BANK OF ALBANIA STATEMENT
Financial Stability Statement for H2 2013

Pursuant to provisions under Article 69 of Law No. 8269, dated 23 December 1997 'On the Bank of Albania', as amended, and Article 8 of Law No. 9962, dated 18 December 2006 'On banks in the Republic of Albania', as amended, to inform the Assembly of the Republic of Albania and the Council of Ministers, and 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 periodic Statement. The Statement is an integral part of the Financial Stability Report for the same stated period.

The Albanian banking sector and financial system were stable in 2013 H2. Despite the lower economic growth, developments in the macroeconomic setting sustained the performance of the financial system. The macroeconomic setting was characterised by low exchange rate volatility and weak inflationary pressures, notwithstanding the easing monetary policy. Moreover, government borrowing costs dropped significantly, in spite of the budget deficit and public debt increase. The agreement with the International Monetary Fund is an important step toward ensuring macroeconomic stability and stabilising economic agents' expectations. However, the acceleration of economic growth assumes primary importance with regard to placing the financial activity on a stable growth track. In financial markets, the volume of trading and number of transactions have been steady. In the banking sector, capitalisation and liquidity indicators were at sound levels, supported by the improved net financial result. The banking activity volume expanded at slower rates, as deposits' increase decelerated and crediting contracted. Non-performing loans have grown at the lowest annual rates since 2008. Credit risk poses the most important challenge to the banking sector, but its size is expected to be more contained. In the near future, it is expected to trend down gradually due to effects from legal amendments and operational measures that will enter into force, or be applied more effectively, during 2014. Such measures will enhance the banking industry's capability to handle non-performing loans systematically. In the meantime, the banking sector's exposure to market and liquidity risks remains limited.

Following is a summary of key developments in the economic landscape and financial system, and assessment of risks facing the banking sector activity, including systemic risk.

• Economic and financial developments

The global economy continued to improve steadily during the second half of 2013, although at lower rates and at different pace across different regions. 
Advanced economies showed positive signs of stability, whereas some of the developing economies slowed down their growth pace. The US economy continued to grow at a satisfactory rate, sustained by higher consumption and exports. The euro area economy is showing steady signs of gradual recovery, although unevenly across Member States. Developing economies continued to be the main contributors to global growth during 2013, but at a slower pace than a year earlier. This phenomenon has reflected the weaker domestic demand in some of these economies, also as a result of tighter lending terms, political uncertainties and more tense financial markets. Globally, inflationary pressures have been low due to stable commodity prices, spare production capacities and well-anchored inflation expectations. In the context of a positive but modest economic performance, the monetary policy in advanced economies continued to be accommodating.

Economies in Central East and South-east Europe continued to recover gradually, also thanks to the economic recovery in the euro area. The economies in our region improved during 2013. GDP grew at positive rates in the countries that had been in recession during 2012. Rates also improved in the rest of the countries. However, low levels of credit to the private sector and rise in non-performing loans are the main challenges for these countries' economic recovery and financial stability.

Financial markets continued to stabilise under the positive effect of support measures by central banks and the better economic performance of advanced economies. In these economies, lending terms eased during the second half of 2013, mainly in the sovereign debt markets in euro area countries. Risk premiums on government securities in the debt-stricken countries have fallen and fragmentation inside the market is lessened. In developing markets, lending terms have been tighter, triggered especially by the actions of the Federal Reserve to reduce its quantitative easing programmes, and the reinstatement of traditional monetary policy in advanced economies.

The global economy is expected to continue improving in the current year, sustained primarily by the recovery of advanced economies. However, a number of risks remain, mainly related to the very low inflation, and the likelihood of sudden rise in interest rates, as a result of unexpected developments in financial markets.

The need to accelerate economic growth in the country became even more evident, after the significant slowdown in 2013. 
After contracting 2.5% in the third quarter, Albania's economy posted 1.1% real growth in the fourth quarter, from the same period a year earlier. The average growth rate for 2013 was 0.44%. In spite of improvement in the fourth quarter in some sectors of the economy such as industry, agriculture and construction, aggregate demand is assessed as weak, given that private investments are low and unemployment rate is higher. During the period under review, foreign demand contributed negatively to economic growth, as current account deficit expanded. Still, exports performed well, driven by the energy and mineral products. During the period, the fiscal policy was overall expansionary, but the volatility in the fiscal performance was higher, reflecting some changes to the decision-making policy dictated by political developments. Budget deficit was funded mainly by domestic resources, with downward costs. In response to these developments and contained inflationary pressures, the Bank of Albania continued to implement a stimulating monetary policy. This was reflected in falling interest rates in financial markets at home, which better support the countercyclical actions for the activity of the banking sector, undertaken during 2013.

In the future, albeit improving, foreign demand will remain limited. Contribution of consumption and private investments to domestic demand may improve, sustained by economic agents' improved expectations because of low interest rates and better liquidity indicators. Fiscal policy is expected to be expansionary, similar to 2013. However, the acceleration of economic growth remains highly important to place the financial activity on a stable growth track. Therefore, reforms for improving the business climate and payment of arrears for public works done by private businesses may provide a significant contribution.

Households and businesses were exposed to indirect credit risks, at similar levels to previous periods. 
During the period under review, households and businesses were more inclined to save, as reflected by deposits performance. Lending to households expanded at low rates, whereas lending to businesses shrank. Only lek-denominated credit gave positive contribution to credit performance. Credit quality improved for households and moderately deteriorated for businesses, generally because of the slowdown of non-performing loans increase. Households and business remain exposed to indirect credit risk, depending on their exposure to credit unhedged against unfavourable exchange rate and interest rate fluctuations.

In financial markets, trading volume increased, whereas interest rates sharpened their downward trend. 
In the government debt securities' market, demand for borrowing was met by investor's higher interest in investing. This has been an additional factor for downward interest rates on all maturities. In the secondary market of government debt securities, the number of transactions fell slightly, whereas yield on 3 and 6-month T-bills increased. In the interbank market, the volume increased significantly, mainly for the short-term 1 and 7-day maturities. Although more volatile at the end of the period, the average weighted interest rate ranged below the base rate, overall, reflecting the better liquidity situation. In the foreign exchange market, throughout the year, the lek depreciated slightly against the euro and appreciated against the US dollar, reflecting the demand and supply in the domestic market and developments in the international forex market.

Technical infrastructure supporting banking sector operation functioned effectively. 
During the period, AIPS and AECH payment systems operated in compliance with the technical conditions for meeting banking sector needs for settling lek payment transactions. In both systems, the volume and the value of transactions increased. The average value per transaction increased, as well.

The financial system increased its share in Albania's economic activity, in the second half of 2013. 
Financial intermediation, calculated as the ratio of financial system assets to Gross Domestic Product (GDP), was up 3 percentage points, to 99.1%, during the period. The banking sector remained the dominant segment of financial intermediation in Albania. Its assets accounted for about 91.4% of total financial system assets and around 90.5% of GDP.

In the banking sector, capitalisation and liquidity levels were adequate, also supported by the improved net financial result. 
Banking sector's total assets rose to ALL 1,234.3 billion, posting 3.9% annual growth. On the asset side, interbank and security transactions registered major increase, reflecting primarily the higher participation of the banking sector in government debt security auctions. Banking activity was financed by increase in public deposits, albeit at lower rates. Banking sector exposure to non-resident institutions was similar to the previous period, reflecting banking sector's low reliance on foreign financing sources. During the year, credit shrank 1.8%. The 2.4% lek credit growth could not offset the 4.2% foreign currency credit contraction. Credit stock fell significantly due to banks' selling off non-performing loans and their write offs.

New loans by the banking sector were 16% down from the same period a year earlier. At the end of 2013, the ratio of non-performing loans to total loans was 23.5%, from 22.5% at end-2012 and 24.2% at end-June 2013. The non-performing loan ratio for lek loans was 19.7%, down 0.4 percentage points from June 2013. The non-performing loan ratio for foreign currency loans was 25.7%, down 0.8 percentage points from June 2013. Deposits totalled ALL 1,013.5 billion, up 3.6% from a year earlier. Lek and foreign currency deposits grew 5.2% and 1.7%, respectively, year on year. The credit to deposit ratio stood at 55.6%. This ratio in lek stood at 40.8%, being stable in the last two years, while in foreign currency, it stood at 69.8%, the lowest rate since 2007, reflecting mostly the contraction of foreign currency loans.

At sectorial level, banks recorded positive profit, with accumulated net profit of ALL 6.6 billion, from ALL 3.8 billion a year earlier. Net interest income totalled ALL 39.5 billion, or 0.6% lower than a year earlier. Loan-loss provisions increased by around ALL 14.9 billion, or 49% lower than a year earlier. During the period, paid-in capital rose by around ALL 10.5 billion, or 11.3%. Regulatory capital rose to ALL 115.2 billion, up 10.6%, whereas risk-weighted assets slipped to ALL 641.3 billion, down 0.4%. Subsequently, the capital adequacy ratio rose to 18.0%.

• Risk assessment

To assess risks, the banking sector performance and its interaction with the real economy, as well as the financial situation of economic agents and other segments of the financial system were considered. To assess the stability of the banking sector against unfavourable macroeconomic developments and the activity of the banking sector, a stress test exercise was conducted.
 
For a synthesised evaluation of risks to the banking sector, real economy and economic agents, the Financial Stability Map (FSM) is used. For 2013, the FSM shows that risks to the financial stability have moved slightly towards economic agents. More specifically, in the case of the domestic economy, the exchange rate stability and low inflation rates were reflected in an almost unchanged risk level, despite the expansion of the negative output gap, in the context of economic growth deceleration. The risk is assessed as increased for businesses, due to contraction of business credit, deterioration of its quality, and downward production index, from a year earlier. For households, the significant increase in the unemployment rate and pessimistic expectations on the economic outlook for the first half of 2014 were reflected in the increase of their risk from a year earlier, regardless of the relative quality improvement of household borrowing at the end of 2013. For the government, the expansion of the budget deficit and the performance of tax revenues contributed to higher risk, from a year earlier. However, this contribution is mitigated by the considerable fall of the sovereign risk premium, due to the downward debt interest rates. Risks arising from the external economy are assessed as downward, because of the relative improvement of economic growth in Albania's main trading partners and decline of interest rates in financial markets, in spite of the high unemployment rate and stable oil and commodity prices. For the banking sector, risks are assessed as downward from a year earlier, mainly because of the improvement of capitalisation and income before taxes, vis-a-vis total assets. Risk related to the structure of the banking sector is down, mainly because of the reduced concentration in banks' activity.

In order to focus the assessment of risk to the financial system, the Financial System Stress Index is used. It measures the financial stress in the economy by aggregating into a single index the financial information on various segments of the banking sector, foreign exchange market, money market, and housing market). For 2013, it shows that the systemic risk is down from a year earlier, although the index remains above the long-term average. In concrete terms, credit and deposit performance below the long-term average is reflected in higher contribution by the banking sector to the overall level of systemic risk. During the period, volatility in the foreign exchange market was low, thus providing no added contribution to the index. On the other hand, given its significant impact on the financial system, the contribution of the exchange rate to the index has ranged in similar levels to that of the banking sector. The downward trend of the interest rate spread has lowered the contribution of the money market to the systemic risk level. Developments in the housing market have also contributed to the fall of the systemic risk index, as the House Price Index increased slightly. Finally, the correlation between the segments of the financial market has increased from the first half of the year and has contributed to higher systemic risk.

To determine more clearly the accumulation and materialisation phases of systemic risk, we use two special indices. The Systemic Risk Accumulation Index identifies the increase of systemic risk until the end of 2012, and the downward pace of accumulation during 2013. The main factors affecting the risk accumulation were quick crediting (especially before 2007), current account deficit expansion, and public debt increase. The Systemic Risk Materialisation Index identifies the emergence of the systemic risk, especially after the first half of 2008. This period is related to shocks to the liquidity of the banking sector, depreciation of the exchange rate and beginning of the deterioration cycle of credit to households and businesses.

Systemic financial risks are subject to economic agents' perception. Therefore, through a special semi-annual survey, the Bank of Albania collects the banking industry's risk perception. From March 2012 to end-2013, the banking industry has perceived two phenomena as developments with a high risk potential: deterioration of the domestic economy and increase of public debt.

Fiscal policy is expected to play an active role in financial stability, during 2014. 
In general, this role will be determined by the ability to find a stable equilibrium for fiscal indicators development, to sustain economic growth. In particular, this role will be especially important to the financial system, because of the liquidity injection in the form of payment of arrears for public works done by the private sector, estimated at 5% of GDP. To achieve the fiscal and development objectives, the authorities have reached an agreement with the IMF, which provides funds and other structural guarantees for meeting these objectives. The agreement is an important step towards ensuring macroeconomic stability and stabilising economic agents' expectations. It creates the necessary space to boost the banking sector's intermediation and its contribution to economic growth. Overall, the agreement envisages objectives for fiscal, monetary and structural indicators, allowing also the necessary flexibility for their achievement. Therefore, the possibilities for meeting the final objectives are considerable, and risks relate mostly to the quality of planning and coordination of intermediate actions by authorities towards achieving these objectives.

Credit risk in the banking sector remains a cause for concern to both the banking industry and the Bank of Albania, but expectations for the current year are better. 
The presence of a high non-performing loan stock in banks' balance sheets increases banks' costs, impairs their ability to engage in financial intermediation and leads to added and inefficient use of their capacities.

Taking into account the actual level of non-performing loans, the risk for a significant increase in the non-performing loan ratio in the foreseeable future is low. Credit risk size is expected to be more contained and start a gradual downtrend in the short-term future. During 2013, the trend of the past two years was reinforced and the non-performing loans increased at notably lower rates. This performance owes primarily to the work done by the banking industry and the Bank of Albania for early identification of non-performing loans, transactions to write them off from balance sheets, through selling them off, and amendments to the regulatory framework to encourage credit restructuring. These factors are associated with higher provisions for covering the credit risk and non-performing loans.

In the near future, legal amendments related to collateral execution and other legal measures on tax treatment of non-performing loans write off are expected to be more broadly and effectively used. Also, payment of arrears to businesses for the public works they have done is expected to take place soon. These developments would improve the conditions for a systematic treatment of non-performing loans by the banking industry, and would contribute significantly to gradually decreasing non-performing loans. However, positive developments in this regard may be stable if the performance of macroeconomic indicators is stabilised and economic growth is improved. Given the above, these developments become important for containing the banking sector's exposure to indirect credit risk.

The banking sector's exposure to direct risk from unfavourable exchange rate and interest rate movements was limited. 
The banking sector's open foreign exchange position was within the historical levels and the values of interest rate-sensitive assets and liabilities were comparable. However, banks appeared sensitive to the effect that the exchange rate and interest rate movements have on their clients. A significant depreciation of the exchange rate or similar increase in the interest rate may harm the solvency of banks' clients, especially businesses. This risk is mainly transmitted through the foreign currency loan, when the main source of borrower's income for its settlement is in the domestic currency, and through the variable-rate loan.

Banking sector liquidity risk was moderate. 
Deposits continued to be the main source of funding for the banking sector. Albeit at decelerated rates, they increased during the past period, as well. Their average maturity term expanded, as clients prefer higher return. Despite the slight increase, non-resident borrowing remains at moderate levels. The sector's liquid assets, both in lek and foreign currency, are above minimum levels required by the regulatory framework. Negative values of the spread between liquid assets and short-term liabilities, by maturity term, up to a year, declined. The credit to deposit ratio is low, reflecting the different performance of credit and deposits, both in lek and in foreign currency.

Capital indicators stood at adequate levels; however, banks should cautiously monitor possible scenarios for future developments and their needs for additional capital. 
The capital increase and lower growth of risk-weighted assets made major contribution to banks' activity capitalisation, during this period. The net financial result of the sector improved thanks to non-performing loans slowdown and provisions for credit risk. Due to the reduction in the non-performing loans stock, after the sales and write offs, the coverage of net non-performing loans with capital improved. Although these are not encouraging developments, it is too soon to consider them as stable. It is, therefore, imperative for banks to continue to cautiously and proactively assess their needs for additional capital in line with their risk profile. When necessary, according to this assessment, banks should take relevant actions to strengthen their capital situation.

The stress test exercise should serve banks as a tool to support the assessment of possible needs for additional capital.
The Bank of Albania conducts regular stress test exercises to assess the sensitivity of the main banking sector capital figures against changes in macroeconomic indicators. Baseline and adverse risk scenarios, which extend through the end of 2015, include assumptions relating to changes in GDP growth rate, exchange rate and interest rate, and lending.

The stress test results revealed that the banking sector was generally resilient to assumed shocks. The banking sector's capitalization remained above the minimum requirement in the event of the baseline scenario. In the event of the adverse scenarios, which include the respective assumptions of decline in GDP growth rate, lower lending and exchange rate depreciation, individual banks may need additional capital. The regulatory and supervisory framework and the international best practices require similar exercises to be regularly conducted by banks, to assist their decision-making process.

The evaluation under the FSAP programme identified the banking system capacities to conduct a stable activity and made relevant recommendations for effective risk management. 
In October-November 2013, upon the request of the Albanian public authorities, the financial system and supervisory framework of its activity were subject to an assessment by the International Monetary Fund (IMF) and World Bank (WB) group. All the segments of the financial system were assessed for the way they are supervised, approximation with international standards, capability of public authorities to identify and administer various risks, and international cooperation in this regard.

The IMF and WB assessments are published in relevant reports by the IMF and the WB. These reports acknowledge, in a realistic way, the progress made in the functioning and supervision of the financial since the assessment in 2005), and identify a number of recommendations for improvement. The focus is on strengthening the institutional, legal and operational framework for managing potential risks to the financial system activity. Therefore, recommendations for improvement focus on all financial system segments, on their supervision methodology. They also identify a number of structural actions related to economic and financial policies, which have an impact, in this regard. Recommendations are both for the short and long term. Some of these recommendations have been incorporated in the terms of the recent agreement with the IMF. Thus, their timely and qualitative realisation assumes particular importance.

Pursuant to provisions under Article 69 of Law No. 8269, dated 23 December 1997 'On the Bank of Albania', as amended, and Article 8 of Law No. 9962, dated 18 December 2006 'On banks in the Republic of Albania', as amended, to inform the Assembly of the Republic of Albania and the Council of Ministers, and 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 periodic Statement. The Statement is an integral part of the Financial Stability Report for the same stated period.

The Albanian banking sector and financial system were stable in 2013 H2. Despite the lower economic growth, developments in the macroeconomic setting sustained the performance of the financial system. The macroeconomic setting was characterised by low exchange rate volatility and weak inflationary pressures, notwithstanding the easing monetary policy. Moreover, government borrowing costs dropped significantly, in spite of the budget deficit and public debt increase. The agreement with the International Monetary Fund is an important step toward ensuring macroeconomic stability and stabilising economic agents' expectations. However, the acceleration of economic growth assumes primary importance with regard to placing the financial activity on a stable growth track. In financial markets, the volume of trading and number of transactions have been steady. In the banking sector, capitalisation and liquidity indicators were at sound levels, supported by the improved net financial result. The banking activity volume expanded at slower rates, as deposits' increase decelerated and crediting contracted. Non-performing loans have grown at the lowest annual rates since 2008. Credit risk poses the most important challenge to the banking sector, but its size is expected to be more contained. In the near future, it is expected to trend down gradually due to effects from legal amendments and operational measures that will enter into force, or be applied more effectively, during 2014. Such measures will enhance the banking industry's capability to handle non-performing loans systematically. In the meantime, the banking sector's exposure to market and liquidity risks remains limited.

Following is a summary of key developments in the economic landscape and financial system, and assessment of risks facing the banking sector activity, including systemic risk.

• Economic and financial developments

The global economy continued to improve steadily during the second half of 2013, although at lower rates and at different pace across different regions. 
Advanced economies showed positive signs of stability, whereas some of the developing economies slowed down their growth pace. The US economy continued to grow at a satisfactory rate, sustained by higher consumption and exports. The euro area economy is showing steady signs of gradual recovery, although unevenly across Member States. Developing economies continued to be the main contributors to global growth during 2013, but at a slower pace than a year earlier. This phenomenon has reflected the weaker domestic demand in some of these economies, also as a result of tighter lending terms, political uncertainties and more tense financial markets. Globally, inflationary pressures have been low due to stable commodity prices, spare production capacities and well-anchored inflation expectations. In the context of a positive but modest economic performance, the monetary policy in advanced economies continued to be accommodating.

Economies in Central East and South-east Europe continued to recover gradually, also thanks to the economic recovery in the euro area. The economies in our region improved during 2013. GDP grew at positive rates in the countries that had been in recession during 2012. Rates also improved in the rest of the countries. However, low levels of credit to the private sector and rise in non-performing loans are the main challenges for these countries' economic recovery and financial stability.

Financial markets continued to stabilise under the positive effect of support measures by central banks and the better economic performance of advanced economies. In these economies, lending terms eased during the second half of 2013, mainly in the sovereign debt markets in euro area countries. Risk premiums on government securities in the debt-stricken countries have fallen and fragmentation inside the market is lessened. In developing markets, lending terms have been tighter, triggered especially by the actions of the Federal Reserve to reduce its quantitative easing programmes, and the reinstatement of traditional monetary policy in advanced economies.

The global economy is expected to continue improving in the current year, sustained primarily by the recovery of advanced economies. However, a number of risks remain, mainly related to the very low inflation, and the likelihood of sudden rise in interest rates, as a result of unexpected developments in financial markets.

The need to accelerate economic growth in the country became even more evident, after the significant slowdown in 2013. 
After contracting 2.5% in the third quarter, Albania's economy posted 1.1% real growth in the fourth quarter, from the same period a year earlier. The average growth rate for 2013 was 0.44%. In spite of improvement in the fourth quarter in some sectors of the economy such as industry, agriculture and construction, aggregate demand is assessed as weak, given that private investments are low and unemployment rate is higher. During the period under review, foreign demand contributed negatively to economic growth, as current account deficit expanded. Still, exports performed well, driven by the energy and mineral products. During the period, the fiscal policy was overall expansionary, but the volatility in the fiscal performance was higher, reflecting some changes to the decision-making policy dictated by political developments. Budget deficit was funded mainly by domestic resources, with downward costs. In response to these developments and contained inflationary pressures, the Bank of Albania continued to implement a stimulating monetary policy. This was reflected in falling interest rates in financial markets at home, which better support the countercyclical actions for the activity of the banking sector, undertaken during 2013.

In the future, albeit improving, foreign demand will remain limited. Contribution of consumption and private investments to domestic demand may improve, sustained by economic agents' improved expectations because of low interest rates and better liquidity indicators. Fiscal policy is expected to be expansionary, similar to 2013. However, the acceleration of economic growth remains highly important to place the financial activity on a stable growth track. Therefore, reforms for improving the business climate and payment of arrears for public works done by private businesses may provide a significant contribution.

Households and businesses were exposed to indirect credit risks, at similar levels to previous periods. 
During the period under review, households and businesses were more inclined to save, as reflected by deposits performance. Lending to households expanded at low rates, whereas lending to businesses shrank. Only lek-denominated credit gave positive contribution to credit performance. Credit quality improved for households and moderately deteriorated for businesses, generally because of the slowdown of non-performing loans increase. Households and business remain exposed to indirect credit risk, depending on their exposure to credit unhedged against unfavourable exchange rate and interest rate fluctuations.

In financial markets, trading volume increased, whereas interest rates sharpened their downward trend. 
In the government debt securities' market, demand for borrowing was met by investor's higher interest in investing. This has been an additional factor for downward interest rates on all maturities. In the secondary market of government debt securities, the number of transactions fell slightly, whereas yield on 3 and 6-month T-bills increased. In the interbank market, the volume increased significantly, mainly for the short-term 1 and 7-day maturities. Although more volatile at the end of the period, the average weighted interest rate ranged below the base rate, overall, reflecting the better liquidity situation. In the foreign exchange market, throughout the year, the lek depreciated slightly against the euro and appreciated against the US dollar, reflecting the demand and supply in the domestic market and developments in the international forex market.

Technical infrastructure supporting banking sector operation functioned effectively. 
During the period, AIPS and AECH payment systems operated in compliance with the technical conditions for meeting banking sector needs for settling lek payment transactions. In both systems, the volume and the value of transactions increased. The average value per transaction increased, as well.

The financial system increased its share in Albania's economic activity, in the second half of 2013. 
Financial intermediation, calculated as the ratio of financial system assets to Gross Domestic Product (GDP), was up 3 percentage points, to 99.1%, during the period. The banking sector remained the dominant segment of financial intermediation in Albania. Its assets accounted for about 91.4% of total financial system assets and around 90.5% of GDP.

In the banking sector, capitalisation and liquidity levels were adequate, also supported by the improved net financial result. 
Banking sector's total assets rose to ALL 1,234.3 billion, posting 3.9% annual growth. On the asset side, interbank and security transactions registered major increase, reflecting primarily the higher participation of the banking sector in government debt security auctions. Banking activity was financed by increase in public deposits, albeit at lower rates. Banking sector exposure to non-resident institutions was similar to the previous period, reflecting banking sector's low reliance on foreign financing sources. During the year, credit shrank 1.8%. The 2.4% lek credit growth could not offset the 4.2% foreign currency credit contraction. Credit stock fell significantly due to banks' selling off non-performing loans and their write offs.

New loans by the banking sector were 16% down from the same period a year earlier. At the end of 2013, the ratio of non-performing loans to total loans was 23.5%, from 22.5% at end-2012 and 24.2% at end-June 2013. The non-performing loan ratio for lek loans was 19.7%, down 0.4 percentage points from June 2013. The non-performing loan ratio for foreign currency loans was 25.7%, down 0.8 percentage points from June 2013. Deposits totalled ALL 1,013.5 billion, up 3.6% from a year earlier. Lek and foreign currency deposits grew 5.2% and 1.7%, respectively, year on year. The credit to deposit ratio stood at 55.6%. This ratio in lek stood at 40.8%, being stable in the last two years, while in foreign currency, it stood at 69.8%, the lowest rate since 2007, reflecting mostly the contraction of foreign currency loans.

At sectorial level, banks recorded positive profit, with accumulated net profit of ALL 6.6 billion, from ALL 3.8 billion a year earlier. Net interest income totalled ALL 39.5 billion, or 0.6% lower than a year earlier. Loan-loss provisions increased by around ALL 14.9 billion, or 49% lower than a year earlier. During the period, paid-in capital rose by around ALL 10.5 billion, or 11.3%. Regulatory capital rose to ALL 115.2 billion, up 10.6%, whereas risk-weighted assets slipped to ALL 641.3 billion, down 0.4%. Subsequently, the capital adequacy ratio rose to 18.0%.

• Risk assessment

To assess risks, the banking sector performance and its interaction with the real economy, as well as the financial situation of economic agents and other segments of the financial system were considered. To assess the stability of the banking sector against unfavourable macroeconomic developments and the activity of the banking sector, a stress test exercise was conducted.
 
For a synthesised evaluation of risks to the banking sector, real economy and economic agents, the Financial Stability Map (FSM) is used. For 2013, the FSM shows that risks to the financial stability have moved slightly towards economic agents. More specifically, in the case of the domestic economy, the exchange rate stability and low inflation rates were reflected in an almost unchanged risk level, despite the expansion of the negative output gap, in the context of economic growth deceleration. The risk is assessed as increased for businesses, due to contraction of business credit, deterioration of its quality, and downward production index, from a year earlier. For households, the significant increase in the unemployment rate and pessimistic expectations on the economic outlook for the first half of 2014 were reflected in the increase of their risk from a year earlier, regardless of the relative quality improvement of household borrowing at the end of 2013. For the government, the expansion of the budget deficit and the performance of tax revenues contributed to higher risk, from a year earlier. However, this contribution is mitigated by the considerable fall of the sovereign risk premium, due to the downward debt interest rates. Risks arising from the external economy are assessed as downward, because of the relative improvement of economic growth in Albania's main trading partners and decline of interest rates in financial markets, in spite of the high unemployment rate and stable oil and commodity prices. For the banking sector, risks are assessed as downward from a year earlier, mainly because of the improvement of capitalisation and income before taxes, vis-a-vis total assets. Risk related to the structure of the banking sector is down, mainly because of the reduced concentration in banks' activity.

In order to focus the assessment of risk to the financial system, the Financial System Stress Index is used. It measures the financial stress in the economy by aggregating into a single index the financial information on various segments of the banking sector, foreign exchange market, money market, and housing market). For 2013, it shows that the systemic risk is down from a year earlier, although the index remains above the long-term average. In concrete terms, credit and deposit performance below the long-term average is reflected in higher contribution by the banking sector to the overall level of systemic risk. During the period, volatility in the foreign exchange market was low, thus providing no added contribution to the index. On the other hand, given its significant impact on the financial system, the contribution of the exchange rate to the index has ranged in similar levels to that of the banking sector. The downward trend of the interest rate spread has lowered the contribution of the money market to the systemic risk level. Developments in the housing market have also contributed to the fall of the systemic risk index, as the House Price Index increased slightly. Finally, the correlation between the segments of the financial market has increased from the first half of the year and has contributed to higher systemic risk.

To determine more clearly the accumulation and materialisation phases of systemic risk, we use two special indices. The Systemic Risk Accumulation Index identifies the increase of systemic risk until the end of 2012, and the downward pace of accumulation during 2013. The main factors affecting the risk accumulation were quick crediting (especially before 2007), current account deficit expansion, and public debt increase. The Systemic Risk Materialisation Index identifies the emergence of the systemic risk, especially after the first half of 2008. This period is related to shocks to the liquidity of the banking sector, depreciation of the exchange rate and beginning of the deterioration cycle of credit to households and businesses.

Systemic financial risks are subject to economic agents' perception. Therefore, through a special semi-annual survey, the Bank of Albania collects the banking industry's risk perception. From March 2012 to end-2013, the banking industry has perceived two phenomena as developments with a high risk potential: deterioration of the domestic economy and increase of public debt.

Fiscal policy is expected to play an active role in financial stability, during 2014. 
In general, this role will be determined by the ability to find a stable equilibrium for fiscal indicators development, to sustain economic growth. In particular, this role will be especially important to the financial system, because of the liquidity injection in the form of payment of arrears for public works done by the private sector, estimated at 5% of GDP. To achieve the fiscal and development objectives, the authorities have reached an agreement with the IMF, which provides funds and other structural guarantees for meeting these objectives. The agreement is an important step towards ensuring macroeconomic stability and stabilising economic agents' expectations. It creates the necessary space to boost the banking sector's intermediation and its contribution to economic growth. Overall, the agreement envisages objectives for fiscal, monetary and structural indicators, allowing also the necessary flexibility for their achievement. Therefore, the possibilities for meeting the final objectives are considerable, and risks relate mostly to the quality of planning and coordination of intermediate actions by authorities towards achieving these objectives.

Credit risk in the banking sector remains a cause for concern to both the banking industry and the Bank of Albania, but expectations for the current year are better. 
The presence of a high non-performing loan stock in banks' balance sheets increases banks' costs, impairs their ability to engage in financial intermediation and leads to added and inefficient use of their capacities.

Taking into account the actual level of non-performing loans, the risk for a significant increase in the non-performing loan ratio in the foreseeable future is low. Credit risk size is expected to be more contained and start a gradual downtrend in the short-term future. During 2013, the trend of the past two years was reinforced and the non-performing loans increased at notably lower rates. This performance owes primarily to the work done by the banking industry and the Bank of Albania for early identification of non-performing loans, transactions to write them off from balance sheets, through selling them off, and amendments to the regulatory framework to encourage credit restructuring. These factors are associated with higher provisions for covering the credit risk and non-performing loans.

In the near future, legal amendments related to collateral execution and other legal measures on tax treatment of non-performing loans write off are expected to be more broadly and effectively used. Also, payment of arrears to businesses for the public works they have done is expected to take place soon. These developments would improve the conditions for a systematic treatment of non-performing loans by the banking industry, and would contribute significantly to gradually decreasing non-performing loans. However, positive developments in this regard may be stable if the performance of macroeconomic indicators is stabilised and economic growth is improved. Given the above, these developments become important for containing the banking sector's exposure to indirect credit risk.

The banking sector's exposure to direct risk from unfavourable exchange rate and interest rate movements was limited. 
The banking sector's open foreign exchange position was within the historical levels and the values of interest rate-sensitive assets and liabilities were comparable. However, banks appeared sensitive to the effect that the exchange rate and interest rate movements have on their clients. A significant depreciation of the exchange rate or similar increase in the interest rate may harm the solvency of banks' clients, especially businesses. This risk is mainly transmitted through the foreign currency loan, when the main source of borrower's income for its settlement is in the domestic currency, and through the variable-rate loan.

Banking sector liquidity risk was moderate. 
Deposits continued to be the main source of funding for the banking sector. Albeit at decelerated rates, they increased during the past period, as well. Their average maturity term expanded, as clients prefer higher return. Despite the slight increase, non-resident borrowing remains at moderate levels. The sector's liquid assets, both in lek and foreign currency, are above minimum levels required by the regulatory framework. Negative values of the spread between liquid assets and short-term liabilities, by maturity term, up to a year, declined. The credit to deposit ratio is low, reflecting the different performance of credit and deposits, both in lek and in foreign currency.

Capital indicators stood at adequate levels; however, banks should cautiously monitor possible scenarios for future developments and their needs for additional capital. 
The capital increase and lower growth of risk-weighted assets made major contribution to banks' activity capitalisation, during this period. The net financial result of the sector improved thanks to non-performing loans slowdown and provisions for credit risk. Due to the reduction in the non-performing loans stock, after the sales and write offs, the coverage of net non-performing loans with capital improved. Although these are not encouraging developments, it is too soon to consider them as stable. It is, therefore, imperative for banks to continue to cautiously and proactively assess their needs for additional capital in line with their risk profile. When necessary, according to this assessment, banks should take relevant actions to strengthen their capital situation.

The stress test exercise should serve banks as a tool to support the assessment of possible needs for additional capital.
The Bank of Albania conducts regular stress test exercises to assess the sensitivity of the main banking sector capital figures against changes in macroeconomic indicators. Baseline and adverse risk scenarios, which extend through the end of 2015, include assumptions relating to changes in GDP growth rate, exchange rate and interest rate, and lending.

The stress test results revealed that the banking sector was generally resilient to assumed shocks. The banking sector's capitalization remained above the minimum requirement in the event of the baseline scenario. In the event of the adverse scenarios, which include the respective assumptions of decline in GDP growth rate, lower lending and exchange rate depreciation, individual banks may need additional capital. The regulatory and supervisory framework and the international best practices require similar exercises to be regularly conducted by banks, to assist their decision-making process.

The evaluation under the FSAP programme identified the banking system capacities to conduct a stable activity and made relevant recommendations for effective risk management. 
In October-November 2013, upon the request of the Albanian public authorities, the financial system and supervisory framework of its activity were subject to an assessment by the International Monetary Fund (IMF) and World Bank (WB) group. All the segments of the financial system were assessed for the way they are supervised, approximation with international standards, capability of public authorities to identify and administer various risks, and international cooperation in this regard.

The IMF and WB assessments are published in relevant reports by the IMF and the WB. These reports acknowledge, in a realistic way, the progress made in the functioning and supervision of the financial since the assessment in 2005), and identify a number of recommendations for improvement. The focus is on strengthening the institutional, legal and operational framework for managing potential risks to the financial system activity. Therefore, recommendations for improvement focus on all financial system segments, on their supervision methodology. They also identify a number of structural actions related to economic and financial policies, which have an impact, in this regard. Recommendations are both for the short and long term. Some of these recommendations have been incorporated in the terms of the recent agreement with the IMF. Thus, their timely and qualitative realisation assumes particular importance.