IMPLEMENTATION COMPLETION AND RESULTS REPORT (IBRD-83730) ON A LOAN IN THE AMOUNT OF USD 100 MILLION TO THE FOR A.

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1 Public Disclosure Authorized Document of The World Bank Report No: ICR Public Disclosure Authorized IMPLEMENTATION COMPLETION AND RESULTS REPORT (IBRD-83730) ON A LOAN IN THE AMOUNT OF USD 100 MILLION Public Disclosure Authorized TO THE REPUBLIC OF ALBANIA FOR A FINANCIAL SECTOR MODERNIZATION LOAN December 16, 2015 Public Disclosure Authorized Finance & Markets Global Practice South East Europe Country Unit Europe and Central Asia Region

2 CURRENCY EQUIVALENTS (Exchange Rate Effective December 16, 2015) Currency Unit = Albanian Lek (ALL) US$1.00 = ALL US$ 1.00 = SDR 0.72 ALBANIA GOVERNMENT FISCAL YEAR January 1 December 31 ABBREVIATIONS AND ACRONYMS (As applicable, plus others) AAB Albanian Association of Bankers IEF Index of Economic Freedom ADIA Albania Deposit Insurance Authority IFC International Finance Corporation AFSA Albanian Financial Supervisory Authority IFIs International Financial Institutions BoA Bank of Albania IMF International Monetary Fund CAD Current Account Deficit JSAN Joint Staff Advisory Note CAS Country Assistance Strategy LDP Letter of Development Policy CDS Credit Default Swaps MDGs Millennium Development Goals DB Doing Business MOC Memorandum of Cooperation DPL Development Policy Loan MoF Ministry of Finance DPO Development Policy Operation MoJ Ministry of Justice EBA European Banking Authority MTBP Medium-Term Budget Plan ECB European Central Bank MTEF Medium-Term Expenditure Framework EFF Extended Fund Facility MTPL Motor Third Party Liability EFSF European Financial Stability Facility NBFI Non-bank financial institutions ESM European Stability Mechanism NPL Non-Performing Loans EU European Union NSDI National Strategy for Development and Integration FIRST Financial Sector Reform and Strengthening PER Public Expenditure Review Initiative FSAP Financial Sector Assessment Program PHRD Japan Policy and Human Resources Development Trust Fund FSAG Financial Stability Action Group PRGF Poverty Reduction and Growth Facility FSVC Financial Services Volunteer Corps ROSC Report on the Observance of Standards and Codes FSML Financial Sector Modernization Loan SDR Special Drawing Rights GDP Gross Domestic Product SOE State-Owned Enterprise GIZ Gessellschaft fur Internationale TA Technical Assistance Zusammenarbeit (German Society for International Cooperation) GNP Gross National Product UNDP United Nations Development Program HIPC Heavily Indebted Poor Countries USAID United States Agency for International Development IADI International Association of Deposit Insurers VAT Value-added tax IBRD International Bank for Reconstruction and Development IDA International Development Association

3 Senior Global Practice Director: Gloria Grandolini Sector Manager: Aurora Ferrari Project Team Leader: Michael Edwards ICR Team Leader: Cevdet Cagdas Unal

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5 REPUBLIC OF ALBANIA FINANCIAL SECTOR MODERNIZATION LOAN Contents 1. Program Context, Development Objectives and Design Context at Appraisal Original Program Development Objectives (PDO) and Key Indicators (as approved) Revised PDO (as approved by original approving authority) and Key Indicators, and Reasons/Justification Original Policy Areas Supported by the Program (as approved) Revised Policy Areas (if applicable) Other significant changes Key Factors Affecting Implementation and Outcomes Program Performance Major Factors Affecting Implementation: Monitoring and Evaluation (M&E) Design, Implementation and Utilization: Expected Next Phase/Follow-up Operation Assessment of Outcomes Relevance of Objectives, Design and Implementation Achievement of Program Development Objectives Justification of Overall Outcome Rating Overarching Themes, Other Outcomes and Impacts Summary of Findings of Beneficiary Survey and/or Stakeholder Workshops Assessment of Risk to Development Outcome Assessment of Bank and Borrower Performance Bank Performance Borrower Performance Lessons Learned Comments on Issues Raised by Borrower/Implementing Agencies/Partners Annex 1 Bank Lending and Implementation Support/Supervision Processes (a) Task Team members (b) Staff Time and Cost Annex 2. Beneficiary Survey Results Annex 3. Stakeholder Workshop Report and Results Annex 4. Summary of Borrower's ICR and/or Comments on Draft ICR Annex 5. Comments of Cofinanciers and Other Partners/Stakeholders Annex 6. List of Supporting Documents MAP

6 A. Basic Information Country: Albania Program Name: AL Financial Sector DPL Program ID: P L/C/TF Number(s): IBRD ICR Date: 12/21/2015 ICR Type: Core ICR Lending Instrument: DPL Borrower: Original Total Commitment: Revised Amount: USD M Implementing Agencies: Ministry of Finance Cofinanciers and Other External Partners: MINISTRY OF FINANCE USD M Disbursed Amount: USD 96.28M B. Key Dates Process Date Process Original Date Revised / Actual Date(s) Concept Review: 01/16/2014 Effectiveness: Appraisal: 03/19/2014 Restructuring(s): Approval: 05/15/2014 Mid-term Review: Closing: 06/30/ /30/2015 C. Ratings Summary C.1 Performance Rating by ICR Outcomes: Risk to Development Outcome: Bank Performance: Borrower Performance: Satisfactory Substantial Satisfactory Satisfactory C.2 Detailed Ratings of Bank and Borrower Performance (by ICR) Bank Ratings Borrower Ratings Quality at Entry: Satisfactory Government: Satisfactory Quality of Supervision: Satisfactory Implementing Agency/Agencies: Satisfactory Overall Bank Performance: Satisfactory Overall Borrower Performance: Satisfactory 2

7 C.3 Quality at Entry and Implementation Performance Indicators Implementation QAG Assessments Indicators Performance (if any) Potential Problem Program at any time (Yes/No): Problem Program at any time (Yes/No): DO rating before Closing/Inactive status: No No Quality at Entry (QEA): Quality of Supervision (QSA): None None Rating: D. Sector and Theme Codes Original Actual Sector Code (as % of total Bank financing) Banking General finance sector Theme Code (as % of total Bank financing) Legal institutions for a market economy Other Financial Sector Development E. Bank Staff Positions At ICR At Approval Vice President: Laura Tuck Jan Walliser Country Director: Ellen A. Goldstein Ellen A. Goldstein Practice Manager/Manager: Aurora Ferrari Aurora Ferrari Program Team Leader: Michael Edwards Michael Edwards ICR Team Leader: ICR Primary Author: Cevdet Cagdas Unal Cevdet Cagdas Unal F. Results Framework Analysis Program Development Objectives (from Project Appraisal Document) The PDO is to strengthen the financial sector regulatory and supervisory regime and mitigate key vulnerabilities of the bank and non-bank financial sectors. The DPL was structured around three pillars: (i) strengthening regulation and supervision of the banking sector and financial safety net; (ii) expediting resolution of 3

8 non-performing loans (NPLs); and (iii) strengthening regulation and supervision of Nonbank Financial Institutions (NBFIs). Revised Program Development Objectives (if any, as approved by original approving authority) (a) PDO Indicator(s) Indicator Indicator 1 : Value (quantitative or Qualitative) Baseline Value Original Target Values (from approval documents) Formally Revised Target Values Actual Value Achieved at Completion or Target Years By end-march 2015, inspections of five of 16 banks are conducted in accordance with the new Risk Based Supervisory Manual and the new Supervisory Operational Policy, including at least two systemic banks. 0 banks. Currently the Supervisory Manual 5 out 16 banks, and Operational Policy including 2 are mostly compliancebased. systemic banks 6 out of 16 banks, including 2 systemic banks Date achieved 03/31/ /31/ /31/2015 Comments (incl. % achievement) As of end March 2015, six banks (5 full scope examinations 1 partial examination), out of which four large systemic banks were inspected using the new risk based supervision manual. By end-march 2015, all banks determined as systemically important submit Indicator 2 : enhanced Recovery Plans to BoA, in line with the new BoA Instruction that formalizes the content to be included in banks Recovery Plans. Value (quantitative or Qualitative) All banks determined as systemically important submit Systemic banks have enhanced submitted Recovery Plans to initial recovery plans to BoA, in line with BoA with no the new BoA formalized content Instruction that formalizes the content to be included in banks Recovery Plans. All banks determined as systemically important submit enhanced Recovery Plans to BoA, in line with the new BoA Instruction that formalizes the content to be included in banks Recovery Plans. Date achieved 03/31/ /31/ /31/2015 According to the BoA Supervisory Council decision (Nr.11) on the 26th of Comments February 2014, banks operating in Albania that are determined as systemically (incl. % important shall submit to BoA their recovery plans (RPs) no later than the end achievement) of the first quarter. By end-march 2015, ADIA completes assessment of compliance of eligible Indicator 3 : SCAs with the legal and technical requirements of ADIA in order to ensure 4

9 Value (quantitative or Qualitative) that eligible SCAs enter the deposit insurance scheme by end ADIA completes assessment of compliance of eligible SCAs with the legal and SCAs are not included technical in the deposit insurance requirements of scheme ADIA in order to ensure that eligible SCAs enter the deposit insurance scheme by end The assessment of compliance of SCAs eligible to enter the deposit insurance scheme was completed in September Date achieved 03/31/ /31/ /30/2014 Comments The assessment of compliance of SCAs eligible to enter the deposit (incl. % insurance scheme was completed in September achievement) Indicator 4 : By end-march 2015, ADIA approves its own budget without BoA ratification. Value (quantitative or Qualitative) ADIA budget is ratified by BoA ADIA budget is ratified by BoA ADIA s board approved in January 2015 the new budget without BoA s ratification. Date achieved 03/31/ /31/ /31/2015 Comments The new ADIA law empowered ADIA s board to approve the new budget (incl. % without BoA s ratification. achievement) By end-march 2015, the ratio of NPLs/total loans declines to 20 percent or Indicator 5 : less, with the write-off of at least lek 20 billion of NPLs. Value (quantitative or Qualitative) 23.5% NPL ratio 20% or less, At least LEK 20 billion written off 20.6% Date achieved 12/31/ /31/ /30/2015 After peaking at 24.9% in Sep 2014 the NPL ratio came down to 20.6 % as of Comments end September In total, Lek 20.3billion of NPLs were written off till the (incl. % end of September 2015, six months after the targeted date due to the delay in achievement) the enforcement. By end- March 2015, AFSA s Board adopts its own organizational structure Indicator 6 : and market-based salary scale independently from Parliament, allowing it to regulate and supervise NBFIs more effectively. Value (quantitative or Qualitative) AFSA AFSA organizational organizational structure is currently structure is approved by Parliament currently approved and salaries are set in by Parliament and accordance with civil salaries are set in servants salary scale accordance with AFSA approved its own structure, including a new own salary scale 5

10 civil servants salary scale Date achieved 03/31/ /31/ /31/2015 Comments (incl. % achievement) Indicator 7 : Value (quantitative or Qualitative) AFSA new board, based on the powers granted through amendments to the La on AFSA, Law on Salaries of Independent Institutions, and Law on Civil Service, has full power to approve AFSA s organizational structure and salaries scale. By end March-2015, funding of the MTPL Compensation Fund is replenished in the amount of Lek 430 Million to enable payment of pending insurance claims. Compensation Fund is depleted with no funds to pay pending insurance claims Funding of the MTPL Compensation Fund is replenished in the amount of Lek 430 Million to enable payment of pending insurance claims. LEK million claims paid-off Date achieved 03/31/ /31/ /31/2015 Comments The MTPL Compensation Fund is replenished as expected. The achievement (incl. % ratio was 105%. achievement) (b) Intermediate Outcome Indicator(s) Indicator Baseline Value Original Target Values (from approval documents) Formally Revised Target Values Actual Value Achieved at Completion or Target Years G. Ratings of Program Performance in ISRs No. Date ISR Archived DO IP Actual Disbursements (USD millions) H. Restructuring (if any) Not Applicable 6

11 1. Program Context, Development Objectives and Design 1.1 Context at Appraisal Albania s sustained high economic growth in the decade prior to the 2008 global financial crisis helped it achieve a middle income status, reduce poverty and increase shared prosperity. During , annual growth averaged 6 percent in real terms. Although this period of strong growth was not matched by the same level of employment creation, it was successful in terms of poverty reduction. Absolute poverty halved from 25 percent in 2002 to about 18 percent by Albania was hit hard by the global crisis, but was able to avoid a recession. The crisis led to lower remittances and other flows, which in turn contributed to lower growth. Gross domestic product (GDP) grew by an average of below 3 percent between 2009 and The economy has been slowing significantly since 2012, as rising government payment arrears - on the back of tax refunds, continued multi-year investment projects and public works - and subdued credit growth contributed to weaknesses in domestic demand. The public debt surged from 55 percent of GDP in 2008 to 71 percent in 2013, posing interest rate and rollover risks. In 2013, growth slowed to 1.4 percent, and is expected to average 2 percent between 2014 and Following the 2008 global financial crisis, the banking sector remained stable (with adequate capital and liquidity), but key vulnerabilities were unresolved as the Greek crisis entered a new phase. High financial euroization, strong financial links between banks and government debt holdings, and the dominant presence of subsidiaries of foreign banks (mostly from Eurozone) increased the banking sector s vulnerabilities to potential shocks. Non-performing loans (NPL) ratios were amongst the highest in the region, leading to a sharp slowdown in credit growth as banks took a conservative approach to lending. The sharp decline in bank profitability and the rise of NPL rates presented key risks to the banking sector, undermining credit growth. Return on equity fell to below 6.4 percent in 2013, from over 20 percent in NPLs increased to 23.5 percent at end-2013, from 3 percent at end The sharp rise of NPLs was due to a combination of factors, including past poor credit underwriting practices by banks, the general economic slowdown, the rise in government arrears (as a result of poor tax revenue performance and continued infrastructure spending), and an unreliable collateral execution regime. Credit growth turned negative at end-november 2013, declining by 2.4 percent (year-onyear). The strong financial links between banks and the government further increased macrofinancial vulnerabilities. A large share of bank assets was invested in government securities, representing more than 60 percent of government debt. This significant interdependence presented systemic risks to banks (that were vulnerable both to the lack of liquidity and to changes in the value of longer term debt securities) and to the government (that depended on the regular roll over of debt by banks to finance its deficit). 7

12 The risk was further heightened by the lack of a well-functioning secondary market, and the emergence of investment funds that faced significant liquidity risks and challenges regarding asset valuation. The nonbank financial sector was small - but new risks emerged in 2013 as investment funds begun growing considerably since late 2012 under an inadequate regulatory and supervisory framework. While these funds had helped diversify the ownership of government securities, their emergence had not been matched with an adequate regulatory and supervisory regime. The insurance market also faced significant challenges, as insurance companies were not financing outstanding liabilities in full. Due to the need for a major institutional reform to achieve financial and operational independence of the nonbank regulator, the regulation and supervision of the sector had lagged behind considerably. The deposit insurance framework, managed by the Albanian Deposit Insurance Agency (ADIA), broadly conformed to international best practice. ADIA ensured approximately 58 percent of deposits in the banking system. ADIA had made impressive progress in improving its operations and in building its organizational structure. The ADIA law was amended in 2012 to address a key set of reforms to extend coverage to Savings and Credit Associations (SCAs), facilitate a prompt pay-out after Bank of Albania (BoA) intervention, and expand ADIA powers to contribute to a purchase and assumption or bridge bank resolution. Overall, during the preparation of this Development Policy Operation (DPO), the domestic and external vulnerabilities in Albania were high and posed serious threats to macroeconomic and financial sector stability. Public debt and fiscal financing needs were among the highest in the region. Heavy trade, financial, and remittance dependence on Italy and Greece remained important potential sources of vulnerability. In response to the challenges mentioned above, the new Government of Albania had committed at a high level to correct fiscal imbalances through fiscal consolidation, and to undertake key reforms to restore macroeconomic and financial sector stability. In particular, the financial sector authorities undertook significant measures to minimize vulnerabilities in the financial sector, including, but not limited, to NPL management and resolution; the introduction of a resolution regime for SCAs; the enhancement of the deposit insurance framework; and the development of the insurance market. Meanwhile, since the early 2000s, Albania had implemented a range of institutional and structural reforms that had moved it closer to EU membership. The European Commission awarded the country with candidate status in June Yet, the Government s ambition and drive to reform are tempered by limited prior public sector experience and the country s historically weak administrative capacity to implement change. Nonetheless, with adequate support from the international community, Albania now has a historic opportunity to break with the past and accelerate its path toward prosperity and integration into the EU. This opportunity has been met with an increased level of The World Bank Group (WBG) support to implement deep and long- 8

13 overdue structural reforms. In particular, the WBG stepped up its engagement in Albania to support the ambitious reform agenda of the new Government on tackling fiscal and financial sector challenges. The WBG intensified its activities on both lending and knowledge sharing. On the lending side, the First Public Finance Development Policy Loan (DPL) was delivered on May 2014, along with this operation. On the knowledge sharing side, the late-2013 FSAP was particularly important, including for this operation, as it provided the fundamental analytical grounds within a broad framework. Last but not the least, the IMF s Extended Fund Facility (EFF) three year program (approved in Feb 2014) in the amount of EUR330.1 million (around US$457.1 million) has been helping Albania to meet its external financing needs, while providing the necessary support to strengthen fiscal and debt sustainability, lower public financing risks, and put the economy on a sustained growth path. 1.2 Original Program Development Objectives (PDO) and Key Indicators (as approved) The PDO is to strengthen the financial sector regulatory and supervisory regime and mitigate key vulnerabilities of the bank and non-bank financial sectors. The DPL was structured around three pillars: (i) strengthening regulation and supervision of the banking sector and financial safety net; (ii) expediting resolution of nonperforming loans (NPLs); and (iii) strengthening regulation and supervision of Nonbank Financial Institutions (NBFIs). The following outcome indicators were used to measure results achieved in this DPL: Pillar I Strengthening regulation and supervision of the banking sector and financial safety net 1. By end-march 2015, inspections of five of 16 banks are conducted in accordance with the new Risk Based Supervisory Manual and the new Supervisory Operational Policy, including at least two systemic banks. 2. By end-march 2015, all banks determined as systemically important submit enhanced Recovery Plans to BoA, in line with the new BoA Instruction that formalizes content that must be included in banks Recovery Plans. 3. By end-march 2015, ADIA completes assessment of compliance of eligible SCAs with the legal and technical requirements of ADIA in order to ensure that eligible SCAs enter the deposit insurance scheme by end By end-march 2015, ADIA approves its own budget without BoA ratification. Pillar II Expediting resolution of NPLs 5. By end-march 2015, the ratio of NPLs/total loans declines to 20 percent or less, with the write-off of at least 20 billion of NPLs. Pillar III Strengthening regulation and supervision of NBFIs 6. By end- March 2015, AFSA s Board adopts its own organizational structure and market-based salary scale independently from Parliament, allowing it to regulate and 9

14 supervise NBFIs more effectively 7. By end March-2015, funding of the MTPL Compensation Fund is replenished in the amount of Lek 430 Million to enable payment of pending insurance claims. 1.3 Revised PDO (as approved by original approving authority) and Key Indicators, and Reasons/Justification None 1.4 Original Policy Areas Supported by the Program (as approved) The Financial Sector Modernization DPL supported a set of ten prior actions to help Albania implement key financial sector reforms: Prior Action #1: BoA Supervisory Council adopts a new comprehensive Risk Based Supervisory Manual and a new Supervisory Operational Policy to increase effectiveness of banking supervision. The adoption of a risk-based supervisory framework will result in more efficient utilization of supervisory resources, and hence will increase the quality of banking supervision and contribute to the stability of the financial system. Prior Action #2: BoA Supervisory Council issues new Instruction for designated systemic banks to adopt Recovery Plans to demonstrate their ability to operate during periods of stress. The formal adoption of a new mandatory Instruction for the preparation of bank specific recovery plans would increase the resiliency of the banking system and allow BoA to better utilize its supervisory resources and resolution powers. Prior Action # 3: Amendments to the Law on Deposit Insurance are accepted by Cabinet of Ministers and submitted to Parliament, to better align the legislation and operations of ADIA with the Core Principles for Effective Deposit Insurance Systems. To fulfill international best practice, ADIA should be provided greater autonomy in its operations. Prior Action # 4: Cabinet of Ministers submits draft amendments of tax law No to Parliament to resolve key NPL tax ambiguities to enable banks to write-off NPLs in protracted litigation. The five prior actions (Nos. 4 8) are to cumulatively contribute to the reduction of the NPL stock. The expected result is that by end-march 2015, the ratio of NPLs/total loans declines to 20% or less. Prior Action # 5: BoA Supervisory Council adopts amended regulation on Credit Risk Administration for the obligatory write-off of stale-dated NPLs following a fixed period of time classified in the loss category. To facilitate the write-off of stale-dated NPLs, the BoA will introduce changes to the regulation On Credit Risk Administration to define a maximum period of holding loss loans in the balance sheet on the bank. Prior Action # 6: BOA issues three sets of guidelines on: (i) loan restructuring for businesses; (ii) loan restructuring for individuals; and (iii) real estate appraisal, based on international good practice. The goal is to allow cooperative borrowers facing financial 10

15 difficulties the opportunity to fulfill their contractual obligations so their businesses can continue and minimize the execution of collateral. Prior Action #7: BoA Supervisory Council adopts a new regulation on Risk Administration for Banks Large Exposures to strengthen credit underwriting practices and NPL recovery and resolution for large borrowers. It is expected that banks will significantly improve their underwriting standards. Prior Action #8: MoJ and MoF to issue new instructions to provide market based incentives for private bailiffs compensation. This will result in increased competition and improved incentives to promptly execute on collateral, a necessary prerequisite to the reduction of NPLs. Prior Action #9: To ensure the financial and operational independence of the AFSA, the Cabinet of Ministers accepts and submits to Parliament: a new Insurance bill, and amendments to AFSA Law, Law on Salaries of Independent Institutions, and the Civil Servant Law. The AFSA Law is to be amended, inter alia, to: (i) abolish the requirements for the AFSA to have its organizational structure approved by the Parliament, and (ii) remove the AFSA from the civil servants compensation and benefits structure, so it has the ability to attract and retain sufficient experienced technical staff. Prior Action #10: The AFSA adopts market stabilization measures to issue: (i) a regulation on minimum MTPL reserving standards; and (ii) a time-bound plan to replenish funding of the Compensation Fund. AFSA has agreed to undertake immediate MTPL market stabilization measures by establishing through regulation minimum reserving standards to ensure a level playing field, adequate claims paying capacity and the overall solvency of the market. 1.5 Revised Policy Areas (if applicable) None 1.6 Other significant changes None 2. Key Factors Affecting Implementation and Outcomes 2.1 Program Performance All the planned policy actions were implemented by authorities. Prior Actions of FSM DPL Status Pillar I. Strengthening regulation and supervision of the banking sector and financial safety net 11

16 BoA Supervisory Council adopted a new comprehensive Risk Based Supervisory Manual and a new Supervisory Operational Policy to increase effectiveness of banking supervision. Completed The Supervisory Operational Policy has been approved by the Supervisory Council of BoA, with Decision No. 9, Date 26 Feb In conjunction with the Supervisory Operational Policy, the Risk Assesment Manual document has also been approved by the First Deputy Governor of the BoA,with the Order No.590, Date 27 Feb 2014, and enters in force by 1 st January BoA Supervisory Council issued a new Instruction for banks to adopt Recovery Plans to demonstrate their ability to operate during periods of stress. BoA Supervisory Council issued a mandatory Guideline on Recovery Plans, on 26 Feb Amendments to the Law on Deposit Insurance were accepted by Cabinet of Ministers and submitted to Parliament, to better align the legislation and operations of ADIA with the Core Principles for Effective Deposit Insurance Systems. This new law ensured ability of ADIA to approve its own budget. But, the Parliament changed the original draft in one of the issues as to increase the proposed coverage for Savings and Credit Associations from the WB proposed ALL 1 million to ALL 2 million, close to the banks coverage of ALL 2.5 million. Completed Completed The new Deposit Insurance draft amendments were approved by the Council of Ministers in the meeting of 26 Mar The Parliament approved the new Deposit Insurance law amendments on 22 May 2014 Pillar II. Expediting the resolution of NPLs Cabinet of Ministers submitted draft amendments of tax law No to Parliament to resolve key NPL tax ambiguities to enable banks to write-off NPLs in protracted litigation. This is expected to facilitate the write-off of NPLs. Approved in the Council of Ministers meeting of 05 Feb Approved amendments to the Tax Law in the Parliament on 03 Apr Completed BoA Supervisory Council amended regulation on Credit Risk Completed 12

17 Administration for the obligatory write-off of stale-dated NPLs following a fixed period of time classified in the loss category. BoA Supervisory Council approved with decision No. 22, dated 27 Feb 2014 an amendment to the regulation No. 62 of BoA on Credit Risk Administration that provides for obligatory requirements for banks related with the write-off process (entered in force in January 2015). To support credit restructuring and repayment BOA issued three sets of guidelines on: (i) loan restructuring for businesses; (ii) loan restructuring for individuals; and (iii) real estate appraisal, based on international good practice. Approved by BoA Supervisory Council in October 2013 BoA Supervisory Council adopted a new regulation on Risk Administration for Banks Large Exposures to strengthen credit underwriting practices and NPL recovery and resolution for large borrowers. BoA Supervisory Council approved by decision No. 10, dated 26 Feb 2014 the new regulation On the risk management from large exposures of banks MoJ and MoF issued a new joint Instruction to provide market based incentives for private bailiffs compensation. Completed Completed Completed Joint instruction of the Ministry of Justice and the Ministry of Finance No.1665/1 dated 5 March 2014 On determining bailiff tariffs for services provided by the private judicial bailiff service was issued. Pillar III. Strengthening regulation and supervision of NBFIs Completed To ensure the financial and operational independence of the AFSA, the Cabinet of Ministers accepted and submitted to Parliament: a new Insurance bill, and amendments to AFSA Law, Law on Salaries of Independent Institutions, and the Civil Servant Law. Council of Ministers approved in the meeting of 19 March 2014: i) draft law On some amendments to the Law No. 9572, dated On the Financial Supervisory Authority ; ii) draft law On an addition to the Law No. 152/2013 On the Civil Service iii) draft law On some changes to the Law No. 9584, dated 13

18 On salaries, rewards and structure of constitutional independent institutions and of other independent institutions, created by law Council of Ministers approved in the meeting of 19 March 2014 the new Insurance draft Law The Parliament of Albania approved: (i) On 29 May 2014 the draft law On some amendments to the Law No. 9572, dated On the Financial Supervisory Authority ; (ii) On 22 May 2014 the new Insurance Law; (iii) On 12 Jun 2014 the draft law On some changes to the Law No. 9584, dated On salaries, rewards and structure of constitutional independent institutions and of other independent institutions, created by law (iv) On 18 Dec 2014, draft law On an addition to the Law No. 152/2013 On the Civil Servant The AFSA adopted insurance market stabilization measures to issue: (i) a regulation on minimum MTPL reserving standards; and (ii) a time-bound plan to replenish funding of the Compensation Fund. Completed i) Decision no. 17 of AFSA Board, dated 28 Feb 2014 On compensation fund for the year 2014 ii) Decision no. 18 of AFSA Board, dated 28 Feb 2014 On the adoption of regulation "Setting the rules for payment from the cash reserve damages covered by insurance contracts in compulsory motor insurance in the transport sector" 2.2 Major Factors Affecting Implementation: Adequacy of government's commitment, stakeholder involvement, and/or participatory processes: The design of the Government s reform program and this operation benefited from extensive consultations with relevant stakeholders. The authorities have pro-actively communicated with the stakeholders and public on the objectives of the DPL supported financial sector reform program. The MoF, BoA and AFSA representatives made appearances on media, issued public information (published on respective web-pages), and organized roundtables to explain the measures taken by the authorities to boost market confidence and restore healthy financial intermediation. 14

19 The changes in legislation were thoroughly discussed with industry stakeholders, and went through an extensive inter-ministerial harmonization process before their submission to the Parliament. The Bank team also consulted widely with stakeholders, including banking sector representatives, Savings and Credit Associations and their Unions, investment funds, insurance companies, bailiffs, academics, and representatives of other key development partners, including the IMF, the EC Delegation, and USAID. Nevertheless, the MoF and MoJ joint instruction on private bailiff s fees, issued in accord with the DPL policy matrix, was subsequently challenged in court by the Bailiff s Chamber. The court ruled in favor of the Bailiff s Chamber and suspended implementation of the new joint instruction. The Government thereafter appealed the court decision, and is currently awaiting a decision by the High Court. In the interim, market participants have signaled the return to prior practices. Soundness of the background analysis supporting the operation(s), lessons learned incorporated, and the rationale for the Bank s intervention: This lending operation followed the late 2013 FSAP. Hence, the project team had unprecedented background analysis on the banking and non-banking sectors alike for the project s preparation. The detailed financial sector featured in Annex 4 of the Project Document demonstrated the depth of understanding of the challenges the financial sector faced as well. The operation incorporated lessons from the World Bank s experiences with the Eurozone crisis, as well as with previous economic and financial crises. A relatively recent comprehensive review of the World Bank s responses to financial crises 1 underscored the following lessons that the operation fulfilled: Need for focus. In responding to an uneven and uncertain external environment, it is crucial that the operation focuses on selected key areas for good outcomes. The operation incorporated this lesson by focusing on a main challenge recognized by the Government and the BoA, namely, addressing key regulatory and supervisory gaps for the bank and non-bank sectors, reducing the stock and flow of NPLs, and strengthening the deposit insurance regime so that the entire financial sector can become more resilient in coping with future shocks, and that the authorities are better prepared for a potential spillover event. Government ownership. The proposed reforms aimed to support the authorities priorities and required an extensive dialogue to ensure ownership of the technically complex and politically sensitive reforms in the financial sector. This operation was prepared in direct collaboration with the top leadership of the MoF, MoJ, BoA, AFSA, ADIA and other key stakeholders. 1 Lessons from Past Financial Crisis Independent Evaluation Group, the World Bank,

20 Timing matters. The current government was elected in mid-2013 and the next elections will only take place in This period gives the government enough time and ability to tackle key financial sector reforms, especially on adopting measures to mitigate the level of NPLs and enhance the independence and capacity of the AFSA. Communication strategy. The operation promoted the understanding of and the appropriate popular support for the financial sector related reforms through a carefully planned and implemented communication strategy by the Government and the World Bank. Staff at the World Bank Tirana office ensured consistent and timely communication with key stakeholders. The Bank also kept the civil society and the general public informed of its position on critical issues through interviews with national media and press releases. Coordination among development partners. Coordination is critical to achieve better results. This operation incorporated this lesson by working closely with the IMF, EC, and USAID. For instance, the World Bank team coordinated closely with the IMF on financial sector reforms, building on the Bank-Fund collaboration during the recent 2013 FSAP and, subsequently, on the delivery of TA with regard to investment funds. The negative impact of the crisis on Albanian s (and the regional) economy provided a strong rationale for the operation, designed to provide a coherent policy response to systemic risks in the banking and non-banking sector. It also laid the foundation for healthier future growth by advancing the regulatory reform agenda in the financial sector. Assessment of the operation s design: The operation was designed to support the Government s efforts to address key challenges across the financial sector. Its policy measures accommodated the most pressing needs identified by the FSAP in 2013, and included fundamental changes that form the basis for further reforms (e.g. the AFSA reforms). The addition of the long-awaited reforms in the SCA sector was also positive, but it posed risks to the efficiency of resource allocation, stretching the operational capacity of the BoA and ADIA. The number of prior actions requiring legislative changes was large in order to achieve the maximum benefit from the highly conducive reform environment. The main stakeholders were the Ministry of Finance, the Ministry of Justice, the BoA, the Financial Supervisory Authority, and the Albanian Deposit Insurance Agency. Except for the MoJ, all these institutions participate in the macro-prudential body, the Financial Stability Advisory Group, and have a strong stake on the policy measures that were advanced by the operation to mitigate risks and maintain financial stability. Relevance of the risks identified at appraisal and effectiveness of mitigation measures: The overall risk assessment for this operation was rated as substantial. The operation was potentially subject to substantial risks arising from domestic and/or external sources. 16

21 A weak domestic economy, with further deterioration in the domestic fiscal outlook, would adversely impact the banking sector. NPLs could increase further as a result of a persistent weak economy (or potentially due to prolonged unpaid Government arrears, and continued problems in the energy sector), requiring additional provisioning and adversely affecting bank profitability. Rising NPLs undermine banks capitalization and their willingness to lend. This risk was partly mitigated by banks high solvency ratios and stringent provisioning rules. The reform program for the growing nonbank sector could also be undermined by the limited capacity of the nonbank regulator. The AFSA was deeply affected by its inability to attract and retain qualified professional staff or take independent regulatory decisions. Given the recent growth experienced in the non-bank sector, it was essential that the AFSA be provided sufficient resources -- legal, human and financial -- to better fulfill its mandate. This operation aimed to address this longstanding deficiency through reforming and modernizing the legal basis of the AFSA. Additionally, in parallel to the DPL preparation, TA was arranged to support the AFSA regarding insurance, private pensions, and investment funds. More broadly, an exit from unconventional monetary policy in the United States could trigger a pullback in global risk appetite, which could reduce foreign funding sources, thereby increasing the rollover risk for the outstanding Eurobond. Given the large external current account deficit, funding pressures could lead to a depreciation of the Lek, threatening the solvency of banks due to the presence of a large proportion of un-hedged borrowers. This risk has been partially mitigated by the FIRST Initiative TA in support of public debt management and the BoA s strengthening of its systemic liquidity and market operation mechanisms, as recommended by the 2013 FSAP. The potential re-emergence of financial stress in the Eurozone (especially from Greece) could increase deleveraging pressures, and/or result in the exit of a foreign bank from the market. De-leveraging pressures could lead to subsidiaries of affected banks to cut bank lending, or exit, potentially undermining public confidence. Although Albania has been relatively successful in protecting itself from the European financial crisis to date, a loss of depositor confidence or a large withdrawal of parent funding could lead to a systemic crisis. If liquidity pressures emerged, the capacity of the BoA to act as a lender of last resort in foreign currency was limited. This set of largely exogenous risks was mitigated by the authorities through, inter alia, enhancing the operational framework for monetary policy, developing a collateralized money market for transactions with the central bank, establishing an external back-stop facility for the deposit insurer and, more broadly, through enhancing the market for government securities. As the Greek economic and debt crisis is again accentuating external risks and continued spill-over risks, a new operation is under preparation to support further measures to ensure stability and resilience in the financial sector. Importantly, the viability of the Financial Sector Modernization DPL program could have been undermined if there was insufficient political consensus to pass in Parliament the five underlying legislation pieces featured in the prior actions, or more broadly, if 17

22 implementation of the financial sector related reforms, which depended upon the continued collaboration and alignment amongst the key policy makers (MoF, MoJ, BoA, AFSA, ADIA) were to stall. These risks were partially mitigated by broad and inclusive consultations with the relevant Ministries and regulators. Moreover, an ad hoc inter-ministerial Committee was formed to coordinate the implementation of prior actions. There was broad support for strengthening the banking sector, reducing NPLs, and improving the regulation and supervision of the insurance sector and investment funds. The implementation of the reform program supported under this operation was closely monitored through ongoing policy dialogue and planned financial sector focused technical assistance building on key FSAP findings and recommendations. 2.3 Monitoring and Evaluation (M&E) Design, Implementation and Utilization: Monitoring and evaluation was supported by the BoA, MoF, the MoJ, the ADIA and AFSA, as well as the Prime Minister s office through legislative and economic data provided by the authorities and verified in official disclosures, directives and regulations. Baseline and updated data were provided by the respective agencies and tracked according to the indicators and outcome measures as shown in the monitoring and results framework of the policy matrix. Design: There were seven indicators to monitor the outcomes, for which targets were established for each indicator to capture the results achieved. The baselines and outcome indicators were objectively formed, demonstrating both the regulator s and financial sector s performance. Having said that, DPL Pillar II was composed of five prior actions and one results indicator - the reduction of NPLs. The headline NPL figure represents a reliable proxy to improve the authorizing environment necessary to support the reduction of NPLs. Yet, the reduction of NPLs is per se outside the direct control of the authorities and could be undermined by other factors, including an economic slowdown and weak credit growth. It is thus welcomed that the team added an indicator on the write-off claims in order to gauge the direct impact of the reforms supported with this operation. Implementation: The M&E and implementation arrangements were continuous throughout the preparation phase and contributed to the implementation of key reforms and the achievement of development objectives. Utilization: The operation supported measures to improve financial sector indicators, and to reform/ enhance the regulation and supervision of the bank and non-bank financial sectors. Therefore, systematic efforts were made with the authorities to define a mix of quantitative and qualitative indicators to facilitate monitoring. 2.4 Expected Next Phase/Follow-up Operation A new financial sector Development Policy Operation is currently under preparation. This is necessary considering that vulnerabilities in the financial sector remain regarding 18

23 the further reduction of NPLs and the restoration of credit growth across the financial sector, as well as the systemic risks posed by the investment funds sector. The financial sector risks are exacerbated by the Greek debt crisis and continued parent de-leveraging pressures towards Albania and other Balkan countries (see section 4 for details). While the Albanian authorities cannot directly influence developments in Greece and the Eurozone, they can proactively further prepare to mitigate risks and effectively manage potential negative effects. Broadly, the new DPL is expected to focus on the following areas: (i) adopt legal reform measures to further reduce NPLs and better ensure the resiliency of the financial sector; (ii) extend coverage of the deposit insurance framework to legal entities; (iii) strengthen the regulation, supervision and resolution regime of Savings and Credit Associations (SCAs); and (iv) strengthen the regulation of investment funds. 3. Assessment of Outcomes 3.1 Relevance of Objectives, Design and Implementation The objectives of the operation were consistent with the first pillar of the Bank s Country Partnership Strategy (CPS) for FY10-FY13: supporting a recovery in Albania's growth rates through improved competitiveness, by strengthening macroeconomic and public expenditure management, improving the business climate, addressing infrastructure bottlenecks, and deepening access to credit. They were also in line with the Government s National Strategy for Development and Investment that emphasizes the importance of the financial sector as a key objective in Pillar 1, towards helping businesses in gaining access to capital needed to support medium and long-term investment. Moreover, the objectives of this operation are also coherent with the objectives of the new Country Partnership Framework ( ). The new CPF has three broad focus areas: (i) restoring macroeconomic balances, (ii) creating conditions for accelerated private sector growth, and (iii) strengthening public sector management and services. The CPF considers macro-fiscal sustainability and financial sector stability to be the highest priority, having a fundamental impact on the country s ability to move towards a sustainable growth model. It lays a strong program of technical and financial support to implement the agreed medium-term macro-fiscal framework, including addressing financial sector vulnerabilities. 3.2 Achievement of Program Development Objectives This ICR assesses the key expected results and outcomes at the end of the operation, as shown in the Project Document. The PDO of the operation was to strengthen the financial sector regulatory and supervisory regime and mitigate key vulnerabilities of the bank and non-bank financial sectors. Overall, the project achieved the PDO on strengthening the financial sector regulatory and supervisory regime and on mitigating key vulnerabilities in the bank and 19

24 non-bank financial sectors as: (i) intensity of supervision of banks now depends on their risk profile and systemic relevance, also enabling BoA to make better use of its limited resources; (ii) the banking sector is more prepared to withstand adverse shocks with formalized recovery plans; (iii) with their enhanced independence, ADIA and AFSA are able to discharge their core obligations more efficiently; and (iv) writing off of NPLs is facilitated through regulatory and legislative changes. The DPL was structured around three pillars to achieve the PDO: (i) strengthen regulation and supervision of the banking sector and financial safety net; (ii) expedite resolution of non-performing loans (NPLs); and (iii) strengthen regulation and supervision of Non Bank Financial Institutions (NBFIs). The DPL strengthened the ability of the BoA to identify and better supervise banking sector risks. The level of NPLs, despite belated decline, remains high on the back of sluggish economic growth, continued difficulties with the collateral execution process, and weaknesses of the judiciary system. The approval of the new Deposit Insurance Law increased the budgetary independence and payout efficiency of ADIA. The assessment of eligible SCAs for inclusion in the deposit insurance scheme has been slowed down by the arrest and discharge of the former BoA Governor, and the protracted search for his successor. Due to significant legal reforms passed by the parliament, the AFSA has gained full financial and operational independence to regulate and supervise the non-bank financial institutions. The Insurance sector has abided by the stabilization measures imposed by the AFSA to replenish the insurance compensation fund. As result, all the results envisaged by this DPL have been achieved to a large extent. The achievement of objectives is elaborated below. Strengthening regulation and supervision of the banking sector and financial safety net. The new Risk Based Supervisory Manual which was approved by BoAs Supervisory Council in December 2014, was first tested/ introduced by supervision staff during the inspections of The new manual was applied alongside with the old inspection manual for a transition period. The new manual fully replaced the old manual for the inspections carried out starting in January As of end March 2015, six banks (5 full scope examinations 1 partial examination), out of which four were large systemic banks, were inspected using the new risk based supervision manual. According to the BoA Supervisory Council decision (Nr.11) on the 26th of February 2014, banks operating in Albania that are determined as systemically important shall submit to BoA their Recovery Plans (RPs) by the end of the first quarter. In order to enhance their work towards fulfilling the requirements presented in the approved decision, the Supervision Department of BoA prepared instruction material during 2014 that was sent to systemically important banks in January After receiving the RPs, the Supervision Department of BoA is to assess compatibility with the requirements laid out in the above mentioned decision Nr.11. All seven systemic banks have submitted the RPs to BoA. 20