BANK OF ALBANIA STATEMENT
On the financial system stability in Albania H1 2008

Pursuant to the requirement of the Law No. 8269, dated 23 December 1997 "On the Bank of Albania", as amended, Article 69, and the Law No. 9962, dated 18 December, 2006 "On Banks in the Republic of Albania", Article 8, to inform the Council of Ministers, the Parliament of the Republic of Albania and to draw the attention of the financial institutions and the public at large, on the situation of the financial system in the country and on the potential risks which may threaten its stability, the Bank of Albania publishes the following periodical statement.

During the first half of 2008, internal macroeconomic developments did not jeopardize the financial system's stability. As of end period, the budget revenues were met by 108% of the projected level, while expenditures were met by 91%. Compared with the same period the previous year, budget revenues and expenditures were met higher by 18% and 23%, respectively. This satisfactory performance in revenues and expenditures led to a positive balance of about 4.4 billion leks in the budget account. Budget-related objectives for the end of the present year require the further increase of Government expenditures for the remaining period. A more uniform timely allocation of expected expenditures will contribute to maintaining the balances in the financial market and in particular, in the interbank market, where the performance of borrowing and public expenditures in terms of meeting the budget indicators by the Government provides a considerable impact. The Bank of Albania has been constantly monitoring the liquidity situation in the interbank market, aiming at maintaining stable liquidity levels and interest rates by employing relevant financial instruments.

There were considerable inflationary pressures during the first half of 2008. The annual increase of the CPI peaked in March when it rose by 4.6%. The performance of consumer prices was mainly affected by the unfavourable situation in the global markets of energy and foods raw materials, which reduced the possible impact of internal monetary policy measures. Accordingly, the Bank of Albania has kept the key interest rate unchanged throughout this period at 6.25%, considering this rate as appropriate to maintain the public stimuli in trusting and investing in the national currency. As of end period, the annual increase of the CPI dropped to 4%, returning to the upper tolerance band of 2% - 4% set by the Bank of Albania. Although the inflationary pressures remain relatively stable, the signals coming from the regional and European economy indicate a slowdown of economic growth, which will in turn help to reduce the inflationary pressures deriving from the imported goods. The Bank of Albania will continue to monitor this situation carefully and be willing to take the necessary measures in view of achieving its objective. The situation in the foreign exchange market presented as stable during this period. The exchange rates of the lek versus the euro and the U.S dollar have fluctuated within the historical intervals reflecting at the same time the situation in the international financial markets.

In developed countries, macroeconomic policies were confronted with challenges in finding the balance between the decline of economic growth and the increase of inflationary pressures. The consequences of the financial crisis and the price rise of energy and food products were materialized in the form of considerable losses in the balance sheets of reputable financial institutions, increase in the producer cost and in overall prices, reduction in consumption, decline of economic growth and increase of unemployment. The harmonized actions of monetary authorities have prevented the collapse of financial markets through interventions which aimed at providing the markets with the necessary liquidity and avoiding the uncertainty related with the stability of the financial infrastructure, including the direct support to some important financial institutions. In April 2008, the U.S. Federal Reserve lowered the key interest rate to 2%. U.S. economy grew at positive rates in the first and second quarter (2.5% and 3.1%, respectively). The improved trade balance as a result of the depreciation of the U.S. dollar in the financial markets provided the main contribution to this growth. However, the annual price rise has been higher throughout the period by about 4%. Hence, there have been increasing pressures on the Federal Reserve to increase the key interest rate.

There were also marked inflationary pressures in the Euro area as well during the first half of 2008. Annual growth rate of the CPI reached 4% at end June, being quite far from the 2% target of the ECB. The latter raised the key interest rate to 4.25%, seeing with concerns the signals for the decline of economic growth. Economic growth in the Euro area was 1.9% in the first quarter and 1.4% in the second one. According to the International Monetary Fund, global inflationary pressures remain constant. In advanced economies, headline inflation rose to 3.5% in May 2008. The increase of inflation is more marked and broader in emerging and developing countries, where headline inflation has risen to 8.6%, the highest rate since around the beginning of the current decade. In these economies, food and fuel make up a larger share of consumption baskets.

Looking forward, in advanced economies, inflationary pressures are likely to be countered by slowing demand. Business and consumer sentiment related to the economic developments in these countries has been decreasing. In emerging and developing countries, the inflationary pressures are more marked, fuelled by soaring commodity prices, strong (but declining) economic growth and accommodative macroeconomic policies. Hence, global economic growth for 2008 is expected to be considerably lower than in 2007. Emerging and developing countries are expected to provide the main contribution to economic growth.

Financial market conditions remain difficult. The uncertainties related to the balance sheets' losses of financial and banking institutions, as a result of the financial crisis, become more marked by the expectations for the economic growth decline. At the same time, extension of new credit by the financial institutions will be constrained by the need to repair balance sheets. According to the IMF, credit conditions in advanced economies are expected to remain tight and efforts aimed at advancing balance sheet repair in financial sectors need to continue.

The Albanian financial system continued to grow at stable rates during the first half of 2008. The good financial result both in the banking and non-banking financial sector, continues to be driven by the rapid growth of high return on investment activities. Consumer deposits make up the main funding source of the banking sector activity. Credit lines extended by the parent banks have grown during the first half of 2008, however, remaining at acceptable levels. Being mainly driven by the banking sector, the growth rate of net income was lower in the first half of 2008 than the same period the previous year and lower than the growth of assets. Consequently, the return on assets and equity has been lower. Capitalization indicator of the financial sector and in particular of the banking sector has increased, being mainly encouraged by the capitalization of last year's profit. Relative to end-year 2007, loan portfolio quality has deteriorated slightly; however, it has been followed by the required increase of reserve funds by the banking sector. Liquidity indicator has been decreasing, however remaining at satisfactory levels and higher than in other regional countries. Given the expansion of financial and banking activity, the current decrease of these indicators is considered as objective and acceptable.

Presently, no risks that may be materialized or which may harm abruptly and severely the activity of the financial system are identified. The Albanian banking sector is well-capitalized and liquid, in line with the requirements of the supervisory regulatory framework. However, given the unfavourable developments in the international financial markets, increased vigilance is required from the financial institutions to maintain low exposures in the markets. Against this background, the Bank of Albania has required the banks' governing structures to establish and take the necessary concrete measures to maintain and improve the capacity to constantly generate a positive financial result, preserving at the same time the quality of assets and the liquidity indicators. The Bank of Albania will constantly orient and support these actions through constant revision of the regulatory framework.

Assets of the financial sector have grown at stable rates, although the non-bank financial sector continues to have a low share in the financial market. As of end the first half of 2008, total assets in the financial system accounted for 85.8% of the GDP for 2007. As of end period, total assets of the banking sector amounted to 807.2 billion leks, accounting for 83% of the GDP. As of end March 2008, total assets of non-bank financial institutions, which are licensed by the Bank of Albania and do not accept public deposits, amounted to 14.2 billion leks accounting for 1.4% of the GDP. According to the Albanian Financial Supervisory Authority (AFSA), total assets of insurance and reinsurance companies, which dominated in the non-bank financial sector, grew by 8.7% to 14.5 billion leks as of end March 2008 compared with the end of 2007. Total assets of insurance and reinsurance companies licensed in Albania have shared about 1.4% of the GDP. Their share to total assets of the banking sector was only 1.9% in the same period, hence remaining the same as in the end of 2007. According to the AFSA, as of end 2007, the activity indicators of this important segment of the non-bank financial sector, namely profitability, insurance capacity and capitalization, were positive and in line with the requirements of the regulatory framework. In addition, the AFSA has continued to improve the regulatory framework of this market and the technological infrastructure of is monitoring.

The banking sector has further expanded investments in loans and securities, maintaining good levels of return. However, the loan portfolio quality and liquidity indicators have been declining. As of end June 2008, the banking sector's loan portfolio rose almost to 43% of total assets of the sector, increasing by 3.6 percentage points relative to end-year 2007. Investments in securities reached about 19% of total assets, increasing by 1 percentage points to end-year 2007. As of end June 2008, return on average assets was estimated at 1.3%, while return on equity reached 16.6%. Lending quality has been affected negatively by the high lending rates driven by market competition. The ratio of non-performing loans to total loan portfolio rose to 4.3%, which is still lower than the average of other regional countries and is considered as acceptable. Loans denominated in foreign currency continue to dominate in the total loan portfolio. Average maturity term of loans has extended. Household deposits, which make up the main funding source of the activity, share 80% of total assets. Credit lines from parent banks, which are another funding source of the banking activity, share 8.6% of total assets. Capital adequacy rate has increased slightly as of end the first half of 2008 to 17.3%. As a result of investments in higher risk assets, the banking sector maintains the downward tendency of liquidity indicators. Liquid assets of the banking sector share 47% of total assets, dropping by about 5.7 percentage points compared with the end-year 2007. However, these indicators are assessed as being in good levels and their average is higher than in other regional countries.

The indicators of the non-bank financial sector, which includes financial institutions licensed by the Bank of Albania and that do not accept household deposits, have performed well. In the first quarter of the present year, their assets amounted to 14.2 billion leks, increasing by 1% compared with the same period the previous year and reducing by 2.3% relative to end-year 2007. The ratio of capital accounts to total assets was nearly 55% in the first quarter of 2008, rising by 6 percentage points to the end-year 2007. As of end the first quarter, loan portfolio shared about 58% of total assets. Non-performing loans accounted for 1% of total loans, dropping insignificantly by 0.09 percentage points relative to end-year 2007. Interest income represents the main source of income for these institutions. In the first quarter of 2008, their share accounted for nearly 55% of total income, which is 11 percentage points higher than in the last quarter the previous year.

By and large, the activity of insurance and reinsurance companies continues to show a positive performance in terms of capitalization, assets' quality and liquidity indicators. According to the AFSA, the insurance market rose 18.2% in the first half of 2008 compared with the same period the previous year. This growth attributes to the increased number of life and non-life contracts and to the increased volume of gross written premiums. Compulsory insurance accounted for 65% of total insurance in the first half of 2008, while voluntary insurance shared the rest. In the first quarter of 2008, equity accounted for 52.7% of total assets, increasing slightly by 0.70 percentage points relative to the last quarter of 2007. For the same period, the ratio of equity to technical reserves, which measures the capacity to recover the losses as a result of exposure to possible risks, was 128%, increasing by 10.2 percentage points relative to the previous quarter. Return on Equity (ROE), measured as the ratio of return from investment to equity, reached 5.3% in the first quarter of 2008. This figure may be considered as low and requires increasing. The diversified products of insurance and reinsurance market, and in particular the expansion of non-life products' market, are expected to affect the improvement of profitability through a more balanced generation of income.

Although the financial outlook of the banking sector is satisfactory, the downward tendency of liquidity indicators and the deterioration of assets' quality require increased prudence by the banking industry. Scenario-based risk analyses confirm that the banking sector has the capacity to cope with the various risks that may arise as a result of the unwelcome shifts in the exchange rates and interest rates. Prudent monitoring of assets' quality is required and time is ripe to pay greater attention to the performance of liquidity indicators. With respect to the latter, the following aspects are crucial to keep under consideration:

First, the absence of a developed money and securities trading market curtails the financial institutions' capacities to meet the unexpected liquidity needs through the sale of assets considered as "liquid". In addition, as a result of the financial crisis in the international markets, the trading of some securities, which were previously considered as favourite to the investors, has become challenging. Accordingly, the Bank of Albania considers as necessary the undertaking of an institutional and legal initiative for the drafting of a single and comprehensive law on financial collateral arrangements in line with the best international practices in this area, as provided in the amended Directive 98/26/EC on settlement finality in payment and securities settlement systems and Directive 2002/47/EC on financial collateral arrangements. The drafting of this law enables the creation of a uniform framework which provides contemporary judicial arrangements for the creation, validity, inconsistency and execution of financial collateral agreements, by replacing their regulation fragmentized in several laws.

Second, the differences in the size of the banking sector's institutions, the collateral's quantity and quality, and the restrictions related to the direct exposure among institutions hamper the circulation of liquid funds in the interbank market in the duly time and extent.

Third, given the enhanced competition, there is a risk that significant disproportions arise between assets and liabilities in the balance sheet, with regard to type of currency and maturity term;

Fourth, some institutions have also turned to borrowing from parent banks in order to maintain the lending speed and size;

Fifth, owing to objective factors that have conditioned the lack of efficiency, the banking sector at home has been characterized by very high liquidity levels. Given the enhanced competition and improved efficiency, it is objectively expected that liquidity indicators begin to shift downward. These factors hamper the setting of the optimum liquidity level, in which the enhanced efficiency in fund use does not shackle the institution's capacity to cope with the business risks.

All these elements provide evidence for the need that the banks' governing structures follow practices that allow the institution itself to meet the expected liquidity needs independently, however, having options which improve their capacity to generate liquidity in urgent cases. Accordingly, banks are advised to re-evaluate the securities' portfolio quality, in particular that in foreign currency, in order to attain the optimum characteristics of safety and tradability. In addition, the Bank of Albania has required the reassessment of certain indicators' adequacy in terms of differences in maturity terms and type of currency of assets and liabilities. With regard to the latter, it is required that they be diversified and maintain low concentration levels. Borrowing from banking groups, which is usually renewable and of short maturity term, represents an alternative funding way of banking activity in addition to households' deposits. As long as it keeps acceptable levels, it plays a key role in sustaining intermediation activity. Banks should however avoid at any cost the dependence on these funds and pay careful attention to preventing the deepening of the spreads that may arise in the type of currency and maturity term.

In the case of the Albanian banking sector, the loan portfolio quality has been decreasing, although at gradual rates, and the situation is presented as entirely manageable. The rapid growth of credit and the challenges certain sectors of the economy that have been lent significantly may be faced with, are factors that will continue to exert pressure on the loan quality in the near future. Hence, it is crucial for banks to implement a policy of rapid detection of non-performing loans and promptly create reserve funds. It is for this reason that the Bank of Albania will increase the frequency of controls to monitor and check this process.

Following the deepening of the crisis in the international financial markets and the uncertainty related to its extent in the future, there is an increased risk of its impact on the Albanian financial system. However, certain factors, namely the relatively low exposure of the Albanian financial system to international financial institutions and to products that instigated the financial crisis, the low integration level in general and the well-capitalized activity of European banking groups and their branches operating in Albania, will serve as shielding elements of our financial system to this risk. In the context of global economic developments, the uncertainty related to the future prospects in consumer prices and economic growth in the euro area EU countries and the USA, will affect the performance of interest rates in the money and credit markets and the exchange rate performance. These changes may affect the internal market, although moderately, through the exposure of the Albanian financial sector to assets and liabilities denominated in foreign currency. In addition, there is a risk that the challenges the economies of the EU countries and broader are going through be reflected in Albania through the fall in workers' remittances, deterioration of trade deficit and decrease of foreign direct investments. However, the materialization level of this risk and its extent will depend on the velocity at which the financial crisis will affect the real economy in the region and broader.

In response to these risk elements and in a broader context, the Bank of Albania will attentively monitor the performance of incentives that drive the rapid growth of credit, in particular that in foreign currency. In addition, it will analyze the factors that establish a better relationship between investments and their way of funding, in order to prevent the deepening of differences between maturity terms of assets and liabilities and to control the dependence on the international markets.

The intensification of dialogue with the banking industry and the co-ordination of actions between the public authorities that supervise the financial market will help in preserving public confidence in the financial system and in sustaining its stable development in the future.