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PROJECT INFORMATION DOCUMENT (PID) APPRAISAL STAGE

Report No.: AB4380

Project Name Afghanistan Financial Sector Strengthening Project

Region SOUTH ASIA Sector Banking (60%);General finance sector (40%) Project ID P110644 Borrower(s) GOVERNMENT OF AFGHANISTAN Implementing Agency Environment Category [ ] A [ ] B [X] C [ ] FI [ ] TBD (to be determined) Date PID Prepared February 5 , 2009 Date of Appraisal Authorization

February 12, 2009

Date of Board Approval April 30, 2009

1. Country and Sector Background Despite a deteriorating security environment and increasing constraints to private sector development, Afghanistan experienced robust economic growth over the last few years: real GDP is expected to have grown by 11.4 percent in 2007/08 (GDP US$9.6 billion) and 7.5 percent in 2008/09 (GDP US$12.8 billion). Per capita income increased from US$125 to US$300 from 2002 to 2008. Alongside of this economic growth in Afghanistan, there also has been considerable effort to rebuild the financial sector in terms of its institutional and legal framework, which has led to an increased number of private commercial banks operating in Afghanistan. Despite this overall growth, a weak financial sector still remains one of the major binding constraints to private sector development in Afghanistan. Currently, the sector does not meet the financial needs of industries and individuals, nor provide adequate financial services to business. Due to highly collateralized lending practices along with a lack of financial intermediation capacity in the financial sector, access to credit remains a serious constraint to private sector development. The share of total credit to GDP is 6.7% (2007) in Afghanistan, which is far less than the average share of credit to GDP within South Asia at 43%. According to the Investment Climate Survey (2005), only 30 percent of the surveyed firms in Afghanistan had bank accounts and access to formal financial services. Most businesses rely on the informal fund transfer system, “hawala”, to make payments and transfer funds, and nearly 21% of firms responding in the survey reported having a loan from “hawaladars” with an average term of 3.8 months. In the most recent Doing Business (2009) rankings for “Getting Credit”, a measure of credit information sharing and legal rights of borrowers and lenders, Afghanistan ranked 178th out of 181 countries. Cognizant of the lack of finance as one of the main challenges to economic development, the Government of Afghanistan (GoA) is committed to financial sector reforms. In the Afghanistan Compact (2006), the GoA committed itself to undertake a series of financial sector reforms including the improvement of the banking supervision function of Da Afghanistan Bank (DAB) and the re-structuring of state-owned banks. In addition, under the Enabling Environment Conference Road Map (2007), the GoA, together with

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development partners and the private sector, agreed to take strategic actions with a view to “strengthening the financial sector to increase access to credit and financial services”1.

These strategic actions in the Road Map have been further reflected the Afghanistan National Development Strategy 2008-13 (ANDS) under the pillar of “Economic Governance and Private Sector Development”. The ANDS sees a modern and competitive financial sector as one of its main development objectives, and articulates a strategy to expand the availability and range of financial products and services, especially targeting small and medium enterprises. Among others, the ANDS is specifically committed to: (i) build capacity in the financial sector by establishing an independent banking and business training institute as a joint commercial bank; (ii) establish a credit information bureau to facilitate commercial and consumer lending; and (iii) significantly expand the outreach and range of financial products and services. These are all integral parts of the Financial Sector Strengthening (FSS) Project. The Bank’s Interim Strategy Note (ISN) for Afghanistan for the period of FY 2007-08 clearly mirrors the GoA’s strategy of financial sector development with “supporting growth of a formal, modern and competitive private sector” as one of three strategic pillars2.

Financial Sector In 2002 after the fall of the Taliban regime, the formal financial sector in Afghanistan was almost inoperative and the legal framework was virtually non-existent. Since then, Afghanistan’s financial sector has gone through two phases of development. During the first phase: ‘re-building basic legal and institutional framework’ (2002-2004), substantial components of the necessary legal and institutional framework for a modern financial sector have been introduced including the Law of Da Afghanistan Bank (2003) and the Law of Banking in Afghanistan (2003). These laws laid a foundation for the re-establishment of DAB as the central bank with autonomous regulatory authority to implement monetary policy and banking regulation and supervision. In the second phase: ‘emergence of the formal financial services’ (2005 to present), there has been growth of private commercial banks. In addition, DAB has also endeavored to improve the financial sector legal framework in order to expand the lending program of commercial banks and to modernize the financial sector. Immediate Challenges in the financial sector: Although significant improvement of the formal financial sector has been achieved in terms of entry of a large number of private commercial banks and increase in the amount of loans and deposits, there has been a disproportionately weak regulatory framework and banking supervision capacity in place in DAB which is required to undertake rigorous banking supervision. Given the developing state of the financial sector in Afghanistan and its fundamental importance to development, the objective of the GoA is to build the capacity of the financial sector so that it can serve the demand for credit from the private sector. In doing so, there are two critical challenges it must address: (i) ensuring that the financial regulator, i.e., DAB has the proper institutional capacity to adequately carry out its core functions, especially supervision of a rapidly growing banking sector and thereby properly manage systemic risk issues; and (ii) finding ways of establishing effective property rights and information that the financial sector can rely on for the purposes of extending credit.

1 Main financial sector reform agreed under the Road Map include: (i) Enacting an appropriate legal framework for the financial sector; (ii) Establishing a Credit Information Bureau; and (iii) Setting up an independent banking training institute. 2 The other two include: (i) building the capacity of the state and its accountability to its citizens to ensure the provision of services that are affordable, accessible and of adequate quality; and (ii) promoting growth of the rural economy and improving rural livelihoods.

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There are also other development challenges in the financial sector which the Government of Afghanistan will have to address. These include: (i) increasing access to financial services generally to the underserved; (ii) expanding financing for small and medium enterprises and in particular to the agricultural and construction sector; (iii) reconciling and determining the role of the two remaining State-owned Commercial Banks; and (iv) continuing to ensure the stability of the financial sector through the prioritization and sustainable development of new services. Legal and Regulatory Framework The Law of Da Afghanistan Bank (2003) is the legal foundation for DAB to operate as the Central Bank of Afghanistan with the overarching objective to achieve and maintain domestic price stability.3 In order to achieve its objectives and tasks, DAB was granted the autonomous power to issue regulations both under the Law of Da Afghanistan Bank and, in specific areas, the Law of Banking in Afghanistan. To date DAB has issued numerous regulations including: (i) licensing of banks; (ii) capital adequacy of banks; (iii) prohibited and authorized activities of banks; and (iv) enforcement powers of DAB in relation to banks failing to meet legal and regulatory requirements. The Law of Banking (2004) forms a legal foundation for banking regulations which subject all commercial banks in Afghanistan to certain requirements, restriction and guidelines. In 2006, DAB also passed a regulation setting out the requirements as to the licensing, corporate governance, permitted and prohibited activities, minimum prudential standards, and reporting of Microfinance institutions, in order to protect depositors. The regulation is based on modern, international best practices and, since it was passed all microfinance institutions are required to comply with its requirements. The Law of Anti-Money Laundering and Proceeds of Crime was enacted in 2004. The law applies to all financial institutions, and tasks DAB with establishing a Financial Intelligence Unit (FIU), as an independent decision making authority, in order to monitor reports from Financial Institutions and analyze them for suspicious transactions. Accordingly, the FIU was established in March 20006. One of the responsibilities of the FIU is to propose and develop new laws and regulations in order to achieve its objectives under the Anti-Money Laundering law. A set of additional Laws have been recently drafted by DAB in an effort to expand the provision of financial services in Afghanistan. These include the Law for Secured transactions on immovable property (Mortgage Law), Law for Secured transactions on movable property, Leasing Law and Negotiable Instruments Law. These are all at various points in the legislative process. The Insurance Law of 1989 was amended by Presidential Decree in 2005. However a new Insurance law and corresponding regulations have been drafted by the Afghanistan Insurance Commission (AIC), which also has the mandate to issue the licenses for and regulate the insurance sector in Afghanistan. The law is currently with the Afghan National Assembly for the final enactment. Commercial Banks There are 15 commercial banks currently operating in Afghanistan, which include: (i) 2 State-owned Commercial Banks (SCB); (ii) 8 Private Commercial Banks (PCB); and (iii) 5 Branches of Foreign

3 Other tasks of DAB which are defined in the DAB law include: (i) to formulate, adopt and execute the monetary policy and the foreign exchange policy of Afghanistan; (iii) to hold and manage the official foreign exchange reserves; (iv) to print and issue Afghani banknotes and coins; (v) to act as banker, adviser and fiscal agent to the State; (vi) to license or register and to regulate and supervise banks, foreign exchange dealers, money service providers, payment systems operators, securities service providers, securities transfer system operators, and such others as are permitted; and (vii) to establish, maintain and promote sound and efficient systems for payments, for transfers of securities issued by the State or DAB.

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Commercial Banks (BFCB)4.. The three SCBs, Millie Bank, Pashtani Bank and the Export Promotion Bank, were licensed at the time when the provisional banking licenses were issued in 2003. However, the Export Promotion Bank was merged with Pashtani Bank in September 2007, and the two SCBs were re-licensed on a condition that granting a permanent license would be considered if they could show good performance. These banks need to improve their management, governance and operations to play a competitive role in the financial sector. Since the first domestic PCB, i.e., Kabul Bank was established in 2002, there has been significant growth of PCBs in terms of the volume of their assets, lending, and deposits. Currently PCBs, particularly the two largest private commercial banks – Kabul Bank and Azizi Bank, dominate the financial market.

The size of total assets in the commercial banks stands at about AFG 60,413 million as of August 2008, which is 14.5% growth from March 2008. As indicated in Table 1, PCBs hold 63 % of the total assets of the market, while two largest PCBs own about 45%. The assets of 5 BFCBs exceed those of 2 SCBs which have 40 branches in total. In terms of the size of loans, the PCBs significantly dominate other banks, holding almost 80% of the total loans in the banking sector. The two largest PCBs hold about 66% of total loans, which is largely provided in USD currency. Unlike other types of bank, SCBs provide about two thirds of their loans in Afghani, which is about 35% of total Afghani loans. Before SCBs started limited lending in 2006, they had not been lending for about two years. Currently, Millie Bank is making SME loans and also preparing for housing loans. It appears that SCBs still have the Afghan public’s confidence. With some management improvement, SCBs are likely to increase the offering of financial services, especially in rural areas, where the presence of PCBs is limited. Most deposits, especially in USD currency, are also held in the PCBs, accounting for about 67% of total deposits. A major share of the deposits with SCBs is in Afghanis. Foreign banks’ deposits in terms of Afghanis are minimal, while their share of USD deposit is significant at about 26%. These deposits are mostly from donors and international NGOs. However, mobilization of the USD deposit does not go to the domestic investment market, but goes to the short term international money market. Only 17% of BFCB’s deposits in USD are invested in the local market.

Table 1: Banking Sector in Afghanistan (as of 30 August 2008)

(in Afghan Millions) PCBs

SCBs Two largest Others

FCBBs Total

Total Assets 17,039 43,374 17,039 18,395 95,847 Share of the total assets (%) (18%) (45%) (18%) (19%) (100%)

Total Loans (gross) 6,931 32,291 6,210 2,458 47,890 Afghani 4,238 5,354 2,490 12 12,094 USD 2,693 26,937 3,680 2,446 35,756 Other currencies 0 0 40 0 40 Share of the total loans (%) (14.5%) (67.5%) (13%) (5%) (100%)

Total Deposits 6,187 37,327 12,759 17,439 74,177 Afghani 3,481 7,777 4,186 2,260 17,704 USD 2,281 28,548 7,116 13,699 51,644 Other currencies 425 1,002 1,457 1,945 4,829 Share of the total deposits (%) (9%) (50%) (17%) (24%) (100%)

4 Fifteen Commercial Banks include: 2 SCBs - (i) Millie Bank and (ii) Pashtani Bank; 8 PCBs -: (i) Kabul Bank, (ii) Azizi Bank, (iii) Afghanistan International Bank, (iv) First Microfinance Bank, (v) Arian Bank, (vi) BRAC Bank, (vii) Development Bank of Afghanistan, and (viii) Afghan United Bank; 5 BFCB -. (i) Standard Chartered Bank, (ii) Punjab National Bank, (iii) National Bank of Pakistan, (iv) Habib Bank Limited, and (v) Bank Alfalah Limited.

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Source: Da Afghanistan Bank

As shown in Table 2, the banking sector in Afghanistan has been growing significantly over the last four years. Three salient trends are: (i) a tremendous growth of the overall banking sector; (ii) significant expansion of the PCBs in terms of deposits and loans; and (iii) a notable decrease of SCBs in the market share. While the market share in total assets of the SCBs has decreased from 83% to 17% during last four years, that of the PCBs has increased from 4% to 64% during the same period.

Table 2: Growth of Afghanistan Banking Sector (in Afghan Millions)

2004/05 2005/06 2006/07 2007/08 2008.8

Total Assets 19,300 30,700 54,150 83,700 95,847 State owned Banks (% of total assets) (54%) (39%) (21%) (19%) (18%)

Private Commercial Banks (% of total assets) (21%) (37%) (58%) (61%) (63%)

Foreign Banks (% of total assets) (25%) (24%) (21%) (20%) (19%)

Total Loans 2,850 8,100 21,950 40,250 47,890 State owned Banks (% of total loans) (37%) (24%) (10%) (14%) (14%)

Private Commercial Banks (% of total loans) (54%) (72%) (87%) (82%) (81%)

Foreign Banks (% of total loans) (9%) (4%) (3%) (4%) (5%)

Total Deposits 9,100 19,700 40,600 63,900 74,177 State owned Banks (% of total deposits) (26%) (16%) (9%) (9%) (9%)

Private Commercial Banks (% of total deposits) (28%) (49%) (64%) (67%) (67%)

Foreign Banks (% of total deposits) (46%) (35%) (27%) (24%) (24%)

Source: Da Afghanistan Bank

In a situation where the growth of private sector banking represents mainly the growth of the two largest banks, the bad performance or failure of this bank would create huge impact on the financial sector and also shatter public confidence on the private commercial banks. Microfinance Institutions Since it would take some time for commercial banks to be in a position to serve the majority of people, the government established the Microfinance Investment Support Facility for Afghanistan (MISFA) in 2003. MISFA is a private non-shareholding company, owned by the Ministry of Finance that provides funding and capacity support to Micro Finance Institutions (MFIs), as a vehicle through which Government and donors could channel funds to build up the lower end of the financial sector. MISFA is intended to (i) coordinate donor funding so that conflicting priorities endemic in post conflict situations did not end up duplicating efforts and distorting markets, (ii) help start-up microfinance institutions scale up rapidly and become sustainable, and (iii) build systems for transparent reporting and instill a culture of accountability. Significant progress was made by the end of September 2008. There were 15 MFIs active in 24 out of 34 provinces, servicing 447,633 active clients (63 percent women) with US$518.69 million loan disbursements (cumulative) to clients, since the start of the program. The average loan size per borrower is US$311 with a repayment rate of 95.5 percent. Some loans provided are up to US$5,000. Loans are taken for trade and services, agriculture, livestock, small manufacturing and handicrafts production. The operational self-sufficiency for the entire sector is 84.4 percent with three MFIs being operationally self-sustainable. In the year from March 2007 to March 2008 the sector added around 8,400 active clients per month and loan disbursements averaged $2.7 million per month. Financial Market Infrastructure

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Credit Information sharing: Although total lending from commercial banks has grown substantially since 2001, the percentage of individuals and firms who are able to access these services is extremely limited with a population ratio to credit of only 0.18%. Unsecured credit is not popular among the banks. On the contrary, collateral is a precondition and always present, without exception, in the credit transactions, not only in the case of large corporate borrowers, but with individuals as well, in the sporadic cases they are considered eligible for a loan. However, as a result of the absence of strong creditor’s rights and in presence of a seriously weak legal framework, lenders face serious problems to enforce collateral. This makes credit more risky and more expensive. Afghanistan shows one of the lowest credit penetrations worldwide and there is strict correlation between the restriction on credit access and the lack of credit information.

Payment and clearance systems are underdeveloped. As a result of the concentration of banking institutions in Kabul, many SMEs and other businesses have no bank accounts and rely on informal funds transfer systems of the hawala money dealers. These informal financial services are as efficient as commercial bank services. However, many of the new fast growing banks, like Azizi Bank and Kabul Bank offer modern online banking services, ATMs and Mobile Banking. In addition, a mobile operator in Afghanistan launched a mobile payment services in February 2008. This allows MFIs and their clients to disburse and repay the loans through mobile phones. Other Financial Services Insurance Industry: In addition to the limited access to external finance, Afghan firms are faced with the near absence of insurance services, which in turn constitutes a serious hindrance to new investment and the development of enterprises and financial institutions. The insurance sector is regulated by the Afghanistan Insurance Commission (AIC) which was established in the Ministry of Finance in 2007. Until 2008, there was only one state-owned insurance company in Afghanistan. In February 2008, however, the AIC licensed the first private insurance company to commence operations in Afghanistan – the Insurance Corporation of Afghanistan. There are also two insurance brokers currently operating. Leasing Services: The development of other financial services institutions and products in Afghanistan remains relatively low. One company offers leasing services mainly in agricultural products. The leasing operation is Sharia compliant and should attract the interest of investors. However, the leasing operations failed to expand in Afghanistan because of (i) absence of legal framework under which the leasing operations could expand, while protecting the interest of the leasing company (a Secured Transaction Law is currently in the Parliament to provide such protection to Leasing Companies); and (ii) absence of a Leasing law, which failed to promote competition as new Leasing Companies entered into the market to provide choice to the customers and also bring about competition to extend competitive services. IFC assisted DAB to draft a Leasing Law, which is now with the Ministry of Justice for legal review, before the law is sent to the cabinet for approval and to the Parliament for enactment. The Leasing Law will provide provisions for new entrants to the market, licensed by the DAB and also create protection for the Leasing companies against any default. Deposit insurance: As a result of the world financial crisis, DAB has become increasingly interested in potentially developing a system of deposit insurance for commercial banks. DAB, in the DAB Strategic Plan 2008-2013, has proposed to establish the Afghan Deposit Insurance Corporation (ADIC). DAB has been working to establish the appropriate regulatory framework for ADIC. However, there are concerns among stakeholders about developing a system of deposit insurance within Afghanistan at this early stage in the development of the financial sector. The primary concern is that the supervision framework in Afghanistan is not strong enough at present to mitigate against a collapse of a commercial bank. Additionally, without a strong supervision system in place in Afghanistan, the development of a deposit

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insurance system may encourage risky behavior by banks who know that the deposits are backed by a deposit insurance scheme. Generally, stakeholders have been concerned about the lack of analysis setting out the parameters for a system of deposit insurance in Afghanistan to date and questions have been raised as to whether this is really a priority given the limited resources in Afghanistan. 2. Objectives The main objective of the FSS Project is to attain greater efficiency in the banking system and improve access to formal banking services to the underserved by establishing key initial building blocks for broader financial sector reform. This will be achieved by strengthening the overall capacity of DAB including banking supervision, enhancing credit information flow among the financial institutions, and providing better training for staff in financial institutions. Key outputs of the project will include: (i) enhanced capacity of DAB in carrying out its core function of financial sector stability, which can be measured in terms of a clean audit report by the external auditors, an assessment of compliance with Basel Core Principles, and the establishment of a modern human resource management system; (ii) improved capacity to assess credit risk of borrowers, increased range of assets that can serve as acceptable loan collaterals, and increased quality and number of qualified bankers. 3. Rationale for Bank Involvement A significant amount of analysis had gone into indentifying and designing the relevant components under the FSS Project. Background work, such as the Investment Climate Assessment for Afghanistan (2005) and the annual Doing Business reports have demonstrated that lack of access to finance is a significant constraint to the development of the private sector in Afghanistan. Additional analysis which has guided the project includes an analysis of the Afghanistan Financial Sector Study (2004) and Credit Bureau Development in South Asia (2004) carried out by the World Bank; an assessment of Credit Information Bureau in Afghanistan (2005) by USAID; the Enabling Environment Conference Road Map (2007) and; five consultants’ reports for each component of the Project prepared after the design mission in February 2008. A detailed list of analytical work is included in annex 12. The ‘DAB strategic Plan for 2008-2013’ (the Plan) was prepared by internal DAB staff and management team in 2008. The Plan lays out DAB’s strategic framework 5 which would lead to it achieving its mission and vision. In the Plan, DAB reiterates its commitment to building a robust financial system for private sector development and economic growth. The Plan also contains a set of detailed activities with a timeline and responsible department. The components of the FSS project are also identified as a priority in the Plan: (i) strengthening its supervisory function; (ii) building an accurate credit information system; (iii) Human resources reform; and (iv) enhancing capacity in the financial sector. The Plan not only clearly shows DAB’s strong ownership of the FSS Project, but also provides a very important conceptual framework for the FSS project. The Afghanistan National Development Strategy (ANDS) for 2008-2013, which was finalized in April of 2008 and sets out the country’s development strategy, also placed increasing access to credit as an important development benchmark for the country. In order to achieve this end, the ANDS stated the following four priority actions: (i) Passage and enactment of four key financial laws: Secured Transactions, Mortgage, Leasing and Negotiable Instruments Laws; (ii) Establish an independent banking and business training institute as a joint commercial bank – DAB initiative; (iii) A credit information

5 The strategic framework is composed of 5 pillars: (i) improve the effectiveness of monetary policy; (ii) deepen financial intermediation; (iii) accelerate capacity building; (iv) effective information management; and (v) promote good corporate governance.

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bureau will be established to facilitate commercial and consumer lending; and (iv) The financial tribunal will be established to provide swift legal resolution of financial disputes. Against the background above, at the request of the DAB Governor, an IDA mission on private sector development worked with DAB to identify seven possible areas in February 2007, where DAB could work with the World Bank Group to improve access to credit. These were: (i) financial sector strategy; (ii) strengthening the supervisory capacity of the central bank; (iii) enhancing the anti-money laundering and combating financing of terrorism framework; (iv) financial sector training facilities; (v) establishing a Public Credit Registry; (vi) financial tribunal; and (vii) collateral registry. However, following detailed discussions, the Ministry of Finance (MoF), DAB, and the Bank have agreed that there is a strong need to: (i) enable DAB to effectively carry out its core functions of ensuring price stability and financial sector stability; (ii) develop the necessary financial sector infrastructure to help the growth process; and (iii) enhance capacity of the commercial banks to help efficient and transparent banking services to support developing a competitive and efficient financial sector. The FSS Project is an important entry point for a sustainable engagement for broader financial sector reforms, which include the restructuring of the State-owned Commercial Banks (SCBs) and the provision of financial services across the nation. USAID, through BearingPoint, has made a significant contribution over the last five years in bringing Afghanistan and DAB from Ground Zero to a level of reasonable competency in financial sector development issues; however, there still remains much to be done in the long term agenda of financial sector strengthening. The FSS Project will also allow the Bank to continue having a dialogue about the broader financial sector development issues in Afghanistan. 4. Description Component 1 – Strengthening the capacity of Da Afghanistan Bank Strengthening the capacity of DAB has been a focus of the GoA since the fall of the Taliban regime. DAB has, for some time, been working in close collaboration with various development partners including the World Bank6, USAID and IMF on strengthening its internal administration and bank supervisory capacity. While there has been some very good progress, DAB now recognizes it needs to upgrade its capabilities in three critical areas:

• Develop the off-site supervision systems and supervision competencies in DAB • Creating an effective accounting and internal auditing system functioning to generally acceptable

international standards, which is critical operationally and goes to the heart of DAB’s credibility as a Central Bank; and

• Establishing an effective human resource management system so it can move from relying on expatriate advisors to well-trained and empowered local staff;

(a) Banking Supervision Infrastructural Weaknesses: The absence of standard supervisory infrastructure within DAB and the usual means of mitigating the consequent weaknesses expose the commercial banks to significant risks. As experience is short in the supervision department, these risks are difficult to measure, and thus difficult to manage. It also means that DAB is handicapped in delivering an effective system of supervision. Many of

6 World Bank Group involvement in the Afghanistan financial sector has significant value added, and includes: the Financial Sector Study (2004); Afghanistan Investment Guarantee Facility (2005); Investment Climate Assessment (2006); Microfinance project (2006/07); Housing finance study (2007); Enabling Environment Conference (2007); AML/CTF workshop (Ongoing); and Afghanistan Rural Enterprise Development Program (under preparation).

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the wider infrastructural weaknesses in the legal system are, however, being resolved through the drafting of new laws, e.g. the Mortgage Law and the Secured Transaction Law. Systemic Risks: Systemic risks relating to the rapid development of the private banking sector are also increasing. Although these have been somewhat improved by supervisory measures, these are only temporary solutions. Systemic risks include:

• Access to credit: accessing credit is relatively new for borrowers, while the banks in Afghanistan generally have unseasoned loan books. The weak infrastructure, combined with the lack of management depth in the banks poses a significant risk;

• Loan structure: credit culture is informal and loans are not structured in a Western sense. Lending is still done through personal knowledge of the customer and the problem of measuring credit risk remains acute despite DAB’s strides in requiring banks to introduce a more formal approach;

• Risk on liabilities side of the balance sheet: the deposit base of banks may well be volatile in Afghanistan due to unusual inducements such as lotteries; and

• Excess capital: while public banks are now highly liquid and have excess capital; this will evaporate quite quickly if their loan books continue to expand rapidly.

Current On-Site Supervisory Procedures: As regards on-site examination, considerable efforts have been put into training and coaching since 1st November 2002, largely by the Bearing Point advisers as set out in Annex 1. Although the Bearing Point consultants will leave DAB in February 2009 following the “no cost extension” of their contract, it is likely that USAID will continue to support the examiner capacity development through a new contract. In addition the IMF, largely through METAC, its regional technical assistance centre, will continue to provide training for banking supervision. There is, however, a need to further build up the capacity for DAB staff to audit IT systems in commercial banks.

Off-Site Supervisory Procedures: The off-site supervisory function needs to be strengthened. Currently this aspect of supervision is undertaken by those who collect and check data derived from regular reporting by banks. Then specified examiners, when not occupied with examinations, are also responsible for acting as contact persons for individual banks. Each examiner prepares assessments for the bank to which he has been assigned and the output for these is considered when assessing priorities for the examination program and other supervisory action. There is also a special supervision section which handles banks under supervisory action of varying types. One of the deputy directors is responsible for aggregating bank reported data and preparing assessments of the whole sector. The results of both exercises are then circulated to the Governor and senior officials. The current off-site analysis process is a poor cousin to the on-site examination procedures, and analytical time devoted to it necessarily comes second to the time spent on examinations. Many of the current deficiencies could be addressed through automating the off-site supervisory processes.

Although there is presently a case manager for each bank, the job is secondary to the examiner’s responsibility to fulfill his or her obligations to the examination program. The expansion of the Financial Supervision Department (FSD) will allow for the enhancement of the role of case manager who will become the individual responsible for managing the supervision of the bank allocated. The case manager would become the recipient of off-site reporting and other intelligence received by the FSD. He or she would be responsible for periodic analysis based on received data, proposing the supervisory strategy for the bank, including the priority for inclusion in the examination schedule, targeted examinations etc., briefing of examiners, participating in examinations if appropriate, ensuring that points raised in the examination report are followed up, the supervisory strategy amended, and so on. The case manager

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would also be the principal point of contact for correspondence with the bank on risk management and other policies that require or should require to be approved by DAB. Much of this work can be done between examinations although on-site examination provides the best method of verification that it has been done correctly. The case manager should also be the instigator of discussions with external auditors and should process approvals of new managers, directors, shareholders etc. Finally, the case manager should also be responsible for managing corrective action with the help of the specialist team in the ‘special supervision’ function. Career Development for Supervisory Staff, Case Managers and IT Staff: A further important need in DAB is the skill and career development of supervisory staff. The career development is extremely important in ensuring that supervisory staff have an incentive to develop professionally and are fully effective. Suffice it to say that application of modern human resource management will not be effective in the FSD until a Director General is appointed and retains the post long enough to exercise effective management.

The FSS Project will support the automation of the off-site supervisory capabilities of DAB by replacing the Excel spreadsheets which are currently used with a more modern system in order to reduce time in producing reports and then validating and removing errors. Additionally, the project will finance the training of the staff who will be involved in the off-site supervision work, developing a career development plan and enhancing the role of the case manager. (b) Accounting and Internal Audit Accounting The accounting system in DAB was set up initially in 1965. In 2003, DAB, with the help of their advisers, developed an in-house system called ‘Database’ using MS Access program. It was developed from a currency conversion program with functionality extended to banking operations, payments, inter bank transfers, accounting, market operations etc. While DAB was able to capture all its transactions with this system, the Database results were not very reliable or acceptable as it had certain inherent deficiencies. In 2006, a Core Banking Solution (CBS) system was acquired by DAB, funded by USAID, to address the increase in the volume of transactions, and changes in DAB’s role with the licensing of new commercial banks. Though the software was designed for a commercial bank, the scope of the software had the ability to be extended to central bank operations. DAB, with the assistance from Bearing Point consultants, also developed an exhaustive Chart of Accounts for this system in compliance with the International Financial Reporting System (IFRS). Currently, the main module of the software has been implemented in all the departments of the Head Office, and the six regional (zonal) offices. It is now being extended to two of the 20 priority branches. The specific modules like Payroll, Fixed Assets, Market Operations, Budgets, etc. have not yet been implemented. It would take about five years for this system to be fully operational in all the functions and activities of DAB at the Head Office, regional offices and the branches. CBS is, however, unlikely to fully meet DAB’s accounting and Management Information System (MIS) needs. It is advisable that DAB should continue to use this system for a few years, but in the medium to long run it should move on to a customized comprehensive central banking IT system for its accounting and MIS system. Without having a proper accounting and internal audit system in itself, it would be difficult for DAB to impose the placement of such a system on the commercial banks, and to undertake rigorous banking supervision. Current weaknesses in the Accounting Department: Despite the introduction of the CBS system, there are still numerous weaknesses in the internal control systems in DAB. For example there is more reliance on

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the inbuilt system controls without adequate manual controls, checks and balances to ensure the integrity of the input data and the information provided by the system. The procedures and policies in respect of transactions in core activities were developed when required but they were not well documented or collated. Additionally, in the absence of a well documented procedure, there is a lack of consistency in the account coding, and further, the account code allocated is not cross checked or verified by anyone, other than the Supervisor of the Accounting Methodology section in the Accounting Department. Moreover, although the vouchers received from other divisions are numbered they do not appear to be sequential. Hence it cannot be confirmed whether all vouchers have been received and recorded. Reconciling the manual books to the database balances is posing a difficulty since the documents developed during the Taliban era were not maintained properly or was not readily available. The reconciliation for the subsequent period seems to be progressing smoothly in respect of correspondent banks subject to certain differences due to reconciling items. However, branch reconciliation is delayed due to a communication gap and DAB has been able to reconcile to date only about 26 branches out of 71, while the others are in progress.  Accounting Manual: DAB has been formulating the Accounting Policies and Operational Procedures as and when required but has not collated and documented it into a formal Accounting Manual. An Accounting Manual would generally elucidate policies and procedures in respect of transactions of each core activity of the bank, and the documentation required for these processes. The internal review and verification procedure would also be performed while complying with such laid down procedures. Although, Bearing Point’s Accounting Advisor was working to develop an Accounting Manual, only 25-30% work has been completed to date. Moreover, the Accounting Manual has to be well understood by the staff in order to properly follow the outlined procedures. In light of these internal controls and other weaknesses, the financial reports produced by DAB cannot be relied upon. The financial statements of DAB for the period ending March 20, 2006 (SY1384) were qualified due to a number of factors including: (i) the opening balances of assets and liabilities were estimated rather than fully authentic and reliable; (ii) DAB’s General Ledger was not complete in all respects; and (iii) the need to reconcile the assets and liabilities swapped between the Ministry of Finance and DAB. It also received a disclaimer of opinion for the period ending March 20, 2007 (SY1385) due to several reasons, among others: (i) no proper accounting procedure is built in the system; (ii) there is no Accounting Manual; and (iii) DAB does not follow a system of periodic internal review, verification, and reconciliation of balance. The External Auditors in their “Report of Factual Findings” dated 8th January 2008 have also observed control weaknesses in the area of foreign reserve operation over accounting and reporting of the Reserve Assets of DAB. The Auditor’s Report also noted that there is a need to strengthen the internal control system that is commensurate with the size and nature of the business of DAB to ensure adequate integrity of balances in the financial statements. Staff Capacity and Training: The existing staff in the Accounting Department only have a basic understanding of book keeping, and traditionally maintain details of DAB’s transactions in manual registers. With the exception of a few staff, many staff members do not have a technical knowledge or training in preparing financial statements. Only a few staff have exposure to International Accounting Standards (IAS) or IFRS requirements. Most staff are trained in the basic module of the CBS software, while some are trained in other modules such as Fixed Assets, Payroll, Market Operations, Budget, etc. The FSS project will support DAB to hire an expert to complete the Accounting Manual and also prepare the Accounting Policy and Operation Procedures for effective implementation of the Accounting Manual. An expatriate consultant will be hired for 12-18 months on a full time basis to undertake the entirety of the completion of the Accounting Manual, policies and procedures, and also assist in capacity building in order for successful implementation of the Accounting Manual. The project will also assist the development of staff capacity in the Accounting Department in terms of financing short courses

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(internally and externally), including external long term courses for professional development and career enhancement. This will be assessed and implemented by the Human Resources Department in conjunction with the Accounting Department.

Internal Auditing

The Department was established in 2004 with an Acting Internal Auditor and about 15 staff members. In accordance with the Law of Da Afghanistan Bank, this department should be led by a Comptroller General appointed for a period of five years. There has been no Comptroller General of the Audit Department since its creation in 2004. The department generally performs compliance audits in respect of all departments and branches, it does not, however, undertake risk based audits. Generally, an audit is conducted by a team of three staff members who report in Dari language, through the Comptroller General, to the Governor, First Deputy Governor, the Chief of the Audit Committee and its two members. All members of the Audit Committee are also members of the Supreme Council of DAB – this structure is defined in the Law of Da Afghanistan Bank 2003. Since the Audit Department’s establishment, no audit of the accounting department has been done as the staff were engaged in the preparation of financial statements for the past years and the external audit. The Auditor’s Report stated that there is need to strengthen the internal control system to ensure adequate integrity of balances in the financial statements. The capacity of the Audit Department needs to be strengthened further so that it can discharge its function more effectively. Although staffs have all been given training in and access to the current CBS system, the competence to perform audits is considerably lacking. Audit Manual: The Audit Department does not have a proper Audit Manual nor Policies or Operational Procedures. It also does not have the policies and operational procedures of the other departments in order to monitor them. Bearing Point is helping to develop an Internal Audit Manual, but since the “no cost extension” will end in February 2009, the work will not be completed within this time. The Audit Department assessed that about 30-35% work on the Audit Manual and Operational Procedures may be completed by February 2009. Moreover, the departmental staff will require to be trained in the usage of the manual for them to follow in the future. Staff Capacity and Training: The internal audits are performed by the staff more out of experience in banking operations than by proper education or training and they are not well exposed to modern international banking and international accounting requirements or trained in them. Therefore, appropriate training needs to be assessed and accordingly a training program developed. The FSS project will support DAB to hire a consultant to complete the Audit Manual and also prepare the Audit Policy and Operation Procedures for effective implementation of the Audit Manual. An expatriate consultant will be hired for 12 months to undertake the entirety of this task and also in capacity building in order for successful implementation of the Auditing Manual. It will also assist the development of staff capacity in the Audit Department in terms of financing short courses (internally and externally), including external long term courses for professional development and career enhancement. The training needs will be assessed and implemented by the Human Resources Department in conjunction with the Audit Department. (c) Human Resources

The Human Resources Department (HRD) needs to be reformed and organized to properly reflect its core functions. The middle level capacity needs to be assessed and strengthened and new, modernized business processes need to be developed. General HR reform will have to be complemented by a

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strengthening of the staff skills to operate the new systems and processes. Furthermore, the management of these skilled staff will require good practices to attract, motivate and retain qualified staff.

HRD policies need to be developed covering (i) Recruitment policy that matches the short and long term skills requirement of DAB; (ii) placement and mobility policy to ensure that there is adequate specialization and least disruption to key department functioning; (iii) training and career development policy that is in line with skills requirement, which is both sustainable and effective as well as safeguarding DAB from excessive turnover of staff; (iv) performance evaluation that is structured, participative and constructive; (v) rewards management and compensation policy that encourages productivity; (vi) exit mechanisms to ensure that non performers have a way out of the system; and (vii) termination benefits policy that provides the right incentives and warnings to performers and non performers. Furthermore, there is a need for developing comprehensive procedures on grievance handling, code of conduct and the HR manual in line with the strategy and aspiration of DAB

Additionally there is a strong need for the HRD to carry out an analysis of staff competencies in order to identify gaps in current training practices and provide recommendations for new training components to all departments. Job descriptions of all DAB staff will be prepared in terms of their importance and contribution to the organization. Based on the job description and current competencies of the staff, it would be possible to assess the training needs of the key staff to design a comprehensive training program for DAB staff. Both local and international training in the core areas of central banking would be needed to upgrade the professional skills that the new organization would demand and expect from all staff. The training assessment will also analyze both behavioral and technical training priorities. Specially tailored management development programs could be arranged through local and international training institutes for the middle management at DAB. As new HR policies are rolled out, there will need to be a large communication and training effort to assist with the comprehension and application of various new policies as well as the strategic plan. The FSS project will therefore finance an HR adviser for up to 12 months to advise and develop a set of new HR policies as set out above and assist in their implementation for HR reform in DAB which would include ‘Gender Mainstreaming’ as described in Annex 10. The HR Adviser will work closely with the HR Director and HRD to ensure that the new HR policies are in line with DAB’s Strategic Plan and that an adequate training program is developed to build necessary capacity in DAB. Additionally, it will finance the training of HR staff to develop the capacity of the HRD and to be able to effectively implement the policies developed under the project, with a view to designing and implementing, in cooperation with all departments, an overall training program for DAB. This will be supported through the development of an understanding for the rationale of change and how it will affect individuals personally. A good, comprehensive and varied communications program will help new HR policies to succeed. Finally, the project will fund the automation of HR management for HRD to store and maintain a database of information about each employee for efficient HR data management, based on the results of the above two tasks. (d) IT Development of DAB IT System Strategic Plan for DAB DAB envisages that further automation will also be required in the next few years in order for it to achieve its mission of fostering price stability and building a robust financial system while implementing the five strategic pillars under the ‘DAB Strategic Plan for 2008-2014’, DAB requires up to date and accurate information on a variety of aspects related to the monetary, financial and associated sectors of the economy in performing its functions as the central bank.

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The current IT system cannot provide this. The management at DAB is aware of the existing deficiencies and would like to initiate an organization wide program to upgrade the IT environment at DAB. To ensure that the planned investment envisaged in this area yields measurable productivity, operational and strategic gains, DAB management desires that:

• The up-gradation in the technology and skills capacity be defined and driven by the information requirements of the fundamental business process that DAB has to perform to carry out its mission, achieve its objectives, and plan & organize its work programs;

• The prioritization of initiatives be carried out by identifying key areas which present the maximum opportunities for improvement; and

• The urgent need for a broader spread of modern office technology systems and processes to be addressed as early as possible.

The IT consultants financed by the FSS project will therefore assist DAB update their Information Systems Strategy Plan (ISSP). The ISSP is expected to provide a plan for 5 years of development. The ISSP would derive the hardware and software requirements from an analysis of the fundamental business processes carried out by DAB, the information requirements and information flows associated with these business processes and identify specific information systems that would need to be implemented to satisfy these requirements. The ISSP would identify priority applications on the basis of need and opportunity as determined by DAB management. It would estimate the cost and time required for implementation of the system and the specific items of hardware and software that would need to be acquired. It would include an implementation plan and suggest a phasing of activities in accordance with management priorities and the absorptive capacity of the organization. In particular it would identify areas of maximum opportunity and tasks, which should be carried out to address immediate needs and those of the longer-term requirements. It would identify the human resource requirements in areas of skill set required for implementing the plan and derive a training plan for existing staff and the skill set to be added by additional recruitment. IT System Development The FSS project will also assist DAB in carrying out a cross-cutting IT system development for automation of off-site supervision, automation of HR management; and for the Public Credit Registry and Collateral Registry. In order to determine the specifications for the IT systems required for off-site supervision and the HR management, a consulting firm will be hired to conduct an IT assessment to determine the exact specifications required for the hardware and software. The IT assessment will also assist in determining basic requirements for operation of the Public Credit Registry and Collateral Registry by analyzing: the current level and performance of DAB’s IT systems, its suitability and capacity of hosting the Public Credit Registry and Collateral Registry, as well as reliability and performance of the telecommunications network. It would also include:

• Determine the changes and upgrades required in terms of hardware and software configuration and telecommunications that DAB’s IT main system will require to satisfy the fundamental technical requirements and needs of the Collateral Registry and Public Credit Registry;

• Determine the level of internal capacity of DAB’s IT staff to support the development of the systems, manage and operate them;

• Broadly define the training needs, for DAB’s personnel to reach self sufficiency in hosting, handling and maintaining sophisticated systems such as the Public Credit Registry and Collateral Registry; and

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• Broadly define IT staffing needs in terms of position, responsibilities, and profiles required by DAB to smoothly run the internal main system and manage the ancillary systems including Public Credit Registry and Collateral Registry.

The exact technical specifications for the Public Credit Registry and Collateral Registry will be determined by a vendor based on the RFP requirements drafted by DAB with the assistance of the IFC. The IFC will also determine the final training requirements of DAB IT staff based on the final software and hardware specifications developed and implemented by the vendor.

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Component 2 – Development of necessary infrastructure in the financial sector Improving access to finance is a long and arduous process but is essential to support the development of the private sector. Resolving the core constraints to lending to the private sector involves a number of important steps, among others: (i) establishing secure property rights on movable and immovable property; (ii) devising means to establish and enforce the realization of collateral; (iii) enhancing credit information flow and identifying “good” and “bad” customers; (iv) developing new financing mechanisms such as leasing and Islamic financing; (v) training bankers in the assessment of private sector credit risks; (vi) building appraisal capacity to establish values; and (vii) developing insurance markets to insure collateral against hazardous events. The World Bank in consultation with DAB and the private sector prioritized the following components to be included in the FSS Project:

• Establishing a collateral registry for movable property that will provide lenders the ability to effectively use their property as collateral;

• Setting up a credit information bureau that will provide lenders information for efficient risk assessment on borrowers; and

• Developing a banker’s training institute that can build credit assessment skills throughout the banking system.

Under this component costs are being shared between IDA and IFC for the establishment of the Collateral Registry and the Public Credit Registry. IFC will provide technical assistance and fund the “soft” parts of the component – the necessary legal reviews, support for any amendment to relevant laws and/or drafting of new laws/regulations. Additionally, IFC will also provide advice to DAB on developing the Request for Proposal for the hardware and software components. Basic information about the suitability of DAB’s IT operations and training requirements will be provided by the IT review funded by IDA under Component 1, however, the exact specifications of the systems, and training for DAB IT staff, for the Collateral Registry and the Public Credit Registry will be determined by the vendor, based on the RFP developed by DAB with technical assistance from the IFC. Once the enabling environment for both the Collateral Registry and the Public Credit Registry has been established, IFC will also finance awareness raising campaigns among key stakeholders. IDA will finance the procurement of the necessary computer hardware and software for the physical infrastructure. (a) Public Credit Registry Financial markets in Afghanistan are largely dominated by a few commercial banks in terms of loan volume while an active microfinance sector represents almost 90% of loans by number. Commercial banks primarily focus on larger and public organizations which have left a large gap in the availability of finance for smaller, private firms in Afghanistan. In the process of loan assessment by the financial institutions, for all intents and purposes, no credit information is currently available to lenders in Afghanistan. Only very limited data is exchanged between DAB and the 15 commercial banks, which is basic statistical information on outstanding portfolios and deposits. However, this information is aggregated in consolidated amounts of all exposures, transmitted on paper, and of no added value in terms of risk assessment. Furthermore, information can be only utilized by DAB for statistical purposes, very limited supervision activities, and to comply with international standard requirements. Dissemination of information to lenders is not contemplated, and there is no information returned from DAB to the banks for credit underwriting purposes. There is no other alternative source of credit information, neither public nor private used by the lenders to underwrite credit. The absence of reliable credit information is a significant impediment to the expansion and development of a healthy financial sector in Afghanistan. Developing a new credit information sharing system would include new risk management tools and procedures to collect and make available exhaustive, complete and predictive full-file credit profiles and information. While it is premature given the current state of the credit markets in Afghanistan to consider

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a private credit bureau, the project intends to assist DAB in initially establishing a Public Credit Registry. Once the market conditions are supportive, private, for-profit credit bureaus should be encouraged and enabled to enter the market with DAB’s role related to sharing of credit information migrating to that of the new private bureaus. The introduction of effective private credit bureaus should be planned once consumer literacy and utilization of credit are customary and broader, when risk management skills of lenders are more developed, and when reputable, international operators are motivated to make a direct investment in Afghanistan. Current Legal framework for credit information sharing: The existing legal and regulatory framework, mainly the Law of Da Afghanistan Bank, and Law on Banking in Afghanistan, seems to give DAB sufficient, autonomous powers to collect information for supervisory and statistical purposes. However, it does not appear tailored to allow the establishment of a full-file credit-reporting infrastructure, i.e., positive and negative information on all loans. Further, under the current legal framework, it does not seem feasible for DAB to have the authority to issue new or amended regulations to modify and enhance current legislation. An alternative to cope with this matter would be to rely on consent by borrowers which, in some jurisdictions, e.g., Saudi Arabia, is sufficient to establish credit information sharing platforms. This alternative needs to be coupled by a Code of Conduct issued by DAB and applied by all lenders. This option should be explored in Afghanistan as it is the simplest way to establish a legal base for credit information sharing. However despite the draw backs, this option could be a good starting point to launch the development of the credit reporting system. DAB should, however, work in parallel to this process to ensure that a transparent legal framework for credit reporting is in place in Afghanistan. The FSS project will therefore assist DAB to develop a Public Credit Registry (PCR) in two phases. PHASE I: Laying a Solid Legal Foundation for Credit Information Sharing

A review of existing legislation is needed to determine options of creating an effective enabling environment for credit information sharing. The options to be explored include: (i) a new, specialized law and related regulations; (ii) DAB-issued regulations; or (iii) using borrower consent as legal authority. IFC will undertake this review before the project is approved by the World Bank Board. Results from the review are expected in early to mid-February 2009. Following the above assessment, if DAB decides to seek adoption of a new Law or Regulations on Credit Reporting, the Law or Regulations need to be prepared to allow for collection and sharing of comprehensive, full-file information among financial institutions: i.e., supervisory purposes for DAB; and loan assessment and risk management purposes for financial institutions. In addition, the Law or Regulations should ensure that the lender’s need for credit information and the consumer’s right to privacy will be effectively balanced. The Law or Regulation should provide a legitimate legal basis for immediate inclusion of all the available lenders/credit data from both regulated and-non regulated entities, including MFIs; and contain mandatory requirements on borrowers to consent to share data and on lenders to collect data, immediately and all inclusively. The Project will assist DAB in setting up the necessary legal foundation for credit information sharing in Afghanistan by: drafting the Law or Regulations if necessary; supporting discussions among DAB and others during the enactment process; conducting a workshop(s) for DAB, lenders and other stakeholders to explain the benefits of credit reporting systems and details of the necessary legislative reforms. The IFC expect to engage a legal consultant by February 2009 to review the relevant laws and regulations. The results of this review will be made known by mid February 2009. Once this review is

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complete, IFC will be able to advise DAB about the best method for creating an effective enabling environment for credit information sharing. PHASE II: Physical development

The FSS Project will support physical development of a PCR by providing necessary resources for software and hardware development. Once effective enabling legislation is in place, an RFP for a technical service provider would be drafted, advertised and awarded to establish the PCR. The Project will also support DAB during the process and assist in the monitoring of the vendor’s progress and adherence to contractual obligations. The PCR will be built as a first class system by an external reputable technical service provider, and have the same functionality as a modern private credit bureau. It is inevitable that DAB initially runs the PCR, however it is advisable the PCR will be hived off to the private sector in the medium/long term. During the vendor selection process, the IFC will assist DAB in drafting and floating a RFP. DAB will also form a selection committee with selection criteria to be prepared by DAB in discussion with IFC and IDA. During the course of physical development, IDA procurement guideline will be applied. Implementation arrangement shall be designed in a way to ensure DAB’s full participation and ownership by forming project steering committee and/or technical working group.

Technical Assistance: The FSS Project will also provide necessary technical assistance such as organization of a study tour; workshops for lenders and policymakers; provision of support to outreach event such as a conference to raise awareness and educate interested parties.

The PCR will represent the first full-file information sharing experiment in the country, and an effective response to the need to supply DAB with an efficient tool to conduct rigorous supervision of the credit system. It is also essential to enable the financial institutions to access complete credit information without any limitations, under the form of complete credit reports, thus improving credit underwriting and introducing other risk management systems. (b) Collateral Registry Lending in Afghanistan is heavily reliant on collateral and firms cannot utilize most of their movable assets such as equipment, inventory, accounts receivable as collateral due to the absence of the movable assets registries and effective functioning legal framework which would support property rights of lenders. Since there is no centralized collateral registration for movable properties in Afghanistan, it is difficult for creditors to check whether proposed collateral has already been offered to other creditors. This makes debt enforcement by creditors difficult, increases the cost of credit and ultimately reduces willingness of lenders to deal with movable collateral, thus limiting financing opportunities in general. Reforms to increase the efficiency of collateral laws and registries can have a positive impact on increasing access to credit. Economic analysis also indicates that countries that have better collateral laws and registries have greater access to credit, better ratings of financial system stability, lower rates of non performing loans, and a lower cost of credit. Current Legal framework for secured lending: There is currently no legal and regulatory framework to allow having a movable collateral registry in Afghanistan, and relying on the existing legal framework, i.e., Civil and Commercial Codes of Afghanistan, would not be a prudent option. The provisions of this legislation do not meet the requirements of the modern secured financing systems and would not support

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effective operation of the collateral registry. The process of amending these legislative acts would be cumbersome and time consuming. Approach for establishing the Collateral Registry: Modern best practice principles are based on notice registration, which means providing notice of a transaction that includes only the information necessary to alert third parties to the potential existence of a charge covering identified assets. Such registries are simple and fast to use, both for registration and for retrieval of information from them. They require disclosure of minimal information and require no formalities because registration is not a pre-requisite to effectiveness between the parties. Registration serves only two purposes: (i) to give notice to third parties; and (ii) to establish priority of the registrant according to the time of registration. Most modern best practices registries provide for registrants to register electronically via the internet. Such registries do not require discretionary decisions by the small registry staff, so they reduce or eliminate opportunity for error and corruption. Electronic registration is instantaneous, since acceptance decisions are made by the registry software. Best practice registries are very inexpensive to operate compared to traditional registries. Such a registry can be placed in any entity which has sufficient technical capacity. DAB for example, having relevant infrastructure could host the Registry in this case. Though several stakeholders in Afghanistan understood such registration principles, for many it represents a novelty. A full acceptance of the approach would depend on the extensive public awareness raising which will target primarily governmental and financial institutions, and will aim to illustrate benefits associated with such registration process. The FSS Project will assist DAB in establishing a Collateral Registry in two phases: PHASE I: Adoption of an effective legal framework for Secured Lending

The Draft Law of Secured Transactions, which is currently being discussed in the Parliament of Afghanistan, includes the features of a modern secured transactions law. So far as the draft law goes, it generally conforms to modern secured lending principles; and though there are some minor gaps, those should not hinder the effectiveness of this proposed framework.. IFC provided recommendations to the DAB on how to improve and strengthen the proposed draft law. The majority of the proposed recommendations were incorporated into the draft law and it will now be considered by the Parliament during the upcoming session in February/March 2009. IFC will continue providing support to the DAB, Parliament and other stakeholders, as necessary, to ensure that Draft is adopted by the Parliament in its current form. In addition, the Government of Afghanistan would have to issue detailed Regulations that will address the issue of registration. IFC will support DAB by drafting these Regulations. Buy-in from public institutions, lenders and various stakeholders is critical to ensure the successful establishment of a collateral registry. In order to raise awareness amongst the different stakeholders and improve the overall environment for secured lending in Afghanistan, during this phase, a workshop will be conducted for regulators, lenders, legislators on the benefits of the Registry. PHASE II: Physical Establishment of the Collateral Registry

Physical development: Upon completion of, or in parallel with the first phase of the program, the Collateral Registry (CR) will be designed and established on the base of the modern notice filing system and according to the legal framework adopted. The data shall be recorded and maintained in a computerized system using an IT solution and a web-site designed for the online application. Hardware and system software will be as required to operate the application software, to include appropriate facilities.

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Detailed specifications for hardware and system software to fit the local needs, i.e. the law and the limitations on the form and location of the registry will be developed by the Registry expert funded by the IFC. These specifications would be the basis for the RFP which the IFC will assist DAB in drafting. The RFP shall be floated and awarded for procuring the application software, including necessary adjustments to meet local needs, and the supporting hardware and system software. The IDA and IFC would support DAB during the process and assist in the monitoring of the vendor’s progress and adherence to contractual obligations.

Technical Assistance: Once the policies are developed and the Registry is set up, the following activities could be undertaken with support from the Project:

• Building Internal Capacity of the Collateral Registry: Training would be necessary for the DAB staff on how to effectively run the CR;

• Internal circulars to support operation of the CR: To ensure that there is a full set of rules under which the Registry will function, necessary regulations and instructions will be developed. These shall describe in detail the policies and procedures governing the Registry;

• Raising awareness among stakeholders about the Registry: In order to increase awareness among various stakeholder groups in Afghanistan, an awareness campaign will be undertaken, which will focus on educating the public, including the finance and entrepreneurial community, government entities, regular citizens, about the existence of the Registry, its objectives and associated benefits; and

• Registry Guide and the Manual development: Further support can be provided through development of: (i) “Registry Guide for Lenders” on the use of the Registry, which will aim at providing information to clients on how to register transactions and do searches; it will help lenders understand the importance of the filing system and the processes for application; and (ii) “Registry Manual” which will provide a comprehensive overview of the registration process, optimally provided on the web-site as an integral part of the software.

(c) Afghanistan Institute of Banking and Finance

The weak human resource capacity in the financial sector remains an obstacle to financial sector development. As such there is immediate demand for an institute to help improve the skills available in the financial sector. Given the rapid growth of the financial sector, the capacity building of the commercial banks and DAB is important in order to provide efficient and transparent banking services to clients. While some individual banks are developing their own training programs, these are not adequate to meet the national need. In order to meet this challenge, a ‘Bankers Training Institute Steering Committee’7 was formed under the leadership of DAB on February 25, 2008 to establish the Afghanistan Institute of Banking and Finance (AIBF). The AIBF will aim at improving human resources of financial institutions by: (i) upgrading the skills and knowledge of credit officers, managers and administrators; and (ii) conducting research and promoting discussions on financial sector policy issues to help national development. The AIBF will be run as a private “for profit” organization. The Board of Directors has been determined and will consist of 5-7. This will include: the DAB Governor (who will chair the Board), 3 members of the ABA (one each from the Private Commercial Banks, State Commercial Banks and one of the branches of the foreign owned banks), a representative from the Chamber of Commerce and a representative from the American University in Kabul.

7 Bankers Training Steering Committee comprises 7 members: Da Afghanistan Bank, Afghanistan Bankers Association, Bank Millie, and 4 private commercial banks.

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In order to ensure the successful operation of the AIBF, the FSS Project will assist the AIBF in developing a 3-5 year collaboration with a regional banker’s training institute in the South Asia Region. Under this collaboration, staff from both the AIBF and from the regional banker’s training institute will visit each other’s respective institutions. The staff from the AIBF will be able to see how a modern and effective banker’s training institute is run and take part in lessons and learning programs while visiting. The staff from the regional institute will visit Kabul and stay in order to provide best practice assistance to the AIBF and assist in implementing a modern curriculum in the AIBF. It is also expected that they will conduct some limited teaching. Over the years, the level of assistance the AIBF will require from the regional banker’s training institute will decrease, however, it is expected that long term ties are forged and the institutes continue to work together through joint seminars, teaching programs and so on. The FSS project will support the creation of the AIBF and also its physical development by establishing it, at first, within rented premises, purchasing necessary equipment and hiring key staff, in addition to the 3-5 year collaboration set out above. The initial focus of the AIBF will be on providing training to the existing banks in Afghanistan. As the AIBF develops, the curriculum and facilities will be expanded to accommodate demand from the financial services industry in Afghanistan. The World Bank’s contribution of US$0.25 million will be matched by DAB, while the Afghan Banker’s Association will provide a further $0.5 million, in order to provide an initial funds pool. Running costs for the AIBF will be borne by yearly contributions from ABA members. 5. Financing Source: ($m.) IDA Grant 8.00 IFC/PEP-MENA 0.59 Counter funding from clients 0.87 Total 9.46 6. Implementation DAB has no experience implementing a donor funded project. Although, the US funded Bearing Point Consultants have been assisting DAB since 2003 to build their capacity in bank supervision, monetary policy, accounting systems and human resource development, the project implementation responsibility was entirely vested in the Bearing Point Team, led by their Team Leader. Such an implementation arrangement did not create project implementation capacity within DAB. DAB’s ownership of the project was less effective, since the project was managed directly within the various departments without much coordination. Therefore, there has been lack of coordination and overall knowledge on the project from DAB’s side and it did not help integrating the implementation and assessing the overall project impact. In carrying out the FSS Project, unlike the Bearing Point model, the approach to capacity building relies on client execution that will be the key to provide support for the transition from dependence on expatriate advisors to self-reliance on qualified local staff in Afghanistan. There will be two levels of implementation, supervision and monitoring arrangements: (i) Project Implementation Cell (PIC), which will be created to provide technical support as well as supervision of the overall project implementation; and (ii) Project Steering Committee (PSC), which will consist of the senior management to oversee the implementation as well as provide key management decisions to implement the project. The PIC will be led by a Project Director, who will directly report to either the Governor or the First Deputy Governor, provide technical support as well as conduct fortnightly or monthly project implementation review meetings. The Project Director will be a full-time DAB staff member, with adequate qualifications and experience to implement the project. The Project Director will be helped by a

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project team with expertise in relevant fields. The project team members will be located in their parent departments. Each department, which is included in the project, will nominate a focal point staff with relevant experience to PIC. PIC will have access as well as authority to demand the focal point staff to provide assistance and attend project implementation meetings as and when necessary. The department’s focal point staff will brief their department head on the progress of implementation. Capacity within the relevant department will be created in procurement, financial management, IT and other areas as required for project implementation. To build such capacity, the expatriate consultants positions created in the project will be hired and placed in the respective department. The focal point staff of the department will be attached to the expatriate consultants for capacity building so that over time the local project staff can take charge of the project implementation. The expatriate consultants, although placed in the relevant department, will work in full coordination with PIC. PIC will have the same access to them as it will have to the local focal point staff PIC’s specific responsibilities will be as follows: (i) hire or select local staff with educational qualification and experience in relevant fields in coordination with the respective department for implementation of the project components; (ii) hire expatriate consultants, in coordination with the respective department, mainly in the field of procurement, IT, HR and on accounting and auditing to implement the project and also to build local capacity through on the job training; (iii) prepare bid documents for various software, IT package, equipments, etc.; (iv) monitor the work of the expatriate consultants and vendors in accordance with deliverables listed in ToR to ascertain delivery quality and project implementation progress; (v) prepare disbursement application for payments to consultants, vendors and other purchases; (vi) manage the financial records for all PIC activities and prepare accounts for standard financial reporting and management; (vii) prepare and submit quarterly implementation progress report for all project components to the World Bank; and (viii) prepare bi-monthly implementation reports for the Project Steering Committee and organize coordination meetings with various department heads under the chair of the Governor or the First Deputy Governor to assess the progress project implementation and also address issues those are impeding project implementation. The Project Director for the PIC has been hired by DAB and has started familiarizing himself with all the relevant documents and issues under the project. In addition, the structure of the PIC has also been agreed upon (see diagram below). PIC members will be used as focal points in their relevant departments for the Project Director. The expatriate consultants will assist the focal points in supervising and monitoring the project components specific to their departments, and prepare progress reports for the PIC. Overall the focal points will provide their progress report to the Project Director. The international consultants will have two tasks: one working with the all staff of the departments and their other task will be working with the focal points. The PIC members including the consultants will meet every other week to discuss their progress and problems. The consultants will be based in their respective department and will monitor and assist the department in its daily activities. The PSC will be the supreme body to supervise, monitor and make decisions for effective implementation of the project. The Governor or the First Deputy Governor, in DAB will chair the coordination meeting. The PSC will consist of all the department heads who are implementing the project. The Governor may include any other department in PSC if the Governor finds it necessary and important for project implementation. The PSC will participate in the Coordination meeting at least on a biannual basis. However, if the Chair of the Coordination team considers it necessary to have meetings on an emergency basis, such meetings will be organized by the Project Director of the PIC. The PSC will have the following responsibilities: (i) ensure that the Coordination meetings are held regularly; (ii) review the bimonthly implementation progress report prepared by PIC; (iii) examine the progress of implementation of all project components and give guidance and also decisions as required to PIC for smooth project implementation; (iv) ensure that PIC is following the World Bank procurement

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guidelines and approve all the procurement decisions which should include (a) selection and hiring of the local staff and the expatriate consultants, (b) equipment needed for the departments, which are financed by the project, (c) approval of bid evaluation reports, selection of supplier or vendors and the Contract document for the procurement of IT equipment; (v) approval of award of all contracts, including the Contract Agreement; (vi) review of the quarterly disbursement and financial management reports prepared by PIC; and (vi) ensure that all relevant project implementation formalities including the agreed project conditions are met as agreed with the World Bank and that the quarterly project implementation report, financial management report are submitted in time. PIC and PSC will provide full cooperation to the World Bank Country Office, the International Finance Corporation (IFC) and their project supervision missions as and when the project is supervised. DAB and its relevant departments, including the Afghanistan Institute of Banking and Finance, will provide necessary information to asses the progress of the project implementation. Moreover, the PIC and PSC will furnish the progress reports, the relevant information required to assess progress in meeting the Project Development Objectives (PDOs) and the Intermediate Outcome Indicators (IOIs). The World Bank supervision missions of the project will be arranged in such a manner to ensure it consists of members of the IFC in undertaking bi-annual supervision. A joint supervision of the project is essential since the IFC and the Bank are combining efforts to establish the Public Credit Registry and the Collateral Registry. Coordination in supervision will be critical in order to move from Phase I (IFC) - the implementation of the “soft” components to Phase II (WB), implementation of the computer hardware and software component. The hardware component is only possible where there is the physical establishment of the Public Credit Registry and Collateral Registry and there is full implementation cooperation between the Bank and IFC to design RFPs, which meet the purpose and objectives of setting up the Public Credit Registry and Collateral Registry. Financial Management – (i) Monitoring and evaluation of progress – The PIC will meet every other week to discuss the progress of the project against the benchmarks agreed in Annex 3. The meetings will also provide an opportunity to identify problems in implementation and make necessary changes to the project implementation. Progress reports will be prepared on a monthly basis and provided to the World Bank. (ii) Reporting – guidance on producing audit reports, Interim Financial Reporting (IFR) and other reports required for effective project monitoring, evaluation, and disclosure, will be provided by international consultants supporting the relevant departments of DAB within the PIC. The timing of all required reports will be agreed with the World Bank staff and will be finalized in the Legal Agreement. Generally, the PIC will ensure, with initial help from international consultants that all staff involved in the management of funds conforms in every respect with the relevant World Bank procedures by monitoring and assisting the department in its daily procedures. Where necessary, the World Bank will provide further training to remedy any deficiencies identified. All the departments, through their focal points, will provide their reports to the Project Director. Procurement - The PIC shall be responsible for preparing a detailed annual work plan and budget, including a Procurement Plan and Training Plan, which will be reviewed at the end of each year of the project. Procurement will be carried out based on this annual Procurement Plan. The Procurement Plan will be updated in agreement with the Project Team annually or as required to reflect the actual project implementation needs and improvements in institutional capacity. Any amendments made to the Procurement Plan during the year will be agreed with World Bank staff. 7. Sustainability

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8. Lessons Learned from Past Operations in the Country/Sector Lessons have been taken from other similar projects in post conflict environments as well as in other South Asian countries in addition to lessons from other development projects in Afghanistan. Two lessons have been particularly influential in the design of this project. • Setting clear objectives and instituting performance based funding. It is important to have clear,

focused objectives and the ability to monitor indicators to measure progress against those objectives right from the start.

• Building local institutions and capacity. There are immediate gains and added value early on from brining international experience into the local institutions to start work and provide benefits to many people quickly. It has been especially true that organizations with prior experience in Afghanistan or significant regional experience were able to scale up and be effective more quickly.

9. Safeguard Policies (including public consultation) The project is not funding any activity which will have any potential direct impact on the local environment Also the project is categorized C from the Safeguards point of view. There is therefore no requirement for an Environmental and Social Management Framework Review. 10. List of Factual Technical Documents Bank/IFC Staff Assessments

1. World Bank: Project Concept Note 2. World Bank: Aide Memoire Design Mission 20 February – 5 March 2008 3. World Bank: Aide Memoire Pre-Appraisal Mission 30 August –10 September 2008 4. World Bank: Integrated Safeguards Datasheet 19 September 2008 (concept stage) 5. World Bank: Project Information Document (concept stage) 6. IFC: An assessment of the Credit Market and of the Information Sharing System, May 2008 7. IFC: Diagnostic Assessment of a Collateral Registry System for Afghanistan Registry May 2008 8. World Bank Report: Afghanistan Financial Sector Strengthening Project Banking Supervision

Component May 2008 9. World Bank Report: Afghanistan Financial Sector Strengthening Project Internal Auditing and

Accounting in Da Afghanistan Bank Component May 2008 10. World Bank Report: Proposal on the Establishment of the Afghanistan Institute for Banking and

Finance May 2008 11. World Bank: Report on Human Resource Management in Da Afghanistan Bank June 2008 12. World Bank Report: Assessment of IT Systems in DAB September 2008 13. World Bank: “Doing Business” 2009 14. World Bank: Afghanistan Investment Climate Assessment (ICA), December 2005 15. World Bank: “The Financial Sector in Afghanistan” 2004 16. World Bank: “Credit Bureau Development in South Asia”, 2004

Others

1. Da Afghanistan Bank Strategic Plan 1387-1392 2. DFID: “Growth Diagnostic Scoping Study Final Report” September 2008 3. USAID: “An Assessment of the Prospects for A Credit Information Bureau in Afghanistan”

(2005) 4. Afghanistan National Development Strategy 2008-2013

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5. World Bank: Country Study: Afghanistan – State Building, Sustaining Growth, and Reducing Poverty, dated September 2004

11. Contact point Contact: Md. Reazul Islam Title: Sr Operations Off. Tel: 5764+402 Email: Mislam4@worldbank.org Contact: Kyoo-Won Oh Title: Financial Sector Specialist Tel: 1-202-473-2829 Email: koh1@worldbank.org 12. For more information contact:

The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-4500 Fax: (202) 522-1500 Email: pic@worldbank.org Web: http://www.worldbank.org/infoshop