How the EU can help Bulgaria avert another banking crisis

In the wake of KTB’s collapse, Bulgaria’s banking sector is at a critical juncture and much rides on what changes the next governor will bring.

Can the sector reinvent itself, as it did following a meltdown in 1997? Or will the systemic problems uncovered by the KTB debacle persist and deepen, ultimately threatening financial stability?

The EU has significant interest in avoiding financial turmoil in yet another member state. This is particularly true in Bulgaria, given that European banks hold 75 percent of the country’s banking assets.

To date European policymakers appear to have paid little attention to Bulgaria’s financial drama. Now is the time for the EU to engage, and encourage reforms to the governance of the central bank.

The toxic mix of politics and banking

While the public may never learn all the details surrounding the rise and fall of KTB, the case painfully reveals the toxic consequences of mixing politics and banking.

KTB’s success was enabled by several governments, which concentrated the deposits of publicly owned companies at the bank, giving it a cheap source of funding.

Politicians found this useful because the bank owner was allegedly affiliated with a powerful MP and media mogul, who offered positive media coverage in exchange for cheap financing.

In summer 2014, a bank run led to the closure of KTB. An accounting post-mortem revealed a hole of $2.6 bn, or two thirds of the bank assets (worth 5% of Bulgaria's GDP), traced back to fraudulent lending by the bank owner to companies controlled by himself or his political partner.

Paying out insured deposits pushed Bulgaria’s deficit to 3.7 percent of GDP and over the Maastricht criteria.

Where were the regulators?

Some newspapers had run stories on KTB’s political connections as early as the beginning of 2013. This raises a painful question: where were the regulators?

The role of regulators is to supervise banks and to correct market failures by behaving as independent technocrats.

Yet, such agencies are vulnerable to capture by political and economic agents as the benefits of regulation are diffused across the whole population, while its costs are concentrated among a small group of powerful and organized vested interests.

As long as these interest groups were aligned, their influence pushed Bulgarian regulators to turn a blind eye to KTB’s mounting issues.

Three priorities for Central Bank reform

What will it take to ensure Bulgarian regulators act in the interest of the public and not in that of well-connected individuals?

Three crucial reforms are needed to improve the leadership, accountability and transparency of the Bulgarian National Bank (BNB), which is responsible for regulating the country’s banks.

First, the next governor, due for appointment in late 2015, should be a respected technocrat selected in a transparent manner.

Governors need to be approved by the national parliament, which has resulted in appointees based on political loyalty rather than economic knowledge. This time the process should be structured as an open public competition above party politics.

Bulgaria can follow the example of the United Kingdom which advertised openly for the position of governor in 2012, drew a shortlist, and published a detailed report of the procedure after the appointment.

Second, the KTB case has revealed accountability weaknesses in the institutional setup of the Bulgarian National Bank, BNB, that must be fixed.

In particular, while the deputy-governor responsible for banking supervision has been put under criminal investigation, the governor himself has implausibly denied responsibility for regulatory failures.

If banking supervision is to remain within the central bank, the governor needs to also be made legally responsible for the actions of the deputy-governors.

Otherwise, banking supervision should be separated into an independent agency in order to streamline accountability and increase the costs of capturing regulatory processes.

Third, the BNB needs to significantly increase transparency.

In particular, it should carry out an inquiry into the systemic regulatory failures that led to KTB’s collapse.

Furthermore, regulators should recognise the key role of the media and whistleblowers in exposing irregularities and develop procedures to trigger investigations of such claims.

Unfortunately, key regulators have recently been moving in the opposite direction, using their powers to silence critical media outlets.

Towards adoption of the euro

Improving governance begins at home, but the EU has the power to play a key role in supporting the process.

Since mid-2014 there has been a wide political commitment within Bulgaria to join the ECB’s Single Supervisory Mechanism (SSM). Joining the SSM is likely to remain a key objective for Bulgaria, especially if it is to move towards adoption of the euro.

The ECB should clearly articulate that strengthening the accountability, transparency and independence of the BNB is a key prerequisite for Bulgaria’s application to join the SSM.

For Bulgaria’s policymakers, this will provide strong political incentives to reform the BNB – starting with organising the selection process for the next governor in a transparent manner.

For the ECB, this would guarantee that the new SSM member would be abiding by the key norms of central banking. For the Bulgarian taxpayer, this would hopefully mean better bank supervision and no more KTB-like failure.

Memories of last summer’s banking debacle are fading quickly and other priorities are beginning to dominate the political agenda. Yet, as experience has shown, in Bulgaria the prospective benefits of the EU are among the strongest drivers of reform.

The upcoming selection of a new governor provides a window of opportunity to tackle the problem of capture through changes in the structure, leadership, and transparency of regulatory agencies.

Bulgarians should heed Churchill’s dictum: “Never let a good crisis go to waste”.

Ivaylo Iaydjiev is a doctoral candidate at the Blavatnik School of Government at the University of Oxford, affiliated with the Global Economic Governance Programme and worked previously in the Office of the President in Bulgaria.