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«Produced by: For: Michael Borish and Company, Inc. United States Agency for International Development 137 Howick Street NDK Office Building ...»

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Produced by: For:

Michael Borish and Company, Inc. United States Agency for International


137 Howick Street NDK Office Building

Rockcliffe, Ontario K1M 0G9 Bulgaria Square, 1

Canada 1463 Sofia, Bulgaria date: July 6, 2001 Table of Contents Page I. Introduction 1 II. Methodology of the Rating System 1 III. The Bulgaria Rating 3 A. Section 1: Assessment of Financial Sector Infrastructure 6 B. Section 2: Assessment of Economic and Structural Factors 12 C. Section 3: Assessment of Banking Structure and System Profile 18 D. Section 4: Assessment of Banking Sector Development Based on Prudential Norms 23 ANNEX 1: The Bank Rating System 27 ANNEX 2: A Detailed Assessment of the Bulgarian Banking System 32 ANNEX 3: Comparison with Poland and Romania 116 ANNEX 4: List of Contacts 127 ANNEX 5: Bibliography 130


BULGARIAN BANKING SYSTEM: 2001 I. Introduction The following assessment of the Bulgarian banking system has been produced under contract to the United States Agency for International Development/Bulgaria by Michael Borish and Company, Inc. Michael Borish and Company, Inc. would like to thank Debra McFarland (USAID/Bulgaria Mission Director), William Foerderer, Rayna Dimitrova, David Lieberman, Ivanka Tzankova and Nora Ovcharova of USAID/Bulgaria for their kind support and guidance.

Michael Borish and Company, Inc. would also like to thank the many people who provided time and documentation for this assessment to be carried out with effectiveness. A list of the people with whom the team met is found in Annex 5. Michael Borish visited Bulgaria from April 29-May 11, 2001, in conjunction with this project.

The banking sector assessment is an update from an earlier assessment conducted in early 1998, shortly after the introduction of the currency board arrangement and major new legislation and regulations for the banking sector. This update is different from the one conducted in 1998 in that it has substantially more information (due to increased availability of information in Bulgaria), and it includes a comparative annex (see Annex 3) with banking sector indicators in Romania and Poland. These two countries were selected for ease of relative peer comparability with Romania (e.g., second-tier EU accession country, relatively late reformer), and similarities in many banking sector reform approaches with the more advanced Poland (e.g., substantial investment in banking supervision development, movement from a fairly insular approach to foreign investment to a more open environment).

In addition, the banking sector assessment (along with inputs from many other firms) is being used by USAID as part of its strategic planning exercise for the next three-five years of assistance. It should be noted that the work conducted by Michael Borish and Company, Inc. in this regard is based strictly on the firm’s own assessment of developments in Bulgaria, and does not in any way bind USAID to those recommendations. A separate document related to USAID projects, performance indicators and recommendations can be found in a separate volume entitled “Considerations for USAID Financial Sector Assistance to Bulgaria: 2002-2006”.

II. Methodology of the Banking Sector Assessment Rating System

The rating system utilized to assess the banking sector of Bulgaria is based on a review of more than 200 issues and topics that have been used to construct a diagnostic methodology for the review of banking systems. This tool has been utilized by USAID in other transition economies, and is applicable to virtually all banking sectors in the world.

In its simplest form, the rating system is focused on four general areas of activity—based

on 28 “sub-categories,” and subject to five general classifications. The activities and subcategories include the following:

–  –  –

The following classifications are utilized to provide a scoring for the individual issues assessed, as well as in developing a composite rating for the banking sector as a whole. Annex 1 provides greater descriptive detail about how the ratings apply by sub-category. Essentially, the methodology matches the description of the rating for each of the 28 sub-categories, assigns a rating for each, synthesizes the collection of ratings by each of the four areas of activity, and then ultimately arrives at a composite rating for the country. No effort is made to weight individual variables, or to quantify ratings along mathematical lines. Rather, 28 major sub-categories of the four main groupings are all rated within the five-point rating system, with allowances for pluses and minuses in the event that the direct numerical classification does not fully match with performance. The evaluation is both qualitative based on trends and assessments, and quantitative to the extent the figures are useful and meaningful. In the case of Bulgaria, the ratings by each subcategory also take into account trends from the 1998 assessment.

2 USAID Banking Sector Rating System Scoring Description Outstanding; world class; state-of-the-art; best practices; virtually no serious systemic risks 5 Solid; strong; satisfactory; competitive; few systemic risks or problems, and those are manageable 4 Adequate; favorable trend; improvement needed; potential for major systemic risks 3 Inadequate; weak; significant improvements needed; major potential for destabilization via systemic 2 risks Dismal; monopolist; resistant to competition and change; no confidence; widespread corruption;

1 weak institutions It can be noted that the current assessment is far more comprehensive than the earlier one conducted in 1998. This has much to do with greater availability of useful information, the willingness of bankers to speak more freely about their problems and challenges, and the achievement of macroeconomic and banking stabilization that was only partly in place in early

1998. At the time, most major banks were still state-owned, and financial information was weak.

By early 2001, financial and statistical information are still not strong, but they are vastly improved and more openly available than in 1998. In particular, the banking sector and the Bulgarian National Bank (BNB) have established web sites that disseminate useful information about the financial condition of banking institutions. Several web sites also convey the impressions of bank management on market developments.

III. The Bulgaria Rating

The composite score awarded for 2001 (based on 2000 data plus trends into 2001) in Bulgaria is 3, as compared with 2+/3- in 1998. The improved rating reflects modest progress in most areas evaluated, and impressive progress in a few areas. Most important is the achievement of macroeconomic and banking sector stability, which now presents an opportunity for banks to move on to the next stage of intermediation and risk assumption. Specific to the banking sector, them most impressive accomplishment has been strategic privatization, which is expected to professionalize banking standards, governance and management and enhance system competitiveness. Based prudential norms, virtually all categories showed equal or improved performance (i.e., capital, asset quality, liquidity, operating environment, transparency, sensitivity to market risk), with the only weakness being in the unimpressive level of earnings. From a macroeconomic and structural standpoint, the economy has shown improvement in terms of real growth, monetary and fiscal discipline, and the balance of payments. The private sector now plays a more prominent role in the economy. As for financial sector infrastructure, modest progress was noted in the legal framework and role of associations. BNB’s supervision department continues to make progress.

Negatives and weaknesses specific to the financial sector that prevent a higher rating include many of the banking sector aggregates (i.e., size of assets/deposits/capital, lending to the real sector, number of banks with limited lending authority and product offerings) and still underdeveloped non-bank financial services. These weaknesses are compounded by inefficient and unproductive methods of privatization in the enterprise sector, continued weak information and data on borrower credit worthiness, judicial enforcement of creditor claims when borrowers default. The absence of an adequate bank resolution framework, and currently untested risk 3 management systems at many banks will also present a challenge as lending and risk profiles

increase. Thus, as of summer 2001, the assessment of the Bulgarian banking system is as follows:

The Bulgarian Banking System—Summer, 2001 Composite Score: 3 (as compared with 2+/3- in 1998) The Bulgarian banking system has undergone considerable transformation since economic collapse in 1996-early 1997. The authorities initiated major changes in the legal and regulatory framework in 1997-98, introducing a currency board, stabilizing macroeconomic fundamentals, and putting the banking system on a privatization track based on open markets and the attraction of strategic foreign investment. These objectives have been achieved, an impressive accomplishment in light of economic collapse four years ago.

From a macroeconomic standpoint, the authorities have been effective in maintaining monetary stability and achieving near fiscal balance. Gross foreign exchange reserves now provide significantly greater import cover than in 1996, largely on the strength of rising exports and steady increases in foreign direct investment.

In terms of banking, Bulgaria has privatized five of the six major banks slated for privatization, and only four state banks remain. The five banks privatized since 1998 include Bulgaria’s two largest, both of which were privatized via strategic investment from EU member state banks. In effect, Bulgaria shifted ownership of the banking system from 82 percent state ownership of assets in 1996 to 80 percent private ownership by end 2000. While lending to the real sector is still low at 12.5 percent of 2000 GDP, it is poised for growth now that strategic investors are in the market, IT and MIS are coming on stream, margins have shrunk in the corporate sector, and banks are seeking higher returns. In addition, Bulgaria has introduced a deposit insurance scheme that provides modest coverage (up to 6,900 leva), and has already administered two failed bank deposit payouts without any noticeable panic in the marketplace.

Recognition of Bulgaria’s accomplishments has manifested itself in an invitation from the European Union in December 1999 to commence formal negotiations for entry into the EU. This has been followed by a steady increase in trade with the EU and other advanced countries, along with increasing regional trade with other EU aspirants (CEFTA and others).

Notwithstanding Bulgaria’s accomplishments, several weaknesses and problems remain. The legal and institutional framework remains weak, particularly in the judiciary. Accounting, statistics and financial information are inadequate and incomplete. There is limited infrastructural capacity in terms of credit information for more systematic and precise risk classification of borrowers prior to lending.

The absence of an effective bank resolution framework is unfortunate, and will need to be remedied if Bulgaria is to manage the failed bank process in a more systematic, transparent and predictable way.

Many Group IV banks appear limited in terms of what they can offer in terms of size, and a few are reported to be weak and/or engaging in financial practices of questionable legality or prudence. The non-bank sector remains weak and underdeveloped. Earnings in the banking sector are unimpressive and insufficient for the needed investments for modern banking systems and technologies. In the real sector, accounting standards are poor, projects are often infeasible, financial requests are often predicated on excess leverage, and disclosure practices of companies undermine confidence in credit quality. At the structural level, privatization by management-employee buyout or mass privatization via vouchers has not produced adequate incentives for improved performance and enhanced credit worthiness.

The conclusion is that conditions have improved since 1997-98, and the authorities are to be commended for following sound policies in support of stabilization, market discipline, and strategic privatization. This has been combined with some notable progress in terms of institutional capacity, namely banking supervision. However, many banks and regulators are untested in new and more complex areas of risk that are likely to be present in the market in the coming years. Intermediation levels can be expected to increase, particularly in the consumer/retail market. With increased lending and risk will come losses and some measure of consolidation. The net effect will be positive, although the market, the public, and the supervisory authorities will need to contend with higher degrees of

4volatility than they have encountered in the last three-four years.

• The banking system is now majority private and foreign-owned—all but four banks are private;

foreign banks account for 75 percent of total assets; state banks only account for 20 percent of assets

• There is still high concentration in Bulbank (foreign trade bank) and DSK (local currency household deposits), but concentration is diminishing with competition

• There are 35 banks in Bulgaria, and increased competition should eventually trigger consolidation—mainly of the Group IV banks are small and limited in terms of what they will be able to provide to the marketplace as the larger banks penetrate the retail market and offer a broader spectrum of products and services

• Total assets of banking system are less than $5 billion (average assets approximate $133 million per bank)—most banks are small

• Total deposits are less than $3.4 billion (average deposits are less than $100 million per bank), even though deposits account for nearly 80 percent of total funding

• Banks have high levels of regulatory capital, but are small in terms of aggregate capital— CARs are 35.6 percent, but total capital is only $656 million ($24 million on average)

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