BANK OF ALBANIA STATEMENT
Financial Stability Statement for H1 2012

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 Parliament of the Republic of Albania and the Council of Ministers, and to draw the attention of financial institutions and 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 Regular Statement, which is an integral part of the Financial Stability Report for the same stated period.

The financial system and banking sector's situation and performance remained stable throughout the period. The banking sector and the financial system operated within a more challenging environment, characterised by slow domestic and foreign economic growth, reduced public financial stimulus, slower investments and public consumption, decreased bank lending rates and quality, as well as imposed structural changes in the interbank liquidity market. However, the banking sector generated income and presented good capitalisation and liquidity indicators over the period. The direct impact of market risks on the banking sector was moderate, but the indirect impact arising from exposure of households and businesses was significant, suggesting the need for a prudential monitoring by the banking system.  The deteriorated credit quality represents the main concern about the stability of the banking sector's financial indicators. As Albanian and foreign economic developments do not reveal any stable improvement of operators' expectations, the credit quality improvement may not occur duly and timely only through the smooth operation of banks. To effectively address this issue, the banking sector and Albanian public authorities should cooperate and be committed to taking parallel measures in several directions, as follows:

First, the banks should continue improving credit monitoring to: strengthen respective structures for assessing a borrower's creditworthiness and for collecting loans; accelerate operations which provide loan restructuring for potential borrowers; proactively create provisions to hedge against credit risk; perform operations to detect the financial effect of loan losses, write them off from the balance-sheet and execute collateral for the maximum recovery of credit value. If these operations are performed correctly and professionally, they will provide the banking sector with financial resources to better support lending in the periods ahead;  

Second, the public authorities, including the Ministry of Justice and the Ministry of Finance, should be committed to promoting and accelerating these processes in the banking sector, by establishing the needed legal and financial stimuli.  The Bank of Albania lays emphasis on the importance of rapid improvements in the legal framework to strengthen the collateral execution infrastructure on bank loan. It also assesses positively the important reform of establishing private bailiff entities. However, other legal and operational improvements are needed to: improve the financial education of lawyers and increase court's efficiency in dealing correctly and in due time with lending practices; provide consistency of decisions across same-level courts related to similar lending practices; improve the collateral auction result securing a loan; better connect the financial compensation of private bailiff entities to their performance in executing the collateral execution order; encourage the out-of-court resolution of disputes between a lender and a borrower; enable establishment and entry into the market of non-bank financial institutions, which through negotiations with banks, undertake to assess and manage or purchase part of non-performing loan portfolio. The Bank of Albania assesses that these proposals, identified through the cooperation among public authorities, international financial institutions and Albanian Banks Association, provide solutions already tested in countries that share similar characteristics, hence creating premises for a comprehensive addressing of and stable solutions to non-performing loans. 

Third, the banking sector should continue to be well-capitalised and liquid throughout this process. To this end, the Bank of Albania shall ensure that banks conduct correct estimations of their needs for additional capital and liquid assets, by prudentially analysing their operational risk profile and acting proactively to ensure them.
 
In more concrete terms, the following outlines the financial system's interaction with the economic environment and exposure to various risks in 2012 H1:

Global economy grew at unstable rates during 2012 H1. They reflected the sluggish economic performance of the euro area and the structural vulnerabilities, mainly in the labour and real estate markets. Advanced economies provided a considerably lower contribution to global economic growth, compared to emerging and developing economies. The lower expectations about global economic growth and tensions in financial markets, particularly in the euro area, urged the European authorities to take certain measures to reduce the refinancing cost of public debt for the peripheral member countries, stabilise the banking system and strengthen the European mechanisms for its capitalisation. The euro-area countries and other countries surrounding the European Union, which are negatively affected by the euro-area situation through the trading channels, human and financial capital movement, and financial system integration, are all interested in the success of these measures. 

The downward foreign demand appears to have impacted the weak performance of domestic economy. In 2012 Q1, GDP contracted by 0.2% y-o-y and 1.2% q-o-q.  Industry, construction, post-telecommunication and transport contributed to this fall. Services, trade and agriculture performed positively. Indirect data suggest that developments in consumption and private investments are slow, thus providing lower contribution to economic growth. Fiscal consolidation is accompanied by a contracted public financial stimulus for the economy. The weak foreign demand is followed by considerably slowed Albanian exports, compared to the same period of the previous year.

Household and business financial situation maintained the same trend in 2012 H2 as in the previous period. Households deepened their creditor position further, owing to faster growth of deposits compared to loans at the financial system. Businesses continued to deepen their debtor position, mostly in foreign currency. Lending to businesses increased at lower paces in 2012 H1, while lending to households decreased. Business and household loan quality decreased. Households and businesses are exposed to indirect credit risk arising from adverse exchange-rate or interest-rate movements.

Operators have expanded their activity in the financial markets. The interbank market is characterised by higher transaction volumes and stable interest rates, thus demonstrating the ability to meet the banks' needs for liquidity. Debt securities market recorded higher demand and supply in the primary market as well as their trading in the secondary market. During the period under review, the debt securities' secondary market recorded higher trading volumes, hence reflecting interbank operations to adapt to structural changes in liquidity and the entry of new non-bank operators into the market. One of the main developments in the financial markets was the unexpected decision of a large bank in Albania - part of an important European banking group - to withdraw from the Albanian Government debt auctions. This decision was driven by the request from the regulatory authority of its country of origin for improving the capital adequacy of the largest European banking groups, pursuant to recommendations by the European Banking Authority. The liquidity supply by other banks of the sector and the strongly supporting actions taken by the Bank of Albania helped fill the created vacuum and maintain a low volatility of interest rate on Government debt securities. This event, which tested the Bank of Albania's framework on market operations, showed the need to raise competition in the banking market, expand investors' base in Government debt securities, and improve the secondary-market function, in order to lower the concentration in debt allocation and reduce the refinancing risk. In the exchange market, the trading volumes increased, and the national currency appeared stable against the major foreign-currency basket.

The financial system expanded its activity further, albeit at slower rates. Measured as the ratio of financial system assets to Gross Domestic Product (GDP), the level of financial intermediation in Albania, was estimated at 92.8% as at end-June 2012, from 89.5% as at end-2011 and 86.9% in the same period of 2011. The banking sector remains the dominant segment of financial intermediation in Albania. Its assets account for about 93.9% of total financial system assets and about 87.2% of GDP. Over the period, the banking sector assets grew by about 3.4% compared to end-2011, and by about 11% compared to the same period of 2011. Insurance companies represent the second most important segment of the financial system. Over the period, a financial institution was established to provide collective investment schemes, by expanding investment opportunities for different entities.

In the banking system, lending is the main contributor to asset performance, despite its downtrend due to decelerated economic growth and bank's reluctance to lend. Deposits have financed banking activity almost totally. This development is assessed as positive, affecting the stability of the banking system's liquidity position. On the other hand, this development highlights the need for retaining public confidence in the banking sector.  As at the end of the period, capital adequacy ratio resulted 15.7%. The banking system generated a positive profit, although it remained concentrated in the largest banks. Loan quality deteriorated in almost all its categories. The ratio of non-performing loans to total loans stood at 21.1% at the end of the period.

Risks to the financial system arise from its interaction with the surrounding economic environment and its own activity.

Concerning the impact of macroeconomic developments, fiscal stimulus and the contribution of foreign demand to economic growth remain low. The Bank of Albania deems that the priority of fiscal policy should be operations that aim at: lowering the budget deficit and public debt; reducing the refinancing risk through the extension of average debt maturity duration and expansion of institutional investors and individuals' base; and providing the sources needed for financing or settling foreign-currency liabilities. Some of these objectives are more difficult due to economic performance in 2012 Q1, the sluggish foreign demand and the downward expectations of economic growth for 2012. In the foreseeable future, inflationary pressures may remain weak, hence providing more opportunities for the monetary authority to maintain accommodative monetary conditions. Nevertheless, the benefit that economic operators gain from more favourable monetary conditions would also depend on their financial position, the quantity of bank lending and respective interest rate.  

Direct and indirect credit risks represent the major risk to the banking sector. Though at different rates, credit quality has deteriorated for lek and foreign currency loans to businesses and households. The credit quality deteriorated in all the main sectors of the economy. Addressing non-performing loan concerns in the banking sector is important to the lending pace and future contribution of the banking sector and financial system to Albania's economic development. Therefore, the Bank of Albania encourages public authorities and the banking sector to cooperate and take measures for providing a lasting and comprehensive solution to this issue. Some of these measures are outlined in the Financial Stability Statement of this Report.

The banking sector appears relatively hedged against direct risk arising from adverse exchange rate and interest rate movements, but sensitivity has increased. The open foreign exchange position of the banking sector appears within the historical levels, while the values of assets and liabilities sensitive to interest rate are comparable to each-other. It, however, appears sensitive to the impact of exchange rate and interest rate movements on bank clients. A significant level of exchange rate depreciation or a similar increase in the interest rate may impair bank clients' solvency, particularly businesses' solvency. This risk arises mainly from foreign currency-denominated loans, when the main source of their settlement is in the national currency, and also from variable interest rate loans.

Liquidity risk to the banking sector is also at moderate levels. Deposits continue to be the key financing source for the banking sector and grew at good rates. Borrowing from non-residents remains contained. Banking sector's liquid assets in lek and in the major foreign currencies remained above the minimum rates required by the regulatory framework.

Capitalisation indicators are at good levels, but banks should assess carefully their needs for additional capital in the future. During the period under review, the sluggish growth of risk-weighted assets and the moderate increase of capital provided the main contribution to this performance. Despite the positive financial result, banking sector's capacity to generate sufficient income for supporting the increase in capital and carrying out its activity through domestic resources remains unstable. On the other hand, the covering of net non-performing loans with capital decreased. Therefore, banks should assess carefully and proactively their needs for additional capital in line with their activity risk profile.

Stress testing may serve banks as an instrument to assess possible needs for additional capital. The Bank of Albania conducts regular stress tests to assess the sensitivity of key banking sector capitalisation indicators to movements in macroeconomic indicators. The baseline and adverse scenarios include assumptions related to movements in GDP growth rate, exchange rate and interest rate, and the credit level. They run over a two-year time period until end-2013. Stress-test results show that, overall, the banking sector appears resilient in the event the assumptions about respective indicators take place. Capitalisation level for the entire sector remains above the required minimum for the baseline scenario. In the event of the most severe scenarios, which assume fall in GDP growth rate and in lending, as well as depreciation of the exchange rate, individual banks may need additional capital.

The technical infrastructure supporting banking sector activity is assessed to have operated in line with the expected parameters. Payment systems constitute an important part of the financial system structure, enabling the transfer of funds between banks, other financial institutions and customers. As a consequence, their stable and efficient operation contributes significantly to safeguarding financial stability. In this context, AIPS and AECH systems, the basic infrastructure of lek payments, have operated in compliance with the requirements under their regulatory and operational framework. The Bank of Albania remains committed to carrying out improvements in the regulatory framework and supportive technological infrastructure, so that the performance of these systems precedes the operators' needs for a safe and efficient activity.

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 Parliament of the Republic of Albania and the Council of Ministers, and to draw the attention of financial institutions and 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 Regular Statement, which is an integral part of the Financial Stability Report for the same stated period.

The financial system and banking sector's situation and performance remained stable throughout the period. The banking sector and the financial system operated within a more challenging environment, characterised by slow domestic and foreign economic growth, reduced public financial stimulus, slower investments and public consumption, decreased bank lending rates and quality, as well as imposed structural changes in the interbank liquidity market. However, the banking sector generated income and presented good capitalisation and liquidity indicators over the period. The direct impact of market risks on the banking sector was moderate, but the indirect impact arising from exposure of households and businesses was significant, suggesting the need for a prudential monitoring by the banking system.  The deteriorated credit quality represents the main concern about the stability of the banking sector's financial indicators. As Albanian and foreign economic developments do not reveal any stable improvement of operators' expectations, the credit quality improvement may not occur duly and timely only through the smooth operation of banks. To effectively address this issue, the banking sector and Albanian public authorities should cooperate and be committed to taking parallel measures in several directions, as follows:

First, the banks should continue improving credit monitoring to: strengthen respective structures for assessing a borrower's creditworthiness and for collecting loans; accelerate operations which provide loan restructuring for potential borrowers; proactively create provisions to hedge against credit risk; perform operations to detect the financial effect of loan losses, write them off from the balance-sheet and execute collateral for the maximum recovery of credit value. If these operations are performed correctly and professionally, they will provide the banking sector with financial resources to better support lending in the periods ahead;  

Second, the public authorities, including the Ministry of Justice and the Ministry of Finance, should be committed to promoting and accelerating these processes in the banking sector, by establishing the needed legal and financial stimuli.  The Bank of Albania lays emphasis on the importance of rapid improvements in the legal framework to strengthen the collateral execution infrastructure on bank loan. It also assesses positively the important reform of establishing private bailiff entities. However, other legal and operational improvements are needed to: improve the financial education of lawyers and increase court's efficiency in dealing correctly and in due time with lending practices; provide consistency of decisions across same-level courts related to similar lending practices; improve the collateral auction result securing a loan; better connect the financial compensation of private bailiff entities to their performance in executing the collateral execution order; encourage the out-of-court resolution of disputes between a lender and a borrower; enable establishment and entry into the market of non-bank financial institutions, which through negotiations with banks, undertake to assess and manage or purchase part of non-performing loan portfolio. The Bank of Albania assesses that these proposals, identified through the cooperation among public authorities, international financial institutions and Albanian Banks Association, provide solutions already tested in countries that share similar characteristics, hence creating premises for a comprehensive addressing of and stable solutions to non-performing loans. 

Third, the banking sector should continue to be well-capitalised and liquid throughout this process. To this end, the Bank of Albania shall ensure that banks conduct correct estimations of their needs for additional capital and liquid assets, by prudentially analysing their operational risk profile and acting proactively to ensure them.
 
In more concrete terms, the following outlines the financial system's interaction with the economic environment and exposure to various risks in 2012 H1:

Global economy grew at unstable rates during 2012 H1. They reflected the sluggish economic performance of the euro area and the structural vulnerabilities, mainly in the labour and real estate markets. Advanced economies provided a considerably lower contribution to global economic growth, compared to emerging and developing economies. The lower expectations about global economic growth and tensions in financial markets, particularly in the euro area, urged the European authorities to take certain measures to reduce the refinancing cost of public debt for the peripheral member countries, stabilise the banking system and strengthen the European mechanisms for its capitalisation. The euro-area countries and other countries surrounding the European Union, which are negatively affected by the euro-area situation through the trading channels, human and financial capital movement, and financial system integration, are all interested in the success of these measures. 

The downward foreign demand appears to have impacted the weak performance of domestic economy. In 2012 Q1, GDP contracted by 0.2% y-o-y and 1.2% q-o-q.  Industry, construction, post-telecommunication and transport contributed to this fall. Services, trade and agriculture performed positively. Indirect data suggest that developments in consumption and private investments are slow, thus providing lower contribution to economic growth. Fiscal consolidation is accompanied by a contracted public financial stimulus for the economy. The weak foreign demand is followed by considerably slowed Albanian exports, compared to the same period of the previous year.

Household and business financial situation maintained the same trend in 2012 H2 as in the previous period. Households deepened their creditor position further, owing to faster growth of deposits compared to loans at the financial system. Businesses continued to deepen their debtor position, mostly in foreign currency. Lending to businesses increased at lower paces in 2012 H1, while lending to households decreased. Business and household loan quality decreased. Households and businesses are exposed to indirect credit risk arising from adverse exchange-rate or interest-rate movements.

Operators have expanded their activity in the financial markets. The interbank market is characterised by higher transaction volumes and stable interest rates, thus demonstrating the ability to meet the banks' needs for liquidity. Debt securities market recorded higher demand and supply in the primary market as well as their trading in the secondary market. During the period under review, the debt securities' secondary market recorded higher trading volumes, hence reflecting interbank operations to adapt to structural changes in liquidity and the entry of new non-bank operators into the market. One of the main developments in the financial markets was the unexpected decision of a large bank in Albania - part of an important European banking group - to withdraw from the Albanian Government debt auctions. This decision was driven by the request from the regulatory authority of its country of origin for improving the capital adequacy of the largest European banking groups, pursuant to recommendations by the European Banking Authority. The liquidity supply by other banks of the sector and the strongly supporting actions taken by the Bank of Albania helped fill the created vacuum and maintain a low volatility of interest rate on Government debt securities. This event, which tested the Bank of Albania's framework on market operations, showed the need to raise competition in the banking market, expand investors' base in Government debt securities, and improve the secondary-market function, in order to lower the concentration in debt allocation and reduce the refinancing risk. In the exchange market, the trading volumes increased, and the national currency appeared stable against the major foreign-currency basket.

The financial system expanded its activity further, albeit at slower rates. Measured as the ratio of financial system assets to Gross Domestic Product (GDP), the level of financial intermediation in Albania, was estimated at 92.8% as at end-June 2012, from 89.5% as at end-2011 and 86.9% in the same period of 2011. The banking sector remains the dominant segment of financial intermediation in Albania. Its assets account for about 93.9% of total financial system assets and about 87.2% of GDP. Over the period, the banking sector assets grew by about 3.4% compared to end-2011, and by about 11% compared to the same period of 2011. Insurance companies represent the second most important segment of the financial system. Over the period, a financial institution was established to provide collective investment schemes, by expanding investment opportunities for different entities.

In the banking system, lending is the main contributor to asset performance, despite its downtrend due to decelerated economic growth and bank's reluctance to lend. Deposits have financed banking activity almost totally. This development is assessed as positive, affecting the stability of the banking system's liquidity position. On the other hand, this development highlights the need for retaining public confidence in the banking sector.  As at the end of the period, capital adequacy ratio resulted 15.7%. The banking system generated a positive profit, although it remained concentrated in the largest banks. Loan quality deteriorated in almost all its categories. The ratio of non-performing loans to total loans stood at 21.1% at the end of the period.

Risks to the financial system arise from its interaction with the surrounding economic environment and its own activity.

Concerning the impact of macroeconomic developments, fiscal stimulus and the contribution of foreign demand to economic growth remain low. The Bank of Albania deems that the priority of fiscal policy should be operations that aim at: lowering the budget deficit and public debt; reducing the refinancing risk through the extension of average debt maturity duration and expansion of institutional investors and individuals' base; and providing the sources needed for financing or settling foreign-currency liabilities. Some of these objectives are more difficult due to economic performance in 2012 Q1, the sluggish foreign demand and the downward expectations of economic growth for 2012. In the foreseeable future, inflationary pressures may remain weak, hence providing more opportunities for the monetary authority to maintain accommodative monetary conditions. Nevertheless, the benefit that economic operators gain from more favourable monetary conditions would also depend on their financial position, the quantity of bank lending and respective interest rate.  

Direct and indirect credit risks represent the major risk to the banking sector. Though at different rates, credit quality has deteriorated for lek and foreign currency loans to businesses and households. The credit quality deteriorated in all the main sectors of the economy. Addressing non-performing loan concerns in the banking sector is important to the lending pace and future contribution of the banking sector and financial system to Albania's economic development. Therefore, the Bank of Albania encourages public authorities and the banking sector to cooperate and take measures for providing a lasting and comprehensive solution to this issue. Some of these measures are outlined in the Financial Stability Statement of this Report.

The banking sector appears relatively hedged against direct risk arising from adverse exchange rate and interest rate movements, but sensitivity has increased. The open foreign exchange position of the banking sector appears within the historical levels, while the values of assets and liabilities sensitive to interest rate are comparable to each-other. It, however, appears sensitive to the impact of exchange rate and interest rate movements on bank clients. A significant level of exchange rate depreciation or a similar increase in the interest rate may impair bank clients' solvency, particularly businesses' solvency. This risk arises mainly from foreign currency-denominated loans, when the main source of their settlement is in the national currency, and also from variable interest rate loans.

Liquidity risk to the banking sector is also at moderate levels. Deposits continue to be the key financing source for the banking sector and grew at good rates. Borrowing from non-residents remains contained. Banking sector's liquid assets in lek and in the major foreign currencies remained above the minimum rates required by the regulatory framework.

Capitalisation indicators are at good levels, but banks should assess carefully their needs for additional capital in the future. During the period under review, the sluggish growth of risk-weighted assets and the moderate increase of capital provided the main contribution to this performance. Despite the positive financial result, banking sector's capacity to generate sufficient income for supporting the increase in capital and carrying out its activity through domestic resources remains unstable. On the other hand, the covering of net non-performing loans with capital decreased. Therefore, banks should assess carefully and proactively their needs for additional capital in line with their activity risk profile.

Stress testing may serve banks as an instrument to assess possible needs for additional capital. The Bank of Albania conducts regular stress tests to assess the sensitivity of key banking sector capitalisation indicators to movements in macroeconomic indicators. The baseline and adverse scenarios include assumptions related to movements in GDP growth rate, exchange rate and interest rate, and the credit level. They run over a two-year time period until end-2013. Stress-test results show that, overall, the banking sector appears resilient in the event the assumptions about respective indicators take place. Capitalisation level for the entire sector remains above the required minimum for the baseline scenario. In the event of the most severe scenarios, which assume fall in GDP growth rate and in lending, as well as depreciation of the exchange rate, individual banks may need additional capital.

The technical infrastructure supporting banking sector activity is assessed to have operated in line with the expected parameters. Payment systems constitute an important part of the financial system structure, enabling the transfer of funds between banks, other financial institutions and customers. As a consequence, their stable and efficient operation contributes significantly to safeguarding financial stability. In this context, AIPS and AECH systems, the basic infrastructure of lek payments, have operated in compliance with the requirements under their regulatory and operational framework. The Bank of Albania remains committed to carrying out improvements in the regulatory framework and supportive technological infrastructure, so that the performance of these systems precedes the operators' needs for a safe and efficient activity.