86214 FINANCIAL SECTOR ASSESSMENT UPDATE ALBANIA FEBRUARY 2014 FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY EUROPE & CENTRAL ASIA REGION VICE PRESIDENCY This Financial Sector Assessment summarizes the findings of a joint IMF-World Bank mission that visited Tirana October 28 to November 11, 2013 to update the findings of the Financial Sector Assessment Program (FSAP) that had been conducted in 2005. 1 1 The team comprised Michael Edwards (Mission Chief, World Bank), S. Erik Oppers (Mission Chief, IMF), Eugene Gurenko, Thordur Jonasson, Claire McGuire, Elena Mekhova, Will Price, Olga Akcadag, Marc Schrijver (all World Bank), Alejandro López-Mejía, Nicolás Arregui, Mario Catalán, Mathew Gaertner, Darryl King, David Parker (all IMF) and Joel Shapiro and Erik Huitfeldt (external experts). Contents Page Glossary ..................................................................................................................................... 3 I. OVERALL ASSESSMENT AND MAIN RECOMMENDATIONS ............................................... 4 II. BACKGROUND ................................................................................................................ 8 A. Financial Sector Overview ................................................................................ 8 B. Macroeconomic situation and potential risks .................................................. 10 III. FINANCIAL SECTOR VULNERABILITIES AND SYSTEMIC LIQUIDITY FRAMEWORK ......... 12 A. Vulnerabilities in the Banking Sector, Stress-testing and NPL resolution ...... 12 B. Systemic Liquidity and Market Operations ..................................................... 15 IV. FINANCIAL SECTOR SUPERVISORY FRAMEWORK ......................................................... 16 A. Macroprudential Framework ........................................................................... 16 B. Banking Supervision ....................................................................................... 17 C. Supervision of Insurance, Capital markets and Pension funds ....................... 17 D. Anti-Money Laundering and Combating the Financing of Terrorism ............ 18 V. FINANCIAL SECTOR SAFETY NET, CRISIS PREPAREDNESS AND MANAGEMENT ............ 19 A. Emergency Liquidity Assistance ..................................................................... 19 B. Bank Resolution Framework ........................................................................... 19 C. Deposit Insurance framework ......................................................................... 20 D. Crisis Preparedness and Management ............................................................. 20 VI. PUBLIC DEBT MANAGEMENT, PENSION AND ACCOUNTING ISSUES .............................. 21 A. Public Debt Management ................................................................................ 21 B. Pension Reform ............................................................................................... 22 C. Introduction of IFRS financial reporting ......................................................... 23 ANNEX 1. FINANCIAL SOUNDNESS INDICATORS, DECEMBER 2007 – SEPTEMBER 2013............ 25 ANNEX 2. KEY RECOMMENDATIONS OF 2005 FSAP ................................................................ 26 2 Glossary ADIA Albanian Deposit Insurance Agency AFSA Albanian Financial Supervisory Authority AML/CFT Anti Money Laundering and Combating the Financing of Terrorism ASE Albanian Stock Exchange BoA Central Bank of Albania COREP Common Reporting Framework ELA Emergency Liquidity Assistance EU European Union FINREP Financial Reporting Framework FSAG Financial Stability Advisory Group GDPDM General Directorate of Public Debt Management IFC International Finance Corporation IFRS International Reporting Standards MIGA Multilateral, Investment Guarantee Agency MoF Ministry of Finance MOU Memorandum of Understanding MoW Ministry of Welfare and Youth MRA Master Repurchase Agreement MTPL Motor Third Party Liability NBFIs Nonbank Financial Institutions NPLs Non-Performing Loans P&A Purchase and Assumption PIE Public Interest Entities SCAs Savings and Credit Associations SME Small and Medium Enterprises UCITS Undertakings for Collective Investment in Transferable Securities 3 I. OVERALL ASSESSMENT AND MAIN RECOMMENDATIONS 1. Although the Albanian financial system withstood the shocks of 2008 global crisis relatively well, it continues to operate in highly uncertain macroeconomic environment, which triggers increased vulnerabilities in the system. The decline in profitability, growing non-performing loans (NPLs), substantial level of euroization, continued deleveraging of foreign bank subsidiaries and significant investments in government bonds in the absence of active secondary market are the main challenges that banking system faces. Given strong trade and financial links with euro area, the financial system and real sector in general are increasingly vulnerable to external shocks as well. 2. Since 2007 the Bank of Albania (BoA) has introduced several macroprudential measures to safeguard financial stability in the country. 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; and (iii) the regulation on related-party exposure was enhanced. In addition to that, the risk weights for unhedged borrowers were increased to 150 percent and a limit of such loans was set to 400 percent of capital. 3. The BoA has begun the process of moving towards risk-based supervision approach, though so far supervision remains predominantly compliance based. A transformation to a new comprehensive risk based supervisory framework is essential and will result in more efficient utilization of supervisory resources and effectiveness of supervisory actions by the BoA. Upon the forthcoming risk-based supervisory methodology a new bank rating system should be introduced, which captures forward looking dimensions as well. In light of the establishment of new investment funds, consolidated supervision should be enhanced. To support its efforts towards a sufficiently risk-based approach, the BOA should expand its supervision staff either. 4. While in comparison with international norms the BoA has conservative capital adequacy and provisioning requirements, stress tests show that banks remain vulnerable to shocks. In severe macroeconomic scenarios, banks suffer simultaneous losses from credit, market, and sovereign risks, and at least 6 banks (representing 21 percent of the assets of the banking system) become undercapitalized. Sensitivity tests also indicate that a lek depreciation would deteriorate the quality of loan portfolios and that credit risk is exacerbated by the high concentration of loan portfolios. Liquidity stress tests confirm that banks are amply liquid and are able to confront large deposit withdrawals. Direct contagion risk through bilateral domestic interbank exposures is limited. 5. Mitigating the vulnerabilities identified by the stress tests is crucial. Having one of the highest levels of NPLs in the region the authorities are encouraged to intensify efforts to 4 ensure the resolution of the stock of existing and limit the flow of new NPLs. Measures should be adopted to: (i) resolve key NPL tax ambiguities to enable banks to write-off NPLs; (ii) amend the regulation to facilitate obligatory write-off of stale-dated NPLs; (iii) improve the insolvency regime, collateral execution and private bailiff incentive structure; (iv) clarify regulatory and supervisory requirements for buyers of NPL books to encourage the sale of such assets, (v) require banks to prepare NPL resolution strategies; and (vi) adopt measures to strengthen banks’ credit policies and underwriting standards, especially towards large exposures. 6. Albania’s high public debt poses significant challenges going forward. Domestic debt grew sharply recently, emanating largely from poor tax revenue performance, slower economic growth and continued infrastructure spending, resulting in a large stock of unpaid arrears. Large holdings of government securities present potential systemic risks for banks, making them vulnerable to changes in interest rates and the value of debt securities. At the same time, the government depends on regular rollover of debt by banks. The risk is heightened by the lack of a well-functioning secondary market and the emergence of investment funds, which face significant liquidity risk and challenges regarding asset valuation. On the government side, public debt management capacity has been undermined by public sector wide staff reductions now put in place at the General Directorate of Public Debt Management (GDPDM). 7. While recently established investment funds helped to diversify the concentration of government securities in the financial system, their fast growth gives rise to potentially higher systemic risk in the country. As investment funds are a new phenomenon in Albania the Albanian Financial Supervisory Authority (AFSA) is not properly equipped to supervise and regulate that market. As a result investment funds do not keep adequate liquidity coverage, invest mostly in longer-term securities and do not fully disclose to the clients the difference between investments in the investment fund units and bank deposits. 8. With new insurance and investment fund complexities arising, it is key to improve the organizational structure and capacity of the AFSA. Insurance and investment fund supervision requires major institutional reform to achieve AFSA’s financial and operational independence. To do so, the AFSA Law must be amended, including by abolishing the requirement for the AFSA to have its organizational structure approved by the Parliament and removing the AFSA from the government employee compensation structure so that it can attract and retain experienced staff. The legal protection of AFSA’s board and staff must be strengthened by affording legal protection for the bona fide discharge by staff of their governmental, regulatory and administrative functions and powers. As a priority, the new draft Insurance Law should be passed and the AFSA should take action to address major problems faced by the Motor Third Party Liability (MTPL) insurance market. 9. The legal and institutional framework for macroprudential policy, the financial sector safety net, and crisis preparedness are generally strong. The macroprudential mandate of the BoA is supplemented by the Financial Stability Advisory Group (FSAG), whose role could be enhanced by focusing its mandate and making some operational changes. The crisis management and resolution framework could be improved by formalizing the recovery and 5 resolution planning process, enhancing detailed contingency plans by all FSAG members, holding periodic crisis management exercises, strengthening the existing legal framework to enable extraordinary actions in a crisis, and developing a clear communication strategy. 10. Albania’s deposit insurance system is largely based on modern principles. The mandate of the deposit insurer as a paybox is appropriate for the development and size of the financial sector. The use of a flat rate deposit insurance premium (as opposed to risk-based premia) is prudent given Albanian Deposit Insurance Agency’s (ADIA) relatively recent establishment. However, the absence of coverage for enterprises contravenes European Union (EU) guidance on coverage. The ADIA has developed procedures for admitting qualified Savings and Credit Associations (SCAs) to the deposit insurance scheme, but it is essential that the initial capital of 50 million lek seed funding be provided, which the government included in its 2014 budget. 11. Albania is a young but rapidly aging country where comprehensive reform agenda aimed at building diversified pension system is required. The current system relies almost exclusively on state provision (first pillar). Poor incentives and informal labor markets result in contributions vastly below required levels. Some positive reforms, such as increases in the retirement age, have been offset by reduced contributions. The first pillar reform is urgent (and is currently being considered by the government) and the introduction of a second pillar with auto enrollment should be considered in the medium term. A critical part of building and sustaining a long term vision for pensions is to develop government, political and external understanding and agreement towards introduction of a public-private pension system. The reform process could follow a ‘launch-design-build-operate’ program starting in 2013 and leading to the start of the new system in 2020. 12. Overall, financial reporting legislation in Albania has improved recently and has a high degree of alignment with the acquis communautaire of the EU. However, it needs further revisions to align the legislation better with the European Union acquis and with good international practice. The most critical legislation amendments are: (i) the definition of Public Interest Entities (PIEs) (those required to apply IFRS) needs further revision in the Law on Accounting and Financial Statements; (ii) the law on Statutory Audits should provide for adequate funding of the audit public oversight system, appropriate institutional arrangements, independence of board members, and representation of financial sector regulators in the Public Oversight Board; (iii) requirements for mandatory audits of financial statements should fully align with the European Union acquis, as this would reduce the number of audits and ease the burden on smaller entities. 6 Table 1. Main FSAP Recommendations 2 Recommendations Term Institution Bank Supervision and Regulation and NPL issues Encourage prompt cleanup of banks’ balance sheets, including by creating a working group to resolve issues ST BoA/MoF preventing the write-off of bad loans. Initiate an asset quality review in banks ST BoA Working with banks to improve bottom up stress tests. LT BoA/MoF Enhance consolidated supervision ST BoA/AFSA Strengthen supervision of credit risk and problem loan management. ST BoA Fill authorized staff positions in banking supervision. ST BoA Facilitate exchange of information with foreign bank supervisors. MT BoA/MOF Improve the effectiveness of the internal audit function in banks. LT BoA Make the supervisory methodology risk-based and amend Supervision Operations Policy. LT BoA Systemic Liquidity and Market Operations Expand collateral eligibility in domestic operations to include all Albanian government lek securities MT BoA Develop the collateralized money market (encourage use of standard MRA). MT BoA Increase the liquidity requirement on foreign currency deposits ST BoA/AFSA Macroprudential Framework Intensify supervision for systemic banks, and if necessary, introduce systemic capital surcharges. MT BoA Safety Net and Crisis Preparedness and Management Bank Resolution: Develop cooperative resolution strategies and agreements among home and host authorities. ST BoA Deposit Insurance: Determine which SCAs can become ADIA members; amend ADIA law, provide pledged ST BoA/ADIA/ government resources for a deposit insurance fund for SCAs. MoF Crisis Preparedness: Obtain support letters from mother banks agreeing to provide liquidity and solvency ST BoA support to their subsidiaries. Crisis Management: Set a framework for extraordinary actions in crisis. MT FSAG Financial Supervisory Authority AFSA: Stabilize insurance market by establishing and enforcing actuarially sound claims reserving ST AFSA/MoF requirements for MTPL and restore funding of Compensation Fund. Pass amendments to FSA law, enact draft Insurance Law and supporting by-laws. ST AFSA Mitigate impact of MTPL stabilization measures, including by establishing compulsory earthquake insurance ST AFSA and waiving VAT on non-compulsory, insurance products. Investment Funds: Amend the regulatory framework, including on liquidity management and unit value ST AFSA determination. Public Debt Management Separate the BOA allocation from the portion that is offered to the market and reduce the proportion allocated ST MoF on a non-competitive basis in primary auctions Establish a dealer arrangement for secondary market participation MT MoF Assure institutional arrangements are compatible with the formulation of a Debt Management Strategy and ST MoF management of public debt. Strengthen the cash forecasting and cash management function within the General Directorate of Public Debt MT GDPDM Management. Pension Reform Establish cross government and external Pension Reform Commission to work to build a diversified pension ST MoW system and start design of data collection and pilots to support reform. Put first pillar pensions on fiscally sustainable path, set out public vision for public and private systems, and MT MoW/ prepare and launch second Pillar system. Commission 2 Term refers to the expected time of completion, with short term (ST) referring to 1 year, medium term (MT) to 1-3 years, and long term (LT) to more than 3 years. 7 II. BACKGROUND A. Financial Sector Overview 13. The financial sector in Albania is concentrated and dominated by foreign banks. Banks represent about 94 percent of total financial system assets, equivalent to 88 percent of GDP in 2012. The largest five banks hold about three-quarters of system assets and deposits. Subsidiaries of foreign banks represent about 93 percent of total banking sector assets (Fig. 1). 14. Bank credit is concentrated in the corporate sector. About 74 percent of loan portfolio in 2012 was to the corporate sector, whereas 40 percent was represented by real estate loans. While the credit to Small and Medium-sized Enterprises (SMEs) increased 29 percent during 2007-12, its share in total loans decreased from 37 percent to 25 percent. 15. The quality of the loan portfolio has deteriorated markedly since the onset of the crisis. At end-September 2013 gross non-performing loans (NPLs) represented 24.2 percent of total loans, among the highest in the region, though provisioning rules are conservative, and total provisions represented 62.3 percent of NPLs at end-September 2013. 16. The remainder of the financial system is small (6 percent of financial system assets). As of mid-2013, it included 11 insurance companies, two investment funds, 126 savings and credit associations in two unions, two independent SCAs, 3 pension funds, and 21 other non- bank (that is, non-deposit-taking) financial institutions: • Insurance. Albania has one of the smallest insurance markets in Europe, with very low market penetration rate of about 2,860 lek (€20) per capita. The development of the sector has been hindered by the lax insurance regulation, low disposable income, a poor industry record of claims performance and the lack of trust in insurance among the public. Local insurance companies have been engaged in a Motor Third Party Liability (MTPL) price war, which over time has led to reduced growth of premium written, considerably increased risk exposure, an inadequate level of reserves, and weak underwriting performance. • Investment funds. First investment fund was established in 2012 by Raiffeisen Invest, a subsidiary of Albanian Raiffeisen bank. The timing coincided with a withdrawal by the Albanian subsidiary of Raiffeisen from government debt markets as a result of pressures from its parent bank to limit its exposure to the Albanian sovereign. A second fund, the Raiffeisen Invest Euro fund, was subsequently added and these two funds have now grown to a total net-asset value of 316.7 million euro (as of late-October 2013). They have more than 22,000 investors (largely individuals). • Savings and Credit Cooperatives. The assets of SCAs accounted for about 0.8 percent of financial system assets in 2012. There are two unions (with 124 member SCAs) and two independent SCAs. A considerable share of the unions’ assets (30 percent) is invested in bank shares and treasury bills. About 83 percent of assets are directed toward loans to 8 members, mostly in the agricultural sector. There is increasing share of female borrowers from the SCAs (in one women lead SCA 55% of borrowers are women, while in others the share of women cosigners reaches 80%). Figure 1. Financial Sector Overview The financial sector in Albania is concentrated and dominated by foreign banks. The financial system is dominated by banks... ...which have been growing since 2005. Financial System, September 2013 Evolution of the Financial System (Percent of Total Financial Assets) (Percent of GDP) 0.8 1.6 3.0 Banking system Sept. 2.6 2005 2013 Nonbank financial institutions Savings and loan Banking system 75.9 90.8 associations Nonbank financial institution 1.5 2.5 Insurance companies Savings and loan associations 0.6 0.8 Pension funds Insurance companies 1.4 1.6 92.0 Pension funds - - Investment funds Investment funds - 3.0 Source: Bank of Albania The banking system is primarily foreign owned... ...and credit is concentrated in the corporate sector. Banking System Structure, 2008-12 Outstanding Loans, September 2013 (Bank Financial Assets as Percent of Total) 35.0 30.0 Business 25.0 2012 2008 Households 20.0 15.0 10.0 26.6 5.0 0.0 Credit Bank of … Intesa Sanpaolo … National Bank of … National … International … Societe Generale … United Bank of… Raiffeisen Procredit Bank Union Bank First Investment Bank Credit Agricole Bank Alpha Bank Tirana Bank Veneto Bank Credins Bank 73.4 While business loans are evenly distributed... ...household loans are skewed towards real estate. Business Loans Outstanding, September 2013 Household Loans Outstanding, September 2013 35.0 80.0 (Percent) (Percent) 30.0 70.0 60.0 25.0 50.0 20.0 40.0 15.0 30.0 10.0 20.0 5.0 10.0 0.0 0.0 Overdraft Working Equipment Real estate Overdraft Nondurable Durable Real estate Operations capital goods goods 9 Source: Bank of Albania, IMF and WB staff calculations • 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. 3 There were 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. • Other nonbank financial institutions (NBFIs). These hold 2.7 percent of financial system assets and comprise mainly non-deposit-taking lending institutions and leasing, with a share of 65 percent and 30 percent, respectively. Other institutions undertake money transfers services and factoring. NBFIs are funded primarily through borrowing (about 60 percent) and their capital (about 35 percent). 17. The Bank of Albania (BoA) supervises the domestic banking system, saving and credit associations, and other nonbank financial institutions (including foreign exchange bureaus), while the Albanian Financial Regulatory Authority (AFSA) supervises insurance companies, pension and investments funds. B. Macroeconomic situation and potential risks 18. Albania weathered the 2008 global financial crisis relatively well. The growth shock was less severe than elsewhere in Europe thanks in part to monetary accommodation and a moderate fiscal stimulus. Inflation remained low and stable. The BoA effectively managed spillover risk from the presence of Greek and other peripheral euro country banks and relative stability in the financial system was maintained. 19. The economy remains weak and macroeconomic imbalances are large. Real GDP growth is projected to have remained slow at around 1.3 percent in 2013, below potential 2.7 percent. Despite a cumulative nominal depreciation of about 12 percent since 2008 the external current account deficit remains high, largely reflecting persistent fiscal deficits and worsening terms of trade. Policy buffers are depleted, with the debt-to-GDP ratio projected to be around 71 percent of GDP in 2013 (after incorporating government domestic payment arrears and guarantees), and a large share of short-term public debt poses financing risks. 20. The credit cycle entered a new stage in the last few years and developments in real estate deserve close monitoring. Prior to the global financial crisis, credit growth in Albania was excessive, but it has moved into a downturn and repair stage, as suggested by the slowdown in credit and moderation in house prices, the sharp increase in non-performing loans and the reduction in banks profitability margins (Figure 2). Given that banks’ exposures to the sector are significant a sharp downward correction in prices could potentially have a systemic impact. 3 The public pension scheme (‘first pillar’) is the backbone of Albania’s social security system. It is a mandatory pay-as- you-go system with universal coverage. Its management is entrusted to the Social Insurance Institute, an independent public entity under the supervision of the Ministry of Labor and Social Affairs. 10 Figure 2. Real estate prices have fluctuated sharply during the same period The credit cycle in Albania has entered a downturn and repair stage, and real estate prices have increased significantly. Following the credit boom experienced prior to 2008... ... credit has stalled,... 45 80 Credit to GDP Credit growth 40 70 (in percent) (yoy; in percent) 35 60 50 30 40 25 30 20 20 15 10 Credit to GDP ratio 0 10 -10 Nominal credit growth 5 -20 Real credit growth 0 -30 2000 2002 2004 2006 2008 2010 2012 1995 1997 1999 2001 2003 2005 2007 2009 2011 ... NPLs have risen sharply... ...and banks' profitability margins have fallen. 30 1.8 Banks asset quality Bank profitability 1.6 25 (in percent) (in percent) 1.4 20 1.2 1 15 Non-performing loans ratio 0.8 Return on assets 10 0.6 0.4 5 0.2 0 0 2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012 While the increase in house prices appears mild relative to some Eastern European countries... ...it is comparable to well-known boom-bust cases. 300 180 Real housing prices Real housing prices (2004Q1=100) 160 (2004Q1=100) 250 ESP 140 IRL 200 USA NZL 150 120 ALB 100 100 50 80 BGR CZE LTU LVA RUS UKR ALB 0 60 2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012 Source: BoA, OECD, WEO database, IMF and WB staff calculations 11 21. The authorities’ determination to address the macro-economic challenges will be critical. Sustained fiscal consolidation over the medium term to reduce public debt, manage rollover risks, and rebuild buffers is key for reducing vulnerabilities and supporting medium term growth. Significant tax policy and expenditure reforms are needed to tackle the root causes of high fiscal deficits and resolving the NPL problem is a prerequisite for a sustained increase of credit to the economy. 22. As Albanian financial sector continues to operate in an uncertain macroeconomic environment, the potential external risks that are more likely to materialize are: • An exit from unconventional monetary policy in the United States could trigger a pull back in global risk appetite. This would reduce foreign funding and increase the rollover risk for the outstanding Eurobond. Given the large external current account deficit, funding pressures could lead to a depreciation of the lek, threatening the solvency of banks due to the presence of un-hedged borrowers. • Re-emergence of financial stress in the euro area could increase deleveraging pressures. Subsidiaries of affected banks, especially from Greece and Italy, 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. • Deterioration in market sentiment (associated with external and/or domestic developments) could trigger a systemic crisis given the strong financial linkages between the sovereign, the banking sector, and the emerging investment fund sector. 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 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. III. FINANCIAL SECTOR VULNERABILITIES AND SYSTEMIC LIQUIDITY FRAMEWORK A. Vulnerabilities in the Banking Sector, Stress-testing and NPL resolution 23. Several features of the banking sector increase its vulnerability to shocks: • The decline in bank profitability and the rapidly rising rate of NPLs. Bank profitability has declined sharply with the return on equity falling from over 20 percent in 2007 to below 3 percent in mid-2013. NPLs have increased from 3.4 percent at end-2007 to more than 24 percent in September 2013. The rapid increase of NPLs likely involves a combination of factors, including the economic slowdown, government payment arrears and systemic risk that may have built up during the credit boom before the financial 12 crisis. Also, loss loans are not being cleared from banks’ books due to a lack of clarity in the tax treatment of write-offs. • High financial euroization. 50 percent of loans are in foreign currency and essentially unhedged which in combination with large maturity mismatches could create significant risks in case of negative foreign currency shocks. • The strong financial links between banks and the sovereign. 32 percent of bank assets consist of government securities, and these holdings represent 64 percent of total government debt. This significant financial interdependence represents systemic risks for banks and for the government, which depends on regular rollover of debt by banks. In addition the rapid expansion of investment funds which mainly invest in government bonds exacerbates the risks for the financial system as a whole. • A significant foreign bank presence, including from Austria, Greece, Italy, and Turkey. Financial difficulties in parent countries can affect Albanian institutions through direct contagion, defunding pressures or higher NPLs. Figure 3. Share of FX loans, region Figure 4. NPLs, region 100 35 FX Loans Non Performing Loans 90 2008 (Percent of Total Loans) 30 (Percent of Total Loans) 2012 80 2008 Median 2012 70 25 Median 60 20 50 40 15 30 10 20 10 5 0 0 Source: IMF Staff reports and FSI database. 24. Given the vulnerabilities in the financial system, stress tests were conducted during the mission to assess the resilience of the banking system to specific solvency, liquidity, and contagion risks. The stress tests included a series of top-down and bottom-up exercises based on macroeconomic scenarios and sensitivity analyses. 25. Top-Down stress tests. The result of stress tests show that six to ten banks out of sixteen could become undercapitalized in case of adverse macroeconomic shocks, which represent up to 78 percent of system assets. The combined effect of the decline in GDP growth, lek depreciation and higher interest rates could increase the banking system’s NPL ratio from 24 percent in 2013 up to 44 percent throughout 2014-2015, in worst case scenario. While lek depreciation corresponds in profits on long positions, it will not outweigh potential credit losses from unhedged borrowers. Another significant risk is the high exposure to sovereign debt, which 13 in case of adverse macroeconomic scenario could cause losses equivalent to 8 percent of the initial valuations, with significant impact on bank capitalization. Sensitivity tests targeting specific risk factors largely confirm the results of the macroeconomic scenarios. Recorded high concentration of loan portfolios exacerbates credit risk further, where the sum of exposures of all the banks to their five largest borrowers represents 105 percent of total regulatory capital in the system. Liquidity stress tests reveal that banks would be able to handle large deposit withdrawals without emergency liquidity assistance from the BOA and the direct contagion risk through bilateral domestic interbank exposures is limited, as these exposures are small compared to banks’ capitalization. 26. Bottom-up stress tests. The results from the bottom-up tests conducted by the banks show significant differences with those of the top-down tests conducted by the BOA. Although the methodology for bottom-up stress testing developed by the BOA is robust, banks use mostly expert judgment to undertake the stress tests and often fail to incorporate the shocks embedded in the macroeconomic scenarios, so further refinement of banks’ stress testing methodologies is needed. The BOA should engage each bank with their individual stress test results and require them to (i) adopt mitigation measures; (ii) improve risk management in the areas that show specific vulnerability; and (iii) monitor progress going forward and adopt enforcement measures if necessary. 27. As credit risk continues to be a major risk that banks faces the rising trend of NPLs in the banking system should be tackled decisively. So far BoA’s NPL supervisory actions were more corrective than forward-looking, which imposes the need for more detailed and granular prudential standards on NPL management and resolution to better shape banks’ incentives for more proper and forward-looking NPL-related actions. 28. In a bid to draw from international best practices surround the mitigation of NPLs, the BOA entered into an MOU with the World Bank Vienna Financial Sector Advisory Center (FinSAC) in October 2012. FinSAC experts undertook separate legal and prudential assessments to identify impediments necessary in order to expedite the enforcement of collateral executions. Thereafter, a series of key Civil Procedure Code changes were adopted by Parliament in April 2013 (effective in October 2013), which strengthen banks’ ability to enforce their collateral. 29. More broadly, the authorities recognize the need to accelerate the adoption of further legal, tax and prudential measures to reduce the stock and flow of NPLs. To that end, a serious set of new measures are being adopted to support the resolution of NPLs: (i) the BoA published in November new debt restructuring and appraisal guidelines; (ii) the BoA is committed to issue in early-2014 a new prudential regulation to encourage NPL sales to specialized NBFIs; (iii) the International Financial Corporation (IFC) proposed to provide the Ministry of Justice with substantial grant funding over three years to support insolvency reforms; (iv) a Working Group composed of BoA, Ministry of Finance (MoF) and Albanian Association of Banks initiated changes in tax legislation to tackle longstanding tax related ambiguities for banks; (v) following tax code changes the BoA will adopt regulation for the 14 obligatory write-off of stale-dated NPLs, (vi) FinSAC will provide BoA continued TA for the preparation by banks of NPL reduction strategies and enhance the framework among banks and borrowers for voluntary debt resolution, and (vii) the BoA will enhance regulatory framework for banks to strengthen credit underwriting practices, especially towards large exposures. 30. Additionally, a set of specific key measures have been proposed to the Ministry of Justice to clarify articles of the Civil Code on the court’s discretion to postpone payments as well as to issue new instruction to provide private bailiffs market based incentives to expedite the execution of collateral necessary to lower the level of NPLs. B. Systemic Liquidity and Market Operations 31. An inflation targeting framework has been in place since 2000. The BoA uses a mid- corridor approach to implement monetary policy with eligible collateral policy determined by the type of operation. It has a clearly articulated interevention policy and has not transacted to affect the foreign exchange rate since 2009; all its recent activity was to manage its international reserves. To further strengthen the monetary operational framework the BoA could: (i) apply the same collateral standards to all monetary operations, (ii) expand collateral eligibility to include treasury bonds with a maximum time-to-maturity of five years, (iii) establish a more granular matrix of haircuts, taking into account the length of the transaction and the duration of the collateral, and (iv) use the liquidity requirement primarily to manage prudential risks. 32. Potential systemic liquidity risks arise from constrained market access and the involvement of some poorly regulated participants. Three specific sources of risk are identified: • Illiquid lek money and government securities markets. Money market activity is concentrated in the interbank overnight and 7-day segments and many players have no limits set for other banks. There is no robust legal foundation upon which the repo market could develop given the record of ownership of government securities is maintained manually. In addition Albanian government securities can only be converted into cash by banks if they are accepted in BoA operations. The liquidity management could be improved through a robust operational framework for repo transactions. The adoption of standard Master Repurchase Agreement (MRA) framework in line with expected implementation of a central securities depository interfaced with the real-time payments system will help eliminate settlement risks on securities transactions. The BoA should assess the efficacy of proposed Interbank Collateralized Market Platform to ensure that it does not bear the financial risks arising from transactions between private counterparties • High level of euroization. There are potential systemic liquidity risks given that 53 percent of bank deposits are in foreign currency and the BoA does not offer regular liquidity facilities in foreign currency. The mission recommends that the liquidity 15 requirement in foreign currency be set higher than in lek. In addition some restrictions could be imposed for the lending in foreign exchange to unhedged borrowers. • Operations of investment funds. Diversification of ownership lessens the systemic risks from the strong financial interdependence arising from the large bank holdings of government securities. However, the investment funds also add to systemic risk, in particular, the lack of an established secondary market for government securities represents a key liquidity risk to the investment funds. Meanwhile, the AFSA’s current regulatory framework does not require the investment funds to hold liquidity buffers to meet the demands for the redemption of units. These risks are exacerbated by a lack of clarity on the liquidity policy and the methodology for establishing the value of the units, both of which should be addressed. The mission recommends to strengthen the regulatory framework for investment funds by: (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; (ii) introduce capital adequacy requirements aligned with the EU’s UCITS directive; and (iii) introduce liquidity requirements consistent with the UCITS directive and ensure that investment funds have adequate liquidity contingency arrangements in place with banks. In addition, investment funds should be required to prominently disclose to their clients that investment fund units are not insured by the Albanian Deposit Insurance Agency (ADIA). IV. FINANCIAL SECTOR SUPERVISORY FRAMEWORK A. Macroprudential Framework 33. The BOA has clear macroprudential mandate in the existing legislation to secure financial stability of the banking system. The macroprudential role of the BoA is complemented by the inter-agency Financial Stability Advisory Group (FSAG) which was established in 2006 as a consultative entity to assist in the coordination of policies and to ensure the exchange of information among the MoF, BoA and AFSA. In 2012 a MOU was signed to enhance cooperation among its members towards three objectives: financial development, crisis prevention and crisis management, which also resulted in the involvement of the Albanian Deposit Insurance Agency (ADIA) in the FSAG. The role of the FSAG can be enhanced further by focusing more on systemically important financial institutions and risks, with its financial development mandate assigned to another body. 34. While a number of macroprudential policies were put in place since 2007, BoA’s macroprudential toolkit could be strengthened further. In spite of the fact that BoA has adopted tighter approach in the earlier stage by converting foreign bank branches into subsidiaries and by tightening liquidity regulations, in 2013 to stimulate a credit growth it has again eased the liquidity requirements and reduced capital coverage for those banks that expand credit growth within a range of 4 to 10 percent, as well as introduced disincentives for banks to hold funds overseas. As the impact of these measures is likely to be limited, the authorities should continually weigh the potential effectiveness of such measures in the near term with the 16 longer term potential costs. Looking forward, the macroprudential toolkit can be expanded to include instruments addressing the procyclicality of credit (like countercyclical capital buffers). Authorities could also consider systemic capital surcharges, but should weigh in the risk of intensifying deleveraging pressures of foreign owned subsidiaries. B. Banking Supervision 35. The quality of banking supervision has improved significantly since the last FSAP. The BoA has incorporated many guidelines from the Basel Accords by establishing corporate governance criteria, bank management standards, internal audit function and tighter prudential norms for more risky operations. The legal protection available to supervisors has been enhanced as well, but further improvements regarding indemnification from the costs of litigation are necessary. 36. However, it is essential to address remaining weaknesses to underpin the necessary improvement in the health of the banking sector. In particular, supervision continues to be predominantly compliance based and corrective measures imposed on banks are mostly derived from prudential standards rather than focused on addressing risk management weaknesses. Consolidated supervision should be enhanced in light of the establishment of the new investment funds as well. The developed road map on new capital adequacy regulation and guidelines for Pillar 1 and Pillar 2 of Basel II should be implemented together with new risk based supervisory policy. The BoA is also considering implementation of the liquidity component of Basel III, a move which the mission supports. A serious of measures aimed at resolution of NPLs and strengthening loan underwriting standards should be seriously expedited. Finally, to support effective move to the risk-based supervisory approach, BoA should consider expanding the banking supervision staff. C. Supervision of Insurance, Capital markets and Pension funds 37. In 2006, following the 2005 FSAP recommendation, the Albanian Financial Supervisory Authority (AFSA) was established to take over regulatory and supervisory functions from the Insurance Supervisory Authority, the Albanian Securities Commission and the Inspectorate of Supplementary Private Pensions’ Institutions. During the years of its operation, the AFSA institutional setup has proven to be ineffective owing to its lack of real independence, severely constrained financial resources, absence of representation in the law- making process and the acute shortage of qualified personnel. The effectiveness of the AFSA is impeded by a regulatory framework that does not comply with the international best practice standards. As a result, insurance supervision and regulation is only partially compliant with the International Association of Insurance Supervisors’ requirements for a modern and effective insurance supervisory authority and investment fund supervision is similarly constrained. 38. Major institutional reform will be needed to achieve AFSA’s financial and operational independence and turn it into an effective regulator of the local market. To do so, the package of laws must be amended, inter alia, to (i) abolish the requirements for the 17 AFSA to have its organizational structure approved by the Parliament (amendments to AFSA Law), and (ii) remove the AFSA from the government employee compensation and benefits structure (amendments to Law on Salaries of Independent Institutions and Civil Servant Law), so it has the ability to attract and retain sufficient experienced technical staff. The legal protection of AFSA’s board and staff must also be strengthened by giving them legal protection for the bona fide discharge of their governmental, regulatory and administrative functions and powers. In addition, new Insurance Law should be adopted allowing the AFSA to introduce a new risk based supervision approach, provide risk ratings and early warnings, as well as a suitably flexible on-site inspection mandate. 39. As a matter of immediate priority, the AFSA should take action to address the major problems faced by the MTPL insurance market. The AFSA should establish actuarially sound claims reserving practices in MTPL insurance to ensure a level playing field, adequate claims paying capacity and overall solvency of the market. The funding of the MTPL Compensation Fund should be immediately restored by requiring insurance companies to finance the outstanding liabilities. 40. To facilitate the further development of the insurance market, the government should consider several supportive measures. In particular, through: (i) waiving the VAT requirement for non-compulsory insurance products in line with EU directives; (ii) introducing liability insurance requirements for various professional services; and (iii) establishing a national compulsory earthquake insurance program, as per examples of similar programs in Turkey and Romania that complies with proper risk management requirements, so that full payment of insured claims can be guaranteed even after the worst of catastrophic events. D. Anti-Money Laundering and Combating the Financing of Terrorism 41. Albania has taken significant steps to enhance its anti-money laundering and combating the financing of terrorism (AML/CFT) framework and is encouraged to address remaining deficiencies. At the time of Albania’s last assessment in 2011, the AML/CFT framework had a number of 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 2013 the Parliament adopted a law on measures against terrorist financing, which will be reviewed by the International Cooperation Review Group (FATF). 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. 18 V. FINANCIAL SECTOR SAFETY NET, CRISIS PREPAREDNESS AND MANAGEMENT A. Emergency Liquidity Assistance 42. The BOA provides Emergency Liquidity Assistance (ELA) in lek and in foreign currency, but none has been granted under the current facility. ELA is available to solvent but temporarily illiquid banks for a maximum of 92-days and must be fully collateralized. Lek loans are priced at four percent above the BoA’s policy interest rate and foreign currency loans are set at four percent above market rates or the bank’s average cost of funds. 43. While the BoA has issued a credible regulation, the operational framework for the provision of ELA could be strengthened. BoA should increase its supervisory reach and intrusion on eligible banks by imposing restrictions on risky transactions and payments of dividends and staff bonuses. The list of eligible collateral could be revised to use banks’ loan portfolio as collateral, given all financial, legal and operational considerations are met. It is also suggested that the BoA considers the possibility of developing an internal guideline for ELA reporting, based on Albania’s unique circumstances. To fully test the staff preparedness and operational procedures the conduct of simulations for stressed scenarios would be another useful instrument for BoA. B. Bank Resolution Framework 44. The bank resolution framework is generally effective but can be improved. The BoA is the resolution authority and has comprehensive enforcement powers. In the event that enforcement measures fail to cure inherent problems, the BoA could appoint a Conservator, and, in extremis, revoke a bank’s license. However, the BoA is advised to be very judicious in using this tool because of the risk of triggering a run on a bank that is placed under Conservatorship. BoA should also have a list of possible Conservators ready for probable future assignments on short notice. While Albania has MOUs with most supervisory agencies for cross-border linkages, these should be supplemented with cooperative resolution strategies and agreements among home and host authorities. 45. Albania has a special bank resolution regime, which provides that BoA’s decision to revoke a bank’s license cannot be reversed by any court. This legal 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. The mission recommends that the BoA maintains a list of strong banks that can be approached—with utmost confidentiality—to determine if they were interested in taking over the insured deposits and some good assets of a failing bank. It is also recommended that BoA and ADIA conduct periodic bilateral bank resolution simulations. 46. Joining many jurisdictions, Albania underwent the first round of recovery and resolution planning process for systemic banks in 2013 which needs to be enhanced and formalized. It is recommended to issue new mandatory instruction for banks deemed 19 systemically important to adopt Recovery Plans and updated annually thereafter, upon which BoA should design resolution plans. C. Deposit Insurance framework 47. 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 and about 58 percent of all system deposits. ADIA is Compliant or Largely Compliant with 14 of the 18 Core Principles for Effective Deposit Insurance Systems (one Principle is not applicable) and has made impressive progress in improving its operations and building its organizational structure. The mandate of the deposit insurer as a paybox is appropriate for the development and size of the financial sector and the use of a flat rate deposit insurance premium of 0.5 percent of insured deposits as opposed to risk-based premia is prudent. 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. 48. There are a number of issues that need to be addressed to bring ADIA into full compliance with the Core Principles. ADIA should be provided greater autonomy in its operations in accordance with Core Principle 5 (Governance). ADIA should enhance information sharing arrangements with BOA and relevant regional deposit insurance agencies and should seek greater latitude for its investments so as to be better able to diversify its funding. Full legal protection including a provision for defense costs on an ex ante basis should be provided to all ADIA staff. 49. Admitting SCAs into the deposit insurance system was recommended in the 2005 FSAP. The BoA and ADIA have made significant progress on this recommendation with the 2012 amendment of ADIA's law, following which ADIA has developed procedures for admitting qualified SCAs to the deposit insurance scheme. However, the preliminary screening showed that some SCAs do not meet neither technical nor prudential requirements. Thus it is imperative that ADIA and BoA work together to address these issues so that non eligible SCAs either come into compliance, consolidate or close within an agreed period. It is also essential that government has planned will provide the initial capital of 50 million lek in 2014 as seed funding for SCA deposit insurance, so that the ADIA may establish a separate fund for the insurance of deposits in eligible SCAs approved for membership. D. Crisis Preparedness and Management 50. Crisis preparedness includes developing and testing agency-specific and national crisis contingency plans, engaging in crisis simulations, and establishing a framework for extraordinary actions. As was done by the BoA, other FSAG member agencies should also develop or update their own contingency plans, which should then be rolled up into a national contingency plan coordinated by the FSAG. All FSAG members should participate in conducting periodic crisis simulations, while assessing the skills, information, analysis, 20 procedures, and documents required achieving the objective of minimizing the disruption and costs to the public from a crisis situation. 51. Establishing, ex ante, a legal framework to enable extraordinary actions in a crisis together with clear communication strategy is critical. 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. The authorities may also want to consider creating a resolution fund, paid for by assessments on systemic banks, to help defray future bank resolution expenses. In parallel the BoA should obtain support letters from mother banks agreeing to provide liquidity and solvency support as necessary and should coordinate appropriate actions with home supervisors. On the communication front, the authorities should agree on a “one voice” strategy including, but not limited to, 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. 52. Because public resources are used in crisis situations, the MoF should take the lead in crisis management. Any solvency assistance from the government should carry strict conditions, including: (i) shareholders taking the first loss; (ii) management replacement; (iii) no distribution of dividends; (iv) executive compensation limits; and, (v) a business plan detailing the exit strategy. However since Albania’s banking sector is primarily dominated by subsidiaries of foreign banks, the authorities must be cautious in using such powers. The preferred solution should be that parent banks ensure adequate liquidity and capital and only if the parent cannot support the subsidiaries, these extraordinary powers should be used. In such cases, the authorities should “ring-fence” the assets and operations of the subsidiary to ensure that public support funds are not up-streamed to the benefit of the parent and detriment of Albania taxpayers. 53. The BoA is authorized to create a bridge bank, but this should be restricted to systemic banks. 4 This resolution tool is preferred to outright nationalization or recapitalization with taxpayer funds and doing it via a P&A can minimize litigation risks. That said, it is important to amend the Banking Law to limit the use of the bridge bank tool to resolving systemically important banks and the MoF must be prepared to own and operate bridge banks. VI. PUBLIC DEBT MANAGEMENT, PENSION AND ACCOUNTING ISSUES A. Public Debt Management 54. Albania's high public debt poses significant challenges going forward. Rollover risk could worsen because of large financing needs, which banks unable to cover. Domestic debt 4 A bridge bank is a temporary financial institution created by license revocation of the troubled systemic bank and executing a P&A transaction with the government, which will own and operate it until it can be privatized. 21 grew sharply recently, emanating largely from poor tax revenue performance, continued fiscal expenditure which has in turn yielded a large stock of unpaid bills and arrears. Market risks are mainly in the form of interest rate risk and rollover risk due to a large short-term debt (65 percent matures within 12 months). The pressure on foreign-owned banks may be magnified by the forthcoming Comprehensive Assessments of most European parent banks by the European Central Bank. The maturity profile of external debt is relatively even with the exception of the countries' debut €300 million Eurobond maturing in 2015. External debt is mainly exposed to euro and non-concessional external debt is now almost at par with concessional debt. 55. The relatively high capacity in public debt management has been undermined by public sector wide staff reductions now put in place as austerity measures. This has resulted in fifty percent staff cut for the GDPDM. The changes, announced in early November, would reverse the 2008 best practice establishment of separate front-, middle- and back-office functions. Another great challenge to debt management is its Treasury’s cash management framework, as there is a chronic lack of a clear system for commitments of expenditure, which can lead to cash rationing. In such an environment, minimum cash buffers for Treasury balances should be adopted in concert with a comprehensive robust program of budget control and commitments is necessary. 56. The primary market can be improved by increasing transmission of price signals. The heavy participation of the BoA and retail investors (that bid on a non-competitive basis) does not foster price discovery. The rollover of Treasury bills held by the BoA could be detached from the primary auctions, while a few banks could be designated as intermediaries following a competitive selection. In the medium-term, retail investors should withdraw entirely from placing direct bids. Bidding processes during primary auctions should be improved by eliminating the limit for number of bids that can be submitted by each bidder and allowing banks to effectively submit an entire demand schedule, which in turn could encourage other institutions to submit bids through the banks. 57. As there is almost no activity in the secondary market, market participants cannot use government securities to manage their liquidity position. Banks’ practice of holding government securities on a hold-to-maturity basis in the absence of a framework to value them on a daily basis should be addressed by preparation of a valuation model that would use the most recent primary market results as well as secondary market activity as it increases. Such a mark-to-model is complex, has clear limitations and should be regarded as a temporary measure. To further support the development of the secondary market, the GDPDM should modify its issuance program and focus on key maturities on the yield curve by increasing the frequency of 5 and 7-year bond issuing from quarterly to bi-monthly. B. Pension Reform 58. Albania is a young but rapidly aging country. Crucial decisions on pensions are required in the short, medium and long term. The current system relies almost exclusively on state provision (first pillar). Poor incentives and informal labor markets mean contributions are 22 vastly below required levels. Positive reforms such as increasing retirement ages have been offset by reduced contributions and increased generosity. First pillar reform is urgent (and is currently being considered by the government). Fiscal sustainability will be helped by linking retirement ages automatically to changing life expectancy. 59. A critical part of building and sustaining a long term vision for pensions is to develop government, political and external understanding and agreement. A well thought thorough time-bound plan can provide reassurance during the short term challenges. Creating a diversified system even by 2020 will require focused but achievable steps in the coming years. The strategic and technical issues must be substantially advanced before the next election in 2017, with final decisions soon after. 60. The Government should seize the opportunity to reap the benefits of the ‘science of delivery’. It should develop a deep understanding of the dynamics in the formal and informal labor market and pilot solutions so the ultimate design works in the Albania context. The newly constituted pension commission should set clear objectives for the new system through an outcomes based assessment. The lessons on creating scale, expertise, and member-focused governance, as well as on cutting distribution costs should be studied. Further investment strategies must balance modeling on maximizing long term returns with the need to build trust and confidence given low financial inclusion and the legacy of the 1990s pyramid scandal. And relevant lessons can be drawn now that the third pillar pensions are live (albeit still very small). 61. Creating the foundations for a robust and diversified pension system will enhance and build upon the EU accession process. A number of the recommendations pick up on themes in the latest European Union progress report and fit well with the European Union’s 2012 White Paper on Aging. The recommendations also address issues identified in the 2005 FSAP and in a range of expert reviews to the government. A central issue will be to meet international standards and ensure the independence and resourcing of the AFSA, passing planned changes to the 2009 Pension Act to meet all EU directives and develop the capacity to prepare for a future second pillar. Other key issues include fixing the current confusion over pension tax relief in the third pillar, developing joint annuities for the future to ensure better gender equality in pension outcomes and the progressive development of domestic investment opportunities, building on innovative IFC and MIGA projects in a range of sectors. C. Introduction of IFRS financial reporting 62. Overall, financial reporting legislation in Albania has improved recently and has a high degree of alignment with the EU acquis communautaire. However, further revisions to the legislation is required, of which the most critical are: (i) on the Law on Accounting and Financial Statements, the definition of PIEs required to apply IFRS needs further revision to limit these entities to those that are economically significant or represent the public interest; (ii) on the Law on Statutory Audits, adequate funding of the audit public oversight system, appropriate institutional arrangements, independence of board members and representation of financial sector regulators in the Public Oversight board would enable its proper functioning; 23 (iii) revising the requirements to have financial statements audited to fully align with the European Union acquis, as this would reduce the number of audits and ease the burden on smaller entities. 63. The BOA has sufficient powers and undertakes enforcement activities in the area of banks’ financial reporting and audit. It needs to continue its efforts to enhance the relationship between general purpose financial reporting and prudential reporting. This effort will need to be sustained through the implementation of FINREP 5 and COREP. 6 Currently banks prepare general purpose financial statements on the basis of IFRS (which they report to tax authorities and publish), and also according to the methodology of BoA for regulatory purposes. 64. The AFSA has sufficient power to enforce financial reporting and audit standards towards its regulated entities, but it lacks adequate capacity to discharge this duty effectively. The AFSA has been unable to retain staff with suitable qualifications in accounting and auditing who could efficiently monitor and enforce the application of standards by entities. This would require, inter alia, its regular review of financial statements, assessing the relationship with external auditors and taking action in case of non-compliance or, issuance of qualified audit reports or internal control issues identified by auditors in management letters. It would also entail their enforcement of transparency requirements for public interest entities and monitoring of public availability of full sets of audited financial statements and the function of audit committees required for public interest entities by the audit law. 65. While audited financial statements of banks are publicly available, this is not always the case with insurance companies and other public interest entities. Similarly to banks, insurance companies and other public interest entities should be required to make their financial statements and audit reports easily accessible by the public. Current insurance and securities legislation provisions requiring disclosure and application are in practice largely inadequate. The practical solution might be for the AFSA to issue a specific regulation to require those regulated entities that are PIEs to make their annual financial statements publicly available. 5 FINREP is a standardised EU-wide framework for reporting financial (accounting) data. It comprises templates for reporting the income statement and the balance sheet, as well as breakdowns of other data. 6 Once Basel II is adopted, Bank of Albania should build a database based on prudential and capital data for analysis and data aggregation. Unlike FINREP which is based on IFRS data, COREP is based on prudential and capital requirements data. 24 ANNEX 1. FINANCIAL SOUNDNESS INDICATORS, DECEMBER 2007 – SEPTEMBER 2013 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 I Capital-based (i) Regulatory capital as a percent of risk-weighted assets 17.1 17.2 16.2 15.4 15.6 15.9 15.7 15.9 16.2 16.8 17.0 17.8 (ii) Regulatory Tier 1 capital as a percent of risk-weighted assets 16.0 16.3 15.3 14.5 14.3 14.7 14.5 14.5 14.6 15.2 15.4 14.8 (iii) Capital as a percent of total assets Regulatory Tier 1 capital as a percent of total assets 5.8 6.7 8.7 8.6 8.1 8.3 8.0 7.9 7.9 8.2 7.9 7.7 Regulatory capital as a percent of total assets 6.2 7.0 9.2 9.1 8.8 9.0 8.6 8.6 8.8 9.0 8.8 9.2 Shareholders' equity as a percent of total assets 7.6 8.6 9.6 9.4 8.7 8.7 8.6 8.5 8.6 8.6 8.5 8.3 (iv) Nonperforming loans net of provisions as a percent of capital Nonperforming loans net of provisions as a percent of regulatory Tier 1 capital 12.0 27.2 29.9 38.1 56.6 58.8 60.5 64.9 61.8 62.8 62.5 54.7 Nonperforming loans net of provisions as a percent of regulatory capital 11.2 25.7 28.2 35.9 52.0 54.2 55.8 59.5 55.6 57.0 56.4 45.4 Nonperforming loans net of provisions as a percent of shareholders' equity 9.1 21.1 27.1 34.8 52.6 56.0 56.3 60.8 56.9 59.4 58.4 50.7 (v) Return on equity (ROE) (annual basis) 20.7 11.4 4.6 7.6 0.8 8.0 4.8 4.2 3.8 5.2 2.9 (1.7) (vi) Net open position in foreign exchange as a percent of capital Net open position in foreign exchange as a percent of regulatory Tier 1 capital 1.8 4.5 4.1 5.3 4.3 4.3 6.5 4.5 4.1 4.0 4.5 5.2 Net open position in foreign exchange as a percent of regulatory capital 1.7 4.3 3.9 5.0 3.9 4.0 6.0 4.1 3.7 3.6 4.0 4.3 Net open position in foreign exchange as a percent of shareholders' equity 1.4 3.5 3.7 4.9 4.0 4.1 6.1 4.2 3.8 3.8 4.2 5.2 II Asset-based (vii) Liquid assets as a percent of total assets (Liquid-asset ratio) 1/ 49.8 42.8 27.6 25.9 26.5 29.0 35.9 29.0 29.4 29.1 27.4 29.2 (viii) Liquid assets as a percent of short-term liabilities 1/ 55.6 104.7 32.6 30.6 33.1 36.1 36.0 35.8 34.9 34.9 33.8 36.5 (ix) Return on assets (ROA) (net income to average total assets) (annual basis) 1.6 0.9 0.4 0.7 0.1 0.7 0.4 0.4 0.3 0.4 0.3 (0.1) (x) Nonperforming loans (gross) as a percent of total loans 3.4 6.6 10.5 14.0 18.8 20.1 21.1 22.7 22.5 23.7 24.2 24.2 III Income and expense-based (xii) Interest margin to gross income 92.7 106.5 119.6 118.9 147.7 119.7 129.5 130.6 130.4 123.6 131.2 148.3 (xiii) Noninterest expenses to gross income /2 58.5 69.6 83.0 75.5 91.3 71.7 80.4 82.2 85.0 78.7 87.5 98.3 IV Memorandum items Other (noncore) indicators: Customer deposits as a percent of total (non-interbank) loans 215.5 162.6 154.3 166.4 163.2 164.0 168.1 172.3 171.6 171.9 173.9 180.9 Foreign currency-denominated loans to total loans 72.5 72.6 70.2 69.8 67.9 68.2 67.1 66.5 64.5 64.8 64.5 63.7 Foreign currency-denominated liabilities as a percent of total liabilities 46.9 48.5 48.9 51.0 51.9 52.1 52.3 53.7 52.6 52.4 51.8 52.9 Other indicators: Risk weighted assets as a percent of total assets 36.4 40.8 56.7 59.2 56.5 56.3 55.2 54.5 54.2 53.7 51.7 52.0 Total loans as a percent of total assets 39.4 47.6 50.8 49.6 50.5 50.2 49.4 48.5 48.6 48.6 48.1 46.0 Total loans as a percent of shareholders' equity 516.4 555.1 530.2 527.0 581.9 578.8 575.5 573.6 567.4 562.4 566.7 555.0 Source: Data provided by Bank of Albania. 1/ Definition of liquid assets and short term liabilities were changed in October 2009. 2/ Noninterest expenses defined as expenses other than those from core banking activity. 25 ANNEX 2. KEY RECOMMENDATIONS OF 2005 FSAP Area/Issue Recommendations Time Frame Status/Comments Strengthen • Establish a separate Monetary Policy Short-term Under current legislation the only body that can decide on monetary policy is the Supervisory Monetary Policy Committee, in which only monetary policy Council; and it cannot delegate this responsibility. In 2006 the BoA established The Committee Management at discussions and decisions would be taken. for Implementation of Monetary Policy responsible for decisions on bank’s operations in the BoA monetary and foreign exchange markets. Additionally, this committee provides recommendations to the SC in an advisory capacity. • Facilitate communication with the public The Foreign Relations, European Integration and Communication Department has an integrated by creating a specialized unit responsible specialized unit to design and implement the BoA’s overall communication strategy. In for designing and implementing a monetary Short-term cooperation with the Monetary Policy Department, a strategy for communicating monetary policy communication strategy and policy has been designed and made public. The implementation of this strategy is ongoing and it establishing regular meetings with market is mostly focused on improving the monetary policy reports; improving inflation forecasting participants. models with the eventual aim of publication; strengthening communication and cooperation with stakeholders; and training media and students on monetary policy issues. • Remove potential doubts about BoA Short-term The BoA has publicly disclosed all the rules and procedures of BoA role as a fiscal agent in independence by disclosing the terms of the government debt issuance. Further, BoA applies a standard commission for intermediating agreement between the BoA and MoF for government securities in the primary market, which is comparable with those applied by the BoA’s role as fiscal agent in commercial banks. government debt issuances and the costs incurred thereby; and moving to eventually end the option of monetizing government debt as cash management in the MoF improves. • Establishing explicit internal control and Short-term The relevant regulations now incorporate these recommendations and are publicly available. oversight mechanisms; strengthen code of conduct standards for BoA board members; and disclose the rules and procedures behind the foreign exchange market operations in the domestic market, including selection criteria for counterparts. Improve • Articulate clearly the objectives of, and the Short-term According to the Debt Management Performance Assessment (DEMPA ) (June 2011), of more Institutional strategy and the decision-making process than 50 countries assessed by the World Bank, Albania is one of the few which has sound debt Capacity for for, public debt management. management practices across a large number of areas. Public Debt Management The medium-term debt management strategy is based on debt management objectives, covers interest rate, refinancing and foreign currency risks, includes a description of measures aimed at supporting domestic debt market development, and has realistic target levels for indicators of 26 Area/Issue Recommendations Time Frame Status/Comments interest rate, refinancing and foreign currency risks. The strategy is prepared by the principal debt management entity, the views of BoA on the proposal are obtained, and the proposal is approved by the Council of Ministers. The strategy is updated annually and is publicly available. Areas for improvements are external borrowing (by moving to a more systematic planning and assessment of potential borrowings and creditors) and some parts of the operational risk management framework. The latest Eurobond issue highlighted that the decision-making process for external market borrowing is rather cumbersome. Additionally, there is no systematic tracking of foreign holding of the government securities issued in the domestic market. • Revise the organizational structure of the The General Directorate of Public Debt Management at MoF (GDPDM) has in place a debt management department at the MoF in Long-term separation of responsibilities between key debt management functions. In 2008, the GDPDM order to ensure a segregation of was set up as a designated unit in the MoF to take the lead in all borrowing activities, promote responsibilities, and address existing development of the domestic debt market, and prepare a medium-term debt management operational risks via appropriate staffing, strategy with annual updates on a rolling basis. It is organized in accordance with sound training and systems development policies. principles by having separate front- middle- and back-office functions with appropriate staffing. However this may be threatened in the near term due to planned downsizing and/or reorganization. • Ensure implementation of the cost recovery Medium-term Around 22,000 retail investors have invested directly in T-bills and hold Lek 69 billion principle in governing the MoF’s agency (14 percent of domestic debt). Following an advertising campaign and distribution through post agreement with the BoA. Continue the offices retail investments grew further. This share continues to be a stable portion of the investor retail public debt auction window at the base but is concentrated in T-bills. The BoA operates the retail public debt auction window but BoA albeit with recovery of handling costs not under a cost recovery principle. reflecting costs to the BoA, declining as efficiency improves. • Defer decision on primary dealership until Long-term The decision on establishing a primary dealership scheme has been deferred and is not part of the public debt holding is more diversified the Government’s debt market development agenda. and an active inter-bank market develops. Strengthen • Undertake review of bank exit/receivership Short-term The Law on Banks (Chapter VII) establishes the power of BoA to place a bank in Financial provisions, contingency planning conservatorship or liquidation. The law provides for the appointment of a conservator in Markets arrangements, using “emergency bank appropriate circumstances. In 2010 BoA adopted an operating manual containing processes and (Banking and failure scenarios” to ensure that BoA is able procedures that would be employed in the resolution of a bank. The Federal Deposit Insurance Non-Banking) to move fast in an emergency in dealing Corporation (FDIC) assisted in the development of the manual, which can be used under both Supervision with such eventualities. conservatorship and liquidation scenarios. Recently, some amendments to the Law on Banks were adopted to grant the BoA more powers to administer systemic risk situations. The amendments enable BoA to provide remedies for the 27 Area/Issue Recommendations Time Frame Status/Comments resolution of a problem bank more effectively, and include the power to pursue a purchase and assumption strategy to facilitate the takeover of the weaker bank by a stronger institution, establish a bridge bank to remove problem assets from a weak institution, and convert foreign bank branches to subsidiaries to preserve liquidity in the banking system. • Encourage or require banks to discuss Short-term The regulation addressing consumer protection was strengthened to clarify the terms and exchange rate risk explicitly with conditions under which a client is entering a contract with a bank for a loan or deposit. The borrowers; before contracts are signed. regulation requires banks to provide certain types of information on the borrowing relationship (e.g. a bank must: provide a warning to clients advising of the dangers in borrowing in foreign currency; and advise the borrower of the effective interest rate of a loan). • Discuss with banks means of assessing BoA’s regulation governing credit risk administration now addresses unhedged foreign currency Short-term likely foreign exchange hedging by credit exposure held by banks. BoA established a limit for banks by prohibiting a bank from borrowers and consider whether or how having such an exposure in aggregate exceeding 400 percent of its regulatory capital. Exposures loan classification and provisioning exceeding the limit are deducted from regulatory capital. Moreover, the risk weight for these requirements might need to be adjusted for exposures was set at 150 percent. unhedged FX risk and other growing risks. • Mandate bank collection of necessary Completed. Banks are now required to collect such data and ADIA has recently undertaken a electronic information regarding names and verification exercise to identify depositor accounts with the banks that are missing necessary addresses of depositors to assist the Deposit Short-term information. Insurance Agency in maintaining current files. • In order to retain the quality of banking The BoA has aimed at maintaining competitiveness in recruiting new staff. Accordingly a new supervision within BoA, maintain salaries Medium-term salary system comparable and competitive to that of the private sector was adopted in 2009. more in line with private sector alternatives, However, the salary scale has not staunched the rate of turnover. Economic conditions are a and resist recent pressure to move salaries larger driver of lower turnover, as other market opportunities remain limited. The concern of BoA employees toward the general civil remains that remuneration policies inhibit BoA’s ability to attract individuals with the skills or service pay scale. experience needed. • Amend the law to extend legal protection to The Law on Banks provides legal protection for the Supervisory Council and all employees all supervisory and inspection staff, in against liability for performing their duties in good faith, either from acts of commission or Medium-term omission. BoA also indemnifies its employees in the event of legal action from damages, but addition to the higher administrative levels that are currently covered by the law. only in the event an employee who is a defendant wins the court case. • Include senior qualified and experienced The Albanian Financial Supervisory Authority (AFSA) has been severely hampered in its ability Short-term finance professionals (preferably with to retain competent senior level insurance professionals to the organization due to the legal insurance sector background) in the constraints. leadership of ISA both at the supervisory board level and management to provide 28 Area/Issue Recommendations Time Frame Status/Comments effective leadership and enhance market credibility. • In order to attract and retain high quality The AFSA ability to effectively supervise an increasingly complex sector has been weakened by insurance professionals both at the Short-term its inability to retain staff due to restrictions on remuneration. AFSA has been losing management and staff level, ensure their professional staff due the restrictions on remuneration levels. With the recent market growth and remuneration is closer to the private sector increasing presence of foreign insurance companies, this is harming the quality of supervision. by removing them from the civil service The World Bank recommended that the AFSA, in consultation with the Government and the pay scale if necessary. Parliament, should explore all options for retaining highly qualified staff so that the organization can properly exercise its role. • Issue insurance sector prudential Although over the last few years the AFSA has been receiving assistance from the World Bank regulations in line with international Short-term and FIRST little progress has been made towards improving the quality of insurance supervision. standards and best practices; and enhance the knowledge and technical skills of the ISA staff with the help of specific insurance focused courses, training, and technical assistance. • Begin integration of all non-banking Medium-term The integration of non-bank regulatory entities into the AFSA is complete, but not fully regulation and supervision entities (ISA, effective. ASC and OIISP) at the earliest opportunity into an integrated non-banking regulator in the first stage, and then re-examine the feasibility of integrating with the banking supervision function as a single institution at a later stage. Improve • Continue important reforms like gradual Short-term The Urban and Rural schemes remain substantially different, although the level of the rural Finances of the unification of the rural and urban self- pension has been moved closer to the urban pension. This has exacerbated fiscal pressures Public Pension employed schemes and increases in the because most eligible workers do not contribute and contribution coverage is particularly low in System retirement age. the rural scheme. The increase in the pension age from 55 to 60 for women and 60 to 65 for men was completed in 2012, but other changes have offset the effect (e.g. over-indexation of pension benefits, leading to a growing deficit). • Recover or write off Social Insurance Institute (SII) dues from government/non- government entities, and replenish the SII’s Medium-term Partly implemented. Reserve Fund as a policy priority. • Proceed cautiously on introduction of A new system of voluntary private pensions (3rd pillar) was introduced with the passage of private pensions. Analyze key strategic Long-term legislation in 2009. Three providers have been licensed by the AFSA. The system is still questions (e.g. take-up potential, cost extremely small – with under 8,000 members and US$3.4m in total assets. The system of tax 29 Area/Issue Recommendations Time Frame Status/Comments efficiency, safeguards, fiscal implications, incentives is not working as envisaged in the pension law because of a different approach in impact on the financial system) before recent tax legislation. The legislation has been reviewed for compliance with the relevant EU finalizing the legal and regulatory directives (and international standards) and updated legislation incorporating recommended framework. changes is currently out for consultation with the pension industry. • Begin gradual preparation for the eventual There is no current work on developing a second pillar in Government. A Technical Note on creation of a second mandatory pillar only options and a reform process is part of the 2013 FSAP. An attempt was made in 2006 to develop after the first pillar is sustainable and Long-term a reform pathway but it did not lead to concrete action. The sustainability of the first pillar assessment of fiscal costs executed. (state) pension system remains to be achieved. The 2013 FSAP recognizes the vital importance of taking decision on the first pillar. The 2013 FSAP will set out steps that should be taken on developing pre-conditions and options for the second pillar to ensure that the creation of a diversified pension system with public and private components is not unduly delayed – learning from lessons in countries such as Kosovo which have introduced successful multi-pillar reforms in similarly challenging circumstances. Encourage • Instead of the more ambitious goal of Short-term Following the 2005 FSAP, the BoA requested further assistance to conduct an assessment of Growth and immediately transforming Mountain Area the current legal, regulatory, and supervisory framework for microfinance, and an assessment Development of Finance Fund (MAFF) into a rural of MFIs, including the Savings and Credit Associations (SCAs) and their CUs, to identify Credit Unions cooperative bank, initiate the future development priorities. transformation of MAFF into a member- owned rural savings and credit association Decision No. 904 (September 2008) of the Council of Ministers adopted the strategy to duly licensed and supervised by the BoA transform MAFF into the joint stock company. In 2009 BOA revoked the license of MAFF and authorized to collect savings as a first since its activity was transferred to First Development Finance Company – FAF S.A. step. • Encourage the various unions, the SCA Union, Jehona, the transformed MAFF and The World Bank prepared a report on Microfinance Institutions and Credit Unions in Albania - Long-term any new SCAs, as part of an organic, Regulatory, Supervisory and Market Development Issues, in June 2008. The report provided a bottom up development of the sector to set of recommendations on the legal and supervisory aspects. Several of the recommendations explore the possibility of pooling their of this report were addressed and microfinance institutions have developed, including MAFF resources into a larger consolidated merged as explained above, and the SCA Union is in the process of collaboration with one of the banks cooperative union in order to achieve a to transfer in the bank all its financial transactions. There is no initiative for a larger critical mass in mobilizing future resources consolidated merged cooperative union. and providing a wider range of financial products and services to their members. • Harmonize regulations governing the ADIA and BoA are in the process of developing a plan for the integration of the SCAs into the various credit unions and introduce deposit Medium to DIS. ADIA’s law was amended in 2012 to allow for such integration but the government insurance for savings deposits held by Long-term contribution to begin a separate fund administered by ADIA as set forth in the amended law credit unions on behalf of their members. has not been made. 30 Area/Issue Recommendations Time Frame Status/Comments Improve • Ensure effective implementation of proper Medium-term Overall, financial reporting legislation in Albania has improved and has a high degree of Quality, Breadth accounting standards in order to improve alignment with the EU acquis communautaire. The legislation contains differentiated financial and Depth of transparency and disclosure of enterprise reporting requirements, including requirements to apply International Financial reporting Financial financial information. Standards (IFRS) for Public Interest Entities (PIEs), and National Accounting Standards (NAS) Intermediation for other entities. • Improve judicial procedures for collateral Changes in the Civil Procedural Code (CPC) were approved by Parliament in April 2013 and are enforcement, by streamlining performance Medium-term targeted to: (a) reduce the scope for suspension of collateral execution (art. 206, 202-203, and of court bailiffs and auction procedures. 517); (b) modernize the real estate appraisal and auction procedures (art. 577);(c) remove the right to long-term suspension when the executive title is featured in a bank’s loan contract (art. 609); (d) the exclusion of the suspension procedure in case of actions against court appointed bailiffs (art. 611); (e) curbed court discretion to suspend execution procedure (art. 615); and (f) limit the abrogation of suspension of execution (art. 616). This crucial set of CPC changes became effective on October 1, 2013 and going forward are widely expected to positively impact the collateral execution process for creditors. • Facilitate the creation of a well-functioning Short-term credit bureau under the leadership of BoA Completed as a priority and obtain TA from multilateral agencies if necessary for this purpose. • Facilitate development of leasing, by Laws adopted. The IFC has been providing assistance in these aspects. adopting the law on leasing; and of Short-term factoring, by introducing legal provisions which would recognize invoices as legally enforceable debt obligations. • Offer the ASE to the private financial sector for a nominal amount to own and run Not implemented. Albanian Stock Exchange still exists, though it is practically dysfunctional. Short-term it, failing that, close down the idle ASE to avoid additional budgetary expenses. In progress. Still a problematic issue and a big reform agenda lie ahead. The World Bank • Improve land registration and titling Medium-term supports country authorities with the Land Administration and Management Project which began systems in order to eliminate widespread in 2007 and will end in June, 2014. The project supports the completion of the systematic land ownership ambiguities, thus registration of 400,000 properties in 140 priority urban cadastral zones, and the development of strengthening value of land as collateral. the centralized IT system to manage property registration information. The IT system has been rolled out to 5 large offices and another 5 offices are planned prior to the end of the project. In the future the government should develop a plan to complete the IT system roll out to all 35 offices, the completion of First Registration in the remaining zones (approximately 100 cadastral zones) and data quality improvement of the paper based registration data for approximately 2,000 zones (over 2 million properties) that need to be digitized and uploaded into the new IT system. 31 Area/Issue Recommendations Time Frame Status/Comments Improve the • Based on current draft, revise the AML law Short-term Completed AML/CFT to bring it into line with the FATF Enforcement Recommendations 2003. Framework • Increase the capacity of the financial Medium-term intelligence unit (FIU) with increased Staff has been increased, data management has been improved and the reporting of suspicious staffing, training, and electronic transactions has become more focused. The analytical function of the FIU has been strengthened, recording/data management; and narrow but staffing for on-site and off-site inspections remains inadequate. the focus of reporting suspicious transactions in consultation with the banks to permit better utilization of existing resources. • Take steps to achieve effective Further progress is required to strengthen AML/CFT supervision of the insurance and securities Medium-term implementation of appropriate AML/CFT sectors and tackle more effectively the illicit cross-border transportation of currency measures in insurance sectors, and for designated nonfinancial businesses and professions, in accordance with international standards. 32