68692 EXPANDING THE OUTREACH OF FINANCIAL SERVICES: THE EXPERIENCE OF FINANCIAL INSTITUTIONS Case study prepared for the Enabling Environment Conference I. CONTEXT AND BACKGROUND signed by the President in January 2007. In 2002, the formal financial sector was inefficient  The strengthening of the supervisory framework for and dominated by state-owned commercial banks financial institutions with the aims of improving and certain specialized banks. Most of these banks deposit protection and confidence in the financial were bankrupt and too weak to provide efficient system, and enhancing the private sector’s access to financial services. Moreover, the legal framework finance. This includes reforms of the banking for the financial sector was essentially non-existent sector, the bulk of which is scheduled to be or inappropriate. Da Afghanistan Bank (DAB), the implemented by the end of 2008. Regulations for central bank of Afghanistan, had a structure which the microfinance sector were introduced at the end was moribund and staff which were too unskilled to of 2006. undertake efficient monitoring and supervision of  The broadening and deepening of financial service the financial sector. delivery by building capacity in financial institutions as well as adopting and implementing There was an urgent need for a strong central bank national accounting and auditing standards. Most of as well as a legal framework with prudential these measures have yet to be implemented, with a regulations. Against this backdrop, restructuring target of end 2008. and modernization of the DAB began in mid-2003. In September of the same year, the President issued Overall, the major reforms of the financial sector a decree to pass a new central bank law that would are scheduled to be completed by the end of 2008. provide a strong framework for a two-tier banking In the meantime, however, the outreach of financial system: state commercial banking activities and services in Afghanistan remains very limited and private commercial banking activities. It also small and medium businesses have almost no provided the DAB with autonomous regulatory access to bank credit and only limited access to power to implement monetary and banking banking services. In the most recent Doing supervision policy. Business (2007) rankings for Getting Credit, a measure of credit information sharing and legal The DAB is in the process of enacting the rights of borrowers and lenders, Afghanistan ranked following three laws to initiate commercial banks to 174th out of 175 countries. expand their lending programme to the private sector: (a) Secured transaction law; (b) Mortgage There has been significant growth of private law; and (c) Negotiable instruments laws. These commercial banks, 15 banks have been licensed, laws are particularly aimed at modernizing the while 14 of them are operating in Afghanistan. The financial sector as well as improving the enabling banks are mostly concentrated in Kabul and provide environment for the private sector. Other services primarily to international donors, large programmes for reform of the private and financial businesses, foreign NGOs and foreign government sector are also underway and include: agencies. There are also a small, but ever increasing number of non-bank financial institutions,  The establishment of a facilitative legal framework including one credit union and 13 microfinance for private sector development, with a list of 10 institutions that provide limited services and small priority laws to be approved, four of which were amounts of credit. Furthermore, a leasing finance THE ENABLING ENVIRONMENT CONFERENCE company is also operating in Kabul, but with term loans as being quite high. One of these limited capital to employ in the business. Although businessmen is interested in constructing a cement the extent of financial services is expanding, these manufacturing plant and expressed interest in institutions are nascent and able to provide only a seeking one or more bank loans from an fraction of what is needed. international institution. However, often these businessmen do not see the importance of due As a result, Afghan businesses are almost entirely diligence required from the financial institutions. reliant on internal funds from friends, relatives and money lenders. Informal fund transfer systems Case Study I: Kabul City Center (Safi Land Mark) (hawala) used to make payments and transfer funds are also dominant. Although informal financial Safi Bothers Import and Export Company, with its sector credit may be playing an important role in main office in Dubai, is the owner of the Safi Land manufacturing and commercial activities, it is not Mark, the largest shopping complex and hotel in adequate for long-term private sector development Kabul with UN security clearance. The because such funds are often costly and short-term. construction cost of the Safi Land Mark was about There is therefore a pressing need for bank and $35 million and was entirely financed by Safi non-bank financial institutions to provide viable Brothers; no bank loans were taken out. Safi alternatives to the informal sector. As the economy Brothers exports dry fruit and imports construction expands, the inability of firms to obtain reliable materials and is also building a “twin tower� in external financing at competitive costs could be a Herat province. Safi Brothers recently established a serious constraint to growth. Gypsum factory in Kandahar with a total investment of $20 million, also self –financed In summary, while some considerable advances without any bank loan. have been made with respect to basic legislation, some central banking reform, the introduction of a Case Study 2: Kabul Trade Center new currency, and the beginnings of a microfinance sector – much work still remains to be done. Mr. Basir Omarzai owns the Kabul Trade Center, a shopping and office complex in Kabul. The cost of These case studies examine the experience of the construction is estimated to have been about $20 following five different groups of financial market million. Mr. Omarzai met the entire cost from his participants operating in Afghanistan. The own resources and was not keen to seek any bank examination of each institution will address the loan. He is a businessman based in Dubai and has a factors that have facilitated expansion and the paper manufacturing company there. constraints it has faced in further expanding financial services. Small & Medium Entrepreneurs (SMEs):  Reputable private investors ‘Limited access to finance’  Small & Medium Entrepreneurs  BRAC, a Microfinance Institution Case Study 3: Sabaoon Aryana Construction  Kabul Bank, a fast growing commercial bank Company, Kabul  Bank Millie, a state-owned bank Small businesses are undergoing hardship since This paper also analyses the constraints and they have almost no access to finance. Sabaoon opportunities that are common to one, several or all Aryana Construction Company could have of these financial market participants, and expanded its growth by many times if it had had concludes with recommendations from the $250,000 from the bank or leasing company to buy perspectives of these institutions. an asphalt machine. Mr. Wahed Ahmad is the owner of Sabaoon II. THE CASE STUDIES Construction Company, which was established in 2004. He invested $300,000 in the construction Reputable private investors: business. Initially he started with building ‘Doing business out of my own pocket’ construction, but later moved to road construction. In 2005, the company’s annual turnover from road Shafi Brothers and Kabul Trade Center are the construction was $210,000. However, in 2006, the leading business conglomerates in Afghanistan. annual turnover tripled to $600,000. The However, they remain outside the formal banking construction company created permanent system. These businessmen are reluctant to go to employment for 24 people. Sabaoon lost one large the banks as they perceive the process of obtaining contract of $1.28 million from the United Nations loans to be cumbersome and interest rates for long- Office for Project Services (UNOPS) because it did Kabul, Afghanistan June 2007 2 Financial Institutions not have an asphalt machine. UNOPS told Mr. Microfinance Institutions: Ahmad that although they had been very happy ‘Finding niche market where the current with his work, the road contract could not be given banking system does not work’ to Sabaoon since it did not have an asphalt machine. Currently, he buys asphalt from a Case Study 5: Bangladesh Rural Advancement supplier, but UNOPS is not happy with the quality. Committee (BRAC), Small Enterprise Project He was told by UNOPS that if Sabaoon procured an asphalt machine in 2007, the company could get BRAC is the largest MFI in Afghanistan. It started road contracts amounting to $4 to 5 million. the Small Enterprise Program (SEP) in April 2005, Mr. Ahmad needs $250,000 to buy this machine. targeting small businesses mainly in Kabul area. The profit from the UNOPS contracts would enable him to pay for this machine in two to three years. The main objective of the programme is to help He uses Standard Chartered Bank to cash the generate income and employment in rural and semi- checks received from the contracts. The urban areas through enterprise development. The commercial banks are fully aware about his regular type of enterprises it is extending loans to comprise cash flow transactions, but are not willing to bakeries, grocery stores, carpet weaving shops, provide investment or working capital loans. tailoring shops, various types of workshops, Sabaoon Aryana said the following: “What is the goldsmiths, beauty parlours, pharmacies, home purpose of having so many banks in Kabul, if they appliance delivery stores and shoe-making do not lend money to the deserving investors?� factories. The typical loan size varies from $800 to $10,000. Loan tenure is one year as for the Case Study 4: Ahmad Printing Press, Kabul microfinance, but the payment is on monthly, rather than weekly basis in microfinance. Savings from Ahmad Printing Press, a medium-sized printing the borrower is mandatory, and is collected at the company, is also very unhappy with the time of monthly payments. Unlike microfinance, commercial banks because of their reluctance to the SEP requires collateral. help the small businesses and the high interest rates that they charge. Currently SEP has been implemented in 10 Provinces and 10 Districts. There are 41 Area Ahmad Printing Press invested about $450,000 Offices, but these offices are the same offices used from its own capital. The owner, Ahmad Hossain for the Microfinance programme. A Senior Farhad, has about $400,000 as working capital to Regional Manager is heading the SEP operations, do a big order. He always has working capital supported by 10 District Managers and 56 shortages to bid for large supply contracts for Programme Organizers. There are a total of 1,200 books. He needs about $700,000 as working capital borrowers, out of which 979 have current to implement a large contact. When Mr. Farhad outstanding loans. The total amount disbursed so needs working capital, he usually borrows money far was $1.4 million and the current outstanding is from friends at a higher interest rate (25 to 30 $869,100. percent) to execute large supply orders. Ahmad Printing Press has a bank account at the Standard Case Study 6: Kabul Carpet Store, ‘Desire to be a Chartered Bank, which is needed to cash the checks Client of the BRAC Afghanistan Bank’ that are received as payment from donor contracts. Although the bank has good knowledge of Ahmad BRAC SEP is helping the small businesses grow, Printing Press’ cash flows, it is not keen to extend and they are happy with their credit relationship any working capital loans to it. Mr. Farhad with BRAC. However, they think that BRAC commented, “Although I am doing my business should do more since the size of the fund is not transaction with a reputable bank, […] I cannot enough to help business expansion. The owner of receive any working capital loan for my business.� Kabul Carpet store needs about $40,000 for his If Ahmad Printing Press had enough working business growth because he imports carpets from capital, it could expand its printing activities by Turkey and Iran. The loan amount he received from three to four times. Mr. Farhad has good BRAC SEP programme only amounted to 10 management and marketing skills; however, due to percent of his requirement. However, he wants to the shortage of funds, he cannot further expand his continue the credit relationship with BRAC SEP business and create more employment. because he believes that this relationship will one day help him to be a client of BRAC Afghanistan Bank. Ghulam Abbas is the owner of Kabul Carpet Store at Que Marcus. He has been a borrower of BRAC SEP since February 2006. He borrowed $4,000 and 3 Case Study THE ENABLING ENVIRONMENT CONFERENCE has been paying in installments of $392 and a credit. I have developed a long-standing credit saving of US$10 monthly. Ghulam employs eight relationship and trust with the traders. The small people in the shop and pays $720 in wages, $1,300 traders are very regular to make payments and this in rent and $80 in electricity per month. He imports trade credit is also profitable business for me.� He carpets from Iran and Turkey and wholesales them has said that BRAC SEP could make him an agent in the local market. Each import consignment costs to disburse funds to the small traders and he would about US$95,000 to US$100,000. Total stock of be ready to retail the loans on behalf of BRAC with carpets in his shop amounts to about $200,000 or a small commission and undertake all the credit more. He says that his monthly sale varies between risk. Bariwalai has also never failed to pay his US$25,000 and US$30,000 and his net profit is installment and wants to maintain a good credit about 10 to 15 percent of sales value. Ghulam is relationship with BRAC. In the future, he would also a good tax payer. He pays a total annual tax of like to borrow $20,000 from BRAC SEP and would $500 and operates through a trade license from the like to increase the range of products and the trade Municipality which he renews each year. credit, and expand his business. Given the scale of Ghulam’s carpet business, one wonders why he would borrow $4,000 from BRAC Kabul Bank: ‘Constraints to expand the SEP. His answer to this was revealing: “I cannot loan portfolio’ get loans from the banks, although I do an honest business with recorded transactions. So I wanted to Case Study 8: Kabul Bank be a BRAC client and prove my credit record and worthiness.� He also said, “I heard BRAC is Established in June 26 2004 as the first private opening a Bank in Kabul, I want to establish a Afghan commercial bank, the Kabul Bank has credit relationship with BRAC SEP to eventually be emerged as the leading commercial bank in a client of BRAC bank and borrow about Afghanistan in the last two and a half years. Its US$40,000 to help consolidate and expand my initial capital of $20 million in 2004 has increased business.� to $38 million due to infusion of new capital and reinvested profit. The deposit from March 2006 to Case Study 7: Brotheren Ittehfaq Hardware Store, March 2007 (SY1385) has been increased by about ‘Effective use of SEP Loan as working capital’ 180 percent, reaching the current deposit of $348 million. The bank is expecting to steadily improve Mr. Bariwalai Nakshbandi, the owner of Ittehfaq its deposit and its management believes that there is Hardware, is helping other small informal hardware ample opportunity to mobilize significant deposits, businesses, which have no access to any form of despite the number of new entrants in the market. loans, by providing trade credit to them. Although he borrowed a loan of $6,000 from SEP, he needed The current lending of the bank is $260 million, at least $20,000 to expand his own business and the with a lending to deposit ratio of 75 percent. The businesses of the small traders. bank sees opportunities to increase this ratio further, but is constrained by the DAB limit of 75 Bariwalai Nakshbandi is the owner of Brotheren percent ratio. The lending growth during March Ittehfaq Hardware Store. He is a reputable 2006 to March 2007 was about 167 percent, where businessman in the market and has ten shops selling most of the loans were extended to traders in the various types of goods. Bariwalai received a loan of import-export business and about 10 percent of the $6,000 from BRAC SEP in April 2006. His loans were given to the industry sector including monthly instalment is $588 and he contributes a flour mills, steel forging, oil storage tank, tea saving of $12.5. He owns the shop, which has a processing and cigarette packaging. The loan market rent of $3,000. He employs two people and portfolio has been quite sound; only about 1.86 has a monthly wage bill of $200 and an electricity percent of the total loan portfolio constitutes non- bill of $20. His monthly sale is about $18,000 to performing loans. In 2006, the average interest rate $20,000 with a monthly profit of $1,200 to $1,500. for loans was about 8 percent, and its net profit was Total stock of the shop is about $100,000. $2.3 million. Bariwalai has a trade license and pays an annual tax amounting to $1,600 for all his shops. Bariwalai has said that the SEP loan is very useful to him, since it perfectly meets his working capital needs. Due to this loan he has been able to increase his stock and provide credit to the small traders. He commented, “They never fail to pay and I have already provided goods worth $2,400 on trade Kabul, Afghanistan June 2007 4 Financial Institutions The management of the bank wants to further bank of Afghanistan until 1939, when Da expand its loan portfolio; however, there are several Afghanistan Bank was established and took over factors holding it back from doing so. First, the the responsibility. Based on a presidential decree in absence of a Credit Information Bureau (CIB), 1976, the bank became a government entity. The coupled with the absence of audited balanced sheets Ministry of Finance currently holds the majority of makes it very difficult and costly to assess the shares (96.6 percent). Bank Millie has 21 branches, credit risk of borrowers. This causes banks to out of which nine branches are operating in require borrowers to provide extraordinary amounts different parts of Kabul city, and 10 branches are of collateral and consequently to increase the cost operating in the provinces. Recently the bank re- of loans. Second, high cost of collateral registration started lending and so far has approximately 3,600 leads borrowers to be hesitant to borrow money small and medium barrowers. It has a capital of from banks. It takes 3 percent of the value of the $140 million including real estate assets. Total contract (loan amount) to execute the collateral loans made are $19.6 million. registration and another 3 percent to release the property from registration, i.e., a total of 6 percent. Bank Millie’s management has voiced that efforts However, property transfer as collateral in the name to restructure the bank have been constrained, by of the bank takes about 6 percent of the property several factors, particularly the lack of skilled labor value, and thereby another 6 percent to transfer it with strong financial experience and knowledge at back to the owner. Therefore, a total of 12 percent all levels of banking operations. The restructuring is needed for transfer and re-transfer to the owner – of a bank inevitably entails replacement of a very high cost for the borrower. Third, because of unqualified staff by capable new staff. However, weak human resource capacity in the financial Bank Millie is finding this to be very difficult for sector, it is very difficult to hire qualified various reasons. First, the specific salary ceiling for banking experts. each position is too low to attract qualified staff from the region or even within Afghanistan. Management also expressed that capacity building Second, the stakeholders require the Bank Millie to of both the commercial bank staff and the staff of hire only Afghans in key positions in order to build DAB would be essential, and could be done by local capacity in the banking sector. Given that establishing a banking training institute. Afghanistan has few experienced bank Furthermore, the enactment of a Secured professionals, the key positions are usually filled by Transaction law, Mortgage Laws and the less competent employees who can incur additional Negotiable Instruments Law would help improve costs without improving operational efficiency in the lending situation. Once this legislation is in the bank. Third, the Bank Millie is short of place, the banks could widen their proposal professional banking experts from outside who evaluation to include more customers for extension could carry out the restructuring process. Currently of loans. only one advisor from BearingPoint is supporting the bank operation. Although the government Bank Millie: ‘Struggling with lack of promised to send one more expert, this is still not qualified staff’ enough to undertake a successful restructuring process. Finally, Bank Millie is overstaffed with Case Study 9: Bank Millie unqualified employees. The bank now has 545 employees, although 67 of these were given a The Bank Millie was one of the three licensed state- golden handshake. Out of 280 employees recently owned commercial banks (SCBs) which were re- tested for basic banking competence, only 125 licensed in 2003. It is the largest SCB, followed by passed. There is little understanding of the Bank Pashtany and the Export Promotion Bank. components of profit and loss, cash/funds flows, Although Millie has much higher capital than any financial intermediation, computer and automation other commercial bank, the quality of the lending technology, accounting, loan administration, and portfolio is very weak with about 53 percent of the risk assessment and management. Although most of loan portfolio being non-performing. Non- the staff have long tenures in the banks, this has not performance of the SCBs initiated restructuring of translated into genuine banking experience owing these banks. The Cabinet has decided to have two to more than two decades of economic and banking SCBs: the Bank Millie remaining as an independent inactivity due to war and internal strife. Hardly a bank; and the Export Promotion Bank merging with single employee has been exposed to modern Pashtany Bank. accounting and organizational systems or technology. Bank Millie was the first bank to be created in Afghanistan and was established with a 72 percent share of the private sector and 28 percent of the government in 1933. It was operating as the central 5 Case Study THE ENABLING ENVIRONMENT CONFERENCE III. ANALYSIS under the Afghanistan Investment Support Agency (AISA), shows that institutional financing in terms The banks in Afghanistan are mostly risk averse of working capital or investment capital could have and not willing to extend loans to a new borrower, a positive impact on business competitiveness, even to the reputable investors without secured resulting in business expansion, increased collaterals. According to the World Bank’s recent employment, and improved profitability. investment climate survey (2006), only three out of 335 firms in five major cities in Afghanistan More recently, the banking sector has grown (Kabul, Kandahar, Mazar-e-Sharif, Jalalabad, and significantly. Fourteen banks in operation have Herat) reported having bank credit for new successfully been able to mobilise funds in terms of investment. On average, nearly 94 percent of new deposits from the informal sector of the economy, investment by firms was funded by either internal which previously avoided banking services. funds or money from family and friends. Even Although mobilisation of deposits has been some of the large investors in Kabul did not access growing, there has been little improvement on the bank financing as they found it very difficult to lending side. Overall, lending to the manufacturing obtain such financing. It will be a challenge for the or service sector, except for the increase in trade financial institutions to bring these types of financing, has been less significant due to the investors into the banking network. Inclusion of absence of CIB, the higher cost of registration and them in banking services would certainly the weak capacity of banking human resources. strengthen the economic growth of the country. Commercial bankers have stated that the legal Access to finance is extremely limited for almost framework is not strong enough and that the court all SMEs in Afghanistan. This is severely system is too week to enforce contracts. The constraining the overall growth of small businesses enactment of three new financial laws initiated by in the country and reducing the prospect of DAB would help improve this situation. However, employment generation and expansion of individual the enforcement issue will remain and this will small business. Although there is strong demand for require setting up special commercial courts, credit from SMEs, the financial institutions are not recruiting and training of judges and also facilitate responding to it. Limited access to finance, infrastructural facilities. particularly for working capital, is a severe problem SMEs. Discussions with the AISA registered SCBs have been plagued by problems such as weak entrepreneur have found that due to the shortage of corporate governance and management structures, working capital, some SMEs pay higher price for unskilled labour, outdated technological capacity, the raw materials which they buy in the local and serious liquidity and solvency problems. The market with deferred payment conditions. The price first financial assessment of the banks conducted in they pay is 20 to 25 percent higher than the price January 2003 concluded that all the banks were in they would have paid if they were importing these dire financial condition. Restructuring of three materials either from Pakistan or India. licensed SCBs is underway, and the Cabinet has recently approved a strategy paper on restructuring Since private commercial banks (PCBs) have been of t Bank Millie to meet the IMF’s benchmark for comfortable lending extensively for trading the financial sector. A similar restructuring paper activities with secured cash collaterals, they are for the Pashtany Bank will be placed in the Cabinet reluctant to venture to widen their lending base to in June 2007 to meet the benchmark. Although, the loans for industries. Lending for industries, in restructuring effort of these banks is in progress, the particular SMEs, was virtually absent in the case of extent and intensity of the process needs to be PCBs. Financial systems or commercial banking evaluated properly to examine its impact on does not see the small businesses as a potential improving the operational and financial market source for sustainable investment and performance of these banks. commercial banking, thus losing the potential earnings from these credit relationships. On the contrary, Microfinance Institutions (MFIs) have taken advantage of this situation to expand their business to SMEs with great success in the absence of competition from commercial banks. The World Bank’s investment climate survey (2006) stated that 51 percent of firms considered access to finance a major problem for investment and business operations in Afghanistan. A World Bank ongoing survey of 50 enterprises, registered Kabul, Afghanistan June 2007 6 Financial Institutions IV. RECOMMENDATIONS V. QUESTIONS FOR DISCUSSION Improving access to financial services 1. Even some of the large investors in Kabul did not access bank financing as they found it very Lack of access to adequate financing on reasonable difficult to obtain. What are the main reasons for terms is partly caused by the risk averseness of the this? conservative banking systems in Afghanistan, which have neither the necessary credit information 2. Why does commercial banking not see the on small borrowers to price risks accurately, nor the small businesses as a potential market source for instruments to transfer such risks. In this context, sustainable investment and commercial banking, the goal of improving access to finance will, over while some MFIs, i.e. BRAC SEP see them as the longer-term, be met by building efficient excellent business opportunities? financial markets and institutions, and the necessary infrastructure underpinning these markets. 3. What are the success factors for BRAC SEP to However, in the period of transition to an efficient be able to expand SME loans? banking system, targeted approaches to help jump- start financing are needed. Such approaches would 4. In case of the Bank Millie, what would be include innovative risk-sharing methods, such as more important, ‘building local capacity in the credit guarantee instruments designed to share banking sector’ or ‘revitalizing the bank by banks’ risks in lending; providing housing loans to allowing the bank to hire qualified international low-income groups; and developing leasing banking experts’ or both? markets which could meet the financial needs of small businesses as an alternative to traditional 5. How serious is the problem of lack of capacity formal banking finance. in banking human resources, and what are the efficient ways to develop the capacity? Setting up a banking training institution 6. How could a CIB help financial institutions The capacity building of the commercial banks has assess the credit risk of borrowers, and how urgent become important in order to provide efficient and it is to establish a CIB in Afghanistan? transparent banking services. Establishment of a Banking Training Institute (BTI) will improve the 7. Why is the cost of collateral registration so skills of the employees of commercial banks, high and what are the ways to bring down the cost financial institutions and the central bank. While for efficient financial transactions? some individual banks are developing their own programmes, these are not adequate to meet the national need. The BTI can directly contribute to: (i) upgrading the skills, knowledge of credit officers, managers and administrators; (ii) developing banking system with qualified professionals; and (iii) conducting research and promoting discussions on the financial sector policy issues to help national development. Establishing a Credit Information Bureau Establishment of a Credit Information Bureau (CIB) in Afghanistan could help the banking and financial institutions to maintain high quality loan portfolio of the customers. Commercial banks and financial institutions strongly support the establishment of a CIB for gathering, processing, and storing information on the payment behaviour of businesses and consumers to help with risk assessments of the borrowers. The CIB needs to be linked to the central bank, since DAB has natural advantages to collect such information from the commercial and other financial institutions. 7 Case Study