Research Title

Basel II Capital Accord and implementation implications in Albania

Prepared: Elda Lila

Mentor : Professor William Handorf, Ph.D.,

July 2007

Abstract: Basel II Capital Accord and implementation implications in Albania 2

Abstract: Basel II Capital Accord and implementation implications in Albania 2

I. What is New Basel Capital Accord and its Evolution 4

II. Adoption of Basel II 5

BCBS Countries 5

In Other Countries 6

Banking Supervision Improvement Priorities 6

III. History of Banking Supervision in Albania (Banking System in Albania and Supervisory Process. 7

IV. Three Pillars of Basel II and the implications related to the implementation in Albania: 10

1.Pillar 1 – Capital Defined 11

1.1 Pillar 1 – Credit Risk 11

1.2 Pillar 1 – Market Risk 15

1.3 Pillar 1 – Operational Risk 16

2. Pillar 2 – The Supervisory Review Process 16

3. Pillar 3 – Market Disclosure 18

V. Reference List 21

Abstract: Basel II Capital Accord and implementation implications in Albania

I. The first part is concentrated in what is new Basel Capital Accord and its Evolution. Supervisors have long sought to ensure that banks maintain adequate capital to cover all risks. In 1988, the Basel Committee on Banking Supervision agreed the 'International Convergence of Capital Measurement and Capital Standards', more commonly known as the Basel Capital Accord which in most countries is fully implemented in 1992.

The evolution of banking worldwide led the Basel Committee to initiate revisions to the 1988 Accord. First proposed in 1999, and due to come into effect in many jurisdictions by the end of 2008 the revised Capital Accord – Basel II – is a comprehensive agreement that establishes a spectrum of risk sensitive approaches for banks' calculations of minimum capital requirements for banks.

II. The second part is related to the adoption of the Basel II Accord in BSBC countries and other countries and banking supervision improvements priorities in these countries. The implementation plans vary from country to country, but the trend is to put the simpler, less risk sensitive approaches in place before the more complex, more risk sensitive approaches. III. The third part is about the history of banking system in Albania and supervisory process. The banking system in Albania is still a new and developing one, although there are big developments in the last years. Albania was the last of the central and eastern European countries to embark upon democratic and free market reforms.
Banking sector, even though operating in not-well informed (educated) banking environment, has represented a tendency to grow since 1992. The developments in Albanian financial system and banking require a more risk-oriented supervision process. IV. The fourth and the last part explain three Pillars of Basel II and the implications related to the implementation in Albania. Basel II is structured around three so-called pillars: Pillar 1 – Capital Defined Pillar 2 – The Supervisory Review Process Pillar 3 – Market Disclosure
Each national supervisor needs to carefully consider Basel II's benefits, taking into account the characteristics of its own domestic banking system. IS Albania ready to implement Basel II? The answer is: not yet in the short run. For Albania more time will be needed for laying the groundwork for the adoption of Basel II. As a result, a longer timeframe may be required for implementation but it is a direction that Albanian banking system and supervisory process should move to.
Basel Capital Accord and implementation implications in Albania

I. What is New Basel Capital Accord and its Evolution

When a bank fails, the consequences can spread far beyond the bank, affecting customers and institutions that have deposited funds or invested capital there, and having negative effects in the domestic and, in some cases, international markets. Although it is recognized that the regulation of banks, per se, cannot prevent failures, the application of sound risk management standards together with the maintenance of appropriate levels of capital can lower the probability of such occurrences.

Supervisors have long sought to ensure that banks maintain adequate capital to cover all risks. In 1988, the Basel Committee on Banking Supervision agreed the 'International Convergence of Capital Measurement and Capital Standards', more commonly known as the Basel Capital Accord. Fully implemented in 1992, the Capital Accord introduced a basic risk sensitive capital adequacy regime which provided essentially only one option for measuring the appropriate capital of internationally active banks.

More than a decade later, the evolution of banking worldwide and the realization that the best way to measure, manage and mitigate risks, differs from bank to bank, led the Basel Committee to initiate revisions to the 1988 Accord. First proposed in 1999, and due to come into effect in many jurisdictions by the end of 2008 (Europe in 2008 and USA in 2009), the revised Capital Accord – Basel II – is a comprehensive agreement that establishes a spectrum of risk sensitive approaches for banks' calculations of minimum capital requirements, provides a supervisory review process for banks to maintain capital at levels commensurate with their risk profiles and encourages market discipline by requiring the disclosure of pertinent information.

II. Adoption of Basel II

BCBS Countries

BCBS members intend to implement Basel II in 2007 and 2008. However, there is considerable divergence regarding:

• the banks and banking groups to which Basel II would apply • the extent to which supervisors make available the full range of approaches from the simple to the more sophisticated

The publication of Basel II has intensified the implementation efforts of BCBS member countries. In addition, plans are also underway in a number of other countries that intend to implement Basel II approaches concurrently with BCBS member countries or shortly thereafter.

Even though there is strong interest in the Basel II framework in all parts of the world, the banking sectors in different countries display much variety in terms of size, complexity and sophistication. Similarly, banking supervisory structures and capabilities in different countries vary extensively. These differences have implications for the type of capital adequacy regime that can be implemented.
The implementation plans vary from country to country, but the trend is to put the simpler, less risk sensitive approaches in place before the more complex, more risk sensitive approaches.

In Other Countries

The adoption of Basel II in non-BCBS member countries will depend on many factors.
In a number of these countries, Basel I-based capital adequacy regimes were implemented some time ago. Also, the banking sector has developed to the extent that implementation of Basel II, including the more risk sensitive approaches, is feasible. It is expected that in these countries, Basel II will be implemented in much the same timeframe as in BCBS-member countries.

However, there are a number of other countries where the adoption of Basel II, particularly the more complex and risk sensitive approaches, may not be the top priority in terms of supervisory initiatives in the near future. Instead, the priority may be to continue the processes already in place to strengthen: • legal and regulatory frameworks • supervisory capabilities

Banking Supervision Improvement Priorities

Basel II requires a solid foundation of capital regulation, prudent supervision and market discipline to encourage better risk management and enhance financial stability.
In jurisdictions where further work is needed to achieve full compliance with the Core Principles for Effective Banking Supervision, efforts and resources are likely to be devoted to improving banking supervision. This may mean that more time will be needed for laying the groundwork for the adoption of Basel II. As a result, a longer timeframe may be required for certain countries.

Each national supervisor needs to carefully consider Basel II's benefits, taking into account the characteristics of its own domestic banking system. Those characteristics and the supervisor's resources will be important factors in developing a timetable and an approach to implementation. The first priority, however, will be to ensure the supervisory system and the legal infrastructure meet minimum requirements.

III. History of Banking Supervision in Albania (Banking System in Albania and Supervisory Process.

The approval in 1992 of the law “On the Bank of Albania” and “On banks in the Republic of Albania” acknowledged the Bank of Albania the performance of the Banking Supervision function. In 2006 is approved the new and updated law “On the Bank of Albania” and “On banks in the Republic of Albania”.

According to the above mentioned laws, Banking Supervision Department was established to perform supervision functions on second tier banks oriented to the market economy, and preparing regulatory framework of the Banking Supervision.
Albania was the last of the central and eastern European countries to apply the democratic and free market reforms. Until 1991, Albanian economy was totally integrated into a centralized economy, focused mainly in agricultural sector and heavy industry, until 1991.

Banking sector, even though operating in not-well informed (educated) banking environment, has represented a tendency to grow since 1992. So, in 1994, there were 6 banks in Albania totaling 146.2 billions lek (approximately 1.46 billion USD) being a portion of 79% of GDP.

The banking system has been expanding over the last years in Albania. During the years 1995-1996, the banking system changed its composition. New joint ventures, branches of foreign banks and private banks incorporated in Albania were introduced. The expansion of the banking system with private banks brought several changes on the bank operation and services.

The year 1998 was be considered as the year where qualitative steps have been taken in improving either regulatory framework of the Banking Supervision and the examination of the banks and branches of foreign banks. The above steps were dictated by the changes in the banking system, that consisted in entering of new banks and branches of foreign banks in the Albanian banking market with special features with respect to their ownership and the activities they conduct and particularly by the Core Principles for an effective Banking Supervision of the Basle Committee, published in September 1997.
During 2003, the banking sector also experienced important improvements. The entering of two new banks and the privatization of the second biggest bank in the country indicated a productivity and competitively of the banking system in Albania.

The weight of banking system’s assets to GDP indicates the increase in the intermediation role of the banks in the Albanian financial system. This indicator was calculated to be 59.3 per cent by the end of 2005.

During 2005 the banks started massively crediting the Albanian economy. The year 2005 showed the increase of the banking system’s loan portfolio balance was increased by 57.6 billion lek (570 million USD) or 0.82 per cent. This high increasing pace shows the credit expansion of the banking system in Albania.
The banking system assets during eight first months of 2006 have increased by 12 per cent representing 60 per cent of GDP. The banking system has resulted in profit and is liquid and and well capitalized. The entry of an important European bank in the banking system of Albania, which besides its shares at the Italian-Albanian Bank has bought 80 per cent of the American bank of Albania (these two banks are among the biggest banks in Albania), is a very important event and will open the way to further consolidation of the banking system in Albania.
Credit to economy grew under stable rates over the first two months of 2007,amounting to 203.5 billion lek (2.25 billion USD) at end February and accounting for 22.4 per cent of GDP. This was mostly a consequence of the increasing contribution of short term loans, foreign currency loans and of business loans.
Total assets of the banking system in Albania as of December 31st, 2006 was 624 billion lek (approximately 6.24 billion USD). The asset structure shows a better diversification during the last years. The banks in Albania started to look for better investment possibilities bringing better return and lower risk for the banks.
The foreign equity has the biggest weight in the total capital of the banking system in Albania. So, the foreign capital’s weight is 86.3%. The foreign ownership of the banks of Albania is considered positive factor for the Albanian economy in terms of the implementation of new technology and good financial power of the foreign shareholders, which is not affected from local Albanian economy.

IV. Three Pillars of Basel II and the implications related to the implementation in Albania:

Basel II is structured around three so-called pillars. • Pillar 1 relates to the minimum capital requirements each bank must hold to cover its exposure to credit, market and operational risk.

• Pillar 2 is concerned with supervisory reviews that aim to ensure that a bank's capital level is sufficient to cover its overall risk.

• Pillar 3 relates to market discipline and details minimum levels of public disclosure.

1.Pillar 1 – Capital Defined

Pillar 1 sets out minimum capital requirements as they relate to credit, market and operational risk. Under Basel II, banks must maintain a minimum eight percent of capital to risk-weighted assets.

1. Pillar 1 – Credit Risk

Basel II allows a financial institution to measure credit risk for regulatory capital purposes in one of two ways: • Under the Standardized Approach (SA)
Under the standardized approach the bank allocates a risk weight to each asset and off-balance sheet position, producing a sum of risk-weighted assets as follows:
Risk-weighted Asset = Amount of Exposure x Risk Weight
The allocation of each individual risk weight is based on the broad category of the borrower (sovereign, bank or corporate), refined by reviewing the rating provided by an external credit assessment institution. This assessment can be adjusted, based on qualifying credit risk mitigants.

The standardized approach establishes risk weights corresponding to different types of assets and makes use of external credit assessments to enhance risk sensitivity compared to the current Accord. The risk weights for sovereign, inter bank, and corporate exposures are differentiated based on external credit assessments.

Standardized approach is the most likely to be implemented in Albania relating to the size and the business performed by the banks. However, the greatest concern relates to the use of external credit assessment relying on external rating agencies. Rating Agencies in Albania are totally absent and taking into the consideration the high cost that it takes, it is almost impossible for our small business, to be clients of internationally rating agencies. As a result, the unrated small business representing the main borrowers for Albanian banks will be assigned 100% risk according Basel II. This could bring the risk sensitivity very similar to Basel I.
Another concern is related to the Albanian government treasury bills and notes. A considerable portion of investments in domestic currency are the government treasury bills and notes. According to Basel II standardized approach the sovereign debt is assigned 0%-150%, while under Basel I is assigned 0% risk. As the credit risk of the sovereign debt is not rated, most likely this debt category will be assigned 100% risk weight. This might bring the banks in Albania to a situation that they have to increase capital allocation in order to comply with the capital adequacy ratio requirements.

• The Internal Ratings Based Approach (IRB)
The IRB approach recognizes that banks generally know more than credit rating agencies about their borrowers. This approach enables a bank to apply much finer differentiation between risks than the seven risk-weight buckets (0, 20, 35, 50, 75, 100 and 150%) in the standardized approach.
There are two IRB approaches, both of which are subject to strict methodological and disclosure standards, and the approval of the supervisor. • Foundation IRB - the bank estimates the probability of default (PD) associated with each borrower, and the supervisor supplies other inputs, such as loss given default and exposure at default. • Advanced IRB - in addition to PD, the bank adds other inputs such as exposure at default, loss given default, and maturity. The requirements for this approach are more exacting.
Albania is not yet ready to implement the IRB approach (even the Foundation IRB). The banks should start with the Standardized Approach and then slowly move to Foundation IRB Approach. Moving to the more advanced approach means a more accurate linking of capital to risk.
But, are the banks and the bank supervisors ready to accurately asses the risk by themselves? No. Albanian banking system is experiencing a fast credit growth recent years. Fast credit growth might bring a series of risks for banking system and financial stability in the country. When assessing these risks, banks and bank supervisors have to consider that this rapid growth in credit and private sector calls for more careful and detailed risk assessment keeping in mind that rapid credit growth is one of the main predictors (but not necessary leading) to financial turmoil. So, lacking experience of both banks and supervisors in credit in Albania requires a very close monitoring of credit growth. Besides the progress of the banks in monitoring the credit risk, the lack of the credit bureau makes the credit monitoring costly and difficult.
This calls for developing a credit history database as a way to provide more information and lower risk for banks and at the same time domestic rating agency for assessing borrowers.

Albania as many other Balkan Countries, is hosting a significant number of banks from EU countries. These banks might have to implement the advanced approaches as their head offices do, as a banking group usually has uniform risk management practices throughout the group, This will require the Bank of Albania supervision to asses the implementation of Internal Ratings Based (IRB) models by these banks. This raises two sensitive issues:

➢ The likelihood and practicability of IRB application is complicated by the lack of dependable and consistent data on at least a full business cycle in Albania. As I have mentioned above Albania is opened to market economy less than 20 years ago and the economy was suffering for a long period the transition period, so the

historical data for at least a full business cycle is missing.

➢ Second, to examine the reliability and accurateness of banks’ IRB models and risk assessment, it requires the host country banking supervisors to be trained and well prepared about Basel II IRB approach and new rules, otherwise, the capital allocation system could become broken down. The supervising department of the bank of Albania should keep cooperating and coordinating the bank supervision with the home countries banks to gain from their experience.[1]

1.2 Pillar 1 – Market Risk

Since January 1, 1998, banks in the G10 countries are required to maintain regulatory capital to cover market risk (this is commonly referred to as the Market Risk Amendment to the Basel Accord).
Regarding to the Market Risk we should mention that Albania has big challenges in the upcoming future. Financial system in Albania is still dominated by commercial banks. Capital market, in spite of the creation of the Albanian Stock Exchange is not functioning. Albanian government debt securities in national currency are the sole representative of the “capital” market, while no company is listed in the formally existing Stock exchange. The derivative instruments are not yet applied in Albania, so the banks do not use the derivative instruments for hedging purposes.

Another concern is the implementation of the International Accounting Standards which differ from the current national Accounting standards. Most of the banks are audited in compliance with the IAS/IFRS, but the expertise in the financial sector for this issue appears to be limited. The expertise is limited not only among banks, but among supervisors of the Bank of Albania as well.

3. Pillar 1 – Operational Risk

Operational risk is defined by the Basel Committee as "the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events".
Operational risk is a new concept for banking system in Albania and the banks have to implement models to quantify and qualify the operational risk which is a difficult process. This means increasing in costs for banks investing either in IT or in training of staff which will be more difficult for Albanian owned banks.

2. Pillar 2 – The Supervisory Review Process

The supervisory review process aims to ensure that banks assess their capital adequacy positions relative to their overall risks, and that supervisor’s review and take appropriate actions in response to those assessments.
Supervisors may require banks to hold capital in excess of minimum regulatory capital ratios or take other remedial measures such as strengthening pertinent risk management or other practices. If higher ratios are required, supervisors will need to intervene if capital falls below these levels.
Pillar 2 requires that banks perform stress tests to estimate the extent to which their IRB capital requirements could increase during a stress scenario. The results of such tests should be used by banks and supervisors to ensure that banks hold sufficient capital buffers.
Pillar 2 has four key principles: • banks should have processes to assess overall capital adequacy given the risk profile strategy to maintain capital levels • supervisors should review and evaluate banks' internal capital adequacy assessments and strategies, and their ability to monitor and ensure compliance with regulatory capital ratios • supervisors should expect financial institutions to operate above the minimum regulatory capital ratios, and should have the ability to require banks to hold capital in excess of the minimum
For Albania more time will be needed for laying the groundwork for the adoption of Basel II. As a result, a longer timeframe may be required for implementation.
Each national supervisor needs to carefully consider Basel II's benefits, taking into account the characteristics of its own domestic banking system. Those characteristics and the supervisor's resources will be important factors in developing a timetable and an approach to implementation. But the main concern is: are the supervisors ready for the Pillar 2 – Supervisory Process? The banking system in Albania is new, as Albania was one of the last countries to change to opened market economy. The supervision department needs to invest more in training the supervisors as they are not yet ready for the Supervising Process of the Basel 2. Bank of Albania is in a process of adopting risk based supervision from compliance based one. Also it has started to apply supervisory rules and practices that support consolidated supervision.
The first priority, however, will be to ensure the supervisory system and the legal infrastructure meet minimum requirements on which Albania is making progress (the new banking law approved on 2006).

3. Pillar 3 – Market Disclosure

Pillar 3 sets out disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution.
Disclosure refers to publicly available information about a company's activities, performance, risks and environment. Disclosure includes both quantitative and qualitative information.
Financial statements, such as balance sheets and income statements, provide aggregate numeric data, and are the key components of quantitative information. Qualitative information typically includes information about the company's valuation approaches, business model and management strategies.
Public disclosures provide a means for assessing a counterparty or potential counterparty and to overcome information asymmetries.
The counterparties to a bank with an interest in disclosures include actual and potential shareholders or owners, lenders and customers. The bank's supervisors also have an interest in a bank's disclosures in order to promote financial stability.
Banks in Albania already disclose financial information regularly to comply with accounting standards and other mandatory regimes. To increase the role of market discipline, Bank of Albania have initiated a process of preparing changes to the regulatory framework that would contain stronger requirements for banks activity public disclosure.
The private sector does not disclose completely financial information and this is related to informal economy. The economy in Albania is an emerging market economy. Besides the big progress that Albania is doing, still the informal economy and money laundering are not under total control of government. The main activity of the banking system in Albania is crediting the private sector. The informal economy affects the banking sector relating to the performance of the loan portfolio and the credit risk of the banks in Albania (this is also related to Pilar1).
The informal economy may affect also the potential foreign creditors for the banks in Albania. When potential creditors are considering making a debt investment, they need to have sufficient information about the bank's business, risks and financial condition and these are also related to the informal economy and country’s risk,

Also, in Albania information disclosure in short run might have some negative implication. Public is usually more sensitive to bad news than good news showing positive developments. In Albania, reactions between good or bad news are sometimes more asymmetric than in developed countries which have mature market economies. Public in Albania is over-reactive toward severe news on banking sector or on a certain bank and tend to ignore positive news. This could be due to both historical factors, e.g. the crisis of financial system in 1997, and mentality factors (e.g. low level of bank business understanding, e.g. the overreaction of public to the introduction of the Deposit Insurance Law in 2002. This means that enhanced information disclosure required by Basle II, could be problematic if not supported by a proper public understanding[2]).

So, in this paper I was trying to find the answer “Will Albania move to Basle II direction”?. The answer is: not yet in the short run. For Albania more time will be needed for laying the groundwork for the adoption of Basel II. As a result, a longer timeframe may be required for implementation but it is a direction that Albanian banking system and supervisory process should move to. Albania has the good chance to be a developing country in European continent. So Albania will follow developed countries’ instructions and models.

V. Reference List

Books 1. Ingrid Mattaus – Maier, J.D. von Pischke (November 2003). EU-Accession-Financial Sector Opportunities and challenges for Southeast Europe. Springer, 1st Edition.
Online sources: 1. Ardian Fullani: Recent banking developments in Albania, Speech by Mr Ardian Fullani, Governor of the Bank of Albania, at the ceremony dedicated to the launch of the autumn 2005 issue of the legal journal, Law in transition, online, published by, EBRD, Rogner Hotel, Tirana, 18 October 2005; From http://www.bis.org/review/r051024b.pdf 2. Ardian Fullani: Basel II, its implications, opportunities and challenges ahead for Albania and Southeastern Europe. Speech by Mr Ardian Fullani, Governor of the Bank of Albania, at the Southeastern European Financial Forum, the Second Edition, Bucharest, Romania, 11 November 2005. From http://www.bis.org/review/r051212e.pdf 3. Basel 2 at mid – 2006: Prospect for implementation and other recent developments. From www.g24.org 4. Ernst & Young, June 2005. Basel II survey Central and Eastern Europe. From http://www.ey.com/global/download.nsf/Norway/Basel_II_Survey_Central_and_Eastern_Europe_2005/$file/Basel%20II%20Survey%20Central 5. Institute of International Finance, November 2005. The Implementation of Basel II. From http://www-cfap.jbs.cam.ac.uk/events/files/Implementation_Report.pdf
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[1] Taken from the speech of Mr. Fullani, Governor of the Bank of Albania, at the Southeastern European Financial Forum, the Secon Edition, Bucharest, Romania, November 11th 2005.
[2] Taken from the speech of Mr. Fullani, Governor of the Bank of Albania, at the Southeastern European Financial Forum, the Secon Edition, Bucharest, Romania, November 11th 2005.