In the last few days, we had three pretty interesting developments related to the banking sector around the globe: EU developments, Basel 3, and an IMF report regarding China’s banks. In the EU, important steps were taken preparing for a Banking Union that will close the “doom loop” in which banks buy local sovereign bonds irrespectively of the idiosyncratic risks and that will also push for a single supervisor (the ECB) as well as a single resolution authority to deal with failed banks. In addition, new buffers were introduced that enhance banking standards and that should advance the EU banking sector’s viability. Furthermore, on January 3rd MiFID2 (Markets in Financial Instruments Directive) takes effect which advances transparency and reduces derivatives’ risk (the ultimate culprit of the 2008 financial crisis).

We believe that such measures not only add credibility to the EU’s banking outlook but also make the EU’s banking sector stronger, given the many weaknesses it has been suffering from for more than ten years now. The absence of an EU-wide deposit insurance, in conjunction with the still-weak shock absorbers, will be problematic if another financial crisis emerges in the next 2-4 years – especially because stronger capital standards were not adopted. Our expectation is that EU banks’ profits will become more volatile now that IFRS 9 (International Financial Reporting Standards) will be adopted effective next month, given that provisions should be made for expected losses rather than wait until those losses materialize.

We have some concerns regarding the chosen path related to capital requirements for the risks that large EU banks are taking on (RWAs). The large EU banks have been found – and possibly continue down that path – as the big laggards regarding their equity relative to the risks they are taking on. As the Basel Committee reported, the large EU banks are “materially non-compliant”. Such non-compliance involves a capital shortfall close to $200 billion, and hence the risks to the whole EU financial sector would be significant if another crisis were to happen. American banks, on the other hand, are mostly compliant with Basel 3 since they put their houses in order after the crisis.

Moving now from the EU to China, we cannot neglect the report that the IMF published last week regarding the health of the Chinese financial sector. The IMF report reflects important concerns regarding imbalances in the Chinese financial sector. About 80% of Chinese banks (especially the medium size banks) are vulnerable to financial shocks. Of the 33 banks subjected to stress tests, 27 were found to have less than adequate capital. Let’s not forget the fact that those 33 banks hold assets of about $25 trillion. We can all understand what it means for both the stock and the bond markets around the whole world if those banks should go into crisis mode. As we have discussed before, this is the result of debt financing which always comes back to bite when fortunes reverse course. China’s total debt exceeds 230% of its GDP and we doubt that this is sustainable.

However, transformation is both theoretically possible and also viable in a practical sense. In 2012 and 2013 the country of Cyprus and its largest bank (the Bank of Cyprus) entered an unprecedented crisis mode that resulted in bail-ins in which depositors lost millions of Euros. Most of the world believed that the Bank of Cyprus was dead and chances for its revival were almost non-existent. Guess what? The Bank of Cyprus has undergone an unbelievable transformation, demonstrating that with commitment to higher standards (including of course higher capital standards), transparency, and excellence in governance, you can be recognized as the Best Governed Bank of the Year. The fact is that the Bank of Cyprus has been reborn and paves the way as an example of what a bank transformation is all about. Its listing on the London Stock Exchange is but one small reflection of such rebirth. Banks need to clean up their books, demonstrate outstanding principles of governance, and strengthen their capital base in order to become engines of growing and viable economies.

It is not a surprise, then, that Bank of Cyprus was named the Best Corporate Governance Institution for 2017.

The Bank of Cyprus, under its leadership and especially through its compliance division headed by Mr. Marios Skandalis, has performed a banking miracle. We encourage our readers to watch the two short videos below to witness for themselves that transformation is possible in the midst of death sirens:

Bank of Cyprus Not Afraid to Forgo Profits in Financial Crime Clean-Up

How Bank of Cyprus Came Back from Its Bail-In to Listing in London