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Bulgaria bank fail flags region’s ‘Achilles heel’

Contagion from Bulgaria's dual bank run is viewed as unlikely, but the crisis has put the spotlight back on eastern Europe's troubled financial sector.

"Commercial banks have been the Achilles' heel, both for Bulgaria and for the rest of the region, over the past six years. Indeed, they partly explain why emerging Europe has been the worst performing emerging market region since the 2008-09 global financial crisis," said William Jackson, an emerging market economist at Capital Economics, in a research note.

Nikolay Doychinov | AFP | Getty Images

Bulgaria's fourth largest lender, the Corporate Commercial Bank (CCB), was nationalized last week with a view to recapitalization. It came after depositors rushed to make withdrawals from both CCB and its rival, First Investment Bank, following allegations of financial mismanagement. The Bulgarian central bank described these reports as "malicious" attacks aimed at destabilizing the country's banks.

Bulgaria's benchmark SOFIX index fell by over 7 percent on June 20 amid concerns about CCB. Shares have subsequently stabilized, however, and signs of systematic stress across the financial sector have been limited. Indeed, the SOFIX got a 5 percent boost on Monday when the European Commission approved a $2.3 billion credit line to Bulgaria to support its banks.

Meanwhile, interbank interest rates in Bulgaria have remained steady and there has been limited market reaction in nearby emerging European countries such as Romania, Serbia, Hungary and Croatia.

Common problem

Although markets are treating the situation in Bulgaria as an isolated event, its financial sector faces a problem common in the region: rising levels of non-performing loans (NPLs).

Banks in Croatia, Romania and Hungary, as well as Bulgaria, are weighed down by loans that turned sour following the surge in credit in the build-up to the global financial crisis of 2008/09. The problem has been compounded by a tightening of credit conditions since the crisis, with the parent banks of many local lenders (often headquartered in western Europe) no longer willing or able to roll over credit lines.

NPLs accounted for 16.6 percent of total loans in Bulgaria, according to the latest data from the World Bank. This compares to 21.6 percent in Romania and 15.4 percent in Croatia, but only around 5 percent in nearby Slovakia and Poland.

"Vulnerabilities in the region's banks have declined over the past three years, but they haven't gone away altogether. Accordingly, it wouldn't be surprising to see further bank failures from time-to-time over the coming years," said Jackson.

"This seems likely to happen in those countries that have seen the largest rise in non-performing loans. This includes Bulgaria, Hungary, Romania and Croatia."

Analysts including Jackson noted that the predominance of foreign-ownership in emerging Europe's financial sector left its banks vulnerable to shocks elsewhere in the Europe.

In common with some of its neighbors, Bulgaria's two biggest banks are both foreign-owned. UniCredit Bulbank is part of the Italian banking giant and DSK Bank belongs to Hungary's OTP Bank.

With that in mind, Simon Maughan, head of research at OTAS Technologies, said that Bulgaria's difficulties were a timely reminder of Europe's vulnerabilities.

"Europe remains reasonably fragile in terms of the banking system and it shows us that the biggest point of weakness for western economies is their banking systems," he told CNBC on Monday.

—By CNBC's Katy Barnato