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While Cyprus and its banking sector are struggling to deal with losses from Greek sovereign bonds, a bigger risk looms: a wave of non-performing loans from the private sector that could savage the capital and liquidity position of Cypriot banks in Greece.
Cyprus has asked the EU for a bailout to support its banking sector, which has been badly affected by holdings in Greek sovereign bonds. But this is only part of the story. Far more serious than the losses from sovereign holdings is the prospect of a wave of deposit outflows - and non-performing loans - hitting Cypriot banks in Greece.
Lending to Greece from Cypriot banks amounts to around 135% of Cyprus's GDP, and the prospect of a prolonged depression in Greece is expected to trigger a meltdown in the Cypriot banking system even after a prospective infusion of capital to offset losses on Greek sovereign bonds.
Above all, a settlement is needed with Greece on the Greek lending from Cypriot banks, says Gabriel Sterne, an economist at Exotix. If the NPL [non-performing loan] ratio gets high enough, then the losses to the Cypriot banking sector could hit 50% of Cypruss GDP. While thats an extreme scenario, the losses could reach 30-40% fairly easily, particularly if you include the losses already incurred on their holdings of Greek government bonds.
The worst-case scenario here would essentially be a Greek exit from the eurozone, something that would trigger a spike in Greek NPLs. Given that the NPL ratio on Greek loans from Cyprus Popular Bank (CPB) Cypruss second largest lender are at around 26%, this could amount to the proverbial straw breaking the camels back.
The spike in contingent and realized liabilities on the Cypriot governments balance sheet suggests the government will need to tap the International Monetary Fund (IMF) and the eurozones crisis stabilization funds more than markets are expecting.
In March, Moodys took ratings actions on three Cypriot banks, citing their extensive operations in Greece. It downgraded by one notch the Bank of Cyprus (BoC) and Hellenic Bank to B2 and B1, respectively, while placing CPB's B3 rating on negative watch.
It said: The rated Cypriot banks maintain extensive branch operations in Greece, with exposures to Greek borrowers amounting to 42% of net loans for CPB, to 34% of gross loans for BoC, and 17% of gross loans for Hellenic. As such, their capital positions remain susceptible to the direct and indirect consequences of a Greek exit.
Cyprus is going to need a further injection of cash from external sources the European Union and the IMF seem the most likely benefactors but this is likely to offer scant solace to the Cypriot citizens, who will eventually have to foot the bill for any external loans to the sovereign.
The idea of citizens paying that much on behalf of bank operations in a foreign country is very serious, says Sterne. The situation in Cyprus goes beyond even Iceland at least in Iceland many of the bad deals were made from the head office, and not branches in another country.
He added: Sentiment is on a knife-edge in Greece, and if anything goes badly wrong then it could cause even more deposit flight from Greek banks, says Sterne.
In terms of being prepared for the worst, it seems to be something of a mixed bag for the Cypriot banks, domestically.
We have not yet seen any significant deposit flight, says Michalis Florentiades, economist at Hellenic Bank Cypruss third largest lender. "There may have been some modest withdrawals in May but nothing too dramatic."
The banks are, however, looking as though they might struggle to meet Saturday's deadline for the European Banking Authoritys stress tests. The countrys two largest lenders Bank of Cyprus and Popular Bank have requested government assistance.