BANK OF ALBANIA STATEMENT
Financial Stability Statement for 2014 H2

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 situation and performance of the Albanian banking sector and financial system was stable in the second half of 2014. The volume of activity grew and the financial performance improved further.

The banking sector's liquidity and capitalisation ratios were at an adequate level during the period. The credit portfolio quality improved at the end of the year, although the level of non-performing loans is assessed as still high. Loan loss provisions and collateralisation of non-performing loans were at good 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 a good functioning of financial markets and lower financing costs.

Despite an improved financial situation, the banking sector's risk exposure remains similar to that in the previous period.

The credit risk remains significant as legal and regulatory improvements with regard to collateral execution/management, modalities of bank taxation in the case of loan write offs from banks' balance sheets, and restructuring of non-performing loans need to be interpreted and implemented consistently in order to reinforce their positive impact. Legal ambiguities in the process of borrowers' bankruptcy, especially identified in the case of borrowers exposed to more than one bank, emphasise the need for improvements in this regard as well. Moreover, the sale or transfer of the non-performing loans portfolio from banks to specialised non-bank financial institutions is a process that needs to be specified in regulatory requirements and encouraged through different forms, to prevent legal uncertainties and stir up the interest of these institutions. The Bank of Albania considers that overall, the process of the management and solution of non-performing loans would benefit from a thorough analysis of the difficulties faced, which would serve as a basis for a coordinated and determined approach by public authorities aimed at providing a systematic and sustainable solution to this problem. The Bank of Albania shall remain active in this regard, in compliance with the legal requirements and the relations with the banking industry.

Banking sector's exposure to market and liquidity risks remains limited, but requires cautious monitoring. Also, it is important to assess the total, direct and indirect impact arising from fluctuations in the values of market indicators (exchange rate and interest rate) on the banks' balance sheets.

Domestic demand is expected to remain the main factor driving economic growth in Albania. Developments in the external economic and financial environment, especially those related to the EU and euro area, remain unclear about their possible spill-over effect on the Albanian economy. Economic and financial developments in Greece add the uncertainty in financial markets. In the meantime, regulatory requirements for European banking groups, introduced by national supervisory authorities and the European Central Bank, point to the strengthening of requirements pertaining to risk management and capitalisation levels. These developments will exercise pressures on the contribution of their branches in the process of financial intermediation, for both public and private sectors in Albania.

Stress test results suggest that the banking sector is overall resilient to supposed shocks resulting from fluctuations of macroeconomic indicators and of the value of its investment portfolio.

Following is 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

During the second half of 2014, the global economic activity improved gradually, but at lower-than-expected rates  and evident divergences between the regions. Inflationary pressures fell globally, reflecting downward commodity prices, mainly of oil and its by-products. The euro depreciated against the major currencies, especially the US dollar. Divergences in economic growth between major regions are reflected in different attitudes of monetary policy by central banks. Financial markets have been generally stable. Global economic activity is expected to continue to improve at slow rates , sustained also by the drop in oil prices.

During 2014, private consumption and investments provided significant contribution to economic recovery, while the fiscal policy maintains its consolidating trend. In the last quarter of 2014, the Albanian economy was estimated to have grown 2.42% in annual terms or 1.12% from the previous quarter. During the quarter, the contribution of fiscal policy to domestic demand increased. The improvement in terms of the economic activity has not been reflected yet in the labour market, as the unemployment rate rose to 18%. Developments in the external sector of the economy contributed negatively to economic growth. Low inflationary pressures have contributed to the monetary policy of the Bank of Albania remaining accommodative. Preliminary data as at end-2014 show that the consolidation trend of the fiscal policy persists. Although in absolute value the budget deficit stood higher than in the previous year, it fell vis-à-vis the Gross Domestic Product (GDP). In the future, domestic demand is majorly expected to maintain its positive contribution to economic growth. An expected improvement of economic activity in Albania's main trading partners will contribute positively to the growth of foreign demand for Albanian exports.

Households and businesses remain exposed to direct and indirect credit risks. In the second half of 2014, households continued to be oriented towards savings, as reflected by the expansion of deposits both in annual and half-yearly terms. Credit to households grew as well, but slower than deposits. Lending in the national currency made the main contribution to the growth of credit, both for households and businesses. The debt position of businesses was somewhat lower, due to the faster increase in deposits, mainly as a result of the continuation of the payment of arrears. In relation to risks, households decreased, whereas businesses increased their exposure to the indirect credit risk arising from the exchange rate. The credit portfolio quality improved both for households and businesses.

In financial markets, interest rates continued to drop, and the nominal value of the Albanian lek against the main foreign currencies fell. During the period under review, the Albanian financial markets showed a stable performance. Following the accommodative monetary policy of the Bank of Albania, the financial markets were characterised by downward rates, especially in the primary securities market, regarding banking sector's credit and deposit products, and in the interbank market. Lek's exchange rate was steady against the euro, but depreciated against the US dollar and currencies that mimic it. This performance has reflected mostly developments in international foreign exchange markets.

Volume of transactions in the payment systems and use of electronic payment instruments by bank clients increased. AIPS and AECH payment systems operated in compliance with the technical conditions for meeting the banking sector needs for settling payment transactions in the national currency. In both systems, the volume and value of transactions increased. In addition, the volume and value was up in payments by bank clients through other payment instruments, including bank cards and other electronic forms.

During the period under review, the financial system increased its share in Albania's economic activity. As at December 2014, the level of financial intermediation in Albania, calculated as the ratio of financial system assets to the GDP was estimated at 101.4%.

Banking sector's performance was stable, and the liquidity and capitalisation ratios were at an adequate level, driven also by the improved net financial result. At the end of December 2014 banking sector assets surged to ALL 1,294 billion, expanding by 4.8%, at the end of the year. On the assets side, investments in securities and lending contributed to the expansion of the activity. Banking activity was financed through the increase in public deposits, though at slower rates. Banking sector exposure to non-resident institutions was similar to the previous period, reflecting weak reliance on foreign financing sources. During 2014, credit grew almost 5%, with both lek and foreign currency credit providing positive contribution. The latter was affected by credit to non-residents and the statistical effect of the exchange rate change. The new bank credit during 2014 stood 13.8% higher than in the previous year.

Deposits amounted to ALL 1,072.2 billion, up 4.6% year-over-year. Lek and foreign currency deposits grew 2.8% and 3.7%, respectively, annually. Households' deposits rose 2.6% and businesses deposits surged around 9.2% in annual terms Government's payment of arrears to businesses has also contributed to this performance. The loan-to-deposit ratio was 55.5%.

At the sectoral level, the net profit was positive, amounting to ALL 11.2 billion, from ALL 6.6 billion in the previous year. The main contribution to this result was given by downward expenditure for asset quality and upward net income from interest relying on the activity of investment in securities and lending. During the period under review, the regulatory capital marked 1.3% annual increase, rising to ALL 116.7 billion. Risk-weighted assets rose to ALL 692.9 billion or 8% from a year earlier. As a result, at the end of 2014, the capital adequacy ratio fell to 16.8%.

• 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. To consolidate the risk assessment, we have used some representative indices.

Overall, indices show a deceleration of the risk level during the second half of 2014.
 
Risks to the banking sector, real economy and economic agents are assessed in a single approach by using the Financial Stability Map (FSM). Compared to the end of 2013, the FSM shows that during the period under review, risks to the financial stability were subdued, due to the better performance of economic agents.

In concrete terms, in the case of the 'domestic economy', the increase in the external financing of the public and private sectors, as well as the performance of the exchange rate have contributed to the expansion of risk, whereas the narrowing of the negative output gap has subdued it. For 'households' and 'businesses', the risk is assessed as moderate, benefiting mainly from their better expectations for the outlook of the economy. However, other factors related to the level of unemployment, and the pace and quality of lending  had a negative impact on the size of risk of these economic agents. For the 'government', the risk level is assessed as downward, given the positive performance of income, downward borrowing costs and reduction of the budget deficit. The risk arising from the "external economic environment" has decreased slightly, though it remains at average levels, due to improved unemployment rates in countries with stronger economic relations with Albania and a fall in oil prices. For the banking sector, the risk of 'capitalisation and profitability' and of 'financing and liquidity' is considered as average risk, affected by, respectively, the improvement of the financial result, lowering of the non-performing loan ratio, and differences between short-term assets and liabilities.

Risks to the financial system are assessed using the Financial Systemic Stress Index (FSSI). 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. As at December 2014, the systemic risk is assessed as downward, mainly due to the performance of deposits, credit and net margin of interests during the second half of the year.

Accumulation and materialization phases of systemic risk in the financial system are clearly identified using two specific indices: Risk Accumulation Index and Risk Materialisation Index. As at December 2014, the accumulation of the systemic risk from factors related to the banking sector and the real economy appears as upward compared to the same period in the previous year. The contraction of foreign currency lending and the performance of the housing market mitigated the accumulation of the systemic risk, whereas the increase in the debt level in general and foreign currency debt had an opposite effect. The index on the materialisation of the systemic risk stood slightly up from the previous year, reflecting the credit quality deterioration for businesses and households, the higher unemployment rate and deprecation of the national currency, mainly against the US dollar.

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. For 2014 H2, the industry assesses that the 'worsening of the domestic economy' is the most significant systemic risk, but the perception of the banking sector for this risk has been gradually subduing during 2014. The attention to the risk from 'shocks from the external economy' is up, reflecting the concern over the still-sluggish economy in the euro area, especially in Greece and Italy.

Risks arising from fiscal indicators remain contained. The consolidating trend of the fiscal policy is expected to persist in 2015. Meanwhile, financing of most of public borrowing through foreign sources during this year, if realised as projected, is expected to maintain the pressure on the level of interest rates in the primary market of government debt securities. These factors will diversify the structure of public debt and will keep repayment costs at relatively low levels. At the same time, they will serve to control the size and concentration of financing government borrowing from the banking and non-banking financial sectors, and will serve to create more space for bank lending to the private sector.

Credit risk remains a concern for banking activity. At the end of the period under review, the ratio of non-performing loans to total loans was 22.8%, the lowest in the last two years. The ratio for lek loans stood at 17.5%, down 2.2 percentage points, in annual terms. The ratio for foreign currency loans stood at 26%, up 0.3 percentage points.

Despite the fall in the non-performing loan ratio and the positive impact materialising gradually from the legal improvements and other measures by the authorities, the credit risk remains important. In fact, the insofar experience, shows that legal and regulatory improvements on collateral execution/management, modalities for the taxation of banks in the case of loan write offs from their balance sheets, and restructuring of non-performing loans need to be interpreted and implemented consistently. Legal ambiguities in the process of borrowers' bankruptcy, especially identified in the case of borrowers exposed to more than one bank, emphasise the need for improvements in this regard as well. Moreover, the sale or transfer of the non-performing loans portfolio from banks to specialised non-bank financial institutions is a process that needs to be specified in regulatory requirements and encouraged through different forms, to prevent legal uncertainties and stir up the interest of these institutions. Overall, the process of non-performing loan solution would benefit from a thorough analysis of its performance and difficulties facing it insofar, which would serve as a basis for a coordinated and determined approach by public authorities in order to provide a systematic and definite solution to this problem.

Banking sector exposure to unfavourable fluctuations in the exchange rate and interest rate should be assessed regularly and monitored carefully. The banking sector's open foreign exchange position was long and within the historical levels. Interest rate-sensitive assets and liabilities provide negative difference for maturities up to one year. While the direct impact of exchange rate and interest rate fluctuations is manageable, the banking sector appears sensitive to the negative impact of unfavourable exchange rate and interest rate fluctuations on the situation of the 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 national currency, and variable-rate loans.

Banking sector liquidity risk was moderate. Like before, deposits are the main source of financing for the banking sector. They grew, even faster than in the previous year. Borrowing from non-residents remained moderate. The sector's liquid assets, both in lek and foreign currency, stood above the minimum levels required by the regulatory framework. The 'credit/deposit' ratio was at optimum levels from risk perspective.

Capitalisation indicators were at good levels; however, banks should cautiously assess potential scenarios for future events and their needs for additional capital. During the period under review, the capital adequacy ratio fell, remaining, however, at good levels. Net financial result improved evidently from a year earlier, thanks to the deceleration in non-performing loans, and decrease in 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. Therefore, a cautious and proactive assessment of their needs for additional capital in line with their operational risk profile and their capital increase, when necessary, is a continuous recommendation for banks.

Stress-testing shows that the stability of the banking sector is similar to the previous period. The Bank of Albania conducts regular stress-testing exercises to assess the sensitivity of the main banking sector capitalization figures to changes in macroeconomic indicators and decline in the value of investments in money and securities markets.

For the first exercise that tests the sector's sensitivity to macroeconomic scenarios, the baseline and adverse risk scenarios include assumptions about changes in GDP growth rate, exchange rate and interest rate, and lending, extending through the end of 2016. For the second exercise that tests the sector's sensitivity to the size of loss in the investment value, the scenarios include assumptions about the loss in value of securities.

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 banking sector 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.

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 process 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 situation and performance of the Albanian banking sector and financial system was stable in the second half of 2014. The volume of activity grew and the financial performance improved further.

The banking sector's liquidity and capitalisation ratios were at an adequate level during the period. The credit portfolio quality improved at the end of the year, although the level of non-performing loans is assessed as still high. Loan loss provisions and collateralisation of non-performing loans were at good 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 a good functioning of financial markets and lower financing costs.

Despite an improved financial situation, the banking sector's risk exposure remains similar to that in the previous period.

The credit risk remains significant as legal and regulatory improvements with regard to collateral execution/management, modalities of bank taxation in the case of loan write offs from banks' balance sheets, and restructuring of non-performing loans need to be interpreted and implemented consistently in order to reinforce their positive impact. Legal ambiguities in the process of borrowers' bankruptcy, especially identified in the case of borrowers exposed to more than one bank, emphasise the need for improvements in this regard as well. Moreover, the sale or transfer of the non-performing loans portfolio from banks to specialised non-bank financial institutions is a process that needs to be specified in regulatory requirements and encouraged through different forms, to prevent legal uncertainties and stir up the interest of these institutions. The Bank of Albania considers that overall, the process of the management and solution of non-performing loans would benefit from a thorough analysis of the difficulties faced, which would serve as a basis for a coordinated and determined approach by public authorities aimed at providing a systematic and sustainable solution to this problem. The Bank of Albania shall remain active in this regard, in compliance with the legal requirements and the relations with the banking industry.

Banking sector's exposure to market and liquidity risks remains limited, but requires cautious monitoring. Also, it is important to assess the total, direct and indirect impact arising from fluctuations in the values of market indicators (exchange rate and interest rate) on the banks' balance sheets.

Domestic demand is expected to remain the main factor driving economic growth in Albania. Developments in the external economic and financial environment, especially those related to the EU and euro area, remain unclear about their possible spill-over effect on the Albanian economy. Economic and financial developments in Greece add the uncertainty in financial markets. In the meantime, regulatory requirements for European banking groups, introduced by national supervisory authorities and the European Central Bank, point to the strengthening of requirements pertaining to risk management and capitalisation levels. These developments will exercise pressures on the contribution of their branches in the process of financial intermediation, for both public and private sectors in Albania.

Stress test results suggest that the banking sector is overall resilient to supposed shocks resulting from fluctuations of macroeconomic indicators and of the value of its investment portfolio.

Following is 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

During the second half of 2014, the global economic activity improved gradually, but at lower-than-expected rates  and evident divergences between the regions. Inflationary pressures fell globally, reflecting downward commodity prices, mainly of oil and its by-products. The euro depreciated against the major currencies, especially the US dollar. Divergences in economic growth between major regions are reflected in different attitudes of monetary policy by central banks. Financial markets have been generally stable. Global economic activity is expected to continue to improve at slow rates , sustained also by the drop in oil prices.

During 2014, private consumption and investments provided significant contribution to economic recovery, while the fiscal policy maintains its consolidating trend. In the last quarter of 2014, the Albanian economy was estimated to have grown 2.42% in annual terms or 1.12% from the previous quarter. During the quarter, the contribution of fiscal policy to domestic demand increased. The improvement in terms of the economic activity has not been reflected yet in the labour market, as the unemployment rate rose to 18%. Developments in the external sector of the economy contributed negatively to economic growth. Low inflationary pressures have contributed to the monetary policy of the Bank of Albania remaining accommodative. Preliminary data as at end-2014 show that the consolidation trend of the fiscal policy persists. Although in absolute value the budget deficit stood higher than in the previous year, it fell vis-à-vis the Gross Domestic Product (GDP). In the future, domestic demand is majorly expected to maintain its positive contribution to economic growth. An expected improvement of economic activity in Albania's main trading partners will contribute positively to the growth of foreign demand for Albanian exports.

Households and businesses remain exposed to direct and indirect credit risks. In the second half of 2014, households continued to be oriented towards savings, as reflected by the expansion of deposits both in annual and half-yearly terms. Credit to households grew as well, but slower than deposits. Lending in the national currency made the main contribution to the growth of credit, both for households and businesses. The debt position of businesses was somewhat lower, due to the faster increase in deposits, mainly as a result of the continuation of the payment of arrears. In relation to risks, households decreased, whereas businesses increased their exposure to the indirect credit risk arising from the exchange rate. The credit portfolio quality improved both for households and businesses.

In financial markets, interest rates continued to drop, and the nominal value of the Albanian lek against the main foreign currencies fell. During the period under review, the Albanian financial markets showed a stable performance. Following the accommodative monetary policy of the Bank of Albania, the financial markets were characterised by downward rates, especially in the primary securities market, regarding banking sector's credit and deposit products, and in the interbank market. Lek's exchange rate was steady against the euro, but depreciated against the US dollar and currencies that mimic it. This performance has reflected mostly developments in international foreign exchange markets.

Volume of transactions in the payment systems and use of electronic payment instruments by bank clients increased. AIPS and AECH payment systems operated in compliance with the technical conditions for meeting the banking sector needs for settling payment transactions in the national currency. In both systems, the volume and value of transactions increased. In addition, the volume and value was up in payments by bank clients through other payment instruments, including bank cards and other electronic forms.

During the period under review, the financial system increased its share in Albania's economic activity. As at December 2014, the level of financial intermediation in Albania, calculated as the ratio of financial system assets to the GDP was estimated at 101.4%.

Banking sector's performance was stable, and the liquidity and capitalisation ratios were at an adequate level, driven also by the improved net financial result. At the end of December 2014 banking sector assets surged to ALL 1,294 billion, expanding by 4.8%, at the end of the year. On the assets side, investments in securities and lending contributed to the expansion of the activity. Banking activity was financed through the increase in public deposits, though at slower rates. Banking sector exposure to non-resident institutions was similar to the previous period, reflecting weak reliance on foreign financing sources. During 2014, credit grew almost 5%, with both lek and foreign currency credit providing positive contribution. The latter was affected by credit to non-residents and the statistical effect of the exchange rate change. The new bank credit during 2014 stood 13.8% higher than in the previous year.

Deposits amounted to ALL 1,072.2 billion, up 4.6% year-over-year. Lek and foreign currency deposits grew 2.8% and 3.7%, respectively, annually. Households' deposits rose 2.6% and businesses deposits surged around 9.2% in annual terms Government's payment of arrears to businesses has also contributed to this performance. The loan-to-deposit ratio was 55.5%.

At the sectoral level, the net profit was positive, amounting to ALL 11.2 billion, from ALL 6.6 billion in the previous year. The main contribution to this result was given by downward expenditure for asset quality and upward net income from interest relying on the activity of investment in securities and lending. During the period under review, the regulatory capital marked 1.3% annual increase, rising to ALL 116.7 billion. Risk-weighted assets rose to ALL 692.9 billion or 8% from a year earlier. As a result, at the end of 2014, the capital adequacy ratio fell to 16.8%.

• 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. To consolidate the risk assessment, we have used some representative indices.

Overall, indices show a deceleration of the risk level during the second half of 2014.
 
Risks to the banking sector, real economy and economic agents are assessed in a single approach by using the Financial Stability Map (FSM). Compared to the end of 2013, the FSM shows that during the period under review, risks to the financial stability were subdued, due to the better performance of economic agents.

In concrete terms, in the case of the 'domestic economy', the increase in the external financing of the public and private sectors, as well as the performance of the exchange rate have contributed to the expansion of risk, whereas the narrowing of the negative output gap has subdued it. For 'households' and 'businesses', the risk is assessed as moderate, benefiting mainly from their better expectations for the outlook of the economy. However, other factors related to the level of unemployment, and the pace and quality of lending  had a negative impact on the size of risk of these economic agents. For the 'government', the risk level is assessed as downward, given the positive performance of income, downward borrowing costs and reduction of the budget deficit. The risk arising from the "external economic environment" has decreased slightly, though it remains at average levels, due to improved unemployment rates in countries with stronger economic relations with Albania and a fall in oil prices. For the banking sector, the risk of 'capitalisation and profitability' and of 'financing and liquidity' is considered as average risk, affected by, respectively, the improvement of the financial result, lowering of the non-performing loan ratio, and differences between short-term assets and liabilities.

Risks to the financial system are assessed using the Financial Systemic Stress Index (FSSI). 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. As at December 2014, the systemic risk is assessed as downward, mainly due to the performance of deposits, credit and net margin of interests during the second half of the year.

Accumulation and materialization phases of systemic risk in the financial system are clearly identified using two specific indices: Risk Accumulation Index and Risk Materialisation Index. As at December 2014, the accumulation of the systemic risk from factors related to the banking sector and the real economy appears as upward compared to the same period in the previous year. The contraction of foreign currency lending and the performance of the housing market mitigated the accumulation of the systemic risk, whereas the increase in the debt level in general and foreign currency debt had an opposite effect. The index on the materialisation of the systemic risk stood slightly up from the previous year, reflecting the credit quality deterioration for businesses and households, the higher unemployment rate and deprecation of the national currency, mainly against the US dollar.

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. For 2014 H2, the industry assesses that the 'worsening of the domestic economy' is the most significant systemic risk, but the perception of the banking sector for this risk has been gradually subduing during 2014. The attention to the risk from 'shocks from the external economy' is up, reflecting the concern over the still-sluggish economy in the euro area, especially in Greece and Italy.

Risks arising from fiscal indicators remain contained. The consolidating trend of the fiscal policy is expected to persist in 2015. Meanwhile, financing of most of public borrowing through foreign sources during this year, if realised as projected, is expected to maintain the pressure on the level of interest rates in the primary market of government debt securities. These factors will diversify the structure of public debt and will keep repayment costs at relatively low levels. At the same time, they will serve to control the size and concentration of financing government borrowing from the banking and non-banking financial sectors, and will serve to create more space for bank lending to the private sector.

Credit risk remains a concern for banking activity. At the end of the period under review, the ratio of non-performing loans to total loans was 22.8%, the lowest in the last two years. The ratio for lek loans stood at 17.5%, down 2.2 percentage points, in annual terms. The ratio for foreign currency loans stood at 26%, up 0.3 percentage points.

Despite the fall in the non-performing loan ratio and the positive impact materialising gradually from the legal improvements and other measures by the authorities, the credit risk remains important. In fact, the insofar experience, shows that legal and regulatory improvements on collateral execution/management, modalities for the taxation of banks in the case of loan write offs from their balance sheets, and restructuring of non-performing loans need to be interpreted and implemented consistently. Legal ambiguities in the process of borrowers' bankruptcy, especially identified in the case of borrowers exposed to more than one bank, emphasise the need for improvements in this regard as well. Moreover, the sale or transfer of the non-performing loans portfolio from banks to specialised non-bank financial institutions is a process that needs to be specified in regulatory requirements and encouraged through different forms, to prevent legal uncertainties and stir up the interest of these institutions. Overall, the process of non-performing loan solution would benefit from a thorough analysis of its performance and difficulties facing it insofar, which would serve as a basis for a coordinated and determined approach by public authorities in order to provide a systematic and definite solution to this problem.

Banking sector exposure to unfavourable fluctuations in the exchange rate and interest rate should be assessed regularly and monitored carefully. The banking sector's open foreign exchange position was long and within the historical levels. Interest rate-sensitive assets and liabilities provide negative difference for maturities up to one year. While the direct impact of exchange rate and interest rate fluctuations is manageable, the banking sector appears sensitive to the negative impact of unfavourable exchange rate and interest rate fluctuations on the situation of the 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 national currency, and variable-rate loans.

Banking sector liquidity risk was moderate. Like before, deposits are the main source of financing for the banking sector. They grew, even faster than in the previous year. Borrowing from non-residents remained moderate. The sector's liquid assets, both in lek and foreign currency, stood above the minimum levels required by the regulatory framework. The 'credit/deposit' ratio was at optimum levels from risk perspective.

Capitalisation indicators were at good levels; however, banks should cautiously assess potential scenarios for future events and their needs for additional capital. During the period under review, the capital adequacy ratio fell, remaining, however, at good levels. Net financial result improved evidently from a year earlier, thanks to the deceleration in non-performing loans, and decrease in 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. Therefore, a cautious and proactive assessment of their needs for additional capital in line with their operational risk profile and their capital increase, when necessary, is a continuous recommendation for banks.

Stress-testing shows that the stability of the banking sector is similar to the previous period. The Bank of Albania conducts regular stress-testing exercises to assess the sensitivity of the main banking sector capitalization figures to changes in macroeconomic indicators and decline in the value of investments in money and securities markets.

For the first exercise that tests the sector's sensitivity to macroeconomic scenarios, the baseline and adverse risk scenarios include assumptions about changes in GDP growth rate, exchange rate and interest rate, and lending, extending through the end of 2016. For the second exercise that tests the sector's sensitivity to the size of loss in the investment value, the scenarios include assumptions about the loss in value of securities.

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 banking sector 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.

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 process and keep risk in their activity under control.