UPDATE 5-Bulgaria to allow its fourth-biggest bank to collapse
* Plan aims to stop fallout from bank run last month
* Audit indicates "serious felony": interior ministry
* Substantial parts of loan dossier missing: cenbank
* Bulgaria's credit default swaps at one-week high
* Prosecutors detain Corpbank executive in Black Sea town (Adds lawyer comment)
SOFIA, July 11 (Reuters) - Bulgaria is to allow its fourth-biggest lender to collapse but could spend up to 2 billion levs ($1.39 billion) making sure customers do not lose out, as the Balkan country battles to clean up its worst financial scandal since the 1990s.
The central bank said it was removing Corporate Commercial Bank's (Corpbank) banking licence and would hive off its healthy activities into a separate bank, marking the first banking collapse since a 1996-1997 domestic financial crisis.
The Bulgarian National Bank (BNB) is also alerting prosecutors to the possibility that Corpbank's main shareholder stole almost 206 million levs just before the central bank took over its operations on June 20 after depositors withdrew about 1 billion levs.
The bank run was prompted by media reports accusing top shareholder Tsvetan Vassilev of shady business deals. It spread quickly to another lender, forcing Sofia to set up a protective $2.3 billion credit line for its banks - a reminder that parts of Europe's financial system are still far from secure despite progress from the worst days of the global financial crisis.
Vassilev has denied the allegations against him.
"For several months now a massive, targeted and extremely manipulative campaign has started against me, which spilled over on everything associated with my name," he told Bulgarian news agency BGNES, echoing comments he made previously to Reuters.
But the results of an audit into Corpbank showed "actions incompatible with the law and good banking practices", BNB said. Auditors were unable to value about 65 percent of Corpbank's 5.4-billion-lev loan portfolio because crucial documentation was missing - "most likely destroyed in the days before the central bank sent administrators there," the BNB added.
The results of the audit scotched earlier hopes of recapitalising Corpbank with funds from existing shareholders.
"BARREL WITHOUT A BOTTOM"
All of Corpbank's good assets, and deposits not linked to Vassilev, will be moved to a unit of the bank called Credit Agricole - acquired by Corpbank from the French bank bearing the same name a week before the BNB took action - and Bulgaria plans to have this unit nationalised and re-opened on July 21.
"We cannot continue to fill a barrel without a bottom, as the wise Bulgarian people say, and we cannot nationalise Corporate Commercial Bank in its current state," the BNB said.
Though the main bank will collapse, Finance Minister Petar Chobanov said the rescue could still cost between 1.5-2 billion levs, potentially swelling the country's fiscal deficit this year to more than 3 percent of gross domestic product (GDP) against a planned target of 1.8 percent.
The cost is so high because the authorities have vowed to repay all of the bank's depositors except those linked to Vassilev. Corpbank's financial statements show that depositors were owed almost 6 billion levs on March 31 - and since the bank may not get repayment on much of its loan books it has a substantial gap to fill.
The BNB has not provided any figures more recent than that financial statement, nor said what proportion of the deposits were linked to Vassilev. It has said that prosecutors will have to determine whether his withdrawal of 206 million levs via a third party amounted to theft.
Orlin Rusev, chairperson of the bank's management board, was detained in Bulgaria's Black Sea resort of Sozopol on Friday in relation to Vassilev's withdrawal of funds, prosecutors said. A second executive at the bank's treasury department, Margarita Petrova, was charged with embezzlement in relation to the same withdrawals on Thursday.
A lawyer for Petrova dismissed the idea of people taking money out of the bank in cash and said the BNB had made that accusation to cover up its own bungling of the Corpbank crisis.
"As you can guess, 200 million levs were not taken out in boxes, suitcases and trucks and the fact that the finance minister, the central bank governor say this is simply shocking, shocking." Tatiana Doncheva told BTV television. "This is absurd."
Rusev could not immediately be reached for comment. Corpbank's spokeswoman has said the central bank has banned it from making public statements without its approval.
THE "ONLY POSSIBLE" PLAN
The scandal has stoked memories of a 1996-97 crisis when 14 Bulgarian banks collapsed and comes as Europe's banks emerge from a financial crisis that led to multiple bank meltdowns.
It has also raised the question of whether the institutions tasked with ensuring a robust, accountable banking sector are up to the job. Official documents published earlier this year suggested Corpbank was in rude financial health, with less than 1 percent of its loan book classed as non-performing at the end of 2013, against a sector average of 17 percent.
The BNB hopes its actions will reassure investors that Corpbank's woes are isolated and pose no broader risk to the financial stability of the EU's poorest member state. Nonetheless, the cost of insuring against default on Bulgaria's benchmark five-year bond rose to one-week highs on Friday.
It was not immediately clear what would happen to the bondholders of Corpbank, in light of the results of the audit. Prior to Friday's findings, the finance minister had told Reuters that bondholders would be protected.
The central bank said an insolvency process would now be launched. The privileged creditor will be the state.
"The central bank's plan looks like the only possible one," said Lachezar Bogdanov, economist with Sofia-based Industry Watch think-tank. "If the central bank finds a swift solution now and really gets the support of the state, Bulgaria can ... issue a strong signal that it has working institutions." ($1 = 1.4375 Bulgarian Levs) (Writing by Matthias Williams; additional reporting by Laura Noonan in London and Angel Krasimirov in Sofia; editing by Sophie Walker and Gareth Jones)