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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY IMPLEMENTATION COMPLETION REPORT (IDA-36690) ON A CREDIT IN THE AMOUNT OF SDR 12 MILLION (US$15 MILLION EQUIVALENT) TO ALBANIA FOR A FINANCIAL SECTOR ADJUSTMENT CREDIT (FSAC) June 20, 2005 Report No: This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS (Exchange Rate Effective March 31, 2005) Currency Unit = Lek Lek 1 = US$ US$ 1 = Lek FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS BoA - Bank of Albania BART - Bank Asset Resolution Trust (Loan Collection Agency - LCA) CAS - Country Assistance Strategy DIA - Deposit Insurance Agency EBRD - European Bank for Reconstruction and Development ECSPF - Europe and Central Asia, Private and Financial Sector Development Unit EU - European Union FSAC - Financial Sector Adjustment Credit FSIBTA - Financial Sector Institution Building Technical Assistance Project GDP - Gross Domestic Product IAS - International Accounting Standards IDA - International Development Association IDP - Institutional Development Plan for the Bankruptcy Framework IFC - International Finance Corporation IMF - International Monetary Fund INSIG - Insurance Institute of Albania ISA - Insurance Supervision Agency (formerly ISC - Insurance Supervision Commission) MoF - Ministry of Finance MoJ - Ministry of Justice NCB - National Commercial Bank NSSED - National Strategy for Social and Economic Development PHRD - Policy and Human Resources Development Fund PRGF - Poverty Reduction and Growth Facility PRSC - Poverty Reduction Support Credit PRSP - Poverty Reduction Strategy Paper RCB - Rural Commercial Bank RPTA - Recovery Program Technical Assistance Project RTGS - Real Time Gross Settlement SDP - Supervisory Development Plan for Banking Supervision SvB - Savings Bank TA - Technical Assistance USAID - United States Agency for International Development Vice President: Country Director Sector Manager Task Team Leader/Task Manager: Shigeo Katsu Orsalia Kalantzopoulos Fernando Montes-Negret Hormoz Aghdaey

3 ALBANIA Financial Sector Adjustment Credit (FSAC) CONTENTS Page No. 1. Project Data 1 2. Principal Performance Ratings 1 3. Assessment of Development Objective and Design, and of Quality at Entry 2 4. Achievement of Objective and Outputs 4 5. Major Factors Affecting Implementation and Outcome 8 6. Sustainability 9 7. Bank and Borrower Performance 9 8. Lessons Learned Partner Comments Additional Information 16 Annex 1. Key Performance Indicators/Log Frame Matrix 18 Annex 2. Project Costs and Financing 19 Annex 3. Economic Costs and Benefits 20 Annex 4. Bank Inputs 21 Annex 5. Ratings for Achievement of Objectives/Outputs of Components 23 Annex 6. Ratings of Bank and Borrower Performance 24 Annex 7. List of Supporting Documents 25

4 Project ID: P Team Leader: Hormoz Aghdaey Project Name: Financial Sector Adjustment Credit (FSAC) TL Unit: ECSPF ICR Type: Core ICR Report Date: June 20, Project Data Name: Financial Sector Adjustment Credit (FSAC) L/C/TF Number: IDA Country/Department: ALBANIA Region: Europe and Central Asia Region Sector/subsector: Banking (54%); Non-compulsory pensions, insurance and contractual savings (31%); General industry and trade sector (15%) Theme: Regulation and competition policy (P); State enterprise/bank restructuring and privatization (S); Other financial and private sector development (S); International financial architecture (S) KEY DATES Original Revised/Actual PCD: 10/05/2001 Effective: 08/07/2002 Appraisal: 01/30/2002 MTR: Approval: 06/20/2002 Closing: 03/31/ /31/2004 Borrower/Implementing Agency: Other Partners: Albania/Ministry of Finance Bank of Albania, Insurance Supervision Agency, Bank Asset Resolution Trust STAFF Current At Appraisal Vice President: Shigeo Katsu Johannes Linn Country Director: Orsalia Kalantzopoulos Christiaan J. Poortman Sector Manager: Fernando Montes-Negret Paul Siegelbaum Team Leader at ICR: Hormoz Aghdaey Hormoz Aghdaey ICR Primary Author: Hormoz Aghdaey; Rochelle Hilton 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: Sustainability: Institutional Development Impact: Bank Performance: Borrower Performance: S HL H S S QAG (if available) Quality at Entry: Project at Risk at Any Time: No ICR S

5 3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: The objective of this operation was to support the Government of Albania's program to consolidate and take reforms in the financial sector further to foster better engagement of the financial sector in the development of the Albanian economy. The proposed program consisted of three broad components: (i) continued reform of the banking sector including the privatization of the Savings Bank (SvB) and further strengthening of the banking regulation and supervision, (ii) enhancement of the bankruptcy and debt resolution framework, and (iii) reform of the non-bank financial sector, including further development of the regulatory and supervisory framework for the insurance sector and the privatization of the Insurance Institute of Albania (INSIG). The project objective was clear and realistic. It was fully consistent with the CAS and the 2002 National Strategy for Social and Economic Development (NSSED) (previously the Growth and Poverty Reduction Strategy). The current CAS (FY03-05) was built around three pillars: (i) Improve governance and strengthen institutions: build efficient and inclusive public institutions; increase transparency and accountability at all levels; strengthen monitoring and evaluation; and use community-based approaches that build institutions from the bottom up; (ii) Promote sustainable private sector growth: maintain macroeconomic stability in conjunction with the IMF Poverty Reduction and Growth Facility (PRGF); improve the environment for private investment; continue to reform the financial sector, and complete enterprise privatization; sustain agricultural growth and foster broad-based rural growth; improve infrastructure and create institutional environments conducive to infrastructure sustainability, especially through community or private sector participation; and promote environmental sustainability and sustainable use of natural resources; and (iii) Foster human development: improve access to and quality of education and healthcare in both urban and rural areas; strengthen the sustainability and equity of the social insurance system; and improve targeting and efficacy of social assistance and community social services. The FSAC was fundamental to the goals of the CAS and related directly to the first two pillars. The project built on ongoing efforts, had a clear focus, and enjoyed the full ownership of the Government and the central bank. These factors enabled the program to cover complex and challenging reform areas. 3.2 Revised Objective: n/a 3.3 Original Components: Background and context: Although the democratic and economic transformation in Albania began later than in other Central and Eastern European countries, the implementation of the initial phase of reforms in the early 1990s was rapid and impressive with high growth rates, low inflation, an improved current account balance and significantly improved fiscal deficit. Reforms in the public administration and financial sectors, however, advanced at a much slower pace. By early 1996, it was clear that many problems had not been resolved, and others were emerging. Structural reforms had stalled, especially in the critical area of banking, evident in the lack of progress in resolution of the problems in the state-owned banks, and in further development and enforcement of banking regulation and supervision. Despite some initial efforts at reforms, the institutional and financial infrastructure was unable to adequately support sound credit practices and the effective functioning of the market. The legal system remained underdeveloped and could not effectively enforce contracts. Comprehensive and well-defined accounting principles based on International Accounting Standards (IAS) were not introduced. Hence, accurate and transparent information on the financial performance of banks and enterprises was not available and there was insufficient information on which to base credit and investment decisions. Effective systems for internal risk management and control, with - 2 -

6 strict accountability to owners, directors and senior management, were not fully developed and enforced. Financial institutions were not adequately supervised and even the most basic regulations such as those ensuring adequacy of risk capital were not enforced. At the same time, the supervisory and regulatory authorities did not have adequate skills, resources and independence from political interference to perform their functions. The inadequacy of the financial system, especially its regulatory and supervisory framework, led to the proliferation of informal financial arrangements including pyramid schemes, the collapse of which triggered the civil crisis of early 1997, and the subsequent fall of the government. The economic fallout from the crisis was severe, with GDP contracting by 7 percent and inflation increasing to over 40 percent in The Government, which took office after the elections of July 1997, quickly re-established macroeconomic control and started implementing a broad-based program of reforms in the public administration and financial sectors, including institution-building, civil service reform, and divestiture/privatization of state-owned banks. In consultation with IDA and the IMF, it adopted an ambitious program to cease all lending activities by state-owned banks, and to divest itself from the banking sector. In line with this program, it immediately liquidated the Rural Commercial Bank (RCB) in December 1997, undertook to offer the National Commercial Bank (NCB) for privatization within a one year time-frame and put SvB under a tight governance contract with a view to its privatization. The authorities made substantial progress in implementing this element of their program, although the ambitious timetable established was not met. Privatization of NCB was concluded in October The governance contract with SvB prohibited it from lending and prescribed steps, including defensive restructuring measures, to be followed in preparing the bank for privatization. Intensive dialogue with the Bank supported the implementation of this program, although specific preparation of the FSAC had not yet started. As a result of this dialogue, the Government took many major policy decisions prior to Board presentation of the FSAC. Successive governments have maintained this commitment to macroeconomic stability and structural reforms, with support from the international donor community led by IDA and the IMF. The Government, which came to power in 2002, confirmed its intention to proceed with the implementation of the reform program agreed in Building on past actions, the FSAC support the program going forward. Although the credit was expected to fully disburse in a period of 1-2 years, no strict deadline was specified for meeting the conditions since the focus was on the implementation of capacity building programs which took into account the long-term nature of the reforms. The capacity building plans were supported through the IDA-funded Financial Sector Institution Building Technical Assistance Project (FSIBTA) and other donors, especially the IMF and USAID. Components: The FSAC supported the implementation of a comprehensive reform program in the following areas: Continued Reform of the Banking Sector focusing on the privatization of SvB and improvement of the institutional, regulatory, and supervisory framework for banking; Enhancement of the Bankruptcy and Debt Resolution Framework focusing on the adoption of the new insolvency legislation and capacity building for and implementation of the insolvency and secured financing framework, and debt workout activities of the Loan Collection Agency (BART); and Reform of the Non-Bank Financial Sector focusing on further development of the regulatory and supervisory framework for the insurance sector and the privatization of INSIG. The project achieved all of its major objectives and the design of the operation was well tailored to the Government's overall goals. The focus on capacity building and results, rather than on passage of legislation proved to be effective, and the FSAC is highly likely to achieve substantial development results - 3 -

7 without any major shortcomings. The program the FSAC supported is highly likely to be sustainable as the many of the actions taken are irreversible. Taking into account lessons learned from implementation of other operations in the region, the FSAC was, by design, preceded by the related FSIBTA, which, in turn, has been instrumental in ensuring the proper implementation of the Government and BoA's policies and programs in the financial sector. Given the capacity on the ground, the relatively narrow focus of the FSAC was justified in order to maintain momentum in implementing reforms which are so fundamental to the development of the financial sector. Albania now has the platform and the confidence to launch the next phase of its financial sector reforms, giving more attention to the non-bank financial sector. 3.4 Revised Components: n/a 3.5 Quality at Entry: A voluntary Quality Enhancement Review concluded that the project was well designed and focussed. It assessed the quality of the operation to be satisfactory. The design of the project benefited from this review, particularly in terms of streamlining the conditionality and increasing the focus on outcomes. As mentioned above, the program was clearly linked to the CAS/NSSED priorities. The risks were clearly identified and carefully evaluated. The main risks related to political instability and lack of absorptive capacity. To mitigate the political risk, the FSAC was designed to ensure that key (and irreversible) steps were taken prior to Board presentation. The risk that the weak institutional capacity in the country would impact implementation of the FSAC was mitigated by a number of technical assistance (TA) initiatives that were already underway prior to approval of this operation, including the FSIBTA and Legal and Judicial Reform Project, as well as programs from other donors. An additional risk related to internal and external macroeconomic imbalances, which were largely mitigated through the program agreed with the IMF. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: The achievement of the objectives and outputs is considered satisfactory. The FSAC has contributed to the strengthening and deepening of the financial sector. The supervisory and legal framework for the banking system has been substantially strengthened, especially through the implementation and institutionalization of the Supervisory Development Plan for banking supervision (SDP). The privatization of the SvB, which marked the exit of the state from any major ownership role in the banking sector, has led to the entry of a reputable West European Bank into the market and is already showing results by improving competition in the banking sector. The number and quality of banking products and services is gradually increasing (for instance, about 9 banks have installed ATMs and many can now be seen around Tirana). In regard to intermediation, according to the BoA, credit to the private sector grew by about 31% in 2003 and 38% in Private sector deposits have also increased, with a growth of about 15% per year in 2003 and As a percentage of GDP, credit to the private sector has increased from 4.6% in 2001 to almost 8% in The overall quality of the portfolio (as measured by the level of non-performing loans, reported by the BoA) remains good. In regard to the bankruptcy and debt resolution framework, new legislation for the bankruptcy framework has been enacted, training of a pilot group of bankruptcy professionals has been completed, bankruptcy programs have been included in university and magistrates school curricula and BART has achieved positive results in its loan resolution activities. Also noteworthy is the progress made in meeting other indicators that relate to the Government's own agenda, such as the successful operation of the RTGS and enactment of a satisfactory accounting law. There were no major shortcomings in the achievement of the FSAC's objectives, although the full impact of all of the reforms will be realized only in the long-term. For example, substantial improvements have been - 4 -

8 made in efforts to increase effectiveness of supervision of the insurance sector. The legal framework has been strengthened with the approval of primary legislation broadly in line with EU requirements, but appropriate secondary legislation is not yet in place. In addition, much remains to be done to further enhance the capacity of the regulator and to ensure that the sector can operate based on acceptable market principles. The authorities are taking steps to improve enforcement and secondary legislation, particularly in relation to the application and oversight of compulsory TPL activities. However, as identified in the risks in the FSAC President's Report, implementation of this component has been undermined by the limited absorptive capacity. The original Closing Date was extended by 9 months to December 31, 2004, particularly to allow more time to implement changes to insurance legislation and for implementation of the Institution Development Plan for the bankruptcy framework (IDP). The latter was delayed because of the lack of timely provision of expected donor funding. 4.2 Outputs by components: Continued Reform of the Banking Sector: This component is rated as highly satisfactory and included several elements, with the following outputs as part of the core conditionality of the FSAC: Finalization of sale of at least 50% + 1 of SvB shares. The initial attempt to sell the SvB was not successful, in large part due to an unfavorable environment in the international financial markets. The Government took a strong stand to pursue an eventual privatization, including resisting pressures to break up the bank. This led to the sale of 100% of the bank (completed in April 2004). This sale is recognized as the most successful privatization to date for Albania. Establishment of the Deposit Insurance Agency (DIA) and satisfactory progress in implementing its financing plan.the DIA was established in accordance with the provisions of the October 2002 Deposit Insurance Law. The DIA has been capitalized to the agreed levels, is adequately staffed and funded; a 3-year financing plan is in place and is being implemented satisfactorily. As provided for in the Deposit Insurance Law, following the initial capitalization from the State budget, all banks have been paying contributions to the Deposit Insurance Fund and its ratio to insured deposits has increased. Investments are made through foreign-based banks acting as brokers and custodians. Implementation of the BoA's SDP for Banking Supervision. The SDP has yielded many positive outputs in the area of banking supervision. The BoA is following a Supervisory Operating Policy, which outlines and discusses the method of bank supervision. Supervision strategies are being followed for each bank in the system. These strategies have become increasingly robust and more risk-based, with improvements in the quality and comprehensiveness of the risk analysis, management evaluations and supervisory plans. Two-way communication with the banking industry has increased, as has BoA's dialogue with external auditors. As a result of this comprehensive plan, the skills and quality of banking supervision personnel has improved. The BoA recognizes that the SDP is a "living document", the benefits of which will continue. The BoA intends to continue efforts to implement the SDP and further improve supervision as part of its long-term goals. (In addition to IDA, support for banking supervision and the regulatory framework has been provided by the IMF and USAID, through its FSVC program.) Additional outputs which were part of the Government's program and reflected in the FSAC as monitorable indicators, included: Improving banking competition, through: (i) outsourcing of budgetary and fiscal functions through open auctions. The responsibility for the management of pension services was transferred from SvB to Albapost. Other budgetary services have been contracted out to commercial banks, through auctions in the larger towns where an adequate number of banks were present, and by negotiations elsewhere; (ii) - 5 -

9 increasing credits to the private sector as a percentage of GDP. As mentioned above, this percentage has increased to almost 8% in 2004; (iii) reduction in interest rate spreads. Interest rate spreads dropped significantly between 2000 and 2001 but, given the dynamics of the sector - a sharp increase in small retail loans, increased maturity of loans and the overall low level of intermediation - it is too soon to observe a sustained reduction in spreads. It would be interesting to observe this in about 2 years from now when competition in the banking sector has matured; and (iv) increase in sales of Treasury bills to the public. Since the opening of BoA's window for individuals to participate in the auction of Treasury Bills in 2000, sales to the public have increased from less than 1% of the total to about 6% in At end-2004 the total value of Treasury Bills held by this group was over Lek 15 billion. Improving banking regulation, through: (i) adoption by parliament of amendments to the Banking Law and Law on the Bank of Albania. Agreed and satisfactory legislation was adopted in mid Nevertheless, as part of the process of harmonization with EU directives, the authorities have prepared a draft new Banking Law which is currently under review; and (ii) Adoption by BoA of satisfactory regulations. BoA has revised and adopted a number of important regulations, including on issuing licenses; managing credit risk; capital adequacy; money laundering; and connected lending. Development of an efficient payments system, through: (i) establishment of the necessary legislative framework for the operation of a bulk clearing and settlement (retail payments) system. The legislative framework is in place and the establishment of a fully automated bulk clearing system is nearing completion. This system is expected to facilitate increasing payments through the banking system of civil servants/government employees' salaries; and (ii) initiation of operations of a real time gross settlement (RTGS) system and connection of not less than 5 banks to the system. The RTGS system was launched at the beginning of 2004 and is functioning well. All banks are connected to the system. Together these two systems will ensure that the basic infrastructure is in place in the country to meet the payment system demands necessary for an efficient banking system. Enhancement of the Bankruptcy and Debt Resolution Framework: This component is rated as satisfactory and included the following outputs as part of the core conditionality of the FSAC: Satisfactory progress in implementation of the Institutional Development Plan for bankruptcy enforcement and secured financing (IDP). This framework incorporates provisions in the Law on Bankruptcy, specific articles of the Civil Code and the Law for Securing Charges, and provides the primary laws to deal effectively with the protection of creditors' rights. To help oversee and manage the implementation of the agreed IDP, the authorities established a working group with representatives of the Ministry of Finance (MoF), Ministry of Justice and of the legal profession. In line with the IDP, a comprehensive Manual on the Albanian Insolvency Law has been prepared, with the help of foreign experts and reputable local legal firms. It is available as a tool to help courts and administrators in the implementation of the Insolvency Law. The Manual also provides guidance to creditors and debtors on how to use the system. The Tirana Magistrates School has provided training to judges on liquidation and reorganization, using the Manual as the basis for these sessions. Furthermore, bankruptcy and property rights legislation is being included in the curriculum for future students of the Magistrates School and the curricula of two universities, including the Faculty of Law at Tirana University. GtZ, in cooperation with the MoF, agreed to provide additional training for administrators and to organize public awareness campaigns by mid Completion of no less than 3 pilot cases to test the operation of the framework. The courts have acted on at least three cases initiated by secured creditors against debtors who defaulted on the payments of their obligations. These cases have provided a demonstration effect and have increased the willingness of credits to advance credits, as the courts have recognized the rights of secured creditors. Satisfactory implementation of BART's Strategic and Business Plan, including divestiture of 15% of its portfolio value. The structure of BART has been strengthened, and a Global Scheme, which - 6 -

10 reflected its strategic and business plan, adopted. This scheme introduced a step-by-step strategy to improve collections by dividing BART's portfolio into several different categories, grouped by size and methods of disposal of the assets. By focusing on the groups which were assessed to be the less problematic, starting in 2003, BART posted impressive results in its collection and divestiture performance, with the total value of its portfolio declining by almost 38% by end This included the write-off of a number of loans relating to state enterprises that either no longer existed or were dormant, as well as the sale to an Albanian commercial bank of one large loan for about US$2 million. A large number of cases have been submitted to the courts and are either awaiting court decisions or disposal actions by the bailiffs. There is a backlog in the actual sale of the assets, partly due to inefficiencies in the bailiffs' system and partly because of legal requirements relating to public auction procedures, which impose a floor on the value for which property can be sold. Although these issues did not prevent BART meeting the target of the FSAC program, they could affect the final resolution and in the interest of creditors' rights, they will need to be addressed. Discussions are underway between the Government and BART on appropriate steps to prepare for the orderly dissolution of BART by end-2005, as provided for in the existing BART law. Additional outputs which were part of the Government's program and reflected in the FSAC as monitorable indicators, included: Improving collateral enforcement, through the maintenance of at least 2 staff for the Secured Charges Registry. The Registry of Secured Charges is adequately staffed with 3 persons and operates effectively. It has been upgraded to an internet-based registry. Improving financial reporting, through: (i) the enactment of a satisfactory Accounting Law and of amendments to relevant legislation. A satisfactory Accounting Law, substantially in line EU directives,has been enacted. The legislation mandates full implementation of IAS (now IFRS) for banks, insurance companies, and entities with public trust obligations, mandatory implementation of IAS for corporations issuing securities to the public and their use of an appropriate chart of accounts. Banks implemented IAS several years ago, based on BoA requirements. A comprehensive effort is nearing completion, with external TA, to prepare national accounting standards, consistent with EU directives, to enable reporting by the corporate sector in 2006, as mandated by the Law. Reform of the Non-Bank Financial Sector: This component is rated as marginally satisfactory and included the following outputs as part of the core conditionality of the FSAC: Enactment of satisfactory insurance legislation. New Laws on Insurance, Reinsurance and Brokers and on the Operation of the ISA, approved by Parliament in September 2004, and amended prior to release of second tranche of the FSAC, substantially comply with minimum requirements of modern good practice. Improvement has been made in the development and use of basic financial and statistical reports, and the ISA has been using these for corrective action purposes. However, there is a need to develop more comprehensive statistical reporting so that technical reserves and solvency can be monitored by ISA. In regard to the compulsory motor insurance (the main activity of insurance companies), an actuarially based premium rating system establishing transparent guidelines for setting premiums and reserving for TPL insurance was introduced. However, compliance with the regulations is weak. To remedy this situation and further strengthen supervision, the Minister of Finance has issued orders (regulations) to enforce prudent reinsurance practices and a review the entire TPL system is underway, with a view to implementing long-term reforms and improving enforcement. Establishment of an insurance regulatory agency with budgetary and operational independence, acceptable to IDA. The Law on the Operation of the ISA is in line with relevant requirements of the International Association of Insurance Supervisors in regard to budgetary and operational independence. The ISA Supervisory Council, working with the State Audit Bureau, has signed off on a business plan for the next two years and the MoF has provided written confirmation that arrangements - 7 -

11 will be put in place to ensure adequate funding of the ISA, in compliance with the Law. Additional outputs which were part of the Government's program and reflected in the FSAC as monitorable indicators, included: The Privatization of INSIG, through: (i) the signing of a sales contract with a strategic investor and/or IFI; (ii) an independent board and commercial management structure for INSIG; and (iii) retention by MoF of professional advice to help with the privatization program. In view of IFC's proposed investment in INSIG (which was approved at the same time as the FSAC), no conditionality for this privatization was incorporated in the FSAC, to avoid any conflict of interest. The Bank supported the privatization but was concerned that changes in management at INSIG and weaknesses in the regulation of the compulsory TPL system could undermine the value of INSIG. This concern proved to be valid as, over the period , INSIG's share of the non-life insurance market dropped from 60% to less than 30%. Public offering of the balance on INSIG to private investors, delayed pending improvement in the health of the international financial markets, is planned for the coming year. The indicators were robust and provided good benchmarks for measuring progress in meeting program objectives. 4.3 Net Present Value/Economic rate of return: n/a 4.4 Financial rate of return: n/a 4.5 Institutional development impact: The project's institutional development impact is assessed as high. Participation of all project beneficiaries in preparation and implementation of the program assisted in capacity building. Notably, the Banking Supervision Department of the BoA has been substantially strengthened as a result of both the development and implementation of the SDP; BART is a more structured organization, with functioning supervisory and investment boards which meet regularly, and operates as a much more effective loan collection agency. Through its improved capacity, it has helped to instill a credit culture which was previously lacking in Albania. A deposit insurance agency was established and has been operating effectively. In the case of the ISA, the institutional development impact has been marginal. Staff are now technically better equipped to fulfill their functions, but the ISA is not yet effectively carrying out its role as supervisor. The authorities are aware of these shortcomings and strengthening the ISA is the focus of ongoing efforts. The approval of the primary laws for this industry should set the basis for further improvements. 5. Major Factors Affecting Implementation and Outcome 5.1 Factors outside the control of government or implementing agency: The unfavorable situation in international financial markets led to the initial failure to privatize the SvB. After this failure, the decision to offer the bank as a whole was re-examined. The approach was found to be sound and a decision was made to intensify marketing efforts and re-offer the bank once the environment improved. Given the importance of this privatization to the Government, the delay in the privatization diverted the attention of the Government from other components of the program early on. Lack of expected donor funding delayed implementation of the IDP. The preliminary agreement that was in place for grant funding at the time the FSAC went to the Board did not materialize and alternative sources to support implementation of the bankruptcy reforms had to be identified. In retrospect, it would have been - 8 -

12 beneficial to have incorporated support for the IDP in the FSIBTA. This was, however, not done since a separate TA project for legal and judicial reform was being processed. 5.2 Factors generally subject to government control: The program supported by the FSAC enjoyed strong government commitment, at the highest levels. This is noteworthy as several changes in government, for the most part, did not negatively impact implementation of the program. The institutional weakness of ISA was exacerbated by frequent changes in key officials. This reduced the effectiveness of some of the institutional development support provided to help strengthen the insurance supervisory framework. 5.3 Factors generally subject to implementing agency control: Working level counterpart arrangements were, for brief periods, not clear. This led to a lack of proactivity in monitoring project progress (although a monitoring mechanism was in place) and in coordination with other agencies involved in the program. The actions taken to address this issue during the last year of the FSAC improved the implementation, coordination and reporting and monitoring of the program. 5.4 Costs and financing: The FSAC was comprised two tranches of SDR 6 million each. There was a one 9-month extension of the Closing Date. However, during the preparation of the FSAC, it was recognized that completing the activities incorporated in the program would be challenging and should be flexible, without strict timetables and deadlines. There were no changes in financing during project implementation and disbursements were handled as soon as the tranche release conditions were met. 6. Sustainability 6.1 Rationale for sustainability rating: Sustainability is rated as highly likely (HL). The reforms supported by the FSAC have been far-reaching and comprehensive. The associated changes have had a significant impact on the overall health of the financial sector. Concrete and noticeable improvements have been made in banking supervision as a result of the SDP; all banks are privately owned; and professionalism of the banking sector has improved. Most importantly, the successful privatization of the Savings Bank has increased the confidence of the Government in adhering to well-defined strategies and courses of action. This in turn is being evidenced by increased public confidence in the banking system. Activities have been strongly supported by adequate legislative changes, such as in the areas of deposit insurance, insurance and accounting. In addition, the bankruptcy and debt resolution framework has been institutionalized, as illustrated by introduction of materials and training programs developed under the auspices of the FSAC into curricula at the magistrates school and university. Although more needs to be done to continue to deepen financial sector reforms, especially in regard to effective supervision of the insurance market, these achievements are considered to be irreversible and are expected to contribute to the growth of the private sector. The Government and the BoA continue to be fully committed to the program articulated in the Letter of Development Policy. 6.2 Transition arrangement to regular operations: BoA has fully integrated the SDP into its commercial banking supervision plan. The IDP has been institutionalized, and the TA program is continuing. Support for insurance sector continues through the FSIBTA. The Government has indicated that strengthening insurance supervision is high on its agenda and that it intends to continue to focus on addressing the shortcomings. In regard to follow up activities, the need to focus on improving the business environment has been highlighted as a priority area in the NSSED. Related policy actions are expected to be supported in the next generation of policy-based loans

13 Continued attention also needs to be paid to strengthening the rule of law. The FSAP, currently underway, is expected to identify specifically future assistance needs for financial sector development. 7. Bank and Borrower Performance Bank 7.1 Lending: Satisfactory. The program took into account the country's development priorities. It was closely coordinated, and built strong partnerships, with the various Albanian stakeholders, IFC, IMF and other lead donors, such as EBRD and USAID. As the executing agency for the Japanese PHRD Grant for project preparation, Bank staff were instrumental in identifying and selecting high quality consultants to help with preparatory activities, such as identifying a program to strengthen BART. The team included an excellent mix of skills - insurance sector experts, banking sector and banking supervision specialists, debt workout and bankruptcy framework experts, operational staff, accounting and financial management experts, as well as a capital markets specialist. Of particular note was the close collaboration with the BoA in the development of an SDP. The FSAC was developed based on solid knowledge of the sector, backed by sector work that was incorporated in the December 1998 Country Economic Memorandum (Albania Beyond the Crisis - A Strategy for Recovery and Growth - Report No ALB). The design built heavily on achievements to date and lessons learned. Given the importance of the sector, an early decision was made to go forward with the FSAC as a free-standing policy-based operation, rather than incorporating financial sector conditionality in a Poverty Reduction Support Credit (which was being prepared simultaneously), and risking dilution of the financial sector reform agenda. 7.2 Supervision: Satisfactory. Formal supervision missions were supplemented by short technical visits (especially for insurance and banking supervision), as well as by video and audio conferences. As most staff also worked on the related FSIBTA, synergies were realized, both in substance and cost. Furthermore, a regular and open dialogue was maintained with the counterpart team throughout implementation of the program. Field office staff played a critical and substantive role in the overall success of the operation. The competency of FSAC team helped to reduce to a minimum the need for management inputs - which were available when necessary. Project reporting has been timely and of a good quality. 7.3 Overall Bank performance: Satisfactory. The continuity of staffing working on this program was a critical factor in the success of the operation. The team maintained excellent working relationships with various counterparts and the quality of the documents show that the authorities developed a high level of trust in the team. Borrower 7.4 Preparation: Highly satisfactory. The Borrower's performance throughout preparation was highly satisfactory. The Government and the BoA exhibited strong commitment to the program. The Minister of Finance and the Governor of the BoA were strong champions who actively participated in the design of the program and assigned a fully competent team to work on the details with the Bank. This resulted in the Government taking full ownership of the activities. It profited from expert assistance provided under PHRD grant, especially for development of the IDP and the elaboration of the program for strengthening BART. The SDP was strongly and actively promoted by the BoA. The Letter of Development Policy clearly articulated the steps that the authorities planned to take to continue and strengthen the implementation of their financial sector reform program

14 7.5 Government implementation performance: Satisfactory. Initially, the authorities, given their limited capacity, clearly devoted most attention to issues relating to the privatization of the SvB, including participation in high-level strategy discussions, roundtables and marketing. The involvement of highest level officials was maintained throughout the process to ensure that corrective actions (if needed) could be taken in a timely manner so that activities did not get off track and these officials were fully available for discussions and meetings with missions. Effective use of TA helped the authorities in their management of the program. 7.6 Implementing Agency: Satisfactory. Management effectiveness was satisfactory although changes in the working level counterpart weakened monitoring during the course of implementation. This improved as soon as corrective actions were taken by the MoF. Credit covenants were complied with and overall the program was effectively monitored. 7.7 Overall Borrower performance: Satisfactory. The Borrower remained highly committed the financial sector reform program throughout the period, in spite of pressures to act differently, especially in regard to options for divestiture from government control of the SvB. The Borrower actively sought, and was receptive to, the Bank's advice. 8. Lessons Learned Technical assistance greatly enhances the reform process, especially when it is in place prior to the policy-based operation. The provision of timely and sufficient TA through the FSIBTA was part of the strategy for the financial sector reform program and was instrumental in supporting the preparation and implementation of the FSAC. The early availability of these resources facilitated the design of an operation with strong up-front conditionality. It also served to reinforce the Government's commitment to the program. Clear project design and quality at entry are important. The attention paid to project design led to development of a challenging program with realistic outcomes. It helped establish that the focus of the program should be on capacity building and implementation, i.e. establishing a framework is not enough, if the implementation capacity does not exist. This focus also proved helpful in keeping the reform program on track as it facilitated good measurement of achievements over time. Furthermore, the sequencing of the reforms is important. Given the limited capacity of the Government, it needed to concentrate on its banking privatization program before moving ahead at full speed with other areas of financial sector reform. Commitment of the borrower and other beneficiaries is essential for the success of a reform program. Obtaining and maintaining real commitment and ownership for the reforms are key to the success of the program, which is heavily dependent on effective champions. A frank and open dialogue contributed to good understandings of the reform objectives and the specific requirements of each component. The MoF (even though there were several changes in Ministers during the life of the operation), and the BoA consistently displayed strong ownership of the program. Staffing continuity facilitates implementation of the reform program. The fact that the same team supported the development, preparation and implementation of the program was an important factor in maintaining the focus of the operation and was key in the openness of the dialogue. The quality of this dialogue helped establish an atmosphere of trust, as a result of which the authorities did not hesitate to approach the team for advice and guidance. Coordination with other IFIs should be maintained to ensure the consistency of approach. Throughout

15 the preparation and implementation of the FSAC, close coordination was maintained with the IMF to ensure that the conditionality of the two institutions was complementary. This also helped to reinforce the program, provide leverage for the Government in pursuing difficult or controversial agendas, particularly in regard to privatizing the SvB. Joint meetings with IFC and EBRD in regard to the privatization strategy for the banks and insurance company were also key to the successful implementation of this agenda. Although synergies can be realized by involving other members of the Bank Group, extra care needs to be taken in project design to avoid real and perceived conflicts of interest. Although the privatization of INSIG was included in the FSAC program, it was dropped from the final conditionality because of IFC's expected pre-privatization agreement to invest in INSIG. While retaining INSIG in the program was important for the overall development of the financial sector, the Bank's options in regard to pursuing conditionality relating to INSIG were limited as a potential conflict of interest could have resulted from IFC's eventual privatization investment. 9. Partner Comments (a) Borrower/implementing agency: Translation of joint letter dated June 10, 2005, from the Ministry of Finance and Bank of Albania, to Mr. Hormoz Aghdaey, FSAC Team Leader, providing the Government of Albania Assessment on the Financial Sector Adjustment Credit Implementation Dear Mr. Aghdaey, Kindly find below our assessment of the process of the formulation and development of the FSAC. The main components of this agreement focused in the reform in the financial sector, which in itself included the key elements of this program such as: Continuation of the reform in the banking sector; Improving the legal framework regarding bankruptcy and dispute settlement; Reform in the financial non-banking system. The biggest event in the banking system reform was the successful privatization of the Savings Bank from Raiffeisen Bank. As you are informed, the process of restructuring and privatization of state-owned banks began in 1997, with the decision for winding down the Rural Commercial Bank (RCB) and the transfer of its assets and liabilities to the Savings Bank. In order to ensure proper administration of non-performing assets of the second tier banks that would embark on the privatization process, the LCA (BART) was established via special legislation. Approximately Lek 3.6 billion non-performing assets (mainly small rural credits) were transferred from the balance sheet of RCB to the LCA. This process was the first stage of this reform. The second stage of the process was the restructuring and privatization of NCB. This was achieved via important technical assistance for the rationalization and modernization of the NCB operations. In 2000, approximately Lek 10.4 billion non-performing assets were transferred to the LCA and the bank was recapitalized and sold to a consortium of private investors. The third stage of the program aimed at the privatization of the Savings Bank. This is considered as the most important event in the banking system reform, which is bringing important changes in the financial system of Albania with regard to the diversity of banking services, as well as with regard to technology,

16 real competition, a re-dimensioning of the banks and a new mentality in their management. The entry in the market of Raiffeisen Bank, together with the licensing of new banks has created very appropriate conditions for real growth of market competition and improving the quantity and quality of products delivered to the public at large. There has been a considerable increase in the level of crediting of various sectors of economy, and a spread in the public use of modern payment instruments such as debt and credit cards. The LCA was also part of the FSAC agreement with clear tasks and objectives, which led to the realization of their quantitative and qualitative indicators. Also, as a result of the objectives established in the FSAC, for the first time the balance-sheet and financial statements of the LCA were audited, and the accounting was brought in line with the recommendations of KPMG and internationally accepted standards. Regarding the satisfactory results in the recovery of non-performing assets in the LCA, we would like to point out the need for the further existence of this institution in this future and for your assistance due to the legal deadline for the exercise of its activity until the end of To this end, keeping the LCA as an institution that will continue to take care of paying off the remaining portfolio or the establishment of another institution, which would include LCA in its composition, would be an alternative or another step forward in the context of the launched reform. Also, the Bank of Albania was directly involved in the implementation of some pre-requisites related to FSAC. Through that, BoA managed to: (i) strengthen the supervision function through implementation of the matrix of actions defined in the Supervisory Development Plan (SDP); (ii) introducing the RTGS and AECH systems; and (iii) enhancing competition in the banking market. As a result of the FSAC, tangible progress has been made with regard to meeting the requirements of the SDP, which has consisted in parallel work with regard to improving the regulatory framework, and supervision practices. In the context of improving the regulatory framework, several existing regulations have been reviewed, as well as some new ones have been approved. We can mention here the regulations on Prevention of money laundering, External bank accountants, Credit management, etc. The goal behind these changes and additions was to bring the procedures and regulations closer to the best international practice. The supervision practice has witnessed substantial improvements. Work began with the definition of the role of supervision through the annual publication of the Supervision Mission (i.e. goal). Also, the internal procedures for decision-making have been introduced through the approval of the Decision-Making Matrix by the Supervisory Board of the Bank of Albania. There is in place a Document of Supervision Operational Policies, which guides the supervisory process towards the identification and risk assessment in the banking activity. This document also determines the supervisory actions for a bank with a given risk profile through the supervisory cycle. Within the Supervision Department there are now clear internal procedures for the assessment of the necessary human resources, and for the quality of the supervisory practices. In the context of supervisory practices, importance is attached also to the direct communication with the banking industry and the external audit firms of the banks. Contacts have increased considerably with the banks, and there is in place an improved process of exchange of thoughts on various/different issues of concern for both parties. External audit firms play a pivotal role in this relation. There is strengthened