IV. Bulgaria’s Credit Boom: After Credit Limits
Core Questions and Findings
- Were the administrative limits on bank credit that were in place during 2005-06 effective in slowing credit growth? No. While the limits slowed bank credit growth, overall credit continued to boom as nonbank institutions and cross-border lending compensated for slower bank credit growth.
- Why did the credit limits not work as intended? In the context of a market-based financial sector coupled with an open capital account, administrative credit limits seem to quickly loose their constraining effects.
- Did the credit limits help diversify risk by stimulating nonbank financial intermediation? Perhaps to some extent. But most of the growth in nonbank financial intermediation was done by bank-affiliated companies. Still, nonbank financial products have grown faster than might have been the case in absence of the credit limits.
- How does Bulgaria’s nonbank sector compare with regional peers? Bulgaria consistently ranks in the middle range among its peers in terms of private debt and equity market development, as well as institutional investor size.
- Is there scope for diversifying financial risk through developing private debt markets? The market has nonnegligible growth potential in the medium term. As in other countries in the region, nonfinancial corporates are not expected to be major issuer of corporate bonds in the medium term.
- Is there scope for diversifying financial risk through developing local equity markets? The local equity market has been buoyant and has the potential to contribute to risk transfer and risk exposure diversification in the medium term, but some critical problems need to be addressed first to improve the asset pricing mechanism and to diversify the investor base.
70. Bulgaria’s commercial banks dominate the financial sector. Bank assets are more than ten times larger than total assets of the next largest financial subsector, but some of the other subsectors are growing much faster than commercial banks, albeit from a small base (Table IV.1).
|Assets||Asset Growth||No of companies|
|Dec 2006- June 2007|
|(BGN million)||(perc. GDP)||(Percent)|
|Fin. corporations engaged in lending||1,538||2.7||17.8||68|
71. The banking sector remains well capitalized and profitable following years of rapid credit growth. Initially credit to the corporate sector dominated total bank lending. But following years of rapid growth in bank lending to the household sector, bank lending to the corporate sector represents just 60 percent of total bank lending to the nonfinancial sector (Figure IV.1). Banks are profitable and the return on equity has reached around 25 percent, up from 15 percent in 2002. During 2002-04, capital inflows financed about a third of total bank lending and the risk-weighted capital adequacy ratio declined from 25 to 17 percent. Loan quality remained good and nonperforming loans are a stable 2.2 percent of total loans, partially as a result of the rapid credit growth.
Figure IV.1.Bulgaria: Bank Loans to the Private Sector, 2001-07
Sources: BNB and Fund staff calculations.
72. This chapter asks two questions. What was the impact of administrative limits on bank lending that were in effect during March 2005-December 2006? What is the scope for diversifying financial risk through capital market development?
73. Section A argues that the administrative limits on bank lending stimulated nonbank financial intermediation and constrained total credit flows for only a brief period. Various forms of nonbank financial intermediation picked up the slack. Further banks could observe the credit limits by selling their loan portfolio. Following the lapsing of the credit limits in 2007, some of these loan portfolio sales were reversed.
74. Section B notes that there is scope for further expanding the role of the domestic private debt and equity market in financial intermediation. Bulgaria already ranks ahead of several more advanced countries in the region in private debt market size, and equity market capitalization growth has been very strong in recent years, although market liquidity remains thin. Banks’ access to the capital market has been rising from a small base. Nonfinancial enterprises are not expected to be major bond issuers in the local market, although the recent rise in IPOs at the BSE indicates that they are increasingly turning to the stock market for capital. While stock market development is welcome in principle, the pricing of stocks raises questions about the market’s role in allocating scarce capital, and capital market regulation and supervision needs further strengthening to support sustainable equity market development.
A. Post Mortem on Bulgaria’s Credit Limits17
75. The BNB put limits on bank lending during April 2005-December 2006. The authorities (and Fund staff) were concerned about: (a) the macroeconomic impact of booming bank lending, in particular on the current account balance; and (b) a possible deterioration in bank loan quality as a result of excessive risk taking by Bulgaria’s banks. In response to the boom, the BNB had already tried several routes: (a) enhance the information flows so that banks and customers were aware of risks; (b) strengthen prudential supervision; and (c) adopt liquidity measures, which withdrew a total of leva 0.5 billion from the banking system (1.3 percent of 2004 GDP).18 However, these measures were largely ineffective because banks were able to freely borrow abroad, due to the open capital account. Individual banks were keen to maintain or increase their market share, and were reluctant to take the lead in curbing credit to the private sector.
76. In early-2005, the BNB attempted to reduce the aggregate credit expansion to the non-government sector in a further effort to contain risks to the stability of the banking sector. The aim was to limit credit growth to 30 percent, from 49 percent in 2004. Banks were allowed to expand credit by 6 percent per quarter, taking end-March 2005 as the base period. Bank credit in excess of this limit would be subject to a marginal reserve requirement by the BNB, comprising 200 percent of the excess. The measure was expected to only be temporarily effective and was originally initiated for one year until March 2006. In November 2005, the BNB announced that the measures would remain in effect until the end of 2006, when Bulgaria was expected to join the EU. When some banks continued to lend beyond the credit limits while paying the penalty deposits, the BNB temporarily raised the marginal penalty deposits for banks that exceeded the limits by a wide margin to 400 percent.
Financial Sector Responses to the Measures
77. overall, the initial impact of the measures in constraining overall credit growth evaporated quickly. Bulgaria continued to maintain an open capital account and a liberal economy where banks and others were free to borrow abroad and to set up nonbank financial intermediaries that were not subject to the credit limits. The BNB had anticipated some of these developments and set up a data collection system that allowed continued monitoring of some of the macroeconomic developments. Notably, the BNB monitored developments in the leasing sector and also required banks to provide data to the credit registry on loans that they had sold. These data, as well as information collected by the NSI, provide the basis for an overview of the response to the credit measures. In spite of the measures, overall credit extension by the financial sector continued to boom. Once the limits lapsed at the end of 2006, bank-credit growth accelerated again, reaching 56 percent in September 2007. Financial soundness indicators continue to suggest that the banking sector remains well capitalized and profitable.
78. The responses of banks varied. Some banks observed the limits, while others circumvented the measures. A small number of banks continued to lend and pay the penalty rates. At the time, there were 28 registered Bulgarian banks and 6 branches of foreign banks. After the first quarter during which the measures were in effect, four Bulgarian banks and one branch of a foreign bank exceeded the limits (Petkova and Manolov, 2007). Some of these banks continued to exceed the credit limits over time. In response, in March 2006, the BNB increased the penalty deposits for banks whose lending exceeded the credit limits by 1-2 percent to 300 percent and to 400 percent for banks that exceeded the limits by more than percent. Even at these rates, the penalty rates were largely compensated by the banks’ lending margins; bank loans could be funded at rates of around 3½ percent and consumer loan rates were around 12 percent. Some banks continued to exceed the limits and by the end 2006 when the limits lapsed, total penalty deposits amounted to leva 1 billion, almost 2½ percent of GDP and 10 percent of reserve money.
79. Banks circumvented the measures by selling part of their loan portfolio to either foreign banks or Bulgarian nonbank financial institutions (Figure IV.2). Initially during 2005, banks sold loans to foreign banks. However in November 2005, the BNB announced that the credit limits were extended until the end of 2006. However, at the time banks had already established institutional arrangements to sell loans to Bulgarian nonbank financial institutions. A variety of loans were sold, including corporate loans, mortgage-backed mortgages and consumer loans. Initially, the BNB required that there be no affiliation between any bank that sells loans and the Bulgarian institutions that buys the securities. However, over time this requirement was not strictly enforced because some banks arranged or guaranteed the financing of the nonbank financial companies to which the loans were sold. After the measures lapsed at the end of 2006, some sales of loan portfolios were reversed. Hence the sale of some of their loan portfolio may not have diversified risks from the banks to nonbank financial institutions. In September, the BNB raised the reserve requirement to 12 percent, up from 8 percent thus increasing the cost of financial intermediation through the banking system. During this month sales of bank loan portfolios accelerated once again, possibly in response to the higher reserve requirement.
Figure IV.2Bulgaria: Sales and Repurchases of Loans from the Banking System to Residents and Nonresidents, 2006-07
Sources: BNB and Fund staff calculations.
80. In response to limits on bank lending, growth in the nonbank financial sector accelerated. Markets for asset-backed securities developed from a very small base as banks sold their portfolios. As anticipated by the BNB, leasing also became much more important, and the share of leasing assets in GDP doubled during the time that the measures were in effect (Figure IV.3). Some leasing companies were owned by banks, but others were not and—on balance—their growth diversified risks from the banks to the nonbank financial institutions. Since the measures lapsed, growth of leasing activities slowed to 65 percent down from 82 percent during 2006.
Figure IV.3.Bulgaria: Leasing Company Assets, 2005-07.
Sources: BNB and Fund staff calculations.
81. There is anecdotal evidence that the measures limited bank credit to the corporate sector during the immediate period after they were announced. While bank credit to the corporate sector contracted, there is evidence that the corporate sector found alternative sources of finance. Intercompany credit increased dramatically, in particular for foreign-owned companies. The institutional structures for intercompany lending were well established since such credit is a regular form of finance. However, the use of this form of corporate finance expanded dramatically in the wake of the limits on bank lending.19 The data do not allow to analyze developments in intercompany lending during 2006, but the incentives for such loans may have diminished.
82. The bank loan flow to households was initially stable but increased again in 2006 when banks were able to securitize these loans. In 2005, the loan flow to households was some 6 percent of GDP, largely consisting of consumer loans and residential mortgages (Figure IV.4). The loan flow began to grow rapidly during 2006 when banks were able to securitize household loans. After the measures were lifted, commercial bank consumer credit and mortgages began to grow rapidly again, and securitization became less important.
Figure IV.4.Bulgaria: Bank Credit Flow to Households, 2002-07
Source: BNB and Fund staff calculations.
83. During the time that the measures were in place, banks became familiar with selling loans and this experience remains at their disposal. It remains to be seen whether the institutional arrangements that developed in response to the banking limits will be sufficient when banks are unconstrained but need to carry the costs of prudential regulations. The cost of these regulations is substantial as Bulgaria has the highest minimum capital adequacy ratio among all EU new member states. Further, in response to the growth in bank credit, the BNB raised reserve requirements from 8 to 12 percent in September 2007. On balance, the BNB’s tight prudential policies strengthen the banking system but also encourage the development of the nonbank financial sector.
B. Diversifying Financial Risk Through Capital Market Development20
84. The benefits of diversified financial sectors are well-known The efficiency and stability of financial intermediation is greatly enhanced by well-functioning and liquid local capital markets. Markets provide the best (though sometimes imperfect) mechanism for asset pricing. Risk transfer and pricing mechanisms in the securities market allow financial institutions to manage risk more efficiently, and thus contribute to financial stability. Deeper local markets enable the diversification of risk exposure more evenly in the financial sector, thus alleviate the concentration of risk in the banking system. They allow institutional investors and households to diversify their portfolios. They are also crucial for the absorption of pension savings in reformed pension systems.
85. In small countries like Bulgaria, capital market development faces particular challenges arising from banking sector dominance and finding local comparative advantages in an environment of increasing capital market integration in Europe. At this point, though growing in importance, the Bulgarian capital market and non-bank financial intermediaries remain underdeveloped compared to the banking sector, similar to most Central and Eastern European countries (CEE). Nevertheless, recent developments—including a boost by the BNB’s credit limits imposed on the banking sector in 2005-06—and demand and supply incentives indicate that there is potential for the development of the private debt and equity markets in the medium term.21 The sustainable development of these markets, however, requires addressing some key bottlenecks, especially in the investor base and the stock market.
The Bulgarian Capital Market in Regional Comparison
86. The current stage of private debt and equity market development, as well as institutional investor size, consistently put Bulgaria in the middle range among CEE countries. Financial development in emerging Europe has progressed considerably in the last decade, with overall banking sector domination and significant differences across countries in securities market development.22 The size and composition of the institutional investor base has depended heavily on the timing of Pillar II and III pension reforms and the general development level of the country.
87. Bulgaria’s ranking in private debt market size is ahead of several more advanced countries in the region (Figure IV.5). As in most CEE countries, corporate bonds have been predominantly issued by the financial sector.23 Similarly to the Czech Republic and Hungary, mortgage covered bonds account for a large share of financial sector bonds in Bulgaria, making up about half of the outstanding stock at end-2006. In terms of mortgage covered bonds, Bulgaria had the fifth and fourth largest outstanding amount at end-2006 in absolute terms and relative to GDP, respectively. There are several reasons behind the relatively high ranking in private debt market size: (i) credit controls imposed by the BNB gave a big boost to corporate bond issuance in 2005 and 2006 by banks and the nonbank financial sector; (ii) transaction costs for bond issuance are low; (iii) the local bond market has been a convenient source of financing for banks with no access to cheap foreign parent funding; and (iv) demand has been increasing from domestic institutional investors, especially in the context of small government securities stock.
Figure IV.5.Bulgaria: Fixed income securities and the institutional investor base in regional comparison
Sources: Bank for International Settlements, Standard&Poor’s; Bloomberg, National authorities, OECD, European Covered Bond Fact Book, Investment Company Institute, Swiss Re, WEO.
88. The nonfinancial corporate sector has not relied extensively on the bond market for funding given the strong competition in the banking sector. The largely foreign-owned and well-capitalized banking sectors of most CEE countries have been in a good position to provide the necessary funding to the corporate sector at competitive interest rates. Russia has been a notable exception where significant domestic ownership in the banking sector and the large size of some corporations relative to banks made bond market funding attractive for the corporate sector.
89. The composition of the institutional investor base is rather diverse in CEE, with pension fund dominance in Bulgaria. Countries that adopted pillar II and III pension systems relatively early—such as Bulgaria in 2001—have gradually accumulated sizeable pension fund assets. Given their investment guidelines, pension funds’ demand for domestic securities has been growing along with the continuous rise in pension fund savings and it has important implications for local capital market development. Mutual fund assets have been negligible in Bulgaria compared to most new EU members, though the sustained rise in BSE stock prices has given a significant boost to assets under management since 2006. Finally, the size of the Bulgarian insurance sector has been comparable to other new EU members, but due to the overwhelming dominance of the non-life segment, the insurance sector is not a major player in the capital market yet.
90. Equity market capitalization growth has been among the strongest compared to other CEEs in recent years (Figure IV.6). This increase has been mainly driven by rapidly rising stock prices, but IPOs have also been picking up. Market capitalization of the Bulgarian Stock Exchange (BSE) at 40 percent of GDP at end-June 2007 was in the middle range in the region, commensurate with larger new EU member states.24 BSE capitalization increased fourfold between end-2004 and mid-2007, but market liquidity remains very low with a turnover ratio of 20 percent in 2006. Low turnover can be largely explained by the large number of companies with low free-float in the unofficial market segment that were listed in the early stage of transition, and the low share and trading activity of foreign investors who are usually the most active traders in more advanced countries in the region. The latter is due to the BSE’s “frontier market” status, thus its miniscule weight in emerging market portfolios.
Figure IV.6.Bulgaria: The Equity Market in Regional Comparison
Sources: IMF staff calculations based on data from EMDB, Bloomberg and WEO.
Scope for Diversifying Risk Through Private Debt Market Development
91. The Bulgarian primary market for corporate bonds and asset-backed securities has grown considerably since the first issue in 2002. The financial sector has been the most active issuer of bonds, accounting for three quarters of the outstanding amount in October 2007 (Table IV.2). In addition to corporate bonds, the assets of real estate investment trusts and securities issued by special purpose vehicles and backed by receivables stood at 420 million euros and 49 million euros, respectively.25 Credit controls imposed by the BNB gave a burst to NBFI corporate bond issuance in 2005 and 2006. These bonds were a mix of asset-backed securities (ABS, mostly backed by receivables), collateralized and uncollateralized bonds. With the lapse of credit controls, issuance subsided in 2007. Secondary market activity has been low.
|Annual corporate bond issuance|
|total value in EUR million||52.8||88.2||73.7||361.1||620.8||178.8|
|Financial sector issues|
|number of issues||2||3||3||10||10||9|
|value in EUR million||52.8||43.3||96.0||302.3||517.7||117.3|
|Nonfinancial Sector issues|
|number of issues||3||8||10||20||9|
|value in EUR million||45||64||59||103||61|
|Outstanding corporate bonds at-end year|
|total value in EUR million||52.8||141.0||212.7||518.0||1,117.3||1,281.7|
|Financial sector issues|
|number of issues||2||5||8||15||23||30|
|value in EUR million||52.8||96.1||105.7||352.2||849.2||961.9|
|Nonfinancial Sector issues|
|number of issues||3||7||17||36||44|
|value in EUR million||44.9||107.0||165.8||268.1||319.8|
Public placements of issues.
Public placements of issues.
92. There is scope for risk transfer and risk exposure diversification through further expanding the role of the private debt market, mainly based on incentives for financial sector bond issuance. As in most CEEs, corporate bonds (including mortgage bonds) by the financial sector are likely to be the main driver of the private bond market also in the future. Given the established legal base and the lower transaction costs, mortgage covered bonds are likely to be the preferred structure to true-sale mortgage-backed securities. Bonds and asset-backed securities are likely to continue to be a funding source for nonbank financial institutions in Bulgaria, mainly for leasing companies with no parent banks. Finally, no strong pick-up in issuing activity is expected from nonfinancial corporates.
93. Bond issues can reduce the growing maturity mismatch in the banking sector. The maturity mismatch in the banking system is increasing with the lengthening of the average maturity of assets, especially mortgage loans. At the same time, the average maturity of liabilities remains very short. The increasing mismatch gives banks an incentive to extend the average maturity of liabilities through mortgage bond or unsecured bond issuance. Recently, maturities for unsecured and mortgage bonds have been between two and five years, with interest rates shifting towards floating rates tied to Euribor or the local Sofibor. As in other countries in the region, bond maturities are expected to gradually lengthen further in the future.
94. Recourse to the domestic bond market can reduce reliance on foreign funding. Recently, credit expansion has been mainly financed by deposit growth as capital inflows have been overwhelmingly FDI. To a lesser extent, euro deposits by credit institutions, syndicated lending, and Eurobond issuance by domestically-owned banks have also been used as funding sources. Going forward, the share of domestic deposits in total funding is likely to decline. Growing reliance on foreign financing would increase banks’ FX liquidity risk and give additional incentives to banks to increase their funding from the local capital market. Recognizing these incentives, in addition to domestic banks, several foreign-owned banks have issued unsecured and mortgage bonds with a wide range of sizes in the local market in recent years. Given most of these banks’ have high ratings and transaction costs are low even for small issues, the local market can help them optimize their funding structure.
95. For nonbank financial institutions, bond financing is likely to remain an important funding source, while nonfinancial corporates continue to have weak incentives to issue domestic bonds. Though a large part of the past two years’ issuance by NBFIs was artificially generated by the credit controls, leasing companies and consumer finance companies without a parent bank continue to raise funds through corporate bonds and ABS relatively cheaply. However, a potential problem for future growth of this segment is that these companies are unsupervised and their issues are unrated, and a default in this sector can set back the sector and ABS issues substantially.26 Nonfinancial corporates are not expected to be major bond issuers as their funding needs can be fulfilled by the banking sector at competitive interest rates.
96. Demand for domestic private debt instruments have been growing along with the expansion of the institutional investor base. Bulk of the demand comes from pension funds, but the life insurance sector is also expected to grow in the medium-term as the penetration rate is currently very low in Bulgaria, even compared to other new EU members. Mutual funds providing a large variety of risk-return alternatives have been also expanding rapidly in the last two years. These investors have a high demand for domestic private debt securities, since during the convergence process, returns in Bulgaria are expected to be higher than in mature markets. Nevertheless, the share of foreign assets has been growing in institutional investors’ portfolio, and this trend is expected to continue.
Scope for Diversifying Risk Through Equity Market Development
97. The BSE has showed spectacular performance in the last three years, but liquidity remains very low. Market capitalization increased sharply in both the official and unofficial segments in recent years (Table IV.3). The major SOFIX and BG-40 indices grew by 82 and 220 percent year-on-year in October 2007, but the market has trended downwards since end-October (Figure IV.7). At end-June 2007 the share of the 20 largest company in market capitalization was 71.4 percent, and the average free float of equities traded was 25.15 percent. IPO activity at the BSE has picked up since 2005 and several of these listings involved relatively large manufacturing companies and financial institutions.27 The BSE has intensified efforts to attract promising Bulgarian companies to the stock market through outreach and education activities, improvements in financial disclosure and corporate governance guidelines, and upgrades in trade transparency, infrastructure and supervision.28 The FSC’s efforts to raise financial disclosure standards have also contributed to the increased supply and demand for equity investments.
Figure IV.7.Bulgaria: Main Stock Price Indices at the Bulgarian Stock Exchange
Sources: Bloomberg; and Bulgaria stock exchange.
|2003 Dec||2004 Dec||2005 Dec||2006 Dec||2007 June|
|Official market A||28.0||53.4||122.1||319.3||485.1|
|Official market B||283.5||423.3||688.5||3239.1||4629.9|
|Official market C||674.5||898.1||1337.7||2084.2||abolished|
98. The local equity market has the potential to serve large and medium-sized domestic companies and alleviate reliance on the banking sector for funding. The medium and long-term developmental potential of the BSE is influenced by the following: (i) there are only a few large domestic companies left to be listed, and some major companies are expected to be delisted; (ii) companies currently listed at the BSE are too small to migrate to major European exchanges because of the home bias factor and high transaction costs; (iii) there is significant potential for the listing of medium-sized companies and raising new capital by listed companies as already manifested by increasing number of IPOs.
99. The supply of IPOs by medium-sized companies is expected to increase. Growing IPO activity is likely for the following supply reasons: (i) companies with short track record are eager to use the BSE as bank lending to these firms is insufficient and expensive; (ii) high growth and profit expectations by companies during the convergence process increase their need for capital; (iii) the BSE efforts to encourage IPOs and upgrade infrastructure; (iv) underwriting capacities exist.
100. Strong demand from investors for domestic equities underpins the potential for market growth. Demand for Bulgarian stocks is supported by (i) large and growing amount of assets managed by pension funds compared to the size of the local stock market, (ii) improved services and product offering by the rapidly developing mutual funds segment; (iii) good performance predicted for Bulgarian companies in the convergence process; and importantly (iv) improving financial disclosure and corporate governance standards.
101. Nevertheless, there are indications that the pricing mechanism in the stock market is not functioning properly and investor base diversification is inadequate. Stock prices may have been growing too fast recently. Valuations have reached high levels fuelled by strong demand from domestic institutional investors, a nascent investment culture by end-investors, and insufficient differentiation of market segments and companies. The investor base is heavily dominated by domestic pension funds and collective investment schemes, both characterized by herding behavior due largely to the benchmarking regulation for pension funds and to very strong focus on recent return and low risk awareness by end-investors.29 Given the BSE’s relatively small size and frontier market status currently, foreign investors with strong risk management standards and analytical capacities account for a much smaller share of trading than in more advanced markets in the CEE region. Further growth of market capitalization and liquidity would raise the attractiveness of the market for foreign investors, thus improve risk exposure diversification and price discovery.
102. A potential large correction may be damaging for the short and medium-term development of the market. as the reputational risks for the BSE and equity investments can be high, and the short-term adverse consequences for pension funds’ performance, foreign investor flows and the financial industry’s reputation can be substantial.
103. To reduce the potential for the build-up of boom-bust cycles by improving the asset pricing mechanism, and thus support the sustainable development of the market, capital market regulation and supervision needs further strengthening. The mission recommended that the authorities consider (i) changes in the minimum return guarantee regulation for pension funds to alleviate incentives for herding behavior; (ii) further increase efforts to enforce regulations and educate the public about stock market risks; and (iv) consider a change in the structure and listing requirements for BSE to have a clearer differentiation of segments.
HerderscheeJohannes and Li LianOng (2006) “Bulgaria–The Implications of Bank Behavior and Credit Measures for Solvency Risk” in: IMF Country Report No. 6/299 (Washington, D.C.: IMF).
International Monetary Fund (2007) “Regional Economic Outlook: Europe, Strengthening Financial Systems” November (Washington, D.C.: IMF).
Iorgova and Ong (2007) “The Capital Markets of Emerging Europe: Institutions, Instruments and Investors” IMF WP forthcoming.
PetkovaVeselka and StoyanManolov (2007) “Credit Growth Slowdown: the Experience of Bulgaria” in: Charles Enoch and Inci Otker-Robe Rapid Credit Growth in Central and Eastern Europe Endless Boom or Early Warning page 145–153 (New York: Palgrave MacMillan).