Cyprus banks face bad debts challenge

Nicosia - Cyprus Central Bank chief Panicos Demetriades said on Monday the main challenge still facing the country's troubled banking sector after last year's bailout haircut is clawing back bad debt.

"Arrears management and loan restructuring is one of the most challenging issues currently facing the banking sector in Cyprus in its path to the restoration of financial soundness," Demetriades told a conference.

In return for €10bn ($14bn) in aid from a troika of international lenders, the island in March agreed to wind down its second largest bank - Laiki - and impose losses on depositors in the Bank of Cyprus, the under-capitalised largest lender.

The unprecedented eurozone "haircut" on deposits forced the government to close all the island's banks for nearly two weeks in March and impose draconian controls when they reopened.

Restrictions - Cyprus is the only eurozone state to have them - are being eased but a €300 daily withdrawal limit remains in place.

Banking sector bad loans will be on the agenda when the troika of international lenders begin their third assessment of the Cypriot economy on Wednesday.

Demetriades said Cyprus entered the financial crisis with large private sector indebtedness accumulated over decades, similar to the situation in Iceland, which faced a banking meltdown, and in fellow bailout recipient Ireland.

"Private sector indebtedness peaked at over 500% of GDP (gross domestic product) in Iceland, and 300% in Ireland. By comparison, private sector indebtedness stands at 300% in Cyprus," he said.

Demetriades said the problem could be "addressed and defused" such as through a targeted case-by-case approach to debt restructuring, effective arrears management and the strengthening of the legal framework.

He added that loans should be assessed by shifting lending from asset-based criteria to assessing the ability to repay.

"Asset-based lending is no longer acceptable and ability to repay should be the main criterion that governs a credit approval decision," said Demetriades.

"Collateral should be just that, an added layer of security in case things do not evolve as expected, and should not be expected to be the primary source of repayment."

The Central Bank, he added, would conduct an assessment of credit institutions' effectiveness, operational capacity, and arrears management policies in the first half of 2014.