Run on Bulgarian banks: currency peg is not a factor of stability, foreign exchange reserves and conservative balance sheets are

A CNBC video today suggested that the current run on the Bulgarian banks is a matter of pure sentiment and that this does not pose a threat to the banking system because Bulgaria is in the EU, its currency is pegged to the euro and its debt to GDP ratio is quite low compared to most developed countries (18%).

While indeed the banking system is in no danger, neither of the above arguments appear to be particularly convincing. Membership in the EU is a factor of political stability and an opportunity to tap into the huge EU market but that in itself does not guarantee banks’ stability. The fact that the Bulgarian currency is pegged to the euro is widely regarded as a factor of stability. The fixed exchange rate is a legacy of the 1996-97 hyperinflation in Bulgaria when it played the role of imposing discipline on the system which did arrest the runaway inflation. But fixing the exchange rate is a factor that also creates stress in the foreign exchange market which results from the efforts to maintain a fixed price while the market’s logic is pushing the price of foreign money constantly up and down. Finally, it is reassuring to have a low debt to GDP ratio, but again this as such does not indicate a stable banking system. By way of example, Iceland’s debt to GDP ratio just prior to its banking crisis was also low at 30%.

Is Bulgarian banking crisis posing a serious risk? It is not, but for other reasons:

First, precisely because the Bulgarian currency is pegged to the euro its banking system may be put under stress if the bank run turns into an external drain, i.e. if depositors demand to convert their money into euros. This is because the Central Bank (Bulgarian National Bank) will not have the ability to devalue the local currency as a response to the increased demand and discourage people  form switching into euros. However, the Central Bank currently does have a substantial foreign exchange reserve, worth approximately 13.5 billion euros, including euro deposits, gold and SDR. It can therefore absorb a substantial pressure and maintain the fixed par (two levs for a euro).

Secondly, the Bulgarian banks maintain sufficient reserves at the central bank. While holding private deposits worth EUR 29 billion, Bulgarian banks have approximately EUR 4 billion reserves at the Central Bank which can be converted into paper lev bills. Additionally, the banking system has EUR 4 billion is highly liquid bonds and treasury bills. This demonstrates a very high level of liquidity that should render the system very robust (on the negative side it demonstrates insufficient utilisation of resources to boost economic growth but that is another question).

Finally, following the banking crisis of 1996-97 Bulgarian banks have maintained relatively conservative balance sheets. (It is still somewhat worrying that the non-performing loans of the Bulgarian commercial banks currently stands at 18% of their total loans, up from 16.6% in 2012.) As a result in case of a full blown crisis the Central Bank can backstop the banks using a significant part of the loans on their balance sheets as a good collateral.

The run on the Bulgarian banks is thus based on irrational fears.  Nonetheless, banks and central banks should always stay alert and ready to stop a crisis. No matter how baseless a run may be, it has the potential to turn into  a self-fulfilling prophecy if not handled promptly and decisively. The  decision of the Bulgarian government to open a EUR 1.65 billion credit line for the banking system is a measure that so far worked well to stop the run. The more powerful weapon of Central Bank intervening to increase banks’ reserves (by issuing collateralised loans or purchasing securities from the banks) convertible into paper bills was not used. This proves that even as pure sentiment the run on the Bulgarian banks has no real momentum.

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