a. Financial Relations with the Government and Interbank Claims

In order to strengthen the balance sheets of the new commercial banks, the government assumed responsibility for most old loans to the state enterprises, farms and cooperatives outstanding as of mid-1992--about lek 10 billion--most of which was either already nonperforming or considered unlikely to be repaid (Table 4). ^1/ In October 1992, lek 1.9 billion of government bonds were issued to replace loans to the former agricultural cooperatives; the bonds were issued to the Bank of Albania since it had funded these loans, even though they were administered by the BAD. Government bond issues to replace the remaining lek 2.8 billion of BAD claims on former state farms and lek 4.9 billion of NCB claims on state enterprises were deferred--in an attempt to limit the injection of liquidity and minimize the moral hazard associated with recapitalization, prior to reorganization and improvements in governance.

These old claims also gave rise, however, to a complex web of interbank liabilities. because the NCB had funded BAD lending to state farms, while the SB in turn had partly funded NCB lending. These claims hampered the development of commercial relations among the banks, as the BAD and NCB refused to service their liabilities to the other state-owned banks until the government had issued recapitalization bonds and began to service the old debts. The SB responded by withdrawing its remaining interbank deposits from the NCB and placing them with the BOA in early 1993, precipitating severe liquidity problems at the NCB. Ultimately, the Ministry of Finance made an interest payment to the NCB at the end of 1993 to avert a loss when the balance sheet was closed out, and for the same reason the BOA began to remunerate the SB’s excess reserves. ^2/

During 1994, the Ministry of Finance and the BOA worked with the stateowned banks to net out the banks’ cross claims preparatory to the issuing of recapitalization bonds, which is now expected to take place around mid-1995. ^1/ The claim on the government stemming from the lek 2.8 billion loaned to state farms was assigned directly to the SB, as the original provider of funding. Since December 1994, the BOA has been working with the NCB and the SB to resolve the treatment of the bonds corresponding to the remaining lek 4.3 billion of loans to state enterprises. ^2/ Tentative agreement has been reached that lek 2.5 billion of this total will be transferred to the SB, in exchange for the sale of some foreign exchange and the cancellation of almost lek 2 billion of new NCB interbank borrowing from the SB. The remainder would be used to repay a lek 1.7 billion loan extended by the BOA to capitalize the former NBA when it was created in mid-1992.

b. NCB License

The largest bank in Albania, NCB, does not have a banking license. The BOA turned down the merged NCB’s request for a banking license in late 1993 because the lek 1.7 billion BOA loan to the former NBA had never been repaid. After the loan is repaid, the NCB will be left with a capital base of lek 1.3 billion, created from the retention of reported profits of lek 600 million in 1993 and lek 740 million in 1994. Originally it was to have built up capital of lek 2.7 billion by the end of 1996. The BOA plans to issue a temporary banking license to the NCB shortly, and then work with the Government to establish a more adequate capital base. The amount of capital required will depend on the true size of the NCB’s balance sheet, which remains clouded by many pre-1992 assets and liabilities inherited from the old SBA for which the government should assume responsibility (e.g. arrears on inoperative bilateral payments agreements). NCB management hopes to clarify these relationships and produce a more transparent balance sheet by the end of 1995.

c. Non-performing Loans

One of the biggest problems facing the state-owned banks now is the rapid growth of new, non-performing loans, whose share in total new credit outstanding (i.e. post-June 1992 lending) has increased steadily from 10 percent at mid-1993, to 27 percent at end-1994 (Table 5). ^1/ The worst category is short-term loans, where the share of non-performing loans reached 39 percent of new outstanding loans by end-1994. Reflecting the transition to a market economy, credit to the emerging private sector increased manyfold to account for 30 percent of new credit outstanding by end-1992 and almost 75 percent at end-1994. ^2/ Unfortunately a large and growing share of this new lending has not been repaid on time, and non-performing loans to the private sector accounted for 90 percent of total non-performing loans by end-1994. The proportion of non-performing loans considered “lost” rose from 29 percent at the beginning of 1994 to 39 percent by end-year (Table 6).

The second tier banks were supposed to make commercial loans on the basis of credit analysis following their creation in mid-1992. But in practice--as in other formerly centrally planned economies--the institutional, legal and cultural changes necessary to support such commercial lending have followed much more slowly. A number of common problems have contributed to the unsatisfactory collection performance by the state-owned banks:

º Poor lending practices and follow-up. The volume of lending expanded quickly following the creation of the second-tier banks (Table 7), carried out by loan officers with no training in credit analysis and no access to financial statements (which were unknown under the old regime). Loan officers had little incentive to vigorously pursue collection, since salaries were unrelated to performance, and little further contact with borrowers once loans were disbursed. These problems have been exacerbated by the poor communications and lack of oversight between headquarters and branches, and by a lack of effective direction by the Government during 1993-94.

º Problems with collateral. Legal provisions exist for accepting and enforcing collateral. However, a number of problems have emerged including loans made without collateral, overvaluation of collateral, and difficulties getting legal backing for the enforcement of claims from judges who lack exposure to market mechanisms and private property rights. Moreover, while houses have been accepted as collateral, it is now considered socially and politically impossible for the banks to attempt to enforce those claims. Banks have also found it difficult to resell other types of collateral due to social pressures which discourage potential buyers.

º Inappropriate extension of short-term credits in the absence of clear credit guidelines. The sharply upward-sloping yield curve has made short-term credits more attractive to borrowers than long-term loans, and such credits have been extended even where long-term loans would have been more appropriate (e.g. for tractors and bread production lines).

º Persistent expectations of loan forgiveness based on old socialist practices is a problem for all the state-owned banks. The problem is particularly acute for the RCB in its lending to agriculture.

d. Reform of the State-owned Commercial Banks

In the face of mounting loan delinquencies, the BOA further tightened the ceilings on new lending by the state-owned banks during the second half of 1994. The banks were instructed to focus on improving collections, and future lending was made contingent on improved performance. The continued deterioration in loan portfolios by end-1994, in spite of these measures, underscored the urgent need for improved management, accounting, and legal frameworks for the commercial banks, as well as for further strengthening of bank supervision. ^1/ Continued poor results also highlighted the need for improved corporate governance by the Government as the owner of the banks. This led, in December 1994, to intensified collaboration between the BOA and the Government to reform the state-owned commercial banks.

In January 1995, the Council of Ministers approved a decree intended to strengthen the governance of the state-owned commercial banks and vesting the exercise of the state’s ownership rights in the Ministry of Finance. Under the provisions of the decree, the Ministry has established a unit to work with the state banks to set future objectives in business plans and oversee their implementation; clarify the banks’ financial relations with the Government, including the consolidation of government accounts and licensing of the NCB; implement the new chart of accounts; review bank organization and reduce excess staffing; and assess whether the state banks’ statutes provide for an appropriate degree of accountability. ^2/

The government also appointed new management at both the NCB and SB. The new management teams are aware of the need to improve lending procedures, and have agreed on basic strategies with the BOA and Ministry of Finance. The RCB has recently had an external audit to identify key problems, and is working with outside consultants to map out a future strategy. Planned measures to improve collections of existing loans by the state banks include:

º Targeted collection efforts. The banks are classifying their non-performing loans into three categories: loans which were diverted for other purposes; loans which were used for the stated purpose, but the venture failed; and loans which were used successfully for the original purpose. The banks are to focus collection efforts on the last category, where non-repayment is clearly by choice, and restructure or write off most others.

º Public education. The banks realize that they have to persuade clients that they are serious about enforcing loan contracts. The SB plans to do this by publicizing on television its efforts to seize premises and auction property for non-repayment. The NCB has found it difficult to resell business premises which have been foreclosed for non-repayment; it therefore proposes to bulldoze a few visible premises to signal its determination to enforce claims.

º More vigorous legal enforcement. The Ministry of Finance and BOA have also agreed with the Ministry of Justice to enforce claims more vigorously through the court system. However, there are practical limits to the effectiveness of this approach including an excessive case load, lack of knowledge about appropriate procedures, and the absence of a modern bankruptcy law and liquidation procedures. ^1/ To ensure the availability of staff to assist with better enforcement, the SB is paying the salaries of 15 additional employees at the Ministry of Justice.

º Reschedule delinquent loans. The banks propose to begin rescheduling some loans--for example, short term loans for long term projects--where the clients are unable to pay under present terms but are willing to service their obligation. Retroactive adjustment of high overdue accrued interest--which can be at an annual rate of 50-60 percent ^2/ compared to current 12-month lending rates around 20 percent--is also under consideration.

New credit policies and procedures to improve future lending have also been proposed based on extensive discussions between the authorities and the commercial banks:

º Closer lender/client relationships. The banks intend to emulate the one example of effective credit administration. For the past two years a small unit at the NCB has successfully administered onlending of concessional credits from the Kreditanstalt für Wiederaufbau (KfW) in support of agricultural mechanization. The key to their success has been continuous contact with clients, including close monitoring of projects and showing up promptly to collect payments as soon as the projects generate earnings. In addition, for future state bank lending, advances are to be limited with disbursements tied to documented purchases, and there will be a move away from the use of bullet repayments ^1/ toward monthly installment payments.

º Assign more personal responsibility to credit officers. Besides requiring credit officers to maintain closer contacts with clients, performance-based salaries are to be introduced--at least at the SB--to provide the appropriate incentives for improving collections.

º Greater use of security. More financial information will be demanded from potential borrowers. Credit officers are to insist on collateral, to accept only collateral which can be resold (e.g. land rather than houses), and to lend no more than 60-70 percent of its market value.

º General improvements to operations. Measures planned to improve the general operations of the banks should also bolster efforts to improve credit operations. These include technical assistance to improve the professionalism of the staff; computerization of the branches and headquarters and improved communications between them; and improving and extending the legislative framework for the banking system.

All of these steps will undoubtedly help to improve the performance of the state banks over time if implemented quickly and firmly. However, the experience of other Central and East European countries suggests that the necessary changes will not happen overnight. Many of these countries embarked on the transformation of their banking systems much earlier, yet still confront the same basic problems. Technical assistance, while useful, is not sufficient to change bank operations rapidly, as demonstrated by the experience of the RCB. Intensive technical assistance has been provided to the RCB by the World Bank since its creation in late 1993 in credit policy, accounting and computerization. Yet the RCB’s credit performance now is no better than any of the other state banks. Based on the way banks operated under socialism, it appears that so long as these banks remain state-owned it will be difficult to persuade the populace that they are serious about requiring repayment. And it is not clear that under state ownership the banks will have the right incentives to become strong, effective lending institutions.

a. Direct Instruments

Monetary policy has relied mainly on direct instruments of monetary control, given the rudimentary state of the banking system and the lack of a well-functioning formal credit market. The quantity of credit has been controlled since mid-1992 through bank-by-bank ceilings on net credit to the nongovernment sector. The ceilings are tradable, to provide some flexibility and encourage banks to begin interbank transactions.

The monitoring of these ceilings initially was complicated by long delays in reporting from the commercial banks, and the ceilings were set on a quarterly basis. The problems of reporting delays and inconsistencies have been reduced, and since late 1993 the BOA has sought to adjust the ceilings monthly in order to react more quickly to changing credit developments and needs. As noted above, the ceilings were lowered during the course of 1994 in light of the rapid increase in non-performing loans, and future increases in state bank lending were made contingent upon improved loan collection performance.

Interest rates are determined mainly by official guidelines (described below), which are set to keep deposit interest rates positive in real terms.

b. Indirect Instruments

The groundwork is being laid for a gradual transition to indirect monetary control. Important instruments of indirect control have already been introduced, including a refinancing window, reserve and liquidity requirements, and--most recently--a treasury bill market. The BOA has been able to influence the liquidity of the commercial banks most effectively through access to its refinancing window, remuneration of excess reserves, and purchases of foreign exchange from (or sales to) the commercial banks. With the development of the T-bill market, BOA intervention in the primary market is expected to become the main indirect monetary instrument. During 1994, the BOA made good progress in monitoring base money developments and implementing the techniques of base money forecasting, with the assistance of MAE. The expansion of the T-bill market will provide the BOA with the first opportunity to pursue an active base money program.

Banks are required to place 10 percent of all lek and foreign exchange deposits at the BOA as required reserves, for which they are not remunerated. Compliance with reserve requirements has improved steadily since they were introduced in mid-1992. By end-1993, all banks except the NCB were generally meeting their reserve requirements. The NCB had not been forced to meet its reserve requirement in foreign exchange since it had a large foreign exchange claim on the BOA for assets which were assigned to the former NBA at its creation, but never transferred. This outstanding claim was settled in March 1994, at which time the BOA transferred part of the foreign exchange directly to meet the NCB’s reserve requirement, and purchased the remainder.

In mid-1994, the BOA tightened the enforcement of reserve requirements in conjunction with the establishment of new BOA rediscount facilities based on MAE technical recommendations. If a commercial bank has a shortfall on required reserves, ^1/ funds are now automatically transferred from any excess reserves or--in the absence of sufficient funds--funds are advanced at a penalty refinancing rate. The penalty refinancing rate for unmet lek required reserves is the basic refinancing rate (currently 25 percent) plus 15 percentage points. The penalty rate on unmet foreign exchange required reserves is the 6-month U.S. dollar deposit rate plus 5 percent. ^2/

There are also two regulations in place intended to prevent the creation of large uncovered foreign exchange positions. A liquidity requirement is imposed on banks’ foreign exchange deposits for prudential reasons. The cover requirement was originally set at 100 percent, but was reduced to 90 percent in mid-1993 to encourage banks to meet the growing demand for trade financing and begin actively managing their foreign exchange positions. The 10 percent required reserves held at the BOA count against the total; banks largely meet the remainder of the cover requirement by redepositing foreign exchange with banks abroad in interest-bearing time deposits.

State banks are also subject to overall ceilings on net open positions in foreign exchange, but all three state banks have accumulated substantial long positions in foreign exchange in excess of these ceilings during the past two years. ^1/ These appear to stem from a combination of a lack of outlets to resell large volumes of foreign exchange purchased from clients, and speculative holdings in the absence of profitable alternative investments. The BOA has been reluctant to press the banks to unwind their long positions, out of concern that the magnitude of such sales would lead to sharp appreciation of the exchange rate. Judging that large uncovered foreign asset positions pose a risk to the stability of the banking system, however, the BOA plans to purchase most of the excess foreign exchange from the state banks, who in turn are to invest the resulting lek liquidity in T-bills.

Since the Savings Bank still holds the majority of household deposits but has the smallest lending operations, early development of the interbank market was seen as an efficient way to channel household savings into financing for private investment. Development of an interbank market was hampered, however, by poor management at the NCB and by the withdrawal of the SB from the market in 1993, as noted above. The BOA has brokered a cautious resumption of the interbank market since mid-1994, in order to limit refinancing to the banks needing funds and to reduce the excess liquidity of the SB. The NCB has been the main borrower in this market, although the RCB has also borrowed small amounts. The contracts have been drawn up under close BOA supervision, and the maturities have been kept short (one to three months). The proposed clearing of interbank arrears described above--related to lek 4.3 billion in old loans to state enterprises--will largely extinguish outstanding interbank credits. An active and competitive interbank market is unlikely to develop until after the state banks have been restructured and established a better track record, or are replaced by private banks.

Development of a government securities market has been a high priority. In the short run, T-bills provide an interest-bearing instrument to the SB and other quasi-financial institutions (such as the Insurance Company). They will also reduce the future need for direct financing of the government deficit by the BOA and provide an important instrument for future indirect monetary operations. The first auction of T-bills (with a maturity of three months) took place in July 1994, and auctions have generally been held twice monthly since then (Table 9). Six-month T-bills were introduced in September. The auctions are open to all financial institutions ^1/, private companies and individuals--including foreign residents. Only public entities and enterprises are excluded. ^2/ In practice, however the market has been very thin; it is dominated by the Savings Bank (which accounted for at least 50 percent of total sales in most of the auctions), and the maximum number of bidders in any auction was about ten.

The initial development of the T-bill market was promising, but in late 1994 the Ministry of Finance began to reject most bids on the grounds that the implied interest rates were too high. The rejection of bids reflected both concerns about the market power of the SB, and the absence of internal guidelines for determining “reasonable” cut-off rates. By the end of 1994, the Ministry was making net repayments on the outstanding stock of T-bills just as its financing needs were at a peak. For the year as a whole, T-bill sales financed only 7 percent of the domestic financing requirement (5.5 percent excluding BOA holdings).

The rejection of most bids continued in early 1995, and auctions were discontinued entirely during February, a period of seasonal budget surplus. The BOA has since agreed with the Government on a number of important operational and policy changes--based in part on past MAE recommendations--as part of a broader agreement with the Ministry of Finance on procedures for financing the 1995 budget deficit. Use of the Ministry of Finance overdraft account at the BOA will be limited for the first time to no more than 10 percent of the previous year’s fiscal revenues, as required under the 1992 central bank law. This implies a ceiling of lek 4.6 billion during 1995 out of a targeted deficit of lek 14 billion. The remaining lek 9.4 billion are to be raised through net sales of T-bills (including potential BOA purchases). ^3/

Agreement has been reached on measures to expand the T-bill market commensurately. On the supply side, the Ministry of Finance will seek to auction a relatively uniform volume of T-bills throughout the year in spite of the highly seasonal pattern of Government financing needs. 12-month T-bills are being introduced to be more attractive to both potential private bidders and to the SB. To avoid further diluting the already-thin market, bills at shorter maturities will be offered only at selected auctions. The Ministry of Finance has adopted new objective guidelines under which it would generally accept bids for 12-month T-bills implying interest rates of up to 2 percent higher than the minimum deposit rate at the 12-month maturity; similar guidelines will apply to shorter maturities. Since the main source of funds is the excess liquidity of the SB, the margin has been set taking into account the SB’s cost of funds (see below) in order to avoid the creation of a quasi-fiscal loss at the SB. The Ministry of Finance will also begin to securitize its outstanding debt to the BOA with 6-month T-bills, in compliance with the central bank law and to provide the BOA with a portfolio of securities which it can use in open market operations.

On the demand side, the new interest rate guideline is expected to be high enough to attract private participation into the T-bill market. Other measures being developed therefore focus on reducing barriers to private participation. An advertising campaign is planned to expand popular understanding and awareness of the market. Private participation is to be facilitated through the streamlining of escrow requirements, the collection of applications by the BOA branches, and the introduction of a regulatory framework and secondary market to make T-bills negotiable. The possibility of having the SB act as a primary dealer is also being explored.

c. Interest rates

Historically interest rates played no allocative role in Albania, and were kept unchanged until 1990. Depositors received low nominal interest (0.5-3.0 percent per annum) commensurate with zero official inflation, and there was no differentiation among lending rates (1-2 percent) by maturity or purpose until late 1991 (Table 10). Interest rates were revised marginally in November 1991, widening the term structure for deposits and differentiating credit rates by sector of activity. But the increases did not begin to keep up with skyrocketing inflation, leaving real rates on lekdenominated assets and liabilities steeply negative in real terms by end-1991.

When the economic adjustment effort began in mid-1992, moving to positive real interest rates was seen as essential for mobilizing financial resources for investment, including attracting foreign exchange remittances and transfers into the financial system. Deposit and lending rates were therefore raised enough to be positive in real terms by the end of the first program year (Table 11): the 12-month deposit rate was set at 32 percent, and the 12-month lending rate at 39 percent. The main reasons for not raising nominal interest rates more at the beginning were: (i) to influence inflation expectations and underscore that the jump in the price level following large increases in administered prices was temporary; and (ii) to avoid an excessive increase in public sector borrowing costs.

In response to good inflation performance and exchange rate stability, the authorities reduced guideline deposit and lending interest rates by 400-900 basis points across the board in June 1993, at the same time narrowing the large spread between deposit and lending rates. Interest rates were then lowered further in January 1994, again accompanied by a reduction in the deposit/lending rate spread.

During the summer of 1994, the lek appreciated first gradually, then sharply, from 100 leks per U.S. dollar in May to around 84 leks per U.S. dollar in mid-August. While the exchange rate had also tended to appreciate during the summer months in previous years, the speed and extent of the implied real appreciation were of concern to the authorities. In response, the BOA reduced guideline interest rates three times during August and September, for an overall reduction of 550 basis points (12-month deposits), yielding new guideline 12-month deposit and lending rates, respectively, of 16.5 and 20 percent. Deposit and lending rates at six-month and longer maturities have remained higher than the underlying rate of inflation after each of these changes. ^1/ The yield curve remains steep considering the continuous in the inflation rate during the past two years.

To encourage banks to become more active in setting interest rates, a band of plus-or-minus 200 basis points was set around the guideline deposit rates in mid-1993. The lower end of the deposit rate band is enforced as a minimum to protect the goal of mobilizing financial resources through the banking system. ^2/ There is no cap on deposit or lending rates, and actual lending rates have exceeded the guideline lending rates. The highest interest rates have typically been charged on foreign exchange loans, reflecting strong demand for trade financing.

Households have displayed significant interest-rate sensitivity, and since mid-1993 more than 90 percent of household deposits have been kept in 12-month time deposits (Table 12). The long maturity structure of deposits has created a mismatch between the SB’s assets and liabilities, since the low-risk investment instruments available--T-bills, deposits at the BOA, and interbank deposits--have all had short maturities (one to six months). An important consideration underlying the introduction of 12-month T-bills this year is to provide the SB with an asset that matches its present liability structure. Moreover, as described above, the aim of many of the SB’s planned service improvements--along with recent changes in the penalties for early withdrawal of deposits--is to attract deposits into current accounts in an effort to shorten the maturity structure of deposits.