BANK OF ALBANIA STATEMENT
On the financial system stability in Albania H2 2009

In its meeting of 14 April 2010, the Supervisory Council of the Bank of Albania analyzed and approved the "Financial Stability Report for 2009".

The following provides a summary of this Report.

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 the potential risks that may jeopardize its stability, the Bank of Albania releases the following periodical statement as part of the Financial Stability Report.

As a result of the extraordinary fiscal and monetary stimulus provided during 2008 and 2009 and following the improvement of the financial sector situation, the global economy has stabilized and its stable recovery is underway. In more concrete terms:

1. The extraordinary monetary and fiscal stimulus provided by the public authorities global-wide proved effective in lowering the pressures on the financial markets and mitigating the negative impact of the crisis on the real sectors of the economy. The return of financial markets to a stable situation happened faster than expected, however many of the markets’ parameters that relate to volumes, liquidity or prices remain far from their pre-crisis levels, reflecting the presence of uncertainty among the economic agents. Borrowing conditions are still difficult, particularly for small and medium-sized enterprises and consumers. Structured products markets remain impaired, encumbering the intermediation role of financial institutions, while the functioning of capital markets in uncollateralized or low-quality segments was poor and at a high cost.
2. The financial sector’s performance affected the performance of the real sector of the economy; however the recovery of the latter has by and large been slow. Advanced economies’ economic activity contracted by 3.9 percent in 2009; however under the impact of stimulating policies there have been clear signs of stabilization in the second half of year. The recovery of these countries’ economy is expected to be slow and output will remain below its historical trend, at least until 2011. Emerging markets provided the major contribution to the global economic output, posting an average total growth of 2.1 percent in 2009. Within this group of countries, Asian emerging markets provided the major contribution to the economic growth, while the European emerging markets displayed a slower economic recovery.
3. Europe’s economic performance improved ever-increasingly over the course of the year 2009, in particular during the last quarter; however, the improvement was slower than in the U.S. and there were marked differences among the countries in the region. Monetary and fiscal stimulus and the recovery of trade activity were the two key factors that boosted the region’s economic stabilization. Central and South-East European countries contracted by 4.3 percent in 2009. Euro Zone countries contracted by 4 percent. The European Commission forecasts that the latter will grow in 2010 at a modest rate of 0.7 percent, with the bigger countries like Germany and France expected to provide the major contribution. Some other countries like Greece or Spain will continue to face contraction of their economies. The recovery pace of the economy will by and large depend on the financial sector’s intermediation capacity, the performance of non-financial asset markets, the fiscal situation and the developments in the labour market.
4. The developments in the foreign exchange markets have reflected the markets’ perception of the impact level of the international financial crisis on the most advanced economies. The U.S. dollar depreciated against the Euro and other major currencies in 2009. However, it seems that in the last two months of 2009 the expectations for a more rapid recovery of the major economies, the movements in the policy rates and the stable fiscal positions gave rise to the appreciation of the U.S. dollar against the Euro. Nonetheless, volatility in these markets remained high reflecting the investors’ uncertainty and the higher sovereign credit risk.
5. Following the dramatic fall of energy and primary commodity prices in the second half of 2008, prices stabilized in the early part of 2009 to later rise after the second quarter the same year. This performance owes primarily to the recovery of economic activity in emerging markets and to the improvement of conditions in the global financial markets.
   Despite the expectations for the stable recovery of global economy there are certain risks that may give rise to episodes of instability in various countries or regions. These risks will provide their impact in a longer-term and they originate from the measures taken to withstand the short-term effects of the crisis. In more concrete terms:
6. Because the stabilization of global economy has been achieved against a backdrop of extraordinary fiscal and monetary stimulus, it was accompanied by a deteriorated fiscal position and an unstable rise of financial and non-financial asset prices. These consequences require the withdrawal of the stimulus gradually and prudently. A number of factors that relate to the difficulties in harmonizing these policies at a global-wide level, to the potential halt of the economic recovery process in advanced economies and to the appearance of considerable volatilities in the financial indicators have preserved the financial markets’ uncertainty about the performance of global economy in the future and encumber the development of economy at faster paces.
7. The fast increase of budget deficits and public debt worldwide has put the various governments’ solvency into question. Given its set-up and other structure-related issues, the European Union perceives the investors’ reluctance more than in the U.S. The strained fiscal situation in some Euro Zone countries require that the strong corrective measures taken to reduce the budget deficit at a national level be backed with sufficient financial support at a European Union level, so that the stability of this joint political and monetary project is not seriously put into question. On the other hand, in more practical terms, this financial assistance is also necessary to mitigate the higher cost of debt for the private sector and to alleviate the contraction of economy as a result of the substantial decline of the fiscal stimulus.
8. The economies of Central and South-East European countries are still facing important challenges, According to the ECB’s report, unemployment, the fall in income and private sector failures will remain at high levels in 2010, maintaining the negative impact on the banking loan portfolio quality and economic growth. In addition, the private sector’s sensitivity to the exchange rate risk remains high due to the existing foreign currency borrowing.
9. Private entrepreneurship may still face a hard year as long as the withdrawal of the fiscal stimulus is not coupled with the increase of the financial system’s intermediation. The private sector’s capacity to finance their investment needs in the capital markets will be adversely affected by the excess capacities and inventories against a background of lower demand and higher private debt issuance cost. The slow recovery of the economy would lead to the further correction of costs and profit margins, hence determining the capacity of private entrepreneurship to withstand the possible fall of demand for goods.
   Albania posted a positive economic growth during 2009, despite the impact of the global financial and economic crisis. The financial system, dominated by the banking sector, was stable and the fiscal and monetary stimulus mitigated the difficulties of the real sector of the economy. More concretely:
10. The Albanian economy faced slower economic growth rates during 2009, however maintaining a positive economic growth and displaying satisfactory resilience to the impact of the international financial and economic crisis. Among the factors that led to lower economic growth rate we can mention: the trade balance deficit sustainability; harder times for the private entrepreneurship due to lower foreign demand and contraction of banking sector lending; and lower dynamics in household consumption owing to the decline of banks’ financing, lower workers’ remittances and uncertainty over the devaluation of the national currency exchange rate. Among the factors that boosted economic growth over the course of 2009 we can mention the public authorities’ measures to rapidly restore public confidence in the financial system and the banking sector, and the fiscal stimulus provided through the increase of public expenditure, particularly of public investments.
11. With regard to fiscal policy, as at end 2009 budget surplus was negative and amounted to ALL 79 billion or 7.1 percent of GDP. According to the Ministry of Finance, budget revenues totalled ALL 298 billion, meeting 93.2 percent of the Ministry of Finance’s revised budget plan, up by 2.4 percent from 2008. Budget expenditure amounted to ALL 377 billion, meeting 94 percent of the Ministry of Finance’s revised budget plan, up by 7.8 percent from 2008. The increase of the budget deficit was followed by higher borrowing needs to finance it. Domestic resources financed 64 percent of the budget deficit, wherein privatization receipts accounted for slightly more than half of domestic resources. The rest was financed through external resources, out of which 63 percent were loans extended from non-resident financial institutions. The share of financing provided through borrowing from resident entities, through debt securities or loans, totalled ALL 23.8 billion or 30.8 percent of total deficit financing needs. The same indicators for 2008 were ALL 19 billion or 31.5 percent, respectively. As regards the instruments employed, there was a lower issuance rate of long-term debt securities relative to 2008. The rationale behind is the greater preference of investors –mainly banks and individuals– to invest in short-term instruments against a background of higher uncertainty over their needs for liquid funds. In the short run, the expansionary fiscal policy provided a counter-cyclical response to the impact of the global crisis on the performance of domestic economy. Worth taking into consideration is the fact that this stimulus’ effect on economic development was weaker in the last quarter of 2009, hence calling for a better acknowledgement of the structural factors that condition the transmission of fiscal and monetary stimulus to the development of the economy. Stated otherwise, the real efficiency of an expansionary fiscal policy may be more accurately defined only by assessing the efficiency of the fiscal stimulus use in different development projects.
12. With respect to the real sector of the economy during 2009, various indicators attest to a generally less satisfactory situation than in 2008. This trend was more pronounced in the last quarter of 2009. Among the indicators we can mention the decline of budget revenues collected in the form of tax, the fall of investment and consumption as a result of lower banking sector lending and workers’ remittances, and the economic growth slowdown. The information obtained through surveys confirms the same situation. Although the nominal sales grew by an average of 6 percent in 2009, their growth was only 2 percent in the last quarter of 2009. Industry and construction provided a negative contribution to the performance of sales, while services provided the major positive contribution. As far as the business economic situation is concerned, there were higher unexploited capacities and investments declined. In addition, the expectations about the overall performance of the economy have deteriorated. As at year-end 2009, the use of business capacities declined to 66 percent compared to the long-term average of 74 percent. After recording a positive performance in the previous two quarters, in the last quarter of 2009 economic expectations index dropped 16.8 percentage points from its long-term average. Business confidence index recorded losses in the last quarter of 2009 in its main components of industry, construction and less in services. On the other hand, consumer expectations about the development of the economy were more stable. With respect to the performance of the balance of payments in 2009, the current account and trade deficit recorded a slight decline in absolute terms. However, as a share of GDP, trade deficit was 27 percent, similar as in 2007 and 2008. Annual workers’ remittances amounted to EUR 780 million, down by EUR 53 million from the previous year.
13. The financial system expanded its activity in 2009 although at lower rates than in 2008. Financial intermediation in Albania, measured as the share of financial system’s [1] assets to the GDP, rose to 83 percent as at year-end 2009 compared to 82 percent as at year-end 2008. Financial institutions’ assets grew 7 percent relative to the previous year. The banking sector dominates the overall assets of the financial system. As at year-end 2009, in Albania operated 16 banks and their assets accounted for about 94.7 percent of total financial system’s assets and about 78.5 percent of GDP. The banking sector’s assets grew to ALL 886.3 billion, posting an annual nominal growth of 6.3 percent or a real growth [2] of 1.2 percent relative to the year-end 2008. The performance of the financial system’s financial resources, revenue and capital was affected by the international financial crisis and its impact on Albania’s real economy. As far as the banking sector is concerned, the decline of public deposits terminated at the end of the first quarter, and their return to banks progressed at stable rates during the rest of 2009. However, the changes in the liquidity situation, the exchange rate devaluation and the difficulties encountered by the real sector of the economy gave rise to slower lending and deteriorated loan quality. As at end 2009, lending, including the accrued interests, accounted for about 50.8 percent of total banking sector’s assets or as much as 40 percent of GDP. In the meantime, the ratio of non-performing loans to total loan portfolio rose to 10.5 percent. The need to increase the reserve funds for coping with the credit risk from banks led to the decline of the banking sector’s financial result. For these reasons, the latter was positive for about ALL 3.5 billion, almost half as much as the previous year. Business capitalization was adequate during 2009, as a result of lower high-risk bank investments, injection of new capital by the shareholders and the preservation of a net positive result. As at end 2009, capital adequacy ratio was 16.2 percent. The public authorities took several measures in 2009 to support the financial system and the banking sector in particular. Among these measures, we could mention the approval of the law which increased the insurance amount of public deposits, and the decisions of the Supervisory Council of the Bank of Albania to limit banks’ exposure to foreign banking groups and to suspend the allocation of banks’ profit in 2008 and 2009. Along with these decisions, during 2009 a number of other Bank of Albania decisions taken since the last quarter of 2008 continued to be implemented. These decisions related to the establishment of more facilitating conditions as far as the provision of liquidity in the interbank market is concerned. The Bank of Albania decisions in January and October, which cut the key interest rate by 1 percentage point to 5.25 percent, contributed further to increasing the banking sector’s opportunities to provide liquidity at a lower cost.
    Given the need to attain a stable economic development, some actions need to be taken in order to correct the imbalances generated in 2009. More precisely:
14. Economic development at home during 2010 will be supported by a more favourable global economic situation, which will provide a better setting for foreign investments and will better boost the demand for the Albanian exports. However, this positive development is expected to be limited owing to the negative developments in the Greek economy. In the domestic economy, the developments noted during 2009 as regards the increase of budget deficit and domestic debt, the lower banking sector lending, and a more rigid situation in production and consumption need to be addressed through quick and decisive actions and in the course of an adequate time span. It is therefore indispensable to keep the budget deficit for 2010 under check and at levels that guarantee the observance of the targets outlined in the Medium-term Macroeconomic Framework as regards budget deficit and public debt level. The cut in expenditure, in particular current expenditure, should be the main instrument to achieve this objective in the conditions when the performance of public revenue remains unclear and their growth potential seems limited. The cut of public expenditure will improve the current account deficit in the balance of payments, hence providing a positive impact on the factors determining the exchange rate stability. On the other hand, the consolidation of public finances, reflected through the restoring of budget deficit’s downward trend is of great importance in terms of the decline of its financing cost. It will also lead to improved liquidity situation in the financial market, releasing more financial resources into the system, the use of which will boost the private sector lending. Private entrepreneurship and households will continue to experience difficulties during 2010 as long as the unstable performance of disposable income and consumption will affect the preservation of free capacities and the low rate in private investment. However, this period should be used by the private entrepreneurship to control the costs and take the necessary measures for restructuring the activity in order to enhance the efficiency. In general, these actions of the fiscal authority and the private economic agents are in the short-term necessary to provide a more adequate environment that will enable the undertaking of other measures for increasing the contribution of production to economic growth and increasing the domestic savings in a longer-term.
15. The financial system will continue to expand its activity during the year 2010. Given the low share in the financial system, non-bank financial institutions will continue to expand their activity naturally. The banking sector will expand its activity at higher rates than in 2009, however less than the average long-term annual growth. The expansion of activity will likely be more rapid in the second half of the year. As regards the financial resources, the banking sector will benefit from the stable growth of public deposits. The growth of ALL deposits will continue to be supported by the more stable savers’ flows, the positive real return and the expectation for greater exchange rate stability. The growth of foreign currency deposits will reflect the seasonal performance, hence being higher during summer. The maturity structure of deposits is not expected to display any significant changes from the present situation; however the average maturity term of deposits is expected to be longer in 2010 relative to 2009. The extent of this change will be determined by the performance of depositors’ income and the stimulus set by banks to orient the structure of savings. The Bank of Albania will continue to provide the necessary liquidity to the interbank market. As far as the credit lines and shareholders’ capital are concerned, the Bank of Albania will continue to require from banks that they maintain the necessary amounts not only in order to carry out a normal banking business and comply with the regulatory framework requirements, but also in order to support the recovery of banking business at well-controlled risks. With regard to bank investments, the Bank of Albania expects slightly higher lending rates by the banking sector in 2010 relative to 2009, with the largest part of growth expected to take place in the second half of the year.

ASSESSMENT OF THE BANKING SECTOR’S RISK SENSITIVITY

The financial system’s and particularly the banking sector’s stability is defined in terms of the financial relations with the internal and external economic developments, and their interaction with the internal situation in the financial system. Based on the development analysis of 2009, general evaluations indicate that the level of risk for the financial system and the banking sector has decreased. Despite the short-term improvement of some financial activity-related elements, several challenges emerged over the course of the year 2009 that will affect the financial system and particularly the banking sector’s activity in the medium term, hence requiring careful monitoring.

In the short-term, the banking sector’s financial situation has benefited positively from the following developments:

a) Substantial improvement of liquidity situation against a background of public confidence recovery and stable deposit growth. It is assessed that during 2009, the annual growth of public deposits was 7.6 percent, rising to ALL 694.3 billion. This deposit level is almost similar to that of end September 2008, prior to the beginning of the deposit withdrawal. However, when comparing, we need to take into account the devaluation of the ALL exchange rate during 2009, which increases the ALL value of foreign currency deposits. Nonetheless, it is important that the growth of public deposits during 2009 maintained the stable rates in the early part of 2010 as well. The growth rate of public deposits would have been higher if the situation in the real sector of the economy had improved and the banking sector lending had recovered.

b) Lower growth rate of the banking sector’s risk-weighted assets. During 2009, the growth of the banking sector’s risk-weighted assets reduced substantially, owing mainly to the much lower growth rate of lending and the lower expansion of banking business in general. In fact, during 2009 the banking sector increased lending by about 13.2 percent, compared to the growth by about 35.7 percent in 2008. It is assessed that ALL loans grew about 23 percent, while foreign currency loans grew about 9 percent. However, in real terms, the real growth of foreign currency lending was negative.

c) The devaluation of the national currency exchange rate during 2009 is assessed to have been at a reasonable rate and extent, providing the banking sector and other economic agents with the necessary time to take adequate and protective measures. There are greater expectations for a stable exchange rate during 2010. However, the movements in the exchange rate against a background of a flexible regime are normal and should be an expected phenomenon by the economic agents and which they should be prepared for.

d) The sustainability of the financial system’s and particularly the banking sector’s fundamental technical infrastructure such as the payment systems. In this respect, it is assessed that the payment systems managed by the Bank of Albania have operated properly and have been adequately oversighted by the central bank. In order to ensure a normal operation and oversight of the payment systems, large and small value payments, the Bank of Albania has assigned the necessary human, financial and technological resources and has further improved the regulatory framework that enhances the payment systems’ efficiency and safety. In addition, in the light of the increase in transactions’ volume, the need for the improvement of procedures and technological infrastructure in order to support the normal operation of these systems in the future will be regularly assessed.

The main sources of risk mainly relate to the macroeconomic situation at home and the internal situation of some banking business indicators. More concretely:

1. By and large, the economic developments will exert pressure on the private entrepreneurship and households’ economic situation, at least in the first half of 2010. The improvements in global economy are expected to mitigate the effect of the expected and required reduction of fiscal stimulus on Albania’s economic growth. However, this positive impact is expected to be more pronounced in the second half of 2010 once the Greek economy stabilizes and after the seasonal impact of tourism. The improvement of global economy will improve Albania’s position in relation to the international one and will provide a positive contribution to the size of current account deficit. Nonetheless, this effect is expected to be more pronounced in the medium run. The financial situation of the real sector of economy, private entrepreneurship and households is generally expected to remain unchanged and its recovery is expected to take place in the second half of the year. This implies that the banking sector’s lending activity will continue to face a challenging environment and the improvements in the loan quality require more time.
2. The banking sector should aim at a gradual recovery of lending through the monitoring of loan quality. The recovery of lending is a desirable development; however it should be carried out on the basis of a prudential analysis, monitoring carefully the loan quality performance. It is assessed that the deterioration of loan quality will mark its peak in the first half of 2010 to later stabilize in the second half of the year. Its gradual but stable improvement is expected to take place in 2011. However, these general estimations require the prudential monitoring of the situation at individual banks, which may display a different performance from the average of the sector. Taking this into account and in more practical terms, it is necessary that banks fully reflect the size of non-performing loans for the existing loans and create appropriate reserves for covering the risk of loan losses. As far as non-performing loans are concerned, banks must identify customers with temporary and surmountable problems, and should set up policies that provide support to these customers in exchange to additional elements that hedge the bank against such credit risk in the future. As regards the customers assessed as having low creditworthiness, banks should without hesitation follow the procedures for the execution of the collateral and other forms of collateral, in order to recover as large as possible amount of credit. The entire decision-making in this process should be clear and documented, and should be based on the analysis of specialized bank structures. With respect to new loans, taking into account the experience of banks faced with loan portfolio problems, there should be a better sectoral distribution and a more reasonable balance between public and private investment projects, between customers representing business or household undertaking, between the forms of lending in ALL or in foreign currency, etc.., orienting lending in order to reduce the exposure to more problematic forms and the concentration of lending in general. Assessing first and foremost the borrowers’ creditworthiness and lending safety, the Bank of Albania considers that there is sufficient room for commercial banks -depending on their size and opportunities- to support the SMEs with more lending and provide greater funding opportunities in ALL. The performance of loan portfolio quality will continue to exert pressure on banks' financial result. In this context, the prudential monitoring of banking activity capitalization rates is of great importance, despite its current sufficient levels.
3. The banking sector remains sensitive to highly volatile exchange rate movements, in particular considering their impact on the loan portfolio quality which is dominated by the foreign currency lending. The best solution would be provided by implementing more balanced lending policies that aim at increasing the share of ALL lending. With respect to the foreign currency position, the banking sector will as previously maintain a net open position in low values, curbing the extent of possible losses substantially.

In a broader context, the experience of other countries as regards the 2008 and 2009 events should encourage the Albanian public authorities to improve the legal and procedural framework of the actions for managing the situations that may jeopardize the financial system’s stability, based on the changes being outlined by the standard-setting international bodies. This process should be harmonized among the public authorities observing the share of individual financial system segments.

The Bank of Albania concludes that the financial system and the banking sector’s situation has improved relative to the year-end 2008 as regards the business management in the short term. In a longer term, the banking sector should pay great attention to handling the loan portfolio quality-related concerns. In spite of these developments, stress-test analysis and different scenarios of the development of some important macroeconomic and financial indicators show a stable banking sector.

[1] The financial system is composed of banks and all other non-bank financial institutions, where insurance companies are part of.

[2] Considering the lek’s exchange rate against the major currencies unchanged throughout 2009.