73056 BULGARIA POLICY NOTE – FINANCIAL SECTOR I. Banking Sector Developments 1. Banking Sector Condition. The banking sector has remained stable throughout the ongoing financial crisis, although profitability is declining. Indicators suggest that banks are generally sound. Capital cushions are adequate in relation to comparator countries: the average capital ratio for the system is reportedly close to one quarter above the regulatory minimum at around 16%. Banks will not distribute their 2008 profits and the same policy is expected for 2009 which should provide continued capital cushions provided portfolio quality can be maintained. Non-performing loans (NPLs) increased at a gradual pace from 2.0% in September 2008 to 3.1% in February 2009. This increase has mainly been in unsecured consumer loans, while mortgages and corporations have not yet shown a sharp increase. Banks that were more aggressive in their lending experienced the largest increase in NPLs. Table 1. Condition of the banking sector % 2007 06/2008 09/2008 2008 02/2009 Return on assets (ROA) 2.37 2.40 2.32 2.14 1.07 Return on equity (ROE) 23.9 24.5 24.47 22.74 9.06 Capital adequacy 13.9 14.6 14.35 14.86 14.88 Profit (mln. leva) 1151 729 1100 1387 124 NPL (more than 90 days overdue) 2.05 1.91 2.03 2.41 3.08 Cost of funds 2.92 3.42 3.58 3.75 3.93 Liquidity 28.0 24.0 22.34 21.71 20.78 Credit growth 62.5 51.9 46.6 32.3 26.5 2. Funding of Bank Operations. Although credit grow has been significant in Bulgaria since 2002 with extremely high annualized rates, a time exceeding 50%, it has since declined with the onset of the global financial crisis. Banks’ long term funding has declined in relation to total liabilities, even while funding from parent banks to domestic subsidiaries has increased. For the banking system as a whole, resident bank deposits declined by 21% between the third and fourth quarters of 2008, but have recovered since. 3. Wholesale Bank Funding. Domestic interbank market borrowing also declined by end 2008 but has now rebounded in 2009. In part due to global conditions, bond market funding for banks declined substantially since the first half of 2008, while third party (non parent) foreign banks and investors reduced most funding to the domestic banking sector. At the same time parent bank funding increased by 24% from midyear 2008 through the first quarter of 2009, reflecting a strong commitment of foreign bank shareholders to Bulgarian subsidiaries. These funding shifts and other developments have been reflected in increases in the aggregate loan to deposit ratio (Figure 1). While such commitments are welcome, the BNB and Government should nevertheless continue to strengthen transparency provisions in corporate law to ensure a full and reliable identification of interconnected exposures with banks, shareholders and owners, to assure that changes in funding sources count on the proper accounting of liquidity and solvency requirements on a more consolidated scope. Figure 1. Loan to Deposit Ratio in the Banking System 140 120 128 100 80 60 40 20 0 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Dec-98 Sep-99 Dec-99 Sep-00 Dec-00 Sep-01 Dec-01 Sep-02 Dec-02 Sep-03 Dec-03 Sep-04 Dec-04 Sep-05 Dec-05 Sep-06 Dec-06 Sep-07 Dec-07 Sep-08 Dec-08 Source: BNB II. Response to Financial Stresses 4. Central Bank Measures. The Bulgarian National Bank (BNB) actions have helped to ensure financial stability in the banking sector. The BNB has actively monitored and tried to mitigate the impact of the global financial crisis. Actions taken to increase banks’ capital and liquidity cushion include releasing existing prudential “buffers�, for example by lowering the reserve requirements,1 and working with parent banks to ensure credit lines to foreign-owned subsidiaries remained available and profits are recapitalized. The BNB intensified its monitoring, strengthened stress testing capabilities2 and reviewed the crisis management framework as a contingency measure. The BNB should continue to develop its internal modeling capabilities to independently evaluate the risks and capital contingencies required of banks, to be used as a benchmark 1 On November, 27, 2008, the BNB Governing Council adopted amendments to Ordinance No. 21 on the minimum required reserves maintained by banks with the central bank: (i) effective December 1, 2008, the minimum required reserves on all attracted funds of the banks are decreased from 12 percent to 10 percent; (ii) effective January 1, 2009, the minimum required reserves on funds attracted by the banks from abroad will be decreased from 10 percent to 5 percent; and (iii) effective January 1, 2009, no minimum required reserves will be imposed on funds attracted from the state and local government budgets. Currently the BNB considers there is enough liquidity in the banking system and a further reduction of required reserves is unlikely to reduce interest rates. 2 The BNB conducts stress tests on a quarterly basis in the form of sensitivity analyses. Several types of risks are analyzed, but the most relevant and quantitatively significant to the Bulgarian context are credit risk and liquidity risk. Market risks only constitute a small share of the capital requirement. vis-à-vis banks’ models and provide an objective assessment of future trends in credit quality. 5. Confidence Building Measures. In parallel with other EU countries, the deposit insurance was increased to €50,000 per depositor per bank and is to be further increased to €100,000 in 2009, providing comfort to depositors. Overall, the contagion effects have been appropriately managed, sustaining confidence in the BNB and its role as a policy anchor in a time of external uncertainty and elections at home. It is recommended, nevertheless, that BNB continue to take a proactive stance in ensuring strong coordination with overseas home country regulatory authorities for those foreign owned Bulgarian bank subsidiaries, and conducting joint exercises including simulations regarding possible adverse developments in liquidity as well as capital stresses or other contingent scenarios. III. Structure of External Funding in the Economy and Banking Sector 6. External Funding Dynamics. The risk for the financial system relates to rollover of private external debt, which has been creating significant shifts in balance sheet financing. As mentioned, Bulgaria had experienced a large credit boom, especially funding the corporate loan segment. External debt mainly via banks increased to 109% of GDP (Nov 2008), with such debt mostly owed by the private sector. Public sector external debt was only 12% of GDP by 2008. 7. Foreign Currency Lending. Foreign currency mismatches are substantial (Figure 2) and the corporate sector has high direct foreign currency exposure, mostly in euro. Short-term external debt (deposits and borrowings) of banks almost doubled within a year in 2008 and account for close to 80% of banks’ external debt. Short-term debt of firms accounts for 54% of the total debt of firms. While the focus to date has been on risk management and liquidity of the banks, the Government needs to begin to assess the solvency of the corporate sector and determine whether the legal and regulatory framework provides flexibility for debt workouts if these are needed, as well as corporate restructuring windows (without formal bankruptcy) to allow firms and SMEs to continue viable operations and service existing debts while the supply, price, and maturity of credit remains limited. Figure 2. Share of foreign currency credit 100 100 80 80 73 60 60 57 % % 40 40 30 20 20 0 0 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Dec-99 Sep-00 Dec-00 Sep-01 Dec-01 Sep-02 Dec-02 Sep-03 Dec-03 Sep-04 Dec-04 Sep-05 Dec-05 Sep-06 Dec-06 Sep-07 Dec-07 Sep-08 Dec-08 Credit to corporate sector Credit to household sector Total credit Source: BNB 8. Proactive Financial/Macro Policies. Despite some of the above potential vulnerabilities, central bank and government policies are sustaining confidence in the banking system and the currency board. Funding rollovers and currency risks have been one of the drivers behind the widening CDS spreads (Table 2) yet creditors have been comforted to-date by Bulgaria’s policies. This is also reflected in Fitch’s decision to affirm Bulgaria's long-term foreign currency rating at BBB- and long-term local currency rating at 'BBB'. As the rating agency asserts, the cost of implementing the economic adjustment to reduce the high current account deficit has increased by the deterioration of the global economic outlook, yet the currency board arrangement remains well supported. It also notes that external debt level is above the BBB median, and the rating is supported by solid fiscal policies. Table 2. Sovereign Credit Default Swaps (CDS) spreads Change (bp) 6/24/2009 1 Day 1 Week 1 Mo 1 Yr Bulgaria 3 yr 418.4 -6.0 31.9 123.5 317.7 Bulgaria 5 yr 414.2 -4.0 28.2 116.3 268.8 Source: Bloomberg, Datastream. IV. Recent Trends in Credit to the Enterprise Sector 9. Bank Credit and Economic Trends. Going forward, demand for banking credit and especially investment finance will fall, in line with the economic downturn. Preliminary GDP figures confirm a decline of GDP of 3.5% year-on-year in Q1-2009 with worsening industrial output (-12.4%) contributing most to the GDP decline. Manufacturing has been hardest hit with a 17% decline y-o-y on account of weak external demand and gas supply. Construction declined by 6.5% in Q1 after growing at double digit rates over the last several years. After a high growth period credit growth appears to flattening out and declining in some sectors. 10. Other Credit Demand Factors. Services seem to have been less affected by the crisis and grew by 2.5%. Credit growth decelerated in the first months of 2009, with private sector credit growth slowing as demand for credit weakened and credit risks increased. There has been a slight increase in lending to some corporate sectors and households, and a reduction in retail lending. Investment, one of the main drivers of growth over the last several years, fell by 20% as companies scaled back their investment plans and stocks were depleted. 11. Enterprise Credit Reduction. While credit growth has declined, some sectors experienced practically zero credit growth between end-2008 through the first quarter of 2009. Manufacturing industries representing 13% of private sector borrowers, showed only a 1% increase in credit during this period. The trade and motor sector experienced a 2% decline in credit availability – this sector represents 20% of private sector borrowing. Real estate credit declined by 68%, understandably given the effects on property values from the global crisis (this sector having represented 7 percent of private sector borrowing before the drop). Overall, about 20% of private sector industries experienced credit levels that remained at zero or decreased slightly. 12. New Loan Originations and Funding Gaps in Enterprise Credit. The above figures reflect existing stocks of debt plus new loans. When one examine new loans extended, incremental corporate borrowing in local currency, showed declines in new originations by 58%, from July 2008 through April 2009. Euro denominated new loans also feel by 35% in the same period. While interest rates did not fluctuate excessively, for corporate borrowing in the same period, new loans in local currency were about one percentage point higher. 13. Credit Availability in the Upcoming Economic Environment. The afore mentioned figures suggest that banks have become much more conservative in extending new loans though some demand factors may also be in play, something which might hamper economic reactivation if sound business investment opportunities exist. Because of this situation, the government’s credit reactivation program and consideration of its expansion seems justified. However, any such program should ensure that lending maturities can serve both business working capital needs as well as fixed investment funding that goes beyond the five year maturity range, necessary for generating returns on investment and corporate sustainability in the medium term. V. Pension Sector and the Capital Markets 14. Equity Market Developments. Looking beyond the banking sector, Bulgaria’s stock market plunged, with adverse consequences for pension funds. Global deleveraging by foreign institutional investors led to a withdrawal of their holdings from the Sofia stock exchange, leading to a collapse of stock market prices. The SOFIX index saw a 69% year-on-year decline up to June 2009, the largest of all ECA exchanges. This has led to a decline in the share of foreign investors, which fell under 30% at the end of 2008. Domestic investors did not have the same need for cash and divested to a lower extent. 15. Pension Fund Developments. The movements in the equity market led to losses in pension funds (Table 3) which held close to the 25% portfolio limit in equity investments, with holdings that were highly concentrated in Bulgarian shares, although funds could legally diversify into other markets. The losses do not have an immediate impact on the fund beneficiaries, as the first payout wave under universal mandatory pension schemes is set to begin around 2020-2023, which is fortunate to allow for future recovery. In this context, the financial authorities should review investment regulations of pension funds to facilitate the adoption of life cycle and multiple fund types to reduce market risk for near-retirees. The authorities should also begin considering the design of the pay-out phase including defining the retirement products and their regulation; such as annuities, phased withdrawals and other options while taking into account risks to beneficiaries and the industry, such as market, credit and longevity risks. Table 3: Overview of the developments for private pension funds3 31 December 31 December Change 2007 2008 Balance sheet information (million EUR) Total Net Assets 1,184.7 1,175.5 -0.8 % Universal Pension Funds 627.9 741.2 18.0 % Occupational Pension Funds 210.1 187.8 -10.6 % Voluntary Pension Funds 346.7 246.3 -29.0 % Investments in equity 370.2 187.8 -49.3 % Universal Pension Funds 187.7 102.3 -45.5 % Occupational Pension Funds 69.3 33.3 -51.2 % Voluntary Pension Funds 113.2 52.2 -53.4 % Average rate of return on assets4 31 March 31 March 2008 2009 Universal Pension Funds 8.15 % - 6.36 % Occupational Pension Funds 8.03 % - 7.82 % Voluntary Pension Funds 8.08 % - 9.29 % Source: Financial Supervision Commission 3 The data for private pension funds as of the end of 2008 is preliminary and it is subject to change. 4 Annualized weighted average rate of return for 24-months period VI. Summary of Issues and Policy Recommendations in the Financial Sector 16. Monitoring changes in bank funding sources and corporate funding relationships. While parent bank commitments are welcome to maintain liquidity in the sector, the BNB and Government should continue to strengthen transparency provisions in corporate law to ensure a full and reliable identification of interconnected exposures with banks, shareholders and owners, to assure that changes or expansion of funding sources count on the proper accounting that meet both liquidity and solvency requirements from a regulatory and prudential perspective, but based on a more consolidated scope. 17. Assessing future developments in portfolio quality and credit risk. The BNB should continue to develop its internal modeling capabilities to independently evaluate the risks and capital contingencies required of banks, to be used as a benchmark vis-à-vis banks’ models and provide an objective assessment of future trends in credit quality. 18. Preparing contingency plans including cross-border coordination. The BNB should continue to take a proactive stance in ensuring strong coordination with overseas home country regulatory authorities for those foreign owned Bulgarian bank subsidiaries, and conducting joint exercises including simulations regarding possible adverse developments in liquidity as well as capital stresses or other contingent scenarios where supervisory coordination and cross-border resolution of troubled banks may be needed. 19. Addressing deficiencies in the bankruptcy resolution framework. More nimble mechanisms could improve reallocation of resources in the event of increased bankruptcies that typically clog up the judiciary system. In this context, it would be useful to carry out Insolvency and Creditor Rights Review (ROSC) to identify which issues could be resolved in the short-term, and how to best implement an out-of-court system if this became necessary. While the focus to date has been on risk management and liquidity of the banks, the Government needs to begin to assess the solvency of the corporate sector and determine whether the legal and regulatory framework provides flexibility for debt workouts if these are needed, as well as corporate restructuring windows (without formal bankruptcy procedures) to allow firms and SMEs to continue viable operations and service existing debts while the supply, price, and maturity of credit remains limited. 20. Ensuring a continued flow of credit to the enterprise sector. Mitigating credit tightening related to the liquidity and funding conditions for banks could help to smooth the effects of the external shocks on employment and in investment. One option is arranging credit lines to reach private sector enterprises that are under temporary stress, for example the government provided funds from the fiscal reserve to Bulgaria’s development bank. More operations may be needed if the downturn continues. Because of this situation, the government’s credit reactivation program and consideration of its expansion seems justified. However, any such program should ensure that lending maturities can serve both business working capital needs as well as fixed investment funding that goes beyond the five year maturity range, necessary for generating returns on investment and corporate sustainability in the medium term. 21. Improving the supervisory functions for non-bank financial institutions. Pensions, securities markets, and the insurance industries remain relatively small and underdeveloped despite rapid growth. The legal and regulatory framework is consistent with pertinent EU Directives, but enforcement and risk management is lagging. In particular, given the events that have affected the assets values in the pension sector, the authorities should reform the investment regulations to facilitate the adoption of life cycle and multiple fund types to reduce market risk for near-retirees. The authorities should also begin considering the design of the pay-out phase including defining the retirement products and their regulation; such as annuities, phased withdrawals and other options while taking into account risks to beneficiaries and the industry, such as market, credit and longevity risks.