47730 FINANCIAL SECTOR ASSESSMENT REPUBLIC OF TAJIKISTAN MARCH 2009 EUROPE CENTRALASIA VICEPRESIDENCY AND FINANCIAL AND PRIVATE SECTORDEVELOPMENT PRESIDENCY VICE BASED THEJOINT IMF-WORLDBANKFSAP ON As part ofthejoint IMF-World BankFinancial Sector Assessment Program(FSAP), two missions visited Tajikistan, one inMarch2007 andthe second inAugust 2007.' The purpose o f the FSAP was to identifypotential vulnerabilities andrisks inthe financial systemof Tajikistan that could have macroeconomic consequences, to recommendmeasuresto reduce those risks, and to identify appropriate areas for further development o f the financial sector. The team helddiscussions withthe President's Advisor on Economic Policies; the Chairman o f the National Bank o f Tajikistan (NBT); the Minister of Finance; senior NBT and government officials; and selected market participants. The team would like to express its gratitude to all these counterparts for their availability and excellent support to the work of the FSAP, andtheir appreciation for the generoushospitality o fthe Tajik authorities. 1The FSAP team comprisedHormoz Aghdaey (team leader, World Bank), Marina Moretti (deputy team leader, IMF),Ashok Bhatia,; Andrea Maechler,** Rafael Portillo,* Mariusz Sumlinski,** and Alexander Tieman**(all IMF),Laura Ard,* Mehmet Can Atacik,; JosB Antonio Garcia Garcia Luna,* Peter Kyle, Serap Oguz Gonulal, Sue Rutledge,* Emanuel Salinas,; Tatiana Segal, and Ramin Shojai (all World Bank), and Peter Phelan* (consultant, formerly UK Financial Services Authority). Luc Moers (IMF Resident Representative) and Bahrom Shukurov provided valuable support to the team from the Dushanbe IMF representative office. 1 I.SUMMARYOFKEYFINDINGS 1. Financial intermediation in Tajikistan has deepenedinrecentyears, albeit from a low base. This is reflectedinthe overall growth of the financial system, greater diversification, andthe expansion o f lending to previously under-servedsectors, such as agriculture and small- and medium-sizedenterprises. Evenafter the expansion, however, the financial sector remains small and cannot serve all the financing needs o f the economy. 2. While banks are generallywell capitalizedand liquid, their rapid growth has brought new risk exposures that should be carefully monitored and appropriately addressed. Inparticular, rapid loan growth could leadto a build-upo funrecognized credit risk andgiveriseto anincrease innonperformingloans (NPLs). Becauseofextensive dollarization, the exposure o f banksto exchange-rate induced credit risk i s another significant cause for concern. Also, the exceptionally rapid growth o f nonresident deposits without clear knowledge of their sources exposes the bankingsystemto reputational risk. 3. Significant strengthening of the regulatory and supervisory framework will be neededto sustainthe system's health inthe face of rapid growth. e Bankingregulationand supervision, while substantially strengthenedinrecent years, require further enhancement, notably on licensing, remedialactions, and central bank autonomy and governance. e The insurance sector inTajikistan is growing inan unregulated andunsupervised environment. Significant upgradingo f the legal, regulatory, and supervisory framework i s neededinvirtually all areas. 4. Adequate pricing and management of credit riskwill require an enhanced financial infrastructure. Weaknesses inthe infrastructure include deficiencies inthe legal framework for bankruptcy, secured lending, and foreclosure, the lack o f ajudicial system capable o f enforcing contracts and ensuringproperty rights, and the absence o f borrower information. 5. More generally, implementation and enforcementof the legal framework remain weak. The legal framework governing the financial sector has undergone significant reform over the last decade. Nevertheless, enforcement of the laws has proven ineffective. 6. Governance inthe financial sector needs significant strengthening. Improvements are neededto ensure the integrity o f the regulatory bodies andto guarantee that all financial transactions are conducted at arms' lengthand priced on a market basis. a An appreciation o f the negative impact o f conflicts o f interest onthe functioning and regulationo f markets appears to be missing. Lack o f public disclosure o f significant shareholders o f financial institutions and o f legal definitions for connected business interests and beneficial ownership are key obstacles inthis respect. 2 0 Some features o f the financial system suggest weak competition, including extremely highinterest rate spreads andthe lack ofa levelplaying field among banks, notably in their transactions with the NBT. 7. Fair andtransparent resolutionof the largestock of distressedcottondebt would demonstratethe government's commitmentto market principlesand good governance.The authorities shouldtake measuresto minimize the risk of recurrence ofthis problemby addressing the underlyingcauses, including land use rights, competition among investors, and inappropriate interventions by local governments. The resolutionprocess should involve all affectedparties and, as a matter o fprinciple, public funds should not be usedto bail out private interests. A first step should be an immediate halt of Kredit Invest's (KI)activities other thanthe management ofits distressed assets. 8. Systemicliquiditymanagementand the monetarypolicyframework require upgrading. 0 The interbankmoney market is virtually nonexistent, and there are no standing central bank facilities. Inthe absence o f marketsand centralized facilities for active liquidity management, banks maintainexcess reserves. Government bond issuance would help address these shortcomings by providing collateral for interbank transactions, an instrument for the NBT to absorb bank liquidity, and the foundations for the development o f securities markets. 0 The NBT is insolvent andwill needto berecapitalized. The NBT's financial position discourages it from makingeffective use o f the monetary policy instruments it has available and makes its credibility dependent uponthe government's willingnessto underwrite its current and future losses. 0 TheNBT's practiceo fproviding direct credit to financial institutions should be discontinued. Such commercial activities adversely affect the objectivity o fthe NBT as the regulator o f the financial sector, undermines risk management by financial institutions, lead to a perceptiono f bias by the market, and negatively affect the NBT's financial health. 11. SUMMARY OFPOLICYRECOMMENDATIONS 9. The key recommendationsof the FSAPteam are summarizedbelow. Short Term (High Priorities) Strengthenthe surveillance framework to monitor the build-upof credit risk inthe bankingsystemto ensure that problems can be addressedpromptly. Develop and implement a strategy for the resolution o f cotton debt. 3 Strengthen the governance andautonomy o fthe NBT. Inparticular, rules for the appointment, dismissal, andterms of office of the chairmanand Board members should be spelled out and clear provisions on conflict of interest should be introduced inthe law. Stop all direct lending activities by the NBT for commercial purposes as a preconditionto its recapitalization. Strengthen the legal framework for bank licensing by reintroducing legal provisions on the NBT's authority to license banks, and allow the NBTto check on the suitability o f beneficial owners o f banks. Medium Term e Launcha program o f issuance of government securities, includingthrough the securitizationo f government debt heldby the NBT. e Continue strengthening the bank regulatory and supervisory framework, including by submitting state-owned banks to annual independent external audits. e Eliminate the monopoly privileges of state-owned insurance companies on compulsory insurance products. e Bringthe new draft insurance law inline with internationalgoodpractice. e Bringthe new draft deposit insurance law inline with internationalgoodpractice. e Bringthe newdraft law on creditbureausinline with internationalgoodpractice. e Ensure the business continuity o f the Real Time Gross Settlement (RTGS) system. e Progressively migrate all large-value domestic currency payments from bilateral correspondent accounts to the RTGS. 111. RISKSTO THEFINANCIAL SYSTEM A. MacroeconomicBackground and Risks 10. Real GDP has expanded at an average annual rate of about 9 percent during the last five years. Inthis process, the sectoral compositiono f GDP has gradually shiftedtoward services and away from industryand agriculture -although the latter still accounts for 22 percent o f GDP in2006 and almost 70 percent o f employment. The poverty rate, while declining, is high- estimated by the World Bank at 57 percent in2004. 11. Inflation, after falling to single digits in2004-05, acceleratedin the past two years, reaching close to 20 percent at end-2007. This was mostly due to a surge in international wheat prices and energy, but also reflectedrapidmonetary expansion-notably 4 as a result o f domestic credits to the agricultural sector. Fiscal performance has been solid, the government havingrunsmall surpluses for the last five years. 12. The current account deficitaveragedabout 3 percentof GDP during2002-06. Cotton and aluminum exports, traditionally the largest source o f foreign exchange inflows, have recently been overtaken by workers' remittances. It is estimated that each year migrants numberingmore than 10percent o fthe populationtravel abroad, mostly to Russia, insearch o f employment. Their homeward remittances, through official channels, amounted to about 35 percent o f GDP in2007. Despite significant foreign exchange inflows, the exchange rate has continued to depreciate. Internationalreserves are relatively low interms o f months of imports (less than 1month). 13. The current externaldebt is estimatedat 33 percentof GDP,with externaldebt service amounting to about 15 percent of exportsin2006. The external debt stock, which exceededGDP inthe late 1 9 9 0 ~ ~ has beenbrought down to current levels through debt restructuring with bilateral creditors, especially Russia, and rapid economic growth. Tajikistan i s also a beneficiary o f IMFdebt reliefinthe context o f the Multilateral Debt ReliefInitiative. However, guarantees o f at least $320 million issuedbyNBTto international creditors to finance the cotton sector, disclosed inOctober 2007, have created a significant contingent liability for the government. Moreover, concessional infrastructure loans fiom China are projectedto increase the debt-to-GDP ratio to almost 60 percent by 2009. Table 1 summarizes key macroeconomic indicators. Table 1. Tajikistan: Selected Macroeconomic Indicators, 2005-08 2005 2006 2007 2008 (pr0.j.> Real GDP (annual percentage change) 6.7 7.0 7.8 5.0 CPI Inflation(annual percentage change) 7.1 12.5 19.8 15.0 Revenueand grants (percent o f GDP) 20.1 23.6 21.6 22.4 Expenditure and net lending (percent o f GDP) 23.0 21.9 27.8 30.4 Balance (percent o f GDP,including externally- financed PIP) -2.9 1.7 -6.2 -8.0 Net domestic assets o f the banking sector (12 month percentage change) 129.6 87.5 112.7 40.8 Broadmoney (12 month percentage change) 30.2 63.4 78.8 24.7 Current account balance ($ millions) -62 -79 -414 -429 Percent o f GDP -2.7 -2.8 -11.2 -10.0 Gross official reserves (months o f imports, excl. imports financed by loans from China) 0.9 0.7 0.5 0.8 Average exchange rate (somoni per dollar) 3.12 3.30 3.44 ... 5 B. RiskExposuresof Tajik Banks 14. The rapidgrowth of Tajik banks has brought new riskexposures to the system. Albeit from a low base, bank deposits have grown very rapidly since 2004 (Figure 1) - at annual rates o f 80 and 100 percent, respectively, in2005 and 2006, and 75 percent inthe first half of 2007. Net loans also grew but not as rapidly as deposits -at 68 percent in2006 and a further 47 percent inthe first halfof 2007. The risksposedby rapiddeposit and loangrowth should be monitored carefully by the authorities. While this credit growth supports much- neededfinancial deepening, an excessively rapidincrease could leadto a build-upof unrecognized credit risk. 15. Loan growth to the agriculture sector will needto bewatched carefully as the sector has traditionally carried high credit risk.Banks' agricultural credit portfolios agriculture doubled inthe first half of 2007, bringingtheir share intotal loans to 11percent. Moreover, withthe cessation of lendingby KIin2008, bankshave beenpersuaded to borrow TJS 140million from the Ministryo f Finance and lendto the cotton sector. This represents 22 percent o f bank capital as o f June 2008. Giventhe poor track record o f agriculture in terms of loan repayments (44 percent o f these loans were nonperforming at end-2006), this is clearly an area o f heightened risk for banks. 16. Growth indollar lendinghas also increasedthe vulnerability of banks. Loan dollarization increased from 57 percent at end-2004 to 71 percent inmid-2007. However, there seems to be a lack o f awareness by borrowers and banks o f the exchange-rate-induced credit risk; Le., the risk o f default o f unhedgedborrowers inthe event of sizable exchange rate depreciations. 17. The rapid accumulation of nonresidentdeposits without clear knowledgeof their sources exposes the banking system to reputational risk.A third o f the growth indeposits in2006 andhalfof growthin2007 are onaccount ofnonresidents' foreigncurrency demand deposits. As a result, nonresident deposits now account for 57 percent o f total deposits inthe system. The bulk o f those deposits reportedly accrue to a few accounts at the largest bank in the system.The authorities shouldinvestigate the sources ofthis fundingto ensure that no illegal activity i s involved. Iv. STRENGTHSAND VULNERABILITIES:INSTITUTIONS 18. The Tajik financial system is small and dominatedby banks. Table 1presentsthe structure o f the financial sector. Despite rapid growth, banking system assets were only 17.5 percent o f GDP at end-2006. Banks represent over 80 percent o f total financial system assets, with assets concentrated inthe three largest banks. The remainder is largely accounted for by KI,aprivate asset management company, which holds a sizeable portfolio ofdistressedloans to the cotton sector. Securities markets are virtually nonexistent. 6 A. Banks Financingpatterns 19. Despitethe rapid increaseinintermediation,the bankingsystem is notyet in a positionto serve the needs of the economy. Just a third ofbank assets are net loans. Credit growth has lagged behindthe growth inbank assets, with the loan share falling from 48 percent o f total assets at end-2005 to 40 percent inJune 2007. Onthe deposit side, growth has beenrapid but access to banks by the less-serviced populationremains constrained. Loans to individuals and small- and medium-sized enterprises (SMEs), mainly for trading activities, have grown most rapidly, but commercial and industrial loans still account for the lion's share ofthe outstanding volume. Average loanmaturity i s about six months (Figure 2), and average loan sizes o f the top three banks range from $10,000 to $60,000. 20. Interest rate spreads inTajikistan are the highestinthe regionand could contribute to adverseselectionof borrowers.Ex-ante bank spreadshave declined inrecent years but remainhigh at 24 percent inforeign currency and 22 percent insomoni, compared to a medianworldwide o f about 6 percent in2003. The highspreads are drivenby three main factors - limited credit risk assessment and mitigation mechanisms, weak competition, and the costs associated with the lack o f liquidity management tools and infrastructure. 21. While banks' financingto agricultureis increasing, anecdotalevidencesuggests that access by potentialrural clients remainslimited. Skills for extending rural and agricultural credit remain poorly developed, with products and procedures that are not adaptedto the needs o f farmers and other small- and medium-sizedproducers inrural areas. Banks' reliance on collateralposes a key constraint inrural areas giventhat agricultural land cannot be used effectively as collateral. 22. Expandingthe networksof banksoutside of the main urban areas shouldbe encouragedto enhance access to financialservices. In2006, there were about 220 bank branches, about one branchfor every 30,000 people, which is low by internationalstandards. The current licensingrequirementsfor opening branches and representative agencies should be eliminated. Banks shouldbe allowed to open new branches and agencies providedthey follow NBT guidelines. 23. Remittancesare an important source of fee incomefor banks, but less than 20 percentof them remain inthe bankingsystem. Efforts shouldbe made to improve banks' services and products to encourage remittance recipients to retain the funds inthe banks. 7 8 Performance 24. Banks appear well capitalized, highly liquid, and profitable. Against a mandated minimumcapital adequacy ratio (CAR) of 12percent, the averagefor the industrywas 24 percent in2007 (down from 30 percent in2006). With intermediationmargins at very high levels, returns on assets o f Tajik banks are very high, so banks can afford to operate with very highcapital and liquidity. Competitive pressures are likely to increase as a result of foreign bank entry. Inaddition, the NBT should take measures conducive to greater competition, including requiring increased transparency inthe pricing o f financial products. 25. Asset classification practices may give an upward bias to reported profits and capital. With total gross loans increasing twice as fast as past-dues, the NPL ratio fell to 10percent inmid-2007 but the underlyingNPL stock is increasing andremains particularly highinthe agricultural sector. Loanclassification andprovisioningrules were recently tightened, but loopholes remain. Inparticular, loans can be restructured once withno effect on classificationbut must be classified no betterthan substandard ifrestructured more than once. Since substandard loans represent 50 percent ofNPLs, this raises questions as to the true quality o f these assets. Provisionsare low at 26 percent o fNPLs. 26. The authorities should reconsider the need for the existence of credit societies. These institutions have played a limited role infinancial intermediation. There are currently ' eight credit societies, accountingfor 2 percent of bankingsystemassets. They are licensed under the BankingLaw, butwith arestricted license; unlikecredit unions, credit societies are not restricted by membership. Credit societies were created in2005 as a temporary solution for banksthat could not meet the $5 million absolute capital requirement; since then, several of these institutions have been liquidated. B. Nonbank FinancialInstitutions 27. NBFIscomprise MFOs, insurance firms, leasingcompanies, and KI.There were 67 MFOs, 14 insurance firms, and 5 leasing companies as o f June 2007. KI-the asset management company established for the resolutiono f cotton debt-is covered inthe next section. Microfinanceorganizations 28. The MFO sector is growing fast and already provides services to a sizeable number of borrowers. Lending by MFOs grew by more than200 percent in2006 and a further 80 percent inthe first half2007. Despite this growththe sector remains small, with an aggregate loan portfolio equivalent to $37 millionat June 2007, roughly equivalent to 13 percent o f the aggregate loanportfolio o f banks. MFOs' client base i s significant with more than 50,000 borrowers in2007. MFOshave focused on financing commercial activities but are becomingincreasingly focused on rural clients. However, the small short-term loans 9 typical of MFOs are not suitable for activities with longer gestation periods andhigher capital requirements. 29. Three types ofMFOsare licensedunderthe 2004 law on microfinance- microcreditfunds (38 institutions),microcreditcommercialorganizations(23), and microcreditdeposit-takinginstitutions(6). Microcredit funds canbe created inthe form of social funds, with no required capital. They have a total loan portfolio o f $20 million, receive most of their funds from donors, and service about 30,000 clients. Microcredit commercial organizations require a minimumcapital o f $10,000 andcan borrow from other institutions. Their combinedportfolio is equivalent to $5 million andthey have about 4,000 clients. Microcredit deposit taking institutions are subject to a minimum capital requirement of $100,000 and hold $6 million inloans and $1 million indeposits. They have about 5,000 clients. Insurance 30. Despiterapidgrowthinrecentyears, the insurancesector is underdeveloped comparedwith neighboringcountries.Total gross premiums in2006 were equivalent to $20 million (or 0.3 percent o f GDP). Several factors contribute to the low insurance penetration, including poverty, income distribution, lack o f understandingo f insurance products, low public confidence inthe sector, and an out-of-date legal framework. 31. The majority of Tajik insurancecompaniesare undercapitalizedandtheir managementhaslimitedexperience inthe insurancebusiness.As of end-2006, 14 insurance companies operated inTajikistan. Although the two state-owned companies have a monopoly on compulsory classes o f insurance and all government business, the largest private domestic company dominates the market with 60 percent o f all premiumsin 2006. The privilege o f the state-owned companies to operate inall o f the compulsory insurance classes, including compulsory third-partymotor, should be abolished, as it creates an unevenplaying field and constitutes a barrier to the development o f the private insurance industry. Leasing 32. Leasingis an emergingsource of finance but the lack oflong-termsources of fundingis a major obstacleto development.The volume of leasing remains negligibleat an equivalent o f about $3 million(or 0.1 percent o f GDP). As o f June 2007, 5 leasing companies were inoperation, 2 o f which had ownership links with commercial banks. Leasing is especially important for Tajikistan giventhe lack o f long-term funds for manufacturers' capital investmentsand because it allows businesses without an adequate credit history to finance equipment based on collateral. 10 C. Cotton Debt 33. The resolutionof the large outstandingstockof distressedcottondebt features high on the authorities' agenda. At end-2003, a "good bank-bad bank" split of AIB resultedinthe creationo f KI, the asset management company. KI's record inasset management has been lackluster, havingreportedly recovered only about 10percent o f assets. KI's focus shiftedtoward other activities, such as fresh lendingto agriculture, financed by foreign credit lines guaranteedby the NBT and domestic credit lines extendedby the NBT. While data on KIwas unavailable to the FSAPteam, subsequent information revealed that KIhad assets (loans) of about $562 millionas o fNovember 2007, the vast majority o f which are nonperforming. Provisions, however, were only $11.4 million. Among its liabilities are foreign credit lines of at least $320 million, guaranteed by the NBT, and TJS 885 million borroweddirectly from NBT.KIis currently undergoinga special audit by an internationalauditing firm. 34. An effective cottondebt resolutionstrategy must be transparent and encompass all parties involved.These include foreign lenders, KI, local investors, and farmers. This would allow for a transparent recognition o f all disputed claims as well as a transparent and fair negotiation o f how the debt burdenis to be allocated. The strategy should be basedon a proper assessment o f the impact o f various debt resolution options on the financing o fthe sector. Any write-down on the amount o f debt owed to the investors and agreements on repayment terms should be based on objective criteria. Only to the extent that government guarantees are outstanding shouldthe government take direct responsibility for repayment. Last but not least, it should include implementationand enforcement o f mechanisms for prevention o f similar debt accumulation inthe future. KIshould immediately halt all activities other than the management o f its distressed assets. 35. Going forward, access to finance for current cottonfarmers will require a comprehensivereformof the cotton sector - as envisagedinthe authorities' road map. This would requirea halt to practices by the central andlocal authorities that restrict farmer's freedom to select crops, andthe de-linkage betweenfarmers and cotton investors. Itwould also require strengthening the legal framework for landuse rights and secured lending. The NBT's system o f export authorizationprevents farmers inarrears from exporting cotton or other produce and should be endedimmediately. v. STRENGTHSAND VULNERABILITIES: FINANCIAL POLICY FRAMEWORK A. Regulatory and SupervisoryFramework Banking 36. Muchwork has beendone inrecentyears to enhancebankingsupervisionand regulation. The two key laws governingthe financial sector -the NBT law andthe law on banks and banking-provide the N B T with adequate authority inmost areas, but are unclear 11 and incomplete inmany respects. Considerable efforts have also beenmade to strengthenthe NBT's supervisory capacity, particularlyinthe areaof on-site examinationcapabilities, the introductiono f a robust off-site reporting regime, andthe enhancement of the NBT's capacity to analyze the data that it receives (although there i s still a tendency for the NBT to focus on the violation o f rules rather than on the underlyingproblems o f which these violations may be symptoms). 37. Despitethese efforts, importantshortcomingsremain.Laws andregulations require strengtheninginseveral key areas, notably regarding licensing, remedial actions, and NBTautonomy andgovernance. O fequal concern is the ability ofNBT supervisors to address any identifiedbank problems -whether compliance, safety, or soundness -giventhe perceived or real positiono f power o f many bank owners. Untilthe existing environment changes, the effectiveness o f the NBT supervisory effort will likely remainrestricted. The remaining weaknesses are reflectedina low degree o f compliance with the Base1Core Principles for Effective Banking Supervision. 38. Boththe licensingregimeand the remedialactionapproachneedenhancement: The legal foundation for licensing is deficient inthat it does not provide for checks onthe suitability o f shareholders (including beneficial owners), board members, and senior management. Inaddition, there i s no provision for the examinationo f the proposed organizational structure. On remedial action, boththe legal framework and the process requiresubstantial improvement. There is no legal requirement that the NBTtake action should it consider the safety and soundness of an institution to be compromised. The remedialaction regime should be transparent and predictable. 39. NBT autonomyand governancerequireconsiderablestrengthening.TheNBT should be appropriately capitalizedso that its financial independence can be assured. In addition, the NBT chairmanand his deputies should be appointed for fixed terms, which do not coincide with the electoral cycle, andthe reasons for their dismissal should be explicitly outlined inthe law. The board should be fully staffed -it currently consists only o f the chairman and three deputies, the three nonexecutive members provided for inthe law never havingbeenappointed. The ability ofthe chairmanandboard members to determine each others' level o f remunerationi s highlyunusual; the parameters governing the board's remuneration policy should be publicly disclosed. Clear provisions covering conflicts of interest should be introducedinthe law. NBT staff (and all government officials) should be obliged to disclose their personal holdings infinancial institutions and recuse themselves from official decisions affecting those institutions. 40. There are a number of other areas that requirethe attentionof supervisors. These include corporate governance, ethical standards, and internal controls and audit; insider lending; the application o f International Financial ReportingStandards (IFRS) accounting for all banks; legal protectionfor the NBT and its staff for supervisory actions 12 taken ingood faith; and consolidated supervision. A review o f the NBT's transparency practices inbanking supervisionfound those practices to be broadly satisfactory, Insurance 41. The lack of an adequate regulatory and supervisory environment could undermine the sustainable growth of the insurance sector. As a key priority, ongoing efforts to upgrade the legal framework governing insurance should continue. The 1994 insurance law i s far from international standards-it covers the regulation o f insurance companies, insurance contract law, and insolvency of insurers, but does not provide real protectionto the policyholder from abuses andthe insolvency risks o f insurers. 42. The market is regulated by the State Insurance Supervisory Service (SISS), a department of the ministryof finance. The knowledge, technical skills, and experience o f SISS technical staff (currently five including a director), needs considerable enhancement, which can be achieved through focused training and technical assistance. Skills inthe areas of licensing, on-going supervision, prudentialrequirements, markets and consumers, and insurance products need particular strengthening. 43. The absence of standardized accounting rules across companies hinders proper evaluation of the condition and performance of insurers. Accurate accounting provides authorities with the practical means to performproper supervision, while at the same time beinga resourceful instrument for the management of companies. Deposit insurance 44. The Tajik deposit insurance system needs improvement. A new deposit insurance scheme was established in2003 but has significant shortcomings. With the fund's balances equivalent to less than one percent o f estimated insureddeposits, the absence of contingency financing arrangements i s a key weakness o f the scheme. Other problems include the voluntary nature o f the scheme, no cap on insurance coverage (70 percent o f eligible deposits are covered independent o f their size), and insufficient exclusion o f bank shareholders and relatedparties from coverage. Technical assistance i s currently working with NBT to propose amendmentsto the law to address these and other shortcomings. B. FinancialInfrastructure Legal framework 45. The legal framework governing Tajikistan's financial sector has undergone significant reform over the last decade. The result has been the adoption o f a series o f laws and regulations that are reasonably comprehensive. Incommon with other transition economies, however, the laws are often conflicting, open to varying interpretations and not 13 widely disseminated. Moreover, the implementationand enforcement ofthe laws has generally been weak. 46. Bankruptcy and insolvencyare governedby the 2003 bankruptcy law but the law is regarded as deficientinalmost all key areas of insolvency. Specifically, the law provides for no measurable reorganization provisions, no requirement for independent assessment o f reorganizationplans, very little involvement o f the general body o f creditors, vague criteria for the commencement o f insolvency proceedings, and virtually no requirements for insolvency administrators to have professional qualifications.Nor are there any provisions relatingto the avoidance ofpre-bankruptcy transactions or cross-border insolvencies. Cases o f insolvency are uncommon and expertise inthis area i s almost non- existent. 47. One of the biggestobstacles to financial developmentinTajikistan is the lack of an adequate, reliable, and trustworthy judicial system capable of enforcingcontracts and ensuringproperty rights. Court proceedings slow andunpredictable. Opinions and decisions are often secret andnot revealed to the parties, andthe procurator's office wields excessive influence over thejudges. Judges are not well remunerated, their conditions of service are poor, andthejudicial infrastructure is barely adequate. As a result, banksresort to the courts only when absolutely necessary. Collateral and creditor information systems 48. The laws governingsecuredlendingare often overlappingand inconflictwith each other. For example, the landcode prohibits the mortgaging o f immovableproperty while the civil code andthe mortgage law provide for this possibility. Other laws affecting collateral issues include the civil procedure code andthe law on pledge o f movableproperty. This lack o f coherence and redundancy creates confusionas to the effectiveness ofthe collateral. 49. The framework for property registrationand enforcement is subject to a number of weaknesses. There is no uniform systemfor title registrationon property and related transactions. Multiplebodies are involved depending on the type o f property. The information contained inthe property registries is not publicly available, which, coupled with the lack of appropriate legal mechanisms, fails to protect good faith property purchasers duringthe title registrationprocess. Judicial foreclosure carries significant risks for mortgage lenders. 50. The establishmentof a creditor information systemwould support better credit riskassessment by banks. To this effect, the authorities have draftedlegislationthat would allow for the establishment o f a private credit bureau. Compared to a public credit registry, a private credit bureau can have a broader scope interms o f both information collected and institutionscovered (including, for instance, MFOs, trade credit providers, and utilities). It is 14 reasonable that financial institutions, as the mainbeneficiary o f the services, bear the costs of establishing and maintainingthe bureau. Corporate governance 5 1. The authoritieshavetaken major stepsto improvegovernanceinthe corporate and bankingsectorsalthoughsubstantialweaknesses remain. Despite commendable reforms-including the establishment o f a central share registry for all openjoint stock companies and privatization o f mediumand large companies -the standard o f corporate governance remains weak. To further improve corporate governance focus should be placed on increasing transparency of ownership and control. 52. All credit institutionsshouldbesubjectto annualindependent audits oftheir financialstatementsandthe capacity ofthe auditingprofessionshouldbestrengthened. By law, all openjoint stock companies -which include all private banks- are obligedto have annual independent audits o f their financial statements. This excludes state-owned banks, which are subject to external audits only once every two years, as well as KI, which as a closedjoint stock company, i s not subject to external audits. Inaddition, Tajikistan needs to license sufficient professional audit firms capable o f auditing financial institutions. 53. The enactmentearlier this year of a newLaw onJoint StockCompanieshas broughtsubstantialimprovementto the legalframeworkfor corporategovernance.The law incorporates much improved provisions on related-party transactions, major asset sales, corporate governance, meetings o f shareholders, and electiono f members o f boards of directors. The law also establishes clear fiduciary duties for members o f boards o f directors and other senior corporate officials. Nevertheless, still more improvements will be neededto bringTajikistaninline withinternationalgoodpractice on corporate governance. C. SystemicLiquidityManagement 54. Systemicliquiditymanagementand the monetarypolicyframework are rudimentary.TheNBT's main monetary instrumentsare unremunerated reserve requirements(12 percent ofdeposits) andoutright sales ofNBTcertificates o fdeposit; there are no standing facilities. NBTauctionvolumes are small (roughly $1 million per week) and the state-owned bankpurchases almost every issue at negative real interest rates, which suggests lack o f competitive market pricing. There i s no secondary market for NBT certificates. There are no market-determined interest rates and no yield curve; the NBT's monetary policy interest rate, the refinancing rate, i s not tied to any actual transaction. 55. The NBT is insolventandwill needto berecapitalized.The most recent audit puts theNBT's negative equity at $18 million, resulting from anoldportfolio ofloss loans and more recently, net payments to the government. The financial positiono f the NBT discourages it from makingeffective use o f the monetary policy instruments it has available interms ofbothrates andvolumes, thus underminingthe ability to mopupexcess liquidity. 15 The NBT's financial positionmakes its credibility dependentuponthe government's willingnessto underwrite its current and future losses.As a apreconditionfor its recapitalization, the NBT involvement incommercial activities shouldbe stopped. 56. The limitedstock of governmentsecurities constrainsmonetarymanagementas well as banks' efficiency and capacity to lend. Inthe absence of domestic financing requirements, the ministryof finance has not issuedsecurities since 2001.NBT certificates were launched in2003 but the NBT's insolvency discourages larger issuance volumes and market-based pricing. The resultingpaucity of freely transferable collateral precludes repurchase operations by the NBT andpreventsthe development o f an interbank money market. These constraints coupledwith the absence of formalized standingfacilities heighten the incentives for banksto maintainexcessreserves. Government bond issuancewould be beneficial for several reasons and should be started as soon as possible. A useful first step could be the securitization o f the non-marketable government bond on the NBT's books. D. PaymentSystems 57. The RTGSsystem, launchedin2002 and operatedby the NBT,is handling increasingvolumes of electronic paymentorders and is the only major interbank paymentssystem inthe country. The RTGS system has contributedto a better integration betweenthe central bank andthe banks, andanoverall improvement ofpayment and settlement arrangements inthe country. The system processes somoni-denominated payment orders only. Since its launch, the value settledthrough it increased at a rate o f nearly 30 percent per year, while the number o f transactions grew at a more modest pace o f about 6 percent annually. In2006, the systemprocessed an average o f 1,600 transactions eachday. 58. Despitethe existenceof an RTGSsystem, a significant portion of domestic interbank paymenttransactions is made through bilateral correspondentaccounts. While for payments denominated inforeign currency Tajik commercial banks-like banksin most other countries -use their correspondent accounts with foreign banks, for payments denominated insomoni they also frequently use bilateral accounts they holdone with the other inside Tajikistan. This implies that the benefits o fthe RTGS system are not beingfully realized. 59. There is a needto ensure businesscontinuityfor the RTGSsystem. At a very minimum, the system needs to bebacked-up with secondary server(s) that are able to resume the operations quickly, without any loss o f transaction data, incase o f a failure o f the primary server. 60. The existinglegalframework lacksmany ofthe basicelementsthat underpinthe operation,regulationand oversightof a modernpaymentssystem. The law on theNBT provides the central bank with clear, although somewhat general powers to operate and regulate payment systems. However, key concepts such as the timing o f settlement finality, legal protectionto the system from insolvency effects, or the timely seizure o f collateral 16 . pledgedinconnectionwithpayment systems, are absent inthe current legal andregulatory framework. 61. The NBT should also play a leadingrole inpromotingthe development of electronicretailpaymentinstrumentsand systems.Dependingonthe circumstances and the degreeo f cooperation among banks, this role couldrange from actingas facilitator, catalyst for change, or even as a direct service provider. 62. Inthe mediumterm, the NBT also needsto develop and fully implementits payment system oversightfunction. At present, the NBTperforms some basic payment systemoversight functions such as the analysis of data andthe publication o f statistics for the . RTGS and cardpayment systems. However, it has not established specific objectives inthis field, or the requirements that the various payment systems must meet andways to enforce such requirements. For the NBT to perform this function effectively, it will needto establish appropriate organizational arrangementsand staffing.