BANK OF ALBANIA STATEMENT
Financial Stability Statement, 2016 H1

Pursuant to provisions under Article 69 of the Law No. 8269, dated 23 December 1997 "On the Bank of Albania", as amended, and Article 8 of the Law No. 9962, dated 18 December 2006 "On Banks in the Republic of Albania", as amended, to inform the Assembly of the Republic of Albania and the Council of Ministers, and draw the attention of financial institutions and of the public on the Albanian financial system situation and the potential risks that may jeopardise its stability, the Bank of Albania releases this periodic statement. This statement is an integral part of the Financial Stability Report for the same stated period.

The Financial Stability Report and in the statement that prefaces it assess the banking sector"s exposure to risks arising from its interaction with external and internal economic developments, real economy agents, financial markets in Albania as well as risks related to the way the baking sector conducts its activity. In addition, these risks are faced with the financial situation of the banking sector and are stressed through the stress test to assess the banking sector"s resilience.

The Bank of Albania considers that the activity of the banking sector and of the financial system has been stable during 2016 H1. The main financial indicators of the banking sector- including capitalization, liquidity and profitability -attest to its full capacity to withstand the activity risks at normal conditions, as well as to show endurance against strong shocks.

Economic and financial highlights

During 2016 H1, the international economic and financial developments have been in line with expectations. Incentivising policies, particularly in the advanced economies, have supported the moderate growth of the world economy. Commodity and oil prices have settled at low levels and the signals for their recovery need consolidating. Overall, inflationary pressures remained weak, despite a relative improvement in the labour market in more advanced economies. Liquidity in the financial markets appears better, attributable to the easing monetary policies of central banks in the larger countries. Foreign exchange markets were overall stable, despite the volatility at the end of the period following the unexpected Brexit referendum result. In the sovereign debt markets of the advanced economies, the yields curve continued to be close to or below zero for all maturities. In the capital markets, the value of bank's share, especially the European banks, declined mainly due to concerns related to the assets" quality, uncertainties regarding the impact of regulatory changes, and profitability levels. However, the stress test conducted on European banks for this year, showed their resilience attributable to better capitalization. Overall, during the period, international developments had no significant impact on the performance of the financial system and the banking sector in Albania.

During the period, economic developments in Albania were positive. Economic growth, driven mainly by the domestic demand, accelerated during Q1 to 2.96% (annual growth) and employment indicators improved. Inflationary pressures remained weak and the Bank of Albania deepened the easing monetary policy stance by lowering the policy rate two times by 0.25 percentage point to 1.25%. Fiscal policy maintained its consolidation trend through the increase in revenues and the decrease in budget expenditures. The decrease of budget deficit was accompanied with declining needs for funding, which were fulfilled almost entirely with foreign sources. In the domestic financial market, interest rates on lek financial products, declined during the period, due to monetary and fiscal policy actions. During the period, liquidity in the interbank market was stable and trading volume has slightly increased. The foreign exchange market reflected developments in international markets, and lek appreciated slightly against major currencies.

Households and enterprises appear to have stable financial balance sheets. During the period, the notable credit financial position of households declined slightly as a result of the faster growth of credit, especially in lek, compared with the growth of their deposits. On the other hand, the enterprises debt financial position deepened somehow due to the decline of deposits and growth of credit. Regarding quality, the non-performing loans decreased for households but increased for enterprises.

During the period, the banking sector and financial system activity expanded even further, but the growth pace slowed down and the financial system's share in GDP fell to 100.7%. The sluggish growth of the banking sector activity was the main contributor to this performance. Banking sector's assets make up 90.8% of the financial system's assets. In annual terms, in the banking sector activity, securities (increase) and reserve funds (decrease) in the assets side of the balance sheet, and treasury and interbank transactions (decrease) and permanent resources (increase) in the liabilities side experienced the biggest change.

During the period, the banking sector expanded the credit by 1.9% and increased the investments in debt securities. The activity was funded again through deposits, which make up 82.3% of the banking sector's assets, and showed steady value during the period. Despite the slight increase during the period, the relationship between the banking sector and non-residents remained stable during last year.

Banking sector exposure to operational risks

Regarding the banking sector activity risks for the Bank of Albania assesses as follows: a) Credit risk increased during the period. The value of non-performing loans rose by 11.7% and the ratio of non-performing loans in the banking sector rose to 20%, from 18.2% at the end of 2015. Credit to enterprises, foreign currency credit and medium-term credit gave the main contribution to this increase.

The increase in non-performing loans is associated with the slight reduction of their coverage with reserve and capital funds, albeit these indicators remained at the same levels as a year ago. The increase in non-performing loans points to the difficulty for their resolution and the need to closely monitor this process. The Bank of Albania expects the NPLs curve to trend down, although their value may fluctuate over time. In this regard, the Bank of Albania will carefully monitor the banks proactive approach to timely identify, and to provision non-performing loans, as well as the way they implement the regulatory requirements for writing off lost loans from the balance sheet. In addition, it will be important to verify the impact that the approval of the draft law "On Bankruptcy" will have in the relationship between banks, debtors and other parties that interact in the resolution of problematic debt. As evidenced by the Albania Financial Forum IV proceedings in June 2016, in cooperation with the banking industry and the government, the Bank of Albania will assess the need for taking additional measures that reduce the uncertainty in the financial intermediation process and improve the implementation of legal requirements in this field.

b) Liquidity risk in the banking activity is assessed as low. The low value of loans to deposits ratio, continuation of deposits growth and the high presence of liquid assets above the minimum regulatory requirements, show a very good situation of liquidity in the banking sector. This situation shows the space and need for improving the financial intermediation, as a necessary phenomenon to contribute, among other things, to improving the efficiency of banking activity. However, it must be taken into account that the share of very short-term sources of the banking sector in the form of current accounts and demand deposits continues to grow. This performance dictates maintaining high levels of liquid assets and negatively affects the performance of income from interests. The good liquidity situation was proven through a special stress test exercise, which took place in June.

c) The banking sector is significantly exposed to the market risk (including the exchange rate risk and interest rate risk) regardless of the reduction of exposure size during the period.

As previously assessed, the direct exchange rate risk in the banking activity is limited, as foreign currency assets and liabilities have approximate values. However, risk increases when the assessment includes the indirect impact from the exchange rate, transmitted mainly through foreign currency loans to resident entities, whose main income is in lek . Despite the decline in this loan category during the period, it accounts for about 26.5% of the total outstanding loans, which is considered as a high share. Banks as well as borrowers should carefully evaluate the risks stemming from foreign currency lending, where the parties are exposed to adverse fluctuations of the exchange rate. Transparent communications between parties regarding the recognition of risk and the implementation of concrete procedures by banks for its quantitative assessment should be part of this careful assessment.

Interest rate risk is present in the banking activity in both its direct and indirect forms. In its direct form, the risk is transmitted through the gap between assets and liabilities of the banking sector according to repricing periods. This gap is negative and has widened somewhat in the short term. The risk would materialize in the case of an increase of the interest rate, which, due to the negative gap, would have a faster impact on the banking activity costs compared with its revenues. This risk has an indirect component related to the negative effect from the increase of interest rate on borrowers who have variable interest rate loan. In such case, it is necessary for banks to quantitatively assess the impact of adverse scenarios and work on reducing the exposure.

d) The events that affected the transport security and safeguarding of monetary values point to the necessity of strengthening the procedures that banks apply for operational risk management. This should not include only the physical security but also the electronic and IT-related security, which are of critical importance for a secure banking activity. In this regard, the Bank of Albania promotes cooperation between banks and law enforcement authorities to resolve concrete cases and take measures to eliminate loopholes. More generally, regarding the operational risk management, the Bank of Albania emphasizes the need of a holistic approach, where the assessment of operational risk is based on its impact on the reputation, strategy, and finances of the institution, as well as on a full analysis on risk likelihood. Thus, the control system should be established and implemented on such basis, and the procedures' quality and compliance, and the suitability of the whole supportive infrastructure of the process is part of the periodic test and regular evaluation by special bank structures. The Bank of Albania notes that it will strengthen its supervisory and regulatory activity in terms of the verification and evaluation of the operational risk management systems by banks, inter alia, by increasing the significance of this process on the banks' overall evaluation and in particular on their management structures.

e) The significant presence of foreign banks in Albania and the exposure of the banking sector to non-residents, underpins the need for close monitoring of international developments. In this regard, the stress tests conducted on the biggest European banks were of particular interest. The results, which were published in -July, confirmed that none of the banks operating in Albania, part of the stress test, had any problems regarding activity sustainability. In general, the stress test showed that European banks have much better conditions of capitalization and liquidity than in previous years.

The European financial markets showed an increase of their activity volatility by the end of the period , following the somewhat unexpected "Brexit" referendum result. The foreign exchange markets were the most volatile, with the British currency depreciating rapidly. The depreciation of the British currency could, in short term, be accompanied by a decreasing value of the Albanian banking products in this currency. Based on the performed analysis, the Bank of Albania considered that this was a minimal effect, since public's loans and deposits denominated in the British currency were negligible. Also, the Albanian banking sector investments in British currency in the form of placements (account, deposits) or securities were quite limited. In a longer term, Brexit impact on the Albanian economy would be determined by the volume of trade relations. The analysis showed that exports, imports, foreign investments and remittances to/ or from the UK, were in each case less than 1% of the GDP, thus considerably limiting the adverse impact of Brexit. It should also be noted that the Brexit process will require time and is surrounded by uncertainties. However, the measures taken by the monetary and fiscal authorities in the UK and Europe, to ensure a smooth process, without causing dramatic volatility in the respective economic and financial indicators, will mitigate the potential effects from this process on other countries.

Risks to financial stability

To assess systemic risks, the performance of indicators was analysed related to the materialization and accumulation of the systematic risk, with the stress level in the financial system and with the banking industry perception regarding the banking activity exposure to systemic risks. Also, the financial stability map, aims to achieve a consolidated approach of risks to financial stability. In general, the indices show a slight increase of risks to financial stability over the period. In the banking sector, the increase of non-performing loans, relative decrease of profitability indicators, slowdown of deposits' growth and banks' perception on risk levels have made the main contribution. In the real economy, the increase of the external debt of Albania and the still-volatile expectations of the private sector for the economy's performance contributed to the increase of risks. In general, economic growth, fiscal performance of the government and decline of foreign currency loans in the banking sector, contributed positively to the reduction of risks evaluation.

Banking sector's ability to cope with risks

The banking sector's ability to cope with risks is assessed by analysing its capitalization and profitability situation, as well as by stressing these indicators using the stress test. At the end of the period, the banking sector's capital adequacy ratio was 16.1%, about 0.1 p.p. higher compared to the end of 2015, about 0.6 p.p. higher than a year ago, and significantly above the minimum required level for this indicator, at 12%. Despite the increase of risk-weighted assets coefficient by almost 3.9%, the increase of the regulatory capital by 4.2% retained the indicator's upward trend. Financial leverage indicator, measured as the ratio of total assets to shareholders' equity was 10.4 times and is considered to be at a good level. The maintenance of a good capital position is determined by the performance of the banking sector financial result. During the period, the banking sector made a profit, albeit lower than a year ago. The decrease in income from interests and the increase of the provisioning for credit risk led to the profit decline. The decrease of income from interests has reflected the fall in return rates from investments for financial instruments both in foreign currency and in lek. Increased provisioning for credit risk, has reflected the growth of non-performing loans during the period. Banking sector profitability indicators, Return on Assets (RoA) and Return on Equity (RoE) were 0.8% and 8%, respectively.

The adequacy of the above indices has been proven during the stress test with scenarios that assumed adverse changes in macroeconomic and financial indicators for the 2016-2017 period. As part of the extreme assumptions, but with a low probability of adverse scenario likelihood, the contraction of the economy and of credit, and the rapid increase of interest rates and the strong depreciation of the exchange rate were included. The results of the stress test showed that in the baseline and the moderate scenario, the banking sector remains capitalized, whilst it would need a capital increase in the adverse scenario. Additional capital requirement for specific banks is evident in the moderate scenario.

Based on this analysis, the Bank of Albania considers that banks capitalization and profitability is sufficient to cope with activity risks. Banking sector activity, in the medium term, will benefit in the case of an acceleration of economic growth, by improving the revenues' structure and consolidating the positive performance of the financial result. But, in a shorter-term period, the banking sector's profitability may continue to feel the pressure of the low interest rates and the volatility in the level of activity costs. Thus, the Bank of Albania assesses that banks should continue to efficiently use the revenues, and maintain the indicators of the activity capitalization.

Pursuant to provisions under Article 69 of the Law No. 8269, dated 23 December 1997 "On the Bank of Albania", as amended, and Article 8 of the Law No. 9962, dated 18 December 2006 "On Banks in the Republic of Albania", as amended, to inform the Assembly of the Republic of Albania and the Council of Ministers, and draw the attention of financial institutions and of the public on the Albanian financial system situation and the potential risks that may jeopardise its stability, the Bank of Albania releases this periodic statement. This statement is an integral part of the Financial Stability Report for the same stated period.

The Financial Stability Report and in the statement that prefaces it assess the banking sector"s exposure to risks arising from its interaction with external and internal economic developments, real economy agents, financial markets in Albania as well as risks related to the way the baking sector conducts its activity. In addition, these risks are faced with the financial situation of the banking sector and are stressed through the stress test to assess the banking sector"s resilience.

The Bank of Albania considers that the activity of the banking sector and of the financial system has been stable during 2016 H1. The main financial indicators of the banking sector- including capitalization, liquidity and profitability -attest to its full capacity to withstand the activity risks at normal conditions, as well as to show endurance against strong shocks.

Economic and financial highlights

During 2016 H1, the international economic and financial developments have been in line with expectations. Incentivising policies, particularly in the advanced economies, have supported the moderate growth of the world economy. Commodity and oil prices have settled at low levels and the signals for their recovery need consolidating. Overall, inflationary pressures remained weak, despite a relative improvement in the labour market in more advanced economies. Liquidity in the financial markets appears better, attributable to the easing monetary policies of central banks in the larger countries. Foreign exchange markets were overall stable, despite the volatility at the end of the period following the unexpected Brexit referendum result. In the sovereign debt markets of the advanced economies, the yields curve continued to be close to or below zero for all maturities. In the capital markets, the value of bank's share, especially the European banks, declined mainly due to concerns related to the assets" quality, uncertainties regarding the impact of regulatory changes, and profitability levels. However, the stress test conducted on European banks for this year, showed their resilience attributable to better capitalization. Overall, during the period, international developments had no significant impact on the performance of the financial system and the banking sector in Albania.

During the period, economic developments in Albania were positive. Economic growth, driven mainly by the domestic demand, accelerated during Q1 to 2.96% (annual growth) and employment indicators improved. Inflationary pressures remained weak and the Bank of Albania deepened the easing monetary policy stance by lowering the policy rate two times by 0.25 percentage point to 1.25%. Fiscal policy maintained its consolidation trend through the increase in revenues and the decrease in budget expenditures. The decrease of budget deficit was accompanied with declining needs for funding, which were fulfilled almost entirely with foreign sources. In the domestic financial market, interest rates on lek financial products, declined during the period, due to monetary and fiscal policy actions. During the period, liquidity in the interbank market was stable and trading volume has slightly increased. The foreign exchange market reflected developments in international markets, and lek appreciated slightly against major currencies.

Households and enterprises appear to have stable financial balance sheets. During the period, the notable credit financial position of households declined slightly as a result of the faster growth of credit, especially in lek, compared with the growth of their deposits. On the other hand, the enterprises debt financial position deepened somehow due to the decline of deposits and growth of credit. Regarding quality, the non-performing loans decreased for households but increased for enterprises.

During the period, the banking sector and financial system activity expanded even further, but the growth pace slowed down and the financial system's share in GDP fell to 100.7%. The sluggish growth of the banking sector activity was the main contributor to this performance. Banking sector's assets make up 90.8% of the financial system's assets. In annual terms, in the banking sector activity, securities (increase) and reserve funds (decrease) in the assets side of the balance sheet, and treasury and interbank transactions (decrease) and permanent resources (increase) in the liabilities side experienced the biggest change.

During the period, the banking sector expanded the credit by 1.9% and increased the investments in debt securities. The activity was funded again through deposits, which make up 82.3% of the banking sector's assets, and showed steady value during the period. Despite the slight increase during the period, the relationship between the banking sector and non-residents remained stable during last year.

Banking sector exposure to operational risks

Regarding the banking sector activity risks for the Bank of Albania assesses as follows: a) Credit risk increased during the period. The value of non-performing loans rose by 11.7% and the ratio of non-performing loans in the banking sector rose to 20%, from 18.2% at the end of 2015. Credit to enterprises, foreign currency credit and medium-term credit gave the main contribution to this increase.

The increase in non-performing loans is associated with the slight reduction of their coverage with reserve and capital funds, albeit these indicators remained at the same levels as a year ago. The increase in non-performing loans points to the difficulty for their resolution and the need to closely monitor this process. The Bank of Albania expects the NPLs curve to trend down, although their value may fluctuate over time. In this regard, the Bank of Albania will carefully monitor the banks proactive approach to timely identify, and to provision non-performing loans, as well as the way they implement the regulatory requirements for writing off lost loans from the balance sheet. In addition, it will be important to verify the impact that the approval of the draft law "On Bankruptcy" will have in the relationship between banks, debtors and other parties that interact in the resolution of problematic debt. As evidenced by the Albania Financial Forum IV proceedings in June 2016, in cooperation with the banking industry and the government, the Bank of Albania will assess the need for taking additional measures that reduce the uncertainty in the financial intermediation process and improve the implementation of legal requirements in this field.

b) Liquidity risk in the banking activity is assessed as low. The low value of loans to deposits ratio, continuation of deposits growth and the high presence of liquid assets above the minimum regulatory requirements, show a very good situation of liquidity in the banking sector. This situation shows the space and need for improving the financial intermediation, as a necessary phenomenon to contribute, among other things, to improving the efficiency of banking activity. However, it must be taken into account that the share of very short-term sources of the banking sector in the form of current accounts and demand deposits continues to grow. This performance dictates maintaining high levels of liquid assets and negatively affects the performance of income from interests. The good liquidity situation was proven through a special stress test exercise, which took place in June.

c) The banking sector is significantly exposed to the market risk (including the exchange rate risk and interest rate risk) regardless of the reduction of exposure size during the period.

As previously assessed, the direct exchange rate risk in the banking activity is limited, as foreign currency assets and liabilities have approximate values. However, risk increases when the assessment includes the indirect impact from the exchange rate, transmitted mainly through foreign currency loans to resident entities, whose main income is in lek . Despite the decline in this loan category during the period, it accounts for about 26.5% of the total outstanding loans, which is considered as a high share. Banks as well as borrowers should carefully evaluate the risks stemming from foreign currency lending, where the parties are exposed to adverse fluctuations of the exchange rate. Transparent communications between parties regarding the recognition of risk and the implementation of concrete procedures by banks for its quantitative assessment should be part of this careful assessment.

Interest rate risk is present in the banking activity in both its direct and indirect forms. In its direct form, the risk is transmitted through the gap between assets and liabilities of the banking sector according to repricing periods. This gap is negative and has widened somewhat in the short term. The risk would materialize in the case of an increase of the interest rate, which, due to the negative gap, would have a faster impact on the banking activity costs compared with its revenues. This risk has an indirect component related to the negative effect from the increase of interest rate on borrowers who have variable interest rate loan. In such case, it is necessary for banks to quantitatively assess the impact of adverse scenarios and work on reducing the exposure.

d) The events that affected the transport security and safeguarding of monetary values point to the necessity of strengthening the procedures that banks apply for operational risk management. This should not include only the physical security but also the electronic and IT-related security, which are of critical importance for a secure banking activity. In this regard, the Bank of Albania promotes cooperation between banks and law enforcement authorities to resolve concrete cases and take measures to eliminate loopholes. More generally, regarding the operational risk management, the Bank of Albania emphasizes the need of a holistic approach, where the assessment of operational risk is based on its impact on the reputation, strategy, and finances of the institution, as well as on a full analysis on risk likelihood. Thus, the control system should be established and implemented on such basis, and the procedures' quality and compliance, and the suitability of the whole supportive infrastructure of the process is part of the periodic test and regular evaluation by special bank structures. The Bank of Albania notes that it will strengthen its supervisory and regulatory activity in terms of the verification and evaluation of the operational risk management systems by banks, inter alia, by increasing the significance of this process on the banks' overall evaluation and in particular on their management structures.

e) The significant presence of foreign banks in Albania and the exposure of the banking sector to non-residents, underpins the need for close monitoring of international developments. In this regard, the stress tests conducted on the biggest European banks were of particular interest. The results, which were published in -July, confirmed that none of the banks operating in Albania, part of the stress test, had any problems regarding activity sustainability. In general, the stress test showed that European banks have much better conditions of capitalization and liquidity than in previous years.

The European financial markets showed an increase of their activity volatility by the end of the period , following the somewhat unexpected "Brexit" referendum result. The foreign exchange markets were the most volatile, with the British currency depreciating rapidly. The depreciation of the British currency could, in short term, be accompanied by a decreasing value of the Albanian banking products in this currency. Based on the performed analysis, the Bank of Albania considered that this was a minimal effect, since public's loans and deposits denominated in the British currency were negligible. Also, the Albanian banking sector investments in British currency in the form of placements (account, deposits) or securities were quite limited. In a longer term, Brexit impact on the Albanian economy would be determined by the volume of trade relations. The analysis showed that exports, imports, foreign investments and remittances to/ or from the UK, were in each case less than 1% of the GDP, thus considerably limiting the adverse impact of Brexit. It should also be noted that the Brexit process will require time and is surrounded by uncertainties. However, the measures taken by the monetary and fiscal authorities in the UK and Europe, to ensure a smooth process, without causing dramatic volatility in the respective economic and financial indicators, will mitigate the potential effects from this process on other countries.

Risks to financial stability

To assess systemic risks, the performance of indicators was analysed related to the materialization and accumulation of the systematic risk, with the stress level in the financial system and with the banking industry perception regarding the banking activity exposure to systemic risks. Also, the financial stability map, aims to achieve a consolidated approach of risks to financial stability. In general, the indices show a slight increase of risks to financial stability over the period. In the banking sector, the increase of non-performing loans, relative decrease of profitability indicators, slowdown of deposits' growth and banks' perception on risk levels have made the main contribution. In the real economy, the increase of the external debt of Albania and the still-volatile expectations of the private sector for the economy's performance contributed to the increase of risks. In general, economic growth, fiscal performance of the government and decline of foreign currency loans in the banking sector, contributed positively to the reduction of risks evaluation.

Banking sector's ability to cope with risks

The banking sector's ability to cope with risks is assessed by analysing its capitalization and profitability situation, as well as by stressing these indicators using the stress test. At the end of the period, the banking sector's capital adequacy ratio was 16.1%, about 0.1 p.p. higher compared to the end of 2015, about 0.6 p.p. higher than a year ago, and significantly above the minimum required level for this indicator, at 12%. Despite the increase of risk-weighted assets coefficient by almost 3.9%, the increase of the regulatory capital by 4.2% retained the indicator's upward trend. Financial leverage indicator, measured as the ratio of total assets to shareholders' equity was 10.4 times and is considered to be at a good level. The maintenance of a good capital position is determined by the performance of the banking sector financial result. During the period, the banking sector made a profit, albeit lower than a year ago. The decrease in income from interests and the increase of the provisioning for credit risk led to the profit decline. The decrease of income from interests has reflected the fall in return rates from investments for financial instruments both in foreign currency and in lek. Increased provisioning for credit risk, has reflected the growth of non-performing loans during the period. Banking sector profitability indicators, Return on Assets (RoA) and Return on Equity (RoE) were 0.8% and 8%, respectively.

The adequacy of the above indices has been proven during the stress test with scenarios that assumed adverse changes in macroeconomic and financial indicators for the 2016-2017 period. As part of the extreme assumptions, but with a low probability of adverse scenario likelihood, the contraction of the economy and of credit, and the rapid increase of interest rates and the strong depreciation of the exchange rate were included. The results of the stress test showed that in the baseline and the moderate scenario, the banking sector remains capitalized, whilst it would need a capital increase in the adverse scenario. Additional capital requirement for specific banks is evident in the moderate scenario.

Based on this analysis, the Bank of Albania considers that banks capitalization and profitability is sufficient to cope with activity risks. Banking sector activity, in the medium term, will benefit in the case of an acceleration of economic growth, by improving the revenues' structure and consolidating the positive performance of the financial result. But, in a shorter-term period, the banking sector's profitability may continue to feel the pressure of the low interest rates and the volatility in the level of activity costs. Thus, the Bank of Albania assesses that banks should continue to efficiently use the revenues, and maintain the indicators of the activity capitalization.