Traditional trade finance instruments like Letters of Credit presuppose that the credit risk on a commercial bank is superior to that of a commercial customer. Having an L/C issued by, for example, a major bank in Cyprus should shield you, the exporter, from taking credit risk on the importer, a client of that major Cyprus bank.
Then you can ask one of your own banks to add a confirmation to the Letter of Credit, which insulates you not only against the risk on the Cyprus bank but against the political and transfer risk associated with dealing with Cyprus at all, assuming your own bank is in the UK, Germany, France, USA, Sweden or wherever.
This logic goes into reverse in a country like Cyprus, where the Cyprus Business Mail announced on July 12 2018 that Non-performing loans ("NPLs") in the Cypriot banking system had fallen in March 2018 by almost €2.1bn to €19.9bn compared to February's figure, and that this was the lowest figure for NPLs since December 2014, according to figures issued by the Central Bank of Cyprus ("CBC").
The "good" news: 43% of the total loans made by Cyprus' banks are bad, €19.9bn out of €46.28bn.
NPLs to corporates made up €8.7bn and NPLs to households made up €10.8bn, with presumably NPLs to other types of borrower being €0.4bn.
Further statistics are given illuminate the accounting issues behind whether a loan is counted as an NPL at all if it has been "restructured" - meaning things like the unpaid interest has been capitalised, the repayments have been stretched out and other forbearance actions taken. The loan can be taken out of NPLs and counted as Performing, and the loan cannot fall back into NPLs whatever happens for a year.
What this means is that a reasonable portion of the loans recorded as Performing – the other 57% of loans or €26.4bn out of €46.28bn – have been NPLs at some stage, and that the main measures used to reduce NPLs have been these "restructurings" involving forbearance techniques and also the pledging of mortgage security of whatever quality.
If you are considering taking unsecured risk, on Open Account, on any commercial counterparty in Cyprus you need first to find out whether they have loans from any banks that are on Non-performing status now, and then if they have not, whether they have loans from any banks that are on Performing status now but which have been on Non-performing status in the past. If there is a positive answer to this, you need to know when the "restructuring" took place and on what terms.
You are trying to unearth the 30% or so of all borrowers from Cyprus' banks whose loans have never been on Non-performing status, and who thus merit trading with on Open Account.
As regards taking Cyprus bank risk, you can be assured that this is a banking system with a big black hole in it and that the bigger the bank, the bigger the hole. We can probe into the capital position of the banks by the yardstick that they should have capital in the order of 9% of their loans, and that their loans should all be Performing bar a few, perhaps 1-2% of NPLs out of the total.
This 9% will be an average: banks are permitted to apply a risk-weighting methodology, which will result in their identifying some loans upon which the risk of loss is so small that capital of 1% of the loan will be deemed adequate. At the same time there will be others where capital of 18% will be needed. However, all these loans need to be Performing to justify a risk-weighting of 1-18%.
Once a loan becomes Non-performing, though, the risk of loss must cause the loan amount to be backed with 25% of capital as an absolute minimum, going up to 100% if it is a bad loan upon which there is no realistic chance of any recovery being made.
Furthermore the bank is subject to an overall Leverage Ratio where total loans (their face value, not their risk-weighted value) cannot be more than twenty times the bank's capital.
Assuming Cyprus' banks adhere to this Leverage Ratio and knowing they have total loans of €46.28bn, their capital will be €2.31bn, and their remaining funding – deposits and bonds – will be €43.97bn.
The deposits are real and are protected by the Deposit Guarantee and Resolution of Credit and Other Institutions Scheme, up to €100,00 per depositor per bank. The scheme is unfunded so a pay-out to depositors would have to be met by the Republic of Cyprus raising new debt. At any rate, the deposits are real liabilities and will have to be paid out by someone: they cannot just be disappeared.
The assets, on the other hand, are illusory to a meaningful degree. Even a portion of the Performing loans are "restructured" NPLs. If Cyprus' banks had adequate capital they would be holding 9% of their Performing loans as a minimum (9% x €26.4bn = €2.37bn), and an average of 50% of NPLs (50% x €19.9bn = €9.95bn), meaning €12.32bn, compared to the €2.31bn they actually have.
The difference is a capital deficit of €10.01bn, and could be regarded as low-ball given that Performing loans contain many that have been coaxed out of NPL status.
Cyprus' banks are not in a position to repay their liabilities (the deposits and bonds) as they fall due from the proceeds of their assets: the system is insolvent. It is dependent upon access to the European System of Central Banks to lend against the banks' own bonds, both to refinance the bank's existing bonds as they fall due for repayment, as well as to meet any shortfall between withdrawals of deposits and new pay-ins (would you deposit new money with these banks?).
Exporters should not be expected to take this sort of credit risk on importers' banks, so at the very least exporters should be requiring a confirmed Letter of Credit (confirmed by a good bank in a country that is creditworthy), or a Bank Payment Obligation from that same bank, or cash upfront before shipment.
Of course, the first two of these three options presuppose there is a good bank that is prepared to either confirm a Cyprus bank's L/C or to issue a Bank Payment Obligation for the importer’s account directly. If there are no such banks, then the terms-of-trade must be cash upfront.
Other countries in the Eurozone have a similar black hole in their banking system and are dependent upon central bank funding, meaning ultimately upon Germany, the Netherlands, Luxembourg and Finland lending back their export surpluses into the countries that bought their exports in the first place. How long can this merry-go-round carry on?
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