Bulgaria: Selected Issues and Statistical Appendix

This paper assesses key aspects of Bulgaria’s competitiveness. The behavior of a variety of a real exchange rate indicators and export performance is also examined in this study. The Balassa–Samuelson effect refers to the impact of differential productivity growth rates in the tradables and nontradables sectors on the real exchange rate. The following statistical data are also included in detail: total and private agricultural production, income accounts, labor force, employment and unemployment, monetary survey, foreign assets of the banking system, and so on.


This paper assesses key aspects of Bulgaria’s competitiveness. The behavior of a variety of a real exchange rate indicators and export performance is also examined in this study. The Balassa–Samuelson effect refers to the impact of differential productivity growth rates in the tradables and nontradables sectors on the real exchange rate. The following statistical data are also included in detail: total and private agricultural production, income accounts, labor force, employment and unemployment, monetary survey, foreign assets of the banking system, and so on.

III. Why is Private Sector Credit So Low in Bulgaria?1

A. Introduction and Summary

1. This chapter explores the reasons for and implications of low bank credit to the private sector in Bulgaria, and discusses measures that would facilitate prudent credit growth. The perception that the provision of bank credit to the private sector is inadequate is widespread in Bulgaria. For example, a recent report by the Bulgarian Industrial Association (BIA, 2000) claims that the “availability of credit resources is turning into a determining factor for ensuring and encouraging the growth of the economy.” This chapter attempts to answer a number of pertinent questions: (i) to what extent credit levels in Bulgaria can be considered low; (ii) whether lack of credit is a significant obstacle to faster economic growth; (iii) what factors account for the observed low levels of bank credit to the private sector; and (iv) what steps can be taken to promote a healthy expansion of private sector credit. The remainder of this introductory section provides a summary of the main findings.

2. Bank lending to the private sector is low in Bulgaria by any standard. As of end-1999, the ratio of private sector credit to GDP was only 12 percent. This represents almost half of the level reached before the 1996 banking crisis, and only two thirds of the average level for transition economies. The difference is much starker when compared with the industrialized countries, which typically have ratios above 100 percent. Financial intermediation is low even when controlling for Bulgaria’s stage of development. A crosscountry regression for 176 countries during 1989-98 indicates that per capita output and the ratio of private sector credit to GDP are positively correlated, and that a country with Bulgaria’s per capita GDP is expected to have a 30 percent ratio of private sector credit to GDP. This is even true when restricting the comparison to transition economies, which tend to have underdeveloped banking sectors.

3. A more developed banking system would likely help Bulgaria achieve faster economic growth. There is mounting international evidence that increased financial intermediation can have a significant impact on economic growth. This is because financial intermediaries mobilize saving, transform maturities, exert corporate control, and channel funds to their most productive uses. These factors can be especially relevant for Bulgaria, where the economy is still maturing and becoming more market oriented. Estimates from a cross-country study suggest that were Bulgaria to develop its banking system to the average level of countries in its income group, its yearly growth rate could be 1–2 percentage points higher.

4. The low level of private sector credit reflects mostly supply and institutional factors. Low credit demand does not appear to be the reason for the present low levels of bank lending, because investment is strong, and alternative financing channels are not readily available. However, the supply of credit is limited for a number of reasons. Banks have become more cautious because of the 1996 banking crisis and the ensuing new environment where they had to build up risk management capacities. The economic restructuring also adversely impacted credit to private sector, because many old customers ceased to exist. New customers from the emerging private sector typically do not have a credit history or appropriate collateral, and transparent financial information is often lacking. Another factor is the lack of full competition, which has allowed banks to keep credit levels low while maintaining high interest spreads. Finally, banks have been cautious in their lending behavior because of an imperfect legal environment. The resolution of financial disputes is often slow, and contract enforcement is weak. Collateral is hard to seize, and bankruptcy and liquidation procedures remain fraught with ambiguity and uncertainty. A legal provision that criminalizes the extension of loans without “proper security” even in the absence of fraudulent intent acts as a deterrent for bank officials.

5. The Bulgarian authorities have already taken significant measures to facilitate prudent growth of bank credit to the private sector. Continuing bank privatization is promoting competition in the banking sector. A central credit registry will soon be made operational fully, improving the information base for credit decisions. The planned training of judges on financial issues should help accelerate the resolution of disputes. Amendments to the Commercial Code are being drafted to accelerate and improve the handling of bankruptcy cases. A law on land registration and cadastre, which would facilitate the use of land as collateral, is being discussed in parliament.

6. However, challenges remain. While the existing legislation is generally solid, and is set to improve further with planned changes, more effort is needed to enforce this legislation strictly. In addition, it should be complemented by clear implementing regulations. To improve transparency and help overcome information asymmetries, accounting standards and disclosure rules need to be implemented stringently. To help banks gain more confidence, creditor’s rights should be enforced more consistently. Enterprise bankruptcy cases should be handled more quickly. To this end, the existing draft amendments to the Commercial Code should be adopted quickly. A thorough review of the existing practices governing insolvency and liquidation procedures would be desirable. Finally, consideration should also be given to the removal of the provision in the Criminal Code that penalizes the extension of loans without “proper security”. At a minimum, the law should be clarified so as not to criminalize reasonable lending practices.

B. The Level of Bank Lending to the Private Sector

7. As of end-1999, bank credit to private sector was low, at only 12 percent of GDP. Before the severe banking crisis in 1996, the level of credit to the private enterprises was almost twice as high, at around 20 percent of GDP (Figure 1). At the time, credit to the state-owned enterprises (SOEs) stood at a similar level, so that total credit to the non-government sector was around 40 percent of GDP in 1995 (Table A32).2 However, because of the banking crisis and the ensuing macroeconomic instability and hyperinflation, the value of total credit to the non-government sector eroded rapidly. By mid-1997, bank credit to both the SOEs and the private enterprises were halved. With the setup of the currency board, the government dramatically reduced its borrowing from the banking system (Tables A32 and A37). This in principle allowed for a “crowding in” of enterprise credit. In fact, the credit to private sector started to increase moderately, as real credit growth reached 15 percent per annum on average in 1998–99. However, this increase was partially due to higher leva value of the U.S. dollar denominated loans, and real credit remained well below the pre-crisis levels. Credit to the SOEs has continued to shrink, partly because average credit volume to these enterprises declined, and partly the number of SOEs decreased as a result of privatization and liquidation. Credit to households was the only component of the total credit to the non-government sector that exceeded its pre-crisis levels, but remained low in absolute terms.3

Figure 1.
Figure 1.

Bulgaria: Credit to the Private Sector, 1995-99

Citation: IMF Staff Country Reports 2000, 054; 10.5089/9781451804393.002.A003

Source: Monetary Survey, the BNB, and staff calculations.

8. The level of bank credit to the private sector is low compared with other countries. Industrial countries have much deeper financial structures, with the ratio of private sector credit to GDP well above 50 percent (Figure 2). Transition countries also tend to have higher ratios, with an average of 17 percent. Even controlling for Bulgaria’s stage of development, financial intermediation is low. A regression of the ratio of private sector credit to GDP on the per-capita PPP-GDP and its square for 176 countries during 1989–98 indicates that a country with Bulgaria’s income should have 30 percent private sector credit to GDP ratio.4 Even when restricting the estimation to the group of transition economies or developing countries with similar income levels the results remain broadly the same: a regression with 25 transition countries yields a predicted value of 19 percent for Bulgaria, while a regression with 25 non-transition economies with similar GDP per capita results in a predicted value of 24 percent for Bulgaria.

Figure 2.
Figure 2.

Bulgaria: Credit to the Private Sector, 1989-98

Citation: IMF Staff Country Reports 2000, 054; 10.5089/9781451804393.002.A003

Source: International Financial Statistics, and staff calculations.1/ The solid line indicates the fitted values from a regression of the ratio of private sector credit to GDP on per capita PPP-GDP for 185 countries in 1989-98.

C. How Important is Credit for Growth in Bulgaria?

9. Financial intermediation facilitates the efficient allocation of resources in an economy. Financial intermediaries mobilize savings, transform maturities, exert corporate control, and channel funds to their most productive uses.5 For example, if some firms are denied access to credit, they need to finance investments with retained earnings. In such cases, the economy wide selection of investment projects will be determined by enterprise liquidity rather than project profitability. In addition, those firms that invest using their own resources usually do not benefit from external monitoring.

10. There is mounting international evidence that the level of financial intermediation has a causal effect on growth. Levine, Loayza, and Beck (1999) find strong econometric evidence for the hypothesis that financial intermediary development exerts a statistically significant and economically large impact on economic growth.6 Their estimates suggest that if Bulgaria increased its share of private sector credit in GDP to the mean predicted by its GDP per capita (0.3), its annual growth rate could be 1–2 percentage points higher.7

11. In the case of Bulgaria, it is likely that the availability of credit will have an important influence on growth. Bulgaria is in the midst of a large-scale structural transformation of the economy. While the public sector is downsizing, a whole new group of entrepreneurs is emerging, and new small and medium-sized enterprises are trying to establish themselves in the market. In most cases, these new firms are dependent on bank financing for their expansion. Increased financial intermediation through banks would contribute to an improvement in corporate control and thereby enhance the business climate for private sector development. Such gains can be expected to be higher in a transition country that is striving to develop fully functioning markets than in a mature economy.

D. The Reasons for Low Credit to the Private Sector

12. Low credit to the private sector can in principle reflect both demand and supply factors. Potential factors reducing credit demand include the absence of profitable investment opportunities, and the availability of alternative financing instruments, such as capital markets, inter-enterprise arrears and informal lending. Factors affecting loan supply include liquidity, the impact of the 1996 crisis, increased uncertainty as a result of economic restructuring, lack of competition in the banking system, underdeveloped short-term capital markets, the punishment of risky behavior by depositors, lack of information about the quality of borrower, changes in regulation, and an imperfect legal environment. Since it is notoriously difficult to quantitatively separate demand and supply effects on credit markets, this section discusses the potential factors in mostly qualitatively terms, supported by quantitative evidence where possible.8

13. A review of the potential factors suggests that the reasons for low private sector credit in Bulgaria are mostly linked to supply and institutional factors. Depressed demand for credit is unlikely to be the main reason for the low lending levels, because investment is strong, and alternative financing channels are not readily available. On the supply side, the behavior of the banks has changed dramatically after the 1996 banking crisis and the ongoing restructuring in the economy. In addition, lack of competition has not promoted credit expansion. Finally, institutional factors, including legal and contract enforcement problems, insufficient information about borrowers, and strict bank laws and regulations contributed to banks’ reluctance to lend. The remainder of this section elaborates these arguments.

Demand factors

14. Significant and accelerating investment activity and high lending rates suggest that low credit demand is unlikely to be the main reason for the observed low lending volumes. Weak credit demand would typically be associated with low investment and lending rates, neither of which is the case in Bulgaria. Spreads between deposit and lending rates have been high, around ten percent since the introduction of the currency board arrangement (see Figure 3). These levels are similar to those currently prevailing in Mexico, a country seen as suffering from a severe “credit crunch” since the 1994-95 crisis, and higher than those in other countries that experienced credit contractions in the aftermath of crises, such as Argentina, Korea, and Thailand.9 In addition, investment rates have been increasing from 11.4 percent of GDP in 1997 to 18.5 percent in the first three quarters of 1999 (Table A2). These investment rates are not excessively low by international standard.

Figure 3.
Figure 3.

Bulgaria: Credit to the Private Sector Indicators, 1996-99

Citation: IMF Staff Country Reports 2000, 054; 10.5089/9781451804393.002.A003

Source: The BNB, Kaufmann, Kraay and Zoido-Lobaton (1999), and staff calculations.

15. Alternative financing channels, including capital markets, inter-enterprise arrears, and informal lending, are unlikely to substitute significantly for bank credit. Capital markets are very small in Bulgaria, with a stock market capitalization only a fraction of GDP (around 5 percent). Inter-enterprise arrears are not large and are unlikely to increase, because budget constraints have been hardened substantially over the last three years. Bulgaria now scores much better in this regard than many other transition economies: in a survey carried out by the EBRD (1999), the percentage of firms reporting that they had substantial arrears with either the national government, the local government or state-owned utilities companies was only 12 percent. While this figure is higher than those for some more advanced transition economies are, it is roughly equal to that for the Slovak Republic and only slightly higher than that for Poland. The percentage of firms that failed to pay their taxes in 1999 is much lower than in Czech Republic, Croatia, Poland, the Slovak Republic, and Slovenia.10 However, while their significance is difficult to assess, other informal lending mechanisms may still play a role in financing investment in Bulgaria.

Supply and institutional factors

16. The main factors that may affect loan supply are bank liquidity, the need to adjust to the new environment after the 1996 banking crisis, the ongoing restructuring, lack of competition in the banking system, lack of information about the quality of borrowers, and an imperfect legal environment. Underdeveloped short-term capital markets, the punishment of risky behavior by depositors, and changes in regulation may also affect loan supply. At the outset, we should note that the low levels of credit are not the result of a lack of liquidity. Banks are liquid, but prefer to hold domestic or foreign bonds instead of loans as assets. Banks hold only 29 percent of their earning assets in the form of loans to enterprises and households. Bank lending capacity has increased markedly since the establishment of the currency board and is at similar levels as in late 1996 (Figure 3, second panel).11 The other factors are discussed below.

The 1996 banking crisis

17. Bank credit to private sector remained low in Bulgaria after the banking crisis, which is consistent with the experience of other countries. International comparisons show that when a banking crisis is associated with a decline in credit, it sometimes takes many years for the credit levels to recover. Figure 4 shows the behavior of the share of private sector credit in GDP after banking crises in eight countries.

Figure 4.
Figure 4.

Bulgaria: Share of Private Credit Around Banking Crises

(t = 2 denotes date of banking crisis)

Citation: IMF Staff Country Reports 2000, 054; 10.5089/9781451804393.002.A003

Sources: IFS, and staff calculations.

18. One reason is that the banks started to lend cautiously to strengthen their balance sheets, which were weakened in the run up to the crisis. Before the crisis, in 1995, the share of capital in total liabilities was more than 6.5 percent. However, this ratio dropped substantially during the crisis, to close to 4 percent. At the same time, the share of classified loans in total loans increased from 60 percent to close to 70 percent in 1996. Since then, banks have managed to boost the share of capital in total liabilities to more than 10 percent. At the same time, capital adequacy ratio doubled from around 20 percent in 1995 to close to 40 percent in 1999 (Table A38). In parallel, the share of classified loans in total loans declined to 15 percent.

19. Moreover, Bulgarian banks are now operating under very different circumstances than three years ago, and need time to adjust particularly their risk assessment capacities. Banks, which prior to the crisis channeled funds to state-owned enterprises and engaged in connected lending, are still in the process of building up risk assessment, credit evaluation, and project monitoring techniques. Such a process, which requires personnel training and hiring, accumulation of experience, as well as the implementation of adequate computer and software capacities, is likely to take time. However, as noted by the OECD (1999), the incentives for banks to invest in the acquisition of these skills will depend on the institutional environment, including the degree of competition, and the ability for banks to collect their claims—a point discussed further below.

20. The more aggressive lending strategies on the part of foreign banks, which can be assumed to possess the necessary expertise, attest to this need. The average ratio of loans to total assets is 44 percent for foreign banks against 35 for domestic ones. It is noteworthy that the title “Banker of the Year” was awarded by the magazine “The Banker” to the manager of a foreign bank, BNP-Dresdner Bank, in recognition of that institution’s fast-growing lending business. This is despite the general view that foreign banks are less likely to be familiar with specific Bulgarian borrowers, an effect which tends to work in the opposite direction.

Economic restructuring

21. During economic restructuring investment risk can increase, and information asymmetries may worsen, leading banks to curb lending. When markets are changing fundamentally, objective default risk is likely to be higher. This implies that even if banks could correctly assess the probability of default of an individual borrower, so that there were no adverse selection problem, they would supply credit only at higher interest rates. On the other hand, even if objective risks do not increase with restructuring, information asymmetries are likely to do so as a result of the loss of old customers bases.

22. While it is not possible to fully assess the level of investment risk in Bulgaria in this study, the current indicators do not indicate high risk levels. In fact, the percentage of nonperforming loans has decreased sharply since the banking crisis, and has stabilized below 10 percent. This is comparable to the CEE economies, where this ratio is close to 7 percent, although still substantially higher than the EU average, which is less than 2 percent. On the other hand, the Agency for Economic Analysis and Forecasting (AEAF) wrote in its report on the first half of 1999 (p. 17) an opposite view: “Risk in the Bulgarian economy remains rather high and makes changes in banks’ strategies for asset and liability management unlikely”.

23. The restructuring of Bulgaria’s economy has led to a sharp increase in informational problems. Under the large structural changes in the economy since 1997, many old bank customers ceased or reduced operations, or have become uncreditworthy. New customers from the emerging private sector and previously state-owned enterprises under new management typically do not have a credit history or appropriate collateral. Moreover, given the economic instability prior to the establishment of the currency board, past performance is not likely to be a good predictor of future performance even for firms that have already been operating for many years.

24. While these factors imply that restructuring may initially adversely affect credit levels, they do not account for all the difference in lending between Bulgaria and other countries. The private sector share of GDP, and indices measuring progress in liberalization of the economy, such as those compiled by the EBRD, are all positively correlated with credit. However, countries like the Czech Republic and Hungary had already achieved deeper intermediation when their private sector share of GDP was similar to Bulgaria’s current levels. Other countries, like Croatia or Slovenia, do not have higher private sector shares in GDP, but markedly higher levels of private sector lending. Similarly, while countries that have made more progress with privatization and bank liberalization, tend to have higher credit levels, variations in indices attempting to measure progress in this regard are not able to explain much of the variation in lending across transition economies. Table 1 shows some of these indicators for seven European transition economies.

Table 1.

Bulgaria: Private Sector Credit and other Indicators in Transition Economies, 1995-99

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Source: EBRD Transition Report 1999.
Lack of competition

25. The degree of competition influences the level of intermediation, as well as the spreads between lending and deposit interest rates and the efficiency of the banks. A monopolist, or an enterprise in an oligopolistic market, would maximize its profits by limiting its lending much below the levels attainable under perfect competition, and keep the prices—in this case, interest rate spreads—high. This microeconomic principle mirrors in empirical results, including a panel study by Rother (1999) where he finds a negative correlation between market concentration measures and financial intermediation levels in transition economies. In addition, in non-competitive markets, banks have little incentives to minimize costs, and thus in general operate inefficiently.

26. State-owned banks dominate the Bulgarian banking system. Out of 35 banks, the top two banks are state owned and hold 40 percent of the total assets in the banking system. The next five largest banks, which were mostly state-owned until this year, hold 30 percent of the total assets, with the remaining 28 banks holding only 30 percent of the total assets. These 28 banks are mostly very small, or branches of foreign banks.

27. There are indications that the Bulgarian banks behave oligopolistically. All the characteristics of a non-competitive market are present: intermediation is low, interest rate spreads are large, and banks in general are inefficient. They have high operating costs relative to the CEE average and industrial countries in Europe (Table 2).

Table 2.

Bulgaria: Financial Ratios, 1995-98

article image
Source: BankStat and BankScope.

Based on most banks in these countries that publicly disclose their balance sheets and income statements. For a complete list, see BankStat.

CEE: Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Slovak Republic.

EU Other: Austria, Belgium, Denmark, Finland, Greece, Ireland, Netherlands, Portugal, Spain, and Sweden.

EU large: Germany, France, Italy, and the United Kingdom.

28. Empirical evidence based on a panel data covering the past two years also supports the view that the banking system in Bulgaria is not perfectly competitive (see the annex for the technical details). The empirical work makes use of the result from microeconomic theory that links the degree of competition and the sensitivity of total revenue to costs (see Panzar and Rose (1987) for this type of methodology). A one-to-one correlation would indicate perfect correlation, while lack of any correlation would indicate that banks behave like local monopolies. The panel estimation results and the tests on the relevant coefficients show that while there is some correlation between costs and revenues, it is significantly less than one, implying that the Bulgarian banks behave oligopolistically.

Lack of reliable financial information

29. Informational asymmetries are at the heart of credit markets. Lenders lack full information about the characteristics and the behavior of borrowers, and this has implications for the behavior of both parties. In particular, it may induce credit rationing on the side of banks.12

30. A general lack of reliable financial information makes it difficult for banks to assess the situation of borrowers. While international accounting standards have largely been adopted in Bulgarian laws, in some areas, there is still scope for improvement. More important, the degree of implementation and enforcement of accounting standards is very weak. For example, although the law contains reasonable disclosure requirements, in practice most companies do not provide this type of information, reducing the informational content of balance sheets and income and loss statements. In addition, a central credit registry is only now being put in place.

Legal and contract enforcement problems

31. An environment fraught with legal uncertainties and contract enforcement problems, will restrict banks’ willingness to lend. For example, banks often require collateral as a way of overcoming the informational asymmetry problems described above. If, however, it is difficult to establish a clear title regarding collateral, or if the judicial system works too slowly or unpredictably to ensure that collateral can in fact be seized, this avenue of dealing with informational asymmetries will be closed.

32. Bulgaria still ranks low in an international comparison of the prevalence of the “Rule of Law”. Kaufmann, Kraay and Zoido-Lobatón (1999) have recently constructed an aggregate variable measuring the prevalence of the “rule of law” for 167 countries based on a variety of individual surveys and ratings. According to this variable, Bulgarian ranks number 81, below most transition economies that show higher financial intermediation. Across countries, stronger prevalence of the rule of law is clearly associated with higher levels of credit to the private sector, and in a simple OLS regression, the rule of law variable explains 43 percent of variation in credit shares in GDP. Interestingly, the rule-of-law variable seems to be matter for private sector credit to GDP even after controlling for per-capita GDP (Figure 3, third panel).13

33. More disaggregated results from various surveys support the view that major additional efforts are needed to improve governance in Bulgaria. For example, the EBRD has recently carried out an enterprise survey asking firms how problematic different factors were for the operation and growth of their businesses. The results concerning “Law and order” landed Bulgaria on place 15 of 20 transition economies. In the 1999 Transparency International Corruption Perceptions Index, Bulgaria fares slightly better, ranking on place 63, below other transition economies such as Slovenia (25), Czech Republic (39), Lithuania (50), the Slovak Republic (53), Latvia (58), and at the same level as Macedonia, Romania, Egypt and Ghana. In the same vein, the 1999 Corruption Assessment Report published by the Coalition 2000 highlights the inefficiency of the judicial system and stresses the need for judicial reform. On the other hand, a recent report by FIAS mentions that investors did not see corruption as a particularly acute problem in Bulgaria. The general perception of a lack of reliable legal framework appears to be affecting banks directly. According to a survey among banks conducted by Koford and Tschoegl (1999), nine out often respondents answered positively to the question “Do you have difficulties with court action?” A recent assessment of the judicial system by the World Bank (1999) highlights a variety of shortcomings such as understaffing, low salaries, potential corruption, insufficient training mechanisms, and overly complex legal procedures.14 Since law enforcement is weak, banks have difficulties in seizing collateral.15 It can often take many months before the creditor can physically assume possession of the pledged property. Courts are generally overloaded 16, and enforcement by the executive is often slow.

34. Bankruptcy and liquidation procedures remain fraught with ambiguity and uncertainty. Debtors can delay the process easily, allowing them to continue operating with impunity.17 Currently, the Commercial Code contains provisions under Part IV for bankruptcy and under Chapter 17 for liquidations. However, Chapter 17 addresses procedures for voluntary liquidation only. The application of the provisions in Chapter 17 for insolvent companies leads to many practical complications: for example, there is no order of priority concerning the payment of creditors. On the other hand, according to the provisions in Part IV, bankruptcy procedures are entirely controlled by the Court, which generally results in slow procedures. Recently, an amendment to the Commercial Code was submitted to parliament, which addresses some of these problems and should help to accelerate bankruptcy procedures. A related issue concerns the selection, training, and supervision of trustees in bankruptcy cases. The Ministry of Justice maintains a list of persons eligible as trustees, but their training and supervision are inadequate. As a result, trustee practices vary widely, and often lack the required professionalism.

35. Until recently, there were problems with establishing a clear title for collateral. According to the aforementioned survey by Koford and Tschoegl (1999), banks reported that, when trying to seize collateral, they often found out that the borrower had pledged it to several banks. However, a central collateral register for moveable property has by now been established and appears to be operating well. In agriculture, there are still some remaining problems regarding the clarification of ownership and the registration of land, which constitute obstacles for the extension of credit to farmers.18 The current cadastre and registration system does not function well. A new Registration and Cadastre Law has been drafted, but has been moving very slowly through Parliament.

36. In the absence of a predictable enforcement of creditor’s rights, banks will have little incentive to invest in the acquisition of skills and technology. If the marginal return to an additional investment in the human capital and equipment needed for an expansion of lending activities is not greater than the return from holding safe assets, banks will have no incentives to change their current practices, and the problems discussed in section D will continue to limit their role as financial intermediaries.

Restrictive laws and regulations

37. While changes in bank regulations can to some extent explain the decline in borrowing after the crisis, these regulations are not overly restrictive and cannot alone account for the low intermediation levels. Several requirements have been either tightened substantially or implemented more strictly after the crisis, including those on capital adequacy, foreign exchange open positions, large loans and minimum reserves. However, these changes were consistent with a return to more prudent banking, and are in line with the Basel Core Principles in Effective Banking Supervision (see IMF (1999b)). In addition, part of these restrictions are being relaxed, including the provisioning rules, and the minimum reserve requirement, in parallel to the decreasing risk in the banking sector.

38. However, the articles of the Criminal Code that relate to lending may have an adverse impact on banking intermediation. The law criminalizes the extension of loans without “proper security” when the loan is not paid back. The corresponding provision in the Criminal Code, Article 220 (3), was created in 1997 as a reaction to the banking crisis. The law does not require the presence of any embezzlement intend from the part of the bank official. The “proper security” prescribed by the law is not clearly defined, and could be interpreted as to prescribing 100 percent collateral—a stricter requirement as those contained in the Banking Act. While not many bank officials have been punished under this provision, the law is certainly exerting an effect on bankers’ behavior. According to BIA (2000), the requested collateral is usually about or over 200 percent of the amount of the requested credit. Similar information was obtained by the mission in conversation with bankers. It is noteworthy that an excessive reliance on collateral for lending decision not only typically results in a suboptimal allocation of resources, since many profitable investments are not carried out, but also does not protect the banking system from aggregate shocks.19

High liquidity requirement in a currency board

39. Banks may feel obliged to maintain high liquidity given the limited lender-of-last resort function of the currency board. 20 As pointed out by Caprio and Honohan (1993), banks can be faced with sudden bunching of withdrawals, the nonrenewal of credit lines by other intermediaries, or the sudden need to make credit available to important clients. In the absence of the possibility of borrowing from the central bank, the amount of liquidity that banks will hold will depend on the depth of money markets. If short-term money markets are shallow, banks will be forced to hold larger reserves. A lack of advanced technology of liquidity management will similarly induce banks to hold higher liquidity.

40. While Bulgarian banks are very liquid, this is not only due to prudential reasons or the absence of short term capital markets, but also because of weak liquidity management. The minimum reserve requirement has been set high at 11 percent, given the limited lender-of-last-resort capability of the BNB, and the legacy of the crisis. Even then, banks have regularly maintained excess reserves that fluctuated between 2 and 23 percent of minimum required reserves in 1999. Also, the primary and secondary liquidity ratios for the banking system have been 15 and 35 percent, respectively, much higher than what can be expected for prudential reasons.

Depositor threat

41. If depositors punish risky behavior by banks, this may induce a conservative bank asset management. Martinez and Schmukler (1999) provide international evidence that this is indeed the case.21 Using bank panel data from Argentina, Chile and Mexico, they find that even small, insured depositors withdraw money from risky banks.

42. There are incentives for the depositors to punish risky behavior by banks in Bulgaria. The currency board arrangement limits the lender-of-last-resort function of the BNB, and the memories of the banking crisis are still alive. In addition, the new deposit insurance scheme that was introduced in 1998 protects most depositors up to BGN 5,000, without full coverage.

43. However, this does not seem to have a substantial effect on bank lending. To the extent that the smaller banks are seen as less likely to be bailed out by the government in case of difficulties, they may be the ones to be more subject to depositors’ discipline.22 Accordingly, if the disciplining effect exerted by depositors is important, we should ceteris paribus observe a more conservative asset management by smaller institutions. This is not the case for Bulgaria - the correlation between the ratio of loans to assets and total assets is not significantly different from zero. Moreover, when the State Savings Bank (SSB) was given full deposit insurance during the banking crisis, this did not result in a noticeable change in the structure or volume of deposits, indicating that this factor is not likely to be the decisive one explaining the conservative banking practices prevalent in Bulgaria.

E. Policy Implications

44. While it cannot be in the interest of Bulgaria to promote a return to lax lending practices, policies to foster sound financial intermediation can be beneficial for growth. Tight controls of risks in the banking system are particularly important in the context of a currency board with a very limited lender-of-last resort facility, and when it comes to bank regulation, it is good to err on the side of caution. However, the discussion above revealed a number of areas where policy measures could be implemented to promote the development of healthy lending without jeopardizing the stability of the banking system:

  • Competition in the financial sector needs to be promoted through a continuation of privatization of banks. The authorities are taking steps to complete the privatization of the banking system. This is expected to increase the incentives in the banking sector to maximize profits by reducing inefficiencies in bank operations and investing in the acquisition of skills. Moreover, the engagement of strategic foreign investors is likely to accelerate the adoption of modern practices in the banking sector.

  • Creditors’ rights could be improved further, the enforcement of existing laws could be enhanced, and processes streamlined. In order to accelerate and improve the handling of bankruptcy cases, the authorities have drafted amendments to the Commercial Code. Quick adoption of these amendments would be a step in the right direction. Moreover, a thorough and broader review of existing practices governing insolvency and liquidation procedures with a view of strengthening creditors’ rights would be desirable. Another important measure would be the establishment of a body within the Ministry of Justice that supervises and trains trustees in bankruptcy cases.23 Courts’ capacities to handle these cases need to be strengthened through increased training of judges and improvement of caseload management.

  • The flow of information and transparency in the financial sector could be promoted further. The central credit registry is about to be operational fully. In the area of accounting standards, existing requirements, particularly in the area of disclosure, may need to be strengthened and be enforced more stringently. The development of the accounting profession could be encouraged and the tax administration personnel could be trained further accordingly.

  • The provision in the Criminal Law penalizing the extension of loans without “proper security” could be removed or clarified. Careful consideration should be given to the removal of this provision in the Criminal Code. At the minimum, the law could be clarified so as not to criminalize reasonable lending practices.

  • The development of short-term money markets could be promoted. The deeper money markets are, the lower banks’ precautionary holdings of liquidity need to be. The development of markets for certificates of deposit, commercial paper, treasury bills, interbank lines, and bankers acceptances would contribute to increased levels of financial intermediation.24

  • The remaining obstacles for the establishment of a working agricultural land market could be removed. The existing system of notarizing deeds needs to be replaced with a parcel-based registration system linked to a unified cadastre. A registration and Cadastre Law is currently being discussed in parliament. Its adoption would represent an important step in the right direction. After its adoption, this and other laws regulating the land market need to be implemented consistently, which requires the building of adequate institutional capacity.

ANNEX I This appendix describes the methodology used in estimating the market structure of the banking system in Bulgaria, and presents the technical results.

The methodology for estimating the market structure

1. The methodology is based on microeconomic theory that links total revenue to the marginal cost curve (see Panzar and Rosse (1987)). When input prices increase and shift the marginal cost curve up, a monopoly’s total revenue declines. On the other hand, in a perfectly competitive market, a similar increase would lead to a one-to-one increase in total revenues, because those firms that cannot increase their revenues fully start incurring losses and have to exit the market. In between these two extremes is the case of an oligopolistic market, where, as marginal cost curve shifts upward, total revenues increase, but less than one-to-one with the percent increase in costs. More specifically, let


where, y is total revenue, x is a vector of input factor prices, z is all other factors that affect revenue—mostly cost and demand side variables—and q is the revenue function. Panzar and Rosse show that if the sum of the input factor price coefficients are less than zero, then it means that as costs increase, total revenue declines, indicating a monopolistic market structure. Instead, if the sum of the input coefficients is between zero and one, then the firms behave like oligopolies. Finally, if the sum of the input coefficients is one, then firms increase their revenue one to one with their costs, and thus operate in a fully competitive environment. Any sum that is larger than one is not compatible with this methodology, and indicates a misspecification. All these arguments are for elasticities, therefore the variables are all in natural logs.

2. In the case of the banking sector, the production function of the banking services are defined as follows:


where, trit is the total revenue, iit is the unit price of funds, wit is the unit labor cost, onit is the unit price of other costs, zit is all other variables that affect total revenue, and b is the vector of coefficients of (see Coccorese (1998) for an application to the Italian banking system).25 Specifically, unit price of funds is calculated as the ratio of total interest expense of a bank to total deposits; unit labor cost is calculated as the ratio of total salaries and social security contributions to total assets; and unit price of other costs is the ratio of other operating costs to total assets. Other variables consist of total deposits (td) to use as a proxy for demand; total administered funds (taf) to capture the fact that the larger the funds are, the larger on average total revenues should be; and the risk capital to administered fund ratio (rcaf), and the loans to administered funds ratio (laf) to proxy for risk. All variables are in natural logarithms.

3. Tests are as follows: Let H = bi + bw + b0, where the three coefficients correspond to the unit cost of funds variable, the unit labor cost variable, and the unit price of other costs variable, respectively. If the null hypothesis that H is less than or equal to zero is rejected, this implies that the market structure is not monopolistic. In addition, if the null hypothesis that H is between zero and one is rejected, then the market structure is not oligopolistic either. However, in addition, if the null hypothesis that H is equal to 1 is rejected, then the results would be inconsistent with the theory, implying that there is misspecification in the model or the estimated equation.


4. The model is applied to a panel data set on the Bulgarian banks. The data set contains bank specific data on all Bulgarian banks that were in operation in 1998-99. For estimation, standard panel data estimation techniques are used, which include fixed and random effects.

5. The results show that Bulgarian banks behave oligopolistically (Table 3). The sum of the input factor price coefficients of the panel data estimation are significantly larger than zero, allowing us to reject the hypothesis that the banks behave monopolistically. At the same time, the sum of the coefficients is smaller than one, allowing us to reject also perfect competition in the banking system. Both factor prices of funds and of other costs are significantly greater than zero, while unit labor costs are not correlated with total revenues. The results from fixed and random effects do not differ substantially.

Table 3.

Bulgaria: Market Structure Regression Results, 1998-99

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Source: staff calculations.

The dependent variable is total revenue (tr). The independent variables are as follows: the unit price of funds (i), the unit labor cost (w), the unit price of other costs (o), total deposits (td), total administered funds (taf), the risk capital to administered fund ratio (rcaf), and the loans to administered funds ratio (laf). All variables are in natural logarithms.

Results pertain to random panel data estimation, with a sample from 1998 to 1999. Regular ordinary least squares results are similar. Fixed effects results are all insignificant, given the shortness of the time series dimension. These results are not reported; however, they can be requested from the author. T-statistics are in paranthesis.

H = b_i + b_w + b_o, where b_x is the coefficient estimate of variable x. The tests use 10 percent significance level.

6. Other coefficient estimates indicate that the level of risk and the size of the banks in addition to what is captured by their deposit base are not important in determining their total revenues. This can be seen from the coefficient estimates of the two risk measures—the ratio of risk capital to total administered funds (rcaf), and the ratio of loans to total administered funds (laf)—which are very close to zero, and insignificant. This is not surprising, given that the sample period coincides with good banking supervision and a period of cautious banking.


Table A1.

Bulgaria: National Accounts, 1991-95

(Old classification) 1/

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Sources: National Statistical Institute and staff estimates.

In 1996, the classification of activities changed.

Including holding gains.

Table A2.

Bulgaria: National Accounts, 1996-99

(New classification)

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Sources: National Statistical Institute and staff estimates.In 1996, the classification of activities changed

Preliminary data.

Includes: hotels and restaurants; real estate, renting and business activities; public administration and defense.

Table A3:

Bulgaria: Selected Transition Economies: Cumulative Change in GDP, 1989-99

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Source: WEO.

Compares the GDP in the year of its lowest level since the beginning of the transition with

Table A4.

Bulgaria: Industrial Sector, 1991-95 1/

(Old classification) 2/

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Sources: National Statistical Institute and staff estimates.

Includes state and private sectors, using the SNA methodology.

The classification changed in 1996.

Including holding gains/losses.

Self-employed and other small private unincorporated firms engaged in market production; included in other headings from 1997.

Table A5.

Bulgaria: Industrial Sector, 1996-99 1/

(New Classification) 2/

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Sources: National Statistical Institute and staff estimates.

Includes state and private sectors, using the SNA methodology.

The classification changed in 1996.

Preliminary data

Table A6.

Bulgaria: Services Sector: Total, State, and Private, 1991-99

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Sources: National Statistical Institute; and staff estimates.

Including holding gains/losses.

Preliminary data.

3/ From 1996, this row also includes repair of motor vehicles and personal and household appliances

Includes: housing and municipal services; business services; science; education, culture and art; health and social security, sports recreation and tourism; finance, credit and insurance; government; and other sectors of non-material production.

Table A7.

Bulgaria: Services by Branches, 1992-1999

(Old Classification) 1/

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Sources: National Statistical Institute.

Classification system changed in 1996.

Preliminary data.

Table A8.

Bulgaria: Total and Private Agricultural Production, 1991-99

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Sources: National Statistical Institute; and staff estimates.1/ According to National Classification of Economic Activities.