BANK OF ALBANIA STATEMENT
Financial Stability Statement for 2015 H1

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

Economic activity in Albania expanded over the first half of 2015, driven by a boost in private investments - with foreign direct investments an important contributor - and by an improved trade balance. 

The monetary policy easing and the fiscal policy consolidation combined to support the stability of the macroeconomic framework. Volatility of the domestic currency exchange rate and interest rates where low. Government debt securities and interbank market operated normally, amid adequate liquidity conditions. International markets operated within a low interest rate environment, endeavouring to strengthen the global economy upward trend.  

Financial system's activity expanded during the period, up to 103% of the Gross Domestic Product. In the banking sector, the expansion of the activity was driven by interbank investments and credit growth, mainly in favour of non-residents. Banking sector's deposits rose by 4.4% in annual terms, driven both by domestic and foreign currency deposits. The loan portfolio rose by 5.5% in annual terms, driven by both domestic and foreign currency lending, amid downward trend in interest rates. Nevertheless, the loan portfolio grew only by 0.5%, impacted by the write-offs of lost loans from banks' balance sheet, amounting to ALL 11 billion. The write-off of "lost loans" from banking sector's balance sheets enhanced the credit quality of the portfolio. The ratio of non-performing loans to total loans fell to 21%, at the end of the period. Loan portfolio quality improved for both domestic and foreign currency loans, as well as for businesses and households. The banking sector's financial performance improved on annual basis, mainly a result of operational costs control. The largest banks have provided the main contribution to the sector's financial performance. 

Overall, positive developments in the real economy and in the banking sector contributed to the strengthening of the financial stability during the period, as evidenced by the performance of the respective indices. However, risks remain present. More concretely:

a) The level of non-performing loans is yet considered as high. The dynamics in non-performing loans during the period were reflected in the increase of loan loss provisions by the banking sector. The high ratio of collateralized non-performing loans enables banks to recover its value; however, the concentration of collateral in "real estate" type and lack of proper functioning of this market during collateral foreclosure, make this process complex and uncertain. On the other hand, agents' expectations have not yet factorized an acceleration of the economic growth, further impacting their consumption and investments plans. The need of a faster economic growth as an important factor for further deepening of the financial intermediation has been identified by the banking industry as well. For such reasons, loan demand and supply are esteemed to be below their potential, reflecting difficulties impacting non performing loans' resolution.

 Under these circumstances, the Bank of Albania will:

• require banks to maintain adequate capital and liquidity levels, whilst they strictly identify non-performing loans;
• monitor the accomplishment of the common Action Plan with the Government, for lowering non-performing loans level, focusing on legal and regulatory enhancements;
• maintain a close communication with the banking industry, to assess problems that may arise in the framework of collateral foreclosure, aiming at identifying the necessary actions for improving the process itself. 

b) The short-term maturity and the current structure of the banking sector liabilities does not provide the necessary support for a sustainable revival of the lending process, and exposes the sector to the interest rate risk. The banking sector's liabilities have historically been short-term ones, thus determining the structure and size of its assets, as well as the structure and size of the loan portfolio. Currently, liabilities' structure reflects a further increase in the demand deposits' share, due to the downward cycle of interest rates. The increase in short-term liabilities is accompanied with the need to increase the sector's liquid assets and might affect the shortening of the time horizon of its long-term investments. Also, it increases the sensitivity of banks' balance sheet items' to interest rate risk, in case of a rapid increase of the rates. Bank of Albania deems that banks should be more proactive in developing and merchandising products that generate long-term financing sources, which improve the balance and the structure of their liabilities.  

c) Developments in international markets will be regularly monitored and assessed whether they generate volatility in the domestic financial market. One of these developments is the possibility of a global economic growth acceleration and the resumption of a tight monetary policy cycle in advanced economies. Although still uncertain, this development may affect the country by inducing volatility in financial flows and domestic exchange rate against major foreign currencies. According to the balance of payments, financial flows in the form of foreign direct investments, representing long-term and sustainable investment decisions, prevail the inflows in the economy. Temporary portfolio financial flows are not important; hence the effect through this channel might be limited. On the other hand, short-term exchange rate performance reflects the movement of financial flows as well. Considering all other elements as invariable, the lack of temporary financial flows contributes to maintaining low volatility in the exchange rate. The implementation of the new agreement between Greece and the institutional creditors should be monitored carefully, particularly the way banking sector would rebound to normality. Core expectations forecast that the parties will abide by the agreement, and that the Greek banking sector, as part of this agreement, will be recapitalised thanks to the measures taken for the restructuring of its activity and the injection of fresh capital. The Bank of Albania will regularly assess the implementation of this agreement and its effects, and will regularly communicate its position to the public and other interested parties.

d) The banking sector is exposed to fluctuations in the exchange rate and interest rate. The most probable transmission channel, in this case, is the size of foreign currency denominated loan portfolio, if borrower's income are in the domestic currency. At the end of the period, foreign currency loans accounted for 27% of business loan portfolio versus 31% of households. Although these ratios have decreased during the period in consideration, overall, the debt position of businesses declined and the loan quality of businesses and households improved, whilst exchange rate fluctuations are considered as important in terms of their solvency. Over the last couple of years, the upward trend of expanding domestic currency loan portfolio has diminished this exposure; therefore, the banking sector and economic agents should further support such trend. Due to the mismatch between assets and liabilities sensitive to interest rate, the sector is exposed to a rapid increase in the interest rates itself. Although the probability of such event is actually low, banks should incorporate the assessment of this risk in their analyses, and act to minimise it if deemed important.

e) The considerable size of banking sectors' investments in Government debt securities dictates the need to improve the size and the depth of the market, where these securities are traded, as an important instrument to manage and minimize respective risks. Banking sector's investments in Government debt securities accounts for around 60% of the domestic debt, and around 25% of their assets' value. This considerable concentration exposes the parties to the reciprocal financial and sustainability performance. The measures for controlling debt levels and expanding this market to other non-banking participants, will further contribute to lowering this dependence. Also, the short term average maturity of the debt exposes the investment risk of non-renovation in debt securities by investing entities. The continuing shift of issued government debt securities toward longer maturities, and the continuous communication between the parties, contributes to mitigating such risk. On the other hand, the prolongation of the debt maturity term, if not accompanied with a proportional increase in liabilities maturity term, exposes banks to an interest rate increase risk and encourages their hesitation to further invest in securities. This risk would decline, if the absorbing capacity of the secondary market, where these securities are traded, improves. The shift of government's borrowing toward foreign currency borrowing in external market limits the banking sector's exposure to the Government. Since borrowing mainly occurs with international financial institutions, and generally at low interest rates, it might affect the improvement in Government's debt service structure. Nevertheless, this borrowing exposes the Government to fluctuations in domestic exchange rate and highlights the need for a careful planning and usage of its foreign currency assets.   

The banking sector financial performance is assessed as good and stable. Indicators of the capitalisation and liquidity stand at good levels and the banking sector generates profit. Therefore, its resilience to various shocks has strengthened over the period. This is also confirmed by the stress test exercise in accordance with macroeconomic scenarios and various risks for the liquidity situation.

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

Economic activity in Albania expanded over the first half of 2015, driven by a boost in private investments - with foreign direct investments an important contributor - and by an improved trade balance. 

The monetary policy easing and the fiscal policy consolidation combined to support the stability of the macroeconomic framework. Volatility of the domestic currency exchange rate and interest rates where low. Government debt securities and interbank market operated normally, amid adequate liquidity conditions. International markets operated within a low interest rate environment, endeavouring to strengthen the global economy upward trend.  

Financial system's activity expanded during the period, up to 103% of the Gross Domestic Product. In the banking sector, the expansion of the activity was driven by interbank investments and credit growth, mainly in favour of non-residents. Banking sector's deposits rose by 4.4% in annual terms, driven both by domestic and foreign currency deposits. The loan portfolio rose by 5.5% in annual terms, driven by both domestic and foreign currency lending, amid downward trend in interest rates. Nevertheless, the loan portfolio grew only by 0.5%, impacted by the write-offs of lost loans from banks' balance sheet, amounting to ALL 11 billion. The write-off of "lost loans" from banking sector's balance sheets enhanced the credit quality of the portfolio. The ratio of non-performing loans to total loans fell to 21%, at the end of the period. Loan portfolio quality improved for both domestic and foreign currency loans, as well as for businesses and households. The banking sector's financial performance improved on annual basis, mainly a result of operational costs control. The largest banks have provided the main contribution to the sector's financial performance. 

Overall, positive developments in the real economy and in the banking sector contributed to the strengthening of the financial stability during the period, as evidenced by the performance of the respective indices. However, risks remain present. More concretely:

a) The level of non-performing loans is yet considered as high. The dynamics in non-performing loans during the period were reflected in the increase of loan loss provisions by the banking sector. The high ratio of collateralized non-performing loans enables banks to recover its value; however, the concentration of collateral in "real estate" type and lack of proper functioning of this market during collateral foreclosure, make this process complex and uncertain. On the other hand, agents' expectations have not yet factorized an acceleration of the economic growth, further impacting their consumption and investments plans. The need of a faster economic growth as an important factor for further deepening of the financial intermediation has been identified by the banking industry as well. For such reasons, loan demand and supply are esteemed to be below their potential, reflecting difficulties impacting non performing loans' resolution.

 Under these circumstances, the Bank of Albania will:

• require banks to maintain adequate capital and liquidity levels, whilst they strictly identify non-performing loans;
• monitor the accomplishment of the common Action Plan with the Government, for lowering non-performing loans level, focusing on legal and regulatory enhancements;
• maintain a close communication with the banking industry, to assess problems that may arise in the framework of collateral foreclosure, aiming at identifying the necessary actions for improving the process itself. 

b) The short-term maturity and the current structure of the banking sector liabilities does not provide the necessary support for a sustainable revival of the lending process, and exposes the sector to the interest rate risk. The banking sector's liabilities have historically been short-term ones, thus determining the structure and size of its assets, as well as the structure and size of the loan portfolio. Currently, liabilities' structure reflects a further increase in the demand deposits' share, due to the downward cycle of interest rates. The increase in short-term liabilities is accompanied with the need to increase the sector's liquid assets and might affect the shortening of the time horizon of its long-term investments. Also, it increases the sensitivity of banks' balance sheet items' to interest rate risk, in case of a rapid increase of the rates. Bank of Albania deems that banks should be more proactive in developing and merchandising products that generate long-term financing sources, which improve the balance and the structure of their liabilities.  

c) Developments in international markets will be regularly monitored and assessed whether they generate volatility in the domestic financial market. One of these developments is the possibility of a global economic growth acceleration and the resumption of a tight monetary policy cycle in advanced economies. Although still uncertain, this development may affect the country by inducing volatility in financial flows and domestic exchange rate against major foreign currencies. According to the balance of payments, financial flows in the form of foreign direct investments, representing long-term and sustainable investment decisions, prevail the inflows in the economy. Temporary portfolio financial flows are not important; hence the effect through this channel might be limited. On the other hand, short-term exchange rate performance reflects the movement of financial flows as well. Considering all other elements as invariable, the lack of temporary financial flows contributes to maintaining low volatility in the exchange rate. The implementation of the new agreement between Greece and the institutional creditors should be monitored carefully, particularly the way banking sector would rebound to normality. Core expectations forecast that the parties will abide by the agreement, and that the Greek banking sector, as part of this agreement, will be recapitalised thanks to the measures taken for the restructuring of its activity and the injection of fresh capital. The Bank of Albania will regularly assess the implementation of this agreement and its effects, and will regularly communicate its position to the public and other interested parties.

d) The banking sector is exposed to fluctuations in the exchange rate and interest rate. The most probable transmission channel, in this case, is the size of foreign currency denominated loan portfolio, if borrower's income are in the domestic currency. At the end of the period, foreign currency loans accounted for 27% of business loan portfolio versus 31% of households. Although these ratios have decreased during the period in consideration, overall, the debt position of businesses declined and the loan quality of businesses and households improved, whilst exchange rate fluctuations are considered as important in terms of their solvency. Over the last couple of years, the upward trend of expanding domestic currency loan portfolio has diminished this exposure; therefore, the banking sector and economic agents should further support such trend. Due to the mismatch between assets and liabilities sensitive to interest rate, the sector is exposed to a rapid increase in the interest rates itself. Although the probability of such event is actually low, banks should incorporate the assessment of this risk in their analyses, and act to minimise it if deemed important.

e) The considerable size of banking sectors' investments in Government debt securities dictates the need to improve the size and the depth of the market, where these securities are traded, as an important instrument to manage and minimize respective risks. Banking sector's investments in Government debt securities accounts for around 60% of the domestic debt, and around 25% of their assets' value. This considerable concentration exposes the parties to the reciprocal financial and sustainability performance. The measures for controlling debt levels and expanding this market to other non-banking participants, will further contribute to lowering this dependence. Also, the short term average maturity of the debt exposes the investment risk of non-renovation in debt securities by investing entities. The continuing shift of issued government debt securities toward longer maturities, and the continuous communication between the parties, contributes to mitigating such risk. On the other hand, the prolongation of the debt maturity term, if not accompanied with a proportional increase in liabilities maturity term, exposes banks to an interest rate increase risk and encourages their hesitation to further invest in securities. This risk would decline, if the absorbing capacity of the secondary market, where these securities are traded, improves. The shift of government's borrowing toward foreign currency borrowing in external market limits the banking sector's exposure to the Government. Since borrowing mainly occurs with international financial institutions, and generally at low interest rates, it might affect the improvement in Government's debt service structure. Nevertheless, this borrowing exposes the Government to fluctuations in domestic exchange rate and highlights the need for a careful planning and usage of its foreign currency assets.   

The banking sector financial performance is assessed as good and stable. Indicators of the capitalisation and liquidity stand at good levels and the banking sector generates profit. Therefore, its resilience to various shocks has strengthened over the period. This is also confirmed by the stress test exercise in accordance with macroeconomic scenarios and various risks for the liquidity situation.