Technical Assistance Consultant’s Report Project Number: 43359 September 2013 Regional: Financial Sector Development in Central and West Asia (Financed by the Asian Development Bank’s Technical Assistance Special Fund) Kazakhstan: Boosting Access and Development Prepared by David Lucock, Patricia McKean, Silke Mueffelmann, and Kairat Shalabay of Frankfurt School of Finance & Management This consultant’s report does not necessarily reflect the views of ADB or the government concerned, and ADB and the government cannot be held liable for its contents. (For project preparatory technical assistance: All the views expressed herein may not be incorporated into the proposed project’s design.) CURRENCY EQUIVALENTS (as of 4 September 2013) Currency Unit – Tenge (t) T1.00 = $0.0065 $1.00 = T153.52 ABBREVIATIONS ADB – Asian Development Bank AMFOK – Association of Microfinance Organizations of Kazakhstan CPF – Central Provident Fund DAMU – DAMU Small Entrepreneurship Development Fund EBRD – European Bank for Reconstruction and Development FIAK – Financial Institutions’ Associations of Kazakhstan FSC – Financial Supervision Committee GDP – gross domestic product GMRA – Global Master Repurchase Agreement HCSB – Housing Construction Savings Bank IAIS – International Association of Insurance Supervisors IFC – International Finance Corporation IFRS – International Financial Reporting Standards IMF – International Monetary Fund IPO – initial public offering JERP – Joint Economic Research Program JICA – Japan International Cooperation Agency KASE – Kazakhstan Stock Exchange KMC – Kazakhstan Mortgage Corporation MAOKAM – Government Medium-term Special Treasury Obligations MEKKAM – Government Short-term Treasury Obligations MEOKAM – Government Medium-term Treasury Obligations MEUJKAM – Government Long-term Savings Treasury Obligations MEUKAM – Government Long-term Treasury Obligations MTM – market-to-market NBK – National Bank of Kazakhstan OTC – over-the-counter PAIMO – Pension Assets Investment Management Organisation PRC – People's Republic of China S$ – Singapore Dollar SGS – Singapore Government Securities TONIA – Tenge Overnight Index Average UNDP – United Nations Development Programme USAID – United States Agency for International Development NOTES (i) The fiscal year of the government and its agencies ends on 31 December. (ii) In this report, “$” refers to US dollars unless otherwise stated. CONTENTS EXECUTIVE SUMMARY I I. INTRODUCTION 1 A. Macroeconomic Development 1 B. Fiscal Sustainability 2 C. Business Environment: Access to Financial Services 2 D. Financial Sector: Structure and Development 4 II. SECTOR PERFORMANCE, PROBLEMS AND OPPORTUNITIES 10 A. Banking Sector 10 B. The Microfinance Subsector 22 C. Banking Sector Roadmap for Technical Assistance 26 D. Insurance Sector 30 E. Securities Market Development 48 III. GOVERNMENT’S SECTOR STRATEGY 83 A. Current Status 83 B. Development Goals 84 IV. ADB SECTOR EXPERIENCE AND PROGRAM 85 A. Summary of Experience 85 B. Harmonization of Activities of Other International Finance Institutions 86 DONOR ACTIVITIES IN KAZAKHSTAN 87 EXAMPLES OF PROPOSED TERMS OF REFERENCE 94 PROBLEM TREE 98 FINANCIAL SECTOR TABLES 99 EXECUTIVE SUMMARY The over-rapid expansion of lending and subsequent adverse effects of the global financial crisis left banks in Kazakhstan with large amounts of overdue loans and less able to refinance their loan portfolios. It also left many businesses and households with debts they were unable to repay or service. The values of securities provided against loans depreciated and became inadequate for full recovery of the debt. Nonperforming loans rose from about 3.0% before the global economic and financial crisis of 2008 to 35.9% at end of 2011. Loan portfolio quality improved only marginally in the two years mid-2011, and a rapid increase in overdue interest income has further undermined quality. The requirement that banks pay tax on loan write-offs, leading them to show bad debt in their balance sheets rather than following a program of loan write-offs, compounded the problem. While the banking sector is characterized by poor earnings and a restructuring of three large banks in aggregate, some banks are taking advantage of market conditions to expand market share and have satisfactory levels of earnings. Banks also appear to be learning from their recent experience and are incorporating better management practices into operations. The tax code used to treat loan write-offs and associated loss provisions as taxable income, encouraging banks to keep bad loans on their books. The Amendment to the Tax Code, valid only during 2012, allowed banks to write-off bad loans without incurring income tax. Consideration could be given to make this amendment permanent (or should be extended until the banks clear their balance sheets). An outstanding concern is that the forgiveness of debt should be treated as taxable income in the hands of the debtor. The National Bank of Kazakhstan (NBK), the central bank, require all banks to comply with Basel III and International Financial Reporting Standards 9 requirements from 1 January 2013. The central bank is receiving hands-on advice and assistance in bank supervision. Ensuring full compliance may cause financial asset values to decline, however, and result in a need for many banks to add capital to their businesses. The Law on Risk Minimization, which came into effect in February 2012, is intended to provide greater transparency in shareholder structures in the finance and corporate sectors, more information on the sources and uses of earnings, and lead to more stringent regulation of related-party lending. This should improve investor confidence in firms and lead to more efficient and better allocation of investor and lender funds. Most business and debt restructuring has been in larger firms. In the 2008–2012 time period, lending to small enterprises declined, while the business failure among small firms is 10 times that of large businesses. Because small firms are able to respond quickly to changes in the economic climate and are substantial employers, this attrition rate is a concern. Strengthened bank staff capacity evaluating and restructuring small businesses in difficulty could help further develop the small business sector. The rehabilitation of businesses, especially small businesses, could be reviewed against recent amendments to the Law on Bankruptcy to determine where procedures related to the law could be streamlined to expedite business and debt recovery. While most banks provide internet banking services, uptake has been minimal, with banks focusing more on cleaning up their loan portfolios. There has been widespread expansion, however, in the use of payment cards through ATMs and point-of-sale outlets. One bank in particular plans to expand the range of products available through electronic banking and is fully aware of the opportunities in financial service products and the success of electronic banking in other countries. Another nonbank financial institution will implement electronic banking for a ii limited range of financial products, such as municipal tax payments, in addition to pension payments. These institutions are expected to acquire proprietary value through their own efforts. Microfinance services are developing through bank partnerships with mobile network operators, which will allow for microcredit disbursements and repayments, deposit services, access to cash through point-of-sale outlets and ATMs, money transfers, and better access to microinsurance products such as accident and health insurance. Microinsurance is included as a service that microfinance organizations, as agents for insurance firms, can provide under the new law on microfinance organizations. The law on microfinance organizations, approved in November 2012, does not allow microfinance organizations to take deposits, making it difficult for them to compete with banks in the provision of a broader range of electronic banking services. 1 Furthermore, the need for microfinance organizations to finance asset growth only out of borrowing additional equity and retained earnings will constrain their lending outreach. Kazakhstan is the largest insurance market in Central Asia and is ranked 68th in the world on premium ranking (0.03% of world market share). The nonlife insurance segment dominates the insurance sector, with about 78% market share. The gross written premium in 2012 reached 0.6% of gross domestic product (GDP) ($1.57 billion), of which voluntary insurance accounted for 75% of GDP and compulsory for 25% of GDP. Of the gross written premium, voluntary nonlife insurance purchases contribute 52% and compulsory insurance 26%. By comparison, life insurance in Kazakhstan is still at a nascent stage, and nearly 71.4% of the life portfolio in 2012 was comprised of annuities. The three largest insurance companies held 40.6% of subsector assets in 2011. The insurance market in 2013 is expected to maintain the trends of 2012 amid favorable economic conditions and steady oil prices. Potentially negative factors in the sector would include a downward trend in underwriting performance, deterioration in risk-adjusted capitalization and the credit quality of investments, a sustained increase in credit risk exposure associated with reinsurance placements, and a decline in country risk fundamentals. Rapid economic growth, high inflation, and underdeveloped financial markets tend to expose both insurers and supervisors to challenging decisions. Insurance supervision