Felix Fischer

Felix Fischer

After more than two decades of war and conflict, regional tensions, and endemic security concerns, very little was left of Afghanistan’s financial system when the Taliban departed at the end of 2001. Although six commercial banks still retained banking licenses, none of them was operational. Virtually no loans had been made since 1995 and banks had lost their credibility as deposit-taking institutions. The central bank had been changed into a Soviet-style dirigiste institution, interfering in the allocation of credit and the setting of interest rates, and abrogating its responsibility to undertake the traditional functions of a central bank. Its financial role was reduced to monetizing successive governments’ fiscal deficits. The banking system could no longer provide a payment system, which was instead taken over by the informal hawala system.

The speed at which Afghanistan’s economy could be rebuilt, sustainable economic growth achieved, and widespread poverty reduced depended crucially on a rapid and sound redevelopment of its financial sector.1 For the government to pay the wages of its civil servants, procure goods and services, undertake investment in infrastructure, collect taxes and customs duties efficiently, and make the best use of the substantial donor funds destined for Afghanistan’s reconstruction, a rudimentary payment system and basic financial services were essential. It was thus paramount for the Afghan authorities to quickly initiate reforms to move away from cash as the sole medium of exchange and to lay down the enabling framework for an efficient commercial banking system to develop and flourish. For all this to be done while safeguarding against fraud and bank failure, it was necessary to rebuild a modern central bank, with a supervisory capacity in line with international standards to oversee the operations of the new banking system as it develops.2 The passage, on September 16, 2003, of a modern central bank law and a modern banking law and the subsequent granting of banking licenses to a number of foreign banks have laid the groundwork in this endeavor.

After the Taliban: Financial System at the End of 2001

At the end of 2001, there was no functioning banking sector in Afghanistan, notwithstanding the existence of a number of financial institutions with a banking license and a roster of staff on the payroll. Most of what remained of the financial system was based in Kabul. Although not much is known about the state of the financial system in the provinces, it is not believed to have been extensive, let alone operational. The Afghan financial system comprised, in principle, Da Afghanistan Bank (DAB), a hybrid institution with central banking and commercial banking functions; two state-owned commercial banks; and four state-owned special purpose development banks. In addition, there were about 300 registered money trading entities reportedly operating in Kabul with some 5,000 traders.

Assessing the conditions of the financial sector in Afghanistan that prevailed at the end of 2001 proved in itself to be a major challenge. Qualified translators were few and the difficult security situation, particularly outside of Kabul, seriously hampered a systematic and rapid assessment of the financial sector on a nationwide scale. Communication lines between most of the branches of the central bank or commercial banks and their headquarters had largely broken down. In most cases, there had been no exchanges with correspondent banks abroad for years and accurate information on assets and liabilities, either domestic or external, was unavailable. The books kept at the banks in Kabul were completely out-of-date and, moreover, had been prepared according to Soviet accounting systems that were incompatible with internationally accepted accounting standards. At the aggregate level, meanwhile, the databases of international institutions, such as the IMF, on Afghanistan’s financial sector had not been updated for more than a decade. A proper assessment of the informal financial system, the registered money traders, and the rest of the hawala was, by its nature, even harder to make. As a result, information collected was often ambiguous or contradictory and it was impossible to properly assess the soundness of the banking sector, let alone to conduct any due diligence of reported data. It thus took considerable time to assess the post-Taliban conditions of the financial sector and even today the assessment remains approximate.

Legal Foundations

Until the enactment of the new central bank law and the banking law in September 2003, the legal basis for the central bank and for the commercial banks was the Law on Money and Banking. This law, which was enacted in 1994, had a number of serious flaws. First, it was designed on the now outdated socialist principle that the purpose of monetary policy was to direct credit. It was therefore unsuitable for a market economy. Second, it involved a number of important conflicts of interest between the government, the central bank, and commercial banks. Third, it omitted important modern prudential standards and enforcement tools. During the Taliban era, this law was largely ignored. Although this law has recently been replaced by modern legislation, it is still instructive to recall its main elements because they help comprehend the dismal situation of the financial system encountered at the end of 2001. Box 6.1 summarizes some of the main issues and shortcomings of the Law on Money and Banking.

Other aspects of the legal foundations of the financial system seem, on the face of it, to be less problematic, because they were derived from Western market-oriented laws and thus do not bear the communist legacy.3 Afghanistan’s civil code was adopted in the 1960s with assistance from the Egyptian government, and is reported to be almost identical to the civil code of Egypt, which was originally based on French law.4 The commercial code of Afghanistan, in turn, was received from Turkey where it had been modeled after German law. It covers general company law, transport law, insurance law, and special financial transactions. It also includes provisions on bills of exchange, promissory notes, and checks. Finally, bankruptcy law provisions can be found in both the civil code and the commercial code and apply equally to state-owned and private banks. Bankruptcies are administered by the courts. For these laws to be made operational, however, there needs to be the necessary infrastructure: record-keeping institutions, functioning courts and police, and an impartial and independent judicial system. Given the difficult environment in Afghanistan, many of these elements are either not yet in place or are in a state of substantial disrepair.

The Law on Money and Banking of the Islamic State of Afghanistan1

The 1994 Law on Money and Banking was a compound law of a central bank law and a banking law for the period 1994-September 2003. The law was poorly written and at times contradictory. Part I defined the legal tender, the Afghani, and its value, ambiguously in terms of both gold and SDRs. It also defined the minimum reserves DAB had to hold against issued banknotes at 25 percent.

Part II of the law related to DAB, its objectives, responsibilities, powers, and organizational structure. It stated that DAB was responsible for the implementation of the government’s monetary and credit policy and that it had to maintain the value of the Afghani in order to facilitate banking and commercial transactions. It also empowered DAB to supervise operations of banks and credit institutions and to regulate and carry out foreign exchange operations. It mandated DAB to determine the commercial banks’ interest rates for deposits and loans and to set minima and maxima on their commissions. DAB was also mandated to define liquidity and capital requirements and limits on large loan exposure. However, these provisions were mostly ill defined and did not comply with international best practice. There were no loan classification or provisioning requirements. Furthermore, the law only empowered DAB to define ratios and to collect information, but no provisions existed on the enforcement of the regulations. Part II further required DAB to manage government accounts and, if necessary, to finance the government budget deficit, as well as to grant loans to government institutions, agencies, and municipalities.

The final section of Part II defined the composition and the role of DAB’s organs, namely the Supreme Council, the Monetary and Credit Committee, the Executive Board, the Board of Supervisors, and the Banknote Reserves Supervision Board. The highest organ was the Supreme Council, which consisted of eight ministers, including the prime minister, and the governor of DAB. The Supreme Council was supposed to meet at least four times a year and to decide on all important matters of DAB or on recommendations made by the other supervisory organs. It notably had to approve all regulations. The Monetary and Credit Committee, in turn, was charged with drafting regulations and recommending the level of interest rates to the Supreme Council. It consisted of the governor and the first deputy governor of DAB, directors of three different ministries, the president of the Chamber of Commerce and Industry, two presidents of commercial banks, and a professor of economics. The composition of the Supreme Council and of the Monetary and Credit Committee was highly problematic because it politicized decisions that should have been made on purely technical grounds. DAB thus lacked the necessary independence that a modern central bank should have. The Executive Board consisted of the governor and his two deputies. Finally, a Board of Supervisors with a chairman and two members was supposed to supervise DAB’s banking operations and accounting practices, and submit monthly reports to the MoF and quarterly reports to the Supreme Council. This control function had not been fulfilled for years.

Part III of the law related to banking, including the definition of a bank, a “private bank,” and the conditions for establishing a bank. The law required banks to use a double-entry accounting method and to submit to DAB its annual balance sheet and profit and loss statement within four months following the end of each year, together with an audit report. The law empowered the Supreme Council to transfer the management of a bank to DAB, to take measures for the management of the bank, or to close the bank (if, for example, the bank acted against the law or its bylaws). For the liquidation of an insolvent bank, the law envisaged the possibility of including officials of the failed bank in the liquidation team. The involvement of the management of the closed bank is particularly problematic if a bank failed for fraudulent reasons. If a government bank is closed, all outstanding deposits, salaries, and claims of other creditors would be paid by the government.

1The contents of this box are based on an unofficial translation of the law from Dari into English.

Da Afghanistan Bank

At the end of 2001, DAB was actively performing two main functions. First, it was cashier to the Ministry of Finance (MoF) and was, in principle, responsible for salary and other budget payments, and receiving government revenues for deposit, across the country. Second, it issued banknotes and managed the stock of cash monies. The bank was also performing many commercial banking operations that a central bank in a modern two-tier banking system should not, while at the same time it was not carrying out many of the typical central bank functions that a modern central bank should. Meanwhile, DAB was fulfilling its tasks with a totally inadequate physical infrastructure and security features (see Box 6.2).

On the commercial side, DAB offered commercial banking services, extended long-term loans to banks and enterprises, and accepted deposits from the public. Although most of these operations were discontinued in 1995, a number of DAB accounts (debit and credit) were still current.5 Under the old Law on Money and Banking, the governor of DAB remained legally the chairman of the governing boards of all the commercial and development banks. This role involved a substantial and undesirable conflict of interest with the traditional functions of a central bank, in particular with banking supervision. By late 2001, however, the governor of DAB refrained from exercising this role. As it was, the central banking side of DAB was minimal. DAB did not supervise the banking sector either by issuing prudential regulations or by checking compliance through on- and off-site inspections. DAB did not provide or supervise an efficient payment system. Nor did it offer any lender-of-last-resort facility for illiquid but solvent banks. Finally, DAB lacked a meaningful and credible monetary or foreign exchange policy (see Chapter 5 for a discussion of monetary and exchange rate policy).

While best practice in central banking would require that DAB be granted a high degree of autonomy, combined with stringent rules for accountability, under the old law DAB was fully controlled by the government. DAB’s ultimate decision-making organ, the Supreme Council, as well as the Monetary and Credit Committee, which drafted regulations and governed the operational aspects of DAB, both included representatives from different ministries.

Commercial Banks

After 23 years of military conflict, the financial system in Afghanistan at the end of 2001 bore little resemblance to a modern Western banking system. During the procommunist and later the Soviet era (1973-89), the banking system was nationalized and Soviet-style accounting, financial control, and management systems were introduced. The situation of the banks deteriorated further during the Mujahedin period and the associated civil strife, with continued government interference in bank management, directed lending, and administered interest rates. Finally, during the Taliban period, financial institutions were forbidden to charge interest on their loans or pay interest on deposits. The banks’ loan portfolios suffered widespread loan defaults, reflecting one of the effects of constant warfare. Deposit mobilization collapsed and the banks discontinued lending. During this same period, the registered money changers and the rest of the hawala system replaced the banks in providing payments and liquidity in the economy, in addition to providing certain deposit and lending services.

Physical Infrastructure and Security of Da Afghanistan Bank

A critical weakness of DAB was the design of the main office, which was not adequate for a central bank. The security features associated with the storage of cash were most disturbing. DAB’s main currency reserve stock was held in two major vaults in Kabul. Although there were well established procedures for accessing the vault, requiring two certified key holders and a witness, the vault area was situated near counters to which the general public had access and was not monitored by electronic surveillance or access technology. During banking hours, the security of the premises was entrusted to unarmed guards and armed military personnel. After working hours, the exterior of DAB was patrolled by military personnel. DAB’s lack of suitable vehicles and the poor and insecure road conditions made transporting cash to the provinces very difficult and highly risky. In early 2002, DAB had only two trucks, one bus, and one Land Rover. All these vehicles were old and unsuitable for transporting cash. Only exceptionally could DAB benefit from air transport provided by the army to deliver cash to the provinces. As a result, cash delivery was often delayed. This forced some branches to rely on their local provincial authorities and private sources to transport cash from Kabul to the provinces.

Box 6.3 summarizes each bank’s history and particularities. Briefly, the commercial banks may still have been solvent in 2002 and even had a positive cash flow, but that was because of the real estate they owned and returns on foreign currency deposits abroad that had been frozen during the Taliban era. Most of the banks’ other assets had been substantially eroded by inflation and/or could probably be written down to zero. For example, most of the banks’ loan portfolio was past due by 7-15 years and many borrowers were either dead or had disappeared. On the liability side, the deposit base had been eroded substantially by the high inflation rates that prevailed until the end of the war. However, none of the banks had been effectively engaged in the banking business for many years, nor did any of them have a management cadre, an accounting framework, or risk management systems that would remotely resemble modern banking. As such, the six banks should probably be characterized as shell banks, that is, institutions that may have assets and a banking license but cannot become operational without a fundamental restructuring and a substantial improvement of their management.

Six Licensed Banks in Afghanistan

The Banke Millie Afghan (BMA) was established in 1933 as a private bank and is the oldest and largest commercial bank in Afghanistan. Until the establishment of the central bank, DAB, in 1939, BMA is believed to have undertaken certain core central banking activities. During the first 40 years, the bank expanded aggressively, both domestically and internationally. BMA was nationalized in 1974, and since then has been fully owned and managed by DAB. Since its nationalization, the bank has suffered from political interference and consequently weak corporate governance and management structure. Following a serious deterioration of the bank’s financial condition, it effectively ceased all forms of financial intermediation in 1992.

The Pashtany Tejaraty Bank (PTB) was set up in 1955 mainly to provide financial services to the growing trade business community. Although the bank was majority owned by the government through DAB, the MoF, and the Ministry of Commerce (together with 58.3 percent of shareholdings), its 12-member board had an equal representation from both the private sector and the government. Until its full nationalization in 1974, the bank performed relatively well. Thereafter, the shrinking private sector reduced lending opportunities, and political interference made the bank entirely dependent on DAB for policy direction and operational instructions. By the early 1990s, the bank’s operations were limited to receiving payments of government utilities and small-value deposits.

The Agricultural Development Bank (AgBank) was established in 1954 as the Agricultural and Handicraft Bank by the MoF, DAB, and Banke Millie Afghan, and has not changed its ownership structure since then. The bank’s objective was to provide financial services to small farmers and handicraft producers. After an unsuccessful start, the bank was reorganized and renamed in 1969. The restructured bank successfully refocused its business on financing the agricultural supply chain from producers to processing and export. During the Soviet period, the bank’s activities declined, concentrating on importing and selling Russian equipment. After the Soviets left, the bank essentially became inoperative.

The Export Promotion Bank (EPB), was established in 1976 by MoF, the Chamber of Commerce, and several local producer cooperations. Despite its name, the EPB mainly financed import letters of credit. Apart from trade finance, no other loans were offered. The bank’s operations continued during the Soviet period, but they fell back drastically after 1992 and were effectively suspended under the Taliban regime.

The Industrial Development Bank of Afghanistan (IDBA) was founded in 1973 as a private financial institution by domestic shareholders and six foreign investors, including Chase Manhattan Bank, First National City Bank of New York (predecessor of Citicorp), the International Finance Corporation of the World Bank Group, National Westminster Bank of London, Industrial Bank of Japan, and Credit Lyonaise of France. The bank provided short- and long-term secured and unsecured loans to the private sector, state owned enterprises, and joint private-government enterprises. Most projects that were financed were for production of alcohol, carpets, shoes, medical products, and textiles in Kabul. With its nationalization in 1977, its new owners became DAB, the MoF, Pashthany Tejaraty Bank, Bank Millie Afghan, and the Afghanistan Chamber of Commerce. The bank’s activities were disrupted during the Soviet and Mujahedin periods and totally halted with the arrival of the Taliban in 1996.

The Mortgage and Construction Bank (MCB) was established in 1948 to finance residential and commercial construction in Afghanistan. From its inception, the bank was majority state-owned. The composition of the private shareholders is not known as the bank’s records were destroyed. After nationalization in 1974, the bank’s share structure was divided between DAB, the Afghan Chamber of Commerce, MoF, and Banke Millie Afghan. The MCB extended its last loan in 1995. As of 2003, MCB’s main activity is to collect rents of repossessed buildings and interest rates on some 300 loans, the principal of which had already been collected during the Taliban regime.

Sources: Interviews in February and July 2002 and May 2003; diagnostic studies conducted by the World Bank.

Payment System

With the decline of the commercial banking system to a near-moribund state at the end of 2001, most domestic and international payments in Afghanistan came to be undertaken by the money dealers (see Box 6.4). As the only viable payment system, this informal financial network had become crucial for the functioning of the Afghan economy. But it was also vulnerable to money laundering, drug trafficking, and terrorist financing.6 At the end of 2001, there was an urgent need for a formal payment system for payments by the government and by the donor community. These payments, for a variety of reasons, were not best suited to be made under the hawala payment system. Not only did the central government need to make salary and other budgetary payments to and collect customs revenues from the provinces, but the success of the currency conversion critically depended on being able to reactivate DAB’s branch system for the conversion to take place nationwide. In the absence of a functioning banking system, therefore, the responsibility fell to DAB to provide leadership in the reform and development of the formal national payment system.

Modernizing the Financial Sector in Afghanistan

New Legal Framework

A completely new central bank law and a banking law, properly defining the separate roles of the central bank and commercial banks, replaced, on September 16, 2003, the Law on Money and Banking, which was outdated and incompatible with a modern two-tier banking system.7 The enactment of the modern central bank and banking law through a presidential decree has been a crucial first step for the development of a sound and resilient private banking sector and more generally for macroeconomic stability and growth in Afghanistan. The laws have opened the doors for foreign banks, with their much-needed technology and management know-how, to set up businesses in Afghanistan. Immediately following the enactment of the new laws, DAB issued banking licenses to Standard Chartered Bank, the National Bank of Pakistan, and the First MicroFinance Bank, which was established by the Aga Khan Fund for Economic Development. For such banks, investing in Afghanistan offers potentially lucrative opportunities, but—given the low institutional development—they have substantial risks. Under the new laws, investors are given transparent, predictable, and sound “rules of the game.” At the same time, the central bank has been given the proper tools to regulate and supervise the banking system without government and political interference. With the basic legal foundations for the financial sector in place, the next step is for authorities to press ahead with creating the necessary institutional framework, including the governing bodies of DAB, and the technical capacities to be able to effectively perform the duties prescribed by the laws. Furthermore, complementary laws should also be enacted soon, including a modern payment system law and a law on anti-money laundering (AML) and combating the financing of terrorism (CFT). This would help to restore the confidence of the public in the banking system and regenerate the deposit base that banks need to be able to extend credit.

The central bank law includes provisions that give DAB the overriding responsibility to achieve and maintain price stability, and grants it full autonomy in pursuing this objective. In order to mark the clear departure from its socialist legacy, the law also specifies that DAB shall act in accordance with the principle of an open market economy with free competition. It further entrusts DAB with the tasks of defining, adopting, and implementing Afghanistan’s monetary and foreign exchange policy; issuing banknotes and coins; holding and managing the official foreign exchange reserves; acting as advisor and fiscal agent of the government; and licensing, regulating, and supervising institutions engaged in banking business. The law prohibits financing the government budget deficit, thereby closing one important channel through which macroeconomic instability and high inflation might otherwise emerge. DAB is also prohibited from providing loans to commercial banks. The one exception to this rule is that DAB is permitted to act as a lender of last resort and to extend short-term liquidity support to solvent but illiquid banks, especially in the event of a systemic liquidity crisis.

Money Dealers in Afghanistan

In 2003, there were approximately 5,000 money traders in Kabul, of which some 300 had shops and were licensed by DAB.1 DAB licensed money changers for a fee, but did not regulate or supervise them. Some of the unlicensed money traders are affiliated with shops, which typically have two to five traders. Most traders, however, work independently and thus without a license. In provincial towns, there are on average around 80-150 licensed money traders with shops and about 500 traders. The Afghan people have relied on this informal sector for hundreds of years. The money transfer system is usually referred to as the hawala system.2

Funds can be transferred within 6-12 hours from Peshawar, Dubai, or London to Kabul, and with improving communication, the transfer time continues to diminish. Transfers to provinces usually take a little longer. While regional money dealers are mostly located in provincial cities, from where they organize the distribution to villages through their local offices or representatives, the international dealers are mainly based in Kabul. For international transfers, the traditional counterparts are situated in the Islamic Republic of Iran, Pakistan, India, Saudi Arabia, Qatar, the United Arab Emirates, and Oman. Rather than conducting transactions in cash, some clients wire funds to a correspondent account in Peshawar or Dubai, and upon confirmation of receipt of funds, the counterpart is released immediately at the desired destination. Some 10-15 of the larger traders have correspondent accounts with banks abroad. Affiliated traders can also benefit from this network. Reputable customers can cash checks or require receipt of the counterpart prior to making the corresponding wire. Such services are usually negotiated at a higher cost. Depending on the amount, destination, financial relationship, the currency of exchange, and security environment, the cost for making international transfers varies between 0 and 2 percent of the amount transacted. Domestic transfers are typically more expensive with an additional charge of ½ –1 percent. In exceptional circumstances, such as immediately after September 11, 2001, and until early 2002, the fees have been as high as 4 percent. In principle, money transfers operate on a netting system with other traders in the provinces or abroad. Physical transfer of cash, or at times in legal or illicit goods, is only made when a trader has no representation in a particular town, or where a net position needs to be settled. Outstanding balances are usually settled between two dealers on a weekly or monthly basis, but at times, when the volume of transactions is high, settlement of accounts is made daily.

Besides the transfer of funds, the other main financial service provided by the money dealers is foreign exchange dealing, mainly in U.S. dollars, Pakistani rupees, and Iranian rials. Virtually any currency can be traded. The 30 largest traders cover about 70 percent of all transactions and roughly half of their trading consists of transactions in U.S. dollars. Daily trade volumes in the Kabul foreign exchange market reportedly run in to several millions of U.S. dollars, and most of this is transacted in cash. There are no limits on transaction volumes. Traders have reported that buying or selling $1 million in cash can be accommodated easily. Other financial services include deposit taking, granting of short-term loans, trade finance, and microfinance. However, money traders extend loans or accept deposits only to and from people whom they personally know and trust.

The money traders operate without standard documentary requirements and usually design and maintain their own documentary policies and procedures. Transactions generally involve comprehensive and detailed records for the entire process of remittance and settlement of each money transfer. The documentation is kept at least until the entire transaction and its settlement are completed. The money market is not subject to any reporting requirements or supervision. It is fully based on reputation and trust, but also benefits from self-regulation by the Money Dealers Association formed by the 20-30 leading traders. The association has unwritten rules of conduct and practices. Traders who do not respect these rules can be expelled from the market.

Sources: Maimbo (2003); El Qorchi, Maimbo, and Wilson (2003), and meetings held with money changers in Afghanistan in February and July 2002 and May 2003.1Until early 2003, money traders were licensed by the foreign relations department of DAB.2The term “hawala” is used throughout the Middle East and means “transfer.” Equivalent informal transfer systems exist in other countries under a different terminology: feich’ien (China), hui kuan (Hong Kong), hundi (India), padala (Philippines), and phei kwan (Thailand).

The new central bank law grants DAB complete legal, operational, and administrative autonomy from the state and any other person or authority, in the pursuit of its objectives and the performance of its tasks.8 Independence requires accountability, and this is also stipulated in the law. Accountability will be achieved by a clear mandate and by reporting requirements to the Parliament and to the public on DAB’s financial condition, on its success in achieving its objectives, and on how it performed its tasks. Accountability will increasingly also be enhanced by prohibiting DAB senior officials from holding other government positions and by excluding them from engaging in other tasks incompatible with their duties, which would create a conflict of interest.9 The governor, first deputy governor, and members of the Supreme Council of DAB are appointed, remunerated, and dismissed in accordance with specified procedures and conditions.

The law also stipulates DAB’s right to be consulted on any proposed legislative or public administrative act of the government in DAB’s field of competence. This provision ensures that the overall legal framework of the financial system continues to be consistent and coherent. In consideration of the difficulties involved in passing several laws at the same time, the central bank law already includes specific basic issues that under normal circumstances would have been covered by separate additional laws, including currency, cash payments, payment system issues, and securities services and securities transfer systems. Some of these issues should, however, be further extended by separate legislations. Furthermore, DAB has the powers to issue regulations for the hawala dealers as nonbank providers of money and payment services.

The main features of the banking law include a precise definition of a bank as an entity engaged in the business of accepting deposits or other repayable funds from the public and using such funds either for extending loans or for making investments for its own account. The law introduces a two-stage process for filling out applications of banking licenses with only essential information to be submitted in the first stage. It gives DAB the mandate to issue regulations to further specify the necessary conditions for obtaining a banking license. The law stipulates that before an application is considered, DAB would need to conduct a fit and proper test of future owners, board members, and senior managers of the bank. The draft law defines the banking activities that banks are allowed to pursue. They are further detailed in their banking licenses.10

The law includes the standard rules of a modern banking system for sound management, prudent risk management, and transparent and adequate accounting. Specifically, the law includes provisions related to the banks’ corporate governance and on DAB’s powers to review changes in bank ownership, the board, and senior management. The law also includes requirements of credit documentation, risk management, as well as provisions that banks should maintain their accounts in accordance with international accounting standards (IAS). Furthermore, banks will be subject to specific auditing requirements, including the establishment of an audit committee. DAB’s oversight role will be strengthened through the conduct of on-site examinations. The last part of the law is dedicated to specifying DAB’s enforcement measures to address infractions by banks and situations where a bank’s capital declines. It defines a graduated system of prompt corrective actions to be imposed by DAB, including the power to order the removal from office of board members or senior managers of banks, and explicit provisions for dealing with banks undergoing solvency problems. Finally, the law grants DAB the exclusive authority to revoke a license and to initiate insolvency proceedings, with comprehensive explicit provisions for the resolution of insolvent banks under the oversight of a financial service tribunal.

Modern Central Bank in a Two-Tier Banking System

In the two years since the fall of the Taliban, DAB has made important progress in a number of areas. Most importantly, it has successfully implemented the currency exchange and gained control over the issuance of currency, which is a prerequisite for an effective monetary policy (see Chapter 5). It has also created a banking supervision department and thereby addressed one of the key weaknesses of DAB. Progress in other areas, in particular the restructuring of the central bank, has been slower.

Basic training in the business of banking will be a crucial prerequisite for successfully reforming the financial sector. At the end of 2001, there existed a fundamental misunderstanding by both the banks and the supervisors regarding the role that banks and banking supervision had to perform. In the future, supervisors will have to be concerned about the safety of the banks’ depositors, rather than about any social, political, or developmental agenda. Bank managers, in turn, will need to be concerned about proper pricing of risk, risk management, and return on equity.

Banking Supervision

One of the most important improvements in DAB took place with the initial steps in establishing effective banking supervision. By the end of 2003, a new supervision department had been created, a number of prudential regulations and manuals had been drafted, and the training of supervisors had been initiated. In the first phase, staff received training in basic balance sheet analysis and concepts of prudential ratios. This was soon followed by “real life” off-site staff supervision of the operating banks and on-site supervision of Banke Millie Afghan, under the supervision of a foreign expert.

The licensing of money traders was shifted from the foreign relations department to the new supervision department. In November 2002, all licensed money traders had to renew their licenses, a process that was enforced with the help of the local police. In 2003, the department began the process of improving the collection of personal data on the licensed money traders.


Apart from the new supervision department, progress in other areas of the reorganization of DAB started more slowly. By end-2003, DAB still ran under its original organizational chart and continued to employ a large number of unqualified staff with no assignments. Pending an overall reorganization, parts of some departments were instead restructured individually into what corresponds to a monetary policy department, a payment systems department, an accounting department, a banknote operations department, and a banking supervision department, with foreign experts assisting each of these departments.

Accounting Reform

On the accounting side, DAB began working toward the introduction of a new chart of accounts, as well as a general ledger software package that would enable it to produce its balance sheet on a regular basis. However, by end-2003, the reform agenda in the accounting area remained substantial. Accounting regulations still needed to be drafted, together with operating manuals and procedures, and staff needed to be trained. Furthermore, the consolidation of financial accounts could not be completed without reforms in DAB’s branches. An ambitious project was initiated to improve the connectivity of DAB’s branches with the main office (see below). Improvements were also made in data collection with the production of a Quarterly Economic and Statistical Bulletin.

Commercial Operations

DAB also made notable progress in the efficiency of its commercial services. Almost all banking activities for the international organizations and for many of the NGOs in Afghanistan during 2002 and 2003 were conducted by the commercial arm of DAB. Although DAB’s services included the opening of accounts, deposits, and international money transfers, this was solely to facilitate international payments for international organizations, including USAID, World Bank-funded programs, NGOs, as well as the U.S. army. The efficiency of the payment service was substantially improved with the introduction of SWIFT. Improvements in the commercial area included the development and introduction of procedures that expedited the opening of letters of credit by the MoF under grant programs. New current accounts could only be opened by money changers, NGOs, or international organizations, but not by the general public.11 DAB ceased to extend loans. DAB’s commercial arm expanded rapidly in 2003. Although these commercial operations did not belong in a central bank, the prevailing vacuum in the banking system left DAB with little option but to fill the gap, at least until commercial banks have resumed operations in Afghanistan. When that time comes, DAB intends to divest itself of all the commercial bank activities it now undertakes as soon as possible and no later than September 2005.12 A conscious effort is being made to develop the commercial activities in such a way that they can be easily split off from the core operations of DAB at a later stage.

Domestic Payment System

Developments in the payment area by commercial banks will likely be limited for some time. In the meantime, by late 2003, DAB had reconnected 35 of its main provincial branches to DAB’s head office in Kabul. These branches were connected by laptops with Immarsat connections, which allowed them to report to the center their balances and account movements on a daily basis.13 Bank branches in Kabul were to be connected by a computer network. The next step will be to identify the branches that need to be rehabilitated to meet the necessary security standards. The decision about which branch to reopen or to rehabilitate will need to be taken based on a needs assessment, including an estimate of the reflow of refugees and internally displaced people. The disbursement of government salaries, the main expenditure item in the provinces, would probably require fewer operational provincial branches than existed in the past.14 DAB would further need to develop a physical distribution system with some regional cash centers from where the distribution of cash could be made. This would also include the introduction of a software system for the management of the currency inventory and the purchase of armored cars and/or use of an aircraft suited for the important, yet risky, task of transporting cash within and outside Kabul. For the medium term, with the emergence of a commercial banking system, DAB plans to implement two payment systems that will represent the core of the National Payment System. These payment systems will provide the clearing and settlement of both high and low value payments, using a real time gross settlement (RTGS) system and a direct giro credit (GC) system.

Other Changes

With the assistance of a foreign expert, DAB is also in the process of unblocking and consolidating existing DAB accounts in international banks, and is improving the management of its foreign reserves. Tasks for the future include the removal from the DAB balance sheet of all assets and liabilities held by both the foreign and domestic loans general department and the foreign trade general department, together with all records associated with them, and their transferal to a public agency designated to settle these balances. DAB will also need to address the pension department, which is responsible for the pensions of employees of both DAB and the commercial banks. Options would include transferring these pension accounts to an outside private agency or to a national pension system.

Seeking the Renaissance of Commercial Banks

The development of an effective banking sector in Afghanistan will need to be based on three important pillars: competition, good corporate governance, and strong banking supervision.15 The enactment of the central bank and banking laws has been the first major step toward this new structure. But the passing of these new laws is not a sufficient basis for the redevelopment of the banking system without improved contract enforcement and well-defined property rights. Reforms will be needed simultaneously on a number of different fronts, including accounting reform and training in commercial banking and risk assessment.

A good number of reforms can be imported into the banking system by foreign banks. The recent granting of banking licenses to a number of foreign banks represents an important window of opportunity for the development of an efficient banking system. These new banks are expected to have modern management and risk assessment techniques. In house rules will require them to apply international accounting standards. However, foreign banks cannot provide all the answers. To begin with, foreign banks will most likely limit their operations to the larger cities, starting with Kabul, and to certain types of customers, namely international organizations, NGOs, the diplomatic corps, and the largest corporations, leaving small and medium-size enterprises and rural areas unbanked. Most banks will likely also focus their operations initially on facilitating payments and few can be expected to engage in significant domestic lending at the outset. This indicates that there remains an important role for DAB, microfinance institutions, and a rehabilitated domestic banking sector to deliver financial services outside of Kabul and to a client base unlikely to be served by the international banks.

Afghanistan needs a comprehensive medium- to long-term financial sector development strategy, possibly including a strategy to rehabilitate part of the existing domestic banking system. Such a strategy would likely require an experienced and competent management team to make a detailed diagnostic and action strategy with voluntary retrenchment plans, training of remaining staff, and introduction of modern banking technology. Domestic bank restructuring will only bear dividends if qualified and experienced people are assigned board and management positions; if the organization and corporate governance are well restructured; if the operating systems, management tools, and operating policies and procedures are strengthened and automated; if the duties, responsibilities, and scope of authority at all levels of management and staff are well defined; and if the bank is sufficiently capitalized after full due diligence and after financial, management, and operational audits have been performed on the banks being restructured. Institutions that are unable to perform should ultimately be liquidated.

Money Changers and the Hawala System

Even with the emergence of a modern banking system, the informal hawala system will likely continue to exist, as is the case in many other countries in the Middle East. Given the need to counter untransparent, undocumented, and adverse practices, DAB will need to evaluate the options available to partly regulate and supervise this market without pushing it underground.16 In this context, simply extending banking regulations and supervision practices with respect to licensing requirements, customer identification, suspicious activity reporting, and record keeping to the money dealers is not a viable option. It would not be feasible to regulate in this manner, given the huge number of traders involved, and this level of regulation would probably push the activity underground. But two alternative options might instead be envisaged. First, the hawala dealers could, at least as an interim solution, subject themselves to self-regulation and supervision. This market already benefits from an association that enforces a number of unwritten rules. The association could be encouraged to draft written rules and regulations.17 Second, recognizing the distinct features of the hawala system would justify the development of special regulations and supervision techniques, which would mainly attempt to increase the level of transparency in the business while keeping intact the characteristics that made this market so efficient. Such regulations could include the requirements of (1) registration but not licensing of the hawala dealers, (2) the ability to identify customers and keep records on their identity, and (3) cooperation in investigations if the need arises, which would include the right of DAB to enter and inspect the money dealers’ premises when there is a reasonable suspicion of a committed offense. Finally, through information campaigns, DAB could seek to educate the money dealers about their responsibility to report suspicious activities.


  • Asian Development Bank, 2003, National Payments System for the Islamic Republic of Afghanistan (draft (B) issued August 19), Final Report TA 3874-AFG, prepared by Schlumberger Sema.

    • Search Google Scholar
    • Export Citation
  • El Qorchi, Mohammed, Samuel Munzele Maimbo, John F. Wilson, 2003, Informal Funds Transfer: An Analysis of the Hawala System, IMF Occasional Paper No. 222 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2001, Guidelines for Foreign Exchange Reserve Management (Washington). Available via the Internet: http://www.imf.org/external/np/mae/ferm/eng/index.htm.

    • Search Google Scholar
    • Export Citation
  • Maimbo, Samuel Munzele, 2003, “The Money Exchange Dealers of Kabul—A Study of the Hawala System in Afghanistan,” World Bank Working Paper No. 13 (Washington: World Bank).

    • Search Google Scholar
    • Export Citation



See Holden and Prokopenko (2001) for a literature review on the linkages between the financial sector growth, economic growth, and poverty. See also Levin, Loayza, and Beck (2000) for an econometric analysis showing the positive link between financial intermediation and growth. The study also confirms that legal and accounting reforms that strengthen creditor rights, contract enforcement, and accounting practices can boost financial development and accelerate growth.


Banking supervision does not necessarily have to be performed by a central bank. Some countries have chosen to set up a separate institution for this purpose.


However, a detailed assessment of the old legal framework would be necessary to determine the adequacy and mutual consistency of the laws. Given the variety of origins that the legal framework has been built on, it is likely that at least parts of the laws could be contradictory or incompatible.


Based on the very rudimentary information available, the property law and the law of obligations could, in principle, be adequate for supporting banking transactions in Afghanistan. Again, a more thorough review of the laws would be necessary to determine their adequacy for banking activities.


In DAB’s headquarters there were only 5,000 active accounts out of a total of 100,000 accounts (35,000 of which had a zero balance). In the first 30 branches assessed in May 2002, fewer than 6,000 accounts were found to be active. Active accounts are defined as those that had any movements since the beginning of the year or that had a customer who declared an interest for his or her account.


Afghanistan remains the largest opium producer in the world. See Chapter 2 (Appendix 2.1) for an account of opium production in Afghanistan.


Drafts of the central bank and banking laws were prepared with the help of the IMF and benefited from comments from a number of international organizations, law firms, and consulting firms. The draft laws had been extensively discussed with senior officials in the Afghan government at a legal seminar in December 2002.


For a period of three years after the enactment of the law, the Minister of Finance can, however, nominate one member of the Supreme Council of DAB, other than the governor and the first vice governor (transitional provisions of the central bank law, Article 133).


The transitional provision of the central bank law (Article 135) allows, however, for political activities to be continued until a successor administration of the Transitional Islamic State of Afghanistan is in place.


The draft law also provides DAB with the powers to specify by regulation additional activities for banks to the extent not specifically restricted by law.


In early 2002, DAB resumed paying interest on the savings accounts.


See transitional provision (Article 129) of the central bank law.


As the volume of transactions increases, it is planned that the Immarsat connections would be replaced by a VSAT network.


Facilitating the Ministry of Rural Development’s scheme to make grant payments to 7,000 villages commencing end-September 2003 and using the DAB branch network outside Kabul represents one of DAB’s biggest immediate tasks. As regards the MoF individual salary payment requirements, this is still in the planning stage by a task force at the ministry. Retail salary payments in Afghanistan are currently made by cash payments at the employees’ place of work in the municipalities, rather than by bank transfers to commercial banks (which are not possible) or through individual payments at DAB’s branches around the country. The number of DAB branches required to undertake this operation is limited by the fact that, after the money has been sent to the local DAB branch, provincial payments are thereafter the responsibility of the local representative of the MoF (Mustufi).


For experience gained in banking sector reform in Central and Eastern Europe, see Bokros (2001).


For a detailed discussion of regulatory options for the hawala system, see Maimbo (2003); and El Qorchi, Maimbo, and Wilson (2003).


The disadvantage of self-regulation is that it risks becoming self-serving with a high degree of regulatory forbearance.