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PROJECT INFORMATION DOCUMENT (PID) APPRAISAL STAGE Report No.: AB4380 Afghanistan Financial Sector Strengthening Project Project Name Public Disclosure Authorized Region SOUTH ASIA Sector Banking (60%);General finance sector (40%) Project ID P110644 Borrower(s) GOVERNMENT OF AFGHANISTAN Implementing Agency Environment Category [ ] A [ ] B [X] C [ ] FI [ ] TBD (to be determined) Date PID Prepared February 5 , 2009 Date of Appraisal February 12, 2009 Authorization Date of Board Approval April 30, 2009 1. Country and Sector Background Public Disclosure Authorized Despite a deteriorating security environment and increasing constraints to private sector development, Afghanistan experienced robust economic growth over the last few years: real GDP is expected to have grown by 11.4 percent in 2007/08 (GDP US$9.6 billion) and 7.5 percent in 2008/09 (GDP US$12.8 billion). Per capita income increased from US$125 to US$300 from 2002 to 2008. Alongside of this economic growth in Afghanistan, there also has been considerable effort to rebuild the financial sector in terms of its institutional and legal framework, which has led to an increased number of private commercial banks operating in Afghanistan. Despite this overall growth, a weak financial sector still remains one of the major binding constraints to private sector development in Afghanistan. Currently, the sector does not meet the financial needs of industries and individuals, nor provide adequate financial services to business. Due to highly Public Disclosure Authorized collateralized lending practices along with a lack of financial intermediation capacity in the financial sector, access to credit remains a serious constraint to private sector development. The share of total credit to GDP is 6.7% (2007) in Afghanistan, which is far less than the average share of credit to GDP within South Asia at 43%. According to the Investment Climate Survey (2005), only 30 percent of the surveyed firms in Afghanistan had bank accounts and access to formal financial services. Most businesses rely on the informal fund transfer system, “hawala”, to make payments and transfer funds, and nearly 21% of firms responding in the survey reported having a loan from “hawaladars” with an average term of 3.8 months. In the most recent Doing Business (2009) rankings for “Getting Credit”, a measure of credit information sharing and legal rights of borrowers and lenders, Afghanistan ranked 178th out of 181 countries. Cognizant of the lack of finance as one of the main challenges to economic development, the Government of Afghanistan (GoA) is committed to financial sector reforms. In the Afghanistan Compact (2006), the GoA committed itself to undertake a series of financial sector reforms including the improvement of the banking supervision function of Da Afghanistan Bank (DAB) and the re-structuring of state-owned banks. Public Disclosure Authorized In addition, under the Enabling Environment Conference Road Map (2007), the GoA, together with 1 development partners and the private sector, agreed to take strategic actions with a view to “strengthening the financial sector to increase access to credit and financial services”1. These strategic actions in the Road Map have been further reflected the Afghanistan National Development Strategy 2008-13 (ANDS) under the pillar of “Economic Governance and Private Sector Development”. The ANDS sees a modern and competitive financial sector as one of its main development objectives, and articulates a strategy to expand the availability and range of financial products and services, especially targeting small and medium enterprises. Among others, the ANDS is specifically committed to: (i) build capacity in the financial sector by establishing an independent banking and business training institute as a joint commercial bank; (ii) establish a credit information bureau to facilitate commercial and consumer lending; and (iii) significantly expand the outreach and range of financial products and services. These are all integral parts of the Financial Sector Strengthening (FSS) Project. The Bank’s Interim Strategy Note (ISN) for Afghanistan for the period of FY 2007-08 clearly mirrors the GoA’s strategy of financial sector development with “supporting growth of a formal, modern and competitive private sector” as one of three strategic pillars2. Financial Sector In 2002 after the fall of the Taliban regime, the formal financial sector in Afghanistan was almost inoperative and the legal framework was virtually non-existent. Since then, Afghanistan’s financial sector has gone through two phases of development. During the first phase: ‘re-building basic legal and institutional framework’ (2002-2004), substantial components of the necessary legal and institutional framework for a modern financial sector have been introduced including the Law of Da Afghanistan Bank (2003) and the Law of Banking in Afghanistan (2003). These laws laid a foundation for the re- establishment of DAB as the central bank with autonomous regulatory authority to implement monetary policy and banking regulation and supervision. In the second phase: ‘emergence of the formal financial services’ (2005 to present), there has been growth of private commercial banks. In addition, DAB has also endeavored to improve the financial sector legal framework in order to expand the lending program of commercial banks and to modernize the financial sector. Immediate Challenges in the financial sector: Although significant improvement of the formal financial sector has been achieved in terms of entry of a large number of private commercial banks and increase in the amount of loans and deposits, there has been a disproportionately weak regulatory framework and banking supervision capacity in place in DAB which is required to undertake rigorous banking supervision. Given the developing state of the financial sector in Afghanistan and its fundamental importance to development, the objective of the GoA is to build the capacity of the financial sector so that it can serve the demand for credit from the private sector. In doing so, there are two critical challenges it must address: (i) ensuring that the financial regulator, i.e., DAB has the proper institutional capacity to adequately carry out its core functions, especially supervision of a rapidly growing banking sector and thereby properly manage systemic risk issues; and (ii) finding ways of establishing effective property rights and information that the financial sector can rely on for the purposes of extending credit. 1 Main financial sector reform agreed under the Road Map include: (i) Enacting an appropriate legal framework for the financial sector; (ii) Establishing a Credit Information Bureau; and (iii) Setting up an independent banking training institute. 2 The other two include: (i) building the capacity of the state and its accountability to its citizens to ensure the provision of services that are affordable, accessible and of adequate quality; and (ii) promoting growth of the rural economy and improving rural livelihoods. 2 There are also other development challenges in the financial sector which the Government of Afghanistan will have to address. These include: (i) increasing access to financial services generally to the underserved; (ii) expanding financing for small and medium enterprises and in particular to the agricultural and construction sector; (iii) reconciling and determining the role of the two remaining State- owned Commercial Banks; and (iv) continuing to ensure the stability of the financial sector through the prioritization and sustainable development of new services. Legal and Regulatory Framework The Law of Da Afghanistan Bank (2003) is the legal foundation for DAB to operate as the Central Bank of Afghanistan with the overarching objective to achieve and maintain domestic price stability.3 In order to achieve its objectives and tasks, DAB was granted the autonomous power to issue regulations both under the Law of Da Afghanistan Bank and, in specific areas, the Law of Banking in Afghanistan. To date DAB has issued numerous regulations including: (i) licensing of banks; (ii) capital adequacy of banks; (iii) prohibited and authorized activities of banks; and (iv) enforcement powers of DAB in relation to banks failing to meet legal and regulatory requirements. The Law of Banking (2004) forms a legal foundation for banking regulations which subject all commercial banks in Afghanistan to certain requirements, restriction and guidelines. In 2006, DAB also passed a regulation setting out the requirements as to the licensing, corporate governance, permitted and prohibited activities, minimum prudential standards, and reporting of Microfinance institutions, in order to protect depositors. The regulation is based on modern, international best practices and, since it was passed all microfinance institutions are required to comply with its requirements. The Law of Anti-Money Laundering and Proceeds of Crime was enacted in 2004. The law applies to all financial institutions, and tasks DAB with establishing a Financial Intelligence Unit (FIU), as an independent decision making authority, in order to monitor reports from Financial Institutions and analyze them for suspicious transactions. Accordingly, the FIU was established in March 20006. One of the responsibilities of the FIU is to propose and develop new laws and regulations in order to achieve its objectives under the Anti-Money Laundering law. A set of additional Laws have been recently drafted by DAB in