Provisional draft, 9 April 2013Contains sensitive information, not for further distribution
1. Financial sector reform
The banking sector has been severely affected by the broader European economic andsovereign crisis, in particular through its exposure to Greece. However, many of the sector'sproblems are home-grown and relate to overexpansion in the property market as aconsequence of the poor risk management practices of banks. Furthermore, the financialsector is vulnerable because of its size relative to that of the domestic economy. The handlingof problems in the sector has been complicated by the sensitivity of collateral valuations toproperty prices, and banks have used certain gaps in the supervisory framework to delay therecognition of loan losses, thus leading to significant under-provisioning. The banking sectorwould benefit from a considerable downsizing and restructuring in order to restore itssolvency and viability, reinforce its resilience and regain public confidence.
Progress to date
The domestic banking sector, including the cooperative credit institutions, represented untilrecently 550% of GDP.
The necessary downsizing and restructuring of the banking sector isalready under way. The House of Representatives adopted legislation on 22 March 2013establishing a comprehensive framework for the recovery and resolution of credit institutions,drawing, inter alia, on the relevant proposal of the European Commission
(EC). Under theterms of that legislation, the Central Bank of Cyprus (CBC) is the single resolution authorityfor banks and cooperative credit institutions alike. Using this new framework, the Cypriotauthorities have proceeded with (i) the carve-out of the Greek operations of the largestCypriot banks, (ii) the resolution of Cyprus Popular Bank and the absorption of selectedassets and liabilities by the Bank of Cyprus and (iii) the recapitalisation of the Bank of Cyprus through a debt to equity conversion, without the use of public money. As a result of these actions, the Cypriot banking sector was downsized immediately and significantly to% of GDP and the Bank of Cyprus has been fully recapitalised in order to regain itseligible counterparty status for the purpose of its participation in regular Eurosystemmonetary policy operations. Further downsizing will be achieved through the restructuring of the cooperative credit institutions. To preserve the liquidity of the Cypriot banking sector,administrative measures have also been imposed.
A. Regulation and supervisionMaintaining liquidity in the banking sector
As bank liquidity was under pressure, exceptional measures were necessary with aview to preventing large deposit outflows and preserving the solvency and liquidity of thecredit institutions. Cash withdrawals, electronic payments and transfers abroad weretemporarily restricted. The implementation of these measures was designed to minimisedisruptions in the payment systems, and to ensure the execution of transactions essential forthe functioning of the economy. The Government committed to managing the introductionand implementation of restrictions in line with the rules on the free movement of capital setout in the Treaty on the Functioning of the European Union. The impact of the restrictions