FAST Report

Project Number: 50171-001 December 2016

Loan

Khushhali Bank Limited

Expanding Access to Credit for Agriculture and Micro, Small, and Medium-Sized Enterprise Borrowers (Pakistan) This is an abbreviated version of the document approved by ADB's Board of Directors that excludes information that is subject to exceptions to disclosure set forth in ADB's Public Communications Policy 2011.

CURRENCY EQUIVALENTS (as of 11 October 2016)

Currency unit – Pakistan rupee/s (PR/PRs)

PRe1.00 = $0.0096

$1.00 = PRs104

ABBREVIATIONS

ADB – Asian Development Bank CAGR – compound annual growth rate KBL – Khushhali Bank Limited GDP – gross domestic product MFB – microfinance bank

MFI – microfinance institution MSDP – microfinance sector development program MSMEs – micro, small, and medium-sized enterprises NPL – nonperforming loan RSP – rural support program SBP – State Bank of Pakistan SMEs – small and medium-sized enterprises

NOTES

(i) The fiscal year (FY) of the Government of Pakistan ends on 30 June, and the fiscal

year of Khushhali Bank Limited ends on 31 December.

(ii) In this report, "$" refers to US dollars.

Vice-President D. Gupta, Private Sector and Cofinancing Operations Director General M. Barrow, Private Sector Operations Department (PSOD) Director C. Engstrom, Financial Institutions Division, PSOD Team leader A. Cheema, Senior Investment Specialist, PSOD Team members S. Choudhry, Senior Investment Officer, Pakistan Resident Mission

M. Greenhow, Principal Counsel, Officer of the General Counsel L. Johannes, Senior Results Management Specialist, PSOD J. Munsayac, Senior Safeguards Specialist, PSOD A. Porras, Senior Safeguards Officer, PSOD

T. Rohner, Young Professional, PSOD R. Samiano, Safeguards Officer, PSOD

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS Page

I. INTRODUCTION 1

II. THE FINANCIAL INTERMEDIARY 1

A. Investment Identification and Description 1 B. Business Overview and Strategy 3 C. Ownership, Management, and Governance 5 D. Financial Performance 6

III. THE ADB ASSISTANCE 7

A. The Assistance 7 B. Implementation Arrangements 7 C. Value Added by ADB Assistance 7 D. Risks 8

IV. DEVELOPMENT IMPACT AND STRATEGIC ALIGNMENT 9

A. Development Impact, Outcome, and Outputs 9 B. Alignment with ADB Strategy and Operations 9

V. POLICY COMPLIANCE 9

A. Safeguards and Social Dimensions 9 B. Anticorruption Policy 10 C. Investment Limitations 10 D. Assurances 10

VI. THE PRESIDENT’S DECISION 10

I. INTRODUCTION 1. This is an eligible transaction under the Faster Approach to Small Nonsovereign Transactions (FAST) framework. 1 The transaction involves a loan of up to $20,000,000 or Pakistan rupee equivalent to Khushhali Bank Limited (KBL) for Expanding Access to Credit for Agriculture and Micro, Small, and Medium-Sized Enterprise Borrowers in Pakistan.

II. THE FINANCIAL INTERMEDIARY A. Investment Identification and Description 2. The long-run gross domestic product (GDP) growth of Pakistan is characterized by repeated cycles of rapid growth followed by slowdowns. After expanding at an average growth rate of 6.2% from fiscal year (FY) 2003 to FY2008,2 GDP growth slowed between FY2008 and FY2013 to an average rate of 3.0% on the back of a challenging investment climate, high inflation, and an unresolved energy crisis. 3 Since FY2014, Pakistan’s economy has gained positive momentum with FY2016 GDP growth at 4.7%, which was the highest growth since FY2007 but below the target of 5.5% set by the government.4 This was mainly due to weak performance of the agriculture sector, which showed negative growth of 0.19% against the target of 3.90% due to low commodity prices and poor weather conditions. 3. The acceleration in economic growth can be attributed to (i) the government’s successful 3-year, $6.4 billion macroeconomic and structural reform program, supported by the International Monetary Fund (IMF), that ended in September 2016; (ii) lower oil prices that have lowered imports by 9.1%, and high remittances of $9.7 billion in the first 6 months of 2016; and (iii) an improved security situation. 4. Finance sector. The finance sector in Pakistan is underdeveloped. Total bank assets increased by 16.1% during FY2016 to PRs15,374 billion.5 Growth was largely driven by increased holdings of government securities, which equaled a high 53.6% of total assets by the end of FY2016. The loan–deposit ratio for the Pakistan banking industry stood at 55.2% in FY2016 compared to 77.6% in India and 72% in Bangladesh. Customer deposits have expanded with a growth rate of 10.5% from PRs9,980 billion in FY2015 to PRs11,024 billion in FY2016. Net advances grew at 13.8% from PRs4,552 billion in FY2015 to PRs5,180 billion in FY2016, but still remain at 39.3% of total banking industry assets in Pakistan. Sector dynamics strongly favor large banks as larger branch networks and scale coincide with better spreads and cost–income ratios, resulting in higher profitability and valuation than mid-sized banks. There are 41 banks operating in the country. The top five banks (Habib Bank, National Bank of Pakistan, United Bank, MCB Bank, and Allied Bank) earned 61.8% of sector pretax profits in FY2016 while holding only 51.1% of sector assets. Capital adequacy is sound, even after implementation of Basel III at the beginning of 2014.6 Capital adequacy of the sector was 16.1% at the end of FY2016 under the Basel III standard as compared to 17.2% at the end of FY2015.

1 Asian Development Bank (ADB). 2015. Faster Approach to Small Nonsovereign Transactions. Manila. 2 Government of Pakistan. 2008. Pakistan Economic Survey 2007–2008. Islamabad. 3 Government of Pakistan. 2016. Pakistan Economic Survey 2015–2016. Islamabad. 4 Government of Pakistan. 2010. Pakistan Economic Survey 2009–2010. Islamabad. 5 State Bank of Pakistan. 2016. Quarterly Compendium: Statistics of the Banking System. http://www.sbp.org.pk/

ecodata/fsi/qc/2016/Jun.pdf 6 According to the Basel III framework, the minimum total capital was increased to 8.0% in 2014 and will gradually

increase to 10.5% by 2019.

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5. Fifty entities operate in Pakistan’s microfinance subsector. Microfinance providers primarily include microfinance banks (MFBs), microfinance institutions (MFIs), rural support programs (RSPs), and other microfinance practitioners running microfinance operations as part of their multidimensional service offering (including telecommunications companies). MFBs are entities that provide credit and take deposits from the general public and are regulated by the State Bank of Pakistan (SBP), the country’s central bank. MFIs are institutions that provide micro credit to their clients but do not raise deposits from the general public. RSPs provide micro credit as part of their multidimensional rural support programs.7 6. Since 2005, the microfinance subsector has grown six times in terms of borrowers and 15 times in terms of outstanding credit. The gross loan portfolio of the microfinance subsector stood at PRs104 billion ($1 billion) at the end of the first quarter of 2016. The Pakistan Microfinance Network estimates the potential microfinance market at 20.5 million individuals, with a current penetration rate of 19.5%. The microfinance subsector offers group loans as well as individual and micro, small, and medium-sized enterprise (MSME) loans. Group loans used to comprise the majority of the gross loan portfolio, but have been declining since 2012 and now account for 38.8% of the gross loan portfolio (as of the first quarter of 2016), as an increasing number of borrowers graduate to individual and MSME lending. 7. Access to finance is very limited. Access to finance is highly constrained in Pakistan. According to World Bank estimates, only 10.3% of Pakistani adults and only 3% of women over the age of 15 have a bank account with a formal financial institution. This is well below both the South Asian average of 33.0% and the average for all lower middle-income countries of 41.4%.8 An estimated 86% of the population in Pakistan has no access to formal financial services; 56% of adults in Pakistan use neither formal nor informal products and, while 36% of adults save, only 4% save with a formal financial institution. Similarly, while one-third of adults borrow money, only 3% borrow from a formal financial institution. The use of mobile money is growing rapidly but is still limited to 11% of males and 3% of females. Two-thirds of the country lives in rural areas, where often the only sources of capital are informal lenders, who charge exorbitant interest rates and capitalize on the vulnerability of the poor.9 8. Access to finance is particularly constrained for MSMEs and individual micro borrowers, including farmers. Banks in Pakistan tend to be selective in risk taking, with a clear preference for providing working capital and trade finance to large corporations with lower risk profiles and an aversion to lending to small and medium-sized enterprises (SMEs). Domestic credit to the private sector as a percentage of GDP stood at 15.4% in 2015 (footnote 8). Nonperforming loans (NPLs) are high but adequately provisioned. At the end of FY2016, the gross NPL ratio was 11.1%, an improvement from the peak of 16.7% at the end of September 2011. SMEs had the highest NPL ratio (26.5%), followed by agriculture (15.5%). The poor quality of SME loans can be attributed, in part, to inadequate credit risk appraisal and the effect of chronic power shortages on business profitability. Access to finance for micro enterprises is even more limited and remains largely unmet by the formal finance sector. The limited supply of credit to micro enterprises is a major concern to policy makers in Pakistan and the SBP has been encouraging microfinance banks to provide larger loans to micro enterprises. It recently increased the maximum loan size of microfinance banks from PRs150,000 to PRs500,000.

7 Pakistan Microfinance Network. 2016. MicroWatch: A Quarterly Update on Microfinance Outreach in Pakistan.

http://www.microfinanceconnect.info/assets/articles/67c46230ff56934efe801fd0e1c4b25f.pdf (accessed 11 October 2016).

8 World Bank (WB). 2016. World Bank Open Data. Washington, DC. 9 SBP. 2015. National Financial Inclusion Strategy Pakistan. Islamabad.

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9. Micro, small, and medium-sized enterprises and agriculture. Financing needs of MSMEs are largely unmet. There are 3.2 million SMEs in Pakistan but only approximately 188,000 loans outstanding on banks’ books. MSMEs receive only 7% of total bank credit to the private sector but contribute 40% to GDP.10 MSMEs are estimated to account for 98% of all enterprises in Pakistan and are estimated to employ more than 80% of the nonagricultural labor force. SME lending increased in the early 2000s but has dropped significantly since 2008. The SME Bank, which was set up by the government to boost the development of SME finance, has almost stopped lending because of poor asset quality and accumulated losses. Loans for working capital are the most common type of SME lending. Value-chain finance and cash-flow lending are very rarely used.11

10. Agriculture is an important sector for Pakistan’s economy with 120 million people directly depending on agriculture to survive; however, 85% of farmers are financially excluded. Agriculture employs nearly 45% of the labor force, and major crops such as wheat, paddy, maize, sugar cane, and cotton provide employment to around 13.5 million households. Despite the sector contributing almost 19% of GDP, credit to the agriculture sector remains small and amounted to only 5.2% of total bank loans by FY2016. The SBP estimates total demand for agriculture credit to be PRs790.0 billion, against the current portfolio of PRs296.6 billion. MFB loans account for only 7% of the total value of loans outstanding but for approximately one-third of borrowers. 11. Investment rationale. Given the very low credit extended to the private sector, specifically to MSMEs and agri-borrowers, and the importance of these two segments to economic growth and poverty alleviation in Pakistan, the Asian Development Bank (ADB) met with a number of banks and nonbank finance companies in 2016 to identify candidates for funding. KBL is one of the few MFBs with a long and successful track record in agriculture and MSME lending. As the largest microfinance institution in Pakistan, KBL has nationwide presence through 129 branches and is ideally positioned to utilize ADB’s funding for the improvement of access to finance for the underserved. It currently serves over 500,000 low-income borrowers. KBL’s strategy since its founding in 2000 also includes empowerment of women by providing women with increased opportunities to access financing. About 25% of the current portfolio consists of female borrowers. KBL actively markets the case studies of some of its female clients, branded as ”the Wonder Women of Khushhalibank”, as role models for other women and to enhance financial awareness. B. Business Overview and Strategy 12. Founded in 2000, KBL was a part of the government’s poverty reduction strategy and its microfinance sector development program, development of which was facilitated by ADB. As noted, KBL is the largest MFB in Pakistan with a nationwide presence in all districts of the country and a network of 129 branches, which is expected to grow to 139 branches by the end of 2016. KBL has the largest client base among MFBs in Pakistan and offers diverse products for both its loan and deposit clients. At the end of 2015, KBL served over 0.5 million active borrowers and managed a gross loan portfolio of over PRs17 billion ($162.4 million). KBL has over 1 million active savers with total deposits exceeding PRs15 billion. The bank also offers remittance services and micro insurance products. 13. KBL’s 5-year strategy will enable it to transform its portfolio from primarily micro group-based loans to a good mix of group, individual, and MSME loans. The number of KBL’s total active borrowers is projected to reach over 600,000 with a gross loan portfolio of PRs45 billion by

10 WB. 2016. What Will It Take for Pakistan to Achieve Financial Inclusion? Washington, DC. 11 SBP. 2015. National Financial Inclusion Strategy Pakistan. Islamabad.

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FY2020, reflecting a compound annual growth rate (CAGR) of 20.0% from FY2015 to FY2020. Since acquisition by its current shareholders in 2012, KBL has embarked on a growth-driven strategy which entails product mix diversification. While KBL continued to cater to rural and urban markets through its core group lending product, the bank also scaled-up its secured portfolio to diversify its loan book and has established its presence in the MSME segment. The product portfolio of KBL includes the following:

(i) Group loans. Group loans constituted 67% of the total loan portfolio as of the end of CY2015. These loans are uncollateralized group loans with group sizes of 5–20 members and loan sizes of PRs10,000–PRs50,000 ($100–$950). The average tenor of these loans is 12 months and repayment options are offered in both equal monthly installments and seasonal bullets. Currently, over 90% of the group loan portfolio comprises agriculture and livestock bullet loans. Based on its past experience, KBL intends to limit this portfolio to the agriculture sector only and exit from group lending based on equal monthly installments as farmers’ cash flows are linked to a crop cycle. Based on KBL’s 5-year business plan, its group loan portfolio is expected to grow at a low CAGR of 1.6% from FY2015 to FY2020 because of management’s concerted efforts to diversify KBL’s loan book. This will gradually reduce the proportion of these loans from 67% of total loans in FY2015 to 30% of total loans by FY2020. KBL maintains very high client retention rates for this product and expects to maintain an 80% retention rate.

(ii) Individual loans. Individual loans represent 30% of the bank’s total portfolio and are targeted toward slightly larger businesses in urban markets with loan sizes of PRs25,000–PRs150,000 ($240–$1,430). These loans are primarily collateralized and backed by securities such as gold, KBL term deposit certificates, and national savings certificates. Payments are predominantly structured as equal monthly installments. KBL expects to maintain an individual loan share of 30% in the overall portfolio for 2017-2021. For that purpose, it is offering a diversified suite of individual loan products to its customers including value chain financing, Shandar Bachat Scheme12 (savings-based), and livestock and revolving credit facilities. Diversification will also be instrumental for growth and to achieve portfolio concentration limits. The individual portfolio is projected to grow by over 100% in from 2017-2021, from PRs5 billion to over PRs12 billion. While these loans are secured by collateral, they are only offered for cash-flow-generating businesses and, hence, KBL provides specialized cash-flow-based lending training to its staff offering this product. The individual loans portfolio is expected to grow at a CAGR of approximately 19.1% from 2015 to 2020.

(iii) Micro, small, and medium-sized enterprise loans. With the introduction of an SBP regulation allowing for the extension of loans to the MSME segment of up to PRs500,000 ($4,760), KBL has developed a new product which caters to the needs of larger micro enterprises which have worked with KBL in the past but have financial needs that have outgrown the bank’s standard products. The development of the MSME product is supported by the Small Business Banking Network of the United States. At the end of FY2015, the MSME portfolio constituted 3% of the total loan portfolio. As a strategy, the MSME portfolio build-up will be gradual and done in phases to maintain asset quality. The MSME product roll-out will enhance the sector diversification of KBL’s loan portfolio from mainly agriculture to a wide range of sectors serviced by micro enterprises. KBL plans to extend MSME outreach from a base of 350 borrowers in FY2015 to over 70,000 in

12 This scheme was designed to attract and retain small savings from KBL’s target market segment, especially women,

in current account category with an additional offer of a loan facility for the enterprises and livestock sectors.

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FY2020. Average loan sizes are projected to grow from PRs250,000 in 2015 to PRs412,000 in 2020 with average loan tenor of 18 months. MSME loans are expected to comprise 37% of the total outstanding loan portfolio by the end of 2020, representing a CAGR of 62.8% from FY2015 to FY2020.

(iv) Housing and Islamic finance. These new products for KBL, expected to be rolled out by the end of 2016, will feature housing and Islamic finance in accordance with the regulations, with loans up to PRs500,000 with terms initially from 60 months to 120 months. The International Finance Corporation is providing technical assistance to the bank to develop the housing finance product. Based on KBL’s projections, the combined housing and Islamic finance loan portfolio is expected to grow at a CAGR of 75.7% from FY2016 to FY2020.

14. From 2017-2021, KBL’s strategy is focused on two key areas: (i) diversifying and de-risking its loan portfolio, and (ii) enhancing profitability and return on assets. While the majority of its business will continue to comprise group and individual loans, the MSME product roll-out will enable the bank to develop a new niche for itself, improve its receivables, diversify product concentration, and bring greater profitability to the branches. New initiatives such as housing and Islamic finance will further diversify KBL’s asset portfolio. In terms of de-risking its portfolio, KBL is offering crop insurance and livestock insurance by rolling out third-party insurance products. It is also implementing a new core banking system for improved business processes, enhanced efficiency and productivity, and better risk management. 15. The second key focus area of KBL’s strategy of enhancing profitability relies on its ability to improve its cost of funds. Deposits will be the primary source of funding to support loan portfolio growth and KBL is placing strong emphasis on deposit mobilization by (i) offering a suite of current accounts, savings accounts, and term deposit offerings; (ii) increased investments in service delivery options by new branch openings (10 new branches every year from 2017-2021); and (iii) digital banking initiatives. Being the largest MFB in Pakistan with an existing branch network of 129 and over 2,000 branch staff, KBL has the advantage of maintaining over 1 million customer relationships. KBL aims to focus on cross-selling, leveraging its large branch network and gradually building its current account and savings account (CASA) book. KBL’s loan–deposit ratio is expected to improve from 125% in FY2015 to 84% by FY2020. In addition, KBL will pursue a mix of local and international institutional funding sources and is currently in discussions with the Overseas Private Investment Corporation OPIC and the International Finance Corporation, in addition to ADB. C. Ownership, Management, and Governance 16. Ownership. The shareholding of KBL is largely vested with a consortium led by one of the largest commercial banks in Pakistan, United Bank Limited, which holds a 29.7% shareholding. The other shareholders include Rural Impulse Fund II (24.5%), responsAbility Global Microfinance Fund (19.9%), ShoreCap II Limited (14.3%), ASN-Novib Microkredietfonds (9.9%), and Bank Al Habib Limited (1.8%). 17. Management. KBL’s 10-member executive management team is responsible for the day-to-day management of the bank. The management team has many years of experience in the banking industry. Ghalib Nishtar, the president and chief executive officer, founded the bank in 2000 and was part of the process initiated by the Government of Pakistan to reform the finance sector under the microfinance sector development program.

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18. Governance structure. KBL’s board of directors comprises seven members and includes leading commercial bankers, fund managers, and microfinance experts from across the globe. This autonomous, private sector board provides stewardship and guidance to the management. KBL is regulated by the SBP. 19. Risk management. KBL is governed by a board-approved risk management policy that oversees all aspects of risk including credit, operational, market, liquidity, interest rate, and compliance. The board’s Risk Management Committee consists of four members and is updated regularly on the risks and the mitigating actions taken to manage them. 20. Integrity due diligence has been conducted in accordance with ADB's Integrity Due Diligence Guidelines for Nonsovereign Operations.13 ADB’s review of the ownership structure does not give ADB cause to believe that such entity has been established, or is being used for cross-border tax evasion, money laundering, or terrorism financing in the jurisdictions involved in the investment. D. Financial Performance 21. Credit rating. KBL has the highest credit rating in the microfinance subsector in Pakistan. In April 2015, JCR-VIS Credit Rating Company upgraded the entity rating of KBL from A/A-1 (Single A/A-One) to A+/A-1 (Single A Plus/A-One). 22. Capital adequacy. KBL has maintained healthy capitalization with a total capital adequacy ratio (CAR) of 20.24% at the end of 2015, well above SBP’s minimum regulatory floor of 15.00%. It dropped from 24.6% in 2014 largely because of the rapid increase in loans. Total capital grew 20.3% in 2015, but this was slower than growth in assets. 23. Earnings and profitability. KBL ended FY2015 with a pretax profit of PRs1.18 billion ($11.3 million), up 25.5% from Rs942 million ($9.1 million) reported as of FY2014. After-tax profit stood at PRs824 million, an increase of 17.2% from the FY2014 profit of PRs703 million. The increase in profit resulted from continued growth in the balance sheet and improved non-interest income. The return on equity improved from 18.5% to 20.2% and return on average assets marginally decreased from 3.7% in FY2014 to 3.4% in FY2015. 24. Portfolio and asset quality. In FY2015, KBL’s total assets increased to PRs26.7 billion, an increase of 60% over FY2014. The gross loan portfolio grew by 43% to PRs17.5 billion in FY2015 from PRs12.2 billion in FY2014. Asset quality deteriorated in FY2015 and PAR3014 increased from 1.0% in FY2014 to 2.1% in FY2015. This was primarily because of stress in the agriculture sector in Pakistan due to weather and delayed payments of major crops, especially cotton, rice, and potatoes. 25. Funding and liquidity. KBL has maintained a comfortable liquidity and solvency position. In FY2015, KBL’s liquid assets to deposits and money market funding was 11.7%, down from 15.8% in FY2014. KBL has set a higher floor for a liquid assets reserve of 15% of total assets in its 5-year plan. The higher liquid assets target is expected to achieve a higher statutory liquidity ratio of 25% to provide a cushion over and above the regulatory floor of 10%. In terms of funding, KBL’s retail deposits increased by 79% from PRs8.7 billion in FY2014 to PRs15.6 billion in FY2015.

13 ADB. 2015. Integrity Due Diligence Guidelines for Nonsovereign Operations. Manila. 14 Portfolio at Risk greater than 30 days which measures loans overdue by 30 days or more.

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III. THE ADB ASSISTANCE

A. The Assistance 26. The ADB transaction will support financial inclusion for agri-borrowers and MSMEs.15 The proposed ADB assistance consists of a senior unsecured loan to KBL of up to $20 million with a 4-year tenor. Up to 25% of ADB’s funding will be targeted to female borrowers. ADB is planning to complement the proposed loan with technical assistance of up to $400,000, which will be processed separately. The technical assistance will support the establishment of an MSME training academy as well as investments in KBL’s risk management systems. B. Implementation Arrangements 27. Monitoring and reporting. ADB’s Private Sector Operations Department will carry out project monitoring. KBL will provide ADB with financial reports at predetermined regular intervals and as requested. These will include (i) annual audited financial statements, (ii) quarterly unaudited financial statements, (iii) quarterly compliance certificates for loan covenants, (iv) semiannual reporting on MSME and agriculture loan portfolios, and (v) semiannual reporting on selected development indicators agreed by ADB and the borrower.

28. Evaluation. Monitoring reports will be prepared and submitted to ADB regularly, and at least annually. The first report will be submitted no later than 12 months after the first disbursement. C. Value Added by ADB Assistance 29. Broadening access to finance. ADB’s funding will help KBL to continue to grow and reach unbanked, lower-income customer segments in Pakistan. It will support the roll-out of its MSME product—a market currently being serviced by the highly expensive informal finance sector—as well as support further growth of its agriculture portfolio. ADB’s funding is expected to result in enhanced financial inclusion in a country that lags significantly behind other South Asian countries in this area. 30. Supporting microfinance bank development. As discussed, the banking industry in Pakistan has been risk averse to a number of segments, resulting in these segments being served through nonbank finance companies at present. To support lending to a broader spectrum of underserved segments, the SBP recently raised the regulatory cap on micro credit from PRs150,000 to PRs500,000. This was done to encourage MFBs to serve the MSME segment as well as offer new products (i.e., rural housing finance). By providing funding for onlending to the MSME segment, ADB has a unique opportunity to support microfinance banking reforms and promote credit to MSMEs. 31. Provision of longer tenor debt. KBL has historically focused on group loans, with relatively short loan tenors of less than 12 months. As KBL management focuses on diversifying its loan portfolio and growing its MSME loan portfolio, which have relatively longer tenors, the

15 The State Bank of Pakistan definition for MSMEs will be used. Micro enterprises are those entities that have up to

10 employees. A small enterprise has up to 50 employees and up to PRs150 million in annual turnover. A medium-sized enterprise has 51–250 employees if it is operating in manufacturing and service and 51–100 employees if it is operating in trading. Annual turnover for a medium-sized enterprise is PRs150 million–PRs800 million.

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bank needs additional sources of longer tenor financing. Therefore, ADB’s loan will provide scarce medium-term funds needed by KBL to diversify its product portfolio. 32. Increase lending to women. KBL is committed to increasing lending to women. Access to finance for women in Pakistan is still severely limited with only 3% of adult women over the age 15 having a bank account. Up to 25% of ADB’s loan will be dedicated to lending to women. In addition, ADB has agreed a Gender Action Plan (GAP) with KBL that will include staff training to enhance lending to women. D. Risks 33. Execution risk. KBL’s business plan foresees strong growth rates in loan assets, deposits and capital accumulation. Expansion into new asset classes that require new risk management capacities and increases KBL’s exposure to higher risk agriculture sector lending. KBL’s solid track record in managing its growth provides comfort in its ability to grow without loosening risk standards.

34. High staff attrition. In line with industry average, KBL experienced a high staff attrition rate of 18% in 2015 primarily among loan officers. This exposes KBL to significant operating risk, especially in terms due diligence and loan collections. To address this, KBL has implemented new training, and more market-based and performance-driven compensation. Staff attrition will be included as part of the quarterly management reports submitted to ADB to monitor this risk.

35. Evolving institutional capacities need improvement. As MSME lending started in 2015, KBL’s operational capabilities for this business segment are still to be tested. Loan approvals are based on cash flow analysis performed by its loan officers, who are mostly fresh graduates with limited experience. Although loan officers are compensated based on loan accounts and asset quality, loan origination and approval are managed by the same team under the stipulated credit policy guidelines of the Risk Management. 36. Asset quality and profitability. KBL has experienced strong growth in recent years and is expanding into new asset classes. Historically, the MSME and housing finance segments in Pakistan have seen high NPL rates and most of the commercial banks avoid these segments. This notwithstanding, KBL has maintained good asset quality with sound underwriting standards. 37. Currency risk. The loan is expected to be denominated in US dollars while the bank’s clients, which are mostly not naturally hedged, borrow in local currency. KBL is planning to hedge the currency risk through foreign exchange swaps. 38. Country risk. Pakistan remains a challenging operating environment. Security risks and high vulnerability to natural disasters (earthquakes and floods) have the potential to disrupt public service delivery and impact individuals and small businesses in particular. KBL has a long track record of operating in this environment. Its management is cognizant of the challenges and mitigates these risks in a number of ways, including a conservatively managed capital position and a well-diversified portfolio. 39. The proposed loan of up to $20,000,000 or Pakistan rupee equivalent to KBL has an obligor risk rating of NSO 1016 and a facility risk rating of NSO 10.

16 Since the rating after systemic support is NSO 9 and the door-to-door tenor is less than 10 years, the transaction is

eligible for FAST processing.

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IV. DEVELOPMENT IMPACT AND STRATEGIC ALIGNMENT

A. Development Impact, Outcome, and Outputs 40. Impact. Access to finance for MSMEs and agri-borrowers will increase in alignment with the SBP’s National Financial Inclusion Strategy 2015.17 41. Outcome. Increased uptake of financial services by MSMEs and agriculture-related clients will provide employment and income benefits for the poor. KBL retains good asset quality. 42. Outputs. Increased Capacity of KBL to serve MSMEs and agriculture-related clients with a particular focus on women will result in financing for the underserved in Pakistan through KBL as evidenced by (i) KBL’s total loan portfolio growing at a minimum of 20% per annum, (ii) KBL’s MSME loans increasing from 3% of the loan portfolio in FY2015 to 30% in FY2024, and (iii) female borrowers increasing from 25% of the total loan portfolio in FY2015 to 30% in FY2024. B. Alignment with ADB Strategy and Operations 43. Consistency with ADB strategy and country strategy. Under the Midterm Review of Strategy 2020, ADB aims to strengthen its support for the finance sector by assisting the development of financial infrastructure, institutions, and products and services, and by promoting inclusive growth. 18 The borrower’s emphasis on funding segments where the potential for employment and income generation is high will support inclusive growth. The ADB loan will help the borrower provide loans to MSMEs and farmers in order to realize their investment needs. This is consistent with ADB’s country partnership strategy for Pakistan, 2015–2019, which specifically identifies inclusive growth through supporting financial services to segments whose access to finance is limited.19 44. Consistency with sector strategy and relevant ADB operations. ADB plays a tangible role in supporting the deepening of financial services in Pakistan. ADB has been active in the finance sector since 2000 through the microfinance sector development program, of which KBL was a beneficiary. The proposed loan to KBL will continue to build on ADB’s past efforts in supporting financial inclusion and widening access to finance.

V. POLICY COMPLIANCE A. Safeguards and Social Dimensions 45. In compliance with ADB’s Safeguard Policy Statement (2009), the senior loan is classified as category FI based on potential impacts on the environment, and category FI treated as C for impacts on involuntary resettlement and indigenous peoples. Subloans categorized as A on environment and A or B on involuntary resettlement and indigenous peoples will not be financed

17 SBP. 2015. National Financial Inclusion Strategy. Karachi. 18 ADB. 2014. Midterm Review of Strategy 2020: Meeting the Challenges of a Transforming Asia and Pacific. Manila. 19 ADB. 2015. Country Partnership Strategy: Pakistan, 2015–2019. Manila.

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under the loan. The existing social and environmental management system established by KBL will be enhanced to comply with ADB’s Safeguard Policy Statement and the requirements of ADB’s Social Protection Strategy20, and will be adopted before the first disbursement. KBL will prohibit subloans from using ADB funds for any business activities on ADB’s prohibited investment activities list, and will require subloans to abide by applicable national laws and regulations. KBL will monitor and provide information on its compliance with the ADB Safeguard Policy Statement and with relevant national laws, standards, and guidelines in the annual report. The project is categorized as effective gender mainstreaming. A gender action plan was prepared and provides clear gender targets and monitoring indicators to achieve the desired improvement in women’s access to KBL loans. B. Anticorruption Policy 46. KBL was advised of ADB’s policy of implementing best international practice relating to combating corruption, money laundering, and the financing of terrorism. ADB will ensure that the investment documentation includes appropriate provisions prohibiting corruption, money laundering, and the financing of terrorism, and remedies for ADB in the event of noncompliance. C. Investment Limitations 47. The proposed loan is within the medium-term, country, industry, group, and single investment exposure limits for nonsovereign investments. D. Assurances 48. Consistent with the Agreement Establishing the Asian Development Bank (the Charter),21 ADB will proceed with the assistance upon establishing that the Government of Pakistan has no objection to the assistance to KBL. ADB will enter into suitable finance documentation, in form and substance satisfactory to ADB.

VI. THE PRESIDENT’S DECISION 49. The President, acting under the authority delegated by the Board, has approved the loan of up to $20,000,000 or Pakistan rupee equivalent from ADB’s ordinary capital resources to Khushhali Bank Limited for Expanding Access to Credit for Agriculture and Micro, Small, and Medium-Sized Enterprise Borrowers in Pakistan, and hereby reports this action to the Board. 12 December 2016

20 ADB. 2001. Social Protection Strategy. Manila. 21 ADB. 1966. Agreement Establishing the Asian Development Bank. Manila.

Appendix 1 11

DESIGN AND MONITORING FRAMEWORK

Impact the Project is Aligned with

Access to finance for MSMEs and agri-borrowers increased (State Bank of Pakistan’s National Financial Inclusion Strategy 2015)a

Results Chain Performance Indicators with Targets and

Baselines Data Sources and

Reporting Risks

Outcome By 2024

Increased uptake of KBL’s financial services by MSMEs and agriculture-related clients

a. Number of active MSME borrowers increased to 15,000 (baseline: 350, FY2015)

b. Number of active MSME borrowers that are women or businesses owned or managed by women increased to 3,000 (baseline: 62, FY2015)

c. Number of active agriculture sector borrowers increased to 750,000 (baseline: 430,000, FY2015)

d. Number of women agriculture sector borrowers increased to 200,000 (baseline: 115,000, FY2015)

e. Nonperforming loans (90 days past due) no more than 5.00% (baseline: 0.54%, FY2015)

a–e. KBL annual monitoring report

KBL’s asset quality deteriorates significantly with the rapid growth of the portfolio. MSME roll-out slower than planned because of resource constraints

Outputs 1. Capacity of KBL to serve MSMEs and agriculture-related clients increased 2. KBL’s capacity for loans to women borrowers increased

By 2024 1a. Total amount of MSME loans disbursed at least PRs10 billion (baseline: PRs365 million) 1b. Total amount of agriculture loans disbursed at least PRs25 billion (baseline: PRs15 billion, FY2015) 2a. KBL’s female borrowers as a percentage of total borrowers increased to 30% (baseline: 25%, FY2015) 2b. Amount of MSME loans disbursed to women or and businesses owned or managed by women at least PRs2.5 billion (baseline: PRs80 million, FY2015) 2c. Amount of agriculture loans disbursed to women or businesses owned or managed by women at least PRs6.5 billion (baseline: PRs4 billion, FY2015)

KBL unable to build deposit base and other funding sources in time to respond to growth in demand. Slow pickup in credit demand for MSMEs

1–2. KBL annual monitoring report

12 Appendix 1

Key Activities with Milestones

Outputs 1 and 2: Increased capacity of KBL to serve MSMEs and agriculture-related clients, with a particular focus on female borrowers 1.1 ADB executes legal agreements in first half of 2017. 1.2 ADB loan is fully disbursed by fourth quarter of 2018.

Inputs ADB: $20 million (loan)

Assumptions for Partner Financing

Not applicable

ADB= Asian Development Bank, KBL = Khushhali Bank Limited, MSMEs = micro, small, and medium-sized enterprises. a State Bank of Pakistan. 2015. National Financial Inclusion Strategy. Karachi. Source: Asian Development Bank.