There are multiple reasons why an academic case study on FBME Bank shows an interesting view on the current financial landscape in regards to risk, regulation and money laundering. The bank with the main office in Tanzania and a branch in Cyprus was placed under resolution by the Central Banks in 2014, following accusations of being a primary money laundering concern (Notice of Finding, 2014).
From a socio-political point of view, the Republic of Cyprus was the first European country to implement a bail-in for bank customers that had to accept a ‘hair-cut’ during the financial crisis of 2012. The interconnectedness with Greece, poor risk management and the relatively weak credit default rules resulted in a situation where the government had to interfere with capital controls and a bail-in.
The structure of FBME Bank, where main, international, activities focused towards offshore companies and high net worth individuals, were executed via the branch in Cyprus and the main office serviced the local market in Tanzania, leads to an interesting debate on the jurisdiction that determines the applicable law. The bank is still involved in numerous international court cases to avoid the definitive closure, although the banks’ license to operate a branch in Cyprus was already revoked in 2015 (Revocation of License, 2015).
An obvious reason for failing banks is the credit default risk and a weak funding mechanism for capital attraction. The resolution of FBME Bank can be unclear for outsiders. This resolution was triggered by a joint action of the Central Bank of Cyprus and the Financial Crimes Enforcement Network (FinCEN), a US agency appointed with duties to protect the US financial system. The firm accusations of FinCEN, and the way evidence was gathered are almost three years after its inception still challenged in US court.
This paper investigates the challenges the Cyprus banking sector experienced during the last lustrum. It follows the outcome the bail-in for Laiki Bank customers had and provides insights for regulators in relation to customers in future bank resolutions. It shows that not all banks are the same and that a one size fits all model for regulation should include additional measures, like internal compliance and external investment allocation and exposure.
The Cyprus financial crisis of 2012
A combination of consecutive events triggered the financial crisis in Cyprus. The global financial crisis with the collapse of Lehman Brothers initiated worldwide panic and many governments had to intervene. The Greek economy collapsed and a bailout program had to avoid the bankruptcy of the nation. Cyprus banks had substantial exposure to volatile Greek debt. In Cyprus, the low corporate tax rate and a banking sector seven times the size of GDP (Mackintosh G., 2013), attracted the interest of foreign investors and international tax planners. Poor risk management by banks, heavy exposure to bloated real estate and regulatory gaps resulted in under-provisioning.
The total exposure of Cypriot banks to Greek government bonds and the local economy was in 2011 estimated at 28 Billion Euro. Laiki Bank, the second largest bank in Cyprus, had exposure in almost all declining markets, both in Cyprus as well as in Greece. Meanwhile, unemployment in Cyprus remained high and the default percentage in domestic loan portfolios grew.
Technically, there was a run on all banks in Greece, including Laiki and Bank of Cyprus. Laiki experienced compelling liquidity challenges and requested Emergency Liquidity Assistance from the Central Bank of Cyprus. Laiki suggested a recovery programme that included third-party capital injections and a rapid debt reducing strategy as collateral for capital deficit coverage.
Calculation of the deficit seemed difficult at the time due to the constant downgrades of the creditworthiness of Greece. Deposit outflows of banks in Greece and Cyprus further lowered the Tier 1 capital, increasing the need for government support. The capital shortfall in Laiki Bank was initially covered by a 1,8 Billion Euro unfunded government bond, granting the Cyprus government 84% of the banks’ share capital (Rescue Programme, 2013). The possibility of a ´Grexit´ created even more chaos. Laiki, a systemic bank in Cyprus, needed an additional rescue plan and immediate capital injections.
Fitch decreased the credit rating of Cyprus from BBB- to BB+. Thus, Cypriot government bonds were not accepted anymore by the European Central Bank for monetary policy operations. In a three-month period, debt to the ELA grew from 3,8 Billion Euro to 9,6 Billion Euro. The Cyprus Government formally applied to the European Stability Mechanism. Discussions with the Troika started.
The urge to find a swift solution was a close call. The Eurogroup decided to apply a ‘general haircut’ of 10% on all deposits in Cyprus to provide collateral for financial assistance. Cyprus parliament rejected this decision. The European Central Bank responded to this rejection and stopped ELA to Laiki, making the 6.4 Billion Euro due five days later.
Without a new agreement, the country would go bankrupt. A new levy was agreed for shareholders, bondholders and depositors with the two largest banks in Cyprus. The first 100.000 Euro at Laiki and Bank of Cyprus was secured and a haircut was agreed at 47,5% on the remains.
The Eurogroup agreed to provide conditional financial assistance. An amount of 10 Billion Euro was agreed to safeguard financial stability in Cyprus and the Eurozone. The conditions under which support was provided were; (i) Protection of bank deposits up to 100.000 Euro; (ii) Downsizing of the financial sector to the EU average by 2018; (iii) Fiscal consolidation; (iv) Structural reforms; and (v) Privatisation. Additionally, anti-money laundering policies were extended and sharpened and withholding tax on capital income and the corporate tax rate was increased (Eurogroup Statement on Cyprus, 2013).
Bank deposits in member states of the European Union are protected via domestic Deposit Guarantee Schemes (DGS). The DGS in Cyprus had insufficient funds and could cover a total of 125 Million Euro in bank deposits. Cooperation with other DGSs (Guidelines on cooperation, 2016) to create an additional buffer was unlikely and raising premiums to amplify the DGS to the needed coverage of Laiki and BoC deposits was not an option since deposit risk did not change for the other participating banks. Also, the traditional creditor hierarchy where the DGS becomes a preferential creditor to the failed bank, would not cover the insured deposits due to the failure.
A DGS aims to lower the risk for the taxpayer by offering a limited amount of protection for bank deposits. Although the DGS is an external insurance, it should be backed by national governments (Cecchetti, 2007) to avoid difficulties during a systemic crisis. The Cyprus financial crisis revealed a specific challenge for a DGS; funding and capital growth must be safeguarded and the recovery of advanced security for depositors could be modified to plain insurance, raising the liquidity position of the bank and lower taxpayer risk. The consequence of such an implementation lies in moral hazard; government-subsidized risk can be an incentive to excessive risk taking (Dowd, Hutchinson, Ashby & Hinchliffe, 2011).
Risk, regulation and supervision
It is inevitable that a financial crisis has an impact on consumer confidence. Speculative information by media and stakeholders form a biased public opinion. We’ve seen in Cyprus that the central bank doesn’t excel in providing tangible information and evidence from the very first moment of crises. It is understandable that a unique crisis is difficult to predict and explain. However, the collapse of Laiki could have paved the path for a future media and communication plan to avoid further reputational risk. The resolution of FBME Bank shows a comparative picture where misinformation and misunderstanding prevails. In an era where ‘fake news’ is on the agenda, clarity is necessary.
In general, regulators have several options to restructure financial institutions that are at risk of default. The aim of these resolution strategies is to resolve distress. Laiki had very few options when challenges started. The global systemic nature of the Greek crisis and the rapid concatenation of events made it impossible to sell the bank to another owner or engage in an M&A deal. The bank initially tried to improve its capital adequacy by deleveraging and a receiving a capital injection from private investors. This plan failed and the Cyprus government had to cover the capital deficit acting as a lender of last resort. The result was a much-debated haircut on customer accounts.
Little attention is given to the effect money laundering can have on the operations a financial institution. FBME Bank was placed under resolution by the central banks in Cyprus and Tanzania after accusations of being a primary money laundering concern. The Central Bank of Cyprus initially planned to sell parts of FBME Bank (Decree, 2014) but was remanded by the Arbitrage Tribunal of the International Chamber of Commerce. Lengthy court cases in Cyprus and the United States started, while customers of the bank have no access to their accounts and wait in vain for a permanent solution.
The Central Bank of Cyprus
Central banks are responsible for their countries monetary policy and act as the supervisor of domestic banks and branches of foreign banks. Supervisory powers provide a central bank with access to relevant information giving them first-hand knowledge of the condition and performance of banks (Barth, Caprio & Levine, 2010). Supervisory models differentiate financial stability and conduct of business. The sectoral model, common practice in the past (Kremers, Schoenmaker & Wierts, 2003), separates supervision on banks, insurance companies and securities firms. In Cyprus (Recent developments, 2006), the central bank (CBC) is the supervisor of banks and electronic money institutions. The CBC ensures the stability of the banking system, monitors systemic risk and protect bank deposits. Investment firms, collective investment schemes and the Cyprus Stock Exchange are monitored by the Cyprus Securities and Exchange Commission, CySEC.
Although Cyprus gradually lowers its exposure to foreign capital in the local economy to the EU average, the Cyprus banking sector was calculated at 800% of GDP at its peak. The financial crisis of 2012 showed that imbalance between the financial sector and GDP leads to an uncontrollable situation with severe impact to the local economy.
To safeguard confidence in the financial system, a regulatory framework should create an infrastructure where all stakeholders can rely on. Central banks always face the challenge to find a balance between economic growth, employment and risk.
Local banks in Cyprus, together with branches of foreign banks, have limited connexion. However, the nature of activities of nearly all banks and the dependence on a few revenue models show risk for contagion, and systemic risk is a realistic threat. Following Demetriades (2012), poor risk management by largely investing in one single financial instrument and excessive concentration in Greek debt provoked a crisis and must be avoided in the future.
In 2014, when the Cyprus economy slowly recovered, a new banking crisis commenced; the Federal Bank of the Middle East (FBME) was placed under resolution. As a resolution strategy (Bank recovery, 2014), the central bank attempted to forcefully sell the branch operations to protect FBME bank deposits. A bailout with taxpayer money was never an option for FBME because the resolution decree emanated from legal issues. Customers of the bank, however, need to realise that a bail-in scenario is realistic and that they probably will not get all their deposited funds returned.
One can argue whether the followed Basel guidelines and further risk management procedures were sufficient. When we see the collapse of two banks within a relatively short period, somewhere something does not go as planned. The question remains how to avoid a combination of reputational damage and bank failure.
The Federal Bank of the Middle East
Since 1987 the Federal Bank of the Middle East, later rebranded as FBME Bank, has a strong presence in Cyprus, though no services were offered to the local market. The bank is privately owned. The main office in Tanzania holds a full banking license since 2003. In Cyprus, a license to operate as a branch was granted. Due to the technical infrastructure, the branch in Cyprus was responsible for 90% of its global activities.
The activities of FBME Bank in Cyprus were tailored towards offshore companies and high net worth individuals. Since most customers of the bank are located outside Cyprus the bank relied on customer acquisition, mostly, on approved business introducers, ‘referred agents’ and personal contacts of the banks’ owners. These introducers had a strong involvement in the due diligence process of new bank customers, and therefore there was often ‘no direct contact with bank customers to verify their identity, business and risk profile’ (FBME Report, 2014).
A conflict of interest occurred when introducers received an introduction fee from the bank and often also from the customer. An incentive-based decision to introduce a customer to a specific bank is not always in the best interest of the client.
When still fully operational, the banks’ loan book was healthy. Via its subsidiary FBME Card Services, the bank offered customers a debit card with VISA or MasterCard functionality. A credit facility was offered only when the limit was blocked on the customers’ account. This ‘loan back’ strategy of own funds is well known in offshore banking and risk-free for the bank.
FBME further engaged in the short term and relatively safe, trade finance (Trade finance, 2014) and provided working capital for international transactions and payment risk reductions. These off-balance sheet commitments, e.g. letters of credit, guaranteed payment to an exporter on behalf of an importer. The underlying payment is made once delivery of goods gets confirmed and administrative procedures are followed and completed. Account managers of the bank introduced customers to ‘Saab Financial (Bermuda) Limited’ to participate in a ‘private placement programme’. The owners of this investment entity are also the owners of FBME Bank.
Early 2014, FBME Card Services upgraded its license from payment institution to e-money institution and the bank launched a ‘new’ anonymous credit card for its foreign clientele. A substantial number of customers of the bank used offshore companies or used the bank as part of their international tax planning structure. The banks’ clientele has an advantage with secrecy, which is manifested by the fact that certain customers requested the bank to include the banks address on certain transactions (FBME Report, 2014).
Court records show evidence of weak anti-money laundering processes, inadequate KYC procedures and the inability of the bank to finalise their customer review procedure.
After the decision by the Eurogroup to implement a general haircut on deposits of all banks in Cyprus, FBME Bank tried to protect its customers by offering a rapid migration of customer accounts from Cyprus to the main office in Tanzania. This suggestion is questionable. In 2012, Tanzania was placed by the FATF on the list of ‘Non-Cooperative Countries or Territories’ (NCCTs) that form a risk to the international financial system (Hopton, 2009). Although at the end of June 2014, Tanzania was removed from this ‘blacklist’, due to the significant progress and improvement in its AML/CFT regime, in March 2013, at the time the general haircut was decided by the Eurogroup on all Cyprus bank accounts, Tanzania was still listed.
The above clearly shows that risk management by regulators was weak during the pre-crisis era. The rapid implementation of new rules, upgrades, Troika requirements and Basel guidelines gained momentum and although the actions taken by CBC and FinCEN seem legit, FBME Bank suffered from these changes.
Basel agreements and their effects on the overall Cyprus banking sector
Basel II relied on self-regulation and market discipline. It is understandable that, in a commercial setting, market players try to find maximum profitability. This quest often leads to excessive risk taking, especially when governments backup failures. Basel III does not limit this excessive risk taking. It also does not guarantee market discipline. It ‘only’ improves capital and liquidity. These improvements will be sufficient for standard banking institutions and in times of economic prosperity, but when things go wrong, in an ever increasing and more complicated financial society, it is uncertain who is going to pay the bill.
The aim of Basel III is to prevent bank failure. It consequently pushes troubled banks, who enter difficulties due to a variety of reasons, towards a bail-in scenario where customers take a cut in the losses of the bank. There is a market for traditional insurance to guarantee the surplus above government backed deposit guarantee schemes, however, it will reduce profitability and might trigger further risk taking since failure is further secured.
The Laiki and FBME Bank cases show that one size fits all solutions for risk and regulation might work in standard situations, but specific situations need tailoring input.
The Cyprus financial crisis was triggered by the size of the banking sector and the inability of the government to back up the failure of the biggest domestic banks. The size of the banking sector was a motive for investment strategies with poor risk management; uncontrollable economic growth, overexpansion in the property market, heavy exposure to Greece (Foxman, 2013), and failure to acknowledge that asset allocation is essential for stability.
Liquidity risk management of FBME Bank was exemplary. Its customer service was excellent. The loyal staff followed the banks’ management in their endeavours. FBME Bank is one of the few banks that would easily pass the Basel III capital requirements. It is ironic that a bank that does so many things incredibly well, lacked proper internal compliance procedures.
Cyprus confirmed to the Basel standards through their EU membership. Small and relatively weak economies need strict capital requirements to intercept risk. Cyprus is on its way to recovery; in January 2017, ELA obtained by Bank of Cyprus during the financial crisis was fully repaid. Additionally, the CET1 capital ratio of the Cypriot banking sector improved for the third consecutive year and reached 16%. Deposits in the banking system are still rising, loan demand is increasing while lenders apply stricter criteria and the non-performing loan portfolio continued their downward trend (Newsletter no.17, 2017).
If Basel agreements do not include compliance, diversity in asset allocation, education, and e.g. a banker’s oath these agreements on itself will not make a difference for systemic failure as we saw in Greece and Cyprus or in a different way for banks like FBME. We can even conclude that banking supervision might have been improved but financial stability is not fully safeguarded in times of crises.
 FinCEN safeguards the financial system from illicit use and combat money laundering and promote national security through the collection, analysis, and dissemination of financial intelligence and strategic use of financial authorities.
 On July, 15th 2014, FinCEN published a Notice of Finding that FBME is a Financial Institution of Primary Money Laundering Concern.
 Emergency Liquidity Assistance allows European credit institutions to receive central bank credit in exceptional circumstances.
 Fitch Ratings, Inc. is a credit rating agency. Its data is used by lenders and investors to determine risk involved in a specific transaction.
 The Troika is a group of negotiators and decision makers formed by the European Commission, the European Central Bank and the International Monetary Fund.
 Hence the response from the CBC, Rescue Programme for Laiki Bank, on the 30rd of March 2013.
 At the time of publication of this article, court cases in Cyprus and the USA are still in progress.
 Panicos Demetriades was the Governor of the Central Bank of Cyprus from May 2014 to April 2014.
 A general diagnostic review of all banks in March 2013 by the AML unit showed that 22% of FBME’s depositors are companies incorporated outside the EU and 16% of total depositors are foreign political exposed persons. Court records (FBME v Lew) state that 75% of the companies are incorporated in offshore centres, 16% are Cypriot companies and 9% are registered in European countries.
 The review procedure was completed for 3% of the banks customers.
 The Financial Action Task Force (FATF) is the global standard setting body for anti-money laundering and combating the financing of terrorism (AML/CFT).
 The presumption of innocence: one is considered innocent until proven guilty.
 27% of loans by Cypriot banks in Greece were non- performing after the countries first default.
 The banks external auditor also acts as a business introducer for prospects willing to open an account with the bank. (FBME Report, 2014).
 A professional oath for bankers is applied in The Netherlands to enforce integrity and care.
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