THE BANK FINANCIAL SYSTEM

INTRODUCTION

During the ten years since the fall of the Berlin Wall and the beginning of the
economic reforms in Bulgaria there have been two periods of sharp economic decline and
high inflation. The first period of economic disruption was in the early 1990s as the
transformation to a market economy began. The second was a severe financial crisis in 1996
- 97. The banking system played a central role in both of these events.
The first event coincided with rapid changes in banking institutions as Bulgaria
moved swiftly to transform the old monobanking system that existed under central planning
into a two - tier banking system designed to support a market economy. While new banking
institutions were created quickly, fashioning well - functioning financial institutions proved
to be a much more formidable task.
During the early transition period the money supply grew rapidly. Many newly
formed commercial banks were poorly capitalized and the level of bad loans on their books
expanded dramatically. Attempts by the government to manage these problems by
recapitalizing the banks largely failed. Since the banks were recapitalized by substituting
government debt for bad loans on bank balance sheets, government debt increased
dramatically. Banks balance sheets did not improve as commercial banks continued to make
additional bad loans. With so much credit pouring into state enterprises, there was little
incentive to restructure and the real sector of the economy suffered as well. Weaknesses in
both government and bank balance sheets led to the financial crisis of 1996 - 97. The lev
depreciated from 0. 078 lev/$ in March 1996 to more than 2.7 lev/$ in February 1997, an
increase of 34 times its original level. Several banks, holding about one third of bank assets,
folded. The crisis ended when the IMF provided additional support and a currency board
was established in July 1997. The crisis and the establishment of the currency board were a
turning point for the banking system. Under a currency board system the central bank has no
discretion to conduct monetary policy. The growth rate of the money supply has slowed
significantly and commercial bank balance sheets have improved. The flow of easy credit to
the real sector has ceased. Indeed, since the establishment of the currency board, it has been
very difficult for firms to get any credit. An important remaining question is whether the
banking system can be reformed so that it becomes a reliable intermediary between savers
and investors.

THE STRUCTURE OF THE BANKING SYSTEM

First Stage: The Centrally-Planned Economy and the Monobank (until 1980)

Under the centrally-planned economy the Bulgarian banking system can be

characterized as a state-operated monobank. The central bank combined issue and credit
functions, and implemented the “cash and credit plan” which formed part of the general
economic plan. The Bulgarian National Bank (BNB) was under the direct control of the
government. Besides the BNB there were only two other banking institutions, each with
strictly limited functions. The State Savings Bank (SSB), established in 1951, was the only
financial institution permitted to hold the accounts of individuals. The Bulgarian Foreign
Trade Bank, created in 1964, handled all foreign exchange operations.
 Second Stage: Reform Efforts within the Monobank (1981 - 1989)

This structure remained in place until the early 1980s when the first commercial banks
were formed within the state-owned one-tier banking system. In 1981 the first commercial
bank, Mineralbank, was created in Bulgaria with the specific purpose to finance projects in
the energy sector and the extracting industry and to participate in the establishment of both
domestic and foreign joint ventures.
In 1987 eight sector-specific commercial banks were formed, each restricted to
lending in a particular sector of the economy. These banks were: Electronica CB, Biochim
CB, Autotechnica CB, Agricultural and Cooperative Bank, Construction Bank, Transport
Bank and Economic Bank. Shareholders in these banks were enterprises from their respective
sectors of the economy. The activities of these banks were restricted to servicing their
shareholders, i.e. enterprises in the specific sector. The creation of sector-specific banks did
not alter the monobank structure of the Bulgarian banking system since these banks were not
allowed to accept deposits from nor provide bank services to individuals. The liabilities of
these quasi-banks included accounts of sector-specific enterprises, credits extended by the
BNB and their own capital. In practice, the BNB provided funds to sector-specific
commercial banks, which in turn loaned these funds to enterprises in their sector of the
economy.

Third Stage: The Two-Tier Banking System (after 1990)

At the end of 1989 large-scale restructuring of the Bulgarian financial and banking
system began. This reflected the need to shift to a modern two-tier banking system typical of
a market economy. The sector-specific banks were transformed into classical commercial
banks, accepting deposits from individuals. These banks were separate legal entities, making
loans to households and all sectors of the economy. The existing 59 branches of the BNB
were transformed into autonomous commercial banks. The Post Bank was recreated. By
early 1991 the banking system comprised the BNB, the SSB and 69 commercial banks
organized as autonomous joint stock companies.
With the adoption of the Law on the BNB in June 1991 the roles, objectives and
functions of the BNB and the commercial banks were redefined. The new Law granted the
BNB substantial independence from the government and set objectives and functions typical
of modern central banks.
In 1992 the Bank Consolidation Company (BCC) was formed for the purpose of
consolidating, restructuring and privatizing state owned commercial banks. While the BCC
was not equipped with the appropriate staff and financial resources needed to achieve its
ambitious goals, especially in the area of privatization, it did assist in the consolidation of
several banking groups. This included the creation of United Bulgarian Bank from the
merger of twenty-two smaller banks, and Expressbank, which represented the consolidation
of twelve smaller banks.
In March of the same year the Law on Banks and Credit Activity was adopted. This
law established the regulatory framework for the activities of banking institutions. Under this
law commercial banks were granted either a restricted license or a full license. Banks with a
restricted license were allowed to operate only within the national boundaries. Banks with a
full license were permitted to operate both domestically and internationally.
The BNB adopted a liberal licensing policy. By the end of 1992, there were 59
commercial banks. The large number of commercial banks and the low capitalization levels
in many banks generated interest in banking sector consolidation. The first stage of
consolidation took place through the BCC. The first consolidated bank, the United Bulgarian
Bank (UBB), was formed at the end of 1992. The second wave of consolidation took place in
1993. During this period Expressbank and Hebrosbank emerged. The last wave of the
process of consolidation ended in 1995 with the take-over of Sofiabank by Biochim
Commercial Bank.
Paralleling this initiative, the BNB pursued a policy of promoting consolidation of
private commercial banks by raising minimum capital requirements. This policy did not
result in the consolidation of private banks as these banks were guided by group interests and
it was difficult to find common ground for consolidation. After the process of consolidation
was completed the Bulgarian banking sector continued to be dominated by state-owned
banks. This was a major reason for the severe financial crisis of 1996. During the period
leading up to the crisis commercial banks were used by the government to provide implicit
subsidies in the form of credits to loss-making state-owned enterprises. Bank balance sheets
were weakened further as the BNB continued to provided additional resources to the
commercial banks through refinancing. Private banks also expanded their lending to many
newly incorporated private companies. Quite often these loans violated the regulatory
framework designed which was deigned to maintain bank solvency by restricting the size of
loans and limit the loans to bank officers.
In a survey conducted in May and June 1997 Koford and Tchoegl (1999) investigated
banking practices in Bulgaria. They found numerous problems. Bankers often lacked
sufficient training and internal controls on bank loan decisions were weak. While banks
were required to collateralize their loans, the system did not work well. Poor communication
among bankers and inadequate data banks made it more difficult to identify poor credit risks.
The courts were also ineffective in convicting borrowers when fraudulent behavior led to
loan defaults.
The severe bank crisis of 1996 was a logical outcome of the failure of banks to adhere
to basic principles of sound commercial banking. During the crisis conservators were
appointed for 17 banks and bankruptcy proceedings were initiated. These 17 banks accounted
for one-third of overall banking system assets.
The introduction of the currency board in mid-1997 brought about radical changes in
the structure of the banking system as can be seen in the aggregates described in Table 3. The
currency board arrangement eliminated extremely distorted incentives in the commercial
banks. It also focused attention on the need to integrate the national banking system into the
international financial system, a prerequisite for the stability of the monetary regime. A major
step toward this goal was the restructuring of commercial bank through privatization of state-
owned banks and encouraging the entry of foreign banks.
Before 1995 a policy of restricting the presence of foreign banks had been pursued.
There was concern that domestic banks would be incapable of competing with large
international banks. In 1994, five years after the launch of banking sector reform, two foreign
banks' branches started operations in Bulgaria (Xios and ING Bank). In 1995 two more
foreign banks, BNP-Dresdner Bank and Ionian Bank opened By the end of 1999 more than
half of the 35 banks operating in the country were foreign banks or banks with foreign stakes.

THE BULGARIAN NATIONAL BANK

Brief History of the BNB

In January 1999 the Bulgarian National Bank (BNB) celebrated its 120th Anniversary.
The first governor of the BNB, appointed in 1897, was an officer in the Ministry of Finance
in Russia. Initially the BNB had no power to issue banknotes, and it struggled financially.
National coins of other countries were the principle medium- of-exchange in Bulgaria.
Because of distrust the BNB failed in its attempt to issue gold-backed banknotes in 1885.
During these early years the lack of sufficient gold reserves made it difficult for Bulgaria to
adhere strictly to the gold standard.
World War I brought on pressures to finance war expenditures by issuing fiat money.
Following the war Bulgaria struggled with attempts to return to the gold standard and in the
early 1930s faced a crisis when there was massive flight from the currency. This forced a
moratorium on foreign debt payments.
During World War II the BNB again financed government wartime expenditures.
After the war there was high inflation and commodity shortages. In 1947 the financial
system in Bulgaria was reorganized to become part of the centrally-planned economy. The
BNB became a ‘monobank’ with branches throughout the country.
After the creation of a two-tier banking system in 1989 the Law on the Bulgarian
National Bank (1991) and the Law on Banks and Credit Activity (1992) were passed. These
laws defined the role of the Bulgarian National Bank (BNB). The BNB was charged with
carrying out monetary policy and regulating the commercial banking system. During the
period leading up to the financial crisis in 1996 important weaknesses were revealed. Two
important problems stand out. The law provided for an independent central bank, but the
BNB was not able to resist political pressures. Secondly, while the BNB regulated the
banking system, many difficulties arose when the BNB tried to close insolvent banks.
When the transition began the hard currency reserves of the BNB were small. A
floating exchange system was adopted, but there was extensive intervention by the BNB in
the foreign exchange market. Between February 1991 and the beginning of the financial
crisis in 1996 the nominal level of the lev depreciated slowly. The one exception to
reasonable stability was in 1994 when the nominal exchange depreciated by about 50 per
cent. Because of the very high inflation rates the real exchange appreciated during most of
this period.
The BNB had several instruments to control the supply of credit. In the early 1990s
the most important instrument was credit ceilings. After the market for government
securities markets developed, credit ceilings were abandoned and the BNB tried to control the
level of bank reserves using open market operations.
Political pressures led to a rapidly growing money supply. These pressures operated
through two main channels. The government needed to finance large fiscal deficits.
Secondly, public concern that closing state enterprises would lead to layoffs, created pressure
to support these enterprises with bank loans. The BNB supported this process by refinancing
the commercial banks.
Supervision and regulation of the commercial banks was also problematic for the
BNB. While the BNB had the legal right to license banks, it did not have the power to
liquidate banks when they became insolvent. During the early 1990s the BNB had difficulty
forcing banks to close while the banks appealed the BNB’s decisions in the courts.
In response to the financial crisis of 1996 - 99 the IMF pressured Bulgaria to establish
a currency board. The establishment of the currency board created dramatic changes in the
financial system. The new Law on the Bulgarian National Bank (1997), which established the
currency board, fixed the nominal exchange rate and limited the discretion of the BNB to
alter the money supply
The establishment of the currency board reduced the growth rates of the money
supply. The movement of M2 for the 1990s is plotted in Figure 1. Before the currency crisis
in 1996 the money supply grew at a compound annual rate of 64 per cent. In 1996 and 1997
the money supply exploded, but in the two years after the establishment of the currency board
in July 1997, the money supply grew at 15 per cent per annum.
The regulatory power of the BNB was also expanded under the 1997 laws. The BNB
can now revoke a banking license and close a bank. Neither the bank nor the courts can
really contest this decision. The BNB used these new powers to place 17 banks, holding 25
per cent of banking system assets, in receivership. (OECD, 1999, p. 33)

Banking Supervision, Accounting and Deposit Insurance

Banking supervision

With the adoption of the Law on the BNB in 1991 the central bank was given
responsibility as the supervisor of commercial banks, brokerage financial houses and
exchange bureaus. Major BNB supervisory powers included granting of licenses for
conducting banking operations, adopting regulations, and carrying out both off-site and on-
site audits. In the case of violations the BNB was granted the power to appoint conservators
and, ultimately, to revoke licenses. The new laws passed in 1997 brought the Bulgarian law
into closer conformity with EU legislation and gave the BNB better control of the regulatory
process.
Under a currency board arrangement there are strict limitations on refinancing. This
has necessitated the adoption of stricter supervisory requirements for commercial banks. To
strengthen confidence much higher minimum capital adequacy, liquidity and asset
classification requirements were set. The general adequacy ratio was gradually raised from 8
per cent in 1997 to 10 per cent and ultimately to 12 per cent. Open foreign currency positions
of banks were also altered. The commercial banks are not required to hold a percentage of
their foreign currency assets in the reserve currency (euro). The ceiling for the other foreign
currency assets is 25 per cent of their equity.

Accounting

Until mid - 1995 there was no uniform chart of accounts for the banking system.
Commercial banks, the SSB and Bulbank (former Foreign Trade Bank) applied three
different accounting systems. It was not until June 1995 that uniform accounting standards
for the whole banking system were adopted. Although this was a serious step forward, a
number of weaknesses in their practical implementation remained.
Weaknesses reflected the disparity between national and international standards. For
example, under the law effective in 1995 government securities were recorded in commercial
bank portfolios at their face amount even though the market value of these assets was less
than half this value. This disparity concealed the actual state of bank assets. This proved to
be a time bomb. The financial position of the banks at the time of the crisis was much
weaker than had generally been understood.
In 1997, following the crisis, accounting legislation was modified so that it complies
fully with international accounting standards and EU directives.

Deposit insurance

Although the public may have implicitly believed there was some form of deposit
insurance, there was no formal insurance arrangement during the early 1990s. At the end of
1995 the Managing Board of the BNB adopted a regulation for banks to contribute to a
special insurance fund managed by the BNB. When the 1996 banking crisis stormed through
the banking system, the resources of this fund proved insufficient.
A law protecting deposits at insolvent commercial banks was quickly passed in May
1996. Although the government budget situation did not allow for a further increases in
domestic debt, the law was passed to avoid public discontent. The new law covered 100 per
cent of deposit losses of individuals and 50 per cent of deposit losses of legal entities. Under
this law the government issued government securities denominated in national and foreign
currencies to solvent banks which took over insolvent banks and committed to repay deposits
of the failed banks.
In 1997 when the currency board was introduced, the Law on Bank Deposit Insurance
was passed. A special deposit insurance fund in levs and foreign currency was established.
Commercial banks make mandatory annual premium contributions of 0.5 per cent of their
deposit base on 31 December. 95 per cent of deposits up to 2 000 levs are guaranteed. 80
per cent of deposits from 2 000 to 5 000 levs are guaranteed. The law also mandates that the
insurance agency exercise restricted supervisory powers over the commercial banks.

CURRENT STATE OF THE FINANCIAL SECTOR

The situation in the financial sector of the Bulgarian economy changed radically in
1997 with the creation of the currency board, the isolation of failing state enterprises and new
efforts to privatize the banking system. The first stage of the voucher privatization auctions
were also completed in 1997. Now that citizens had shares in nearly one thousand former
state enterprises, there were pressures to create a stock exchange. More attention was also
focused on developing better pension arrangements and improving the laws regulating
insurance companies.

Currency Board

The creation of a currency board with a fixed exchange rate of one Lev to the DM,
was established on the 1st of July 1997. The new institutional arrangements proved extremely
successful, and a new three-year Stand-By arrangement (lasting until the year 2001) was
negotiated with the IMF in mid-1998. On the 1st of January 1999 the DM was replaced by the
Euro as the currency against which the exchange rate was fixed (without any change in
nominal valuation versus the German mark.)
During the economic crisis of 1996 and 1997 neither monetary nor fiscal policy had
proved to be effective. The BNB was constantly bailing out banks on the verge of
bankruptcy, and the fiscal authorities were having to cope with an increasingly heavy burden
of servicing the debt. By 1996 government interest payments on this debt were 17 per cent of
GDP.
Under the currency board the Issue Department of the BNB is allowed to hold only
foreign (but not domestic) assets and is committed to buying and selling foreign or domestic
currency at the fixed exchange rate. As a result the BNB is no longer able to control the
money supply and the supply of domestic currency is now determined by demand at the
existing exchange rate, with foreign currency reserves always being sufficient to sustain it.
The implication for the fiscal authorities is that the deficit can be financed only through
external borrowing or the sale of state assets. This obviously entails more fiscal discipline
and a strengthening in the fiscal position. As for commercial banks they are no longer being
refinanced by the BNB in the event of a liquidity crisis. However the BNB still has access to
IMF funding for the possible extension of a loan to the Ministry of Finance, and still has a
Banking Department with a limited refinancing facility which can be used in an emergency
(systemic risk). Finally it was decided that the government should hold the majority of its
surplus accounts with the BNB (rather than commercial banks). This reduces the volatility
of the monetary base when IMF tranches are received or foreign debt payments are made.
Since the introduction of the currency board money supply growth has been linked to
balance of payments movements and inflation has dropped sharply reflecting the revised
expectations of agents. It was debated at the time whether an exchange rate of one Lev to the
DM was optimal, some economists arguing that a further devaluation would be beneficial in
terms of competitiveness, other expressing concern about the possibility of stronger
inflationary pressures. In fact, after initially being higher than forecast, inflation has been
tamed.
Progress has been considerable under the currency board. In the first two years, its
reserves doubled, and there have been clear benefits in terms of macroeconomic stability and
transparency of economic policy. In particular, the achievements on the fiscal consolidation
front have been impressive, with sizeable reductions in interest payments budget deficits
were very small in 1998 and 1999.

Bank Privatisation

Another area where there has been substantial change the last two years is the
privatisation of the banking system, largely to foreign interests. Rather than seeing foreign
banks as unfair competition, the entry of foreign banks is now seen as a way to increase
training, bringing in more expertise and improving the overall functioning of the commercial
banking system Prior to 1996 bank privatisation was suppose to be undertaken under the
direction of the BCC, but it was perceived to be a political issue rather than a means of
enhancing competitiveness in the economy. For this reason the BCC did not pursue any
concrete measures to accelerate the process. The year 1997 marked a turning point because it
was then that the first privatisation deal was concluded. The majority package of shares of
UBB, the third largest bank, was sold to the Openheimer Group and the EBRD. In 1998 four
state-owned banks were prepared for privatisation. One of them, the Bulgarian Post Bank,
was sold in the last quarter of 1998 to a consortium led by American Insurance Group. In
1999 two other big state-owned banks, Expressbank - Varna, and Hebrosbank - Plovdiv, were
purchased by Societe General and the Regent Pacific Group, respectively. In 2000 Bulbank
and Biochim CB are due to be privatised. The government's program envisages the
privatisation process in the banking sector to be completed by mid-2001 with the sale of SSB.
The comparatively long preparation period for the privatisation of the SSB is driven
by the necessity to restructure the SSB from a purely savings bank into a commercial bank.
The crisis and the establishment of the currency board were a turning point for the banking
system. Under a currency board system the central bank has no discretion to conduct
monetary policy. The growth rate of the money supply has slowed significantly and
commercial bank balance sheets have improved. The flow of easy credit to the real sector
has ceased. Indeed, since the establishment of the currency board, it has been very difficult
for firms to get any credit. An important remaining question is whether the banking system
can be reformed so that it becomes a reliable intermediary between savers and investors.
Student: Istratoaie Ana-Maria
Specializare: Adminstrarea afacerii
Grupa:3
Anul:2