Cypriot politicians and bankers were so swept up in the short-term benefits of the Mediterranean island's adoption of the euro that they ignored warnings over the resulting lending boom.
The island's 2008 entry to the euro zone was the first in a series of events which have led to a situation in which ATMs in Cyprus may soon run out of cash.
Before joining the euro, the Central Bank of Cyprus only allowed banks to use up to 30 percent of their foreign deposits to support local lending, a measure designed to prevent sizeable deposits from Greeks and Russians fueling a bubble.
When Cyprus joined the single European currency, Greek and other euro-area deposits were reclassified as domestic, leading to billions more local lending, Pambos Papageorgiou, a member of Cyprus's parliament and a former central bank board member said.
"In terms of regulation we were not prepared for such a credit bubble," he told Reuters.
Banks' loan books expanded almost 32 percent in 2008 as newly gained euro zone status made Cyprus a more attractive destination for banking and business generally, but Cypriot banks maintained the unusual position of funding almost all their lending from deposits.
"The banks were considered super conservative," said Alexander Apostolides an economic historian at Cyprus' European University, a private university on the outskirts of Nicosia.
When Lehman Brothers collapsed in the summer of 2008, most of the world's banks suffered in the fallout, but not Cyprus's.
"Everyone here was sitting pretty," said Fiona Mullen, a Nicosia-based economist, reflecting on the fact Cypriot banks did not depend on capital markets for funding and did not invest in complex financial products that felled other institutions.
Marios Mavrides, a finance lecturer and government politician, says his warnings about the detrimental impact on the economy of so much extra lending fell on deaf ears.
"I was talking about the (property) bubble but nobody wanted to listen, because everyone was making money," he said.
The fact that the main Cyprus property taxes are payable on sale made people hold onto property, further fueling prices, Papageorgiou added.
A separate source with direct knowledge of the central bank's board said supervision was inhibited by outdated regulations that largely date back to the 1960s.
Michael Olympios, chairman of the Cyprus Investor Association that represents 27,000 individual stock market investors, said he too criticized the central bank for "lax" regulation that facilitated excessive risk taking.
Athanasios Ophanides, the former central bank governor who was ultimately responsible for banking supervision from May 2007 to May 2012, declined to comment. He has previously denied any supervisory failings.
A source at one of the banks, who asked not to be named, said his institution did not have "serious problems with lending," adding that Cypriot banks typically demanded a down payment of 30 percent for home loans, well above the average in most countries.
The rapid expansion left Cyprus with a banking system eight times the size of its national output, as its accommodative regime of not taxing foreigners' dividends and capital gains lured investors from countries like Russia.
A senior European Union official said the European Commission advised the Cypriot government in a November 2011 telephone call to reduce the size of its banking sector but the advice was ignored.
The island became a finance center without a financial district, a channelling point for massive amounts of money without any of the trappings that dominate the cityscapes of centers like London, Frankfurt, New York and Zurich.
"This is the funny thing," said Mullen. "There are essentially two retail banks and then a couple of dozen individual branches, mainly private banking and corporate banking. It's not investment banking, we don't have JP Morgan and all those kind of things here."
It also offered rates which could not be matched.
A depositor would have earned 31,000 euros on a 100,000 euro deposit held for the last five years in Cyprus, compared to the 15,000 to 18,000 euros the same deposit would have made in Italy and Spain, and the 8,000 interest it would have earned in Germany, according to figures from UniCredit.
Bulging deposit books not only fueled lending expansion at home, it also drove Cypriot banks overseas. Greece, where many Cypriots claim heritage, was the destination of choice for the island's two biggest lenders, Cyprus Popular Bank, formerly called Laiki, and Bank of Cyprus.
The extent of this exposure was laid bare in the European Banking Authority's 2011 "stress tests," which were published that July, as the European Union and International Monetary Fund were battling to come up with a fresh rescue deal to save Greece.
The EBA figures showed 30 percent (11 billion euros) of Bank of Cyprus' total loan book was wrapped up in Greece by December 2010, as was 43 percent (or 19 billion euros) of Laiki's, which was then known as Marfin Popular.
More striking was the banks' exposure to Greek debt.
At the time, Bank of Cyprus's 2.4 billion euros of Greek debt was enough to wipe out 75 percent of the bank's total capital, while Laiki's 3.4 billion euros exposure outstripped its 3.2 billion euros of total capital.
The close ties between Greece and Cyprus meant the Cypriot banks did not listen to warnings about this exposure.
The banks sold down some of their Greek holdings, but then got back into the market as yields rose. "When the Germans were selling, they were buying," said Apostolides, referring to the German banks' 2011 dumping of Greek debt.
Simona Mihai, assistant professor at Cyprus European University's banking and finance department, said the banks' exposure stemmed from a desire to help their nearest neighbors, and a belief that Greece could recover.
"People are thinking in hope," she said. "They do not see it from an analytical perspective."
A former executive of one of the banks, who did not sit on the management team and asked not to be named, said the exposure and the banks' overall expansion stemmed from greed. "To help deliver profits, they lent and lent and lent and invested in Greek bonds," the person said.
Staff, who mostly got small bonuses and annual pay rises of around three or four percent, were unhappy about the mounting exposure to Greece but powerless to stop it, the source added.
Whatever the motive, the Greek exposure defied country risk standards typically applied by central banks; a clause in Cyprus' EU/IMF December memorandum of understanding explicitly requires the banks to have more diversified portfolios of higher credit quality.
"That (the way the exposures were allowed to build) was a problem of supervision," said Papageorgiou, who was a member of the six-man board of directors of the central bank at the time.
The board, which met less than once a month, never knew how much Greek debt the banks were holding, both Papageorgiou and another person with direct knowledge of the situation told Reuters.
Papageorgiou and two other directors voiced concerns about the toothless nature of the central bank board, leading to public and bitter clashes with Orphanides, who stringently denied any lapses and said he had encouraged the banks to offload their Greek positions.
"It was very sad, he accused me of undermining him," said Papageorgiou, who left the central bank board when he was elected to parliament in 2011 for the then-ruling AKEL party, which lost power to the right wing Democratic Rally party in Feb. 24 elections.
Orphanides also clashed with leaders of the AKEL government. Apostolides says the central bank governor had told Cyprus' president that the banks could survive a maximum 25 percent loss on their Greek bonds.
The "haircut" ultimately agreed to by European leaders, including Cyprus' president Demetris Christofias, was more than 70 percent, heaping losses of 4.5 billion euros on the banks.
When Orphanides' five-year contract expired in May 2012, it was not renewed. He had criticized government spending and Cyprus' growing indebtedness for years, culminating in an especially sharp report in his last week in office.
Christofias hit back by using a trade union rally to criticize the governor's role: "Mr. Orphanides' responsibilities for the Cypriot banks' exposure to Greek bonds is overwhelming," the president said.
Last year, the central bank board appointed consultants Alvarez and Marsal to carry out an investigation into what really went wrong in the banking sector. It is expected to be completed in April.
Olympios says he knows of several investors, both institutional and individual, who will use the results of the report as a springboard for legal action to take cases for mismanagement against the bank's then-directors.
One, who lost millions on his shares in Bank of Cyprus and Laiki, is already working with lawyers on a case.
"Cyprus is a small country and we are all friends but I am going to go against them," said the investor, who asked not to be named. "I was an outside observer, they told me everything was all right."
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