By Jan Strupczewski

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.

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.

[Reuters]