Support for Non-Performing Loans in Cyprus

Public assistance to households to pay for their mortgages is not State aid. Public assistance to enterprises to pay for their loans may be qualified as de minimis aid. Public assistance to households and de minimis aid to enterprises to pay for their loans are indirect aid to banks, which, however, falls outside the directive on bank recovery and resolution because it is not “extraordinary public financial support”.

 

Introduction
 
Paragraph 116 of the Commission’s Notice on the Notion of State Aid makes a distinction between “mere secondary economic effects that are inherent in almost all State aid measures” and “indirect” effects. Article 107(1) TFEU does catch aid that generates indirect advantages that flow through the direct recipients to identified third parties. In December 2018, the Commission in decision SA.49554, approved a measure of indirect aid whose purpose was to facilitate the restructuring of non-performing loans that were collateralised with primary residences.1The measure that had been notified by Cyprus aimed to help “vulnerable borrowers” who could not repay mortgages or other loans that were secured against their primary residence. In some cases, loans were collateralised with primary residences that belonged to persons other than the direct borrowers [e.g. parents].The scheme would be open to all licensed credit institutions in Cyprus. Banks wishing to participate in the scheme [so-called participating institutions] would have to sign a Memorandum of Understanding with the relevant public authority [henceforth, “agency”] that would manage the scheme. The agency would provide to participating institutions annual cash payments for the purpose of reducing the instalments of the borrowers.

According to the Cypriot authorities the scheme would cover non-performing loans amounting to EUR 3.4 billion. However, since the financial help to borrowers would only be a fraction of their total borrowing costs, the amount of the required funds would be about EUR 815 million over 25 years or about EUR 33 million annually.

 

Eligible loans

The criteria for loans to be eligible for support were the following:

  1. The loan had to be secured with a mortgage on the borrower’s main residence.
  2. The current market value of the residence could not exceed EUR 350,000.
  3. At least 20% of the total outstanding balance of the borrower’s credit exposure towards the participating institution had to be overdue by more than 90 days.

 

Eligible borrowers

Eligible borrowers were either individuals with a mortgage or micro and small businesses with a business loan. The scheme had the following common eligibility criteria for both types of borrowers:

  1. The maximum gross annual household income could not exceed certain thresholds varying from EUR 20,000 for a single applicant up to EUR 60,000 for an applicant with four dependent family members.
  2. The household net wealth of the borrower without the main residence could not exceed EUR 250,000.

 

Requirement for restructuring of mortgages and loans

Participating institutions would be obliged to restructure loans so that the “restructured nominal amount” would be equal to the lower of either (i) the “outstanding nominal amount” of the eligible loan at the time of restructuring or (ii) the market value of the main residence or the market value of other collaterals that had been pledged as security against loans [the market value of the collateral]. This meant that participating institutions would contribute to the scheme through a reduction of the outstanding loan amount in cases where the market value of the main residence was lower than the outstanding amount of the loan. The Cypriot authorities expected that outstanding loans would be reduced by about 32%. The existing collateral/guarantees supporting the loans would be retained.

In addition, any cash or deposits in excess of 20% of the borrower’s net household wealth would have to be used to repay the loan before the restructuring.

The interest rate of the restructured loan would be flexible throughout the repayment period and would be equal to Euribor plus a margin of 2.5% for the first seven years, reduced to 2.0% thereafter.

The responsible public agency, supported by independent external experts, would be empowered to audit the scheme in order to ensure compliance with its provisions by participating institutions and borrowers.

 

Participation in the scheme

Banks wishing to participate in the scheme would have to collect all required information from borrowers and submit it to the agency on behalf of those borrowers. In order to perform the necessary verification, the agency would be granted access to records held at the social insurance authority, tax authority and land registry.

At the end of every fiscal year and until the maturity of restructured loans, the agency would pay participating institutions one third of the total monthly instalments (covering both principal and interest) due in a given year. Borrowers would have to pay the remaining two thirds of the total monthly instalments of the restructured loans.

The agency would sign contracts with borrowers conferring to it the right to recover any grant payments, ranking pari passu with banks’ claims towards borrowers, in case of a new default of borrowers. In this eventuality, the restructured loan would be converted back to its original status in terms of amount, interest rates and maturity. Such loans would be subject to an immediate foreclosure.

 

Presence of State aid?

The Cypriot authorities claimed that the scheme did not involve State aid for the following reasons. First, beneficiary households were not undertakings. Second, beneficiary enterprises would not receive any aid exceeding the de minimis ceiling of EUR 200,000. Third, participating institutions were merely channels through which aid flowed to households and enterprises.

 

Commission assessment

With respect to the existence of State aid, there was no doubt that state resources were involved and that the scheme was selective. With the exception of de minimis aid, the affectation of trade and consequent distortion of competition could not be excluded. The main questions were i) whether households were undertakings, ii) whether enterprises would receive aid exceeding the de minimis threshold, iii) whether participating institutions would derive an (indirect) advantage and iv) whether the Banking Union rules allowed aid to financial institutions.

According to the Commission, “(43) with regard to the individual mortgage borrowers, only natural persons who reside in the property underlying the mortgage contract are eligible to participate. Therefore, they cannot be regarded as undertakings within the meaning of Article 107(1) TFEU and, thus, assistance to them falls outside the scope of State aid rules.”

“(44) With respect to micro and small-businesses, the support constitutes de minimis aid under the De Minimis Regulation. According to Article 4(1) of the De Minimis Regulation, it applies only to “transparent aid” which is defined as aid in respect of which it is possible to calculate precisely the gross grant equivalent ex ante without any need to undertake a risk assessment. Under the Scheme, the subsidy covers 1/3 of the outstanding amount plus 1/3 of the interests due under the restructured loans. This is economically equivalent to the repayment by the State of 1/3 of the restructured loan, subject to the borrower continuing to repay the other 2/3. As the present economic value of the restructured loans cannot exceed EUR 350,000, the value of the 1/3 part that is repaid by the State cannot exceed EUR 116,666. Article 3(2) of the De Minimis Regulation provides that “the total amount of de minimis aid granted per Member State to a single undertaking shall not exceed EUR 200,000 over any period of three fiscal years”. In this context, the subsidy to micro and small businesses is within de minimis ceiling. Moreover, Cyprus will ensure that all requirements of the De Minimis Regulation, including cumulation, are complied with.”

“(45) Therefore, as regards micro and small businesses, the Commission observes that the conditions of the De Minimis Regulation are met and, as a result, the measure at stake is deemed not to have any effect on trade between Member States and not to distort or threaten to distort competition. As the measure does not meet all the criteria laid down in Article 107(1) TFEU, it is not subject to the notification requirement under Article 108(2) TFEU.”

With respect to participating institutions, the Commission made the following points:

“(47) (a) If the loans do not turn performing as a result of the Scheme, the situation for the Participating Institutions would not change as compared to the current situation; the institutions would have recourse to the loans’ collateral up to their Outstanding Nominal Amount, including through the foreclosure process.

(b) If the loans turn performing as a result of the Scheme, the Participating Institutions will be able to restart collecting cash-flows, as long as the borrowers do not re-default, up to the loans’ Restructured Nominal Amount. This amount may be lower than the Outstanding Nominal Amount, if the latter is higher than the Collateral’s MV, i.e. if the loan’s equity is negative.”

“(48) The Scheme would then have two opposite effects on the Participating Institutions:

(a) On the one hand, the State subsidy will help the defaulted borrower to restart paying the restructured loans to the Participating Institutions. This entails a positive economic effect for the Participating Institutions as long as the loans’ Restructured Nominal Amount is higher than the potential proceeds from the banks’ recourse to the loans’ collateral, including through the foreclosure process, under the current loans‘ terms.

(b) On the other hand, the Participating Institutions may give up some potential economic upside as long as the Restructured Nominal Amount is lower than the Outstanding Nominal Amount.”

“(49) To the extent that the Scheme is effective in improving the perspectives of the Participating Institutions to turn the NPLs into performing loans, the positive effect (of recovering a value higher than the proceeds from the recourse to the loans’ collateral and up to the Restructured Nominal Amount) would tend to prevail over the negative effect (of giving up a potential upside above the Restructured Nominal Amount and up to the Outstanding Nominal Amount). Since participation to the Scheme by Financial Institutions is voluntary, the group of Participating Institutions will reasonably encompass those Financial Institutions that have studied those two types of effects on their NPLs and expect an overall profitable outcome in their favour.”

“(50) In conclusion, the Participating Institutions indirectly benefit from the Scheme and its embedded subsidies.”

 

Compatibility with the internal market

Normally, when banks are direct beneficiaries, the Commission assesses the compatibility of aid on the basis of Article 107(3)(b). But in this case, the direct beneficiaries were households and enterprises. Therefore, “(56) with respect to the different groups of eligible beneficiaries, the compatibility of the indirect aid to the Participating Institutions will be assessed under two distinct legal bases. More specifically, with regard to individual borrowers as final beneficiaries, Article 107(2)(a) TFEU constitutes the compatibility basis. However, with regard to micro and small businesses as final beneficiaries, Article 107(3)(c) TFEU serves as the applicable compatibility basis. For the avoidance of doubt, the indirect aid to the Participating Institutions will not be assessed under Article 107(3)(b) TFEU, which is the legal basis under which the Commission has been consistently assessing any restructuring or liquidation aid to financial institutions since the beginning of the financial crisis. Therefore, the Crisis Communications, detailing the compatibility assessment under Article 107(3)(b) TFEU are not applicable.”

 

Article 107(2)(a) TFEU: Compatibility of the indirect aid to the banks from the support to individuals

Indirect aid to participating institutions was exempted as aid to individuals having a “social character”.

“(59) The proposed Scheme primarily intends to safeguard the main residence of borrowers from the risk of repossession. As a consequence of the crisis that Cyprus has suffered, mainly since 2012, the unemployment rate has increased while at the same time wages have decreased and house prices have fallen substantially from their pre-crisis peak. As a result, the amount of defaults on the repayment of loans has dramatically increased and the threat of repossession has emerged for a significant part of the population. To the extent that the Scheme aims at securing that households are protected from the risk of foreclosure, it reflects both short-term and long-term social concerns.”

“(60) The Commission, therefore, accepts that the Scheme is predominantly of a social nature. For instance, the eligibility criteria take into account the income and wealth of the borrower’s household.”

“(61) The Commission also concludes that the Scheme fulfils the condition under Article 107(2)(a) TFEU that the aid must be “granted without discrimination related to the origin of the products concerned” since all mortgage lenders established in Cyprus are able to access the Scheme.”

 

Article 107(3)(c) TFEU: Compatibility of the indirect aid to the banks from the support to micro and small businesses

The Commission assessed the scheme directly on the basis of Article 107(3)(c) TFEU according to the common assessment principles.

Objective of common interest: “(65) The Scheme aims at avoiding the foreclosure of small entrepreneurs from the house in which they live. Without it, the activation of foreclosure proceedings would likely involve serious hardships as these entrepreneurs would be evicted from their homes. Thus, the aid pursues an objective of common interest which consists in addressing the social hardships particular to the vulnerabilities faced by owners of micro and small businesses.”

Appropriateness: “(66) The measure is suitably designed to achieve the objective of common interest, since the State will pay part of the monthly instalment due by the entrepreneurs to the Participating Institution, such that the institution does not proceed with foreclosure and seize up the residence of the entrepreneurs. Hence, the Scheme seems well-targeted and appropriate to the intended objective. The Scheme is designed in such a way so as to alleviate the current risks of foreclosure faced by entrepreneurs operating micro and small businesses.”

Necessity: “(67) The criteria [of the scheme] are designed so as to target vulnerable owners of those micro and small businesses only and, thus, it avoids targeting the entire stock of existing NPLs held by Cypriot Financial Institutions. In addition, the Scheme is limited to payments of part of the monthly instalment; the Participating Institutions will continue to bear the credit risk vis-à-vis such loans, for the amount of the loan still outstanding post-restructuring. This means that the risk of default is not eliminated by the Scheme.”

Proportionality: “(68) The measure seems to be limited to what is necessary to achieve the objective pursued. The aid cannot generate unnecessary advantages to the Participating Institutions and hence cannot generate undue distortion of competition. Cyprus has estimated a budget for the grant available under the Scheme of 33 million EUR per year for a maximum of 25 years. The Eligible Loans would amount to a total of up to ca. EUR 3.4 billion, i.e. ca. 16% of Cypriot banks‘ total NPLs (amounting to ca. EUR 21.5 billion), or ca. 5% of total assets (amounting to ca. EUR 67.2 billion) as of end of September 2017 (i.e. the cut-off date for the eligibility of the NPLs). The amount of NPLs eventually subject to the subsidy can get reduced by the Financial Institutions‘ participation and the application of the Means Criteria.”

On the basis of the above reasoning, the Commission concluded that the scheme was compatible with the internal market, even though it did not formally examine whether trade was not affected to an extent that would be contrary to the common interest.

 

Intrinsically linked provisions of EU law: Compatibility with the Banking Union rules

The Commission also considered whether the scheme would infringe other provisions of EU law.

“(70) It has been established that the Scheme provides indirectly aid to the Participating Institutions. To the extent that some Participating Institutions, notably the banks, fall into the scope of Directive 2014/59/EU [on the recovery and resolution of banks] as defined in Article 1, it needs to be assessed whether such aid qualifies as „extraordinary public financial support“, as defined pursuant to Article 2(28).” “(71) This is necessary because the Commission cannot approve aid as compatible with the internal market if it breaches another intrinsically linked provision of Union law.”

“(72) Article 2(28) of the Directive defines extraordinary public financial support as: “State aid within the meaning of Article 107(1) TFEU, or any other public financial support at supra-national level, which, if provided for at national level, would constitute State aid, that is provided in order to preserve or restore the viability, liquidity or solvency of an institution or entity referred to in point (b), (c) or (d) of Article 1(1) or of a group of which such an institution or entity forms part.””

“(73) That definition does not encompass any type of aid, but only aid whose objective is “to preserve or restore the viability, liquidity or solvency” of a bank. The Scheme’s objective is two-fold depending on whether the direct beneficiary is a natural person or a micro/small enterprise. In the first case, the aid objectively pursues the social goal of Article 107(2)(a) TFEU. In the second case, the aid objectively pursues the goal of addressing the social hardships particular to the vulnerabilities faced by owners of micro and small businesses under Article 107(3)(c) TFEU. Nevertheless, in both cases, the predominantly social objective indicates that the Scheme’s objective is not to preserve or restore the viability, liquidity or solvency of a bank. The Participating Institutions benefit only indirectly by channelling the aid to those two categories of direct beneficiaries. This is corroborated by the fact that the aid does not qualify as one of the types of aid contemplated by the Crisis Communications, as indicated in recital (56).”

“(74) Furthermore, it is expected that the size of the support to each Participating Institution would anyway not be sufficiently large to have a material effect on the viability, liquidity or solvency of the bank. As discussed in recital (66), the total budget of the Scheme is small compared to the stock of NPLs and to the size of the banks active in Cyprus. In addition, compared to the potential maximum benefit implied by the total budget, the actual benefit will be reduced by certain factors – including the number of applicants as resulting from the eligibility filters and the take-up, the actual ability of the Scheme in turning the NPLs into performing loans, the re-default rates.”

“(75) In conclusion, the Scheme’s objective is not to preserve or restore the viability, liquidity or solvency of a bank and it is also unlikely that it would result in any material effect on any of the financial institutions‘ viability, liquidity or solvency.” “(76) Therefore, the criteria for the aid to be considered as „extraordinary public financial support“ are not fulfilled and the Scheme does not fall under the scope of Directive 2014/59/EU.”

Since the scheme did not infringe Directive 2014/59, the Commission approved the scheme.

 

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1 The full text of the Commission decision can be accessed at: http://ec.europa.eu/competition/state_aid/cases/276985/276985_2032224_96_2.pdf.

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Phedon Nicolaides

Dr. Nicolaides was educated in the United States, the Netherlands and the United Kingdom. He has a PhD in Economics and a PhD in Law. He presently holds positions at the College of Europe and the University of Maastricht. He has published extensively on European integration, competition policy and State aid. He is also on the editorial boards of several journals. Dr. Nicolaides has organised seminars and workshops in many different Member States, and has acted as consultant to several public authorities.

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