THE CURRENT FINANCIAL CRISIS : THEORY , PRACTICE AND LESSONS

1. THE CURRENT FINANCIAL CRISIS: THEORY, PRACTICE AND LESSONS TSVETAN MANCHEV, Ph.D. DEPUTY GOVERNOR OF THE BULGARIAN NATIONAL BANK CONFERENCE “THE FINANCIAL SECTOR IN THE CONDITIONS OF A GLOBAL FINANCIAL AND ECONOMIC CRISIS” Plovdiv, 4 March 2009

2. MAJOR ISSUES • What are the principal theoretical and practical results and conclusions from the recent developments and how does the macroeconomic policy respond to them? • What are the possible scenarios for the development of the process? • What are the conclusions to be drawn for small and open economies? • Where do we fall? • What should (not) be done?

3. FACTORS FOR THE GLOBAL CRISIS 2008-2009 Factors known to theory, inferred from previous crises: • „The bubble burst”– the priсe bubble that burst on the US real estate market. Its effect was exacerbated by the practice of subprime lending and loan securitization (the originate-to-distribute model)by financial institutions, instrumental to keeping liquidity high and hence interest rates at historically low levels; • «Inconsistent and incomplete regulation»of the US financial sector that allowed investment banks, hedge funds, etc. to earn profits significantly higher than the average market levels; • «Lack of incentives»mortgage loans were taken out of commercial banks’ balance sheets, which LEAVES NO INCENTIVES for the lending banks tomonitor the condition of these loans and the borrowers’ creditworthiness; • «Errors»made by credit rating agencies which increase the «asymmetry of information». Factors that turned the crisis global: • «Imbalances»in the world economy; • The role of the US dollar as a global currency.

4. THEORETICAL AND PRACTICAL CONCLUSIONS FROM THE DEVELOPMENTS IN THE 15 MONTHS SINCE SEPTEMBER 2007 What underlies the crisis is the interaction between the global macroeconomic imbalancesbuilding up in the last 10 years, and the trends in the major international financial markets evidenced for almost 30 years now but which gained particular momentum under the impact of the above imbalances.

5. INITIAL MEASURES TO COPE WITH THE CRISIS • Practically unlimited provision of liquidity not only by central banks but also by GOVERNMENTS • Guarantees to protect depositors and creditors, even in the extreme form of the so-called „UNSECURED GUARANTEES” • Structuring of programs for direct government lending to non-financial corporations (the automotive industry) • Structuring of programs for large-scale purchases by governments of considerable share participation in banks and financial institutions, not excluding the possibility for these programs to cover also non-financial corporations • Structuring of government programs for support of small and medium-sized enterprisesand protection against unemployment, and of borrower protection programs.

6. THE SUCCESSFUL CRISIS RESOLUTION POLICY (1) • Bringing the process to a s stop by means of a new social agreementbetween the agents to: • Restrict the unfavourable impact of the crisis on the main macroeconomic indicators; • Restructure the institutions that have lost public credibility so that they can pursue an adequate macroeconomic, and particularly monetary, policy. This means intensifying of various elements of the economic policy and of the regulations on micro, mezo, and macro level to reduce the uncertainty and clearly set the rules on the markets, including: • Active, but transparent, central banking policy to maintain high bank liquidity; • Bringing the regulatory capital adequacy of debtors in line with market requirements;

7. THE SUCCESSFUL CRISIS RESOLUTION POLICY (2) • Strengthening banking supervision and enhancing transparency of creditors and borrowers; • Legal guarantees in case of bankruptcyas a principal means for debt problem resolution, besides within time limits needed by the market; • Establishing and maintaining long-term relations between credit institutions and borrowers and supporting detailed information by means of accessible credit registers for real time exchange of information between credit institutions for risk management purposes; • Enforcing, where necessary, additional legal restrictions and regulation of banks and other financial intermediaries in these sectors approaching the rate of profit in the other sectors.

8. CURRENT RESULTS The main conclusion is that the initial response for handling the crisis globally was not efficient, as it was not well coordinated worldwide, not well targeted at (focused on) eliminating the factors behind it, and not fully taking into account past experience. This has already multiplied the cost of accommodation and the time needed for it compared to preliminary expectations, and has further increased uncertainty and mistrust.

9. POSSIBLE SCENARIOS FOR WORLD ECONOMY DEVELOPMENT IN THE MID-TERM (3-5 years) • Continuing downfall and disintegration of global economy • Quick recovery • “State” capitalism” • “Liberal regionalism” (Restricting liberalisation at the global level while preserving it within the respective economic and monetary unions)

10. IS CAPITALISM “DYING”? First,the politicians’ acting too hastily to prevent the crisis with the state being overly and fully involved from the very beginning, which has already made apparent the sizeable long-term costs, should not be regarded as a long-term policy. Second,the so far failed attempts of politicians and civil servants to act as bankers have in many countries already drained the public credit of trust in them, which too makes them reconsider their strategies and return to the sound theoretical principles of market economy. Third,it has become clear that neither the expansionist, however opaque, monetary policy of the major central banks, nor any of the forms of capital control introduced by individual developing countries can substitute a framework of supervisory regulations adequate to market requirements and globally observed by all participants.

11. CONCLUSIONS FOR SMALL OPEN ECONOMIES (1) • Countries with small open economies in the global crisis environment are not unaffected and need to adjust. • The tools of competitiveness of these countries are even more limited in times of crisis, i.e. they need the crisis to end soonest more than the others. • Small open economies which are part of economic and monetary unions are in a better competitive position than the others as they enjoy, at least at a minimum, the generally higher market confidence in the major participants in these unions and in the unions in general. • The individual starting point and the level of affectedness by the crisis of each small open economy, either participating or not in a monetary union, are of GREAT importance where national adjustment strategies and actions need to be developed.

12. CONCLUSIONS FOR SMALL OPEN ECONOMIES (2) • A small open economy with a sustainable and transparent long-term macroeconomic and monetary policy, supported by political consensus, which has not undergone fundamental changes over the recent months enjoys a better understanding, public and investors’ trust and will adjust relatively much easier with no need for the country to become “indebted”. • In the above case the main strategy should aim at further cutting down government expenditure and enhancing labour market flexibility, which is regarded higher by markets than are «blank» guarantees or other forms of state intervention that only disrupt markets’ long-term functioning leaving imbalances unrestricted.This is also the EU position. • It has to be carefully watched to which of the above scenarios the global economy will evolve in the mid-term so that an adequate adjustment strategy and a range of actions be looked for and found on a timely basis.

13. WHERE ARE WE? (1) • There is a clear political consensus on key long-term policies – currency board in place till the adoption of the Euro; at least a balanced budget after taking account of cyclical factors; low taxes as the main tool for better competitiveness; keeping the current high degree of freedom of movement of people, capitals, goods and services; • The monetary policy has been based on clear rules for a long time and in times of crisis liquidity is provided in a transparent for the market way, observing the rules of the currency board arrangement; • Strong public finances and low debt burden of the public sector; • Lack of a direct channel for “infecting” banks owing to the long-standing, closely related to traditional banking markets, evaluation of financial instruments;

14. WHERE ARE WE? (2) • Stable, though decreasing, funding from parent banks which are also in good financial shape, are among the relatively less affected by the crisis, and so far have not taken unexpected actions towards their subsidiaries; • Well-diversified domestic financial market in terms of institutions by countries, instruments, currencies, counterparties; • Quick change in banks’ behaviour (adaptation) in the new situation – change in the risk appetite; improving the methods and models for its management; trying to ensure symmetry of information through an active dialogue with regulators, markets and customers; • Current profits are not affected by “impairment losses” resultant from worsened quality of loans;

15. WHERE ARE WE? (3) • Transparent and clearly-defined “anti-cyclical” regulatory framework: • Conservative approach in provisioning, generating capital cushions; • Additional provisions when capital charges are required (other than those for impairment losses under IFRS); • High level of MRR (currently 10%, but effectively over 7%); • Pro-activeand clearly-defined “anti-cyclical” monetary policy of the BNB in recent years. A number of measures have been taken in a transparent and timely manner to slow down credit growth, which provided a basis for a sound increase in banking intermediation. In a consistent, transparent and timely manner we also take measures to normalise liquidity after the shocks in the past months; • Yet there are some sporadic “cases” of, and “markets” with, unequal legal or regulatory treatment of participants during the crisis.

16. CURRENT CONDITION OF THE BANKING SYSTEM

17. CURRENT CONDITION OF THE BANKING SYSTEM – latest data Data at January 2009: • BGN 72 million monthly profit (one of the few banking systems in Europe that generate profits even in 2009) • The foundation is being reinforced: • Audited profits for 2008 will be included in banks’ capital • Quality of assets is still high and stable • Liquidity ratio is above 20% • Stable financing for banks in the coming periods

18. THE RESULTS SO FAR • All markets function normally; we did not allow any «failure» on the major markets – money, banking, credit, debt, labour, investment. • The major conclusion is that Bulgaria is getting adapted smoothly and consistently, in a market way, to the new global balance. There is economic growth, even though decreasing. There is also positive, though relatively low, growth of credit to the non-financial sector which corresponds to the changes in agents’ risk appetite. • Market participants’ increasing uncertainty and distrust as to borrowers’ abilities to repay their debts given the decelarating economic growth in Bulgaria in 2009 – 2010.

19. WHAT SHOULD (NOT) BE DONE? AS MARKETS FUNCTION EVEN DURING THE CRISIS,WE NEED MORE THAN EVER PREDICTABILITY AND CONSISTENCY OF THE MACROECONOMIC POLICY AND UNCONDITIONAL OBSERVANCE OF MARKET PRINCIPLES!!! • Keeping and strengthening the political consensus on key long-term policies; keeping the current crises response framework – a currency board accompanied by a strong transparent anti-cyclical fiscal policy, supported with a pro-active transparent monetary policy and an anti-cyclical transparent regulatory policy • Giving up any inconsistent (ad hoc) legal and regulatory intervention in the functioning markets • The public dialogue about “the Bulgarian strategy”and individuals’ behaviour during the crisisshould not take heed of the interests of “fear sellers” and those who were making profits well above market levels in the period before the crisis; • Implementing a package of measures aimed to increase the administrative capacity in accordance with the European Commission latest report on the performance of Lisbon Strategy objectives • Continuous participation in the search for and quick finding of a generally accepted strategy for restructuring after the crisis within the EU, actively supporting any proposal for consistent liberalisation of markets and equal treatment of participants.

20. THANK YOU FOR YOUR ATTENTION!