The legal system in the Republic of Cyprus is based on the English common law. Lawmakers codified additional rules and as being a member of the European Union, the European Court of Justice ensures the application of Union law within the Cypriot legal system. The Central Bank of Cyprus (CBC) is responsible for the monetary policy of the country and oversight of the banking system. The Securities and Exchange Commission (CySEC) is responsible for the local investment related ecosystem. Together the CBC and CySEC are the financial regulators of the Republic. Their duty is to maintain confidence in the local financial system and protect it from abuse.
In the past, banks in Cyprus failed for monetary reasons and assumed regulatory violations. Both triggered local and international public outrage. Due to its positioning, the country always attracted foreign investors and non-resident business people. The result is a skewed growth in its local financial sector. The European debt crisis, where the inflow of foreign capital abruptly stopped, the outflow of funds spiraled, and the exposure to high risk investments, both local and international, grew to uncontrollable levels, nearly forced the Republic of Cyprus into bankruptcy. The country was bailed-out by a consortium of the European Commission, European Central Bank and International Monetary Fund. Cyprus repaid the bail-out package, while numerous investors in and depositors of Laiki Bank and Bank of Cyprus lost most of their bank deposit.
The business of banking
The business of banking is in fact a form of financial intermediation. Financial institutions take deposits from savers to lend these same funds to borrowers. The margin between the price paid by the borrower and the disbursements made to creditors is the profit for the bank. For profit generating and risk management purposes, banks leverage their business model in two main ways. The first way to do this is by increasing the supply and demand of lending via securitization and fractional reserve programs. The second business growth model is that banks also intermediate via direct finance where the bank acts as a security company to connect savers and issuers of notes, bonds or equity. The risk of the bank is limited in direct finance because the investor takes full responsibility of the transaction.
In a free market economy, financial institutions and their customers are subject to civil understanding and contract law. A central bank acts as a lender of last resort and thus final liquidity provider for the banking sector. Yet, in a more complex global financial market place, regulators and central banks obtain further responsibilities and competencies. As a result, financial institutions can be placed under special administrations in matters of financial distress, alleged sanctions violations and other assumed regulatory violations.
Bank resolution in Cyprus
The financial sector in Cyprus has distinguished local banks from systemically important financial institutions. The latter group requires a more sophisticated approach to avoid risk to society for activities that are subject to the arrangement between a bank and their customers. During the global financial crisis, and more particular the European debt crisis, Cyprus was the first European country where bank liquidation took place in the form of a bail-in. This approach is derived from the traditional creditor and insolvency hierarchy in corporate liquidation and compels depositors, investors and other creditors to participate in the losses of the bank to ensure the continuation of the bank. The alternatives are to bankrupt the bank or to bail it out with tax payer input.
Resolution is the first step in the bank failure process. Once the central bank or resolution authority determines that a bank is failing or likely to fail, it closes the bank to avoid a run on its liquidity and appoints a special administrator to protect the interests of the bank and its stakeholders. To maintain confidence in the local financial system, depositors may get restricted access to their account balances and the domestic deposit protection scheme is activated to return qualifying depositors up to 100.000 euro of their deposit. Once the DGS payments are made to those who filed their claim and are eligible for insurance payout, bank liquidation can be started. This however requires the court to approve the liquidation request and appoint an independent liquidator.
Bank liquidation in Cyprus
Several administrative procedures are initiated following the approval of a bank liquidation by the appropriate authorities. An independent liquidator oversees the banks cash flow, assets, and liabilities in order to honor the claims of creditors. An inspection committee may be appointed to help the liquidator make important decisions. Creditors are often under the impression that once the liquidation is approved, their money is immediately returned. The collections and realisation of external assets in reality takes time and occurs infrequently. Repayments are therefore often made in tranches. While the liquidator tries to secure the corporate assets, creditors are asked to submit a proof of claim to substantiate their position. This is because it is the responsibility of the liquidator to ensure that future payments go to the correct creditors.
As soon as the liquidator obtains access to corporate assets, distribution to qualified creditors can begin. When assets are fragmented and governed by different laws in different jurisdictions, collections occur at different points in time. As a result, repayments in bank liquidation are often made in several tranches.
Creditors must be paid according to the applicable creditor hierarchy in bank liquidation, which distinguishes between liquidation costs and other preferential charges, senior or secured claims, unsecured liabilities, and subordinate debt. Bank deposits are considered unsecured liabilities and therefore come after the preferential charges and secured claims are repaid. At the end of the liquidation, when all claims are honored, or all assets are realized, the bank is dissolved. A mismatch between assets and liabilities may leave creditors with a financial loss. Quantified damages can then be claimed from wrongdoers. Bear in mind that such additional claims are often difficult to obtain since they require strong causality between the loss of money and the wrongdoing.