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FINANCIAL 
SECTOR 
ASSESSMENT 
KYRGYZ 
REPUBLIC 
APRIL 
2003 
EUROPE 
& 
CENTRAL  ASIA  REGION  VICE  PRESIDENCY 
FINANCIAL  SECTOR  VICE  PRESIDENCY 
BASED 
ON 
THE JOINT 
IMF-WORLD 
BANK 
FINANCIAL 
SECTOR 
ASSESSMENT 
PROGRAM' 
A. 
INTRODUCTION 
1. 
. 
The 
Kyrgyz  financial  system 
is 
dominated 
by 
commercial  banks  and 
to 
a 
lesser 
degree 
by 
non-bank  financial  intermediaries  that  are  mostly 
donor 
funded. 
The 
system  is 
small, 
with total 
bank  assets  of  about 
7 
percent 
of 
GDP, 
and  total  non-bank  financial 
intermediary 
assets  of  about 
2.5 
percent 
of 
GDP. 
The  capital  markets,  insurance,  and  pension 
sectors are 
all 
extremely 
small, 
if 
not  embryonic,  and  not  systemically  significant. 
2. 
In 
recent  years, 
some 
progress  has  been  made 
in 
terms 
of 
consolidation  and 
rationalization 
of 
the  sector  and  improvement  of  financial 
infrastructure, 
especially 
in 
banking 
supervision  and  resolution.  Weaknesses  remain 
in 
corporate  governance  and  the 
legal  and 
regulatory 
framework, 
as well 
as 
in 
the  judiciary,  which 
is 
of 
major  concern  and  a 
constrain to 
development.  The  system  also  suffers 
from 
a  severe  lack 
of public 
confidence  in 
commercial  banks 
and 
weak  demand  for  current  accounts  because 
of 
a  narrow  range 
of 
payments 
services. 
3. 
Given 
the 
overall  small  size 
of 
the 
Kyrgyz 
financial  system,  vulnerabilities 
do not 
represent  a  short-term  threat  to  macroeconomic  stability,  especially 
if 
compared  with  the 
The 
FSAP 
team included Richard 
Abrams  (Leader, 
IMF), 
Tunc 
Uyanik 
(Deputy, 
World 
Bank), 
Gianni De 
Nicolo 
George Iden, 
P. 
Moni Sengupta, Joerg 
Zeuner 
and 
Rozanna 
Nikdjou (all 
IMF); 
Hormoz 
Aghdaey, 
Nagavalli Annamalai, Joselito Gallardo, Serap 
Gonulal, 
Robert 
Gourley, 
Gordon 
Johnson, 
Zeynep Kantur, 
Takashi Miyahara, Adolfo Rouillon, Mehnaz Safavian, Carlo 
Segni,  Rimas 
Survilla and Sanjay 
Vani 
(all World 
Bank); Richard Breeden 
(USA, 
FDIC), Robert 
Glading  (Reserve 
Bank 
of 
Australia), Niels Larsen (formerly 
Federal Reserve Bank of Boston) and Martin 
Ohms 
(Austrain National 
Bank). 
Page  2
high 
level of 
the  country’s  public  debt,  which  peaked 
at 
94  percent  of  GDP 
in 
2001. 
Most of 
this 
debt 
is 
externally 
held  and  denominated 
in 
foreign  currency,  thus  exposing  Kyrgyz 
Republic 
to 
foreign  exchange  risk.  However, 
if 
vulnerabilities 
in the 
financial  system  persist, 
they  could  lead  to  disorderly  exits 
of 
failed  banks.  This,  in  turn,  could  further  endanger 
any 
restoration 
of  depositors’  confidence  and  undermine  the  system’s  capability 
to 
support 
private 
sector  development,  which 
is 
key  to  sustainable  economic  growth  and 
to 
reducing  the 
country’s  debt. 
B. 
MACROECONOMIC 
ENVIRONMENT 
4.  The  Kyrgyz  Republic 
is 
one  of  the  more  liberalized  countries 
in 
Central  Asia.  Soon 
after 
independence,  the  country  embarked 
on 
a  comprehensive  reform 
to 
transition 
to 
a 
market  economy. 
The 
strategy  included  the  divestiture 
of 
state-owned  assets,  the  introduction 
of the Som, the 
national  currency,  and  the  establishment 
of 
a 
modem 
financial  and  legal 
infrastructure to 
support  private  and  financial  sector  development.  The  Kyrgyz  Republic 
is 
also  the 
only country 
in 
the  region  that 
is 
a  member 
of 
the  WTO  (1998). 
5. 
Despite the 
intense  reform  efforts  of  the  early  1990s,  Kyrgyz  Republic  has  remained 
one of the poorest 
countries 
in 
the 
CIS, 
with  a  per  capita  GDP 
of 
about 
US$308 
in 
2001.  This 
is due to 
the 
country’s 
geographical  isolation,  the  scarcity  of  natural  resources,  heavy 
dependence 
on 
gold  and  agriculture  output,  and  the  effects 
of the 
Russian 
crisis of 
1998. 
Despite these 
adverse  conditions,  the  country’s  macroeconomic  performance 
has been 
improving  significantly 
since 
1998 
- 
real  GDP  grew  at  an  average  annual  rate 
of 
5.5  percent 
during 
1996-2001,  although 
it is 
expected  to 
turn 
slightly  negative  in 
2002 
Inflation 
is 
under 
control 
as  the 
12-month 
average  inflation  rate  has  declined  from  23.5  percent 
in 1997 
to 
2 
percent 
in 
2002. 
C. 
PUBLIC 
EXTERNAL 
DEBT 
6. 
Public 
external  debt  rose  from 
36 
percent  of  GDP 
in 
1995, 
to 51 
percent 
in 1997 
and 
94  percent 
in 
2001 
- 
remains  a  major  concern.  The  reasons  for 
the 
rapid  accumulation 
of 
foreign  debt  include: 
(a) the 
relatively  large  borrowing  for  the  Public  Investment  Program; 
(b) the 
accumulation 
of 
a  large  stock 
of 
contingent  liabilities  through  government  guarantees 
of 
state-owned  enterprise  borrowings;  and  (c)  the  Russian  financial  crisis 
in 
1998  with 
the 
subsequent  devaluation 
of 
the  Som. 
7. 
In 
the last 
two 
years,  the  government  has  re-established  a  positive  track  record  in 
addressing external debt. 
The  institutional  framework  has  been  strengthened 
with 
the  Law 
on 
Public 
and  Non-Public  Debt,  and  a  database  for  domestic  and  foreign  debt 
has 
been 
Preliminary figures show a contraction 
of 
0.5 
percent 
in 
2002, 
mainly  due 
to 
an accident 
at 
Kumtor 
goldmine. 
According 
to 
a World 
Bank 
Mining 
Sector  Review, 
the 
gold  mining 
sector’s share 
of 
GDP 
was 
around 
7 
percent 
in 
2001. 
2 
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developed.  At 
the 
same  time,  tight  monetary  and  fiscal  policy,  improvements 
in 
revenue 
collection, 
and  containment  of  public  expenditures  have  led 
to 
stabilization 
of 
the  currency 
and 
lower inflation. 
The  fiscal  deficit  also  fell  from  9  percent  of  GDP 
in 
2000 
to 
5 
percent 
in 
2001, 
and  it 
was 
expected 
to 
remain  at  this  level  for  2002. 
In 
addition,  with  the  support 
of 
the 
IMF,  the  government  designed  a  comprehensive  debt  strategy  which  gained  Paris  Club 
support in 
March 
2002,  as  creditors  granted  a  flow  rescheduling  of  the  Kyrgyz  debt.  The 
government  also  signed  a  3-year  Poverty  Reduction  Grant  Facility  (PRGF)  program  with  the 
IMF,  and  decided  to  update  and  automate  treasury  operation  functions. 
D. 
THE 
Banking 
SECTOR 
8. 
There  are 
19 
commercial  banks 
in 
the  Kyrgyz  Republic. 
In 
terms  of  total  assets, 
the 
banking 
sector 
is 
small  and 
fragile 
but  on 
its way 
to  recovery  from  the 
crisis in 
1998.  The 
crisis 
brought 
inflation 
and  devaluation,  the  collapse 
of 
the  largest  energy  conglomerate  and 
the 
bankruptcy 
of 
two 
of the 
largest  banks  in  the  country.  The  Kyrgyz  State  currently 
owns 
two  banks,  the 
Savings 
and  Settlement  Corporation  (SSC)  and  Kairat,  which  together 
represent 
about 
12 
percent  of  total  assets 
of 
the  banking  sector. 
SSC 
has  a  limited  banking 
license 
with  activities  restricted  to  inter-bank  lending,  government  securities  transactions, 
deposit  taking, 
fiscal 
and  quasi-fiscal  payments  services,  and  payments  services  for 
budgetary 
entities.  It  has  the  largest  branch  network  in  the  country.  Kairat 
is 
also  a  narrow 
bank, 
and 
its 
activities  range  from  deposit  taking,  cash  transfers  and  foreign  exchange 
to 
inter-bank  lending. 
9. 
Following  the  Russian  crisis,  the  government  and  the  National 
Bank 
of 
Kyrgyz 
Republic 
(NBKR) 
devoted  considerable  efforts  in  reforming  the  sector.  The 
NBKR 
closed 
nine 
problem  banks,  increased  the  minimum  statutory  capital  requirement  and  introduced  a 
new minimum 
threshold  for  Tier  1  capital.  The 
NBKR 
also  strengthened 
its 
banking 
supervision 
department  and  introduced  a  Regulatory  Response 
Policy 
based 
on 
CAMEL 
ratings. 
The 
government  supported 
NBKR’s 
efforts  by  providing  financial  resources 
to close 
two 
banks  and 
to 
rescue  a  third  from  bankruptcy. 
10. 
Despite these 
achievements,  the  financial  condition 
of  Kyrgyz  commercial  banks 
remains fragile 
as  they  face  difficulties 
in 
generating  income  and  developing 
capacity 
and  a 
product 
base. 
In 
this 
regard,  the  main  problems  include:  (a)  the 
inability 
of  banks 
to assess 
credit 
risk, 
due 
to  the  lack 
of 
banking  skills  and  transparency 
in 
the  real 
sector; 
(b) 
judicial 
uncertainties,  which 
make 
lending  difficult  and  risky;  and  (c) 
inability 
to  generate  sufficient 
revenues  from  operations  due  to  the  low  demand  and  low  marginal  value  of  banking 
transactions partly 
due 
to 
inefficiencies 
in 
payments  system  infrastructure.  Bank  lending  has 
been  declining, 
with 
total  bank  credits 
to 
the  real  sector  decreasing  from 
6.5 
percent 
in 
1995 
to 
3.8 
percent 
of 
GDP 
in 
2001.  Banks  currently  invest  about  one-third  of 
their 
assets  in  short- 
term  securities  and  correspondent  bank  accounts  whose  returns  are  declining  with  interest 
rates. 
In 
addition, 
lack 
of 
confidence  in  the  banking  system  imposes  high  cost  of 
funds 
for 
banks. 
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Page  4
11. 
Asset  quality 
is 
a  major  concern. 
The 
ration  of  total  non-performing  loans 
(NPLs) 
to 
total 
loans 
was 
around 
14 
percent  at  end-2002,  but  generally  worse  for  larger  banks,  due  to 
their 
lending  concentration 
in 
certain  sectors 
of 
economy.  While  most  banks  reported 
profitability, 
in 
some 
cases  profits  could  have  been  overstated  due 
to 
roll-overs 
of 
non- 
performing  credits.  The 
NBKR 
is  aware  of  this  problem  and  has  intensified  its  efforts 
to 
verify financial 
reporting. 
In 
addition,  the  total  capital 
of 
some 
banks 
may 
have  been 
overstated 
due 
to  cross-shareholding. 
12. 
There 
are 
pressures  to  introduce  deposit  insurance  as 
a 
step 
to 
restore  confidence 
in 
the 
banking 
system.  However,  preconditions  for  a  system  include  healthy  and  sound  banks, 
strong  supervision,  and  improved  accounting  and  auditing,  corporate  governance  and 
judiciary 
systems.  At  present,  these  preconditions  are  largely  not  in  place  in 
the 
Kyrgyz 
Republic. 
As  a 
result, 
the  introduction 
of 
deposit  insurance  should 
be 
delayed  and  considered 
only 
as  a  medium-term  objective. 
E. 
BANKING 
SUPERVISION 
AND 
RESOLUTION 
13. 
The 
NBKR 
is 
the 
supervision  and  licensing  authority  for  the  banking  sector.  The  legal 
framework 
is 
based  on  the  National  Bank  Law  and  the  Law  on 
Banks 
and  Banking 
Activities. The 
law  provides  the 
NBKR 
with  extensive  powers  to 
issue 
both  general  and 
specific regulations 
and  instructions  to  banks.  Should  a  bank  fail  to  comply  with  these 
regulations 
and  instructions,  the 
NBKR 
can  impose  a 
full 
range  of  corrective  measures  and 
penalties,  including  revoking  a  bank’s  license. 
14. 
The 
overall  framework  for  banking  supervision  and  resolution 
is in 
place,  although 
gaps  and  inconsistencies  remain.  The  annual  NBKR  on-site  inspection  program 
is largely 
satisfactory. The 
effectiveness 
of 
on-site  inspections  benefits  from  unhindered  access 
to 
banks’  books,  accounts,  documents,  and  employees,  as  granted 
to 
the 
NBKR 
by 
the  Banking 
Law.  Off-site  supervision  has  some  room  for  improvements.  Given 
the 
number 
of 
tasks 
required 
of off-site 
examiners,  it  appears  there  is  limited  time  available  for  thorough  analysis. 
The 
NBKR 
is  currently  in  the  process 
of 
implementing 
an  automated  data  collection  and 
analysis 
program  that 
will 
greatly  improve  the  effectiveness  of  off-site  supervision. 
15. 
Despite 
the  large  number  of  banks  closed  or  liquidated  during  the  past  few  years  and 
improvements  in  supervision,  there 
is 
need  to  strengthen  bank  resolution.  There 
have 
been 
delays 
in 
the 
NBKR 
interventions,  mainly  due 
to  weaknesses  and  inconsistencies 
in 
the 
legal 
and 
regulatory 
framework  combined  with  weak  financial  information  disclosure  and 
corporate 
governance.  Moreover,  bank  resolution  is  frequently  hampered 
by the 
courts, 
where corruption is 
rampant 
NBKR decisions have been challenged in civil 
court,  where  outcomes  are 
sometimes unpredictable. The 
appeals process is often protracted, and 
this  hampers 
the 
banking 
resolution efforts of the 
NJKR 
and increases 
transaction costs for 
banks. 
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Page  5
F. 
CREDITORS’ 
RIGHTS 
AND 
CORPORATE 
GOVERNANCE 
16. 
The legal and institutional 
frameworks 
supporting credit 
and 
creditor rights 
in 
the 
Kyrgyz Republic are inadequate 
and 
inefficient. 
Creditor  rights 
remain weak, collateral 
systems 
- 
other than for traditional 
mortgages 
- 
are 
poorly 
developed, and the enforcement 
procedures of the courts are slow 
and 
unreliable. These 
weaknesses 
create distortions 
in  the 
lending market, as lenders require fully 
secured 
loans and sometimes as high as 
200 
percent 
collateral. 
Efforts 
to 
Work 
Out 
Problem Portfolios 
of 
the 
Banks 
The government of the 
Kyrgyz 
Republic established the debt resolution agency 
(DEBRA) 
in 
1996 
to facilitate 
bank 
resolution through the conservation and 
liquidation 
of 
assets of failed 
banks.  DEBRA’S  performance 
has been 
weakening throughout 
the 
years. The 
main 
problems include: 
(a) 
its legal 
status 
as 
a department 
in 
the 
MoF, 
which does 
not 
guarantee the necessary 
independence; 
(b) 
inadequate funding; 
and 
(c) 
weak 
technical 
and 
operational 
capacity. 
The 
authorities recognize the 
need 
to strengthen the role of 
DEBRA 
as 
mean 
to enforce credit discipline 
and, 
in 
the 
long  run, 
to establish a credit 
culture 
in 
the country. 
In 
the 
summer 
of 2002, the Parliament enacted 
an 
, 
amendment 
to 
the 
Bankruptcy  Law. 
According to the 
amendment,  DEBRA 
shall be 
the 
sole liquidator 
of 
failed 
banks. 
The 
government 
will restructure 
DEBRA, 
transform 
it 
into an independent agency 
and 
strengthen 
and 
enhance 
its technical 
and 
operational structure. 
17. 
Lack of good corporate governance 
and 
a 
good  accounting  and 
auditing framework 
and practice are significant weaknesses. 
To  remedy 
this situation, a 
new  Law 
on 
Accounting, 
enacted 
in 
April 2002, introduces 
improved 
financial reporting requirements and 
an 
ambitious timetable for switchover 
to  IAS.  All  banks  and 
other financial institutions have 
now 
switched over. 
All 
other legal entities are 
required 
to 
comply  by  end-2004. 
This 
timetable 
is 
very ambitious, 
as 
there are not enough 
accounting  and 
auditing professionals 
in 
the country capable of implementing 
IAS  and 
monitoring compliance. 
18. 
The audit profession is in its 
infancy 
and the 
audit 
firms 
are 
struggling to grow 
professionally and 
in 
size. 
In 
addition, the 
regulatory 
authority for the audit profession has 
weak 
disciplinary and governance arrangements. The 
Law 
on 
Auditing prohibits external 
auditors from disclosing information 
to 
third parties, including the 
NBKR. 
The 
NBKR 
is 
not 
entitled to share information 
with  other 
domestic enforcement agencies without prior consent 
by 
the 
banks and their clients. Furthermore, the framework on internal audit 
and 
control has 
serious gaps. The Banking 
Law 
itself, 
for  example,  does 
not require that internal auditors 
be 
independent 
and 
report directly to the 
board. 
G. 
AML/CFT 
5 
Page  6
19. 
The 
AML/CFT 
framework  is  weak,  exposing  financial  institutions 
to 
the  risk 
of 
abuse 
by 
money 
launderers  and  other  criminals. 
At 
present,  the  legal  framework:  (a)  lacks  criminal 
provisions  that  meet  international  standards;  (b)  does  not  provide  for  mandatory  suspicious 
transaction 
reporting 
to 
a 
Financial  Intelligence 
Unit; 
(c)  has  limited  provisions  for 
confiscation,  freezing  or  provisional  measures;  (d)  does  not  require  sufficient 
minimum 
requirements  for  customer  identification 
or 
application 
of 
fit-and-proper  tests;  and 
(e) 
discourages 
early 
involvement 
of 
law  enforcement  in  investigations,  due 
limits 
on 
the 
disclosure of banking 
secrets. 
20.  The  weaknesses 
in 
the  legal  and  regulatory  framework  impede  the  development 
of 
necessary  supervision  framework.  One  notable  risk  arises  from  the  provisions 
of the 
Law 
on 
Licensing,  which  impedes 
the 
full 
application 
of 
the  fit-and-proper  test  for  bank  managers 
and 
shareholders. 
This  undermines  an  important  measure 
to 
prevent  criminals  and 
unqualified 
persons/entities 
from  becoming  shareholders,  directors,  and/or  senior  managers 
of 
financial 
institutions. 
In  addition,  another  impediment 
is 
the  stringent  legislation 
on 
banking 
secrecy in 
the  country.  The 
NBKR 
has  prepared 
a 
draft 
AML 
law,  which 
is an 
encouraging 
step 
forward. 
H. PAYMENT 
SYSTEM 
21. 
The  National  Payments  system 
is 
operated 
by 
the 
NBKR 
and  consists 
of a 
gross 
inter- 
bank settlement 
system  and 
a 
net  clearing  system.  The  system  still 
relies on 
paper  documents 
and  does 
not provide 
affordable,  convenient  payment  services.  The 
NEKR 
is 
currently 
developing 
a 
payments  system  reform  strategy,  with  the  objective 
of 
making  payments 
cheaper, 
more 
reliable  and  more  transparent.  The  strategy  aims 
to 
establish: 
(a) a 
Real 
Time 
Grass Settlement 
System  (RTGS);  (b) 
a 
clearing  system  for  small  and  recurrent  payments;  (c) 
a 
card 
clearing 
system;  and  (d)  the  general  ledger  of  the 
NBKR. 
The  expected  outcome 
of 
the 
strategy 
would 
be 
to 
enable 
banks  to  provide  efficient  payments  and  banking  services 
in 
order 
to 
expand  their  customer  base  and,  ultimately, 
to 
help  restore  depositors’  confidence. 
I. 
THE 
NON-BANK 
FINANCIAL 
INSTITUTIONS 
(NBFIS) 
AND 
CAPITAL  MARKETS 
22. 
The 
NBFIs 
are  playing 
an 
increasingly  important  role 
in 
the 
financial 
sector 
by 
providing 
the  bulk  of  credit  to  small-  and  medium-sized  enterprises  as  well  as  rural 
borrowers. Microfinance 
programs 
in 
the  Kyrgyz  Republic  currently  have  about 
33,000 
customers. 
A 
concern 
in this 
area  is  the  interest  rate  subsidies  from  competing  institutions, 
which 
are  causing  distortions 
in 
the  credit  market. 
In 
the  long 
run, 
this 
could  lead 
to a 
reduction 
of 
services  for 
the 
target  borrowers,  because  pervasive,  subsidized 
rates 
discourage 
new 
entrants, reduce 
outreach,  and  may, 
in 
the  extreme,  induce  market-based  microfinance 
intermediaries 
to  exit  the  market  altogether. 
23. 
The 
Parliament  enacted 
a 
new  Law 
on 
Microfinance  Organizations 
in 
August  2002. 
The 
law  assigns  supervisory  and  regulatory  responsibility  to  the 
NBKR 
and  enables 
MFIs 
to 
collect  deposits.  The 
new 
law  represents 
a 
major  challenge  for  the 
NBKR 
which  needs 
to 
develop 
the 
framework  for  supervision,  monitoring  and  resolution  for 
a 
sector  that  is  already 
G 
Page  7
developed 
and 
that could 
complement  banks 
in 
delivering financial 
and 
basic banking 
services 
in 
the most remote areas of the country. 
24. 
Capital markets, insurance 
and 
pension sectors are extremely small. 
The 
development 
of 
these sectors should remain a long-term objective, as the supervisory and regulatory 
framework and enforcement capacity 
are  extremely 
weak. 
J. 
CONCLUSION 
25. 
There a 
number 
of 
structural 
weaknesses  and 
developmental issues 
in 
the Kyrgyz 
financial system, resulting 
in 
the 
low 
degree 
of 
intermediation 
of 
banks 
and 
lack of financial 
support 
to 
private sector growth. The 
FSAP 
mission 
prepared 
a 
number 
policy 
recommendations, which have been incorporated 
in 
the government’s 
and 
the 
NBKR’s 
financial sector strategy section of the National Poverty Reduction Strategy 
now 
under 
implementation. 
The 
government has requested the 
Bank 
to help with the implementation 
of 
the 
strategy and coordination 
of 
donors’ assistance. 
26. 
H 
H 
D 
H 
H 
H 
27. 
H 
H 
H 
H 
H 
H 
The authorities have already started measure to: 
improve the effective 
management 
of 
external debt; 
enhance supervision, 
governance  and 
the 
framework 
for creditor rights; 
further consolidate the banking 
system; 
initiate 
the 
payments system 
reform; 
initiate legal 
and 
judicial 
reforms; 
and 
develop the 
AML/CFT 
framework. 
The 
medium-term outcomes of the strategy 
are 
expected to include: 
implementing the payment system 
reforms; 
addressing 
key 
legal 
and 
judicial 
measures; 
implementing the framework for 
AML/CFT; 
developing 
the 
micro finance sector 
that 
could serve to complement 
the 
banking 
sector 
in 
delivering financial 
and 
basic banking services 
in  the 
rural 
areas; 
setting 
up 
a deposit insurance scheme provided 
that 
banks are more sound 
and 
supervision, corporate 
governance  and 
transparency are improved; 
and 
addressing weaknesses and 
delays 
in the 
framework  for 
accounting 
and 
auditing. 
7