BANK OF ALBANIA STATEMENT
Financial Stability Statement for H2 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 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. This Statement 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 improved further its profit, capitalisation and liquidity indicators. The volume of activity expanded at lower paces due to the slower increase in deposits and the considerable decrease in lending rates. Macroeconomic framework appeared stable despite the further slowdown of economic growth. It is characterised by a low fluctuating exchange rate, weak inflationary pressures and decreased government borrowing cost despite the increase in budget deficit and public debt. Financial markets operated in line with their last years' trend, characterised by upward activity volume and transactions. Credit risk represents the most important challenge to the banking sector. Banking sector's exposure to market and liquidity risks remains contained. The following provides an overview of developments in the surrounding economic environment, both internal and external ones, and within the financial system.

Notwithstanding the improved functioning of global financial markets, economic developments remain unstable. Economic growth in advanced economies contracted, whereas developing economies continue to provide positive contribution to economic growth. The United States and Europe recorded a more pronounced slowdown of economic growth in 2012 Q4. Also, countries in South-Eastern Europe recorded a further decrease in economic growth in the last part of 2012, or a contraction across different countries. Inflationary pressures remained weak due to the sustainable output gap, increased unemployment and decrease in oil and food prices. Monetary policies remain deeply eased, while governments' actions, particularly in Europe, are aiming at fiscal consolidation, business climate improvement and labour market liberalisation, mainly with a medium-term effect. Situation in financial markets remains more stabilised, particularly after the European Central Bank actions. However, the demand for loans, particularly in euro area and Central and South-Eastern Europe, continues to remain weak due to the perceived credit risk and the need for further restructuring of banks and other credit institutions' balance-sheets. Capital markets, particularly in the United States, increased driven by the improved investors' confidence following the more optimistic indicators on the economic growth. Economic developments at home remain similar to the previous period, characterised by a slower pace of economic growth. Albania's economic growth averaged 1.6% in 2012 Q4. Consumption and private investments continue to be weak, whilst unemployment rate remains stable. Industry, agriculture and services provided positive contribution to economic growth, whereas transport and construction provided a negative contribution.  ver the period under review, external demand provided positive contribution to economic growth leading to a decrease in both current and trade account deficit, in absolute value and as a percentage of GDP. Economic developments were reflected in an annual decrease in fiscal revenues, mainly driven by the fall in tax revenues. Fiscal deficit was estimated at 3.4% of GDP as at end-2012. The Parliament approved the Government request to increase public debt to GDP ratio to above 60%, motivated by the need to increase the contribution of fiscal incentive to economic growth. The average term of debt continued to increase due to the sharper increase in the value of debt issues with maturity term longer than 12 months. During the period under review, due to the low inflationary pressures, Bank of Albania implemented an easing monetary policy by cutting the interest rate on one-week repurchase agreements several times. This monetary policy stance aims at providing better conditions to support consumption and private investments th ough lowering the financing costs in the domestic currency.

Businesses and households' financial position and sensitivity against risks did not show any substantial change throughout the period. Households' creditor position deepened, mainly driven by the considerable increase in foreign currency deposits. Loan quality for households has been worsening in almost all its components. Households' exposure against unfavourable exchange rate and interest rate changes does not show substantial changes from the previous period. Businesses' debtor position has been reducing during the period due to the lower increase in loans than in deposits. Businesses' debtor position is mainly impacted by the activity in foreign currency. Business nonperforming loan ratio increased due to the considerable slowdown in lending, despite the lower growth rate of non-performing loans. Businesses' exposure to unfavourable exchange rate and interest rate changes, albeit still high, reduced slightly during the period.

Overall, financial markets at home pursued the recent years' tendency. Related to non-financial assets, worth noting is the simultaneous fall and at similar paces of house and rental price index. This was due to the lower increase in the relative cost of real estate loan payment in the last quarter of 2012. Combined, this information suggests a more stable continuation of the downward trend in house prices. In the government debt securities market, there was an increasing preference for debt issues of longer than 12 months maturity. Interest rates have been decreasing, reflecting the cut of the key interest rate by the Bank of Albania, and the ample liquidity due to the considerable slowdown in lending to the private sector. In the secondary market for debt securities, trading volumes remain low and concentrated only in T-bills. Volume in the interbank market grew considerably. Overnight transactions had the main share in the number of transactions, although oneweek transactions grew considerably. Interest rate in interbank transactions has reflected the performance of the key interest rate. In the foreign exchange market, lek was relatively stable against both, euro and US dollar. Technical infrastructure supporting banking sector activity has operated in line with the expected parameters. Payment systems constitute an important part of financial system structure being the channels to transfer funds between banks, other financial institutions  nd customers. As a consequence, their stable and efficient operation contributes significantly to safeguarding financial stability. During this period, AIPS and AECH systems have operated in compliance with the technical requirements to meet the banking sector needs relating to settling payment transactions in the domestic currency. The volume and value of transactions processed in AIPS increased in 2012, followed by an almost doubled value per transaction. The number and value of transactions processed in AECH have been falling. In both systems, transactions processed on behalf of banks' customers have the main share in the value and number of transactions. According to banks, the four most active banks in both systems account for 2/3 of the number and value of processed transactions. Due to the importance of these systems, the Bank of Albania shall engage in carrying out all the required improvements to the regulatory framework and supportive technological infrastructure, in order to ensure that their performance precedes the operators' needs for a safe  nd effective payment activity.

Banking sector improved its profit, capitalisation and liquidity indicators further in 2012 H2. Activity volume increased at lower paces, due to the sluggish increase in deposits and considerable decrease in lending pace. The level of financial intermediation in Albania, as measured by the ratio of financial system2 assets to GDP, was 93.9% at end-2012, from 92.8% in 2012 H1 and 89.5% in the same period a year earlier. The volume of financial institutions' assets grew by about 2.9% from 2012 H1 and by about 7.3% from a year earlier. The banking sector remains the dominant segment of financial intermediation in Albania. Its assets account for about 93.6% of total financial system assets and about 87.9% of GDP.

Total banking sector's assets grew to ALL 1,187.98 billion, up by 6.1% from the previous year, but down by 0.1% in 2012 Q4. The annual growth rate of lending slowed down considerably to 2%. Due to the contraction in foreign currency lending, the growth of lending in lek by 12.8% provided the sole contribution to the growth of lending. The slowdown in banking sector indicators was more evident during 2012 Q4, as the economic growth decelerated compared to the previous period. Loan-to-deposit ratio was 58.6% as at end-2012. Loan stock increased ALL 11.8 billion during the year, from ALL 75.2 billion in 2011. Despite the low growth in loans, new banking sector loans during 2012 were comparable to the previous year. Hence, the increase in loan repayments at higher levels over 2012 impacted the credit stock performance. Non-performing loans to total loans ratio stood at 22.5%, down by 0.24 percentage points in 2012 Q4, but up 3.72 percentage points from end-2011. Lek loan ratio stood at 18.5%, up by 1.6 percentage points from December 2011 and improving by 0.9 percentage points from September 2012. Foreign currency loan ratio stood at 24.7%, up by 5.0 percentage points from end-2011 and increasing by 0.3 percentage points in 2012 Q4. Deposits amounted to ALL 991.6 billion, increasing by 7.3% during the year. The growth of foreign currency deposits was higher than that of lek deposits.

The banking sector registered a positive financial result, with an accumulated net profit of ALL 3.8 billion. "Net interest income" totalled ALL 39.8 billion, or 0.3% higher than in the previous year. Loan loss provisions increased by about ALL 19 billion, or about 12% lower than a year earlier. Paid in capital increased by about ALL 9.5 billion (about 2/3 of the increase took place during 2012 H1). Regulatory capital climbed to ALL 104.1 billion, up by 5.7%. Risk-weighted assets rose to ALL 643.7 billion, up 1.7%, y-o-y. Consequently, capital adequacy ratio rose to 16.2%. Risks to the financial system stem from its interaction with the surrounding economic environment and its own activity.

Concerning the impact of macroeconomic developments, fiscal stimulus contribution to economic growth would be more significant if accompanied by improved confidence of economic agents in the sustainability of medium-term fiscal indicators. The increase in budget deficit and public debt is expected to be accompanied by a higher fiscal stimulus in the economic activity at home. The orientation of expenses to capital ones, including those in the form of settlement of existing liabilities to private sector entities, would be important to improve the financial situation of these entities and related ones in business relationships. This behaviour would improve their solvency and the quality of debt they have against the banking sector. On the other hand, economic agents' perception about the economic situation determines the difficulties the Albanian and global economy are encountering. A prolonged negative perception becomes a lack of confidence for an optimistic outlook and impels economic agents to undertake actions that aim to restrict the damage in their financial performance. In a more generalised framework, these actions undertaken individually reinforce the decelerating cycle of economic developments bringing about negative consequences in a broader context. Therefore, the Bank of Albania deems that fiscal policy objective to encourage economic growth should be followed with the objective of improving the economic agents' confidence in the stability of fiscal indicators. This would require the establishment of a stable fiscal rule in the short-term, which will set the maximum public debt limits in the medium-term and will provide the return of this indicator to a downward stable trend. Bank of Albania has formulated the proposals in this regard and is willing to contribute to this process on the way this rule will be established and function. The Bank of Albania assesses positively the Ministry of Finance's policy to increase the issue of debt securities with a maturity l nger than 12 months. The extension of the average maturity of debt reduces the re-investment risk in debt securities and its cost volatility. For this reason, this policy should continue to carefully consider the liquidity situation in the interbank market and other investors' demand. The cautious monitoring of foreign currency liabilities is another important element in fiscal policy. Actions to provide, in due time and at an acceptable cost, the foreign currency sources to meet these obligations, contributes to avoi ing instabilities in the market and fostering financial stability.

In the activity of financial system, direct and indirect credit risk represent major risks, particularly to the banking sector. Credit quality deterioration during 2012 was accompanied by a considerable slowdown in lending pace. As both tendencies have a strengthennig effect on each other, the Bank of Albania undertook some measures to encourage banks to lend and engage in earlier loan restructuring. More specifically, in order to boost lending, the regulatory amendments provide for:

a. removal of capital requirements for the annual growth of lending to the economy if it ranges between 4-10%.

b. the increase in capital requirements for the additional banking sector investments with non-resident financial institutions.

c. overall decrease by 5 percentage points of the regulatory requirement for the minimum liquidity ratio in total, in lek and foreign currency, compared to the existing level, by banks' risk profile. To address the phenomenon of non-performing loans increase, the regulatory amendments provide for:

a. loan restructuring since the stage it is categorised as standard but the borrower begins to manifest the first problems in paying the credit. The new terms and conditions following the loan modification process seek to preserve borrower's solvency and loan quality. This loan will continue to be classified as standard (in the first two categorisation classes) but will require higher provisioning of 10%.

b. decreasing from nine months (or until the borrower has paid 3 loan instalments) to six months of the restructured loan classified in the same category, to encourage banks' interest toward the restructuring process. The change in capital requirements for the annual growth of credit and banking sector investments with non-resident financial institutions is counter cyclical and transitory, and will be effective for 2013-14. Unless otherwise decided by the Bank of Albania, these amendments will be repealed upon the termination of the effect period, and banks will ensure compliance with the current regulatory framework requirements by June 2015. This mechanism is considered important to preserve banks' cautious lending and well-capitalised activity.

These measures follow-up on the legal proposals for amendments to the Civil Code and Code of Civil Procedure, which aim at improving the collateral execution process. The Bank of Albania considers that the timely approval of these amendments by the Albanian Parliament will be conducive to tackling and easing banking sector's non-performing loan situation, contributing in turn to recovering lending.

The primary objective of the Bank of Albania is to maintain a stable banking sector. Under the impact of these amendments, banks' behaviour will therefore be monitored closely and continuously, in order to assess the impact of these measures on banking activity indicators and identify the need for further action. The presence of high non-performing loans stock in banks' balance sheet, give rise to the banks' activity cost and imposes an increased and inefficient use of their capacities. As a result, bank services tend to be more expensive for the consumer. Typically, the above measures aim to slowdown the further increase of non-performing loans ratio to total loans. In this framework, it is important to assess the needed additional actions as well address the existing stock of non-performing loans.

The Albanian 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 customers. A significant level of exchange rate depreciation or a similar increase in the interest rate may impair bank customers' solvency, particularly in the business sector. This risk arises mainly from foreign currency-denominated loans, when the main source of their settlement is in the domestic currency, and also from the variable interest rate loans. Liquidity risk to the banking sector is assessed at moderate levels. As in the previous periods, deposits constitute the key financing source for the banking sector. They grew at satisfactory rates, abeit slower, during 2012. Borrowing from non-residents pursued a fal ing tendency and remains controlled. Banking sector's liquid assets in lek and in major foreign currencies remained notably above the minimum rates required by the regulatory framework. Loan to deposit ratio stands at optimal levels due to the sluggish lending. Currently, capitalisation indicators are at good levels, although banks should assess carefully their needs for additional capital in the future. During the period under review, the sluggish growth of risk-weighted assets provided the main contribution to this increase. Despite the positive financial result, banking sector's ability to generate sufficient income to support the increase in capital and carry out its activity through domestic resources remains unstable. On the other hand, net non-performing loan coverage with capital was lower. Banks should, therefore, assess carefully and proactively their needs for additional capital in line  ith their activity risk profile. Whenever needed, based on this assessment, banks should act to enhance their capital position, initially by restric ing the allocation of profit and then by injecting additional capital.

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-2014. Stress-test results show that, overall, the banking sector appears resilient in the event the assumptions about respective indicators take place. Capitalisation for the entire sector remains above the required minimum for the baseline scenario. In the event of the most severe scenarios, which assume the fall in GDP growth rate, credit slowdown and exchange rate depreciation, individual banks may need additional capital.

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 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. This Statement 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 improved further its profit, capitalisation and liquidity indicators. The volume of activity expanded at lower paces due to the slower increase in deposits and the considerable decrease in lending rates. Macroeconomic framework appeared stable despite the further slowdown of economic growth. It is characterised by a low fluctuating exchange rate, weak inflationary pressures and decreased government borrowing cost despite the increase in budget deficit and public debt. Financial markets operated in line with their last years' trend, characterised by upward activity volume and transactions. Credit risk represents the most important challenge to the banking sector. Banking sector's exposure to market and liquidity risks remains contained. The following provides an overview of developments in the surrounding economic environment, both internal and external ones, and within the financial system.

Notwithstanding the improved functioning of global financial markets, economic developments remain unstable. Economic growth in advanced economies contracted, whereas developing economies continue to provide positive contribution to economic growth. The United States and Europe recorded a more pronounced slowdown of economic growth in 2012 Q4. Also, countries in South-Eastern Europe recorded a further decrease in economic growth in the last part of 2012, or a contraction across different countries. Inflationary pressures remained weak due to the sustainable output gap, increased unemployment and decrease in oil and food prices. Monetary policies remain deeply eased, while governments' actions, particularly in Europe, are aiming at fiscal consolidation, business climate improvement and labour market liberalisation, mainly with a medium-term effect. Situation in financial markets remains more stabilised, particularly after the European Central Bank actions. However, the demand for loans, particularly in euro area and Central and South-Eastern Europe, continues to remain weak due to the perceived credit risk and the need for further restructuring of banks and other credit institutions' balance-sheets. Capital markets, particularly in the United States, increased driven by the improved investors' confidence following the more optimistic indicators on the economic growth. Economic developments at home remain similar to the previous period, characterised by a slower pace of economic growth. Albania's economic growth averaged 1.6% in 2012 Q4. Consumption and private investments continue to be weak, whilst unemployment rate remains stable. Industry, agriculture and services provided positive contribution to economic growth, whereas transport and construction provided a negative contribution.  ver the period under review, external demand provided positive contribution to economic growth leading to a decrease in both current and trade account deficit, in absolute value and as a percentage of GDP. Economic developments were reflected in an annual decrease in fiscal revenues, mainly driven by the fall in tax revenues. Fiscal deficit was estimated at 3.4% of GDP as at end-2012. The Parliament approved the Government request to increase public debt to GDP ratio to above 60%, motivated by the need to increase the contribution of fiscal incentive to economic growth. The average term of debt continued to increase due to the sharper increase in the value of debt issues with maturity term longer than 12 months. During the period under review, due to the low inflationary pressures, Bank of Albania implemented an easing monetary policy by cutting the interest rate on one-week repurchase agreements several times. This monetary policy stance aims at providing better conditions to support consumption and private investments th ough lowering the financing costs in the domestic currency.

Businesses and households' financial position and sensitivity against risks did not show any substantial change throughout the period. Households' creditor position deepened, mainly driven by the considerable increase in foreign currency deposits. Loan quality for households has been worsening in almost all its components. Households' exposure against unfavourable exchange rate and interest rate changes does not show substantial changes from the previous period. Businesses' debtor position has been reducing during the period due to the lower increase in loans than in deposits. Businesses' debtor position is mainly impacted by the activity in foreign currency. Business nonperforming loan ratio increased due to the considerable slowdown in lending, despite the lower growth rate of non-performing loans. Businesses' exposure to unfavourable exchange rate and interest rate changes, albeit still high, reduced slightly during the period.

Overall, financial markets at home pursued the recent years' tendency. Related to non-financial assets, worth noting is the simultaneous fall and at similar paces of house and rental price index. This was due to the lower increase in the relative cost of real estate loan payment in the last quarter of 2012. Combined, this information suggests a more stable continuation of the downward trend in house prices. In the government debt securities market, there was an increasing preference for debt issues of longer than 12 months maturity. Interest rates have been decreasing, reflecting the cut of the key interest rate by the Bank of Albania, and the ample liquidity due to the considerable slowdown in lending to the private sector. In the secondary market for debt securities, trading volumes remain low and concentrated only in T-bills. Volume in the interbank market grew considerably. Overnight transactions had the main share in the number of transactions, although oneweek transactions grew considerably. Interest rate in interbank transactions has reflected the performance of the key interest rate. In the foreign exchange market, lek was relatively stable against both, euro and US dollar. Technical infrastructure supporting banking sector activity has operated in line with the expected parameters. Payment systems constitute an important part of financial system structure being the channels to transfer funds between banks, other financial institutions  nd customers. As a consequence, their stable and efficient operation contributes significantly to safeguarding financial stability. During this period, AIPS and AECH systems have operated in compliance with the technical requirements to meet the banking sector needs relating to settling payment transactions in the domestic currency. The volume and value of transactions processed in AIPS increased in 2012, followed by an almost doubled value per transaction. The number and value of transactions processed in AECH have been falling. In both systems, transactions processed on behalf of banks' customers have the main share in the value and number of transactions. According to banks, the four most active banks in both systems account for 2/3 of the number and value of processed transactions. Due to the importance of these systems, the Bank of Albania shall engage in carrying out all the required improvements to the regulatory framework and supportive technological infrastructure, in order to ensure that their performance precedes the operators' needs for a safe  nd effective payment activity.

Banking sector improved its profit, capitalisation and liquidity indicators further in 2012 H2. Activity volume increased at lower paces, due to the sluggish increase in deposits and considerable decrease in lending pace. The level of financial intermediation in Albania, as measured by the ratio of financial system2 assets to GDP, was 93.9% at end-2012, from 92.8% in 2012 H1 and 89.5% in the same period a year earlier. The volume of financial institutions' assets grew by about 2.9% from 2012 H1 and by about 7.3% from a year earlier. The banking sector remains the dominant segment of financial intermediation in Albania. Its assets account for about 93.6% of total financial system assets and about 87.9% of GDP.

Total banking sector's assets grew to ALL 1,187.98 billion, up by 6.1% from the previous year, but down by 0.1% in 2012 Q4. The annual growth rate of lending slowed down considerably to 2%. Due to the contraction in foreign currency lending, the growth of lending in lek by 12.8% provided the sole contribution to the growth of lending. The slowdown in banking sector indicators was more evident during 2012 Q4, as the economic growth decelerated compared to the previous period. Loan-to-deposit ratio was 58.6% as at end-2012. Loan stock increased ALL 11.8 billion during the year, from ALL 75.2 billion in 2011. Despite the low growth in loans, new banking sector loans during 2012 were comparable to the previous year. Hence, the increase in loan repayments at higher levels over 2012 impacted the credit stock performance. Non-performing loans to total loans ratio stood at 22.5%, down by 0.24 percentage points in 2012 Q4, but up 3.72 percentage points from end-2011. Lek loan ratio stood at 18.5%, up by 1.6 percentage points from December 2011 and improving by 0.9 percentage points from September 2012. Foreign currency loan ratio stood at 24.7%, up by 5.0 percentage points from end-2011 and increasing by 0.3 percentage points in 2012 Q4. Deposits amounted to ALL 991.6 billion, increasing by 7.3% during the year. The growth of foreign currency deposits was higher than that of lek deposits.

The banking sector registered a positive financial result, with an accumulated net profit of ALL 3.8 billion. "Net interest income" totalled ALL 39.8 billion, or 0.3% higher than in the previous year. Loan loss provisions increased by about ALL 19 billion, or about 12% lower than a year earlier. Paid in capital increased by about ALL 9.5 billion (about 2/3 of the increase took place during 2012 H1). Regulatory capital climbed to ALL 104.1 billion, up by 5.7%. Risk-weighted assets rose to ALL 643.7 billion, up 1.7%, y-o-y. Consequently, capital adequacy ratio rose to 16.2%. Risks to the financial system stem from its interaction with the surrounding economic environment and its own activity.

Concerning the impact of macroeconomic developments, fiscal stimulus contribution to economic growth would be more significant if accompanied by improved confidence of economic agents in the sustainability of medium-term fiscal indicators. The increase in budget deficit and public debt is expected to be accompanied by a higher fiscal stimulus in the economic activity at home. The orientation of expenses to capital ones, including those in the form of settlement of existing liabilities to private sector entities, would be important to improve the financial situation of these entities and related ones in business relationships. This behaviour would improve their solvency and the quality of debt they have against the banking sector. On the other hand, economic agents' perception about the economic situation determines the difficulties the Albanian and global economy are encountering. A prolonged negative perception becomes a lack of confidence for an optimistic outlook and impels economic agents to undertake actions that aim to restrict the damage in their financial performance. In a more generalised framework, these actions undertaken individually reinforce the decelerating cycle of economic developments bringing about negative consequences in a broader context. Therefore, the Bank of Albania deems that fiscal policy objective to encourage economic growth should be followed with the objective of improving the economic agents' confidence in the stability of fiscal indicators. This would require the establishment of a stable fiscal rule in the short-term, which will set the maximum public debt limits in the medium-term and will provide the return of this indicator to a downward stable trend. Bank of Albania has formulated the proposals in this regard and is willing to contribute to this process on the way this rule will be established and function. The Bank of Albania assesses positively the Ministry of Finance's policy to increase the issue of debt securities with a maturity l nger than 12 months. The extension of the average maturity of debt reduces the re-investment risk in debt securities and its cost volatility. For this reason, this policy should continue to carefully consider the liquidity situation in the interbank market and other investors' demand. The cautious monitoring of foreign currency liabilities is another important element in fiscal policy. Actions to provide, in due time and at an acceptable cost, the foreign currency sources to meet these obligations, contributes to avoi ing instabilities in the market and fostering financial stability.

In the activity of financial system, direct and indirect credit risk represent major risks, particularly to the banking sector. Credit quality deterioration during 2012 was accompanied by a considerable slowdown in lending pace. As both tendencies have a strengthennig effect on each other, the Bank of Albania undertook some measures to encourage banks to lend and engage in earlier loan restructuring. More specifically, in order to boost lending, the regulatory amendments provide for:

a. removal of capital requirements for the annual growth of lending to the economy if it ranges between 4-10%.

b. the increase in capital requirements for the additional banking sector investments with non-resident financial institutions.

c. overall decrease by 5 percentage points of the regulatory requirement for the minimum liquidity ratio in total, in lek and foreign currency, compared to the existing level, by banks' risk profile. To address the phenomenon of non-performing loans increase, the regulatory amendments provide for:

a. loan restructuring since the stage it is categorised as standard but the borrower begins to manifest the first problems in paying the credit. The new terms and conditions following the loan modification process seek to preserve borrower's solvency and loan quality. This loan will continue to be classified as standard (in the first two categorisation classes) but will require higher provisioning of 10%.

b. decreasing from nine months (or until the borrower has paid 3 loan instalments) to six months of the restructured loan classified in the same category, to encourage banks' interest toward the restructuring process. The change in capital requirements for the annual growth of credit and banking sector investments with non-resident financial institutions is counter cyclical and transitory, and will be effective for 2013-14. Unless otherwise decided by the Bank of Albania, these amendments will be repealed upon the termination of the effect period, and banks will ensure compliance with the current regulatory framework requirements by June 2015. This mechanism is considered important to preserve banks' cautious lending and well-capitalised activity.

These measures follow-up on the legal proposals for amendments to the Civil Code and Code of Civil Procedure, which aim at improving the collateral execution process. The Bank of Albania considers that the timely approval of these amendments by the Albanian Parliament will be conducive to tackling and easing banking sector's non-performing loan situation, contributing in turn to recovering lending.

The primary objective of the Bank of Albania is to maintain a stable banking sector. Under the impact of these amendments, banks' behaviour will therefore be monitored closely and continuously, in order to assess the impact of these measures on banking activity indicators and identify the need for further action. The presence of high non-performing loans stock in banks' balance sheet, give rise to the banks' activity cost and imposes an increased and inefficient use of their capacities. As a result, bank services tend to be more expensive for the consumer. Typically, the above measures aim to slowdown the further increase of non-performing loans ratio to total loans. In this framework, it is important to assess the needed additional actions as well address the existing stock of non-performing loans.

The Albanian 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 customers. A significant level of exchange rate depreciation or a similar increase in the interest rate may impair bank customers' solvency, particularly in the business sector. This risk arises mainly from foreign currency-denominated loans, when the main source of their settlement is in the domestic currency, and also from the variable interest rate loans. Liquidity risk to the banking sector is assessed at moderate levels. As in the previous periods, deposits constitute the key financing source for the banking sector. They grew at satisfactory rates, abeit slower, during 2012. Borrowing from non-residents pursued a fal ing tendency and remains controlled. Banking sector's liquid assets in lek and in major foreign currencies remained notably above the minimum rates required by the regulatory framework. Loan to deposit ratio stands at optimal levels due to the sluggish lending. Currently, capitalisation indicators are at good levels, although banks should assess carefully their needs for additional capital in the future. During the period under review, the sluggish growth of risk-weighted assets provided the main contribution to this increase. Despite the positive financial result, banking sector's ability to generate sufficient income to support the increase in capital and carry out its activity through domestic resources remains unstable. On the other hand, net non-performing loan coverage with capital was lower. Banks should, therefore, assess carefully and proactively their needs for additional capital in line  ith their activity risk profile. Whenever needed, based on this assessment, banks should act to enhance their capital position, initially by restric ing the allocation of profit and then by injecting additional capital.

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-2014. Stress-test results show that, overall, the banking sector appears resilient in the event the assumptions about respective indicators take place. Capitalisation for the entire sector remains above the required minimum for the baseline scenario. In the event of the most severe scenarios, which assume the fall in GDP growth rate, credit slowdown and exchange rate depreciation, individual banks may need additional capital.