## Cyprus — Financial System Stability Assessment (FSAP), July 22, 2009 (_cr09308)

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### Executive summary — system-wide findings and vulnerabilities
- Banking system size: 690 percent of GDP.
- Banks have "managed to avoid the worst effects of the global financial crisis," but credit risk remains high.
- High exposure to real estate and construction sectors; loan quality likely to deteriorate as the global slump hits Cyprus.
- Household debt-to-GDP ratio: 122 percent of GDP at end-December 2008.
- Banks’ liquidity "fallen somewhat" but remains comfortable due to reliance on deposits and prudent liquidity management.
- Stress-test high-level results:
  - Credit risk is the key source of risk for banks.
  - Banks are resilient to medium-size shocks.
  - Under extreme shocks, banks would require significant capital injections; one extreme but plausible scenario implies costs of around 10 percent of GDP.
- Supervisory and contingency frameworks require strengthening to manage high credit and cross-border risks.

### Priority policy recommendations (selected)
- Maintain ample capital buffers to offset expected credit risk deterioration.
  - Status: New recommendation. Timing: ST. Priority: High.
- Maintain prudential stance on liquidity and closely monitor liquidity developments in banks.
  - Status: Continued / Implemented. Timing: ST. Priority: High.
- Strengthen the financial stability function at the Central Bank of Cyprus (CBC):
  - Increase resources and extend stress-testing coverage of institutions and risks.
  - Status: Not started / Started. Timing: ST. Priority: High.
- CyStat to compile reliable data on household debt, debt service, income; and real estate prices.
  - Status: Started. Timing: ST. Priority: Medium.
- Enhance deposit insurance schemes (funding, coverage).
  - Status: Draft laws ready. Timing: ST. Priority: High.
- Develop operational guidance for emergency liquidity assistance (ELA).
  - Status: Started. Timing: ST. Priority: High.
- Establish legal framework for covered bonds.
  - Status: New; started. Timing: ST. Priority: High.
- Clarify bank resolution framework—check consistency of Banking and Corporate Laws; develop crisis management law consistent with EU Guidelines.
  - Status: Not started / Started. Timing: ST. Priority: High.
- Conduct crisis simulation exercises.
  - Status: Not started. Timing: MT. Priority: High.
- Tighten prudential norms on connected lending.
  - Status: Implemented. Timing: ST. Priority: High.
- Increase and extend monetary penalties.
  - Status: Implemented. Timing: ST. Priority: Medium.
- Supervise credit institutions by a single supervisor.
  - Status: Not started. Timing: MT. Priority: Medium.
- Increase independence of insurance supervisor.
  - Status: Not started. Timing: ST. Priority: High.
- Carry out onsite inspection of the Stock Exchange.
  - Status: Not started. Timing: ST. Priority: High.
- Focus on foreign-owned intermediaries with overseas clients.
  - Status: Started. Timing: ST. Priority: High.
- Consider creating an integrated supervisory agency and consider integrating supervision of pensions.
  - Status: Not started. Timing: MT / LT. Priority: Medium.

### Macroeconomic context and key indicators (selected)
- Euro adoption: Transition to the Euro on January 1, 2008 was "smooth."
- Inflation: 2.2 percent in 2007; 4.4 percent in 2008.
- Private sector credit growth: 22.7 percent in 2007; 28.6 percent in 2008.
- Current account deficit: 18 percent of GDP for 2008.
- Growth: 4.4 percent in 2007; 3.6 percent in 2008.
- Budget balance: surplus of 0.9 percent in 2008.
- Gross public debt: fell well below the Maastricht ceiling of 60 percent.

### Financial system structure, scale, and market indicators
- Composition: commercial banks, cooperative credit institutions, accounting and insurance companies, pension funds, and capital markets; high intersectoral integration.
- Banking sector assets: 690 percent of GDP (as a percentage of GDP larger than the United Kingdom or Switzerland).
- Cooperative banks: assets around 70 percent of GDP.
- Foreign control: 38 percent of total consolidated banking assets under foreign control as of end-2008.
- Household debt-GDP ratio: 140 percent at end-December 2007; EU average: 60 percent.
- Profitability indicators:
  - Aggregate ROE: 37 percent as of end-2007.
  - Aggregate ROA: 2 percent as of end-2007.
- Capital ratios:
  - Tier I capital to risk-weighted assets: 10 percent as of end-2007, falling to 8.6 percent in 2008.
- Principal banks’ equity prices: declined by 70-80 percent from their peak in recent months (reflecting deterioration in outlook for banks’ emerging Europe subsidiaries).
- Distance-to-default indicators recorded a similar fall.

### Key risks, liquidity, and cross-border exposures
- Real estate and construction exposure: supervisors should ensure banks hold ample capital buffers above regulatory minimums.
- Household and tourism-related credit risk: mortgage loans to foreigners and declining tourism increase credit risk; collateral values may decline despite tightened LTV ratios.
- Liquidity indicators:
  - Aggregate customer deposits to (non-interbank) loans: 104 percent at end-2008, down from 122 percent in 2007.
  - Deposits by non-residents: about 30 percent of banking system deposits at end-2007.
  - Regulatory requirement: banks required to invest at least 70 percent of non-resident deposits into liquid assets.
- Counterparty exposures (including bond investments) at end-March 2009:
  - EUR 12.6 billion to other euro area banks.
  - EUR 12.2 billion to the rest of the world.
- Risk dependence on double-tax treaties for foreign short-term deposits noted; treaty with Russia agreed to be renewed.

### Stress testing — design, scenarios, and main findings
- Methodology: combined single-factor sensitivity calculations and scenario analysis; top-down and bottom-up approaches; CBC staff, FSAP mission, and four largest banks participated; results cross-checked.
- Single-factor findings:
  - Credit shocks had the largest and most diffuse impact owing to real estate exposure.
  - Exchange rate risk: direct losses negligible for most banks due to very small net open FX positions.
  - Interest rate risk: direct impact relatively small; increase in interest rates generally improves banks’ situation as assets reprice more quickly than liabilities.
  - Equity exposure: very small (bank equity investments stood at 0.25 percent of total assets as of end-April 2009).
- Bottom-up shock parameters used by banks:
  - Interest rate shifts: 200 bps parallel; joint 3-month and 12-month changes up to 200 bps and 100 bps respectively.
  - Exchange rate moves: depreciation/appreciation of the euro by up to 30 percent.
  - Asset price shocks: equity declines of 30 percent and 50 percent; real estate declines up to 30 percent.
  - Credit risk: NPL ratios increasing up to 100 percent; declines in net interest margin by 0.5-2.0 percentage points.
  - Liquidity: scenarios including 30 percent deposit withdrawal and 30 percent reduction in available collateral.
- Liquidity stress-test (top-down extreme liability scenario) assumptions:
  - 30 percent of demand deposits withdrawn;
  - banks can use only their liquid assets;
  - no recourse to other banks or lender of last resort.
  - Under that extreme scenario:
    - it would take three days for the first bank to become illiquid;
    - it would take five days for all the major banks to become illiquid.
- Multi-shock extreme scenario combined:
  - NPLs increase by 100 percent;
  - real estate price decline by 30 percent;
  - interest rates decline by 200 basis points;
  - exchange rate appreciation by 30 percent;
  - equity price decline by 50 percent.
  - Under this extreme scenario:
    - aggregate CAR would decline to about 4.7 percent (text also reports 4.8 percent / Appendix Table 11 aggregated post-shock CAR: 4.7 5.0 6.3 4.3 4.8);
    - capital injections equivalent to about 10.5 percent of GDP would be needed to ensure all banks satisfy the minimum CAR of 8 percent (Appendix Table 6 shows capital injections: 10.6 2.7 5.2 0.4 2.5 in percent of 2008 GDP).
- Sensitivity analysis highlights (bottom-up aggregate outcomes):
  - Pre-shock CAR: 10.7 10.9 11.3 10.1 11.0.
  - Post-shock CAR (LGD = 50%): NPLs up by 100% → 8.0 8.2 9.3 7.8 7.9.
  - Post-shock CAR (LGD = 80%): NPLs up by 100% → 6.4 6.6 8.0 5.9 6.3.
  - Concentration risk: default largest 5 exposures (excl. government) → 6.3 7.7 11.3 4.3 7.6.
  - Net interest margin risk: reduction of NIM by 2.0 percentage points → 7.3 7.8 8.9 5.6 8.4.
  - Counterparty/bond price shocks: all financial institutions' bond prices decline by 10 percent → CAR falls by about 1 percent in aggregate; one bank becomes undercapitalized.

### Liquidity stress-test quantitative outcomes (selected)
- CBC top-down pre-shock liquidity ratio (liquid assets to total borrowing): 46.
- Post-shock (10% reduction in deposits): 44.
- Post-shock (30% reduction in deposits): 40.
- Bottom-up bank-level pre-shock liquid asset ratios (examples across banks): 26, 31, 23, 26, 29, 34, 17, 29.
- Bottom-up scenario examples show material declines in post-shock liquid asset ratios at 5 and 30 days; severe scenarios produce negative ratios for some banks.

### Banking regulation, supervision, and architecture
- Recent progress:
  - Staffing levels and expertise in CBC and ASDCS have been boosted.
  - EU Capital Requirements Directive (CRD) implemented; Banking and Cooperative Societies Laws modified for conformity with acquis communautaire.
  - Cooperative Central Bank (CCB) assumed central role for most credit cooperatives.
- Recommended structural change:
  - Move toward a single supervisor for all deposit-taking institutions to reduce overlap and enhance effectiveness and efficiency; strong case for integrating prudential supervision of commercial banks and cooperative credit institutions.
- Prudential actions:
  - Maintain capital cushions above regulatory minimums as loan quality deteriorates.
  - Tighten prudential practices in selected areas (e.g., reduce connected lending limits; reporting frequency increased to quarterly for CAR and large exposures).
  - Improve home-host supervisory coordination, particularly with Greek supervisors.
- Supervisory capacity building and follow-up (selected):
  - Increase frequency of reporting from 6 to 3 months for capital adequacy and large exposure limits (BCP recommendations).
  - Intensify on-site supervision and expand joint inspections between CBC and ASDCS.
  - Develop offsite models, early warning systems, and extend stress testing to cooperatives.

### Cooperative credit institutions and pension/insurance/securities sectors
- Cooperative sector consolidation:
  - Number of cooperatives: around 360 in early 2000s; 116 as of end-2008.
  - Market share: about 10 percent of total assets of deposit-taking institutions.
- Cooperative FSIs (selected series 2003–08 examples):
  - Regulatory capital to risk-weighted assets examples: 11.1, 11.3, 12.1, 13.8.
  - Return on assets examples: -0.1, 0.7, 0.6, 0.7, 0.7, 0.4 (2003–08 entries).
  - Customer deposits to total (non-interbank) loans examples: 135.2, 129.3, 129.2, 133.9, 131.4, 116.9.
  - Residential real estate loans to total loans examples: 36.5, 35.0, 32.0, 32.0, 33.3, 33.8.
- Insurance sector:
  - QIS4 / Solvency II participation showed high concentration risk.
  - Change to best estimate plus risk margin: reduction in liabilities; increase in capital requirements by 25 percent on average.
  - Concentration risk charges produced sharp increases in capital requirements; almost all solvency ratios declined; one company showed a solvency margin below 100 percent.
  - Recommended supervisory responses: tighten regulatory environment, stricter fit-and-proper testing, raise supervisory fees, increase ICCS independence and resources.
- Securities sector and CySEC:
  - Regulations aligned with MiFID; focus on implementation.
  - CySEC considered professional and skilled; recommended immediate onsite inspection of the Cyprus Stock Exchange (CSE).
  - Government ownership of the CSE should be re-examined.
  - Pay particular attention to market intermediaries that are foreign-owned and provide services largely to overseas clients (about 40 of 67 intermediaries owned by Russian interests as of end-2007).

### Crisis preparedness, ELA, deposit insurance, and coordination
- MoU on crisis management "provides a good foundation" but needs testing and augmentation.
- Deposit insurance amendments pending parliamentary approval to:
  - increase the level to the new EU minimum;
  - increase payout to 100 percent of guaranteed deposits;
  - shorten payout time by increasing preparedness;
  - improve financial strength and coverage by increasing member contributions, supplemental contributions, and borrowing arrangements.
- ELA recommendations:
  - CBC should complete preparations for ELA modalities outside the ECB framework.
  - Set thresholds for insolvency and for seeking MoF backing in advance.
  - Publicly disclose principles underlying ELA; operations eventually made public.
  - Foreign-currency liquidity crisis management merits special consideration given significant U.S. dollar deposits.
- Domestic coordination shortcomings:
  - No simulation exercises held to test cooperation.
  - Unclear role of minister of finance in accepting contingent liabilities.
  - Thresholds for triggering consultation in potential insolvency not clearly set.
  - No obligation to formulate a formal contingency plan.
  - Need for coordinated public responses to avoid contradictory messages.
- Regional and EU measures:
  - ECB adjusted eurozone liquidity management in 2008 (increased amounts, extended maturities, eased collateral, increased eligible counterparties).
  - European finance ministers agreed in October 2008 to harmonize deposit protection in the EUR 50,000–100,000 range.
  - European Council endorsement on June 19, 2009 of overhaul to create a European Systemic Risk Board and a European System of Financial Supervisors.
- Cross-border cooperation: Cyprus participates in multiple MoUs and planned supervisory colleges by end-2009; deepen operational contacts, especially with Greek banking supervision authorities.
- Bank resolution framework: needs clarification on conditions for CBC control, use of corporate law modalities (purchase-and-assumption, bridge banks), central role of supervisor in insolvency proceedings, and information sharing.

### Follow-up on 2005 OFC recommendations and implementation status (selected)
- Banking supervision staffing increased; 90 days in arrears rule effective 1 January 2006 for interest suspension aligned with IAS 39 adjustments forthcoming.
- ASDCS: staffing increases from 56 in 2005 to planned 76; regulatory decisions issued on permissible activities, participation in other enterprises, and 6-month reporting for capital adequacy.
- Insurance supervision (ICCS): staff nearly doubled since 2005 with actuarial and accounting expertise added; computerization introduced June 2008; QIS4 participation and market analysis capacity improved.
- CySEC: transposition of MiFID removed anomaly where one public administrative body supervised another; information-sharing limitations with non-EU regulators remain pending legislation.

*Prepared by the Monetary and Capital Markets and European Departments; FSAP mission September–October 2008; assessment discussed during Article IV consultation mission of June 2009. Main author: Karl Driessen, with input from Martin Čihák, Heiko Hesse, and Yinqiu Lu.*

### 2009. The views expressed in this document are those of the staff team and do not necessarily reflect

### Cyprus — Financial System Stability Assessment (FSAP), July 22, 2009

### Executive summary — system-wide findings and vulnerabilities
- The banking system is large at 690 percent of GDP and has "managed to avoid the worst effects of the global financial crisis," but credit risk remains high.
- High exposure to real estate and construction sectors; loan quality likely to deteriorate as the global slump hits Cyprus.
- Household debt-to-GDP ratio was 122 percent of GDP at end-December 2008.
- Banks’ liquidity has "fallen somewhat" but remains comfortable due to reliance on deposits and prudent liquidity management; strict liquidity regulations are considered appropriate.
- Stress tests indicate:
  - Credit risk is the key source of risk for banks.
  - Banks are resilient to medium-size shocks.
  - Under extreme shocks, banks would require significant capital injections; one extreme but plausible scenario implies costs of around 10 percent of GDP.
- Supervisory and contingency frameworks require strengthening to manage high credit and cross-border risks.

### Priority policy recommendations (selected)
- Maintain ample capital buffers to offset expected credit risk deterioration.
  - Status: New recommendation.
  - Timing: ST.
  - Priority: High.
- Maintain prudential stance on liquidity and closely monitor liquidity developments in banks.
  - Status: Continued / Implemented.
  - Timing: ST.
  - Priority: High.
- Strengthen the financial stability function at the Central Bank of Cyprus (CBC):
  - Increase resources and extend stress-testing coverage of institutions and risks.
  - Status: Not started / Started.
  - Timing: ST.
  - Priority: High.
- CyStat to compile reliable data on household debt, debt service, income; and real estate prices.
  - Status: Started.
  - Timing: ST.
  - Priority: Medium.
- Enhance deposit insurance schemes (funding, coverage).
  - Status: Draft laws ready.
  - Timing: ST.
  - Priority: High.
- Develop operational guidance for emergency liquidity assistance (ELA).
  - Status: Started.
  - Timing: ST.
  - Priority: High.
- Establish legal framework for covered bonds.
  - Status: New; started.
  - Timing: ST.
  - Priority: High.
- Clarify bank resolution framework—check consistency of Banking and Corporate Laws; develop crisis management law consistent with EU Guidelines.
  - Status: Not started / Started.
  - Timing: ST.
  - Priority: High.
- Conduct crisis simulation exercises.
  - Status: Not started.
  - Timing: MT.
  - Priority: High.
- Improve remedial action framework (draft law).
  - Status: Not started.
  - Timing: MT.
  - Priority: Medium.
- Tighten prudential norms on connected lending.
  - Status: Implemented.
  - Timing: ST.
  - Priority: High.
- Increase and extend monetary penalties.
  - Status: Implemented.
  - Timing: ST.
  - Priority: Medium.
- Supervise credit institutions by a single supervisor.
  - Status: Not started.
  - Timing: MT.
  - Priority: Medium.
- Increase independence of insurance supervisor.
  - Status: Not started.
  - Timing: ST.
  - Priority: High.
- Carry out onsite inspection of the Stock Exchange.
  - Status: Not started.
  - Timing: ST.
  - Priority: High.
- Focus on foreign-owned intermediaries with overseas clients.
  - Status: Started.
  - Timing: ST.
  - Priority: High.
- Consider creating an integrated supervisory agency and consider integrating supervision of pensions.
  - Status: Not started.
  - Timing: MT / LT.
  - Priority: Medium.

### Crisis preparedness and management
- The authorities’ memorandum of understanding (MoU) on crisis management "provides a good foundation."
- Suggested improvements:
  - Bolster deposit insurance schemes (an amendment increasing funding and coverage is currently before parliament).
  - Develop operational guidelines for ELA.
  - Undertake crisis simulation exercises.
  - Strengthen home-host coordination arrangements in the context of EU initiatives.
  - Carefully review the bank resolution framework.
- Stress-testing enhancements recommended:
  - Improve methodology for modeling credit risk in banks’ loan portfolios.
  - Broaden coverage of stress tests.

### Banking regulation and supervision
- Recent progress:
  - Staffing levels and expertise in both the CBC and Authority for the Supervision and Development of Cooperative Societies (ASDCS) have been boosted.
  - EU Capital Requirements Directive (CRD) has been put in place.
  - Cooperative Central Bank (CCB) has taken a new role as central body for most credit cooperatives.
- Recommended structural change:
  - Move toward a single supervisor for all deposit-taking institutions to reduce overlap and enhance effectiveness and efficiency of supervision and maintain a level playing field.
- Prudential actions:
  - Maintain capital cushions above regulatory minimums as loan quality deteriorates.
  - Tighten prudential practices in selected areas.
  - Improve home-host supervisory coordination, particularly with Greek supervisors given important interlinkages.

### Insurance and securities supervision
- Insurance:
  - Significant reforms introduced, but further strengthening needed to reflect market and regulatory developments and address weaknesses.
  - Recommendations include increasing independence for the insurance supervisory agency, decreasing concentration risk, and extending full-scale on-site inspections.
- Securities:
  - Regulations aligned with MiFID; focus should shift to implementation.
  - Securities supervisor appears effective but should proceed with an onsite inspection of the Cyprus Stock Exchange; government ownership of the stock exchange should be re-examined.
  - Pay particular attention to market intermediaries that are foreign-owned and provide services largely to overseas clients.

### Cross-border exposures, home-host coordination, and supervisory architecture
- Large cross-border exposures of domestic financial institutions heighten the need for effective home-host supervisory coordination.
- Operational cooperation with Greek supervisors is being intensified.
- Committee of European Banking Supervisors’ initiatives on enhanced supervisory cooperation, including with non-EU agencies, are welcomed.
- Over the medium term, consider integration of various supervisory agencies beyond deposit-taking institutions because of strong cross-sectoral linkages and the small absolute size of the financial sector; any transition must ensure greater supervisory independence, better information sharing, and adequate resources.

### Macroeconomic context and key indicators (selected)
- Transition to the Euro on January 1, 2008 was "smooth."
- Inflation rose from 2.2 percent in 2007 to 4.4 percent in 2008.
- Private sector credit growth: 22.7 percent in 2007 and 28.6 percent in 2008.
- Current account deficit: 18 percent of GDP for 2008.
- Growth: 4.4 percent in 2007 and 3.6 percent in 2008.
- Budget balance: surplus of 0.9 percent in 2008.
- Gross public debt: fell well below the Maastricht ceiling of 60 percent.

### Data, statistics, and analytical infrastructure
- Recommendation: CyStat to collect statistics on borrower incomes and balance sheets to enable better analysis.
- Recommendation: Establish a credit registry that would enable sharing of positive information about borrowers; the Association of Cyprus banks is currently working on this.

*Prepared by the Monetary and Capital Markets and European Departments; FSAP mission September–October 2008; assessment discussed during Article IV consultation mission of June 2009. Main author: Karl Driessen, with input from Martin Čihák, Heiko Hesse, and Yinqiu Lu.*

### 3.      For a small economy, the financial system is large and complex owing to its

### _cr09308 - 3.      For a small economy, the financial system is large and complex owing to its

### Financial system structure and scale
- Composed of commercial banks, cooperative credit institutions, accounting and insurance companies, pension funds, and capital markets, with a high degree of intersectoral integration.
- As a percentage of GDP, Cyprus’ banking sector assets—at 690 percent—are larger than those of the United Kingdom or Switzerland.
- Cooperative banks: assets around 70 percent of GDP.
- Foreign banks’ presence: 38 percent of total consolidated banking assets under foreign control as of end-2008.
- Bank concentration: high but coming down due to foreign entry.
- Two largest domestic banks: strong presence in Greece and expanded into emerging European markets.
- International business sector drivers: geographical location, an extensive network of over 30 double taxation treaties, and still comparatively favorable tax rates.

### Financial soundness indicators (FSIs) and recent performance
- Banking profitability:
  - Aggregate return on equity (ROE) of 37 percent as of end-2007.
  - Aggregate return on assets (ROA) of 2 percent as of end-2007.
- Profitability drivers: robust interest margins, growing loan portfolios, and contained costs; also commissions on foreign exchange transactions and buoyant real estate sector (factors no longer fully in place).
- Profitability trend:
  - 2008: profitability fell slightly due to squeezed interest margins from enhanced competition and funding pressures for foreign acquisitions.
  - 2009: interest spreads increased again to counter sharply lower euribor-indexed lending rates.
- Capital ratios:
  - Tier I capital to risk-weighted assets: 10 percent as of end-2007, falling to 8.6 percent in 2008.
- Nonperforming loans (NPLs): decreasing ratios until recently contributed to high profitability; threshold for NPL classification changed from 6 months in arrears to 3 months in 2006.
- Cross-country averages (2002–07):
  - Capital to Risk-Weighted Assets: Cyprus 12.2
  - NPLs to Total Loans: Cyprus 8.1
  - Return on Assets: Cyprus 0.6
  - Return on Equity: Cyprus 10.9

### Market indicators and relative weakness
- FSIs and market indicators for Cypriot banks have lagged advanced economy peers.
- Bond spreads, distance-to-default indicators, and z-scores found Cypriot banks weaker than peers.
- Relatively smaller exposure to hard-hit emerging markets provided some resilience relative to other regional banks.
- Principal banks’ equity prices: declined by 70-80 percent from their peak in recent months (reflecting deterioration in outlook for banks’ emerging Europe subsidiaries).
- Bank distance-to-default (DD) indicators recorded a similar fall.

### Key risks and supervisory recommendations
- Real estate and construction sector exposure:
  - Supervisors should ensure banks hold ample capital buffers—above minimum regulatory requirements—to offset high exposure.
  - Loan quality will depend on external developments due to increasing credit risk related to mortgage loans to foreigners and declining tourism.
  - Collateral values may decline when real estate prices come down, despite tightened loan-to-value ratios and likely gradual property price adjustments.
  - Recommendation: banks should be conservative in provisioning and possibly suspend dividends until the outlook on the loan portfolio improves to provide a cushion if additional capital needs arise.
- Liquidity risk:
  - Aggregate customer deposits to (non-interbank) loans: 104 percent at end-2008, down from 122 percent in 2007.
  - Deposits by non-residents: about 30 percent of banking system deposits at end-2007; have grown during the current crisis due to Cyprus’ “safe haven” status.
  - Regulatory requirement: banks are required to invest at least 70 percent of such (non-resident) deposits into liquid assets.
  - Supervisory advice: ensure banks exceed regulatory minima for liquidity to preserve reputation and prevent adverse shifts in foreign sentiment.
  - Risk of dependence on double-tax treaties for foreign short-term deposits if treaties are not renewed; treaty with Russia agreed to be renewed.
- Counterparty risk:
  - Exposures (including through bond investments) at end-March 2009:
    - EUR 12.6 billion to other euro area banks.
    - EUR 12.2 billion to the rest of the world.
  - Counterparty risk remains large but is diminishing as markets normalize.

### Cooperative credit institutions
- Cooperative banks undergoing consolidation.
- Capitalization ratios and NPL ratios broadly similar for commercial and cooperative banks.
- Commercial banks on average have significantly higher ROA than cooperatives but with greater volatility.
- Some indicators suggest cooperative banks appear somewhat more stable than commercial banks in Cyprus in 2003–07, though aggregate figures mask substantial differences among individual cooperative banks.
- Selected FSIs for cooperatives (2003–08):
  - Regulatory capital to risk-weighted assets examples: 11.1, 11.3, 12.1, 13.8 (years within period).
  - Return on assets examples: -0.1, 0.7, 0.6, 0.7, 0.7, 0.4 (2003–08 entries).
  - Customer deposits to total (non-interbank) loans examples: 135.2, 129.3, 129.2, 133.9, 131.4, 116.9 (2003–08 entries).
  - Residential real estate loans to total loans examples: 36.5, 35.0, 32.0, 32.0, 33.3, 33.8 (2003–08 entries).

### Stress testing for banks
- Stress tests combined single-factor sensitivity calculations and scenario analysis reflecting interplay of multiple risk factors influenced by macroeconomic developments.
- Approaches: top-down and bottom-up performed by CBC staff, the FSAP mission team, and the largest four banks; spillover risks were studied.
- Results of exercises cross-checked for consistency; discrepancies discussed among FSAP team, authorities, and individual bank representatives.
- Stress tests confirm the importance of exposure to real estate and construction sectors (see supervisory recommendations above).

*Source: IMF staff analysis contained in the provided content unit.*

### 12. Among single factor shocks, credit shocks had the largest and most diffuse

### _cr09308 - 12. Among single factor shocks, credit shocks had the largest and most diffuse

### Impact of single-factor shocks on banks
- Credit shocks had the largest and most diffuse impact owing to banks’ exposure to the real estate market.
- Cyprus household debt-GDP ratio: 140 percent at end-December 2007; corresponding EU average: 60 percent.
- Exchange rate risk: direct losses from exchange rate shocks are negligible for most banks due to very small net open positions in foreign exchange (FX).
- Interest rate risk: direct impact on banks’ soundness is relatively small; generally, an increase in interest rates improves banks’ situation as asset size reprices more quickly than liabilities.
- Equity exposure: banks’ exposure to equity stock prices is very small, reflecting reductions after the early 2000s stock price bubble.

### Liquidity stress-test findings
- Top-down liquidity stress test: analyzed maximum deposit outflow manageable without uncollateralized borrowing from the central bank or other banks.
- Results indicate reasonably high liquidity buffers.
- Extreme liability-side scenario assumptions:
  - 30 percent of demand deposits withdrawn;
  - banks can use only their liquid assets;
  - banks have no recourse to other banks or to the lender of last resort.
- Under that extreme scenario:
  - it would take three days for the first bank to become illiquid;
  - it would take five days for all the major banks to become illiquid.
- Caveat: tests considered only liability-side liquidity shocks; liquidity of “safe” assets can suddenly decline, magnifying severe deposit outflows.
- Liquidity stress scenarios (bottom-up exercise) included a 30 percent withdrawal in deposits, and 30 percent reduction in the available collateral.

### Bottom-up stress testing by banks (exercise design and shock parameters)
- Participating banks: four major banks (based on end-December 2007 positions; comparative end-December 2006; results updated to end-2008).
- Common assumption: no extraordinary sources of income or injections of new capital to offset shocks.
- Interest rate risk shocks:
  - parallel downward and upward shifts in the yield curve by 200 bps;
  - joint changes of 3-month and 12-month interest rates by up to 200 bps and 100 bps respectively.
- Exchange rate risk: depreciation and appreciation of the euro by up to 30 percent against all other currencies.
- Asset price risk:
  - equity price declines by 30 percent and 50 percent;
  - real estate price declines in residential and commercial real estate by up to 30 percent.
- Credit risk:
  - sensitivity analyses with NPL ratios increasing up to 100 percent;
  - defaults on a set of largest exposures and on loans to specific sectors;
  - declines in net interest margin by 0.5-2.0 percentage points.
- Liquidity risk: 4 scenarios including major shocks noted above.

### Multi-shock scenario analysis and extreme scenario results
- Scenario used combines broad macroeconomic stress and capital account shocks; one extreme scenario combined:
  - NPLs increase by 100 percent;
  - real estate price decline by 30 percent;
  - interest rates decline by 200 basis points;
  - exchange rate appreciation by 30 percent;
  - equity price decline by 50 percent.
- Under this extreme scenario:
  - aggregate capital adequacy ratio (CAR) would decline to about 4.7 percent;
  - capital injections equivalent to about 10.5 percent of GDP would be needed to ensure all banks satisfy the minimum CAR of 8 percent.

### Insurance sector stress-test findings and structural issues
- Insurance companies participated in stress test exercise (QIS4) under EU’s Solvency II scenarios.
- Results indicate high concentration risk.
- Change in reserving basis to a best estimate approach plus a risk margin led to:
  - reduction in liabilities;
  - increase in capital requirements by 25 percent on average.
- Concentration risk charges produced a sharp increase in capital requirements; almost all solvency ratios declined, with one company showing a solvency margin below 100 percent.
- Structural lack of profitability in several insurance firms favors industry consolidation; many small, solvent firms are parts of nonfinancial groups.
- Recommended supervisory responses: tighten regulatory environment, stricter fit-and-proper testing, and raise supervisory fees.

### Crisis preparedness, management, and safety nets — findings and recommendations
- CBC powers: specific (e.g., removal of bank director or manager) and broad (assumption of control without a court order) powers exist; authorities should supplement with:
  - explicit authorization for CBC to prohibit or limit dividend distributions;
  - explicit allowance to disclose remedial action;
  - quantitative and qualitative supervisory frameworks with more explicit intervention triggers to ensure early remedial action.
- Deposit insurance funds: proposed amendments pending parliamentary approval to:
  - increase the level to the new EU minimum;
  - increase payout to 100 percent of guaranteed deposits;
  - shorten payout time by increasing preparedness;
  - improve financial strength and coverage by increasing member contributions, supplemental contributions, and borrowing arrangements.
- Domestic coordination framework (MoU among CBC, supervisory agencies, MoF) exists but needs testing; shortcomings include:
  - no simulation exercises held to test cooperation;
  - unclear role of the minister of finance in accepting contingent liabilities;
  - thresholds for triggering consultation in potential insolvency not clearly set;
  - unclear timing, materiality, and initiation of communication for consultations;
  - no obligation to formulate a formal contingency plan;
  - need for coordinated public responses to avoid contradictory messages.
- Regional arrangements and EU/ECB measures affecting Cyprus include:
  - ECB adjusted eurozone liquidity management (increased amounts, extended maturities, eased collateral, increased eligible counterparties);
  - European finance ministers agreed in October 2008 to harmonize deposit protection in the EUR 50,000–100,000 range;
  - European Council endorsement on June 19, 2009 of a comprehensive overhaul to create a European Systemic Risk Board and a European System of Financial Supervisors.
- Cross-border cooperation: Cyprus participates in multiple MoUs and regional arrangements (including supervisory colleges by end-2009); authorities should deepen operational contacts, especially with Greek banking supervision authorities.
- Emergency Liquidity Assistance (ELA) and foreign-currency liquidity:
  - CBC should complete preparations for ELA modalities outside the ECB framework;
  - thresholds for insolvency and for seeking MoF backing should be set in advance;
  - principles underlying ELA should be publicly disclosed and operations eventually made public;
  - foreign currency liquidity crisis management should receive special consideration given significant U.S. dollar deposits in Cyprus;
  - access to regular ECB refinancing is for euro assets only; temporary access to dollar liquidity has been provided; legal framework for covered bonds (under drafting) will facilitate access.
- Bank resolution framework: needs clarification to ensure a well-developed bank insolvency regime emphasizing timely action:
  - CBC can take control of a bank under the Banking Law, but conditions for such action are not defined and should be clarified;
  - confirm ability to use corporate law modalities (purchase-and-assumption, bridge banks) for bank restructuring;
  - supervisor should have a central role in insolvency proceedings and promote information sharing and coordination.

### Supervisory and regulatory framework enhancements
- Since OFC 2005 assessment, regulatory framework improvements include:
  - substantial revision of cooperative bank regulation to align with EU banking directives;
  - adoption of changes in EU financial framework including MiFID;
  - upon joining the euro area in early 2008, interest rates and required reserves were lowered.
- Prudential adjustments noted:
  - liquidity ratio reduced from 25 percent to 20 percent;
  - loan-to-value ratio increased from 60 percent to 70 percent on vacation home mortgages.
- Recommendations to strengthen stress-testing and financial stability work at the CBC:
  - involve major banks regularly in bottom-up stress test calculations;
  - issue specific guidelines to banks on stress testing and monitor results systematically, including counterparty risk stress testing;
  - deepen analysis of the mortgage loan portfolio;
  - extend stress testing to cooperatives;
  - develop an early warning system model for banks to cross-check with stress testing results.

*Source: IMF Financial Sector Assessment content unit _cr09308 - 12. Among single factor shocks, credit shocks had the largest and most diffuse*

### 28. The CBC and the Authority for the Supervision and Development of

### 28. The CBC and the Authority for the Supervision and Development of

### Banking supervision: progress and implementation
- The CBC and the Authority for the Supervision and Development of Cooperative Societies (ASDCS) "have made impressive progress to strengthen the supervisory framework for credit institutions, and must now focus on implementation."
- Legal and regulatory alignment:
  - "The transition period for the CRD is now over, and the Banking and Cooperative Societies Laws (CSL) have been modified to ensure full conformity with the acquis communautaire."
  - "Capital requirements are now imposed on the basis of the new approaches laid down in the CRD."
- Structural outcomes:
  - "The number of credit cooperatives was brought down sharply to meet the new minimum capital requirements."
  - "The CCB took on the role of central body for most credit cooperatives, exempting them from certain provisions while guaranteeing their obligations."
- Supervisory capacity building:
  - Authorities "have worked to enhance the quality of supervision, inter alia in the organizational area, upgrading the number of staff and staff expertise."
  - Planned measures include "an intensification of on-site supervision" and "further build-up of staff expertise and skills."
  - "The ASDCS will undergo further changes, including expanding the joint inspection program with the CBC (a first joint inspection has taken place), and must also narrowly coordinate its work with the CCB."
- Institutional design issue:
  - "Overlap between supervisors must be addressed in the context of the redesign of the supervisory architecture."
  - Recommendation: "A single supervisor for all banks operating in Cyprus could enhance the effectiveness and efficiency of supervision and would support the creation of a level playing field for all banks."
  - Caveat: such an entity "should contribute to safeguarding the stability of the financial sector, and should not be given other, potentially conflicting, mandates."
- Recent supervisory improvements:
  - (a) "a decrease in limits on lending to connected persons;"
  - (b) "an increase in frequency of prudential reporting of the CAR and large exposures to quarterly;"
  - (c) "an increase in the level of and extent of monetary penalties."
  - "Work is nearly complete on the organization of risk management, internal control, and audit of smaller credit cooperatives."

### Insurance supervision: reforms and remaining weaknesses
- Progress since 2005:
  - "Significant reforms have been introduced in insurance regulation and supervision since the OFC assessment in 2005."
  - "The regulatory approach appropriately reflects the straightforward insurance market in Cyprus."
- Remaining measures needed:
  - (a) "increasing independence for the insurance company control service (ICCS), so that it can recruit the resources it needs (including importantly legal and actuarial services) to perform its core duties;"
  - (b) "decreasing counterparty limits to avoid excessive concentration risk, in a gradual fashion to facilitate balance sheet adjustments;"
  - (c) "holding regular and planned on-site inspections covering the full range of insurance activities, based on a handbook that needs to be developed;"
  - (d) "requiring written confirmation from companies conducting non-domestic business outside the EU that they are in contact with local authorities and that all existing standards and regulation are met, and informing respective market authorities in case of non-fulfillment."

### Securities regulation: updates and supervisory priorities
- Framework and regulator capacity:
  - "The legislative framework for supervising the securities sector has been updated to reflect developments in EU law."
  - "The securities regulator (the Cyprus Securities and Exchange Commission (CySEC)) was considered professional, skilled and knowledgeable about the subject matter of its responsibilities."
- Priority actions for CySEC:
  - "CySEC’s recent comprehensive desk review of the Cyprus Stock Exchange (CSE) should be followed by an onsite inspection of the CSE as a matter of urgency to satisfy itself that the CSE is well positioned to implement its strategic vision."
  - "The wider question of whether the CSE should be privatized should also be considered."
  - For market intermediaries, give "particular attention to those intermediaries that are foreign owned and provide investment services largely to overseas clients, particularly from a code of conduct (how they interact with their customers) and a ‘know-your-client’ point of view."
  - "A number of other largely technical recommendations are scheduled to be addressed in upcoming legislation."

### Architecture of regulation and supervision: integration debate and criteria
- International context:
  - "The debate over which model is best for organizing financial supervisory agencies has gained much attention in recent years."
  - "The distribution of countries across supervision structures has been fairly even, with both advanced and developing countries represented in the spectrum of single integrated to separate supervision authorities."
  - "In recent years, however, more countries have adopted a system of integrated supervision by either creating a single integrated regulator for the entire financial system or merging some of the main supervisory functions."
  - Emerging empirical evidence: "integrated supervisory frameworks are associated with higher quality of supervision."
  - Transition costs: "making the transition from one supervision structure to another can be highly disruptive because of the diversion of management resources, the structural reorganizations and the potential loss of staff, experience and focus during the process of change."
- Arguments for integration in Cyprus:
  - "The integrated nature of the financial sector in Cyprus provides a strong argument for a more integrated supervisory structure that is difficult to achieve using the current sectoral approach."
  - Ownership/linkages: "The main segments of Cyprus’ financial system are closely integrated through ownership and other financial linkages, with the largest insurance companies and investment firms being owned by the three main domestic banks."
  - Product similarity: "there are many similarities in the products and services offered by the various financial institutions."
  - Synergies from merger: "merging the supervisory institutions would among other things allow to reduce duplication in support services (e.g., information technology, human resources, actuarial, and legal services)."
- Recommended approach:
  - "The creation of a single financial supervisory authority could therefore be considered in the medium to long term."
  - Decision factors: "The choice whether to create an integrated supervisory agency needs to be based on a careful consideration of the pros and cons, including whether financial sector supervision should fall under three ministries."
  - Strong case: "There is a particularly strong case for integrating prudential supervision of commercial banks and cooperative credit institutions."
- Preconditions for restructuring to meet international standards:
  - (a) "more independent supervision, supported by a strong governance structure, accountability and transparency;"
  - (b) "good access by the central bank to the relevant prudential data on individual financial institutions;"
  - (c) "adequate resources for supervision, including a salary structure that enables the regulatory authorities to attract top-quality staff;"
  - (d) "a strong regulatory and supervisory capacity;"
  - (e) "fewer prudential gaps and a level playing field across financial service industries."

### Other issues: Anti-Money Laundering framework
- Legislative update:
  - "The Prevention and Suppression of Money Laundering Activities Law, enacted in December 2007 and effective since January 1, 2008, repeals the former law in this area."
  - Purpose: "This new law aims at implementing the EU Third Directive on ML/FT and at addressing the recommendations formulated by the 2006 Moneyval report."
- Key features:
  - "The new law expanded customer due diligence requirements (in particular requiring the identification and verification of beneficial ownership of legal entities) and covers financial institutions and designated non-financial businesses and professions."
  - Covered entities include "banking institutions, cooperative institutions, private collective investment schemes, insurance companies, lawyers and accountants."
  - Supervisory designations: "The respective regulatory authorities and professional bodies are designated as the supervisory authority in each case, MOKAS (the unit for combating money laundering) for dealers in precious metals and stones, and for real estate agents."
- Follow-up directives:
  - "In April 2008, the CBC issued a revised directive to banks, and in May 2008 the ASDCS issued a revised directive to credit cooperatives."
  - "In February 2009 similar directives were issued for securities and insurance firms and for lawyers and accountants."

### Appendix — Cross-country financial sector comparison and structure
- Relative size and features:
  - "Given its role as an international financial center, the Cypriot financial sector is larger than many of its country peers while its banking sector seems more concentrated as well as exhibits a lower stock market turnover."
  - Benchmark data source: "The updated financial development database of Beck, Demirgüç-Kunt, and Levin (2000) is employed to compare Cyprus on different dimensions with high income countries as well as countries in Europe and Central Asia."
  - "The amount of private credit and liquid liabilities exceeded GDP in Cyprus in 2006 and serves as an indicator for Cyprus well-developed financial system."
- Concentration and market liquidity:
  - "The concentration ratio in Cyprus, here taken as the percentage of assets of the three largest commercial banks, lagged well behind other high income and European and Central Asian countries."
  - "In 2008, only EUR 7 million was on average traded daily on the CSE, down from EUR 16 million in 2007."
  - "Only the larger stocks have liquid markets while a significant trading of Cyprus shares also occurs on the ASE after the common platform was established in 2006."
- Financial system composition and market shares:
  - "Cyprus’ financial system is comprised of commercial banks, cooperative banks, insurance companies, pension funds, and capital markets."
  - "Three publicly-listed commercial banks are at the center of financial groups that dominate the sector. Together they hold about 54 percent of total non-consolidated banking assets excluding the cooperative banks, and 47 percent of system assets, including the cooperatives."
- Selected table highlights (end-2008 and related series):
  - Banking sector counts (2001–08): "Credit Institutions 399 405 403 401 390 333 212 162"
  - Cooperative credit institutions counts (2001–08): "363 363 361 358 348 293 170 119"
  - Total assets, credit institutions (percent of GDP series as presented): "43.4 41.7 43.0 48.0 61.9 74.7 91.1 116.0"
  - Commercial banks' assets (percent of GDP series as presented): "26.0 27.2 27.2 28.3 30.7 38.4 64.5 79.4" 
  - No. of bank branches (selected years): "501 490 476 470 451 468 474 496"
  - No. of bank branches per 100,000 inhabitants (selected years): "71 68 65 63 59 60 60 63"
  - Insurance sector counts (selected years): "65 58 47 39 39 41 41 ..."
  - Stock market capitalization (percent of GDP series as presented): "9.7 7.6 7.6 7.8 10.9 12.4 20.2 ..."
- Three financial groups (end-2008): structure summaries for Bank A, Bank B, Bank C listing domestic and foreign subsidiaries, insurance subsidiaries/branches, investment banking, asset management, and other financial activities as presented in the appendix tables.

*Source: _cr09308 - 28. The CBC and the Authority for the Supervision and Development of (IMF PDF content provided).*

### 45. Cooperative banking continues to play an important role in the Cypriot banking

### 45. Cooperative banking continues to play an important role in the Cypriot banking system

### Cooperative credit sector: consolidation and market position
- The cooperative credit sector has been going through a major consolidation in the last 3 years, mostly in response to the new regulatory environment.
- Number of cooperative credit institutions: around 360 in the first half of 2000s; 116 as of end-2008.
- Cooperatives’ overall market share: broadly stable, at around 10 percent in terms of total assets of deposit-taking institutions.
- Borrowing from cooperatives traditionally cheaper because of:
  - nonprofit orientation;
  - lower regulatory costs until recently;
  - exemption from tax on profits generated by operations with members.

### Cyprus as a financial center and banking structure
- Cyprus has a relatively large financial center with a significant international component.
- Compared with selected peers (Estonia, Greece, Malta, Portugal, and Slovenia), Cyprus:
  - has the largest number of credit institutions;
  - ranks among the highest in terms of bank branches and subsidiaries per capita (from EU and third countries);
  - ranks high in terms of total bank assets to GDP.
- Funding profile:
  - Dependence on customer deposits is relatively high, providing a degree of funding stability.
- Investment fund industry:
  - The investment fund industry in Cyprus is relatively small.

### Insurance sector structure and business mix
- Life market concentration: four largest companies control three quarters of premium income.
- Nonlife market concentration: largest three nonlife companies controlled 36 percent of premium income.
- Companies’ investments are mainly in debt securities, bank deposits, and money market instruments.
- International insurers’ business:
  - Most international business was reinsurance and life business.
  - Business based on strong geographic business relationships and favorable tax rates relative to home jurisdictions.
- Domestic insurance activity: life and motor insurance are the two most important areas.
- Life insurance role: unit-linked policies have served as an important savings vehicle in the absence of domestic mutual funds and the presence of capital controls.

### Securities sector and Cyprus Stock Exchange (CSE)
- Securities sector components: CSE, market intermediaries, and collective investment schemes.
- CSE characteristics:
  - State-owned with a relatively small number of listed companies.
  - 13 listings in the main market (of which the two large banks dominate), 127 supplementary listings, 44 government bond issues and 10 corporate bond issues.
  - Mainly deals in equities and bonds.
  - Stock lending and short selling are prohibited.
- Market capitalization and turnover:
  - Market capitalization: EUR 10.3 billion at end 2008, down from EUR 25.3 billion at end 2007.
  - Turnover for the CSE for 2008: EUR 1.5 billion.
  - Average daily turnover for 2008: EUR 6.3 million per trading day.
  - Comparatives for 2007: turnover EUR 3.9 billion; average daily turnover EUR 15.7 million.

### Market intermediaries and collective investment schemes
- Investment services supervision:
  - All market intermediaries providing investment services (including stock broking) and investment advice are supervised by CySEC under the Investment Firms Law (which transposed the EU MiFID).
  - As of end 2007, 67 market intermediaries authorized: about 40 owned by Russian interests, 10 by Cypriots, remainder by other overseas interests.
  - Russian-owned firms largely provide investment services to overseas clients, many in Russia and Ukraine, mainly on a cross border basis.
  - About 60 percent of all trades on the Moscow Stock Exchange originate in Cyprus due to the favorable double taxation agreement between the two jurisdictions.
- Collective investment schemes regimes:
  - Two types: (a) Undertakings in Collective Investment Transferable Securities (UCITS), supervised by CySEC; and (b) private investment schemes, currently supervised by the CBC.
  - UCITS currently targeted at retail investors; unfavorable tax treatment of UCITS has resulted in no UCITS authorized to date.
  - Legislation being prepared to harmonize taxes between shares and UCITS and to transfer supervision of international investment schemes to CySEC.
  - Private investment schemes supervised by the CBC were originally targeted at non-resident institutional/sophisticated investors; after abolition of exchange controls in 2004, opened to local institutional/sophisticated investors (number of such investors is miniscule).
  - Number of private investment funds: about 40 with a net asset value of US$675 million.

### Supervisory structure and deposit protection
- Regulatory and supervisory authorities:
  - Five authorities regulate and supervise financial institutions: the CBC (commercial banks), the ASDCS (cooperative credit institutions), the Superintendent of Insurance (SI), CySEC, and a pension supervisor.
  - At political level: three ministries involved—MoF; ministry of commerce, industry and tourism; and ministry of labor and social insurance.
- CBC and International Banking Units (IBUs):
  - CBC is supervisor for commercial banks.
  - Tax reform: July 2002 introduced a uniform rate of tax (10 percent) on all enterprises effective January 1, 2003, giving IBUs the option to engage with Cyprus residents and be subject to the same tax rate or continue with restrictions and preferential tax rate of 4.25 percent until end-2005.
  - All IBUs receive similar tax treatment from end-2005 following amendments to banking license conditions.
- Cooperative supervision:
  - Legislation governing cooperatives amended in 2003 to transpose EU directives on credit institutions.
  - Cooperatives’ regulatory conditions now similar to those of banks but supervised by ASDCS.
  - Cooperatives expected to conform to capital requirements and other prudential obligations of EU credit institutions; smaller ones can opt to be affiliated with the CCB to meet consolidated prudential requirements.
  - ASDCS: governing body consists of the commissioner and four members appointed by the council of ministers for five years.
  - ASDCS staffing: commissioner, four senior officers, 43 officers (including 12 officers on a non-permanent basis) and 20 secretarial staff.
  - Commissioner’s powers include on-site inspections and off-site monitoring.
- Deposit and client protection schemes:
  - Deposit protection scheme covering all locally-incorporated banks licensed by the CBC which accept deposits from the general public, including branches operating in the EU, introduced in September 2000.
  - Scheme brought into conformity with EU regulations on May 1, 2004, when branches of banks from countries outside the EU joined.
  - Deposits of EU branches operating in Cyprus are covered by corresponding Schemes in their country of incorporation.
  - A fund to protect clients of investment firms was created in 2004.
  - Deposit protection scheme for credit cooperatives established by the Cooperative Societies (Establishment and Operation of the Deposit Guarantee Scheme) Rules for 2000 and 2004, in operation since 2000; reportedly very similar to that of banks and conforms to EU Directive 94/19/EC.
  - Solidarity fund covering credit cooperatives introduced in January 2008; ASDCS Regulative Decision governs implementation and participation is mandatory; used to address cooperative institution liquidity or solvency issues at an early stage.
- Insurance supervision:
  - Superintendent of Insurance (SI) authorized by the Law on Insurance Services and Other Related Issues (2002); supported by the ICCS of Cyprus.
  - ICCS staff governed by the Civil Service Law; budget part of MoF’s budget.
  - SI and deputy superintendent appointed by the council of ministers; staffed by nine skilled personnel and seven support staff.
  - Domestic and international insurance companies are similarly regulated and supervised.
- Securities supervision:
  - Two regulatory bodies in the securities sector, chief of which is CySEC.
  - CySEC responsible for regulating the CSE, retail collective investment schemes and all intermediaries.
  - CBC retains oversight responsibility for nonretail collective investment schemes, with legislation committed to transfer that responsibility to CySEC.
  - CySEC staff: 42.

### Pension system: structure, reserves, and reforms
- Composition:
  - Mandatory social security fund (SIF) and voluntary occupational pension funds and provident funds.
- SIF characteristics:
  - Managed by the ministry of labor and social insurance.
  - Defined benefit plan with reserves of around 40 percent of GDP mostly invested in non-tradable government debt.
  - Since most debt is non tradable, reserves are largely “notional” and de facto the SIF is pay-as-you-go.
  - Authorities have been considering establishing an investment function to manage effective reserves of around 10 percent of GDP.
- Other longevity insurance and funds:
  - Very little longevity insurance in the country; mainly provided by central and local authorities, large utilities companies and banks.
  - No data is available on the number of these funds which are believed to be around 70.
  - The largest 50 funds reported to have unfunded liabilities in the order of USD1.6bln.
  - It is believed that banks are allowed to keep pension funds liabilities on their balance sheet.
- Provident and occupational funds:
  - Around 1,750 funds in operation on the island with only 100 having more than 100 members.
  - Transposition of the European Commission’s directive (2003/41/EC) will require provident funds to modernize governance and investment processes; only a handful seeking professional advice to do so.
  - Total assets of both pension and provident funds estimated at around US$4.5 billion with asset allocation: 60 percent in bank deposits, 15 percent in shares, and 13 percent in loans.
  - EU pension directive (2003/41/EC) transposed by Law 146(I)/2006 covering pension provident funds with more than 100 members; smaller funds governed by provident funds law 44 of 1981.
  - Ministry of labor and social insurance recently established a separate supervisor for occupational and provident funds; this entity is not yet believed to be fully operational.

*IMF staff report content unit _cr09308 - 45.*

### APPENDIX II. FOLLOW-UP ON RECOMMENDATIONS OF THE 2005 OFC ASSESSMENT

### APPENDIX II. FOLLOW-UP ON RECOMMENDATIONS OF THE 2005 OFC ASSESSMENT

### BCP—Banks
- CP 1.2 Independence
  - Recommended action: Additional qualified supervision staff is needed.
  - Status: Since the 2005 FSAP the number of staff of the Banking Supervision and Regulation Division (which now excludes financial stability) increased by two employees. The Division’s staff participates actively in training seminars and has extensive experience in all of the CBC’s supervisory tasks.

- CP 8 Loan Evaluating and Loan Loss Provisioning
  - Recommended action: Finalize implementation of the more stringent criteria for interest suspension.
  - Status: Effective 1 January 2006 the 90 days in arrears rule applies and this will be further refined upon the alignment of the calculation of the interest to be suspended with the provisions of the International Accounting Standard 39.

- CP 11 Country Risk
  - Recommended action: Establish formal guidance for a framework for country and transfer risk.
  - Status: The CBC issued guidelines to banks requiring them to have adequate systems and procedures in place.

- CP 12 Market Risks
  - Recommended action: Improve market risk expertise and supervision.
  - Status: The CBC issued guidelines on the management of market risk and has recruited an expert in financial modeling.

### BCP—Cooperative Credit Institutions
- CP 1.1 Objectives
  - Recommended action: Manage changes during the transitional period through a global change committee.
  - Status: Since 2005 a comprehensive transitional regulatory and supervisory system has been completed that requires every credit cooperative to conform to the EU banking directives from the end of 2007.

- CP 1.2 Independence
  - Recommended action: Full government support of supervisory strengthening capacity.
  - Status: When the recent recruitment process is completed, staff numbers will stand at 76 compared to 56 in 2005.

- CP 2 Permissible Activities
  - Recommended action: Finalize regulatory decision defining permissible services and activities. Make provision that the term “Cooperative Credit Institution” or any derivative of this term cannot be used without the approval of the ASDCS.
  - Status: A regulative decision has been issued regarding the services and activities that credit cooperatives can offer and a law was introduced that prohibits the use of the term “Cooperative Credit Institution” or any derivative thereof without the ASDCS Commissioner’s approval.

- CP 5 Investment Criteria
  - Recommended action: Finalize regulatory decision regarding participation in other enterprises.
  - Status: A regulative decision was issued, in accordance with relevant EU directives, in relation to credit cooperatives’ participation in entities, both financial and nonfinancial.

- CP 6 Capital Adequacy
  - Recommended action: Mandatory semi-annual reporting on each credit cooperative’s compliance with capital requirements regime.
  - Status: A regulative decision has been introduced requiring 6 monthly reporting of capital adequacy positions.

- CP 7 Credit Policies
  - Recommended action: Strengthen supervisory capacity. Enhance the supervisors’ capacity to evaluate loan policies.
  - Status: Twenty additional staff have or are in course of being recruited since 2005 and increased training on supervisory matters have also been strengthened.

- CP 8 Loan Evaluation
  - Recommended action: Strengthen supervisory capacity. Provide for additional prudential reporting.
  - Status: Following the introduction of new software, ASDCS has now access to a wide range of o data for monitoring purposes.

- CP 9 Large Exposure Limits
  - Recommended action: Strengthen supervisory capacity.
  - Status: Twenty additional staff have or are in the course of being recruited and there has been a significant increase in the number of inspections over the three year period.

- CP 10 Connected Lending
  - Recommended action: Strengthen supervisory capacity. Facilities to connected persons should not be granted on terms more favorable than those used in the normal course of business.
  - Status: Article 41 KD in amended law 37(I)/2007 prohibits the granting of credit facilities to the members of the credit cooperative’s Committee and Supervision Board, to the Secretary/Directors and to the other staff members and their connected persons on more favorable terms.

- CP 12 Market Risks
  - Recommended action: Adjust and develop expertise to supervise new risks.
  - Status: Credit cooperatives are not currently exposed to market or FX rate risk. Nonetheless, staff have attended seminars and received training on the matter.

- CP 13 Other Risks
  - Recommended action: Strengthen supervisory capacity. Organize accelerated access to centralized reporting system regarding interest rate risk.
  - Status: The ability to acquire information on a regular basis and analyze such information has been, or is in the course of being, introduced. This will include information on interest rate risk.

- CP 14 Internal Controls
  - Recommended action: Strengthen supervisory capacity. Undertake efforts to encourage mergers favoring critical mass and organizational capabilities of credit cooperatives.
  - Status: There has been a considerable number of mergers since 2005.

- CP 15 Money Laundering
  - Recommended action: Update guidance note.
  - Status: A revised directive has been introduced.

- CP 16 On-site and Off-site Supervision
  - Recommended action: Strengthen supervisory capacity.
  - Status: Additional staff and increased training have been introduced to address this issue. In addition, it is proposed to carry out an on-site inspection of all credit cooperatives in 2009/2010.

- CP 17 Bank Management Contact
  - Recommended action: Impose mandatory and timely communication of material changes in activities and adverse developments.
  - Status: A regulative decision was issued in 2008 requiring all credit cooperatives to notify the Commissioner of all material changes in activities and adverse developments.

- CP 18 Off-site Supervision
  - Recommended action: Strengthen supervisory capacity. Accelerate direct connection to central data server.
  - Status: The ASDCS’s computerized project is almost complete which will provide it with full access to all credit cooperatives’ databases.

- CP 19 Validation of Supervisory Information
  - Recommended action: Strengthen supervisory capacity.
  - Status: This has been facilitated by the recruitment of the additional staff referred to in Principle 1.2 above.

### Insurance Regulation and Supervision
- ICP 1 Effective Insurance Supervision
  - Recommended action: Regulation has to be developed to set a framework in which insurance undertakings can operate and in order to create clear expectations from a supervisory standpoint towards the companies.
  - Status: Since 2005 legal services from the European Public Law Center in Greece have been acquired for further harmonization of the LIS and its Regulations with new EU Directives. The House of Representatives has already approved the new amendments into Law. The LIS and its Regulations constitute the legal framework of the insurance sector in Cyprus.

- ICP 2 Supervisory Objectives
  - Recommended action: Clear objectives and measures should be defined for the SI and the ICCS. The SI and the ICCS should report on their achievements on a regular basis. Moreover, the SI should communicate through regulation how he wants the LIS to be applied.
  - Status: Since 2005 the “Report on Insurance in Cyprus” has been published annually. Also the SI has issued many instructions through Circulars to Insurance entities regarding the application of the LIS and its Regulations. In this way Insurance entities have a clearer view of their obligations/responsibilities/tasks under the existing legal framework.

- ICP 3 Supervisory Authority
  - Recommended action: The SI has to be granted a budget in order to perform the duties laid out in the LIS. Also, the SI should be charged with producing a plan laying out the priorities for a year. Those plans would set clear expectations for the Council of Ministers and for the staff of the ICCS. Most importantly, there is an urgent need to assess the composition of skills required to properly exercise the powers of the LIS. Whether all those skills identified will have to be allocated within the ICCS remains to be seen. At the time this assessment was carried out, the SI was not provided with resources adequate to perform insurance supervision which is able to respond to critical situations.
  - Status: Since 2005 and specifically between September 2007 and March 2008, more qualified staff has been appointed for the ICCS by the Civil Service Commission, as follows:
    - 2 Senior Insurance Officers, who are qualified Actuaries and have been appointed as Deputy Superintendents of Insurance
    - 2 Insurance Officers A’ who are qualified Chartered Accountants
    - 1 Administrative Officer with accounting and financial academic background
    - 3 Insurance Officers with economics and financial academic background
    - 1 Assistant Insurance Officer with academic background
  - Status continued: One more Insurance Officer is expected to be employed by the end of 2008 and one more Assistant Insurance Officer in 2009. All the above-mentioned new staff constitutes a significant addition to the existing professional staff of the ICCS which has in this way almost doubled since 2005. (The clerical staff remained largely the same in numbers since 2005). Also, since June 2008 the ICCS has introduced a complete computerization system.

- ICP 4 Supervisory Process
  - Recommended action: Given the very limited resources of the ICCS, a more efficient way of conducting ongoing supervision would free up capacity for more structural supervisory involvement. Internal procedures of the supervisor should be standardized for more efficient operation. Also, publications should be made available to the public.
  - Status: The recruitment of additional personnel as described in ICP 3 has created a better organized and more effective staff structure within the ICCS, resulting in a more efficient allocation of duties according to skill specialization and experience. For the purposes of the computerization of the ICCS, a systems specification manual has been prepared listing all internal procedures.

- ICP 5 Supervisory Cooperation and information Sharing
  - Recommended action: The SI should contact the home supervisors to identify how many of the companies under the FoS have actually started business activities.
  - Status: Since 2005 the ICCS is exchanging regularly information with other EU supervisory authorities in this respect.

- ICP 9 Corporate Governance
  - Recommended action: There should be a joint effort to develop governing rules for undertakings in the financial sector. These rules should be developed by all three supervisory authorities. Technical assistance is necessary for the implementation of this recommended action.
  - Status: The SI has already requested assistance from the Institute of Certified Public Accountants.

- ICP 10 Internal control
  - Recommended action: Define standards on internal control as an essential part of sound insurance principles and enforce those standards through reporting and auditing requirements. Internal control procedures should also cover initial procedures for investment decisions and operational risk as it relates to contingency planning.
  - Status: The ICCS has collected data with respect to internal control standards. The issue will be discussed soon with the Institute of Certified Public Accountants within the framework of the assistance already requested by the SI (see ICP 9).

- ICP 11 Market analysis
  - Recommended action: The SI should identify the information about the insurance sector that is required or is of interest to other public services. The SI should also define all information necessary to prepare a market analysis for the insurance sector and determine the process through which this information will be received and updated.
  - Status: Resulting from the increase of staff referred to in ICP 3, and the computerization of the ICCS, is the increased capacity of ICCS for more in-depth market analysis. The ICCS successfully guided the Cyprus insurance industry in its participation in the Quantitative Impact Study 4 (QIS 4) for the Solvency II Directive. The ICCS managed to prepare on time the Cyprus Country Report for QIS 4, following extensive stress testing of the insurance companies involved and relevant market analysis.

- ICP 12 Reporting to supervisors and off-site monitoring
  - Recommended action: Company data should be stored electronically once received. Also, companies should be required to submit the relevant forms in signed hard copies and in electronic files in prescribed formats. There should be a procedure to imply some degree of plausibility testing of received data.
  - Status: Since June 2008 the ICCS has introduced a complete computerization system. The system has a special procedure for testing the plausibility of figures in the Annual Accounting Returns.

- ICP 13 On-site inspection
  - Recommended action: Gain agreement from the MoF to obtain the right to contract third parties to support the carrying out of on-site inspections. Also, develop a plan to perform regular on-site inspections regardless of clear evidence that an inspection is deemed to be necessary.
  - Status: With the recruitment of new qualified staff as described in ICP 3, the aim is to start regular on-site inspections of insurance companies. The preparation of a manual for on-site inspections is under consideration. Meanwhile, targeted on-site inspections will continue where necessary, especially following the review of the Annual Accounting Returns.

- ICP 14 Preventive and corrective measures
  - Recommended action: The ICCS should develop a set of regulatory rules which would enable it to prevent a breach in compliance instead of deciding on corrective measures subsequent to a breach. Consider whether the development of preventive measures could also contribute to a more efficient allocation of resources within the ICCS.
  - Status: This proposed measure is now under consideration. However, the ICCS has never taken any preventive or corrective measures without warning insurance companies in writing and without informing them in advance of the legal consequences following non- compliance with the insurance legislation.

- ICP 15 Enforcement or sanctions
  - Recommended action: The MoF should take steps to improve the independence and credibility of the SI and should therefore review the number of cases in which an appeal is possible. The MoF should review whether the variety of cases in which an appeal is possible should be reduced considerably.
  - Status: The review of the appeal process is not an issue favored by the insurance industry which wants the appeal process to continue to exist as an intermediate step prior to resorting to courts, because the judicial system in Cyprus is very slow and court decisions are much delayed.

- ICP 16 Winding-up and exit from the market
  - Recommended action: As s157 requires the SI to appoint a liquidator, the ICCS should have a short list of potential candidates in order to shorten the appointment process. That list should be part of the process of withdrawing a license.
  - Status: The liquidation procedures so far have worked satisfactorily, as far as the appointment of liquidators are concerned.

- ICP 17 Group-wide supervision
  - Recommended action: Incorporate relevant information exchange processes and terms of reference for the coordinator of financial conglomerate supervision into the 2002 MoU among the supervisors.
  - Status: A relevant MoU for the exchange of information has been signed between the competent authorities of the financial sector in Cyprus. The Solvency II Directive under preparation will incorporate specific terms of reference for the co-ordinator of groups based on which the said MoU will be amended accordingly.

- ICP 18 Risk assessment and management
  - Recommended action: Initial steps toward risk management should be considered when internal control procedures as laid out in ICP 10 are sufficiently regulated and recommendations are implemented through the establishment of sound insurance principles.
  - Status: The response under ICP 10 is relevant. In the context of Solvency II, a circular letter was sent to all insurance companies in April 2008 encouraging them to participate in QIS 4. Seven companies have participated in QIS 4. A seminar was held in June 2008 with 27 insurance companies participating. A technical committee has been formed by the ICCS consisting of members from the Institute of Actuaries, the Cyprus Insurance Association, the Institute of Certified Accountants and the ICCS; the committee meets regularly.

- ICP 19 Insurance activity
  - Recommended action: The ICCS should ask the supervised companies to provide a risk profile stating the introduction of new products, availability of rating factors and changes in its attitude to insurance risks.
  - Status: The upgrading of the quality of staff of the ICCS (see ICP 3) will enable the ICCS to implement fully this recommended action. (The said action is already implemented partially for the Life sector insurance companies as far as pricing and product range are concerned).

- ICP 20 Liabilities
  - Recommended action: The determination of appropriate reserves requires that the ICCS has both the ability to contract external resources and recruit further adequately skilled staff. It is therefore referred to the relevant recommendations on ICP 1 and ICP 3.
  - Status: Since 2005 additional professional staff which consists of two actuaries and two chartered accountants have been employed. Also, chain ladder methods are used widely since 2006 by the ICCS staff for the assessment of general business claims liabilities. Assessment of life liabilities is also carried out by the ICCS actuaries.

- ICP 21 Investments
  - Recommended action: Company investment policy should be part of a risk profile which every insurance company should submit to the ICCS on a regular basis. Also, internal control procedures should cover initial procedures for investment decisions and on operational risk as it refers to contingency plans.
  - Status: The ICCS is examining the investments risk profile for each category of liabilities (Property Linked, Non-Life, General Business etc), through analysis of the Investment Registers submitted to the ICCS by insurance companies every quarter. For Life Business only, the ICCS matches the said investment profile with a more detailed structure of the liabilities, assesses the relevant future expected return and compares it with the valuation interest rate used by the appointed actuaries of insurance companies in their evaluation of the liabilities. Further improvement in this area (i.e. taking into consideration counterparty default risks), will result within the Solvency II framework.

- ICP 22 Derivatives and similar commitments
  - Recommended action: None.
  - Status: None.

- ICP 23 Capital adequacy and solvency
  - Recommended action: Cash collection of premiums should be an essential part of the internal control procedures. Solvency capital should be reported to the ICCS on a quarterly basis in order to avoid currently existing delays.
  - Status: Since 2005 proactive supervisory action was taken for ensuring compliance with Solvency I requirements by insurance companies. As a result, all companies have successfully increased their capital levels to comply with Solvency I requirements. With respect to quarterly reporting, only the companies that are identified by the ICCS as having capital problems are requested to report their solvency levels on a quarterly basis. The rules governing the admissibility of premium debts as an asset for covering technical provisions, have been extended to premium debts covering the solvency margin through Orders issued by the Superintendent in March 2006.

- ICP 24 Intermediaries
  - Recommended action: Given the range of tasks undertaken by the supervisor, the planned allocation of resources, including those devoted to intermediary supervision, could be reviewed.
  - Status: Since 2005 efforts are constantly made for maintaining the minimum possible allocation of resources for intermediary supervision, without jeopardizing the effectiveness of the ICCS in carrying out this type of supervision.

- ICP 25 Consumer protection
  - Recommended action: The SI could publish the frequency of complaints received on a company level to initiate further incentives for companies to react in a more customer-friendly fashion.
  - Status: The Bill for the establishment of a Financial Ombudsman has been submitted in 2007 by the Ministry of Finance to the House of Representatives where it is still pending. A first reading and discussion between all parties concerned has already taken place on June 5, 2008 in the relevant Committee of the House of Representatives. The LIS includes provisions for minimum requirements for insurers and intermediaries when dealing with consumers which include provisions for timely, complete and relevant submission of information to consumers before and after a contract is signed.

- ICP 26 Information, disclosure & transparency toward the market
  - Recommended action: Improve contents and frequency of market reports.
  - Status: Since 2005 the Report is being published annually and its contents have been improved, though there is still room for further improvement which the ICCS is planning to adopt in future Reports.

- ICP 27 Fraud
  - Recommended action: See ICP 10 recommendations for further details.
  - Status: Developments in internal controls under ICP 10 will also include fraud issues.

- ICP 28 Anti-money laundering
  - Recommended action: A common approach should be identified. Also, resources to deal with suspicious transactions reports (STRs) should be provided on an as-needs-basis. During the assessment of the life market, interviewed managers stated that most of the single premiums paid into unit-linked contracts had not been withdrawn from other forms of saving vehicles but had been provided either in cash or from other cash accounts. The sources of those premiums and their provision to the life insurance companies, however, have not led to submission of STRs to the SI.
  - Status: On-site inspections will deal with money laundering issues as well. The SI has already issued Guidance Notes for the insurance companies compliance with the Prevention and Suppression of Money Laundering Activities Law.

### IOSCO Assessment
- Principles 1 and 25
  - Issue: CySEC was unable to supervise effectively the Stock Exchange as both were public administrative bodies and one such body cannot supervise another such body.
  - Recommended action: The transposition of the EU MiFID into Cyprus law removed this anomaly.
  - Status: CySEC is now without question the supervisor of the Stock Exchange.

- Principle 11
  - Issue: CySEC could not share information or carry out investigations on behalf of foreign regulators where CySEC did not have an independent interest in the matter under investigation.
  - Recommended action: An amendment to the law to remove this obstacle.
  - Status: Partly achieved. Following the transposition of a number of EU Directives, CySEC can now share such information and carry and out inspections on behalf of fellow EU regulators but not for non-EU regulators. Legislation is currently before Parliament to address this shortcoming. It is expected to be enacted late 2008/early 2009.

- Principle 13
  - Issue: CySEC was experiencing difficulties in obtaining the identities of the beneficial owners of shares which were registered in the name of lawyers on behalf of the beneficial owners.
  - Recommended action: An amendment to the law that would bring clarity to the matter.
  - Status: Not achieved as yet but is expected to be dealt with in the proposed legislation referred to above.

- Principle 2
  - Issue: CySEC must provide the Minister of Finance with any information he may deem necessary for the benefit of the public good. (This was seen as potentially impacting on the independence of CySEC).
  - Recommended action: That this clause be revoked from the relevant legislation.
  - Status: Not achieved as yet but is expected to be dealt with in the proposed legislation referred to above.

- Principle 20
  - Issue: CySEC did not have specific rules for the valuing of assets of collective investment schemes (UCITS) other than for shares in listed companies.
  - Recommended action: CySEC to introduce such rules and particularly before the authorization of the first UCITS.
  - Status: No local UCITS have been authorized (due to lack of clarity re. tax) but nor have any valuation rules been issued yet. The tax uncertainty is due to be dealt with soon and CySEC has indicated that it will introduce the relevant valuation rules before the first authorization of a UCITS.

*Source: APPENDIX II. FOLLOW-UP ON RECOMMENDATIONS OF THE 2005 OFC ASSESSMENT (IMF PDF).*

### APPENDIX III. DETAILED FSAP RECOMMENDATIONS

### APPENDIX III. DETAILED FSAP RECOMMENDATIONS

### Financial System Stability — Key Recommendations and Responsible Agencies
- Strengthen the financial stability function at the CBC.  
  - Responsible: CBC. Priority/Timeline: High/ST.
- Compile reliable data on household debt service, income and real estate prices.  
  - Responsible: Statistical Service of the Republic (CyStat). Priority/Timeline: High/ST.
- Closely monitor liquidity developments in banks.  
  - Responsible: CBC. Priority/Timeline: High/ST.
- Maintain prudential stance on liquidity ratio.  
  - Responsible: CBC. Priority/Timeline: High/ST.
- Continue stress test exercise with major banks; extend to credit cooperatives.  
  - Responsible: CBC. Priority/Timeline: Medium/MT.
- Conduct regular scenario analysis stress tests; develop tests for financial contagion (banks nonbanks, insurance); deepen analysis of mortgage-related credit risk.  
  - Responsible: CBC. Priority/Timeline: Medium/MT.
- Include sensitivity tests for counterparty risks in stress test exercise.  
  - Responsible: CBC. Priority/Timeline: Medium/MT.
- Develop offsite model for banks and compare with stress test results.  
  - Responsible: CBC. Priority/Timeline: Medium/MT.

Remedial Action
- Consider explicitly prohibiting or reducing dividends.  
  - Responsible: CBC/ASDCS. Priority/Timeline: Medium/MT.
- Consider explicitly allowing disclosure of remedial actions.  
  - Responsible: CBC/ASDCS. Priority/Timeline: Medium/MT.
- Consider adopting early remedial corrective action framework.  
  - Responsible: CBC/ASDCS. Priority/Timeline: Medium/MT.

Deposit Insurance
- Increase level of protection.  
  - Responsible: CBC/ASDCS /MoF. Priority/Timeline: High/ST.
- Increase preparedness (report setoffs; have depositor lists available).  
  - Responsible: CBC/ASDCS. Priority/Timeline: Medium/ST.
- Increase coverage to 100 percent of guaranteed deposit.  
  - Responsible: CBC/ASDCS /MoF. Priority/Timeline: High/ST.
- Shorten time limit on deposit distribution.  
  - Responsible: CBC/ASDCS. Priority/Timeline: Medium/ST.
- Increase contribution to fund.  
  - Responsible: CBC/ASDCS /MoF. Priority/Timeline: High/ST.
- Increase the ability of the Fund to borrow.  
  - Responsible: CBC/ASDCS /MoF. Priority/Timeline: High/ST.
- Allow Management Committees to change technical parameters.  
  - Responsible: CBC/ASDCS /MoF. Priority/Timeline: Medium/ST.

Coordinating Arrangements
- Conduct simulation exercises to test the coordination mechanisms.  
  - Responsible: CBC/ASDCS/MoF. Priority/Timeline: High/MT.
- Enhance transparency and accountability practices to overcome possible communication problems with the MoF.  
  - Responsible: CBC. Priority/Timeline: High/ST.
- Make contingent liabilities of MoF more explicit.  
  - Responsible: MoF. Priority/Timeline: High/ST.
- Take lead role in non-EU supervisory cooperation.  
  - Responsible: CBC. Priority/Timeline: High/MT.

Emergency Liquidity Assistance
- Put in place operational guidance for ELA.  
  - Responsible: CBC/ASDCS. Priority/Timeline: High/ST.
- Explicitly restrict collateralized lending to illiquid but solvent banks.  
  - Responsible: CBC. Priority/Timeline: Medium/ST.
- Monitor liquidity situation of banks intensively in crisis situations.  
  - Responsible: CBC. Priority/Timeline: High/ST.

Bank Resolution
- Define more explicit thresholds for intervention and communication.  
  - Responsible: CBC. Priority/Timeline: High/ST.
- Clarify bank resolution framework.  
  - Responsible: CBC/MoF. Priority/Timeline: High/ST.

Regulatory and Supervisory Architecture
- Consider creating an integrated supervisory agency.  
  - Responsible: Government. Priority/Timeline: Medium/MT/LT.
- Combine supervision of commercial banks and credit cooperatives.  
  - Responsible: Government. Priority/Timeline: Medium/ST/MT.
- Consider integrating pensions supervision with insurance or securities.  
  - Responsible: Government. Priority/Timeline: Medium/MT.

### BCP — Banks: Observations and Recommended Actions (by Reference Principle)
- CP 1.1 Objectives: Evaluation of the approach to banking supervision should be in the medium term focus.
- CP 1.2 Independence: Additional qualified supervision staff is needed. Continue to advance the depth of staff expertise and skills.
- CP 5 Investment Criteria: Finalize the implementation of investment criteria.
- CP 6 Capital Adequacy: Increase the frequency of reporting from 6 to 3 month.
- CP 9 Large Exposure Limits: Increase the frequency of reporting from 6 to 3 month.
- CP 10 Connected Lending: Respective limits should be sharply reduced.
- CP 22 Remedial Measures: Develop a more comprehensive system of monetary penalties.

### BCP — Cooperative Credit Institutions: Observations and Recommended Actions
- CP 1.1 Objectives: An evaluation of the approach to banking supervision should take place as soon as possible.
- CP 1.2 Independence: Continue to advance the depth of staff expertise and skills.
- CP 2 Permissible Activities: ASDCS should publish a list of credit cooperatives they supervise to increase transparency of the cooperative sector.
- CP 3 Licensing: Develop more comprehensive criteria on the fit and properness of the board and senior management.
- CP 6 Capital Adequacy: Increase the frequency of reporting from 6 to 3 month.
- CP 9 Large Exposure Limits: Increase the frequency of reporting from 6 to 3 month.
- CP 13 Other Risks: Finalize the regulatory decision on the implementation of the ICAAP and SREP.
- CP 14 Internal Control and Audit: Decide on the level of support that would be provided by the CCB on internal controls and risk management to affiliated credit cooperatives.
- CP 16 On-site and Off-site Supervision: Evaluate the effectiveness of the new capital regime. Enforce plans for full scope on-site examinations.
- CP 22 Remedial measures: Develop a more comprehensive system of monetary penalties.

### Insurance Regulation and Supervision — Key Recommendations
- The Supervisory System (Reference Principles 2–5):
  - The SI should use the next edition of the Annual Report to communicate more effectively on supervisory objectives and upcoming activities.
  - The SI should require written confirmation from licensed companies that they are in contact with local authorities and meet existing standards; inform market authorities where confirmations are not submitted.
- The Supervised Entities (Principles 6–10):
  - ICCS could collect existing governance rules of supervised companies to identify quality of governance and issue bespoke governance requirements.
  - Apply principle-based regulation carefully; pay specific attention during planned on-site inspections in 2009.
- Ongoing Supervision (Principles 11–17):
  - Extend market analysis to collect macro-economic data in addition to information from supervised companies.
  - Strengthen framework for analyzing off-site information covering financial, operational, solvency and market information; trigger on-site inspections when new information deviates from previous trends.
  - Amend minor winding-up provisions in the ILS to address participation of policyholders and SI independence; prepare contingency plans for winding-ups.
- Prudential Requirements (Principles 18–23):
  - ICCS should participate in CEIOPS courses and liaise with the Cypriot banking supervisor to increase knowledge on risk management.
  - Amend regulation on concentration risk; where companies have more than 40 percent of assets with one counterparty in one non-tradable instrument, require a viable exit-strategy.
  - Request preliminary reports from companies to receive solvency information earlier and update data later with audited accounts.
- Markets and Consumers (Principles 24–27):
  - Increase qualitative information to elaborate on trends and changes and developments within the EU; provide quantitative information on a company level.
  - Liaise with the International Insurance Fraud Agency for further input and international experience.

### Securities Supervision — Key Recommendations (by Principle)
- Principle 26 – Stock Exchange: CySEC should carry out an immediate inspection of the Stock Exchange to ensure readiness to implement its strategic plan. The State should consider whether to remain owner or consider privatization.
- Principle 21 – Market intermediaries: Pay particular attention to foreign-owned intermediaries providing investment services largely to overseas clients.
- Principle 3 – Funding: CySEC should ensure sufficient funds to carry out statutory obligations.
- Principle 11 – Information sharing: Address inability to collect information or carry out investigations on behalf of non-EU regulators where CySEC lacks an independent interest in forthcoming legislation.
- Principle 13 – Assistance to foreign regulators: Ensure forthcoming legislation addresses difficulties in obtaining identities of beneficial owners of shares registered in the name of lawyers.
- Principle 2 – Regulatory independence: Revoke the clause allowing the Minister of Finance to require CySEC to provide any information he deems necessary for the benefit of the public interest. Other corporate governance issues in law are adequate.
- Principle 20 – Collective investment schemes: Introduce rules for the valuation of assets other than shares in listed companies.

### Appendix IV — Stress Tests: Methodology and Main Findings
- Objectives and scope:
  - Purpose: examine potential effects on banks’ financial condition of changes in risk factors corresponding to a range of adverse events; shocks are extreme but with a positive, albeit small, probability of occurrence.
  - Tests combine single-factor sensitivity calculations and macroeconomic scenario analysis.
  - Approaches: top-down (CBC staff coverage 75 percent of total assets) and FSAP team (public data), plus bottom-up exercise by four large banks; results cross-checked for consistency.

A. Sensitivity Analysis — Main Results
- Credit shocks have the largest and most widespread potential impact on banks.
  - A shock that assumes NPLs double and loss-given-default equals 80 percent will lead to a size of 13.7 percent of GDP loss in four banks, leaving three of them undercapitalized and requiring capital injections equivalent to about 5 percent of GDP to ensure the minimum CAR of 8 percent.
- Concentration risk:
  - Failure of the largest five borrowers would push one bank under the minimum capital ratio.
- Real estate exposure:
  - Cyprus's high level of household indebtedness significantly exposes it to adverse real estate shocks.
  - Prolonged foreclosure process prohibits banks from writing off NPLs speedily.
  - Mortgage lending regulation: maximum 80 percent loan-to-value (LTV) ratio for first-home buyers and 70 percent LTV for the second home.
  - Four banks’ bottom-up stress tests show that a 30 percent correction in residential and commercial real estate prices will lead to a reduction of CAR by 1.4 percent.
- Market risk:
  - Exchange rate risk: direct losses from 15 percent and 30 percent depreciation/appreciation of the Euro are negligible for most banks due to very small net open positions in foreign exchange. Banks are required to limit foreign currency open positions to 6 percent of capital.
  - Interest rate risk: impact on banks’ soundness is relatively small; increase in interest rates generally improves profitability as assets reprice more quickly than liabilities. Most mortgage loans are flexible and linked to the Euribor rates.
  - Equity exposure: bank equity investments stood at 0.25 percent of total assets as of end-April 2009; exposure to stock prices is very small.
- Liquidity risk:
  - Bottom-up liquidity tests assess survival without borrowing from the central bank or other banks on an uncollateralized basis for 5 days and 30 days.
  - Under only one extreme scenario two banks will not survive.
  - CBC deposit liquidity stress test: under an extreme scenario assuming 30 percent of all demand deposits are withdrawn, and banks can use only their liquid assets with no recourse to other banks or lender of last resort, banks’ liquidity ratio reduces to 40 percent from 46 percent.

Appendix Table 5 — Cyprus: Sensitivity Analysis Stress Tests, December 2008 (Selected scenarios and reported results)
- Bottom-up stress tests (performed by four largest banks and IMF staff):
  - Interest rate risk:
    - Parallel upward/downward shift in the yield curve by 200 bps — Result: Negligible.
    - 3M and 12M rates up/down by 100 bps and 50 bps respectively — Result: Negligible.
    - 3M and 12M rates up/down by 200 bps and 100 bps respectively — Result: Negligible.
  - Exchange rate risk:
    - 15 percent, and 30 percent depreciation (appreciation) of Euro against all foreign currencies — Result: Negligible.
  - Asset price risk:
    - Equity price 30 percent, 50 percent decline — Result: Negligible.
    - Residential and (or) Commercial real estate price 20 percent, 30 percent decline — Result: No undercapitalized banks.
  - Credit risk (general):
    - NPL (in percent) 20, 50, 100 increase; LGD (in percent) 30, 40, 50, 60, 70, 80 — See Appendix Table 6.
  - Credit risk (concentration):
    - Default largest 3, 5 exposures (excl. government) — See Appendix Table 7.
    - Default largest 3 exposures (excl. gmt and financial institutions).
    - 10 percent of loans to non-financial corporations become NPLs (assuming LGD=20 percent for loans secured by real estate property and LGD=80 percent for loans not secured by real estate property).
    - 10 percent of loans to domestic households become NPLs (assuming LGD=20 percent for loans for house purchase and LGD=80 percent for consumer credit and other household lending).
  - Counterparty risk:
    - All bond prices decline by 5 percent and 10 percent — See Appendix Table 8.
    - All government bond/international organizations bonds/financial institutions decline by 5 percent, respectively.
    - All financial institutions' bond prices decline by 7.5 percent.
    - All corporate bond/covered bond/subordinated debt/other bond prices decline by 10 percent.
  - Net interest margin risk:
    - Reduction of interest margin by 0.5 percent, 1 percent, or 2 percent — See Appendix Table 9.
  - Liquidity risk:
    - Liquid Assets/Total Assets (%) after 5 and 30 days under shocks — See Appendix Table 10.
    - Liquid Assets/Short-Term Liabilities (%) after 5 and 30 days under shocks — See Appendix Table 10.

- Top-down stress test by the CBC (coverage of 75% of total banking assets):
  - Interest rate risk:
    - Parallel downward shift in the yield curve by 100, 200, 300 bps — Result: Negligible.
  - Exchange rate risk:
    - 30 percent and 50 percent appreciation of Euro against all foreign currencies — Result: Negligible.
    - Under the above scenario, assuming 100 percent depreciation leads to 10 percent foreign exchange loans become NPL with 50 percent increase in provisioning rate on the additional NPLs — Result: Negligible.
  - Asset price risk:
    - Equity price (in percent) 10, 30, 50 decline — Result: Negligible.
  - Credit risk:
    - NPL (in percent) 20, 50, and 100 increase; LGD (in percent) 25, 50, and 100 — See Appendix Table 6.
  - Liquidity risk:
    - 10 percent and 30 percent reduction in deposits — See Appendix Table 10.

- Data sources cited for tests: Central Bank of Cyprus, four largest banks, and IMF staff calculations.

*Source: APPENDIX III. DETAILED FSAP RECOMMENDATIONS and APPENDIX IV. STRESS TESTS (selected excerpts) from the provided IMF content unit.*

### Appendix Table 6. Cyprus: Credit Risk Stress Test Results, December 2008

### Appendix Table 6. Cyprus: Credit Risk Stress Test Results, December 2008

### Bottom-up stress tests (aggregated and bank-level CAR outcomes)
- Pre-shock CAR: 10.7 10.9 11.3 10.1 11.0
- Post-shock CAR (Loss-given default = 50%)
  - NPLs up by 20%: 10.2 10.4 11.0 9.6 10.4
  - NPLs up by 50%: 9.3 9.6 10.3 8.9 9.5
  - NPLs up by 100%: 8.0 8.2 9.3 7.8 7.9
- Post-shock CAR (Loss-given default = 60%)
  - NPLs up by 20%: 10.1 10.2 10.9 9.5 10.3
  - NPLs up by 50%: 9.1 9.3 10.1 8.7 9.2
  - NPLs up by 100%: 7.5 7.7 8.9 7.2 7.4
- Post-shock CAR (Loss-given default = 70%)
  - NPLs up by 20%: 10.0 10.1 10.8 9.4 10.2
  - NPLs up by 50%: 8.8 9.0 9.9 8.5 8.9
  - NPLs up by 100%: 7.0 7.2 8.5 6.5 6.9
- Post-shock CAR (Loss-given default = 80%)
  - NPLs up by 20%: 9.9 10.0 10.7 9.4 10.1
  - NPLs up by 50%: 8.6 8.8 9.7 8.2 8.6
  - NPLs up by 100%: 6.4 6.6 8.0 5.9 6.3

### Top-down stress tests (CBC)
- Pre-shock CAR: 10.9 ...... ... ...
- Post-shock CAR (Loss-given default = 25%)
  - NPLs up by 20%: 10.7 ...... ... ...
  - NPLs up by 50%: 10.3 ...... ... ...
  - NPLs up by 100%: 9.7 ...... ... ...
- Post-shock CAR (Loss-given default = 50%)
  - NPLs up by 20%: 10.4 ...... ... ...
  - NPLs up by 50%: 9.7 ...... ... ...
  - NPLs up by 100%: 8.4 ...... ... ...
- Post-shock CAR (Loss-given default = 75%)
  - NPLs up by 20%: 10.2 ...... ... ...
  - NPLs up by 50%: 9.1 ...... ... ...
  - NPLs up by 100%: 7.2 ...... ... ...

### Concentration risk (Appendix Table 7 — selected outcomes)
- Pre-shock CAR: 10.7 10.9 11.3 10.1 11.0
- Post-shock CAR
  - Default largest 3 exposures (excl. government): 8.3 9.2 11.3 6.7 9.4
  - Default largest 3 exposures (excl. gmt and financial institutions): 9.7 10.0 11.3 9.2 9.8
  - Default largest 5 exposures (excl. government): 6.3 7.7 11.3 4.3 7.6
  - Default largest 5 exposures (excl. gmt and financial institutions): 9.3 9.6 11.3 8.7 9.2
  - 10% of loans to non-financial corporations become NPLs (assuming LGD=20% for loans secured by real estate property and LGD=80% for loans not secured by real estate property): 6.2 7.1 9.2 4.7 7.2
  - 10% of loans to domestic households become NPLs (assuming LGD=20% for loans for house purchase and LGD=80% for consumer credit and other household lending): 8.8 9.4 10.4 8.3 9.4

### Counterparty risk (Appendix Table 9 — bond price shocks)
- Pre-shock CAR: 10.7 10.9 11.3 10.1 11.0
- Post-shock CAR
  - All bond prices decline by 5%: 9.9 10.3 11.3 9.0 10.5
  - All bond prices decline by 10%: 9.1 9.8 11.3 7.8 10.0
  - All government bond prices decline by 5%: 10.2 10.7 11.3 9.9 10.8
  - All international organizations' bond prices decline by 5%: 10.4 10.9 11.3 10.1 11.0
  - All financial institutions' bond prices decline by 7.5%: 9.8 10.5 11.3 9.3 10.6
  - All corporate bond prices decline by 10%: 10.1 10.8 11.3 9.7 11.0
  - All covered bond prices decline by 10%: 10.4 10.8 11.3 10.1 11.0
  - All subordinated debt prices decline by 10%: 10.4 10.9 11.3 10.1 11.0
  - All other bond prices decline by 10%: 10.2 10.8 11.3 9.8 11.0
- Additional note from text: At end-December 2008, Cypriot banks held 6.5 and 8.5 percent of total consolidated assets in the form of bonds issued by other Euro area banks and non-Euro area banks. The stress tests show that if all financial institutions’ bond price decline by 10 percent, the CAR will decrease by 1 percent, leaving one bank undercapitalized.

### Net interest margin risk (Appendix Table 8)
- Pre-shock CAR: 10.7 10.9 11.3 10.1 11.0
- Post-shock CAR
  - Reduction in NIM by 0.5 percentage points: 10.1 10.2 10.8 9.5 10.4
  - Reduction in NIM by 1.0 percentage point: 9.1 9.4 10.1 8.2 9.7
  - Reduction in NIM by 2.0 percentage points: 7.3 7.8 8.9 5.6 8.4

### Scenario analysis (aggregate outcomes and implications)
- Description: Scenario analysis combines multiple shocks to capture broader macro-financial linkages beyond single-factor sensitivities.
- Example extreme scenario (described in text): combines NPLs up by 100%, real estate price decline by 30 percent, decline in interest rates by 200 basis points, and exchange rate appreciation by 30 percent.
  - Aggregated post-shock CAR under this scenario: 4.8 percent (Appendix Table 11 reports aggregated post-shock CAR: 4.7 5.0 6.3 4.3 4.8)
  - Capital injections required to restore 8% CAR: 10.6 2.7 5.2 0.4 2.5 (in percent of 2008 GDP)
  - Text summary: aggregated capital adequacy would decline to 4.8 percent, and capital injections equivalent to about 10.5 percent of GDP would be needed to ensure that all banks satisfy the minimum capital adequacy ratio of 8 percent.

### Liquidity stress tests (Appendix Table 10 — selected structure and outcomes)
- Pre-shock liquid asset ratios (by bank, pre-shock): values reported across banks include 26, 31, 23, 26, 29, 34, 17, 29 (liquid asset to total borrowing ratio).
- Post-shock liquidity ratios across scenarios (5 days and 30 days) show material declines; examples:
  - Scenario 1 post-shock examples: 22 18 27 22 20 15 23 17 24 23 27 25 16 15 28 27
  - Scenario 2 post-shock examples: 9 4 11 5 13 8 0 15 16 14 18 17 12 12 21 21
  - Scenario 3 post-shock examples: 8 3 9 4 12 6 13 7 16 14 18 16 11 11 20 20
  - Scenario 4 post-shock examples: -1 -7 -1 -8 5 -2 5 -2 6 4 7 5 6 6 12 12
- Top-down CBC stress tests (liquid asset to total borrowing ratio)
  - Pre-shock liquidity ratio: 46
  - Post-shock: 10% reduction in deposits → 44
  - Post-shock: 30% reduction in deposits → 40
- Scenario assumptions (select)
  - Scenario 1 assumptions include: (1) 10% of loans to other banks are not repaid; (2) Pool of eligible collateral accepted by parties in secured market shrinks by 30% (except gmt bonds and gmt guaranteed assets); (3) 30% of currently eligible assets (except gmt bonds and gmt guaranteed assets) fall below the central bank’s threshold for accepting as collateral; and (4) All wholesale (interbank) funding repaid on maturity, no new funding made available.
  - Scenario 2 assumptions include: (1) 15% of Euro deposits withdrawn over 5 days; (2) All liquid assets take a haircut of 20%; (3) All undrawn and committed credit lines are drawn for 30% of committed value over 5 days; (4) All wholesale (interbank) funding repaid on maturity, no new funding made available.
  - Scenario 3 assumptions include: (1) 50% of FX-denominated deposits withdrawn over 5 days; (2) All liquid assets take a haircut of 20%; (3) All wholesale (interbank) funding repaid on maturity, no new funding made available.
  - Scenario 4 assumptions include: (1) 20% of Euro deposits withdrawn over 5 days; (2) 30% of FX-denominated deposits withdrawn over 5 days; (3) All liquid assets take a haircut of 20%; (4) All undrawn and committed credit lines are drawn for 30% of committed value over 5 days; (5) All wholesale (interbank) funding repaid on maturity, no new funding made available.

*Sources: Central Bank of Cyprus, four largest banks (covering 75% of total banking assets), and IMF staff calculations.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09308.pdf_