Исламское банковское дело: Islamic Banking and Finance

ВозможностиOpportunities в acrossсегменте Micro, Small, микро, малых иand средних Medium Enterprises предприятий in the Kyrgyz Republic Wichtiger HINWEIS ! Innerhalb der Schutzzone (hellblauer Rahmen) darf kein anderes Element platziert werden! Ebenso darf der Abstand zu Format- resp. Papierrand в Кыргызской Республикеdie Schutzzone nicht verletzen! Hellblauen Rahmen der Schutzzone nie drucken!

Siehe auch Handbuch „Corporate Design der Schweizerischen Bundesverwaltung“ Kapitel „Grundlagen“, 1.5 / Schutzzone www. cdbund.admin.ch IN PARTNERSHIP WITH: IFC, a member of the World Bank Group, creates opportunity for people to escape poverty and improve their lives. We foster sustainable economic growth in developing countries by supporting private sector development, mobilizing private capital, and providing advisory and risk mitigation services to businesses and governments. This report was commissioned by IFC through its Financial Institutions Group in Europe, Middle East and North Africa to highlight the need for Islamic Banking across the region.

The conclusions and judgments contained in this report should not be attributed to, and do not necessarily represent the viewsof, IFC or its Board of Directors or the World Bank or its Executive Directors, or the countries they represent. IFC and the World Bank do not guarantee the accuracy of the data in this publication and accept no responsibility for any consequences of their use.

This report can be obtained in print or electronic format at the following address:

IFC in the Kyrgyz Republic Orion Business Center, 4th floor, Erkindik boulevard, 21, Bishkek, 720040, Kyrgyz Republic Tel.: +(996 312) 62 61 62 www.ifc.org Contents

01. Executive Summary 9 02. Overview of Business and the MSME sector in the Kyrgyz Republic 15 Definitions 15 Structure of Kyrgyz commercial establishments 15 Contribution of MSMEs to the Kyrgyz economy 16 Small- and medium-sized business distribution by economic activity 17 MSME distribution by geography 18 Enablers of business growth 19 Key concerns for businesses 21 03. Current Status of Islamic Banking in the Kyrgyz Republic 23 Overview of the banking sector in the Kyrgyz Republic 23 Islamic banking in the Kyrgyz Republic 28 Non-performing loans within the Kyrgyz banking system 31 Challenges facing Kyrgyz Islamic banking 33 Overview of micro-finance institutions in the Kyrgyz Republic 34 04. Islamic Banking Opportunities pertaining to MSMEs 37 Access to finance for the MSME sector 37 Obstacles for financial institutions lending to MSMEs 40 Supply-side analysis – Islamic banking penetration into the MSME sector 40 Potential for Islamic banking in the MSME sector 41 05. Conclusion 45 Research Scope and Methodology 46 Appendix 48 Fundamental Concept behind Islamic Laws & Principles 48 Questionnaire 50 Bibliography 52

3 Index of Figures and Tables

Figure 1: Islamic funding and depository potential 8 Figure 2: Reasons cited by MSMEs for not applying for loans 10 Figure 3: Islamic financing potential – ‘new to bank ’ 12 Figure 4: Depository potential 13 Figure 5: Classification of commercial establishments in the Kyrgyz Republic (2014) 16 Figure 6: MSMEs share of the Kyrgyz economy (2014) 17 Figure 7: Small and medium enterprise classification by economic activity 18 Figure 8: Geographic concentration of MSMEs in the Kyrgyz Republic 19 Figure 9: Recent IFC investments in the Kyrgyz Republic 20 Figure 10: S ignificant Kyrgyz-focused advisory services provided by IFC 20 Figure 11: Major constraints facing businesses 22 Figure 12: Kyrgyz banking structure (2014) 24 Figure 13: Market share of the country’s commercial banks (2013) 26 Figure 14: Total commercial bank loans and deposits in the Kyrgyz Republic ($ billions) 26 Figure 15: Classification of loans by sector (2014) 27 Figure 16: Classification of deposits with Kyrgyz commercial banks (2014) 27 Figure 17: Islamic bank penetration in the Kyrgyz Republic (by number of branches) 30 Figure 18: Growth in Islamic loans and deposits ($ millions) 31 Figure 19: Non-performing loans as a percentage of total lending in the country 31 Figure 20: Growth in micro finance institutional assets and loans ($ millions) 35 Figure 21: Classification of MFI loans by sector (2014) 36 Figure 22: Purposes of loans sought by MSMEs 38 Figure 23: Reasons cited by MSMEs for not applying for loans 39 Figure 24: Funding potential 42 Figure 25: Depository Potential 42

Table 1: Definition of MSMEs in the Kyrgyz Republic 15 Table 2: Kyrgyz banking penetration (2013) 25 Table 3: SME loans and deposits in the Kyrgyz Republic 28

4 Abbreviations and Glossary

ATM Automated Teller Machine CAGR Compound Annual Growth Rate FINSAC Financial Sector Adjustment Credit GDP Gross Domestic Product IDB Islamic Development Bank IFC International Finance Corporation KFG Kompanion Financial Group KGS Kyrgyzstani Som KICB Kyrgyz Investment and Credit Bank MFIs Micro Finance Institutions MoU Memorandum of Understanding MSME Micro, Small, and Medium Enterprises NBKR National Bank of the Kyrgyz Republic NPL Non Performing Loan NSO National Statistical Office OJSC Open Joint Stock Company USD United States Dollar WTO World Trade Organization

Conversion Rates used in the report (KGS/USD)

2014 0.0188 2013 0.0206 2012 0.0213 2011 0.0217 2010 0.0218 2009 0.0233

5 Foreword

Islamic banking refers to a system of banking consonant with the basic principles of Islamic Shariah (the rules and values set by Islam). Essentially this means interest-free financing. Shariah principles disallow ‘riba’ or interest on the lending of money. Islamic banking offers the same facilities as the conventional banking system does globally. The difference is Islamic banking’s strict adherence to Shariah rules or Fiqh al Muamlat (Islamic commercial jurisprudence). Until now, however, the presence and reach of Islamic banking institutions is not as widespread as that of conventional banks. This can pose a supply gap issue for Islamic products and services.

The World Bank Group has conducted several studies to more exactly define and quantify this financing gap, and the overall use of banking services among businesses in the Kyrgyz Republic. In fact, though, little clarity has been achieved in determining how many of these businesses have been excluded owing to the unavailability of Shariah-compliant banking products.

To correct this lack of information, IFC commissioned this study to better understand the levels of actual business demand that exist (especially among MSMEs) and the supply of Islamic banking products (asset and liability products along with other banking services) that are available to address it. The scope comprises: (i) gaps in the banking needs of businesses (particularly MSMEs) in the Islamic products space; (ii) supply-side benchmarking to review the current capacity of financial institutions to offer Islamic products to businesses; (iii) demand-side benchmarking to identify key MSME needs for Islamic products to see how well they are being served; and (iv) the current enabling environment, reviewing its readiness levels taking into consideration its regulatory framework and the legislation in place to govern Islamic banking and Shariah compliance.

In particular the report reveals an emergent ‘new-to-bank’ Kyrgyz Islamic funding and depository opportunity, highlighting the un-served and underserved MSMEs who do not borrow from conventional banks owing to the unavailability of Shariah- compliant banking products. In other words, even though there is very strong latent demand for Islamic banking products, this potential is untapped because banks and financial institutions lack the necessary operational capabilities with the extra burden of having to deal with other constraints such as narrow product offerings, limited outreach, and high costs. This report offers recommendations as to what Islamic banks and other financial institutions need to do in order to capitalize on the nascent opportunities represented by the country’s MSME sector.

Almost 80 percent of the country’s MSMEs have indicated their strong preference for and interest in Islamic banking products and services. Thus if banks successfully implement customer acquisition strategies by focusing on financially un- served and underserved MSMEs, they can capitalize on this “new-to-bank” potential, as quantified below:

Funding Potential Deposit Potential Description Min ($mn) Max ($mn) Min ($mn) Max ($mn) Un-served MSME population – (a) 236.3 315.1 278.0 370.7 Under-served MSME population – (b) 73.3 97.8 86.3 115.0 Total “New to Bank” (a+b) 309.6 412.9 364.3 485.7

In addition to the “new-to-bank” potential there is also a conversion/cannibalization opportunity for “well-served” MSMEs which have access to the formal financing system. This opportunity could be worth an estimated $38.3-51.1 million over the next few years, understanding that these MSMEs might shift their loyalties once Shariah-compliant products are readily available.

6 Preface

Micro, small, and medium enterprises (MSMEs), are the drivers of Kyrgyz economic growth and key contributors to sustainable gross domestic product (GDP). Since the country achieved independence from the Soviet Union in 1991, MSMEs became one of the prime supports of the economy as the number of industrial enterprises declined. Most MSMEs are engaged in the trade and trade-related sectors. These generate significant employment opportunities for skilled and unskilled labor alike.

Despite their importance to economic development, however, the growth of the country's MSMEs has been hindered by their limited access to banking services, along with high tax rates, and inconsistent policies. Thus, government support programs and assistance from multilateral agencies and policy makers are essential to MSME growth.

The Bank Advisory Services of IFC’s Financial Institutions Group provides advisory services to banks in aid of strengthening their capacity and increasing their outreach to the MSME sector. This is achieved through capacity building, training, knowledge sharing, and dissemination of best practices in MSME banking and risk management. IFC’s primary goal is to increase the number of banks that offer banking services to MSMEs in a profitable and sustainable manner. The organization is globally recognized as a market leader in MSME banking, through its various regional engagements. IFC is also recognized for its global expertise and knowledge in this area.

In response to growing market demand, IFC has recently enhanced its advisory services to include Islamic financing. In this respect, the National Bank of Kyrgyz Republic has also expressed an interest in exploring this segment of the market. Indeed, the NBKR is already looking at the possibility of putting regulations for Islamic banking in place.

As a first step, IFC commissioned this study to better understand the demand for and supply of Islamic banking products (asset, liability, and other banking products and services) for the MSME sector in the Kyrgyz Republic. In this study, demand-side benchmarking was conducted to identify key MSME needs for Islamic products and to gauge how well they are being served. Furthermore, IFC made a quick review of the current enabling environment and readiness levels in the country in terms of its regulatory framework and Shariah compliance. Also surveyed were the current capacity of Kyrgyz financial institutions to offer Islamic products to MSMEs.

The study reveals a funding potential of $342.2 to 456.3 million for Islamic financing to MSMEs, with a corresponding depository potential of $402.6–536.9 million over the next few years. This funding potential exists due to the ‘new-to-bank’ funding opportunity within the un-served and underserved MSME segments. These are either partially served by financial institutions or do not borrow at all for various reasons. Findings include ‘new-to-bank’ funding potential of $309.6–412.9 million, which is untapped as banks and other financial institutions lack adequate the strategic focus needed on this segment to offer Shariah-compliant products.

In addition to the ‘new-to-bank’ funding and depository potential, Islamic banks could convert or cannibalize the existing funding/lending and deposit portfolios of conventional banks that serve MSMEs (primarily mid-sized enterprises). These mid-sized enterprises deal with conventional banks mostly because of the unavailability of the appropriate Islamic banking products. The funding potential within this category of well-served MSMEs could be around $30.1 to 41.1 million.

7 Foreword Preface

Islamic banking refers to a system of banking consonant with Islamic funding and depository opportunity, highlighting the Micro, small, and medium enterprises (MSMEs), are the drivers In addition to the ‘new-to-bank’ funding and depository potential, the basic principles of Islamic Shariah (the rules and values set un-served and underserved MSMEs who do not borrow from of the Kyrgyz Republic’s economic growth and key contributors Islamic banks could convert or cannibalize the existing funding/ to sustainable gross domestic product (GDP). Since the country lending and deposit portfolios of conventional banks that serve by Islam). Essentially this means interest-free financing. Shariah conventional banks owing to the unavailability of Shariah- achieved independence from the Soviet Union in 1991, MSMEs MSMEs (primarily mid-sized enterprises). These mid-sized principles disallow ‘riba’ or interest on the lending of money. compliant banking products. In other words, even though there became one of the prime supports of the economy as the number enterprises deal with conventional banks mostly because of the Islamic banking offers the same facilities as the conventional is very strong latent demand for Islamic banking products, this of industrial enterprises declined. Most MSMEs are engaged in unavailability of the appropriate Islamic banking products. The banking system does globally. The difference is Islamic banking’s potential is untapped because banks and financial institutions the trade and trade-related sectors, which is the primary source of funding potential within this category of well-served MSMEs employment generation. Figure 1: Islamic fundingcould andbe arounddepository $30.1 potential to 41.1million. strict adherence to Shariah rules or Fiqh al Muamlat (Islamic lack the necessary operational capabilities with the extra burden Figure 1: Islamic funding and depository potential commercial jurisprudence.). Until now, however, the presence of having to deal with other constraints such as narrow product IFC’s Financial Institutions Group provides advisory services to banks in aid of strengthening their capacity and increasing their and reach of Islamic banking institutions is not as widespread as offerings, limited outreach, and high costs. This report offers outreach to the MSME sector. This is achieved through capacity that of conventional banks. This can pose a supply gap issue for recommendations as to what Islamic banks and other financial building, training, knowledge sharing, and dissemination of Islamic products and services. institutions need to do in order to capitalize on the nascent best practices in MSME banking and risk management. IFC’s BEAR CASE ($mn) BULL CASE ($mn) primary goal is to increase the number of banks that offer banking The World Bank Group has conducted several studies to more opportunities represented by the country’s MSME sector. services to MSMEs in a profitable and sustainable manner. The exactly define and quantify this financing gap, and the overall use Almost 80 percent of the country’s MSMEs have indicated their organization is globally recognized as a market leader in MSME 309.6 New to bank 412.9 of banking services among businesses in the Kyrgyz Republic. strong preference for and interest in Islamic banking products banking, through its various regional engagements. IFC is also In fact, though, little clarity has been achieved in determining and services. Thus if banks successfully implement customer recognized for its global expertise and knowledge in this area. how many of these businesses have been excluded owing to the acquisition strategies by focusing on financially un-served and In response to growing market demand for Islamic finance, IFC 32.6 Conversion of well- 43.5 served MSMEs unavailability of Shariah-compliant banking products. underserved MSMEs, they can capitalize on this “new-to-bank” has recently enhanced its advisory services to include support for Islamic financing. The National Bank of the Kyrgyz Republic has To correct this lack of information, IFC commissioned this potential, as quantified below: also expressed an interest in exploring this segment of the market. study to better understand the levels of actual business demand Indeed, the NBK is already looking at the possibility of putting 342.2 Total Funding 456.4 Potential that exist (especially among MSMEs) and the supply of Islamic Funding Potential Deposit Potential regulations for Islamic banking in place. Description 85% banking products (asset and liability products along with Min Max Min Max As a first step, IFC commissioned this study to better understand other banking services) that are available to address it. The ($mn) ($mn) ($mn) ($mn) the demand for and supply of Islamic banking products (asset, 402.6 Total Depository 536.9 Potential scope comprises: (i) gaps in the banking needs of businesses liability, and other banking products and services) for the un-served MSME population – (a) 236.3 315.1 278.0 370.7 MSME sector in the Kyrgyz Republic. In this study, demand-side (particularly MSMEs) in the Islamic products space; (ii) under-served MSME population – (b) 73.3 97.8 86.3 115.0 benchmarking was conducted to identify key MSME needs for supply-side benchmarking to review the current capacity of Islamic products and to gauge how well they are being served. A The report highlights strategic measures that conventional and financial institutions to offer Islamic products to businesses; Total “New-to-Bank” (a+b) 309.6 412.9 364.3 485.7 quick review of the current enabling environment and Thereadiness report highlights strategic measures that conventional and Islamic banks could undertake to successfully tap the Islamic levels in the country in terms of its regulatory framework and Islamic banks could undertake to successfully tap the Islamic (iii) demand-side benchmarking to identify key MSME needs banking potential of the country's MSMEs. Shariah compliance also formed part of the IFC review as was the banking potential of the country’s MSMEs. for Islamic products to see how well they are being served; and In addition to the “new-to-bank” potential there is also a conver- current capacity of financial institutions to offer IslamicIt is productsexpected thatIt this is expected study will that now this form study a basis will for now understanding form a basis the forneed for Islamic banking and finance based on (iv) the current enabling environment, reviewing its readiness sion/cannibalization opportunity for “well-served” MSMEs which to MSMEs. market demand. Itunderstanding also provides an the outline need of forthe Islamicsteps that banking need to be and taken finance to introduce based Islamic banking and finance in the country, something which the Government of the Kyrgyz Republic is very keen to promote. levels taking into consideration its regulatory framework and have access to the formal financing system. This opportunity The study reveals a funding potential of $342.2 to on market demand. It also provides an outline of the steps that need to be taken to introduce Islamic banking and finance in the the legislation in place to govern Islamic banking and Shariah could be worth an estimated $38.3-51.1 million over the next few 456.3 million for Islamic financing to MSMEs, withIFC acknowledgesa the commitment and cooperation of Israa Capital Management Consultants, Dubai, who carried out this depository potential of $402.6–536.9 country. compliance. years, understanding that these MSMEs might shift their loyalties corresponding study on their behalf. million over the next few years. This funding potential exists due IFC acknowledges the commitment and cooperation of Israa In particular the report reveals an emergent ‘new-to-bank’ Kyrgyz once Shariah-compliant products are readily available. to the ‘new-to-bank’ funding opportunity within the un-servedTomasz A. TelmaCapital Management Consultants, Dubai, who carried out this and underserved MSME segments. These are either partiallyIFC Regional Directorstudy for on Europe their behalf.and Central Asia served by financial institutions or do not borrow at all for various reasons. Findings include ‘new-to-bank’ funding potential of $309.6–412.9 million, which is untapped as banks and other Tomasz A. Telma financial institutions lack adequate the strategic focus needed on this segment to offer Shariah-compliant products. Regional Director IFC – Europe and Central Asia

6 Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 7

8 01. Executive Summary

Given the fact that just one bank offers Shariah-compliant products in the Kyrgyz Republic despite the strong preference for Islamic finance by a large segment of the business clientele there, this study aims to determine the number of businesses (particularly MSMEs) that do not borrow from financial institutions due to this preference, and simply because of limited availability; this would seem to underscore an unmet need. How many of these enterprises prefer Islamic banking, but opt for conventional banks due to the limited availability of adequate Islamic banking products? What is the potential for Islamic finance in the country once Islamic banking regulations are strengthened? This study objectively qualifies and quantifies such aspects.

The importance of MSMEs in the Kyrgyz Republic grew significantly after the dissolution of the Soviet Union, primarily because MSMEs generated considerable numbers of employment opportunities for the local population. As well, though, MSMEs can be characterized as the major drivers of economic development. The country’s mountainous terrain limits industrial growth. This, in turn, increases the society’s dependence on smaller businesses. In 2014, MSMEs employed more than 19 percent of the total Kyrgyz population, a significant rise from the 14.8 percent reported in 2010. The MSME contribution to the country’s GDP has been almost constant at around 29 percent since 2010, and the sector accounted for 31.61 percent of total exports in 20112.

Although a number of initiatives have been undertaken to promote MSME development, however, a number of challenges remain, preventing companies in this sector from capitalizing on their full potential. The biggest are inadequate access to finance, corruption and bureaucratic sand traps.

Bank lending to SMEs in the Kyrgyz Republic remained fairly stable at around 10 percent3 between 2010 and 2014. And in the latter year, total SME lending in Kyrgyzstan stood at $148.1 million, while deposits from SMEs totaled $174.2 million4. Over the same period, MFIs advanced loans to more than 500,000 borrowers, with an aggregate value $370.1 million. Nevertheless, the banking sector’s low penetration of the MSME subsector and the small ticket size of MSME loans have restricted bank lending to these small businesses over the years. Banks perceive MSMEs as risky and unattractive, given that MSMEs typically find it difficult to present adequate credit histories, collateral, guarantees, and cash flow projections, all of which are essential for procuring funds from formal financial institutions.

Moreover, although 80 percent5 of Kyrgyz MSMEs are interested in borrowing under the aegis of Islamic principles, most refrain from approaching any banks (conventional or Islamic) to help with their funding needs because of the reasons cited in Figure 2 below.

1. Brief Statistical Handbook 2011-2013: National Statistical Committee of the Kyrgyz Republic, 2014 2. Private Sector Assessment Update - The Kyrgyz Republic: Asian Development Bank, 2013 3. Primary research 4. Primary research and National Bank of the Kyrgyz Republic 5. Primary research

9 The absence of specific regulatory provisions for Islamic finance documentation). As well most under-report or simply do not in the Kyrgyz Republic has likewise restricted growth in the report revenue to regulating bodies. Furthermore, operations 01. sector. Although Islamic banking was introduced in 2006, the of these MSMEs generally lack transparency and have laws governing the sector as a whole remain underdeveloped. The virtually no internal controls. Executive Summary banking laws which established EcoIslamicBank are silent as to As a result, they are unable to secure financing since banks separate Islamic banking regulations. As a result, EcoIslamicBank insist on verifying a business’ financial health through had to include operational governance provisions for Shariah registration, title documents and tax reporting. Banks tend to compliance in its Articles of Association6. Given the fact that just one bank offers Shariah-compliant products in the Kyrgyz Republic avoid lending to such businesses because the risk of default despite the strong preference for Islamic finance by a large segment of the business clientele While the general perception of the nascent Islamic banking on such loans is very high. This drives such enterprises to there, this study aims to determine the number of businesses (particularly MSMEs) that do industry is positive, the high cost of credit and limited knowledge of depend on informal channels such as moneylenders, friends, not borrow from financial institutions due to this preference, and simply because of limited Islamic banking products are the major factors contributing to weak and family to meet their financing needs. availability; this would seem to underscore an unmet need. How many of these enterprises MSME access to Islamic finance - Accessibility issues hinder expansion: The country’s prefer Islamic banking, but opt for conventional banks due to the limited availability of Almost 86 percent of the Kyrgyz population is Muslim. mountainous terrain also amounts to a major hurdle for adequate Islamic banking products? What is the potential for Islamic finance in the country Furthermore, about 80 percent7 of MSMEs have expressed banks as it restricts their efforts to expand beyond large once Islamic banking regulations are strengthened? This study objectively qualifies and a desire to acquire the financial assistance they need under accessible cities. Adding to the obstacles, poor financial quantifies such aspects. Islamic principles. Statistically, the demand for Islamic finance infrastructure prohibits the country’s commercial banks is estimated at 5–6 percent of the total banking industry. from effectively utilizing technology to implement mobile Considering this untapped potential, many conventional banks or branchless banking services. As a consequence, banks are in the country, such as Kyrgyzkommertsbank, Rosinbank and unable to service the majority of MSMEs operating outside Bai Tushum Bank had expressed interest in setting up Islamic the major urban centers. operations as of April 2015. The importance of MSMEs in the Kyrgyz Republic grew Moreover, although 80 percent5 of Kyrgyz MSMEs are interested - The limited capacities of Kyrgyz banks: Due to low financial significantly after the dissolution of the Soviet Union, primarily in borrowing under the aegis of Islamic principles, most refrain High collateral requirements and borrowing costs: The average literacy, MSMEs in Kyrgyzstan lack the necessary knowledge because MSMEs generated considerable numbers of employment from approaching any banks (conventional or Islamic) to help lending rate charged by banks is about 22.4 percent, whereas and information regarding financial products and solutions, opportunities for the local population. As well, though, with their funding needs because of the reasons cited in Figure 1 that offered by microfinance organizations is 38.5 percent8. especially in terms of Shariah-compliant products. Also, MSMEs can be characterized as the major drivers of economic below. Furthermore, according to the results of the 2013 World Bank the banking sector has not increased its investment in development. The country’s mountainous terrain limits industrial Enterprise Survey, 89 percent of those MSMEs that received marketing activities and consumer education to address growth. This, in turn, increases the society’s dependence on Figure 1: Reasons cited by MSMEs for avoiding loans in the Kyrgyz Republic had to provide collateral averaging the issue. For instance, investment in marketing activities 9 smaller businesses. In 2014, MSMEs employed more thanFigure 19 2 : Reasons citedformal by MSMEs loans for avoiding formal loans 187 percent of their loan’s value. MSMEs are even more credit- by EcoIslamicBank, the only Islamic bank operating in the percent of the total Kyrgyz population, a significant rise from the constrained as their average collateral requirement is usually country, is very low. This directly translates into its slow pace 10 14.8 percent reported in 2010. The MSME contribution to the 0% 10% 20% 30% 40% 50% around 1.5 times that of large corporates . Also, the terms of customer acquisition. country’s GDP has been almost constant at around 29 percent associated with collateral requirements are rigid and strictly These banks also do not have an adequate number of skilled since 2010, and the sector accounted for 31.61 percent of total High interest rates 36% enforced. employees or the technological resources required to either exports in 20112. Already have loans 28% Additionally, Islamic leasing attracts double taxation, increasing scale-up operations or improve operational efficiency. Although a number of initiatives have been undertaken to the applicant’s borrowing costs. This acts to hinder the No requirement of loan Limitations on the availability of shariah-compliant products also promote MSME development, however, a number of challenges 21% development of new Islamic banking products. Most MSMEs do restricts the generation of MSME business by Islamic financial remain, preventing companies in this sector from capitalizing on not have the capacity to incur such high costs and thus refrain Religious beliefs 9% institutions their full potential. The biggest are inadequate access to finance, from all banking (conventional as well as Islamic). corruption and bureaucratic sand traps. Collateral issues 9% Shariah-compliant products offered by Islamic financial Nearly a tenth of Kyrgyz MSMEs prefer not to deal with institutions are largely restricted to working capital and trade Bank lending to SMEs in the Kyrgyz Republic remained fairly Dissatisfaction with loan terms and procedures 4% conventional banks because they believe that paying interest financing based on Mudarabah and Murabaha principles. stable at around 10 percent3 between 2010 and 2014. And in on loans is fundamentally at odds with their values: Although However, other financing products based on more complex the latter year, total SME lending in Kyrgyzstan stood at $148.1 many of these MSMEs are creditworthy, they are excluded from Source: Primary Research structures are not available, once again due to the lack of million, while deposits from SMEs totaled $174.2 million4. Over Source: Primary Research being able to access funds from Islamic financial institutions knowledge and expertise in structuring such products. the same period, MFIs advanced loans to more than 500,000 because Shariah-compliant products are either not available or Around 95 percentAround of Kyrgyz 95 MSMEs percent have of to Kyrgyz rely on MSMEsinformal lenders have to to relyaccess on needed informal financial backing (20-25 percent of Consequently, MSMEs must either approach conventional borrowers, with an aggregate value $370.1 million. Nevertheless, not properly understood by the owners of these businesses; and these enterprises havelenders only partialto access access needed to formal financial financial backing channels; (20-25 the remaining percent 70-75 of these percent have no access to these financial institutions to access a wider range of financing options the banking sector’s low penetration of the MSME subsector and either way they involve lengthy processes. Executing Islamic resources at all) Andenterprises a mere 5 percent have only of Kyrgyz partial MSMEs access have to formal adequate financial access to commercialchannels; banks and other financial or rely on informal channels to meet their financing needs. the small ticket size of MSME loans have restricted bankinstitutions lending6. the remaining 70-75 percent have no access to these resources at transactions tends to be cumbersome. to these small businesses over the years. Banks perceive MSMEs The growth in demand for Islamic finance in the MSME sector all). And a mere 5 percent of Kyrgyz MSMEs have adequate access Banking institutions in the country face obstacles in servicing as risky and unattractive, given that MSMEs typically findThere it are no separate laws for Islamic finance in the country at present could result in a funding opportunity of $342.2–456.3 million over to commercial banks and other financial institutions. MSMEs difficult to present adequate credit histories, collateral, guarantees, the next few years and cash flow projections, all of which are essential forThe procuring government hasThere made are efforts no separate to strengthen laws thefor regulatoryIslamic financeenvironment in the by countryway of amendments at that laid down key- Their informal way of conducting business: A significant Currently, 70-75 percent of the MSMEs operating in the Kyrgyz funds from formal financial institutions. principles of Islamicpresent Banking in 2009 and 2013. Detailed instructions and regulations relating to Islamic finance, credit number of MSMEs operate informally (which is to say Republic do not have any access to finance from formal financial institutions and transactions are provided in the normative and legal acts of the NBKR (30 normative and legal acts). As of without registering the business and lacking proper today, the normative and legal acts of NBKR stipulate requirements on licensing, corporate governance, risk management, institutions. And of the remainder, another 20-25 percent are model agreements standardization and Procedure for specific types of transactions, which comply with the Islamic principles of financing. To implement the pilot project on introduction of Islamic banking and finance principles, a separate package in 1 Brief Statistical Handbook 2011-2013: National Statistical Committeenormative of the Kyrgyz and legal Republic, acts, including 2014 taxation issues, has been developed since 2006 for EcoIslamicBank CJSC. 6 Primary research 2 Private Sector Assessment Update - The Kyrgyz Republic: Asian Development Bank, 2013 7 Primary research 3 Primary research While the general perception of the nascent Islamic banking industry is positive, the high cost of credit and limited 8 Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 4 Primary research and National Bank of the Kyrgyz Republic knowledge of Islamic banking products are the major factors contributing to weak MSME access to Islamic finance 9 The Kyrgyz Republic Strategic Assessment of the Economy: Promoting Inclusive Growth: Asian Development Bank, 2014 5 Primary research 10 Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 Almost 86 percent of the Kyrgyz population is Muslim. Furthermore, about 80 percent7 of MSMEs have expressed a 8 Executive Summary desire to acquire the financial assistance they need under Islamic principles. Statistically, the demand for Islamic finance Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 9 is estimated at 5–6 percent of the total banking industry. Considering this untapped potential, many conventional banks in the country, such as Kyrgyzkommertsbank), RosinBank and Bai-Tushum Bank had expressed interest in setting up Islamic operations as of April 2015. However, high borrowing cost and collateral requirements are restricting development of the sector. The average lending rate charged by banks is about 22.4 percent, whereas that offered by microfinance organizations is 38.5 percent8. Furthermore, according to the results of the 2013 World Bank Enterprise Survey, 89 percent of those MSMEs that received loans in the Kyrgyz Republic had to provide collateral averaging 187 percent9 of their loan’s value. MSMEs are even more credit-constrained as their average collateral requirement is usually around 1.5 times that of large corporates10. Also, the terms associated with collateral requirements are rigid and strictly enforced.

6. Primary research 7. Primary research 8. Asian Development Bank: Private Sector Assessment Update – Kyrgyz Republic 2013 9. The Kyrgyz Republic Strategic Assessment of the Economy: Promoting Inclusive Growth: Asian Development Bank, 2014 10. Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013

10 Additionally, Islamic leasing attracts double taxation, increasing the applicant’s borrowing costs. This acts to hinder the development of new Islamic banking products. Most MSMEs do not have the capacity to incur such high costs and thus refrain from all banking (conventional as well as Islamic).

Nearly a tenth of Kyrgyz MSMEs prefer not to deal with conventional banks because they believe that paying interest on loans is fundamentally at odds with their values:

Although many of these MSMEs are creditworthy, they are excluded from being able to access funds from Islamic financial institutions because Shariah-compliant products are either not available or not properly understood by the owners of these businesses; and either way they involve lengthy processes. Executing Islamic transactions tends to be cumbersome. The recommendations regarding Islamic finance products to be introduced in the Kyrgyz Republic is available on page 45 of the report.

Applying for Shariah-compliant products as compared to conventional banking products can be a lengthy process due to the documentation; the amount of agreements and the sequence of signing these documents often prolong the overall approval and process time as compared to a Conventional bank’s process.

Banking institutions in the country face obstacles in servicing MSMEs

Their informal way of conducting business: A significant number of MSMEs operate informally (which is to say without registering the business and lacking proper documentation). As well most under-report or simply do not report revenue to regulating bodies. Furthermore, operations of these MSMEs generally lack transparency and have virtually no internal controls.

As a result, they are unable to secure financing since banks insist on verifying a business’ financial health through registration, title documents and tax reporting. Banks tend to avoid lending to such businesses because the risk of default on such loans is very high. This drives such enterprises to depend on informal channels such as moneylenders, friends, and family to meet their financing needs. It is recommended that MSMEs follow formal business practices by reporting accurate revenue information to regulatory authorities. This would allow for more transparency.

Accessibility issues hinder expansion: The country’s mountainous terrain also amounts to a major hurdle for banks as it restricts their efforts to expand beyond large accessible cities. Adding to the obstacles, poor financial infrastructure prohibits the country’s commercial banks from effectively utilizing technology to implement mobile or branchless banking services. As a consequence, banks are unable to service the majority of MSMEs operating outside the major urban centers.

The limited capacities of Kyrgyz banks: Due to low financial literacy, MSMEs in Kyrgyzstan lack the necessary knowledge and information regarding financial products and solutions, especially in terms of Shariah-compliant products. Also, the banking sector has not increased its investment in marketing activities and consumer education to address the issue. For instance, investment in marketing activities by EcoIslamicBank, the only Islamic bank operating in the country, is very low. This directly translates into its slow pace of customer acquisition.

These banks also do not have an adequate number of skilled employees or the technological resources required to either scale-up operations or improve operational efficiency.

Limitations on the availability of shariah-compliant products also restricts the generation of MSME business by Islamic financial institutions

Shariah-compliant products offered by Islamic financial institutions are largely restricted to working capital and trade financing based on Mudarabah and Murabaha principles. However, other financing products based on more complex Shariah structures such as Istisna'a, Ijara, Diminishing Musharaka are not available. For instance, Supply Chain Financing (SCF) is a short-term credit facility that optimizes working capital by allowing businesses to lengthen payment terms to their suppliers. It facilitates business expansion and mitigates payment risk benefiting international and local trade.

11 Non-availability of complex products is due to lack of knowledge and expertise in structuring such products. Consequently, MSMEs must either approach conventional financial institutions to access a wider range of financing options or rely on informal channels to meet their financing needs.

The growth in demand for Islamic finance in the MSME sector could result in a funding opportunity of $342.2–456.3 million over the next few years

Currently, 70-75 percent of the MSMEs operating in the Kyrgyz Republic do not have any access to finance from formal financial institutions. And of onlythe remainder, able to partially another meet their20-25 financing percent arerequirements only able fromto partially meetStrategic their operational financing adjustments requirements can help both conventional from formal financial institutions.formal Islamicfinancial financial institutions. institutions If Islamic financialcould penetrate institutions around were 60%-80%and Islamic of the banks financially to target MSMEsun-served more effectively to focus on generating business from these financially un-served 02. Regulatory and legislative framework: There is a pressing need and underserved MSMEs (whichand underserved represents MSMEs,95% of theythe totalcould MSMEs), potentially whichattract acould funding translate into a funding opportunity in to develop a Sharia Governance Regulatory Framework (SGRF), opportunity in the range of $309.6 to $412.9 million over the next Overview of Business and the MSME sector in the Kyrgyz Republic the range of $309.6–412.9 million in the next few years. and thereby create guidelines to oversee legislative regulatory few years. bodies, Islamic banks and thos financial institutions that Additionally, if Islamic financialAdditionally, institutions if Islamic were financial also able institutions to diversify were their also productable to portfoliowould and likecustomize to establish these Islamic offerings windows within their existing to suit the requirements of thosediversify medium-sized their product enterprises portfolio and now customize banking these only offerings with conventionalconventional financial banking institutions, operations. the Commercial establishments, particularly MSMEs, are an important driver of the Kyrgyz to suit the requirements of those medium-sized enterprises now Republic’s economy. They also play an important role in its development. In the years Human capital and talent development: There is a shortage of funding potential inherent in thesebanking well-served only with conventional enterprises financial could amount institutions, to between the funding $30.1 and $41.1 million in the short- to following the country’s independence in 1991, MSMEs supported the economy while the quality talent in the Kyrgyz Islamic finance industry. Banks mid-term. potential inherent in these well-served enterprises could amount number of industrial enterprises dwindled. must, therefore, focus on developing the right talent, offering to between $30.1 and $41.1 million in the short- to mid-term. developmental opportunities, providing adequate training, and The development of the MSME sector is supported by the government’s regulatory reforms Figure 3: Islamic finance potentialFigure – ‘new-to-bank 2: Islamic finance ’ potential – ‘new-to-bank’ on retaining their human capital. and various other initiatives. However, challenges such as inadequate access to finance are hampering its growth. Reducing loan-processing times: The time taken by banks to process and disburse loans (from 2 weeks to 1.5 months MSME on average) in the Kyrgyz Republic is a major hurdle that UNIVERSE MICRO, SMALL & MEDIUM ENTERPRISES inhibits quick access to finance for MSMEs. Streamlining the administrative process using predictive tools and back-end support would ensure that the loan application procedure is less cumbersome. Definitions Once regarded as peripheral to the national UNSERVED UNDERSERVED WELL SERVED Effective targeting and evaluation of MSMEs: Rather than Like most other countries, the Kyrgyz Republic does not have a standard definition by economy, MSMEs have become a key fac- % % % resorting to a one-size-fits-all model, banks must adopt a Current Market 70-75 20-25 5 which it classifies micro, small, and medium enterprises (MSMEs). Even though the tor in Kyrgyz economic development Scenario differentiated customized process for MSMEs. Branch staff ~329,737 ~11,750 797 criteria used in defining these enterprises are similar (for example, metrics detailing need to proactively approach and engage MSME entrepreneurs Blackburn and Schape in ‘The Growth of Export- Avg. Loan rather than relying on them to approach the banks. Moreover, the numbers of employees and turnover), various government bodies and ministries 1,500 1,500 3,000 oriented Small and Medium Amount (USD) banks need to develop a more MSME-specific risk assessment have different definitions. For the purposes of this study, we have considered the Enterprises in Afghanistan, Kyrgyzstan and Tajikistan legislative interpretation provided by the National Statistical Office (NSO). Bear Case model in assessing the credibility of MSMEs, adding non- 60% 60% 60% Penetration financial approaches such as behavioral scoring. Table 1: Defining MSMEs in the Kyrgyz Republic Bull Case 80% 80% 80% Increased focus on extended services: To help MSMEs Penetration overcome the challenges they face (for instance, a lack of Nature of Business Number of Employees Monthly Turnover Bearish Market $223.3mn $69.3mn $30.8mn adequate knowledge of financial products, and inefficient Scenario financial management), banks should consider providing $293mn $31mn Production sector up to 15 up to KGS 150,000 New to bank Conversion increased assistance in the form of extended services. For Micro Enterprises instance, MSME toolkits, helping them to frame their business Total Funding Potential: $323.5mn Services sector up to 7 up to KGS 230,000 plans, and providing guidance on legal issues would help Production sector up to 50 up to KGS 500,000 Bullish Market $297.8mn $92.4mn $41.1mn MSMEs to function more effectively, and at the same time Scenario Small Enterprises improve their creditworthiness. Services sector up to 15 up to KGS 500,000 $390.2mn $41.1mn New to bank Conversion Expanding branch networks and offering non-loan products Production sector 51 to 200 up to KGS 2 million Total Funding Potential: $431.3mn and services: Branch penetration in the Kyrgyz Republic is Medium Enterprises relatively low, meaning smaller towns and rural areas often do Services sector 16 to 50 up to KGS 2 million Islamic banks could potentially generate deposits of $402.6–536.9 not have bank branches in their immediate vicinities. Moreover, Islamic banks could potentially generate deposits of $402.6–536.9 million from the MSME sector Source: Statistical Yearbook of the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2013 million from the MSME sector there is a shortage of quality talent in the Kyrgyz Islamic finance industry. By addressing these issues, banks would Assuming the average loan-to-depositAssuming theratio average in the loan-to-deposit Kyrgyz banking ratio sector in the Kyrgyzremains banking around the 85 percent mark over the next Most of the industrial facilities in the country had major clients in realize a significant part of the untapped potential cited above. Structure of Kyrgyz other Soviet republics, especially Russia. few years, the deposit potentialsector for remains Islamic around banks the within 85 percent the MSMEmark over sector the next in fewthe country wouldIn addition, fall betweenbanks should $402.6 also expandand their non-borrowing years, the deposit potential for Islamic banks within the MSME banking services and products, such as current and savings commercial establishments With the disappearance of the Soviet Union, however, MSMEs $536.9 million. sector in the country would fall between $402.6 and $536.9 accounts, cash management services and other fee-based started to play a major economic role in the Kyrgyz Republic by million. transaction banking services. The MSME sector now accounts for approximately 99 percent of generating employment opportunities for the local population Figure 3: Depository potential commercial establishments in the country; and microenterprises and upholding the country’s economy. In 2014, around 11,500 dominate the MSME sector registered small and medium entities, approximately 350,000 11 12 Figure 4: Depository Potential individual entrepreneurs , and 2,427 large corporations The fall of the Soviet Union in 1991 had a severe impact on large operated in the Kyrgyz Republic. Of all enterprises in the country, industries in the Kyrgyz Republic. Most filed for bankruptcy and 12 97.8 percent are privately owned; another 2.2 percent are state- were forced to either shut down or drastically reduce the scale of owned13. their operations. This was largely due to the fact that the country’s economy and that of the Soviet Union were closely interlinked.

11 National Statistical Office Kyrgyzstan 12 Extrapolated from statistics provided by Sector Assessment (Summary) - Private Sector and Finance: Asian Development Bank, 2010 13 National Statistical Office Kyrgyzstan 10 Executive Summary Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 11 only able to partially meet their financing requirements from Strategic operational adjustments can help both conventional formal financial institutions. If Islamic financial institutions were and Islamic banks to target MSMEs more effectively to focus on generating business from these financially un-served 02. Regulatory and legislative framework: There is a pressing need and underserved MSMEs, they could potentially attract a funding to develop a Sharia Governance Regulatory Framework (SGRF), opportunity in the range of $309.6 to $412.9 million over the next Overview of Business and the MSME sector in the Kyrgyz Republic and thereby create guidelines to oversee legislative regulatory few years. bodies, Islamic banks and thos financial institutions that Additionally, if Islamic financial institutions were also able to would like to establish Islamic windows within their existing diversify their product portfolio and customize these offerings conventional banking operations. Commercial establishments, particularly MSMEs, are an important driver of the Kyrgyz to suit the requirements of those medium-sized enterprises now Republic’s economy. They also play an important role in its development. In the years Human capital and talent development: There is a shortage of banking only with conventional financial institutions, the funding following the country’s independence in 1991, MSMEs supported the economy while the quality talent in the Kyrgyz Islamic finance industry. Banks potential inherent in these well-served enterprises could amount number of industrial enterprises dwindled. must, therefore, focus on developing the right talent, offering to between $30.1 and $41.1 million in the short- to mid-term. developmental opportunities, providing adequate training, and The development of the MSME sector is supported by the government’s regulatory reforms Figure 2: Islamic finance potential – ‘new-to-bank’ on retaining their human capital. and various other initiatives. However, challenges such as inadequate access to finance are hampering its growth. Reducing loan-processing times: The time taken by banks to process and disburse loans (from 2 weeks to 1.5 months MSME on average) in the Kyrgyz Republic is a major hurdle that UNIVERSE MICRO, SMALL & MEDIUM ENTERPRISES inhibits quick access to finance for MSMEs. Streamlining the administrative process using predictive tools and back-end support would ensure that the loan application procedure is less cumbersome. Definitions Once regarded as peripheral to the national UNSERVED UNDERSERVED WELL SERVED Effective targeting and evaluation of MSMEs: Rather than Like most other countries, the Kyrgyz Republic does not have a standard definition by economy, MSMEs have become a key fac- % % % resorting to a one-size-fits-all model, banks must adopt a Current Market 70-75 20-25 5 which it classifies micro, small, and medium enterprises (MSMEs). Even though the tor in Kyrgyz economic development Scenario differentiated customized process for MSMEs. Branch staff ~329,737 ~11,750 797 criteria used in defining these enterprises are similar (for example, metrics detailing need to proactively approach and engage MSME entrepreneurs Blackburn and Schape in ‘The Growth of Export- Avg. Loan rather than relying on them to approach the banks. Moreover, the numbers of employees and turnover), various government bodies and ministries 1,500 1,500 3,000 oriented Small and Medium Amount (USD) banks need to develop a more MSME-specific risk assessment have different definitions. For the purposes of this study, we have considered the Enterprises in Afghanistan, Kyrgyzstan and Tajikistan legislative interpretation provided by the National Statistical Office (NSO). Bear Case model in assessing the credibility of MSMEs, adding non- 60% 60% 60% Penetration financial approaches such as behavioral scoring. Table 1: Defining MSMEs in the Kyrgyz Republic Bull Case 80% 80% 80% Increased focus on extended services: To help MSMEs Penetration overcome the challenges they face (for instance, a lack of Nature of Business Number of Employees Monthly Turnover Bearish Market $223.3mn $69.3mn $30.8mn adequate knowledge of financial products, and inefficient Scenario financial management), banks should consider providing $293mn $31mn Production sector up to 15 up to KGS 150,000 New to bank Conversion increased assistance in the form of extended services. For Micro Enterprises instance, MSME toolkits, helping them to frame their business Total Funding Potential: $323.5mn Services sector up to 7 up to KGS 230,000 plans, and providing guidance on legal issues would help Production sector up to 50 up to KGS 500,000 Bullish Market $297.8mn $92.4mn $41.1mn MSMEs to function more effectively, and at the same time Scenario Small Enterprises improve their creditworthiness. Services sector up to 15 up to KGS 500,000 $390.2mn $41.1mn New to bank Conversion Expanding branch networks and offering non-loan products Production sector 51 to 200 up to KGS 2 million Total Funding Potential: $431.3mn and services: Branch penetration in the Kyrgyz Republic is Medium Enterprises relatively low, meaning smaller towns and rural areas often do Services sector 16 to 50 up to KGS 2 million Islamic banks could potentially generate deposits of $402.6–536.9 not have bank branches in their immediate vicinities. Moreover, Source: Statistical Yearbook of the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2013 million from the MSME sector there is a shortage of quality talent in the Kyrgyz Islamic finance industry. By addressing these issues, banks would Assuming the average loan-to-deposit ratio in the Kyrgyz banking Most of the industrial facilities in the country had major clients in realize a significant part of the untapped potential cited above. Structure of Kyrgyz other Soviet republics, especially Russia. sector remains around the 85 percent mark over the next few In addition, banks should also expand their non-borrowing years, the deposit potential for Islamic banks within the MSME banking services and products, such as current and savings commercial establishments With the disappearance of the Soviet Union, however, MSMEs sector in the country would fall between $402.6 and $536.9 accounts, cash management services and other fee-based started to play a major economic role in the Kyrgyz Republic by million. transaction banking services. The MSME sector now accounts for approximately 99 percent of generating employment opportunities for the local population Figure 3: Depository potential commercial establishments in the country; and microenterprises and upholding the country’s economy. In 2014, around 11,500 dominate the MSME sector registered small and medium entities, approximately 350,000 individual entrepreneurs11, and 2,42712 large corporations The fall of the Soviet Union in 1991 had a severe impact on large operated in the Kyrgyz Republic. Of all enterprises in the country, industries in the Kyrgyz Republic. Most filed for bankruptcy and 97.8 percent are privately owned; another 2.2 percent are state- were forced to either shut down or drastically reduce the scale of owned13. their operations. This was largely due to the fact that the country’s economy and that of the Soviet Union were closely interlinked.

11 National Statistical Office Kyrgyzstan 12 Extrapolated from statistics provided by Sector Assessment (Summary) - Private Sector and Finance: Asian Development Bank, 2010 13 National Statistical Office Kyrgyzstan Strategic operational10 adjustmentsExecutive can Summary help both conventional and Islamic banks to target MSMEs more effectively Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 11 Regulatory and legislative framework: The Kyrgyz banking laws were amended in 2009 and 2013 through the creation of the normative and legal acts of the NBKR which discuss: licensing, corporate governance, risk management, model agreements standardization and procedures for specific types of transactions, which comply with Islamic finance principles.

These principles discuss the creation of a Shariah Council within Islamic banks and those that would like to establish Islamic windows in their existing conventional bank operations. The Shariah Council is responsible for conformity of transactions (contracts) of the bank with the Islamic principles of banking and financing.

However, the Shariah Governance Regulatory Framework (SGRF) in the Kyrgyz Republic remains under development due to the amendment being silent on the governance of such committees. In large Islamic finance markets such as Pakistan and Malaysia, banking regulators have set up Shariah Advisory Councils at the Central Bank level for effective monitoring and governance of Shariah councils at individual banks. These advisory councils are positioned as apex bodies to interpret Shariah principles and ascertain adherence to these principles by Islamic banks in the country. From a practitioners’ perspective, developed Islamic Economies follow a best practice approach where governing parties create a working partnership with banks. Due to the lack of Robust Islamic banks in Kyrgyzstan, this partnership is still in an early stage of development.

Thus, it is recommended that the SGRF sets out specific Shariah governance policies to regulate and monitor Islamic financial institutions in the Kyrgyz Republic. It should provide a comprehensive guidance to the governing bodies, Shariah committees and bank management in discharging duties in matters related to offering Islamic banking products. The SGRF should define policy formulation and directives in addition to the guidelines for compliance of policies required by the Central bank. The deadlines for each Islamic financial institution to comply with the framework should also be elaborated in the SGRF.

The Kyrgyz Republic, being a relatively new entrant into the Islamic Finance Market, can look to more developed Islamic Banking Economies in order to formalize an eco system that promotes Islamic finance in the country.

Human capital and talent development: There is a shortage of quality talent in the Kyrgyz Islamic finance industry. Banks must, therefore, focus on developing the right talent, offering developmental opportunities, providing adequate training, and on retaining their human capital.

Reducing loan-processing times: The time taken by banks to process and disburse loans (from 2 weeks to 1.5 months on average) in the Kyrgyz Republic is a major hurdle that inhibits quick access to finance for MSMEs. Streamlining the administrative process using predictive tools and back-end support would ensure that the loan application procedure is less cumbersome.

Effective targeting and evaluation of MSMEs: Rather than resorting to a one-size-fits-all model, banks must adopt a

13 differentiated customized process for MSMEs. Branch staff need to proactively approach and engage MSME entrepreneurs rather than relying on them to approach the banks. Moreover, banks need to develop a more MSME-specific risk assessment model in assessing the credibility of MSMEs, adding non-financial approaches such as behavioral scoring.

Increased focus on extended services: To help MSMEs overcome the challenges they face (for instance, a lack of adequate knowledge of financial products, and inefficient financial management), banks should consider providing increased assistance in the form of extended services. For instance, MSME toolkits, helping them to frame their business plans, and providing guidance on legal issues would help MSMEs to function more effectively, and at the same time improve their creditworthiness.

Expanding branch networks and offering non-loan products and services: Branch penetration in the Kyrgyz Republic is relatively low, meaning smaller towns and rural areas often do not have bank branches in their immediate vicinities. Moreover, there is a shortage of quality talent in the Kyrgyz Islamic finance industry. By addressing these issues, banks would realize a significant part of the untapped potential cited above. In addition, banks should also expand their non- borrowing banking services and products, such as current and savings accounts, cash management services and other fee- based transaction banking services.

14 02. Overview of Business and MSME sector in Kyrgyz Republic

Commercial establishments, particularly MSMEs, are an important driver of the Kyrgyz Republic’s economy. They also play an important role in its development. In the years following the country’s independence in 1991, MSMEs supported the economy while the number of industrial enterprises dwindled.

The development of the MSME sector is supported by the government’s regulatory reforms and various other initiatives. However, challenges such as inadequate access to finance are hampering its growth.

Definitions Like most other countries, the Kyrgyz Republic does not have a standard definition by which it classifies micro, small, and medium enterprises (MSMEs). Even though the criteria used in defining these enterprises are similar (for example, metrics detailing the numbers of employees and turnover), various government bodies and ministries have different definitions. For the purposes of this study, we have considered the legislative interpretation provided by the National Statistical Office (NSO).

Table 1: Defining MSMEs in the Kyrgyz Republic

Nature of Business Number of Employees Monthly Turnover Micro Enterprises Production Sector up to 15 up to KGS 150,000 Services Sector up to 7 up to KGS 230,000 Small Enterprises Production Sector up to 50 up to KGS 500,000 Services Sector up to 15 up to KGS 500,000 Medium Enterprises Production Sector 51 to 200 up to KGS 2 million Services Sector 16 to 50 up to KGS 2 million

Source: Statistical Yearbook of the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2013

Structure of Kyrgyz’s commercial establishments The MSME sector now accounts for approximately 99 percent of commercial establishments in the country; and microenterprises dominate the MSME sector

The fall of the Soviet Union in 1991 had a severe impact on large industries in the Kyrgyz Republic. Most filed for bankruptcy and were forced to either shut down or drastically reduce the scale of their operations. This was largely due to the fact that the country’s economy and that of the Soviet Union were closely interlinked. Most of the industrial facilities in the country had major clients in other Soviet republics, especially Russia.

15 With the disappearance of the Soviet Union, however, MSMEs started to play a major economic role in the Kyrgyz Republic by generating employment opportunities for the local population and upholding the country’s economy. In 2014, around 11,500 registered small and medium entities, approximately 350,000 individual entrepreneurs11, and 2,42712 large corporations operated in the Kyrgyz Republic. Of all enterprises in the country, 97.8 percent are privately owned; another 2.2 percent are state-owned13. Despite their collective significance, most MSMEs continue Although most (65 percent14) of the Kyrgyz workforce was Figure 6: SME classification by economic activitySource: Despite totheir operate collective on a small significance, scale. This is mostlargely MSMEs due to thecontinue business to operateengaged on a small in peasant scale. farming This is inlargely 2014, MSMEsdue to the employed business more than SME distribution by environmentenvironment in the country,in the country, which which has become has become harsher, harsher, mostly mostly because 19 of percent the cost of theand country’s administrative total population, burden nowup from needed 14.8 percent 15 economic activity to complybecause with ofthe the standards cost and administrativeas entities grow. burden now needed to in 2010 . The contribution of MSMEs to GDP has been almost comply with the standards as entities grow. constant, amounting to about 29 percent since 201016. Moreover, 17 21 the sector contributed 31.6 percent of total exports in 2011 . Classifed by economic activity, an estimated 26.1 percent of Figure 5:Figure Classification 4: Classification of commercial of commercial establishments in the Kyrgyz Republic (2014) Kyrgyz SMEs, excluding individual entrepreneurs, are engaged establishments in the Kyrgyz Republic (2014) in trading activities. That began in earnest after the Soviet years. The MSME share of Kyrgyzstan’s total GDP and employment Growth in this area has been robust, mainly due to the absence of might be much higher, though. Many operate informally and are manufacturing giants. unregistered. They do this to avoid compliance with regulations and their related costs, particularly taxes, and social contributions for workers. According to the Ministry of Economic Development, Unsurprisingly, this market has leaned heavily toward less costly 96.2% as of 2009, almost 100 billion Kyrgyz som ($2.1 billion) were in consumer products, such as apparel, mainly imported from 350,700 circulation in the country’s shadow (informal) market. Even more China. Clothing and footwear products dominate the Kyrgyz remarkably, almost 70 percent of the total employed population in retail trade, accounting for 26 percent22 of the total trade turnover 2011 worked in the informal sector18. of non-food items. This is informed by the fact that most of the Kyrgyz population falls into the low-income category. Other 0.2% 2.9% major product categories include cosmetics, furniture, jewelry, Annual publication pertaining to small and medium businesses in the The percentage of the MSME share of the national economy does Kyrgyz Republic: National Statistical Committee of the Kyrgyz Repub- 754 Commercial 10,709 19 and consumer electronics. lic, 2014 establishments not include the contribution of peasant farms , as most of them in 2014 are likewise unregistered. In 2013, there were around 383,000 20 peasant farms«Once. regarded as peripheral to The most popular distribution channel for consumer goods in the MSME distribution by Kyrgyz Republic is the bazaar, which makes up 70 percent23 of the the national economy, MSMEs 0.7% Figure 5: MSME share of the national retail space. Other major distribution avenues include shopping geography 2,427 economy (2014)have become a key factor in Kyrgyz malls, grocery stores, and street kiosks. As well, more than 40 24 economic development,» percent of the society’s retail trade is concentrated in the capital 26 city of Bishkek, where the number of shopping malls and grocery Over 65 percent of Kirgyz Republic SMEs are located in Blackburn and Schape in ‘The Growth of stores is noticeably on the rise. Bishkek, mirroring the country’s economic distribution. Despite Export-oriented Small and Medium Enterprises a myriad of political and social disruptions, Bishkek is decidedly in Afghanistan, Kyrgyzstan and Tajikistan’ the country’s economic center and its most dynamic and rapidly- Real estate and related services (24.1 percent)21, including all Source: Annual publication on Small and Medium Businesses in the developing city. It boasts four main bazaars: Bishkek-Dordoi, real estate brokerage and agency transactions), accounts for the Source: AnnualKyrgyz Republic: publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Osh, Orto-Sai, and Alamedin. The geographic location is made second largest SME category. These services are primarily driven more desirable by the country’s connection to Siberia via the Republic,National 2014 Statistical Committee of the Kyrgyz Republic, 2014 by the increased demand for residential property, hotels, retail Turk–Sib railway line; other attractions include its developed centers, and warehouses, particularly in Bishkek and the tourist infrastructure and ready availability of skilled human resources. Contribution of MSMEs center Issyk-Kul. These factors have made the Bishkek environment fertile ground Contribution of MSMEs to the Kyrgyz economy for growth. Moreover, modernization development initiatives proposed by the government are concentrated in Bishkek, which to the Kyrgyz economy Manufacturing and processing (14.0 percent), mainly led by the Over the years, the MSME sector has been the major driver of economic growth in the Kyrgyz Republic adds further luster to its appeal. sewing industry, is the third largest economic activity by volume Over the years, the MSME sector has been the major driver of Source: Brief Statistical Handbook 2011-2013: National in which SMEs are engaged. Construction and related fields Statistical Committee of the Kyrgyz Republic, 2014 MSMEseconomic are considered growth inthe the major Kyrgyz drivers Republic of Kyrgyz economic development, as the country’s mountainous terrain limits (10.3 percent) and transport and communication (9.2 percent) Other places in the country with a sizable SME population industrial growth, rendering its economic well-being dependent on smaller businesses. form the fourth- and fifth- largest SME sectors in the country include Chui Province (11.0 percent) and Osh city (6.2 percent)27. respectively25. The remaining country’s remaining SME roster is spread across MSMEs are considered the major drivers of Kyrgyz economic 14 various provinces with no distinct concentration pattern. Althoughdevelopment, most (65 percent as the country’s) of the mountainous Kyrgyz workforce terrain limits was engaged in peasant farming in 2014, MSMEs employed more than 19 industrialpercent of growth, the country’s rendering total its economicpopulation, well-being up from dependent 14.8 percent in 201015. TThe contribution of MSMEs to GDP has been almoston smaller constant, businesses. amounting to about 29 percent since 201016. Moreover, the sector contributed 31.6 percent of total Interestingly, micro enterprises are mainly concentrated in Osh exports in 201117. city (19.4 percent), followed by Bishkek (12.0 percent), and Issyk- Kul (11.9 percent)28. 11. National Statistical Office Kyrgyzstan 12. Extrapolated from statistics provided by Sector Assessment (Summary) - Private Sector and Finance: Asian Development Bank, 2010 13. National Statistical Office Kyrgyzstan 14. Country14 Country profile profile– Kyrgyzstan: – Kyrgyzstan: New Agriculturist,New Agriculturist, September, September, 2010 2010 21 Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 15. Brief Statistical15 Brief Statistical Handbook Handbook 2011-2013: 2011-2013: National National Statistical Statistical Committee Committee of of the the Kyrgyz Kyrgyz Republic,Republic, 2014 2014 22 Consumer Goods Market in Kyrgyzstan: BISNIS, 2008 16. Brief Statistical16 Brief Statistical Handbook Handbook 2011-2013: 2011-2013: National National Statistical Statistical Committee Committee of of the the Kyrgyz Kyrgyz Republic,Republic, 2014 2014 23 Consumer Goods Market in Kyrgyzstan: BISNIS, 2008 17. Private17 SectorPrivate AssessmentSector Assessment Update Update - The - TheKyrgyz Kyrgyz Republic: Republic: Asian Asian Development Development Bank, Bank, 20132013 24 Consumer Goods Market in Kyrgyzstan: BISNIS, 2008 18 Private Sector Assessment Update - The Kyrgyz Republic: Asian Development Bank, 2013 25 Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 16 19 An independent entity that produces agricultural goods on a plot of land owned or rented by members of the peasant farm 26 Annual publication -- Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 20 Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 27 Annual publication -- Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 28 Annual publication -- Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014

12 Overview of Business and the MSME sector in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 13 Despite their collective significance, most MSMEs continue Although most (65 percent14) of the Kyrgyz workforce was Figure 6: SME classification by economic activitySource: to operate on a small scale. This is largely due to the business engaged in peasant farming in 2014, MSMEs employed more than SME distribution by environment in the country, which has become harsher, mostly 19 percent of the country’s total population, up from 14.8 percent because of the cost and administrative burden now needed to in 201015. The contribution of MSMEs to GDP has been almost economic activity comply with the standards as entities grow. constant, amounting to about 29 percent since 201016. Moreover, 17 21 the sector contributed 31.6 percent of total exports in 2011 . Classifed by economic activity, an estimated 26.1 percent of Figure 4: Classification of commercial Kyrgyz SMEs, excluding individual entrepreneurs, are engaged establishments in the Kyrgyz Republic (2014) in trading activities. That began in earnest after the Soviet years. The MSME share of Kyrgyzstan’s total GDP and employment Growth in this area has been robust, mainly due to the absence of might be much higher, though. Many operate informally and are manufacturing giants. unregistered. They do this to avoid compliance with regulations and their related costs, particularly taxes, and social contributions for workers. According to the Ministry of Economic Development, Unsurprisingly, this market has leaned heavily toward less costly 96.2% The MSME share of Kyrgyzstan’sas of 2009, total almost GDP 100 and billion employment Kyrgyz som might ($2.1 bebillion) much were higher, in though. Many operateconsumer informally products, such as apparel, mainly imported from 350,700 China. Clothing and footwear products dominate the Kyrgyz and are unregistered. They circulationdo this to inavoid the country’s compliance shadow with (informal) regulations market. and Even their more related costs, particularly taxes, and remarkably, almost 70 percent of the total employed population in retail trade, accounting for 26 percent22 of the total trade turnover social contributions for workers.2011 Accordingworked in the to informal the Ministry sector of18. Economy, as of 2009, almost 100 billion Kyrgyzof non-food som items. ($2.1 This is informed by the fact that most of the billion) were in circulation in the country’s shadow (informal) market. Even more remarkably, almost 70 percentKyrgyz populationof the total falls into the low-income category. Other Annual publication pertaining to small and medium businesses in the 0.2% 2.9% 18 major product categories include cosmetics, furniture, jewelry, employed population in 2011The worked percentage in the ofinformal the MSME sector share . of the national economy does Kyrgyz Republic: National Statistical Committee of the Kyrgyz Repub- 754 Commercial 10,709 19 and consumer electronics. lic, 2014 establishments not include the contribution of peasant farms , as most of them 19 in 2014 The percentage of the MSMEare share likewise of the unregistered. national economy In 2013, there does were not includearound 383,000the contribution of peasant farms , as most of 20 peasant farms . 20 The most popular distribution channel for consumer goods in the them are likewise unregistered. In 2013, there were around 383,000 peasant farms . 23 MSME distribution by Kyrgyz Republic is the bazaar, which makes up 70 percent of the 0.7% retail space. Other major distribution avenues include shopping Figure 6: MSME share of the nationalFigure 5:economy MSME share(2014) of the national geography 2,427 economy (2014) malls, grocery stores, and street kiosks. As well, more than 40 24 percent of the society’s retail trade is concentrated in the capital 26 city of Bishkek, where the number of shopping malls and grocery Over 65 percent of Kirgyz Republic SMEs are located in stores is noticeably on the rise. Bishkek, mirroring the country’s economic distribution. Despite a myriad of political and social disruptions, Bishkek is decidedly the country’s economic center and its most dynamic and rapidly- Real estate and related services (24.1 percent)21, including all Source: Annual publication on Small and Medium Businesses in the developing city. It boasts four main bazaars: Bishkek-Dordoi, Kyrgyz Republic: real estate brokerage and agency transactions), accounts for the Osh, Orto-Sai, and Alamedin. The geographic location is made National Statistical Committee of the Kyrgyz Republic, 2014 second largest SME category. These services are primarily driven more desirable by the country’s connection to Siberia via the by the increased demand for residential property, hotels, retail Turk–Sib railway line; other attractions include its developed centers, and warehouses, particularly in Bishkek and the tourist infrastructure and ready availability of skilled human resources. Contribution of MSMEs center Issyk-Kul. These factors have made the Bishkek environment fertile ground for growth. Moreover, modernization development initiatives proposed by the government are concentrated in Bishkek, which to the Kyrgyz economy Manufacturing and processing (14.0 percent), mainly led by the adds further luster to its appeal. sewing industry, is the third largest economic activity by volume Over the years, the MSME sector has beenSource: the Briefmajor Statistical driver of HandbookSource: 2011-2013: Brief Statistical National Handbook Statistical 2011-2013: Committee National of the Kyrgyz Republic, 2014 in which SMEs are engaged. Construction and related fields Statistical Committee of the Kyrgyz Republic, 2014 economic growth in the Kyrgyz Republic (10.3 percent) and transport and communication (9.2 percent) Other places in the country with a sizable SME population form the fourth- and fifth- largest SME sectors in the country include Chui Province (11.0 percent) and Osh city (6.2 percent)27. 25 SME distribution by economic activity respectively . The remaining country’s remaining SME roster is spread across MSMEs are considered the major drivers of Kyrgyz economic various provinces with no distinct concentration pattern. development, as the country’s mountainous terrain limits 21 industrial growth, rendering its economicClassifed well-being by dependent economic activity, an estimated 26.1 percent of Kyrgyz SMEs, excluding individual entrepreneurs, are on smaller businesses. engaged in trading activities. That began in earnest after the Soviet years. Growth in this area has been robust, mainly due Interestingly, micro enterprises are mainly concentrated in Osh to the absence of manufacturing giants. city (19.4 percent), followed by Bishkek (12.0 percent), and Issyk- Kul (11.9 percent)28. Unsurprisingly, this market has leaned heavily toward less costly consumer products, such as apparel, mainly imported from China. Clothing and footwear products dominate the Kyrgyz retail trade, accounting for 26 percent22 of the total

14 Country profile – Kyrgyzstan: New Agriculturist,trade September, turnover 2010 of non-food items. This is informed by the fact that most of the Kyrgyz population falls into21 theAnnual low-income publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 15 Brief Statistical Handbook 2011-2013: Nationalcategory. Statistical CommitteeOther major of the productKyrgyz Republic, categories 2014 include cosmetics, furniture, jewelry, and consumer electronics.22 Consumer Goods Market in Kyrgyzstan: BISNIS, 2008 16 Brief Statistical Handbook 2011-2013: National Statistical Committee of the Kyrgyz Republic, 2014 23 Consumer Goods Market in Kyrgyzstan: BISNIS, 2008 17 Private Sector Assessment Update - The Kyrgyz Republic: Asian Development Bank, 2013 24 Consumer Goods23 Market in Kyrgyzstan: BISNIS, 2008 18 Private Sector Assessment Update - The KyrgyzThe Republic: most popularAsian Development distribution Bank, channel2013 for consumer goods in the Kyrgyz Republic is the bazaar, which makes25 up Annual 70 percent publication of on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 19 An independent entity that produces agriculturalthe retailgoods onspace. a plot ofOther land owned major or distribution rented by members avenues of the peasantinclude farm shopping malls, grocery stores, and street kiosks. As well,26 Annual more publication than 40 -- Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 20 Annual publication on Small and Medium Businessespercent in24 theof theKyrgyz society’s Republic: retail National trade Statistical is concentrated Committee of thein theKyrgyz capital Republic, city 2014 of Bishkek, where the number of shopping27 malls Annual and publication grocery -- Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 28 Annual publication -- Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 stores is noticeably on the rise.

Real estate and related services (24.1 percent)21, including all real estate brokerage and agency transactions), accounts for the 12 Overview of Business and the MSMEsecond sector largest in the SME Kyrgyz category. republic These services are primarily driven by the increased demand for residential property, hotels, retail Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 13 centers, and warehouses, particularly in Bishkek and the tourist center Issyk-Kul.

18. Private Sector Assessment Update - The Kyrgyz Republic: Asian Development Bank, 2013 19. An independent entity that produces agricultural goods at land plot owned or rented by members of the peasant farm 20. Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 21. Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 22. Consumer Goods Market in Kyrgyzstan: BISNIS, 2008 23. Consumer Goods Market in Kyrgyzstan: BISNIS, 2008 24. Consumer Goods Market in Kyrgyzstan: BISNIS, 2008

17 Manufacturing and processing (14.0 percent), mainly led by the sewing industry, is the third largest economic activity by volume in which SMEs are engaged. Construction and related fields (10.3 percent) and transport and communication (9.2 percent) form the fourth- and fifth- largest SME sectors in the country respectively25.

Despite their collective significance, most MSMEs continue Although most (65 percent14) of the Kyrgyz workforce was Figure 6: SME classification by economic activitySource: to operate on a small scale. This is largely due to the business engaged in peasant farming in 2014, MSMEs employed more than SME distribution by environment in the country, which has become harsher, mostly 19 percent of the country’s total population, up from 14.8 percent Figure 7: SME classification by economic activity 15 economic activity because of the cost and administrative burden now needed to in 2010 . The contribution of MSMEs to GDP has been almost comply with the standards as entities grow. constant, amounting to about 29 percent since 201016. Moreover, 17 21 the sector contributed 31.6 percent of total exports in 2011 . Classifed by economic activity, an estimated 26.1 percent of Figure 4: Classification of commercial Kyrgyz SMEs, excluding individual entrepreneurs, are engaged establishments in the Kyrgyz Republic (2014) in trading activities. That began in earnest after the Soviet years. The MSME share of Kyrgyzstan’s total GDP and employment Growth in this area has been robust, mainly due to the absence of might be much higher, though. Many operate informally and are manufacturing giants. unregistered. They do this to avoid compliance with regulations and their related costs, particularly taxes, and social contributions for workers. According to the Ministry of Economic Development, Unsurprisingly, this market has leaned heavily toward less costly 96.2% as of 2009, almost 100 billion Kyrgyz som ($2.1 billion) were in consumer products, such as apparel, mainly imported from 350,700 circulation in the country’s shadow (informal) market. Even more China. Clothing and footwear products dominate the Kyrgyz remarkably, almost 70 percent of the total employed population in retail trade, accounting for 26 percent22 of the total trade turnover 2011 worked in the informal sector18. of non-food items. This is informed by the fact that most of the Kyrgyz population falls into the low-income category. Other 0.2% 2.9% major product categories include cosmetics, furniture, jewelry, Annual publication pertaining to small and medium businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Repub- The percentage of the MSME share of the national economy does and consumer electronics. 754 Commercial 10,709 not include the contribution of peasant farms19, as most of them lic, 2014 establishments Source: Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz in 2014 are likewise unregistered. In 2013, there were around 383,000 Republic, 2014 peasant farms20. The most popular distribution channel for consumer goods in the 23 MSME distribution by Kyrgyz Republic is the bazaar, which makes up 70 percent of the 0.7% Figure 5: MSME share of the national retail space. Other major distribution avenues include shopping geography 2,427 economy (2014) malls, grocery stores, and street kiosks. As well,MSME more distributionthan 40 by geography 24 percent of the society’s retail trade is concentrated in the capital26 26 city of Bishkek, where the number of shoppingOver malls 65 percentand grocery of KyrgyzOver Republic 65 percent SMEs of Kirgyz are located Republic in Bishkek,SMEs are mirroringlocated in the country’s economic distribution. Despite stores is noticeably on the rise. a myriad of political andBishkek, social mirroringdisruptions, the country’sBishkek iseconomic decidedly distribution. the country’s Despite economic center and its most dynamic and rapidly- developinga city. myriad It boasts of political four andmain social bazaars: disruptions, Bishkek-Dordoi, Bishkek is decidedlyOsh, Orto-Sai, and Alamedin. The geographic the country’s economic center and its most dynamic and rapidly- Real estate and related services (24.1 percent)location21, including is made all more desirable by the country’s connection to Siberia via the Turk–Sib railway line; other attractions Source: Annual publication on Small and Medium Businesses in the developing city. It boasts four main bazaars: Bishkek-Dordoi, Kyrgyz Republic: real estate brokerage and agency transactions),include accounts its developed for the infrastructureOsh, Orto-Sai, and and ready Alamedin. availability The ofgeographic skilled human location resources. is made These factors have made the Bishkek National Statistical Committee of the Kyrgyz Republic, 2014 second largest SME category. These servicesenvironment are primarily fertiledriven groundmore for desirable growth. by Moreover, the country’s modernization connection to development Siberia via the initiatives proposed by the government are by the increased demand for residential property,concentrated hotels, retail in Bishkek, Turk–Sib which adds railway further line; luster other toattractions its appeal. include its developed centers, and warehouses, particularly in Bishkek and the tourist infrastructure and ready availability of skilled human resources. center Issyk-Kul. Contribution of MSMEs These factors have made the Bishkek environment fertile ground 27 Other places in the countryfor withgrowth. a sizable Moreover, SME modernization population include development Chui Province initiatives (11.0 percent) and Osh city (6.2 percent) . The remaining country’sproposed remaining by SMEthe government roster is spread are concentrated across various in Bishkek, provinces which with no distinct concentration pattern. to the Kyrgyz economy Manufacturing and processing (14.0 percent), mainly led by the adds further luster to its appeal. sewing industry, is the third largest economic activity by volume Interestingly, micro enterprises are mainly concentrated in Osh city (19.4 percent), followed by Bishkek (12.0 percent), and Over the years, the MSME sector has been the major driver of Source: Brief Statistical Handbook 2011-2013: National in which SMEs are engaged. Construction and related fields Statistical Committee of the Kyrgyz Republic, 2014 28 economic growth in the Kyrgyz Republic (10.3 percent) and transport and communicationIssyk-Kul (9.2 percent) (11.9 percent) Other. places in the country with a sizable SME population form the fourth- and fifth- largest SME sectors in the country include Chui Province (11.0 percent) and Osh city (6.2 percent)27. respectively25. The remaining country’s remaining SME roster is spread across MSMEs are considered the major drivers of Kyrgyz economic various provinces with no distinct concentration pattern. development, as the country’s mountainous terrain limits industrial growth, rendering its economic well-being dependent on smaller businesses. Interestingly, micro enterprises are mainly concentrated in Osh city (19.4 percent), followed by Bishkek (12.0 percent), and Issyk- Kul (11.9 percent)28.

25. Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 14 Country profile – Kyrgyzstan: New Agriculturist, September, 2010 21 Annual publication on Small and Medium Businesses26. in Annualthe Kyrgyz publication Republic: onNational Small Statisticaland Medium Committee Businesses of the in Kyrgyz the Kyrgyz Republic, Republic: 2014 National Statistical Committee of the Kyrgyz Republic, 2014 15 Brief Statistical Handbook 2011-2013: National Statistical Committee of the Kyrgyz Republic, 2014 22 Consumer Goods Market in Kyrgyzstan: BISNIS, 200827. Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 16 Brief Statistical Handbook 2011-2013: National Statistical Committee of the Kyrgyz Republic, 2014 23 Consumer Goods Market in Kyrgyzstan: BISNIS, 200828. Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 17 Private Sector Assessment Update - The Kyrgyz Republic: Asian Development Bank, 2013 24 Consumer Goods Market in Kyrgyzstan: BISNIS, 2008 18 Private Sector Assessment Update - The Kyrgyz Republic: Asian Development Bank, 2013 25 Annual publication on Small and Medium Businesses18 in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 19 An independent entity that produces agricultural goods on a plot of land owned or rented by members of the peasant farm 26 Annual publication -- Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 20 Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 27 Annual publication -- Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 28 Annual publication -- Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014

12 Overview of Business and the MSME sector in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 13 Figure 8: Geographic concentration of MSMEs in the Kyrgyz Republic Figure 7: Geographic concentration of MSMEs in the Kyrgyz Republic As of 2015, the Kyrgyz Republic had received funding commitments Specifically, IFC has significantly contributed to the of more than $123 million from IFC since becoming a member development of sustainable micro-finance facilities in the in 1993. As of June 30, 2015, IFC’s Kyrgyz portfolio was valued at Kyrgyz Republic by assisting in setting up FINCA Kyrgyzstan, some $27.4 million, with the bulk of that investment deployed in the the largest microfinance institution in the country, and Bai- financial and real sectors30. Tushum in 1995 and 2000 respectively.

Figure 8: Recent IFC investments in the Kyrgyz Republic Through its advisory services aimed at bettering the investment climate, IFC helps identify and remove regulatory barriers to the entry and operations of private businesses.

Figure 9: Significant advisory services provided by IFC in the Kyrgyz Republic:

2012-present

Central Asia Tax Project / WBG Trade&Competitiveness GPG Helps reduce tax compliance costs for businesses and promote tax transparency and financial disclosure

2009-present

Financial Markets Infrastructure Project / WBG Finance&Markets GPG Aims to expand secure access to finance by improving financial infrastructure and regulatory environment for credit bureaus and developing a Risk Certification Program

Source: Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 2009-present Source: Annual publication on Small and Medium Businesses in theThe Kyrgyz Kyrgyz government Republic: also National adopted a moreStatistical business- andCommittee of the Kyrgyz Investment Climate Project / WBG Trade&Competitiveness GPG Enablers of business growth investment-friendly tax regime (effective January 2009). Under Helps the government establish transparent and effective Republic, 2014 this code, a unified sales tax replaced several previous taxes while regulations to create a favorable business environment The Kyrgyz government has introduced several regulatory reforms many others were either reduced or abolished. For instance, the to bolster the country’s business environment and encourage value-added tax (VAT) was reduced to 12 percent from 29 growth, particularly in the MSME space 20 percent . The new code also improved provisions related to 2006-present collection of duties, introduced automation and e-filing, and Enablers of business growth established the presumption of innocence regarding taxpayers. Corporate Governance Project The Kyrgyz Republic joined the World Trade Organization As a result, the IFC-World Bank Doing Business Report ranked Helps local companies and banks strengthen corporate (WTO) in 1998, and remains the only member among the group the Kirgyz Republic the third- and second-best reformer status governance practices to improve operations and increase The Kyrgyz governmentof Central Asian has countries. introduced In accordance several with the terms regulatory of that reforms to bolster the country’s business environment and globally in 2009 and 2010 respectively. ability to attract investment and financing agreement, the Kyrgyz government has funded several special encourage growth,initiatives particularly and programs in to spurthe growth MSME among space private businesses. These include supporting infrastructure (business incubators and IFC has consistently extended its development support for the technology parks), launching consultation and training centers, Kyrgyz private sector through various investment and advisory The Kyrgyz Republicand introducing joined special the taxWorld regimes, Trade as well as Organization providing financial (WTO) support initiativesin 1998, and remains the only member among theSource: group IFC website Source: IFC website support through loans and grants. In 1999, The Kyrgyz Republic of Central Asianamended countries. its constitution In accordance to allow the private with ownership the termsof land, of that agreement, the Kyrgyz government has funded severalTo improve financial education standards and ensure better access The IFC’s main priority in the Kyrgyz Republic is to support to funds, IFC has focused on MSMEs in the country, and especially Through its investment and advisory special initiatives(by and passing programs a new Land Code).to spur The growth main impetus among in making private this businesses. These include supporting infrastructure (business support to local banks, IFC aims to move was support for small businesses. the development and diversification of the private sector. The those in rural areas. The organization has done this by encouraging overriding goal in this is increasing the country’s competitiveness microfinance organizations to reach out to a larger number of expand the array of financial services incubators and technology parks), launching consultation andand training employment centers, opportunities. and IFC introducing aims to improve special corporate tax regimes, asMSMEs. well It has also collaborated with major lenders such as the offered to business owners and entre- as providing financialIn 2009, establishing support new through businesses loanswas made and easier grants.by In businesses1999, Thepractices Kyrgyz the better Republicto be able to forgeamended a favorable its constitution toKyrgyz allow Investment and Credit Bank (KICB) and Kompanion preneurs eliminating the minimum capital requirement, reducing business environment for private businesses, and especially to Financial Group. These collaborations aim to improve financial — Edward Strawderman, IFC’s Associate the private ownershipregistration of time land, frames, (by and passing eliminating a certain new post-registration Land Code) provideThe main MSMEs impetus with increased in access making to the financethis move they need. was support foraccess small by expanding the portfolio of financial products available Director for Financial Markets in Europe and fees and the requirement that applicants open a bank account to MSMEs, including savings plans, money transfers, and cash Central Asia businesses. before registration. management services.

In 2009, establishing new businesses was made easier by eliminating the minimum capital requirement, reducing registration time frames, and29 Asianeliminating Development Bank: certain Private Sector post-registration Assessment Update – The Kyrgyz fees Republic and 2013 the requirement that applicants open a bank account 30before IFC website registration. 14 Overview of Business and the MSME sector in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 15

The Kyrgyz government also adopted a more business- and investment-friendly tax regime (effective January 2009). Under this code, a unified sales tax replaced several previous taxes while many others were either reduced or abolished. For instance, the value-added tax (VAT) was reduced to 12 percent from 20 percent29. The new code also improved provisions related to collection of duties, introduced automation and e-filing, and established the presumption of innocence regarding taxpayers. As a result, the IFC-World Bank Doing Business Report ranked the Kirgyz Republic the third- and second-best reformer status globally in 2009 and 2010 respectively.

IFC has consistently extended its development support for the Kyrgyz private sector through various investment and advisory support initiatives

29. Asian Development Bank: Private Sector Assessment Update – The Kyrgyz Republic 2013

19 IFC’s main priority in the Kyrgyz Republic is to support the development and diversification of the private sector. The overriding goal in this is increasing the country’s competitiveness and employment opportunities. IFC aims to improve corporate businesses practices the better to be able to forge a favorable business environment for private businesses, and especially to provide MSMEs with increased access to the finance they need.

As of June 30, 2015, IFC’s Kyrgyz portfolio was valued at some $27.4 million, with the bulk of that investment deployed in the financial sectorand real sectors30.

Figure 9: Recent IFC investments in the Kyrgyz Republic

2014 • IFC granted a $4 mn loan to Bank Bai Tushum to expand the bank's SME portfolio, including gender finance component, and provided cross currency swaps

2013 • IFC extended a $12 mn financing package (a $10 million loan and a $2mn credit line under its Global Trade Finance Program) to Kyrgyz Investment & Credit Bank for expanding the bank's SME portfolio and trade finance business

• IFC provided currency swap to Kompanion Financial Group for hedging its currency risk and a $6 mn loan to expand its SMB lending facilities

2012 • IFC extended a loan of $2 mn to Demir Kyrgyz International Bank for supporting the bank's trade finance

2011 • IFC extanded a loan of $2 mn to Demir Kyrgyz International Bank for supporting the bank's trade finance

2009 • IFC extended a loan of $5 mn to Magic Box, Kyrgyzstan's largest producer of cardboard packages, to assist in expansion

Source: IFC website

Figure 10: IFC Advisory Services in the Kyrgyz Republic:

Year of Operation Project Description 2014-present Agri Finance Project Improves access to finance and market for farmers through improved capacity of farmers, supply chain aggregators and financial intermediaries. Donor partner is the Austrian Ministry of Finance.Implements by WBG Finance and Markets Global Practice Group. 2012-present Central Asia Tax Project Helps government reduce tax compliance costs for businesses, and promote tax transparency and financial disclosure. Donor partners are the governments of Switzerland and UK. Implements by WBG Trade and Competitiveness Global Practice Group. 2012-present Housing Microfinance Helps improve housing conditions for low-income Kyrgyz households by introducing an Advisory Services Project innovative housing microfinance lending product to local financial institutions, enabling them to provide funding for home improvements to low-income residents. Donor partner is the government of Switzerland.Implements by WBG Finance and Markets Global Practice Group. 2009 – present Financial Markets Aims to expand secure access to finance for individual consumers and MSMEs by improving Infrastructure Project the financial infrastructure of and regulatory environment for credit bureaus and by developing a Risk Certification Program. Donor partner is the government of Switzerland. Implements by WBG Finance and Markets Global Practice Group.

30. IFC website

20 2009 – present Investment Climate Project Helps the government establish transparent and effective business regulations and create a favorable environment for entrepreneurs. Donor partners are the governments of Switzerland and UK. Implements by WBG Trade and Competitiveness Global Practice Group. 2008 – present Micro and Responsable Provides advisory services to microfinance institutions in Azerbaijan and Central Asia to Finance Project support their transformation processes. Donor partner is the government of Switzerland. Implements by WBG Finance and Markets Global Practice Group. 2006 – present Corporate Governance Project Helps local companies and banks strengthen their corporate governance practices with a view to improving their operations and increasing ability to attract investment and financing. Donor partners are the governments of Switzerland and UK.

Source: IFC website

To improve financial education standards and ensure better access to funds, IFC has focused on MSMEs in the country, and especially those in rural areas. The organization has done this by encouraging microfinance organizations to reach out to a larger number of MSMEs. It has also collaborated with major lenders such as the Kyrgyz Investment and Credit Bank (KICB) and Kompanion Financial Group (KFG). These collaborations aim to improve financial access by expanding the portfolio of financial products available to MSMEs, including savings plans, money transfers, and cash management services. «Through its investment and advisory Specifically, IFC has significantly contributed to the development of sustainable support to local banks, IFC aims to micro-finance facilities in the Kyrgyz Republic by assisting in setting up FINCA expand the array of financial services Kyrgyzstan, the largest microfinance institution in the country, and Bai-Tushum offered to business owners and in 1995 and 2000 respectively. entrepreneurs,» Edward Strawderman, IFC’s Associate Director Through its advisory services aimed at bettering the investment climate, IFC for Financial Markets in Europe and Central helps identify and remove regulatory barriers to the entry and operations of Asia private businesses.

Key concerns for businesses Political instability ranked as the biggest hurdle for businesses

The Kyrgyz Republic has experienced significant political tension since independence. Its first two post-Soviet presidents were ousted in the wake of popular discontent in 2005 and 2010. The Kyrgyz Republic had a political instability index31 of 7.1 in 2009–10, and according to the Economist Intelligence Unit,, a rank of 3 in 2013; both underscored its high political risk32.

Businesses, especially MSMEs, have been severely affected by this political tension. Among other uncertainties, they have produced a demand slump. This has been particularly true in the trade segment, plus the real estate and tourism sectors, which together account for the majority of MSMEs. A high crime rate and inventory carrying costs during periods of political instability have also had a negative effect on competitiveness. And taken together, these things have generally dissuaded entrepreneurs from expanding their businesses.

Limited access to finance has constrained the development of businesses, especially micro and small enterprises, in the Kyrgyz Republic

31. The Political Instability Index shows the level of threat to a particular country’s government due to social protest. The index scores were derived by The Economist by combining measures of economic distress and underlying vulnerability to unrest 32. The Economist – Intelligence Unit

21 Kyrgyz MSMEs find it difficult to procure finance for medium- and long-term investment. This limits their expansion. The high collateral requirement (which on an average was pegged at 187 percent in 2013, but in fact has gone as high as 237 percent), plus, the lending rates charged by commercial banks (~22.4% on average) has put a decided damper on private entrepreneurs approaching banks in aid of securing credit. Instead, they prefer informal sources of funds, such as traditional moneylenders, regardless of the interest rates such lenders demand, which can be as high as 2 percent per month.

Rampant corruption and nepotism are additional and serious barriers to growth for private businesses

The Kyrgyz Republic hasHigh consistently tax rates, unstable scored poorlyeconomic on growth,the Transparency and weak International Corruption Perception Index. The Key concerns for businesses infrastructure add up to impaired businesses country ranked 136th among 174 countries in 201433. The rampant corruption, which penetrates all levels of03. the bureaucracy, Other major hurdles to private sector growth include high Political instability ranked as the biggest hurdleand for nepotism businesses have combinedtaxation to rates create and athe harsh administrative business environment.burden involved This in payingdiscourages entrepreneurs from expanding The Kyrgyz Republic has experienced significantoperations, political and tension thus severelytaxes. impedesThe Kyrgyz growth. Republic has witnessed several bouts of The Current Status of Islamic Banking in the Kyrgyz republic since independence. Its first two post-Soviet presidents were macroeconomic instability, as evidenced by fluctuating GDP ousted in the wake of popular discontent in 2005High and tax 2010. rates, The unstable growth economic since growth, independence and weak (from infrastructure a low of -20.1 add in up 1994 to impairedto a high businesses 31 34 Kyrgyz Republic had a political instability index of 7.1 in 2009– of 10.5 in 2013 ). Furthermore, economic growth slowed to 3.6 The Islamic banking industry has a strong positive image, especially among the country’s 10, and according to the Economist IntelligenceOther Unit, major a rank hurdles of 3 to privatepercent sectorin 2014 growth due to includea decline high in production taxation rates at the and Kumtor the administrative gold burden involved in paying 32 MSMEs. Fully 80 percent of them are interested in obtaining Shariah-compliant products to in 2013; both underscored its high political risktaxes.. The Kyrgyz Republicmine has(which witnessed has contributed several boutsan average of macroeconomic of 12 percent to instability, GDP as evidenced by fluctuatingaddress their GDP financing needs. However, the development of Islamic banking in the country each year since 199735). GDP growth is expected to slow to 1.7% in Businesses, especially MSMEs, have been severelygrowth affected since independence by this (from a low of -20.1 in 1994 to a high of 10.5 in 201334). Furthermore, economic growthdepends slowed on increased penetration, as well as the development of a strong regulatory regime political tension. Among other uncertainties, they have produced 2015 before recovering to 2.0% in 201636. a demand slump. This has been particularly totrue 3.6 in percentthe trade in 2014 due to a decline in production at the Kumtor gold mine (which has contributed an average of 12 The country faces35 infrastructure issues such as unreliable access segment, plus the real estate and tourism sectors,percent which to GDPtogether each yearto electricity since 1997 (due).GDP to numerous growth poweris expected cuts) and to slowthe absence to 1.7% of in 2015 before recovering to 2.0% in account for the majority of MSMEs. A high crime2016 36rate. and effective coordination in industrial development. inventory carrying costs during periods of political instability have also had a negative effect on competitiveness.The And country taken together,faces infrastructure Due to the issues factors such mentioned as unreliable above, access the Kyrgyz to electricity Republic (due has to numerous power cuts) and the absence these things have generally dissuaded of effective coordination in industrial development.consistently ranked poorly in World Bank Doing Business Reports. In 2014, the country entrepreneurs from expanding their Finance in the country is expensive ranked 102nd of 189 countries, dropping three businesses. and short-term Due to the factors mentioned above, the Kyrgyzplaces37 Republic from its standing has consistently in 2013. ranked poorly in World Bank Doing Business Limited access to finance has Reports. In 2014, the country ranked 102nd of 189 countries, dropping three places37 from its standing in 2013. constrained the development of Overview of the Kyrgyz banking This strategy was activated to enhance the overall growth of the businesses, especially micro and small enterprises, in the Kyrgyz banking sector by means of restructuring insolvent banks and Figure 11 : Major constraints facing businesses Republic Figure 10 : Major constraints facing businesses strengthening bank credit policies. sector Kyrgyz MSMEs find it difficult to procure finance for medium- and long-term investment. This limits their expansion. The high In 2010, despite facing political turmoil after the overthrow 54% Since independence, the Kyrgyz banking sector has overcome collateral requirement (which on an average was pegged at 187 38% significant challenges, such as the Russian and global financial of the government led by President Kurmanbek Bakiyev, the percent in 2013, but in fact has gone as high as 237 percent), 31% interim government initiated some further decisive measures to 21% 20% 23% 19% 19% crises, domestic political turmoil, and corruption within the plus, the lending rates charged by commercial banks (~22.4% 15% 14% sector. Owing to these events, growth has been sluggish and the improve the operations and internal controls of banks reeling on average) has put a decided damper on private entrepreneurs sector remains underdeveloped. under the influence of widespread corruption and the lack of approaching banks in aid of securing credit. Instead, they prefer corporate governance. Special regimes were introduced, placing informal sources of funds, such as traditional moneylenders, Political Access Corruption High tax rates Macro- the country’s then-largest bank, Asia Universal Bank, and several regardless of the interest rates such lenders demand, which can be instability to loans economic The Kyrgyz banking system has undergone several important smaller banks, under NBKR control. This led to the uncovering instabilities as high as 2 percent per month. stages of development since the National Bank of the Kyrgyz of numerous irregularities and legislative violations by these Individual entrepreneurs SME Rampant corruption and nepotism are additional and serious Republic (NBKR), the country’s central bank, was established banks, such as the distortion of financial statements, to conceal barriers to growth for private businesses after independence in 1991. Over the period from 1991–95, the suspicious transactions. The result, in 2011, was that the central country’s transition into a market economy had a direct impact bank tabled measures to prevent commercial banks from engaging The Kyrgyz Republic has consistently scored poorly on the on the banking sector, and led to the establishment of several in such unhealthy practices. Transparency International Corruption Perception Index. The commercial banks. country ranked 136th among 174 countries in 201433. The rampant Source: IFC Investment Climate Project in the Kyrgyz Republic corruption, which penetrates all levels of the Source:bureaucracy, IFC Investment and Climate Advisory Services Project in Kyrgyzstan In 2012, the newly-elected parliamentary government undertook nepotism have combined to create a harsh business environment. In 1996, the government introduced the Financial Sector several measures once again intended to improve the banking This discourages entrepreneurs from expanding operations, and Adjustment Credit (FINSAC) program, with funding support system. The most significant was the introduction of the Medium- thus severely impedes growth. from the World Bank. This was mandated to reform the Kyrgyz Term Development Program, which primarily focused on: banking system. The program downsized the banking system, 33. Corruption Perceptions Index: Transparency International, 2014 restructured state-owned banks, and implemented several 34. GDP growth (annual %) - The World Bank website administrative reforms aimed at increasing operational efficiency. - Enhancing the sustainability of the banking system, and 35. Kyrgyz Gold-Mine Debate Pits Poor Country Against Its Richest Taxpayer : Radio Free Europe Radio Liberty, June 2015 However, in 1998, the Russian financial crisis adversely affected extending overall accessibility to its financial services; 36. Kyrgyz Republic: Economy - Excerpted from the Asian Development Outlook 2015: Asian Development Bank the Kyrgyz banking sector, largely due to the huge foreign 37. Doing Business 2015: Going Beyond Efficiency - The World Bank Group currency (mainly Russian ruble) loan portfolios of Kyrgyz - Improving this new accessibility through the introduction of 22 commercial banks. various new financial instruments, including Islamic finance instruments;

31 The Political Instability Index shows the level of threat to a particular country’s government due to social protest. Index scores have been calculated by The Economist These measures sparked an initial credit boom. However, the through combining measures of economic distress and underlying vulnerability to unrest Tulip Revolution of 2005 -- which led to the ouster of President - Preparing the Banking Code of the Kyrgyz Republic; and 32 The Economist Intelligence Unit Askar Akayev – bolstered by the global economic crisis of 33 Corruption Perceptions Index: Transparency International, 2014 2008–09, delivered a heavy blow to the country’s banking system. 34 GDP growth (annual %) - The World Bank website To prevent any further crisis development and improve its - Developing a strategy for the privatization of state-owned 35 Kyrgyz Gold-Mine Debate Pits Poor Country Against Its richest taxpayer : Radio Free Europe - Radio Liberty, June 2015 overall health, the NBKR, in cooperation with the government, banks - among them Zalkar Bank, RSK Bank, and Aiyl Bank – 36 The Kyrgyz Republic: Economy - Excerpted from the Asian Development Outlook 2015: Asian Development Bank introduced the Banking System Development Strategy in 2009. to assure their better management. 37 Doing Business 2015: Going Beyond Efficiency - The World Bank Group

16 Overview of Business and the MSME sector in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 17 03. The current Status of Islamic banking in the Kyrgyz Republic

The Islamic banking industry has a strong positive image, especially among the country’s MSMEs. Fully 80 percent of them are interested in obtaining Shariah-compliant products to address their financing needs. However, the development of Islamic banking in the country depends on increased penetration, as well as the development of a strong regulatory regime.

Overview of the Kyrgyz banking sector Since independence, the Kyrgyz banking sector has overcome significant challenges, such as the Russian and global financial crises, domestic political turmoil, and corruption within the sector. Owing to these events, growth has been sluggish and the sector remains underdeveloped.

The Kyrgyz banking system has undergone several important stages of development since the National Bank of the Kyrgyz Republic (NBKR), the country’s central bank, was established after independence in 1991. Over the period from 1991–95, the country’s transition into a market economy had a direct impact on the banking sector, and led to the establishment of several commercial banks.

In 1996, the government introduced the Financial Sector Adjustment Credit (FINSAC) program, with funding support from the World Bank. This was mandated to reform the Kyrgyz banking system. The program downsized the banking system, restructured state-owned banks, and implemented several administrative reforms aimed at increasing operational efficiency. However, in 1998, the Russian financial crisis adversely affected the Kyrgyz banking sector, largely due to the huge foreign currency (mainly Russian ruble) loan portfolios of Kyrgyz commercial banks.

These measures sparked an initial credit boom. However, the Tulip Revolution of 2005 -- which led to the ouster of President Askar Akayev – bolstered by the global economic crisis of 2008–09, delivered a heavy blow to the country’s banking system. To prevent any further crisis development and improve its overall health, the NBKR, in cooperation with the government, introduced the Banking System Development Strategy in 2009. This strategy was activated to enhance the overall growth of the banking sector by means of restructuring insolvent banks and strengthening bank credit policies.

In 2010, despite facing political turmoil after the overthrow of the government led by President Kurmanbek Bakiyev, the interim government initiated some further decisive measures to improve the operations and internal controls of banks reeling under the influence of widespread corruption and the lack of corporate governance. Special regimes were introduced, placing the country’s then-largest bank, Asia Universal Bank, and several smaller banks, under NBKR control. This led to the uncovering of numerous irregularities and legislative violations by these banks, such as the distortion of financial statements, to conceal suspicious transactions. The result, in 2011, was that the central bank tabled measures to prevent commercial banks from engaging in such unhealthy practices.

23 In 2012, the newly-elected parliamentary government undertook several measures once again intended to improve the banking system. The most significant was the introduction of the Medium-Term Development Program, which primarily focused on:

• Enhancing the sustainability of the banking system, and extending overall accessibility to its financial services; • Improving this new accessibility through the introduction of various new financial instruments, including Islamic finance instruments; • Preparing the Banking Code of the Kyrgyz Republic; and • Developing a strategy for the privatization of state-owned banks – among them Zalkar Bank, RSK Bank, and Aiyl Bank – to assure their better management.

The result was improved stability with positive growth among major performance indicators:

• The total assets of the Kyrgyz banking system increased 8.7 percent YoY to $2.5bn in 2014 38. • As well the banking sector’s capital adequacy and liquidityFigure 11: Banking ratios, structure as of of May the Kyrgyz 2014, were reported as Thebeing result above was improved the stability with positive growth among Table 2: Banking penetration in the Kyrgyz republic (2013) Republic (as of June 2015) major performance indicators: minimum regulatory requirements of 12.0 percent and 30.0 percent, respectively39. Bank Branches Region ATMs per 100,000 Adults Figure 11: Banking structure of the Kyrgyz The result was improved stability with positive growth among- The total assets of the Kyrgyz banking system increased 8.7 per 100,000 Adults • Non-performing loans (NPLs) declined to 4.8 percent in May 2014, as compared with 6.7 percent in 2012. Table 2: Banking38 penetration in the Kyrgyz republic (2013) Republic (as of June 2015) 2%major performance indicators: 18% percent YoY to $2.5bn in 2014 . Uzbekistan 39.8 8.2 Bank Branches - As well the banking Regionsector’s capital adequacy and liquidity ATMs per 100,000 Adults The Kyrgyz banking system comprised 24 commercial banks, all licensed- The total and assets supervised of the Kyrgyz bankingby the system NBKR increased 8.7 Azerbaperijan 1 00,000 Adults 10.3 33.5 2% 18% percent YoY to $2.5bn in 201438. ratios, as of May 2014, were reported as being above the minimum regulatoryUz requirementsbekistan of 12.0 percent and 30.0 39.8 8.2 As of end of 2014, 24 commercial banks operated in the Kyrgyz Republic. This included 16 commercial bankspercent, with respectivelyforeign 39. Kyrgyzstan 7.9 21.0 - As well the banking sector’s capital adequacy and liquidity 40 Azerbaijan 10.3 33.5 share capital. Ten of these have foreign shareholdings of more than 50.0ratios, aspercent. of May 2014, were reported as being above the Tajikistan 6.6 10.6 minimum regulatory requirements of 12.0 percent and 30.0- Non-performing loans (NPLs) declined to 4.8 percent in percent, respectively39. May 2014, as comparedKyrgyzstan with 6.7 percent in 2012. Kazakhstan 7.9 21.0 3.3 71.6 The two state-owned banks – Aiyl Bank and RSK Bank – account for 18 percent of the total banking sector by assets. Taken Figure 11: Banking structure of the Kyrgyz The result was improved stability with positive growthTa amongjikistan Source: Financial Access6.6 Survey: International Monetary Fund,10 2013.6 - Non-performing loans (NPLs) declined to 4.8 percent in The Kyrgyz banking system comprises 24 commercialTable banks, 2: allBanking penetration in the Kyrgyz republic (2013) together, these foreign banks accountedRepublic for 35.8% (as of June of 2015) authorized capital of the bankingmajor system. performance indicators:licensed and supervised by the NBKR May 2014, as compared with 6.7 percent in 2012. Kazakhstan 3.3 71.6 Optima Bank is the country’s largest bank,Bank accounting Branches for more state-controlled RSK Bank and privately-owned Kyrgyzstan Figure 12: Banking structure in Kyrgyzstan (2014) - The total assets of the Kyrgyz banking system increased 8.7 Region than 15 percent of all loans and deposits CommercialATMs per Bank. 100,000 Adults The Kyrgyz banking system comprises 24 commercial banks,By all the end of 2014, 24Source: commercial Financial banks Access operate Survey: inInternational the Kyrgyz Monetary Fund, 2013 per 100,000 Adults percent YoY to $2.5bn in 201438. 2% licensed and18% supervised by the NBKR Republic. This included 16 commercial banks with foreign share capital. Ten of these had foreign shareholdings of moreUz thanbe kistan The Kyrgyz banking sector is highly consolidated.39 .8The top five Optima Bank is 8.2the leading Kyrgyz banking institution, 40 Optima Bank is the country’s largest bank, accounting for more state-controlled RSK Bank and privately-owned Kyrgyzstan - As well the banking sector’s50.0 capital percent adequacy. and liquidity banks account for more than half of the total loans and deposits. contributing 17 percent to the sector’s loan portfolio and 18 By the end of 2014, 24 commercial banks operate in the Kyrgyz than 15 percent of all loans and deposits Commercial Bank. ratios, as of May 2014, were reported as being above the Azerbaijan Optima Bank, Demir Kyrgyz International Bank10 (established.3 with percent to its depository33.5 base. The bank also accounts for 15 Republic. This included 16 commercial banks with foreign share minimum regulatory requirementsThe two ofstate-owned 12.0 percent banks and 30.0– Aiyl Bank and RSK Bank – the assistance of IFC in 1996), and Kyrgyz Investment and Credit percent of the total banking assets, plus with 12 percent of total capital. Ten of these had foreign shareholdings of more than 43 percent, respectively39. The Kyrgyz banking sector is highlyKyrgyzstan consolidated. The top Bank,five (allOptima of which Bank are isforeign-owned), the leading Kyrgyz are the banking three7.9 largestinstitution, capital, and 28 percent21.0 of the banking sector’s net profit . 50.0 percent40. account for 18 percent of the total banking sector by assets. Taken together, the foreignbanks banks account account for more for thanapproximately half of the total loans and deposits.banks operatingcontributing in the 17 country. percent Other to the major sector’s players loan portfolioinclude the and 18 56% 24% Optima Bank, Demir Kyrgyz InternationalTajikistan Bank (established with percent to its depository base. The bank6.6 also accounts for 15 10.6 - Non-performing loans (NPLs)35.8 declinedpercent of to total 4.8 percentassets. in The two state-owned banks – Aiyl Bank and RSK Bank – the assistance of IFC in 1996), and Kyrgyz Investment and CreditFigure 12:percent Market of share the total of commercial banking assets, banks plus in with Kyrgyzstan 12 percent (2013) of total May 2014, as compared with 6.7 percent in 2012. 43 account for 18 percent of the total banking sector by assets. Bank, (all of which are foreign-owned),Kazakhstan are the three largest capital, and 28 percent of the banking sector’s3.3 net profit . 71.6 Taken together, the foreign banks account for approximately The last few years havebanks seen operating a significant in the rise country. in the Othernumber major of players include the 56% 24% DKIB AMANBANK branches plus stationary and field cash offices of theSource: various Financial Access Survey: International Monetary Fund,Total 2013Loans Total Deposits 35.8 percent of total assets. The Kyrgyz banking system comprises 24 commercial banks, all Optima Bank commercial banks. ByFigure the end 12: of Market 2014, there share were of commercial 293 branches banks in Kyrgyzstan (2013) Bank of Asia licensedCapital and supervisedBank by the NBKR 41 and nearly 800 commercial bank cash offices nationwide . Kyrgyz Investment and Credit Bank Optima Bank is the country’s largest bank, accounting for more17% state-controlled RSK Bank and privately-owned Kyrgyzstan18 % Halyk BankThe Kyrgyzstan last few years have seen a significantBank «Bai-Tushum» rise in the number of 22% DKIB AMANBANK branches plus stationary and fieldBy the cash end offices of 2014, of 24 the commercial various banks operate in the Kyrgyz Total Loansthan 15 percent of all loans and deposits 33% Total DepositsCommercialAiyl Ban kBank. Rosinbank This noted, however, the concentration of bank branches Optima Bank commercial banks. By the end Republic.of 2014,BTA there This Bank were included 293 branches 16 commercial banks with foreign share Demir Kyrgyz International Bank Bank of Asia Capital Bank 41 remains low with just 7.98 branches per 100,000 adults, 13% 4% Optimaand Bank nearly 800 commercial bankcapital. cash Tenoffices of these nationwide had foreign. shareholdings of more than The Kyrgyz bankingKyrgyz sectorInvestmen ist andhighly Cred itconsolidated. Bank The top five Optima Bank is the leading Kyrgyz banking institution, 40 compared with 39.8 and 10.3 branches in Uzbekistan17 and% Halyk Bank Kyrgyzstan 50.0 Dos-Kredobankpercent . 22% 18% RSK Bank 8% Bank «Bai-Tushum» Azerbaijan, respectively42. Moreover, Kyrgyz bankingbanks facilities account for more than half of the total loans and deposits. contributing 17 percent to the sector’s loan portfolio and 18 KICB 33% Aiyl Bank 9% 6% This noted, however, the concentrationTolubay of bank branches Optima Bank, Demir Kyrgyz International Bank3% (established with percentKy torg yzstits andepository Commercial B base.ank The bank also accounts for 15 Rosinbank are mostly centered in urban areas. 8% 13% BTA Bank Demir Kyrgyz International Bank 9% Nationalremains Bank of low with just 7.98 branchesThe two per state-owned100,000 adults, banks – Aiyl Bank and RSK Bank – the assistance13% of IFC in 1996), and Kyrgyz Investment4% and8% Credit percent of the total banking assets, plus with 12 percent 16of% total Commercial bank Aman Bank 43 Optima Bank compared with 39.8 and 10.3 branches in Uzbekistan and Bank, (all of which are foreign-owned), are the three largest capital, and 28 percent of the banking sector’s net profit . Dos-KredobankPakistan Bishkek Branch account for 18 percent of the total banking sector by assets. RSK Bank 8% Azerbaijan, respectively42. Moreover,TakenKYRGYZSTAN together, Kyrgyz banking the foreign facilities banksAdditionally, account for in approximatelyMarch 2013 the Kyrgyz Investment Creditbanks operatingBank in the country. Other major players include the Others KICB 3% 9% 6% $1.4 billion 56% Tolubay Kyrgyz-Swissare mostly Bank24% centered in urban areas. introduced mobile banking services to the country for the first Kyrgyzstan Commercial Bank 35.8 percentBakai Bankof total assets. 8% 13% National Bank of time. Nevertheless, mobile banking penetration is still9% quite low, 16% Commercial bank Finca Bank 8% Figure 12: MarketAm anshare Bank of commercial banks in Kyrgyzstan (2013) Pakistan Bishkek Branch Kyrgyzkommertsbank especially in rural areas. Source: Annual Reports of Commercial Banks KYRGYZSTAN Additionally, in March 2013 theThe Kyrgyz last fewInvestment years have Credit seen Banka significant rise in the number of Others Kyrgyz-Swiss Bank DKIB introducedAMANBANK mobile banking servicesbranchesFinanceCreditBank to the plus country stationary for the and first field cash offices of the various Total LoansIn 2014, bank loans and deposits$1.4 billion in the Kyrgyz Republic showedTotal Deposits the banking system. However, regulatory reform initiatives by the Bakai Bank This explains why a considerable part of the country’s economy Optima Bank time. Nevertheless, mobile bankingcommercial penetration banks. is Bystill the quite end low, of 2014, there were 293 branches their highest growth in absolute terms since 2010 central bank, particularly after 2011, as well as the introduction Finca Bank Bank of Asia Capital Bank KyrgyzCredit Bank – and most notably in rural41 areas – still relies on the financial especially in rural areas. and nearly 800 commercial bank cash offices nationwideSource:. Annual Reports of Commercial Banks Kyrgyz Investment and Credit Bank Kyrgyzkommertsbank services offered by the informal banking sector, the most 17% of a new development program by the government in 2012, Halyk Bank Kyrgyzstan 22% 18% Bank «Bai-Tushum» common being currency exchange and ex-officio lending. strengthened the sector overall. As a result, banking activity FinanceCreditBank 33% From 2009–11, bankingAiyl Bank activity in the country remained stagnant Source: National Bank of the Kyrgyz RepublicRosinbank This explains why a considerableThis part noted, of the however, country’s the economy concentration of bank branchesIn 2014, bank loans and deposits in the Kyrgyz Republic showed the banking system. However, regulatory reform initiatives byregained the traction, particularly over the 2013–14 period. BTA Bank due to structuralDemir deficiencies Kyrgyz Interna andtiona thel B anlackk of internal controls in KyrgyzCredit Bank – and most notably in rural areasremains – still low relies with on justthe 7.98financial branches per 100,000 adults,their highest growth in absolute terms since 2010 13% central bank, particularly after 2011, as well4% as the introduction Optima Bank services offered by the informalcompared banking withsector, 39.8 the and most 10.3 branches in Uzbekistan and of a new development program by the government in 2012, 38. Annual Report: National Bank of Kyrgyz Republic, 2014 Dos-Kredobank RSK Bank 8% common being currency exchange and ex-officio lending.42 strengthened the sector overall. As a result, banking activity KICB Azerbaijan, respectively . Moreover, Kyrgyz bankingFrom facilities 2009–11, banking activity in the country remained stagnant 6% 39. Kyrgyz Republic Partnership Program Snapshot: The World Bank Group,38 Annual October Report: National2014Tolubay Bank of Kyrgyz Republic, 2014 3% 9% regainedKyrg traction,yzstan Comm particularlyercial Bank over the 2013–14 period. are mostly centered in urban areas. due to structural deficiencies and the lack of internal8% controls in 13% National Bank of 39 Kyrgyz Republic Partnership Program Snapshot: The World Bank Group, October 2014 9% 16% 40. Annual Report: National Bank of Kyrgyz Republic, 2014 Commercial bank 8% Aman Bank Pakistan Bishkek Branch 40 Annual Report: National Bank of Kyrgyz Republic, 2014 24 41 Annual Report: NationalKYRGYZSTAN Bank of Kyrgyz Republic,Additionally, 2014 in March 2013 the Kyrgyz Investment Credit Bank Others Kyrgyz-Swiss Bank 42 Financial Access Survey: International Monetaryintroduced Fund, 2013 mobile banking services to the country for the first 43 Optima Bank website $1.4 billion 38 Annual Report: National Bank of Kyrgyz Republic, 2014 Bakai Bank 39 Kyrgyz Republic Partnership Program Snapshot:Finca The Bank World Bank Group, October 2014 time. Nevertheless, mobile banking penetration is still quite low, 40 Annual Report: National Bank of Kyrgyz Republic, 2014 Kyrgyzkommertsbank especially in rural areas. Source: Annual Reports of Commercial Banks 41 Annual Report: National Bank of Kyrgyz Republic, 2014 18 The Current Status of Islamic Banking in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 19 42 Financial Access Survey: International Monetary Fund, 2013 FinanceCreditBank 43 Optima Bank website This explains why a considerable part of the country’s economy In 2014, bank loans and deposits in the Kyrgyz Republic showed the banking system. However, regulatory reform initiatives by the KyrgyzCredit Bank – and most notably in rural areas – still relies on the financial their highest growth in absolute terms since 2010 central bank, particularly after 2011, as well as the introduction of a new development program by the government in 2012, 18 The Current Status of Islamic Banking in the Kyrgyz republic services offered by the informal banking sector, the most Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 19 common being currency exchange and ex-officio lending. strengthened the sector overall. As a result, banking activity From 2009–11, banking activity in the country remained stagnant regained traction, particularly over the 2013–14 period. due to structural deficiencies and the lack of internal controls in

38 Annual Report: National Bank of Kyrgyz Republic, 2014 39 Kyrgyz Republic Partnership Program Snapshot: The World Bank Group, October 2014 40 Annual Report: National Bank of Kyrgyz Republic, 2014 41 Annual Report: National Bank of Kyrgyz Republic, 2014 42 Financial Access Survey: International Monetary Fund, 2013 43 Optima Bank website

18 The Current Status of Islamic Banking in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 19 The last few years have seen a significant rise in the number of branches plus stationary and field cash offices of the various commercial banks. By the end of 2014, there were 293 branches and nearly 800 commercial bank cash offices nationwide41.

This noted, however, the concentration of bank branches remains low with just 7.98 branches per 100,000 adults, compared with 39.8 and 10.3 branches in Uzbekistan and Azerbaijan, respectively42. Moreover, Kyrgyz banking facilities are mostly centered in urban areas.

Additionally, in March 2013 the Kyrgyz Investment Credit Bank introduced mobile banking services to the country for the first time. Nevertheless, mobile banking penetration is still quite low, especially in rural areas.

This explains why a considerable part of the country’s economy – and most notably in rural areas – still relies on the financial services offered by the informal banking sector, the most common being currency exchange and ex-officio lending.

Table 2: Banking penetration in the Kyrgyz Republic (2013)

Region Bank Branches ATMs per 100,000 Adults per 100,000 Adults Uzbekistan 39.8 8.2 Azerbaijan 10.3 33.5 Kyrgyzstan 7.9 21.0 Tajikistan 6.6 10.6 Kazakhstan 3.3 71.6

Source: Financial Access Survey: International Monetary Fund, 2013

Optima Bank is the country’s largest bank, accounting for more than 15 percent of all loans and deposits

The Kyrgyz banking sector is highly consolidated. The top five banks account for more than half of the total loans and deposits. Optima Bank, Demir Kyrgyz International Bank, and Kyrgyz Investment and Credit Bank, (all of which are foreign-owned), are the three largest banks operating in the country. Other major players include the state-controlled RSK Bank and privately-owned Kyrgyzstan Commercial Bank.

Optima Bank is the leading Kyrgyz banking institution, contributing 17 percent to the sector’s loan portfolio and 18 percent to its depository base. The bank also accounts for 15 percent of the total banking assets, plus with 12 percent of total capital, and 28 percent of the banking sector’s net profit43.

Figure 13: Market share of commercial banks in Kyrgyzstan (2013)

41. Annual Report: National Bank of Kyrgyz Republic, 2013 42. Financial Access Survey: International Monetary Fund, 2013 43. Optima Bank website

25 Figure 11: Banking structure of the Kyrgyz The result was improved stability with positive growth among Table 2: Banking penetration in the Kyrgyz republic (2013) Republic (as of June 2015) major performance indicators: Bank Branches Region ATMs per 100,000 Adults - The total assets of the Kyrgyz banking system increased 8.7 per 100,000 Adults 2% 18% percent YoY to $2.5bn in 201438. Uzbekistan 39.8 8.2 - As well the banking sector’s capital adequacy and liquidity ratios, as of May 2014, were reported as being above the Azerbaijan 10.3 33.5 minimum regulatory requirements of 12.0 percent and 30.0 percent, respectively39. Kyrgyzstan 7.9 21.0 Tajikistan 6.6 10.6 - Non-performing loans (NPLs) declined to 4.8 percent in May 2014, as compared with 6.7 percent in 2012. Kazakhstan 3.3 71.6

The Kyrgyz banking system comprises 24 commercial banks, all Source: Financial Access Survey: International Monetary Fund, 2013 licensed and supervised by the NBKR Optima Bank is the country’s largest bank, accounting for more state-controlled RSK Bank and privately-owned Kyrgyzstan By the end of 2014, 24 commercial banks operate in the Kyrgyz than 15 percent of all loans and deposits Commercial Bank. Republic. This included 16 commercial banks with foreign share capital. Ten of these had foreign shareholdings of more than The Kyrgyz banking sector is highly consolidated. The top five Optima Bank is the leading Kyrgyz banking institution, 40 50.0 percent . banks account for more than half of the total loans and deposits. contributing 17 percent to the sector’s loan portfolio and 18 Optima Bank, Demir Kyrgyz International Bank (established with percent to its depository base. The bank also accounts for 15 The two state-owned banks – Aiyl Bank and RSK Bank – the assistance of IFC in 1996), and Kyrgyz Investment and Credit percent of the total banking assets, plus with 12 percent of total 43 account for 18 percent of the total banking sector by assets. Bank, (all of which are foreign-owned), are the three largest capital, and 28 percent of the banking sector’s net profit . Taken together, the foreign banks account for approximately banks operating in the country. Other major players include the 56% 24% 35.8 percent of total assets. Figure 12: Market share of commercial banks in Kyrgyzstan (2013) The last few years have seen a significant rise in the number of DKIB AMANBANK branches plus stationary and field cash offices of the various Total Loans Total Deposits commercial banks. By the end of 2014, there were 293 branches Optima Bank Bank of Asia Capital Bank 41 and nearly 800 commercial bank cash offices nationwide . Kyrgyz Investment and Credit Bank 17% 18% Halyk Bank Kyrgyzstan Bank «Bai-Tushum» 22% 33% Aiyl Bank Rosinbank This noted, however, the concentration of bank branches BTA Bank Demir Kyrgyz International Bank remains low with just 7.98 branches per 100,000 adults, 13% 4% Optima Bank Dos-Kredobank compared with 39.8 and 10.3 branches in Uzbekistan and RSK Bank 42 8% KICB Azerbaijan, respectively . Moreover, Kyrgyz banking facilities 6% Tolubay 3% 9% Kyrgyzstan Commercial Bank are mostly centered in urban areas. 8% 13% National Bank of 9% 16% Commercial bank 8% Aman Bank Pakistan Bishkek Branch KYRGYZSTAN Additionally, in March 2013 the Kyrgyz Investment Credit Bank Others Kyrgyz-Swiss Bank introduced mobile banking services to the country for the first $1.4 billion Bakai Bank Finca Bank time. Nevertheless, mobile banking penetration is still quite low, Source: Annual Reports of Commercial Banks Kyrgyzkommertsbank especially in rural areas. Source: Annual Reports of Commercial Banks

FinanceCreditBank In 2014, bank loans and deposits in the Kyrgyz Republic showed their highest growth in absolute terms since 2010 This explains why a considerable part of the country’s economy In 2014, bank loans and deposits in the Kyrgyz Republic showed the banking system. However, regulatory reform initiatives by the their highest growth in absolute terms since 2010 central bank, particularly after 2011, as well as the introduction KyrgyzCredit Bank – and most notably in rural areas – still relies on the financial From 2009–11, banking activity in the country remained stagnant due to structural deficiencies and the lack of internal services offered by the informal banking sector, the most of a new development program by the government in 2012, common being currency exchange and ex-officio lending. controls in the banking system. However, regulatory reform initiativesstrengthened by the the central sector overall. bank, particularlyAs a result, banking after 2011, activity as well From 2009–11, banking activity in the country remained stagnant regained traction, particularly over the 2013–14 period. dueas the to structuralintroduction deficiencies of a new and development the lack of internal program controls by the in government in 2012, strengthened the sector overall. As a result, banking activity regained traction, particularly over the 2013–14 period. Figure 13: Total Kyrgyz commercial bank loans and Time and demand deposits together account for over two-thirds collectively valued at more than $150 million53 were issued to the Almighty, whose knowledge has no limits, and so cannot be Figure 14 : Total Kyrgyz commercialdeposits bank in ($loans billion) and deposits in ($ billion) of total deposits over 11,000 MSMEs. However, the coverage of this program abridged or removed by any human authority. The prohibition of 38 Annual Report: National Bank of Kyrgyz Republic, 2014 was limited as only about 3 percent54 of the total number of riba (usury or interest), gambling, hoarding, dealing in unlawful 39 Kyrgyz Republic Partnership Program Snapshot: The World Bank Group, October 2014 SMEs could acquire loans on these preferential terms. That is goods or services, short sales and speculative transactions are 40 Annual Report: National Bank of Kyrgyz Republic, 2014 The total deposit base of Kyrgyz commercial banks totaled $1.6 2 why the program has been extended to 2016–17, to encourage some examples of these divine restrictions. And taken together, all 41 Annual Report: National Bank of Kyrgyz Republic, 2014 billion47 in 2014. Significantly, however, most households in 42 Financial Access Survey: International Monetary Fund, 2013 43 Optima Bank website CAGr more SMEs to borrow from formal sources. have the cumulative effect of maintaining the balance, justice and 1,6 the country preferred to keep their money at home rather than loans: 25.7% 1,5 equality of opportunities. 2 1,4 in banks. This is changing, though, due in no small part to the Table 3: SME loans and deposits in the Kyrgyz Deposits: 23.0% impact of financial literacy programs such as those conducted by 18 The Current Status of Islamic Banking in the Kyrgyz republic Islamic Banking 1,1and Finance.1,1 Opportunities across MSMEs in the Kyrgyz republic 19 republic Asset-backed financing is one of the most important IFC and the European Bank for Reconstruction and Development 0,8 0,9 characteristics of Islamic finance 1 0,7 (EBRD). Such programs have led to an increase in the number 0,7 Region 2012 2013 2014 0,6 of bank accounts and the overall value of deposits. Moreover, Conventional financing assumes that the banks and financial 1 the large number of Kyrgyz migrants sending money home from institutions deal in money and monetary papers only. That is why abroad has encouraged consumers to open savings accounts with SME lending as a 10% 10% 10% they are forbidden, in most countries, from trading in goods and banks. Inward remittances to the country have grown steadily percentage of total lending accumulating inventories. 0 from 31 percent in 2013 to 34.1 percent in 201448, making a 2010 2011 2012 2013 2014 marked contribution to the expansion of the country’s deposit Total SME lending ($mn) 85.4 111.2 148.1 Islamic finance, on the other hand, does not recognize money Total Loans Total deposits base along the way. as the subject matter of trade, except in some special instances. Source: National Bank of the Kyrgyz Republic Total SME deposits ($mn)* 100.5 130.8 174.2 Source: National Bank of the Kyrgyz Republic Money has no fundamental utility; it is only a medium of exchange. Each unit of money is 100 percent equal to another unit Time deposits accounted for 45 percent of the total deposit value The trade and agriculture sectorsThe trade account and agriculturefor more than sectors half account of the loansfor more disbursed than half by of Kyrgyz commercial banks of the same denomination; therefore, there is no scope for making in 2014, up from 39 percent in 2013. Meanwhile, the share of profit through the exchange of these units. Profit is generated the loans disbursed by Kyrgyz commercial banks 49 Islamic banking in the demand deposits declined to 22 percent from 25 percent . when something having an intrinsic utility is sold for money, or In 2014, the total credit portfolio value of the country’s commercial banks increased by 33.2 percent to $1.5 billion44. Figure 15: Classification of deposits in Kyrgyz when different currencies are exchanged, one for another. The This rise was mainly due toIn the 2014, buildup the total of agriculturalcredit portfolio loans value and of increased the country’s exposure to the trading sector. Together these Kyrgyz republic 44 commercial banks (2014) profit earned through dealing in money (of the same currency) or accounted for almost 54 percentcommercial of the totalbanks loans increased disbursed by 33.2 by percent Kyrgyz to commercial $1.5 billion banks. in 201345. the papers representing them is interest, and hence prohibited. This rise was mainly due to the buildup of agricultural loans Certain divine restrictions have been imposed on economic and increased exposure to the trading sector. Together these activities as per Islamic principles. The intent is to ensure that Agriculture is the major source of income for 65 percent of the country’s workforce. This drives the high demand for agro The real and ideal instruments of financing in Shariah-compliant accounted for almost 54 percent of the total loans disbursed by balance is maintained in the economy, and the concentration of banking are Musharakah and Mudarabah. When a financier loans46. Similarly, trade is an essential element of the Kyrgyz45 economy, in large part a function of the country’s traditional Kyrgyz commercial banks in 2013 . 22% Time deposits wealth into the hands of a few is avoided. contributes money on the basis of these two instruments, it strength in this area, because of its strategic location at the commercial crossroads between Russia and China. is bound to be converted into the assets. Profits are generated Islamic finance does not negate active market forces nor the Agriculture is the major source of income for 65 percent of the 45% through the sale of these real assets. Figure 15: Classification of deposits in Kyrgyz commercial banks (2014) Settlement natural ebb and flow of the economy. The profit motive is country’s workforce. This drives the high demand for agro loans46. accounts considered acceptable, albeit with some limitations.Private owners Financing on the basis of Salam and Istisna also creates real assets. 44. National bank of Kyrgyz RepublicSimilarly, website trade is an essential element of the Kyrgyz economy, hip is likewise not totally negated. The financier, in the case of the former, receives real goods and 45. National bank of Kyrgyz Republicin large website part a function of the country’s traditional strength in Demand deposits can profit by selling them in the market. In the latter instance, 46. Country profile – Kyrgyzstan: thisNew area,Agriculturist, because September, of its strategic 2010 location at the commercial 33% There is a basic difference, however, between a capitalist and financing is affected through the manufacture of real assets; and as crossroads between Russia and China. Islamic economy, namely that in secular capitalism the profit a reward for doing this the financier earns his or her profit. 26 motive or private ownership are given unrestrained power to Figure 14: Classification of loans by sector (2014) Source: National Bank of the Kyrgyz Republic make economic decisions. Their liberty is not constrained by any The instruments of leasing, Ijara and Murabahah, are likewise divine caveats. And if there are some restrictions, they are those fully backed by assets and financing through these instruments, The SME sector accounts for 10 percent of the loans disbursed by imposed by the society and thus always subject to change through and are therefore clearly distinguishable from interest-based all commercial banks in the Kyrgyz Republic democratically determined legislation. financing. 13% This has generated a number of practices which result in social 6% It is evident that every financing in an Islamic system creates 36% SME lending forms only a small part of both the conventional imbalances: for example, interest, gambling, and speculative real assets. It is known, on the other hand, that interest-based 8% and Islamic banking loan portfolios at present. SME segment transactions tend to concentrate wealth in the hands of the few. financing does not necessarily create real assets. Hence, the supply 50 loans make up approximately 10 percent of the total loans Human instincts are exploited to gain through immoral and of money via loans advanced by financial institutions, does not 8% disbursed by commercial banks each year. This is mainly due injurious products or activities. Furthermore, uncontrolled profit normally equate with the real goods and services produced in the to the small ticket size of SME lending. The average amount seeking creates monopolies which ultimately paralyze market society. This alludes to loans creating the illusion of an increase 11% borrowed by SMEs is about $1,50051. 18% forces or, at least, hinder their natural operation. Thus, the natural in money, without creating real assets in the same quantity. This ebb and flow of supply and demand is disturbed as these forces gap between the supply of money and production of real assets can only function properly in an atmosphere of free competition. In 2012 the government launched a three-year program under creates and fuels inflation. Hence, financing in an Islamic system Trade Agriculture Mortgage They are antithetical to a monopolistic environment. which MSMEs were provided with loans at lower-than-market is always backed by real assets. Consumer loans Industrials Construction 52 interest rates. From 2012 until 2015, preferential loans After the tacit recognition of private ownership, the profit motive Others The success of Islamic finance in several Asian and Middle and market forces, therefore, certain divine restrictions have been Source: National Bank of the Kyrgyz Republic Eastern countries encouraged EcoIslamicBank introduce Islamic input as per Islamic principles. These cover economic activities banking in 2006. However, the country’s Islamic banking sector is in particular and economic structures in general. Believers hold, still relatively nascent. 44 National bank of Kyrgyz Republic website 49 National bank of Kyrgyz Republic website as an article of faith, that such restrictions are imposed by Allah 45 National bank of Kyrgyz Republic website 50 Primary research 46 Country profile – Kyrgyzstan: New Agriculturist, September, 2010 51 Primary research 47 National bank of Kyrgyz Republic website 52 The preferential loan program is a government sponsored initiative to 53 Primary research 48 World Bank stimulate capital investment by providing loans at below market interest 54 Primary research rates 20 The Current Status of Islamic Banking in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 21 Figure 13: Total Kyrgyz commercial bank loans and Time and demand deposits together account for over two-thirds collectively valued at more than $150 million53 were issued to the Almighty, whose knowledge has no limits, and so cannot be deposits in ($ billion) of total deposits over 11,000 MSMEs. However, the coverage of this program abridged or removed by any human authority. The prohibition of was limited as only about 3 percent54 of the total number of riba (usury or interest), gambling, hoarding, dealing in unlawful SMEs could acquire loans on these preferential terms. That is goods or services, short sales and speculative transactions are The total deposit base of Kyrgyz commercial banks totaled $1.6 2 47 why the program has been extended to 2016–17, to encourage some examples of these divine restrictions. And taken together, all CAGr billion in 2014. Significantly, however, most households in more SMEs to borrow from formal sources. have the cumulative effect of maintaining the balance, justice and 1,6 the country preferred to keep their money at home rather than loans: 25.7% 1,5 equality of opportunities. 2 1,4 in banks. This is changing, though, due in no small part to the Table 3: SME loans and deposits in the Kyrgyz Deposits: 23.0% 1,1 1,1 impact of financial literacy programs such as those conducted by republic Asset-backed financing is one of the most important IFC and the European Bank for Reconstruction and Development 0,8 0,9 characteristics of Islamic finance 1 0,7 (EBRD). Such programs have led to an increase in the number 0,7 Region 2012 2013 2014 0,6 of bank accounts and the overall value of deposits. Moreover, Conventional financing assumes that the banks and financial 1 the large number of Kyrgyz migrants sending money home from institutions deal in money and monetary papers only. That is why abroad has encouraged consumers to open savings accounts with SME lending as a 10% 10% 10% they are forbidden, in most countries, from trading in goods and banks. Inward remittances to the country have grown steadily percentage of total lending accumulating inventories. 0 from 31 percent in 2013 to 34.1 percent in 201448, making a 2010 2011 2012 2013 2014 marked contribution to the expansion of the country’s deposit Total SME lending ($mn) 85.4 111.2 148.1 Islamic finance, on the other hand, does not recognize money Total Loans Total deposits base along the way. as the subject matter of trade, except in some special instances. Total SME deposits ($mn)* 100.5 130.8 174.2 Source: National Bank of the Kyrgyz Republic Money has no fundamental utility; it is only a medium of exchange. Each unit of money is 100 percent equal to another unit The trade and agriculture sectors account for more than half of Time deposits accounted for 45 percent of the total deposit value of the same denomination; therefore, there is no scope for making in 2014, up from 39 percent in 2013. Meanwhile, the share of profit through the exchange of these units. Profit is generated the loans disbursed by Kyrgyz commercial banks 49 Islamic banking in the demand deposits declined to 22 percent from 25 percent . when something having an intrinsic utility is sold for money, or when different currencies are exchanged, one for another. The In 2014, the total credit portfolio value of the country’s Figure 15: Classification of deposits in Kyrgyz Kyrgyz republic 44 commercial banks (2014) profit earned through dealing in money (of the same currency) or commercial banks increased by 33.2 percent to $1.5 billion . the papers representing them is interest, and hence prohibited. This rise was mainly due to the buildup of agricultural loans Certain divine restrictions have been imposed on economic and increased exposure to the trading sector. Together these activities as per Islamic principles. The intent is to ensure that The real and ideal instruments of financing in Shariah-compliant accounted for almost 54 percent of the total loans disbursed by balance is maintained in the economy, and the concentration of banking are Musharakah and Mudarabah. When a financier 45 Kyrgyz commercial banks in 2013 . 22% Time deposits wealth into the hands of a few is avoided. contributes money on the basis of these two instruments, it is bound to be converted into the assets. Profits are generated Islamic finance does not negate active market forces nor the 45% through the sale of these real assets. Agriculture is the major source of income for 65 percent of the Settlement natural ebb and flow of the economy. The profit motive is country’s workforce. This drives the high demand for agro loans46. accounts considered acceptable, albeit with some limitations.Private owners Financing on the basis of Salam and Istisna also creates real assets. Similarly, trade is an essential element of the Kyrgyz economy, hip is likewise not totally negated. The financier, in the case of the former, receives real goods and in large part a function of the country’s traditional strength in Demand deposits can profit by selling them in the market. In the latter instance, this area, because of its strategic location at the commercial 33% There is a basic difference, however, between a capitalist and financing is affected through the manufacture of real assets; and as crossroads between Russia and China. Islamic economy, namely that in secular capitalism the profit a reward for doing this the financier earns his or her profit. motive or private ownership are given unrestrained power to Figure 14: Classification of loans by sector (2014) Source: National Bank of the Kyrgyz Republic make economic decisions. Their liberty is not constrained by any The instruments of leasing, Ijara and Murabahah, are likewise divine caveats. And if there are some restrictions, they are those fully backed by assets and financing through these instruments, The SME sector accounts for 10 percent of the loans disbursed by imposed by the society and thus always subject to change through and are therefore clearly distinguishable from interest-based all commercial banks in the Kyrgyz Republic democratically determined legislation. financing. 13% This has generated a number of practices which result in social 6% It is evident that every financing in an Islamic system creates 36% SME lending forms only a small part of both the conventional imbalances: for example, interest, gambling, and speculative real assets. It is known, on the other hand, that interest-based 8% and Islamic banking loan portfolios at present. SME segment transactions tend to concentrate wealth in the hands of the few. financing does not necessarily create real assets. Hence, the supply 50 loans make up approximately 10 percent of the total loans Human instincts are exploited to gain through immoral and of money via loans advanced by financial institutions, does not 8% disbursed by commercial banks each year. This is mainly due injurious products or activities. Furthermore, uncontrolled profit normally equate with the real goods and services produced in the to the small ticket size of SME lending. The average amount seeking creates monopolies which ultimately paralyze market society. This alludes to loans creating the illusion of an increase 51 11% borrowed by SMEs is about $1,500 . 53 Figure 13: Total Kyrgyz commercial bank loans and Time and demand deposits together account18% for over two-thirds collectively valued at more than $150 million were issued to forcesthe or, Almighty, at least, hinder whose their knowledge natural operation. has no limits, Thus, and the sonatural cannot in be money, without creating real assets in the same quantity. This deposits in ($ billion) of total deposits over 11,000 MSMEs. However, the coverage of this program ebb andabridged flow ofor supply removed and bydemand any human is disturbed authority. as these The forces prohibition gap ofbetween the supply of money and production of real assets 54 can only function properly in an atmosphere of free competition. In 2012 the governmentwas limited launched as only a three-yearabout 3 percent program of under the total number of riba (usury or interest), gambling, hoarding, dealing in unlawfulcreates and fuels inflation. Hence, financing in an Islamic system Trade Agriculture Mortgage They are antithetical to a monopolistic environment. which MSMEs wereSMEs provided could acquire with loans loans at lower-than-marketon these preferential terms. That is goods or services, short sales and speculative transactions areis always backed by real assets. The total Cdepositonsumer base loans of KyrgyzIndu commercialstrials banksC totaledonstruction $1.6 interest rates. From 2012 until 2015, preferential loans52 2 47 why the program has been extended to 2016–17, to encourage Aftersome the tacit examples recognition of these of privatedivine ownership,restrictions. the And profit taken motive together, The all success of Islamic finance in several Asian and Middle CAGr billion inOt 2014.hers Significantly, however, most households in more SMEs to borrow from formal sources. have the cumulative effect of maintaining the balance, justice and 1,6 the country preferred to keep their money at home rather than and market forces, therefore, certain divine restrictions have been Eastern countries encouraged EcoIslamicBank introduce Islamic loans: 25.7% Source:1,5 National Bank of theSource: Kyrgyz National Republic Bank of the Kyrgyz Republic inputequality as per Islamic of opportunities. principles. These cover economic activities 2 1,4 in banks. This is changing, though, due in no small part to the Table 3: SME loans and deposits in the Kyrgyz banking in 2006. However, the country’s Islamic banking sector is Deposits: 23.0% in particular and economic structures in general. Believers hold, still relatively nascent. 1,1 impact44 of National financial bank ofliteracy Kyrgyz Republic programs website such as those conducted by 49 National bank of Kyrgyz Republic website 1,1 Time and demand deposits together account for over two-thirds of total deposits republic as anAsset-backed article of faith, financing that such restrictions is one of the are imposedmost important by Allah IFC and45 Nationalthe European bank of Kyrgyz Bank Republic for Reconstruction website and Development 50 Primary research 0,8 0,9 characteristics of Islamic finance 1 0,7 (EBRD).46 Country Such programs profile – Kyrgyzstan: have led New to Agriculturist,an increase September, in the number2010 51 Primary research 0,7 The total deposit base of Kyrgyz47 National commercial bank of Kyrgyz banks Republic totaled website $1.6 billion47 in 2014. Significantly,52 The however,preferential loanRegionmost program households is a government sponsored initiative2012 to 2013 2014 0,6 of bank accounts and the overall value of deposits. Moreover, 53 PrimaryConventional research financing assumes that the banks and financial 48 World Bank stimulate capital investment by providing loans at below market interest in the country preferred to keep their money at home rather than in banks. This is changing, though, due in no small part 54 Primary research 1 the large number of Kyrgyz migrants sending money home from rates institutions deal in money and monetary papers only. That is why to the impact of financialabroad literacy has encouraged programs consumers such as those to openconducted savings by accounts IFC. Such with programs have led to anSME increase lend ingin the as a 10% 10% 10% they are forbidden, in most countries, from trading in goods and number of bank accountsbanks.20 and InwardThe the Currentoverall remittances Statusvalue of toof deposits.theIslamic country Banking Moreover, have in grownthe the Kyrgyz large steadily r numberepublic of Kyrgyz migrants pesendingrcentage money of total lending accumulating inventories. Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 21 0 home from abroad hasfrom encouraged 31 percent consumers in 2013 to to 34.1 open percent savings in accounts 201448, making with banks. a Inward remittances to the country have Total SME lending ($mn) 85.4 111.2 148.1 2010 2011 2012 2013 grown201 steadily4 frommarked 31 percent contribution in 2013 toto 34.1the expansion percent in of 2014 the48 country’s, making deposita marked contribution to the expansion of the Islamic finance, on the other hand, does not recognize money Total Loans Total deposits base along the way. as the subject matter of trade, except in some special instances. country’s deposit base along the way. Total SME deposits ($mn)* 100.5 130.8 174.2 Source: National Bank of the Kyrgyz Republic Money has no fundamental utility; it is only a medium of exchange. Each unit of money is 100 percent equal to another unit Time deposits accountedTime fordeposits 45 percent accounted of the fortotal 45 deposit percent value of the in 2014,total deposit up from value 39 percent in 2013. Meanwhile, the share of the same denomination; therefore, there is no scope for making The trade and agriculture sectors account for more than half of 49 of demand deposits indeclined 2014, up to from22 percent 39 percent from 25in 2013.percent Meanwhile,. the share of profit through the exchange of these units. Profit is generated the loans disbursed by Kyrgyz commercial banks 49 Islamic banking in the demand deposits declined to 22 percent from 25 percent . when something having an intrinsic utility is sold for money, or Figure 16: Classification of deposits in Kyrgyz commercial banks (2014) Figure 15: Classification of deposits in Kyrgyz when different currencies are exchanged, one for another. The In 2014, the total credit portfolio value of the country’s Kyrgyz republic 44 commercial banks (2014) profit earned through dealing in money (of the same currency) or commercial banks increased by 33.2 percent to $1.5 billion . the papers representing them is interest, and hence prohibited. This rise was mainly due to the buildup of agricultural loans Certain divine restrictions have been imposed on economic and increased exposure to the trading sector. Together these activities as per Islamic principles. The intent is to ensure that The real and ideal instruments of financing in Shariah-compliant accounted for almost 54 percent of the total loans disbursed by balance is maintained in the economy, and the concentration of banking are Musharakah and Mudarabah. When a financier 45 Kyrgyz commercial banks in 2013 . 22% Time deposits wealth into the hands of a few is avoided. contributes money on the basis of these two instruments, it is bound to be converted into the assets. Profits are generated Islamic finance does not negate active market forces nor the 45% through the sale of these real assets. Agriculture is the major source of income for 65 percent of the Settlement natural ebb and flow of the economy. The profit motive is country’s workforce. This drives the high demand for agro loans46. accounts considered acceptable, albeit with some limitations.Private owners Financing on the basis of Salam and Istisna also creates real assets. Similarly, trade is an essential element of the Kyrgyz economy, hip is likewise not totally negated. The financier, in the case of the former, receives real goods and in large part a function of the country’s traditional strength in Demand deposits can profit by selling them in the market. In the latter instance, this area, because of its strategic location at the commercial 33% There is a basic difference, however, between a capitalist and financing is affected through the manufacture of real assets; and as crossroads between Russia and China. Islamic economy, namely that in secular capitalism the profit a reward for doing this the financier earns his or her profit. motive or private ownership are given unrestrained power to Figure 14: Classification of loans by sector (2014) Source: National Bank of the Kyrgyz Republic make economic decisions. Their liberty is not constrained by any The instruments of leasing, Ijara and Murabahah, are likewise divine caveats. And if there are some restrictions, they are those Source: National Bank of the Kyrgyz Republic fully backed by assets and financing through these instruments, The SME sector accounts for 10 percent of the loans disbursed by imposed by the society and thus always subject to change through and are therefore clearly distinguishable from interest-based all commercial banks in the Kyrgyz Republic democratically determined legislation. financing. 13% 47. National bank of Kyrgyz Republic website This has generated a number of practices which result in social It is evident that every financing in an Islamic system creates 6% 36% 48. World Bank SME lending forms only a small part of both the conventional imbalances: for example, interest, gambling, and speculative 49. National bank of Kyrgyz Republic website real assets. It is known, on the other hand, that interest-based 8% and Islamic banking loan portfolios at present. SME segment transactions tend to concentrate wealth in the hands of the few. financing does not necessarily create real assets. Hence, the supply 50 loans make up approximately 10 percent of the total loans Human instincts27 are exploited to gain through immoral and of money via loans advanced by financial institutions, does not 8% disbursed by commercial banks each year. This is mainly due injurious products or activities. Furthermore, uncontrolled profit normally equate with the real goods and services produced in the to the small ticket size of SME lending. The average amount seeking creates monopolies which ultimately paralyze market society. This alludes to loans creating the illusion of an increase 11% borrowed by SMEs is about $1,50051. 18% forces or, at least, hinder their natural operation. Thus, the natural in money, without creating real assets in the same quantity. This ebb and flow of supply and demand is disturbed as these forces gap between the supply of money and production of real assets can only function properly in an atmosphere of free competition. In 2012 the government launched a three-year program under creates and fuels inflation. Hence, financing in an Islamic system Trade Agriculture Mortgage They are antithetical to a monopolistic environment. which MSMEs were provided with loans at lower-than-market is always backed by real assets. Consumer loans Industrials Construction 52 interest rates. From 2012 until 2015, preferential loans After the tacit recognition of private ownership, the profit motive Others The success of Islamic finance in several Asian and Middle and market forces, therefore, certain divine restrictions have been Source: National Bank of the Kyrgyz Republic Eastern countries encouraged EcoIslamicBank introduce Islamic input as per Islamic principles. These cover economic activities banking in 2006. However, the country’s Islamic banking sector is in particular and economic structures in general. Believers hold, still relatively nascent. 44 National bank of Kyrgyz Republic website 49 National bank of Kyrgyz Republic website as an article of faith, that such restrictions are imposed by Allah 45 National bank of Kyrgyz Republic website 50 Primary research 46 Country profile – Kyrgyzstan: New Agriculturist, September, 2010 51 Primary research 47 National bank of Kyrgyz Republic website 52 The preferential loan program is a government sponsored initiative to 53 Primary research 48 World Bank stimulate capital investment by providing loans at below market interest 54 Primary research rates 20 The Current Status of Islamic Banking in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 21 The SME sector accounts for 10 percent of the loans disbursed by all commercial banks in the Kyrgyz Republic

SME lending forms only a small part of both the conventional and Islamic banking loan portfolios at present. SME segment loans make up approximately 10 percent50 of the total loans disbursed by commercial banks each year. This is mainly due to the small ticket size of SME lending. The average amount borrowed by SMEs is about $1,50051.

In 2012 the government launched a three-year program under which MSMEs were provided with loans at lower-than-market interest rates. From 2012 until 2015, preferential loans52 collectively valued at more than $150 million53 were issued to over 11,000 MSMEs. However, the coverage of this program was limited as only about 3 percent54 of the total number of SMEs could acquire loans on these preferential terms. That is why the program has been extended to 2016–17, to encourage more SMEs to borrow from formal sources.

Table 3: SME loans and deposits in the Kyrgyz Republic Region 2012 2013 2014 SME lending as a 10% 10% 10% percentage of total lending Total SME lending ($mn) 85.4 111.2 148.1 Total SME deposits 100.5 130.8 174.2 ($mn)*

Source: Primary research and National Bank of the Kyrgyz Republic * based on average loan to deposit ratio for 2012-14 (85%)

Islamic banking in the Kyrgyz Republic Certain divine restrictions have been imposed on economic activities as per Islamic principles. The intent is to ensure that balance is maintained in the economy, and the concentration of wealth into the hands of a few is avoided

Islamic finance does not negate active market forces nor the natural ebb and flow of the economy. The profit motive is considered acceptable, albeit with some limitations. Private ownership is likewise not totally negated.

There is a basic difference, however, between a capitalist and Islamic economy, namely that in secular capitalism the profit motive or private ownership are given unrestrained power to make economic decisions. Their liberty is not constrained by any divine caveats. And if there are some restrictions, they are those imposed by the society and thus always subject to change through democratically determined legislation.

This has generated a number of practices which result in social imbalances: for example, interest, gambling, and speculative transactions tend to concentrate wealth in the hands of the few. Human instincts are exploited to gain through immoral and injurious products or activities. Furthermore, uncontrolled profit seeking creates monopolies which ultimately paralyze market forces or, at least, hinder their natural operation. Thus, the natural ebb and flow of supply and demand is disturbed as these forces can only function properly in an atmosphere of free competition. They are antithetical to a monopolistic environment.

50. Primary Research 51. Primary Research 52. Preferential loan program is a government sponsored initiative to stimulate capital investment by providing loans at below market interest rates 53. Primary Research 54. Primary Research

28 After the tacit recognition of private ownership, the profit motive and market forces, therefore, certain divine restrictions have been input as per Islamic principles. These cover economic activities in particular and economic structures in general. Believers hold, as an article of faith, that such restrictions are imposed by Allah the Almighty, whose knowledge has no limits, and so cannot be abridged or removed by any human authority. The prohibition of riba (usury or interest), gambling, hoarding, dealing in unlawful goods or services, short sales and speculative transactions are some examples of these divine restrictions. And taken together, all have the cumulative effect of maintaining the balance, justice and equality of opportunities.

Asset-backed financing is one of the most important characteristics of Islamic finance

Conventional financing assumes that the banks and financial institutions deal in money and monetary papers only. That is why they are forbidden, in most countries, from trading in goods and accumulating inventories.

Islamic finance, on the other hand, does not recognize money as the subject matter of trade, except in some special instances. Money has no fundamental utility; it is only a medium of exchange. Each unit of money is 100 percent equal to another unit of the same denomination; therefore, there is no scope for making profit through the exchange of these units. Profit is generated when something having an intrinsic utility is sold for money, or when different currencies are exchanged, one for another. The profit earned through dealing in money (of the same currency) or the papers representing them is interest, and hence prohibited.

The real and ideal instruments of financing in Shariah-compliant banking are Musharakah and Mudarabah. When a financier contributes money on the basis of these two instruments, it is bound to be converted into the assets. Profits are generated through the sale of these real assets.

Financing on the basis of Salam and Istisna also creates real assets. The financier, in the case of the former, receives real goods and can profit by selling them in the market. In the latter instance, financing is affected through the manufacture of real assets; and as a reward for doing this the financier earns his or her profit.

The instruments of leasing, Ijara and Murabahah, are likewise fully backed by assets and financing through these instruments, and are therefore clearly distinguishable from interest-based financing.

It is evident that every financing in an Islamic system creates real assets. It is known, on the other hand, that interest-based financing does not necessarily create real assets. Hence, the supply of money via loans advanced by financial institutions, does not normally equate with the real goods and services produced in the society. This alludes to loans creating the illusion of an increase in money, without creating real assets in the same quantity. This gap between the supply of money and production of real assets creates and fuels inflation. Hence, financing in an Islamic system is always backed by real assets.

The success of Islamic finance in several Asian and Middle Eastern countries encouraged EcoIslamicBank launched Islamic financing services in 2006. However, the country’s Islamic banking sector is still relatively nascent.

After the dissolution of the Soviet Union, the Kyrgyz Republic became the first Central Asian country to join the Islamic Development Bank (IDB) in 1993. Nevertheless, this introduction of Islamic banking in the country faced obstacles that were. mainly due to initial apprehensions concerning Islamic finance among the secular elite population and government officials. Nevertheless, the success attained by Islamic finance principles in other Asian and Middle Eastern countries, particularly Malaysia, encouraged the government to introduce Islamic banking in the Kyrgyz Republic in 2007. Furthermore, IDB, which has funded several key Kyrgyz projects, has manifestly assisted the country in implementing a dual banking system (namely Islamic banking in conjunction with traditional banking).

The Kyrgyz Republic signed a memorandum of understanding with IDB and Eco Bank to develop the country’s Islamic banking system back in 2007. The MoU was specifically aimed at introducing and implementing the principles of Shariah- compliant finance in the country. Following the signing of the MoU, EcoIslamicBank was established as the pilot project for Islamic banking in the Kyrgyz Republic.

29 After the dissolution of the Soviet Union, the Kyrgyz Republic EcoIslamicBank is the only commercial Islamic bank licensed by Despite its slow growth in terms of the number of branches, of 18.9 percent over the same time frame. The bank’s loan book became the first Central Asian country to join the Islamic NBKR to offer Shariah-compliant financial products and services EcoIslamicBank’s business has grown substantially, as evidenced accounted for 1.6 percent59 of the loans provided by all Kyrgyz The Kyrgyz IslamicDevelopment banking Bank (IDB)system in 1993. comprises Nevertheless, just this one introduction commercial in the Kyrgyz bank, Republic. with 12 The branches bank is regulated licensed and supervised and regulated by by NBKRby its loan book and the volume of deposits it has attracted. commercial banks last year. Moreover, consumer loans make up of Islamic banking in the country faced obstacles that were. NBKR. EcoIslamicBank provides several Islamic banking and the majority of EcoIslamicBank’s loan portfolio. The average size mainly due to initial apprehensions concerning Islamic finance financial services, including deposit and investment accounts, of a loan advanced by the bank is about $1500. EcoIslamicBankamong is the secular only elite commercial population and Islamic government bank officials. licensed and by financing NBKR and to credit offer facilities Shariah-compliant to individuals and businesses, financial products Theand asset base of EcoIslamicBank expanded at a CAGR of 15.9 percent from 2010 through 2014, or to the point where it now Nevertheless, the success attained by Islamic finance principles in particularly MSMEs. 58 services in the otherKyrgyz Asian Republic.and Middle Eastern The countries,bank is particularly regulated Malaysia, and supervised by NBKR. EcoIslamicBank provides several Islamicaccounts for 3 percent of the total banking system’s assets . EcoIslamicBank’s deposits increased at a CAGR of 42.1 percent encouraged the government to introduce Islamic banking in the Growth in the number of EcoIslamicBank branches has been This expansion could be ascribed to growth in the bank’s from 2010–14. And these deposits accounted for 3.7 percent of banking and financial services, including deposit and investment accounts, and financing and credit55 facilities to individuals 60 Kyrgyz Republic in 2007. Furthermore, IDB, which has funded slow, limiting the bank’s outreach. As of 2013, it had 12 branches financing activity. The value of financing increased at a CAGR the deposit base of all commercial banks in the country last year . and businesses,several particularly key Kyrgyz projects,MSMEs. has manifestly assisted the country in providing Islamic banking products and services nationwide. The implementing a dual banking system (namely Islamic banking in number of branches increased at a CAGR of 5.92 percent from 9 56 conjunction with traditional banking). in 2008 to 12 in 2013 . Figure 17: Growth in Islamic loans and deposits ($ million) Growth in the number of EcoIslamicBank branches has been slow, limiting the bank’s outreach. As of 2013, it had 1255 The Kyrgyz Republic signed a memorandum of understanding Still, the concentration of EcoIslamicBank’s branches remained at 57 branches providingwith IDB Islamic and Eco Bankbanking to develop products the country’s and Islamic services nationwide.just 3.23 branches The pernumber million adultsof branches in 2013 .The increased bank’s branch at a CAGR of 5.92 banking system back in 2007. The56 MoU was specifically aimed network is sparse and concentrated in economically important 60 52 51 53 percent from 9at in introducing 2008 to and 12 implementing in 2013 the. principles of Shariah- provinces. compliant finance in the country. And after the MoU was signed 50 CAGr Within these provinces, branches are located in major ities; rural Eco Bank became the pilot project for Islamic banking in the 57 loans: 18.9% Still, the concentration of EcoIslamicBank’s branches remainedareas, at do just not have 3.23 easy branches access to Islamic per finance. million adults in 2013 . Bank’s 40 Kyrgyz Republic causing it to be renamed EcoIslamicBank. Deposits: 42.1% branch network is sparse and concentrated in economically important provinces. Within these provinces, branches are 30 24 24 The Kyrgyz Islamic banking system comprises just one 20 19 20 located in majorcommercial cities; bank,rural with areas, 12 branches do not licensed have and easy regulated access by to Islamic finance. 20 12 13 NBKR 10 Figure 17 : The Figurepenetration 16 : The ofpenetration Islamic banking of Islamic in bankingthe Kyrgyz in the Republic Kyrgyz republic (number (number of branches) of branches) 0 2010 2011 2012 2013 2014

Total Loans Total Deposits

4 Source: National Bank of the Kyrgyz Republic, EcoIslamicBank Annual Reports

Bishkek 1 2

Chui Talas 1 Non-performing loans s in the The ratio of Kyrgyz NPLs to total loans decreased from 6.7 percent in 2012 to 4.3 percent in 201562. This was largely due Issyk-Kul 1 banking system to the selective lending practices adopted by most commercial banks. Given that the demand for financing exceeds the Jalalabat availability of funds, the country’s, banks can simply choose The number of NPLs in the Kyrgyz banking system has improved clients with a low chance of non-repayment. in recent years; but it remains abnormally high in the Islamic 2 banking sector 1 At the same time, EcoIslamicBank has one of the highest NPL Batken Osh ratios among Kyrgyz banks. In 2015, the firm’s ratio of NPLs to The proportion of non-performing loans in the Kyrgyz Republic total loans was pegged at 19.5 percent, down from 24.5 percent is low as compared to the levels seen in other Central Asian in 201263. This is mainly because the lion’s share of the bank’s countries such as Kazakhstan and Tajikistan, which carry NPL portfolio is made up of small consumer loans, in particular for Total branches 61 ratios of over 10 percent . the purchase of small household appliances. These carry a greater risk of default.

9 11 12 2008 2010 2013

58 National Bank of the Kyrgyz Republic 59 National Bank of the Kyrgyz Republic Source: NationalSource: Bank National of the Bank Kyrgyz of the Kyrgyz Republic Republic Annual Annual Reports Reports 60 National Bank of the Kyrgyz Republic 61 OUTLOOK 2014: Eurasia to stand on the shoulders of giants: bne IntelliNews 55 National bank of the Kyrgyz Republic 62 Primary research 56 National bank of the Kyrgyz Republic 63 Primary research Despite its slow57 growthNational bank in of theterms Kyrgyz ofRepublic the and number the World Bank of branches, EcoIslamicBank’s business has grown substantially, as evidenced by its loan book22 andThe Current the volume Status of Islamicof deposits Banking in it the has Kyrgyz attracted. republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 23

The asset base of EcoIslamicBank expanded at a CAGR of 15.9 percent from 2010 through 2014, or to the point where it now accounts for 3 percent of the total banking system’s assets58. This expansion could be ascribed to growth in the bank’s financing activity. The value of financing increased at a CAGR of 18.9 percent over the same time frame. The bank’s loan book accounted for 1.6 percent59 of the loans provided by all Kyrgyz commercial banks last year. Moreover, consumer loans make up the majority of EcoIslamicBank’s loan portfolio. The average size of a loan advanced by the bank is about $1500.

55. National bank of the Kyrgyz Republic 56. National bank of the Kyrgyz Republic 57. National bank of the Kyrgyz Republic and the World Bank 58. National bank of the Kyrgyz Republic 59. National bank of the Kyrgyz Republic

30 After the dissolution of the Soviet Union, the Kyrgyz Republic EcoIslamicBank is the only commercial Islamic bank licensed by Despite its slow growth in terms of the number of branches, of 18.9 percent over the same time frame. The bank’s loan book became the first Central Asian country to join the Islamic NBKR to offer Shariah-compliant financial products and services EcoIslamicBank’s business has grown substantially, as evidenced accounted for 1.6 percent59 of the loans provided by all Kyrgyz Development Bank (IDB) in 1993. Nevertheless, this introduction in the Kyrgyz Republic. The bank is regulated and supervised by by its loan book and the volume of deposits it has attracted. commercial banks last year. Moreover, consumer loans make up of Islamic banking in the country faced obstacles that were. NBKR. EcoIslamicBank provides several Islamic banking and the majority of EcoIslamicBank’s loan portfolio. The average size mainly due to initial apprehensions concerning Islamic finance financial services, including deposit and investment accounts, of a loan advanced by the bank is about $1500. among the secular elite population and government officials. and financing and credit facilities to individuals and businesses, The asset base of EcoIslamicBank expanded at a CAGR of 15.9 percent from 2010 through 2014, or to the point where it now Nevertheless, the success attained by Islamic finance principles in particularly MSMEs. 58 other Asian and Middle Eastern countries, particularly Malaysia, accounts for 3 percent of the total banking system’s assets . EcoIslamicBank’s deposits increased at a CAGR of 42.1 percent encouraged the government to introduce Islamic banking in the Growth in the number of EcoIslamicBank branches has been This expansion could be ascribed to growth in the bank’s from 2010–14. And these deposits accounted for 3.7 percent of 55 60 Kyrgyz Republic in 2007. Furthermore, IDB, which has funded slow, limiting the bank’s outreach. As of 2013, it had 12 branches EcoIslamicBank’sfinancing activity. deposits The increasedvalue of financing at a CAGRincreased at of a 42.1CAGR percentthe deposit from base 2010–14. of all commercial And banks these in the deposits country last accounted year . for 3.7 several key Kyrgyz projects, has manifestly assisted the country in providing Islamic banking products and services nationwide. The 60 implementing a dual banking system (namely Islamic banking in number of branches increased at a CAGR of 5.92 percent from 9 percent of the deposit base of all commercial banks in the country last year . 56 conjunction with traditional banking). in 2008 to 12 in 2013 . Figure 17: Growth in Islamic loans and deposits ($ million) Figure 18 : Growth in Islamic loans and deposits ($ million) The Kyrgyz Republic signed a memorandum of understanding Still, the concentration of EcoIslamicBank’s branches remained at 57 with IDB and Eco Bank to develop the country’s Islamic just 3.23 branches per million adults in 2013 .The bank’s branch banking system back in 2007. The MoU was specifically aimed network is sparse and concentrated in economically important 60 52 51 53 at introducing and implementing the principles of Shariah- provinces. compliant finance in the country. And after the MoU was signed 50 CAGr Within these provinces, branches are located in major ities; rural Eco Bank became the pilot project for Islamic banking in the loans: 18.9% areas, do not have easy access to Islamic finance. 40 Kyrgyz Republic causing it to be renamed EcoIslamicBank. Deposits: 42.1% 30 24 24 The Kyrgyz Islamic banking system comprises just one 20 19 20 commercial bank, with 12 branches licensed and regulated by 20 12 13 NBKR 10 Figure 16 : The penetration of Islamic banking in the Kyrgyz republic (number of branches) 0 2010 2011 2012 2013 2014 Total Loans Total Deposits 4 Source: NationalSource: NationalBank of Bank the of Kyrgyzthe Kyrgyz Republic,Republic, EcoIslamicBank EcoIslamicBank Annual Reports Annual Reports Bishkek 1 2

Talas Chui Non-performingloans s in the banking system 1 Non-performing loans s in the The ratio of Kyrgyz NPLs to total loans decreased from 6.7 percent in 2012 to 4.3 percent in 201562. This was largely due Issyk-Kul The number of NPLs in the Kyrgyz banking system has improved in recent years; but it remains abnormally high in the 1 banking system to the selective lending practices adopted by most commercial Islamic banking sector banks. Given that the demand for financing exceeds the Jalalabat availability of funds, the country’s, banks can simply choose The number of NPLs in the Kyrgyz banking system has improved clients with a low chance of non-repayment. The proportionin recent of years;non-performing but it remains abnormally loans in highthe inKyrgyz the Islamic Republic is low as compared to the levels seen in other Central Asian 2 banking sector 61 1 countries such as Kazakhstan and Tajikistan, which carry NPL Atratios the same of overtime, EcoIslamicBank 10 percent has. one of the highest NPL Batken Osh ratios among Kyrgyz banks. In 2015, the firm’s ratio of NPLs to The ratio ofThe Kyrgyz proportion NPLs of non-performing to total loans loans decreased in the Kyrgyz from Republic 6.7 percenttotal loans in was2012 pegged to 4.3at 19.5 percent percent, indown 2015 from62 .24.5 This percent was largely due is low as compared to the levels seen in other Central Asian in 201263. This is mainly because the lion’s share of the bank’s to the selectivecountries lending such as Kazakhstanpractices and adopted Tajikistan, by which most carry commercial NPL portfolio banks. is made Given up of that small the consumer demand loans, for in particular financing for exceeds the Total branches 61 availabilityratios of funds, of over 10the percent country’s,. banks can simply choose clientsthe purchase with of a smalllow householdchance ofappliances. non-repayment. These carry a greater risk of default. At the same time, EcoIslamicBank has one of the highest NPL ratios among Kyrgyz banks. In 2015, the firm’s ratio of NPLs 9 11 12 to total loans was pegged at 19.5 percent, down from 24.5 percent in 201263.This is mainly because the lion’s share of the 2008 2010 2013 bank’s portfolio is made up of small consumer loans, in particular for the purchase of small household appliances. These carry a greater risk of default. 58Figure National 18 Bank : NPlsof the Kyrgyz as a Republic percentage of total lending in the Kyrgyz republic IDB has been active in financing the construction of Islamic Limited reach and lack of competitive products: Just one Islamic Figure 19 : NPLs59 National as Banka percentage of the Kyrgyz Republic of total lending in the Kyrgyz Republic schools and vocational centers. Furthermore, IDB has been an bank services the entire country’s Islamic finance requirements. Source: National Bank of the Kyrgyz Republic Annual Reports 60 National Bank of the Kyrgyz Republic active participant in the social and economic development of And that bank’s reach is limited because of its few branches 61 OUTLOOK 2014: Eurasia to stand on the shoulders of giants: bne IntelliNews 55 National bank of the Kyrgyz Republic the country, and is involved in co-financing important projects and the inadequacy of its menu of fully Shariah-compliant 62 Primary research 56 National bank of the Kyrgyz Republic in various sectors such as energy, transport infrastructure and products. Thus, in the absence of more operators, Islamic banking 63 Primary 30research,0% 57 National bank of the Kyrgyz Republic and the World Bank agriculture, while at the same time providing credit lines to growth potential in the country is limited. There is a clear need 25,0% Kyrgyz banks. to increase the number of banks offering the critical mass of 22 The Current Status of Islamic Banking in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 23 Shariah-compliant products required to establish a strong 24,5% 20,0% presence for this kind of banking in the Kyrgyz Republic. 20,0% 19,5% 15,0% Challenges facing Islamic Effective interest rates are higher in Islamic banks than is the case with their conventional counterparts. So despite the strong 10,0% banking demand for Shariah-compliant products, customers are deterred by the higher costs involved. This disparity of costs is bound up 5,0% with the high cost of structuring Islamic products. Furthermore, 6,7% 5,6% As Islamic banking expands, the sector must compete with 4,3% the Islamic finance products now offered in the country cannot 0,0% established conventional banks already entrenched in the Kyrgyz compete with the product portfolio of the conventional banks. banking system. At the same time they have no choice but to deal 2012 2013 2014 with a weak regulatory environment and a shortage of products Overall banking NPL (%) Islamic banking NPL (%) and funds Shortage of working capital: Obtaining Shariah-compliant funds for working capital requirements has proven a challenge for Source: PrimarySource: ResearchPrimary Research EcoIslamicBank, since Islamic banks cannot use non-Shariah- Lack of a robust regulatory environment: At present, there are compliant funds. Such funds now come from donors and/or as Kaz-Komerz) already have significant experience in setting up no specific regulatory provisions covering Islamic finance in other international financial institutions such as IDB. This limits 60. National Factorsbank of the Kyrgyz driving Republic Kyrgyz Islamic the Kyrgyz Republic. This has limited the growth of the sector. 61. OUTLOOK 2014: Eurasia to stand on shoulders of giants: bne IntelliNews and operating Islamic banking windows in their home countries. Islamic bank flexibility in terms of financial operations and the And many of them have been exploring ways to leverage Although the first Islamic bank was established in 2007, the laws replenishment of funds. 62. Primary Researchbanking growth this experience to set up Shariah-complaint Kyrgyz banking that govern the sector remain underdeveloped. The memorandum 63. Primary Research operations. Additionally, several traditional banks in the country of understanding, which established the Shortage in the skilled workforce: are looking to attract funds from wealthy Russian Muslims EcoIslamicBank, is silent on this subject. Expansion of the Kyrgyz Islamic Additionally, Kyrgyz banks and financial A increasingly positive perception of Islamic banking among seeking to invest in Shariah-compliant products/opportunities 31 This has prompted EcoIslamicBank, financial industry is a key IDB institutions find it difficult to hire qualified the Kyrgyz population; a simultaneous increase in the interest outside of their home country. to include provisions for Shariah strategic thrust conventional banks now have in Islamic operations; aid via the compliance in its own Articles of managers and staff with some level of IDB’s support initiatives; all are driving the visible growth of IDB’s contribution to Islamic finance’s development: IDB has Association. expertise in Islamic banking. In some Islamic banking in the Kyrgyz Republic. contributed to the development of Islamic finance in the country instances, recruiting experts, such as accountants and product The country’s banking laws likewise do not include any specific managers, among others, is challenging because such personnel 64 through various initiatives dating back to when the Kyrgyz A positive perception of Islamic banking: Almost 86 percent of Republic became a member in 1993. These development initiatives provisions for regulating Islamic finance. Given the low market are simply unavailable locally. Kyrgyzstan’s population follows Islam. Potential customers are are aimed at forging a suitable regulatory environment likely share Islamic banking has garnered to date, regulators have not Without the necessary know-how and skilled workforce capability mostly private businesses, with their natural need for banking to increase the presence of Islamic banking and finance. They paid much attention to this issue. Even the Kyrgyz taxation system at their disposal, Islamic banks cannot maximize their product products. However these generally seek to avoid the offerings include: does not have provisions to support Islamic banking. Moreover, and services of conventional banks because they see paying Islamic leasing attracts double taxation, which naturally increases portfolio by developing structures. interest as not being aligned with their values. ■ Reviewing the existing legal framework pertaining to banking the applicant’s borrowing costs. This, in turn, translates into and financial activities, and proposing amendments or drafting another hindrance in terms of developing new Islamic banking Around 80 percent of the MSMEs surveyed expressed a desire a new stand-alone law to enable Islamic finance to operate products. to borrow, or obtain financing, under the aegis of Islamic efficiently; principles. This amounts to significant untapped potential, as there is just one Islamic bank operating in the Kyrgyz Republic at ■ Assisting EcoIslamicBank to introduce new Islamic banking present, and it accounts for only 1.6 percent65 of all commercial products; bank lending. The Kyrgyz Islamic banking industry is underdeveloped, primarily due to the lack of legislative and regulatory support ■ Widespread training at EcoIslamicBank, NBKR, the from the government and the country’s central bank. Although the latter amended its banking rules to permit the operation Conventional bank interest in Islamic banking is growing: Ministry of Economy and Finance, the Ministry of Economic of Islamic banks and windows, it has not yet been able to establish the stand-alone legislation which would encourage Considering this untapped potential, many conventional banks Development and Trade, and the Ministry of Justice as well development of the sector. The current banking rules -- created for conventional banks -- also need to be followed by Islamic in the country, such as Kaz-Komerz (Kazkommertsbank), as at the Financial Market & Supervision Service covering the banks, restricting their ability to manage investments and raise capital through avenues that are compliant with Shariah RosInBank (Zalkar), and Bai Tushum Bank, had expressed their operation and supervision of Islamic banking; and principles. interest in setting up Islamic banking operations in the Kyrgyz Republic as of April 2015. In fact these banks have already ■ Creating a suitable environment in which to launch Sukuk started the process, conducting relevant feasibility studies and (the Islamic equivalent of bonds) and Takaful (contributory Although several existing foreign banks operating in the country have been evaluating the possibility of setting up an Islamic appointing experts on regulatory compliance. communal insurance for members against future loss or bank (or window), the present environment does little to encourage them in accelerating their plans. damage) as further aids in the development of Islamic Additionally, some foreign banks operating in the country (such products in the country.

64 Islam in Kyrgyzstan: Wkipedia 65 National Bank of the Kyrgyz Republic

24 The Current Status of Islamic Banking in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 25 Factors driving Kyrgyz Islamic banking growth

A increasingly positive perception of Islamic banking among the Kyrgyz population; a simultaneous increase in the interest conventional banks now have in Islamic operations; aid via the IDB’s support initiatives; all are driving the visible growth of Islamic banking in the Kyrgyz Republic

A positive perception of Islamic banking: Almost 86 percent64 of Kyrgyzstan’s population follows Islam. Potential customers are mostly private businesses, with their natural need for banking products. However these generally seek to avoid the offerings and services of conventional banks because they see paying interest as not being aligned with their values.

Around 80 percent of the MSMEs surveyed expressed a desire to borrow, or obtain financing, under the aegis of Islamic principles. This amounts to significant untapped potential, as there is just one Islamic bank operating in the Kyrgyz Republic at present, and it accounts for only 1.6 percent65 of all commercial bank lending.

Conventional bank interest in Islamic banking is growing: Considering this untapped potential, many conventional banks in the country, such as Kyrgyzkommertsbank), RosinBank, and Bai-Tushum Bank, had expressed their interest in setting up Islamic banking operations in the Kyrgyz Republic as of April 2015. In fact these banks have already started the process, conducting relevant feasibility studies and appointing experts on regulatory compliance.

Additionally, some foreign banks operating in the country already have significant experience in setting up and operating Islamic banking windows in their home countries. And many of them have been exploring ways to leverage this experience to set up Shariah-complaint Kyrgyz banking operations. Additionally, several traditional banks in the country are looking to attract funds from wealthy Russian Muslims seeking to invest in Shariah-compliant products/opportunities outside of their home country.

IDB’s contribution to Islamic finance’s development: IDB has contributed to the development of Islamic finance in the country through various initiatives dating back to when the Kyrgyz Republic became a member in 1993. These development initiatives are aimed at forging a suitable regulatory environment likely to increase the presence of Islamic banking and finance. They include:

• Reviewing the existing legal framework pertaining to banking and financial activities, and proposing amendments or drafting a new stand-alone law to enable Islamic finance to operate efficiently;

• Assisting EcoIslamicBank to introduce new Islamic banking products;

• W idespread training at EcoIslamicBank, NBKR, the Ministry Finance, the Ministry of Economy, and the Ministry of Justice as well as at the Financial Market & Supervision Service covering the operation and supervision of Islamic banking; and

• Creating a suitable environment in which to launch Sukuk (the Islamic equivalent of bonds) and Takaful (contributory communal insurance for members against future loss or damage) as further aids in the development of Islamic products in the country.

IDB has been active in financing the construction of Islamic schools and vocational centers. Furthermore, IDB has been an active participant in the social and economic development of the country, and is involved in co-financing important projects in various sectors such as energy, transport infrastructure and agriculture, while at the same time providing credit lines to Kyrgyz banks.

Expansion of the Kyrgyz Islamic financial industry is a key IDB strategic thrust

64. Islam in Kyrgyzstan: Wkipedia 65. National bank of the Kyrgyz Republic

32 Challenges facing Islamic banking As Islamic banking expands, the sector must compete with established conventional banks already entrenched in the Kyrgyz banking system. At the same time they have no choice but to deal with a weak regulatory environment and a shortage of products and funds

Taking steps towards the development of a robust regulatory environment: Due to regulatory provisions for Islamic finance in the Kyrgyz Republic, being in the developmental stages, it has restricted growth of the sector. Although the first Islamic bank was established in 2007, EcoIslamicBank had to include operational governance provisions for Shariah compliance in its Articles of Association, due to lack of specific governance laws and local knowledge of Islamic Finance.

Also, the bank currently operates as a pilot project on the basis of a Memorandum of Understanding between Kyrgyz Republic, Islamic Development Bank and EcoIslamicBank which was signed in 2006 with a view to introduce and develop Islamic banking in the country. However, the necessary procedures to convert it into a full-fledged Islamic bank were never implemented due to lack of reflection of the Islamic principles.

Certain amendments to the banking law were introduced in 2009 and 2013 to the Law of the Kyrgyz Republic known as the normative legal acts of NBKR. These laws provided detailed instructions and regulations relating to Islamic finance, credit institutions and transactions.

Given the low market share Islamic banking has garnered to date, regulators have not paid much attention to this issue. Even the Kyrgyz taxation system does not have provisions to support Islamic banking. Moreover, Islamic leasing attracts double taxation, which naturally increases the applicant’s borrowing costs. This, in turn, translates into another hindrance in terms of developing new Islamic banking products.

Limited reach and lack of competitive products: Just one Islamic bank services the entire country’s Islamic finance requirements. And that bank’s reach is limited because of its few branches and the inadequacy of its menu of fully Shariah- compliant products. Thus, in the absence of more operators, Islamic banking growth potential in the country is limited. There is a clear need to increase the number of banks offering the critical mass of Shariah-compliant products required to establish a strong presence for this kind of banking in the Kyrgyz Republic.

Effective profit is usually higher in Islamic banks compared with interest rates charged by conventional banks. So despite the strong demand for Shariah-compliant products, customers are deterred by the higher costs involved. This disparity of costs is bound up with the high cost of structuring Islamic products. Furthermore, the Islamic finance products now offered in the country cannot compete with the product portfolio of the conventional banks.

Shortage of working capital: Obtaining Shariah-compliant funds for working capital requirements has proven a challenge for EcoIslamicBank, since Islamic banks cannot use non-Shariah-compliant funds. Such funds now come from donors and/ or other international financial institutions such as IDB. This limits Islamic bank flexibility in terms of financial operations and the replenishment of funds.

Shortage in the skilled workforce: Additionally, Kyrgyz banks and financial institutions find it difficult to hire qualified managers and staff with some level of expertise in Islamic banking. In some instances, recruiting experts, such as accountants and product managers, among others, is challenging because such personnel are simply unavailable locally.

Without the necessary know-how and skilled workforce capability at their disposal, Islamic banks cannot maximize their product portfolio by developing.

33 The Kyrgyz Islamic banking industry is underdeveloped, primarily due to the lack of legislative and regulatory support from the government and the country’s central bank. Although the latter amended its banking rules to permit the operation of Islamic banks and windows, it has not yet been able to establish the stand-alone legislation which would encourage development of the sector. The current banking rules -- created for conventional banks -- also need to be followed by Islamic banks, restricting their ability to manage investments and raise capital through avenues that are compliant with Shariah principles. Although several existing foreign banks operating in the country have been evaluating the possibility of setting up an Islamic bank (or window), the present environment does little to encourage them in accelerating their plans.

Overview of micro-finance institutions in the Kyrgyz Republic The establishment of FINCA in 1995 signaled the arrival of microfinance in the Kyrgyz Republic. Even so, the industry was largely characterized by foreign institutions providing grants on the basis of international agreements until August 2002, when the government adopted the legislation ‘On Microfinance Organizations in the Kyrgyz Republic’.

Historically, microfinance developed swiftly dating back to the latter part of 1990s; in fact, the country is among Central Asia’s leaders in this segment. Since 1995, international financial institutions and donor organizations, such as The Foundation for International Community Assistance (FINCA), have been focused on improving the loan access which would enable many more micro enterprises to obtain financing. Microfinance institutions are an important part of the Kyrgyz credit sector as they are generally the sole finance providers in rural areas. This is mainly because MFIs offer unsecured loans, whereas banks focus on urban borrowers who can put up collateral.

Kyrgyz MFIs are well-regulated; the NBKR is responsible for licensing and supervising all MFIs in the country. The law ‘On Microfinance Organizations in the Kyrgyz Republic’, introduced in June 2002, led to the mandatory registration of all MFIs and the need for appropriate certification or a license from NBKR for all legal entities conducting microfinance activities.

Furthermore, the Kyrgyz government passed a law in 2012 to address the parallel loans issue (multiple borrowings by the same customer) in the MFI sector. This piece of legislation was intended to limit such parallel loans by mandating the MFIs providing them to make clients aware of the possible negative effects. The regulation also mandated MFIs to regularly report loan details to the Credit Bureau. This resulted in an 8 percent66 reduction in the number of parallel loans, yet without disrupting MFI operations.

To address growing concerns over rising interest rates, the government passed a Law On Restrictions on Usury Activities in the Kyrgyz Republic in 2013 to protect the rights of borrowers by capping interest rates in excess of the maximum allowable percentage as prescribed by the NBKR. This sparked a sharp decline in the interest rates charged by MFIs, to 31.0 percent in 2013, down from 38.8 percent in 2010.67 This law has also affected the number of MFIs in the country.

The Kyrgyz MFI sector is highly concentrated; around 5 percent of the total 277 licensed micro finance institutions account for more than 85 percent of total MFI loans, and boast of having about 90 percent of the total number of borrowers

277 MFIs have been operating in the Kyrgyz Republic since October 2013,. That is a considerable reduction from the 454 reported in 2011. Of these, 21268 were microcredit companies (MCCs)69, among which two were Islamic institutions, while 6570 were microcredit agencies (MCA)71.

66. Microfinance Barometer – Convergences, 2014 67. Sector Assessment (Summary) – Multisector for Private Sector Development: Asian Development Bank, 2013 68. Microfinance in Kyrgyzstan: Legal Barriers to Development, Kalikova Associates, 2014 69. A licensed MFI established as a legal entity in any organizational and/or legal form of a commercial organization 70. Microfinance in Kyrgyzstan: Legal Barriers to Development, Kalikova Associates, 2014 71. A licensed MFI established as a non-commercial entity

34 Kyrgyz MFIs now service over 500,000 borrowers; and an estimated 16 percent of these borrow from more than one MFI. The 15 largest institutions account for 87 percent of the total MFI loan portfolio and 93 percent of the total number of micro borrowers.72 The top MFIs are relatively well-capitalized, having access to wholesale funding from domestic and international markets.

MFI assets and loans have been growing since 2012, largely in lock-step with an expanding customer base

From 2012–14, MFI assets grew at an average annual rate of 8.4 percent to $467 million. Despite strong growth, however, MFIs currently account for a modest 20 percent market share in the Kyrgyz financial sector by asset value. MFI assets amounted to 6.8 percent of Kyrgyz GDP in 2013.

During the 2012–14 period, the value of loans provided by such institutions increased at an average annual rate of 11.4 percent, up to $370.1 million. This growth was mainly driven by the expansion of the MFI customer base, given that the average individual loan size has remained fairly flat.

The quality of loans disbursed by MFIs have also improved in recent years, as evidenced by the marked decline seen in the NPL rate from 11 percent in 2012 to 7 percent in 2014.

The Kyrgyz MFI sector is highly concentrated; around 5 percent of FigureFigure 20 : Growth 19 : Growth of MFI ofassets MFI and assets loans and ($ million) loans ($ million) Overview of micro-finance insti- the total 277 licensed micro finance institutions account for more than 85 percent of total MFI loans, and boast of having about 90 tutions in the Kyrgyz republic percent of the total number of borrowers Assets ($mn) loans ($mn) 467 The establishment of FINCA in 1995 signaled the arrival of 440 277 MFIs have been operating in the Kyrgyz Republic since 398 microfinance in the Kyrgyz Republic. Even so, the industry was 358 370 October 2013. That is a considerable reduction from the 454 300 largely characterized by foreign institutions providing grants 68 on the basis of international agreements until August 2002, reported in 2011. Of these, 212 were microcredit companies (MCCs)69, among which two were Islamic institutions, while 6570 when the government adopted the legislation ‘On Microfinance 71 Organizations in the Kyrgyz Republic’. were microcredit agencies (MCA) .

Kyrgyz MFIs now service over 500,000 borrowers; and an Historically, microfinance developed swiftly dating back to the Number of MFIs 320 277 215 latter part of 1990s; in fact, the country is among Central Asia’s estimated 16 percent of these borrow from more than one MFI. leaders in this segment. Since 1995, international financial The 15 largest institutions account for 87 percent of the total NPL Rate 11% 7.7% 7.0% MFI loan portfolio and 93 percent of the total number of micro institutions and donor organizations, such as The Foundation 72 Year 2012 2013 2014 for International Community Assistance (FINCA), have been borrowers . The top MFIs are relatively well-capitalized, having focused on improving the loan access which would enable access to wholesale funding from domestic and international many more micro enterprises to obtain financing. Microfinance markets. institutions are an important part of the Kyrgyz credit sector as Agricultural lending dominates MFI loan portfolios, with over a one-third share by value they are generally the sole finance providers in rural areas. This is MFI assets and loans have been growing since 2012, largely in lock- mainly because MFIs offer unsecured loans, whereas banks focus step with an expanding customer base Agricultural lending dominates MFI loan portfolios, with over a one-third share by value on urban borrowers who can put up collateral. In 2014, the agriculture sector accounted for around 37 percent of the total loans disbursed by microfinance organizations, compared with 18 percent for banks. This was followed by trade (20 percent), consumer loans (13 percent), the service sector (6 percent), and the From 2012–14, MFI assets grew at an average annual rate of 8.4 In 2014,construction the agriculture industry (4sector percent). accounted for around 37 percent of the total loans disbursed by microfinance organizations, Kyrgyz MFIs are well-regulated; the NBKR is responsible for percent to $467 million. Despite strong growth, however, MFIs compared with 18 percent for banks. This was followed by trade (20 percent), consumer loans (13 percent), the service licensing and supervising all MFIs in the country. The law ‘On currently account for a modest 20 percent market share in the sector (6 percent), and the construction industry (4 percent). Microfinance Organizations in the Kyrgyz Republic’, introduced Kyrgyz financial sector by asset value. MFI assets amounted to 6.8 in June 2002, led to the mandatory registration of all MFIs and percent of Kyrgyz GDP in 2013. Figure 20: Classification of MFI loans by sector (2014) the need for appropriate certification or a license from NBKR for all legal entities conducting microfinance activities. During the 2012–14 period, the value of loans provided by such institutions increased at an average annual rate of 11.4 percent, up Agriculture Furthermore, the Kyrgyz government passed a law in 2012 to to $370.1 million. This growth was mainly driven by the expansion 20% address the parallel loans issue (multiple borrowings by the of the MFI customer base, given that the average individual loan Trade and commerce same customer) in the MFI sector. This piece of legislation was size has remained fairly flat. 37% intended to limit such parallel loans by mandating the MFIs 4% Consumer loans providing them to make clients aware of the possible negative $370 million effects. The regulation also mandated MFIs to regularly report The quality of loans disbursed by MFIs have also improved in 6% Services loan details to the Credit Bureau. This resulted in an 8 percent66 recent years, as evidenced by the marked decline seen in the NPL rate from 11 percent in 2012 to 72. Sector Assessment (Summary) – Multisector for Private Sector Development: Asian DevelopmentConstruction Bank, and Mort2013gage reduction in the number of parallel loans, yet without disrupting 13% MFI operations. 7 percent in 2014. 20% Others 35 To address growing concerns over rising interest rates, the government passed a Law On Restrictions on Usury Activities in the Kyrgyz Republic in 2013 to protect the rights of borrowers by capping interest rates in excess of the maximum allowable percentage as prescribed by the NBKR. This sparked a sharp decline in the interest rates charged by MFIs, to 31.0 percent in 2013, down from 38.8 percent in 201067. This law has also affected the number of MFIs in the country.

66 Microfinance Barometer – Convergences, 2014 67 Sector Assessment (Summary) – Multisector for Private Sector Development: Asian Development Bank, 2013 68 Microfinance in Kyrgyzstan: Legal Barriers to Development, Kalikova Associates, 2014 69 A licensed MFI established as a legal entity in any organizational and/or legal form of a commercial organization 70 Microfinance in Kyrgyzstan: Legal Barriers to Development, Kalikova Associates, 2014 71 A licensed MFI established as a non-commercial entity 72 Sector Assessment (Summary) – Multisector for Private Sector Development: Asian Development Bank, 2013

26 The Current Status of Islamic Banking in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 27 The Kyrgyz MFI sector is highly concentrated; around 5 percent of Figure 19 : Growth of MFI assets and loans ($ million) Overview of micro-finance insti- the total 277 licensed micro finance institutions account for more than 85 percent of total MFI loans, and boast of having about 90 tutions in the Kyrgyz republic percent of the total number of borrowers Assets ($mn) loans ($mn) 467 The establishment of FINCA in 1995 signaled the arrival of 440 277 MFIs have been operating in the Kyrgyz Republic since 398 microfinance in the Kyrgyz Republic. Even so, the industry was 358 370 October 2013. That is a considerable reduction from the 454 300 largely characterized by foreign institutions providing grants 68 on the basis of international agreements until August 2002, reported in 2011. Of these, 212 were microcredit companies (MCCs)69, among which two were Islamic institutions, while 6570 when the government adopted the legislation ‘On Microfinance 71 Organizations in the Kyrgyz Republic’. were microcredit agencies (MCA) .

Kyrgyz MFIs now service over 500,000 borrowers; and an Historically, microfinance developed swiftly dating back to the Number of MFIs 320 277 215 latter part of 1990s; in fact, the country is among Central Asia’s estimated 16 percent of these borrow from more than one MFI. leaders in this segment. Since 1995, international financial The 15 largest institutions account for 87 percent of the total NPL Rate 11% 7.7% 7.0% MFI loan portfolio and 93 percent of the total number of micro institutions and donor organizations, such as The Foundation 72 Year 2012 2013 2014 for International Community Assistance (FINCA), have been borrowers . The top MFIs are relatively well-capitalized, having focused on improving the loan access which would enable access to wholesale funding from domestic and international many more micro enterprises to obtain financing. Microfinance markets. institutions are an important part of the Kyrgyz credit sector as Agricultural lending dominates MFI loan portfolios, with over a one-third share by value they are generally the sole finance providers in rural areas. This is MFI assets and loans have been growing since 2012, largely in lock- mainly because MFIs offer unsecured loans, whereas banks focus step with an expanding customer base on urban borrowers who can put up collateral. In 2014, the agriculture sector accounted for around 37 percent of the total loans disbursed by microfinance organizations, compared with 18 percent for banks. This was followed by trade (20 percent), consumer loans (13 percent), the service sector (6 percent), and the From 2012–14, MFI assets grew at an average annual rate of 8.4 construction industry (4 percent). Kyrgyz MFIs are well-regulated; the NBKR is responsible for percent to $467 million. Despite strong growth, however, MFIs licensing and supervising all MFIs in the country. The law ‘On currently account for a modest 20 percent market share in the Microfinance Organizations in the Kyrgyz Republic’, introduced Kyrgyz financial sector by asset value. MFI assets amounted to 6.8 Figure 21: Classification of MFI loans by sector (2014) in June 2002, led to the mandatory registration of all MFIs and percent of Kyrgyz GDP in 2013. Figure 20: Classification of MFI loans by sector (2014) the need for appropriate certification or a license from NBKR for all legal entities conducting microfinance activities. During the 2012–14 period, the value of loans provided by such institutions increased at an average annual rate of 11.4 percent, up Agriculture Furthermore, the Kyrgyz government passed a law in 2012 to to $370.1 million. This growth was mainly driven by the expansion 20% address the parallel loans issue (multiple borrowings by the of the MFI customer base, given that the average individual loan Trade and commerce same customer) in the MFI sector. This piece of legislation was size has remained fairly flat. 37% intended to limit such parallel loans by mandating the MFIs 4% Consumer loans providing them to make clients aware of the possible negative $370 million effects. The regulation also mandated MFIs to regularly report The quality of loans disbursed by MFIs have also improved in 6% Services loan details to the Credit Bureau. This resulted in an 8 percent66 recent years, as evidenced by the marked decline seen in the NPL rate from 11 percent in 2012 to Construction and Mortgage reduction in the number of parallel loans, yet without disrupting 13% MFI operations. 7 percent in 2014. 20% Others To address growing concerns over rising interest rates, the government passed a Law On Restrictions on Usury Activities in the Kyrgyz Republic in 2013 to protect the rights of borrowers by capping interest rates in excess of the maximum allowable percentage as prescribed by the NBKR. This sparked a sharp decline in the interest rates charged by MFIs, to 31.0 percent in 2013, down from 38.8 percent in 201067. This law has also affected the number of MFIs in the country.

66 Microfinance Barometer – Convergences, 2014 67 Sector Assessment (Summary) – Multisector for Private Sector Development: Asian Development Bank, 2013 68 Microfinance in Kyrgyzstan: Legal Barriers to Development, Kalikova Associates, 2014 69 A licensed MFI established as a legal entity in any organizational and/or legal form of a commercial organization 70 Microfinance in Kyrgyzstan: Legal Barriers to Development, Kalikova Associates, 2014 71 A licensed MFI established as a non-commercial entity 72 Sector Assessment (Summary) – Multisector for Private Sector Development: Asian Development Bank, 2013

26 The Current Status of Islamic Banking in the Kyrgyz republic Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 27

36 04. Islamic Banking Opportunities among MSMEs

Because 95% of MSMEs are unable to meet their financial needs through formal channels, a significant opportunity for Islamic banks exists inthe Kyrgyz Republic. And over the next few years, the Islamic financing opportunity represented by these MSMEs is projected to be worth $342.2 to $456.3 million, with deposit potential in the range of $402.6 to $536.9 million.

Access to finance for the MSME sector MSME penetration of formal financing channels in the country is low. Moreover, the banking facilities are largely concentrated in urban areas. Thus, easy access to finance is a major constraint for the MSME sector

Kyrgyz MSME lending has picked up momentum over the last few years, driven by certain government initiatives, such as the introduction of preferential loans. Nevertheless, banking activity in the country remains weak because of the relatively small number of bank branches and ATMs. In addition, a pronounced lack of financial literacy and low confidence in the banking system has led the majority of the Kyrgyz population to opt for keeping their money at home rather than in banks.

Bank funding in the country is among the lowest in Eastern Europe and Central Asia. According to a 2011 World Bank Group study, the Kyrgyz Republic ranked 24th among 2973 Eastern European and Central Asian countries pertaining to its access to bank credit for investment. Moreover, the country had the lowest levels of credit provided to the private sector over the same vast region (12.9 percent of GDP in 201174). Simply put, businesses rely less on bank financing and more on internal sources of funding.

As a consequence, access to finance is a major issue for MSMEs in the country. Only 5 percent75 of MSMEs are able to adequately meet their financing needs through banks and other formal financial institutions. Moreover, those MSMEs able to do so are generally mid-sized enterprises concentrated in urban centers. The other two MSME categories, classified by their access to finance, are as follows:

• Under served MSMEs: Barring a few small enterprises with established track records, the financing needs of a significant portion of the country’s MSMEs are only partially met. These enterprises (representing 20–25 percent76 of the total number of MSMEs) avail themselves of formal financing (Islamic or conventional), which amounts to less than 20 percent of their requirements.

• Unserved MSMEs: These are the mostly small enterprises in either rural or urban areas with no access to formal sources for loans and funding. That is simply a result of banking products and services being unavailable in their locales. Thus this category of MSMEs largely relies on informal sources, such as family and friends. And it represents some 70–75 percent77 of the MSME population, who do not borrow at all for various reasons. Included among these is the fact that their Islamic beliefs prohibit them from paying interest on loans.

73. Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 74. Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 75. Primary Research 76. Primary Research 77. Primary Research

37 MSMEs in Kyrgyzstan mostly borrowfollowed to meet by working loans for capital working requirements capital purposes (54 percent), trade such informal lenders require limited-to-no-paperwork and offer financing (14 percent), and loans for capital expenditures, such as flexible repayment terms, unlike financial institutions. 04. The needs of Kyrgyz MSMEs in termsland, buildingsof banking and services machinery and financial (11 percent) requirements78. are basic. For most (irrespective of their business category) this means current accounts for day-to-day transacting and cash management services are their top Islamic Banking Opportunities among MSMEs priorities, followed by loans for working capital purposes (54 percent), trade financing (14 percent), andThe loans time for takencapital by banks to disburse loans varies from Other forms of financial support, such as leasing and factoring, 2 weeks to 1.5 months, which is not an ideal fit vis-à-vis the often expenditures, such as land, buildings and machinery (11 percent)78. issuing letters of credit, payment cards, and guarantees have urgent funding requirements of MSME businesses. not yet become prominent. Hence, only a few banks offer such Because 95% of MSMEs are unable to meet their financial needs through formal channels, a Other forms of financial support,services such as (and leasing on aand limited factoring, scale). issuing Moreover, letters the of low credit, financial payment cards, and guarantees significant opportunity for Islamic banks exists in the Kyrgyz Republic. And over the next few have not yet become prominent. Hence,literacy only quotient a few among banks offerMSME such entrepreneurs services (and in on general, a limited scale). Moreover,High collateral the low and guarantee requirements prevent MSMEs from years, the Islamic financing opportunity represented by these MSMEs is projected to be worth financial literacy quotient among andMSME their entrepreneurs ambiguity in in termsgeneral, of understandingand their ambiguity operational in terms of understandingapplying operational to banks and microfinance companies $342.2 to $456.3 million, with deposit potential in the range of $402.6 to $536.9 million. requirements, help to keep the demandrequirements, for such financial help to keep products the demand to a minimum. for such financial products to a minimum. Figure 22: Purposes of loans taken outFigure by MSMEs 21: Purposes of loans taken out by MSMEs Figure 22: Why MSMEs avoid applying for loans

0% 10% 20% 30% 40% 50% 21% High interest rates 36% generally mid-sized enterprises concentrated in urban centers. Access to finance for the MSME The other two MSME categories, classified by their access to Already have loans 28% finance, are as follows: 11% 54% sector No requirement of loan 21% ■ Under-served MSMEs: Barring a few small enterprises with MSME penetration of formal financing channels in the country 14% Religious beliefs 9% is low. Moreover, the banking facilities are largely concentrated in established track records, the financing needs of a significant urban areas. Thus, easy access to finance is a major constraint for portion of the country’s MSMEs are only partially met. These the MSME sector. enterprises (representing 20–25 percent of the total number Collateral issues 9% of MSMEs) avail themselves of formal financing (Islamic or Kyrgyz MSME lending has picked up momentum over the last conventional), which amounts to less than 20 percent of their Problem with repayment Working Capital 4% few years, driven by certain government initiatives, such as the requirements. schedule introduction of preferential loans. Nevertheless, banking activity Trade Financing Loans for incurring capital expenditure Source: Primary Research in the country remains weak because of the relatively small ■ Unserved MSMEs: These are the mostly small enterprises in number of bank branches and ATMs. In addition, a pronounced either rural or urban areas with no access to formal sources for Others (including personal loans) The high lending rate is the main reason cited by MSMEs for lack of financial literacy and low confidence in the banking system loans and funding. That is simply a result of banking products Source: M-Vector Survey of MSMEs, March 2015 not availing themselves of loans from financial institutions. has led the majority of the Kyrgyz population to opt for keeping and services being unavailable in their locales. Thus this Source: M-Vector Survey of MSMEs, March 2015 The average lending rates charged by banks and microfinance their money at home rather than in banks. category of MSMEs largely relies on informal sources, such as Reasons behind the popularity of informal funding channels among Kyrgyz MSMEs organizations in 2014 were 22.4 percent and 38.5 percent, family and friends. And it represents some 70–75 percent77 of Bank funding in the country is among the lowest in Eastern respectively; moneylenders, on the other hand, charge 2 percent the MSME population, who do not borrow at all for various Reasons behind the popularity of informal funding channels among Europe and Central Asia. According to a 2011 World Bank Group Because of the low levels of financial literacy in this segment, and their characteristically informal manner of conducting79 Kyrgyz MSMEs per month . study, the Kyrgyz Republic ranked 24th among 2973 Eastern reasons. Included among these is the fact that their Islamic beliefs prohibit them from paying interest on loans.business (particularly in the rural areas), a large segment of Kyrgyz MSMEs prefer to acquire any additional funds they European and Central Asian countries pertaining to its access to require through informal channels. These business owners are more comfortable in dealing with informal lenders, given bank credit for investment. Moreover, the country had the lowest Because of the low levels of financial literacy in this segment, and MSMEs are subject to even stricter terms. Their average collateral that funding by this route is based on acquaintanceship and trust. In addition, such informal lenders requirerequirement limited-to-no- is usually around 1.5 times that of large corporations. levels of credit provided to the private sector over the same vast MSMEs in Kyrgyzstan mostly borrow to meet working capital their characteristically informal manner of conducting business 74 paperwork and offer flexible repayment terms, unlike financial institutions. According to the results of the 2013 World Bank Enterprise region (12.9 percent of GDP in 2011 ). Simply put, businesses rely requirements (particularly in the rural areas), a large segment of Kyrgyz less on bank financing and more on internal sources of funding. Survey, 89 percent of the MSMEs receiving loans in the Kyrgyz The time taken by banks to disburseMSMEs loans prefervaries tofrom acquire 2 weeks any toadditional 1.5 months, funds which they is require not an ideal fit vis-à-vis the often through informal channels. These business owners are more Republic had to provide collateral averaging 187 percent of the urgent funding requirements of MSME businesses. 80 As a consequence, access to finance is a major issue for MSMEs The needs of Kyrgyz MSMEs in terms of banking services and comfortable in dealing with informal lenders, given that funding loan value . The average collateral value ranged from 164 percent 75 in the country. Only 5 percent of MSMEs are able to adequately financial requirements are basic. For most (irrespective of their by this route is based on acquaintanceship and trust. In addition, for firms in the services sector to 237 percent for those in the meet their financing needs through banks and other formal business category) this means current accounts for day-to-dayHigh collateral and guarantee requirements prevent MSMEs from applying to banks and microfinance companiesmanufacturing and processing sector81. financial institutions. Moreover, those MSMEs able to do so are transacting and cash management services are their top priorities,

78. M-Vector Survey of MSMEs, March 2015

38

73 Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 78 M-Vector Survey of MSMEs, March 2015 74 Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 79 Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 75 Primary research 80 The Kyrgyz Republic Strategic Assessment of the Economy: Promoting Inclusive Growth: Asian Development Bank, 2014 76 Primary research 81 The Kyrgyz Republic Strategic Assessment of the Economy: Promoting Inclusive Growth: Asian Development Bank, 2014 77 Primary research

28 Islamic Banking Opportunities among MSMEs Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 29 followed by loans for working capital purposes (54 percent), trade such informal lenders require limited-to-no-paperwork and offer financing (14 percent), and loans for capital expenditures, such as flexible repayment terms, unlike financial institutions. 04. land, buildings and machinery (11 percent)78. Islamic Banking Opportunities among MSMEs The time taken by banks to disburse loans varies from Other forms of financial support, such as leasing and factoring, 2 weeks to 1.5 months, which is not an ideal fit vis-à-vis the often issuing letters of credit, payment cards, and guarantees have urgent funding requirements of MSME businesses. not yet become prominent. Hence, only a few banks offer such Because 95% of MSMEs are unable to meet their financial needs through formal channels, a services (and on a limited scale). Moreover, the low financial significant opportunity for Islamic banks exists in the Kyrgyz Republic. And over the next few literacy quotient among MSME entrepreneurs in general, High collateral and guarantee requirements prevent MSMEs from years, the Islamic financing opportunity represented by these MSMEs is projected to be worth and their ambiguity in terms of understanding operational applying to banks and microfinance companies $342.2 to $456.3 million, with deposit potential in the range of $402.6 to $536.9 million. requirements, help to keep the demand for such financial products to a minimum. Figure 21: Purposes of loans taken out by MSMEs Figure 23: Why MSMEs avoidFigure applying 22: Whyfor loans MSMEs avoid applying for loans

0% 10% 20% 30% 40% 50% 21% High interest rates 36% generally mid-sized enterprises concentrated in urban centers. Access to finance for the MSME The other two MSME categories, classified by their access to Already have loans 28% finance, are as follows: 11% 54% sector No requirement of loan 21% ■ Under-served MSMEs: Barring a few small enterprises with MSME penetration of formal financing channels in the country 14% Religious beliefs 9% is low. Moreover, the banking facilities are largely concentrated in established track records, the financing needs of a significant urban areas. Thus, easy access to finance is a major constraint for portion of the country’s MSMEs are only partially met. These the MSME sector. enterprises (representing 20–25 percent of the total number Collateral issues 9% of MSMEs) avail themselves of formal financing (Islamic or Kyrgyz MSME lending has picked up momentum over the last conventional), which amounts to less than 20 percent of their Problem with repayment Working Capital 4% few years, driven by certain government initiatives, such as the requirements. schedule introduction of preferential loans. Nevertheless, banking activity Trade Financing Loans for incurring capital expendSource:iture Primary ResearchSource: Primary Research in the country remains weak because of the relatively small ■ Unserved MSMEs: These are the mostly small enterprises in number of bank branches and ATMs. In addition, a pronounced either rural or urban areas with no access to formal sources for Others (including personal loans) The high lending rate is the main reason cited by MSMEs for lack of financial literacy and low confidence in the banking system loans and funding. That is simply a result of banking products The high lending rate is the main reason cited by MSMEs for not availing themselves of loans from financial institutions. not availing themselves of loans from financial institutions. has led the majority of the Kyrgyz population to opt for keeping and services being unavailable in their locales. Thus this The average lending rates charged by banks and microfinance organizations in 2014 were 22.4 percent and 38.5 percent, Source: M-Vector Survey of MSMEs, March 2015 The average lending rates charged by banks and microfinance their money at home rather than in banks. category of MSMEs largely relies on informal sources, such as respectively; moneylenders, on the other hand, charge 2 percent per month79. 77 organizations in 2014 were 22.4 percent and 38.5 percent, Bank funding in the country is among the lowest in Eastern family and friends. And it represents some 70–75 percent of Reasons behind the popularity of informal funding channels among respectively; moneylenders, on the other hand, charge 2 percent Europe and Central Asia. According to a 2011 World Bank Group the MSME population, who do not borrow at all for various MSMEs are subject to even stricter79 terms. Their average collateral requirement is usually around 1.5 times that of large Kyrgyz MSMEs per month . study, the Kyrgyz Republic ranked 24th among 2973 Eastern reasons. Included among these is the fact that their Islamic corporations. According to the results of the 2013 World Bank Enterprise Survey, 89 percent of the MSMEs receiving loans European and Central Asian countries pertaining to its access to beliefs prohibit them from paying interest on loans. in the Kyrgyz Republic had to provide collateral averaging 187 percent of the loan value80. The average collateral value MSMEs are subject to even stricter terms. Their average collateral bank credit for investment. Moreover, the country had the lowest Because of the low levels of financial literacy in this segment, and 81 ranged from 164 percentrequirement for firms in isthe usually services around sector 1.5 to times237 percentthat of largefor those corporations. in the manufacturing and processing sector. levels of credit provided to the private sector over the same vast MSMEs in Kyrgyzstan mostly borrow to meet working capital their characteristically informal manner of conducting business 74 According to the results of the 2013 World Bank Enterprise region (12.9 percent of GDP in 2011 ). Simply put, businesses rely requirements (particularly in the rural areas), a large segmentAs aof result, Kyrgyz the majority of the funds came from the retained earnings of existing enterprises and household savings, rather less on bank financing and more on internal sources of funding. MSMEs prefer to acquire any additional funds they require Survey, 89 percent of the MSMEs receiving loans in the Kyrgyz than banks and other formalRepublic financial had to institutions. provide collateral averaging 187 percent of the through informal channels. These business owners are more 80 As a consequence, access to finance is a major issue for MSMEs The needs of Kyrgyz MSMEs in terms of banking services and comfortable in dealing with informal lenders, given that funding loan value . The average collateral value ranged from 164 percent in the country. Only 5 percent75 of MSMEs are able to adequately financial requirements are basic. For most (irrespective of their A significant minority (9for percent firms82 in of the Kyrgyz services MSMEs sector do to not237 dealpercent with for the those conventional in the banking system because their faith by this route is based on acquaintanceship and trust. In addition, 81 meet their financing needs through banks and other formal business category) this means current accounts for day-to-day prohibits them from payingmanufacturing interest on loans.and processing sector . financial institutions. Moreover, those MSMEs able to do so are transacting and cash management services are their top priorities, Although many of these MSMEs are creditworthy, they are excluded from being readily able to obtain funds from Islamic financial institutions either because Shariah-compliant products are unavailable or are not properly understood by the owners of these businesses; and in either case such applications tend to involve lengthy processes, making the execution of Islamic

73 Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 78 M-Vector Survey of MSMEs, March 2015 transactions cumbersome. 74 Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 79 Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 75 Primary research 80 The Kyrgyz Republic Strategic Assessment of the Economy:Bank preferencePromoting Inclusive for lending Growth: toAsian the Development trade sector, Bank, leads 2014 to the lessened availability of funds for MSMEs operating in other 76 Primary research 81 The Kyrgyz Republic Strategic Assessment of the Economy:sectors Promoting Inclusive Growth: Asian Development Bank, 2014 77 Primary research Of the total bank credit issued in the Kyrgyz Republic in 2014, almost 36 percent 83 was concentrated on the trade sector. 28 Islamic Banking Opportunities among MSMEs SimilarIslamic inequality Banking prevails and Finance. with respect Opportunities to access acrossto finance MSMEs for inthe the MSME Kyrgyz sector, republic with banks29 preferring to lend to businesses involved in trade.

79. Asian Development Bank: Private Sector Assessment Update - Kyrgyz Republic 2013 80. The Kyrgyz Republic Strategic Assessment of the Economy: Promoting Inclusive Growth: Asian Development Bank, 2014 81. The Kyrgyz Republic Strategic Assessment of the Economy: Promoting Inclusive Growth: Asian Development Bank, 2014 82. M-Vector Survey of MSMEs, March 2015 83. National Bank of the Kyrgyz Republic

39 That is because few MSMEs from other sectors are profitable enough to afford the country’s high financing costs. Moreover, with bank loan terms averaging about two years, only frequent cash-flow investment projects (typically for those engaged in trade) are able to repay this type of short-term loan. Thus, the majority of MSMEs in other sectors are overlooked for financing by the formal financial institutions in the country.

Obstacles for financial institutions in lending to MSMEs Their informal manner of conducting business

A large number of Kyrgyz MSMEs operate in the informal sector. Most of them either do not report. or under-report revenues to regulating bodies. This effectively bars such businesses from accessing the financing they need since banks need to verify a business’ financial viability through registration, title documents and tax reporting.

Most MSMEs (formal as well as informal) are owned and operated by a single individual or their family members. Such businesses rarely have a long-term plan or business strategy. They also tend to lack transparency and internal controls.

All of this inclines banks to avoid lending to them, given the perception that the risk of loan defaults is high.

Accessibility issues hinder expansion

Banks in the Kyrgyz Republic face another major hurdle in the form of the country’s mountainous terrain. This has prevented several of the country’s banks from expanding beyond the few large accessible cities. Additionally, poor financial infrastructure prohibits commercial bank usage of the full technological suite in launching the most effective mobile or branchless banking services in more remote areas. In effect this means that banks are simply unable to service the majority of MSMEs, who operate outside of the major urban centers.

Limited capacities of Kyrgyz banks

Due to their limited financial literacy, Kyrgyz MSMEs do not have sufficient knowledge and information regarding financial products and solutions, particularly Shariah-compliant products. As well, the banking sector has not increased its investment in marketing activities and consumer education to counter this limitation. For instance, the investment in marketing activities by EcoIslamicBank (the only Islamic bank operating in the country) is noticeably low, as is reflected in its slow rate of customer acquisition.

Also, the banking sector generally does not have an adequate number of skilled employees or the technological resources needed to scale up operations or improve operational efficiency.

Supply side analysis – penetration of Islamic Banking into the MSME sector The Islamic banking sector in the Kyrgyz Republic is underdeveloped. As noted above, there is only one fully-fledged Shariah-compliant bank along with three Islamic MFIs operating in the country. Thus despite the favorable perception such lenders enjoy (especially among MSMEs), their product portfolio does not match conventional bank offerings.

The Islamic banking sector in the Kyrgyz Republic is underdeveloped. As noted above, there is only one fully-fledged Shariah-compliant bank along with three Islamic MFIs operating in the country. Thus despite the favorable perception such lenders enjoy (especially among MSMEs), their product portfolio does not match conventional bank offerings.

EcoIslamicBank's banking products are focused on both individual (retail segment) and corporate (especially small businesses) customers. And within the corporate banking segment, the bank concentrates on the MSME group in particular,

40 as is evidenced by the bulk of the loans in its portfolio being small loans. Other products offered include deposit accounts, safety desposit boxes, and currency exchange services plus product financing. The bank also provides trade finance and bank guarantees to businesses operating in the country

MFIs, by comparison, offer group loans (the minimum amount being $65 for 3-18 months), unsecured loans (up to $3,200 over the maximum tenure of a year), secured loans (up to $31,200 for 3 months to 3 years), home purchase and home improvement loans (up to $15,500 for a maximum of 10 years), and education loans (in collaboration with USAID).

Most of these products are structured based on Mudarabah and Murabaha principles. Other Shariah- compliant financing products based on more complex structures are not available, though, due to the under-developed banking infrastructure and lack of personnel with sufficient know-how pertaining to Islamic banking principles and structures.

Islamic banking potential in the MSME sector The Islamic banking sector could potentially fill a funding gap ranging between $342.2 and $456.3 million.

At present, there are a total of 362,16384 MSMEs operating in the Kyrgyz Republic. Of these, only 5 percent (generally mid- sized) have sufficient access to finance through formal channels to be considered financially well-served. By contrast, 20-25 percent85 of these enterprises (generally small businesses) have limited financial access and are financially underserved, while another 70-75 percent86 (generally micro and small businesses) have little access to finance to be deemed financially un-served, at least by formal financial institutions.

The funding potential for Islamic banking in the MSME sector seen from both bull and bear case standpoints:

The bull case scenario: This rests on the assumption that Islamic banking institutions prove capable of implementing a model which extends branch networks to all areas, urban and rural alike; and that they further, improve understanding and knowledge of Shariah-compliant products amongst SMEs, while hiring skilled professionals who can structure Islamic products, and offer competitive Shariah-compliant products under more favorable conditions (for instance with flexible tenure and collateral requirements, at lower cost, and with less documentation) compared to conventional banks. In such a scenario, approximately 80 percent87 of MSMEs have already exhibited their interest in availing themselves of Shariah- compliant financing.

• In the above scenario, Islamic bank penetration over the next few years is estimated as capable of reaching 80 percent of the un-served and underserved MSME market (which, again, represents 95 percent of the total number of MSMEs). At an average loan size of $1500 each, the resulting aggregate value would be $412.9 million.

The bear case scenario: Assumes that the penetration of Islamic banking remains primarily limited to urban areas, offering more diversity in Islamic-structured products while making loan processing easier for MSMEs.

• Given the above conditions, Islamic banking institutions have been estimated as capable of tapping into at least 60 percent of the un-served and under-served market (meaning 95 percent of the total number of MSMEs); thus, with an average loan size of $1500 each, the resulting value would total $309.6 million.

Islamic banks may also expect to cannibalize or convert the existing well-served MSME portfolios of conventional banks anticipating that these MSMEs might migrate elsewhere for better products or quality of services. To be able to achieve this, however, Islamic financial institutions would have to ensure that they are able to diversify their product portfolios and

84. Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 85. Primary Research 86. Primary Research 87. Primary Research

41 As a result, the majority of the funds came from the retained in launching the most effective mobile or branchless banking though, due to the under-developed banking infrastructure and better products or quality of services. To be able to achieve this, earnings of existing enterprises and household savings, rather services in more remote areas. In effect this means that banks are lack of personnel with sufficient know-how pertaining to Islamic however, Islamic financial institutions would have to ensure than banks and other formal financial institutions. simply unable to service the majority of MSMEs, who operate banking principles and structures. that they are able to diversify their product portfolios and outside of the major urban centers. customize these offerings to suit the financing requirements of 82 A significant minority (9 percent ) of Kyrgyz MSMEs do not deal this segment, as well as offer an end-to-end banking solution to with the conventional banking system because their faith prohibits Limited capacities of Kyrgyz banks Islamic banking potentialcustomize in thethese offerings these to suitbusinesses. the financing Assuming requirements a penetration of ratethis ofsegment, 60–80%, as the well as offer an end-to-end banking solution them from paying interest on loans. funding potential within this category of MSMEs could be worth Due to their limited financial literacy, Kyrgyz MSMEs do not to these businesses. Assuming a penetration rate of 60–80%, the funding potential within this category of MSMEs could be MSME sector $32.6–$43.5 million. Although many of these MSMEs are creditworthy, they are have sufficient knowledge and information regarding financial worth $32.6–$43.5 million. excluded from being readily able to obtain funds from Islamic products and solutions, particularly Shariah-compliant products. The Islamic banking sector could potentially fill a funding gap Thus, the total funding potential for Islamic banking in financial institutions either because Shariah-compliant products As well, the banking sector has not increased its investment in ranging between $342.2 and $456.3 million. Thus, the total funding Kyrgyzstanpotential for would Islamic likely banking range from in Kyrgyzstan $342.2 million would in a likely bear case range from $342.2 million in a bear case 84 are unavailable or are not properly understood by the owners marketing activities and consumer education to counter this At present, there are a total of 362,163 MSMEsscenario operating to $456.3 in the millionscenario in a bull to $456.3 case scenario. million in a bull case scenario. of these businesses; and in either case such applications tend limitation. For instance, the investment in marketing activities by Kyrgyz Republic. Of these, only 5 percent (generally mid-sized) to involve lengthy processes, making the execution of Islamic EcoIslamicBank (the only Islamic bank operating in the country) have sufficient access to finance through formalFigure channels24 : Funding to be potentialFigure 23 : Funding potential transactions cumbersome. is noticeably low, as is reflected in its slow rate of customer considered financially well-served. By contrast, 20-25 percent85 acquisition. of these enterprises (generally small businesses) have limited Bank preference for lending to the trade sector, leads to the lessened financial access and are financially underserved, while another MSME 86 availability of funds for MSMEs operating in other sectors Also, the banking sector generally does not have an adequate 70-75 percent (generally micro and small businesses) have little UNIVERSE MICRO, SMALL & MEDIUM ENTERPRISES number of skilled employees or the technological resources access to finance to be deemed financially un-served, at least by Of the total bank credit issued in the Kyrgyz Republic in 2014, needed to scale up operations or improve operational efficiency. formal financial institutions. almost 36 percent83 was concentrated on the trade sector. Similar inequality prevails with respect to access to finance for the MSME The funding potential for Islamic banking in the MSME sector UNSERVED UNDERSERVED WELL SERVED sector, with banks preferring to lend to businesses involved in seen from both bull and bear case standpoints: 70-75% 20-25% 5% Supply side analysis – Current Market Scenario trade. The bull case scenario: This rests on the assumption that ~262,568 ~81,487 ~18,108

Avg. Loan penetration of Islamic Banking Islamic banking institutions prove capable of implementing a 1,500 1,500 3,000 That is because few MSMEs from other sectors are profitable Amount (USD) enough to afford the country’s high financing costs. Moreover, model which extends branch networks to all areas, urban and Bear Case into the MSME sector rural alike; and that they further, improve understanding and 60% 60% 60% with bank loan terms averaging about two years, only frequent Penetration knowledge of Shariah-compliant products amongst SMEs, cash-flow investment projects (typically for those engaged in The product portfolios of the four Islamic financial institutions in Bull Case while hiring skilled professionals who can structure Islamic 80% 80% 80% trade) are able to repay this type of short-term loan. Thus, the the country is very limited, which places them at a disadvantage to Penetration products, and offer competitive Shariah-compliant products majority of MSMEs in other sectors are overlooked for financing conventional banks; and they lack the critical mass of capabilities Bearish Market $236.3mn $73.3mn $32.6mn by the formal financial institutions in the country. in terms of personnel and expertise to expand their credit under more favorable conditions (for instance with flexible Scenario tenure and collateral requirements, at lower cost, and with less $309.6mn $32.6mn offerings. New to bank Conversion documentation) compared to conventional banks. In such a Total Funding Potential: $342.2mn The Islamic banking sector in the Kyrgyz Republic is scenario, approximately 80 percent87 of MSMEs have already Bullish Market $315.1mn $97.8mn $43.5mn Obstacles for financial institu- underdeveloped. As noted above, there is only one fully-fledged exhibited their interest in availing themselves of Shariah- Scenario Shariah-compliant bank along with three Islamic MFIs operating compliant financing. $412.9mn $43.5mn tions in lending to MSMEs New to bank Conversion in the country. Thus despite the favorable perception such lenders ■ In the above scenario, Islamic bank penetration over the next Total Funding Potential: $456.3mn Their informal manner of conducting business enjoy (especially among MSMEs), their product portfolio does not match conventional bank offerings. few years is estimated as capable of reaching 80 percent of A large number of Kyrgyz MSMEs operate in the informal sector. the un-served and underserved MSME market (which, again, Most of them either do not report or under-report revenues to represents 95 percent of the total numberThe of MSMEs). deposit potentialAt an for Islamic banking from MSMEs could be $402.6 to $536.9 million over the short- to mid-term future. regulating bodies. This effectively bars such businesses from EcoIslamicBank’s banking products are focused on both individual (retail segment) and corporate (especially small businesses) average loan size of $1500 each, the resulting aggregate value The deposit potential for Islamic banking from MSMEs could be accessing the financing they need since banks need to verify a would be $412.9 million. The loan-to-deposit ratio$402.6 of the to banking $536.9 million sector overin the the Kyrgyz short- toRepublic mid-term averaged future. 85 percent over the last three years (2012– business’ financial viability through registration, title documents customers. And within the corporate banking segment, the bank and tax reporting. concentrates on the MSME group in particular, as is evidenced The bear case scenario: Assumes that the penetration14). Assuming of Islamic this continues at the same level, the resulting depository potential for Islamic banks within the MSME by the bulk of the loans in its portfolio being small loans. Other banking remains primarily limited to urban areas,sector offering in a bull morecase scenario,The loan-to-deposit where Islamic ratio banking of the penetration banking sector is high in the in bothKyrgyz the urban and rural environments, and the Most MSMEs (formal as well as informal) are owned and products offered include deposit accounts, safety desposit boxes, diversity in Islamic-structured products whileregulatory making loan environment Republicremains averagedfavorable 85 for percent Islamic over banking, the last wouldthree years be $536.9 (2012– million over the next few years. operated by a single individual or their family members. Such and currency exchange services plus product financing. The bank processing easier for MSMEs. 14). Assuming this continues at the same level, the resulting businesses rarely have a long-term plan or business strategy. They also provides trade finance and bank guarantees to businesses depository potential for Islamic banks within the MSME sector ■ Given the above conditions, Islamic bankingOn theinstitutions other hand, have if Islamic banking continues to lack strong penetration of the country’s rural areas, its deposit potential also tend to lack transparency and internal controls. operating in the country. in a bull case scenario, where Islamic banking penetration is high been estimated as capable of tapping into isat expectedleast 60 percent to amount of to about $402.6 million, (applying the same loan-to-deposit ratio). in both the urban and rural environments, and the regulatory MFIs, by comparison, offer group loans (the minimum amount the un-served and under-served market (meaning 95 percent All of this inclines banks to avoid lending to them, given the environment remains favorable for Islamic banking, would be being $65 for 3-18 months), unsecured loans (up to $3,200 over of the total number of MSMEs); thus, withFigure an average 25 : Depository loan Potential Figure 24 : Deposit potential of asset (borrower MSME) quality bolstered by an effective perception that the risk of loan defaults is high. $536.9 million over the next few years. the maximum tenure of a year), secured loans (up to $31,200 for 3 size of $1500 each, the resulting value would total $309.6 collections mechanism to ensure low default rates. Accessibility issues hinder expansion months to 3 years), home purchase and home improvement loans million. 05. Increased focus on non-financial extension services: To help (up to $15,500 for a maximum of 10 years), and education loans Islamic banks may also expect to cannibalize or convert the On the other hand, if Islamic banking continues to lack strong MSMEs overcome the challenges they face (for instance their Banks in the Kyrgyz Republic face another major hurdle in the (in collaboration with USAID). penetration of the country’s rural areas, its deposit potential is Conclusion form of the country’s mountainous terrain. This has prevented existing well-served MSME portfolios of conventional banks lack of knowledge regarding financial products, their informal anticipating that these MSMEs might migrate elsewhere for expected to amount to about $402.6 million, (applying the same methods of conducting business and inefficient financial several of the country’s banks from expanding beyond the few Most of these products are structured based on Mudarabah loan-to-deposit ratio). large accessible cities. Additionally, poor financial infrastructure and Murabaha principles. Other Shariah- compliant financing management), banks should consider providing increased prohibits commercial bank usage of the full technological suite products based on more complex structures are not available, assistance in the form of non-financial extension services. For Although Islamic banking in the Kyrgyz Republic is still in its infancy, there is strong interest 84 Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 instance, MSME toolkits, assistance in framing business plans, in Shariah-compliant financing, particularly among MSMEs. With continued development 85 Primary research guidance on legal and tax rules and regulations, and information and improvement in the regulatory and legislative environment, and in strengthening 82 M-Vector Survey of MSMEs, March 2015 86 Primary research on other related topics, such as finance and management, would 83 National Bank of the Kyrgyz Republic institutional capacities to meet growing MSME demand, the Islamic financing market 87 Primary research help these MSMEs function effectively while improving their opportunity is estimated to reach between $342.2 and $456.3 million going forward. 30 Islamic Banking Opportunities among MSMEs Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 31 creditworthiness. Expanding branch networks and offering non-borrowing products 42 and services: Branch penetration in the country is relatively low, Strategic operational adjustments can help both conventional and meaning smaller towns and rural areas often do not have bank Islamic banks target MSMEs more effectively branches in their immediate vicinities. The regulatory and legislative framework: Additionally, banks should evaluate the viability of offering non- There is a real need to develop a Sharia Governance Regulatory borrowing banking services and products such as current and Framework (SGRF). These regulations should cover governance savings accounts, cash management or payment management, and guidelines for the legislative regulatory bodies, and for the payroll management, and other fee-based transaction banking services. are now evaluating the feasibility of setting up Islamic banking full commercial stand-alone Islamic banks as well as those banks Definitions operations within their businesses in the country. that would like to establish Islamic windows in their existing conventional bank operations. In summary, the development of the Islamic banking sector Despite the political upheavals and volatility within Kyrgyz depends on the implementation of a robust regulatory framework Human capital and talent development: Unsurprisingly, there is a banking generally as a result of irregularities and legislative that aids growth in Shariah-compliant institutions. Though the shortage of quality talent in the Kyrgyz Islamic finance industry. violations, the sector stabilized in recent years after the government and central bank have already initiated measures to Well-educated and experienced human resources within it are, implementation of regulatory measures by the NBKR and the ease Islamic banking operations, the overall business environment unsurprisingly, in high demand. That is why banks must focus on introduction of an effective development initiative (the Medium- for them remains weak. The Kyrgyz Islamic banking sector is developing the right talent, offering development opportunities, Term Development Program) by the government. At present currently facing a shortage of working capital and has a limited and providing adequate training if they are to stand the best there are 24 commercial banks operating in the country, with a scale of operations. Moreover, the cost of structuring Islamic chance of retaining their human capital. By addressing these combined asset base of $2.5 billion (as of 2014). Foreign banks products is markedly high, putting them at a disadvantage relative issues, they should also be able to realize a significant part of their account for 45 percent of the total assets. These are followed by to conventional banks. untapped potential. private domestic banks (with 34 percent) and state-controlled Reduction of loan-processing time: The time taken by banks banks (with 18 percent). Meanwhile, the only Shariah-complaint At the same time, high costs and their lack of capacities have to process and disburse loans is a major hurdle miring access bank, EcoIslamicBank, accounts for the remaining 3 percent of curtailed penetration of MSMEs by the Islamic banking sector. to MSME financing. Thus banks need to streamline their the assets . In fact, even the large conventional banks have not been active administrative processes to ensure that loan application in lending to SMEs in the Kyrgyz Republic. Total lending by the procedures become less cumbersome in terms of both the Although the level of banking sector activity from 2009 through banking system to SMEs stands at only about 10 percent of the documents required and processing time taken. To accomplish 2011 remained stagnant due to structural deficiencies, regulatory total ($148.1 million in loans and $174.2 in deposits), despite the this, frontline staff need to be provided with predictive tools, and and legislative reforms continued apace, strengthening the system remarkable fact that the segment accounts for approximately 99 back-end support to ensure faster loan processing. as a whole. This resulted in a significant increase in banking percent of all commercial establishments in the country. activity during 2013 and 2014, with both the industry’s loan book Effective segmentation, targeting and evaluation of MSMEs: and deposit base growing at an average annualized rate of more 20 At the present time, only 5 percent of the 362,163 MSMEs have Banks need to frame better methods of segmenting and targeting percent.. adequate access to formal financing. Otherwise, the financing potential MSME customers and evaluating the lending risk they requirements of the remaining MSMEs are either only partially represent. Rather than resorting to a one-size-fits-all business The Islamic banking sector, in particular, has likewise witnessed met by financial institutions (20-25 percent of these businesses model, they must adopt differentiated customized business strong growth over the past few years. Its financing activity are financially under-served) or not met at all (70-75 percent of models and processes for varied MSME targets. In addition, their increased at a CAGR of 18.9 percent, while its deposit base grew at the total number of MSMEs do not have any access to financial branch staff needs to proactively approach and engage MSME an even more rigorous CAGR of 42.1 percent from 2010 to 2014 . support) . entrepreneurs rather than passively relying on these people to The Kyrgyz authorities, although late in allowing Islamic banks a approach the banks. significant role in the industry, have been attempting to improve To effectively target the MSME sector, Islamic banks need to focus on expanding their reach while diversifying product offerings, In particular, banks need to develop a more MSME-specific risk the regulatory landscape as a means to boost development in the sector in the context of the increasing demand for Islamic finance training their workforces regarding Islamic banking products and assessment and underwriting model to assess the credibility of MSME banking, and implementing SME-specific risk assessment MSMEs via bank statements, utility payments, property lease by local businesses. About 5–6 percent of the total population (about 10 percent in the southern provinces and 5.4 percent in tools while simplifying loan procedures. However, if Islamic agreements, technology and/or other such methods. There is also financing institutions are able to capitalize on the positive interest a need to apply cash flow forecasting tools, and non-financial the north) have signaled their interest in Shariah-compliant financing. This is even higher among businesses, with 80 percent in Shariah-compliant banking through such initiatives, then they approaches, such as behavioral scoring, to better understand the stand to tap into a funding opportunity estimated at $342.2 to risks. Effective targeting should parallel continuous monitoring of MSMEs expressing strong interest in borrowing from Islamic financing institutions. As a result, several conventional banks, 456.3 million within these un-served, underserved, and, indeed, such as Kyrgyzkommertsbank, Rosinbank, and Bai-Tushum Bank, well-served categories of MSMEs over the next few years.

32 Islamic Banking Opportunities among MSMEs Islamic Banking and Finance. Opportunities across MSMEs in the Kyrgyz republic 33 Strategic operational adjustments can help both conventional and Islamic banks target MSMEs more effectively

The regulatory and legislative framework: The government has made efforts to strengthen the regulatory environment by way of amendments that laid down key principles of Islamic Banking in 2009 and 2013. Detailed instructions and regulations relating to Islamic finance, credit institutions and transactions are provided in the normative and legal acts of the NBKR (30 normative and legal acts). As of today, the normative and legal acts of NBKR stipulate requirements on licensing, corporate governance, risk management, model agreements standardization and Procedure for specific types of transactions, which comply with the Islamic principles of financing. To implement the pilot project on introduction of Islamic banking and finance principles, a separate package in normative and legal acts, including taxation issues, has been developed since 2006 for EcoIslamicBank. To address the issue, certain amendments were made in normative and legal acts of NBKR, which mandated the establishment of a Shariah Council at Islamic banks and those banks that would like to establish Islamic windows in their existing conventional bank operations. This council would be responsible for compliance of banking operations with Islamic principles.

However, the Shariah Governance Regulatory Framework (SGRF) in Kyrgyzstan is still in the development phase. As discussed earlier, in comparatively matured Islamic finance markets such as Pakistan and Malaysia, regulatory bodies assisted the Central Banks by establishing Shariah Advisory Councils to monitor Shariah operations of banks. This has allowed Central Banks and their Shariah Council to implement the principles of Islamic Banking.

A robust and comprehensive SGRF is required to communicate Shariah governing policies to the Islamic financial institutions and closely monitor all operations from management to product development of the Islamic financial institutions assuring strict adherence to its regulations and policies. The framework should also develop a roadmap for policy formulation and implementation, in addition to drafting guidelines for compliance of policies required by the central bank.

From a practitioners’ perspective, the Kyrgyz Republic is accurately following the roadmap to building a Robust Islamic Banking eco system. By looking at more developed Islamic Banking economies the Kyrgyz Republic can build on its existing Islamic Banking regulations and work closely with banks in order to formalize said ecosystem.

Human capital and talent development: Unsurprisingly, there is a shortage of quality talent in the Kyrgyz Islamic finance industry. Well-educated and experienced human resources within it are, unsurprisingly, in high demand. That is why banks must focus on developing the right talent, offering development opportunities, and providing adequate training if they are to stand the best chance of retaining their human capital. By addressing these issues, they should also be able to realize a significant part of their untapped potential.

Reduction of loan-processing time: The time taken by banks to process and disburse loans is a major hurdle miring access to MSME financing. Thus banks need to streamline their administrative processes to ensure that loan application procedures become less cumbersome in terms of both the documents required and processing time taken. To accomplish this, frontline staff need to be provided with predictive tools, and back-end support to ensure faster loan processing.

Effective segmentation, targeting and evaluation of MSMEs: Banks need to frame better methods of segmenting and targeting potential MSME customers and evaluating the lending risk they represent. Rather than resorting to a one-size-fits- all business model, they must adopt differentiated customized business models and processes for varied MSME targets. In addition, their branch staff needs to proactively approach and engage MSME entrepreneurs rather than passively relying on these people to approach the banks.

In particular, banks need to develop a more MSME-specific risk assessment and underwriting model to assess the credibility of MSMEs via bank statements, utility payments, property lease agreements, technology and/or other such methods. There is also a need to apply cash flow forecasting tools, and non-financial approaches, such as behavioral scoring, to better understand the risks. Effective targeting should parallel continuous monitoring of asset (borrower MSME) quality bolstered by an effective collections mechanism to ensure low default rates.

43 Increased focus on non-financial extension services: To help MSMEs overcome the challenges they face (for instance their lack of knowledge regarding financial products, their informal methods of conducting business and inefficient financial management), banks should consider providing increased assistance in the form of non-financial extension services. For instance, MSME toolkits, assistance in framing business plans, guidance on legal and tax rules and regulations, and information on other related topics, such as finance and management, would help these MSMEs function effectively while improving their creditworthiness.

Expanding branch networks and offering non-borrowing products and services: Branch penetration in the country is relatively low, meaning smaller towns and rural areas often do not have bank branches in their immediate vicinities. Therefore, increasing the number of branches is essential to increase banking opportunities in the Kyrgyz Republic.

Additionally, banks should evaluate the viability of offering non-borrowing banking services and products such as current and savings accounts, cash management or payment management, payroll management, and other fee-based transaction banking services.

Widen the range of products available: As Kyrgyz MSME sector develops further, the range of Islamic products available in the country would have to become broader. A few examples of Islamic banking products are explained below:

• Simple products: Trade finance products such as LC (letter of credit) Musharkah and letter of guarantee which will promote international trading and allow banks to act as guarantors and help facilitate businesses; asset finance products such as securitized loans and lease finance which will allow MSMEs to participate in economic development as well as infrastructure development of the country.

• Complex products: Complex working capital loans such as supply chain financing (SCF) on Bai Ajal or Murabaha. SCF is a short-term credit facility that optimizes working capital by allowing businesses to lengthen payment terms to their suppliers. It facilitates business expansion and mitigates payment risk.

44 05. Conclusion

Although Islamic banking in the Kyrgyz Republic is still in its infancy, there is strong interest in Shariah-compliant financing, particularly among MSMEs. With continued development and improvement in the regulatory and legislative environment, and in strengthening institutional capacities to meet growing MSME demand, the Islamic financing market opportunity is estimated to reach between $342.2 and $456.3 million going forward.

Despite the political upheavals and volatility within Kyrgyz banking generally as a result of irregularities and legislative violations, the sector stabilized in recent years after the implementation of regulatory measures by the NBKR and the introduction of an effective development initiative (the Medium-Term Development Program) by the government. At present there are 24 commercial banks operating in the country, with a combined asset base of $2.5 billion (as of 2014). Foreign banks account for 45 percent of the total assets. These are followed by private domestic banks (with 34 percent) and state-controlled banks (with 18 percent). Meanwhile, the only Shariah-complaint bank, EcoIslamicBank, accounts for the remaining 3 percent of the assets88.

Although the level of banking sector activity from 2009 through 2011 remained stagnant due to structural deficiencies, regulatory and legislative reforms continued apace, strengthening the system as a whole. This resulted in a significant increase in banking activity during 2013 and 2014, with both the industry’s loan book and deposit base growing at an average annualized rate of more 20 percent.

The Islamic banking sector, in particular, has likewise witnessed strong growth over the past few years. Its financing activity increased at a CAGR of 18.9 percent, while its deposit base grew at an even more rigorous CAGR of 42.1 percent from 2010 to 201489. Although the Kyrgyz authorities introduced certain changes to the banking law (in 2006, 2009 and 2013) to facilitate the functioning of Islamic banks, the government should attempt to improve the regulatory landscape to boost development of the sector in view of the increasing demand for Islamic finance by local businesses. About 5–6 percent of the total population (about 10 percent in the southern provinces and 5.4 percent in the north)90 have signaled their interest in Shariah-compliant financing. This is even higher among businesses, with 80 percent91 of MSMEs expressing strong interest in borrowing from Islamic financing institutions. As a result, several conventional banks, such as Kyrgyzkommertsbank), RosinBank, and Bai -Tushum Bank, are now evaluating the feasibility of setting up Islamic banking operations within their businesses in the country.

At the same time, high costs and their lack of capacities have curtailed penetration of MSMEs by the Islamic banking sector. In fact, even the large conventional banks have not been active in lending to SMEs in the Kyrgyz Republic. Total lending by the banking system to SMEs stands at only about 10 percent of the total ($148.1 million in loans and $174.2 in deposits), despite the remarkable fact that the segment accounts for approximately 99 percent of all commercial establishments in the country.

88. National Bank of Kyrgyz Republic 89. National Bank of Kyrgyz Republic 90. Primary Research 91. Primary Research

45 At the same time, high costs and their lack of capacities have curtailed penetration of MSMEs by the Islamic banking sector. In fact, even the large conventional banks have not been active in lending to SMEs in the Kyrgyz Republic. Total lending by the banking system to SMEs stands at only about 10 percent92 of the total ($148.1 million in loans and $174.2 in deposits), despite the remarkable fact that the segment accounts for approximately 99 percent of all commercial establishments in the country.

At the present time, only 5 percent93 of the 362,163 MSMEs have adequate access to formal financing. Otherwise, the financing requirements of the remaining MSMEs are either only partially met by financial institutions (20-25 percent of these businesses are financially under-served) or not met at all (70-75 percent of the total number of MSMEs do not have any access to financial support)94.

To effectively target the MSME sector, Islamic banks need to focus on expanding their reach while diversifying product offerings, training their workforces regarding Islamic banking products and MSME banking, and implementing SME-specific risk assessment tools while simplifying loan procedures. However, if Islamic financing institutions are able to capitalize on the positive interest in Shariah-compliant banking through such initiatives, then they stand to tap into a funding opportunity estimated at $342.2 to 456.3 million within these un-served, underserved, and, indeed, well-served categories of MSMEs over the next few years.

Research Scope and Methodology

IFC, a part of the World Bank Group, provides a combination of advisory and investment services to MSMEs through its Financial Institutions Group (FIG). These services are offered with the following objectives:

Advisory Services:

• Building the capacity of financial institutions in strategy, market segmentation, credit risk management, and product development by taking new approaches and introducing new systems to scale up their financing for MSMEs on a sustainable basis

• Promoting sub-sector focus, especially on women-owned SMEs, sustainable energy SME projects, agricultural SMEs, and leasing

• Raising awareness about best practices in the SME finance space

• Developing credit reporting infrastructure based on country needs

• Supporting the development of secured transactions, collateral registries, and legal and regulatory frameworks

• Building the capacity of public/private stakeholders through advice and training

Investment Services:

• Making equity investments in financial institutions/equity funds for SMEs • Funding lines to expand investment and working capital lines, especially in illiquid markets • Blending finance options to support the expansion of IFC risk appetites, for example; extending grace periods, performance-based pricing, subordination, higher risk/lower security or in limited cases, local currency positions) for selected projects

92. Primary Research 93. Primary Research 94. Primary Research

46 • Increasing the focus on underserved segments, for example pertaining to gender, fragile/conflict, agriculture, climate • Providing risk sharing facilities/partial credit guarantees to enhance risk- taking capacity and offer capital relief via low- risk weightings; avoiding FX mismatches and encouraging domestic resources for SME financing. The primary objective of this report is to enable IFC to determine the market opportunity for Islamic finance in the Kyrgyz Republic. The main questions the report addresses are: • What is the overall number of MSMEs and businesses in the country and how are these establishments structured? • Is Islamic banking there mature enough to adequately cater to the finance and banking needs of MSMEs and other businesses? • What are the products and services that MSMEs want from banks? • What is the size of the MSME market opportunity for Islamic finance? To get data on the above, we devised a questionnaire to be used in discussions with industry experts (Appendix – II).

47 Appendix

Fundamental Concept behind Islamic Laws & Principles

The basic belief around which all Islamic laws and principles revolve is that the whole universe has been created and is controlled by only one God. He created man and appointed him as His vice-regent on Earth to fulfill certain objectives.

The assumption behind this belief is that human reason, despite its immense capabilities, cannot claim to have the unlimited power needed to reach absolute truth and justice. Rather it has definite limits beyond which it either cannot function fully or is bound to make mistakes.

It is thus evident that the sphere of the work delegated to humanity by its Creator is not unlimited. There are areas where human reason simply cannot give appropriate guidance or may fall prey to errors. And it is in these areas that Allah Almighty, the Creator of the universe, has provided guidance through His revelations sent down to His prophets. On the basis of these divine revelations it is the firm belief of every Muslim that the commands given through the last Messenger are to be followed and cannot be violated or ignored on the basis of one's rational arguments or inner desires.

Therefore, all human activities must always be subject to these commands and must work within the limits prescribed for them. Islam is not confined to some moral teachings, some rituals or some modes of worship. Rather it contains guidance pertaining to every sphere of life, including socio-economic fields and activities. Obedience by the servants of Allah is required not only in worship, but also extends to their economic activities, even though this may be at the expense of some apparent benefits -- because these apparent benefits may go against the collective interest of the society.

The origin of the Islamic banking system can be traced back to the advent of Islam when the Prophet himself carried out trading operations for his wife. The “Mudarbah” or Islamic partnerships have been widely appreciated by the Muslim business community for centuries; but the concept of “Riba”, or interest, gained very little traction in regular or day-to-day transactions. Early experiments with Islamic banking took place in Malaysia in the mid-1940s and in Pakistan in the late 1950s. However, the first Islamic banking model was introduced by Mit Ghamr Savings Bank in Egypt in 1963. Ahmad Al Najjar was the chief founder of this bank and the key features it introduced were profit sharing on the non-interest based Shariah philosophy. In 1974, the Organization of Islamic Countries established the first fully Islamic bank called the Islamic Development Bank. Its basic business model was to provide financial assistance and support on profit sharing.

By the end of 1970s, several Islamic banking systems had been established throughout the world, including the first private commercial bank in Dubai (1975), followed by the Bahrain Islamic Bank (1979) and the Faisal Islamic Bank of Sudan (1977). By 2003 Islamic banks had become increasingly popular in the Arab world and in countries like Malaysia.

In more recent times, Shariah-compliant finance has been the fastest-growing area of finance globally and has evolved into two forms:

• Restructuring of the whole financial system of the country in accordance with Shariah principles.

• Islamic financial institutions operating alongside conventional financial institutions, either autonomously oras ‘windows’ within conventional banking set-ups.

By April 2013, there were more than 500 financial institutions worldwide that were either fully Islamic or provided Islamic financial products to their customers. Beyond these, there are several hundred Islamic investment banks and insurance companies, or takaful,

48 The following products are available under Islamic finance:

Islamic forms of deposits

Mudarabah: This is a partnership between the "capital provider" and the "entrepreneur," whereby the former receives a share of the profit against his capital and the latter receives a share of the profit against his labor and management.

Wakala: This is one of the contracts used in Islamic banks to invest money. Under Wakala, the client gives the bank the authorization to invest his money in Islamic activities for a certain percentage of the capital to be deducted from realized profit.

Islamic types of financing

Murabha: This is defined as ‘a sale at the original price plus a profit’. In Murabaha, the bank buys and owns the commodities identified by the customer, including consumer goods and production assets according to specifications determined by the customer. After assuming ownership, the bank sells these goods to the client for a price including the purchase cost plus a determined profit against the efforts exerted for the purchase and the expenses borne by the bank. The commodity is then delivered to the customer within the required specifications.

The client pays for the commodity in periodic installments, subject to the contract of sale. Murabaha sale is offered to companies by providing local or foreign raw materials, equipments and machinery with the aim of establishing and expanding production lines.

Musharkah: In Musharkah financing, the client requests financing for a particular project where the bank shares the anticipated profits or losses of the project with the client. The Musharakah contract is done according to a previously arranged, mutually agreed upon set of distribution rules and principles, in compliance with Shariah. Unlike the case of loans, in Musharkah financing, there are no interest rates.

The concept of ‘Musharkah financing’ is based on the idea that the bank provides the financing required by the client for a particular project without a fixed interest rate, contrary to loans. The realized financial outcome is shared between the bank and the customer, as per the percentages they have mutually agreed.

Ijara: An Ijara lease is defined as a contract that allows the customer to lease a particular asset and utilize it for a specific period of time. After completion of the specified period, the asset can be owned by the customer. This financial lease is adopted in response to the customer's inability to buy a particular asset in cash.

Istisna'a: This is a contract under which the client asks the bank for construction of a manufacturing unit with certain specifications. The bank has to meet the desire of the client and to provide that unit according to specifications set by the client who then pays the price in installments.

The above products have various applications in diverse fields, including within the corporate sector. Of these, Murabaha and Ijara are particularly used by retail customers for buying or leasing cars, home, electronic appliances and home furniture.

49 Questionnaire

MSME access to finance:

• How do you define micro, small and medium enterprises in your institution? (by number of employees?) • How do MSMEs typically access finance in the Kyrgyz Republic? Is it easy for a MSME to obtainl financing? • If access to finance is limited, what are the main reasons why? • Does access to finance vary by the type of enterprise, sub-segments or sector? • Does what is required mutate with the various segments? Do micro and medium differ significantly when it comes to getting funded? Are manufacturing units, for instance, less reliable than service enterprises?

Products offered by the institution:

• What are the comparable market shares of the various banks based on their loans and deposit bases? • Do you offer Islamic banking services? • If yes, what products and services do you offer, and to which segments? • To what degree is your business exposed to MSME’s? (in terms of total loans disbursed/amount of loans disbursed) • If you do not offer Islamic banking products, what other products and services does your institution offer to MSME’s at present? What are the products most eagerly sought by the various MSME segments? • What are the documentation and approval procedures? What guarantees/collateral does your institution demand? • In your opinion, are the products now on offer by the banking adequate to meet MSME needs – presently and in the years to come? • In your opinion what are the products most likely to be in high demand looking out five years? • What challenges do you face when dealing with the MSME sector?

Islamic banking and MSMEs: • How many full-fledged Islamic banks operate in theKyrgyz Republic? What are their names? • How many conventional banks operate Islamic windows? Any detail you can provide on this aspect would be appreciated. • What are the comparable market shares of these Islamic banks (both full-fledged and ‘window’ operations), as informed by loans, financing and deposits? • How far up the development curve is Islamic banking in the Kyrgyz Republic? • To what degree are the businesses of Islamic banks exposed to MSME’s? (for instance, in terms of total loans disbursed/amounts of loans disbursed) • What factors hamper the growth of Islamic banking in the country? • Has the government undertaken any initiatives to promote its development? • What size is the Islamic banking business and presence, as indicated by assets, loans and deposits? • How would you classify Islamic loans, by sector?

50 • What percentage of loans extended become non-performing in Islamic finance? And what is the percentage, among these, of NPLs specifically linked to Islamic loans granted to MSMEs? • What of the current Islamic banking regulatory environment? (We need to understand the current rules, how they compare other markets, and what, if any, amendments might be expected) • What initiatives has the central bank initiated to promote Islamic bank development in the country? Has any effort been made, or plans mooted, specifically to encourage Islamic bank lending to the MSME sector? • Do Islamic banks/financial houses have a significantrole to play in MSME sector development? ­ If not, could you cite some of the reasons for the low adoption pace of Islamic finance products in this segment? What might be the best strategy options to counteract these problems? • Do these banks have products specially designed for the MSME sector? What are the different products/services they now offer? • Is there real latent demand for Islamic finance products on the part of Kyrgyz MSME enterprises? (Y/N – and why?). • What do most MSMEs require, by category, in terms of their financing needs? Does this vary much by sub-segments within their sector? ­• Specifically, what are the most promising MSME sectors where Islamic banking products are most likely to play a major role? • If yes, which specific products would be best suited ot which segments, in terms of the overall offering? • What, in your opinion, are the biggest opportunities for banks in the MSME sector, and specifically for Islamic finance products?

51 Bibliography

Annual publication on Small and Medium Businesses in the Kyrgyz Republic: National Statistical Committee of the Kyrgyz Republic, 2014 Sector Assessment (Summary) - Private Sector and Finance: Asian Development Bank, 2010 Brief Statistical Handbook 2011-2013: National Statistical Committee of the Kyrgyz Republic, 2014 Private Sector Assessment Update - The Kyrgyz Republic: Asian Development Bank, 2013 Consumer Goods Market in Kyrgyzstan: BISNIS, 2008 The Economist Intelligence Unit Corruption Perceptions Index: Transparency International, 2014 GDP growth (annual %) - The World Bank website The Kyrgyz Republic: Economy - Excerpted from the Asian Development Outlook 2015: Asian Development Bank Doing Business 2015: Going Beyond Efficiency - The World Bank Group Annual Report: National Bank of Kyrgyz Republic, 2013 Kyrgyz Republic Partnership Program Snapshot: The World Bank Group, October 2014 Financial Access Survey: International Monetary Fund, 2013 National Bank of Kyrgyz Republic website Country profile – Kyrgyzstan: New Agriculturist, September, 2010 The Kyrgyz Republic Strategic Assessment of the Economy: Promoting Inclusive Growth: Asian Development Bank, 2014 Microfinance Barometer – Convergences, 2014 Sector Assessment (Summary) – Multisector for Private Sector Development: Asian Development Bank, 2013 Microfinance in Kyrgyzstan: Legal Barriers to Development, Kalikova Associates, 2014

52 Notes

53 Notes

54 Notes

55 Xavier Reille Financial Institutions Group Advisory Services Manager Europe, Midle East and North Africa E-mail: [email protected]

Kaiser Naseem Program Manager Banking Advisory Services Midle East and North Africa E-mail: [email protected]

Bishkek, Kyrgyz Republic 720040 Business Centre Orion, 4th Floor Tel.: +996 312 626162 Fax: +996 312 626165 February, 2016