BANK OF ALBANIA STATEMENT
On financial system stability in Albania H2 2007

In accordance with the Law No. 8269, dated 23.12.1997 "On the Bank of Albania" and with the purpose of drawing the attention of the domestic public institutions, of the financial market and of its operators as well as of the public, about the potential risks that could threaten the stability of the domestic financial system, the Bank of Albania publishes this periodic statement.

The macro-economic indicators marked a stable performance during the second half of 2007. The Government, at the end of the year, succeeded to accomplish the targets on the revenues and expenditures level, on the budget deficit, as well as related to the financing amount of a part of expenditures through domestic sources of the financial market. The accomplished expenditures, particularly concentrated during the second half of year, changed the characteristics of the public finances, which until then, showed a positive balance. The Bank of Albania has continuously monitored the liquidity situation of the inter-bank market, where the operations conducted by the Government, especially the borrowing and the expenditures, have a considerable effect. The Ministry of Finance and Bank of Albania, in this framework and during last semester, reached an agreement on the investment of the Government excess liquidity into the respective financial instruments offered by the Bank of Albania. Hence the short-term and harmful pressure on the liquidity level and on the interest rates on the inter-bank market, was reduced.

The inflationary pressures on the domestic economy were aggravated and became clear in the last quarter of year. The consequences of a difficult situation dominating in the global markets of the energy raw materials and of the alimentary products, were added to the negative effects on the local production costs and goods supply due to the dry weather of summer and fall period as well as of the aggravated power situation of the country. The inappropriate domestic production' structure and the dependence from the imported products are the factors that reduce the safeguarding mechanisms of the domestic economy against such regional and global developments. Thus, in September and October 2007, the annual increase of the Consumer Price Index (CPI), according to the assessment of the National Institute of Statistics, resulted respectively 4.4 percent and 4.2 percent, beyond the upper band limit targeted by the Bank of Albania of 4 per cent. To avoid the stickiness of the inflationary pressures, Bank of Albania raised twice the interest rate of the repurchase agreements, up to the level of 6.25 per cent. The annual increase of the CPI, at the end of year, resulted 3.1 per cent, within the limits aimed by the Bank of Albania and close to the point-target of 3 per cent. The situation of foreign exchange markets, throughout the same period, appeared stable. The value of the national currency versus the main foreign currencies have fluctuated within the historic intervals for the period, reflecting also the situation in the international financial markets.

The concern about the slowdown of the world economy growth, due to the expansion of the financial difficulties arising from the weak quality of housing loans mainly in the United States of America, proved to be real in the second half of year 2007. The significant financial losses occurring to some of most important banks and financial institutions of the world, the credit crunch, and the tightening of liquidity terms in the interbanking markets, increased the possibility of a negative impact on the real economy sector through the decreasing of the consumption and investments from the households and businesses. Consequently, the Federal Reserve (FED) of the United States of America and the European Central Bank as well as some other central banks, in co-operation carried out some measures to better meet the short-term financing needs of banks and other financial institutions of a global importance. The United States Administration announced the plan on the approval of a fiscal package. This package would provide a financial stimulation of about USD 150 billion, to safeguard the demand of the real sector of the economy. The differences that the world main central banks have regarding their objectives of the monetary policy, affected their respective positions versus the change of policy interest rates. Thus, the Federal Reserve turned the direction of the policy interest rate movement, by reducing it in three subsequent moves during the period September - November, down at the level of 4.25 per cent. FED also indicated its commitment to continue with further reductions in order to avoid the fall of the economy into recession and the increase in unemployment. Meanwhile, the unfavourable inflationary developments in the euro area, sustained the position of the Central European Bank not to cut its policy interest rate below 4 per cent. This level was maintained up to the end of year. The expectations on a more accelerated slowdown of the economic growth in the United States of America, and the tightening of the interest rates differences, affected the general weakness of the American Dollar versus the other currencies, particularly against the European common currency Euro and the British pound.

The financial system in Albania has continued its stable growth during the second half of 2007. The quite good financial outcome, in both banking sector and non-bank financial sector, was due to the better use of the financial sources and the ongoing relatively quick expansion of the investment activities with high return. The long-term trend for a gradual decline of the capital adequacy indicator of the financial system and particularly of the banking sector has continued, but the declining rate is reducing. This performance has been determined by the behaviour of the most active banks and financial institutions, where the indicators on the activity capital adequacy are close to the minimum levels required by the legal and regulatory framework. During the time period, the inflow of foreign capital in the financial institutions has continued and there have been operations of institutional mergers that support the welcoming consolidation of the financial market. Based on the analysis carried out by the regulatory authorities there is not detected any risk, derived from the regional and global developments and the internal ones, which has high possibility of materialisation and that could promptly and heavily damage the activity of the financial system. Nevertheless, from this point of view, the risks spectrum in the financial system is assessed to have become larger. Consequently, the supervisory authorities of the financial market are carefully monitoring the events, and compiling the necessary legal and regulatory improvements.

The assets of the financial system have been steadily growing, but the weight of the non-banking financial sector still remains low, thus limiting the contribution of this sector on the stable development of the overall financial system. Total assets of the financial system at the end of 2007, is assessed to be close to 78.5 per cent of Gross Domestic Product (GDP). The weight of banking sector has reached 76 percent of GDP, from 69.4 percent resulting last year. According to the evaluation of the Financial Supervision Authority up to September 2007, it is assessed that the total assets of insurance and re-insurance companies, a segment that dominates the non-banking financial institutions, is increased by 12 per cent, amounting to Lek 12.98 billion. It is estimated that the total assets of insurance and re-insurance companies, being granted a licence to operate in our country, has represented about 1.3 percent of GDP. The weight of total assets of insurances and re-insurances companies versus the total assets of banking sector was only 1.9 percent for the same period, thus not having any change compared to the end of 2006. According to the evaluation carried out by the Financial Supervision Authority, at the end of 2007, the activity indicators of this important segment of the non-banking financial sector, including profitability, insurance ability and capitalisation, resulted positive and in compliance with the requirements of the regulatory framework. The penetration degree of the non-banking financial institutions' products in the Albanian market remains low. Hence, its positive impact as a mechanism that improves the risk characteristics of the financial and banking products is limited. Nevertheless, it is assessed that this segment of the market has a high development potential in the future. Such optimism in the non-banking financial market is indicated by the increasing interest of the foreign institutional investors, particularly on market's segment represented by the insurance and re-insurance activity. During the last semester, in the banking sector there have been concluded the procedures for the merger of two commercial banks, demonstrating the welcomed process of the business consolidation. The changes in the shareholders' structure of the financial institutions, alongside with the approval of the supervisory and regulatory authorities of each sector, are analysed related to the effects on the market competitiveness and are approved by the Competitiveness Authority.

The banking sector has further expanded the investments allocated in credits and securities. Thus, this sector has safeguarded sufficient levels of return from the activity but has demonstrated a soft decrease of the capitalisation and liquidity indicators. At the end of year 2007, credit portfolio of the banking sector, reached nearly 40 percent of the sector total assets, marking an increase of 4.4 percentage points compared to the end of June. Investments in securities reached about 18 percent of total assets, increasing by 1.6 percentage points compared to the same period. At the end of 2007, the return on the average assets (ROA) investment resulted 1.6 percent, while the return on share capital investment was 20.7 per cent, close to the levels recorded at the end of 2006. Lending quality, despite being negatively impacted by the high credit growth rate, as dictated by the growing competitiveness in the market, has changed only slightly compared to the end of June 2007 and is still considered as a good one. The credit denominated in foreign currency continues to dominate the overall credit portfolio. The average maturity term of credit is prolonged. Due to the investment in high risk assets, the banking sector preserves the decreasing yearly trend of the capitalisation and liquidity indicators. Nevertheless, these indicators are considered to be at satisfactory levels and are, on average, better than those of the other countries in the region. The capitalisation of the banking sector at the end of the period, as shown by the indicator of capital adequacy ratio, is evaluated 17.1 per cent, higher than the end of June but 0.9 percentage points lower than the end of previous year. Liquid assets of the banking sector represent 49.8 per cent of total assets, recording a decline of 4 percentage points compared to the end of June.

The analysis of the financial activity risks characteristics, indicate an increase of the overall risk level and entails the need for an ongoing monitoring from the proper financial institutions, from the regulatory authorities and from the public. The increase of risk level in the financial and banking activity is an inevitable process. It is dictated by the opening process of the economy and the gradual integration in the regional and global financial markets. At the same time, the need to afford the competitiveness by increasing the activity efficiency, encourage the enlargement of investments in higher return (higher risk) assets. The integration of the Albanian financial system in the regional and global markets is followed by the increase of its vulnerability versus the unfavourable events occurring in the foreign markets, due to the direct or indirect exposures versus the subjects that are damaged from these events. This effect becomes larger if combined with the lack of a sufficient financial buffer by the proper financial institutions of the domestic market.

Bank of Albania assesses that the difficult situation the international financial markets are going through, augments the risk for the Albanian financial system. Due to certain factors related to the characteristics of the local financial activity, such a difficult situation in the international markets is not expected to impose a real and considerable impact on the internal financial market. However, the situation in the financial international markets remains unstable, thus its impact on the internal financial market could change. For that reason, it is needed that the financial institutions and the regulative authorities of the country, follow and analyse carefully these events.

As factors that presently safeguard the Albanian financial system from the unfavourable events occurring in the international financial markets, we can mention as follows:
a) the quite well financial situation of the system and particularly of the banking sector;
b) the absence of the similar and sophisticated financial products, whose value was recently shocked throughout the international financial markets;
c) the rather low levels of the need for financing in the international financial markets from the Albanian financial institutions, and particularly from the banking sector, as there is a lot of space to provide for its financial needs by the internal sources;
d) the rather restricted direct and indirect exposure of the Albanian financial institutions, and particularly of banks, in other institutions and financial products, whose value is negatively impacted by the difficulties of liquidity in the international financial markets;
e) the limited exposure and financially affordable of the European banking groups that operate in Albania, versus "sub-prime" loans financing scheme of the United States of America;
f) The well financial performance demonstrated in these last years by the financial institutions and by the European banking groups that has built on a better financial protection, through the establishment of the necessary reserves and the sufficient capitalisation of the activity to absorb such shocks.

On the other side, the prolongation and possible deterioration of the situation in the international financial markets could reflect a higher impact on the Albanian financial market through some directions, specifying the followings:

g) the worsening of risk characteristics of the rapid lending and particularly the one denominated in foreign currency, due to the increase of fluctuation in foreign exchange rate and of the more frequent change of the interest rates. These are two especially important factors that could determine the paying ability of the borrower, in the case of foreign currency denominated credit. The commercial banks and their borrowing clients should carefully follow the dynamics of these factors and carry out the needed operations to be protected from their unfavourable development. Bank of Albania shall soon approve some regulatory measures which aim to soften this risk for the commercial banks and their clients and to show up that it is important and sound for the economic agents to finance their needs for development, in the same currency they raise their income;
h) the exposure of the financial system against the economy sectors that are negatively impacted by the decrease of regional and global economy. The non-banking financial institutions and the commercial banks, in compliance with the nature of their activity, should monitor the concentration of their products based on the economy sectors (by assessing also the inter-sector impact), aiming the balanced delivery of the activity and
the avoidance of the business concentration. This information must become part of the internal policies and systems of risk assessment, and should sustain the decision-making of these institutions. At the same time, this moment entails the need on an attentive cost/profit analysis from the public authorities, related to the decisions they take which have the potential to inflict by short-term financial difficulties for the important sectors of the economy to which the financial system is exposed;
i) the combination of difficulties in the international financial markets, with the unfavourable dynamic of prices for the energy sources and the raw materials of the world food products. This undesirable combination, hinders the arsenal of instruments of the central banks to potentially react versus the liquidity demand arising from the international financial markets, enlarge the risk that this situation could negatively impact the global demand for consumption and investments and could lead in a slowdown of the economic growth in the world centres of economic development. This situation would affect the safeguard of inflationary pressures in the small economies, such as the Albanian economy, as well as in the tightening of the domestic and external
financing terms for the various economic agents, including the governments;

In the framework of the above stated events and referring to the banking sector, Bank of Albania, re-emphasises the request addressed to the managing structures of the commercial banks to attentively follow the market developments, to enhance the control systems in their institutions and take the necessary measures to better diversify their financial sources and their investment directions, to continuously carry out a well-capitalised activity and to constantly monitor its risks. Bank of Albania shall strengthen the measures to enhancing and implement the regulatory framework toward the overall improvement of the risk assessment in the commercial banks, and shall co-operate with the Financial Supervision Authority to promote the full implementation of these principles in the other part of the financial market.

The relative low degree of the financial market development in Albania, limits the ability of the market participants, and of the economic agents in general, to effectively manage the consequences of an unfavourable financial situation. The insufficiency of the financial market development could act as a natural safeguard mechanism for the conveyance of the financial problems among the different segments of the market and with regard to the international financial markets, but this effect is likely to be short-term. For that reason, the market participants should contribute for establishing a developed and efficient financial market, thus increasing the possibilities to truly price their products, to identify the unrealistic prices of various assets and to accomplish the needed transactions at the required degree and time. By operating in this way, the market supplies an effective and automated mechanism which softens the consequences of a difficult financial situation. On the other side, through the appropriate transactions in a market that operates efficiently, the central banks improve the process of achieving their monetary policy targets, thus contributing to the overall financial stability. Based on these concepts, Bank of Albania has established from years now, the complete framework of the instruments to encourage the development of the inter-banking market. Nevertheless there are detected difficulties related to the insufficient level of competitiveness and the more-than-sufficient level of liquidity that does not offer to the commercial banks the necessary incentives to operate actively in the market. For this, Bank of Albania has encouraged the communication with the commercial banks, to find together the ways for a faster development of the inter-banking market. If necessary, these ways shall include changes of the regulatory framework of the financial instruments, of the supervision regulatory framework as well as other administrative measures. Bank of Albania shall request the cooperation of the Competitiveness Authority in this process, to identify and avoid the cases when certain actions of commercial banks hamper the development of a competitive and efficient market.

The macroeconomic indicators for 2008 are estimate to be accomplished within targets for an economic growth at least equal to the one of last year, but the vulnerability of macro-economic balance versus the fiscal and monetary policy performance is increased. Alongside with certain elements mentioned above in this statement, this year is characterised by the planning of a sizeable government budget. At the same time, due to the need to finance some important investments for the domestic economy, the budget deficit is estimated to increase. These two events would increase the inflationary pressures on the economy. But their impact is expected to be manageable if the government achieves the objectives on directing an important part of expenditures for the big infrastructure projects and if it improves the allocation in due time of the overall revenues and expenditures. The budget size and the growth of the domestic borrowing, enable the Government become an important player of the financial market. Under these conditions, the achievement of its objectives on the modernisation of the public debt management functions acquires a special importance. Bank of Albania shall offer the necessary co-operation throughout this process. Bank of Albania, as usually, shall follow attentively the impact of the various economic developments on the prices level and shall operate in due time by employing the necessary instruments to avoid the stability of the possible inflationary pressures.

Notwithstanding the challenges that public authorities and various economic agents should face, Bank of Albania believes that the performance of the adopted policies as well as the flexibility of the economy shall allow the accomplishment of a stable economic growth during the year 2008. The financial system and particularly the banking sector shall play an active role regarding the financial intermediation and shall support the economic progress of the country, by safeguarding the stability and the outstanding financial performance.