BANK OF ALBANIA STATEMENT
Financial Stability Statement for H2 2011

Pursuant to the provisions stipulated 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 jeopardize its stability, the Bank of Albania releases the following periodical statement, which is an integral part of the Financial Stability Report for the same stated period.

The Bank of Albania assesses that the financial system and banking sector’s situation and performance remain stable. Capitalization and liquidity figures of the banking sector’s activity are at satisfactory levels; however, its capacity to generate sufficient income remains concentrated in individual banks. Banking sector exposure to direct market risks is at low levels, while direct and indirect credit risk represents the main challenge facing the banking sector activity. Developments in the surrounding internal and external economic environment, and households and businesses’ financial situation are assessed as being in line with their medium-term performance. The following elaborates on the interaction of the financial system with the economic environment and exposure to various risks.

Global economy decelerated its growth rates in 2011 H2, particularly owing to the performance of advanced economies. The uncertainties heightened due to the severe sovereign debt crisis in the Euro area. On average, global economic growth decelerated to 3.8% in 2011, compared to 5.2% in 2010. Advanced economies expanded by 1.6%, as a result of the unstable financial situation in the Euro area, sluggish bank lending to real economy and the curbing effect of fiscal consolidation process on economic growth. Emerging and developing economies grew by 6.2%, still lower than in 2010. Global growth is anticipated to slow down further in 2012, with advanced economies expected to expand by 1.2%, and emerging and developing economies by 5.4%.  

In the Euro area, economic activity decelerated as a result of the lower consumer spending and sluggish domestic demand in the large block countries. Unemployment rate rose to 10.4% at end-2011, while the inflationary pressures subsided. Fiscal consolidation remains the main challenge for the Euro area countries, therefore, a number of them, such as Italy, Spain, France etc, have announced measures to reduce the high accumulated debt further and boost economic growth.

Economic activity in Central and Eastern Europe recovered in the second half of the year; however, the growth rates were not uniform across the countries. In Bulgaria, the Czech Republic and Slovakia, economic growth rates slowed down in 2011 Q3 compared to the previous periods, mainly due to the fall of external demand and weaker investment. Growth in countries like Poland and Romania continued to be fairly buoyant, driven mostly by domestic demand. The Balkans, Turkey and FYROM posted higher growth rates.

On the other hand, growth in the United States accelerated in 2011 H2, driven by the improved private investment, consumer spending and net exports. Growth, however, slowed down to 1.7% y-o-y in 2011, from 3% in 2010. Real estate market continued to perform sluggishly, while the unemployment rate fell in the last quarter of 2011, ending the year at 8.5%.

During the period under review, the performance of the global financial markets reflected the difficulties facing the global economy and economic agents. The Euro area money markets were highly volatile and the interest rates were upward. In order to relieve the pressures, the European Central Bank employed different financial instruments to increase liquidity in the market, and cut the key policy rate twice by 25 basis points each in November and December, respectively, to 1%. Despite these measures, overall, the trading volumes in the interbank market remained low in 2011 Q4 and the risk premiums increased higher than in the other markets, reflecting the higher counterparty risk among financial institutions and banks. In the debt securities markets, the pressures for the increase of yields were fairly high, particularly for high-debt countries such as Italy, Spain and France. In stock markets, investors continued to be reluctant to purchase corporate shares and bonds. As a result, the funding cost through them grew higher and the performance of prices in the major stock markets was unstable. In the foreign exchange markets, investors turned to safer currencies, such as the Japanese yen and the Swiss franc. Against this setting, throughout 2011 H2, the Euro has generally been unstable against the other major currencies. In primary commodity markets, the prices were generally downward due to the sluggish global demand. Oil price, however, rose at end-2011, mainly owing to supply-side developments and heightened geopolitical risk in oil-producing countries.

Profitability indicators for Global Large and Complex Banking Groups were relatively stable. The low interest rates and the sluggish credit growth reflected in a considerable decline of interest income in some of the banks. Concerning Euro area banking groups, their financial performance deteriorated during 2011 H2, mainly due to the higher provisioning against credit risk and the sharp decline of trading income. In October 2011, the European Banking Authority conducted EU-wide stress testing exercise, which evidenced the need for the European banks to raise an extra EUR 114.7 billion in new capital. For the period ahead, the uncertainty surrounding the future outlook of the securities market in the Euro area will continue to remain high and the risk of debt crisis contagion to other Euro area countries remains present. On the other hand, the European banking sector needs to increase high-quality capital and it faces the risk of refinancing the liabilities. The deterioration of the private sector credit quality represents a constant source of risk. The level of deterioration, however, varies across different countries and institutions. The financial performance of these banking groups will be positively affected if the European authorities implement some anticipated measures to reduce the systemic risk in some Euro area countries.

The Albanian economy expanded by 3.1% on average in 2011. After decelerating in 2011 Q2, it improved its activity in Q3 and Q4. The growth of economic activity continues to be steadily driven by trade and transportation sectors. The contribution of industry was volatile during 2011, while construction displayed slight improvement in its activity during 2011 H2. Indirect indicators suggest that the contribution of consumption and private investment to economic growth in 2011 was contained. The developments in government spending and foreign trade component also reflect the deceleration of their contribution. As at end-2011, unemployment rate stood at 13.29% compared to 13.49% at end-2010. This improvement was insufficient to support consumption further and shift households’ propensity to save against a background of uncertainty about the future economic outlook. Annual inflation averaged 2.9% in 2011 H2, about 1.1 percentage points less than in H1. Against a background of contained inflationary pressures, the Bank of Albania cut the key interest rate in September and November by 0.25 percentage points each to 4.75%, hence providing more favourable monetary conditions to boost economic activity at home. At end-2011, budget deficit accounted for 3.5% of GDP. After the mid-year budget revision by the Government, revenues and expenditure reduced considerably in H2. The largest part of budget deficit was financed through domestic resources. Public debt accounts for 58.5% of GDP. After increasing in 2011 H1, the average maturity of debt deepened the downward trend, reaching in H2 the lowest level since 2008. As at end-2011, current account deficit accounted for 12% of GDP, increasing slightly from end-2010. Trade deficit reached 22% of GDP, narrowing by 1.5 percentage points from end-2010. At end-2011, exports covered 29.6% of imports compared to an annual average of 36%. Capital and financial account widened by 5.6% y-o-y, financing 80% of the current account deficit. In the real estate market, House Price Index for Tirana rose at a slower pace, while Rental Price Index maintained its declining trend. On the other hand, lending for housing purposes grew by 7.2% y-o-y.
 
Households/individuals and businesses’ financial situation displayed the same trend in 2011 H2 as in the previous period. More specifically, individuals deepened their creditor position vis-à-vis the banking system further, following the considerable growth of deposits compared to the loans received. Creditor position in foreign currency expanded at a faster pace than that in the national currency. Businesses’ debtor position continues to deepen and, for the most part, it is denominated in foreign currency. Lending to the business sector was considerably higher than that to households in 2011. In the meantime, loan quality deteriorated for businesses and households, with businesses suffering higher loan quality deterioration. 

Financial markets in Albania were stable. In 2011 H2, the interbank market recorded higher traded values compared to the previous period. This change, however, was negligible y-o-y. Interbank rates reflected the key interest rate set by monetary policy, the respective maturity structure of the transaction and the fluctuations in banks’ demand for short-term liquidity. Over the period under review, the volume of Government bonds in the primary market declined compared to 2011 H1, reflecting the fall of Government demand for borrowing in H2. The composition of debt issued in the primary market was dominated by debt securities of up to 12-month maturity, although the decline in issues was present in T-bills and bonds. Average interest rate on debt securities issued in 2011 H2 remained close to the previous year’s level. Compared to a year earlier, the average interest rate on T-bills decreased, while that on bonds increased. Debt securities trading market posted growth; however, the comparative base still remains very low. T-bills of 12-month maturity have the major share in the stock of securities traded in the secondary market. In the foreign exchange market, the Lek was stable, depreciating slightly against the Euro and appreciating against the US dollar. In addition, volatility in trading was low. Lek’s exchange rate against the major currencies reflected the changes in supply/demand and the developments in the international foreign exchange market. Compared to 2011 H1, interest rate spread between loans and deposits denominated in Lek, Euro and US dollar narrowed, largely reflecting the lower interest rate on loans denominated in each of these currencies. 

The financial system expanded its activity further in 2011 H2, in line with the key indicators established by the supervisory framework. Banking sector assets grew by 13.7% y-o-y to ALL 1,120.17 billion. Loans increased by 15.5% y-o-y, accounting for about 50% of total banking sector assets. Deposits grew by 13.2%, accounting for 81.4% of total banking sector’s balance sheet. Foreign currency-denominated loans account for about 68% of the loan portfolio, while the share for deposits is almost equal. The average loan maturity is slightly lower, while increasing for deposits. Capital adequacy ratio improved to 15.6% at the end of the period due to the increase in capital for some banks. The continuous growth of deposits at a buoyant pace and the increase in liquid assets pursuant to the supervisory framework requirements provide evidence for a satisfactory liquidity situation. The positive profit, however, declined significantly at the end of the year, causing RoE and RoA to fall compared to end-2011 H1 and end-2010. The low return on investment in the international markets, the sluggish credit growth rates and the higher operating cost contributed to the fall in profit. The higher provisioning against credit risk, however, provided the major contribution in this regard. Loan quality deteriorated in almost all its categories. The ratio of non-performing loans to total loans stood at 18.8% at the end of the year. In 2011, the increase in non-performing loans ratio was slower than in 2010, but this primarily attributes to the faster growth of total loans. 

The performance of the banking sector in 2011 H2 is also assessed through the Financial Strength Index (FSI), which increased by 3.2 units compared to the previous half of the year, but dropped slightly compared to the same period in 2010. The higher FSI reflects the increase in liquidity and capital adequacy sub-indices and the exposure to exchange rate fluctuations. The sub-indices of asset quality, profitability and exposure to interest rate fluctuations provided an adverse contribution to the performance of the FSI.

In November 2011, the Parliament of the Republic of Albania approved some amendments to Law No. 9662, dated 18 December 2006 "On Banks in the Republic of Albania", drafted by the Bank of Albania. In addition to making some amendments in view of providing a clearer definition of electronic money activity and the respective financial institutions, in the framework of a better approach to the relevant EU Directive, the changes aimed at determining the systemic risk and strengthening Bank of Albania’s instruments for its addressing.

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

Concerning the impact of macroeconomic developments, it is assessed that fiscal stimulus and the contribution of foreign demand to economic growth will continue to reduce. Fiscal policy is necessary to continue the consolidation process, aiming at keeping the budget deficit at low levels and gradually lowering the public debt level. In addition, demand for borrowing should make better consideration of the objective for extending the average duration of debt, in order to ensure more appropriate refinancing conditions, including a better reallocation across the institutional investors and individuals. Special attention must be also paid to the performance of foreign currency liabilities over time, which initially requires the creation and cautious management of foreign currency resources. These factors may sharpen the expectations of economic operators for the deceleration of economic growth and may increase the probability for the decline of private investment and consumption. The differences in the economic growth rates and real interest rates between Albania and our trading partners will impact the performance of trade and current account deficit. The direction and magnitude of this impact will, however, depend on other factors as well and it still remains vague. Trade deficit is high and it represents a potential risk to the macroeconomic developments in Albania. Its reduction may become stable only if supported by consistent and long-term policies that stimulate domestic production and improve its competitiveness. In the foreseeable future, the inflationary pressures may continue to remain weak, hence providing more opportunities for the monetary authority to maintain accommodative monetary conditions. The latter have been reflected in the performance of the average interest rate on deposits held with banks. The benefit level of economic operators in the market from the provision of more favourable monetary conditions would also depend on their financial situation and the amount of banking sector lending, as well as the respective interest rate.  

Households and businesses are exposed to indirect credit risk; however, the magnitude of exposure varies due to their financial situation. Concerning households, exposure to adverse exchange rate movements mainly stem from foreign currency loans for house purchase purposes. Exposure to adverse interest rate movements is assessed to have reduced in 2011 H2 due to the lower share of variable interest rate loans in total household loans. However, households’ creditor position vis-à-vis the financial system smoothes out the effect of these risks. Concerning businesses, exposure to adverse exchange rate movements increased in 2011 H2 as a result of the higher share of foreign currency loans, unhedged against exchange rate risk, in total foreign currency loans. The quality deterioration for this category of loans was, however, lower than the decline in total value of business loans. Businesses also show higher exposure to adverse interest rate movements, when the latter increase. Businesses’ capacity to cope with these risks is also affected by their debtor position vis-à-vis the financial system.

Concerning financial system’s activity, direct and indirect credit risks represent the major risk, particularly to the banking sector. Loan quality deteriorated both for Lek and foreign currency loans, extended to businesses and households. However, its deterioration pace varied across the categories. Excluding the agriculture sector, the loan quality deteriorated in all the other sectors, and particularly in construction. In response to this situation, banks increased the level of their provisioning and strengthened the standard procedures for loan extension and monitoring. In this context, banks’ actions to address non-performing loans, including the increase in the number of loan practices submitted to the court for collateral execution, have accelerated over the period under review. These actions are necessary and they should remain consistent in the future as well. Addressing non-performing loan concerns in the banking sector is important to the pace of loan extension and the future contribution of the banking sector and financial system to Albania’s economic development. To this purpose, this issue was a topic of discussion in the last Financial Stability Advisory Group (FSAG) meeting. This meeting concluded that non-performing loans should be handled with priority, elaborately and thoroughly. Lowering the level of non-performing loans is a necessary step to release the considerable potential of the banking sector in financing valuable investment projects submitted by households and businesses. In the context, the FSAG made an assessment of the preliminary results of the work started by an ad hoc inter-institutional working group in identifying the legal and operational solutions that facilitate the collateral execution process, and encouraged their materialization. In addition, the FSAG pointed out that other regulatory and operational improvements, which facilitate and accelerate the loan-performing handling process need to be identified and implemented. The improvement of businesses’ liquidity situation would have a positive impact on the improvement of banking sector’s loan quality. The FSAG, therefore, suggested the Government to provide its contribution by fulfilling its payment obligations to the private sector’s contractors implementing different Government projects in due time and in compliance with the legal provisions for maintaining the fiscal indicators.

The banking sector appears relatively hedged against direct risk arising from adverse exchange rate and interest rate movements. This is evidenced by the low open foreign exchange position and the comparable amount of interest rate sensitive assets and liabilities in the banking sector’s balance sheet. It, however, appears sensitive to the impact of exchange rate and interest rate movements on its clients. A significant level of exchange rate depreciation or a similar increase of the interest rate may impair banking sector clients’ solvency, and particularly businesses’ solvency. Special attention must be paid to foreign currency-denominated loans and its risks, particularly when the main source of its settlement is in the national currency. In the case of a long-term loan transaction, banks and their clients must make well-reasoned decision-making regarding the performance of the interest rate in the future and the reciprocal mitigation of risk by establishing the most appropriate form of loan.

Liquidity risk to the banking sector is also at moderate levels. Deposits represent the key financial source for the banking sector and they grew at buoyant rates. Average maturity of deposits has increased. Borrowing from non-residents remains at contained levels. Banking sector’s liquid assets in Lek and in the major currencies have increased as a result of the higher regulatory requirements. Loan-to-deposit ratio remains at satisfactory levels and it provides necessary room for developing the activity further. Banks can meet their short-term liquidity needs in the interbank market and they can also participate in the liquidity injection operations conducted by the Bank of Albania on a regular basis. In this regard, banks, however, must be cautious in managing appropriate collaterals for borrowing in the interbank market.

Capitalization indicators are generally at better levels than in 2011 H1. The considerable increase of capital by some banks, following the prudential requirements of the Bank of Albania, provided the major contribution to this improvement. However, banking sector’s capacity to generate sufficient income to support the increase of capital, and develop its activity through domestic resources, needs to strengthen. Against a background of higher credit risk provisioning, banks should keep the performance of operating costs under control.

In order to assess the sensitivity of key banking sector capitalization indicators to movements in macroeconomic indicators, the Bank of Albania conducts stress test exercises on a regular basis. Stress testing contains the baseline scenario and one or more risk scenarios. These scenarios include assumptions related to movements in the GDP growth rate, exchange rate and interest rate, and the level of credit, and they run over a two-year time period until end-2013. Stress test results show that, overall, the banking sector appears stable in the event the assumptions about the respective indicators take place. Capitalization level for the entire sector remains above the minimum requirement in the event of the baseline scenario. In the event of the most severe scenario, which assumes the slowdown of lending and the fall in GDP growth rate, the banking sector may need additional capital. Individual banks need additional capital in the severe scenarios and the baseline scenario. In general, banking activity is carried out amidst a changeling internal and external economic environment. Banks should, therefore, monitor their activity closely, in order to identify and meet their needs for additional capital in due time. 

The technical infrastructure supporting banking sector activity is assessed to have operated in line with the expected parameters. This infrastructure is mainly represented by the payments system, which processes all the transactions banks make between them, with their clients or the Bank of Albania, on their behalf or on behalf of their clients. Compared to 2010, the number and value of transactions in the Automated Clearing House AECH) increased in 2011. In the meantime, the number and value of transactions in the Real Time Gross Settlement AIPS) decreased. The latter owes to the increase in the threshold value of transactions cleared in the AECH system and the lower use of Bank of Albania’s financial instruments by banks. The use of credit and debit cards has also increased. The pace of this increase was higher for credit cards due to the lower base. However, debit cards account for about 95% of cards in circulation. During the period under review, banks increased the number of ATMs and POSs further. As at end-2011, 11 banks offered internet banking services to their clients. The number and volume of transactions via the internet increased in 2011 H2.

Pursuant to the provisions stipulated 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 jeopardize its stability, the Bank of Albania releases the following periodical statement, which is an integral part of the Financial Stability Report for the same stated period.

The Bank of Albania assesses that the financial system and banking sector’s situation and performance remain stable. Capitalization and liquidity figures of the banking sector’s activity are at satisfactory levels; however, its capacity to generate sufficient income remains concentrated in individual banks. Banking sector exposure to direct market risks is at low levels, while direct and indirect credit risk represents the main challenge facing the banking sector activity. Developments in the surrounding internal and external economic environment, and households and businesses’ financial situation are assessed as being in line with their medium-term performance. The following elaborates on the interaction of the financial system with the economic environment and exposure to various risks.

Global economy decelerated its growth rates in 2011 H2, particularly owing to the performance of advanced economies. The uncertainties heightened due to the severe sovereign debt crisis in the Euro area. On average, global economic growth decelerated to 3.8% in 2011, compared to 5.2% in 2010. Advanced economies expanded by 1.6%, as a result of the unstable financial situation in the Euro area, sluggish bank lending to real economy and the curbing effect of fiscal consolidation process on economic growth. Emerging and developing economies grew by 6.2%, still lower than in 2010. Global growth is anticipated to slow down further in 2012, with advanced economies expected to expand by 1.2%, and emerging and developing economies by 5.4%.  

In the Euro area, economic activity decelerated as a result of the lower consumer spending and sluggish domestic demand in the large block countries. Unemployment rate rose to 10.4% at end-2011, while the inflationary pressures subsided. Fiscal consolidation remains the main challenge for the Euro area countries, therefore, a number of them, such as Italy, Spain, France etc, have announced measures to reduce the high accumulated debt further and boost economic growth.

Economic activity in Central and Eastern Europe recovered in the second half of the year; however, the growth rates were not uniform across the countries. In Bulgaria, the Czech Republic and Slovakia, economic growth rates slowed down in 2011 Q3 compared to the previous periods, mainly due to the fall of external demand and weaker investment. Growth in countries like Poland and Romania continued to be fairly buoyant, driven mostly by domestic demand. The Balkans, Turkey and FYROM posted higher growth rates.

On the other hand, growth in the United States accelerated in 2011 H2, driven by the improved private investment, consumer spending and net exports. Growth, however, slowed down to 1.7% y-o-y in 2011, from 3% in 2010. Real estate market continued to perform sluggishly, while the unemployment rate fell in the last quarter of 2011, ending the year at 8.5%.

During the period under review, the performance of the global financial markets reflected the difficulties facing the global economy and economic agents. The Euro area money markets were highly volatile and the interest rates were upward. In order to relieve the pressures, the European Central Bank employed different financial instruments to increase liquidity in the market, and cut the key policy rate twice by 25 basis points each in November and December, respectively, to 1%. Despite these measures, overall, the trading volumes in the interbank market remained low in 2011 Q4 and the risk premiums increased higher than in the other markets, reflecting the higher counterparty risk among financial institutions and banks. In the debt securities markets, the pressures for the increase of yields were fairly high, particularly for high-debt countries such as Italy, Spain and France. In stock markets, investors continued to be reluctant to purchase corporate shares and bonds. As a result, the funding cost through them grew higher and the performance of prices in the major stock markets was unstable. In the foreign exchange markets, investors turned to safer currencies, such as the Japanese yen and the Swiss franc. Against this setting, throughout 2011 H2, the Euro has generally been unstable against the other major currencies. In primary commodity markets, the prices were generally downward due to the sluggish global demand. Oil price, however, rose at end-2011, mainly owing to supply-side developments and heightened geopolitical risk in oil-producing countries.

Profitability indicators for Global Large and Complex Banking Groups were relatively stable. The low interest rates and the sluggish credit growth reflected in a considerable decline of interest income in some of the banks. Concerning Euro area banking groups, their financial performance deteriorated during 2011 H2, mainly due to the higher provisioning against credit risk and the sharp decline of trading income. In October 2011, the European Banking Authority conducted EU-wide stress testing exercise, which evidenced the need for the European banks to raise an extra EUR 114.7 billion in new capital. For the period ahead, the uncertainty surrounding the future outlook of the securities market in the Euro area will continue to remain high and the risk of debt crisis contagion to other Euro area countries remains present. On the other hand, the European banking sector needs to increase high-quality capital and it faces the risk of refinancing the liabilities. The deterioration of the private sector credit quality represents a constant source of risk. The level of deterioration, however, varies across different countries and institutions. The financial performance of these banking groups will be positively affected if the European authorities implement some anticipated measures to reduce the systemic risk in some Euro area countries.

The Albanian economy expanded by 3.1% on average in 2011. After decelerating in 2011 Q2, it improved its activity in Q3 and Q4. The growth of economic activity continues to be steadily driven by trade and transportation sectors. The contribution of industry was volatile during 2011, while construction displayed slight improvement in its activity during 2011 H2. Indirect indicators suggest that the contribution of consumption and private investment to economic growth in 2011 was contained. The developments in government spending and foreign trade component also reflect the deceleration of their contribution. As at end-2011, unemployment rate stood at 13.29% compared to 13.49% at end-2010. This improvement was insufficient to support consumption further and shift households’ propensity to save against a background of uncertainty about the future economic outlook. Annual inflation averaged 2.9% in 2011 H2, about 1.1 percentage points less than in H1. Against a background of contained inflationary pressures, the Bank of Albania cut the key interest rate in September and November by 0.25 percentage points each to 4.75%, hence providing more favourable monetary conditions to boost economic activity at home. At end-2011, budget deficit accounted for 3.5% of GDP. After the mid-year budget revision by the Government, revenues and expenditure reduced considerably in H2. The largest part of budget deficit was financed through domestic resources. Public debt accounts for 58.5% of GDP. After increasing in 2011 H1, the average maturity of debt deepened the downward trend, reaching in H2 the lowest level since 2008. As at end-2011, current account deficit accounted for 12% of GDP, increasing slightly from end-2010. Trade deficit reached 22% of GDP, narrowing by 1.5 percentage points from end-2010. At end-2011, exports covered 29.6% of imports compared to an annual average of 36%. Capital and financial account widened by 5.6% y-o-y, financing 80% of the current account deficit. In the real estate market, House Price Index for Tirana rose at a slower pace, while Rental Price Index maintained its declining trend. On the other hand, lending for housing purposes grew by 7.2% y-o-y.
 
Households/individuals and businesses’ financial situation displayed the same trend in 2011 H2 as in the previous period. More specifically, individuals deepened their creditor position vis-à-vis the banking system further, following the considerable growth of deposits compared to the loans received. Creditor position in foreign currency expanded at a faster pace than that in the national currency. Businesses’ debtor position continues to deepen and, for the most part, it is denominated in foreign currency. Lending to the business sector was considerably higher than that to households in 2011. In the meantime, loan quality deteriorated for businesses and households, with businesses suffering higher loan quality deterioration. 

Financial markets in Albania were stable. In 2011 H2, the interbank market recorded higher traded values compared to the previous period. This change, however, was negligible y-o-y. Interbank rates reflected the key interest rate set by monetary policy, the respective maturity structure of the transaction and the fluctuations in banks’ demand for short-term liquidity. Over the period under review, the volume of Government bonds in the primary market declined compared to 2011 H1, reflecting the fall of Government demand for borrowing in H2. The composition of debt issued in the primary market was dominated by debt securities of up to 12-month maturity, although the decline in issues was present in T-bills and bonds. Average interest rate on debt securities issued in 2011 H2 remained close to the previous year’s level. Compared to a year earlier, the average interest rate on T-bills decreased, while that on bonds increased. Debt securities trading market posted growth; however, the comparative base still remains very low. T-bills of 12-month maturity have the major share in the stock of securities traded in the secondary market. In the foreign exchange market, the Lek was stable, depreciating slightly against the Euro and appreciating against the US dollar. In addition, volatility in trading was low. Lek’s exchange rate against the major currencies reflected the changes in supply/demand and the developments in the international foreign exchange market. Compared to 2011 H1, interest rate spread between loans and deposits denominated in Lek, Euro and US dollar narrowed, largely reflecting the lower interest rate on loans denominated in each of these currencies. 

The financial system expanded its activity further in 2011 H2, in line with the key indicators established by the supervisory framework. Banking sector assets grew by 13.7% y-o-y to ALL 1,120.17 billion. Loans increased by 15.5% y-o-y, accounting for about 50% of total banking sector assets. Deposits grew by 13.2%, accounting for 81.4% of total banking sector’s balance sheet. Foreign currency-denominated loans account for about 68% of the loan portfolio, while the share for deposits is almost equal. The average loan maturity is slightly lower, while increasing for deposits. Capital adequacy ratio improved to 15.6% at the end of the period due to the increase in capital for some banks. The continuous growth of deposits at a buoyant pace and the increase in liquid assets pursuant to the supervisory framework requirements provide evidence for a satisfactory liquidity situation. The positive profit, however, declined significantly at the end of the year, causing RoE and RoA to fall compared to end-2011 H1 and end-2010. The low return on investment in the international markets, the sluggish credit growth rates and the higher operating cost contributed to the fall in profit. The higher provisioning against credit risk, however, provided the major contribution in this regard. Loan quality deteriorated in almost all its categories. The ratio of non-performing loans to total loans stood at 18.8% at the end of the year. In 2011, the increase in non-performing loans ratio was slower than in 2010, but this primarily attributes to the faster growth of total loans. 

The performance of the banking sector in 2011 H2 is also assessed through the Financial Strength Index (FSI), which increased by 3.2 units compared to the previous half of the year, but dropped slightly compared to the same period in 2010. The higher FSI reflects the increase in liquidity and capital adequacy sub-indices and the exposure to exchange rate fluctuations. The sub-indices of asset quality, profitability and exposure to interest rate fluctuations provided an adverse contribution to the performance of the FSI.

In November 2011, the Parliament of the Republic of Albania approved some amendments to Law No. 9662, dated 18 December 2006 "On Banks in the Republic of Albania", drafted by the Bank of Albania. In addition to making some amendments in view of providing a clearer definition of electronic money activity and the respective financial institutions, in the framework of a better approach to the relevant EU Directive, the changes aimed at determining the systemic risk and strengthening Bank of Albania’s instruments for its addressing.

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

Concerning the impact of macroeconomic developments, it is assessed that fiscal stimulus and the contribution of foreign demand to economic growth will continue to reduce. Fiscal policy is necessary to continue the consolidation process, aiming at keeping the budget deficit at low levels and gradually lowering the public debt level. In addition, demand for borrowing should make better consideration of the objective for extending the average duration of debt, in order to ensure more appropriate refinancing conditions, including a better reallocation across the institutional investors and individuals. Special attention must be also paid to the performance of foreign currency liabilities over time, which initially requires the creation and cautious management of foreign currency resources. These factors may sharpen the expectations of economic operators for the deceleration of economic growth and may increase the probability for the decline of private investment and consumption. The differences in the economic growth rates and real interest rates between Albania and our trading partners will impact the performance of trade and current account deficit. The direction and magnitude of this impact will, however, depend on other factors as well and it still remains vague. Trade deficit is high and it represents a potential risk to the macroeconomic developments in Albania. Its reduction may become stable only if supported by consistent and long-term policies that stimulate domestic production and improve its competitiveness. In the foreseeable future, the inflationary pressures may continue to remain weak, hence providing more opportunities for the monetary authority to maintain accommodative monetary conditions. The latter have been reflected in the performance of the average interest rate on deposits held with banks. The benefit level of economic operators in the market from the provision of more favourable monetary conditions would also depend on their financial situation and the amount of banking sector lending, as well as the respective interest rate.  

Households and businesses are exposed to indirect credit risk; however, the magnitude of exposure varies due to their financial situation. Concerning households, exposure to adverse exchange rate movements mainly stem from foreign currency loans for house purchase purposes. Exposure to adverse interest rate movements is assessed to have reduced in 2011 H2 due to the lower share of variable interest rate loans in total household loans. However, households’ creditor position vis-à-vis the financial system smoothes out the effect of these risks. Concerning businesses, exposure to adverse exchange rate movements increased in 2011 H2 as a result of the higher share of foreign currency loans, unhedged against exchange rate risk, in total foreign currency loans. The quality deterioration for this category of loans was, however, lower than the decline in total value of business loans. Businesses also show higher exposure to adverse interest rate movements, when the latter increase. Businesses’ capacity to cope with these risks is also affected by their debtor position vis-à-vis the financial system.

Concerning financial system’s activity, direct and indirect credit risks represent the major risk, particularly to the banking sector. Loan quality deteriorated both for Lek and foreign currency loans, extended to businesses and households. However, its deterioration pace varied across the categories. Excluding the agriculture sector, the loan quality deteriorated in all the other sectors, and particularly in construction. In response to this situation, banks increased the level of their provisioning and strengthened the standard procedures for loan extension and monitoring. In this context, banks’ actions to address non-performing loans, including the increase in the number of loan practices submitted to the court for collateral execution, have accelerated over the period under review. These actions are necessary and they should remain consistent in the future as well. Addressing non-performing loan concerns in the banking sector is important to the pace of loan extension and the future contribution of the banking sector and financial system to Albania’s economic development. To this purpose, this issue was a topic of discussion in the last Financial Stability Advisory Group (FSAG) meeting. This meeting concluded that non-performing loans should be handled with priority, elaborately and thoroughly. Lowering the level of non-performing loans is a necessary step to release the considerable potential of the banking sector in financing valuable investment projects submitted by households and businesses. In the context, the FSAG made an assessment of the preliminary results of the work started by an ad hoc inter-institutional working group in identifying the legal and operational solutions that facilitate the collateral execution process, and encouraged their materialization. In addition, the FSAG pointed out that other regulatory and operational improvements, which facilitate and accelerate the loan-performing handling process need to be identified and implemented. The improvement of businesses’ liquidity situation would have a positive impact on the improvement of banking sector’s loan quality. The FSAG, therefore, suggested the Government to provide its contribution by fulfilling its payment obligations to the private sector’s contractors implementing different Government projects in due time and in compliance with the legal provisions for maintaining the fiscal indicators.

The banking sector appears relatively hedged against direct risk arising from adverse exchange rate and interest rate movements. This is evidenced by the low open foreign exchange position and the comparable amount of interest rate sensitive assets and liabilities in the banking sector’s balance sheet. It, however, appears sensitive to the impact of exchange rate and interest rate movements on its clients. A significant level of exchange rate depreciation or a similar increase of the interest rate may impair banking sector clients’ solvency, and particularly businesses’ solvency. Special attention must be paid to foreign currency-denominated loans and its risks, particularly when the main source of its settlement is in the national currency. In the case of a long-term loan transaction, banks and their clients must make well-reasoned decision-making regarding the performance of the interest rate in the future and the reciprocal mitigation of risk by establishing the most appropriate form of loan.

Liquidity risk to the banking sector is also at moderate levels. Deposits represent the key financial source for the banking sector and they grew at buoyant rates. Average maturity of deposits has increased. Borrowing from non-residents remains at contained levels. Banking sector’s liquid assets in Lek and in the major currencies have increased as a result of the higher regulatory requirements. Loan-to-deposit ratio remains at satisfactory levels and it provides necessary room for developing the activity further. Banks can meet their short-term liquidity needs in the interbank market and they can also participate in the liquidity injection operations conducted by the Bank of Albania on a regular basis. In this regard, banks, however, must be cautious in managing appropriate collaterals for borrowing in the interbank market.

Capitalization indicators are generally at better levels than in 2011 H1. The considerable increase of capital by some banks, following the prudential requirements of the Bank of Albania, provided the major contribution to this improvement. However, banking sector’s capacity to generate sufficient income to support the increase of capital, and develop its activity through domestic resources, needs to strengthen. Against a background of higher credit risk provisioning, banks should keep the performance of operating costs under control.

In order to assess the sensitivity of key banking sector capitalization indicators to movements in macroeconomic indicators, the Bank of Albania conducts stress test exercises on a regular basis. Stress testing contains the baseline scenario and one or more risk scenarios. These scenarios include assumptions related to movements in the GDP growth rate, exchange rate and interest rate, and the level of credit, and they run over a two-year time period until end-2013. Stress test results show that, overall, the banking sector appears stable in the event the assumptions about the respective indicators take place. Capitalization level for the entire sector remains above the minimum requirement in the event of the baseline scenario. In the event of the most severe scenario, which assumes the slowdown of lending and the fall in GDP growth rate, the banking sector may need additional capital. Individual banks need additional capital in the severe scenarios and the baseline scenario. In general, banking activity is carried out amidst a changeling internal and external economic environment. Banks should, therefore, monitor their activity closely, in order to identify and meet their needs for additional capital in due time. 

The technical infrastructure supporting banking sector activity is assessed to have operated in line with the expected parameters. This infrastructure is mainly represented by the payments system, which processes all the transactions banks make between them, with their clients or the Bank of Albania, on their behalf or on behalf of their clients. Compared to 2010, the number and value of transactions in the Automated Clearing House AECH) increased in 2011. In the meantime, the number and value of transactions in the Real Time Gross Settlement AIPS) decreased. The latter owes to the increase in the threshold value of transactions cleared in the AECH system and the lower use of Bank of Albania’s financial instruments by banks. The use of credit and debit cards has also increased. The pace of this increase was higher for credit cards due to the lower base. However, debit cards account for about 95% of cards in circulation. During the period under review, banks increased the number of ATMs and POSs further. As at end-2011, 11 banks offered internet banking services to their clients. The number and volume of transactions via the internet increased in 2011 H2.