Financial Sector Development in Afghanistan: Seeking a Renaissance

Felix Fischer

fter more than two decades of war and conflict, investment in infrastructure, collect taxes and cus- A regional tensions, and endemic security con- toms duties efficiently, and make the best use of the cerns, very little was left of Afghanistan’s financial substantial donor funds destined for Afghanistan’s system when the Taliban departed at the end of reconstruction, a rudimentary payment system and 2001. Although six commercial banks still retained basic financial services were essential. It was thus banking licenses, none of them was operational. paramount for the Afghan authorities to quickly ini- Virtually no loans had been made since 1995 and tiate reforms to move away from cash as the sole banks had lost their credibility as deposit-taking in- medium of exchange and to lay down the enabling stitutions. The central bank had been changed into framework for an efficient commercial banking sys- a Soviet-style dirigiste institution, interfering in the tem to develop and flourish. For all this to be done allocation of credit and the setting of interest rates, while safeguarding against fraud and bank failure, it and abrogating its responsibility to undertake the was necessary to rebuild a modern central bank, traditional functions of a central bank. Its financial with a supervisory capacity in line with interna- role was reduced to monetizing successive govern- tional standards to oversee the operations of the ments’ fiscal deficits. The banking system could no new banking system as it develops.2 The passage, on longer provide a payment system, which was instead September 16, 2003, of a modern central bank law taken over by the informal hawala system. and a modern banking law and the subsequent The speed at which Afghanistan’s economy could granting of banking licenses to a number of foreign be rebuilt, sustainable economic growth achieved, banks have laid the groundwork in this endeavor. 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 After the Taliban: Financial civil servants, procure goods and services, undertake System at the End of 2001

At the end of 2001, there was no functioning 1See Holden and Prokopenko (2001) for a literature review on banking sector in Afghanistan, notwithstanding the the linkages between the financial sector growth, economic existence of a number of financial institutions with 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, 2Banking supervision does not necessarily have to be per- contract enforcement, and accounting practices can boost finan- formed by a central bank. Some countries have chosen to set up a cial development and accelerate growth. separate institution for this purpose.

©International Monetary Fund. Not for Redistribution After the Taliban: Financial System at the End of 2001 a banking license and a roster of staff on the payroll. rious flaws. First, it was designed on the now out- Most of what remained of the financial system was dated socialist principle that the purpose of mone- based in Kabul. Although not much is known about tary policy was to direct credit. It was therefore un- the state of the financial system in the provinces, it suitable for a market economy. Second, it involved a is not believed to have been extensive, let alone op- number of important conflicts of interest between erational. The Afghan financial system comprised, the government, the central bank, and commercial in principle, Da Afghanistan Bank (DAB), a hybrid banks. Third, it omitted important modern pruden- institution with central banking and commercial tial standards and enforcement tools. During the banking functions; two state-owned commercial Taliban era, this law was largely ignored. Although banks; and four state-owned special purpose devel- this law has recently been replaced by modern legis- opment banks. In addition, there were about 300 lation, it is still instructive to recall its main ele- registered money trading entities reportedly operat- ments because they help comprehend the dismal sit- ing in Kabul with some 5,000 traders. uation of the financial system encountered at the Assessing the conditions of the financial sector in end of 2001. Box 6.1 summarizes some of the main Afghanistan that prevailed at the end of 2001 issues and shortcomings of the Law on Money and proved in itself to be a major challenge. Qualified Banking. translators were few and the difficult security situa- Other aspects of the legal foundations of the fi- tion, particularly outside of Kabul, seriously ham- nancial system seem, on the face of it, to be less pered a systematic and rapid assessment of the finan- problematic, because they were derived from West- cial sector on a nationwide scale. Communication ern market-oriented laws and thus do not bear the lines between most of the branches of the central communist legacy.3 Afghanistan’s civil code was bank or commercial banks and their headquarters adopted in the 1960s with assistance from the had largely broken down. In most cases, there had Egyptian government, and is reported to be almost been no exchanges with correspondent banks abroad identical to the civil code of Egypt, which was origi- for years and accurate information on assets and lia- nally based on French law.4 The commercial code of bilities, either domestic or external, was unavailable. Afghanistan, in turn, was received from Turkey The books kept at the banks in Kabul were com- where it had been modeled after German law. It pletely out-of-date and, moreover, had been prepared covers general company law, transport law, insur- according to Soviet accounting systems that were in- ance law, and special financial transactions. It also compatible with internationally accepted account- includes provisions on bills of exchange, promissory ing standards. At the aggregate level, meanwhile, notes, and checks. Finally, bankruptcy law provi- the databases of international institutions, such as sions can be found in both the civil code and the the IMF, on Afghanistan’s financial sector had not commercial code and apply equally to state-owned been updated for more than a decade. A proper as- and private banks. Bankruptcies are administered by sessment of the informal financial system, the regis- the courts. For these laws to be made operational, tered money traders, and the rest of the hawala was, however, there needs to be the necessary infrastruc- by its nature, even harder to make. As a result, infor- ture: record-keeping institutions, functioning courts mation collected was often ambiguous or contradic- and police, and an impartial and independent judi- tory and it was impossible to properly assess the cial system. Given the difficult environment in soundness of the banking sector, let alone to conduct Afghanistan, many of these elements are either not any due diligence of reported data. It thus took con- yet in place or are in a state of substantial disrepair. siderable time to assess the post-Taliban conditions of the financial sector and even today the assessment remains approximate. 3However, a detailed assessment of the old legal framework would be necessary to determine the adequacy and mutual con- Legal Foundations sistency 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 Until the enactment of the new central bank law laws could be contradictory or incompatible. and the banking law in September 2003, the legal 4Based on the very rudimentary information available, the basis for the central bank and for the commercial property law and the law of obligations could, in principle, be adequate for supporting banking transactions in Afghanistan. banks was the Law on Money and Banking. This Again, a more thorough review of the laws would be necessary to law, which was enacted in 1994, had a number of se- determine their adequacy for banking activities.

©International Monetary Fund. Not for Redistribution FINANCIAL SECTOR DEVELOPMENT IN AFGHANISTAN

Box 6.1.The Law on Money and Banking of the Islamic State of Afghanistan1

The 1994 Law on Money and Banking was a com- governor of DAB. The Supreme Council was sup- pound law of a central bank law and a banking law for posed to meet at least four times a year and to decide the period 1994–September 2003. The law was poorly on all important matters of DAB or on recommenda- written and at times contradictory. Part I defined the tions made by the other supervisory organs. It notably legal tender, the Afghani, and its value, ambiguously had to approve all regulations. The Monetary and in terms of both gold and SDRs. It also defined the Credit Committee, in turn, was charged with drafting minimum reserves DAB had to hold against issued regulations and recommending the level of interest banknotes at 25 percent. rates to the Supreme Council. It consisted of the governor and the first deputy governor of DAB, directors Part II of the law related to DAB, its objectives, re- of three different ministries, the president of the sponsibilities, powers, and organizational structure. It Chamber of Commerce and Industry, two presidents stated that DAB was responsible for the implementa- of commercial banks, and a professor of economics. tion of the government’s monetary and credit policy The composition of the Supreme Council and of the and that it had to maintain the value of the Afghani Monetary and Credit Committee was highly problem- in order to facilitate banking and commercial transac- atic because it politicized decisions that should have tions. It also empowered DAB to supervise operations been made on purely technical grounds. DAB thus of banks and credit institutions and to regulate and lacked the necessary independence that a modern carry out foreign exchange operations. It mandated central bank should have. The Executive Board con- DAB to determine the commercial banks’ interest sisted of the governor and his two deputies. Finally, a rates for deposits and loans and to set minima and Board of Supervisors with a chairman and two mem- maxima on their commissions. DAB was also man- bers was supposed to supervise DAB’s banking opera- dated to define liquidity and capital requirements and tions and accounting practices, and submit monthly limits on large loan exposure. However, these provi- reports to the MoF and quarterly reports to the sions were mostly ill defined and did not comply with Supreme Council. This control function had not been international best practice. There were no loan classi- fulfilled for years. fication or provisioning requirements. Furthermore, the law only empowered DAB to define ratios and to Part III of the law related to banking, including the collect information, but no provisions existed on the definition of a bank, a “private bank,” and the condi- enforcement of the regulations. Part II further re- tions for establishing a bank. The law required banks quired DAB to manage government accounts and, if to use a double-entry accounting method and to sub- necessary, to finance the government budget deficit, mit to DAB its annual balance sheet and profit and as well as to grant loans to government institutions, loss statement within four months following the end agencies, and municipalities. of each year, together with an audit report. The law empowered the Supreme Council to transfer the man- The final section of Part II defined the composition agement of a bank to DAB, to take measures for the and the role of DAB’s organs, namely the Supreme management of the bank, or to close the bank (if, for Council, the Monetary and Credit Committee, the example, the bank acted against the law or its by- Executive Board, the Board of Supervisors, and the laws). For the liquidation of an insolvent bank, the Banknote Reserves Supervision Board. The highest law envisaged the possibility of including officials of organ was the Supreme Council, which consisted of the failed bank in the liquidation team. The involve- eight ministers, including the prime minister, and the ment 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 1The contents of this box are based on an unofficial trans- deposits, salaries, and claims of other creditors would lation of the law from Dari into English. be paid by the government.

Da Afghanistan Bank the country. Second, it issued banknotes and managed the stock of cash monies. The bank was also At the end of 2001, DAB was actively performing performing many commercial banking operations two main functions. First, it was cashier to the Min- that a central bank in a modern two-tier banking istry of Finance (MoF) and was, in principle, re- system should not, while at the same time it was not sponsible for salary and other budget payments, and carrying out many of the typical central bank func- receiving government revenues for deposit, across tions that a modern central bank should. Mean-

©International Monetary Fund. Not for Redistribution After the Taliban: Financial System at the End of 2001 while, DAB was fulfilling its tasks with a totally in- adequate physical infrastructure and security fea- Box 6.2. Physical Infrastructure and tures (see Box 6.2). Security of Da Afghanistan Bank On the commercial side, DAB offered commercial banking services, extended long-term loans to A critical weakness of DAB was the design of the main office, which was not adequate for a central banks and enterprises, and accepted deposits from bank. The security features associated with the the public. Although most of these operations were storage of cash were most disturbing. DAB’s main discontinued in 1995, a number of DAB accounts currency reserve stock was held in two major (debit and credit) were still current.5 Under the old vaults in Kabul. Although there were well- Law on Money and Banking, the governor of DAB established procedures for accessing the vault, re- remained legally the chairman of the governing quiring two certified key holders and a witness, the boards of all the commercial and development vault area was situated near counters to which the banks. This role involved a substantial and undesir- general public had access and was not monitored by electronic surveillance or access technology. able conflict of interest with the traditional func- During banking hours, the security of the premises tions of a central bank, in particular with banking was entrusted to unarmed guards and armed mili- supervision. By late 2001, however, the governor of tary personnel. After working hours, the exterior DAB refrained from exercising this role. As it was, of DAB was patrolled by military personnel. the central banking side of DAB was minimal. DAB DAB’s lack of suitable vehicles and the poor and did not supervise the banking sector either by issu- insecure road conditions made transporting cash ing prudential regulations or by checking compli- to the provinces very difficult and highly risky. In early 2002, DAB had only two trucks, one bus, and ance through on- and off-site inspections. DAB did one Land Rover. All these vehicles were old and not provide or supervise an efficient payment sys- unsuitable for transporting cash. Only exception- tem. Nor did it offer any lender-of-last-resort facility ally could DAB benefit from air transport provided for illiquid but solvent banks. Finally, DAB lacked a by the army to deliver cash to the provinces. As a meaningful and credible monetary or foreign ex- result, cash delivery was often delayed. This forced change policy (see Chapter 5 for a discussion of some branches to rely on their local provincial au- monetary and exchange rate policy). thorities and private sources to transport cash from While best practice in central banking would re- Kabul to the provinces. quire that DAB be granted a high degree of autonomy, combined with stringent rules for accountability, under the old law DAB was fully controlled by Soviet-style accounting, financial control, and man- the government. DAB’s ultimate decision-making agement systems were introduced. The situation of organ, the Supreme Council, as well as the Monetary the banks deteriorated further during the Muja- and Credit Committee, which drafted regulations hedin period and the associated civil strife, with and governed the operational aspects of DAB, both continued government interference in bank man- included representatives from different ministries. agement, directed lending, and administered interest rates. Finally, during the Taliban period, financial institutions were forbidden to charge interest on Commercial Banks their loans or pay interest on deposits. The banks’ After 23 years of military conflict, the financial loan portfolios suffered widespread loan defaults, re- system in Afghanistan at the end of 2001 bore little flecting one of the effects of constant warfare. De- resemblance to a modern Western banking system. posit mobilization collapsed and the banks discon- During the procommunist and later the Soviet era tinued lending. During this same period, the (1973–89), the banking system was nationalized and 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. 5In 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 Box 6.3 summarizes each bank’s history and par- balance). In the first 30 branches assessed in May 2002, fewer ticularities. Briefly, the commercial banks may still than 6,000 accounts were found to be active. Active accounts are have been solvent in 2002 and even had a positive defined as those that had any movements since the beginning of the year or that had a customer who declared an interest for his cash flow, but that was because of the real estate or her account. they owned and returns on foreign currency deposits

©International Monetary Fund. Not for Redistribution FINANCIAL SECTOR DEVELOPMENT IN AFGHANISTAN

Box 6.3. Six Licensed Banks in Afghanistan

The Banke Millie Afghan (BMA) was established and export. During the Soviet period, the bank’s ac- in 1933 as a private bank and is the oldest and largest tivities declined, concentrating on importing and sell- commercial bank in Afghanistan. Until the establishing Russian equipment. After the Soviets left, the ment of the central bank, DAB, in 1939, BMA is be- bank essentially became inoperative. lieved to have undertaken certain core central bank- The Export Promotion Bank (EPB), was established ing activities. During the first 40 years, the bank in 1976 by MoF, the Chamber of Commerce, and sev- expanded aggressively, both domestically and interna- eral local producer cooperations. Despite its name, the tionally. BMA was nationalized in 1974, and since EPB mainly financed import letters of credit. Apart then has been fully owned and managed by DAB. from trade finance, no other loans were offered. The Since its nationalization, the bank has suffered from bank’s operations continued during the Soviet period, political interference and consequently weak corpo- but they fell back drastically after 1992 and were effec- rate governance and management structure. Follow- tively suspended under the Taliban regime. ing a serious deterioration of the bank’s financial condition, it effectively ceased all forms of financial The Industrial Development Bank of Afghanistan intermediation in 1992. (IDBA) was founded in 1973 as a private financial institution by domestic shareholders and six foreign in- The Pashtany Tejaraty Bank (PTB) was set up in vestors, including Chase Manhattan Bank, First Na- 1955 mainly to provide financial services to the grow- tional City Bank of New York (predecessor of ing trade business community. Although the bank was Citicorp), the International Finance Corporation of majority owned by the government through DAB, the the World Bank Group, National Westminster Bank of MoF, and the Ministry of Commerce (together with London, Industrial Bank of Japan, and Credit Lyonaise 58.3 percent of shareholdings), its 12-member board of France. The bank provided short- and long-term se- had an equal representation from both the private cured and unsecured loans to the private sector, state- sector and the government. Until its full nationaliza- owned enterprises, and joint private-government en- tion in 1974, the bank performed relatively well. terprises. Most projects that were financed were for Thereafter, the shrinking private sector reduced lend- production of alcohol, carpets, shoes, medical products, ing opportunities, and political interference made the and textiles in Kabul. With its nationalization in 1977, bank entirely dependent on DAB for policy direction its new owners became DAB, the MoF, Pashthany Te- and operational instructions. By the early 1990s, the jaraty Bank, Bank Millie Afghan, and the Afghanistan bank’s operations were limited to receiving payments Chamber of Commerce. The bank’s activities were dis- of government utilities and small-value deposits. rupted during the Soviet and Mujahedin periods and The Agricultural Development Bank (AgBank) totally halted with the arrival of the Taliban in 1996. was established in 1954 as the Agricultural and Hand- The Mortgage and Construction Bank (MCB) was icraft Bank by the MoF, DAB, and Banke Millie established in 1948 to finance residential and com- Afghan, and has not changed its ownership structure mercial construction in Afghanistan. From its incep- since then. The bank’s objective was to provide finan- tion, the bank was majority state-owned. The compo- cial services to small farmers and handicraft produc- sition of the private shareholders is not known as the ers. After an unsuccessful start, the bank was reorga- bank’s records were destroyed. After nationalization nized and renamed in 1969. The restructured bank in 1974, the bank’s share structure was divided be- successfully refocused its business on financing the tween DAB, the Afghan Chamber of Commerce, agricultural supply chain from producers to processing 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 Sources: Interviews in February and July 2002 and May rates on some 300 loans, the principal of which had 2003; diagnostic studies conducted by the World Bank. already been collected during the Taliban regime.

abroad that had been frozen during the Taliban era. peared. On the liability side, the deposit base had Most of the banks’ other assets had been substan- been eroded substantially by the high inflation rates tially eroded by inflation and/or could probably be that prevailed until the end of the war. However, written down to zero. For example, most of the none of the banks had been effectively engaged in banks’ loan portfolio was past due by 7–15 years and the banking business for many years, nor did any of many borrowers were either dead or had disap- them have a management cadre, an accounting

©International Monetary Fund. Not for Redistribution Modernizing the Financial Sector in Afghanistan framework, or risk management systems that would the modern central bank and banking law through a remotely resemble modern banking. As such, the six presidential decree has been a crucial first step for banks should probably be characterized as shell the development of a sound and resilient private banks, that is, institutions that may have assets and banking sector and more generally for macroeco- a banking license but cannot become operational nomic stability and growth in Afghanistan. The without a fundamental restructuring and a substan- laws have opened the doors for foreign banks, with tial improvement of their management. their much-needed technology and management know-how, to set up businesses in Afghanistan. Im- mediately following the enactment of the new laws, Payment System DAB issued banking licenses to Standard Chartered With the decline of the commercial banking sys- Bank, the National Bank of Pakistan, and the First tem to a near-moribund state at the end of 2001, MicroFinance Bank, which was established by the most domestic and international payments in Aga Khan Fund for Economic Development. For Afghanistan came to be undertaken by the money such banks, investing in Afghanistan offers poten- dealers (see Box 6.4). As the only viable payment tially lucrative opportunities, but—given the low system, this informal financial network had become institutional development—they have substantial crucial for the functioning of the Afghan economy. risks. Under the new laws, investors are given trans- But it was also vulnerable to money laundering, drug parent, predictable, and sound “rules of the game.” trafficking, and terrorist financing.6 At the end of At the same time, the central bank has been given 2001, there was an urgent need for a formal payment the proper tools to regulate and supervise the bank- system for payments by the government and by the ing system without government and political inter- donor community. These payments, for a variety of ference. With the basic legal foundations for the fi- reasons, were not best suited to be made under the nancial sector in place, the next step is for hawala payment system. Not only did the central authorities to press ahead with creating the neces- government need to make salary and other bud- sary institutional framework, including the govern- getary payments to and collect customs revenues ing bodies of DAB, and the technical capacities to from the provinces, but the success of the currency be able to effectively perform the duties prescribed conversion critically depended on being able to re- by the laws. Furthermore, complementary laws activate DAB’s branch system for the conversion to should also be enacted soon, including a modern take place nationwide. In the absence of a function- payment system law and a law on anti-money laun- ing banking system, therefore, the responsibility fell dering (AML) and combating the financing of ter- to DAB to provide leadership in the reform and de- rorism (CFT). This would help to restore the confi- velopment of the formal national payment system. dence of the public in the banking system and regenerate the deposit base that banks need to be able to extend credit. Modernizing the Financial Sector The central bank law includes provisions that give in Afghanistan DAB the overriding responsibility to achieve and maintain price stability, and grants it full autonomy New Legal Framework in pursuing this objective. In order to mark the clear departure from its socialist legacy, the law also speci- A completely new central bank law and a bank- fies that DAB shall act in accordance with the prin- ing law, properly defining the separate roles of the ciple of an open market economy with free competi- central bank and commercial banks, replaced, on tion. It further entrusts DAB with the tasks of September 16, 2003, the Law on Money and Bank- defining, adopting, and implementing Afghanistan’s ing, which was outdated and incompatible with a monetary and foreign exchange policy; issuing bank- 7 modern two-tier banking system. The enactment of notes and coins; holding and managing the official foreign exchange reserves; acting as advisor and fis- 6Afghanistan remains the largest opium producer in the world. cal agent of the government; and licensing, regulat- See Chapter 2 (Appendix 2.1) for an account of opium production in Afghanistan. 7Drafts of the central bank and banking laws were prepared firms. The draft laws had been extensively discussed with senior with the help of the IMF and benefited from comments from a officials in the Afghan government at a legal seminar in Decem- number of international organizations, law firms, and consulting ber 2002.

©International Monetary Fund. Not for Redistribution FINANCIAL SECTOR DEVELOPMENT IN AFGHANISTAN

Box 6.4. Money Dealers in Afghanistan

In 2003, there were approximately 5,000 money for making international transfers varies between 0 traders in Kabul, of which some 300 had shops and and 2 percent of the amount transacted. Domestic were licensed by DAB.1 DAB licensed money chang- transfers are typically more expensive with an addi- ers for a fee, but did not regulate or supervise them. tional charge of !/2 –1 percent. In exceptional circum- Some of the unlicensed money traders are affiliated stances, such as immediately after September 11, 2001, with shops, which typically have two to five traders. and until early 2002, the fees have been as high as 4 Most traders, however, work independently and thus percent. In principle, money transfers operate on a without a license. In provincial towns, there are on netting system with other traders in the provinces or average around 80–150 licensed money traders with abroad. Physical transfer of cash, or at times in legal or shops and about 500 traders. The Afghan people have illicit goods, is only made when a trader has no repre- relied on this informal sector for hundreds of years. sentation in a particular town, or where a net position The money transfer system is usually referred to as the needs to be settled. Outstanding balances are usually hawala system.2 settled between two dealers on a weekly or monthly basis, but at times, when the volume of transactions is Funds can be transferred within 6–12 hours from Pe- high, settlement of accounts is made daily. shawar, Dubai, or London to Kabul, and with improving communication, the transfer time continues to di- Besides the transfer of funds, the other main finan- minish. Transfers to provinces usually take a little cial service provided by the money dealers is foreign longer. While regional money dealers are mostly lo- exchange dealing, mainly in U.S. dollars, Pakistani cated in provincial cities, from where they organize the rupees, and Iranian rials. Virtually any currency can distribution to villages through their local offices or be traded. The 30 largest traders cover about 70 per- representatives, the international dealers are mainly cent of all transactions and roughly half of their trad- based in Kabul. For international transfers, the tradi- ing consists of transactions in U.S. dollars. Daily trade tional counterparts are situated in the Islamic Repub- volumes in the Kabul foreign exchange market report- lic of Iran, Pakistan, India, Saudi Arabia, Qatar, the edly run in to several millions of U.S. dollars, and United Arab Emirates, and Oman. Rather than con- most of this is transacted in cash. There are no limits ducting transactions in cash, some clients wire funds to on transaction volumes. Traders have reported that a correspondent account in Peshawar or Dubai, and buying or selling $1 million in cash can be accommo- upon confirmation of receipt of funds, the counterpart dated easily. Other financial services include deposit is released immediately at the desired destination. taking, granting of short-term loans, trade finance, Some 10–15 of the larger traders have correspondent and microfinance. However, money traders extend accounts with banks abroad. Affiliated traders can also loans or accept deposits only to and from people benefit from this network. Reputable customers can whom they personally know and trust. cash checks or require receipt of the counterpart prior The money traders operate without standard docu- to making the corresponding wire. Such services are mentary requirements and usually design and main- usually negotiated at a higher cost. Depending on the tain their own documentary policies and procedures. amount, destination, financial relationship, the cur- Transactions generally involve comprehensive and rency of exchange, and security environment, the cost detailed records for the entire process of remittance and settlement of each money transfer. The documen- Sources: Maimbo (2003); El Qorchi, Maimbo, and Wilson tation is kept at least until the entire transaction and (2003), and meetings held with money changers in its settlement are completed. The money market is Afghanistan in February and July 2002 and May 2003. not subject to any reporting requirements or supervi- 1Until early 2003, money traders were licensed by the for- sion. It is fully based on reputation and trust, but also eign relations department of DAB. benefits from self-regulation by the Money Dealers 2 The term “hawala” is used throughout the Middle East Association formed by the 20–30 leading traders. The and means “transfer.” Equivalent informal transfer systems exist in other countries under a different terminology: fei- association has unwritten rules of conduct and prac- ch’ien (China), hui kuan (Hong Kong), hundi (India), tices. Traders who do not respect these rules can be padala (Philippines), and phei kwan (Thailand). expelled from the market.

ing, and supervising institutions engaged in banking and high inflation might otherwise emerge. DAB is business. The law prohibits financing the govern- also prohibited from providing loans to commercial ment budget deficit, thereby closing one important banks. The one exception to this rule is that DAB is channel through which macroeconomic instability permitted to act as a lender of last resort and to ex-

©International Monetary Fund. Not for Redistribution Modernizing the Financial Sector in Afghanistan tend short-term liquidity support to solvent but illiq- extending loans or for making investments for its uid banks, especially in the event of a systemic liq- own account. The law introduces a two-stage process uidity crisis. for filling out applications of banking licenses with The new central bank law grants DAB complete only essential information to be submitted in the legal, operational, and administrative autonomy first stage. It gives DAB the mandate to issue regula- from the state and any other person or authority, in tions to further specify the necessary conditions for the pursuit of its objectives and the performance of obtaining a banking license. The law stipulates that its tasks.8 Independence requires accountability, and before an application is considered, DAB would this is also stipulated in the law. Accountability will need to conduct a fit and proper test of future own- be achieved by a clear mandate and by reporting re- ers, board members, and senior managers of the quirements to the Parliament and to the public on bank. The draft law defines the banking activities DAB’s financial condition, on its success in achiev- that banks are allowed to pursue. They are further ing its objectives, and on how it performed its tasks. detailed in their banking licenses.10 Accountability will increasingly also be enhanced The law includes the standard rules of a modern by prohibiting DAB senior officials from holding banking system for sound management, prudent risk other government positions and by excluding them management, and transparent and adequate ac- from engaging in other tasks incompatible with counting. Specifically, the law includes provisions their duties, which would create a conflict of inter- related to the banks’ corporate governance and on est.9 The governor, first deputy governor, and mem- DAB’s powers to review changes in bank ownership, bers of the Supreme Council of DAB are appointed, the board, and senior management. The law also in- remunerated, and dismissed in accordance with cludes requirements of credit documentation, risk specified procedures and conditions. management, as well as provisions that banks should The law also stipulates DAB’s right to be con- maintain their accounts in accordance with interna- sulted on any proposed legislative or public adminis- tional accounting standards (IAS). Furthermore, trative act of the government in DAB’s field of com- banks will be subject to specific auditing require- petence. This provision ensures that the overall ments, including the establishment of an audit com- legal framework of the financial system continues to mittee. DAB’s oversight role will be strengthened be consistent and coherent. In consideration of the through the conduct of on-site examinations. The difficulties involved in passing several laws at the last part of the law is dedicated to specifying DAB’s same time, the central bank law already includes enforcement measures to address infractions by specific basic issues that under normal circum- banks and situations where a bank’s capital declines. stances would have been covered by separate addi- It defines a graduated system of prompt corrective tional laws, including currency, cash payments, pay- actions to be imposed by DAB, including the power ment system issues, and securities services and to order the removal from office of board members securities transfer systems. Some of these issues or senior managers of banks, and explicit provisions should, however, be further extended by separate for dealing with banks undergoing solvency prob- legislations. Furthermore, DAB has the powers to lems. Finally, the law grants DAB the exclusive au- issue regulations for the hawala dealers as nonbank thority to revoke a license and to initiate insolvency providers of money and payment services. proceedings, with comprehensive explicit provisions The main features of the banking law include a pre- for the resolution of insolvent banks under the over- cise definition of a bank as an entity engaged in the sight of a financial service tribunal. business of accepting deposits or other repayable funds from the public and using such funds either for Modern Central Bank in a Two-Tier Banking System

8For a period of three years after the enactment of the law, the In the two years since the fall of the Taliban, Minister of Finance can, however, nominate one member of the DAB has made important progress in a number of Supreme Council of DAB, other than the governor and the first vice governor (transitional provisions of the central bank law, areas. Most importantly, it has successfully imple- Article 133). 9The transitional provision of the central bank law (Article 135) allows, however, for political activities to be continued 10The draft law also provides DAB with the powers to specify until a successor administration of the Transitional Islamic State by regulation additional activities for banks to the extent not of Afghanistan is in place. specifically restricted by law.

mented the currency exchange and gained control structured individually into what corresponds to a over the issuance of currency, which is a prerequisite monetary policy department, a payment systems de- for an effective monetary policy (see Chapter 5). It partment, an accounting department, a banknote has also created a banking supervision department operations department, and a banking supervision and thereby addressed one of the key weaknesses of department, with foreign experts assisting each of DAB. Progress in other areas, in particular the re- these departments. structuring of the central bank, has been slower. Basic training in the business of banking will be a Accounting Reform crucial prerequisite for successfully reforming the financial sector. At the end of 2001, there existed a On the accounting side, DAB began working to- fundamental misunderstanding by both the banks ward the introduction of a new chart of accounts, as and the supervisors regarding the role that banks well as a general ledger software package that would and banking supervision had to perform. In the fu- enable it to produce its balance sheet on a regular ture, supervisors will have to be concerned about basis. However, by end-2003, the reform agenda in the safety of the banks’ depositors, rather than about the accounting area remained substantial. Account- any social, political, or developmental agenda. Bank ing regulations still needed to be drafted, together managers, in turn, will need to be concerned about with operating manuals and procedures, and staff proper pricing of risk, risk management, and return needed to be trained. Furthermore, the consolida- on equity. tion of financial accounts could not be completed without reforms in DAB’s branches. An ambitious project was initiated to improve the connectivity of Banking Supervision DAB’s branches with the main office (see below). One of the most important improvements in Improvements were also made in data collection DAB took place with the initial steps in establishing with the production of a Quarterly Economic and Sta- effective banking supervision. By the end of 2003, a tistical Bulletin. new supervision department had been created, a number of prudential regulations and manuals had Commercial Operations been drafted, and the training of supervisors had been initiated. In the first phase, staff received DAB also made notable progress in the efficiency training in basic balance sheet analysis and concepts of its commercial services. Almost all banking activ- of prudential ratios. This was soon followed by “real ities for the international organizations and for life” off-site staff supervision of the operating banks many of the NGOs in Afghanistan during 2002 and and on-site supervision of Banke Millie Afghan, 2003 were conducted by the commercial arm of under the supervision of a foreign expert. DAB. Although DAB’s services included the open- The licensing of money traders was shifted from ing of accounts, deposits, and international money the foreign relations department to the new supervi- transfers, this was solely to facilitate international sion department. In November 2002, all licensed payments for international organizations, including money traders had to renew their licenses, a process USAID, World Bank–funded programs, NGOs, as that was enforced with the help of the local police. well as the U.S. army. The efficiency of the payment In 2003, the department began the process of im- service was substantially improved with the intro- proving the collection of personal data on the li- duction of SWIFT. Improvements in the commer- censed money traders. cial area included the development and introduction of procedures that expedited the opening of letters of credit by the MoF under grant programs. Restructuring New current accounts could only be opened by Apart from the new supervision department, money changers, NGOs, or international organiza- progress in other areas of the reorganization of DAB tions, but not by the general public.11 DAB ceased started more slowly. By end-2003, DAB still ran to extend loans. DAB’s commercial arm expanded under its original organizational chart and contin- rapidly in 2003. Although these commercial opera- ued to employ a large number of unqualified staff with no assignments. Pending an overall reorganiza- 11In early 2002, DAB resumed paying interest on the savings tion, parts of some departments were instead re- accounts.

©International Monetary Fund. Not for Redistribution Modernizing the Financial Sector in Afghanistan tions did not belong in a central bank, the prevail- troduction of a software system for the management ing vacuum in the banking system left DAB with of the currency inventory and the purchase of ar- little option but to fill the gap, at least until com- mored cars and/or use of an aircraft suited for the im- mercial banks have resumed operations in portant, yet risky, task of transporting cash within Afghanistan. When that time comes, DAB intends and outside Kabul. For the medium term, with the to divest itself of all the commercial bank activities emergence of a commercial banking system, DAB it now undertakes as soon as possible and no later plans to implement two payment systems that will than September 2005.12 A conscious effort is being represent the core of the National Payment System. made to develop the commercial activities in such a These payment systems will provide the clearing and way that they can be easily split off from the core settlement of both high and low value payments, operations of DAB at a later stage. using a real time gross settlement (RTGS) system and a direct giro credit (GC) system. Domestic Payment System Other Changes Developments in the payment area by commercial banks will likely be limited for some time. In the With the assistance of a foreign expert, DAB is meantime, by late 2003, DAB had reconnected 35 of also in the process of unblocking and consolidating its main provincial branches to DAB’s head office in existing DAB accounts in international banks, and Kabul. These branches were connected by laptops is improving the management of its foreign reserves. with Immarsat connections, which allowed them to Tasks for the future include the removal from the report to the center their balances and account DAB balance sheet of all assets and liabilities held movements on a daily basis.13 Bank branches in by both the foreign and domestic loans general de- Kabul were to be connected by a computer network. partment and the foreign trade general department, The next step will be to identify the branches that together with all records associated with them, and need to be rehabilitated to meet the necessary secu- their transferal to a public agency designated to set- rity standards. The decision about which branch to tle these balances. DAB will also need to address the reopen or to rehabilitate will need to be taken based pension department, which is responsible for the on a needs assessment, including an estimate of the pensions of employees of both DAB and the com- reflow of refugees and internally displaced people. mercial banks. Options would include transferring The disbursement of government salaries, the main these pension accounts to an outside private agency expenditure item in the provinces, would probably or to a national pension system. require fewer operational provincial branches than existed in the past.14 DAB would further need to de- Seeking the Renaissance of velop a physical distribution system with some re- Commercial Banks gional cash centers from where the distribution of cash could be made. This would also include the in- The development of an effective banking sector in Afghanistan will need to be based on three important pillars: competition, good corporate governance, and 12See transitional provision (Article 129) of the central bank law. strong banking supervision.15 The enactment of the 13As the volume of transactions increases, it is planned central bank and banking laws has been the first that the Immarsat connections would be replaced by a VSAT major step toward this new structure. But the passing network. 14Facilitating the Ministry of Rural Development’s scheme to of these new laws is not a sufficient basis for the rede- make grant payments to 7,000 villages commencing end-Septem- velopment of the banking system without improved ber 2003 and using the DAB branch network outside Kabul repre- contract enforcement and well-defined property sents one of DAB’s biggest immediate tasks. As regards the MoF individual salary payment requirements, this is still in the plan- rights. Reforms will be needed simultaneously on a ning stage by a task force at the ministry. Retail salary payments in number of different fronts, including accounting Afghanistan are currently made by cash payments at the employ- reform and training in commercial banking and risk ees’ place of work in the municipalities, rather than by bank transfers to commercial banks (which are not possible) or through assessment. 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 responsibil- 15For experience gained in banking sector reform in Central ity of the local representative of the MoF (Mustufi). and Eastern Europe, see Bokros (2001).

A good number of reforms can be imported into tinue to exist, as is the case in many other countries the banking system by foreign banks. The recent in the Middle East. Given the need to counter un- granting of banking licenses to a number of foreign transparent, undocumented, and adverse practices, banks represents an important window of opportu- DAB will need to evaluate the options available to nity for the development of an efficient banking sys- partly regulate and supervise this market without tem. These new banks are expected to have modern pushing it underground.16 In this context, simply management and risk assessment techniques. In- extending banking regulations and supervision prac- house rules will require them to apply international tices with respect to licensing requirements, cus- accounting standards. However, foreign banks can- tomer identification, suspicious activity reporting, not provide all the answers. To begin with, foreign and record keeping to the money dealers is not a vi- banks will most likely limit their operations to the able option. It would not be feasible to regulate in larger cities, starting with Kabul, and to certain this manner, given the huge number of traders in- types of customers, namely international organiza- volved, and this level of regulation would probably tions, NGOs, the diplomatic corps, and the largest push the activity underground. But two alternative corporations, leaving small and medium-size enter- options might instead be envisaged. First, the prises and rural areas unbanked. Most banks will hawala dealers could, at least as an interim solution, likely also focus their operations initially on facili- subject themselves to self-regulation and supervi- tating payments and few can be expected to engage sion. This market already benefits from an associa- in significant domestic lending at the outset. This tion that enforces a number of unwritten rules. The indicates that there remains an important role for association could be encouraged to draft written DAB, microfinance institutions, and a rehabilitated rules and regulations.17 Second, recognizing the dis- domestic banking sector to deliver financial services tinct features of the hawala system would justify the outside of Kabul and to a client base unlikely to be development of special regulations and supervision served by the international banks. techniques, which would mainly attempt to increase Afghanistan needs a comprehensive medium- to the level of transparency in the business while keep- long-term financial sector development strategy, ing intact the characteristics that made this market possibly including a strategy to rehabilitate part of so efficient. Such regulations could include the re- the existing domestic banking system. Such a strat- quirements of (1) registration but not licensing of egy would likely require an experienced and compe- the hawala dealers, (2) the ability to identify cus- tent management team to make a detailed diagnos- tomers and keep records on their identity, and tic and action strategy with voluntary retrenchment (3) cooperation in investigations if the need arises, plans, training of remaining staff, and introduction which would include the right of DAB to enter and of modern banking technology. Domestic bank re- inspect the money dealers’ premises when there is a structuring will only bear dividends if qualified and reasonable suspicion of a committed offense. Finally, experienced people are assigned board and manage- through information campaigns, DAB could seek to ment positions; if the organization and corporate educate the money dealers about their responsibility governance are well restructured; if the operating to report suspicious activities. systems, management tools, and operating policies and procedures are strengthened and automated; if the duties, responsibilities, and scope of authority at References all levels of management and staff are well defined; and if the bank is sufficiently capitalized after full Asian Development Bank, 2003, National Payments Sys- due diligence and after financial, management, and tem for the Islamic Republic of Afghanistan (draft (B) is- operational audits have been performed on the sued August 19), Final Report TA 3874-AFG, pre- banks being restructured. Institutions that are un- pared by Schlumberger Sema. able to perform should ultimately be liquidated.

Money Changers and the Hawala 16For a detailed discussion of regulatory options for the hawala System system, see Maimbo (2003); and El Qorchi, Maimbo, and Wilson (2003). Even with the emergence of a modern banking 17The disadvantage of self-regulation is that it risks becoming system, the informal hawala system will likely con- self-serving with a high degree of regulatory forbearance.

El Qorchi, Mohammed, Samuel Munzele Maimbo, John F. able via the Internet: http://www.imf.org/external/ Wilson, 2003, Informal Funds Transfer: An Analysis of np/mae/ferm/eng/index.htm. the Hawala System, IMF Occasional Paper No. 222 Maimbo, Samuel Munzele, 2003, “The Money Exchange (Washington: International Monetary Fund). Dealers of Kabul—A Study of the Hawala System in International Monetary Fund, 2001, Guidelines for Foreign Afghanistan,” World Bank Working Paper No. 13 Exchange Reserve Management (Washington). Avail- (Washington: World Bank).