The APF is indemnified by the government, and the income from it – whether positive or negative – gets transferred to 14  All speeches are available online at www.bankofengland.co.uk/news/speeches and @BoE_PressOffice  14  (and from) the Treasury. And the matching liability on the APF balance sheet isn’t zero-interest money but interest-bearing reserves. So a rise in the official interest rate directly and immediately increases the cost of the QE fund14. In these simulations the rise in nominal interest rates, in response to the rise in actual and  Chart 10: QE reduces the maturity of the private sector’s claim on the state and with it the fiscal returns to higher inflation  expected inflation, is itself immediate. It’s impossible to “inflate away” zero-maturity reserves – as the “tax base” for surprise inflation, it’s the longer-term conventional debt in the hands of the private sector that counts. So the impact of the extra inflation would be scaled down by the relative size of the QE fund. If 40% of the conventional debt is in the central banks, and funded by interest-bearing reserves, the impact of higher inflation is also reduced by 40% (Chart 10). A permanent increase of 1% point in the rate of inflation would, at its peak, reduce the real value of the public sector’s liabilities by just under 3%, a 3%-point rise by a little over 7%. In the grand scheme of things, and even if there were no increase in the inflation risk premium in response, these are not large numbers15.
In all options, the Bank of Cyprus will need to create an organisation to manage nonperforming loans. The bank is already moving in this direction, and should it remain as a single entity it is likely that there will still be a dedicated focus on managing the workout of troubled loans. Splitting the Bank of Cyprus into a commercial bank and an asset management/development bank would create a legal and management separation. This – as any other option – has a number of merits and challenges. Two institutions would provide specialisation. The asset management/Development Bank could focus on maximising value through the restructuring of the loan book with no immediate time pressures. It could also act as a specialist bank focussed on real estate and development related activities. The remaining commercial bank could focus on serving the domestic economy. However, a split could be operationally disruptive in the immediate term, even if it was beneficial over time. Substantial progress in the restructuring of the banking system has been made. This has not been easy, and market conditions remain fragile. In determining the way forward any solution should look to meet four objectives; Restoration of Confidence – It is essential that any solution furthers the restoration of confidence. Customers must have confidence in the future of the Bank of Cyprus whether it is one bank or two. As confidence is re-established we can further ease and ultimately lift capital controls. Funded Balance Sheet – The Bank of Cyprus’s reliance on emergency support is well known.