Cleaning up Afghanistan's banking system

When news of Kabul Bank's imminent collapse broke early last fall, some likened the crisis to a slow motion train wreck. Six months later, the failure of Afghanistan's largest commercial bank now looks more like a bullet-train in danger of running the country's precarious reconstruction efforts off the rails.

As further details of Kabul Bank's profligate lending practices and its nearly $1 billion in unresolved debts leaked early last week, it became clear that Afghanistan's Central Bank would have to move quickly to prevent full-on implosion. But it is not at all certain that the Afghan government will act quickly enough on the International Monetary Fund's recommendation that Kabul Bank enter into receivership-a move the international lending institution hopes will prevent collapse of the economy. Nor is it a given that the Afghan government will deliver on its promise to launch criminal investigations against Kabul Bank's politically connected shareholders, including President Hamid Karzai's brother, Mahmoud, who according to recent news reports received $18 million in no strings attached loans.

What is clear is that with a number of other large-scale Afghan commercial banks also buckling under the pressure of bad loans and risky investment strategies more aggressive international intervention is not only likely but necessary. Without it the Afghan economy could plunge into a freefall, reversing the fragile gains the country has made since 2001.

At the start of the U.S. military engagement in 2001, Afghanistan's banking sector was comprised of six defunct state-owned commercial banks. When the Kabul Bank scandal first broke in September 2010, 17 commercial banks were operating in the country with total assets valued at roughly $2.6 billion. This is up from $300 million in total assets in 2004. Kabul Bank and its next closest competitor Azizi Bank have for years dominated the industry, with both banks' holdings representing about 50 percent of the overall commercial market.

Given the tight knit relations between Afghan business elites' interests it should come as no surprise then that Azizi Bank is now also facing scrutiny. Indeed, in addition to Azizi Bank, reviews and full-scale audits are underway at several politically connected Afghan banks, including the United Afghan Bank, whose chairman owns a substantial stake in Mahmoud Karzai's sprawling upscale real estate development in the southern province of Kandahar.

Despite its impressive growth, Afghanistan's banking sector has been under-regulated for years with the vast majority of banks posting very low ratings. On an industry standard scale of 1 to 5 where a rating of five is the lowest, five of Afghanistan's banks were reported to be rated at four in a 2009 IMF report, indicating a troubling imbalance between capital, asset quality, management performance, earnings and liquidity. Though most of the cash slushing through Afghan banks consists of taxpayer dollars drawn from NATO countries, international donors have never showed much interest in pushing for genuine reform. Promoting an agenda of regulatory reform, fiscal responsibility and insisting on accountability and transparency in international assistance is just not as sexy as arming Afghan militias, building up national security forces or shelling out millions to reintegrate insurgents.

Luckily, a few international donors have finally gotten a clue and taken decisive action. In response to the Kabul Bank crisis, the United Kingdom's Department for International Development opted in early March to freeze $137.6 million in contributions to the Afghanistan Reconstruction Trust Fund, the main conduit for international assistance to Afghanistan. The British aid agency said that it was loathe to continue assistance to the fund as long as it remained unclear whether the International Monetary Fund would withdraw its support for aid to Afghanistan.

After visiting Kabul in early February, IMF officials said the only way it will continue its assistance is if Kabul Bank is swiftly liquidated. As the Central Bank continues to dither over whether and how to initiate a sell-off of Kabul Bank's assets, other major European donors are now also considering following the United Kingdom's lead. It is unfortunate that it took international donors so long to use what little leverage they have left to push the Afghan government to do the right thing. Hopefully, Kabul officials will, nonetheless, get the message: clean up, or else.

Given that the Afghanistan Reconstruction Trust Fund finances salaries for almost all of the government's civil service workers, some might argue that withholding contributions to Afghanistan's largest source of cash could pose a threat to stability and the success of the counterinsurgency campaign. How, it likely will be asked, can the Afghan government deliver much needed services in insecure places like Helmand and Kandahar if it can't even pay its civil servants? In the long-term, however, the real question is:  How will U.S. European and Japanese donors be able to justify continued spending in Afghanistan to their financially strapped constituents if Kabul continues to allow commercial banks to finance the lifestyles of Afghanistan's filthy rich and ignominious? The answer is blindingly simple. International donors must do more to ensure greater oversight of their assistance to Afghanistan. Kabul likewise must move aggressively to close regulatory loopholes that foster corruption and allow politically connected high-flyers to profit from the government's failure to do its job.

Several Kabul Bank shareholders have said publicly that they are in the process of paying back the millions in loans they took out to buy luxury estates in Dubai. Let's hope that's the case.  But no one should count on it. If donors hope to reap peace dividends from the billions in aid poured into Afghanistan they would do well adopt more transparency in their assistance programs and to keep the pressure on Kabul until action is finally taken to clean up the Afghan banking sector.