Ardian Fullani: Macrofinancial stability in EU candidate countries and
potential candidate countries - lessons to be learned
Speech by Mr Ardian Fullani, Governor of the Bank of Albania, at the High-level Policy
Workshop on Macro-prudential Policy, Frankfurt am Main, 14 December 2010.
* * *
Dear colleagues,
It is a pleasure to discuss with you our experience with the crisis and share some thoughts
on the relevant lessons for the future. My perspective on this issue will focus on the case of
Albania; an emerging market economy which imported the crisis through financial market
channels and interconnectedness. The challenges posed to eastern European economies
and decision makers were mostly the same in nature, while their policy response differed
according to economic structures, institutional differences and degrees of freedom enjoyed
by them.
Let me briefly preview the three main messages of my speech.
The first one is that there is no conflict between price stability and financial system
stability in the long run - instead, they do mutually re-enforce each other and the resilience
of the economy to external and internal shocks. From a central bank's point of view, a
corollary to this is that any macro-prudential measure taken to enhance financial stability is
an investment in medium and long term price stability. I believe this conclusion is amply
borne from Albania's recent experience.
My second message is that global or even regional financial markets require global or at
least regional supervision and crisis resolution mechanisms. Just as problems originating
on a particular sector of the economy can escalate into general macroeconomic imbalances,
so financial market imbalances in one financial institution or one country can disrupt other
financial institutions or countries. Collaboration between home-host supervisors is therefore a
must, but I would argue that probably more can be done in this regard.
My third message concerns the role of anchors in the design and implementation of
Monetary policy is made credible from the clear focus on a
macro-prudential policies.
transparent measure of price stability (CPI inflation) which in turn increases the accountability
of the central bank pursuing it and ultimately its operational flexibility. Financial stability is
inherently a more difficult concept, even on a theoretical level, but I think more should be
done to quantify the term and unify its understanding. This would allow for more transparent
communication and increased public support for the central bank's action.
I will now expand on these issues.
1. Price stability and macro-prudential measures
A panoramic glance at the experience of central and eastern European economies with the
latest crisis would indicate a broad range of outcomes. While this might look normal at first
view, it is worth remembering that CEE countries share quite a few commonalities in their
economic and financial structures. Furthermore, they were hit by the same type of external
shock, at exactly the same time. One has thus a fair approximation of a controlled
experiment on the role of macroeconomic policies before and during the crisis.
At the risk of generalizing too much, I would say that CEE economies shared broadly the
same development model and problems. We benefited from large capital inflows mainly in
the form of FDI, remittances and cross-border loans. Western European banks penetrated
our financial system, increasing financial intermediation and facilitating capital inflows. This
process resulted in fast credit and economic growth based on a consumption lead model.
While inflation has been generally under control financial imbalances and vulnerabilities were
increasing, in the form of rapid growth in real estate prices and balance sheet exposures in
liquidity and foreign currencies.
Our economies were hit by the crisis since the first week of October 2008. The fear of
contagion was enhanced further by a sharp decrease in the market value of the EU banking
groups that operate in the region. It affected negatively the public trust in the system,
resulting in widespread deposits withdrawals. Later, as the financial crisis progressed and
transformed into a global economic recession, the effects extended to real economy and
exchange rate depreciation. Most of the countries in the region faced a rapid liquidity
shortage caused by the deposits run, lower remittances and FDI outflows. The balance
sheets across the region suffered from both liquidity problems and exchange rate depreciation.
This was negatively reflected in consumption and investment, which further deteriorated the
financial stability outlook with the possibility of a balance sheet deflation and economic
contraction mutually supporting each other in a vicious spiral.
The ability of our economies to absorb these shocks was however different. The natural
instinct of macroeconomic policies facing such a contraction scenario is to engage in
countercyclical measures in the form of expansionary monetary and fiscal policies. However,
the very presence of financial stability concerns in the equation significantly changed the
equation. We can safely argue that countries which experienced the least macroeconomic
and financial imbalances were the ones better placed to pursue countercyclical policies and
in fact the ones which emerged the fastest from the effects of the crisis.
I believe Albania is such a country:

We had no bank failures or public injections of capital;
 We did contain and reverse the confidence crisis in the financial system and its
adverse effects. In fact, we did not experience financial disintermediation;

We did continue to grow, albeit at a slower pace;

We did manage to keep inflation expectations anchored.
Therefore, I will share with you our thoughts and measures throughout this period. To
conclude this topic I will briefly summarize my personal lessons from this crisis.
Before the crisis, Bank of Albania was concerned for the possible financial threats that were
being accumulated during the years of fast financial intermediation. To illustrate the point:
most of the credit growth went in the non-tradable sector, with services and construction
accounting for most of the expansion. At the same time, more than 70 percent of total credit
was in foreign currency with EURO making the biggest share of the outstanding stock.
The tune of that period was the same in the entire region. The overall impression that the
financial innovations had reduced the risk and the abundant global liquidity created a very
optimistic picture. Despite some truth in this, the pace at which financial intermediation grew
annually was frenetically high. In particular there were two main aspects of financial
intermediation that were particularly troubling in my opinion. First, economic agents created
financial excesses using mostly the financial system. While meeting their needs, the financial
system aligns and matches agents' positions according to length of maturity and liquidity.
This holds true under the assumption that all claims and obligation will be fulfilled in timely
manner in the same order. Otherwise if they violate this assumption and end up overlapping
each other than financial system might become unstable. Our concern was that too many
gaps were opening to fast and the Albanian economy seemed to experience some sort of
what latter came to be named as risk-taking channel. Second, there appeared to be a
general mispricing of risks from the banking sector. High concentration in particular sectors
or clients indicated undue risk analysis or risk management from banks, while lending to
un-hedged borrowers in a flexible exchange rate regime seemed to be a potential moral
hazard issue.
We addressed the first issue through increasing information sharing and facilitating the
dialogue between the monetary policy and the financial stability and supervision of the Bank.
Normally, the foresight of monetary policy is from the trough to the pick of the business cycle
because it is mandated with smoothing the fluctuation in economy or prices. However, the
duration of financial gaps and excesses might be very different and usually much longer.
Therefore monetary policy by design has the potential to forget about financial stability;
therefore we were potentially missing important information regarding the effects that
decision making on monetary policy could have on the sustainability of agent's budgets. That
is why I believe was important to have guardians of financial stability in the monetary policy
decision making process. With this reasoning we have brought the director of supervision
and the director of financial stability in the monetary policy advisory committee. In this
respect our monetary policy did not focus only in the discussion of macro effects but also in
the discussion of the micro effects of decision making. This resulted in policy coordination
within the central bank. I believe that this is the first line of defense that we had in our
philosophy. This helped us to strike the correct balance between all policies.
The second issue was addressed through tightening macro-prudential regulations and
policies and strengthening the on-site supervision of banks. Through regulatory and
supervisory interventions, we aimed to improve the commercial bank's governance
and their transparency, to strengthen their risk assessment and risk mitigation
strategies, to improve the capital adequacy and liquidity ratios, as well as to reduce
the exposure to credit risk stemming from un-hedged borrowers in foreign currency or
predatory practices from commercial banks.
On the same line, our policy response during the crisis was cautious, prioritizing financial
stability and the preservation of inflation expectations to outright economic stimulus. By the
beginning of the first quarter of 2009, financial panic, liquidity problems especially in foreign
currency, slowdown in EU economic area and the financial stress in the EU banking system
affected both the real and the financial sectors of Albanian economy. Credit slowed down
considerably, exchange rate started to depreciate, and forecasts for economic growth and
inflation were down. In the mean time deposit withdrawals continued and liquidity concerns
become more prominent.
Bank of Albania provided ample liquidity in domestic currency in the interbank market while
tightening its supervision on banks and increasing the collaboration with their home
supervisors. A specific feature that needs to be mentioned is the timely increase of the
deposit insurance scheme. This move marked a turning point in the confidence crisis of the
public to the banking system and the liquidity problems of the system.
From a narrow perspective centered on its main objective of price stability, the focus of
monetary policy would be an expansionary action. However, considerations of the external
balances of our economy, its financial stability and the need to anchor expectations,
constrained our decisions. I will elaborate briefly on these factors. Faced with contained
upward pressures in inflation, the central bank focused its attention on determinant factors of
financial stability. By refraining from pursuing an expansionary monetary policy, the central
bank did not exacerbate the pressures on the exchange rate which would than put additional
strain on un-hedged borrowers and the bank's balance sheets. Furthermore, interest rate
cuts had the potential to affect deposit withdrawals and cause liquidity problems and further
depreciation. At the time these two were the main concerns to financial stability.
The Albanian economy did however receive some macroeconomic stimulus in the form of
fiscal expansion. This countercyclical policy was made possible because of the previous
work done to consolidate the fiscal position and to anchor macroeconomic policies and public
expectations. Albania approached the crisis with sustainable fiscal position in terms of deficit
and public debt, creating room for maneuver and fiscal expansion to support economy before
monetary policy could intervene.
Therefore the first lesson from the crisis for authorities
would be to follow countercyclical policies, which will permit for bolder action in time
of crisis.
What are the lessons for the future? I think I already mentioned the first one. The second
lesson, which relates to the price and financial stability, is equally important. Price and
financial stability do not conflict each other in the long run. Central bankers should
never forget that fiat money on which we base our way of life and prosperity, is a social
contract, based on the society's trust that every bill will be honored by the creator of that
money, which in most of the cases is the central bank. This trust is one of the important
pillars that guaranty not only the economic system but the entire society.
In my opinion, even in the short run, the central banks are well equipped to pursue these two
goals with the instruments at their disposal: main policy rate on refinancing operation;
macroprudential policies on a systemic level; and, careful and diligent micro supervision of
commercial banks. Having two goals and at least two instruments should allow for an optimal
mix of policies, at least in theory. In practice, as is indicated from our experience, central
banks should not shy to lean against the wing in order to discourage or at least contain
financial imbalances. Furthermore, every time we face fundamental economic problems with
potentially negative systemic implications, we revert to financial stability.
I firmly believe that
the first and most important job for a central bank is to ensure the integrity of money
and the banking system.
2. Joint supervision and crisis response mechanisms
Building bridges of continuous communication with local bank managers, home supervisors
and headquarters of the mother institutions has proved to be critical in dealing with the
problems before they get out of hand. While communication is an advice that is frequently
used, we made a good use of that beyond mere courtesy. We acknowledged that financial
development was following a certain pattern. Financial institutions like all other businesses
adopt marketing strategies and stick to such strategies in all markets. What this means for us
is that once new product are developed and tested in other markets, they will follow the same
pattern of marketing in other markets as well.
In the years that preceded the crisis, financial institutions started the practice of lending in
exotic currencies, offering very low interest rates and being without any economic relation
with the borrower activity. Being aware of these developments, from previous communication
with other central banks in the region, we were alerted to spot the first sign of such behavior
in our economy. Therefore at the first signs of such credits, we discussed with the
management of our banks and stopped administratively lending in these currencies for all
unhedged borrowers.
On a systemic level, I do believe the recent experience highlighted some issues that need to
be looked more carefully in the future. I will highlight here only three of them.

The policies that facilitated the capital inflows into economies of the region were not
followed by actions which could have provided the needed liquidity when these flows
reversed or stopped. Countries of the region did not benefit from the swap
agreements or similar arrangements that would allow us access to short term
liquidity. One can certainly say that in normal times that could be resolved at group
level. However, this didn't necessarily prove to be the case in the recent experience.
Because our financial systems are inter-connected, I think this issue deserves more
attention in the future.

A crucial step in alleviating the financial crisis in CEE countries was the Vienna
initiative, which stabilized both the balance sheets of the big banking groups
operating in the region and the trust of our public in them. I think such a facility
needs to be permanent, at least in the case of global or European potential financial

Financial regulation and regulatory arbitrage was a serious issue before and
throughout the crisis. Before the crisis, banking groups would play regulatory regime
and policies against each other and try to reach some kind of lowest common
denominator throughout the region. Countless times we have heard the complaint
"Why are you not allowing this, your neighbors do!", and I'm sure others people in
this room have heard it too. During the crisis, we experienced several cases of
countries trying to seek individual solutions to common problems. While fully
respecting the idiosyncrasies and different timing priorities of each country, I think
we would all benefit from a more collegial approach to regulation.

On a national level, I believe the stress should be on supervision of Systemically
Important Financial Institutions, with the right care not to create wrong perceptions
related with moral hazard. In our region, these institutions are typically banks. In my
view, these banks should become subject of a more stringent regulatory framework,
in terms of capital and liquidity requirements, business and risk profile, including
contingency plans. The supervisory authority should always be prepared for the
worse and make sure that crisis management procedures are complete and tested.
In this process, valid recommendations of international organizations will be closely
followed for adequate implementation over time. It is important to have close
coordination with other public authorities in the country, including government.
3. Anchors of macro-prudential policies
The role of anchors in monetary policy is well known. I mentioned before that an important
lesson from the crisis for authorities would be to rigorously pursue countercyclical policies. I
would like to stop a bit here and focus on this issue. I believe that Albania was prepared for
the crisis because IMF programs have played an important role as a credible foreign anchor
for economic policies. The IMF programs and similar EU membership process have played a
similar role in all CEE and SEE countries. However as the countries have matured out of
these programs or joined the EU, the political incentives to continue fiscal consolidation have
been fading away. Current events show that the symptoms have spread to other older
members of EU, where such policies become the reason behind instability.
Therefore the role of anchors is very important for preserving and safeguarding financial
stability. Sound, clear and enforceable fiscal rule would be an important step. Effective
supervision based on simple and clear capital adequacy and liquidity rules would be another.
The Basel III accord is a first step in the right direction. A unified approach and technical
toolkit to stress-testing exercises would be also helpful. The joint stress-test exercise
conducted by the ESCB is the right way forward. I would however encourage broadening its
scope in candidate and potential candidate countries of CEE, in order to have a unified
measurement system throughout Europe. Lastly, other measures of financial imbalances
such as excessive asset price increases, under-pricing of risks, search for yields and
increased risk taking need to be better incorporated in the standard models used by central
banks.
Conclusion
In the light of this discussion, a central bank could not avoid the responsibility of engaging to
protect financial stability, even though this is not defined as a particular mandate. Our
experience as an emerging country indicates that price and financial stability are
preconditions for each other. Our motto is that any investment that we make in financial
stability today will return high benefits in price stability in the long run.
Concurrently, I think our collective experience throughout the crisis showed that more can
done in order to develop and institutionalize the proper mechanisms that would allow for
better FX liquidity management in EE countries. A mechanism such as the Vienna initiative
that would encourage the commitment of parent banks to their EE subsidiaries and would
discourage their financial disintermediation in these countries can be made permanent with
added benefits to all the stakeholders. Furthermore, regulatory harmonization can be
improved and regulatory arbitrage can be mitigated.
On macro-prudential policies I argued on the need to develop specific anchors that would
make more credible, transparent and therefore achievable the goal of financial stability.
Measuring financial stability, or instability, might be difficult but that should not discourage us
from trying.
Thank you for your attention.
Box 1
Measures taken in the banking supervision area during the pre-crisis period.

On June 2007, the new Law on Banks in the Republic of Albania entered into force. This Law
stipulates rigorous principles and rules on the risk management, aiming at protecting the
depositors, investors and fostering the banking system's stability.
 On January 2008, the Credit Registry started the operation representing a vital
infrastructurerelated development.

On March 2008, the Bank of Albania adopted a package of regulatory amendments which
were generally oriented to adopting more conservatory policies in several main directions of
day-to-day commercial banking running. In more concrete terms, this therapy can be
described:

In compliance with the new Law On Banks in the Republic of Albania, new quantitative
thresholds were set for the calculation, supervision and reporting of banks' large
exposures to parent banks and related entities.

In order to better diversify the risk arising from the concentration in banks' investments in
the international financial markets, lower thresholds were set for banks' large exposures.

Internal control is considered an integral part of banks' governance. Hence, special
emphasis was put in designing the key principles for an independent, unbiased and
accountable internal control. Internal control should cover each section of the bank in
order to prevent the origination and development of undesired risks.

Accountable governance is a key principle, especially on financial institutions, whose
success is, among others, largely dependent on public confidence in them. Accordingly,
the Bank of Albania considers the quality of human capacities - implying the hiring of
skillful people in the decision-making process and risk management - as fundamental.
The decision making process, should always be based on such expert opinions and
recommendations.

The transparency related to the banking and financial products and services provided,
was also paid special attention. The new legal requirements standardize the manner and
form of providing information to the clients on the banking products and services banks
provide.

Part of this new package was also the standardization of the required information that
banks and branches of foreign banks should disclose, related to the banks' main activity,
their organization and management, their financial performance and position, the risk
management and the accounting policies.