Bulgaria Is Letting Bad Banks Fail; Could the U.S. Do the Same?

Source: Thinkstock

Source: Thinkstock

Last week, the Bulgarian government pulled the plug on its forth largest bank after one of the worst financial scandals in the country since the 1990s came to light. The Bulgarian central bank, after making attempts to rescue Corporate Commercial Bank, found that it was not feasible to save the bank and it was setting a wrong precedent for the future, apart from hurting the economy directly.

Last month, Bulgarian depositors made a run on the bank as reports of illegitimate deals struck between the bank and one of its largest shareholders, Tzvetan Vassilev, surfaced. In the audit review of the Corporate Commercial Bank, Bulgarian central bank found out that all the documentation backing loans worth 3.5 billion levs ($2.43 billion) out of CCB’s total 5.4-billion-lev loan portfolio were missing, according to a Reuters report. The documentation is believed to have been destroyed a day before the central bank took over the bank’s operations on Vassilev’s order.

“We cannot continue to fill a barrel without a bottom, as the wise Bulgarian people say, and we cannot nationalize Corporate Commercial Bank in its current state, as we announced before the results of the audit,” the Bulgarian central bank said. “The results of the review of Corporate Commercial Bank speaks, to put it mildly, about actions incompatible with the law and good banking practices,” the central bank said.

The Bulgarian central bank, before the audit, tried to reach out to other prominent shareholders to see if a rescue plan could be worked out after bank run led to one fifth of deposits being withdrawn in a span of couple of days. After these attempts failed, Plan B was to nationalize the bank by getting two institutions to recapitalize CCB. But the audit reports suggested, that was not feasible either. The decision was made to let the bank fail.

“Our aim remains unchanged — that the citizens and the companies receive the full amount of their funds,” Petar Chobanov, Bulgarian finance minister, said last Friday. “The only exception from that will be the companies of the majority shareholder and parties and companies related to him.”

The central bank has cancelled the license of the bank and decided to hive-off the active assets of the bank into a separate nationalized entity. Bulgarian National Bank has also reported about the malpractices at the bank to the prosecutors, according to Reuters.

A hypothetical question, which nevertheless should be answered is, how would policymakers and regulators in the U.S. have responded if faced with a similar situation? Are the financial reform laws in the U.S. strong enough to handle a Bulgaria-like crisis with such efficiency and speed?

Given that Bulgarian policymakers acted swiftly and competently in the public interest, the U.S. can probably take a leaf out of the Bulgarian book of central banking. It is hard to imagine a repeat of such a response in U.S. if one of the large U.S. banks or the “too big to fail” banks ever were to be involved in a similar crisis; history suggests that government will lean in to support big banks in their time of need, despite previous bad behavior.

Understandably, less than a dozen megabanks, 0.2 percent of all banks, control two-thirds of the assets in the U.S. banking industry. But problem really is not the size of these banks but the unfair competitive advantage these banks have gained because of their size in being able to take greater risks, jeopardize the whole economy if they fail, and a general lack of political will to give more teeth to existing laws to reform the banking industry. Few can put it as well as Richard Fischer, President of the Dallas Federal Reserve, who described the failure of U.S. policymakers to build an effective regulatory mechanism.

“TBTF is a euphemism for a financial institution so large, interconnected, and/or complex that its functions are seen as critical and policymakers think its demise could substantially damage the financial system and economy if it were allowed to fail. Without fear of closure, these banks and their counterparties can take excessive risks,” Fischer said in his Statement before the Committee on Financial Services, U.S. House of Representatives in June last year.

Though Congress passed the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank Act) to correct the excesses of TBTF banks and provide a liquidation framework for such banks in an event that they must have to fail, much remains to be desired. “Regulators cannot enforce rules that are not easily understood,” Fischer said. “Nor can they enforce these rules without creating armies of new supervisors.”

One of the biggest problems with the Dodd Frank is a perception among creditors of the large banks that they will not be allowed to fail, which the Dodd Frank legislation does little to eliminate. In fact, if anything, Dodd Frank institutionalizes this perception.

“Why should a prospective purchaser of bank debt or other type of counterparty practice due diligence if, in the end, regardless of new layers of regulation and oversight, it is widely perceived that the issuing institution and its subsidiaries will not be allowed to fail?” Fischer said.

Dodd Frank Act also fails to have a “convincing fence,” in the words of former IMF Chief Economist Simon Johnson, to ensure that one failing bank does not bring down the entire financial system. “The threat of liquidation for any big company will be credible only if the damage can be limited to people with direct exposure — otherwise someone at the highest level of government, presumably with the approval of the president, will override all plans and provide a backdoor bailout,” Johnson wrote in The New York Times.

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