August 2016 - It has been a turbulent few years for the Bulgarian banking sector. Early summer 2014 saw the failing of the fourth-largest bank, Corporate Commercial Bank, and the subsequent run on the third-largest, First Investment Bank (“FIBank”). Calm was restored after a government intervention, but the trust of depositors and investors was damaged.

More than two years after the events of that turbulent summer, the Bulgarian banking system is at the end of the most comprehensive asset quality review (“AQR”) in its history. The AQR was recommended by the European Commission and is seen by all market players as a breakthrough moment for the development of the local non-performing loan (“NPL”) market as well as for market consolidation. The AQR is the first step of the Comprehensive Assessment (“CA”), which also includes stress tests for banks based on the findings of the AQR and the implementation of recommendations and action plans based on the findings of the AQR and stress tests.

While stress tests provide valuable information regarding the resilience of a bank in downturn situations, the AQR represents a real breakthrough for the investment community, as it provides a detailed picture of the state of the Bulgarian banking sector.

In a nutshell, the CA (based extensively on European Central Bank methodology, with a few local modifications, taking into account the simplified banking model in Bulgaria) aims at number of goals:

  1. to provide an in-depth analysis of the asset quality of the Bulgarian banking system;
  2. to carry out stress tests based on asset quality analyses in order to analyse the resilience of the banks’ balance sheets in different economic scenarios;
  3. to set the timeline and steps needed for the adoption of the European common currency in Bulgaria, as well as the entry into pan-European mechanisms such as the Single Supervisory Mechanism;
  4. to regain the trust of the general public and investment community.

The Bulgarian National Bank (“BNB”) had one year to organise and implement the entire process. Deloitte was appointed as consultant to the BNB, which acted as the on-going supervisor of the project. Each of the other 22 banks established in Bulgaria chose a reputable audit company to carry out the review and to analyse its portfolio asset mix and credit quality. The work of the consulting firms included an on-site check of the premises, a review of physical files and assessing the actual quality of the bank’s portfolios.

“Sampling” was used to examine different parts of the bank’s portfolio based on risk exposure and the level of its provisioning, with a number of actual credit files examined depending on the size of the portfolio (some reports indicate up to 700 actual credit files sampled and examined, with some banks having more than 90% of their respective exposures reviewed). The total number of reviewed credit files was more than 3,400, or around 71% of corporate and SME credits in Bulgaria, representing around EUR 12 billion. The portfolios themselves were segmented into three groups – Corporate, SME and Retail Mortgage. Some exposures were excluded – those provisioned up to 95% and exposures to companies with Debt/EBITDA ratio below 1.0 or equity comprising more than 50% of the assets of the counterparty.

With the results now being published and available to the public, the main takeaways are clearly visible:

Firstly, Bulgaria’s banking system currently operates on a “two-speed” model. The big banks, most of them wholly owned subsidiaries of foreign banking groups (UniCredit, Raiffeisen, OTP, SocGen, NBG), perform well and are over-capitalised (average 18.9% CET1 for the sector, compared to the minimum of 4.5%). Problems occur with some Bulgarian banks and their corporate portfolios, which offset the rather steady and stable income from retail business lines.

The AQR resulted in status adjustments of circa EUR 332 million in assets from performing to non-performing, concentrated mainly in two local banks – the third-largest bank, FIBank, and Investbank. As a result, the two banks will have to undertake a number of measures, including offloading NPLs and collateral in the next two years. It may be expected that some of the significant real estate assets and industrial enterprises that the two banks hold may be offered for sale. Additionally, FIBank has agreed to increase its capital buffers with an additional BGN 206 million (approx. EUR 105 million) by April 2017. The bank has indicated that it may turn to the financial markets.

All of the banks, even with sufficient capital (i.e. more than the minimum required under CRD IV), are overburdened with non-performing loans (21.9% of all loans, including retail), and this impairs their ability to extend credit. The argument of the banks – that these NPLs are sufficiently provisioned with high-quality collateral (real estate and other long term assets) – remains a source of serious contention, which could, in case of a portfolio sale, make the pricing gap too wide for a deal to be concluded. Irrespective of this, we see a growing number of NPL portfolios being offered, and this trend is expected to continue in the coming years. A further catalyst for this could be the implementation of IFRS 9 in less than 18 months, which could result in the increase of total impairment provisions for all bank assets. The AQR report indicates that the BNB is closely monitoring its future implementation in all reviewed credit institutions.

Although last quarter (Q2 2016) was highly profitable for most banks in Bulgaria, the results and conclusions of the AQR suggest that there may be consolidation of the sector. With the top-five banks generating over two-thirds of banking-sector revenue in Bulgaria, pressure remains on some smaller banks to consolidate in order to be commercially viable. A tender is already underway for one of the smaller banks, Victoria, and there are rumours for the expected sale or mergers of other banks, including some of the larger ones.