BANK OF ALBANIA STATEMENT
Financial Stability Statement for 2016 H2

Pursuant to provisions under Article 69 of the Law No. 8269, dated 23.12.1997 "On the Bank of Albania", as amended, and Article 8 of the Law No. 9962, dated 18.12.2006 "On banks in the Republic of Albania", as amended, to inform the Assembly and the Council of Ministers of the Republic of Albania, and promote the awareness of financial institutions and of the public at large on the situation of the Albanian financial system 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 Financial Stability Report and the Statement prefacing it assess the exposure of the banking sector to risks arising from its interaction with the external and internal economic developments, real economy agents, financial markets in Albania, as well as operational risk in the activity of the banking sector. In addition, these risks face the financial situation of the banking sector and are stressed through the stress test to assess the banking sector's resilience.

The Bank of Albania considers the activity of the banking sector and of the overall financial system has been stable during 2016 H2. Overall, the banking sector’s exposure to various risks remains contained and the main activity indicators related to capitalization, liquidity and profitability show its full capacity to withstand operational risks under normal conditions, and show good resilience against stronger shocks.

Highlights in economic and financial developments

Developments in the global economy over the period were overall positive, despite differences across major regions and in economic policies. This performance was driven mainly by more favourable financing conditions in the markets, continuation of growth promoting policies in most advanced and emerging economies, and the rise in commodity and oil prices. The latter’s performance has contributed to the upward inflationary pressures, although they remain overall below central bank targets. In global financial markets, fluctuations in interest and exchange rates have been more notable in the last months of the year, mirroring primarily certain significant political and economic developments in advanced economies. Euro area economy expanded at a moderate but steady pace during the period. Economic activity expanded in most countries of this region, driven mainly by the improvement in domestic demand and positive contributions from inventories in the private sector. The economies in the Western Balkan countries grew at positive rates in 2016, accompanied with an improvement in labour market conditions. The financial situation of European banking groups that operate in Albania remains overall stable. For some of them, the activity contracted over 2016, following the processes for lowering debt and cleaning balance sheets from non-performing loans.

The positive performance of the global economy is expected to persist over 2017-2018, driven by the continuing gradual economic growth in advanced economies and intensification of the positive contribution by emerging economies. In the euro area, the positive effect from the accommodative monetary policy on private consumption and investments will continue to support economic growth. However, political developments in advanced economies and the possibility for them to be accompanied by changes in economic policies are considered currently as the main factors that may contribute to the global economy outlook.

As a result of a further improvement of the global economy, including the euro area and the Balkan region countries, the positive contribution by the external sector to the performance of the Albanian economy will edge upwards. In fact, this contribution appeared stronger in the performance of the balance of payments for 2016 Q4, when the current account deficit decreased following the increase in the positive surplus in the services account and a better performance of exports. Overall, Albania's economic growth in 2016 Q4 accelerated, recording almost 4% growth rate. By sector of the economy, services and production provided positive contribution to economic growth. The growth in economic activity was accompanied by a further drop in unemployment, both in annual and quarterly terms, to 14.2% at the end of the year. At the end of the period, the consolidating fiscal policy resulted in a significant narrowing of the budget deficit for 2016. The deficit was mainly funded with foreign funds, thus reducing the Government's need for borrowing in the domestic market, compared to the previous year. During the period, the Bank of Albania continued to implement an accommodative monetary policy stance, in response to contained inflationary pressures.

In financial markets, the average yield on government debt securities, both long and short-term, shifted slightly upward, but resulted lower than in the previous year. In the interbank market, banks traded lower volumes at interest rates constantly below or close to the policy rate, reflecting a stable liquidity situation. In the currency exchange market, during the period, the Albanian lek appreciated against the European currency and depreciated slightly against the US dollar. In annual terms, the lek appreciated against both major currencies. Following the lowering of the policy rate and improvement of the quality of credit for real estate, the conditions for obtaining this credit have become more favourable and have supported better the housing market. This is evidenced in house prices; surveys show an increase in the price index and a somewhat more optimistic outlook for developments in this market.

During the period, households and enterprises continued to be inclined towards net savings, thus conducing to an expansion of the households’ credit position and narrowing of the enterprises debt position. This performance was driven by the faster growth in foreign currency deposits. Households borrowing accelerated to 3.7% in annual terms, realised totally in Albanian lek. The credit quality for households improved during the period. Improvement was most notable in the foreign currency credit and unhedged credit from unfavourable volatility in the exchange rate. Loans to enterprises, which represent almost 67% of the total credit, expanded by 2.4% in annual terms, directed mainly towards non-resident entities. In the structure of loans to enterprises, lek credit as well as a preference of small and medium-sized enterprises both increased. The credit quality for enterprises also improved during the period. Overall, the process of cleaning the banks’ balance sheets from lost loans contributed to the improvement of the credit quality.

During the period, the activity of the financial system expanded and the other indicators were overall stable. The banking sector accelerated the expansion of its activity, increasing its share to 94.9% of the Gross Domestic Product (GDP). It resulted in profit and adequate capital and liquidity ratios. In the banking sector activity, in annual terms, the transactions in securities (increase), other investments (increase) and reserve funds, contributed most to change in balance assets, whereas treasury and interbank transactions (increase), deposits (increase) and permanent resources (increase) contributed most to change in balance liabilities. From a year earlier, the banking sector expanded the credit position with non-residents and increased the loans outstanding by 2.5% and the deposit stock by 5.2%. The non-banking sector maintained its share in GDP and its performance has contributed to the expansion of activity in non-bank financial institutions and insurance companies. For the non-banking sector, investments in Albanian government securities are significant, although in 2016 such investments recorded a decline. Direct exposure of the non-banking sector to the banking sector is assessed as low, whereas the banking sector’s stability remains a critically important factor for the activity and stability of the non-banking sector.

Banking sector’s exposure to operational risks

In relation to operational risks to the banking sector, the Bank of Albania deems that:

a) Credit risk scaled down during the period; however, it remained close to levels recorded in the previous year. The absolute value of non-performing loans fell by 8% and the ratio of non-performing loans fell by 1.7 percentage points, to 18.3%. The banks actions to collect, restructure and write off (lost loans) from their balance sheets contributed to the reduction of non-performing loans. The reduction of non-performing loans showed a better distribution in terms of sector, currency, and bank. This reduction was accompanied by an improvement in their coverage with reserve funds and capital, whereas the level of loan collateralisation has remained stable.

The reduction in the value of non-performing loans during the period, their better distribution and improvement of provisioning indicators are positive and encouraging developments. The reduction of non-performing loans in the banking sector will gain more stability if expectations materialise for an improvement of both economic growth and functioning of the relevant institutional and legal infrastructure in this process. However, taking into account that determinant factors in this process are diverse and contain uncertainties about the way they develop, the Bank of Albania urges banks to keep their focus on this critical process for a steady growth of their activity, engaging the necessary financial resources and expertise for reducing non-performing loans. A professional analysis at the phase of granting the credit, the effective monitoring and due restructuring are fundamental actions for lowering the probability of a borrower's default (and reduction of non-performing loans flows), whereas the actions related to provisioning, execution of collateral and lost loans write off should, in parallel, contribute to the early recognition and reduction of the stock of non-performing loans.

b) Liquidity risk in the banking activity is assessed as low. The low credit-to-deposit ratio, the continuation of credit growth and the high presence of liquid assets above minimum requirements of the regulatory framework point to a good liquidity situation of the banking sector, both in general and by main currency. During the period, the coverage of current liabilities with liquid assets fell slightly, but as long as they remain significantly above the minimum requirements set out in the regulatory framework, this development should reflect a better utilisation of financial resources by the banking sector. The good liquidity situation of the sector was proven also by a special stress test, based on data for November 2016.

The liquidity capacity of the banking sector by currency, in addition to the adequacy of liquid assets of the banks, should be also assessed in accordance with its ability to convert liquid assets into cash, quickly and without any significant cost. For the national currency, if needed, this process is facilitated through relevant central bank operations with banks, in accordance with the legal stipulations and best standards. If these instruments were to be adjusted for the foreign currency as well, this process would require increasing foreign currency resources of the central bank. Yet, in the case of an emerging economy, such as Albania, this process bears costs for the central bank. As a rule, while not taking into account other factors, the liquid capacities of the banking sector are better in the national currency versus the foreign currency; therefore, the liquidity risk is higher for the foreign currency versus the national currency. For these reasons, it is necessary for it to be introduced in the requirements for banks for a higher level of liquid assets in foreign currency than in the national currency. From a longer-term perspective, the reduction of banks’ foreign currency activity would diminish this source of risk and contribute positively to financial stability.

c) The banking sector remains significantly exposed to market risk (including the exchange rate risk and interest rate risk) regardless of the reduction in the exposure size during the period.

While the open foreign currency position in the balance sheet remains close to the historic levels and the foreign currency credit unhedged against unfavourable exchange rate volatility has a lower share in credit outstanding, the latter is considered to be at high levels and the banking sector’s exposure to exchange rate risk is significant. The increase in foreign currency deposits of the banking sector, against the narrowing of the spread in the average interest rate on lek and foreign currency ones, bears the potential for it to be channelled into foreign currency credit (where a considerable part would be again unhedged against the exchange rate), if credit demand picks up. This would reverse the downward trend of foreign currency credit in recent years. The process is in itself a reinforcing one because, through the currency creation process, foreign currency credit contributes to the expansion of foreign currency deposits, and so on. If this trend materialised, the narrowing of the national currency credit channel and the increase of the banking sector and economic agents’ sensitivity to exchange rate volatility would affect the ability of the central bank's monetary policy to use its transmission channels effectively.

Therefore, in this case, when taking into account factors that have led to higher euroisation levels in the banking sector and assessing with priority the risks it poses to financial stability and monetary policy effectiveness, it is necessary, in addition to the attention to maintain balanced foreign currency positions in the banks and economic agents’ balance sheets, to aim through a sustainable strategy and realistic long-term objectives, at lowering the euroisation level in the financial system at more appropriate levels. In this context, the Bank of Albania is assessing the need for concrete actions which will aim at maintaining an appropriate positive spread between the average rate between the Albanian lek and major currencies, and raise the awareness of borrowers about risks accompanying unjustified foreign currency borrowing. Aware of the complexity of the phenomenon, the Bank of Albania will seek the cooperation of other public authorities for this purpose.

As regards the interest rate risk, it appears more mitigated but remains nonetheless present in the banking activity in both its direct and indirect form. In the direct form, the risk is transmitted through the gap that exists between assets and liabilities of the banking sector by repricing periods, and sensitivity of certain assets to interest rate fluctuations. This gap is negative, but it has narrowed somewhat during the period. The risk would materialize in case of an increase in the interest rate which due to the negative gap would affect faster the operational costs of the bank, compared to its revenues. In addition, the assumed increase in the interest rate would affect negatively (and initially) the value of bank assets sensitive to interest rate fluctuations, such as long-term securities. This risk has an indirect component which is related to the negative effect from the increase in interest rates on borrowers with variable interest rate loans. Also in this case, it is necessary for banks to quantitatively assess the impact of adverse scenarios and work towards containing the exposure to risk. In the meantime, the interest rate risk remains especially necessary to be assessed in the activity of life insurance companies, investment funds and private supplementary pension funds.

ç) Banks systems in place for assessing and controlling operational risk need improving.

While banks reporting show an improvement of coverage with capital of overall operational risks, the supervisory activity of the Bank of Albania has identified the need to further improve the process for the identification and reporting of operational losses in accordance with the profile of the bank’s activity. Also, in response to the infringement of the physical security in the activity of transporting cash funds during the previous year, the Bank of Albania has strengthened the minimum requirements in the relevant regulatory acts, mainly with regard to planning, preparing, monitoring and supervising the compliance with the relevant procedures by the special security units in banks. In the framework of this matter, during 2016, the Bank of Albania has cooperated constantly with the Albanian State Police, contributing to improving the sub-legal acts about the transportation of monetary values. Looking forward, the Bank of Albania will strengthen the focus for assessing the adequacy of banks systems for controlling operational risk, as part of regular inspections at supervised institutions.

d) The contraction of the activity in some of the European banking groups that operate in Albania keeps the stimuli for restructuring the activity, including the change of their network in countries outside the EU.

This phenomenon has been more notable in Central European and Balkan countries, but Albania has not been affected insofar, in relative terms, by this phenomenon. The experience of other countries shows that if the process is well coordinated among all the stakeholders, the exit of a banking group from a certain market may be accompanied by the entry of other valuable investors, who may introduce additional capacities and other priorities in the local banking sector. These changes may yield a positive effect on the banking sector and financial system structure and increase its contribution to bolstering economic growth. The process contains also uncertainties related to the actual phase of the economic and financial cycle in the European Union and the region, as well as the potential of the regional countries to stir the interest of new and valuable investors. It is difficult to determine to what extent and way this process may affect the Albanian subsidiaries of European banking groups. In any case, the Bank of Albania and other authorities in Albania will strengthen their monitoring and evaluating capacities as well as cooperation, in order for the processes to take place in accordance with the legal requirements and the ultimate objective of safeguarding the stability of the financial system in Albania.

Risks to financial stability

For the assessment of systemic risks, the performance of indicators related to the materialization and accumulation of the systematic risk is analysed, with the stress level in the financial system and with the banking industry perception regarding the banking activity exposure to systemic risk. Also, the financial stability map aims to achieve a consolidated approach of risks to financial stability.

Overall, the indices do not show an increase in risks to the financial stability during the period. The lower profit of the banking sector and the slight fall in liquidity indicators (yet, they remain at high levels) are offset by more positive developments in the real economy, with an improvement of economic growth and economic situation for both households and enterprises. The accumulation of risks has been weaker due to the contraction in foreign currency credit, improvement of public debt indicators, and the more positive performance of the real estate market. On the other hand, the probability of materialisation for the systemic risk has reduced, given that the credit quality has improved, unemployment has fallen and exchange rate volatility has been low.

The banking sector's ability to withstand risks

The banking sector's ability to withstand risks is assessed by analysing its capitalization and profitability situation, and by stressing these indicators using the stress test.

At the end of the period, the capital adequacy ratio for the banking sector stood at 15.7%, notably above the 12% required minimum for this indicator. This performance was determined by the increase in risk-weighted assets by almost 4.3% (downward impact on the indicator) and the regulatory capital appreciation by almost 3.8% (upward impact on the indicator). Financial leverage, measured as the ratio of total assets to shareholders' equity was 10.3 times and is considered to be at good level. Maintaining a good capital position is determined also by the performance of the sectors' financial result. In 2016, the banking sectors profit amounted to around ALL 9.3 billion, standing lower on a year earlier. The fall in net interest income and the increase of the provisioning for credit risk contributed to the decline in profit. The fall in net revenues from interests reflected the fall in return from investments, for financial instruments both in foreign currency and in lek, at a faster pace than the fall in expenditure for them. The increase in provisioning for credit risk reflected the shift of non-performing loans toward more extreme classes. Sector profitability indicators, return on assets (RoA) and return on equity (ROE) were 0.7% and 7.2%, respectively.

The adequacy of the above indices has been proven during the stress test with scenarios that assumed adverse changes in macroeconomic and financial indicators for the 2017-2018 period. In the adverse scenario, the contraction of the economy, contraction of credit, rapid growth of interest rates and strong depreciation of the exchange rate, were included as part of the extreme assumptions, but with a low probability of occurrence. The results of the stress test showed that in the baseline and the moderate scenarios, the banking sector remains capitalized, but would need a capital raise in the adverse scenario. Additional capital requirement for specific banks is evident in the adverse scenario.

Based on this analysis, the Bank of Albania considers that capitalization and profitability of banks is adequate for coping with operational risks. Nonetheless, the sensitivity to risks is specific for each bank, depending on its profile and capacities to cope with risks. Therefore, the Bank of Albania reiterates the need for regularly assessing such risks by each bank, undertaking the necessary risks for mitigating them and maintaining capitalisation indicators.

¹ According to the IMF’s outlook, global growth over 2017-2018 is projected around 3.4-3.6 per cent.

Pursuant to provisions under Article 69 of the Law No. 8269, dated 23.12.1997 "On the Bank of Albania", as amended, and Article 8 of the Law No. 9962, dated 18.12.2006 "On banks in the Republic of Albania", as amended, to inform the Assembly and the Council of Ministers of the Republic of Albania, and promote the awareness of financial institutions and of the public at large on the situation of the Albanian financial system 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 Financial Stability Report and the Statement prefacing it assess the exposure of the banking sector to risks arising from its interaction with the external and internal economic developments, real economy agents, financial markets in Albania, as well as operational risk in the activity of the banking sector. In addition, these risks face the financial situation of the banking sector and are stressed through the stress test to assess the banking sector's resilience.

The Bank of Albania considers the activity of the banking sector and of the overall financial system has been stable during 2016 H2. Overall, the banking sector’s exposure to various risks remains contained and the main activity indicators related to capitalization, liquidity and profitability show its full capacity to withstand operational risks under normal conditions, and show good resilience against stronger shocks.

Highlights in economic and financial developments

Developments in the global economy over the period were overall positive, despite differences across major regions and in economic policies. This performance was driven mainly by more favourable financing conditions in the markets, continuation of growth promoting policies in most advanced and emerging economies, and the rise in commodity and oil prices. The latter’s performance has contributed to the upward inflationary pressures, although they remain overall below central bank targets. In global financial markets, fluctuations in interest and exchange rates have been more notable in the last months of the year, mirroring primarily certain significant political and economic developments in advanced economies. Euro area economy expanded at a moderate but steady pace during the period. Economic activity expanded in most countries of this region, driven mainly by the improvement in domestic demand and positive contributions from inventories in the private sector. The economies in the Western Balkan countries grew at positive rates in 2016, accompanied with an improvement in labour market conditions. The financial situation of European banking groups that operate in Albania remains overall stable. For some of them, the activity contracted over 2016, following the processes for lowering debt and cleaning balance sheets from non-performing loans.

The positive performance of the global economy is expected to persist over 2017-2018, driven by the continuing gradual economic growth in advanced economies and intensification of the positive contribution by emerging economies. In the euro area, the positive effect from the accommodative monetary policy on private consumption and investments will continue to support economic growth. However, political developments in advanced economies and the possibility for them to be accompanied by changes in economic policies are considered currently as the main factors that may contribute to the global economy outlook.

As a result of a further improvement of the global economy, including the euro area and the Balkan region countries, the positive contribution by the external sector to the performance of the Albanian economy will edge upwards. In fact, this contribution appeared stronger in the performance of the balance of payments for 2016 Q4, when the current account deficit decreased following the increase in the positive surplus in the services account and a better performance of exports. Overall, Albania's economic growth in 2016 Q4 accelerated, recording almost 4% growth rate. By sector of the economy, services and production provided positive contribution to economic growth. The growth in economic activity was accompanied by a further drop in unemployment, both in annual and quarterly terms, to 14.2% at the end of the year. At the end of the period, the consolidating fiscal policy resulted in a significant narrowing of the budget deficit for 2016. The deficit was mainly funded with foreign funds, thus reducing the Government's need for borrowing in the domestic market, compared to the previous year. During the period, the Bank of Albania continued to implement an accommodative monetary policy stance, in response to contained inflationary pressures.

In financial markets, the average yield on government debt securities, both long and short-term, shifted slightly upward, but resulted lower than in the previous year. In the interbank market, banks traded lower volumes at interest rates constantly below or close to the policy rate, reflecting a stable liquidity situation. In the currency exchange market, during the period, the Albanian lek appreciated against the European currency and depreciated slightly against the US dollar. In annual terms, the lek appreciated against both major currencies. Following the lowering of the policy rate and improvement of the quality of credit for real estate, the conditions for obtaining this credit have become more favourable and have supported better the housing market. This is evidenced in house prices; surveys show an increase in the price index and a somewhat more optimistic outlook for developments in this market.

During the period, households and enterprises continued to be inclined towards net savings, thus conducing to an expansion of the households’ credit position and narrowing of the enterprises debt position. This performance was driven by the faster growth in foreign currency deposits. Households borrowing accelerated to 3.7% in annual terms, realised totally in Albanian lek. The credit quality for households improved during the period. Improvement was most notable in the foreign currency credit and unhedged credit from unfavourable volatility in the exchange rate. Loans to enterprises, which represent almost 67% of the total credit, expanded by 2.4% in annual terms, directed mainly towards non-resident entities. In the structure of loans to enterprises, lek credit as well as a preference of small and medium-sized enterprises both increased. The credit quality for enterprises also improved during the period. Overall, the process of cleaning the banks’ balance sheets from lost loans contributed to the improvement of the credit quality.

During the period, the activity of the financial system expanded and the other indicators were overall stable. The banking sector accelerated the expansion of its activity, increasing its share to 94.9% of the Gross Domestic Product (GDP). It resulted in profit and adequate capital and liquidity ratios. In the banking sector activity, in annual terms, the transactions in securities (increase), other investments (increase) and reserve funds, contributed most to change in balance assets, whereas treasury and interbank transactions (increase), deposits (increase) and permanent resources (increase) contributed most to change in balance liabilities. From a year earlier, the banking sector expanded the credit position with non-residents and increased the loans outstanding by 2.5% and the deposit stock by 5.2%. The non-banking sector maintained its share in GDP and its performance has contributed to the expansion of activity in non-bank financial institutions and insurance companies. For the non-banking sector, investments in Albanian government securities are significant, although in 2016 such investments recorded a decline. Direct exposure of the non-banking sector to the banking sector is assessed as low, whereas the banking sector’s stability remains a critically important factor for the activity and stability of the non-banking sector.

Banking sector’s exposure to operational risks

In relation to operational risks to the banking sector, the Bank of Albania deems that:

a) Credit risk scaled down during the period; however, it remained close to levels recorded in the previous year. The absolute value of non-performing loans fell by 8% and the ratio of non-performing loans fell by 1.7 percentage points, to 18.3%. The banks actions to collect, restructure and write off (lost loans) from their balance sheets contributed to the reduction of non-performing loans. The reduction of non-performing loans showed a better distribution in terms of sector, currency, and bank. This reduction was accompanied by an improvement in their coverage with reserve funds and capital, whereas the level of loan collateralisation has remained stable.

The reduction in the value of non-performing loans during the period, their better distribution and improvement of provisioning indicators are positive and encouraging developments. The reduction of non-performing loans in the banking sector will gain more stability if expectations materialise for an improvement of both economic growth and functioning of the relevant institutional and legal infrastructure in this process. However, taking into account that determinant factors in this process are diverse and contain uncertainties about the way they develop, the Bank of Albania urges banks to keep their focus on this critical process for a steady growth of their activity, engaging the necessary financial resources and expertise for reducing non-performing loans. A professional analysis at the phase of granting the credit, the effective monitoring and due restructuring are fundamental actions for lowering the probability of a borrower's default (and reduction of non-performing loans flows), whereas the actions related to provisioning, execution of collateral and lost loans write off should, in parallel, contribute to the early recognition and reduction of the stock of non-performing loans.

b) Liquidity risk in the banking activity is assessed as low. The low credit-to-deposit ratio, the continuation of credit growth and the high presence of liquid assets above minimum requirements of the regulatory framework point to a good liquidity situation of the banking sector, both in general and by main currency. During the period, the coverage of current liabilities with liquid assets fell slightly, but as long as they remain significantly above the minimum requirements set out in the regulatory framework, this development should reflect a better utilisation of financial resources by the banking sector. The good liquidity situation of the sector was proven also by a special stress test, based on data for November 2016.

The liquidity capacity of the banking sector by currency, in addition to the adequacy of liquid assets of the banks, should be also assessed in accordance with its ability to convert liquid assets into cash, quickly and without any significant cost. For the national currency, if needed, this process is facilitated through relevant central bank operations with banks, in accordance with the legal stipulations and best standards. If these instruments were to be adjusted for the foreign currency as well, this process would require increasing foreign currency resources of the central bank. Yet, in the case of an emerging economy, such as Albania, this process bears costs for the central bank. As a rule, while not taking into account other factors, the liquid capacities of the banking sector are better in the national currency versus the foreign currency; therefore, the liquidity risk is higher for the foreign currency versus the national currency. For these reasons, it is necessary for it to be introduced in the requirements for banks for a higher level of liquid assets in foreign currency than in the national currency. From a longer-term perspective, the reduction of banks’ foreign currency activity would diminish this source of risk and contribute positively to financial stability.

c) The banking sector remains significantly exposed to market risk (including the exchange rate risk and interest rate risk) regardless of the reduction in the exposure size during the period.

While the open foreign currency position in the balance sheet remains close to the historic levels and the foreign currency credit unhedged against unfavourable exchange rate volatility has a lower share in credit outstanding, the latter is considered to be at high levels and the banking sector’s exposure to exchange rate risk is significant. The increase in foreign currency deposits of the banking sector, against the narrowing of the spread in the average interest rate on lek and foreign currency ones, bears the potential for it to be channelled into foreign currency credit (where a considerable part would be again unhedged against the exchange rate), if credit demand picks up. This would reverse the downward trend of foreign currency credit in recent years. The process is in itself a reinforcing one because, through the currency creation process, foreign currency credit contributes to the expansion of foreign currency deposits, and so on. If this trend materialised, the narrowing of the national currency credit channel and the increase of the banking sector and economic agents’ sensitivity to exchange rate volatility would affect the ability of the central bank's monetary policy to use its transmission channels effectively.

Therefore, in this case, when taking into account factors that have led to higher euroisation levels in the banking sector and assessing with priority the risks it poses to financial stability and monetary policy effectiveness, it is necessary, in addition to the attention to maintain balanced foreign currency positions in the banks and economic agents’ balance sheets, to aim through a sustainable strategy and realistic long-term objectives, at lowering the euroisation level in the financial system at more appropriate levels. In this context, the Bank of Albania is assessing the need for concrete actions which will aim at maintaining an appropriate positive spread between the average rate between the Albanian lek and major currencies, and raise the awareness of borrowers about risks accompanying unjustified foreign currency borrowing. Aware of the complexity of the phenomenon, the Bank of Albania will seek the cooperation of other public authorities for this purpose.

As regards the interest rate risk, it appears more mitigated but remains nonetheless present in the banking activity in both its direct and indirect form. In the direct form, the risk is transmitted through the gap that exists between assets and liabilities of the banking sector by repricing periods, and sensitivity of certain assets to interest rate fluctuations. This gap is negative, but it has narrowed somewhat during the period. The risk would materialize in case of an increase in the interest rate which due to the negative gap would affect faster the operational costs of the bank, compared to its revenues. In addition, the assumed increase in the interest rate would affect negatively (and initially) the value of bank assets sensitive to interest rate fluctuations, such as long-term securities. This risk has an indirect component which is related to the negative effect from the increase in interest rates on borrowers with variable interest rate loans. Also in this case, it is necessary for banks to quantitatively assess the impact of adverse scenarios and work towards containing the exposure to risk. In the meantime, the interest rate risk remains especially necessary to be assessed in the activity of life insurance companies, investment funds and private supplementary pension funds.

ç) Banks systems in place for assessing and controlling operational risk need improving.

While banks reporting show an improvement of coverage with capital of overall operational risks, the supervisory activity of the Bank of Albania has identified the need to further improve the process for the identification and reporting of operational losses in accordance with the profile of the bank’s activity. Also, in response to the infringement of the physical security in the activity of transporting cash funds during the previous year, the Bank of Albania has strengthened the minimum requirements in the relevant regulatory acts, mainly with regard to planning, preparing, monitoring and supervising the compliance with the relevant procedures by the special security units in banks. In the framework of this matter, during 2016, the Bank of Albania has cooperated constantly with the Albanian State Police, contributing to improving the sub-legal acts about the transportation of monetary values. Looking forward, the Bank of Albania will strengthen the focus for assessing the adequacy of banks systems for controlling operational risk, as part of regular inspections at supervised institutions.

d) The contraction of the activity in some of the European banking groups that operate in Albania keeps the stimuli for restructuring the activity, including the change of their network in countries outside the EU.

This phenomenon has been more notable in Central European and Balkan countries, but Albania has not been affected insofar, in relative terms, by this phenomenon. The experience of other countries shows that if the process is well coordinated among all the stakeholders, the exit of a banking group from a certain market may be accompanied by the entry of other valuable investors, who may introduce additional capacities and other priorities in the local banking sector. These changes may yield a positive effect on the banking sector and financial system structure and increase its contribution to bolstering economic growth. The process contains also uncertainties related to the actual phase of the economic and financial cycle in the European Union and the region, as well as the potential of the regional countries to stir the interest of new and valuable investors. It is difficult to determine to what extent and way this process may affect the Albanian subsidiaries of European banking groups. In any case, the Bank of Albania and other authorities in Albania will strengthen their monitoring and evaluating capacities as well as cooperation, in order for the processes to take place in accordance with the legal requirements and the ultimate objective of safeguarding the stability of the financial system in Albania.

Risks to financial stability

For the assessment of systemic risks, the performance of indicators related to the materialization and accumulation of the systematic risk is analysed, with the stress level in the financial system and with the banking industry perception regarding the banking activity exposure to systemic risk. Also, the financial stability map aims to achieve a consolidated approach of risks to financial stability.

Overall, the indices do not show an increase in risks to the financial stability during the period. The lower profit of the banking sector and the slight fall in liquidity indicators (yet, they remain at high levels) are offset by more positive developments in the real economy, with an improvement of economic growth and economic situation for both households and enterprises. The accumulation of risks has been weaker due to the contraction in foreign currency credit, improvement of public debt indicators, and the more positive performance of the real estate market. On the other hand, the probability of materialisation for the systemic risk has reduced, given that the credit quality has improved, unemployment has fallen and exchange rate volatility has been low.

The banking sector's ability to withstand risks

The banking sector's ability to withstand risks is assessed by analysing its capitalization and profitability situation, and by stressing these indicators using the stress test.

At the end of the period, the capital adequacy ratio for the banking sector stood at 15.7%, notably above the 12% required minimum for this indicator. This performance was determined by the increase in risk-weighted assets by almost 4.3% (downward impact on the indicator) and the regulatory capital appreciation by almost 3.8% (upward impact on the indicator). Financial leverage, measured as the ratio of total assets to shareholders' equity was 10.3 times and is considered to be at good level. Maintaining a good capital position is determined also by the performance of the sectors' financial result. In 2016, the banking sectors profit amounted to around ALL 9.3 billion, standing lower on a year earlier. The fall in net interest income and the increase of the provisioning for credit risk contributed to the decline in profit. The fall in net revenues from interests reflected the fall in return from investments, for financial instruments both in foreign currency and in lek, at a faster pace than the fall in expenditure for them. The increase in provisioning for credit risk reflected the shift of non-performing loans toward more extreme classes. Sector profitability indicators, return on assets (RoA) and return on equity (ROE) were 0.7% and 7.2%, respectively.

The adequacy of the above indices has been proven during the stress test with scenarios that assumed adverse changes in macroeconomic and financial indicators for the 2017-2018 period. In the adverse scenario, the contraction of the economy, contraction of credit, rapid growth of interest rates and strong depreciation of the exchange rate, were included as part of the extreme assumptions, but with a low probability of occurrence. The results of the stress test showed that in the baseline and the moderate scenarios, the banking sector remains capitalized, but would need a capital raise in the adverse scenario. Additional capital requirement for specific banks is evident in the adverse scenario.

Based on this analysis, the Bank of Albania considers that capitalization and profitability of banks is adequate for coping with operational risks. Nonetheless, the sensitivity to risks is specific for each bank, depending on its profile and capacities to cope with risks. Therefore, the Bank of Albania reiterates the need for regularly assessing such risks by each bank, undertaking the necessary risks for mitigating them and maintaining capitalisation indicators.

¹ According to the IMF’s outlook, global growth over 2017-2018 is projected around 3.4-3.6 per cent.