Cyprus Offers a Lesson in Economic Risk

Among the principles taught in courses ranging from economics to finance is that of diversification. In general, diversification can reduce risk exposure for firms and individuals. In substance, concentration and narrow focus can amplify risk. The very recent headline-garnering financial system crisis in Cyprus offered a cautionary tale of the dangers associated with a lack of diversification.

The International Monetary Fund’s (IMF’s) staff report from its 2011 Article IV Consultation with Cyprus provides good insight into the challenges facing Cyprus ahead of its latest crisis. The report reveals a toxic combination of an oversized financial system, financial system concentration, lack of economic and investment diversity, and linkages to the troubled Greek economy/financial system.

In Cyprus, the banking system had a disproportionately large footprint. According to the IMF report, the banking system held assets that were approximately 835% of that country’s GDP. In contrast, during the fourth quarter of 2012, U.S. bank assets amounted to about 82% of U.S. GDP. In effect, Cyprus’ economy was captive to its financial system in a way few other economies are. In that context, aggregate spending on R&D, which would have the potential to broaden the Island state’s economy was virtually non-existent, accounting for just 0.4% of GDP. Worse, the IMF noted, that investment in future competitiveness was “almost exclusively carried out by the public sector.”

At the same time, the banking system was highly concentrated. Three banks—the Bank of Cyprus, the Marfin Popular Bank, and the Hellenic Bank—held nearly 60% of all the financial system’s assets. The banks also had engaged narrowly-focused lending. Prior to the global financial crisis, almost all of the growth in investment in Cyprus had flowed into the construction sector as a housing bubble driven by foreign demand swelled. Very little investment flowed to productive assets such as machinery and equipment. The housing bubble burst burst in 2008.

Moreover, as large and concentrated as the banking system was, it was also grossly undercapitalized. The IMF stated that the banking system needed to increase its capital by an amount equivalent to at least 20% of the nation’s GDP just to reach the recommended 9% core Tier 1 capital ratio.

Even as the concentrated and narrowly-focused banking system dwarfed the country’s economy, it also had tight linkages to the Greek economy and financial system. On account of those linkages, financial challenges in Greece readily spilled into Cyprus, eroding its economic performance and imperiling its vulnerable financial system. As Greece’s debt-related problems infected Cyprus’ financial institutions, the country’s sovereign credit rating was repeatedly downgraded and the country ultimately lost access to the long-term sovereign debt markets, increasing its reliance on the European Union and European Central Bank for its funding needs.

In sum, Cyprus's financial system was extremely vulnerable due to its concentration, lack of diversified lending, and financial linkages to Greece. At the same time, its footprint was so enormous relative to Cyprus's economy, that any banking system distress would pose severe macroeconomic risks for the nation as a whole. Diversification in the form of a larger number of smaller banks, broader lending portfolio, and more balanced economy could have provided a better buffer against the shocks that culminated in the country’s plunging into its most recent crisis.

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