A. Economic and Institutional Background

Until the 1990s the Bulgarian economy had been fully integrated into the socialist economic block and had specialized in agriculture and certain heavy industries complementary to those in other socialist countries. Bulgaria was correspondingly hit particularly hard by the breakup of the socialist system, in the form of a collapse of demand for its traditional exports and large terms of trade adjustment associated with the move to world market prices. Real output eventually declined by more than a third during the transition process and inflation was persistently high. The enterprise sector had to be profoundly restructured and reoriented to respond to the new pattern of demand and costs. While there was substantial reform momentum in the first year after the break-up of the socialist system, through most of the early 1990s the reform process proceeded less quickly and smoothly than in other countries in central and eastern Europe; continued government subsidies, in particular to the enterprise sector, and lack of fiscal adjustment led to high levels of domestic and international debt. By 1993-94 output had stabilized, but recovery was slow and inflation remained high. Summary macroeconomic data are shown in Table 1.

Table 1.

Bulgaria: Selected Economic Indicators, 1993–98

(In percent except where indicated)

Source: IMF, International Financial Statistics, and IMF staff estimates.

Table 1.

Bulgaria: Selected Economic Indicators, 1993–98

(In percent except where indicated)

	1993	1994	1995	1996	1997	1998
Nominal GDP (in millions of leva)	299	526	880	1749	17,055	21,577
Real GDP growth	-1.5	1.8	2.9	-10.9	-6.9	3.5
Nominal GDP growth	48.8	75.8	67.5	98.6	875.3	26.5
CPI inflation (period average)	72.8	96.0	62.1	123.0	1082.2	22.3
	(end of period)
Broad money (in millions of leva)	234	418	584	1,310	6,019	6,597
Growth in broad money	47.6	78.6	39.6	124.5	359.3	9.6
Broad money/GDP	78.3	79.5	66.3	74.9	35.3	30.6
Credit to the private sector (in billions of leva)	11.1	19.8	185.4	622.1	2,151.8	2,733.7
Credit to the private sector/GDP	3.7	3.8	21.1	35.6	12.6	12.7
Reserve money (in billions of leva)	55	89	154	352	2,174	2,387
Money multiplier	4.27	4.71	3.78	3.73	2.77	2.76
Money market interest rate	48.1	66.4	53.1	119.9	66.4	2.5
Exchange rate (leva per U.S. dollar)	27.6	54.1	67.2	177.9	1,681.0	1,760.7
International reserves including gold (in millions of U.S. dollars)	960	1,311	1,546	793	2,539	3,127
International reserves/reserve money	48.3	80.0	67.3	40.1	196.3	230.6

Source: IMF, International Financial Statistics, and IMF staff estimates.

View Table

Table 1.

Bulgaria: Selected Economic Indicators, 1993–98

(In percent except where indicated)

	1993	1994	1995	1996	1997	1998
Nominal GDP (in millions of leva)	299	526	880	1749	17,055	21,577
Real GDP growth	-1.5	1.8	2.9	-10.9	-6.9	3.5
Nominal GDP growth	48.8	75.8	67.5	98.6	875.3	26.5
CPI inflation (period average)	72.8	96.0	62.1	123.0	1082.2	22.3
	(end of period)
Broad money (in millions of leva)	234	418	584	1,310	6,019	6,597
Growth in broad money	47.6	78.6	39.6	124.5	359.3	9.6
Broad money/GDP	78.3	79.5	66.3	74.9	35.3	30.6
Credit to the private sector (in billions of leva)	11.1	19.8	185.4	622.1	2,151.8	2,733.7
Credit to the private sector/GDP	3.7	3.8	21.1	35.6	12.6	12.7
Reserve money (in billions of leva)	55	89	154	352	2,174	2,387
Money multiplier	4.27	4.71	3.78	3.73	2.77	2.76
Money market interest rate	48.1	66.4	53.1	119.9	66.4	2.5
Exchange rate (leva per U.S. dollar)	27.6	54.1	67.2	177.9	1,681.0	1,760.7
International reserves including gold (in millions of U.S. dollars)	960	1,311	1,546	793	2,539	3,127
International reserves/reserve money	48.3	80.0	67.3	40.1	196.3	230.6

Source: IMF, International Financial Statistics, and IMF staff estimates.

As part of the transition process, the Bulgarian financial system had to be transformed from one designed solely as an ancillary to the system of central planning, to one playing an active role in the generation of savings and the allocation of investment. Before 1987, the Bulgarian banking system mirrored that in other central and eastern European countries. It comprised only three banks: the Bulgarian Bank of Foreign Trade (BFTB), in charge of international reserve and external debt management as well as other foreign exchange transactions; the State Savings Bank (SSB), in charge of household deposit mobilization and housing loans; and the Bulgarian National Bank (BNB), in charge of currency issuance and commercial and investment banking operations with enterprises. As a result of the introduction of a two-tier banking system in 1987–90, seven specialized commercial banks and 59 new commercial banks were created, and the BNB was turned into a central bank.

Three more commercial banks were licensed in July 1990, leading to a system of 71 relatively small banks, often with capital below the statutory minimum.⁶

In response to a view that regarded this fragmented system as inefficient, the incoming Bulgarian government set up a Bank Consolidation Company (BCC) in 1992.⁷ Its purpose was to serve as a temporary holding company for the shares of the state-owned banks, with a mandate to merge the existing banks and to strengthen them for privatization. Following these mergers, the numbers of state banks, excluding the SSB, fell to ten by 1996 (Table 2). At the same time, private banks—which were first licensed in 1991—grew in number, so that by 1996 more than 30 were operating. While most remained small compared to the public institutions, some—most notably the First Private Bank—had reached significant size by 1996 in terms of both assets and branch representation By 1996 five foreign banks and bank branches were also operating in Bulgaria.

Table 2.

Bulgaria: Economic Standing of Banks at the Outset of the Banking Crisis

1/ Including four state owned, one private bank

Table 2.

Bulgaria: Economic Standing of Banks at the Outset of the Banking Crisis

Banks	Number of Banks	Number of banks meeting capital standards	Total Assets	Net Worth	Total Assets	Net Worth	Asset Concentration
			(Dec. ‘95)	(Dec. ‘95)	(April ’96)	(April ’96)	Share in total banking sector assets (April ’96)
			(in millions of leva)		(in millions of leva
State banks	10	1	661,584	-39,777	477,864	-93,532	66.3
Private banks	29	18	242,453	-13,853	236,118	---	32.8
Foreign banks	6	6	6,671	287	6,525	---	0.9
Total	45	25	910,708	-53,343	720,507	-93,532

1/ Including four state owned, one private bank

View Table

Table 2.

Bulgaria: Economic Standing of Banks at the Outset of the Banking Crisis

Banks	Number of Banks	Number of banks meeting capital standards	Total Assets	Net Worth	Total Assets	Net Worth	Asset Concentration
			(Dec. ‘95)	(Dec. ‘95)	(April ’96)	(April ’96)	Share in total banking sector assets (April ’96)
			(in millions of leva)		(in millions of leva
State banks	10	1	661,584	-39,777	477,864	-93,532	66.3
Private banks	29	18	242,453	-13,853	236,118	---	32.8
Foreign banks	6	6	6,671	287	6,525	---	0.9
Total	45	25	910,708	-53,343	720,507	-93,532

1/ Including four state owned, one private bank

In terms of business activities, by early 1996 about one third of lending went to the government, one third to public enterprises, and the remainder to private sector enterprises and households (Table 3) The state banks (excluding the SSB) catered to all sectors of the Bulgarian economy, including the newly emerging private sector, but lending public sector enterprises remained the largest component of their portfolio. Private banks concentrated on lending to the newly emerging private sector, yet they also lent a considerable amount to the government and to nonfinancial public enterprises.⁸

Table 3.

Bulgaria: Loan Portfolio of the Banking Sector by Ownership Group (April 1996)

Source: BNB, BCC, and staff estimates.

Table 3.

Bulgaria: Loan Portfolio of the Banking Sector by Ownership Group (April 1996)

	State Banks		Private Banks		Foreign Banks
	in millions of leva	in percent of total	in millions of leva	in percent of total	in millions of leva	in percent of total
Government	106,531	29.0	22,663	10.8	627	10.6
State funds	20,648	5.6	141	0.1	0/	0.0
Local government	28,349	7.7	1,398	0.7	0	0.0
Public enterprises	130,199	35.5	49,183	23.5	2,851	48.2
Private enterprises	80,342	21.9	130,820	62.5	2,418	40.9
Households	894	0.2	735	0.4	15	0.3
Nonbank financial institutions	102	0.0	4,299	2.1	0	0.0
Total loans outstanding	367,065	100.0	209,239	100.0	5,911	100.0

Source: BNB, BCC, and staff estimates.

View Table

Table 3.

Bulgaria: Loan Portfolio of the Banking Sector by Ownership Group (April 1996)

	State Banks		Private Banks		Foreign Banks
	in millions of leva	in percent of total	in millions of leva	in percent of total	in millions of leva	in percent of total
Government	106,531	29.0	22,663	10.8	627	10.6
State funds	20,648	5.6	141	0.1	0/	0.0
Local government	28,349	7.7	1,398	0.7	0	0.0
Public enterprises	130,199	35.5	49,183	23.5	2,851	48.2
Private enterprises	80,342	21.9	130,820	62.5	2,418	40.9
Households	894	0.2	735	0.4	15	0.3
Nonbank financial institutions	102	0.0	4,299	2.1	0	0.0
Total loans outstanding	367,065	100.0	209,239	100.0	5,911	100.0

Source: BNB, BCC, and staff estimates.

In spite of the structural changes in the banking landscape, certain key problems were evident from the beginning. These included, first, a high degree of concentration: by 1996 the five largest banks (four state owned, one private) held 60 percent of total assets. Second, most banks—especially the state banks—remained to a large extent sectorally and/or regionally oriented, leaving some highly exposed to vulnerable state enterprises (see Appendix I). Third, more or less state-controlled banks were still dominant: in spring of 1996, the ten banks partly- or fully-state owned held two thirds of the assets of the banking sector (Tables 2 and 3).⁹ In addition, the shares in these banks that were not directly held by the government belonged, for the largest part, to enterprises that most often were themselves state owned. The BCC acted also as the state oversight body for these banks. However, while adequate prudential regulations had by and large been put in place, they were largely not enforced. The BNB had almost no supervisory powers over the banks that fell under the BCC, and often exerted only limited authority over the private banks.

B. Early Signs of Banking Sector Weaknesses and Initial Response

Difficult macroeconomic conditions, combined with inadequate internal risk control procedures, and the absence of any loan repayment culture led to a rapid increase in nonperforming loans, soon exceeding 60 percent in a number of banks’ loan portfolios. This derived in large part from the fact that banks allocated much of their lending under government-mandated credit plans, rather than commercial credit analysis, and the major borrowing enterprises were often hard hit by the economic transition. Even after the abolition of directed credit, strong interrelationships persisted between banks and major enterprises, leading to lax credit analysis. The lack of bankruptcies in the enterprise sector throughout the transition period reinforced the pressures on the banks to finance losses. Banking supervision, which was in its infancy, seems to have been ineffectual in preventing this deterioration, in part reportedly because of lack of effective authority of the supervising institutions (the BCC and BNB for the state and private banks respectively) in enforcing their mandates. Insider lending was widespread and there was a perception (evidenced in some high-profile examples) that organized groups were utilizing their influence over the banks and enterprises to profit at the expense of the state. In spite of the BCC’s mandate in that regard, by 1996 none of the state banks had been privatized.

Of the state-owned banks, on the basis of information using Bulgarian accounting standards,¹⁰ only one—Bulbank, the former foreign trade bank—showed positive net worth in early 1996 (Tables 2 and 4). While this bank was the largest in terms of assets, its particular business structure limited potential positive spillovers to other banks and the economy at large: the bank’s activities were concentrated in the trade financing area, with no branch network and few retail banking activities, and it thus had only limited direct interaction with the mainstream of the Bulgarian economy.¹¹

Table 4.

Economic Standing of the State Banks

Source: BCC and staff estimates

Table 4.

Economic Standing of the State Banks

	Assets (Dec. 95)	Net Worth (Dec. 95	Assets (Apr. 96)	Net Worth (Apr. 96)
Bulbank	265,238	31,773	263,243	15,648
Biochim	70,344	-8,219	40,402	12,073
UBB	63,805	-14,903	35,616	-17,476
Balkanbank	61,896	-14,400	29,161	-28,594
Mineral	48,123	-7,740	30,612	-9,133
Economic	41,895	-15,374	16,738	-20,028
Hebrosbank	38,876	-5,158	19,462	-9,482
Expressbank	30,580	-1,429	22,961	-3,133
Bulgarian Post Bank	22,955	-749	18,820	-5,096
Yambol	17,872	-3,578	843	-4,164
Total State Banks	661,584	-39,777	477,864	-93,532
Private Banks	242,453	-13,853	236,118	---
Foreign Banks	6,671	287	6,525	---

Source: BCC and staff estimates

View Table

Table 4.

Economic Standing of the State Banks

	Assets (Dec. 95)	Net Worth (Dec. 95	Assets (Apr. 96)	Net Worth (Apr. 96)
Bulbank	265,238	31,773	263,243	15,648
Biochim	70,344	-8,219	40,402	12,073
UBB	63,805	-14,903	35,616	-17,476
Balkanbank	61,896	-14,400	29,161	-28,594
Mineral	48,123	-7,740	30,612	-9,133
Economic	41,895	-15,374	16,738	-20,028
Hebrosbank	38,876	-5,158	19,462	-9,482
Expressbank	30,580	-1,429	22,961	-3,133
Bulgarian Post Bank	22,955	-749	18,820	-5,096
Yambol	17,872	-3,578	843	-4,164
Total State Banks	661,584	-39,777	477,864	-93,532
Private Banks	242,453	-13,853	236,118	---
Foreign Banks	6,671	287	6,525	---

Source: BCC and staff estimates

The remaining nine state banks—all of which were predominantly engaged in domestic business—showed significant negative net worth at the end of 1995. On one estimate, in three of the state banks nonperforming loans exceeded 90 percent of their total loans. Excluding Bulbank, the average size of state banks’ nonperforming loans relative to total loans was 70 percent at end-December 1995.¹²

According to BNB data, the economic standing of private banks in April 1996 was more mixed. A group of smaller private banks appears to have been relatively more successful in managing their business affairs: in December 1995, among the 20 banks with assets of leva 10 billion (about $65 million) or less, only five reported negative capital. In contrast, more than half of the institutions above that threshold were insolvent.¹³ Notwithstanding such differentiation, all private banks shared in the rapid loss of deposits between December 1995 and April 1996, an indication that the public was unable to distinguish between the relatively more healthy smaller private banks and the remainder of the system.

As a result of the above factors, liquidity and solvency problems emerged in the banking sector. In an earlier effort to address banking sector difficulties, the government had issued bank rehabilitation bonds, so called ZUNK bonds, in exchange for state banks’ nonperforming assets in 1994.¹⁴ Due to flaws in the design of the instrument—in particular their low yields—they only restored solvency in a technical sense, but did little to improve the actual economic sustainability to the banks that had received such bonds.¹⁵ Instead, the BNB and the SSB increasingly acted as lenders of last resort by refinancing all illiquid institutions. The extent of such refinancing—whether through the BNB’s lending facilities, placements by the SSB, or arrears in the payments system—had reached a point where the authorities’ ability to conduct monetary policy was put in question.¹⁶

By the end of 1995 the Bulgarian authorities could no longer ignore the problems in the banking sector. In late 1995 a high-level interdepartmental committee had been established, reporting directly to the Prime Minister. It recognized the seriousness of the incipient crisis, although it could not establish consensus on the necessary remedial measures quickly enough. Nevertheless, a number of steps were taken. From January 1,1996 substantial provisioning requirements were imposed upon the banks. With greater transparency in the banks’ accounts, the situation of the banks was seen to be far worse than had earlier been estimated. Table 4 shows the economic standing of the state banks according to figures supplied by the BCC at end-December 1995 and end-April 1996. The deterioration in the position of the banks between the two dates reflects both weak performance in the first months of 1996 as well as, probably more importantly, the recognition of losses incurred earlier. The authorities had thus obtained evidence that a large number of institutions were technically bankrupt. The BNB apparently felt, however, that under the banking law it did not have a mandate to close failed banks, because the law at that time did not provide a legal basis for the BNB to place conservators in banks. At a more general level, the authorities faced a dilemma because all existing institutions were either infected, or too small, or too specialized to offer a viable continuation of banking services if a comprehensive approach to addressing banking sector weakness were to be adopted; any solution would have to go beyond closings to ensure the continued provision of banking services.

Around this time too the public became fully aware of the banking crisis: banks developed serious liquidity shortages, especially in foreign exchange, and lines outside banks became commonplace. Not surprisingly, there were widespread rumors about the failing health of the banking system, by itself a factor aggravating the problems. Deposit runs occurred against at least two banks of significant size. In addition, the sudden emergence of a large volume of items in arrears in the payment system caused system-wide liquidity shortages and accelerating loss of public confidence in the system. To keep the system afloat the BNB injected leva 25 billion (or 16 percent of end-1995 reserve money) into the system in the first four months of 1996, and the SSB increased interbank lending by leva 12 billion (8 percent of reserve money). At the same time, the BNB’s attempts to establish control over the situation were stymied: in the absence of an efficient bank bankruptcy law it was unsuccessful in trying to close two smaller banks, leading to a further erosion of confidence, and visible financial disintermediation.

C. Comprehensive Approach to Resolution

D. Banking Sector Restructuring and the Introduction of a Currency Board

E. Epilogue

The currency board to date has largely achieved its main macroeconomic targets— reducing inflation, limiting the budget deficit and restoring confidence in the Bulgarian economy—while avoiding any major testing due to renewed banking sector pressures. This outcome can be ascribed to a variety of factors, not least of which are the confidence enhancing measures undertaken prior to, and at the time of, the introduction of the arrangement. In addition, the hyperinflation of the spring of 1997, during the political hiatus at the time of the preparation of the CBA, served to greatly deflate the real value of banks’ liabilities, substantially improving the solvency of the banking system. Finally, the abolition of the minimum price on ZUNK bonds, together with increased demand for these bonds as confidence returned in response to the establishment of the CBA,³⁵ increased the value and the liquidity of the state banks’ assets.³⁶

Notwithstanding the initial positive developments in the banking sector under the currency board, challenges remain. The most important include:

• The subsequent privatization process was initially slow and subject to a number of setbacks. While these, in part, resulted from the changing business plans of potential investors, in part they seemed to derive also from bureaucratic red tape and somewhat unrealistic expectations on the side of the authorities. More recently, however, the process has been brought near to completion.

• The SSB for long operated as a quasi-fiscal organization, intermediating resources between household depositors and government borrowing. The process of changing the SSB from a “narrow bank,” to which the authorities accord full deposit guarantees in exchange for a very limited and safe investment strategy, into a full-fledged commercial bank, now called DSK Bank, with its deposit insurance subject to the same limitations as those of the other banks in the system, is ongoing, with plans for divestiture of the state’s ownership in the bank.

• Despite some economic recovery, banks in Bulgaria have so far not substantially resumed lending.

• Banking supervision long suffered from deficiencies. Since the crisis a new regulatory framework for supervision has been put in place. The focus more recently has moved to compliance and enforcement.

In conclusion, a full recovery of the financial sector in Bulgaria remains closely linked with the prospects for stabilization and growth in the country. Once growth becomes more robust, the banking system will have greater potential to recover its strength. The prospect of EU accession provides a good medium-term framework both for macroeconomic policy and structural measures to further bring about the necessary strengthening and safeguarding of the banking system.

A. Economic and Institutional Background

Lithuania is the southernmost and largest Baltic country, with a population of 3.7 million. From the period after the Second World War up to independence in the early 1990s,³⁷ Lithuania had been part of the former Soviet Union and shared its centrally planned economic and financial system. Output declined by 40 percent during the transition, and inflation peaked at an annual rate of about 1,000 percent.

The macroeconomic situation was transformed by the introduction of a CBA on April 1, 1994, under which the national currency was tightly pegged to the U.S. dollar and full convertibility was enshrined in law.³⁸ Inflation was reduced rapidly and began to converge to the level of the countries’ main trading partners Macroeconomic conditions have been relatively stable throughout the remainder of the period under consideration (Table 5).³⁹

Table 5.

Lithuania: Selected Economic Indicators, 1993-98

(In percent except where indicated)

Source: International Financial Statistics, and staff estimates.

Table 5.

Lithuania: Selected Economic Indicators, 1993-98

(In percent except where indicated)

	1993	1994	1995	1996	1997	1998
Nominal GDP (in billions of litai)	11.6	16.9	24.1	31.6	38.3	42.9
Real GDP growth	-16.2	-9.8	3.3	4.7	5.7	5.1
Nominal GDP growth	240.3	45.8	42.6	31.0	21.4	12.0
CPI inflation (period average)	410.4	72.1	39.5	24.7	8.8	5.1
	(end of period)
Broad money (in billions of litai)	2.7	4.4	5.6	5.4	7.3	9.6
Growth in broad money	100.4	63.0	29.0	-3.5	34.1	32.4
Velocity	23.1	25.8	23.3	17.2	19.0	22.4
Credit to the private sector (in billions of litai)	1.4	5.9	12.1	9.9	7.6	6.9
Credit to the private sector/GDP	12.1	34.9	50.2	31.4	19.8	16.1
Reserve money (in billions of litai)	1.3	1.8	2.4	2.5	3.3	4.3
Money multiplier	2.13	2.40	2.30	2.17	2.20	2.26
Money market interest rate	n.a.	69.5	26.7	20.3	9.6	6.1
Exchange rate (litai per U.S. dollar)	4.3	4.0	4.0	4.0	4.0	4.0
International reserves including gold (in millions of U.S. dollars)	412.2	587.3	819.0	834.3	1062.7	1460.0
International reserves/ reserve money	140.0	128.8	133.9	133.5	128.5	137.1

Source: International Financial Statistics, and staff estimates.

View Table

Table 5.

Lithuania: Selected Economic Indicators, 1993-98

(In percent except where indicated)

	1993	1994	1995	1996	1997	1998
Nominal GDP (in billions of litai)	11.6	16.9	24.1	31.6	38.3	42.9
Real GDP growth	-16.2	-9.8	3.3	4.7	5.7	5.1
Nominal GDP growth	240.3	45.8	42.6	31.0	21.4	12.0
CPI inflation (period average)	410.4	72.1	39.5	24.7	8.8	5.1
	(end of period)
Broad money (in billions of litai)	2.7	4.4	5.6	5.4	7.3	9.6
Growth in broad money	100.4	63.0	29.0	-3.5	34.1	32.4
Velocity	23.1	25.8	23.3	17.2	19.0	22.4
Credit to the private sector (in billions of litai)	1.4	5.9	12.1	9.9	7.6	6.9
Credit to the private sector/GDP	12.1	34.9	50.2	31.4	19.8	16.1
Reserve money (in billions of litai)	1.3	1.8	2.4	2.5	3.3	4.3
Money multiplier	2.13	2.40	2.30	2.17	2.20	2.26
Money market interest rate	n.a.	69.5	26.7	20.3	9.6	6.1
Exchange rate (litai per U.S. dollar)	4.3	4.0	4.0	4.0	4.0	4.0
International reserves including gold (in millions of U.S. dollars)	412.2	587.3	819.0	834.3	1062.7	1460.0
International reserves/ reserve money	140.0	128.8	133.9	133.5	128.5	137.1

Source: International Financial Statistics, and staff estimates.

In the banking sector, the former Soviet financial institutions continued to dominate for a period after independence, at first with unclear ownership relations between Moscow and Lithuania. The Bank of Lithuania (BOL) was founded in 1990 to become the central bank of the new republic.⁴⁰ However, its role initially differed from the classic model of a western central bank in at least two important regards: first, until October 1992 Lithuania was still part of the ruble zone, which left the central bank no room for independent monetary policy.⁴¹ Second, in October 1990 the BOL took over the branches of two former Soviet State banks and was thus initially engaged in both central and commercial banking;⁴² in 1991 it provided as much as 40 percent of total outstanding credit to the economy. In these circumstances, and in the absence of a relevant legal framework, the development of banking supervision was slow.

In the aftermath of independence, Lithuania, like most other transition economies, witnessed a sharp increase in the number of financial institutions. This development mainly reflected the fact that minimum capital requirements were not changed from their 1991 levels, in spite of high inflation and depreciation of the currency (Table 5). By the beginning of 1994, 28 banks operated in Lithuania, some of which acted as lending agencies for one or two enterprises only. In addition, an undetermined number of enterprises were engaged in banking business without having obtained the necessary license.

Nonetheless, concentration remained high: in 1992 two of the old institutions, Agrobank and the Savings Bank, together with the commercial banking arm of BOL (which later became the State Commercial Bank) accounted for more than half of the banking systems’ deposits and loans.⁴³ In late 1995 the five largest banks accounted for 77 percent of deposits and 71 percent of assets. Yet, given the relatively low level of financial intermediation (Table 5), the transmission of financial sector developments to the rest of the economy remained limited ⁴⁴

In light of the perceived weaknesses in the financial system and to form the basis for a modern banking sector, the authorities undertook a series of measures. Important steps included the enactment of the Bank of Lithuania and the Commercial Banking Laws in December 1994, which provided the legal basis for all banking activities, created a clear two- tier banking system, and defined the BOL’s supervisory role. Prudential regulations put in place at that time included a higher minimum core capital requirement, a capital adequacy ratio, limitations on both connected lending and lending to a single borrower, as well as open position limits.⁴⁵ The new banking laws of 1994 created the necessary legal basis for a prudential framework to support a market economy, but significant restructuring within the BOL, as well as training of supervisors, was required to operationalize the framework.

Owing to the previous absence of prudential regulations, the formerly prevalent practice of directed lending, as well as the weak credit evaluation skills of commercial bankers, improved supervision alone could contribute little to a rapid change in the quality of the banking environment. At first banks profited from high inflation—which averaged more than 400 percent in 1993 (Table 5). In the absence of indexation, inflation eroded the real value of both assets and liabilities. Inflation also masked the cash-flow problems that would normally be associated with a similar level of nonperforming loans, allowing banks to continue imprudent lending practices longer than they could have in a more stable environment. However, once macroeconomic policies were tightened—most notably after the introduction of the CBA in April 1994—inflation declined and banks started to feel the liquidity and solvency consequences of their weak loan portfolios.⁴⁶

B. Early Signs of Banking Sector Weakness and Initial Response

A number of banks failed to make progress toward compliance with the prudential norms established in 1994, most notably on capital requirements.⁴⁷ The continued violations of the prudential norms remained unsanctioned. In addition, the prudential norms themselves were not fully consistent with those in a market economy, as the law foresaw a stepwise adjustment toward international practice. As these regulations were progressively being phased in, banks already in breach of the old norms slipped even further into noncompliance.

The increasing stress on the banking system was first felt by the smaller institutions. Starting in 1994, a total of 14 smaller banks were forced into bankruptcy procedures. Yet, in spite of the large number of institutions involved, the economic impact initially remained modest, as these banks’ combined assets only accounted for about 5 percent of the total assets of the banking system.

Signals of deeper banking sector problems first arose during the summer of 1995. Aura Bank, a medium-sized institution, faced liquidity problems after deposit withdrawals that were caused by rumors questioning its solvency. To avoid a crisis, Aura Bank received support both from the government and the BOL. Still, banking problems continued to deepen during the fall of 1995, and public confidence in the system continued to erode. Deposit withdrawals were ongoing, bank capital diminished, and bank losses increased substantially. In the fall of 1995, the government had to provide liquidity support to Vakaru Bank, another medium-sized institution.

By late December 1995 the banking sector fragility had developed into a full-scale crisis. An on-site inspection by the BOL revealed the insolvency of Innovation Bank, the largest private bank, and its would-be merger partner, Litimpex Bank, mainly due to serious portfolio quality problems. The two banks were put under moratoria, which suspended all their commercial banking activities, except for the collection of loans and other assets. Deposits held with both institutions were blocked. Vakaru Bank, which had obtained liquidity support earlier in the fall, again experienced liquidity problems and was now put under conservatorship by the BOL. With the extension of the crisis to these three institutions, about 30 percent of deposits in the system were affected.

Depositors reacted rapidly and shifted their deposits to the state-controlled banks, where individuals’ deposits were fully guaranteed by the Civil Codes, thus liquidity shortages emerged even in relatively solid private banks. The interbank market came to a standstill, deposit withdrawals continued, and confidence in the banking system was shaken. In the event, from December 1995 to March 1996, about 25 percent of the existing household deposits left the banking system. Around this time the press increasingly started to question also the solvency of the three state-owned banks. Audits of two state banks (State Commercial Bank and State Savings Bank) revealed that both had made losses in 1995 and that they would need to be recapitalized in order to meet the capital adequacy ratio. When these audits were published by local newspapers, a systemic crisis appeared in prospect.

After the BOL’s initial intervention no further action was being taken regarding the two commercial banks under moratoria. The attendant uncertainty caused a further loss in public confidence in the financial system as a whole. In an attempt to calm depositors’ rising fears, parliament passed a law pledging state assets to guarantee in full the deposits and creditors at the two banks. This move, however, was not consistent with the deposit insurance law, passed in December 1995, which provided limited insurance of 4,000 litai ($1,000) per depositor, and only applied to litas deposits, excluding the large amount of foreign exchange deposits held with banks.⁴⁸ To restore interbank trading, parliament passed a law providing for the extension of government guarantees of one-year duration for interbank deals for a volume up to a total of 300 million litai ($75 million, or 12 percent of reserve money), albeit with little measurable impact. As a measure of last resort and in order not to weaken banks already in distress, the BOL decided not to enforce penalties on banks that did not meet reserve requirements.

C. Comprehensive Approach to Resolution

By mid-1996, when banks holding more than three quarters of the systems’ assets and liabilities were insolvent or undercapitalized, it became clear that a resolution of the banking crisis would require a strategic plan. Key issues to be decided included whether to rehabilitate or liquidate banks in difficulties, the cost sharing of any rescue operations between shareholders and the government, as well as new “rules of the game” to minimize the likelihood of a recurrence of such problems.

D. Epilogue

Indicators of financial sector health (Table 6), most notably the sharp increase in bank deposits, show that by end-1997 significant progress had been made in overcoming the banking sector crisis. Nevertheless, domestic and international challenges remained that had a potential to endanger previous gains, including the high level of nonperforming loans. Further events showed, however, that the system remained stable, even in the face of further challenges.

Table 6.

Lithuania: Indicators of Financial Sector Soundness and Market Development¹

(In percent)

Source: BOL and IMF.

¹Operating banks. March 1998 excludes the State Commercial Bank.

²The methodology for calculating the ratio was adapted to international norms in the first quarter of 1997.

Table 6.

Lithuania: Indicators of Financial Sector Soundness and Market Development¹

(In percent)

		Dec. 1996	Dec. 1997	March 1998
Capital Adequacy2		10.5	10.8	14.0
Returns on equity		-9.1	-8.3	3.4
	Excluding State Banks	15.4	10.8	5.9
Growth of deposits (annual rate)		-5.0	34.0	30.0
Growth of private sector credit (annual rate)		-4.0	19.0	26.0
Borrowing by banks from nonresidents/total liabilities		3.0	6.0	8.0

Source: BOL and IMF.

¹Operating banks. March 1998 excludes the State Commercial Bank.

²The methodology for calculating the ratio was adapted to international norms in the first quarter of 1997.

View Table

Table 6.

Lithuania: Indicators of Financial Sector Soundness and Market Development¹

(In percent)

		Dec. 1996	Dec. 1997	March 1998
Capital Adequacy2		10.5	10.8	14.0
Returns on equity		-9.1	-8.3	3.4
	Excluding State Banks	15.4	10.8	5.9
Growth of deposits (annual rate)		-5.0	34.0	30.0
Growth of private sector credit (annual rate)		-4.0	19.0	26.0
Borrowing by banks from nonresidents/total liabilities		3.0	6.0	8.0

Source: BOL and IMF.

¹Operating banks. March 1998 excludes the State Commercial Bank.

²The methodology for calculating the ratio was adapted to international norms in the first quarter of 1997.

One challenge included renewed banking sector problems in 1997. It appears, however, that the shift to limited deposit insurance—where the new depositor protection regulations are based on EU standards, with a maximum of 25,000 litai per depositor—has served well to improve confidence.⁵⁸ The new regulations were successfully applied in the case of Taurobank, which failed in July 1997. The limited amount of deposit coverage did not lead to any loss in confidence in the remainder of the system, although a “flight to quality” continues to be noticeable.

The second challenge was the 1998 Russian crisis, which caused a deep recession in Lithuania. The decline in output notwithstanding, bank performance did not deteriorate in the process. Since that time, the momentum for privatization has resumed. The Development Bank and Savings Bank were privatized in 2001; there was a tender also for privatizing the Agricultural Bank in 2001. Lithuania is now preoccupied with putting in place a prudential framework compatible with EU accession, which is likely to take place within a few years.

A. The Deterioration in Bank Soundness

It became apparent already in the early 1990s that the banking system was not functioning satisfactorily. In 1994 the government forced BITI to take over a small bank and Ardyn Bank had to take over Cooperative Bank.⁵⁹ BITI and Ardyn Bank were never compensated for implied reduction in their net worth, although they did receive special refinancing loans from the Mongolbank. This episode does not appear to have been decisive in undermining the soundness of these banks, but the strategy of merging weak banks proved at best a means of gaining time. By 1995 a report by an outside consultant who had inspected Ardyn Bank concluded that it was already insolvent and continuing to lose money.

The causes of the poor performance of banks were manifold. The macroeconomic conditions faced by the banks made sound operations difficult enough: inflation and interest rates fluctuated sharply, and many established enterprises suffered sharp drops in output. Bank management seems often to have been of poor quality or self-serving: reportedly insider lending was widespread, and banks were unwilling or unable to collect on many loans. Banks frequently preferred to capitalize interest on nonperforming loans rather than reveal the extent of losses, and may have made new loans to loss-making enterprises in the hopes of keeping them going and eventually recovering something. These adverse tendencies were compounded by certain government policies, notably the requirement that banks lend to certain privileged sectors and enterprises whose survival was judged to be of strategic or social importance. Such so-called inherited and directed credits were often extended on noncommercial terms, with little expectation that they would be repaid. In addition, banks reportedly came under political pressure not to force large employers into bankruptcy. Moreover, a minimum deposit interest rate was set with the aim of limiting dollarization and capital flight. At least during certain periods, the minimum rate was so high that banks attracted more funds than they could use to finance reasonably safe and viable projects.

During 1996 the state of the banking system began to deteriorate more rapidly. Several banks started to fail to meet prudential norms, credit ceilings, and reserve requirements, sometimes for extended periods. On occasion depositors were unable to withdraw funds on demand, and either had to pay a fee or received only payment orders that could not be cleared and that circulated as a means of payment. Among the major banks, Insurance Bank nearly ceased operating, and Ardyn Bank, Agricultural Bank, and BITI experienced periods of illiquidity and admitted to significant losses. On-site inspections by Mongolbank and reports by external bank auditors revealed an increasingly alarming picture of nonperforming loans, operational ineptitude and, in some banks, managerial complacency.

For example, during the first nine months of 1996 Ardyn Bank repeatedly failed to meet reserve requirements, and suffered a decline of Tog 6 billion (approximately $12 million at the time) in its liquid assets, but the bank extended Tog 4 billion in new loans and continued to spend large sums on the construction of a headquarters building.

Mongolbank felt obliged to provide these banks with liquidity through the extension of ever-larger loans. These loans were not backed by collateral, nor were bank managers required to take immediate action to prevent the recurrence of illiquidity. In addition to explicit credits, some banks were exploiting delays in the clearing system to make payments even when they had no funds available. The government treasury operations were also affected because government deposits at commercial banks became unusable and some enterprises had difficulty paying taxes.⁶⁰

The mounting difficulties of the banking system are illustrated in Figures 1 and 2. The real money stock, as measured by broad money deflated by the Consumer Price Index, fell during the course of 1996, but real currency in circulation increased.⁶¹ Thus, enterprises and especially households were fleeing the banking system. Bank liquidity, and especially bank reserve deposits with Mongolbank were also declining. The fall would have been greater and faster but for the extension of ever-larger refinancing credits from Mongolbank, and the build-up of government deposits at the commercial banks.

Mongolia: Real Monetary Aggregates

(deflated by end-1995 CPI)

Citation: IMF Working Papers 2002, 056; 10.5089/9781451847710.001.A001

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Mongolia: Real Monetary Aggregates

(deflated by end-1995 CPI)

Citation: IMF Working Papers 2002, 056; 10.5089/9781451847710.001.A001

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Mongolia: Real Monetary Aggregates

(deflated by end-1995 CPI)

Citation: IMF Working Papers 2002, 056; 10.5089/9781451847710.001.A001

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Mongolia: Bank Liquidity

(percent of bank deposits)

Citation: IMF Working Papers 2002, 056; 10.5089/9781451847710.001.A001

Source: Mongolbank, and staff estimates

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Mongolia: Bank Liquidity

(percent of bank deposits)

Citation: IMF Working Papers 2002, 056; 10.5089/9781451847710.001.A001

Source: Mongolbank, and staff estimates

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Mongolia: Bank Liquidity

(percent of bank deposits)

Citation: IMF Working Papers 2002, 056; 10.5089/9781451847710.001.A001

Source: Mongolbank, and staff estimates

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The situation of one small bank, Central Asian Bank (CAB), deteriorated to the point where in June 1996 Mongolbank decided to close it down. The value of the bank’s deposits amounted to Tog 1,139 million (approximately $2 million at the then prevailing exchange rate), owed to about 3,000 mostly small depositors. Although there was no deposit insurance in Mongolia, the authorities announced that depositors would be compensated for losses up to Tog 100,000, even though interest accrued in 1995 and the first half of 1996 was annulled.⁶² The assets of CAB were found to have been almost entirely worthless, and indeed it was very difficult to identify assets because the bank had been run in a chaotic manner.

The failure of CAB contributed to a growing public distrust of the banks. Doubts about bank soundness became manifest in a number of forms: the real stock of togrog deposits began to fall; the exchange rate depreciated rapidly; TDB, which has a good reputation, experienced a strong inflow into dollar-denominated deposits.⁶³ There was however no acute run on the banks. The injection of liquidity by Mongolbank and falling demand for togrog-denominated assets accelerated the depreciation of the exchange rate, and led to a revival of inflation.

B. Initial Attempt at Restructuring

By mid-1996 the authorities clearly recognized that the state of the banking system was poor and deteriorating rapidly. The largest bank was illiquid, insolvent, continuing to lose money, and apparently under management that had no intention of altering its strategy. Of the other major banks, one was inactive and entirely illiquid, and two were technically insolvent and in breach of several prudential regulations. Only one major bank seemed to be on a sound footing, largely because of its very tight specialization in foreign exchange business. Many of the small banks were of dubious viability, but because their combined market share was less than 10 percent they were of little systemic importance. The available estimates of the magnitude of the losses were very approximate and probably too optimistic, but indicated that the negative net worth of certain banks was already large.⁶⁴

A broad section of the population and most enterprises were already affected by the dysfunction of the banks, and would be exposed to large losses should the banks fail. Disintermediation, principally in the form of dollarization, was continuing. The rule of law was being undermined as borrowers were not sanctioned for nonrepayment; banks were restricting access to deposits and not paying penalties on breaches of regulations; and the Mongolbank was effectively compelled to extend liquidity-support loans to banks without the safeguards required by the new central bank law. The extension of liquidity-support loans, the disregard of reserve requirements, and the breakdown of the use of deposits as a means of payment undermined the implementation of monetary policy. Fiscal policy was also affected because many government deposits were effectively blocked in illiquid banks.

In late August the authorities began planning a comprehensive strategy to deal with all problem banks. In particular, they decided to move first against Insurance Bank, which by that stage was described as “comatose.” Insurance Bank was widely known to be insolvent, and therefore its closure was expected to be met with little political opposition from vested interests, nor sharply to weaken confidence in other banks. Insurance Bank was also relatively small, so that the logistics of its closure would be manageable and the total volume of losses acceptable even if the government ended up bearing a disproportionate share of the burden.

While Mongolbank was in the midst of the preparations for the closure of Insurance Bank, Ardyn Bank applied for an additional liquidity support loan. The authorities realized that Ardyn Bank was also in a very precarious situation and decided to move against it immediately.

The implementation of this decision turned out to be difficult. It was hard to find anyone to assume the responsibilities of conservator. Eventually someone was appointed for Ardyn Bank, and officials entered both banks on September 18. There was no immediate public announcement of the action, nor any explanation of what would happen to the public’s deposits or whether the banks would continue operating. Indeed, debate on these issues continued among the authorities even after the seizure of the bank. In practice household depositors were allowed to make withdrawals of up to Tog 100,000, and enterprises apparently could make withdrawals freely. Mongolbank supported Ardyn Bank with new liquidity-support loans at favorable interest rates.

The conservator for Ardyn Bank resigned after three days, citing a lack of official support for her actions. Ardyn Bank management had attempted to undermine her authority, and the existing staff had been hostile and uncooperative, while the conservator did not have available the support staff necessary to effect control of Ardyn Bank’s numerous activities, which were often run with little systematic documentation. The practical difficulties of the operation combined, and the political pressure that Ardyn Bank management was able to exert forced the authorities to yield. Control was restored to the old management in both banks. The Governor of Mongolbank publicly apologized and resigned shortly thereafter.

C. The Bank Closure Operation

The collapse of the attempt in September to place two problem banks in conservatorship did not cause the authorities to abandon strong action as politically impossible or resign themselves to “muddling through” in the hope that a general economic recovery would lift the strain on the banks. Rather, the experience led them to the conclusion that a more thought-through and well-organized strategy was necessary.

The authorities also recognized that they faced several constraints on their approach to bank rehabilitation. Implementation capacity was extremely limited. The central bank had only a handful of staff with training in financial analysis and on-site supervision. No pool of trained accountants and auditors, let alone receivers, was available in the country. The authorities had experience only in the closure of one small bank (CAB), which had turned out to be a drawn-out and laborious exercise. Skills in bank management and operations were also in short supply, and it was unclear whether the authorities could identify and attract the ablest bank managers. The judiciary and the legal profession were not fully familiar with market-based economic concepts and in particular banking practice, and in any case the courts were overburdened and reputedly liable to be open to influence.

The nongovernment sector generally could not be relied upon to discipline bank management or provide new capital, even if the banks were economically solvent. Rather, the nongovernment sector relied critically on the banking system to provide transaction services, extend loans, and offer savings instruments. The government also relied on the banks to conduct its business. In this sense the continued functioning of a banking system represented a kind of “public good.” Any costs incurred in maintaining this public good would have to be born at a time of great fiscal stringency, as the government faced myriad spending demands, diminished revenue, and limited financing.

Under these circumstances the authorities realized that they would have to seize back the initiative in rehabilitating the banking system. The government, including the central bank, would have to initiate intervention and in the end bear much of the financial burden involved. Any action to intervene in the troubled banks would have to be as comprehensive and rapid as possible. The constraints on implementation capacity implied that efforts would have to be concentrated on the most urgent problems; the resolution of less immediately threatening problems, and many of the specific issues that would arise from intervention would have to be delayed in the interests of decisiveness. The rehabilitation strategy would also aim to reestablish respect for the rule of law and to restore the effectiveness of monetary policy.

The strategy worked out in November 1996 was designed to accord with these principles. During the initial operation attention would focus on the two large banks that were in the worst condition, namely Ardyn Bank and Insurance Bank. Together, these banks accounted for 45 percent of deposits and loans. Both would be closed and liquidated by receivers. The accounts of their household depositors would be immediately transferred to a new “narrow” bank, the Savings Bank that would hold only safe assets. The accounts of their enterprise depositors in good standing would be transferred after being partially written down, together with nonimpaired loans, to a new commercial bank named Reconstruction Bank (RB). Their impaired loans would be transferred to a collection agency, the Mongolian Asset Realization Agency (MARA). This phase of bank restructuring would be financed by the issue of government bonds. The two other large problem banks (BITI and Agricultural Bank) would be obliged to sign Memoranda of Understanding (MOUs) with the government and the Mongolbank under which they committed themselves to raise capital, streamline operations, and improve their loan portfolio according to an ambitious timetable. Initially the small banks would be largely ignored. Subsequently attention could be directed toward recovering loans and strengthening financial discipline on both banks and borrowers, and improving the operational capacities and financial strength of the banks. Still later decisions would be needed on the further restructuring of the entire banking sector, for example, through additional closures, mergers, and eventually privatization.

The initial operation was planned in detail so that it could be carried out as rapidly and smoothly as possible. The steps that had to be executed included the following:

D. Follow-Up

Much time and effort was required to sort out the final balance sheets of the failed banks and the initial balance sheets of the new institutions. Revised, ex post estimates of the losses, shown in Table 9, were obtained in June 1997. According to these estimates, the total losses were approximately as large as had been estimated in November 1996, but only after numerous positive and negative adjustments had been made. For example, liabilities increased due to the recognition of certain amounts payable or in transit as deposit claims, but assets were increased by income accrued in 1996. The estimates are based on certain, perhaps optimistic, assumptions about how much MARA would be able to recover from the impaired loans that it had taken over.

Table 9.

Mongolia: Estimated Bank Losses and Their Allocation

(In billions of togrog)

Source: Mongolbank and staff estimates.

Table 9.

Mongolia: Estimated Bank Losses and Their Allocation

(In billions of togrog)

		Ardyn Bank	Insurance Bank	Total
Total loss to allocate		26.3	12.0	38.3
(as percent of 1996 GDP)		(4.9)	(2.3)	(7.1)
Government		16.2	7.5	23.6
	Government deposits	0.6	2.0	2.6
	Other	15.6	5.5	21.0
Mongolbank		4.8	1.5	6.3
Enterprises		2.2	1.4	3.7
	Offset to nonperforming loans	1.0	…	1.0
	Deposit write-down	1.3	…	2.7
Shareholders		3.0	1.2	4.2
Others		…	0.5	0.5

Source: Mongolbank and staff estimates.

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Table 9.

Mongolia: Estimated Bank Losses and Their Allocation

(In billions of togrog)

		Ardyn Bank	Insurance Bank	Total
Total loss to allocate		26.3	12.0	38.3
(as percent of 1996 GDP)		(4.9)	(2.3)	(7.1)
Government		16.2	7.5	23.6
	Government deposits	0.6	2.0	2.6
	Other	15.6	5.5	21.0
Mongolbank		4.8	1.5	6.3
Enterprises		2.2	1.4	3.7
	Offset to nonperforming loans	1.0	…	1.0
	Deposit write-down	1.3	…	2.7
Shareholders		3.0	1.2	4.2
Others		…	0.5	0.5

Source: Mongolbank and staff estimates.

Some of the revenue drain may be offset if the new institutions pay dividends or when they are eventually privatized. Interest paid on the bonds held by Mongolbank should also return to government in the form of dividends, and Mongolbank initially at least voluntarily accepted to hand back 80 percent of any interest it received, and interest due was not always paid in cash. However, Mongolbank itself suffered large losses which left it undercapitalized.

MARA was not expected to recover very large amounts from the nonperforming loans that it was given, in part because many of the borrowing enterprises ceased to exist. By June 1997 it had recovered Tog 1.3 billion and seized approximately Tog 2.0 billion in collateral, while incurring expenses of only about Tog 100 million; the overall recovery rate was about 17 percent. One of the purposes of MARA was to set an example of financial discipline by pursuing defaulting borrowers by all legal means, and in this it has reportedly been diligent, within the limits set by an inadequate court system.

In the initial aftermath of the closing operation the situation in the banking system remained generally calm, and there were signs of a return of confidence. The real money stock recovered in 1997, led by a rise in the real value of deposits at commercial banks (Figure 1). The exchange rate displayed some turbulence in the second quarter of 1997, which may largely be attributable to uncertainty surrounding presidential elections, but it was stable over the summer of 1997 after appreciating from its lows in May. Inflation in some months had been negative, albeit due in part to seasonal factors.

Aggregate bank liquidity was adequate, although certain banks were on occasion illiquid (Figure 2). Among individual banks, the Savings Bank lost deposits in the second quarter of 1997 after it lowered interest rates on deposits, but recovered them when it restored rates. In some months it and RB failed to meet reserve requirements, in part because the government was occasionally late in paying interest on the restructuring bonds, and therefore Mongolbank waived penalties on the reserve shortfall. The process of dollarization was not reversed; dollar-denominated deposits at TDB, which was seen as the soundest bank, continued to grow rapidly in the first half of 1997. Some of this trend may be viewed as a stock adjustment as enterprises and households adjusted their portfolios once all deposits became freely available.

Table 8 shows that the structure of the banking industry in Mongolia was indeed transformed. No one bank is as dominant as Ardyn was before, although certain banks retain near-monopolies in their respective segments of the market. The small banks and TDB have expanded their balance sheets and gained market share at the expense of both the successors to Ardyn and Insurance Banks and also the distressed Agricultural Bank and BITI that are subject to MOUs.

E. Epilogue

It was realized at the time of the 1996 operation that the Mongolian banking sector would require substantial further restructuring. Indeed, the subsequent period was marked by the continued severe distress of some banks and the reemergence of large losses, which necessitated a second round of closures in 1999.

Two developments constituted the principal hindrances to the emergence of a sound financial system. First, the two banks under MOUs, namely Agricultural Bank and BITI, failed to meet their commitments, and in particular failed to raise sufficient new capital, improve credit quality, and reduce costs. Second, RB soon went beyond its original mandate and became a universal bank, taking deposits and expanding lending rapidly. Much of this lending seems to have benefited well-connected parties, and prudential supervision was clearly inadequate. At a macroeconomic level, Mongolia was severely affected first by the Asian financial crisis, which caused the prices of its main commodity exports to fall sharply, and then by two years of exceptionally harsh weather. In these circumstance, the share of loans in the banking system that were nonperforming rose to over 30 percent in 1998, and eventually almost all loans in the portfolios of RB and BITI became delinquent. The banking system made losses, and capital was eroded almost to zero; the losses of RB, Agricultural Bank and BITI in 1998 are estimated at Tog 4.1 billion, Tog 5.1 billion, and Tog 12.0 billion, respectively, totaling about 2.4 percent of GDP or more than 20 percent of total lending to nongovernment.

An initial attempt in 1998 to merge RB with a private bank, Golomtbank, was reversed due to political opposition to the way the transaction was carried out. However, in early 1999 RB, BITI, and Agricultural Bank were put into conservatorship, under which they could take no new deposits and grant no new loans. In the fall of that year, RB and BITI were placed in receivership and their licenses revoked; their residual assets were eventually passed to MARA. Agricultural Bank had to be preserved in order to provide financial services to the population and government in the countryside. New, foreign-led management was installed, and an effort undertaken to reduce operating costs. Also in 1999, four small private banks went into voluntary liquidation, and three others voluntarily ceased banking operations.

By mid-2001 there were 13 banks operating in Mongolia. TDB was the largest, with more than 40 percent of all assets in a relatively well-diversified portfolio. TDB at this point appeared to be profitable and well capitalized. The Savings Bank was the second largest institution and held a majority of local currency deposits. However, its capital base was weak, the quality of its loan portfolio was not assured, and it remained dependent on the maintenance of an adequate spread between the interest rate it paid on deposits and that it received on government securities, which still made up three quarters of its assets. Nonetheless, it was marginally profitable and liquid. The privately-owned Golomtbank had the third largest share of assets in the system. Agricultural Bank was just profitable after it resumed lending to small rural borrowers and the new external management made progress in limiting operating expenses, but it still has negative capital. The banking system as a whole appears to be sounder and more commercially oriented than before, but remains vulnerable to the exogenous macroeconomic shocks to which Mongolia is especially prone, and loan quality must remain a concern.

A. Sources of Banking Sector Distress in Transition Countries

B. Implementation of Banking Crisis Resolution

The countries considered here all made initial attempts to deal with the weakness in their banking sectors. However, these initial attempts, and especially the first attempts to close the weakest institutions, generally ended in failure and confusion. The authorities were hindered by the absence of a recognized legal framework, the lack of precedent, their own inexperience, the fear of losses among the banks’ customers, and the political strength of owners or managers. In Mongolia, after one major bank was initially closed, the central bank governor reopened the bank and apologized to owners and staff. In Bulgaria, advance notice of the closures was given to banks’ owners, and the banks’ vaults were found to be empty once the authorities finally entered the premises. Also, the initial closures clearly did not address all the weak banks in the system, leading to pressures for—and expectations of— further bank closures in the near future.

The later and more successful attempts at dealing with systematic banking crises in these countries were characterized by their comprehensiveness and decisiveness. The authorities proved ready to close even very large institutions, to incur considerable costs, and to change the institutional framework supporting the banking sector.⁷³

In most cases the weak surviving institutions were put under a much tighter oversight from the authorities, often involving memoranda of understanding and management changes—in part to mitigate the moral hazard effect of providing public support to insolvent institutions. The surviving banks’ activities were curtailed, and reporting requirements enhanced, with the expectation of a turnaround of financial prospect and an ending of flow losses. In the event of insolvency, banks were recapitalized with government bonds, or their bad loans were bought by the government and placed into a newly formed AMC.⁷⁴

The authorities also committed themselves to requiring strong efforts from the banks and the newly-established agencies to intensify loan collection, in part to recoup some of the government’s outlays on the restructuring, and in part to avoid the moral hazard that debtors might think that the bankruptcy, or restructuring, of their creditor might relieve them of their obligation to service their debts. In Lithuania and Mongolia centralized asset management agencies were introduced; in Bulgaria the authorities maintained a decentralized approach. In all cases the pressure on debtors was intensified.

The process was made possible by the passage of supporting legislation, either immediately before the interventions (as in Mongolia) or rapidly thereafter (as in Bulgaria) to enhance the authority of the central bank, and to facilitate the process of liquidating insolvent institutions. In Mongolia the clear specification in the new legislation of the respective priorities of the claims of the various creditors of the banks formed the basis of the authorities’ full protection of household deposits in the winding up of the major insolvent bank and the establishment of a successor institution. Prudential and accounting regulations were revised, so that the authorities could obtain a true picture of the state of the banks and provide appropriate remedies, and so that public confidence in the surviving institutions would be restored.

Meanwhile, in belated recognition of the costs of a weak banking system, tighter prudential requirements were placed on the surviving banks—for instance, capital adequacy requirements were brought to international levels—and central banks’ supervision departments were enhanced. In Bulgaria the supervisors were given autonomy from the rest of the central bank, to minimize the risk of political interference. More staff were recruited to supervision departments, and enforcement of prudential requirements was taken much more seriously. There was also some recognition of the problems of conflict of interest. Restrictions on insider lending and large exposures were introduced and enforced. Politicians were disbarred from bank ownership—and a strong emphasis was placed on privatization to get the state out of the banks altogether.⁷⁵ In addition, licensing requirements were tightened, and minimum capital requirements increased, to avoid further weak new banks entering the market—and also to provide those interested in entering the market to purchase an existing institution.

The authorities also recognized the need to create a commercial banking culture. Collateral laws were passed; efforts were made to develop financial markets, including treasury bills, in part to create a supply of collateral that could support lending activity.

Overall, while there were broad similarities in how the countries handled their banking systems, there were also differences. Bulgaria had the highest level of banking sector intermediation of any transition economy, at the same time as it already had a huge fiscal burden. In the depth of the crisis, it would have been almost impossible for the authorities to issue any further government debt at any price. This severely constrained the authorities’ ability to take a large share of the burden in addressing the banking sector losses, and thus led to a higher burden being borne by households and enterprises, in large part through the erosion of the bulk of banks’ domestic currency liabilities through inflation. In Mongolia, by contrast, with bank intermediation only a small part of the economy, the magnitude of insolvency was much smaller relative to GDP, and the fiscal situation not in quite such dire straits; hence, it was possible to protect a much larger section of the public (i.e., all households and small enterprises) and to rely more on the issue of government securities.

In all cases the restoration of confidence after the crisis involved also macroeconomic stabilization; indeed, the longer term success of Bulgaria and Lithuania in recovering from their banking crises may be considered to derive in large part from their adherence to their macroeconomic stabilization programs over the ensuing years. In all three cases the banking crisis led to changes in the government. In both Bulgaria and Lithuania they unfolded in the context of far-reaching institutional changes, with the central banks starting to operate according to currency board principles. In the case of Bulgaria in particular the ability of the authorities to intervene in the banking sector through providing liquidity support was drastically curtailed, with support severely limited quantitatively by the amount of resources available in the banking department of the central bank, and institutionally by requiring that the head of supervision certificate that he considered that the liquidity support being provided was needed to combat a systemic threat.