role of foreign currencies both on banks ’ asset and liability sides. it goes without saying that this currency substitution involves risks. this is particularly true for foreign currency lending to unhedged borrowers, especially households. the resulting foreign currency exposure of their clients increases banks ’ indirect foreign exchange risk and thus their credit risk. finally, in most see countries, bank profitability has improved substantially during the first half of the current decade. notwithstanding this improvement, the return on equity levels in 2005 were – with the exception of albania – below the average recorded in the central european and baltic countries. let me now turn to the monetary integration process of candidate and potential candidate countries 2 before and after their accession to the european union. on their way into the eu, the countries in southeastern europe are free in choosing their monetary and exchange rate policy strategies. this is clearly reflected in the variety of exchange rate regimes in place across the region, which range from currency boards to lightly managed floats. moreover, montenegro and kosovo are unilaterally euroized and use the euro as their sole legal tender. let me stress that these two cases are very special, originating from a post - war crisis resolution setting, and definitely do not constitute a precedent for other countries. eu accession represents the first of three stages in the monetary integration process of eu member states. upon accession to the european union, new member states are required to treat their exchange rate policies as a matter of common interest and to pursue price stability as the primary objective of monetary policy. however, beyond these obligations, the choice of the respective monetary and exchange rate strategy remains, in the first instance, a responsibility and prerogative of the individual member states. at the same time, eu member states ( with the notable exception of denmark and the united kingdom ) are committed to striving for the eventual adoption of the euro. croatia and turkey are candidate countries. they started accession negotiations on 3 october 2005. in december 2005, the european council granted the former yugoslav republic of macedonia the status of a candidate country ; accession negotiations have not started. all the other western balkan countries are potential candidate countries : albania, bosnia and herzegovina, montenegro, and serbia including kosovo under un security council resolution 1244. according to the economic reasoning underlying economic and monetary union ( emu ), the eventual adoption of the euro is envisaged as the endpoint of a structured convergence process within a multilateral framework. participation in the exchange rate mechanism ( erm ii ) 3 represents

the republic of macedonia ) privatization took place more recently. institutional reforms and ownership transformation contributed significantly to the deepening of financial intermediation in the region, which has advanced steadily and dynamically, in particular in bulgaria, croatia, and bosnia and herzegovina. in albania, serbia and the republic of macedonia, this process has been less even, and bank assets started to expand somewhat later. the growth of credit to the private sector, in particular to households, has been fairly strong, while credit to the public sector has remained steady or even declined. in the majority of countries in the region ( apart from bulgaria, croatia and romania ), credit growth has essentially been financed by deposit growth, and changes in banks ’ net foreign asset positions appear to be associated, to an important extent, with rising net claims on central banks. this development distinguishes southeastern europe from central europe, where foreign financing has – especially recently – played a bigger role. despite the dynamic developments of the past few years, the degree of intermediation in southeastern europe, with the exception of croatia, is below the average level observed in the cee - 8 countries and well below the average of the euro area. this is, however, not surprising, given that the gdp - per - capita levels in most countries of the region are also central -, eastern - and southeastern europe, excluding cis - countries. substantially lower, and there is an empirical regularity that financial depth increases with rising gdp - per - capita levels. anticipating a catching - up in income levels, prospects of further financial deepening in southeastern europe are certainly intact. let me also point out that prudential indicators of banks in the region have remained broadly solid and have in some cases improved. despite falling moderately in recent years, capital adequacy ratios in southeastern europe remain at double - digit levels and are higher than in the central european and baltic countries and certainly much above the basel minimum threshold of 8 %. certainly, retaining a solid capital buffer against risks is highly appropriate and advisable. in most countries of the region, the share of nonperforming loans has fallen in the first half of this decade. romania and serbia are exceptions in this respect, but in both countries, the rise in the share of npls is attributable to the tightening of classification rules. at the same time, it should be borne in mind that npl ratios are lagging indicators. an important feature of bank intermediation in southeastern europe is the large