BANK OF ALBANIA STATEMENT
Financial Stability Statement for 2014 H1

Pursuant to provisions under Article 69 of the Law No. 8269, dated 23 December 1997 "On the Bank of Albania", as amended, and Article 8 of the Law No. 9962, dated 18 December 2006 "On Banks in the Republic of Albania", as amended, to inform the Assembly of the Republic of Albania and the Council of Ministers, and draw the attention of financial institutions and the public on the Albanian financial system situation and the potential risks that may jeopardise its stability, the Bank of Albania releases this periodic statement. This statement is an integral part of the Financial Stability Report for the same stated period.

The Albanian banking sector and financial system showed stable performance in the first half of 2014. The volume of activity grew and the financial performance improved.

The banking sector's liquidity and capitalisation ratios were at an adequate level during the period. The loan portfolio quality remained a concern, although the non-performing loan ratio appeared more stable and the non-performing loans, in terms of absolute value, were lower year-over-year. Loan loss provisions and collateralisation of non-performing loans were at adequate levels.

The macroeconomic setting is stable, supporting the performance of the financial system. The improved economic growth, and the fiscal and monetary policy actions were accompanied by an adequate functioning of financial markets and lower financing costs.

Banking sector's exposure to credit risk stands similar to the previous period. Credit risk provisions, albeit at an adequate level, must be assessed based on a conservative analysis of future events, to protect banks against any additional costs they may face during the restructuring and collateral management process. Banking sector's exposure to market and liquidity risks remains limited, but requires cautious monitoring. External sector developments suggest the need to assess the potential impact on the banking activity in Albania, of European authorities' actions to review the asset quality, the capitalisation level, and the restructuring measures taken by the largest European banking groups.. The banking sector is overall resilient to assumed shocks arising from fluctuations in macroeconomic indicators and the value of its investment portfolio.

The following provides a summary of the main developments in the surrounding economic environment and the financial system, and the risks facing the banking sector activity, including the systemic risk.

• Economic and financial developments

Global economic activity improved during the first half of 2014, driven mainly by the performance of advanced economies. The economy improved at a slower-than-expected pace, with notable differences across the regions. Global inflationary pressures remained below the historical average, reflecting the stable prices of raw materials and spare capacities in the economy. In the advanced economies, the financial markets remained stable, supported by central banks' policies and positive expectations of market participants. The financial markets were volatile in the developing economies, due to economic deceleration in some countries, political and structural concerns, and expectations for monetary policy tightening in the United States of America. This performance led to depreciation of respective currencies in these countries. Global economic activity is expected to continue to improve for the rest of 2014 and 2015, driven primarily by the positive performance of advanced economies.

Private consumption and investments are making major contribution to the improvement of the Albanian economy. In the first quarter of 2014, the Albanian economy expanded by 1.65% and 0.2%, in annual and quarterly terms. Except for the construction sector, all the other sectors of the economy contributed positively to the economic growth. The latter reflected the relative improvement of domestic demand, affected mainly by private consumption and investments. Nevertheless, with the unemployment rate resulting 17.7%, the economic improvement has to become sustainable to affect the labour market. External sector developments made a negative contribution to economic growth. In June 2014, annual inflation decreased to 1.5%, reflecting the incomplete utilisation of domestic production capacities, the low inflation rates in Albania's trading partners, and the downward short-term expectations for inflation. In response to this performance, the Bank of Albania continued to pursue a stimulating monetary policy. At the end of the first half of 2014, the fiscal indicators pointed to a consolidating fiscal policy, with the revenues being higher and the expenditure lower than the annual plan. Domestic demand is expected to strengthen its positive impact on economic growth, driven by private consumption and investments. The expectations for the improvement of economic activity in Albania's main trading partners for the rest of the year will affect the growth of external demand for Albanian exports positively.

Households and businesses remain exposed to direct and indirect credit risks. Lending increased slightly from end-2013 and continued to be oriented towards lending in Albanian lek. The loan portfolio quality worsened slightly, both for businesses and households. Business deposits grew at a higher pace than household deposits, driven also by Government's payment of arrears to businesses. Despite the relatively lower exposure to loans unhedged against unfavourable exchange rate and interest rate changes, households and businesses remain exposed to this risk.

Trading volume in the financial markets increased, while the interest rates decreased during the first half of 2014. The Albanian financial markets showed a stable performance, characterised by low interest rates. The Bank of Albania's stimulus saw greater impact on the primary securities' market, deposit interest rates and the interbank market. The exchange rate was stable and the Albanian lek strengthened slightly against the two major currencies.

The technical infrastructure supporting the banking sector activity operated effectively during the first half of 2014. AIPS and AECH payment systems operated in compliance with the technical conditions for meeting the banking sector needs for settling lek payment transactions. The volume and value of transactions, and the average value per transaction, increased in the two systems.

The financial system increased its share in Albania's economic activity further. In June 2014, the level of financial intermediation in Albania, as measured by the ratio of financial system assets to GDP, was 99.3%, close to end-2013 level. The banking sector accounted for 90.3% of financial system assets.

The banking sector's performance was stable, and the liquidity and capitalisation ratios were at an adequate level, supported also by the improved net financial result. At the end of June 2014, banking sector assets increased to ALL 1,253 billion, expanding by 4.1% during the last year. On the asset-side, interbank and security transactions recorded major increase. Banking activity was financed through the increase in public deposits, though at a lower rate. Banking sector exposure to non-resident institutions was similar to the previous period, reflecting weak reliance on foreign financing resources. Lending shrank 2.2% during the period. The 4.5% growth of lek-denominated lending could not offset the contraction of foreign currency lending by 5.9%. New lending was 16.1% higher than in the corresponding period in 2013.

The ratio of non-performing loans to total loans was 24.1%. The non-performing loan ratio for lek loans was 18.8%, down 1.3 percentage points from June 2013. The same ratio for foreign currency loans was 27.3%, up 0.8 percentage points from June 2013.

Deposits amounted to ALL 1.038 billion, up 3% year-over-year. Lek and foreign currency deposits grew 1.4% and 4.9%, respectively, annually. The annual growth rate of deposits slowed down to 3%, from 4.7% in June 2013. Household deposits, which accounted for around 87.5% of total deposits, grew at a lower annual rate of 2%, from 4.9% a year earlier. Business deposits grew around 9.8% in annual terms, from 8% in the previous year. This performance may have also been affected by Government's payment of arrears to businesses. The loan-to-deposit ratio was 54.7%.

At the sectoral level, the net financial result was positive, amounting to ALL 5.4 billion, from ALL 1.5 billion in the corresponding period in 2013. Net interest income totalled ALL 20.8 billion, or 9.7% higher year-over-year. Loan loss provisions amounted to around ALL 5.7 billion, or 42% lower year-over-year. Paid-in capital did not undergo any significant changes during the period. The regulatory capital fell 1.6%, whereas risk-weighted assets increased by 1%. As a result, the capital adequacy ratio dropped to 17.5%.

• Risk assessment

To assess the risks, we consider the banking sector performance and its interaction with developments in the real economy, financial situation of economic agents and other financial system segments. We also use some representative indices.
 
For a synthesized assessment of risks to the banking sector, real economy and economic agents, we use the Financial Stability Map (FSM). Compared to end-2013, the FSM shows that risks to financial stability continued to move towards economic agents.

More specifically, in the case of the domestic economy, the wider negative output gap and greater need for external financing contributed to a higher risk, which stands at a moderate level. The risk was assessed as moderate for households and businesses, due to the combined impact of factors relating to their expectations for future economic developments, exposure to credit risk and financing resources, in general. The risk was assessed as downward for the government, due to reduced budget deficit and positive performance of tax revenues. However, the size of debt cost has been assigned the highest risk level since end-2012. The risk arising from the external economic environment is assessed as average because of the weaker economy and high unemployment rates in countries with stronger economic ties with Albania. For the banking sector, capitalisation and profitability ratios were assigned moderate risk. Liquidity and financing ratios showed a higher risk level due to wider negative difference between short-term assets and liabilities, further slowdown in the deposit growth rate and relative increase in financing from non-residents. The risk related to the banking sector structure was assessed as average. It has been maintaining a downward trend due to reduced concentration of banking sector activity in the largest banks, both on the asset and liability side.

For the assessment of risk to focus on the financial system, we use the Financial Systemic Risk Index. It measures the level of financial stress in the economy by aggregating the financial information on different segments of the banking sector, foreign exchange market, money market, and housing market) into a single index. For the first half of 2014, this index remained above its long-term average. The banking sector contributed to a higher systemic risk due to wider negative gap between loans (contraction) and deposits (slowdown) than the long-term trend. This performance was mitigated by the lower contribution of the housing market, whose prices dropped. The interconnection between different market segments was weaker, mitigating, in turn, the aggregate systemic risk level.

For a clearer insight into the accumulation and materialisation phases of systemic risk in the financial system, we use two indices: the risk accumulation index and the risk materialisation index. At the end of the first half of 2014, there was higher systemic risk accumulation, mainly due to worsened external debt, public debt and current account deficit. The contraction in foreign currency lending and lower housing prices contributed to reduced systemic risk accumulation. The materialisation of systemic risk increased during the period under review, reflecting the worsened quality of business and household loans, and the increased unemployment rate.
 
Financial risks are subject to economic agents' perception. The Bank of Albania regularly collects the perception of banking industry about these risks through a special semi-annual survey. From March 2012 to June 2014, the banking industry has perceived two phenomena at a potentially high risk: deterioration of the domestic economy and increase in public debt.

Risks arising from fiscal indicators did not increase further during the first half of 2014. Public debt is high, and the size and concentration of Government borrowing financing by banks and non-bank financial sector are associated with certain risk levels. However, risk did not increase during the period thanks to the consolidating fiscal policy, also supported by the arrangement with the IMF; extended term to maturity and lower borrowing cost; adequate liquidity level in the banking sector; and measures to improve the access to liquidity of non-bank financial institutions investing in Government debt securities. In this regard, deeper reforms to boost economic growth are required for a positive and sustainable performance of fiscal indicators.

Credit risk remains a concern for banking activity. The absolute value of non-performing loans fell during the period. At the same time, there was a shift towards loss loans and increase in loans past due by up to 90 days. The loan restructuring process at banks may be more effective if viewed more than merely as a change in terms and loan instalment. The risk for further deterioration of the loan quality is still present, and banks are urged to cautiously monitor the loan loss provisioning, suggesting its increase through a proactive approach. To address the non-performing loans, banks are taking more decisive actions with respect to the execution of the collateral, which is typically in the form of real estate. As a result, the value of real estate under banks' management is increasing at a steady rate. This phenomenon may put pressure on banks' resources for the management and maintenance of real estate, particularly if the sale pace in the market is low. Housing prices are showing signs of easing, affecting negatively banks' ability to reach the targeted value from the sale of the collateral . Real estate management is not a typical function of a commercial bank. It is, therefore, necessary for banks to explore and design appropriate strategies to effectively address this concern.

The banking sector showed limited exposure to direct risk associated with unfavourable exchange rate and interest rate movements, which, however, requires cautious monitoring. The banking sector's open foreign exchange position was long and within the historical levels. Interest rate-sensitive assets and liabilities were comparable; however, the difference between the two was negative. Despite the limited direct impact of exchange rate and interest rate movements, the banking sector appears sensitive to the negative impact of unfavourable exchange rate and interest rate movements on banking clients. A significant depreciation of the exchange rate or a similar increase in the interest rate may affect the solvency of banking clients, particularly businesses. The main transmission channel of this risk is represented by foreign currency loans, when the main source for its settlement is in the domestic currency, and variable-rate loans.

Banking sector liquidity risk was moderate. Similar to the previous periods, deposits represent the main financing source for the banking sector. They recorded positive growth, though at a slower pace than in the previous period. Borrowing from non-residents, albeit up slightly, remained at a moderate level. The sector's liquid assets, both in lek and foreign currency, were above the minimum levels required by the regulatory framework. The loan-to-deposit ratio was low, reflecting the different performance of lek and foreign currency loans and deposits.

Capitalisation indicators were at adequate levels; however, banks should cautiously monitor potential scenarios for future events and their needs for additional capital. The capital adequacy ratio dropped slightly, remaining, however, at an adequate level. Net profit improved thanks to slower increase in non-performing loans, improved value of debt securities and lower provisions for the credit risk of the assets. Banks may face increased expenses due to additional costs associated with the restructuring and collateral execution process. It is, therefore, imperative for banks to continue to cautiously and proactively assess their needs for additional capital in line with their risk profile and, when necessary, boost their capital level.

Stress-testing exercise should serve banks as a tool to support the assessment of possible needs for additional capital. The Bank of Albania conducts regular stress-testing exercises to assess the sensitivity of the main banking sector capitalisation figures to changes in macroeconomic indicators and decline in the value of investments in money and securities markets.

For the exercise testing the sector's sensitivity to macroeconomic scenarios, the baseline and adverse risk scenarios make assumptions about changes in GDP growth rate, exchange rate and interest rate, and lending, extending through the end of 2015. For the exercise testing the sector's sensitivity to the size of loss in the investment value, the scenarios make assumptions about the loss in value of securities and investment portfolio held with  bank holding groups.

The results of the first exercise show that the banking sector is generally resilient to assumed shocks, in case they materialise. In the event of the baseline scenario, the capitalisation level remains above the minimum requirement. In the event of the more adverse scenarios, which make assumptions about the fall in GDP growth rate, decline in lending and exchange rate depreciation, individual banks may need additional capital.

The results of the second exercise show that individual banks are more exposed to market risk associated with the value of investments in private institutions' securities, whereas exposure to sovereign debt risk is limited. Exposure to placements with bank holding groups is sensitive for medium-sized banks of Greek and French capital origin.

The regulatory and supervisory framework, and the international best practices, require similar exercises to be carried out by banks themselves on a regular basis, in order to assist their decision-making and keep risk in their activity under control.

Pursuant to provisions under Article 69 of the Law No. 8269, dated 23 December 1997 "On the Bank of Albania", as amended, and Article 8 of the Law No. 9962, dated 18 December 2006 "On Banks in the Republic of Albania", as amended, to inform the Assembly of the Republic of Albania and the Council of Ministers, and draw the attention of financial institutions and the public on the Albanian financial system situation and the potential risks that may jeopardise its stability, the Bank of Albania releases this periodic statement. This statement is an integral part of the Financial Stability Report for the same stated period.

The Albanian banking sector and financial system showed stable performance in the first half of 2014. The volume of activity grew and the financial performance improved.

The banking sector's liquidity and capitalisation ratios were at an adequate level during the period. The loan portfolio quality remained a concern, although the non-performing loan ratio appeared more stable and the non-performing loans, in terms of absolute value, were lower year-over-year. Loan loss provisions and collateralisation of non-performing loans were at adequate levels.

The macroeconomic setting is stable, supporting the performance of the financial system. The improved economic growth, and the fiscal and monetary policy actions were accompanied by an adequate functioning of financial markets and lower financing costs.

Banking sector's exposure to credit risk stands similar to the previous period. Credit risk provisions, albeit at an adequate level, must be assessed based on a conservative analysis of future events, to protect banks against any additional costs they may face during the restructuring and collateral management process. Banking sector's exposure to market and liquidity risks remains limited, but requires cautious monitoring. External sector developments suggest the need to assess the potential impact on the banking activity in Albania, of European authorities' actions to review the asset quality, the capitalisation level, and the restructuring measures taken by the largest European banking groups.. The banking sector is overall resilient to assumed shocks arising from fluctuations in macroeconomic indicators and the value of its investment portfolio.

The following provides a summary of the main developments in the surrounding economic environment and the financial system, and the risks facing the banking sector activity, including the systemic risk.

• Economic and financial developments

Global economic activity improved during the first half of 2014, driven mainly by the performance of advanced economies. The economy improved at a slower-than-expected pace, with notable differences across the regions. Global inflationary pressures remained below the historical average, reflecting the stable prices of raw materials and spare capacities in the economy. In the advanced economies, the financial markets remained stable, supported by central banks' policies and positive expectations of market participants. The financial markets were volatile in the developing economies, due to economic deceleration in some countries, political and structural concerns, and expectations for monetary policy tightening in the United States of America. This performance led to depreciation of respective currencies in these countries. Global economic activity is expected to continue to improve for the rest of 2014 and 2015, driven primarily by the positive performance of advanced economies.

Private consumption and investments are making major contribution to the improvement of the Albanian economy. In the first quarter of 2014, the Albanian economy expanded by 1.65% and 0.2%, in annual and quarterly terms. Except for the construction sector, all the other sectors of the economy contributed positively to the economic growth. The latter reflected the relative improvement of domestic demand, affected mainly by private consumption and investments. Nevertheless, with the unemployment rate resulting 17.7%, the economic improvement has to become sustainable to affect the labour market. External sector developments made a negative contribution to economic growth. In June 2014, annual inflation decreased to 1.5%, reflecting the incomplete utilisation of domestic production capacities, the low inflation rates in Albania's trading partners, and the downward short-term expectations for inflation. In response to this performance, the Bank of Albania continued to pursue a stimulating monetary policy. At the end of the first half of 2014, the fiscal indicators pointed to a consolidating fiscal policy, with the revenues being higher and the expenditure lower than the annual plan. Domestic demand is expected to strengthen its positive impact on economic growth, driven by private consumption and investments. The expectations for the improvement of economic activity in Albania's main trading partners for the rest of the year will affect the growth of external demand for Albanian exports positively.

Households and businesses remain exposed to direct and indirect credit risks. Lending increased slightly from end-2013 and continued to be oriented towards lending in Albanian lek. The loan portfolio quality worsened slightly, both for businesses and households. Business deposits grew at a higher pace than household deposits, driven also by Government's payment of arrears to businesses. Despite the relatively lower exposure to loans unhedged against unfavourable exchange rate and interest rate changes, households and businesses remain exposed to this risk.

Trading volume in the financial markets increased, while the interest rates decreased during the first half of 2014. The Albanian financial markets showed a stable performance, characterised by low interest rates. The Bank of Albania's stimulus saw greater impact on the primary securities' market, deposit interest rates and the interbank market. The exchange rate was stable and the Albanian lek strengthened slightly against the two major currencies.

The technical infrastructure supporting the banking sector activity operated effectively during the first half of 2014. AIPS and AECH payment systems operated in compliance with the technical conditions for meeting the banking sector needs for settling lek payment transactions. The volume and value of transactions, and the average value per transaction, increased in the two systems.

The financial system increased its share in Albania's economic activity further. In June 2014, the level of financial intermediation in Albania, as measured by the ratio of financial system assets to GDP, was 99.3%, close to end-2013 level. The banking sector accounted for 90.3% of financial system assets.

The banking sector's performance was stable, and the liquidity and capitalisation ratios were at an adequate level, supported also by the improved net financial result. At the end of June 2014, banking sector assets increased to ALL 1,253 billion, expanding by 4.1% during the last year. On the asset-side, interbank and security transactions recorded major increase. Banking activity was financed through the increase in public deposits, though at a lower rate. Banking sector exposure to non-resident institutions was similar to the previous period, reflecting weak reliance on foreign financing resources. Lending shrank 2.2% during the period. The 4.5% growth of lek-denominated lending could not offset the contraction of foreign currency lending by 5.9%. New lending was 16.1% higher than in the corresponding period in 2013.

The ratio of non-performing loans to total loans was 24.1%. The non-performing loan ratio for lek loans was 18.8%, down 1.3 percentage points from June 2013. The same ratio for foreign currency loans was 27.3%, up 0.8 percentage points from June 2013.

Deposits amounted to ALL 1.038 billion, up 3% year-over-year. Lek and foreign currency deposits grew 1.4% and 4.9%, respectively, annually. The annual growth rate of deposits slowed down to 3%, from 4.7% in June 2013. Household deposits, which accounted for around 87.5% of total deposits, grew at a lower annual rate of 2%, from 4.9% a year earlier. Business deposits grew around 9.8% in annual terms, from 8% in the previous year. This performance may have also been affected by Government's payment of arrears to businesses. The loan-to-deposit ratio was 54.7%.

At the sectoral level, the net financial result was positive, amounting to ALL 5.4 billion, from ALL 1.5 billion in the corresponding period in 2013. Net interest income totalled ALL 20.8 billion, or 9.7% higher year-over-year. Loan loss provisions amounted to around ALL 5.7 billion, or 42% lower year-over-year. Paid-in capital did not undergo any significant changes during the period. The regulatory capital fell 1.6%, whereas risk-weighted assets increased by 1%. As a result, the capital adequacy ratio dropped to 17.5%.

• Risk assessment

To assess the risks, we consider the banking sector performance and its interaction with developments in the real economy, financial situation of economic agents and other financial system segments. We also use some representative indices.
 
For a synthesized assessment of risks to the banking sector, real economy and economic agents, we use the Financial Stability Map (FSM). Compared to end-2013, the FSM shows that risks to financial stability continued to move towards economic agents.

More specifically, in the case of the domestic economy, the wider negative output gap and greater need for external financing contributed to a higher risk, which stands at a moderate level. The risk was assessed as moderate for households and businesses, due to the combined impact of factors relating to their expectations for future economic developments, exposure to credit risk and financing resources, in general. The risk was assessed as downward for the government, due to reduced budget deficit and positive performance of tax revenues. However, the size of debt cost has been assigned the highest risk level since end-2012. The risk arising from the external economic environment is assessed as average because of the weaker economy and high unemployment rates in countries with stronger economic ties with Albania. For the banking sector, capitalisation and profitability ratios were assigned moderate risk. Liquidity and financing ratios showed a higher risk level due to wider negative difference between short-term assets and liabilities, further slowdown in the deposit growth rate and relative increase in financing from non-residents. The risk related to the banking sector structure was assessed as average. It has been maintaining a downward trend due to reduced concentration of banking sector activity in the largest banks, both on the asset and liability side.

For the assessment of risk to focus on the financial system, we use the Financial Systemic Risk Index. It measures the level of financial stress in the economy by aggregating the financial information on different segments of the banking sector, foreign exchange market, money market, and housing market) into a single index. For the first half of 2014, this index remained above its long-term average. The banking sector contributed to a higher systemic risk due to wider negative gap between loans (contraction) and deposits (slowdown) than the long-term trend. This performance was mitigated by the lower contribution of the housing market, whose prices dropped. The interconnection between different market segments was weaker, mitigating, in turn, the aggregate systemic risk level.

For a clearer insight into the accumulation and materialisation phases of systemic risk in the financial system, we use two indices: the risk accumulation index and the risk materialisation index. At the end of the first half of 2014, there was higher systemic risk accumulation, mainly due to worsened external debt, public debt and current account deficit. The contraction in foreign currency lending and lower housing prices contributed to reduced systemic risk accumulation. The materialisation of systemic risk increased during the period under review, reflecting the worsened quality of business and household loans, and the increased unemployment rate.
 
Financial risks are subject to economic agents' perception. The Bank of Albania regularly collects the perception of banking industry about these risks through a special semi-annual survey. From March 2012 to June 2014, the banking industry has perceived two phenomena at a potentially high risk: deterioration of the domestic economy and increase in public debt.

Risks arising from fiscal indicators did not increase further during the first half of 2014. Public debt is high, and the size and concentration of Government borrowing financing by banks and non-bank financial sector are associated with certain risk levels. However, risk did not increase during the period thanks to the consolidating fiscal policy, also supported by the arrangement with the IMF; extended term to maturity and lower borrowing cost; adequate liquidity level in the banking sector; and measures to improve the access to liquidity of non-bank financial institutions investing in Government debt securities. In this regard, deeper reforms to boost economic growth are required for a positive and sustainable performance of fiscal indicators.

Credit risk remains a concern for banking activity. The absolute value of non-performing loans fell during the period. At the same time, there was a shift towards loss loans and increase in loans past due by up to 90 days. The loan restructuring process at banks may be more effective if viewed more than merely as a change in terms and loan instalment. The risk for further deterioration of the loan quality is still present, and banks are urged to cautiously monitor the loan loss provisioning, suggesting its increase through a proactive approach. To address the non-performing loans, banks are taking more decisive actions with respect to the execution of the collateral, which is typically in the form of real estate. As a result, the value of real estate under banks' management is increasing at a steady rate. This phenomenon may put pressure on banks' resources for the management and maintenance of real estate, particularly if the sale pace in the market is low. Housing prices are showing signs of easing, affecting negatively banks' ability to reach the targeted value from the sale of the collateral . Real estate management is not a typical function of a commercial bank. It is, therefore, necessary for banks to explore and design appropriate strategies to effectively address this concern.

The banking sector showed limited exposure to direct risk associated with unfavourable exchange rate and interest rate movements, which, however, requires cautious monitoring. The banking sector's open foreign exchange position was long and within the historical levels. Interest rate-sensitive assets and liabilities were comparable; however, the difference between the two was negative. Despite the limited direct impact of exchange rate and interest rate movements, the banking sector appears sensitive to the negative impact of unfavourable exchange rate and interest rate movements on banking clients. A significant depreciation of the exchange rate or a similar increase in the interest rate may affect the solvency of banking clients, particularly businesses. The main transmission channel of this risk is represented by foreign currency loans, when the main source for its settlement is in the domestic currency, and variable-rate loans.

Banking sector liquidity risk was moderate. Similar to the previous periods, deposits represent the main financing source for the banking sector. They recorded positive growth, though at a slower pace than in the previous period. Borrowing from non-residents, albeit up slightly, remained at a moderate level. The sector's liquid assets, both in lek and foreign currency, were above the minimum levels required by the regulatory framework. The loan-to-deposit ratio was low, reflecting the different performance of lek and foreign currency loans and deposits.

Capitalisation indicators were at adequate levels; however, banks should cautiously monitor potential scenarios for future events and their needs for additional capital. The capital adequacy ratio dropped slightly, remaining, however, at an adequate level. Net profit improved thanks to slower increase in non-performing loans, improved value of debt securities and lower provisions for the credit risk of the assets. Banks may face increased expenses due to additional costs associated with the restructuring and collateral execution process. It is, therefore, imperative for banks to continue to cautiously and proactively assess their needs for additional capital in line with their risk profile and, when necessary, boost their capital level.

Stress-testing exercise should serve banks as a tool to support the assessment of possible needs for additional capital. The Bank of Albania conducts regular stress-testing exercises to assess the sensitivity of the main banking sector capitalisation figures to changes in macroeconomic indicators and decline in the value of investments in money and securities markets.

For the exercise testing the sector's sensitivity to macroeconomic scenarios, the baseline and adverse risk scenarios make assumptions about changes in GDP growth rate, exchange rate and interest rate, and lending, extending through the end of 2015. For the exercise testing the sector's sensitivity to the size of loss in the investment value, the scenarios make assumptions about the loss in value of securities and investment portfolio held with  bank holding groups.

The results of the first exercise show that the banking sector is generally resilient to assumed shocks, in case they materialise. In the event of the baseline scenario, the capitalisation level remains above the minimum requirement. In the event of the more adverse scenarios, which make assumptions about the fall in GDP growth rate, decline in lending and exchange rate depreciation, individual banks may need additional capital.

The results of the second exercise show that individual banks are more exposed to market risk associated with the value of investments in private institutions' securities, whereas exposure to sovereign debt risk is limited. Exposure to placements with bank holding groups is sensitive for medium-sized banks of Greek and French capital origin.

The regulatory and supervisory framework, and the international best practices, require similar exercises to be carried out by banks themselves on a regular basis, in order to assist their decision-making and keep risk in their activity under control.