bank performance and credit availability in the bulgarian banking sector, 1997-2001
TRANSCRIPT
This article was downloaded by: [Flinders University of South Australia]On: 03 October 2014, At: 05:44Publisher: RoutledgeInforma Ltd Registered in England and Wales Registered Number: 1072954Registered office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH,UK
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Bank Performance and CreditAvailability in the BulgarianBanking Sector, 1997-2001Didar Erdinç aa the American University in Bulgaria Blagoevgrad2700 , BulgariaPublished online: 23 Sep 2008.
To cite this article: Didar Erdinç (2004) Bank Performance and Credit Availabilityin the Bulgarian Banking Sector, 1997-2001, Journal of East-West Business, 9:3-4,137-161, DOI: 10.1300/J097v09n03_07
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Bank Performance and Credit Availabilityin the Bulgarian Banking Sector, 1997-2001
Didar Erdinç
ABSTRACT. The 1997 financial crisis wiped out 30% of the Bulgarianbanking sector and created severe strains on corporations. With the es-tablishment of the currency board in 1997 and the new Banking Law,which set the legal framework for proper bank supervision, major Bul-garian banks were rapidly privatized through sales to foreigners, nowcontrolling around 80% of bank assets. Since 1997, the Bulgarian bank-ing sector has recovered from the crisis by improving its profitability andefficiency and adopted a legal framework compatible with the EuropeanUnion standards. Based on a regression analysis of bank balance sheetsand income statements, this paper shows that low level of credit volumeduring 1997-1999 derived from banks’ cautious stance towards credit mak-ing reflecting both the ongoing risks in the real sector, and the stringentnew banking regulations. Large banks, however, benefited from scaleeconomies in improving profitability in the same period. [Article cop-ies available for a fee from The Haworth Document Delivery Service:1-800-HAWORTH. E-mail address: <[email protected]> Website:<http://www.HaworthPress.com> © 2003 by The Haworth Press, Inc. All rights re-served.]
KEYWORDS. Bulgarian banking crisis, bank privatization, credit in-termediation, and bank efficiency and profitability, Bulgaria’s compliancewith European Union standards in bank regulation
Didar Erdinç is Assistant Professor of Economics at the American University inBulgaria, Blagoevgrad 2700, Bulgaria (E-mail: [email protected]).
Journal of East-West Business, Vol. 9(3/4) 2003http://www.haworthpress.com/web/JEB
2003 by The Haworth Press, Inc. All rights reserved.Digital Object Identifier: 10.1300/J097v09n03_07 137
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INTRODUCTION
Since 1997, the Bulgarian banking sector has been recovering froman acute financial crisis triggered by the accumulation of bad loans, un-sound banking practices and lax banking supervision against the back-ground of rapidly deteriorating macroeconomic balances during thefirst half-decade of transition from a planned to a market economy. At theheart of the banking problems were the severe macroeconomic instabil-ity due mostly to economic mismanagement, half-hearted attempts atbanking reform and loss-making enterprises, which left poorly-man-aged banks with a large bad debt problem, undercapitalized and insol-vent. The 1997 crisis wiped out some 30% of the entire banking sectorwith the closure of 17 banks.
Yet, the banking sector rebounded dramatically, thanks to the bankconsolidation and tightening of regulation and supervision with the adop-tion of the new Banking Law in the aftermath of the crisis, but at leastas important, due to the achievement of macroeconomic stability inthe few months following the adoption of the currency board arrange-ment.
Indeed, the Bulgarian currency board has been a tremendous success:The economy recovered rapidly from hyperinflation and resumed growthat a modest 3-4% per year while interest rates came down to 5% afterreaching 200% at the height of the crisis. But the greatest success wasthe discipline imposed on the fiscal accounts and the banking sector.With the discretionary lending of the Central Bank to commercial banksseverely curtailed, bank financing of state enterprises stopped and thisforced them to restructure. A fundamental change in the composition oflending occurred away from credits to the public sector towards morelending to the private enterprises. Two sources of bank risks, interestand exchange rate risks were drastically reduced as Bulgarian Lev (BGL)was pegged to DM.
Since then, Bulgaria adopted a strategy of bank reform toward theprivatization of domestic banks, namely through sales to foreign strate-gic partners, and tightened banking regulations to converge to EuropeanUnion Standards. In both areas, progress to date has been substantial:Bulgarian banks currently satisfy most of the European standards onbanking practices and boast a share of private assets in the order of 82 %as compared to only 30% at the end of 1996. Entry of foreign banks re-sulted in a fundamental change in bank ownership patterns, leading to adomination of foreign-owned banks in the sector. Currently, foreign-owned banks control around 80% of banking sector assets (Table 1).
138 JOURNAL OF EAST-WEST BUSINESS
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With only 2 large state-owned banks (State Savings Bank (DSK) andBiochim) awaiting privatization to be concluded by 2003, thesestate-owned banks hold less than 20% of total bank assets after the pri-vatization of Bulbank, the largest bank in Bulgaria, in 2000. Hence,bank privatization in Bulgaria is almost complete and the country nowholds one of the leading positions in terms of bank privatization, sur-passed only by one or two candidate countries for the European Union.
One of the key challenges facing the Bulgarian economy during1997-2002 was the observed tendency of the banking sector to refrainfrom credit making to private businesses and a strong preference for li-quidity and over-capitalization. Several studies (Levine, Luayza, & Beck,2001) indicate that the level of financial intermediary development ex-erts a positive influence on development and growth. In the absence ofalternatives, private firms almost exclusively rely on bank credit fortheir financing needs. Yet, credit intermediation to the private sector re-mained extraordinarily low at 14.8% of GDP in 2001 while registering amodest increase from 12.2% in 1999. Banks regulated towards safetyunder the 1997 Banking Law which imposed high reserve and liquidityrequirements and loan loss provisions exhibited an extremely risk-aversebehavior and refrained from credit making to new private firms withshort track records. This generated a significant credit crunch during 1997-1998 with negative effects on business growth and bank profitability.Only in the last two years, especially large banks with strong scaleeconomies improved profitability by expanding private loans. Still weakcontract enforcement and protection for creditor rights, absence of ac-counting standards that produce comprehensive and comparable corpo-rate financial statements hamper the development of efficient creditallocation.
Although entry of foreign banks into the sector stimulated competi-tion to some degree, it is too early to determine whether their participa-tion will contribute in a significant manner to the credit intermediationprocess and to the deepening of the financial sector through further di-versification in banking services. So far, the result has been mixed:True, foreign banks compensated for the lack of expertise in loan evalu-ation and monitoring and offered new banking products. But so far,their support for the private sector through loans has only been limitedas these banks preferred to channel funds abroad to safe assets insteadof high-risk lending to businesses. Their major complaints center on theinadequate legal and accounting system, lack of transparency in com-pany books and weak contract enforcement and protection of creditors’rights in Bulgaria.
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Prior to joining the European Union in 2007, Bulgaria is expected tobuild stable, efficient, well-regulated and competitive financial marketsand institutions with diversified instruments and banking services. Adaptinglegislative framework and banking regulations to European standards isby no means a guarantee for a smooth integration to the European finan-cial markets unless the institutional basis of the banking sector is strength-ened.
This paper evaluates the progress of the Bulgarian banking sector after1997 with reference to the level and efficiency of credit intermediation,progress in developing a sound legal framework, market concentration,and bank performance indicators on profitability, capitalization and as-set quality. In the process, the paper also accounts for the factors, whichled to an undesirably low level of credit intermediation in Bulgaria. Theplan of this paper is as follows: Next section describes the banking crisisof the 1997 period and discusses its impact on the post-crisis bank be-havior. Later, the paper evaluates the relevance of financial repression
140 JOURNAL OF EAST-WEST BUSINESS
TABLE 1. Domestic Credit and Bank Assets as % of GDP
1995 1996 1997 1998 1999 2000 2001
Domestic Credit 72.1 115.0 30.1 19.6 18.6 18.3 21.5
Government sector 32.2 51.5 9.6 2.4 0.7 1.9 1.7
Non-government sector 39.9 63.4 20.5 17.2 17.9 16.4 19.8
Claims on non-financialpublic enterprises
18.3 26.5 7.4 4.4 3.1 1.7 1.3
Claims on privateenterprises
20.4 35.3 11.6 10.4 12.2 12.2 14.8
Claims on households 0.6 0.2 1.0 2.2 2.3 2.4 3.4
Claims on non-bankfinancial institutions
0.5 1.4 0.5 0.2 0.2 0.1 0.1
Domestic Credit as % ofM3
108.7 153.4 85.3 64.1 57.6 50.1 47.2
Broad Money as % ofGDP
56.9 44.4 25.0 28.1 28.9
Deposits as % of GDP 59.3 67.7 27.6 22.5 27.1
Bank Assets 113.6 207.6 43.3 34.8 36.4
State-owned banks 67.4 75.4 73.7 54.4
Foreign-owned banks 0.3 1.1 15.2 19.1 33.6
BranchesofForeignBanks 0.5 1.2 8.1 7.1 5.6
Source: World Bank, Bulgaria (May 2000) and BNB reports.
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and credit rationing paradigms for providing an explanation for thecredit crunch observed during the 1997-1999 period. Section on the re-vival of the Bulgarian banking sector analyses the bank performance in-dicators on efficiency and profitability and is followed by the regressionanalysis on the determinants of bank profitability in Bulgaria during the1995-1999 period.
THE 1996-1997 BANKING CRISIS
In mid-1996 the Bulgarian banking system was on the verge of a col-lapse: After years of heavy financing of loss-making state-enterprisesthrough soft loans at preferential rates and excessive crediting of affili-ated companies often through corrupt deals, commercial banks, bur-dened with large amounts of bad loans, recorded negative net worth andsuffered from chronic illiquidity and insolvency which culminated in anacute banking crisis in 1996-1997 under conditions of deteriorating macro-economic conditions.
Faced with the transition shock characterized by loss of export mar-kets, dramatic contraction in output, high inflation and depreciating lev(BGN), many state-owned enterprises began to register losses and turnedto banks to temporarily escape hard budget constraints and delayed re-structuring and liquidation. Meanwhile, in the absence of effective legalframework for supervision and control over banks’ lending activities,new private banks surfacing on the banking scene due to low start-upcapital, expanded risky credit uncontrollably to affiliated companies.Availability of credit from BNB sources and loose capital and provisioningrequirements resulted in a moral hazard problem and distorted banks’incentives towards risky deals. As a result, credit volume reached a levelunseen in any other transition economy, growing to 115% of GDP. By1996, however, around 41% of the loans extended by banks proved irre-coverable and only 39% of total credits extended by private banks werebeing regularly serviced. The growing de-capitalization of the bankingsector together with the crash of several “financial pyramids” triggereda loss of credibility and bank runs which resulted in massive withdraw-als of deposits from the system, contributing to the chronic illiquidityproblem among banks.
In 1996, about one-third of the total number of banks were declared in-solvent and were closed. Fourteen banks with assets around a quarter ofthe banking sector were put under conservatorship. In 1996, bankruptcyprocedures against 5 Bulgarian banks were initiated pursuant to the new
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Banking Law. The crisis peaked at the beginning of 1997 when another 9banks were put under conservatorship and about 10 banks went bankruptafter a court’s decision. Thirty-three banks survived the crisis.
Privatization of Major State Banks
With the closing of 17 banks, a major step towards consolidation wasachieved by weeding out the bad segment of the banking sector in 1997.From then on, the Bank Consolidation Company (BCC)1 embarked onprivatizing of these large state banks through sales to foreign strategicinvestors. Until 1997, political constraints hampered bank reform andrestructuring and delayed bank privatization. As the new government cameto power, represented by the United Democratic Forces (UDF), bankprivatization gained momentum. During the 1997-2000 period, out of 6
142 JOURNAL OF EAST-WEST BUSINESS
TABLE 2. Number of Commercial Banks by Category
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Large Banks 3 4 6 9 9 6 6 6 7 7 7
Ownership by Type
State 3 4 6 9 9 6 5 4 3 2 2
Private 0 0 0 0 0 0 1 2 4 5 5
Ownership byCountry
Bulgarian 3 4 6 9 9 6 5 4 3 2 2
Foreign 0 0 0 0 0 0 1 2 4 5 5
SmallandMedium-Sized Banks
75 76 34 29 28 19 22 20 20 20 21
Ownership by Type
State 69 65 19 6 3 1 1 1 3 2 2
Private 6 11 15 23 25 18 21 19 17 18 19
Ownership byCountry
Bulgarian 75 76 34 29 25 14 14 12 9 8 8
Foreign 0 0 0 0 3 5 8 8 11 12 13
BranchesofForeignBanks 0 0 0 2 4 4 5 7 7 7 7
Savings Banks 1 1 1 1 1 1 1 1 0 0 0
Total
Source: Yotzov, 2002
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large state-owned banks under the control of BCC, which accounted for60% of assets of the banking sector, ownership of 5 banks was trans-ferred to foreigners (United Bulgarian Bank in 1997, Bulgarian PostBank in 1998, Expressbank in 1999, Hebrosbank in 1999, Bulbank in2000). By 2000, as a result of these privatization deals, private bank as-sets rose to 83% of the entire bank assets while foreign ownership ac-counted for more than three quarters of the banking sector.
THE 1997-1999 CREDIT CRUNCH:WAS IT DUE TO FINANCIAL REPRESSION
OR CREDIT DISINTERMEDIATION?
In the post-crisis period, banks made substantial progress in achiev-ing stability and soundness: The sector is now well-capitalized, highly-liquid and modestly profitable (Tables 3 and 5). In fact, the sector hasbeen overcapitalized with capital adequacy ratios as percentage of therisk-weighted assets well above the required levels in the range of anextraordinarily high level of 40% since 1997, a significant improvementover the low capital base of only 5.5% in 1996.2 Overcapitalization cou-pled with a preference for liquidity reflected banks’ concern for solvencyand stability under the stringent regulatory environment.
As Table 3 shows, GS/TA and NetBank/TA ratios indicate a large re-liance on low return government securities and foreign bonds to secureliquidity.3 At the end of 2000, NetBank/TA accounted for a record levelof 39.8% on average of total bank assets, reflecting more than 2.5 timesincrease from 1995 (Table 4, Miller and Petranov, 2001).A comparison of 1995 and 2000 reveals that the ratio of government se-curities to total assets (GS/TA) declined from 32% in 1995 to 15.4% in2000 (Table 4). This decline was entirely due to the lower volume ofgovernment securities issues by the government due to the fiscal disci-pline imposed under the currency board.
Foreign-owned banks also placed excess funds, mostly as deposits inparent companies given the difficulties in lending to the real sector. Therewas substantial variation in terms of profitability both in terms of ROAand ROE measures among the Bulgarian banks. On the credit side,branches of foreign banks (Group V) were more willing to extend loansto the private sector than the rest while large banks (Groups I and II) putmore emphasis on lending to individuals in the form of consumer andreal estate loans.
High liquidity in the banking sector came as a mixed blessing in thepost-crisis period: it was indicative of extreme risk aversion among
Didar Erdinç 143
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144
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banks, deeply rooted in the chaotic recent history of the sector. Hence,in the two years following the crisis, Bulgarian banks pursued a conser-vative policy towards lending, and maintained a large proportion of as-sets in low-risk domestic and foreign securities, sometimes in the orderof 40% of assets. This was a clear sign that banks chose to be extremelyprudent in terms of risks that related to the economic environment in thecountry which registered modest growth rates during the same periodafter contracting significantly until 1997. In the process, domestic creditfell drastically from 67% in 1995 to a mere 19% of GDP in 1999 (WorldBank Report, May 2000: 8).
In 1999, commercial bank loans extended to the private sector repre-sented less than one-third of banks’ total assets, while bank lending toprivate sector stood at 12.2% of GDP (Table 1). When compared withthe average 17% for other transitional countries, and 60% for Czech Re-public, as well as the developed countries with 49% for the USA and120% in the United Kingdom, this low level of credit activity under-lined a significant financial disintermediation in the country with ad-verse effect on its growth prospects.4
As is evident from the broad money and deposit indicators, the publictrust in the banking system is still by no means fully restored despite theexistence of deposit insurance (Table 1). Broad money as a share of GDPis still about 30%, extremely low as compared with other transitionaleconomies such as Slovakia with an equivalent figure of 71%, and theCzech Republic with 75%, and Germany with 131%.
Financial repression paradigm of McKinnon and Shaw (1973) ac-counts for the low level of credit activity with reference to regulatory re-strictions in the form of high reserve requirements, interest ceilings andquantitative restrictions on loans. Until 2000, Bulgarian commercial bankswere obliged to maintain 11% of deposits as reserves. High reserve re-quirement ratio5 repressed the credit volume and bank profitability untilthe year 2000. Banking circles through the Bulgarian Association ofCommercial Banks became increasingly vocal about its adverse effecton bank profitability and lending activity in the same year (Lilova, 2000).
In fact, banks chose to hold liquid instruments in their portfolios aboveand beyond the minimum requirements. With shallow short-term moneymarkets, banks were obliged to maintain high liquidity as they mightface unexpected large withdrawals and nonrenewal of credit lines byother intermediaries. Bankers also viewed the regulations on loan lossprovisioning as overly restrictive. In 2000, the reserve requirement ratiowas reduced from 11% to 8% with a positive impact on credit availabil-ity. Since then, credit somewhat rebounded, lending credence to the view
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that financial repression, at least to a certain extent, was responsible forthe low level of credit activity during the 1997-1999 period.
Although credit disintermediation can be attributed in part to semi-repressed financial environment, Bulgarian banks’ prudent behavior to-wards lending can be best explained with reference to the credit rationingtheory (Stiglitz and Weiss, 1981). This is particularly relevant for a tran-sition economy going through enormous change with future prospectsdifficult to predict. Low lending was optimal from the perspective ofbanks by virtue of the fact that transition-specific circumstances such aslargely unpredictable sweeping institutional changes, radical shifts ingovernment’s economic policies regarding business, fast pace of privat-ization inevitably created new sources of uncertainty and aggravatedthe imperfect information problem regarding the quality of loan appli-cants, thereby drastically increasing the credit risk. Imperfect informa-tion about the quality of loan applicants in a transitional environmentcharacterized by substantial firm exit and new entry made for an uncer-tain customer base. Bank information capital was destroyed due to therestructuring process at the enterprise level, which rendered several oldcustomers suddenly uncreditworthy. Imperfect legal environment withweak contract enforcement and difficulties faced in assessing and seiz-ing collateral in the event of default when combined with limited exper-tise in loan evaluation and monitoring strengthened risk perceptions,leading banks to make loans exclusively to established customers at theexpense of new businesses.
At the heart of the low level of lending was the drastic but welcomechange in the composition of credit that took place in 1997-1999, whichbenefited the private economy at the expense of the state sector. First, anumber of state-owned enterprises were closed down and the isolationprogram eliminated easy access to commercial credit, leading to the dis-appearance of old customers.
146 JOURNAL OF EAST-WEST BUSINESS
TABLE 4. Comparison of Selected Indicators of Commercial Banks
1995 2000
LIQ/TA 9.4 7.6
NETBANK/TA 15.3 39.8
GS/TA 32.0 15.4
Credit/TA 36.7 30.9
Source: Adapted from Miller and Petranov, 2001.
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As a result, banks substantially reduced their exposure to the state-ownedenterprises undergoing privatization and restructuring. Credit to thegovernment sector and the declined from 32% in 1995 to 2% in 2000,while the credit to the non-financial state-owned enterprises droppedfrom 18.3% to 1.7% of GDP during the same period (Table 1).
Second, the share of banking sector claims on the private sector reg-istered a slight increase from 11.6% of GDP in 1997 to about 12.2% in2000. A dramatic shift in the composition of bank lending took place inthe post-crisis period as the share of loans to private sector in total cred-its ballooned to 80.4% in 2000, increasing from 20.7% in 1996 (Millerand Petranov, 2001).
The entry of foreign banks in the sector fostered competition and im-proved efficiency and profitability (Tables 4 and 5). Strikingly, how-ever, foreign domination in the sector did little to improve the creditoutlook during the 1998-1999 period, despite their expertise in loanevaluation and monitoring. Although foreign banks expanded credit at ahigher rate than their domestic counterparts, especially in 2000-2002,uncertain transitional environment and underdeveloped legal frame-work prevented them from taking an aggressive approach to fundingnew private businesses at the expense of profitability.
There are several additional reasons why foreign involvement in thebanking sector has failed to improve credit allocation. First and fore-most, contract enforcement is still quite weak in the absence of effectivecourt proceedings to resolve financial disputes, and laws regarding thebanks’ right to seize collateral in the event of default are cumbersome.Bankruptcy and liquidation procedures remain fraught with ambiguityand uncertainty. Hence, weak legal and judicial environment reducesthe probability of recovering losses in the case of default. Second, evenwhen banks strengthen their capacities for credit and project risk assess-ment, particularly for the small and medium size enterprises, lack of fi-nancial transparency at the company books understandably poses an ob-stacle for credit risk assessment in the absence of rigorous accounting andauditing standards. Such institutional deficiencies might have added tothe perceived credit risks, leading Bulgarian banks to make loans exclu-sively to established customers at the expense of new businesses in1997-1999.
In 2000-2002, there was a visible tendency among banks to expandloans and reduce cash holdings. Although this, in part, reflected the re-duced incidence of financial repression, it was also the result of in-creased pressure on banks to enhance profitability by developing exper-
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tise in loan evaluation and monitoring. The sector also diversified intoconsumer loans to improve profitability.
REVIVAL OF THE BULGARIAN BANKING SECTORIN THE POST-CRISIS PERIOD
Although still modest, profitability of the banking sector improvedsubstantially during the 1997-2000 as the average total return on assets(ROA) increased from 1.5% in 1998 to more than 3% despite the exis-tence of a wide variance among different banks. During 1997-1999, it wasespecially difficult for banks to generate adequate profits as they reliedmostly on low-yielding government securities. Hence, the major sourceof profits remained as non-interest income, reflecting the low credit ac-tivity in the sector.
Large banks (Group I and II in Table 3) consistently outperformedsmall and medium-sized banks in terms of profitability as is evidentfrom ROA indicator in Table 5. In 1997, when small and medium banksexperienced losses, large banks maintained profitability. Table 5 shows
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TABLE 5. Bank Profitability and Capital Adequacy (%)
1995 1996 1997 1998 1999 2000 2001
ROA
Large Banks (*) �0.1 3.3 6.8 2.0 3.0 4.8 3.4
Small & MediumBanks
�1.3 2 �0.6 0.9 1.4 0.8 0.7
ROE
Large Banks �2.6 86.2 303.1 36.5 30.2 29.6 24.4
Small & MediumBanks
�6.7 13.2 �6.0 6.9 10.5 5.7 5.2
Leverage
Large Banks 25.0 43.7 17.0 9.0 8.3
Small & MediumBanks
5.8 8.3 6.4 6.6 7.0
Capital/Assts 5.1 4.3 7.9 10.4
Capital Adequacy 5.5 26.8 36.7 41.7
Inflation (CPI) 310 578 1 6.2 11.4
Source: (*)Assets > EUR 200 million. BNB annual reports, OECD Economic surveys: Bulgaria (1998).
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the evolution of leverage (attracted funds divided by capital) ratios forlarge and small and medium banks for the period 1996-2000. Althoughthe difference is narrowing, large banks attract 3 to 4 times more fundsper unit of capital than their smaller competitors.
As for the market structure, top 6 banks account for about 60% ofdeposits while top 12 banks dominate the overall market by controllingbetween 80-85% of the deposits. Although competition intensified inthe last few years with the entry of foreign banks, the sector still is dom-inated by a handful of banks in terms of deposits and loans despite theexistence of a large number of banks (35 banks) of varying sizes. Ex-perts consider the current market concentration adequate for healthycompetition among banks in a relatively small country like Bulgaria.Still, there are too many small banks, which are inefficient, and bankmergers may help consolidate the sector, improving profitability. Ideally,Bulgarian banking sector can sustain 7-8 large banks as industry leaderswith a small number of “boutique” banks specialized in certain finan-cial services.
The credit risk also declined in the post-crisis period: At the end of1998, the share of standard loans and exposures reached 83.4%, up from58.0% in 1996 (Table 6). By 2001, of total outstanding loans, non-per-forming loans within the banking sector decreased from 13.8% in 1999to 7.7%. Although this ratio is still high by European standards, the sec-tor has been continually improving its expertise in loan evaluation andmonitoring, making fewer mistakes in customer selection.
Reflecting the high credit risks associated with the recovering econ-omy, the lending rates remained high at 12.4% in 1999, while the de-posit rates stood at a low 3.24%. Although record low since 1993, theaverage lending spreads were still high (at around 9%) by internationalstandards in 1999. This was primarily due to banks’ reluctance to lowerthe interest rates for their borrowers, and their preference for non-pricemethods of competition among themselves but also their ability to passhigh operating costs onto their customers. Prior to the 1997 crisis, lend-ing rates remained extremely high due to the financial troubles of thestate-owned banks burdened with a large portfolio of non-performingloans. However, in the post-crisis period, lack of credible competition,the large provisioning expenses, and a limited borrower base created re-sistance to lowering lending rates (World Bank Bulgaria, 2001). Newbanks that entered the sector after 1997 preferred to compete based onnon-price methods such as new banking services instead of offeringlower lending spreads for business loans. Still, decreasing lending spreadsduring the 2000-2001 period implies that efficiency of bank intermedia-
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tion has been gradually improving. Lending spreads are expected to de-cline further as price competition increases with the conclusion of twomore privatization deals and prospective consolidation through mergers.
COMPLIANCE WITH THE EUROPEAN UNION STANDARDSIN BANK REGULATION
As a candidate country for accession to the European Union, Bul-garia progressed considerably in harmonizing its banking regulationswith the European Union directives so as to facilitate its integration in2007. Since the adoption of the new Banking Law in 1997, the develop-ment of the legal and supervisory framework for the banking sector closelyreflected the strong desire of the policy makers to meet the criteria forfuture EU accession. Indeed, the prospect of joining the EU provided acatalyst for a rapid reform in bank supervision and the regulatory frame-work accompanied by a commendable progress in the area of bank pri-vatization.
The 1995 European Union White Paper recommends a sequencingapproach for the adoption of its directives in the financial sector, namelyStage 1 and Stage 2 measures aimed at establishing a well-regulated,stable and competitive system in accordance with market-based rules. Bul-garia has largely implemented Stage 1 directives which called for freecapital movements and elimination of restriction on the provision ofdifferent types of financial services in banking and non-banking sectors(Yotzov, 2002). The Stage 2 measures are concerned with the creation
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TABLE 6. Efficiency of Credit Intermediation in the Banking Sector
1995 1996 1997 1998 1999 2000 2001
Lending Spreads** 20.86 86.33 10.49 9.89 8.87 8.00
Total Credit (EURmillion)
2334.2 2577.9 3781.0 4419.4
Standard 58.0 78.8 83.4 86.2 91.8 92.3
Watch 8.6 3.7 4.7 4.4 2.8 2.9
Substandard 5.9 2.7 2.4 1.4 1.2 0.8
Doubtful 4.7 2.0 0.7 0.9 0.8 0.7
Loss 22.7 12.9 8.6 7.2 3.4 2.7
Provisions – 22.7 12.3 10.0 6.5 5.2
Source: BNB Annual reports. (**) BNB and World Bank Staff estimates (World Bank, May 2000).
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of more sophisticated and well-functioning institutional arrangementsand legal infrastructure compatible with a competitive and well-regu-lated financial sector.
As is evident from Table 7, Bulgaria complies with most of the EUdirectives in the area of the prudential standards related to banking al-though further steps should be taken prior to accession to bring thesestandards fully in line with the EU standards. Most of these prudentialregulations are satisfied sometimes in excess of the requirements, as inthe case of capital adequacy, reflecting the concerns of the authoritieswith bank stability in an uncertain transitional environment.6 There isfurther need to harmonize these regulations upon entry to the EU. Forinstance, the European Central Bank establishes a level of minimum re-quired reserves amounting to 2% for the commercial banks operating inthe Euro zone and accrues interest on the required reserves. The samerate is 8% for Bulgarian banks and these reserves earn no interest, creat-ing a form of reserve tax which contributes to the lending spreads andhence, the cost of credit intermediation.
Bulgaria still needs further refinements in the area of property rightsprotection, bankruptcy and pledge laws to strengthen contract enforce-ment. The judicial system has to be reformed towards more flexibility toadapt to the changing legal infrastructure in the Bulgarian banking sec-tor and its capacity to enforce these laws must be strengthened. Amend-ments to the Banking Law of 1999 which facilitated the liquidation pro-cess of failed banks represent a desirable move in that direction.
METHODOLOGY
A panel data comprising a representative sample of 19 banks whichaccount for around 85% of the banking sector assets in 1995-1999 isused to capture quantitatively some of the key determinants of profit-ability in the Bulgarian banking sector. The dependent variable in theregression analysis is the profitability indicator, ROA (Rate of Returnon Assets). This variable is regressed on several determinants of profit-ability to assess their relative significance in affecting banks’ profitabil-ity. First, the regression analysis attempts to assess the differential impactof bank size on profitability to see whether there exist substantial scaleeconomies in Bulgarian banking. In particular, banks are classified ac-cording to their size, namely Group I comprising large banks (with bankassets in excess of 300 million BGL) and Group II including small andmedium-sized banks. Dummy variable “Large” takes on a value of 1 if
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the bank belongs to Group I, and 0 if it is from Group II. If the sign ofthis variable is found to be positive, then large banks may be consideredmore profitable as compared to the small and medium-sized banks. Thisfinding may be indicative of scale economies in banking such that largebanks with extensive branch networks across the country may bethought to benefit from raising deposit funds at a lower cost than theirsmaller counterparts. Second, comparing the pre-1997 crisis and post-1997 crisis bank behavior for 1995-1996 and 1997-1999, the regressionanalysis gauges the impact of relative macroeconomic stability underthe Currency Board and the strict regulatory environment ensured bythe new Banking Law (1997) on the performance of the banking sector.As discussed before, during the 1997-1999 period, banking sector inBulgaria displayed a very cautious attitude towards credit making be-cause of their concerns about the ongoing risks in the real economy. Inaddition, stringent prudential regulations imposed on banks were highlyeffective in curtailing credit to businesses. The dummy variable,D9799, takes on a value of 1 for the 1997-1999 period and 0 if the data isfrom period 1995-1996. If the sign of D9799 is found to be positive,then it means that bank profitability improved in this period relative to1995-1999. To identify the sources of bank profitability, in addition tosize effects, three financial ratios, namely GSTA (government securi-ties/total assets), CATA (bank capital/total assets) and CRTA (bankcredit/total assets) have been generated based on bank balance sheetsand income statements. Expected signs for these explanatory variablesare provided below.
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TABLE 7. Bulgaria’s Compliance with EU’s Prudential Standards in Bank Regulation
• Capital Adequacy (risk-weighted): 12 percent (1999) (identical to the EU requirement)
• Tier I Capital or risk adjusted assets (see EC directive 89/647): 6 percent.
• Maximum single party exposure: 25 percent of own funds (identical to the EU requirement)
• Aggregate large exposure: 8 times the bank’s own capital (identical to the EU requirement)
• Aggregate exposure to a single party: 10 percent of capital (15 percent of capital in EU)
• Exposure limit to connected companies: 10 percent of capital (20 percent in EU)
• Open forex position: 30 percent of capital per currency; 60 percent of capital for aggregate-Euro excluded (No standard in EU)
• Minimum required reserves: 8 percent of the entire deposit base (prior to June 2000, itwas 11 percent), no interest paid on reserves (2 percent in the EU which accrues interest)
Source: Bulgarian National Bank
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Description of the Data Set and Variables
The data set comprises the financial ratios of 19 banks for the period1995-1999 with 95 observations. It was split based on the size and own-ership characteristics of banks such that there are 7 Large State Banksmaking up for 60% of the banking sector assets and include State Sav-ings Banks (Bank DSK), Bulbank, Hebros Bank, Express Bank, Biochim andCentral Cooperative Bank and United Bulgarian Bank (UBB). With theexception of UBB (July 1997), none of them has been privatized duringthe data period 1995-1999. Small and Medium Private Banks group in-cludes 12 banks with both domestic private and foreign majority owner-ship, controlling around 25% of the banking sector in terms of assets.These banks are Bulgaria Invest-CB, Economic and Investment Bank(BRIBank), Corporate Commercial Bank, Eurobank, First East Interna-tional Bank, First Investment Bank, International Bank for Trade andDevelopment, International Commercial Bank, Municipality Bank, Neft-invest Bank, Rosseximbank, Union Bank.
Following financial ratios and dummy variables were included in theregression equations:
• ROA–Return on assets of an individual bank calculated as its af-ter-tax profit divided by its total assets.
• GSTA–Government securities portfolio held by an individualbank divided by its total assets.
• CRTA–Total credit of an individual bank divided by its total assets.• CATA–Bank Capital of an individual bank divided by its total assets.• Large–Dummy variable which takes on a value of 1 if the bank
belongs to Group I (Large).• D9799–Dummy which takes on a value of 1 if the observation be-
longs to the period 1997-1999.• GSTALarge–Interactive term which measures the differential ef-
fect of GSTA ratio on bank profitability for large banks.• CRTALarge–Interactive term which measures the differential ef-
fect of CRTA ratio on bank profitability for large banks.• CATALarge–Interactive term which measures the differential ef-
fect of CATA ratio on bank profitability for large banks.• D9799Large–Interactive term which measures the differential ef-
fect of the post-crisis period on bank profitability for large banks.• GSTAD9799–Interactive term which measures the differential ef-
fect of GSTA ratio on bank profitability in post-1997 crisis period.
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• CRTAD9799–Interactive term which measures the differential effectof CRTA ratio on bank profitability in the post-1997 crisis period.
• CATAD9799–Interactive term which measures the differential ef-fect of CATA ratio on bank profitability in the post-1997 crisis period.
Expected Signs for the Explanatory Variables
• CRTA–Positive; credits increase interest income, and given largelending spreads, should have a significant positive effect on profit-ability as measured by ROA.
• GSTA–Negative; a larger share of government securities earningshould reduce profitability if they substitute for loans which gener-ate higher interest income.
• CATA–Positive or Negative; The risk of bankruptcy and insol-vency is lower when banks have larger capital base with a positiveeffect on profitability. Large capital base may also reduce the costof deposits attracted by banks. But banks with greater capital gen-erally exhibit more risk-averse behavior and invest in low returninstruments such as government securities which negatively affecttheir profitability. If this effect dominates, the sign could turn neg-ative.
• Large–Positive; Economies of scale and market concentration arepositively correlated with size and has a positive effect on profit-ability. Moreover, Bulgarian depositors prefer to keep their fundsin large banks for confidence reasons after the collapse of manysmall banks during the 1997 banking crisis.
• D9799–Positive or Negative; Macroeconomic stability after 1997lowered credit risk. Making loans during this period should have apositive effect on profitability. Yet, stringent regulations, and tran-sitional uncertainty might have a negative effect on profitability,the net effect depending on which of these two factors dominates.
Interpretation of Empirical Results
Table 8 contains the regression results corrected for heteroscedasticitythrough the Weighted Least Squares (WLS) method due to the exis-tence of substantial amount of variation within the banking sector interms of profitability, size and investment portfolio. T-statistics and p-val-ues were given in parentheses. Although the regressions have relativelypoor fits with R square values (Adjusted R square) values ranging from
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12% (7.3%) to 30% (17%), the signs of the coefficients are in agreementwith expectations given the characteristics of the banking sector and itsenvironment.
Results show that bank profitability in Bulgaria very much dependson credit making rather than investing in low return government securi-ties. This was especially the case during the 1997-1999 period charac-terized by relative economic stability and reduced risks in credit making.The signs of the interactive variables GSTAD9799 and CRTAD9799 are neg-ative and positive respectively and highly significant. This suggests thatduring 1997-1999, relative to the pre-crisis period of 1995-1996, creditmaking proved to be a more profitable activity for banks. Hence, bankswith a larger share of credit in their investment portfolio improved prof-itability more than others which kept a high share of low-yielding gov-ernment securities and foreign bonds at the expense of loans tobusinesses. When these results are interpreted in the light of the break-down of financial indicators among different types of banks (Table 3)
Didar Erdinç 155
TABLE 8. Regression Results on Bank Profitability
Sample Size 95 95 95
ROA DependentVariable
Explanatory Vari-ables
Regression I Regression II Regression III
GSTA 0.173 (0.422) – –
CATA 0.142 (0.493) – –
Large 0.253 (0.001)* 0.233 (0.00)* –
D9799 0.007 (0.411) – –
GSTALarge – – –
CRTALarge �0.444 (0.13)** �0.428 (0.002)* –
CATALarge �0.400 (0.108)** �0.287 (0.139)* –
GSTAD9799 �0.430 (0.064)* �0.205 (0.027) �0.111 (0.18)
CRTAD9799 0.131 (0.278) 0.110 (0.09)* 0.129 (0.074)*
CATAD9799 �0.219 (0.284) – �0.0056 (0.429)
D9799Large – – 0.0085 (0.00)*
R-squared 29.6% 18.7% 12.5%
Adj. R-squared 17.0% 13.0% 7.3%
Note: (*) indicates significance at 10% and (**) indicates significance at 15%.
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along with the negative sign of CRTALarge, smaller banks in Group IImight have benefited more in terms of profitability from expandingloans to businesses. This may be indicative of their better expertise inloan evaluation and monitoring under private and foreign ownership.
Moreover, the signs of both Large and D9799Large variables are sig-nificant and positive; this indicates that large banks are generally moreprofitable than the small and medium-sized banks in Bulgaria and suchbanks became even more profitable after 1997. This reflects the pres-ence of strong scale economies in Bulgarian banking and the relativeadvantage of large banks in raising low-cost deposits through their branchnetworks.
The sign of CATALarge is consistently negative; large banks with greatercapital base tend to exhibit more risk-averse behavior than other smallerbanks with lower capital base and invest much more prudently at the ex-pense of their profitability. CRTALarge is negative and highly signifi-cant in Regression 3. This reflects that large banks with heavy creditportfolios have registered lower profitability as compared to small andmedium-sized banks with a similar share of credit portfolios in total as-sets during the 1995-1999 period. Large banks which remained understate ownership during the period covered by the data might have alsosuffered more from losses associated with non-performing loans rela-tive to their smaller competitors, possibly reflecting their lax lendingpolicies and the pressure they faced in lending to state-owned enter-prises and to businesses affiliated to bank management especially duringthe 1995-1997 period. Given that large banks contracted credit morethan their smaller counterparts during the 1997-1999 period (Table 3),their relatively higher profitability during this period must have derivedfrom alternative sources such as their scale economies, their ability toplace funds in foreign markets and product diversification into con-sumer credits and credit cards rather than sound credit intermediation toprivate businesses.7
However, in light of the previous findings of this paper, privatizationof most of these large banks through sales to foreigners may have posi-tively affected their profitability by enhancing their ability to extend loansafter 1997, partly reflecting the implementation of a better system ofloan evaluation and monitoring under foreign ownership. Yet, it is stilltoo early to judge whether these large banks will systematically performbetter in terms of profitability under foreign ownership by extendingmore loans to Bulgarian companies and by diversifying banking ser-vices. Future research needs to concentrate on large banks’ performance
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and credit activities under foreign ownership to determine the degree offoreigners’ contribution to the Bulgarian banking sector.
CONCLUSIONS
Bulgarian banks have largely recovered from the 1997 crisis and es-tablished a welcome basis for enhanced capacity for crediting the pri-vate sector by improving profitability and efficiency while maintainingprudent standards in terms of liquidity and capital base. Yet, banks’conservative stance towards lending as reflected in the low share of pri-vate sector loans in GDP has demonstrated their high degree of risk aver-sion and low capacity for credit risk assessment. In the absence ofwell-functioning stock and bond markets, the private sector’s exclusivereliance on bank credit is likely to continue, making credit as the keysource of future expansion and growth in the country. Hence, the bank-ing sector can facilitate this growth process by placing greater emphasison fulfilling its credit potential by strengthening its managerial and tech-nical abilities. Besides, the empirical findings of this paper indicate thatbanks can potentially increase their overall profitability by expandingloans to the private sector provided that the sector improves its expertisein loan marketing, evaluation and monitoring. Foreign banks may takethe lead in bringing in valuable experience for developing expertise inrisk evaluation, classification and loan marketing, thereby contributingin a significant way to the further development of credit intermediationprocess while controlling credit risks.
But the sector faces some additional constraints that limit its poten-tial in this area and public policies have a substantial role to play in or-der to aid bank managers to meet these challenges. First and foremost,the institutions to handle bankruptcies and liquidations are still very un-derdeveloped, making it difficult for banks to take action against firmsthat default on loan payments. There is urgent need for judicial reformin accordance with the EU requirements so as to enhance creditor rightsand to facilitate rapid seizure of collateral in the event of loan default.Unless these fundamental weaknesses are addressed, commercial bankswill most likely be quite limited in their abilities to expand loans in aprofitable way. Second, rigorous auditing and accounting standardsacross the corporate sector should be established to help banks build a
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client base based on transparent financial statements of the companiesin need of bank financing.
So far the prospective accession into the European Union has served asa strong catalyst for bank reform, regulatory harmonization and the de-velopment of a more sophisticated legal framework for Bulgarian bank-ing. As the most recent development in this area in accordance with EUdirectives, in early 2003, the Bulgarian Cabinet has approved a decree onthe introduction of International Accounting Standards for the presenta-tion of annual financial reports for the financial year 2003. These stan-dards will apply to banks, insurance, social welfare and investmentscompanies as well as public companies. The act is adopted under the Ac-counting Law, which is a key document in the Company Law Chapter ofBulgaria’s negotiations for EU entry, thereby helping Bulgaria fulfill yetanother EU requirement in the financial sector. Other companies mayalso apply these standards, which will become obligatory for them at thebeginning of 2005.
Across countries, the legal and the regulatory environment in whichbanks operate, has been found to be an important determinant of finan-cial development, and economic growth. Given the importance of a well-developed, competitive and stable banking sector for accession into theEU, reforms that can improve the efficiency of financial intermediationshould be high on the policy makers’ agendas. In particular, bank regu-lators should refrain from excessive regulation in the name of develop-ing the legal framework and seek an appropriate balance betweenprudence in banking to enhance sound banking practices and flexibilityto foster innovation and growth. In particular, bank supervision shouldkeep pace with the growing sophistication in banking services by insist-ing on a proper classification of risks and provisioning. It should alsoseek to achieve greater transparency in banking operations. Public pol-icy measures should encourage greater diversification of commercialbanks into still underdeveloped areas of leasing, insurance and home-equity loans to enhance profitability in the sector while maintainingprudential regulations to limit risks. This is also critical for EU acces-sion which requires stable and competitive banking with sophisticatedfinancial instruments.
Another significant finding of this paper relates to the existence ofstrong scale economies in Bulgarian banking such that large banks havereported higher efficiency and profitability ratios than small and me-dium sized banks throughout the period under investigation. These find-
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ings support the contention that there are still too many banks inBulgaria which are too small to achieve economies of scale in depositcollection and too inefficient to generate adequate profit rates by devel-oping a full range of banking services. Further consolidation in bankingthrough mergers and acquisitions can be encouraged through govern-ment policy to achieve optimal structure in banking which calls forseven to eight large banks dominating the sector, given the small size ofthe Bulgarian economy while retaining a handful of “boutique” banksspecialized in certain areas of retail banking and customer services tofoster effective competition.
It is encouraging to see that the market itself is moving in this directioneven in the absence of specific guidance from public policy. In 2002, thefirst wholly Bulgarian-owned financial group was established with themerger of the Roseximbank and the privatized state insurer DZI.DZI-Rosexim will work to enhance the market share of DZI not only inthe life insurance sector where it currently holds 35-36 percent but inthe general insurance as well. Launching a wide range of financial ser-vices that previously have not been introduced on Bulgaria’s market,the group aims at 25-30 percent of the general insurance market. “Thenew services will target the range from corporate customers to the aver-age Bulgarian individuals,” Emil Kyulev, owner of Rosseximbank saidin an interview.
Clearly, the emergence of Bulgarian banks as major economic andfinancial agents and their future position in international markets willdepend on the pace of banking reform and on the restructuring of bankactivity and organization along these lines. Yet, despite the substantialreduction in reserve requirements, the bank intermediation spreads stillremain quite high at 8 to 9 percent. Such large lending spreads may beindicative of limited price competition among banks and their relianceon product diversification as the preferred method of competition. An-other reason could be the banks’ perceptions of high risks in the corpo-rate environment due to the rapid shifts in ownership structure andmanagement in a relatively unpredictable macroeconomic and policyenvironment. Also, reserve requirements at 8 percent represent a sizabletax as such reserves do not earn interest and contribute to the high lend-ing spreads. Policy measures to remedy this deficiency may help im-prove the efficiency of banking in Bulgaria.
Future research should concentrate on the impact of such current andprospective mergers on price and non-price methods of competition,
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and market concentration. Another strand of future investigation shouldidentify the sources of bank profitability with reference to the role ofscale economies on cost efficiency and product diversification. It willbe also important to see how several public policy measures, and the en-hanced legal framework in line with EU requirements influence lendingdecisions, profitability and competitive behavior among banks, espe-cially those under foreign ownership.
Clearly, bank managers are strongly aware of the need for further con-solidation and diversification in banking to improve profitability. Al-though still at its infancy by way of comparison to their counterparts indeveloped market economies, especially since 1997, banks operating inBulgaria have been introducing new products such as new types of de-posits, credit and debit cards as well as internet banking services albeitat a limited scale. From a managerial perspective, there is still room toimprove quality and diversity of these services to match the Europeanstandards. In terms of banks’ core line of business, the challenge is toestablish long-term credit relationships with corporate customers by wayof developing expertise in loan monitoring and evaluation. Bank man-agers should also emphasize staff training in this area.
NOTES
1. The Bank Consolidation Company (BCC) was established in 1992 to represent thestate’s interest in approximately 70 small state-owned banks with the objectives ofconsolidation of numerous small banks into a few large banks and privatization ofbanks through sales to strategic investors that would undertake deep restructuring andrecapitalization. No bank privatization, however, was carried out until 1997 because ofpolitical constraints.
2. The capital adequacy ratio was increased gradually from 8% in 1997 to 10% in1998, and finally to 12% in 1999 in terms of risk-weighted assets under the bankinglaw in accordance with Basle requirements.
3. It is estimated that in 2000, banks had approximately $1.5 billion invested abroad.4. According to IMF estimates based on cross-country regressions, financial inter-
mediation with domestic credit at around 15 % of GDP is significantly lower than ex-pected from a country with Bulgaria’s per-capita GDP. It is supposed to have privatecredit to GDP ratio of around 30%.
5. The European Central Bank has established a level of minimum required reservesamounting to 2% for the commercial banks operating in the Euro zone and accrues in-terest on the required reserves. As compared to other transitional countries, this ratioremained substantially high at 11%: It is 2% in the Czech Republic (identical to theEU), 5% in Poland, 8% in Slovak Republic and 10% in Lithuania. Only Estonia (13%),Moldova (15%), Ukraine (17%) had higher rates than that of Bulgaria during the 1997-2000 period.
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6. The European Central Bank in accordance with the Basel international standardsrequires that banks maintain capital at 8% of their risk-weighted assets. The capital ad-equacy ratio in Bulgaria was increased gradually from 8% in 1997 to 10% in 1998, andfinally to 12% in 1999 in terms of risk-weighted assets under the Banking Law.
7. Until 1999, large banks attracted three to four times more deposits per unit ofcapital than small and medium sized banks. See leverage ratio for large banks in Ta-ble 5.
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SUBMITTED: May 2002FIRST REVISION: June 2002
SECOND REVISION: January 2003ACCEPTED: April 2003
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