Your Cayman bank is not your Cyprus bank: Thanks, Darwin

Read the article in the Cayman Financial Review Magazine 

The Cyprus meltdown earlier this year focused attention on other offshore financial centres with a significant banking industry. The seekers after dominos went on the hunt; which offshore financial centre would cause the next big banking crisis? 

Rating agency Fitch reviewed the banking industries in Andorra, Luxembourg and Malta, all within the Eurozone and thus seen as potential threats to the euro itself. The agency concluded that none of the three was likely to suffer the same crisis as Cyprus. The banking industry in each was different, in particular because the offshore banking was not heavily intertwined with domestic banking, and the domestic industry was stronger and more soundly based than in Cyprus. As were government finances. The IMF backed that up for Malta with a similar confirmation, but with a mild and familiar warning about deteriorating public finances, in late May 2013.

Cyprus was a perfect storm of bloated public and private sector stupidity and greed – not too dissimilar to the problems that had caused such stress in Greece and Ireland. The party just took rather longer to end. The source of depositor funds (much of it Russian) was not the real problem. Rather, two local banks in particular had made fatal errors in how they invested their account-holders’ money – too many dodgy loans to an overheated real estate sector in Cyprus itself and to many dodgy Greek government bonds.
 

When the “bail in” of Greek bondholders occurred, the resulting haircut in turn finally sank these two banks. The Cyprus government could not “print money” as it was part of the Eurozone and did not otherwise have the wherewithal to bail out the banks. So it turned to the EU, ECB and IMF for help. After many twists and turns, the end result was a “bail in” of (ie losses imposed on) depositors of the two banks with deposits over €100,000, protection (ie no losses) for lesser amounts, restructuring of the two banks and a 22 year €10 billion loan for the Cyprus government.

So how does Cayman compare and could we have the same meltdown here? Cayman has its own currency (the Cayman Islands dollar) but the government cannot “print” its way out of trouble, as it operates under a strict currency board system. There is no central bank, and the Cayman Islands Monetary Authority can only issue the Cayman currency to banks against payment in US dollars at a fixed rate of exchange, CI$1.00=US$1.20.
 

There is only about CI$90 million in physical local currency in circulation (M1 is about CI$327 million). By law, the physical currency must be fully backed by highly rated, liquid and secure assets denominated in US dollars, typically fixed income short-term US Treasuries. The Cayman government is currently precluded under the framework for fiscal responsibility (FFR) with the UK from additional borrowings. Finally, there is no deposit insurance or preference for accountholders, other than a modest liquidation preference of US$24,000 for deposits with locally incorporated retail banks.

Cayman GDP is estimated to be around US$3 billion. Government annual revenue is currently around US$780 million. Total public debt is about US$860 million – compared with most other countries the 29 per cent ratio of public debt to GDP is low, and Cayman government debt continues to be rated Aa3 by Fitch. A small surplus is forecast for the year ended 30 June, 2013. Nevertheless, because of UK concerns about deteriorating public finances, the FFR has imposed real austerity. There are modest signs that public finances have now stabilised in the short term. Longer term structural issues still have to be addressed.
Cayman’s offshore licensed banks have footings of about US$1.44 trillion. At first glance, this seems overwhelming when compared with GDP. But these are wholesale interbank and corporate bookings to the Cayman branches (there are very few Cayman incorporated subsidiaries) of major international banks.

These bookings do not find their way into local loans or investments in Cayman (or into treasure chests buried on the beach), because these banks are not permitted to make local loans and more importantly because, even if they could, the local economy simply could not absorb this level of lending. Typically, the funds flow back into the global banking system and are invested outside Cayman.
 

These flows are well documented and are published quarterly by the Bank for International Settlements (it is also possible to track some of these flows through the statistical data published by the US Treasury and other governmental bodies).
Onshore regulators in the US, Canada, the UK, Europe and elsewhere are well informed about these offshore branches and the type and level of the transactions they conduct. These onshore regulators, not the Cayman regulator, CIMA, have primary supervisory responsibility. Indeed CIMA requires the consent of the home based regulator to the opening of a Cayman branch.
 

Consolidated Retail Bank Figures 2008 – 2012 (in $US) (Table 1)

 

Year     Total
Assets
 
Total
Loans
 
o/w Resident
Loans
 
Total
Deposits 
 
o/w Resident
Deposits
 
June
2008
$12.6 billion$5.5 billion  $2.89 billion
 
$11.3 billion  $5.90 billion
June 2
009
$13.3 billion $6.6 billion $3.60 billion$11.5 billion$6.78 billion
June
2010
 
$13.0 billion $6.5 billion$3.48 billion$11.4 billion$7.28 billion

Source: Cayman Islands Monetary Authority
 

 

Sectoral Distribution of Credit to the Domestic Market (Table 2)

 

Sector June 2010 June 2011 June 2012  
Total Resident Loans $3.48 billion $3.57 billion$3.68 billion
Public Sector
 
$0.30 billion$0.48 billion$0.1 billion
Commercial Private Sector
 
 $1.09 billion $1.09 billion$0.9 billion
Households
 
 $2.01 billion $1.98 billion$2.24 billion
Other Financial Corporations$0.08 billion$0.02 billion$0.05 billion

Source: Cayman Islands Monetary Authority
 

 

Thus, for example, if a major US bank with an offshore branch in Cayman fails or comes near to failing, as occurred post 2008, this is a US not a Cayman risk. Responsibility rests with the relevant US authorities to decide whether and how to bail out such a bank, again as occurred post 2008. The same goes for the authorities in Brazil, Canada, France, Germany, the Netherlands and Switzerland, all of whom have responsibility for banks with significant offshore bookings through branches licensed in Cayman.

The domestic banking figures as at 30 June, 2012, (the latest available from CIMA) provide a more accurate picture of the actual Cayman position. Total assets of Cayman’s seven retail banks were US$13 billion, of which deposits made up US$11.4 billion (see table 1). This is about a manageable four times GDP. Total local deposits were US$7.28 billion (see Table 1) and total local loans US$3.68 billion (see Table 2).

Cayman’s retail banks suffered post 2008 like many banks elsewhere, but none of them has failed (some raised new private capital). The local economy and the real estate/construction market in particular suffered. But there was not a broad overleveraged property bubble to start with, and thus there was no meltdown of the sort seen in the USA and elsewhere. Although bank profitability has been subdued and non-performing loans have increased in line with the slowness of the local economy, overall local bank capital adequacy and liquidity appear reasonably good and above international standards and guidelines (see Table 3). And it appears (anecdotally) local banks sensibly kept clear of poor quality sovereign bonds.

As the US economy continues slowly to improve, that should start to trickle down into and help the local economy and retail banks.

There is very limited historical precedent in Cayman for any government support in the event of financial institution failure. Over the years, a few small local retail banks have failed and with no private or public rescue. Accountholders, depositors, creditors and shareholders all suffered losses. The large retail banks, mostly branches or subsidiaries of major Canadian or British banks (with upstream home-based regulators and none of which required a home bail out post 2008), have traditionally given a frosty response to deposit insurance or to the private or public bail out of their smaller rivals. One exception arose after Hurricane Ivan in 2004, that severely impacted a number of property insurance companies (one foreign insurer did fail). 

The Cayman government rescued the insurance subsidiary of a locally owned bancassurance holding company by accepting a significant reduction in its storm damage insurance claim in exchange for a minority ownership interest in the insurance company – which it still holds. This caused significant criticism in the local financial industry, particularly from competitor insurance companies that had raised new private capital or restructured post Ivan and had paid their claims in full.

Moral hazard should not apply to Cayman banks or any other financial institution. CIMA does not have the legal authority, mandate or financial resources to effect a bail out. It seems inconceivable that the Cayman government would bail out an offshore bank, as there would be no justifiable political reason for government to do so.

And, in any event, it does not have sufficient resources. It seems very unlikely that it would bail out a local retail bank, again because it currently does not have the wherewithal to do so. And the government and CIMA should resist any siren calls to do so in the future. Local deposit insurance has been suggested by the IMF. But this is a stalking horse for moral hazard and should not be taken up. Everyone both locally and internationally should take note that Darwinian principles quite rightly still apply. Such clarity focuses the mind and encourages prudence in bankers, customers, shareholders and regulators alike.

The information in this article is correct as at 11 June 2013.
 

Indicator    2008
Year-end
2009
Year-end
 2010
Year-end
 2011 
Year-end
 June 2012
Year-end
Capital adequacy20.420.6 22.921.520.63
Regulatory capital to risk-weighted assets8.49.010.1 10.911.41
Capital to assets     
Asset quality     
Nonperforming loans net of provisions to capital8.49.810.411.712.3
Nonperforming loans to total gross loans1.9 2.32.42.73.51
Earnings and profitability     
Return on equity (net income to average capital [equity])15.7 7.44.95.76.78
Return on assets (net income to average total assets)1.30.70.50.50.66
Interest margin to gross income33.841.8 48.266.776.35
Non-interest expenses to gross income28.342.251.350.256.99
Liquidity     
Liquid assets to total assets (liquid asset ratio)41.238.836.248.132.2

                  

          
   

   
  
  
  

                   
 

 

 

Money-Cuffs_sm.jpg
SHARE
Previous articleDistressed LBOs and fraudulent conveyances:
Next articleAdam Lebor’s “Tower of Basel”
Timothy Ridley

Timothy Ridley qualified as a solicitor in England and is an attorney-at-law in the Cayman Islands. He provides legal consulting and advisory services and acts as an expert witness in Cayman Islands legal and regulatory matters. He holds directorships in various private companies engaged in a broad range of activities, including fund administration. Prior thereto, he was for many years a senior partner of the leading Cayman Islands law firm and from 1995 until 2000 led the Asia practice in Hong Kong. He specialized in a broad range of international financial transactions.

Tim has wide regulatory and governance experience. Currently he is a member of the Disciplinary Tribunal Committee of the Cayman Islands Society of Professional Accountants (CISPA) and a member of the Board of Advisors of the Foundation for Fund Governance. He served on the Boards of the Cayman Islands Health Services Authority (2002-2005) and the Cayman Islands Monetary Authority (2002-2008, Chairman 2004-2008). He has also served on various consultative committees that advise the Cayman Islands Government on matters relating to the financial services and local industries.

Tim has taught law at the University of Southampton and at Trinity College, Cambridge and writes and speaks widely on Cayman Islands legal, financial and regulatory issues. He is a member of numerous international professional associations and has served on the editorial boards of leading publications, including the Harvard International Law Journal. Most recently he was chairman of the editorial advisory board of the Cayman Financial Review.

He is a graduate of Cambridge University (BA, Senior Scholar, Trinity College) and Harvard Law School (LL.M, Kennedy Memorial Scholar).

In recognition of his services to the financial services industry and the local community in the Cayman Islands, he was appointed an Officer of the British Empire (OBE) in 1996.

Timothy Ridley
Attorney-at-Law
E. timrid100@gmail.com