Closed for business: Kyrgyz police patrol destroyed shops in Osh following violence in June.

Persistent violence in the south of Kyrgyzstan, combined with the interim government's fears about capital flight, are placing heavy pressure on the country's banking sector. Writer Philip Alexander

Physical security remains everyone's top priority in Kyrgyzstan following the upheaval that began in early April 2010. During the overthrow of the government of Kurmanbek Bakiyev, who had himself taken power in an uprising five years earlier, 86 people were killed, most of them protestors confronting armed police.

Unrest continued after the interim government of president Roza Otunbayeva took control, flaring into severe violence between Kyrgyz and Uzbek communities in the southern cities of Osh and Zhalalabad in June, which left an estimated 2000 people dead and hundreds of thousands displaced.

In the worst-affected regions, the new government continues to struggle with basic financial functions such as benefit distribution. The economic effects of the crisis have put public cashflows under strain. There are also allegations that some revenues from state-owned companies and development aid were diverted to the personal accounts of members of the previous regime.

During the instability in early April, banks shut branches in the worst-affected areas and transferred cash to their head offices or to the National Bank of the Republic of Kyrgyzstan (NBRK). Most banks report a handful of branches put out of action, and ATMs destroyed. Sevki Sarilar, the CEO of Demir Kyrgyz International Bank (DKIB), is still puzzled that two of the bank's 800-kilogramme ATMs disappeared altogether. But within a month, the larger banks had reopened their branch networks everywhere except Osh and Zhalalabad.

Lost business

The effect on clients will be much more sustained. Kyrgyzstan already had one of the lowest banking penetration rates in the world - only 6% for retail deposits, according to one banker. A few gold mining, electricity and telecommunications companies account for much of the corporate sector. The rest of the economy is built on agriculture, and on the vast markets of Dordoy (in the capital, Bishkek) and Osh. As many as 30,000 people are thought to be employed in the markets, handling transit trade from China to Kazakhstan and beyond, taking advantage of low Kyrgyz import duties.

However, trading activity, especially for perishable goods, was heavily disrupted when Kazakhstan shut its border with Kyrgyzstan following the upheaval in April 2010. While the border was fully reopened in July, the Kazakhstan-Russia customs union that came into force at the same time has complicated the operations of many Kyrgyz exporters. In addition, following violence in the south in June, Uzbekistan also closed its border.

Small and medium-sized enterprises (SMEs), many in the transit sector, account for more than 80% of the total loan portfolio of $107m at UniCredit Bank Kyrgyzstan - rebranded from ATF bank in July 2010. UniCredit Kyrgyzstan's chairman, Alexander von Gleich, says its staff engaged in an emergency programme to assess the effects of the crisis and border closures.

"In three weeks, we visited all 11,000 of our SME clients to discuss the situation with them, and we offered some 300 clients grace periods of three to six months, as well as providing extra working capital," he says.

Mr Gleich says the Kyrgyz operations were always run on very conservative lines, with provisioning of 8.5% of total loans compared to actual arrears of only 1.5%. But he is in little doubt that arrears will rise, as trading conditions remain difficult. The European Bank for Reconstruction and Development (EBRD) is forecasting a gross domestic product (GDP) contraction of 0.7% for the country in 2010, compared with growth of 2.3% in 2009 and 7.6% in 2008.

DKIB has been partially insulated from the border closures by a decision in 2009 to focus some of its portfolio on local producers, reducing its exposure to transit businesses. Nonetheless, Mr Sarilar says the NBKR is warning that provisions for the whole banking sector may have to rise by one-quarter, which could cause a liquidity squeeze.

Bank clampdown

One of the most serious challenges facing the financial sector has been the interim government's visceral fear that banks were helping the Bakiyev regime siphon public money out of Kyrgyzstan. In April, the interim government took seven local banks into special administration through the national bank. An NBKR press release stated that this was "for the purpose of capital outflow control and safety of assets, taking into account the threat of theft". It later cancelled the administration arrangement for two of these banks (Dos-Credobank and Bank Bakai).

The government also sought to intervene in two foreign-owned banks, ATF and Kyrgyz Investment and Credit Bank (whose founding owners include the EBRD and German state development bank KfW). But withdrawal restrictions on these two banks were quickly reversed following assurances from their shareholders that the banks had strong anti-money-laundering safeguards in place. Bankers in Kyrgyzstan say communication with the NBKR has been confused, because some senior managers there have been replaced not just once, but twice, since the interim government took power.

The most significant intervention was in AsiaUniversalBank (AUB), the country's largest by capital and assets. According to former chairman and majority shareholder Mikhail Nadel, who was out of the country undergoing knee surgery at the time of the intervention, armed men entered AUB's headquarters before dawn on April 8 and sealed its server room. Staff from the NBKR arrived later that morning and announced that the bank had been taken into special administration. Mr Nadel says $40m in cash was removed from the bank's vaults to the national bank, and customer safety deposit boxes were emptied. He claims that witnesses are now too frightened to come forward. A spokesman for AUB says the bank cannot comment on these allegations.

The entire 1700 staff of AUB was dismissed, but most were recalled to work within days, and the bank resumed some operations. However, the senior management was entirely replaced and, on June 4, the NBKR appointed Erik Usubaliev as an administrator for AUB. On June 21, the National Bank announced that AUB would be nationalised, prompting Mr Nadel to launch a lawsuit to recover his share. On July 10, the Kyrgyz constitutional court transferred the case to the Bishkek city court, which ruled against Mr Nadel on August 4.


Mikhail Nadel, former chairman and majority shareholder of AsiaUniversalBank (AUB)

Bakiyev legacy

The interim government has a variety of explanations for its treatment of AUB. First is the claim by interim deputy prime minister Azimbek Beknazarov (a former public prosecutor) that the bank was used to launder money embezzled from the public purse by the Bakiyev regime. The authorities claim that funds worth more than Kgs10bn ($215m) were transferred out of the bank between April 5 and the government's intervention on April 8. These transfers are the subject of an investigation by the public prosecutor.

Michael Laubsch, the founder of a non-governmental organisation (NGO) called Eurasia Transition Group, which seeks to improve public governance in central Asia, claims he has compiled extensive evidence showing AUB was used to launder money. Mr Laubsch, a former foreign policy advisor in the German Bundestag, showed The Banker a dossier that he says was compiled with the help of NGOs and whistleblowers inside Kyrgyzstan.

The dossier includes what appear to be documents from AUB showing transfers worth almost $265m made between April 5 and April 7 to foreign-registered companies. Mr Laubsch alleges that he has traced ownership of these non-resident companies to members and associates of the Bakiyev regime. Mr Laubsch presented his findings in August to the Kyrgyz public prosecutor, who had issued an arrest warrant for Mr Nadel a month earlier.

Mr Nadel denies all allegations of money laundering. He says that, although he was not in Kyrgyzstan at the time, he thinks it is likely that there were major withdrawals from AUB. He maintains that these non-resident accounts were not tied to the Bakiyev regime, but rather belonged to foreign investors in Kyrgyzstan.

"Our foreign clients were frightened; this was the second coup in five years and there was chaos. I have heard that the parent companies of foreign-owned mines in Kyrgyzstan have even refused to transfer funds to their subsidiaries in the country," says Mr Nadel.

Mr Nadel questions whether anyone would be able to access AUB documents without co-operation from the national bank, public prosecutor's office or AUB's interim administration. He claims that any evidence used to justify the nationalisation could have been created by the interim administration of the bank, and alleges that local NGOs are being intimidated into supporting the interim government's allegations.

"Given that the bank has been under the temporary administration for months already, NBKR is able to play with the financial figures of the bank to its heart's content, which is proved by the contradictory figures it has been giving about the bank's assets and capital throughout the past months," says Mr Nadel.

Splitting the difference

A further allegation made by Mr Beknazarov against Mr Nadel is that he used his connections to the Bakiyev regime to expand the bank. Mr Nadel, a Russian national who originally purchased AUB in 1999, dismisses any claims that his bank had a special relationship with the Bakiyev regime, saying "we were the largest bank in 2005 when Mr Bakiyev came to power, and we remained the largest bank afterwards."

AUB certainly processed many official transactions, including pension and social security payments and tax collection. But Mr Nadel says this was inevitable, given that it ran the largest branch network in the country and had a 23% market share. Indeed, on June 11, the interim government resumed using AUB for pension and benefit payments.

However, the interim government plans to overturn a merger between AUB and Kyrgyzpromstroybank (KPSB), which took place in 2008. Mr Beknazarov claimed that KPSB was acquired illegally - there are questions as to why the authorities declared KPSB bankrupt in 2008. It was initially acquired by Kyrgyz Credit Bank (one of the other banks placed under temporary administration in April 2010), from whom AUB then bought KPSB. KPSB's assets were only 10% of those of AUB, but it ran a large Soviet-era branch network.

Mr Nadel says the acquisition was entirely legitimate, as KPSB was genuinely in a dire condition when AUB acquired it, with many branches possessing only one computer. He says he made significant investments to improve the bank.

"It took us a year to integrate the bank; the staff were unprofessional and the IT systems were not capable of managing compliance or credit control to the standards we wanted. We suspended lending for six months, and we were in the process of migrating the entire merged bank to Temenos T24 [banking software] in 2011 - we would have been the first bank in the region to use such a modern system for client relations," says Mr Nadel.

Kyrgyzstan banking market share - Percentage of total assets

Kyrgyzstan banking market share - Percentage of total assets

Tough road ahead

Today, it appears that the wheel has turned full circle. On June 21, the interim government unveiled a rehabilitation plan for AUB, saying the bank needed a credit line of Kgs1.5bn and recapitalisation, as its financial ratios had breached minimum regulatory requirements. On August 6, the government changed its mind, and announced that it would restructure the bank without recapitalisation, owing to budgetary pressures - a press release on the NBKR website promised to protect depositors by creating separate "good" and "bad" banks. All new lending and deposit activity was suspended.

But this appears to contradict AUB's last available audited accounts, for the first quarter of 2010. These indicate a Tier 1 capital adequacy ratio of 17.9%. Loans to customers were just 14.6% of its Kgs25.6bn total assets. According to Semyon Isakov, an analyst at credit rating agency Moody's who covers the bank, the rest of the assets appeared to be mostly liquid financial instruments such as bonds issued by the Russian government or Russian state-owned companies such as Gazprom and Sberbank. A significant part of AUB's business was low-risk cash management for its primarily non-resident client base.

AUB's small loan portfolio mainly comprised credit to some of the country's largest companies, which are now being courted by rival banks. In June 2010, Moody's withdrew its rating on AUB, citing "lack of relevant information" on the source of the bank's impairment.

Even after the outflows in April, the NBKR reported that AUB had assets of Kgs13.6bn (including Kgs4bn in cash) and capital of Kgs2.9bn, well in excess of its liabilities of Kgs10.6bn. On May 4, the temporary management announced in a press release that the bank had a liquidity ratio of 82%, compared with a regulatory minimum of 30%. It is therefore difficult to understand how the bank could need government financial assistance just one month later. By August 6, the NBKR said in a notice that AUB had assets of only Kgs5.3bn, liabilities of Kgs7bn, and negative capital of Kgs1.7bn, because the bank had been required to write off Kgs2.1bn in liquid securities previously on its balance sheet, for which documentation appeared to be missing.

"The temporary administrator did not take any steps to preserve any assets," says Mr Nadel. "More than 90% of AUB's lending was secured. In cases of default, the loan value would be recovered through court hearings and enforcement of security. Instead of recovering loan values through auctions and court hearings, the temporary administrator designated them as 100% loss, thereby deliberately reducing the bank's assets."

Whatever reasons the interim government may have to investigate AUB's activities during the Bakiyev regime, the decision to pursue nationalisation by decree seems difficult to explain on purely financial grounds. A leading commercial lawyer in Bishkek says protecting private property rights will be a key priority for the new government that takes office after the October elections.

"We already have one of the best constitutional frameworks in the region, but laws are not implemented in practice, judges are under political influence, and state officers have ignored the law," says the lawyer.

While interviewees express optimism about prospects after the October elections, government by decree in the interim has unnerved many in the country's commercial sector, says Kuban Ashyrkulov, the executive director of the Kyrgyz International Business Council, whose members include all the country's leading banks.

"Nationalisation is a serious concern for the bigger businesses. The interim government has already nationalised more than 20 large businesses in different sectors, and this could have some consequences that are not good for Kyrgyzstan - investors will appeal to the international courts," says Mr Ashyrkulov.

Mr Laubsch is confident that Ms Otunbayeva is committed to improving the rule of law, but warns that other members of the interim administration are more ambivalent in their conduct.

Yet foreign investors in the banking sector are not deterred, and even see opportunities after the crisis. Mr Sarilar says Turkish-owned DKIB would consider buying branches from AUB if the government chose to sell them. And Mr Gleich says UniCredit's deposit base in the country almost doubled in the months after the fall of the Bakiyev regime.

"A lot of clients are worried what will happen with these banks in temporary administration. We have had an inflow of 50 to 70 new accounts per day," says Mr Gleich. He adds that UniCredit is not only retaining its commitment to Kyrgyzstan, but would be ready to consider increasing the bank's funding if needed.


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