Albania
Financial System Stability Assessment
Author: International Monetary Fund. European Dept.
Publication Date:
19 Mar 2014
eISBN:
9781484338797
Language:
English
Keywords:
ISCR; CR; bank; asset; BOA; loan; liquidity; resolution simulation; banking law; BOA law
Download PDF (1.4 MB)

This paper discusses the Financial System Stability Assessment report on Albania. The IMF report states that the Albanian economy is weak, macroeconomic imbalances are large, and the financial sector faces several risks. Capital-to-asset ratios are sizable, but banks hold large amounts of government bonds that expose banks to sizeable losses in case of a sovereign debt re-pricing and balance sheets have deteriorated as a result of a rapid increase of nonperforming loans (NPLs). The authorities have taken steps to reduce the existing stock of NPLs with technical assistance from the World Bank.

Abstract

This paper discusses the Financial System Stability Assessment report on Albania. The IMF report states that the Albanian economy is weak, macroeconomic imbalances are large, and the financial sector faces several risks. Capital-to-asset ratios are sizable, but banks hold large amounts of government bonds that expose banks to sizeable losses in case of a sovereign debt re-pricing and balance sheets have deteriorated as a result of a rapid increase of nonperforming loans (NPLs). The authorities have taken steps to reduce the existing stock of NPLs with technical assistance from the World Bank.

Background

A. Financial Sector Structure

1. The financial sector in Albania is concentrated and dominated by foreign banks. Banks represent over 90 percent of total financial system assets, equivalent to about 90 percent of GDP in 2012. The largest five banks hold about three-quarters of system assets and deposits (Table 2). Subsidiaries of foreign banks (which include four of the top five banks, including from Austria, Greece, Italy, and Turkey) represent about 90 percent of total banking sector assets (Figure 1).

Table 2.

Albania. Structure of the Banking System

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Source: Bank of Albania
Figure 1.
Figure 1.

Financial Sector Overview

Citation: IMF Staff Country Reports 2014, 079; 10.5089/9781484338797.002.A001

Source: Bank of Albania and IMF staff estimates

2. Bank credit is concentrated in the corporate sector, which owes about three-quarters of the value of all loans. Real estate loans account for about 40 percent of total loans, and overdrafts, equipment purchase, and working capital represented about 25 percent, 17 percent, and 13 percent, respectively, at end-September 2013. The share of credit to Small and Medium-sized Enterprises (SMEs) in total loans was 27 percent in September 2013 (down from 37 percent in 2007).

3. The remainder of the financial system is small (6 percent of financial system assets). As of mid-2013, it included 11 insurance companies, 2 investment funds, 124 Savings and Credit Associations (SCAs) in 2 unions, 2 independent SCAs, 3 pension funds, and 21 other non-bank (that is, non-deposit-taking) financial institutions (NBFIs):

  • Insurance companies. Albania has one of the smallest insurance markets in Europe, with assets of around 1½ percent of total financial system assets. Its development has been hindered by several factors, including lax insurance regulation, low disposable incomes, and a poor record of claims performance

  • Investment funds. The first fund began operations in 2012 when the Albanian subsidiary of Raiffeisen bank established an investment fund. The timing coincided with the decision of Raiffeisen decision to scale back its participation in the public debt market to limit its exposure to the Albanian sovereign. A second fund was added later. The total net-asset value of the two funds was €316.7 million as of October 2013. There are more than 22,000 investors (mostly individuals).

  • SCAs. SCAs hold less than 1 percent of financial system assets. There are two unions (with 124 member SCAs) and two independent SCAs. One-third of the unions’ assets are invested in bank shares and treasury bills. SCAs lend mostly to members, generally in the agricultural sector.

  • Pension funds. The voluntary private pension market (‘third pillar’) holds less than 0.1 percent of financial system assets and aims at supplementing pensions offered under the government’s obligatory scheme.2 There were only three pension funds operating at end-September 2013, with a net asset value of about US$3.4 million and a total membership of 7,784.

  • Nonbank Financial Institutions (NBFIs). These hold 2.6 percent of financial system assets and comprise mainly non-deposit-taking lending institutions and leasing, with a share of 43 percent and 27 percent, respectively. Other institutions undertake money transfers services and factoring.

B. Macroeconomic Performance and Risks

4. Albania weathered the 2008 global financial crisis relatively well, but the economy is weak and macroeconomic imbalances are large. Real GDP growth is estimated at only 0.7 percent in 2013 (Table 3), and is operating well below its potential (the economy fell below potential in 2012 and the output gap is estimated to have increased in 2013). The external current account deficit remains high, mostly reflecting persistent fiscal deficits, Foreign Direct Investment (FDI) related imports and—to some extent—worsening terms of trade. Also, the situation in the euro-zone has weighed on Albania given close export, banking, and migration links. Policy buffers are depleted, with the public debt-to-GDP ratio estimated at 71 percent in 2013 (including government domestic payment arrears and guarantees), with a large share short-term. The economic policies of the new government, for which the authorities are requesting the support of a Fund program, will begin to tackle these vulnerabilities.

Table 3.

Albania. Selected Economic Indicators, 2009–2019

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Sources: Albanian authorities; and IMF staff estimates and projections.

5. In addition, the financial sector operates in an uncertain global macroeconomic and financial environment and faces several risks (Appendix II):

  • Surges in global financial market volatility, associated with the exit from unconventional monetary policies could lead to depreciation pressures and/or increases in domestic interest rates, exposing banks to credit and market risks. While the large current account deficit is mostly financed by foreign direct investment and official loans, funding pressures associated with global market volatility could also complicate the rollover of the outstanding Eurobond.

  • Re-emergence of financial stress in the euro area could increase deleveraging pressures. Subsidiaries of affected banks could be forced to cut back lending. If liquidity pressures emerge, the capacity of the BOA to act as a lender of last resort in foreign currency is limited.

  • A deterioration in domestic market sentiment could trigger significant stress given the strong financial linkages between the sovereign, the banking sector, and the emerging investment fund sector (¶8). If existing macroeconomic imbalances and fiscal pressures are not addressed with determination, the sovereign could lose market access, leading to a sharp depreciation of the lek, threatening the solvency of banks. Alternatively, liquidity pressures in investment funds could lead to a run from government bonds, also undermining the government’s financing needs. Resulting higher interest rates would impart substantial mark-to-market losses on banks given their large holdings of government bonds. Government payment arrears could also increase further, leading to additional increases in NPLs for borrowers with exposure to the government.

  • A protracted period of slower growth in advanced and emerging economies. The economy could remain weak as a result of weak growth in European trading partners (through declines in trade and remittances) or weak implementation of domestic reforms. NPLs could increase further, requiring additional provisioning and adversely affecting bank profitability. If this threatens Albanian banks’ capitalization and foreign parents cannot (or will not) provide additional capital, banks may be forced to deleverage, hurting the economic recovery.

Soundness of the Banking Sector

A. Vulnerabilities

6. Several features of the banking sector increase its vulnerability to shocks (Figure 2 and Table 4):

Figure 2.
Figure 2.

Banking Sector Indicators

Citation: IMF Staff Country Reports 2014, 079; 10.5089/9781484338797.002.A001

Source: IMF staff reports and FSI database.1/ Data refers to December 2012.2/ The Euro is the domestic currency in Montenegro and Slovenia.
Table 4.

Albania. Financial Soundness Indicators, December 2007–September 2013

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Source: Data provided by Bank of Albania.

The decline in ROE in the third quarter of 2013 is due to stepped-up provisioning rates against loan losses and, to a lesser extent, to non-recurrent losses.

Definition of liquid assets and short term liabilities were changed in October 2009.

Noninterest expenses defined as expenses other than those from core banking activity.

Low bank profitability and rapidly rising NPLs. The NPL ratio has increased from 3.4 percent at end-2007 to more than 24 percent in September 2013 (or 9.1 percent net of provisions) (Figure 3). This reflects economic weakness and government arrears (recently estimated at more than 5 percent of GDP),3 but also the consequences of a lending boom prior to the global financial crisis, when deficiencies in supervision allowed underwriting standards to weaken. The credit cycle has now moved into a downturn and repair stage (Figure 4). While these risks are mitigated somewhat by solvency ratios that are above international norms, and domestic provisioning rules are stringent, net NPLs still amount to 55 percent of bank capital.4 In addition, bank profitability has declined sharply and turned negative in September 2013 (-1.7 percent), eroding buffers that had previously supported loan provisioning.

Figure 3.
Figure 3.

Developments in Nonperforming Loans

Citation: IMF Staff Country Reports 2014, 079; 10.5089/9781484338797.002.A001

Source: Albanian authorities and IMF staff calculations.
Figure 4.
Figure 4.

The Credit Cycle

Citation: IMF Staff Country Reports 2014, 079; 10.5089/9781484338797.002.A001

Source: BoA, OECD, WEO database and IMF staff calculations.

  • High financial euroization. Although net open positions in the euro are small, risks include: (i) half of loans in foreign currency are to unhedged borrowers; (ii) there are large maturity mismatches; and (iii) credit risk for euro loans may be underpriced, as indirect exchange rate risk may be difficult to measure. In addition, a sudden stop in FDI would directly affect systemic liquidity in Euros and the BOA has a limited capacity to act as a lender of last resort in foreign currency.

  • Strong systemic links between investment funds, banks, and the sovereign. One-third of bank assets consist of government securities, and these holdings represent two-thirds of total government debt.5 This financial interdependence represents systemic risks for banks, which are vulnerable to changes in the value of longer-term debt securities, and for the government, which depends on regular rollover of debt by banks. In addition, investment funds, which hold mostly illiquid government bonds, present a systemic liquidity risk that affects banks (¶8).

  • A significant foreign bank presence. Financial difficulties in parent countries can affect Albanian institutions through direct contagion, defunding pressures, or higher NPLs (if domestic borrowers have special links with the parent country). Although the conversion of bank branches to subsidiaries was a timely step that served to limit contagion from foreign parent banks to the Albanian banking sector, deleveraging pressures may nevertheless continue (Figure 5).6

Figure 5.
Figure 5.

Deleveraging Pressures in Foreign-Owned Banks

Citation: IMF Staff Country Reports 2014, 079; 10.5089/9781484338797.002.A001

Source: Albanian authorities and IMF staff calculations.

B. Systemic Liquidity and Market Operations

7. Monetary policy is governed by an inflation-targeting framework. The BOA uses a mid-corridor approach to implement monetary policy, and holds weekly repo operations for which treasury bills and bonds with remaining maturity of one year or less are eligible. The exchange system was significantly liberalized in 2009. The BOA has a clearly articulated intervention policy and has not transacted to affect the exchange rate since 2009. The BOA requires the Government to meet its own foreign currency requirements and coordinates closely to prevent market instability. Banks are generally liquid and must hold liquid assets (which exclude some Government securities), covering 15 percent of short-term liabilities in each currency with an aggregate requirement of 20 percent (Figure 6).7

Figure 6.
Figure 6.

Compliance with Liquidity Regulations by Banks, end-August 2013

Citation: IMF Staff Country Reports 2014, 079; 10.5089/9781484338797.002.A001

Source: Bank of Albania

8. Potential systemic liquidity risks arise from illiquid markets, high levels of euroization, the operations of investment funds and public debt management. Specific risks are:

  • Investment funds. These funds have helped diversify the ownership of government securities, thus lessening the risk associated with the bank-sovereign links. However, systemic risk in the financial system may have increased partly because these funds are inadequately supervised and regulated. The funds invest mostly in longer-dated securities and their clients appear to consider the funds as substitutes for bank accounts. Accordingly, and given the lack of a secondary market, the funds face high liquidity risk. Moreover, their close links with banks means that redemption pressures could spill over into deposit runs on banks. These risks are exacerbated by a lack of clarity on the funds’ liquidity policy and the methodology for establishing unit values.8

  • Illiquid lek money markets. Banks face liquidity management constraints because of shallow and illiquid lek markets. Activity is concentrated in the interbank overnight and 7-day segments for unsecured funds. The volume of transactions on a collateralized basis is small largely because of: (i) the lack of a standard framework for conducting repo transactions (encompassing the use of Master Repurchase Agreements (MRA)); and; (ii) risks in the payments and securities settlement process (there is no simultaneous delivery of securities and payment).

  • Euroization. Banks manage their short-term foreign currency liquidity primarily through their parents and correspondent banks as the BOA does not offer foreign currency standing facilities. The BOA has announced an Emergency Liquidity Assistance (ELA) facility which is (conditionally) available on similar terms in lek and foreign currency (¶35). However, the BOA has limited ability to provide foreign currency.

  • Public debt management challenges and imperfect markets for government securities. Volatile treasury balances and antiquated management systems pose significant challenges to public debt management. Price signals in the primary market are undermined by the significant participation of the BOA and retail investors on a non-competitive basis whose bids are filled first—and often leaving few competitive bids upon which the price is set. There is almost no activity in the secondary market primarily because of a narrow investor base and an abundance of liquidity, thus undermining incentives for active management. Consequently, participants cannot use government securities to manage their liquidity positions. In addition, the relatively high public debt management capacity is now being threatened by widespread reduction of staff in the public sector.

9. Several measures can be adopted to mitigate these risks. These include:

  • Strengthening the regulatory framework for investment funds. The regulatory framework for investment funds should be amended to: (i) require that the calculation of the unit value represent the proportionate share of the aggregate market value of the underlying assets of the fund;9 (ii) introduce capital adequacy requirements aligned with relevant E.U. regulations; (iii) introduce liquidity requirements consistent with recent E.U. regulatory developments and the current level of development of the Albanian market; and (iv) ensure that investment funds have adequate liquidity contingency arrangements in place with banks.10 In addition, investment funds should be required to prominently disclose to their clients that investment fund units are not insured by the ADIA.

  • Enhancing the operational framework for monetary policy. Expanding collateral eligibility to include all tradable Albanian government treasury securities (using an appropriate schedule of haircuts based on the maturity of these securities and consistent with the BOA’s risk tolerance) would provide the BOA with greater flexibility to influence liquidity conditions. It could also serve to discourage the use of the euro if it expands lek liquidity. In addition, the liquidity requirement should be used primarily to manage prudential risks (rather than for macroeconomic management).

  • Developing the collateralized money market. The operational framework for repo transactions could be strengthened further by market-wide adoption of a standard MRA. The BOA should limit its own liquidity-injecting operations to deal only with banks that have executed the MRA with the BOA, while encouraging all banks also to execute the document bilaterally. The expected implementation by mid-2014 of a central securities depository interfaced with the real-time payments system will help eliminate settlement risks on securities transactions. Furthermore, the BOA is considering a market structure—the Interbank Collateralized Market Platform— that mitigates concerns about counterparty risk by pooling collateral so that lenders are not exposed to a single borrower. This initiative is encouraged, but the BOA should ensure that it does not bear financial risks arising from transactions between private counterparties.

  • Internalizing the higher liquidity cost of using foreign currency. In order for the BOA to serve as a lender of last resort in foreign currency, it has to hold foreign reserves, which is costly. To internalize these costs to banks, the foreign currency liquidity requirement should be set higher than that for lek. To avoid increasing the aggregate liquidity requirement, this could be achieved by a reduction in the lek requirement and an increase in the foreign currency requirement.11

  • Enhancing the markets for government securities. The transmission of price signals in the primary market would be improved by: (i) separating the BOA allocation from the portion to be raised from the market; and (ii) reducing significantly the amount allocated on a non-competitive basis to retail investors. Moreover, retail investors should gradually be restricted from placing direct bids and, ultimately, all retail participation should be facilitated through intermediaries selected through a competitive process, with such intermediaries effectively supervised (which requires a strengthening of AFSA, ¶32-33). Secondary market development would be supported by (i) rationalizing the bond issuance program (focusing on key maturities on the yield curve) and (ii) expanding the range of assets eligible for satisfying the BOA’s liquidity requirement and for collateral in BOA operations to include all tradable government securities (as the authorities are considering in the context of adopting the Basle III liquidity coverage ratio). A primary dealer arrangement should be considered as market developments warrant over the medium term.

  • Strengthening public debt management. To that end, it is important to enhance cash forecasting and cash management (including by establishing higher minimum cash buffers in the Treasury account), upgrade management systems and ensure that staff reductions in the public sector do not undermine the capacity for debt management within the General Directorate of Treasury.

C. Resilience of Banks: Stress Tests

10. Given these vulnerabilities, the mission conducted stress tests to assess the resilience of the banking system to specific solvency, liquidity, and contagion risks (Appendix III).

Solvency Risk

11. Even in the benign baseline projections, some banks suffer a deterioration in their capital positions. This is a result of previously nonperforming loans deteriorating further in quality (requiring further provisions). Especially in banks that have seen recent declines in profitability, these provisions cannot be fully paid out of profits, leading to a deterioration of capital.

12. Stress tests suggest that banks are vulnerable to extreme but plausible adverse macroeconomic scenarios. Two adverse scenarios are characterized by a cumulative decline of GDP of two standard deviations (12.3 percentage points) relative to the baseline over two years: (i) a U-shaped recession characterized by negative growth of 3.9 percent and 3.2 percent in 2014 and 2015, respectively; and (ii) a V-shaped severe recession, with a decline in GDP of 6.9 percentage points in 2014 followed by no growth in 2015.12 The results indicate that (Figure 7):

  • While several banks would become undercapitalized, the recapitalization need is not large. In the U-shaped scenario, 6 banks with 21 percent of banking system’s assets become undercapitalized, and in the more severe V-shaped scenario, 10 banks (with 78 percent of banking assets) face capital shortfalls. The overall estimated shortfall (relative to a 12 percent capital adequacy threshold for all banks) is small in both cases: 0.5 percentage points and 1.5 percentage points of 2013 GDP for the U-shaped and V-shaped recessions, respectively.13

  • Credit risk is a main vulnerability. For loans in foreign currency, a depreciation and a decline in growth lead to a sharp increase in NPLs; for loans in domestic currency the main effect comes from lower growth (and to a lesser extent from higher domestic interest rates) (Figure 8).14 Bank loan loss provisions rise with higher NPL ratios, with negative effects on profitability.15

  • Banks are highly exposed to domestic sovereign risk. Bank losses from sovereign debt re-pricing (market risk) would be sizable and pose systemic risks. In the adverse macroeconomic scenarios, the duration-adjusted haircuts applied to all the government securities held in the trading and banking books—excluding Treasury bills and floating rate instruments—cause losses equivalent to 8 percent of the initial valuations, with significant impact on bank capitalization.16

The stress tests are based on extreme but plausible adverse scenarios

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Source: IMF Staff estimatesNote: scenarios are based on estimates andprojections from the third quarter of 2013.
Figure 7.
Figure 7.

Results of the Stress Tests: Distribution of Banking Assets by Bank Capitalization

(in percent of total banking system assets)

Citation: IMF Staff Country Reports 2014, 079; 10.5089/9781484338797.002.A001

1/ Note: SOV = increase in sovereign bond yields (20 percent haircut); IR-NII = increase in interest rates (500 bps), effect on net interest income; ND = nominal depreciation (30 percent), effect on NPL ratios; 2 EXP = failure of largest 2 exposures; 5 EXP = failure of largest 5 exposures; 10 EXP = failure of largest 10 exposures.Source: IMF staff estimates
Figure 8.
Figure 8.

Nonperforming Loans Under Extreme Adverse Scenarios

Citation: IMF Staff Country Reports 2014, 079; 10.5089/9781484338797.002.A001

Source: IMF staff estimates

13. Sensitivity tests largely confirm these results. The tests suggest that 6 of the 16 banks, representing 25 percent of the system’s assets, would be undercapitalized after a 30 percent depreciation of the lek. The sensitivity tests also show that credit risk is exacerbated by the high concentration of loan portfolios, with strong effects from default of banks’ largest borrowers.

Liquidity Risk

14. Liquidity stress tests reveal that banks could handle large deposit withdrawals.17 The results of the tests in domestic currency revealed that, with the exception of a small institution, all banks could confront persistent and sizable withdrawals of funding without ELA from the BOA.18 The tests in foreign currency also revealed that in case of stress, only one small bank would need BOA support at a one week horizon; two banks (accounting for less than 5 percent of the system’s assets) would need BOA support at a two-month horizon.

Contagion Risk

15. Direct contagion risk through bilateral domestic interbank exposures is limited. As domestic banks are highly liquid, their reliance on interbank transactions is small. Indeed, for every bank in the system, the sum of all its domestic interbank exposures is smaller than its regulatory capital. Hence, no single failure of domestic banks would trigger knock-on failures in the rest of the system. As of June 2013, however, a failure of domestic banks could result in undercapitalization of other domestic banks because 5 of the 16 banks had total domestic interbank exposures that were larger than their excess of capital over the required minimum (assumed at 12 percent for all banks). Bilateral exposures to foreign banks tend to be larger and highly concentrated and failure of the largest foreign counterpart would cause undercapitalization in 9 banks.

Policy recommendations

16. Specific vulnerabilities in banks should be addressed. The BOA is encouraged to engage each bank with their individual stress test results and require them to adopt mitigation measures, improve risk management in the areas that show specific vulnerability, monitor progress and adopt enforcement measures if necessary. This is especially important for banks that are most affected in the stress test scenarios, which tend to be those that suffer from weak underlying profitability and have high initial NPL ratios, a large share of loans in foreign currency, and a large share of longer-dated fixed-coupon government bonds. For banks that become undercapitalized in the baseline scenario, the authorities could require capital injections to cover the shortfall (estimated at about 0.1 percent of GDP). For those banks that are initially well capitalized but become undercapitalized in the adverse scenarios, the authorities could consider requiring a strengthening of their capital buffers to cover the shortfalls (estimated at about 1.5 percent of GDP, ¶12).

17. Risk to banks of lending in foreign currency should be mitigated through appropriate pricing mechanisms. Risk to borrowers without foreign-currency income can be internalized by requiring more conservative loan-to-value and debt-to-income ratios. In addition, banks could also be required to hold additional capital for exposures arising from foreign currency lending to such unhedged borrowers.19 Robust consumer education and protection to make borrowers fully aware of the associated risks is also important.

18. The rising trend of NPLs has to be tackled decisively. Addressing remaining weakness in bank supervision will help ensure the good quality of new loans (¶30). Also, while the authorities are taking steps to deal with the stock of bad loans, partly with technical assistance by the World Bank, additional measures are needed to encourage the cleanup of banks’ balance sheets, including by clarifying tax rules that are preventing banks from writing off loans, adopting measures to facilitate NPL sales, and accelerating insolvency reforms (see Box 1).

19. Developments in real estate deserve close monitoring. While there has been some downward movement in house prices (for example in the real-estate index for Tirana), the increase experienced during the last decade shows similarities with well-known boom-bust cases (see Figure 4).20 Careful monitoring of developments in real estate will therefore be key, especially given that banks’ exposures to the sector are significant (residential mortgages and construction loans account for 30 percent of portfolios). As collateral execution begins to pick up, a large amount of properties could come into the market, putting pressure on prices.

20. The BOA should encourage further refinement of banks’ stress testing methodologies. The results from the tests conducted by banks show significant differences with the tests conducted by the BOA and IMF staff. Although the bottom-up stress testing methodology developed by the BOA is robust, it presumes that banks use sound models to project credit and profit losses under adverse scenarios. However, banks appear to use mainly expert judgment to undertake stress tests and often appear to fail to incorporate the shocks embedded in the macroeconomic scenarios.

Financial Oversight

21. BOA plays a central role in the oversight of the financial system. By law the BOA responsibilities include formulating and implementing monetary and exchange rate policy, managing international reserves, promoting a smooth operation of the payments system, and supervising the banking system, SCAs, and NBFIs. The Albanian Financial Regulatory Authority (AFSA) supervises insurance companies, pension and investments funds. A high-level Financial Stability Advisory Group (FSAG) became operational in 2012 and meets on a quarterly basis to monitor developments and risks to the financial system.

A. Macroprudential Oversight

Institutional setup

22. A macroprudential mandate for the BOA is found in existing legislation. The BOA Law mandates the BOA to secure the stability of the banking sector and report on a semi-annual basis to Parliament on risks to the financial system and propose ways to manage them. In addition, the Banking Law of 2011 mandates the BOA to take action to mitigate systemic risk.

Tackling Nonperforming Loans in Albania

The authorities are drawing from international best practice to support the mitigation of NPLs. Weaknesses in judicial enforcement and land registration, and a small secondary real estate market have made it difficult to execute collateral. Key changes to the Civil Procedure Code that became effective in October 2013 will help shorten and simplify collateral enforcement procedures. In addition, the authorities should:

  • Enhance supervision regarding NPL management by: (i) amending the regulation on credit risk management to provide detailed requirements on minimum supervisory expectations for NPLs management; (ii) expanding governance requirements for credit risk and NPL management (e.g. banks could separate the credit risk underwriting and review functions, adopt early warning systems for credit risks, regularly monitor loan loss provisions, set and monitor collection goals and develop key performance indicators); and (iii) presenting granular prudential standards on NPL management and resolution.

  • Provide forward guidance on the use of sanctioning powers. A clear regulatory framework would help minimize NPL misclassification errors and ensure a clear understanding of the criteria used to determine supervisory action. Establishing the criteria that the BOA uses when granting approvals to hold property provided as collateral could help prevent accumulation of property on banks’ balance sheets.

The authorities are encouraged to adopt additional measures to clean up bank’s balance sheets, including: (i) creating an interagency working group to clarify tax issues (and propose measures, if necessary) that are preventing banks to write-off loans (the BOA estimates that the NPL ratio could decline by 5-6 percentage points if the tax treatment of write-offs is resolved); (ii) issuing guidelines to facilitate NPL sales; and (iii) strengthening insolvency reforms, including ensuring that private bailiffs are paid on a negotiated or “success fee” basis. In addition, some articles of the Civil Code should be modified to further: (i) regulate courts’ discretion to postpone payments owed to the creditor; and (ii) clarify priority ranking for mortgage claims.

In the medium term, the BOA can foster a robust and transparent accounting and auditing environment. The BOA could: (i) encourage stronger financial reporting practices by larger corporate borrowers; (ii) introduce more punitive risk weights for unaudited accounts submitted during the underwriting process; and (iii) adopt a prudential regulation requiring banks to consider only borrowers’ official tax statements when underwriting loans.

23. The macroprudential role of the BOA is complemented by the inter-agency FSAG. The FSAG was established in 2006 as a consultative entity to assist in the coordination of policies and exchange of information regarding financial development, crisis prevention, and crisis management. Its meetings are attended by the Minister of Finance (chair), the BOA Governor, and the AFSA and ADIA Directors.

24. The role of the FSAG can be enhanced further by focusing its mandate and meeting more frequently. The FSAG should focus on systemically important financial institutions and risks, with its financial development mandate assigned to another body. The FSAG should meet on a quarterly basis, as mandated, and the BOA should assess regularly whether more frequent meetings are necessary given financial developments. It is also recommended that technical staff meet monthly. Meeting agendas and minutes are key to keep track and follow-up on important issues.

Systemic risk monitoring

25. The BOA has made significant progress developing tools to monitor the time and cross-sectional dimensions of systemic risk. The lack of market data is a challenge and the authorities should obtain other data for systemic risk monitoring, including a representative real-estate price, information on the loan-to-value ratios and debt-to-income ratios used by banks and data on bank and non-bank interlinkages.

Macroprudential tools

26. The BOA has used macroprudential tools to safeguard financial stability. In 2007 higher risk weights and stricter loan-to-value and debt-to-income ratios were placed on banks surpassing twin limits on the rate of credit growth and NPL levels. A second set of macroprudential policies was put in place in late 2011 to limit contagion risks and international spillovers: (i) foreign bank branches were converted into subsidiaries; (ii) liquidity regulations were tightened;21 and (iii) the regulation on related-party exposure was enhanced.

27. The authorities should use caution when using prudential measures to attempt to stimulate credit, as the BOA did in 2013. The BOA eased liquidity requirements from 25 to 20 percent, reduced capital requirements for those banks that expand credit growth within a range of 4 percent to 10 percent, and introduced disincentives for banks to hold funds overseas.22 The use of prudential tools to boost credit carries potential risks to financial stability (which should be monitored) and their impact is likely to be limited due to the difficulty of effectively targeting measures (see the IMF’s Global Financial Stability Report of October 2013). In general, prudential measures should not be a substitute for more fundamental (and perhaps difficult) economic and financial reforms.

28. The macroprudential toolkit could be strengthened further. In the time dimension, the toolkit can be expanded to include instruments addressing the procyclicality of credit in preparation for Albania’s next financial cycle (like countercyclical capital buffers).23 In the cross-sectional dimension, special attention should be given to systemically important banks. As a first line of defense, microprudential supervisors should approach these institutions with intensified supervision and with special attention to asset classification and provisioning practices. Authorities could also consider systemic capital surcharges, but should weigh in the risk of potentially intensifying deleveraging pressures of foreign-owned subsidiaries.

B. Microprudential Oversight

Banks

29. The quality of banking supervision has improved significantly since the 2005 FSAP and the regulatory and supervisory framework has moved toward alignment with EU standards. The BOA has incorporated many guidelines from the Basel Accords into its regulatory framework, which has served to strengthen the banking supervisory regime. Progress in implementing the recommendations from the 2005 FSAP includes increased risk weights for unhedged loans denominated in foreign currency to 150 percent and a limit of such loans to 400 percent of capital. The framework for licensing activities, including evaluating the application for a de novo bank, has been strengthened. BOA has established criteria for corporate governance and issued standards for bank management, the internal audit function and several prudential standards.

30. Addressing remaining weaknesses in banking supervision is key to underpin improvements in the health of the banking sector.

  • Enhance consolidated supervision. This is important given the emergence of investment funds. Authorities should: (i) ensure a more systematic information protocol between the BOA and AFSA; (ii) undertake joint on-site examinations of the new funds and their affiliated banks; and (iii) require investment funds to have contingency liquidity arrangements with banks (¶9).

  • Formalize cooperation with relevant foreign supervisors. Cross-border supervision is generally effective, but Memoranda of Understanding (MOUs) are not in place with all relevant home supervisors (including Austria, the home country of the largest bank in Albania). With 93 percent of the banking sector owned by foreign banks, home country supervisors rely principally on the BOA to perform on-site examinations. The lack of MOUs with some foreign bank supervisors appears not to have been an impediment to the BOA to supervise banks effectively.24 Still, the BOA is encouraged to seek ways to facilitate a more formal exchange of supervisory information.

  • Strengthen risk-based supervision. Full implementation of Basel II (using the standard approach) is expected by end-2015. The BOA has developed a road map (with assistance from the IMF) and a new capital adequacy regulation and guidelines for Pillar 1 and Pillar 2 capital requirements (with the assistance of Bank of Italy). The Pillar 2 framework will help enhance the evaluation of risk management practices in banks, but its implementation will be challenging. The regulations on credit risk and problem loan management as well as the Supervision Operations Policy (SOP) will need to be revised to adapt processes to a risk-based approach. The expected implementation of the liquidity component of Basel III is welcomed.

  • Improve the effectiveness of the internal audit functions in banks. This is key, since the expected move towards risk-based supervision will require supervisors to rely more on the work of internal auditors to reduce the scope of examinations so as to focus on areas of highest risks. Among others, audit plans and procedures will need to become more risk-focused and internal auditors will need to be trained in risk-based auditing.

  • Strengthen the legal protection available to supervisors and expand the banking supervision staff. While the legal protection to supervisors has been enhanced since the 2005 FSAP, further improvements regarding indemnification from the costs of litigation are necessary. This would have a positive impact on the willingness and ability to carry out intensive supervision. Existing vacancies should be filled promptly to support the risk based approach with expertise in risk management evaluation, Basel II, and other disciplines.

  • Challenge banks more intensively on the quality of their credit policies and underwriting standards. Beyond taking measures to reduce the existing stock of NPLs (Box 1), supervisors need to evaluate current underwriting standards used by banks more intensively to support the quality of new loans. To help banks in this area, the BOA should foster stronger financial reporting practices by large corporate borrowers. Other measures that could guard against deteriorating performance of future loan vintages are adding risk-based aspects to the regulation on provisioning (paying particular attention to related parties), expanding the definition of related parties, and strengthening the regulation governing the management of loans that are in various stages of non-performance. The mission could not rule out the risk of misclassification of problem loans in banks. To gauge the overall accuracy of asset quality rating in banks, the BOA is also encouraged to undertake an asset quality review.

31. BOA’s enforcement tools have been broadly effective to resolve shortcomings in prudential limits, but their use should be expanded to cover risk management concerns. While the application of corrective measures to address inadequate capital or poor liquidity is appropriate, these may not address fundamental risk management problems in the bank. Correcting underlying safety and soundness problems is equally important and BOA should consider imposing formal enforcement action, including a warning or order, against banks that do not resolve these problems.

The Albanian Financial Services Authority

32. The effectiveness of the AFSA is severely hindered by a weak regulatory framework. The institutional setup of its insurance, pension, and investment fund supervision and regulation is ineffective due to its lack of independence, severely constrained financial resources, absence of representation in the law-making process and the acute shortage of qualified personnel.

  • Insurance. The supervisory powers of AFSA are severely constrained by a rules-based insurance law that prevents AFSA from quickly issuing by-laws to address evolving needs in the sector and from adopting a risk-based approach to prioritizing on-site inspections. The authority of AFSA to regulate the market is further undermined by the ability of insurance companies to suspend AFSA’s rulings by filing an appeal in court.

  • Investment funds. The regulatory framework for investment funds is weak, lacking appropriate liquidity and capital requirements, as well as a clear methodology for determining unit values (¶9).

33. Major institutional reform to turn AFSA into an effective regulator is a priority. AFSA needs the ability to attract and retain sufficient experienced technical staff. To that end, the AFSA Law must be amended, including by abolishing the requirement for Parliament to approve AFSA’s organizational structure and removing the AFSA from the government employee compensation and benefits structure. The legal protection of AFSA’s Board and staff must also be strengthened, as current shortcomings potentially hamper their willingness and ability to carry out effective supervision. Recognizing these challenges, the AFSA has recently put forward key amendments to the AFSA law and a new draft Insurance Law that addresses most shortcomings mentioned above.

Anti-Money Laundering and Combating the Financing of Terrorism

34. Albania has enhanced its framework for Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) and is encouraged to address remaining deficiencies. At the time of Albania’s last assessment in 2011, the AML/CFT framework had significant shortcomings. Since then, the authorities have made steady progress concerning preventive measures (e.g., beneficial ownership and existing clients) and criminalization of terrorist financing. Further remedial action, such as strengthening the analytical function of the Financial Intelligence Unit, is currently underway. In October 2013, the Parliament adopted a law on measures against terrorist financing, which will be reviewed by the Financial Action Task Force International Cooperation Review Group. Further progress is required to strengthen AML/CFT supervision of the insurance and securities sectors and tackle more effectively illicit cross-border transportation of currency. Lacking a recent assessment, the authorities are encouraged to establish an assessment timetable and request an assessment from a competent authority (MONEYVAL) within 18 months of the FSAP mission.

Financial Sector Safety Net and Crisis Preparedness and Management

A. Emergency Liquidity Assistance

35. The institutional framework for the provision of Emergency Liquidity Assistance (ELA) is generally strong, but the capacity to provide assistance in foreign currencies is limited by the BOA’s reserves. Only solvent but temporarily illiquid banks can apply for the loans, which must be fully collateralized. The framework could be strengthened by: (i) increasing supervisory reach and intrusion on banks in receipt of ELA to prevent asset stripping (particularly where foreign currency loans are involved to circumvent up-streaming to parent banks); (ii) considering mechanisms (in conjunction with home country central banks) to provide parent institutions with incentives to supply funding; (iii) establishing a contingency plan to be used in the event the BOA’s foreign currency resources are insufficient to meet ELA demands;25 (iv) establishing internal guidelines for reporting the use of ELA (making sure such reporting does not unduly affect market sentiment);26 and (v) conducting simulations of stressed scenarios to fully test operational procedures.

B. Bank Resolution Framework

36. The bank resolution framework is generally effective. The BOA is the resolution authority and has comprehensive enforcement powers. If enforcement measures were insufficient to restore soundness, the BOA can appoint a Conservator, and, in extremis, revoke a bank’s license.27 A Special Bank Resolution Regime (SRR) is in place, which provides that BOA’s decision to revoke a bank’s license cannot be reversed by any court. This framework, combined with intense advance preparation by BOA and ADIA enables prompt repayment of, or access to, insured depositors’ funds through a Purchase and Assumption (P&A) transaction.28 The BOA requires systemic banks and four medium-sized banks to prepare Recovery and resolution plans (RRP).

37. There is scope for strengthening the framework. In particular, the BOA could: (i) supplement the MOUs that have been signed with home supervisors of European banking groups with cooperative resolution strategies among home and host authorities; (ii) consider the P&A transaction as the preferred resolution tool for non-systemic banks and together with the ADIA conduct periodic bilateral bank resolution simulations; (iii) maintain lists of strong banks that could be potential acquirers and of possible Conservators for possible future assignments on short notice; and (iv) require all banks to prepare comprehensive financial contingency plans based on proportionality (i.e., with complexity of the plan based on the size of the bank).

C. Deposit Insurance

38. Albania’s deposit insurance system is largely based on modern principles. The system provides coverage for deposits of individuals up to 2.5 million lek (approximately US$25,000), which covers 95 percent of depositors, and about 58 percent of all system deposits.29 The mandate of the deposit insurer as a paybox is appropriate for the development of the financial sector. The use of a flat rate deposit insurance premium of 0.5 percent of insured deposits as opposed to risk-based premia is prudent given ADIA’s relatively recent establishment. The fund has assets equal to about 3.7 percent of insured deposits—sufficient to cover net insured deposits of the smallest 8 of the 16 banks insured by the scheme. Once the fund reached 5 percent of insured deposits, it may reduce the premiums it collects.30 However, coverage for small enterprises (currently absent) could usefully be aligned with the E.U. draft Directive on deposit insurance regarding scope of coverage.

39. The ADIA is encouraged to become fully compliant with the Core Principles. To that end, the ADIA needs to enter into information sharing arrangements with relevant regional deposit insurance agencies and enhance cooperation and information sharing with the BOA. The ADIA law has to be amended to help ensure that the agency has greater autonomy in its operations and investments and that its current and former staff have full legal protection. While the ADIA has developed procedures for admitting qualified SCAs to the deposit insurance scheme (in line with the 2005 FSAP recommendations), it is important that the initial capital of 50 million lek be funded, as the government already agreed to provide this funding in the 2012 amendments to ADIA’s law.

D. Crisis Preparedness and Management

40. The crisis preparedness and management framework is generally sound, but there is scope to strengthen it further. The establishment of the FSAG as a coordinating crisis prevention and management group strengthened the framework (¶23). Also, the BOA has generally effective contingency plans (CP) and is authorized to create a bridge bank, a tool preferable to outright nationalization or recapitalization with taxpayer funds. It is important to continue enhancing this framework by:

  • Obtaining, to the extent possible, support letters from mother banks agreeing to provide liquidity and solvency support as necessary, especially with those in jurisdictions with whom the BOA has not signed MOUs of cooperation and information sharing.

  • Enhancing the role of the FSAG further by focusing its mandate and making some operational changes (¶24). All FSAG members should be encouraged to conduct periodic individual and joint crisis simulations and develop/update their own CPs—and these CPs should be rolled up into a national CP coordinated by the FSAG.

  • Establishing, ex ante, a framework to enable extraordinary actions in a crisis. The framework could include measures related to liquidity or solvency support, asset purchases, loans or guarantees to ailing systemic banks, and allowing the government to guarantee uninsured depositors and other creditors.31

  • Creating a resolution fund, paid for by assessments on systemic banks, to help defray future bank resolution expenses.32

  • Amending the Banking Law to limit the use of the bridge bank tool to resolving systemic situations. Moreover, the MOF must be prepared to own and operate bridge banks.

  • Strengthening the communication strategy to ensure public confidence. The authorities are encouraged to agree on draft press releases that clearly communicate the underlying problems of the crisis and how the measures taken address these weaknesses and strengthen the stability of the financial system.

41. Because public resources are used in crisis situations, the MOF is encouraged to take the lead in crisis management. Any solvency assistance from the government should carry strict conditions and caution must be used when exercising such powers. In particular, the preferred solution is that parent banks ensure adequate liquidity and capital; if this support is unavailable the authorities should use appropriate measures to ensure that public funds are not up-streamed to the benefit of the parent and detriment of Albania’s taxpayers.33

Appendix I. Key Recommendations of 2005 FSAP

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Appendix II. Risk Assessment Matrix

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Appendix III. Stress Test Methodology

A. Macroeconomic Scenarios for the Stress Tests

42. The baseline macroeconomic scenario is based on the projections of IMF staff as of early November, 2013. It envisages that growth will remain weak in 2013, followed by a gradual recovery in 2014–15. The weak performance in 2013 is attributed to lackluster credit growth and declines in remittances, foreign direct investment, and export demand. The recovery in 2014 and 2015 is driven by improvements in foreign demand and the trade balance, increased remittances and FDI inflows, and higher credit growth.

43. The extreme but plausible adverse macroeconomic scenarios reflect downside external risks and a domestic credit supply shock. Two adverse scenarios run through the BOA’s macroeconomic model (and BOA judgment) result in a cumulative decline of GDP equivalent to 2 standard deviations (12.3 percentage points, calculated based on data covering 1995–2012) relative to the baseline over two years. The two adverse scenarios are: (i) a U-shaped scenario with negative growth of 3.9 and 3.2 percentage points in 2014 and 2015, respectively; and (ii) a V-shaped scenario with a large decline in GDP of 6.9 percentage points in the first year and no growth in the second year. External shocks are assumed to be more protracted in the U-shaped scenario. The V-shaped scenario is dominated by a large shock to domestic credit growth in 2014 that triggers a deeper decline in GDP.

External and domestic shocks in the U- and V-shaped adverse scenarios

Deviations from baseline, in percent 1/

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Remittances and foreign demand, and the shocks applied to them, are measured in foreign currency units (euros). The declines in real private investment result from shocks to foreign direct investment; a 15 percent pass-through from foreign direct investment to domestic private investment is assumed.

44. More specifically, the adverse scenarios are driven by the following shocks:

  • Remittances. Shocks to remittances are triggered by reduced employment opportunities in the two main host countries of Albanian emigrants (Italy and Greece). These shocks are transmitted to disposable income and consumption (with a long-run coefficient of 0.88). The decline in consumption affects aggregate demand and output, generating second round negative effects.

  • Foreign direct investment and foreign demand. Shocks to foreign direct investment reduce gross capital formation with a 15 percent pass-through. These shocks, in turn, negatively affect aggregate demand and output growth. Also, a deterioration in economic activity in the main trading partners leads to lower demand for Albanian exports.

  • Credit growth. Deleveraging and risk pull back from foreign banks causes a sharp decline in credit growth, with a direct impact on consumption and private investment. It is estimated that a 1 percent slowdown in credit growth leads to declines in consumption and private investment equivalent to 0.06 and 0.14 percent, respectively.

  • Lek depreciation and interest rates. The external and domestic shocks trigger a sharp depreciation of the lek (about 35 percent over 2014-15). Lek depreciation pressures and expectations of U.S. Federal Reserve tapering force Albania to also raise interest rates to prevent inflationary pressures. In the adverse event, interest rates in Albania increase to 14 percent to 15 percent, slowing down credit growth, private investment, and GDP growth.

B. Stress Test Matrix for the Banking Sector

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Appendix IV. Report on the Observance of Standards and Codes: Basel Core Principles—Summary Assessment

A. Overview of the Institutional Setting and Market Structure

45. Financial intermediation in Albania is dominated by banks. Banks represented about 94 percent of total financial system assets, equivalent to 88 percent of GDP in 2012 (up from 76 percent of GDP in 2005). The banking system is concentrated and foreign ownership dominates, with the preponderance of foreign institutions headquartered in EU countries. Out of 16 operating banks, the largest five hold about three-quarters of system assets and deposits. Bank credit is concentrated in the corporate sector (representing 74 percent of loans in 2012) and in few economic sectors, with 45 percent channeled to the trade sector, 22 percent to construction, and 20 percent to industry. Subsidiaries of foreign banks represent about 93 percent of total banking sector assets. Bank credit is funded largely by local deposits (the loan-to-deposit ratio was 58 percent in 2012).

46. A range of laws govern the activities of the banking system. Central to the supervision of the banking system is the Law on Banks (2006, as amended) and the Central Bank Act (1997), supplemented by a series of regulations addressing specific banking activities and risks. Banks are subject to an array of other laws governing their activities, including the Civil Code and legislation addressing accounting and market disclosure, AML/CFT, and competition.

47. The BOA is the sole supervisor of the domestic banking system, saving and loans associations, and certain other NBFIs. The BOA intends to implement Basel II by 2015 and complement the current focus on compliance with a forward-looking risk-based approach to supervision. It cooperates with a number of home supervisors of European banking groups that operate in Albania.

48. There are credit quality concerns in the Albanian banking system. NPLs are high and have exhibited a rising trend over the past several years. NPLs net of provisions as a percentage of regulatory capital was 56 percent in June 2013. The increase in NPLs is partly due to the economic slowdown, but is being exacerbated by unpaid VAT refunds and government payment arrears. Bank efforts to resolve problem loans have been hindered by lengthy loan recovery procedures and adverse treatment of write-offs.

49. The BOA has a relatively high level of compliance with the Basel Core Principles for Effective Banking Supervision (BCP). The preponderance of Principles are rated Largely Compliant, notwithstanding the challenging environment and vulnerabilities to which the banking system has been exposed in the aftermath of the financial crisis. The BOA continues on a course to align its supervisory practices with EU standards.

B. Preconditions for Effective Supervision

50. Macro-economic environment. Albania’s institutional framework supporting the conduct of macro-economic policy is led by the BOA and the MOF. Albania avoided a serious economic slowdown resulting from the financial crisis. However, economic imbalances have become large. Real GDP growth is low and the external current account deficit remains high, largely reflecting persistent fiscal deficits and worsening terms of trade. Albania’s high exposure to the euro zone poses potentially high risks to the economy, as it has large trade, labor market and banking system links with the euro zone. Economic weaknesses and elevated macroeconomic imbalances have resulted in high levels of public debt, in part because of the accumulation of unpaid government bills and arrears and poor tax revenue performance. With public debt estimated at about 71 percent of GDP in 2013, the budget has high financing needs, including because of the short maturity structure of domestic debt.

51. Financial stability framework. The current framework assigns responsibilities in the area of financial stability to several entities (BOA, AFSA, ADIA and MOF), although in practice BOA, being the prudential regulator for the banking system, plays a leading role. To further strengthen the different structures of the financial stability framework, the four regulators with financial stability responsibilities became signatories to a Memorandum of Understanding in 2012 that created a high level financial stability committee, named FSAG.

52. Public Infrastructure. Albania is seeking membership in the EU, and with this goal in mind, reforms to existing legislative codes to bring them in line with EU standards are in process in many areas. Currently, Albania’s legal system governing corporate activities is not well developed. The authorities now largely recognize the need to accelerate the adoption of legal and prudential means to reduce the stock and flow of NPLs, and have begun to seek external inputs to improve its capacities and supporting framework.

53. Crisis management recovery and resolution. The legal framework provides the BOA, the AFSA and the ADIA with a range of tools or responsibilities relative to intervention in the event a crisis situation arises. The banking law specifies going concern resolution powers for capital and liquidity inadequacies, and in cases of declared insolvency.

54. Systemic protection (safety net). Albania’s deposit insurance system provides coverage for deposits of natural persons up to 2.5 million lek (approximately US$25,000), which covers 95 percent of depositors, but only about 58 percent of all system deposits. The mandate of the deposit insurer as a paybox is appropriate for the development and size of the financial sector. Equally the use of a flat rate deposit insurance premium of 0.5 percent of insured deposits as opposed to risk-based premia is prudent given ADIA’s relatively recent establishment. However, the absence of coverage for small enterprises is a material weakness in the safety net for depositors, as it contravenes a primary objective of deposit insurance—to protect small, financially unsophisticated depositors—as well as European Union guidance on coverage.

55. Market discipline. In the medium term, a robust and transparent accounting and auditing environment should be actively encouraged by the BOA so as to enhance the overall quality of financial reporting in Albania. Many borrowers have several sets of financial statements (statutory accounts, management accounts, fiscal accounts). In addition, many customers of banks in Albania do not have audited financial statements. This means that banks’ credit underwriting staffs are obliged to frequently rely on unaudited statutory and/or management accounts. The BOA should encourage stronger reporting practices by larger corporate borrowers.

C. Main Findings

Objectives, powers, independence, accountability and cooperation (CPs 1–3)

56. There is a generally comprehensive set of laws and regulations governing the supervision of the banking industry. BOA is autonomous both from a de jure and de facto perspective. While the legal framework provides some protection to bank supervisors against damages resulting from the discharge of their responsibilities, it is inadequate as it does not provide protection against the costs of defending acts of commission or commission of their duties in good faith unless the supervisor is exonerated in a court of law. Banking supervision would likely be adequately staffed if the existing vacancies were filled, all of which have been authorized. A fully staffed unit is necessary in light of several supervisory initiatives, including implementation of risk-based supervision and Basel II.

57. BOA is empowered to engage in cooperative efforts with both foreign and domestic supervisory authorities. Toward that end it has entered into cooperative arrangements with other financial sector supervisors in Albania and many foreign supervisors whose institutions have operations in Albania. These arrangements have proven to be effective, and have enabled BOA to exchange supervisory-related information with other supervisors. Nevertheless, BOA needs to explore ways that it can enhance its cooperative arrangements with the supervisor of the institution possessing the largest market share in Albania.

Ownership, licensing, and structure (CPs 4–7)

58. The legal framework is clear relative to the types of banking and non-banking activities in which banks may engage. At present, licensing applications are limited principally to increases in capital and approval of members of the Steering Council. Nevertheless, the legal framework, policies and processes are in place to evaluate new banking licenses and changes in control, although they have not been tested.

59. The transfer of ownership is well defined in the law and there explicit definitions for controlling interests. However, the requirements for an acquisition representing either a presumption of control or a controlling interest could be enhanced to differentiate them from the requirements for lower levels of ownership interests. The definition of an indirect ownership in a bank needs to be strengthened, and BOA needs to formally require the reporting of such interests through its regulatory reporting process.

60. The investment by banks in NBFIs and non-financial institutions is governed by a satisfactory set of laws. These feature situations in which prior approval and notification only are required.

Methods of ongoing banking supervision (CPs 8–10)

61. The supervisory approach tends to be compliance-based and should move more towards risk-based supervision. Nevertheless, BOA did adopt different elements of risk-based supervision and prepared the next step of moving towards a more risk based approach. A new supervisory methodology aligned with Basel 2 is set up and planned to be implemented mid-2014 together with a new supervisory cycle that has yet to be developed.

62. The BOA has an appropriate mix of on-site and off-site supervision to evaluate the condition of the banks. It uses some progressive approaches in addressing the root cause outside the perimeter of the supervisor. But, there are some weaknesses that need attention. First, the business model analysis of a bank needs to deepen. Second, although the portfolio managers are qualified to assess the financial condition of a borrower and are willing to intervene if necessary, there is limited expertise on the specific businesses of the borrower to really challenge the payment capacity of a borrower. Part of this is because there is a lack of industry to benchmark. Third, it takes sometimes between one and four months to issue an examination report. This frustrates prompt formal action if needed. This turnaround should be improved. Risk-based supervision will help in this direction.

63. There is an extensive array of reporting requirements for banks that provides a wide range of data and risk management information, principally on a consolidated basis, but solo data is collected as needed. Appropriately, the information is used in the supervision process to evaluate risk and for other objectives. Some of the information must be collated manually at present and this inhibits the amount of data that can be analyzed efficiently. An automated platform is being introduced late in 2013 that should address the problem and facilitate higher quality analytical work.

Corrective and sanctioning powers of supervisor (CP 11)

64. Corrective measures imposed on banks are mostly based on prudential standards rather than focused on addressing risk management issues. While risk management issues have been addressed principally through the examination process, and have been generally successful, there are cases where such issues have lingered. In such cases, the employment of other components of the supervisory toolkit—principally formal enforcement actions—should be applied. The use of such corrective measures to address prudential issues is very important, but applying such measures when underlying risk management issues have not been resolved informally for a protracted period of time also is warranted.

Consolidated and cross-border banking supervision (CPs 12–13)

65. BOA has developed an overall satisfactory program of consolidated supervision. Supervisors are aware of the organizational structure of banking groups, have identified areas of risk, and maintain contract with other foreign bank supervisors and domestic authorities. The program can nevertheless be strengthened by enhancing cooperative efforts with AFSA, the supervisor of investment funds, so that risk management issues can be appropriately identifies and supervised. One such fund is associated with the largest banking group in Albania.

66. Cross-border banking supervision is implemented through participation in supervisory colleges and bilateral relationships with foreign bank supervisors. BOA engages in host-home country relationships commensurate with the size and complexity of the operations of foreign banks operating in Albania, and the one Albanian bank operating abroad. Formal written agreements governing cooperation and information exchange are in effect between BOA and the preponderance of authorities who supervise banks with a presence in Albania. There is no agreement with the authority supervising the bank with the largest market share in Albania, but the communications channels are nonetheless generally effective in communicating important information.

Corporate Governance (CP 14)

67. Supervisors determine adequately that banks have robust corporate governance policies and processes. Though, BOA can deepen their understanding of the board dynamics and balance of power within a bank, and challenge explicitly the risk appetite of banks.

Prudential requirements, regulatory framework (CPs 15–25)

68. While banks are expected to have appropriate risk management policies and processes, organizational structures and measures for measuring and controlling risks, collectively the analysis of risk management is not as robust as it could be. The supervisors determine that a bank has policies and procedures in place, and determine compliance with the policies. The quality of risk management is a more ephemeral evaluation to capture and their view on this facet of risk management analysis is less clear. Furthermore, the implementation of Basel 2 requires that all examination officers have a good understanding of how to evaluate risk management in practice. However, it is observed that the quality of operations depends on a relatively small group of staff. Therefore, BOA needs to invest in the skills of the examining officers to deepen the evaluation of risk management practices in banks.

69. BOA has according to Basel 1 adequate capital requirements (quantity) and definition of capital components (quality). However, currently BOA does not charge capital for operational risk, interest rate risk in banking book and concentration risk. This will be fixed when BOA implements Basel 2. Nevertheless, because BOA requires a higher capital than prescribed according to Basel 1 (more than 12 percent), there is a cushion for some of these risks.

70. BOA can enhance its scrutiny of credit underwriting policy. Although laws, regulations and the supervisor require banks to have adequate credit risk management that covers the full credit lifecycle, bankers should get more (and regularly) challenges on their credit underwriting policies. Despite the fact that corporate borrowers have weak financial reporting practices (unaudited financial statements) and there is a lack of industry data to benchmark against.

71. BOA has put an increasing amount of effort into solving the root cause of the multidimensional NPL problem outside the regulatory perimeter, but should address the problem of misclassification and take the next step in strengthening problem loan management. It is noticed that in a substantial part of the executed examinations the supervisor required several banks to reclassify part of the reviewed loans because of observed misclassifications. Although BOA has devoted significant efforts to solve this problem, misclassification still exists and needs to be adequately addressed. In addition, although there are general provisions in the regulation on credit risk that provide a legal base to set requirements for problem loan management, there are no specific requirements in the regulation on the management of problem loans especially relative to policies and procedures for pre work out, work out, restructuring, collection, recovery and resolution of these assets. It would benefit the banking sector if BOA gives guidance on this topic via regulation.

72. Albanian banks have a substantial concentration risk of Albanian government paper. One systemic bank even has a concentration of Albanian government bonds held-for-trading. This portfolio is valued at fair value and therefore all its gains go directly into the P&L. There has not been a proportional capital charge if the profit turns into losses. Although Basel 2, pillar 2 would address this issue from capital perspective, BOA should address this problem through FSAG.

73. BOA has all the law and regulation in place that addresses abuse and conflict of interest because of related parties, but didn’t capture the informal way of doing business in Albania. Different sources state that relatedness is more important than financial condition in doing business in Albania. This means that not all kind of relatedness is captured by the definition on related parties. For instance, situations where loan officers grant loans based on relatedness instead of financial conditions are not captured by this definition. BOA should therefore review their definition of related parties.

74. Country risk and transfer risk are not explicitly addressed in law and regulation. Although BOA does address country risk issues on an ad hoc base mostly in times of crisis, it needs to develop regulation to address country risk on a regular base.

75. The BOA implemented market risk regulation for interest rate risk and FX risk in the trading book (based on Basel 1) as well as for interest rate risk in the banking book (based on Basel 2). Although duration is a good instrument to measure interest rate risks, BOA needs to assess what the uncertainty is regarding other sources of interest rate risk and if the management information system is capable of capturing these sources.

76. The liquidity regulation stems from 2009 and has been a good starting point for managing liquidity risk. However it is time to align the current liquidity regulation with the new Basel 3 requirements, in particular with regard to liquidity coverage ratio (LCR). The greatest liquidity risk is the market risk of government paper, because the liquidity buffer mainly exists of government paper in a very superficial market dominated by one systemic relevant bank. Although, it can also uses the paper for a repo agreement.

77. BOA has implemented the qualitative side of operational risk of Basel 2, except the self- assessment and the capital requirement. The capital requirements for Basel 2 will be implemented together with the total implementation of pillar 2 during 2014. Banks shall have to choose between the basic indicator approach and the standard approach. The banks are expected to be fully compliant by the end of 2014. It is noted that banks have a growing, though not yet material, position in property as a result of foreclosures. Banks are allowed to take this property on their book. Because managing property is not the core business of a bank, it has operational risks which should be reflected going forward on the implementation in 2014 of Basel 2.

Internal control, internal and external audit, financial reporting, market disclosure and transparency (CPs 26–28)

78. There is a reasonably comprehensive set of rules and regulations governing the mandate and quality of the internal audit function and the requirements for a robust internal control system. In connection with the plan to adopt a risk-based supervision program, the authorities will need to require enhancements to internal audit functions in banks, particularly in risk-based audit planning, and ensuring that audit process and procedures are in accordance with international best practice.

79. External auditors are held to high professional and ethical standards in law and practice by BOA, whose requirements are complemented by a self-regulating organization. BOA is empowered to approve the external auditing firm that is retained by a bank, and requires rotation of audit firms periodically.

80. Disclosure requirements are strict, and follow international standards. The banking system prepares its accounting records and reports financial information in accordance with IFRS. Regulatory returns are filed at present in accordance with NAS, but conversion to IFRS for supervisory reporting is being undertaken concurrently with introduction of the fully automated reporting platform.

Abuse of financial services (CP 29)

81. The law governing the requirements for banks and other financial institutions is reasonably comprehensive for combating AML/CFT. BOA has a dedicated staff exercising supervisory responsibilities over AML/CFT activities. BOA and the FIU have coordinated their efforts through joint examinations, training and in other ways.

D. Authorities’ Response

82. The Bank of Albania deeply appreciates the fruitful and diligent work carried out through the assessment of the Albanian financial sector by the FSAP Assessment Team.

83. The assessment shed light on the current level of compliance with best international practices, while identifying a number of areas for improvement, several of which are currently subject to ongoing efforts to improve. In this context, we would like to highlight several remaining issues.

84. With regard to core principle 18, it is our belief that the position and all the measures already taken by the Bank of Albania go beyond the objectives of the CP. This is reflected also in your recommendations, which provide additional assurance to properly address the resolution of problem assets, and in particular, provisions and reserves. The Bank of Albania believes the assessment did not fully consider the extremely severe market developments that coincided with the assessment’s review period.

85. Moreover, the rating of core principle 19 on government bonds reflect the their liquidity, although many of these bonds are eligible for Bank of Albania operations. We would like to emphasize the fact that this represents a complex matter, going beyond the reach of bank supervision. Nonetheless, Bank of Albania is aware and is already planning the actions to be taken in this respect, also in line with the recommendations of the report.

86. Last, but not least, concerning the issue of related party’s transactions, core principal 23. We accept as true that higher consideration has to be paid to the fact that the definition in the law is fairly broad and encompasses all relationships that could be considered during the credit risk evaluation of a connected group of borrowers. Additionally, the Bank of Albania aims to promote sound credit underwriting criteria based on adequate borrower’s financial information and is committed to strengthen the legal requirements and enforcement regarding relatedness issues.

87. Finally, it should be noted that, the Bank of Albania remains fully committed to implement all these recommendations, and to use the assessment as a guideline for the action plan to advance the level of supervisory standards towards the best practices, considering that this is also the best contribution to its mandate of guaranteeing the banking and financial stability.

Table 1.

Summary Compliance with the Basel Core Principles—Detailed Assessments

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Table 2.

Recommended Action Plan to Improve Compliance with the Basel Core Principles

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Appendix V. Report on the Observance of Standards and Codes: Core Principles for Effective Deposit Insurance Systems—Summary Assessment

A. Background

88. An assessment of compliance with the Core Principles for Effective Deposit Insurance Systems (Core Principles) was conducted as a part of the Financial Sector Assessment Program (FSAP) performed by the International Monetary Fund and the World Bank at the request of the Albanian government. The assessment was conducted during a mission to Albania from October 28 to November 11, 2013.