PROJECT INFORMATION DOCUMENT (PID)

APPRAISAL STAGE

Report No.: AB3730

Project Name

/ Financial Services Modernization Project
Region / EUROPE AND CENTRAL ASIA
Sector / General finance sector (100%)
Project ID / P105917
Borrower(s)
Ministry of Finance
Azerbaijan
Fax: (994-12)-936-055
Implementing Agency
National Bank of Azerbaijan
32 Rashid Beybutov St.
Azerbaijan
Tel: 994-12-931122
/
Environment Category / [ ] A [ ] B [X] C [ ] FI [ ] TBD (to be determined)
Date PID Prepared / March 11, 2008
Date of Appraisal Authorization / May 6, 2008
Date of Board Approval / June 17, 2008
  1. Country and Sector Background

1.1.  The Republic of Azerbaijan is located on the western coast of the Caspian Sea. Azerbaijan today has one of the fastest growing economies in the world. Following the completion in 2005 of the new BTC oil pipeline from Baku on the Caspian coast to Ceyhan on Turkey’s Mediterranean coast, growth has accelerated and GNI per capita as a result has risen from a post independence low in 1995 of $390 to an estimated $2,750 in 2007, and the poverty level has dropped from about 45% in 2002 to about 21% in 2006. Oil and gas have been the engines of growth, now accounting for more than half of Azerbaijan’s GDP. At the same time, non-oil output has also experienced strong growth, averaging 12 percent per annum over the past five years. The Government is seeking to build upon the opportunities provided by its oil and gas revenue to put into place the policies, institutions and investments that will continue to sustain strong non-oil growth in the future and ensure that the full benefits of this growth reach all segments of society.

1.2.  Azerbaijan’s financial sector has developed at an uneven rate. The banking sector grew by more than eightfold from 2002 to the end 2007, albeit starting from a very narrow base, and the number of non-bank credit providers has increased from 58 to 96 over the same period. Although the number of banks has remained static from 2005 until late 2007, several new foreign banks are likely to enter the market in 2008. Total lending to GDP in 2007 came to about 18 percent, compared to 50 percent of GDP for EU accession countries.

1.3.  Sectoral Context: Consumer Protection. Over the five years between 2003 and 2007, bank lending to households sector increased over ten-fold to an estimated AZM 1.6 billion. As a result of this sharp growth, a new emphasis to strengthen consumer disclosures and financial literacy has arisen. In 2007 the NBA received complaints from over 1,000 retail bank customers. However over 80 percent were not disputes, rather, they were inquiries wherein households asked why they were unable to obtain bank credits, particularly mortgage loans. The NBA has initiated programs of consumer communications, holding weekly sessions whereby retail customers pose questions by telephone to the executive management of the NBA. Other financial agencies have also initiated programs of consumer communications. The Deposit Insurance Fund, for example, prepares a short leaflet of information for retail depositors on which deposits are covered and for which amounts. However, the financial supervisory agencies do not have a systematic method of providing clear simple information for financial consumers.

1.4.  At the same time, consumer confidence in the financial sector is not as strong as needed for sustained financial sector development. The Deposit Insurance Fund estimates that for a population of about 8.5 million, only 1.1 million current (checking or savings) accounts have been opened. Current accounts are considered “gateway” financial products by which households become familiar with financial services. Thus, many Azeris do not have basic access to the financial system. Even those with bank accounts may not be aware of the full range of bank services available, as noted by a survey conducted by the Azerbaijan Bank Training Center.

1.5.  Capital Markets Development. The development of the nascent capital market in Azerbaijan is hampered by a number of key impediments, namely (i) weaknesses in the regulatory and supervisory framework; (ii) deficiencies in market architecture and infrastructure; (iii) absence of an organized equity market (iv) absence of legislation for new financial instruments, regulations for investment funds; and (v) absence of a medium to long-term government bond yield curve. The increased participation of the private sector offers a great potential for broadening the supply of investible securities on the domestic market, both equities and corporate bonds.

1.6.  Credit Bureau. The credit registry was introduced in 2005 as part of the World Bank FSTA project. Only banks can provide and receive registry information. Mirroring the extraordinary rise in credit, in less than three years the number of registry inquiries has almost tripled. However, less than 5% of bank credit applications were supported by inquiries to the credit registry. This suggests some banks or borrowers may limit or withhold information, substantially increasing potential credit risks to lenders.

1.7.  Data warehouse. The process of data collection from banks varies considerably, hard copies are required in some cases and in others, electronic versions are sufficient. Similarly, secure network channels are used for the transfer of credit registry data whereas unsecure e-mail are used for the transfer of bank supervision and financial data. Further, the same data is entered manually multiple times in different systems given the lack of connectivity across systems. The high level of manual intervention is inefficient, error prone and costly to the institution. To facilitate better data access and reporting, a data warehouse should be developed at NBA to serve as a technical platform that provides a central, authoritative source of relevant, reliable and comprehensive data both within and outside the NBA.

1.8.  Agricultural producers and processors. Agriculture is a key non-oil sector of the Azerbaijan economy. Over recent years, agriculture has contributed between 11% and 16% of GDP, and around 40% of employment, making it the most important source of employment in Azerbaijan, and essential to economic diversification. The sector was, at one time, a major producer of fruits, vegetables and wine products for the Soviet Union. After independence, traditional agricultural export markets were lost and local marketing channels were disrupted. At the same time, there were drastic reductions in the availability of formerly subsidized inputs such as fertilizers and irrigation. Agricultural output fell rapidly by more than 50% between 1991and 1995. As a result of comprehensive agricultural reforms that started in 1996, the sharp decline in agricultural output has been firmly reserved and the sector has consistently registered positive growth from 1996 onwards. Agriculture has undergone significant transformation, with former collective-farms and state-owned agribusinesses privatized, prices and trade liberalized, and major rehabilitation of the irrigation infrastructure initiated. While the reforms have created an enabling environment for the development of the agricultural sector and helped to restore growth, the sector still faces constraints which impede it from achieving its full potential, including limited access to financial services.

  1. Objectives

2.1.  The project development objective is to assist the Government of Azerbaijan to improve consumer financial protection, develop the capital market, and improve access and transparency of financial information.

2.2.  Key beneficiaries of the project are to be the Ministry of Finance Insurance Directorate, State Commission for Securities (SCS), NBA and the National Depository Center (NDC). In addition to which, financial sector participants, inter alia, bank and non-bank borrowers, insurance policy holders, securities buyers and sellers, credit providers and users of financial data will each benefit from the increased transparency and access to financial information developed through the envisaged project.

2.3.  The introduction of a financial sector consumer protection regime, in combination with undertaking a nationwide financial literacy assessment - from which a national program of financial education program can be launched - will benefit bank and non-bank borrowers, who will be able to better determine and compare the actual cost and terms of credit, their rights in the event of a dispute, etc. Similarly, insurance and securities market participants will also benefit from new transparency of disclosures. Market participants of all types can benefit from broader and deeper access to NBA research and other data. Finally, credit risks arising from the recent sharp increase in lending can be better mitigated through the exchange of borrower information between bank and non-bank lenders.

  1. Rationale for Bank Involvement

3.1.  The CPS envisages a Financial Sector Modernization Project to build on the framework and capacity established by the FSTA, which was successfully completed in 2006, and the on-going FSDP, with a view to furthering reforms in bank and non-bank sectors.

3.2.  The FSMP project rationale is fourfold: (i) the regulatory and supervisory regimes for consumer protection and capital markets have lagged behind growth of the banking sector, negatively affecting market perceptions; (ii) the securities market infrastructure suffers from major inefficiencies that discourage the participation of investors in the market; (iii) with the dramatic increase in bank credit in recent years, credit risks can be better mitigated through both improved access to NBA data (via the data warehouse) and through more efficient, complete exchange of borrower information using a credit bureau; and (iv) insufficient credit to agricultural producers and processors, which grew at less than half the rate of total credits from 2005 to 2007, has been an impediment to growth of the agricultural sector.

  1. Description.

The project consists of six components. These components include:

4.1.  Component I. Consumer protection and financial literacy. This component focuses on the delivery of TA to support three key aspects of financial consumer protection: (i) improving the disclosure of information provided to financial consumers about their rights and responsibilities; (ii) undertake a national financial literacy assessment from which a financial education program can be developed; and (iii) the development of a dispute resolution mechanisms.

4.2.  Component II. Accelerating capital market development. The overall objective of this component is to create the conditions for the broadening and deepening of the capital market, so that it can contribute to the objective of sustainable growth of the non-oil economy over the medium to long-term.

4.3.  Component III. Improving access and transparency of financial information/NBA Data Warehouse Management. The overall objective of this component is to improve access and transparency of financial information to market participants and other stakeholders.

4.4.  Component IV. Upgrading the existing credit registry into a credit bureau. This component will assist NBA in defining and implementing the strategy of transitioning the existing credit registry into a full scale credit bureau accessible to bank and non-bank market participants

4.5.  Component V. Delivering agricultural training program to bank and non-bank lenders. The main objective of this component is to provide training to banks and non-bank lenders in appraising agriculture-related investments and providing suitable adapted financial products.

4.6.  Component VI. Project Management. The objective of this component is to provide technical assistance to the PIU for Project implementation, including audit services.

  1. Financing

Source: / ($m.)
BORROWER/RECIPIENT / 1
International Development Association (IDA) / 10
Total / 11
  1. Implementation

6.1.  The project will be implemented over a period of three years, starting October 1, 2008 (the expected date of effectiveness of the IDA Grant). The Ministry of Finance will be the Recipient and will delegate overall coordination to the Project Steering Committee, which includes the main counterparts, the NBA, MoF, MoED, SCS, and NDC.

6.2.  The project will utilize a well resourced Project Implementation Unit established within the NBA for the on-going Financial Services Development Project, scheduled to close in June 2009.

  1. Sustainability

7.1.  The longer term sustainability of the project is ensured primarily by the project’s focus on concrete institutional strengthening measures being implemented under the project. The project will enhance the financial system’s capacity to modernize, accelerate and achieve the necessary development momentum to sustain the continued growth of its credit and capital markets in future. Under the consumer protection component, in addition to strengthening the legal and regulatory framework for transparency and disclosure, consumer financial literacy and education programs will be enhanced, thereby laying the groundwork for greater public participation and sophistication of financial sector in future.

7.2.  Preparation of a new modern securities law, installation of a new clearing and settlement system, development of the legal and regulatory framework for equity IPOs and fixed income markets envisaged under the project will bring the necessary volume and transparency to the capital markets. This will strengthen SCS’s and NDC’s financial sustainability from increased generation of fees by market participants. Further, most of the institutions to be strengthened under this project belong to the public domain – the MoF Insurance Directorate, NBA, SCS and NDC – and as such, will continue to be financed beyond the life of the project credit (though the credit bureau may later be privatized).

  1. Lessons Learned from Past Operations in the Country/Sector

The design of the project includes key lessons learned from two financial sector operations undertaken in Azerbaijan since 2000. The proposed FSMP will build on this framework. The main lessons from these and similar Bank projects are as follows:

8.1.  Information and services related to financial sector is to be actively disseminated to create public awareness of such information and services available. In this context, it is important to establish a regular dialogue with stakeholders to secure information and determine the TA services continue to respond to the needs of the dynamic financial sector.

8.2.  Institution building and skills improvements, including local offices involved in the project is important, as is the availability of appropriate equipment. During the earlier FSTA project implementation, significant efforts were made to develop the PIU’s capacity to manage implementation of Bank projects. As the FSMP envisages a number of complex ICB procurement packages, the PIU’s experience in this area will play a key role in the project’s overall success.

8.3.  Relevant lessons from other Bank operations include: (i) critical need for training and technical assistance to increase institutional capacity; (ii) phased approach and realistic timetable for implementation; and (iii) need for active involvement of the PIU and other counterparts in project implementation.