The Banking Sector and theGreat Depression in Bulgaria,1924–1938: Interlocking andFinancial Sector Profitability

Kiril Danailov Kossev

September 2008

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DISCUSSION PAPERSDISCUSSION PAPERSDP/68/2008

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DISCUSSION PAPERSEditorial Board:Chairman: Statty Stattev

Members:

Tsvetan Manchev

Nikolay Nenovsky

Mariella Nenova

Pavlina Anachkova

Secretary: Lyudmila Dimova

© Kiril Danailov Kossev, 2008© Bulgarian National Bank, series, 2008

ISBN: 978–954–8579–16–2

Printed in BNB Printing Center.

Views expressed in materials are those of the authors and do not necessarily reflect BNB policy.

Elements of the 1999 banknote with a nominal value of 50 levs are used in cover design.

Send your comments and opinions to:Publications DivisionBulgarian National Bank1. Alexander Battenberg Square1000 Sofia. BulgariaTel.: (+359 2) 9145 1351, 9145 1978, 981 1391Fax: (+359 2) 980 2425e–mail: Dimova.L@bnbank.orgWebsite: www.bnb.bg

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Contents

Introduction1............................................................................................................................................ 5

Bulgarian Economic History Literature on the InterwarPeriod ............................................................................................. 8

Banking Structure and Finance in the Bulgarian Economy,1924–1936 .................................................................................. 11

European Experience during the Depression; TheoreticalModel ........................................................................................... 25

Econometrics and Robustness Checks .................................. 30

Conclusion .................................................................................. 36

References ................................................................................... 38

Publication recommended by the Bulgarian National BankEditorial Board of Finance and Banking History

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8SUMMARY. The economic narratives of Southeast Europe during the first part of the 20th century

are currently being re-written. A story of failed industrialisation and delayed modernisation during theInterwar period has dominated since the pioneering work of Gerschenkron, but not enough aggre-gate data are available to see this as the only interpretation. In particular, virtually nothing is knownabout the financial system. This paper has two aims. First, it looks at the banking sector in Bulgaria inthe 1924 to 1938 period. We provide new data for the 1920s rise and the 1930s decline of the Bul-garian banking sector and we evaluate its potential contribution to Bulgarian economic growth. In thesecond part, we discuss different explanations for the widespread collapse of commercial banks afterthe onset of the Great Depression. Relying on a new data set for over 100 Bulgarian commercialbanks, we show that traditional explanations for the collapse of European commercial banks in the1930s (based on the default of risky loans and falling asset prices due to deflation) need to be comple-mented by the pernicious effects of widespread insider lending in the Bulgarian case. We concludethat insider lending was the single most important factor behind the demise of the private bankingsystem after the onset of the Depression.

The author is a graduate student in Economic History at Nuffield College, University of Oxford.He holds an MSc in Economic History and a BA in Economics and History from Hertford College,University of Oxford. His research interests are centred on quantitative economic history, interna-tional development and international finance. At graduate level, his work is focused on economicgrowth through history, the industrial development in 20th century Eastern Europe and Interwar(1919-1939) economic crises in the region. In particular - financial institutions, their formation andevolution; cooperation with industry and the resulting interlocked networks - as well as impact oneconomic development.

Contact details: Kiril Kossev, Nuffield College, Oxford, OX1 1NF, UK; Kiril.kossev@nuffield.oxac.uk

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Introduction1

In a recent paper, Ivanov and Tooze (2007) have pointed out the lack ofconsistent narratives about the economic development of South-East Europepre-1945.2 While they have put forward this agenda to the attention ofeconomists and economic historians, and have laid some of the groundwork,work on the aggregate is still incomplete. Quantitative analysis of the factorscontributing to growth in the regions is yet to come. The stylised facts ofstagnating agriculture, failed industrialisation and buoyant, yet inefficientfinancial sector, have to be placed in appropriate quantitative framework.

The divergent views on the economic development of the SoutheastEuropean region range from the overly optimistic paper of Good and Ma(1999), through to the extreme pessimism of Palairet (2001).3 The formerview, backed by Maddison in his cross-country GDP estimates, suggests slowconvergence of the European periphery to the core. Palairet's work stops in1914 and presents a bleak picture of stagnation and decline, especially in thepredominant agricultural sector. The rather outdated Bulgarian Economy byJohn Lampe and the economic survey of the Balkan countries during the lastcentury by Lampe and Jackson are rather more moderate.4

Two modern works by Avramov and Daskalov follow the conclusions ofAlexander Gerschenkron about a failed attempt at modernisation and indu-strialisation during the Interwar period.5 Without doubt, the work of Ger-schenkron stands out as a pioneering attempt at using aggregate data, yet itis, as Gerschenkron himself suggested, 'unsystematic and of narrow scope'6.Bulgarian scholars writing in the communist period have adhered to adescriptive tradition presenting a steady decline until 1945, which ignores theobvious dynamics of a developing economy. The works of Berov havebecome classics now.7 They are, however, heavily laden with extremeideological material and provide little in the way of analysis.

1The author is grateful to Matthias Morys (Economic Department, University of Oxford) for his ex-ceptional support. Martin Ivanov (BAS), Nikolay Nenovsky (BNB), Roumen Avramov (CLS), Avner Of-fer, Knick Harley, Jane Humphries and David Chambers (all from the University of Oxford) providedme with invaluable comments. An internship at the Bulgarian National Bank and work with NikolayNenovsky and Kalina Dimitrova (BNB) has given me the time and resources to work at the archivesfor much longer than I could have hoped for otherwise. I am grateful to the Economic and Social Re-search Council in the UK and the George Webb Medley Fund at the Economics Department of Ox-ford University for funding my studies and research.

2Ivanov and Tooze (2007)3Good and Ma (1999), Palairet (2001);4Lampe, (1986), Lampe and Jackson (1988)5Avramov, (2007), Daskalov (2005), Gerschenkron, (1962)6Gerschenkron, 1962; p. 1987Berov, (1989)

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8Contemporaries of the interwar period, on the other hand, have written

numerous and provoking accounts of the country's financial system. Iconicfigures like Stoyan Bochev, a long-term banker and influential figure in theeconomic circles of interwar Bulgaria was a prolific writer. Christoforov – apopular economic scholar, and Tchakalov – director of research at theBulgarian National Bank, both made valuable contributions.8 These, togetherwith an aggregate quantitative analysis can help further our insights into thedynamics of finance in the Interwar Period.

As far as the role of finance and the banking sector in the development ofthe Bulgarian economy is concerned – there is very little in the way ofmodern scholarly research. Avramov (2007) has provided some invaluableinsights through case studies. The first aim of this paper is to provide anoverview of Bulgarian Interwar finance and make suggestions about itspossible influences on economic growth. We provide new data for the 1920srise and the 1930s decline of the Bulgarian banking sector and we evaluateits potential contribution to Bulgarian economic growth. The data isconstructed from a previously unused archive of an institution crated in 1931,the Bank Board, complementary to the Bulgarian National Bank and theMinistry of Finance, to oversee the commercial banking sector and accountfor the widespread insolvencies.9 This new source is a unique opportunity togain a fresh glimpse at the workings of the financial system during InterwarBulgaria. A central problem that emerges from the data is the high levels ofinsider lending. Our hypothesis is therefore that this factor may explain thewidespread bank failures of the 1930s.

Insider lending was by no means unique for Interwar Bulgaria. A greatdeal of economic literature deals with the positive effects of finance oneconomic development. Levine (1993) provides an excellent survey of thetheoretical underpinnings and the empirical tests that have been conducted.More recently, Trew (2006) has summarised the findings of the literature onthe finance-growth nexus. One branch of that literature deals with thesuggestion that the structural specifics of national financial system can haveprofound effects on the development of these nations.10 In particular –universal banking and relationship banking – have been at the core of adebate regarding the benefits of long-term links between banks andindustry.11 Lamoreux (1994) has discussed the practice of insider lending,

8Bochev, (1926), Christoforov, (1946); and Tchakalov, (1946)9Bankersky Suvet (translated to Bank Board by League of Nations 1934 publication on Commercial

Banks).10Cameron, (1967), more recently, Forsyth and Verdier (2003)11Cameron, (1967), Fohlin, (2007)

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associated with universal banking and has concluded positively regarding thisphenomenon using 19th century east-coast US banks. More recent analysisof insider lending has moved away from praise to the other extreme. La Portaet al has blamed this practice for the severity of the mid-1990s banking crisisin Mexico.12 Chapter 4 will discuss the views of the economic literature onthe subject. It will also suggest the theoretical underpinnings of the papersuggested by this literature.

This paper argues that persistent credit constraints led to banks-industryinterlocking and prevalence of insider loans and these set up a trap forunderdeveloped industry during the deflation. Using unique archive material,we are able to test the suggestion that insider lending was one of the maincauses for the sweeping bank failures during the depression. The conclusionis that interlocking – presented as a solution to a moral hazard problem –exemplified the negative consequences of underdeveloped financial marketsin a time of economic crisis. The power of personal relations is linked tocentral problems in economics – agency theory and models of principal-agent incentives. Empirical evidence of the impact of such activities canfurther the finance-growth nexus and help bring these problems to theforefront of policy-making.

The remainder of this paper is organized as follows. In the second section,we will discuss the literature on Bulgarian interwar economic history. Recentresearch might have improved our knowledge of the real economy, but verylittle is known about the financial sector. We will fill this gap, partly at least, inthe third chapter by providing the reader with new data showing the rise ofthe Bulgarian banking system in the 1920s and its dramatic decline after theonset of the Great Depression. We then turn to the second aim of this paper,i.e. explaining the dramatic decline of the banking system in the 1930s. Insection four, we will set the stage by discussing what we know about bankfailures in other European countries in the 1930s. We will also provide sometheoretical guidance to the problem of interlocking. The fifth section is thecentrepiece of this paper in which we show econometrically that widespreadinsider lending was the single most important factor behind the demise of theprivate banking system after the onset of the Depression. The final partconcludes.

12La Porta et al (2002).

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8Bulgarian Economic History Literature on the Interwar

PeriodIvanov and Tooze (2007) suggest that there are three strands to the

debate about East and Southeast European growth experience since the late19th century. Those who write in the spirit of the late 19th centuryglobalisation, like to see convergence to the European core, albeit in verymoderate terms. Revisionists like Michael Palairet, on the contrary, detectdivergence, falls in productivity and digression from a market to a subsistenceagricultural economy. The reason for such divergent views is the lack ofconsistent quantitative evidence, which can establish the growth rates of theeconomy on the aggregate but also the different strands of industry,agriculture and services. Ivanov and Tooze who start off on that path, usingdata for Bulgaria, have pointed to some important conclusions already, whichsuggest a middle ground for thinking about the economic development ofthat country. We have no intention of suggesting a consensus amongst thegrowth narratives and it is not our aim to present a new take on the dataavailable regarding industrial or agricultural performance either. Rather weaim to persuade in this first section that more work is needed to find aconsistent and convincing narrative about economic development andespecially accentuate on the lack of work and data on the aggregate for onevery important sector – banking and finance.

John Lampe's book on the Bulgarian economy is still the only book-lengthaccount in English that attempts to present an aggregate view of the 20thcentury development of that country.13 Thus it is necessarily the benchmarkagainst, which all other analyses are presented. Partially using data from theearlier work by Bairoch, it provides a sterling case for the optimistic view ofconvergence.14 Including the years of the two world wars, Lampe's figure of2.7 per cent growth, nearly double the European average of 1.7 per cent.15

Thus the optimistic case has been more or less influenced by the stylised factof economic catch-up on part of the less developed periphery suggested byneo-classical growth theory. Good and Ma (1999) have framed theirquantitative analysis in such lines. They conclude that the potential growth,consistent with catch-up on the developed core was only achieved in the late19th century up until 1914. During the Interwar period and subsequentcommunist regime there was very little economic advancement. They,

13Lampe, (1986)14Bairoch, (1976), pp.273–34015Lampe, (1986) p.14

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therefore present a middle ground amongst growth historians of the Balkanregion.

Ivanov and Tooze have re-estimated the national income of Bulgaria for1892 and 1911, whilst adding new data points 1899, 1905 and 1921. Thedifficulties of gathering new data has meant that they can not present anunbroken sequence of figures, but from the estimates they provide, a numberof conclusions can be drown. Prior to 1914 no significant progress wasachieved, yet they claim that the Interwar period was notable for the changesthat took place within the agrarian sector in the economy - like switching toproduction of industrial crops. Still figures for industrial share of output werearound 15per cent, which is little changed from earlier parts of the 20thcentury. The literature on Bulgaria presents a predominantly agriculturaleconomy, where the share of the agrarian sector amounted to 70 per cent-80per cent throughout the late 19th and early 20th centuries. This evidenceseems to confirm Palairet's phrase - evolution without development.

The latter has provided a rather bleak picture of the Balkan economiespre-1914.16 His arguments suggest that the break with the Ottoman Empireresulted in restricted domestic markets, redistribution of land into smalllandholding and gradual retreat from the market and a return to subsistencefarming on the part of the peasant populations. This resulted in thedivergence from the European core rather than growth in development.

Bulgarian historians have taken a similar stance. Two recent works byDaskalov and Avramov have largely agreed with the pessimistic narrative.17

They very much agree to a story presented by Gerschenkron in 1950s-amounting to failed modernisation and industrialisation. Daskalov claims thatthe only sectors outside agriculture, which exhibited some growth, were thestate protected industries – mining, metal works, electricity production,chemical products, etc. Figures he borrows from contemporary writers showfourfold increase in the number of enterprises, which received state support,and around threefold increase in the number of workers employed therebetween the years of 1909–1939.18 He gives us a feel for the stagnation inother sectors by putting forward a number of examples to act as case studies.Avramov (2007) uses a similar approach to present not dissimilar results.

The work of Ivanov and Tooze has boosted the case of the pessimists.Given the painstaking efforts to gather data for the period pre-1924 andmatch that across other available estimates, it seems that the case of

16Palairet, (2001)17Avramov (2007), Daskalov (2005)18Daskalov, (2003) p. 323

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8divergence, suggested by Palairet, is more believable than the overlyoptimistic picture, painted by Lampe and Lampe & Jackson. Furtherinconsistency is the evolution of the agrarian sector between the world wars.Ivanov and Tooze's data suggests a move towards industrial crops, decline ingrain production and shifting the balance of exports to tobacco.19 Lampe'sfigures, taken from the Statistical Yearbook of Bulgaria, suggest growth ingrain and tobacco production, but a decline in industrial crops.20 Aconclusion that follows is that agriculture did not stay stagnant – there wereclear efforts to overcome the world-wide decline in the prices of primaryproducts and the increasing trade isolation, faced by the agriculturalproducers in the periphery during and after the Depression.

If aggregate data about the real economy is sparse and difficult to puttogether, then data on the financial sector is even more so. All of Lampe,Avramov and Daskalov talk about expansion in the banking sector during the1920s and then a severe contraction during the 1930s. The second part ofthe Interwar period was also allegedly characterised by an increased role ofstate capital, a centralisation of private bank capital into fewer, but largerinstitutions and a near complete flight of foreign capitals from the country.This very much represented a return to the pre-1919 state of the economy, asAvramov (2007) has suggested. Lampe has provided some data on loan valueof banks during the 1920s to illustrate the much-increased share of privatecommercial banks. He suggests a near doubling in the value of loans givenout by private commercial institutions from 1911 to 1928.21 Avramov hasused case studies to illustrate the dynamics of the microcosm of the financialworld. His conclusions of the overbearing role of the state and foreign capitalin the Bulgarian financial system and the chronic shortage of capital will formthe starting premise of the next chapter. He has also provided some verygood examples of insider lending with fatal consequences for the banks.22

We very much agree with his conclusion of widespread practice of insiderlending, which rotted the banking system from inside – we provide quantitati-ve evidence on the aggregate for this and a formal test in chapter 6. We alsofeel there is a need for a narrative on the aggregate level, about the experien-ce of the banking sector. The following section takes steps towards that aim.

19Ivanov and Tooze, p. 2520Lampe (1986), p. 85, Lampe suggests largest growth in vegetable output between 1931–1935,

by around 29 per cent. For the same period yield per hectare in industrial crop fell by 29 per cent, butdue to increased land in cultivation, actual output per capital increased by 12 per cent. Grain outputper capital increased by 9 per cent, but yield/h went up by some 14 per cent.

21Ibid., p. 6722Avramov, (2007), vol. 2, pp. 405–455

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Banking Structure and Finance in the Bulgarian Economy,1924–1936

Given the uncertainties in quantitative terms about the economicexperience of the Southeast European region and Bulgaria in particularduring the Interwar Period – the majority of scholars have followed thegeneral trend of explaining the 1920s as years of dynamic growth, whichdescended into slowdown and a lengthy depression. The 1930s were thenthe time of slow recovery, but also increasing international isolation.23

Fall in prices of primary products undermined significant parts of theperipheral countries' income. As export income dried up, reparation andforeign debt payments became extremely difficult. By 1931 countries likePoland, Romania, Yugoslavia and Bulgaria were in an untenableindebtedness.24 Policies used to alleviate the crisis involved rigorousexchange controls and increased state intervention into the industrial andfinancial sector. These had significant deflationary effects on enterprises anda knock on effect on the financial and credit facilities. Figure 1, below, showsthe movement of GDP for a selection of Balkan countries and Austria, as acentral European benchmark. Figure 2 shows the movements of Bulgarian NIthroughout the interwar period.

Figure 1

23Lampe, (1986); p. 7824Feinstein, Temin, and Toniolo, in Feinstein, C. (ed.), (1995), p. 35

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1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937

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8Figure 2

For the majority of the countries in South-East Europe the Depressionmeant a long and difficult period of economic stagnation, which lasted untilthe end of World War II. Figure 1 suggests that exceptions were Greece andBulgaria. Given the acute awareness of contemporaries of the economicdepression the figures presented above are puzzling. An interpretationregarding Bulgaria, involve the invigorating injection of foreign capitalthrough two major loans – the Refugee Settlement Loan in 1926 and theStabilisation Loan of 1928.25 There is a danger of overstatement, asexperience from the developing countries tends to show that such loans areusually recycled through the state bureaucracies and hardly ever reach thecredit system or the industrial base of the country in question.26 More workis needed to disentangle the picture resented to us by GDP estimates. Thenominal values of figure 2 are more representative of the depression period– as the real values, corrected for inflation, necessarily present the deflationyears 1929–1933 as a period of stability.

Figure 3 presents a price index of Bulgaria that we have constructed usingsimilar data to Lampe and Jackson, with 1927 as a base year. There, the sharpfall during the turn of the decade is evident. Figure 4 presents a breakdownof the price fall into the prices of manufactured and agricultural goods.

25Pasvolsky, (1930), pp. 109-–1026Dadush and Nielson, (2007), for a most recent view on the inefficiency of international loans and

aid, see Easterling, The White Man's Burden (2007)

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Figure 3

Figure 4

Unambiguous and sharp fall in prices began in the late 1920s. Somewhatsurprisingly our index shows a steady recovery from 1933 onwards, whileBerov's data reaches a bottom around the same time and remains there.

Agricultural production, in terms of total crops output, shrunk by 18 percent.27 The industrial sector shrank by about 34 per cent, but its recovery was

27Pasvolski, p. 438

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8much more rapid in comparison to the agricultural sector.28 Overall theBulgarian economy seems to have reached a nadir in terms of output around1934. The data presented above, however, fully reflects the controversies ofthe scholarly literature. It opens more questions than the answers it canprovide.

* * *Most of our original data comes from previously unused archive materials,

to be found in the Central Archive in Bulgaria. Very useful additions werepublications by contemporaries as well as League of Nations reports on thecommercial banking systems.29 The latter provide a useful crosscheck sincethe financial data is presented in the format of an orderly balance sheet.

The database used in the quantitative analysis of this paper has beencollected from the archive of an institution called Bankerski Suvet (BankingCommittee, BC thereafter), created within the Ministry of Finance, nowpreserved within the Central State Archive of Bulgaria, in Sofia.30 Thisinstitution was set up on 4th January 1931, with the Act for the Protection ofPrivate Deposits.31 Its functions were to act as a regulator to the bankingsector, demand standardized balance sheets and reports from each bank andreview any misconduct of banking institutions. Its members were centralbankers from the Bulgarian National Bank (BNB) and experienced auditorsworking for the BNB as well as the Ministry of Finance, in additional torepresentatives from commercial banks.

Picture 1A SAMPLE OF BNB AUDITOR REPORT

28Tchakalov, (1946), p. 114; see also Avramov, ( 2007), p.6429League of Nations Memorandum on Commercial Banks, Geneva, (1934)30Central State Archive, file 602k, 131Durjaven Vestnik [State Newspaper], v. 227 from 12/1/1931

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The early 1930s saw a series of legislative acts, caused by the anxiety ofconsecutive bank failures and serious increase in the indebtedness of thepopulation. By 1932, three laws were passed to protect banks havingproblems of liquidity, debtors as well as debtors involved in small-scaleagriculture.32 These pieces of legislation were instrumental in establishing setrules for financial accountability.

Importantly, once a bank was in difficulties with the payment of its reservedeposit with the BNB or following complaints by customers for delayedpayment of their deposits, the BC was obliged to send an external auditorwhose job was to examine thoroughly the accounts and report on the banksituation. It is these reports that turned out to be most useful for the currentresearch, because they contain end-of-year balance sheets and, more oftenthan not, a list of main debtors as well as main depositors, list of the membersof the governing council of each bank, and analysis of the external auditor asto the nature of the bank difficulties and the possible reasons. Within thearchived documents of the BC there were 101 folders for each bankregistered with the BC and allowed legally to practice banking. Thesecontained reasonably detailed quantitative information, as well as qualitativereports and opinions by the external auditor.33

Most of the quantitative data was extracted from the balance sheets ofbanks, but gathering the data on interlocking presented some problems ofmethodological nature. I have followed standard legal practice, outlined in LaPorta et al, and have defined related debtors as those who are: (1)shareholder, director or officers of the banks; (2) family members ofshareholders, directors or officers of the bank; (3) firms where the previoustwo categories of individuals are officers or directors; or (4) firms where thebank itself owns shares.34 This information was extracted from the auditorscontrol report, where the auditors themselves have on a number of occasionsbranded debtors as insiders. This procedure is imperfect and it is possible thata certain volume of insider loans were not recorded. The bias however ismore likely to act in support of our conclusions, because it likely that, ifanything, we have underestimated the total volume of insider loans.

* * *What follows is a schematic outline of the findings in aggregate terms of

the structure of the banking sector in interwar Bulgaria as well as itsexperience during the Great Depression.

32ibid., pp.216–217; the laws are Zakon za Predpaznia Konkordat, Zakon za Oblekchenie naDlujnicite and Zakon za Zakrila na Zemedeleca Stopanin

33 for a list of all archival folders, see section on primary sources in the Bibliography.34La Porta et al, (2002), p. 8

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8The financial system of Bulgaria began its development immediately after

the country gained in dependence - in 1880 the lev was adopted as anational currency, while the pillar of the banking system, the BulgarianNational Bank, was set up in 1879. By 1885 the BNB had full issuing rightsand was involved in the provision of credit to customers. BNB's role of acreditor should have legally ended in 1928, but it retained a sizeable 10percent of the direct credit for some time after that.35 The state gave the initialimpetus of the credit sector - within a period of 30 years, 1879-1910, theBNB, the Bulgarska Zemedelska Banka (BZB) and Bulgarska CentralnaKooperativna Banka (BCKB) were created.36

A complex substructure formed below these large institutions –agricultural credit cooperatives operated in the countryside, being fed on thefunds of the BZB, and a town and city equivalent, called popular banks,formed to provide loans to crafts and industrial cooperatives. Therelationship was not entirely unidirectional – sometimes the BZB and BCKBsidestepped the smaller intermediaries and lent directly to the final consumer.

The private banking sector presents a simpler picture. Private finance wasorganized around the representatives of a few foreign banks, which enteredthe credit market in Bulgaria in the 1900s.37 In 1903 there was a reform in thecommercial legislation, which allowed foreign residents to sit in thecontrolling committees of joint stock companies.38 This significantly boostedthe chances of foreign presence and there was real influx of foreign banksand capital after 1919. A total of 13 large foreign banks accounted for some40per cent of the private bank capital of Bulgaria by 1929.39

A number of large independent financial institutions was formed, mainlyin the capital city of Sofia, however after 1919, the difference between theseand the foreign banks became very slight – foreign capital leaked through tothe significant banks based in Sofia. At the bottom, in terms of size accordingto assets and credits were the small shareholding banks, which operatedmainly outside Sofia. These were the institutions, which had to break throughthe credit constraints faced by industrialists, agricultural workers andcraftsmen, who were not large or well-organized enough to obtain access tothe big foreign banks. These were also the institutions hit worst by thedeflation and the prolonged depression - so many of them collapsed that by

35 Annual Reports of the BNB, 1880–192926Avramov, (2007), vol. 2, p. 7237the first foreign bank to enter the Bulgarian credit market was Deutschebank, through the estab-

lishment of Credit Bank in 1906 in Sofia.38Crampton, (2007), p. 30439Lampe, (1986), p. 66

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1935, a Banka Bulgarski Kredit (BBC) was formed to gather the remnants intoone large institution. Although legally private, it was de facto controlled bythe state and its capital was mainly supplied by funds from the BNB reserves.Figure 5, below, shows the assets of private banks in levs, classified accordingto the above discussion, in 1928, just before the onset of the depression.

Figure 5

Private banks, located in Sofia, were by far the largest in terms of assetvolume. Banks with foreign capital were larger as a group that the total of allsmall private banks in Bulgaria.40 It is important to point out that although thefigure above suggests provincial private banks possessed smallest volume ofassets, they were very important for local agricultural producers, merchantsand craftsmen.

Figure 6 compares the asset shares of the three state owned banks versusthe private banks (the latter include all private institutions - from large foreignbanks to small provincial banks). It is evident that state capital was a pillar inthe financial system. BZB, the Agricultural Bank, in particular, possessed asmuch as half of the assets of all private banks in total.

40'Small' is classified as a bank with less than 30,000 leva as total assets.

Assets of Private Banks in 1928 (in levs)

0500,000

1,000,0001,500,0002,000,0002,500,0003,000,0003,500,000

Total ofForeignBanks

Total ofLarge Sofia

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24remianingbanks in

Sofia

95provincial

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Total ofsmall private

banks(24+95)

Source: CDA f.252k, op.1

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8Figure 6

Figure 7

Figure 7 provides further evidence for the structure of the banking sectorin the 1920s. It presents the aggregate assets shares of state banks,cooperative banks (intermediaries between the BCKB and BZB and the finalconsumer), and private banks. The total share of assets of the private banksis larger than each of the shares of state or cooperative banks and just overhalf of the total assets. Given the small number of state institutions – three-each of them is more significant than any of the private banks on its own.More data, providing a further breakdown of the banking sector in 1928 and1932, is shown in the appendix, at the end of the paper.

Assets of the three State Banks vs the Private Banks in 1928 (mln levs)

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BNB BZB BCKB Large SofiaBanks

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Source: CSA, 602k, 1

Bank Assets in 1928 (mln levs)

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Figure 8

Figure 9

Figures 8 and 9 show an overall picture of the credit system in InterwarBulgaria. The early 1920s, years of hyperinflation and currency instabilitybrought very slow development. Sharp increase in the number of institutionsand amount of credit can be seen in 1928–1929 and then a steadycontraction throughout the 1930s. The private commercial banks saw themost dramatic changes in their portfolios. During the second half of the1920s deposits held in them increased by about 100 per cent, while only forthe period 1929–1932 they declined by about 50 per cent.41 In this respect,the Bulgaria banking sector did not have a unique experience – the irrationalexuberance of the 1920s was severely checked by the depression period.

Number of Credit Institutions

020406080

100120140160180200

1923

1924

1925

1926

1927

1928

1929

1930

1931

1932

1933

1934

1935

1936

1937

Source: Statistical Yearbook of Kingdom Bulgaria vols. XIV-XXVIII, 1923-1936

Credit Institutions According to Capital (in thousands of levs)

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1923

1924

1925

1926

1927

1928

1929

1930

1931

1932

1933

1934

1935

1936

1937

Source: Statistical Yearbook of Kingdom Bulgaria vols. XIV-XXVIII, 1923-1936

41Author's own data. See table 2,3 and 4 in the Appendix

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8Figure 10

Figure 11

During the Depression years, significantly, the role of foreign capitaldiminished radically – from 20 per cent of total active capital in 1931, tobelow 7 per cent in 1934. In absolute terms the short-term foreign credits fellfrom 2,500 mln. levs in 1929 to 812 mln. in 1931 and 210 mln. in 1934.42

This had a severe deflationary effect and led to a radical restructuring of thebanking system. The private sector was supposed to fill the gap, and indeed,by 1936 the two largest private institutions had more deposits than the fourforeign banks still present in the Bulgarian credit market after the depression,but also twice as much as all the small private banks together.43 This suggests

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42Christoforov, (1946), p. 17943Avramov, (2007), vol. 2, p. 411

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an interesting dynamic – expectedly, the largest institutions were best placedto survive the depression and retained their assets and increased their marketshare, in light of the distress of small private institutions of local importance.So many of the latter experiences severe difficulties of liquidity, that by 1934,a state intervention was necessary to restructure the feeble private sector.The choice of banks facing ruin was either to merge into the de facto statebank BBC or to be liquidating, if they had lost more than 50per cent of theiroperational capital. Figures 8 and 9 illustrate the results of the liquidity shockthat the depression caused. The former presents the rise in the number ofcredit institutions during the euphoria of the late 1920s, after the Stabilizationand Refugee loans injected liquidity into the credit system, but also thesubsequent fall, caused by bankruptcy and merger, in the early 1930s. Thelatter graph illustrates the same situation, but in terms of capital. There, thedrop seems less significant, but has to be kept in mind, that bank liquidationwas a very slow process, sometimes taking the whole of the 1930s decade,due to prolonged law suits to recover bad loans. Furthermore, many of thebanks, which merged into BBC still counted a substantial part of their capitalas recoverable, while in fact it was either acutely diminished or totally lost,due to the deflation and bankruptcy of their debtors. Figures 10 and 11illustrate a further interesting dynamic, where the state sector took over alarge part of the decline of the private sector. This is illustrated in terms ofshare of deposits and share of loans respectively.

Tables 1 and 2 below, present the changes in commercial bank depositsjust before and during the depression in an international context. We can seethat Bulgaria experiences a healthy increase in deposits of commercial banksduring the 1920s, but by 1932 a sharp decline can be detected – Bulgariawas amongst the countries, the banking sectors of which suffered mostheavily.

Table 1MOVEMENTS OF COMMERCIAL BANK DEPOSITS, 1925–1929

Source: League of Nations, Geneva 1934Increase Increase Increase Increase No increase

of 100 per cent or more 50–100 per cent 25–50 per cent 25–1per cent or Decline

Poland Germany Mexico Yugoslavia SwedenHungary Belgium Switzerland Czechoslovakia India

Latvia Romania Venezuela Canada DenmarkEstonia Lithuania Finland Argentine Bolivia

Colombia Bulgaria Austria USA NorwayFrance JapanBrazil Italy

Urguay England and WalesSpain Netherlands

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8Table 2

PERCENTAGE DECLINE IN TOTAL COMMERCIAL BANK DEPOSITSIN VARIOUS COUNTRIES, 1929–1932

Source: League of Nations, Geneva 1934Decline of 60–40 per cent 30–20 per cent 20–10 per cent 10–0 per cent Increase

Latvia Venezuela Estonia Argentine LithuaniaPoland SA Netherlands Italy SwedenAustria Mexico Chile Czechoslovakia SwitzerlandBulgaria Colombia Canada Australia UKGermany Portugal Norway Hungary BrazilRomania Belgium Ecuador Denmark Bolvia

Yugoslavia France Peru

The experience of the banking sector is consistent with the leakperformance of the overall economy during the Interwar period. In fact thestate of the banking sector and the serious inefficiencies in capital allocationthat we point out resulted from insider lending may have had a furthernegative effect on growth.

Figure 12

Protested Loans (amount in mln levs, numbers in

thousands)

0

1000

2000

3000

4000

1929 1930 1931 1932 1933

0

100

200

300

400

Amount Number

Source: CSA, 602k, 1

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Figure 13

Figure 14

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8

Tab

le 3

SU

MM

AR

Y P

OS

ITIO

N A

T T

HE

EN

D O

F T

HE

FO

LLO

WIN

G Y

EA

RS

(IN

LE

VA

00

0,0

00

)

Sum

mar

y A

cco

unts

fo

r C

om

mer

cial

Ban

ks1926

1927

1928

1929

1930

1931

1932

1933

Num

ber

of

Ban

ks (

bra

nche

s an

d s

ub-b

ranc

hes

110

116

128

135

138

131

129

118

ASS

ETS

cash

597

602

782

714

870

968

884

662

bill

s+in

vest

men

s an

d s

ecur

ites+

par

ticip

atio

ns1

514

2 11

02

965

3 05

62

293

1 86

51

575

1 26

2lo

ans

and d

ues

2 79

32

880

3 48

33

938

3 48

92

621

2 10

11

992

sund

ry a

sset

s287

382

405

511

545

1 13

31

173

1 02

9TO

TAL

ASS

ETS

5 34

96

154

7 83

88

442

7 41

26

684

5 86

15

046

LIA

BIL

ITIE

SN

et P

rofit

99

87

105

118

114

62

30

16

Dep

osi

ts

due

to

ban

ks

oth

er b

orr

ow

ings

4 19

84

983

6 56

36

959

5 88

74

545

3 99

63

347

TOTA

L LI

AB

ILIT

IES

5 34

96

154

7 83

88

442

7 41

26

684

5 86

15

064

So

urce

: Lea

gue

of

Nat

ions

, Gen

eva

1934

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Figures 12, 13, 14, and Table 3 summarise the experience of Depression.The year 1930 was the turning point for the banking system. It marks thatpeak in protested, irrecoverable, loans. It was also the beginning of thegradual erosion of bank assets, which by 1933 had dropped to the precurrency stabilisation year of 1926. In 1930 began the sharp downward slideof bank profits and rise of net losses. By 1932 net losses had outstrippedprofits in the commercial banks balance sheets. The rest of the paper explainsthis drop in profitability and the increase in protested loans and eventuallosses.

European Experience during the Depression; TheoreticalModel

Economic theory suggests that a sophisticated and efficient financialsystem is highly beneficial to the rest of the economy. A basic function offinance is to mobilise aggregate savings and channel them towardsinvestment in productive enterprise.44 Schumpeter's seminal work (1939) hasidentified the role of financial institution in seeking out profitable investmentand thus acting as an essential agent in the process of creative destruction,which drives economic development in a capitalist economy. Asymmetricinformation problems may arise because investors and entrepreneurs havedifferent information about a project. Entrepreneurs have inside informationand can estimate the worthiness of a project much better than outsideinvestors, who will find it costly to acquire information about the profitabilityof a project. More recent literature has put forward the function of financialinstitutions in monitoring firms, in terms of their efficient use of the fundsprovided.45 In this case moral hazard may arise as a post-contractualinformation problem, where entrepreneurs have lower incentive of pursuingtheir project to a profitable end, once they have secured funds for theirexpenses and salaries. Essentially – financial intermediaries are there to solveinformation problems in imperfect investment markets.

A second set of theoretical problems is centred on the idea that well-developed and open financial markets spread opportunity to a wide sectionof economic agents, while underdeveloped credit markets under stronggovernment influence, are prone to restrict access and benefit a select

44Levine (1997), p.69145Paulet (1999), p.3, Levine (1993) provides an excellent survey of the theoretical underpinnings and

the empirical tests that have been conducted on the effects of finance on economic development.More recently, Trew (2006) has summarised the findings of the literature on the finance-growth nexus.

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8group.46 Firstly, this is detrimental to economic growth, as it means that thefunction of seeking out potentially profitable, but possibly risky, projects isseverely constrained, and secondly, it is socially harmful as it deepensinequality. This literature provides theoretical underpinning of our argumentthat insider lending undermines economic efficiency.

Insider lending can thus be damaging to the financial system, as itprevents prudent regulations of lending to take place – like research of theprospective debtor, their financial prospects or real asset ownership, whichcan compensate the bank in case of the latter's bankruptcy.47 It has beenargued that motivation for interlocking exists to increase the potential tofacilitate relationships between corporations and their directors, and hasbeen interpreted in terms of either organizational or class dynamics.48 In thispaper, it is the inter-organizational perspective that is of interest – wherecorporations create interlocks in response to their needs for resourcescontrolled by other organizations in their environment. Particularly attractivepartners for interlocks are banks, because they control one of the mostessential of resources – credit.

Avramov (2007) argued that insider lending due to constrained credit waswidespread in the Interwar Bulgarian banking sector.49 Following in his stepsand those of La Porta et al. this paper's second aim is one of testing ahypothesis that the practice of insider lending prevented the financial systemof playing an active role in the process of economic development and provedits demise during the experience of the Great Depression.

Specific models have been developed to estimate banking efficiency/profitability and their responses to crises and the Great Depression inparticular. Calomiris (1993) reports on the changing perceptions of creditallocation under asymmetric information in recent times.50 Information costsmeans that 'insiders' – firm managers and financial intermediaries with a long-term relationship with the bank/firm – can supply funds at a lower cost than'outsiders' – relatively uninformed stockholders and bondholders.51 Thuschanges in the wealth distribution between insiders and outsiders can alterthe performance of banks. Mishkin (1976) followed up by Bernarke (1983)

46Rajan, R., Zingales, L., (1998), and (2003)47Soref and Zeitlin, (1987), p. 60.48Palmer, D., Friedland, R., Singh, J., (1986), p. 78349Avramov, (2007), pp. 454–46450Calomiris, (1993)51Akerloff's 1970 seminal work began research in this area. Followers were Stiglitz and Weiss

(1981) and Myers ad Majluf (1984)

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have looked deeper into the problem of debt deflation, excessive leverageand allocative consequences of wealth redistribution in the presence ofcapital market imperfections. They have applied this approach to analyse therole of financial factors in the story of the Great Depression in the US.

In European perspective, Jonker and Van Zanden (1995) have found thecommon explanation of bank failure during the Depression to be falling assetprices and default of risky loans.52 Their model is centred on the pattern ofdeflation to try and bring currencies back on par with the levels of 1914. Thiseroded the incomes of banks by squeezing debtors and reducing assetprices. The argument runs as follows – effectively, the changes that took partin the banking practice during the high inflations in the post-1919 worldexposed banks to the latter deflations.

Inflation had positive effects on exporting industries and industries whereassets increase in value. The banking sector, however, where most assetswere nominal, experienced adverse effects. Banks had to increase their realactivities to keep up with the rising prices – as their loans to industrydecreased in value. Two strategies emerged to cope with the inflation periods– to convert nominal assets into real ones, in other words the rise ininvestment banking and the purchase of physical assets, or to expand lendingrapidly, certainly faster than inflation. Both strategies resulted in exposure tothe deflation during the Depression years.

The first strategy directly affected banks liquidity position and the value oftheir balance sheet, once prices of real assets started falling after 1929.Expanding lending rapidly meant increased competition between banks forprofitable loans and as a result the quality of debtors decreased. In this casethe exposure to the deflation was indirect, but just as harmful, since bankruptdebtor meant a loss to the bank. Thus a rational response to the inflations inthe beginning of the 1920s resulted in bank vulnerability by the end of thesame decade when deflation kicked in.

Jonker and Van Zanden's explanation is an appealing one, and it is alsobacked up by compelling empirical evidence. It is aimed at the core ofindustrialised European countries and although putting the blame on ill-conceived loans made during an inflationary period, it does not do enough toexplain the origins of these loans. Particularly for countries where the creditinstitutions were closely linked to industry, it is essential to probe deeper intothe origins of these ties and the likelihood of them being reasons forwidespread bad loans.

52Jonker and Van Zanden, (1995)

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8 We follow the key assumptions of La Porta et. al., to construct an

incentive structure facing the agents involved.53 The model presented belowis an adaptation of their simple model of looting developed to explain a studyof the Mexican banking system. We are focusing on the incentives forinsiders to divert cash for their own benefit. A key assumption is that insidersstructure self-dealing transaction to minimise recovery on related-party loanswhen these default.54 Related agents can avoid repaying their loans at thecost of foregoing their equity in the bank. Consequently, related partiesrepay their bank loans when the value of their equity in the bank is higher,but default otherwise.55

Further assumption is that each bank is controlled by a single shareholderwho owns a fraction α of the cash flows of the bank and a larger fraction β(>α) of the cash flows of an industrial firm (the related party), which he or shealso controls. We also assume that the controlling shareholder has effectivecontrol over lending decisions - i.e. he can ensure the bank lends to relatedparties on non-market terms, but needs to engage in costly transactions toavoid repayment in the bad state (thus when the bank lends L to a relatedparty, the controlling party only receives a fraction ϕ(L)). The model'sdynamics develops over two periods, where loans are be financed bydeposits (D) and shareholder's equity (E); (r) is the promised interest ondeposits. In period 1, the bank lends L to insiders and E+D-L to unrelatedparties (both promise to pay R per borrowed dollar). Loans are due in thesecond period when time ends. The world can be in good state (probabilityq) or bad state (probability (1-q)). In good state the bank recovers all loans, inthe bad, only a fraction γ (<R) from unrelated loans. Expectedly, loans areunprofitable when made to related parties (Rr=q*R<1) and profitable whenmade to unrelated (Ru=q*R+(1-q)*γ>1). In equilibrium, insiders do not defaultin the good state. When α<β, insiders always default. Below are shown theoutcomes of lending policy during different states of the world.

(1) good state: α*(R*(E+D)-r*D) > β*R*L

(2) bad state: α *(γ (E+D-L)+R*L-r*D) < β*R*L

53La Porta et al., (2002), pp.3–654Auditors of the Banking Committee, at the Ministry of Finance, post 1931, often talk about loans

granted without the appropriate reference to the capacity of the debtor to reply; similarly, loans wereprovided against collateral that was either non-existent or did not cover the value of the loan. For in-stance, see the audit report for Bulgarska Chernomorksa Banka, CSA 602/1/36; Mackey, (1999), pro-vides similar evidence for 1990s Mexico.

55La Porta et al, (2002), p. 4

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(3) value of deposits: D=q*[r*D]+(1-q)*[γ*(E+D-L)]

(4) in the good state the insider receives share of the profits of the bank:α *(R*(E+D)-r*D), but looses money on looting: β*R*L; in the bad state theinsider forgoes equity in the bank, but captures β*ϕ(L) from looting.

(5) Expected profits of insider are:E(π)=q*[α *(R*(E+D)-r*D)+β*(ϕ(L) -R*L)]+(1 -q) *[β*ϕ(L)]

(6) From (3) and (5), expected profit can we rewritten as:E(π)=α *[Ru*(E+D-L)+Rr*L-D]+ β*[ϕ(L)-Rr*L], where Ru(=q*R+(1-q)*γ) and

Rr(=q*r) denote the expected rates of return on loans to unrelated and relatedparties, respectively.

Thus from (6) the insider picks the level of related lending to maximize herexpected profits.

(7) The first order condition for the incentive to lend to related parties isas follows: β*ϕ= α *(Ru-Rr) + β*Rr

Easily enough, at the margin the cost from engaging in related lendingmust exactly equal its benefit. Consider the following example: moving 1 unitof local currency from unrelated parties to related ones. The insider is ashareholder in the related party and receives β*ϕ, when the unit is divertedfrom the bank. As a shareholder in the bank, the insider bears a fraction α ofthe reduction in profits resulting from the change (Ru-Rr). At the same timethe insider pays Rr per borrowed unit, as a shareholder of the related firm.Thus, according to the above equation, related lending (or lending throughinterlocking) is restrained by a high equity stake of the insider in the bank andby attractive opportunities to lend to outsiders. Lending to interlocksincreases with the insider's equity stake in the related firm (β) and when theopportunity for attractive borrowing terms on interlocked parties exists.Furthermore, insider lending becomes attractive when credit is rationed andfirms meet with difficulties trying to attract outside funds. This is identical toa situation where β > α and the world is in a bad state. This model is veryuseful in describing the situation in Bulgaria during the interwar period, whenindustry leaders owned stakes in banks, but made most of their profitsthrough non-financial enterprises. Their loyalty was thus to industry and notbanks.

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8Econometrics and Robustness Checks

This part quantitatively examines the influence of interlocking on bankprofitability during the depression period. Our data includes the detailedbalances for 1930 for 101 banks. The table below summarises the data usedin our econometric model.

Table 4SUMMARY OF DATA ON INTERLOCKED BANKS

Banks (N:101, 1930) Total Assets Size of Interlocked Bankrupt(in leva) Interlocked Assets as (N:)

Assets Percentage(in leva) of Total

(per cent)

Total (101) 12 365 118 842 317 709 783 2.6 72Sofia banks (33) 10 613 754 531 215 404 426 2.1 -

Of which Bankrupt (13) 512 486 583 136 121 074 26.5 13Countryside Banks (71) 1 751 364 311 102 305 357 5.8 -Of which Bankrupt (61) 894 586 101 89 085 409 10.1 61

Total (101) 12 365 118 842 317 709 783 2.6 72With Foreign Share (16) 5 449 915 004 44 354 494 0.8 -Of which Bankrupt (5) 110 169 314 44 354 483 40.3 5No Foreign Share (85) 6 915 203 838 273 355 289 4.1 -Of which Bankrupt (66) 1 296 903 370 180 852 000 14.1 67

Total (101) 12 365 118 842 317 709 783 2.6 72Bankrupt (72) 1 407 072 684 225 206 483 16.1 -Survived (29) 10 958 046 158 92 503 300 0.8 -

In our model of bank profitability we use a number of well-knownmeasures and one variable to represent our hypothesis that insider loanswere the underlying reason for the failure of the private bank system.

Return to equity is a measure of profitability used by a number ofstudies.56 Due to lack of data on the dividends paid out by banks a proxy hasbeen used – the ratio between profit/loss for 1930 and the capital. A simplemodel for bank profitability suggests that crucial factors are economies ofscale, level of external competition and attitude to risk.57 We have includedloan quality as a variable, which is represented by the ratio of bad loans, orinterlocked loans, and total loans as well as a possibility for foreign capital

56 See Goddard, Molyneux, Wilson, (2004), p. 24; also Okazaki, Sawada, Yokoyama, (2005); p.13;57 Smirlock, 1985; p. 3; Bourke, P., (1989), p. 15; Berger, (1995), p. 10; Goddard et al., (2004), p.

26;

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share in an institution. The more insider loans were to be found, the weakerthe bank is expected to have been. The opposite must have been trueregarding foreign share - the more foreign capital was invested in a bank, thebigger and more stable a bank is likely to have been. A baseline model ispresented below:

ROE= f {LQ, COM, RISK, ES, EI}

Profitability depends on economies of scale (ES), level of externalcompetition (COM), attitude to risk (RISK), loan quality (LQ) and presence ofexternal investor (EI).

Loan quality is controlled by the variable Interlock2, which is a ratio ofinterlocked loans over total loans. We expect the coefficient on Interlock2 tobe negative, since insider loans were modelled as having negative influenceon bank performance and survival chances during an economic crisis. Ameasure of economies of scale is presented as a variable called lnSize - thetotal assets a bank had in 1930. LnSize es expected have a positive effect onbank performance. External competition - Com - is best measured by thenumber of branches of competing banks in a city or town. In the regressiona ranking represents this, where 3 is for largest cities with highest competitionbetween largest number of banks and branches and 1 for least competition.Standard oligopoly theory suggests that the more concentrated a market is,the higher profits producer can command - in the case of banks, higherinterest rates can be charged for loans and lower given on deposits. Com isexpected to exhibit a negative coefficient.

Attitude to risk is difficult to measure. We have introduced a number ofvariables to control for it – Levd (leverage) performed best and were used inthe final regression. It is expected that the coefficients will be positive, yet aswith Forgn (see below) it is not a clear-cut case. Higher risk can amount tohigher profits, especially, more loans provided should bring back higherrevenue in terms of interest, but in time of economic slowdown, thistendency may be reversed. Presence of external investor, usually foreign iscontrolled by a binary variable, Forgn, which takes the value of 1 when therewas foreign capital in the bank, and 0 otherwise. Forgn can take a positivevalue if we consider foreign capital to have been a factor boosting stability ofprofitability. This, however, is not entirely clear, because foreign capital pulledout during the depression leaving the institutions it used to support exposedto the crisis. It is possible too, that banks with foreign capital presence werevery conservative in their investment decisions, and while a secure strategy -this may not have necessarily boosted profitability to any significant level. It

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8is most like to have only affected the Sofia region. A summary of the variablesand their definitions is presented in table 2, below:

Table 2DESCRIPTION OF VARIABLES

Dependent ROE 2 ROE: as a measure of profitability; proxied by a ratio of Variable profits over set up capital plus reserves (ROE 2); Ideally,

ROE should be calculated using data from stock returns(dividend over the value of stock), however due to datalimitations, the ratio of profit over capital is used.

LQ Interlock2 Percentage of insider loans from total loans;ES LnSize Size of total assets; used in logarithmic form in the

regressionRISK Levd Ratio of deposits over total capital;

Dummies COM Dummy for competition, ranked from 1 (least) to 3(competition) (most) depending on number of banks/branches in

town;EI (Forgn) 1 if foreign capital present in the bank, 0 otherwise;

The final econometric model for the Ordinary Least Squares (OLS)regression is:

ROEi = β0 + β1*(Interlock2) + β2*(lnSize) + β3*(Com) + β4*(Forgn) +β5*(Levd) + εi

* * *Table 3 summarizes basic statistics about the data. Table 3 follows

through with the results from the OLS regression on the whole sample, justbanks in the Sofia region, just countryside banks, banks with only localcapital, and banks with no foreign capital.

Table 3DESCRIPTIVE STATISTICS

Variables: Observations Mean Std. Dev. Min Max

ROE 2 101 2.31 21.04 -107.98 22.75Interlock2 101 0.21 0.26 0 0.93

Levd 101 3.43 4.75 0.06 37.01Forgn 101 0.16 0.36 0 1COM 101 1.90 0.96 1 3

Ln Size 101 16.75 1.65 13.53 22.18

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Columns two and three in table 4 show the results of the OLS regressionfor the whole sample. The coefficient of Interlock2 is negative across allregression and significant for regression of the whole sample, the countrysideand non-foreign banks. The results show that insider lending was notstatistically significant for the large banks in Sofia region and the one withforeign capital. This is consistent with our hypothesis. First – insider lendingwas pointed to as the underlying reason for severely diminished profitabilityduring the depression. Second – our expectation was that it was mostwidespread across small, private, and commercial banks. Third – we pointedout that their auditors better controlled foreign banks and the reason for thedecline in foreign share in the banking sector was the outward flight offoreign capital. All three arguments find support in the econometric analysis.

The positive and significant coefficients on lnSize across all regressionssuggest that economies of scale matter. Too much competition was bad newsfor bank profits during the depression, suggested by the highly significant andnegative coefficient. The risk attitude variable, Levd, is statistically significant.Leveraged position caused distress to banks as the economic slowdownbegan. Foreign capital is only significant at the 10per cent confidence leveland only in the regression of the whole sample. Size rather than presence ofexternal investor was what mattered for profits of large Bulgarian banks.

Table 4OLS REGRESSION

DEPENDENT VARIABLE IS ROE2 (PROFITS/TOTAL HOUSE CAPITAL)

Variable All Banks Large Banks Small Banks Foreign only Non - foreignCoeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.

LQ -25.7 -3.48*** -3.3 -0.28 -30.7 -3.41*** -23.6 -1.02 -19.0 -2.39** (Interlock2)ES (lnSIZE) 5.0 3.48*** 8.6 2.32** 3.7 2.55** 9.73 2.83*** 3.0 1.82**

COM(Com) -11.1 -4.96*** --- --- -8.8 -0.90 -10.3-4.48***

EI -6.9 -1.24* 5.9 0.80 7.1 0.69 --- ---(Forgn)

RISK (Levd) -9.6 -2.07** 1.8 1.45* -1.8 -1.82** -0.4 -0.02 -6.7 -1.43**Intercept -52.2 -2.18**-140.3 -2.38** -30.7 -1.21-155.9 -2.43** -19.1 -0.71R-squared 0.31 0.20 0.24 0.54 0.27Adj. R- 0.28 0.08 0.21 0.38 0.23

squaredF-test (5,95) 8.6(4,28) 1.77 (3,64) 6.92 (4,11) 3.29 (4,80) 7.32N: obs 101 33 68 16 85

(robust st errors used, ***– significant to 1per cent, ** – significant to 5per cent, * – significant to 10 per cent)

Some robustness checks on the results above follow:

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8The econometric results presented above show strong relationship

between interlocking and bank profitability, especially in light of possibledrawbacks/deficiencies in the data. There are a number of ways to improvethe exercise. The results can be checked using alternative measures forinterlocking. Okazaki et al. measure the number of directors, who had postsin banks and industry and use this to represent interlocking . Their idea canbe furthered by gathering data on the number of enterprises interlocked to abank, or the number of interlocks per director. In my case, however, suchdata will be very difficult and much too long to gather, to be of practical use.The most effective manner of improving the data set is to polish theInterlock2 variable by cross referencing data on internal loans. A moreextensive look at the available evidence for individual banks can also allow amore in depth survey of bank case studies, which would throw significantlight on the personal relationships. This in turn will help us better distinguishbetween the theories of information asymmetries and pure looting asanswers to credit rationing.

Alternative measures of interlocking were used in successive regressionsto confirm the robustness of the results. Using Interlock1 (defined aspercentage of insider loans from total assets) provided quantitatively verysimilar results as in table 3, above. Most problematic were the measurements,constructed to control for attitude to risk. Given the data available from bankbalances, we constructed a number of variables. Levd was the bestperforming one in the series of regressions, this why we have chosen it forour model. Tables 5 and 6 below show a list of the variables used in therobustness checks, their definitions and a summary statistics.

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Table 5DESCRIPTION OF ALL VARIABLES

(INCLUDING ONES USED IN THE ROBUSTNESS CHECKS)

Dependent ROE 1 ROE: as a measure of profitability; proxied by aVariables ROE 2 by a ratio of profits over set up capital plus

reserves plus deposits (ROE 1) and profits over setup capital plus reserves (ROE 2); Ideally, ROEshould be calculated using data from stock returns(dividend over the value of stock), however due todata limitations, the ratio of profit over capital isused.

LQ Interlock1 Percentage of insider loans from total assets;(Loan Quality) Interlock2 Percentage of insider loans from total loans;

ES LnSize Size of total assets; used in logarithmic form in the(Economies of Scale) regression

RISK LoanDepo Ratio of total credits to total deposits;(Attitude to Risk) CapDep Ratio of total capital (set up capital plus reserves

plus profits for 1930) over deposits;Levd Ratio of deposits over total capital;

ResDepo Ratio of reserves over total deposits;Sec Ratio of Total Security Holdings (government

bonds and debentures to the Total Value of Capital+ Total Deposits

Dummies COM Dummy for competition, ranked from 1 (least) to 3(competition) (most) depending on number of banks/branches in

town;EI (Forgn) 1 if foreign capital present in the bank, 0

otherwise;

Table 6DESCRIPTIVE STATISTICS OF ALL VARIABLES

(including used in Robustness Checks)

Variables: Observations Mean Std. Dev. Min Max

Ln Size 101 16.75 1.65 13.53 22.18ROE 1 101 0.50 8.31 -56.10 14.00ROE 2 101 2.31 21.04 -107.98 22.75

Interlock1 101 0.14 0.21 0 0.88Interlock2 101 0.21 0.26 0 0.93CapDepo 101 1.25 2.35 0.03 15.66

Sec 101 0.06 0.12 0 0.75LoanDep 101 1.67 1.81 0 11.85ResDepo 101 0.09 0.19 0 1.07

Forgn 101 0.16 0.36 0 1COM 101 1.90 0.96 1 3Levd 101 0.64 0.42 0 1.4Lev 101 3.43 4.75 0.06 37.01

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8Conclusion

More than 40 years ago Gerschenkron proposed his thesis of economicdevelopment in relative backwardness, where the state acted as a substituteto supposed prerequisites of economic growth . Concentrated and mixedbanking sector, where banks were involved in investment, credit provisionand commercial practices, is central to such mode of development.Gerschenkron's ideas about the positive effects of such institutions have beenstrongly contested, especially on the grounds of evidence from the Interwarperiod. Late developing economies and their universal banking systems, likeGermany, Italy and Austria, for different reasons, had very difficult timeduring the depression. Similarly, developing countries in the periphery ofindustrialised Europe experienced widespread bank failures.

In theory, lending to friendly groups can ensure higher information inflowand better opportunities for monitoring ones investment - in other wordsreducing the risk of investment; however, it also means that innovative andpossible more profitable projects may be left out. A further danger is theconsistent and rational channelling of funds to insiders' projects, because theyappear to provide most lucrative returns and an interlocked agent expects toreceive a higher payoff from the enterprise rather than his equity in the bank.A formal model of this type of lending, consistent with La Porta et al, wasused to present it as institutional looting. This hypothesis was suggested inaddition to Jonkers and Van Zanden's model of rational madness inaccumulating bad loans in a hyperinflation-deflation dynamics.

To test the theoretical propositions, this paper studies the experience ofBulgarian banks during the years of the Great Depression – a peripheralcountry with a developing economy and financial sector. A quantitativeexercise, to account for the aggregate effects of interlocking on bankperformance, was applied on a dataset, gathered from previously unusedarchival material.

The econometric results confirm the conclusion the theoretical setting -interlocking and insider lending was prevalent in the interwar Bulgarianfinancial system, not only in the small credit institutions of importance to thelocal economy, but also amongst large and well-established banks. Moreoften than not, interlocking acted in the direction industry-banks, with a clearaim of leaders of business to use their positions in banks to attract as muchfunding as possible to their own enterprises. This had catastrophic effectsduring the long deflationary period during the depression, since both sectorssuffered grievous losses.

Our model confirms some established views from the literature on bankprofitability. Size of banks mattered for their financial success, competition

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reduced profits, while foreign or government backing had positive effects onfinancial stability. Bad loans given to related parties, however, turned out tobe one of the major factors in bank ruins during the outset of the depressionin the Bulgarian economy. This conclusion runs contrary to Lamoreaux'major work on insider lending during 19th century east coast US financialstructures . Economists and economic historians need to consider a two-wayeffect of strong links between banks and industry.

Given the prevalence of insider lending as 'looting' in the present daydeveloping countries, this paper points at two solutions. Low profitability willbe widespread amongst banks ridden with insider loans, and these will failduring economic crises - a case of natural selection . Encouraginggovernment regulation to deal with the problem can be a second solution.The first suggestion burdens a financial system with long-term inefficiencyand then a sharp correction during a downturn. The second - runs against thepolicy recommendation of the neoclassical paradigm, yet may provenecessary given the number and scale of financial crises over the pastdecade.

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DP/1/1998 The First Year of the Currency Board in BulgariaVictor Yotzov, Nikolay Nenovsky, Kalin Hristov, Iva Petrova, Boris Petrov

DP/2/1998 Financial Repression and Credit Rationing under Currency BoardArrangement for BulgariaNikolay Nenovsky, Kalin Hristov

DP/3/1999 Investment Incentives in Bulgaria: Assessment of the Net Tax Effect onthe State BudgetDobrislav Dobrev, Boyko Tzenov, Peter Dobrev, John Ayerst

DP/4/1999 Two Approaches to Fixed Exchange Rate CrisesNikolay Nenovsky, Kalin Hristov, Boris Petrov

DP/5/1999 Monetary Sector Modeling in Bulgaria, 1913–1945Nikolay Nenovsky, Boris Petrov

DP/6/1999 The Role of a Currency Board in Financial Crises: The Case of BulgariaRoumen Avramov

DP/7/1999 The Bulgarian Financial Crisis of 1996–1997Zdravko Balyozov

DP/8/1999 The Economic Philosophy of Friedrich Hayek(The Centenary of his Birth)Nikolay Nenovsky

DP/9/1999 The Currency Board in Bulgaria: Design. Peculiaritiesand Management of Foreign Exchange CoverDobrislav Dobrev

DP/10/1999 Monetary Regimes and the Real Economy (Empirical Tests before andafter the Introduction of the Currency Board in Bulgaria)Nikolay Nenovsky, Kalin Hristov

DP/11/1999 The Currency Board in Bulgaria: The First Two YearsJeffrey B. Miller

DP/12/1999 Fundamentals in Bulgarian Brady Bonds: Price DynamicsNina Budina, Tsvetan Manchev

DP/13/1999 Currency Circulation after Currency Board Introduction in Bulgaria(Transactions Demand, Hoarding, Shadow Economy)Nikolay Nenovsky, Kalin Hristov

DP/14/2000 Macroeconomic Models of the International Monetary Fund and theWorld Bank (Analysis of Theoretical Approaches and Evaluation of TheirEffective Implementation in Bulgaria)Victor Yotzov

DP/15/2000 Bank Reserve Dynamics under Currency Board Arrangement for BulgariaBoris Petrov

DP/16/2000 A Possible Approach to Simulate Macroeconomic Development ofBulgariaVictor Yotzov

DP/17/2001 Banking Supervision on Consolidated Basis (in Bulgarian only)Margarita Prandzheva

DISCUSSION PAPERS

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DP/18/2001 Real Wage Rigidity and the Monetary Regime ChoiceNikolay Nenovsky, Darina Koleva

DP/19/2001 The Financial System in the Bulgarian EconomyJeffrey Miller, Stefan Petranov

DP/20/2002 Forecasting Inflation via Electronic Markets Resultsfrom a Prototype ExperimentMichael Berlemann

DP/21/2002 Corporate Image of Commercial Banks (1996–1997) (in Bulgarian only)Miroslav Nedelchev

DP/22/2002 Fundamental Equilibrium Exchange Rates and Currency Boards: Evidencefrom Argentina and Estonia in the 90’sKalin Hristov

DP/23/2002 Credit Activity of Commercial Banks and Rationing in the Credit Marketin Bulgaria (in Bulgarian only)Kalin Hristov, Mihail Mihailov

DP/24/2001 Balassa – Samuelson Effect in Bulgaria (in Bulgarian only)Georgi Choukalev

DP/25/2002 Money and Monetary Obligations: Nature, Stipulation, FulfilmentStanislav Natsev, Nachko Staykov, Filko Rosov

DP/26/2002 Regarding the Unilateral Euroization of BulgariaIvan Kostov, Jana Kostova

DP/27/2002 Shadowing the Euro: Bulgaria’s Monetary Policy Five Years onMartin Zaimov, Kalin Hristov

DP/28/2002 Improving Monetary Theory in Post–communist Countries – LookingBack to CantillonNikolay Nenovsky

DP/29/2003 Dual Inflation under the Currency Board: The Challenges of BulgarianEU Accession (in Bulgarian only)Nikolay Nenovsky, Kalina Dimitrova

DP/30/2003 Exchange Rate Arrangements, Economic Policy and Inflation: EmpiricalEvidence for Latin AmericaAndreas Freytag

DP/31/2003 Inflation and the Bulgarian Currency BoardStacie Beck, Jeffrey B. Miller, Mohsen Saad

DP/32/2003 Banks – Firms Nexus under the Currency Board: Empirical Evidence fromBulgariaNikolay Nenovsky, Evgeni Peev, Todor Yalamov

DP/33/2003 Modelling Inflation in Bulgaria: Markup Model (in Bulgarian only)Kalin Hristov, Mihail Mihailov

DP/34/2003 Competitiveness of the Bulgarian EconomyKonstantin Pashev

DP/35/2003 Exploring the Currency Board Mechanics: a Basic Formal ModelJean–Baptiste Desquilbet, Nikolay Nenovsky

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8DP/36/2003 A Composite Tendency Indicator for Bulgaria’s Industry

(in Bulgarian only)Tsvetan Tsalinsky

DP/37/2003 The Demand for Euro Cash: A Theoretical Model and Monetary PolicyImplicationsFranz Seitz

DP/38/2004 Credibility Level of the Bulgarian Exchange Rate Regime, 1991–2003:First Attempt at Calibration (in Bulgarian only)Georgi Ganev

DP/39/2004 Credibility and Adjustment: Gold Standards Versus Currency BoardsJean–Baptiste Desquilbet, Nikolay Nenovsky

DP/40/2004 The Currency Board: “The only game in town” (in Bulgarian only)Kalin Hristov

DP/41/2004 The Relationship between Real Convergence and the Real ExchangeRate: the Case of BulgariaMariella Nenova

DP/42/2004 Effective Taxation of Labor, Capital and Consumption in BulgariaPlamen Kaloyanchev

DP/43/2004 The 1911 Balance of Payments of the Kingdom of Bulgaria(in Bulgarian only)Martin Ivanov

DP/44/2004 Beliefs about Exchange Rate Stability: Survey Evidence from theCurrency Board in BulgariaNeven T. Valev, John A. Carlson

DP/45/2004 Opportunities of Designing and Using the Money Circulation Balance (inBulgarian only)Metodi Hristov

DP/46/2005 The Microeconomic Impact of Financial Crises: The Case of BulgariaJonathon Adams–Kane, Jamus Jerome Lim

DP/47/2005 Interest Rate Spreads of Commercial Banks in Bulgaria (in Bulgarian only)Michail Michailov

DP/48/2005 Total Factor Productivity Measurement: Accounting and EconomicGrowth in Bulgaria (in Bulgarian only)Kaloyan Ganev

DP/49/2005 An Attempt at Measurement of Core Inflation in Bulgaria(in Bulgarian only)Kalina Dimitrova

DP/50/2005 Economic and Monetary Union on the HorizonDr Tsvetan Manchev, Mincho Karavastev

DP/51/2005 The Brady Story of Bulgaria (in Bulgarian only)Garabed Minassian

DP/52/2006 General Equilibrium View on the Trade Balance Dynamics in BulgariaHristo Valev

DP/53/2006 The Balkan Railways, International Capital and Banking from the End ofthe 19th Century until the Outbreak of the First World WarPeter Hertner

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DP/54/2006 Bulgarian National Income between 1892 and 1924Martin Ivanov

DP/55/2006 The Role of Securities Investor Compensation Schemes for theDevelopment of the Capital Market (in Bulgarian only)Mileti Mladenov, Irina Kazandzhieva

DP/56/2006 The Optimal Monetary Policy under Conditions of Indefiniteness (inBulgarian only)Nedyalka Dimitrova

DP/57/2007 Two Approaches to Estimating the Potential Output of Bulgaria (inBulgarian only)Tsvetan Tsalinski

DP/58/2007 Informal Sources of Credit and the "Soft" Information Market(Evidence from Sofia)Luc Tardieu

DP/59/2007 Do Common Currencies Reduce Exchange Rate Pass–through?Implications for Bulgaria's Currency BoardSlavi T. Slavov

DP/60/2007 The Bulgarian Economy on Its Way to the EMU: Economic Policy Resultsfrom a Small–scale Dynamic Stochastic General Equilibrium FrameworkJochen Blessing

DP/61/2007 Exchange Rate Control in Bulgaria in the Interwar Period: History andTheoretical ReflectionsNikolay NenovskyKalina Dimitrova

DP/62/2007 Different Methodologies for National Income Accounting in Central andEastern European Countries, 1950–1990Rossitsa Rangelova

DP/63/2008 A Small Open Economy Model with a Currency Board Feature: the Caseof BulgariaIordan IordanovAndrey Vassilev

DP/64/2008 Potential Output Estimation Using Penalized Splines: the Case ofBulgariaMohamad Khaled

DP/65/2008 Bank Lending and Asset Prices: Evidence from BulgariaMichael FrömmelKristina Karagyozova

DP/66/2008 Views from the Trenches: Interviewing Bank Officials in the Midst of aCredit BoomNeven Valev

DP/67/2008 Monetary Policy Transmission:Old Evidence and Some New Facts from BulgariaAlexandru MineaChristophe Rault