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Lending of First versus Lending of Last Resort: The Bulgarian Financial Crisis of 1996/1997

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In 1996/1997 Bulgaria was hit by a severe financial crisis, spreading from a banking crisis to a currency crisis. We argue that the Bulgarian Financial Crisis might serve as an illustrative example of a twin crisis involving both a currency and a banking crisis. While the Bulgarian Crisis had some properties of the so-called fundamental crises, as explained by first-generation models of currency crises, the severity of the crisis was primarily (but not only) due to systematic and path-dependent moral hazard behaviour of the banking sector. Special attention is paid to the crucial role the Bulgarian National Bank played in the pre-crisis and crisis periods when acting more as a lender of first resort rather than a lender of last resort (LOLR). We also show how Bulgaria managed to overcome the crisis by introducing a second-generation currency board allowing the central bank to act strictly as a limited LOLR, thereby making the country less prone to a financial crisis in the future.

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  1. 1.

    3 The complexity of the Bulgarian Crisis has rarely been subject to special analyses. A detailed crisis chronology can be found only in a limited number of publications. It is broadly covered by BNB annual reports (1996, 1997, 1998, 1999, 2000), OECD (1997, 1999), Balyozov (1999), Enoch et al. (2002), and partially by Filipov (1998), Sgard (1999), Mihov (2002), Nenovsky (1999), Dobrinsky (2000), Vutcheva (2001) and Roussenova (2002). In their review of banking crises in transition economies, Tang et al. (2000) point out that Bulgaria is the only transition country where a banking crisis was combined with a currency crisis.

  2. 2.

    4 In this paper, we use ‘currency crisis’ to refer to a sharp sudden devaluation or depreciation. A ‘banking crisis’ occurs when a substantial number of banking institutions fail and/or a substantial amount of bank deposits are lost through failing banks.

  3. 3.

    5 See, for example, the contagion models by Eichengreen et al. (1996) and Drazen (1999) or the herding model by Calvo (1999).

  4. 4.

    6 See, for example, Dooley (2000), Krugman (1998), Chang and Velasco (1998), Buch and Heinrich (1999) or Flood and Marion (2000).

  5. 5.

    7 For example, a central bank might decide to give liquidity assistance to banks suffering from temporary illiquidity problems, thereby increasing domestic money supply in spite of the fact that the exchange rate peg has to be abandoned because foreign currency reserves are exhausted. See for example, Chang and Velasco (1998).

  6. 6.

    8 It should be noted that this strong form of moral hazard only applies to the case where intermediaries do not invest on their own and thus have nothing to lose when going bankrupt.

  7. 7.

    9 Hochreiter and Kowalski (2000) argue that the legal independence of central banks in Eastern and Central Europe did not automatically lead to de facto independence. In most cases, the governments found ways to impose its fiscal interests by surmounting legal restrictions.

  8. 8.

    10 For a general discussion of the process of transition, see Kornai (2000). He distinguishes between soft budget constraints (i) inherited from socialism and (ii) specific to the transition process.

  9. 9.

    11 According to Balyozov (1999), during the whole period of 1995–1996 two big state-owned banks regularly obtained refinancing in order to prevent shocks to the payments system.

  10. 10.

    12 Uncollateralised refinancing is captured under ‘deposits and other’ in Table 2. Revised monetary data are available since 1995. The data before 1995 are not compatible with the newly revised data.

  11. 11.

    13 For instance, refinancing by DSK and BNB as a percentage of GDP was 11.5 respectively 8.8 per cent in 1993, 8.5 respectively 6.6 per cent in 1994 and 6.0 respectively 5.2 per cent in 1995. In July 1996, DSK was directed to stop uncollateralised refinancing as well as participating in the deposit market (OECD, 1997, p. 109). At the end of 1996, refinancing operations fell to 2 per cent of GDP and only 0.1 per cent at the end of 1997 (data for 1993, 1994 and 1995 are taken from OECD reports and for 1996 and 1997 from BNB staff reports).

  12. 12.

    14 The Bulgarian accounting practice in that period was guided by the intention to show better bank results. However, even with these standards in the beginning of 1996 only one or two banks had positive net worth (Enoch et al., 2002). See also Roussenova (2002) for a discussion of accounting standards in Bulgaria.

  13. 13.

    15 BNB's limited possibilities to initiate bankruptcy, coupled with the cumbersome bankruptcy proceedings in that period, are major reasons for the delayed banking reform (Enoch et al., 2002).

  14. 14.

    16 There were already some signs of the upcoming crisis in late 1995 when liquidity shortages arose and several rumours of bank failures were reported (Enoch et al., 2002).

  15. 15.

    17 Conservatorship is a legal procedure (introduced in May 1996) allowing BNB to suspend the operation of a bank close to insolvency. In that case, BNB appoints a conservator who (temporarily) manages the bank.

  16. 16.

    18 At first, individuals were allowed to withdraw their deposits in lev (without any restrictions) before the court declared its decision on closed banks (withdrawals of foreign currency deposits were allowed only by portions). Lev deposits withdrawn were quickly directed to the foreign currency market where the lev came under pressure. Later, the permission to withdraw the full amount of lev deposits was abolished and lev deposits were also blocked like deposits in foreign currency.

  17. 17.

    19 BNB changed the minimum reserve requirements in opposite directions. First, it lowered them from 9.5 per cent to 8.5 per cent; in December 1996 BNB began raising them up to a level of 11 per cent.

  18. 18.

    20 It should be noted that the decision to raise the base interest rate was suggested by IMF although the negative side effects have already been recognised during the former crises in Latin America in 1997–1998.

  19. 19.

    21 The increase of the base interest rate was partially caused by BNB's active open market operations (primarily reverse repurchase agreements) in order to withdraw liquidity (Balyozov, 1999).

  20. 20.

    22 According to the then BNB Governor Lubomir Filipov, BNB was subject to an assault by both the Bulgarian government and Parliament in mid-1996. At that time, the Parliament passed a law allowing to remove Managing Board members with qualified majority (Filipov, 1998).

  21. 21.

    23 According to the then BNB Chief Economist, the BNB Managing Board expressed disagreement with this credit in a special letter to the Government and the Parliament (Roussenova, 2002).

  22. 22.

    24 For a detailed survey on the financial sector in transition countries, see Bonin and Wachtel (2002).

  23. 23.

    25 At some point, all political forces competed to introduce the CB arrangement and curry favour with the IMF. For more details, see Nenovsky and Rizopoulos (2003).

  24. 24.

    26 ‘Resident capital flight’ could be considered as still another form of capital flight; the term was introduced by BNB to denote the outflow of capital from the banking system (see also Dobrinsky, 2000).

  25. 25.

    27 The features of orthodox (or ‘first-generation’) CBs, typical of the colonial system, are well known in broad outlines (compare Schuler, 1992; Schwartz, 1993). An orthodox CB completely rejects monetary policy. A CB is backed by a simple and clear rule which determines the relationship between balance of payments, reserve money (or money supply) and interest rate dynamics (compare Hanke and Schuler, 1991; Williamson, 1995).

  26. 26.

    28 For a detailed description of the Bulgarian CB, see Miller (1999), Nenovsky and Hristov (2002) and Nenovsky et al. (2002).

  27. 27.

    29 Some economists think that such a separation is impossible (Goodfriend and King, 1988), although in the 18th century Thornton and Bagehot tried to distinguish between them.

  28. 28.

    30 For surveys, see Bordo (1989) or Denise (2001).

  29. 29.

    31 See Bordo and Kydland (1996). For example, the Bank of England was supported by the Banque de France in 1890, and several more times in the beginning of the 19th century. It is possible that the European Central Bank will carry out the LOLR function for Bulgaria since Bulgaria is currently in the process of EU accession. See White (1999) and Goodhart (1987) for details.

  30. 30.

    32 In order to guarantee the restoration of the gold parity before 1866, the Bank of England issued letters of indemnity.

  31. 31.

    33 While Bagehot's advice to support only solvent banks with liquidity problems is implemented in Bulgaria, it is often hard to judge whether a certain bank asking for liquidity assistance is solvent or not. This information problem is even harder to solve in the short period of time the central bank has to decide on LOLR assistance (Goodhart and Huang, 1999, p. 6).

  32. 32.

    34 BNB's Regulation N6 defines liquidity risk as a situation where the amount of the ordered but unpaid payment documents in the Banking Integrated System for Electronic Transfer (BISERA) exceeds 15 per cent of its total amount for both the last 2 days. In addition, the liquidity risk for the banking system is a condition caused by a bank delay or an announcement that the bank is going to postpone the settlement of the submitted payment documents for more than 3 days, and if the bank has at least eight per cent share of all interbank payments for each of the last five business days prior to filing a request for a loan with BNB (BNB, 1999).

  33. 33.

    35 The importance of respecting the rules of the game during the gold standard is underlined in Bordo and Kydland (1996).

  34. 34.

    36 This conclusion is drawn in a review by Garcia (1999). He shows that the optimal guarantee is between one and two times the annual GDP per capita. For details about the specific features of deposit guarantees in transition countries, see Hermes and Lensink (2000).

  35. 35.

    37 Details for Bulgaria are given in Nenovsky and Petrov (2002).

  36. 36.

    38 See the survey conducted by Carlson and Valev (2001).

  37. 37.

    39 The recent events in Argentina teach us that a strategy which worked quite well for some years must not be adequate in the long run.

  38. 38.

    40 In the beginning of 1999 Credit Bank was declared to be insolvent (BNB, 1998), and in the beginning of the following year Bulgarian Universal Bank went bankrupt (BNB, 2000).


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We are very grateful for a large number of helpful comments by Jeffrey Miller. We are also indebted to the participants of the conference ‘Institutional and Organizational Dynamics in the Post-Socialist Transformation’ in January 2002 in Amiens as well as Christian Hott, Alexander Karmann, Lena Roussenova and two anonymous referees. We also thank Kalina Dimitrova for technical assistance. Financial support of Altana Stiftung is gratefully acknowledged.

2 A possible reason for the relatively low level of international interest in the Bulgarian crisis is that Bulgaria is a small country that was not a part of the European Community. In addition, Bulgaria is not an important trading partner of major European countries and did not receive significant foreign direct investments. International investors did not worry very much about a possible Bulgarian crisis nor did they fear that such a crisis could infect other economies of interest to international investors. Furthermore, the Asian Crisis started soon after the Bulgarian Crisis.

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Berlemann, M., Nenovsky, N. Lending of First versus Lending of Last Resort: The Bulgarian Financial Crisis of 1996/1997. Comp Econ Stud 46, 245–271 (2004). https://doi.org/10.1057/palgrave.ces.8100028

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  • lender of last resort
  • financial crises
  • twin crises
  • currency boards
  • Bulgaria

JEL Classifications

  • E42
  • E5
  • F02
  • P34