In recent months, there have been increasing concerns, both at the national and international level, as to how banks can better manage the excess liquidity in the system. Banks have been left with limited options in dealing with this problem. In order to better assess the available options for banks, one should first review why liquidity is important and define excessive liquidity.
The European Central Bank (ECB) offers some very insightful comments regarding liquidity: As part of their core operations, healthy banks may hold long-term assets such as house mortgages but face very short-term calls to pay out on liabilities, as in the case of money out of ATMs, for example. Banks also need liquidity to fulfil minimum reserve requirements. One place that solvent banks can turn to for such short-term liquidity is the Central Bank. All liquidity available in the banking system that exceeds the needs of banks is called excess liquidity.
Under normal conditions, banks are required to hold adequate liquidity that is compliant with the regulatory requirements and will allow them to successfully manage operational needs. The risk is for banks to face liquidity shortages that may create panic among customers and result in bank runs and possible systemic repercussions.
The problem banks currently face in Cyprus is the opposite. Local banks not only have adequate liquidity to meet the requirements but, even more, they have excess liquidity, which if not utilised properly is a burden. According to the latest data from the Central Bank, the banking system had excess liquidity of €20.7 billion in November 2021, while, at the end of December 2019, the corresponding amount was €14.3 billion, demonstrating an upward trend in recent years. Importantly, the current situation for Cypriot banks is not a Cypriot phenomenon, but something that affects the global banking system.
Theoretically, the options for liquidity management by banks include the granting of new lending and/or investments. In practice, however, both options are currently difficult to implement because: (1) competition for low-risk investments with satisfactory returns is intense internationally, limiting the choices of Cypriot banks, and (2) as for new loans, many companies in Cyprus are already heavily indebted and will hardly be able to secure new loans from banks, which are particularly strict these days in terms of the criteria set for granting new loans.
One possible solution for managing excess liquidity at the European level would be for the ECB to proceed with a quantitative tightening and to reverse the quantitative easing program it has implemented in recent years. This would mean that the ECB would sell instead of buy bonds, which would reduce money in the banking system and consequently raise interest rates. Such a policy, at present, is not in the ECB’s options, as the prevailing view is that the current inflationary pressures are a matter of imbalance between supply and demand following the reopening of the economy. As a result, banks need to look for other ways to deal with excess liquidity. Especially in Cyprus, where businesses and households are already over-indebted, and non-performing loans are comparatively higher than in other European countries, the options available to banks are even more limited.
A suggestion would be for the banks to develop separate units where they could evaluate lending to “start-ups” based on innovative ideas and a sustainable business plan. From the banks’ point of view, reaching out to these companies requires investment, as it needs specialised knowledge and properly trained staff that can review the companies’ potential and the associated risks. Although this option is not expected to lead to increased lending, at least not in the short run, Cypriot banks need to adapt to market trends and pursue every possible opportunity and prospect. In Greece, for example, start-ups thrive mainly in the technology sector as well as in the agri-food and tourism sectors, and local banks there have already responded accordingly, albeit to a limited extent.
Banks could also seek to participate in syndicated loans abroad. A banking consortium is defined as cooperation between two or more banks to meet the needs of their customers for large financing that cannot be fully covered by one bank. Within such a consortium, Cypriot banks would not have the role of financial leader but, given their size, would merely participate in the consortium. Such a role carries certain risks, both in terms of the banks’ ability to evaluate loans of this size and the limited participation that a small bank will have in the consortium’s decisions. These risks are something that Cypriot banks must consider seriously before committing to such lending.
Another possible option for the banks would be to coordinate their movements according to the strategic plans, both at the European and national level, for the promotion of sustainable growth. The EU’s Sustainable Finance Action Plan has clear deadlines and targets in promoting net-zero greenhouse gas emissions by 2050 and meeting the 17 UN Sustainable Development Goals. Incorporating ESG (Environmental Social Governance) principles is a one-way road for private companies’ business strategies and banks’ risk assessments. Significant European and state subsidies will be available for this purpose and, as part of the Cyprus Recovery and Resilience Plan (2021-2026), local banks could offer loans to individuals and companies and enable them to take advantage of European and state funded programmes. Again, the need for specialised knowledge on sustainable finance is an issue that banks need to address.
Banks could also study the possibility of working with stores that want to offer consumers the opportunity to buy their products in instalments. This is a common practice abroad, but it has not yet been implemented in the Cypriot market, at least not to a large extent. Such a payment facilitation program should have clear terms and conditions on how it will evaluate customers and their ability to repay, as well as who bears the risk of non-repayment. This risk assessment and management is particularly important for the Cypriot market given the over-indebtedness of several households.
Finally, there is always the option of investing abroad in government or corporate bonds. In such a case and under the current circumstances, banks will not be able to target “AAA” rating categories (low-risk bonds of high quality) if they want to avoid negative interest rates. As a result, they will have to choose less credible investment products, and this presupposes increased risk. Given the previous bitter experience of Cypriot banks acquiring disproportionate Greek government bonds that later suffered a ‘hair-cut’ and led to their downfall and current restrictions set by the supervisor, such a move should be made with great caution.
What is certain is that there are no easy solutions in a globalised environment where all markets are called upon to find ways to manage excess liquidity. Banks need to be willing to move away from traditional lending channels and practices and adopt innovative policies with calculated risks, ones where the benefit to the bank clearly outweighs the risks.
Adonis Pegasiou
EIMF Academic Director
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