Running Head: NPL IN THE ALBANIAN BANKING SYSTEM

Running Head: NPL IN THE ALBANIAN BANKING SYSTEM

NON-PERFORMING LOANSINTHE ALBANIAN BANKING SYSTEM

Armela Hasmuca EPOKA University

ABSTRACTThis journal aim to give a clear picture of causes and potential actions in cognation to levels of NPL in the Albanian Banking system and to show some possible opportunities the banks could have in order to decrement the authentic elevate of non-performing loans. In this journal, certain variables such as economic conditions, interest rate, inflation rate, regime intervention, and GDP were utilized, in order to expound the relationship that subsist between those factors with NPLs.It amasses the condensed ken-how of the frontline departments dealing with the NPL in an endeavor to analyze and apportion these opinions for the utilization of all bankers and other parties that are intrigued to ken more about the recent sharp increases in NPL.For the fulfillment of the journal, different Banks documents were investigated for accumulating data. The conceptions, which are presented in this paper, have resulted from a qualitative research and through the reading of research literature.

Keywords: NPL, Albanian Banking system, collateral policy, interest rate, loan monitoring, property inflation, unemployment, strategy, economic courses.

INTRODUCTIONThese last 10 years were characterized by a boom in lending activity fueled by a growing economy and paramount increase in the caliber of banking intermediation.But, the issue of non-performing loans (NPLs) has gained incrementing attentions in the last few decades. In recent years banks were faced with an extraordinariness increase in the Non Performing Loans (NPL) by the contribution of the economic crisis but withal accentuated by other internal and external factors. The efficacious factors in incrementing of NPLs are divided into two sections:1- Internal factors: these factors are caused by internal functions and activities of bank, and are due to decisions and practices of officials and staffs functions. These factors are controllable and manager can obviates them by utilizing congruous method, resoluteness of impuissance and elimination them and amendment of process.2- External factors: these factors can be controlled by bank scarcely and are caused by external environment and its effect on implementation of decisions and additionally regime policies. Unexpected events, transmuting in rules and obligations, political and economic changes (inflation and slump) are external factors.My study is focused in identification of efficacious factors in engendering NPLs and most paramount of it is, finding ways to avert NPLs, suggestions provided to instauration NPLs.We are cognizant that the immediate effect of large amount of NPLs in the banking sector means bank failure. A nonperforming loan in the financial sector is viewed as an facade mirror image of an poorly unprofitable enterprise. From this perspective, we could say that the purge of non-performing loans is an mandatory condition to amend the economic position. If the nonperforming loans are kept subsisting and continually rolled over, the resources are caged in unprofitable sectors; thus, obstructing the economic magnification and impairing the economic effectiveness.Thought this journal I want to raise paramount questions about the quality of credit portfolios in the Banking system, its root causes and remedial actions. Transcending mere analysis of data and builds on the experience and knowhow developed by the banks in these recent years of dealing with the NPL quandary.We will optically discern that the caliber of cognizance of the banks in cognation to the causes has incremented significantly with the last years. It is pellucid that banks are taking or are disposed to take consequential transmutations in the way the lending activity is conducted in order to adjust for material external events such as the crisis but withal for other quandaries present in the environment such as: lack of reliable financial information, clients poor business orchestrating and execution, inefficient collateral amassment processes etc.I hope that the study of this journal will provide insight into the recent phenomenon of incrementation in NPLs in the Albanian Banking system as well as share conceptions on taking preventive or corrective action in regard.This dissertation was conducted with the support of the Credit Risk Department of BKT Bank that facilitated the distribution and gathering of questionnaires.NPL IN THE ALBANIAN BANKING SYSTEM

NPL IN THE ALBANIAN BANKING SYSTEM 2

NPL IN THE ALBANIAN BANKING SYSTEM 1

Certain statistical data mentioned in continuing are obtained from the reports and bulletins of Bank of Albania, Albania Association of Banks and Sweedbank.

Current Size and Concentration Of The NPL In The Albanian Banking System1. What does Non-performing Loan mean?A simple definition of non-performing is: A loan that is not earning income and: (1) full payment of principal and interest is no longer anticipated, (2) principal or interest is 90 days or more delinquent, or (3) the maturity date has passed and payment in full has not been made.NPLs according to Basel: Any loan that is past due for more than 90 days, but subject to national variation.NPLs according to Central Bank of Albania: Any loan classified in the last three 1.2 According to BIS[footnoteRef:2], the standard loan classifications are defined as follows: [2: The details of the loan classifications are collected from various BIS documents.]

2. Passed: Solvent loans;3. Special Mention: Loans to enterprises which may pose some accumulation difficulties, for instance, because of perpetuating business losses;4. Substandard: Loans whose interest or principal payments are longer than three months in arrears and lending conditions are facilitated. The banks make 10% provision for the unsecured portion of the loans relegated as substandard;

5. Doubtful: Full liquidation of outstanding debts appears dubious and the accounts suggest that there will be a loss, the exact amount of which cannot be tenacious as yet. Banks make 50% provision for doubtful loans;6. Virtual Loss and Loss (Unrecoverable): Outstanding debts are regarded as not collectable, customarily loans to firms which applied for licit resolution and aegis under bankruptcy laws. Banks make 100% provision for loss loans 2. The Albanian Banking Sector In 2012In last recent years, banks have been working in a difficult atmosphere, characterized by high uncertainties, sluggish domestic demand and changing domestic and internationally regulatory agenda. The economic situation in European countries continued to be weak during 2012, while the policymakers and the regulatory bodies at an international level enforced continuous regulatory changes and measures on the banking industry aiming at preserving the financial stability. Albeit the Albanian banking system has had a very low exposure toward problematic regime securities, the European originated banks were influenced by the imposed rules of their parent banks and conservative approach toward lending, which conditioned the banking activity of their subsidiaries not only in the Albania, but withal in the region. The quality of the subsisting loan portfolio further deteriorated, while the households inclination towards preserving enabled a good performance of deposits. Overall, banks were remuneratively lucrative, with vigorous liquidity and well capitalized during 2012. The structure of the banking sector in Albania remained unchanged in 2012, with 16 banks thoroughly privately owned, while the remaining peregrine bank branches were converted into subsidiaries.In 2012, the Albanian banking system grew by6 per cent and its total assets reached 88 per cent of GDP.Its loan book grew by 2 per cent only, while the non-performing loans reached 22.7 %. We can verbalize that Albania now has one of the worst NPL ratios in Europe. This translates into impotent earnings, and the return on equity of the system in 2012 was merely 3.8 per cent[footnoteRef:3]. [3: Based on: Bank Of Albania.(2013). Statistical Report 2013.Tirane: Bank of Albania, pp 50.]

Two major issues cognate with the lamentable loans are collateral execution and impairment methodology. I am jubilant to report progress as of the inditement regarding the former: Amendments and Integrations to the Civil Procedures Code have been approved by the Parliament and will be in force from September 2013. They will make the execution of collateral more efficient. A third issue with regards to deplorable loans is the indite-off procedures as practiced by the fiscal ascendancy.3. The expanding credit activity and the recent deterioration in qualityThe lending activity optically discerned its consequential increase in Albania in the last 10 years going from 7.3% of the GDP to about 40%. This represents a nominal magnification of over 10 times. Such magnification was facilitated by the incrementation in credit demand in years of GDP magnification and the constant increase in the caliber of banking intermediation.Figure 1: Total loan portfolios and assets (in billions of Lek) from year 2003 to 2012[footnoteRef:4] [4: Based on: Deloitte.(2013). Albanian Non performing Loan Report, Seeing beyond the waves.Tirane: Deloitte pp.8.]

Loans and advances to clients represent now about 50% of the total banking assets in Albania (14% in 2003) and their quality is crucial to the banking system.The quality of the imprest portfolios in the Albanian Banking System was typically high until 2007. Levels of NPL commenced to visually perceive an incrementation from year 2008. As such, the caliber of NPL went from 3.3% at the cessation of 2007 to 18.9% at the terminus of 2011 in a virtually steady magnification pattern.

Figure 2: Level of NPL (%) from 2007 to 2012[footnoteRef:5] [5: Based on:Bank Of Albania.(2013). Statistical Report 2013.Tirane: Bank of Albania, pp 20-25.]

At the terminus of the third quarter of year 2012, the Bank of Albania published in its statistical report a caliber of NPL of 22.7%. Loan loss reserves have incremented sharply in recent years additionally, going to 13.1% of total loan portfolios as at the cessation of the third quarter of 2012 to 8.07% as at the cessation of 2007.4. An overview of the current banking business situationMore than a moiety of the banks believe that the caliber of NPL in the Albanian Banking System is higher than what reported. This might denote a prospect that NPL level is not going to decrement organically in the short term.The NPL seems to have affected more business loans. As such, about 79% of the banks reported their NPL portfolio to be concentrated in business and corporate loans rather than in consumer or individuals loans. It should be mentioned that business loans comprise withal more than 70% of the total lending activity in Albania.

Figure 3: Concentration of NPLI want to accentuate that more sizable voluminous loans are withal most exposed to performance quandaries. This is consistent with above finding of concentration of non-performance in business loans. As a result, banks reported their NPL portfolio to be more present in loans disbursed at amounts of over Euro 200 thousand.Figure 4: Distribution of NPL over industries[footnoteRef:6] [6: Based on: Bank Of Albania.(2013). Statistical Report 2013.Tirane: Bank of Albania.]

It is withal mentioned that, from the group of business loans disbursed, the industry pinpointed as the most problematic (93% concurred to it) is the Construction Industry. Definitely the Construction Industry, as reported by several reports, was affected considerably by the economic downturn of the last years and is currently experiencing a period with quandaries in sales and liquidity, thus affecting directly repayment capacity.Key Causes to the Incrementation in NPL in Albania1. The main factors and causes that have influence NPL magnification.The astronomical majority of the banks attributed the incrementation of NPL levels to the external causes. Certainly, the credit risk models on which the portfolios were developed did not prognosticate the stringency and longevity of the economic crisis. As such, about 86% referred concretely to the effect in the economy of the economic crisis as the main external cause[footnoteRef:7]. [7: Bank Of Albania. (2013). Statistical Report 2013.Tirane: Bank of Albania.]

External Causes

Figure 5: Internal vs. External causes

1. Economic ConditionThe effect of the economic crisis is the predominant external factor. Other paramount secondary factors are over borrowing from certain industries (i.e. Construction) and poor financial orchestrating and reporting from clients. To be more detailed, I want to mention some of economic factors with a consequential impact in banking industry, which had affected the NPL magnification in indirect way. 2. Interest RateInterest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds (Sullivan Arthur, 2003)[footnoteRef:8]. The longer it takes to make arrangement, the higher it will be for the interest rate. In the case of BKT the product which gave them the highest profit is their financing product. It consists of personal financing, housing financing, car financing, and a few more financing. [8: Cited by: Arthur, S. (2003). In S. M. (2003), Economics: Principles in action (p. 261). Upper Saddle River, New Jersey: Pearson Prentice Hall.]

At a time when interest rate is at its lowest, demand for financing is high by customers. This shows negative connection among interest rate and authoritatively mandate for loan, while when interest rate is high, demand for financing is low. People opt to preserve their funds in higher interest rates, and only apply for financing when the rate is decrementing. By doing so, the amount that needed to pay for bank as a result for making a loan is marginally lower, contrast to when the moment when interest rate is high.By referring to data of BOA interest rate and BKT financial verbalization, we can visually perceive the positive relationship between interest rate and NPLs. When the interest rate is low, net NPLs is withal low. And when interest rate is high, the amount of NPLs will additionally increase. According to all models, NPLs are very sedulously assiduous, which would suggest that the replication of credit losses to the macroeconomic cycle could take time to materialize, albeit it would withal implicatively insinuate that NPL would then cumulate to high calibers. For instance, Fuentes and Maquieira (2003) found, visually examining Chilean banks, that interest rates had a more preponderant effect on NPLs than the business cycle. Other macroeconomic variables, in particular the exchange rate, unemployment, and asset and house prices can withal be paramount.As we have visually perceived, BOA recently has decremented the norm of interest rate at 3.5%, the lowest in history, in order to increment the aggregate demand.BOA expects that this mitigation of monetary policy will engender room for rapid rectification with a lower cost for public finances.3. UnemploymentThe labour supply of the population has two components: unemployed persons and employed persons. The labour authoritative ordinance of enterprises and other engenderment units, additionally, can be broken down in two components: jobs (filled posts) and job vacancies (unfilled posts). Due to the existence of multiple jobholding, the number of jobs tends to belarger than the number of employed persons (Ralf Hussmanns)[footnoteRef:9]. Unemployment occurs when people are without jobs and they have actively probed for work within the past four weeks (International Labor Organization, 2007). [9: Based on: Ralf Hussmanns (1991), Surveys of Economically Active Population, Employment, Unemployment and Underemployment (pp.152).International Labour Office, January 1991]

I want to mention that during unemployment, debtors are incapable to repay it as a consequence of losing their jobs. Their incomes are reduced sharply without salary. So, they are not able to pay their imprest obligations. Now we can accentuate the effect, when unemployment rate is high, the NPLs raise as well. As a consequence of the recession, increasing unemployment is pushing levels of NPLs even higher.

4. Inflation RateKevin L. Kliesen and Frank A. Schmid (2004) mentioned the surprised in monetary policy actions bears on both measures of inflation prospects. Monetary policy actions bear on both measures of inflation prospects. Monetary policy actions that are viewed as tighter than expected by the market lead the economic agents to revise down the expected rate of inflation[footnoteRef:10]. Further, one measure designate that federal reserved communication reduces skepticality about the future rate of inflation, while surprises in monetary policy actions increase about the path the rate of inflation is going to take. Schwartzman (1992), he verbalized that, the elevate of Inflation that mundanely occurs as the economy grows betokens that the price of goods and accommodations raise. The incrementation in inflation ultimately forces interest rates upwards. It signifies that inflation rates is only profound the impact on the interest rate and not other factors. In Cooley and Hansen (1989) studies, shot that the caliber of output perpetually falls as the inflation rate increases. Figure 7: Internal vs External causes that have contributed in the increase of NPL[footnoteRef:11] [10: Kevin L. K. and Frank A. S. (2004), Monetary Policy Actions, and Inflation ExpectationsFederal Reserve Bank of St. Louis Review, May/June 2004, 86(3), pp. 9-21] [11: Based on: Bank Of Albania.(2013). Statistical Report 2013.Tirane: Bank of Albania.]

Among the internal causes, one can be pellucidly distinguished from the rest. Looking back at the expeditious credit magnification over the last years and the more recent increase in NPL, banks believe they could have been less truculent with their magnification targets.

Figure 8: Important internal causes that have contributed in the increase of NPL

Given poor financial reporting and orchestrating from clients (additionally identified as an external cause) banks are often put in a position of making decisions with low quality of data. This in turn results in poor evaluation of business potential, or of the financial situation at the time of approbation and other factors that are identified as secondary internal causes by the banks. Other causes Client and/or Loan officer fraud In pre-approval phase poor evaluation of financial situation Inappropriate loan product terms with client requirements Poor loan monitoring Poor evaluation of business prospective Aggressive budgeting on the lending process The recent trends in NPL and external events highlighted the paramount connection between low quality of reporting and orchestrating in the Albanian businesses and the difficulties this engenders for banks in making quality credit decisions.Ways to Deal With The NPL Portfolio And Cognate Difficulties1. Doing the best to amassIt was noted that about a moiety of the banks were focused in reprogramming of loans and the other half in accumulating the collateral as primary betokens of accumulating assets from the distressed loans [footnoteRef:12]. None of the Albanian banks considered the sale of the NPL portfolio as an alternative they are fixating on at the moment. This stems primarily from the lack of a developed internal market for distressed assets. [12: Albania Assosiation of Banks. (2012). Annual Report 2012. Annual Report , pp. 20.]

2. Key difficulties currently faced in the endeavor to reprogram the imprests in NPLI optate to mention 3 most paramount key difficulties banks here in Albania are facing in the endeavor to reprogram the NPL loans. Clients generally are not able to stick to reprogrammed terms Clients have poor / unreliable financial reporting Difficult to project cash flows due to consequential fluctuationsAs we ken that these elements are evident in Albanian economy system and it is very arduous to rehabilitate them and need a long run to be developed by the sector. These three factors in amalgamation make it very arduous to develop a reliable loan restructuring program on which the Bank can depend on for its credit risk management purposes. Many companies work with two balance sheets for purport of tax office and are arduous to have formal data that show the true income of them. Additionally another issue cognate to the retail portfolio customers is that many of them have a job but are not registered as workers, so they cant provide a document to the bank to make it reliable. These issues make the work of credit officers very arduous as they have to consider higher risks when they project the mazuma flows or repayment ability of the imprest requested by customer.3. Key difficulties currently faced in amassment of collateral for the imprests in NPL Difficulties in executing the collateral due to other claims Execution process is long and costly Significant collateral accumulated with the bank takes time to convert to cash Value has decremented significantly due to market conditions or passage of timeAbove I have mentioned the primary difficulties faced in accumulation of collateral. Such quandaries additionally impact the estimates that need to be made in regard to present value of collateral that can be accumulated; an amount that is crucial in evaluating credit risk reserves for these imprests.4. How to achieve our main goal?Actions to Avert Future Increase of NPLFrom the mere analysis of data I bring the conclusion that the three most consequential actions that the banks are already taking to avert future increase in NPL are as follows:1. Tighter loan monitoring process2. Reduce exposure to certain industries that are riskier.3. Restructure the Bank management processes Their future priority remedial action includes actions marked as 1 and 3 above and Be more conservative in credit scoring models being the other top 3rd action. However, we visually perceive certain actions that the banks seem to believe need to be given higher priority as well. They are listed below predicated on their incremented paramountcy level:1. Request immensely colossal clients to get financial verbal expressions audited from reputable companies2. Focus lending on more minute loans3. Amend fraud obviation and detection mechanisms A paramount fact to descry is that while 71% of the banks seem to be fixating on reducing exposure to certain industries right now, only 7% optically discern this as a paramount remedial action for the future.CONCLUSIONRegarding all the above mentioned points in the journal, nowadays the bank credibility is highly effect by the external factors such as market conditions, economic conditions, competition, and regulatory changes. On the other hand, also internal factors are important; the adequacy of credit risk management processes is the main determinants of the quality of the NPLs portfolio. Some of the strategies that banks should consider in order to reduce the non-performing loans in their portfolio were.1. Conservative lending processes and techniques: a) customer financial analysis, b). collateral policy, c). client loan repayment2. Solid risk management structure3. Effective collection policies4. Bank expansion/growth policy should be in line with the bank risk appetiteOne of the internal processes that bank must be careful was Credit Quality Improvement Diagnose the current state on risk awareness Check effectiveness of credit control and related policies Draft guidelines, training proposalAlso during this study, I realized than none of the Banks had taking in consideration the sale of NPL portfolio. This stems primarily from the lack of a developed internal market for distressed assets.From the mere analysis of data, I bring the conclusion that the three most significant actions that the banks are already taking to prevent future increase in NPL are as follows:1. Tightening the monitoring process of the loan 2. Reduce lending to the riskier industries such as Construction industry3. Restructure the risk management processes of the BankTheir future priority remedial action includes actions marked as 1 and 3 above and Be more conservative in credit scoring models being the other top 3rd action. However, we see certain actions that the banks seem to be given higher priority as well. To conclude the above ideas, in order to deal with bad loans banks have to request large clients to get financial statements audited from reputable companies, focus lending on smaller loans and improve fraud prevention and detection mechanisms.

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Epstein, Larry G. and Zin, Stanley E. Substitution, Risk Aversion, and the Temporal Behavior of Asset Returns.Retrieved from: http://www.imf.org/external/pubs/cat/longres.aspx?sk=24258.0

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