal ceiling of 9 percent on lending rates was removed.

March and October 2002: New guidance notes were issued under the money laundering law, requiring, inter alia, enhanced customer due diligence on beneficiaries and politically exposed persons, and covering money transmission services.

July 2002: The Central Bank of Cyprus Law and Cypriot constitution were amended to make the central bank independent.

December 2002: The CBC issued a directive, effective January 2003, harmonizing capital adequacy with the EU directive.

January 2003: Start of the five-year transition period allowed to cooperative credit institutions to prepare for conformity with EU credit institution directives by end 2007; implementation of the Insurance Services Law transposing EU directives.

July 2003: Banking Law amendment harmonizing rules with the EU directive on credit institutions, inter alia, establishing the “single passport” for EU cross-border banking, fitness and propriety for credit institution executives.

July 2003: Deposit Protection Scheme, which initially covered only deposits in Cyprus pounds, was extended to cover deposits in all EU currencies.

July 2003: The anti-money laundering act was amended to transpose the EU directive on money laundering.

January 2003–January 2005: Increasingly stringent criteria for suspension of interest recognition on loans were implemented, with the time period beyond which interest is to be suspended gradually reduced to 90 days.

April 2004: UCITS law harmonizing the legal regime for CIS with EU regulations came into force.

September 2005: Laws harmonizing the listing of securities on the stock exchange, prospectus information, and rules on insider dealing and market manipulation/abuse came into force.

Taxation

July 2002: A single corporate tax rate of 10 percent was introduced from January 1, 2003. All international business enterprises, including International Banking Units (IBUs), operating in Cyprus at December 31, 2001 were given the option of being taxed at the new rate from January 1, 2003 and catering to Cypriot residents, or of being taxed at the original lower rate of 4.25 percent and restricted to doing business with nonresidents until December 31, 2005.

January 1, 2006: All IBUs are subject to tax at the new corporate tax rate, and restrictions on business with Cypriots are removed.

Note: This list represents only a summary of the main changes in legislation and regulation. Further, these will continue to evolve with EU law.

7. In recent years, the performance of financial institutions and markets has been most affected by the stock market volatility experienced at the end of the nineties. Banks had expanded their investment business and lent for share purchase in the rising market up to 1999. Following the collapse of stock prices, banks had to recognize losses and increase provisions (see Table 3), impacting their profits. In 2004, results were recovering.

Table 3.

Banking System

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Sources: Central Bank of Cyprus and IMF, International Financial Statistics

Data is on a cross-border and cross-sector (excluding insurance) consolidated basis. Data for 2005 is for first half only.

Data for 2004 is at September.

8. The Cypriot banking sector has three distinct components although differences are diminishing with the obligations of EU accession: (i) commercial banks; (ii) cooperative credit institutions (together forming the domestic banking system); and (iii) the international banking units. The domestic credit institutions consist of 14 commercial banks, including 3 specialized institutions with commercial banking licenses, and 358 cooperative credit institutions. Domestic commercial banking is dominated by three banks which together hold about 70 percent of system assets excluding the cooperative banks, and about half of system assets, including the cooperatives.5 These three banks, all locally owned, operate internationally (see Table 4).

Table 4.

Three Financial Groups

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Source: CBC

Note: The “group” here is as defined in the September 2005 CBC “Direction on the Supplementary Supervision of Banks which belong in a Financial Conglomerate.”

9. In recent years, the strategy of the commercial banks has been influenced both by policy and by the need to compete in a heavily banked market. In 2003, the government-controlled area of Cyprus had 65 bank branches per 100,000 residents, as compared to the average of 49 in the 15 members of the EU prior to the last accessions. Interest rates were controlled (at 9 percent) until the end of 2000, encouraging non-price competition, including through the branch network. Deregulation of interest rates has enhanced overall competition in banking, particularly between the commercial banks and cooperative credit institutions. As Table 2 illustrates, the number of branches has been declining but a powerful bank employees’ union probably constrains the rate of decline.

10. Deposits at cooperative credit institutions represented about one third of total deposits in local currency in all credit institutions at end-2004. Virtually every village in the government-controlled area of Cyprus has its own cooperative society, and most Cypriots apparently continue to save with their regional or professional financial cooperatives. Borrowing from cooperatives is cheaper because of their nonprofit orientation, lower regulatory costs to date, and exemption from tax on profits generated by operations with members.6 The only cooperative credit institution supervised by the CBC is the Cooperative Central Bank Ltd, which is a licensed commercial bank. It provides banking and other services to the cooperative credit institutions, accepting their surpluses as deposits, lending to them as necessary, and acting as their clearing agent.

11. There are 29 licensed international banking units, although only 26 are in operation. Two of these belong to companies which also have operations in the domestic banking sector. There is one representative bank office. The international banks have a wide range of ownership origin but the largest are headquartered in Austria (a bank specialized in public finance), Ireland, France, and the United Kingdom. Lebanon is the home country for eight, Jordan and Russia for four and three, respectively. They vary in size, some having only 4–5 employees, and others up to 60.

12. The international banks’ presence in Cyprus can be attributed to a combination of geographical location, and preferential corporate tax rates. The Lebanese banks located offices in Cyprus in large part to service Lebanese companies which moved to Cyprus during the civil war in Lebanon. Similarly, East European operations were attracted to Cyprus by its stability and the tax advantages resulting from a longstanding double taxation treaty with the former Soviet Union (signed in 1962) which was originally grandfathered by Russia and the other component states. The domestic profit tax rate on these banks was 4.5 percent until end-2005 when all were made subject to a 10 percent tax rate (see Box 1). It seems probable that the change in tax rate will have little effect on the sector. Cyprus has a network of over 30 double taxation treaties.

13. The insurance sector also has domestic and international institutions, with the latter originally insulated, like banks, from the domestic market by the exchange controls and tax conditions—31 licensed companies operate in the domestic market, two of which are foreign undertakings, and 14 international insurers or reinsurers (two of which are captives). Only one of the international insurers has large operations. EU entry has also introduced two other categories—companies in Cyprus under the EU passport which allows for licensed entities in one member to establish in other EU jurisdictions (5 companies), and 119, most from the United Kingdom, were registered(at March 2005) to provide services in Cyprus under the EU passport (it is not clear whether these companies are actually operating as yet). Mainly as a result of the introduction of EU law and regulation, 26 companies exited the non-life market.7 At the end of 2004, of the 43 companies writing insurance, 11 were life, 4 composite, and 28 non-life (these numbers include the international companies, but do not include EU branches) (Table 5). The life market is highly concentrated, with the four largest companies controlling three quarters of premium income. The largest three nonlife companies only controlled 36 percent of premium income. The companies’ investments are mainly in debt securities, bank deposits, and money market instruments, with less than 20 percent in equity at end-2003, reflecting the stock market crash (see below).8

Table 5.

Insurance Industry Indicators

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Source: Insurance Companies Control Service

The figures for years 2000-2002 do not include international insurance business units. The data files containingn them were relocated and difficult to access

Composite insurance companies are not included.

Separate data was not kept for years prior to 2003.

Ratio of gross premiums of the bank-controlled companies to total gross premiums.

The figures were extracted from the Directory of the Insurance Association of Cyprus and do not include international business units.

14. The business of the most significant international insurers is based on strong geographic business relationships and favorable tax rates relative to their home jurisdictions. Of the 26 nonlife companies exiting the market as a result of EU entry, ten were international, mainly captive, insurers. In 2004, most of the international business was reinsurance (72 percent) and life business (22 percent).

15. Life and motor insurance are the two most important areas of domestic insurance activity. In life insurance, unit-linked9 policies have served as an important savings vehicle in the absence of domestic mutual funds and the presence of capital controls, and motor insurance was stimulated by high car ownership and a legal requirement for third party liability coverage. Unit-linked policies were especially popular during the stock market bubble period.

16. The securities sector in Cyprus covers the Stock Exchange, market intermediaries, a limited number of collective investment schemes and certain international financial services companies (Table 6). Unlike many other international and offshore financial centers, it is not a center for the domiciling of mutual funds.

Table 6.

Stock Market

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Source: Cyprus Stock Exchange

17. The Stock Exchange is state owned, and has a relatively small number of listed companies (155 overall). Turnover is very modest—in the region of $500,000 daily at end-April 2005, while it averaged $1.8 million in the first 75 trading days of the year. The exchange deals mainly in equities and bonds. The market is dominated by the large banks and utilities, with some 50 percent of market capitalization represented by the three largest banks (67 percent by 10 companies).

18. The Exchange has five classes of issuers—the bond market, the investment companies market, and three equity issuers. The equity issuers are, in descending order of size and standing, the main, parallel, and alternative markets. The main market, which includes the major banks, has 18 listings and, in the first quarter of 2005, its average daily turnover was approximately 70 percent of total turnover. Of the three supplementary markets, the parallel market had10 20 listings, the alternative market 89 listings, and the investment funds’ market 28 listings. In 1999/2000, two years after it was established, the Exchange witnessed a severe collapse in listed prices—its index fell from about 800 to 80 points over a period of one and a half years. Fiscal measures to stimulate use of the market, in the context of an unsophisticated investor public and accompanied by a less comprehensive regulatory regime than currently exists, may have contributed to the stock market bubble that peaked at the end of 1999.

19. The other actors or institutions in the securities market are market intermediaries, and international financial services firms:

  • There are 47 authorized market intermediaries, generally offering a broad range of investment services. Thirty-two of these intermediaries offer their services almost exclusively to nonresidents. The remaining 15 intermediaries offer their services locally; many provide stock-broking services.

  • There are two categories of international financial service companies (i) international collective investment schemes; and (ii) independent financial advisory firms. Both offer their services almost exclusively to non-residents. Fifteen international collective investment schemes have been authorized with a total net asset value of approximately $400 million. There are about 40 international financial advisors. They offer investment advice only; they do not execute orders or manage portfolios.

The domestic collective investment schemes industry is in its infancy. Cyprus has just transposed the recently adopted EU UCITS Directives but has not licensed any schemes to date.

20. The formal distinction between international business companies and domestic companies no longer exists following the removal of capital controls and differential taxation as a result of EU accession. However, the markets they serve will probably continue to differ since the international companies locate in Cyprus to take advantage of the location, extensive network of double taxation treaties, and relative political stability. For example, companies offering international financial services can register subsidiaries in Cyprus to reduce the effective tax rate on portfolio capital gains and on income borne by investors.

C. Regulatory Framework, Oversight, and Market Integrity Arrangements

21. Financial institutions in Cyprus are regulated and supervised by four authorities: the Central Bank of Cyprus (CBC), which is responsible for the supervision of domestic banks and international banking units (IBUs); the Cooperative Societies Supervision and Development Authority (CSSDA), supervising the cooperative credit institutions; the Superintendent for Insurance Control (SI); and the Cyprus Securities and Exchange Commission (CySEC).

22. The CBC is the supervisor for domestic banks and IBUs. The two sectors have always been similarly supervised, but have been segmented by exchange control and tax law. In preparation for joining the EU, Cyprus amended its tax laws in July 2002 to introduce a uniform rate of tax (10 percent) on all enterprises, including banks, irrespective of residence of the owner. With the abolition of exchange controls, IBUs who opted to be taxed at 10 percent may operate domestically. All IBUs are treated similarly from end-2005 (see Box 1).

23. The legislation governing cooperatives was amended in 2003 to transpose the EU directives on credit institutions and hence their regulatory conditions are similar to those of the banks. The resulting arrangements resemble those of other cooperative credit movements in Europe. The cooperatives will now be expected to conform to the capital requirements and other prudential obligations of EU credit institutions. It is expected that some will prove too small for this to be feasible, and these can opt to be affiliated with the Cooperative Central Bank, meeting consolidated prudential requirements. An independent authority, the Cooperative Societies Supervision and Development Authority (CSSDA) has, since its inception, provided supervision, and development advice, for the cooperative movement in accordance with the Cooperative Societies’ Law (CSL). In 2003 the CSL was harmonized with the EU directives—increased requirements for prudential supervision were incorporated and a separate supervisory division created within CSSDA. The governing body of the CSSDA consists of the commissioner and four members appointed by the Council of Ministers for five years. The staff of the Authority consists of the commissioner, two senior officers, 36 officers and secretarial staff. Legally, the commissioner has all the usual financial supervisory powers, including the right to conduct on-site inspections and off-site monitoring.

24. A Deposit Protection Scheme covering domestic banks was introduced in September 2000 and was brought into conformity with all EU regulations on May 1, 2004, when the IBUs joined, with the exception of those incorporated in other EU member states. An investment compensation scheme for clients of banks which offer investment services commenced operation in May 2004. An investment fund for clients of investment firms was also created in 2004.

25. A deposit protection scheme for CCIs, established by the Cooperative Societies (Establishment and Operation of the Deposit Guarantee Scheme) Rules for 2000 and 2004, has been in operation since 2000. The scheme is reportedly very similar to that of banks and conforms to EU Directive 94/19/EC. In addition, the CSL provides that the CSSDA, in cooperation with the Pancyprian Cooperative Confederation Ltd., can issue a legally binding regulation requiring the establishment of a solidarity fund in which CCI participation is mandatory. The solidarity fund would be used to address liquidity or solvency issues before the deposit protection scheme. A preliminary regulation is in draft.

26. The Superintendent of Insurance (SI) is supported by the Insurance Company Control Service (ICCS) of Cyprus. The SI was authorized by the Law on Insurance Services and Other Related Issues, 2002, and the staff of the ICCS is governed by the Civil Service Law, while its budget forms part of the Ministry of Finance’s budget. The superintendent and the deputy superintendent are appointed by the Council of Ministers and are both public employees. The service is staffed by nine skilled personnel and seven support staff. Domestic and international companies are similarly regulated and supervised.

27. There are two regulatory bodies in the securities sector the chief of which is the CySEC. CySEC is responsible for regulating the Exchange, collective investment schemes and a range of market intermediaries. The Central Bank retains responsibility for the oversight of the international financial advisors and non-retail collective investment schemes referred to above. CySEC has a skilled staff of 40. The CBC has skilled and experienced securities regulation staff.

28. The Prevention and Suppression of Money Laundering Activities Law of 1996–2004 (PSMLAL), covers, inter alia, credit institutions, investment firms, life insurance companies (domestic and international), and nonlife insurance companies, operating outside of Cyprus, as well as lawyers (in respect of financing business) and accountants/auditor. The financial regulators in these sectors and the professional bodies of lawyers and accountants/auditors are designated as the responsible supervisory authorities. Each of the supervisors has issued guidance notes under the law for the relevant institutions. PSMLAL criminalizes money laundering with predicate offenses covering all crimes subject to a maximum sentence of 12 months or more, provides for confiscation, freezing and restraint orders for proceeds, and requires customer identification, record keeping, internal control, staff training and suspicious transaction reporting. The financial intelligence unit (FIU) is a multidisciplinary unit with 14 staff; as Chair of the Advisory Authority, it is currently the lead in strategic policy making on AML/CFT.

II. Strengths and Vulnerabilities in the Implementation of Financial Standards

29. Supervision of the commercial banks is particularly strong; however, supervision of the cooperative credit institutions (CCIs) and insurance requires enhancement, and securities sector cooperation could be improved. While the legal framework is in place for the supervision of the cooperative credit institutions, implementation is just beginning. EU directives for the insurance sector have been transposed, but supervision requires significant enhancement to be consistent with the EU framework. Regulation of securities activities is also well-developed, though there are shortcomings in international cooperation. The Cypriot supervisors have in large part a satisfactory legal framework and implementation record in cross-border cooperation, information exchange, and consolidated supervision, though clarity is required for the securities framework.

A. Cross-Border Cooperation and Information Exchange

30. The legal and formal arrangements are in place to permit international information exchange by regulators in the banking, cooperative and insurance sectors, with implementation reflecting the general supervision in the sectors.

31. Given the conglomerate structure of the domestic institutions, the ability to communicate among the different sectoral supervisors is important for international cooperation. A domestic MOU was signed in 2002 by the three regulatory authorities—the CBC, CySEC, and the SI. In November 2003, it was also signed by the CSSDA. The MOU allows for mutual notification of cross-border provision of activity and exchange of supervisory information, addresses the need for consolidated supervision information, and explicitly allows for cases where cross-sectoral cooperation is needed for cross-border cooperation, and where the issue is connected to enforcement of the AML law. The agreement nevertheless explicitly excuses the CBC and the CSSDA from sharing information on individual deposit accounts, although there are informal gateways among domestic as well as international banking supervisory and financial regulatory authorities for exchanging supervisory information without any restrictions.

32. The CBC is authorized to share information with all competent authorities, no matter the sector, by Section 27(1) of the Banking Law, and has a thorough operational program of on-site visits and off-site monitoring of the foreign branches/subsidiaries for which they are home supervisors. Section 27(4) of the BL requires that the CBC be satisfied that the same confidentiality applies to the information receiving authority as to the CBC itself. Home supervisors of foreign banks located in Cyprus conduct on-site examinations in Cyprus and discuss the results with the CBC.

33. The CBC has also signed MOUs in the field of banking supervision with several foreign supervisory authorities—the Central Bank of the Russian Federation, the Bulgarian National Bank, the National Bank of the Republic of Belarus, the National Bank of Ukraine, the National Bank of Yugoslavia, the National Bank of Romania, the Financial and Capital Market Commission of the Republic of Latvia, the National Bank of Slovakia, the Bank of Tanzania, the Central Bank of Jordan, the Bank of Greece, and the Central Bank of Lebanon. In addition, MOUs are being negotiated with a number of overseas banking and regulatory authorities, including authorities in the United Kingdom and Ireland. The CBC has also signed MOUs in the field of international financial services with the following foreign supervisory authorities: the Greek Capital Markets Commission, the Federal Commission for the Securities Market of Russia, the Czech Securities Commission, and the Lithuanian Securities Commission. CySEC is a signatory to the MOU sponsored by the EU Commission of European Securities Regulators (CESR), and is working towards becoming a full signatory to the IOSCO Multilateral MOU, being currently listed in Appendix B of the MOU. It has also signed MOUs with the securities regulators of several states, and is currently negotiating the conclusion of MOUs with non-EU securities regulators.

34. The insurance law provides for cross-border cooperation in the supervisor’s role as home or host supervisor and the insurance supervisor (ICCS) has joined the EU protocols laying out the process for cooperation in the context of home/host supervision. The supervisor should, however, adopt a more proactive stance with regard to the EU companies operating under freedom of service (FoS), contacting their home supervisors to identify which have begun operations.

35. Useful provisions for cooperation and information exchange are provided for in the laws governing CySEC, but there are legislative shortcomings in two areas: the regulators cannot adequately cooperate with foreign regulators where CySEC does not have an independent interest in the matter being investigated; and CySEC has experienced difficulties in obtaining information identifying beneficial owners of shares from lawyers acting as nominees for the beneficial owners. However, a forthcoming bill is expected to correct these shortcomings.

B. Sectoral Findings

Banking

36. Supervision of international banks and domestic commercial banks, already found to be very competent in the assessment of 2001 (see Annex I) has progressed to reach high standards, although additional resources are recommended. Independence of the central bank is now assured, both by changes in the central bank law and its enshrinement in the Constitution of the Republic. Prudential oversight has improved with internationally conforming standards provided for nonperforming loan classification, although market risk would be better supervised if the supervisor enhanced its oversight of systems and provided staff with specialized training.

37. The laws and regulatory structure are in place for the establishment of a satisfactory level of supervision of the credit cooperatives. However, although implementation has started, it will take some time to complete, and the authorities face a considerable challenge in developing the appropriate affiliation (or merger) arrangements by end-2007, as required, although the impetus and incentives provided by EU accession have proved powerful.

38. Supervision of banks and cooperatives credit institutions by the CBC and the CSSDA, respectively, puts in place two separate supervisory bodies for deposit-taking institutions. The objectives and operations of these agencies still differ to some degree, although the CSSDA is moving to generally adopt the supervisory policies and procedures of the CBC. Consequently, these arrangements are likely to prove relatively and unnecessarily costly since supervisory functions will be duplicated, a factor the authorities may wish to consider in their overall longer-term planning.11

Insurance

39. The legal framework for insurance supervision is largely in place, and provides accountability and budgetary autonomy, however significant operational enhancement is required. The institutional structure should provide the supervisor with greater independence, and a structure of responsibility that is less dependent on the functions of a single individual, viz. the SI. The supervision division does not have enough resources, in particular in terms of skills, to usher the industry into the EU framework for solvency.

Securities

40. The skills of the regulators and the rules governing their actions were generally impressive, but important shortcomings were found in information exchange. The regulators were unable to collect information and investigate on behalf of foreign authorities where CySEC had no independent regulatory interest in the matter being investigated; and the regulator has had difficulty accessing information identifying the beneficial owner of shares registered in the names of lawyers acting as nominees on behalf of the beneficial owners. The regulator is seeking an amendment in legislation that would confirm access to such information and remove the above restriction on CySEC’s ability to cooperate with foreign authorities. Clearer authority for CySEC in its role as supervisor of the stock exchange is also necessary.12

Cross-sectoral matters

41. The arrangements among supervisors to oversee the financial groups which dominate the market would benefit from elaboration and formalization. However, the insurance companies are a relatively insignificant component of the major banks’ balance sheets and incomes; furthermore, banks’ risk assessed capital is purposely insulated from insurance risk in the course of supervision (that is, insurance assets do not qualify as capital); the bank supervisors keep a watching brief on insurance sector developments, and can undertake inspections of insurance companies. The sectoral supervisors meet regularly to share information, and these meetings could usefully take under formal consideration the implications of insurance companies’ forthcoming compliance with the EU Solvency I directive.

42. The CBC is developing a comprehensive regulation on corporate governance for banks, and it would be useful if the work in this area could be developed and extended in cooperation with the other regulatory agencies to cover all financial institutions, including small, family-owned and -run firms. The regulation being developed will supplement the guidance provided in their 2001 regulation on internal control systems, and should be issued by September 2005. The extension of such guidance to all financial firms would improve overall decision making and monitoring in the financial sector.

Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT)

43. The following summary reflects the findings of the MONEYVAL mutual evaluation mission which visited Cyprus in the period April 3 to 9, 2005.13

44. The criminalization of money laundering meets the relevant criteria in all respects, but criminalization of terrorist financing should be expanded to include collection of funds. Powers to trace, freeze, and confiscate proceeds and the necessary associated investigative powers are also well provided for in the law. Cyprus law does not provide for civil forfeiture, but confiscation is actively pursued in criminal cases. Criminalization of the financing of terrorism as defined in the UN Convention for the Suppression of the Financing of Terrorism is fully achieved and requirements for the suspicious transaction reporting on terrorist financing are in place. However, the financing of terrorism crime should include the collection of funds in the knowledge that they are to be used by terrorist(s).

45. Supervision by the CBC, CSSDA, and CySEC is quite satisfactory, and these agencies, together with the SI, the Bar Association and the Institute of Certified Public Accountants, are issuing guidance in line with the FATF 40+9. The CySEC and CSSDA are in the process of issuing revised Guidance Notes.14 The Bar Association is also drafting a Guidance Note to be issued to its members.15 Guidance notes should deal explicitly with terrorist financing to provide information to reporting enterprises. The SI should recruit additional staff and conduct on-site inspections. Trust and company service providers are at present regulated only through the supervision of lawyers and accountants/auditors. Legislation is in the process of being drafted for the regulation by the CBC of the provision of trust and company services by persons other than lawyers and accountants/auditors. The Cypriot authorities’ resolve to reduce vulnerability to money laundering was noted, and the AML law and enforceable and sanctionable guidance notes were found to meet basic preventive obligations; however, it was recommended that certain provisions currently in supervisory guidance should be in legislation. Formal review of measures covering nonprofit organizations would be beneficial. The FIU is efficient and effective in all aspects of its work.

Annex I: Assessment of the Supervision of International Banking: Status of 2001 Recommendations

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Annex II: Reports on the Observance of Standards and Codes—Summary Assessments

This Annex contains summary assessments of adherence to international standards and codes relevant for the financial sector. The assessments have helped to provide a source of recommendations for improved financial regulation and supervision in various areas.

The following assessments of financial sector standards were undertaken:

  • The Basel Core Principles for Effective Banking Supervision (BCP), by Messrs. Marcel Maes and Timothy Sullivan, Consultants;

  • IAIS Insurance Core Principles (ICP), by Mr. Henning Göbel, Bundesanstalt für Finanzleistungsaufsicht (BaFin), using the ICP methodology adopted in October 2003; and

  • The IOSCO Objectives and Principles of Securities Regulation, by Mr. Michael Deasy, Irish Financial Services Regulatory Authority (IFSRA), using the methodology adopted in October 2003.

The assessments were carried out during a mission to Cyprus from March 28 to April 8, 2005. Additional information was added during the review process. All the assessments were based on the laws, regulations, policies, and practices in place at the time the assessments were made.

The assessments were based on the following sources:

  • Self-assessments by the supervisory authorities;

  • Reviews of relevant legislation, decrees, regulations, policy statements and other documentation; and

  • Detailed interviews with the supervisory authorities.

  • Meetings with industry associations, financial institutions, and auditing firms.

Summary Assessment of Compliance of the Basel Core Principles for Effective Banking Supervision

A. General

46. This Report on the Observance of Standards and Codes (ROSC) for the Basel Core Principles for Effective Bank Supervision was prepared by a team of two independent bank supervision experts.16 The report provides a summary of the level of observance of the regulation and supervision of banks licensed by the Central Bank of Cyprus (the CBC) with the Basel Core Principles.

B. Institutional and Macroprudential Setting, Market Structure—Overview

47. The main event affecting the financial sector and its supervision since the 2001 Module 2 assessment has been the Cyprus accession to the European Union (EU) in May 2004. Major institutional and regulatory reforms, many affecting the financial sector, have been put in place as a result. While these have taxed the public and private sectors, they are expected to benefit growth. Following a relatively weak performance in 2003–04, the economy recovered with real growth expected at 3.4 percent in 2004 and 3.8 percent in 2005. Recovery has been led by consumption fed by fiscal easing and, possibly, a confidence effect from entry to the EU, though sluggish tourist spending lowered the contribution of expanded arrivals.17 Unemployment remains low by European standards, while inflation has crept up modestly on rising energy prices.

48. The sector (“finance, insurance, real estate”) reflecting international services is, at 22 percent of GDP, the single greatest contributor to real output, and remains an important factor in economic growth, with real growth of 2.7 percent in 2003. Output in the second most important sector, tourism (20 percent of real GDP in 2003), declined by 0.4 percent in real terms in 2003.

49. The Cypriot banking sector has two distinct components, although differences are diminishing with the obligations of EU accession: the domestic banking system and the international banking units. The domestic credit institutions consist of 11 commercial banks, three specialized institutions, and 358 cooperative credit institutions (see Table 2). Domestic commercial banking is dominated by three banks which together hold about 70 percent of system assets, excluding the cooperative credit institutions but including the Cooperative Central Bank, and about half of system assets, including the cooperatives.18 The three largest, Bank of Cyprus, Cyprus Popular Bank (Laiki), and Hellenic Bank, all locally owned, are all international groups with operations in both financial (insurance, asset management) and nonfinancial areas. The three specialized institutions are the Mortgage Bank of Cyprus (a subsidiary of the Bank of Cyprus), which lends longer term for tourism and manufacturing, the Cyprus Development Bank which, in addition to standard development bank services, does consulting, and the Housing Finance Corporation, which provides long-term housing loans to low and middle-income families. The latter two are publicly owned, but total assets of the three are only a small proportion of banking system assets.

50. Currently, there are 26 international banking units operating in Cyprus, 2 of which also carry on domestic banking business (Arab Bank PLC headquartered in Jordan and Société Générale of France).19 UBS AG has a representative office. They have a wide range of ownership origin but the largest are Kommunalkredit International Bank Ltd. (Austria), DePfa Investment Bank Ltd. (Ireland), Russian Commercial Bank (Cyprus) Ltd., Crédit Suisse First Boston (Cyprus), Ltd (Switzerland), and Barclays Bank PLC (United Kingdom). In preparation for joining the EU, Cyprus amended its tax laws in July 2002 to introduce a uniform rate of tax (10 percent) on all enterprises, including banks, irrespective of residence of the owner. As a result, as of January 1, 2003, the privileged tax treatment of nonresidents was removed but foreign enterprises could elect, for a transitional period terminating at end-2005, to maintain the lower tax rate (4.25 percent), continuing to deal primarily with nonresidents. With the abolition of exchange controls, IBUs who opted to be taxed at 10 percent may provide services to residents. All IBUs will be treated similarly at end-2005.

51. The cooperative credit institutions cater—as is usual—to members and operate in the context of a cooperative movement that includes manufacturing and marketing cooperatives which the credit institutions “self finance.” They hold about one quarter of system deposits. A licensed commercial bank, the Cooperative Central Bank Ltd., provides banking and other services to the cooperative credit institutions, accepting their surpluses as deposits, and lending to them as necessary.

C. Main Findings

52. Prudential regulations and powers for the Cypriot banking sector are strong and the supervisory process, in general, is effective. This opinion is supported by the fact that all core principles were considered to be compliant or largely compliant.

53. No issues are really predominant. However, the increased demands on the staff of the supervisory department of the Central Bank of Cyprus that supervises the banks, and which are related to the accession of Cyprus to the EU and the development and innovation process of the financial sector, requires a number of additional adequately trained and experienced staff. The supervisory authority might also wish to develop and circulate a comprehensive framework of guidelines regarding country and market risk, and finalize the ongoing implementation of the more stringent criteria for the suspension of the recognition of interest on problem loans.20

54. The cooperative credit institutions are supervised by the Cooperative Societies’ Supervision and Development Authority (CSSDA). They have heretofore been subject to fewer regulations; however, the need to be in line with EU banking directives requires all cooperative credit cooperatives to be compliant by end-2007 with an impressive number of additional requirements pertaining to their organization, internal controls and audit systems, corporate governance and sharp improvement of their prudential ratios. The smaller and weaker ones may have to merge in order to do so and those unable to meet the requirements individually have the option of affiliating themselves with the Cooperative Central Bank and meeting the prudential requirements on a consolidated basis.

D. Principle-by-Principle Findings for the Banks
Objectives, autonomy, powers, and resources (CP 1)

55. Prudential regulations are sound. The CBC is to be commended for the actions taken to enhance Cyprus’ regulatory regime and its endeavor to meet international standards.

Licensing and structure (CPs 2–5)

56. An effective licensing authority is in place supplemented by fair and equitable criteria to ensure a consistent approach is applied to permissible activities and ownership.

Prudential regulations and requirements (CPs 6–15)

57. CBC requires licensed banks to maintain an amount of capital commensurate with the nature and scale of its risks. In practice, all Cyprus’ banks are operating at capital adequacy levels in excess of the required minimum of 10 percent. As to the more stringent rules on the suspension of interest recognition established in 2004, Cyprus will only gain full compliancy at the end of the transition period on January 1, 2006.21 Although market risks are rather limited for the moment, the CBC should require banks to put in place a number of systems and procedures in order to acknowledge the special nature of market risk and enhance its management.

Methods of ongoing supervision (CPs 16–20)

58. Although there are no material differences between the CBC’s supervision of domestic banks and its international banks, it has to be noted that for the international banks, the CBC established a risk-focused on-site supervision program in January 2005.22 On-site examinations are to be conducted annually for the domestic banks and the subsidiaries of foreign banks and every two years for the branches of foreign banks. CBC conducts on-site examinations at branches and subsidiaries of its banks located overseas, and promotes cooperative arrangements and exchanges of information with host country supervisors.

59. The off-site supervision function reviews data from various returns. The accuracy of these returns is independently verified during the on-site examinations. CBC supplements its on-site supervision program with a series of tri-lateral meetings held annually with senior management of each bank and the external auditor. The meetings are held to review financial performance, market conditions, supervisory issues, and strategic plans. Additional meetings are held with external auditors.

Information requirements (CP 21)

60. CBC has established requirements for adequate accounting, records, and internal control systems and determines whether each bank has satisfactory accounting processes and internal control systems.

Formal powers of supervisors (CP 22)

61. CBC has extensive legal powers where a bank fails to comply with any of the provisions of the banking law.

Cross-border banking (CPs 23–25)

62. CBC practices consolidated supervision globally by undertaking on-site examination of the branches and subsidiaries of Cyprus’ banks located overseas. A dialogue with host country supervisors is arranged during the on-site examinations of overseas subsidiaries/branches. MOUs have been signed with a number of overseas supervisors.

Table 1.

Banks: Recommended Action Plan to Improve Compliance with the Basel Core Principles

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Authorities’ response

The CBC welcomes the assessors’ recognition of the overall quality and effectiveness of Cyprus’s banking regulatory and supervisory framework in place and the resulting very high degree of compliance with the Basel Core Principles.

Following is the CBC’s Action Plan to address the specific recommendations cited in the report:

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Table 2.

Cooperative Credit Institutions: Recommended Action Plan to Improve Compliance of the Basel Core Principles

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E. Principle-by-Principle Findings for the Cooperative Credit Institutions
Objectives, autonomy, powers, and resources (CP 1)

63. Prudential regulations have been adapted to the acquis communautaire, and the authorities are to be commended for the actions taken to enhance Cyprus’ regulatory regime and its endeavor to meet international standards. However, during a transitional period that will only end on December 31, 2007, the CCIs are allowed to continue their activities without having to comply with the international standards. During this period, the CSSDA will have to develop its supervisory capacity, issue administrative rules, guidelines and best practices papers and encourage the restructuring of the predominantly small CCIs. The support and unwavering efforts of the authorities will be essential to the success of this operation. The dramatically extended responsibilities and objectives assigned to the CSSDA will necessitate additional experienced staff which will have to be facilitated by an appropriate salary system.

Licensing and structure (CPs 2–5)

64. An effective licensing authority is in place supplemented by fair and equitable criteria. However, permissible activities should be defined by regulatory decision.

Prudential regulations and requirements (CPs 6–15)

65. Again, during the transitional period, CCIs will not be subjected to mandatory new capital adequacy requirements. However, the supervisor should enhance his monitoring capabilities in order to allow for timely action if need be. Enhanced prudential reporting should also be installed regarding loans, whereas increased supervisory capacity should facilitate oversight of large exposures and connected lending, expertise regarding new types of risks, and vital organizational issues such as internal control systems of the CCIs. The updating of existing guidance notes on AML/CFT is also to be accelerated.

Methods of ongoing supervision (CPs 16–20)

66. On-site and off-site supervision will of course have to be adapted and developed to the dramatically extended responsibilities and objectives assigned to the CSSDA and will therefore necessitate additional experienced staff.

Information requirements (CP 21)

67. Regulative decisions are in place regarding the establishment of accounts and their auditing according to international standards.

Formal powers of supervisors (CP 22)

68. A range of remedial measures can be used where a CCI fails to comply with any of the provisions of the law.

Cross-border banking (CPs 23–25)

69. No cross-border financial services are performed by the CCIs.

Authorities’ response

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Summary Assessment of Observance of the Insurance Core Principles

A. General

70. This section provides summary findings from the assessment of the IAIS Core Principles. The assessment was based on discussions held with the Superintendent of Insurance and her deputy, the staff of the Insurance Company Control Service (ICCS), representatives from domestic insurance companies, the Insurance Association of Cyprus, an auditor, and the Association of Actuaries of Cyprus. The assessment considered several documents:

  • Law on Insurance Services and Other Related Issues of 2002 (LIS);

  • Amendments I to V to the LIS;

  • Guidance for the submission of an application to carry on insurance business;

  • Guidance notes on the completion of the annual returns under the LIS;

  • Orders concerning the format and contents of annual accounts;

  • Report on Insurance in Cyprus for the years 1983–2002; and

  • The Audit of Insurers in Cyprus, published by the Institute of Certified Public Accountants of Cyprus.

71. The assessment took account of annual returns and market trends at December 2003.23

72. In addition to the Insurance Core Principles, the relevant EU directives were also considered.

B. Institutional and Macroprudential Setting-Overview

73. The Cypriot market is relatively small and highly fragmented. There are about 44 companies being supervised and approximately 1,600 agents active in the distribution of insurance products. The Cypriot insurance market ranks as follows:

Table 1.

Market Share Rankings in World and European Markets

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74. The following tables show the distribution of financial variables by line of business in 2003 and 2004:

Table 2.

Insurance Sector’s Domestic Financial Variables by Line of Business, 2003 and 2004

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Source: Insurance Companies Control Service
Table 3.

Financial Variables by Line of Business for Insurance Companies Transacting Business Outside of Cyprus, 2003 and 2004

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Source: Insurance Companies Control Service

75. The leading three life insurance companies have 80 percent of the whole market and these are owned by the leading banks of Cyprus.

76. The general lines market is more fragmented with a total of 30 companies under supervision in 2004 (with only 28 writing business). Only five companies have GWPs of more than £C 10 million. Ten companies have market shares of less than 1 percent each. In both life and general lines, the wide variation in company size implies that the variance in professionalism is significant. Most companies are operating from a family-based platform.

77. The supervision in fact takes a ring-fencing approach against total failure rather than seeking to establish a secure and stable financial infrastructure for the domestic market.

78. Whether all companies in the market will be able to meet future capital requirements, even at a minimum level, needs to be assessed.

C. Main Findings
Background

79. The market is too segregated. The number of companies is not sustainable since current return levels will not lead to or enable significant investment in the market. Further development therefore requires a strong improvement in professionalism which can be obtained and enforced through strict application of EU standards. The operational procedure in the Cypriot insurance market is very labor intensive. The 38 companies who are members of the Insurance Association of Cyprus currently employ 1,640 staff, implying a GWP of £C 250,000 per staff member. The number of agents is expected to drop from approximately 3,600 to 1,600 (the number currently active), but that would still imply an average portfolio of approximately £C 190,000 per agent. As the total market is very small and very fractured, it is unlikely that larger international insurance companies would enter the market.

80. Reserving levels are not satisfactory for a number of companies. Moreover, the reserving techniques recently introduced lead to higher reserving requirements. The existing capital positions of 14 companies are below the minimum requirements of the EU based on Solvency I.

Findings

81. With its current capacity, insurance supervision in Cyprus will not be able to respond adequately to major systematic shocks. The level of skills and resources provided to the SI is suboptimal. Nor is the level of regulation precise enough to set clear expectations for the supervised companies. The authorities should develop a plan of how the insurance supervision can be enabled to perform its duties in a more efficient manner. Adequate resources and skills should be determined, training and legal support should be improved.

82. The assessment against the insurance core principles has to be seen in the light of the existing constraints of the SI and the ICCS. Given the situation as described, improvements in the supervision of the insurance market will require substantial support, financially and politically. Adequate resources, in terms of both finance and skills, is absolutely essential to the performance of a supervisory authority.

83. The superintendent will have to improve regulation and supervisory guidelines. The existing draft of prudential standards is a good starting point. For the internal purposes of the ICCS, supervisory processes should be more clearly defined. The licensing process and rules on fit-and-proper criteria for individuals are in place and appropriate. A joint effort should be made by all regulatory authorities of Cyprus to define applicable rules on corporate governance.

84. More guidance should be given to insurance companies on internal control procedures, business continuity plans and insurance fraud. The SI should also stress the ability to act more preventively.

85. Reserving techniques and the assessment of liabilities should be more closely examined. At the time of the assessment, there were five insurance companies operating in the market with suboptimal reserving levels.24 Assets not qualified as admissible to cover reserves should not be recognized for solvency purposes. Premium receivables should be depreciated and a strict aging structure should be requested to ensure that those assets can be materialized if needed.

Table 3.

Recommended Action Plan to Improve Observance of IAIS Insurance Core Principles

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Authorities’ response

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A. Summary Assessment of Implementation of the IOSCO Objectives and Principles of Securities Regulation

A. General

86. The assessment was undertaken as part of the offshore financial center assessment program. It was based on the IOSCO Assessment Methodology of October 2003 for Assessing Implementation of IOSCO’s Objectives and Principles of Securities Regulation.

87. The main securities supervisory authority in Cyprus is the Securities and Exchange Commission (CySEC). It was established in 2001 and supervises the Stock Exchange, retail collective investment schemes, market intermediaries and issuers of securities on the Stock Exchange. There are two investment services activities carried out by (i) international collective investment schemes, and (ii) independent financial advisory firms, which are supervised by the CBC. Both services are offered almost exclusively to nonresidents.

88. The main pieces of legislation governing the securities area are the CySEC Law (2001–2004) which established CySEC and the Stock Exchange Law (1993–2005) which established the Stock Exchange. The Exchange Control Law, now revoked, was the basis of the Central Bank’s role in the supervision of international financial activities. The Stock Exchange has a limited self-regulatory role in respect of some of its activities. Apart from the Exchange there are no self-regulatory organizations in Cyprus. There is, however, an Association, namely the Cyprus International Financial Services Association (CIFSA), established at the instigation of the CBC, whose purpose is to promote and protect the interests of its members which are international financial services companies. CIFSA acts as a liaison with the financial supervisory authorities in Cyprus. It also examines the complaints filed by investors against its members.

89. In addition to the above named laws, the assessment was based on the self assessments completed by both CySEC and the Central Bank. This information was supplemented by information provided by both authorities and data available on the website. Detailed discussions were held with CySEC, the Central Bank, and the Stock Exchange as well as with relevant private sector companies, representative bodies, the accountancy supervisor, and accountancy firms.

90. Cooperation was freely given by all concerned.

B. Information and Methodology used for Assessment

91. The Stock Exchange is state owned, has a relatively small number of listed companies (18 main and 137 supplementary listings), and turnover is very modest and fluctuating—in the region of $500,000 daily at the end of April 2005, down from $1.8 million in the first 75 trading days of the year. In 1999/2000, two years after it was established, the exchange witnessed a severe collapse in market prices—its index fell from about 800 to 80 points in the course of a year and a half.

92. There are 47 authorized market intermediaries, generally offering a broad range of investment services. Thirty-two of these intermediaries offer their services almost exclusively to nonresidents. The remaining 15 intermediaries offer their services locally; many of them are members of the Stock Exchange.

93. The retail collective investment scheme sector is in its infancy in Cyprus. Cyprus has just transposed into national law the recently adopted EU UCITS Directives but has not authorized any schemes to date.

94. There are about 15 authorized non-retail collective investment schemes with a net asset value of about $400 million. There are about 40 international financial advisors. Supervision of these will pass shortly to CySEC in keeping with the transposition of relevant EU legislation so that the only supervisory role remaining with the Central Bank in the area of securities is that of supervising non-retail collective investment schemes.

C. General Preconditions for Effective Securities Regulation

95. The regulatory regime has been very strongly influenced by Cyprus’s membership of the European Union. Cyprus has transposed and continues to transpose the many securities regulatory directives of the EU, and its supervisory regime, laws, and regulations are almost exclusively based on the EU directives. Its legal, accounting, company law, and taxation regimes are heavily influenced by their U.K. equivalents. In the accounting area, Cyprus has adopted International Financial Reporting Standards (IFRS) and all statutorily based financial reporting must use the standards. Its accounting and auditing systems appear to be well supervised.

D. Principle-by-Principle Assessment

96. In general, the legislative supervisory framework is comprehensive. It has developed significantly in recent years as Cyprus prepared itself for EU membership. It had adopted all the relevant directives by the date of its accession in May 2004 and continues to do so as more and more EU securities directives are adopted.

97. At present, CySEC appears to have adequate staff resources. These appear to be well trained and competent and showed a detailed knowledge of their work.

98. The medium term challenges facing securities regulation will be the ability of CySEC to retain its current staff and to increase staff numbers as it assumes more responsibilities (e.g., the implementation of a number of significant new EU directives).

99. Regulator (Principles 1–5). The regulatory responsibilities of CySEC are generally clearly set down in legislation and CySEC appears to apply them in a clear and consistent manner. One area that requires clarity, however, is the respective roles of CySEC and the Stock Exchange in the supervision of issuers of securities (i.e., listed companies). CySEC’s competency in this area has recently been questioned by the courts and an appeal is pending. CySEC is also seeking an amendment to the Stock Exchange Law to put its regulatory role beyond doubt.25

100. Currently, staff numbers appear adequate, but extra resources will be required in the near future to deal with extra responsibilities which CySEC will be required to assume, e.g., implementation of recently adopted EU directives. The current staff appear to have the requisite skill sets and competencies to carry out the responsibilities of CySEC effectively.

101. Self-regulatory organizations (Principles 6–7). Apart from a limited self-regulatory role of the stock exchange, there are no self-regulatory organizations in Cyprus.

102. Inspections, investigations, and enforcement (Principles 8–10). CySEC has wide powers of inspection, investigation, and enforcement. However, for constitutional and legal reasons it cannot supervise the Stock Exchange effectively (see below Principles 25–30—Principles for the Secondary Market).

103. Information sharing and cooperation (Principles 11–13). There is provision in the law allowing for the sharing of information with both domestic regulators and foreign regulators. However, CySEC cannot collect information and carry out investigations on behalf of foreign regulators unless it has an independent interest in the matter being investigated. CySEC has experienced difficulties in obtaining information identifying the beneficial owners of shares from lawyers acting as nominees on behalf of the beneficial owners. However, a forthcoming bill is expected to correct the above shortcomings.

104. Issuers (Principles 14–16). The public offering law, stock exchange law, and company law provide for accurate and timely disclosure of financial results and adequate safeguards for the fair and equitable treatment of shareholders, and there is no reason to believe that these laws are not being implemented effectively. Accounting and auditing standards are in line with best international practice. Cyprus has adopted International Financial Reporting Standards (IFRSs) for accounting purposes.

105. Collective Investment Schemes (Principles 17–20). There are two distinct collective investment schemes regimes in Cyprus. One is supervised by CySEC and is based on the EU UCITS Directives. These are targeted at the retail market and can be marketed to Cyprus and non-Cyprus residents alike. The relevant UCITS legislation has just been adopted in Cyprus, and, to date, no Cyprus UCITS has been authorized. The legislation is comprehensive, but CySEC needs to introduce specific rules for the valuing of assets other than shares in publicly quoted companies held by UCITS. CySEC intends to have these rules in place before any UCITS are authorized.

106. The second type—international collective investment schemes—are not marketed to the public and are largely targeted at nonresidents. About 15 such schemes have been authorized to date with a total net asset value of about $400 million. There are two types of schemes: (i) those marketed to experienced investors and carrying a minimum investor subscription of $50,000; and (ii) private schemes which restrict the number of investors to 100. These schemes are supervised and regulated by the CBC, which is the regulatory authority for such schemes under the provisions of the International Collective Investment Schemes Law, 1999.

107. Market Intermediaries (Principles 21–24). All market intermediaries with the exception of investment advisors (investment advisors give advice only; they do not, for instance, receive or execute orders, hold client assets or manage investment portfolios) must be authorized by CySEC. Following the transposition of the recently adopted EU Markets in Financial Instruments Directive, which recognizes investment advice as a core investment service for the first time, investment advisors, of which none currently exist in the domestic market, will fall to be supervised as an investment intermediary by CySEC.

108. There are 47 market intermediaries authorized by CySEC, generally offering a broad range of services. Thirty-two of these intermediaries offer their services almost exclusively to nonresidents and were previously categorized as international financial intermediaries supervised by the Central Bank. The remaining 15 intermediaries generally offer their services locally; many provide stock-broking services. The CBC continues to supervise the international financial services companies that offer only investment advice so as to avoid a regulatory gap until the transposition of the EU directive referred to above, when these firms will fall to be supervised by CySEC. There are about 40 of these.

109. The legislative regime for the supervision of market intermediaries and its implementation appear effective.

110. Principles for the Secondary Market (Principles 25–30). CySEC is charged with the supervision of the Stock Exchange. However, it faces a particular difficulty in carrying out this function. CySEC, like the Stock Exchange, is a public administrative body and one public administrative body cannot supervise another public administrative body. Consequently, it cannot legally apply a whole range of regulatory tools, such as the imposition of conditions or restrictions, nor has it ever carried out an inspection of the exchange because of these constitutional difficulties. It could, in extreme circumstances, through a circuitous route involving the Council of Ministers, order the temporary suspension of the exchange. In practice, CySEC and the exchange appear to have a satisfactory supervisor/supervisee relationship; for example, CySEC monitors trading on the exchange on a real-time and daily basis.

111. The Stock Exchange is the only securities exchange in Cyprus. It has exclusive rights to undertake stock market transactions in movable securities in Cyprus. This is for political and historical reasons related to the nongovernment controlled areas issues, and not to restrict new entrants into the market. In any event, Cyprus will be required to establish exchange authorization criteria when the recently adopted EU Markets in Financial Instruments Directive is transposed into Cyprus law.

E. Recommended Actions

112. Principle 26. Legislation should be introduced as a matter of urgency to allow CySEC to supervise effectively the Stock Exchange. This would entail a revision to the equal constitutional status of both bodies where by CySEC as a public administrative body cannot supervise the exchange, another public administrative body.

113. Principle 11. It is recommended that the authorities remove the obstacle that prevents CySEC from sharing information and carrying out investigations on behalf of foreign regulators in situations where CySEC does not have an independent interest in the matter being investigated. It is noted that this issue will be addressed in forthcoming legislation.

114. Principle 13. In the interests of being able to cooperate fully with foreign regulators, it is important that the legal uncertainty surrounding CySEC’s ability to obtain information identifying the beneficial owners of shares which are registered in the names of lawyers acting as nominees on behalf of beneficial owners. It is noted that CySEC is seeking an amendment in forthcoming legislation to remove the uncertainty.

115. Principle 1. The uncertainty surrounding the respective responsibilities of CySEC and the Stock Exchange in the supervision of issuers of securities should be addressed as a matter of urgency to bring clarity to the situation. It is noted that an appropriate amendment is to be made to the Stock Exchange Law.26

116. Principle 20. It is recommended that for UCITS, CySEC introduced specific rules for the valuing of assets other than shares in publicly quoted companies. It is understood that such rules are currently being drafted.

117. Principle 17. It is recommended that the Central Bank take a more proactive role, e.g., through the inspection process, in ensuring that no members of the public are investing in the non-retail (that is, ICIS sold to experienced investors and private ICISs) collective investment schemes.27

118. Principle 2. It is recommended that the provision in the CySEC Law where by CySEC must provide the Minister of Finance with any information he may deem necessary for the benefit of the public interest should be revoked to maintain without question the operational independence of CySEC. It is noted that this issue will be addressed in forthcoming legislation.

119. Principle 3. While staff numbers appear to be generally adequate at present, extra resources will be required in the future to cope with the expanding workload of CySEC, e.g., the implementation of new EU Directives.

F. Authorities’ Response
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Reference the final sentence of paragraph 18:

CySEC disagrees with this position. The position of CySEC is that bubbles are created even in the best regulated markets worldwide for various reasons, and the absence of non-comprehensive regulation cannot be said to create or contribute to the creation of bubbles. Regulation, however, can limit instances of abuse which can occur during stock market bubbles. The Commission concedes that, should there have existed a more comprehensive regulatory regime in place in the Cyprus capital market during the time of the bubble, it could have limited the extent of abuses which were inevitable to occur during such time.

1

The territory remains divided with reunification an issue of international interest. See http://www.imf.org, Cyprus—Staff Report for the 2004 Article IV Consultation, March 22, 2005, Country Report 05/107.

2

The data in this paper refer only to the government-controlled areas.

3

See Country Report 05/107.

4

The term “group” is used in this report to accord with the definitions of the CBC’s “Directive for the supplementary supervision of banks in a financial conglomerate” issued in September 2005. The directive defines a “group” as a group of undertakings consisting of a parent, subsidiaries, entities in which the parent or a subsidiar have a shareholding of at least 20 percent, and entities related by unified management, and sets size threshold on the smallest sector for classification as a financial conglomerate of a group with cross-sectoral holdings.

5

Information from Fitch Sovereign Ratings for Cyprus, August 17, 2004. The banks’published consolidated balance sheets do not provide financial information for the individual banking entities.

6

This exemption was granted by the EU after detailed consultations.

7

Satisfactory arrangements were made for customers and beneficiaries.

8

See Insurance in Cyprus, Directory and Statistical Information, 2003, Insurance Association of Cyprus.

9

These are life policies whose investments are linked to the performance of units or the index of a pre-agreed investment.

10

At end-April, 2005.

11

This aspect of the supervisory structure was not discussed at the time of the mission. The CSSDA notes that the authorities discussed this issue in 2003, deciding to maintain two separate supervisory bodies for credit institutions. An MOU has since been signed by the four supervisory bodies.

12

The relevant amendment to the Stock Exchange Act was enacted in September 2005. It is expected to have provided the necessary clarification for CySEC’s regulatory role.

13

This description was revised on the basis of the draft executive summary of the mutual evaluation report considered by the MONEYVAL plenary in February 2006.

14

The CSSDA advises that its guidance note was issued on May 16, 2005.

15

The authorities have informed that these guidelines have been finalized and issued to the supervised entities/members concerned.

16

Marcel Maes (Belgium) and Timothy Sullivan (USA)

17

See IMF Country Report No. 05/107, Cyprus—Staff Report for the 2004 Article IV Consultation, January 31, 2005.

18

Information from Fitch Sovereign Ratings for Cyprus, August 17, 2004. The banks’published consolidated balance sheets do not provide financial information for the individual banking entities.

19

An additional three IBUs are licensed but non-operational.

20

In December 2005, the CBC issued the “Directive on the suspension of interest and other income on nonperforming credit facilities,” which imposed the 90-day rule for the classification of credit as nonperforming and defined the procedures for interest suspension. The Directive came into force on January 1, 2006.

21

See Footnote 20.

22

In January 2006, a similar program was established for domestic banks.

23

Information was updated for end 2004 following the mission.

24

The authorities point out that the companies had been required to increase their reserves.

25

The authorities have indicated that the planned amendment to the Stock Exchange Act was enacted in September 2005. It is expected to have provided the necessary clarification for CySEC’s regulatory role.

26

See Footnote 25.

27

In accordance with the ICIS law, private/non-retail ICIS can have a maximum of 100 investors. No such limit exists for public/retail ICIS. The CBC’s position is that through(a) its approval of a private/non-retail ICIS’s constitutional documents; (b) its offsite review of prudential; and (c) its conduct of ongoing inspections; it can ensure that the number of investors in private/non-retail ICIS does not exceed 100. Hence, the comment made by the assessors that the CBC should ensure that “no members of the public are investing in the non-retail collective investment schemes” is, in the opinion of the CBC, non-applicable.