Cyprus
Detailed Assessments of Observance of Standards and Codes for Banking Supervision, Insurance Supervision, and Securities Regulation

The Compliance of the Basel Core Principles welcomes the assessors’ recognition of the overall quality and effectiveness of Cyprus’s banking regulatory and supervisory framework in place, and the resulting high degree of compliance with the Basel Core Principles. Regulation has to be defined to set a frame in which insurance undertakings can operate. Clear objectives and measures should be defined for the Superintendent of Insurance. The International Organization of Securities Commissions Principles was assessed in accordance with the criteria in the Guidance Note.

Abstract

The Compliance of the Basel Core Principles welcomes the assessors’ recognition of the overall quality and effectiveness of Cyprus’s banking regulatory and supervisory framework in place, and the resulting high degree of compliance with the Basel Core Principles. Regulation has to be defined to set a frame in which insurance undertakings can operate. Clear objectives and measures should be defined for the Superintendent of Insurance. The International Organization of Securities Commissions Principles was assessed in accordance with the criteria in the Guidance Note.

I. Detailed Assessment of Compliance with the Basel Core Principles for Effective Banking Supervision

A. General

1. With the agreement of the Central Bank of Cyprus (CBC) and the Cooperative Societies’ Supervision and Development Authority (CSSDA), the mission assessed these institutions’ compliance with the Basel Core Principles for Effective Banking Supervision (BCP) using the Core Principles Methodology. The assessments were undertaken in the context of the Offshore Financial Center (OFC) Assessment Program.

2. The domestic and offshore sectors of the banking sector were not subject to individual assessments since they are both covered by the same legislation and are similarly supervised by the Banking Supervision and Regulation Division (BSD) of the CBC.

3. The assessment of the CSSDA took note of its ongoing program to substantially expand and enhance its supervisory capacity and activities and the effects of the transition period available to the credit cooperative institutions to achieve required prudential standards or affiliate with the Cooperative Central Bank (Central Body), pursuant to an arrangement reached by the government as a part of its accession to the European Union (EU).

4. The assessments took place in March and April 2005 and were undertaken by Marcel Maes, formerly with the Commission of Banking, Finance, and Insurance of Belgium, and Timothy Sullivan, formerly with the Office of the Comptroller of the Currency of the United States.

B. Information and Methodology used for Assessment

5. The assessment of compliance with the core principles is not, and is not intended to be an exact science. Banking systems differ from one country to the next as do their domestic circumstances. Furthermore, banking activities are changing rapidly around the world, and theories, policies, and best practices of supervision are swiftly evolving. Nevertheless, it is internationally acknowledged that the core principles are seen as minimum standards.

6. This assessment of compliance with each principle has been made on a qualitative basis. A five-part assessment system is used: compliant, largely compliant, materially noncompliant, noncompliant, and not applicable. To achieve a “compliant” assessment with a principle, all “essential” criteria generally must be met without any significant deficiencies. There may be instances where a country can demonstrate that the principle has been achieved through different means. Conversely, due to specific conditions in individual countries, the essential criteria may not always be sufficient to achieve the objective of the principle, and therefore, one or more additional criteria and/or other measures may also be deemed necessary by the assessor to judge that compliance is achieved. A “largely compliant” assessment is given if only minor shortcomings are observed, and these are not seen as sufficient to raise serious doubts about the authority’s ability to achieve the objective of that principle. A “materially noncompliant assessment” is given when the shortcoming is sufficient to raise doubts about the authority’s ability to achieve compliance, but substantive progress had been made. A “noncompliant” assessment is given when no substantive progress towards compliance has been achieved, or when insufficient information was available to allow a reliable determination that substantive progress had been made towards compliance. An assessment of “not applicable” is rendered for a principle deemed by the assessors to not have relevance.

7. The assessment was based on a review of the applicable laws, regulations, and prudential guidelines, although the assessment of the CSSDA was affected by the absence of English-language translations of many documents. The assessors held discussions with officers and staff of the CBC and the CCSDA. They also met with the auditor general of Cyprus and the Director of the Audit Office of Cooperative Societies (AOCS), officers and staff of the Cooperative Central Bank, representatives of individual financial institutions, professional associations, and bank external auditors. Before the mission, both the CBC and the CSSDA had seperately prepared formal self assessments.

C. Institutional and Macroprudential setting, Market structure

8. Cyprus, as a recent entry to the European Union (EU) (in May 2004), has benefited from the structure, institutions, and rules whose adoption is required for acceptance. From being a relatively closely controlled system, the requirements of accession resulted in both a liberalization and a tightening of prudential regulation. Thus, on January 1, 2001, a nine percent ceiling on interest rates that had been in place since 1944 was removed as an initial step to capital account liberalization. At the same time, the authorities instituted a three-phase process of exchange control relaxation which was completed on accession at May 1, 2004, when the Capital Movement Law repealed the Exchange Control Law. The exchange rate of the Cypriot pound, whose central rate has been pegged to the Euro since January 1999, had its fluctuation margins widened to ±15 percent in August 2001, and the authorities are pursuing a Euro-adoption strategy. This will foster required fiscal adjustment. Inflation, averaging about three percent a year over the past four years, is expected to remain subdued.

9. Cyprus adopted International Accounting Standards (IAS) in 1981 and has a large professional body of accountants as well as a strong association of certified accountants who have disciplinary powers and arrangements. The big four accounting firms are represented.

10. Deposit protection schemes were established in September 2000 for banks and cooperative societies. Compensation is set at 90 percent of total deposits of each depositor up to a maximum of EUR 20,000. In addition, the cooperative societies laws (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 cooperative credit institutions’ (CCIs) 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.

11. Through their participation in the work of the Banking Supervision Committee of the European System of Central Banks, its Working Group on Macro-prudential Analysis, and in the “Coordinated Compilation Exercise for Financial Soundness Indicators,” the CBC has established the basis for developing a framework for macro-prudential surveillance and analysis.

12. The banking industry consists of three distinct segments. The domestic market is supplied by two: 11 commercial banks with three specialized institutions (each of which has a commercial banking license) and some 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.1 The three largest banks, all locally owned, are international groups2 with major insurance companies as subsidiaries. The three specialized institutions are a mortgage bank (a subsidiary of the largest commercial bank) which lends longer term for tourism and manufacturing, the Cyprus Development Bank which, in addition to standard development bank services, provides consulting services, 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 portion of the banking system. The remaining domestic banks include 3 small local banks and foreign-owned branches (2) and subsidiaries (3).

13. Cooperative credit institutions3 have maintained a strong role, with their deposits representing 32 percent of total deposits in local currency at end-2004. As a result of their nonprofit nature, lower operating costs and lower regulatory costs, they have been able to compete effectively with commercial banks. Most Cypriots continue to deposit with their local cooperatives. Their clearing agent, the Cooperative Central Bank, is a licensed commercial bank.

14. The third segment of the banking market are the 26 international banking units, the largest number of which are from Lebanon (8), Jordan (4), and Russia (3). Until recently, with the new rules introduced by EU accession, they were ring-fenced from the domestic market, although subject to supervision by the central bank similar to that of domestic commercial banks. At the end of 2004, IBU assets of $12.5 billion represented 30 percent of domestic banking assets (excluding the cooperatives).

15. The economy of government-controlled Cyprus is heavily banked. As a result, the larger banks are expanding by establishing branches and subsidiaries in overseas markets with important Greek communities.

16. As a result of the fallout from the bursting of the 1999 stock market bubble, lower output in the tourism sector and depressed activity in the world economy, domestic banks have had losses in both 2002 (negative return on equity of 11.1 percent) and 2003 (negative 4.7 percent). In 2004, however, performance improved to a positive 4.3 percent ROE at mid-2004. Non-performing loans to total gross loans were 11.7 percent at mid-2004. The central bank has begun to require the suspension of interest on non-performing loans by the banks. Despite improved collections, the reported NPL ratio may deteriorate when the calculation is brought fully into line with EU requirements at start-2006. Overall risk-weighted capital remains adequate at roughly 13 percent in 2004.

17. The principle-by-principle assessments for banking in this volume (see Tables 1 and 2) reflect the different supervisory regimes applied in the market. While domestic commercial banks and international banking units are similarly supervised by the CBC, CCIs are supervised by the CSSDA.

Table 1.

Detailed Assessment of Compliance of the Basel Core Principles (CBC)

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Table 2.

Summary Compliance of the Basel Core Principles (CBC)

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C: Compliant.

LC: Largely compliant.

MNC: Materially non-compliant.

NC: Non-compliant.

NA: Not applicable.

18. The CCIs have heretofore been subject to fewer regulations; however, the need to be in line with EU banking directives requires that all credit cooperatives sharply improve their prudential ratios by end-2007. A number of CCIs will comply on an individual basis; the remaining CCIs will comply by affiliating themselves with the CCB and by meeting the prudential requirements on a consolidated basis. The assessment therefore evaluates supervision for the commercial banks (whether domestic or international) separately from that of credit cooperatives (see Tables 1 and 2).

D. General Preconditions for Effective Banking Supervision

19. The preconditions for effective banking supervision in Cyprus are generally in place. Currently, there are no macroeconomic vulnerabilities and risks that could have implications for the effectiveness of prudential safeguards or the stability of the financial system. The public infrastructure provides for an environment that fosters the honoring and enforcement of financial contracts.

20. There is a comprehensive set of laws, which governs the financial sector. These laws are supported by a body of professional lawyers and judges. The court system is efficient. Cyprus has adopted both International Accounting Standards and International Auditing Standards. The supervision of other financial sectors and markets is generally efficient. There has been no evidence of government efforts to influence lending operations. There is a deposit insurance program in place. The financial services regulators have a process in place to address distressed financial institutions.

E. Principle by Principle Assessment—Central Bank of Cyprus

F. Recommended Action Plan and Authorities’ Response to the Assessment Recommended action plan

Table 3.

Recommended Action Plan to Improve Compliance of the Basel Core Principles (CBC)

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Authorities’ response to the assessment

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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G. Principle by Principle Assessment—Cooperative Societies’ Supervision and Development Authority

Table 4.

Detailed Assessment of Compliance with the Basel Core Principles (CSSDA)

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