Islamic Republic of Afghanistan: Selected Issues

Fiscal sustainability is one of several policy objectives that Afghanistan is expected to achieve in the context of the Poverty Reduction Growth Facility-supported program. There is a need to develop a comprehensive financial sector strategy aimed at deepening financial intermediation and reducing key vulnerabilities. The aim of this paper is to analyze the conduct of monetary and exchange rate policy in Afghanistan. This paper also discusses the current monetary policy framework in Afghanistan, reviews its implementation, and recommends measures to improve its effectiveness.

Abstract

Fiscal sustainability is one of several policy objectives that Afghanistan is expected to achieve in the context of the Poverty Reduction Growth Facility-supported program. There is a need to develop a comprehensive financial sector strategy aimed at deepening financial intermediation and reducing key vulnerabilities. The aim of this paper is to analyze the conduct of monetary and exchange rate policy in Afghanistan. This paper also discusses the current monetary policy framework in Afghanistan, reviews its implementation, and recommends measures to improve its effectiveness.

II. Banking Sector Developments in Afghanistan

A. Overview1

1. Since the fall of Taliban in 2001, Afghanistan has made considerable progress in revitalizing its financial sector. The authorities have established a modern central bank, which is responsible for supervising the banking sector, and have put in place the main components of a legal framework that is in line with international standards. As a result, the banking institutions have improved their capacity as financial intermediaries and have grown substantially over the last couple of years. The rapid growth of the banking system broadened the range of financial services available to the private sector, but it also created challenges for the supervisory authorities. DAB is addressing these challenges through closer scrutiny of emerging vulnerabilities and capacity building with extensive donor support.

2. This chapter reviews developments in the banking sector and provides recommendations on how to address emerging vulnerabilities. Section B examines banks’ balance sheets and the level of intermediation, while Section C discusses some key financial soundness indicators. Section D reviews developments in supervision and the banking sector’s legal framework. Section E provides some recommendations.

B. Recent Developments in the Financial Sector

3. The financial system in Afghanistan consists of banks, foreign exchange dealers, microfinance institutions, and money service providers. As of end-2007, there were 16 licensed banks (compared with six banks in 2001), including three state-owned banks and five branches of foreign banks (Table II.1). Banks had 171 branches in 20 provinces. In addition to the formal banking sector, there are 311 foreign exchange dealers throughout the country, including 171 dealers in Kabul. Additionally, there are 89 licensed money service providers, and 8 more in the process of being licensed. Also, 14 microfinance institutions, including 12 nongovernmental organizations, provide financial assistance to small businesses. Finally, DAB has 75 branches, 14 of which are in Kabul. The vast majority of DAB’s branches offer commercial banking services.

Table II.1.

Islamic Republic of Afghanistan: Financial System Structure, 2004/05–2007

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Sources: Da Afghanistan Bank; and Fund staff estimates.

4. Afghanistan’s banking system has been growing rapidly over the last few years. After a long period of slow growth, assets of the banking system more than tripled over the last couple of years, from $388 million (7 percent of GDP) in March 2005 to $1.3 billion (about 15 percent of GDP) in September 2007. This increase was mainly due to the expansion of private banks, whose share of the total assets of the banking system increased from 21 percent to 60 percent (Figure II.1). In fact, the assets of the two largest domestic private banks accounted for about 50 percent of banks’ total assets in September 2007. Regarding the composition of assets, the ratio of banks’ loan portfolios to total assets was 46 percent in September 2007, compared with only 15 percent in March 2005. On the liability side, banking sector deposits have grown almost five fold since March 2005, reaching about 78 percent of the consolidated banks’ balance sheet (deposits plus capital) in September 2007.

Figure II.1.
Figure II.1.

Islamic Republic of Afghanistan: Banking Sector’s Assets and Deposits, 2004/05-September 2007

Citation: IMF Staff Country Reports 2008, 071; 10.5089/9781451800340.002.A002

Sources: Da Afghanistan Bank (DAB); and Fund staff estimates.

5. Despite the rapid growth of the banking sector, financial intermediation remains relatively low. Indicators of financial depth, including bank credit to the private sector and deposits as a percent of GDP, remain well below those of neighboring countries (Figure II.2).

Figure II.2.
Figure II.2.

Islamic Republic of Afghanistan: Selected Indicators of Financial Intermediation, 2006

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 071; 10.5089/9781451800340.002.A002

Sources: Data provided by the Afghan authorities; and Fund staff estimates.

6. The bulk of activities of the banking sector remains in foreign currencies. As of September 2007, about 77 percent of the total deposits and loans were denominated in U.S. dollars, a proportion slightly higher than in March 2005. Also, all interbank deposits were in foreign currencies, with 80 percent being denominated in U.S. dollars. About 35 percent of the deposit base of state-owned banks and 55 percent of their loans at end-September 2007 were denominated in U.S. dollars, indicating a currency mismatch for these banks. The deposit base of foreign banks’ branches is mainly in U.S. dollars.

Figure II.3.
Figure II.3.

Islamic Republic of Afghanistan: Interest Rates, 2006Q2–07Q2

(In percent)

Citation: IMF Staff Country Reports 2008, 071; 10.5089/9781451800340.002.A002

Sources: Da Afghanistan Bank (DAB); and Fund staff estimates.

7. Interest rate spreads are wide, in part reflecting significant overhead costs. As of June 2007, the average Afghani lending rate was about 20 percent, while that on Afghani deposits was 7 percent (Figure II.3). The wide interest rate spread reflects the high cost of doing business in Afghanistan, the absence of an institutional infrastructure for obtaining credit information, and the lack of competition in the banking sector.2 It also reflects a weak credit culture and credit collection, lack of collateral, and insufficient bank capacity for proper credit assessment and risk management. Under these conditions, short-term credit continues to account for the bulk of bank lending.

8. Only a small segment of the population has access to formal financial services. The lack of a core set of basic commercial laws, including mortgage, secured transaction, and commercial arbitration laws, prevents banks from providing credit to small- and medium-sized businesses. As a result, the formal banking sector in Afghanistan coexists with a large and vibrant informal financial sector, which has played an important role in both internal and external trade finance. The hawala dealers, major operators in the informal sector, offer a diverse range of services: money exchange, transfer of funds domestically and internationally, trade finance, microfinance, and limited deposit taking.

C. Financial Status of the Banking Sector

9. DAB’s on-site examination of banks has revealed considerable violations of prudential regulations. These include violations related to lending to connected persons and open foreign exchange positions. Also, lending by some banks was found to be heavily concentrated in a few sectors, including the petroleum sector. Moreover, two state-owned banks had real estate holdings larger than allowed under the current regulations.

10. Following on-site examinations, DAB is addressing the vulnerabilities that were identified in a number of banks. Five banks, accounting for more than 60 percent of the assets of the banking system, were given a CAMEL rating of 4 on a scale of 1–5 by DAB, while another 4 banks with total assets equivalent to about 15 percent of total banking sector’s assets were given a rating of 3.3 DAB has taken corrective actions in the case of the banks that are not complying with prudential regulations. These banks are monitored on a monthly basis and are subject to special targeted examinations.

Capital

11. As of end-September 2007, the banking system was well capitalized, with an average capital adequacy ratio of 32 percent well above the statutory requirement of 12 percent (Table II.2). However, there is considerable variation across individual banks. In particular, some systemic private banks that have recently experienced significant growth in their loan portfolios have seen a drop in their capital adequacy ratios below the regulatory norm on a few occasions. The financial capital of all banks is well above the minimum required level of $5 million.

Table II.2.

Islamic Republic of Afghanistan: Selected Macroprudential Indicators, 2005/06-2007

(In percent, unless indicated otherwise)

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Source: Da Afghanistan Bank (DAB).

Classified credit includes substandard, doubtful and loss.

12. The rapid growth of some private banks requires additional capital. Part of the additional capital should have been secured through profits. However, high fixed and security costs and ambitious branch expansion plans have limited banks’ earnings. On some occasions, sufficient capital was either not provided or provided with a lag, resulting in some banks not meeting the minimum capital adequacy requirements.

13. Provisioning appears to be insufficient. Banks are often reluctant to provision, since intermediation margins are too low to cover additional provisions.

Asset classification

14. As of end-September 2007, the ratio of classified and watch loans to total loans was 4.6 percent. This ratio is relatively low because it appears to reflect mainly the widespread practice of rolling over unsecured overdraft loans. In fact, only when the amount outstanding exceeds the facility limit, would a bank move loans to the classified category. If the limit is increased on review, then the point at which the balance outstanding becomes at risk is simply deferred. Moreover, DAB’s classification of assets is mainly based on a single criterion of past due days, rather than on several criteria that are listed in the regulations and are necessary to appropriately judge risks.

15. Banks do not have sufficient experience in credit assessment. Often, credit is provided without collateral to customers who lack experience of a business relationship with financial institutions. Frequently, borrowers are not in a position to provide financial statements and cash flow forecasts, which would enable banks to assess and monitor their creditworthiness. Moreover, the assets of some banks are highly concentrated in a few industries, such as the petroleum sector (over 30 percent of private banks’ loans). Also, exposure to start-up companies and borrowers whose primary business activities are outside Afghanistan is high.

Management

16. On-site examination of banks has revealed weaknesses in some banks’management, suggesting that corporate governance remains a significant problem.

Earning

17. On aggregate, banks appear to be profitable, although, as noted above, profitmargins are relatively modest. Total net profits of the sector amounted to Af 2.7 billion in the first nine months of 2007, with an annualized return on assets of 1.75 percent. The main component of banks’ income is interest income, accounting for 45 percent of total income as of September 2007. As of that date, the ratio of total expenses to total income was 49 percent.

Liquidity

18. As of September 2007, all banks complied with the 15 percent minimum broadliquidity ratio requirement (i.e., liquid assets as a percentage of attracted funds). In fact, the banking sector had excess liquid assets, which is attributable to deposit volatility. Some private banks have relied extensively on volatile non-interest-bearing accounts, where the remuneration consists of the right to participate in a draw for a reward. While DAB has encouraged banks to secure more conventional forms of deposits, a significant proportion of deposits remains in this “lottery” form, which increases volatility.

D. Legal Framework and Banking Supervision

19. Banking supervision has improved but enforcement remains weak (Table II.3). DAB conducts regular on-site full examinations. These are followed by targeted examinations when weaknesses are identified and action plans to address them are drawn up. However, while DAB initially takes appropriate action, enforcement remains limited, and partial compliance is not followed up with more severe measures. Instead, banks are given more time to comply, while the timing of the next full scope examination is accelerated.

Table II.3.

Islamic Republic of Afghanistan: Prudential Ratios

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Source: Da Afghanistan Bank (DAB).

20. DAB has recently completed a self-assessment against the Basel Core Principles for Effective Bank Supervision. The assessment indicated that DAB is in substantive compliance with most of the Principles. It also yielded a roadmap for addressing deficiencies (Box II.1).

Da Afghanistan Bank’s Self-Assessment Against the Basel Core Principles

DAB completed an assessment of banking supervision using the Basel Core Principles (2006) in November 2007. The areas that were identified as being materially noncompliant included:

Principle 5: Major acquisitions. Require DAB notification of “significant” asset and investment acquisitions, including foreign bank holdings; specify prior approval requirements and criteria; require post acquisition notification for banks and nonbanks when deemed not “significant” per a defined capital threshold; and clarify reference to regulatory language concerning agreement for supervisory cooperation between cross-border supervisors of bank and nonbank entities.

Principle 7: Risk management process. Require minimum standards, risk parameters and measurement processes for all risk categories, i.e. credit, interest rates, liquidity, price, foreign exchange, transaction, compliance, reputation and strategic risks; require models in use by a bank to be periodically validated; require introduction of new products and services to be guided by adequate policies and control procedures; and require risk evaluation, monitoring, and control or mitigation functions to be clearly segregated from risk-taking functions in the bank.

Principle 12: Country and transfer risks. Modify regulation to include instructions on obtaining and reviewing sufficient and timely information on country risk and transfer risk by individual banks; provide guidance on minimum qualitative monitoring processes and application of counterparty measures employing risk based methodology; and provide requirements for specific provisioning against changing conditions within countries.

Principle 13: Market risk. Amend regulations providing for bank limits in all identified market risk instruments; and require appropriate policies, procedures, internal controls, administrative expertise and reporting processes in place before a bank engages in any market risk instrument transaction. Develop appropriate examination procedures to comply with regulation changes and provide necessary training to supervision staff.

Principle 15: Operational risk. Implement regulations specifically governing operational risk issues inclusive of bank policies and procedures governing technology, outsourcing, and litigation risk. Expand examination procedures appropriately and develop training processes to ensure adequate expertise and coverage of highly technical specialty areas.

Principle 16: Interest rate risk. Develop an interest rate risk regulation that includes minimum standards for interest rate risk management, i.e., policy, strategy, measurement processes inclusive of capital ratio analysis, and ensures that risk management responsibilities and risk-taking responsibilities are segregated.

Principles 24 and 25: Consolidated supervision. A formal agreement with cross-border supervisors is drafted but needs to be authorized by DAB and distributed to foreign regulators for their endorsement. DAB needs to alert domestic banks of the cooperative arrangements. DAB needs to enact regulation establishing a framework for minimum level and frequency of information to be shared while preserving confidentiality, and expand examination procedures to assess and verify consolidated information, the consolidated financial condition of foreign banking entities, and the quality of supervisory support provided by home/host regulators.

E. A Reform Strategy

21. There is a need to develop a comprehensive financial sector strategy aimed at deepening financial intermediation and reducing key vulnerabilities. This strategy should also include a timetable for spinning off commercial activities of DAB and completing the restructuring of state-owned banks.

22. DAB needs to focus on banks’ exposure to risks. As noted above, credit risk is the main source of vulnerability in the banking system, and the loan portfolio is highly concentrated in a few borrowers and sectors. Failure to comply with prudential regulations must be dealt with expeditiously. Also, banks need to enhance their capacity to analyze credit risk.

23. DAB should strengthen the enforcement of prudential regulations. The current form of ‘prompt corrective action’ needs to be strengthened by a system of trip wires which would automatically set off a supervisory response. Fines on the banks or on specific individuals for each day they fail to comply with a DAB order should be introduced. A degree of automaticity in enforcement actions would reduce the scope for political and other undue influence being brought to bear on the supervisors.

24. Expansion of weak banks—those with CAMEL ratings of 4 and 5—needs to be limited. The authorities have started placing limits on the expansion of weak banks by restricting their credit growth to 5 percent per quarter and suspending the issuance of licenses for new branches. These measures will be in effect until the relevant banks’ CAMEL ratings are reassessed to be less than 4.

25. The legal framework needs to be strengthened further. As noted above, the self-assessment report should provide a roadmap for addressing areas where DAB is not fully compliant. DAB has already strengthened the legal framework by issuing regulations on credit-granting standards and the credit-monitoring process, and on setting limits on sectoral loan concentration. Finally, a core set of basic commercial laws, including mortgage, secured transactions, and commercial arbitration laws is needed in order to reduce credit risks and allow banks to increase lending to small and medium-sized businesses, thereby reducing the size of the informal sector.

1

This paper was prepared by Mitra Farahbaksh.

2

The bank concentration ratio is also high, with one bank accounting for two-thirds of total bank loans.

3

CAMEL stands for Capital, Asset Quality, Management, Earnings, and Liquidity. The system uses a five-point scale for grading each category. An overall composite rating is also assigned based on the same scale, with 1 being the highest rating and 5 the lowest. Two newly charted banks with assets equivalent to 2 percent of the total were not assigned ratings.

Islamic Republic of Afghanistan: Selected Issues
Author: International Monetary Fund
  • View in gallery

    Islamic Republic of Afghanistan: Banking Sector’s Assets and Deposits, 2004/05-September 2007

  • View in gallery

    Islamic Republic of Afghanistan: Selected Indicators of Financial Intermediation, 2006

    (In percent of GDP)

  • View in gallery

    Islamic Republic of Afghanistan: Interest Rates, 2006Q2–07Q2

    (In percent)