* Huge Cypriot banking sector drew no attention until 2011
* Sector is 7.5 times the size of island state's economy
* Not only euro zone state with outsized financial sector
By Jan Strupczewski
BRUSSELS, March 21 There was no official red
flag that Cyprus's oversized banking sector posed a big risk to
its economy until last year, when the European Union set up
tools to monitor such imbalances, a Reuters review of EU reports
dating back to 2003 showed.
The total consolidated assets of the Cypriot banking sector,
dominated by three large banks, are 7.5 times the size of the
island's economy, which produces almost 18 billion euros ($23.27
billion) a year.
Because Cypriot banks suffered heavy losses in the Greek
sovereign debt restructuring last year, Nicosia now needs an
international bailout. Most of the emergency loans from the euro
zone, once agreed, will go to recapitalise the banks.
One of the conditions for the bailout, however, if that
Cyprus will more than halve the size of its banking sector by
2018 to match the EU average of around 3.5 times GDP.
"The banking sector is completely over-sized. That's why the
preconditions to solving this problem are very difficult,"
German Finance Minister Wolfgang Schaeuble said last week.
"Solutions have to be found to that. The Cypriot banking
sector, like in other countries, with its special rules that led
to it becoming over-sized, has contributed significantly to the
cause of the problem," he said.
This is a relatively recent conclusion.
When Cyprus was examined as to whether it met the criteria
to join the European Union in 2003, a European Commission report
on its readiness mentioned no problems with the banking sector -
it was not a criterion for membership.
Neither did the European Central Bank mention that anything
was wrong with Cypriot banks or their business model - based on
funding from deposits, almost half of which are from
non-residents - when it evaluated whether Cyprus was fit to
joint the euro zone in a 2007 report.
"They had 10 years to make this point and while it was made
informally here or there, nobody ever said or did anything about
it," one euro zone official said.
CYPRUS IS NOT THE ONLY ONE
Neither is the size of the Cypriot banking sector unique.
In a report published almost a year ago, the first public
mention of the threat that Cypriot banks might pose to the
financial stability of the island, the European Commission said
Cyprus ranked only fourth in the euro area.
Luxembourg has a banking sector 24 times the size of its
economy, Ireland eight times and tiny Malta 7.8 times bigger
than its GDP.
A senior EU official said that the European Commission told
the Cypriot government in a telephone call already in November
2011 that it should reduce the size of the banking sector, but
that advice was ignored.
"If the question is, were economists and policymakers able
to see the crisis coming and if they did something about it, I
think it is fair to say - not much," the EU official said.
"But once the crisis has struck, especially after the
Iceland and Irish cases, it has become clear the oversized
banking sectors are a serious problem for a country and the euro
zone as a whole."
The first official indication that the size and business
model of the Cypriot banking sector might become a problem was
in a Commission report from May 2012, prepared under the newly
agreed procedure to detect macroeconomic imbalances.
"Although banks are supported by a strong deposit base,
partly of foreign origin, funding and liquidity remain among the
main risks for financial stability. Funding remains rather tight
and the dependence on foreign deposits poses a risk as the
latter represent one third of total banks' deposits," it said.
"This in-depth review concludes that Cyprus is experiencing
very serious macroeconomic imbalances, which are not excessive
but need to be urgently addressed," it said.
The European Union on Thursday gave Cyprus until Monday to
raise the billions of euros it needs to clinch an international
bailout or face the collapse of its financial system and
probable exit from the euro zone.