ICRR 14060 Report Number : ICRR14060 IEG ICR Review Independent Evaluation Group 1. Project Data: Date Posted : 04/24/2013 Country : Nepal Project ID : P071291 Appraisal Actual Project Name : Financial Sector US$M ): Project Costs (US$M): 30.1 21.58 Technical Assistance Project L/C Number : C3727 Loan/ US$M): Loan /Credit (US$M): 16.0 9.52 Sector Board : Cofinancing (US$M): US$M ): 14.1 12.06 Cofinanciers : Board Approval Date : 12/19/2002 Closing Date : 06/30/2007 12/31/2011 Sector (s): Banking (98%); Vocational training (1%); Media (1%) Theme (s): State-owned enterprise restructuring and privatization (29% - P); Regulation and competition policy (29% - P); International financial standards and systems (28% - P); Corporate governance (14% - S) Prepared by : Reviewed by : ICR Review Group : Coordinator : Robert Keyfitz Rene I. Vandendries Ismail Arslan IEGPS2 2. Project Objectives and Components: a. Objectives: The Financial Sector Technical Assistance Project (FSTAP) was envisaged as the first stage of a programmatic Financial Sector Reform Program (FSRP) with as overarching objective, "to support the renewed efforts of His Majesty's Government of Nepal (HMGN) to improve the sector in order to bring macroeconomic stability and promote private-sector led economic growth." (PAD, p. 2) Specific objectives of the FSTAP as stated in the PAD are, "(a) helping to restructure and re -engineer the Central Bank (Nepal Rastra Bank-NRB), so that it can effectively perform its key central banking functions; (b) commencing commercial banking reform in the two large ailing commercial banks that dominate the sector (Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL)) -- by introducing stronger bank management that protects the financial integrity of the two banks and would take on a conservator role to prepare the banks for the next steps of restructuring; and (c) supporting a better environment for financial sector reform in areas such as enhanced credit information, better financial news reporting, and better training for staff in financial institutions .� (PAD, p. 2) The wording in the Development Credit Agreement is materially the same : The objectives of the Project are to assist the Borrower in : (i) restructuring and re-engineering the Nepal Rastra Bank for it to effectively perform key central banking functions; (ii) implementing reforms in the commercial banking sector that will focus initially on restructuring Rastriya Banijya Bank and Nepal Bank Limited; and (iii) improving the environment for financial sector reforms in areas such as credit information and financial news reporting through specialized training and capacity building .� (DCA, p. 19) In April 2011, a Level 1 restructuring amended the objectives in the Development Credit Agreement : “The objectives of the Project are to assist the Borrower in : (i) developing capacity of Nepal Rastra Bank to effectively perform key central banking functions; (ii) implementing restructuring program of Rastriya Banijya Bank and carrying out diagnostic reviews of Nepal Bank Limited, to prepare these state -owned commercial banks for the next steps of restructuring; (iii) creating an enabling environment for financial sector development, specifically in the area of credit information Bureau, secure transaction registry and financial news reporting ." While the PAD version is somewhat more detailed and descriptive, for the sake of consistency between the original and amended objectives, the DCA versions will be used in this review . In broad terms, the April 2011 restructuring, (i) downplayed and lowered expectations about the extent of central bank restructuring; (ii) limited the preparation for final resolution of the two restructured commercial banks to only one of them, Nepal Bank Limited; and (iii) detailed more explicitly the improvements in the financial sector enabling environment. The changes were relatively minor and, moreover, were introduced only 8 months before the project closed. Very little if any money was disbursed under the restructured objectives . Therefore, the project will be evaluated in relation to the original objectives, only . b.Were the project objectives/key associated outcome targets revised during implementation? Yes If yes, did the Board approve the revised objectives /key associated outcome targets? Yes Date of Board Approval: 04/01/2011 c. Components: The FSTAP comprised three components . The versions given here are from the original project .: (i) Restructuring and re-engineering the Nepal Rastra Bank for it to effectively perform key central banking functions: The FSTAP’s first component targeted a range of problem areas in the central bank . Specific actions included: (i) Providing legal support for implementing the new NRB Act (2002) to increase the central bank's autonomy and independence; and finalizing and implementing a new Banking and Financial Institutions Act (BFIA) and other legal reforms; (ii) Developing a Human Resources ( HR) strategy to right-size staff and implement a voluntary retirement scheme (VRS), decompress the salary structure to improve incentives for performance, and computerize HR functions; (iii) Strengthening supervisory and regulatory capacity through recruitment of experienced bank supervisors and inspectors, implementation of a strategic plan for financial sector surveillance and upgrading of computer systems; and (iv) Providing other support, including building capacity in the research department and computerizing the library, strengthening accounting and auditing capabilities, supporting internal audit functions, and providing training for professional development . (ii) Implementing reforms in the commercial banking sector that will focus initially on restructuring Rastriya Banijya Bank and Nepal Bank Limited : This component called for replacing the management of RBB and NBL with new teams to take complete control over day -to-day operations, stabilize operational and financial positions, strengthen accounting departments and develop human resource programs, with the eventual aim of privatizing or liquidating them. The new management teams, to be hired for periods of three years, comprised eight professional staff, including a CEO, and heads of credit, loan recoveries, accounting, internal audit, IT, treasury and personnel. (iii) Improving the environment for financial sector reforms in areas such as credit information and financial news reporting through specialized training and capacity building : To increase the financial sector ’s effectiveness, this component aimed to build capacity at the Bankers Training Center (BTC), strengthen the credit information bureau, and improve the competence of local journalists to cover financial sector issues . The component also aimed to strengthen program management capacity in the Coordination Support Team (CST), the FSTAP implementation unit established at the central bank . In four successive restructurings, various activities were added and deleted from the project .components. The most significant of these, in June 2008, concerned transferring the final resolution of RBB and NBL from the FSRP which was to be closed early . However, this was dropped from the FSTAP in April 2011. The April 2011 restructuring added one new activity, conducting a fast track diagnostic assessment of NBL to help determine the next restructuring steps for the bank . d. Comments on Project Cost, Financing, Borrower Contribution, and Dates: IDA's $16 million was cofinanced with a US$10 million grant from DFID and US$4.1 million commitment from the government. After the Bank downgraded its assessment to Moderately Unsatisfactory in July 2010, DFID decided to withdraw and closed its grant in March 2011 after spending $8.35 of its $10 million commitment. By the time the project finally closed in December 2011, total disbursement was $9.52 million from IDA, $8.35 million from DFID, and $3.71 from the Government. 3. Relevance of Objectives & Design: a. Relevance of Objectives: The CAS at closing (2003) retained the financial sector as a priority sector for the Bank's engagement, with the FSRP as the primary vehicle (CAS Annexes B9, B10). Over the CAS period, 2004-06, an allocation of $145 million to financial sector reform was anticipated, 23% of base case lending (Annex B3). No new CAS has been prepared since 2003, hence this reference was quite out of date by the time the project closed . Subsequently, the Bank has prepared regular Interim Strategy Notes . The latest one, dated August 4, 2011 covered FY12-FY13 and would have been in force when the project closed . It continued the Bank’s engagement in the financial sector, though with a focus on microfinance and program delivery mainly through IFC . Although the Government showed great interest in the project at first, its priorities changed and the political situation deteriorated after the initial closing date of 6/30/2007. By the time it eventually closed in December 2011, the project's ambitions had been downsized to reflect what was achievable with regard to strengthening the central bank and improving efficiency and effectiveness of the banking sector . The ICR argued that as the Government's priorities progressively deviated from the project's original intent, it should have been fundamentally restructured or closed earlier . While the picture is mixed, given the overall relevance of modernizing Nepal's financial sector and the importance of a resolution of the RBB and NBL, the relevance of both the original and restructured objectives is rated as substantial . b. Relevance of Design: The FSTAP was based on extensive diagnostic work which provided a detailed analysis of the financial sector's problems. The central bank was ineffective in overseeing the financial sector, especially commercial banking, because of a lack of independence and autonomy, and weak supervisory and regulatory capacity . In the commercial banking sector, full or majority government ownership of the two leading banks had resulted in inadequate capitalization, weak loan portfolios, poor financial accounting practices, and massive accumulated losses. More generally, the financial sector suffered from poor training, a lack of credit information, and low levels of financial literacy and sophistication in the general public which impeded wider demand for financial services. Such problems are by no means unfamiliar and the FSTAP's detailed proposals conformed to best practice approaches in dealing with them. A recently passed Central Bank Act, prepared in conjunction with the FSTAP, increased the NRB’s independence and a new legal framework for the commercial banking sector was imminent. Capacity constraints at the NRB would be addressed through a combination of outside hiring and better HR management. In the commercial banking sector, the most obvious solution was to put new management in place at the RBB and NBL, with a clear mandate to reform the banks' operations and clean up their balance sheets. Finally, a relatively small component of the project to strengthen training, improve credit information, and train journalists addressed the market's inefficiency and poor integration into the economy . Nevertheless, the design was overambitious and bundled together a large number of loosely related elements -- reforming the financial sector's legal and institutional framework, computerizing and building capacity throughout the central bank's operations and, last but by no means least, resolving the problems of two insolvent commercial banks which represented a massive fiscal liability for the government . In fact, the fiscal risk was the rationale for the entire project. But, completing the task was separated out and left for the FSRP, while the FSTAP incorporated numerous other unrelated needs of Nepal's financial sector . A more streamlined project with a narrower focus might well have moved faster toward a resolution of the RBB and NBL while the Government's commitment remained strong . Instead, momentum was lost before the task was completed, putting at risk the project's central objectives . A second design flaw was reliance on the central bank's procurement which was known to be weak and which was subsequently responsible for derailing the project as critical procurement ground to a halt . A design which was (i) narrower and more focused, and (ii) relied less on Government procurement, might well have contributed to a better outcome . Curiously, the PAD was well aware of these risks and anticipated some of the problems which subsequently arose . Results framework: The results framework leaves much to be desired . It is confusing and difficult to follow . There are numerous inconsistencies between the indicators listed in the text of the PAD (Section A.2, pp. 2-3) and the "Project Design Summary" table in Annex 1 (pp. 23-25). The Annex table (p. 25) includes the FSTAP’s budget allocations as performance indicators which is odd and probably an error, although that is not clear from the presentation. The PAD distinguishes Sectoral Indicators, Outcome /Impact Indicators, and Output Indicators, with no explanation of this unusual taxonomy . In fact, there is only one Sectoral Indicator, stated as : Comprehensive financial sector reform that eliminates the need for additional (real or contingent) budgetary support for the financial system – once the banks have been restructured and privatized or liquidated . Notably, though,budgetary transfers are only peripherally mentioned in the PAD, and privatization and liquidation of the RBB and NBL were not envisaged within the FSTAP ’s time frame, so this indicator could not possibly have been achieved by closing . Other indicators in the results framework are qualitative and imprecise, resembling objectives more than indicators. E.g. from the PAD, p. 3: An increase in the range and sophistication of financial instruments and services available at competitive prices. A more prudently operated financial sector with better trained staff, a better informed general public and an enhanced system of credit information . Creating a leaner, more efficient, and professional Central Bank No metrics or baseline data are given for any of the indicators and the ICR makes relatively little use of them in describing the project's achievements . Relevance of design is rates as modest . 4. Achievement of Objectives (Efficacy): The FSTAP got off to a good start, with strong Government support and credible progress toward its objectives . Disbursements through the first few years were below expectations, but mainly due to savings in restructuring RBB and NBL (Component 2) and underspending on the training (Component 1). Apart from these, procurement and disbursement were largely on track (ICR, p. 11). The first restructuring in June 2007 extended the closing date by a year at the Government ’s request to maintain continuity in restructuring the NBL (ICR, p. 8). Nevertheless, after 2007 the project stalled due to a combination of unforeseeable events, political developments and a weakening of the Government's commitment . By the time the project finally closed, its early achievements had eroded significantly . Results under each of the objectives are outlined below : (i) Restructuring and re-engineering the Nepal Rastra Bank for it to effectively perform key central banking functions: The new NRB Act was prepared and passed in conjunction with FSTAP's preparation and appraisal, hence had largely been achieved at effectiveness . However the remainder of the legislative reform agenda, namely revision of the Banking and Financial Institutions Act (BFIA) is still pending. Moreover, capacity constraints prevented the NRB from capitalizing on its newfound independence and autonomy to carry out its mandate. A halt in procurement delayed computerization and hiring of additional bank supervisors and inspectors and as a result the NRB's supervision capacity has not been strengthened . Meanwhile, lengthy delays persist in the publication of NRB, RBB and NBL annual reports because of slow progress on computerization and continued reliance on manual accounting procedures . NRB reports are still not compliant with International Accounting Standards (IAS). Progress on HR reform has been limited . An HR expert was hired and prepared new policies and manuals, but rather than hiring another expert to oversee implementation the NRB decided to utilize in-house expertise, and the pace of reform ground to a halt . Efficacy rating for the first objective is modest . (ii) Iimplementing reforms in the commercial banking sector that will focus initially on restructuring Rastriya Banijya Bank and Nepal Bank Limited : The FSTAP's original objectives of restructuring the NBL and RBB and preparing them for privatization or liquidation were substantially achieved by the project's original closing date . Under the new management teams, NPLs at the two banks were brought down from around 60% to 5.3% and 10.9%, more than 80% of the deposit bases were computerized, and staff levels were more than halved largely due to the FSRP-funded VRS. Due to the success which had been achieved, the FSTAP's first restructuring added final resolution of NBL and RBB through either sale or closure to the second component . However, this was not achieved as the government subsequently backed away from this resolution . A Bank Restructuring and Sales Advisor was to have been hired at NRB for the purpose using project funds, but this also was not done as the government had not decided on the disposition of its shares in the two banks . NBL also decided against recruiting a new CEO using project funds . Due to procurement delays, the fast track diagnostic of NBL (added in the April, 2011 restructuring) was not completed. Meanwhile, reluctance to move ahead toward an ultimate resolution has allowed some of the project's achievements (notably in the HR area) to begin unravelling, while others are at risk. Efficacy rating for the second objective is modest . (iii) Improving the environment for financial sector reforms in areas such as credit information and financial news reporting through specialized training and capacity building : objectives under this component were partially achieved. The Credit Information Bureau was reconstituting as a private Credit Information Center Ltd . (CICL) and its performance substantially improved . The Secured Transaction Registry (STR) was established, though is not yet fully operational. The project enhanced the capacity Of the Debt Recovery Tribunal (DRT) and the Banker's Training Center. Finally, international training was organized for 44 financial journalists. Efficacy rating for the third objective is substantial . 5. Efficiency: The ICR was unable to calculate an accurate measure of overall efficiency or an Economic Rate of Return for the entire project, in part because some of the ultimate results have yet to be realized, especially the resolution of NBL and RBB. Nevertheless, it is clear that very significant savings were achieved . The two restructured banks, RBB and NBL, have generated US$ 400 million in operating profits since 2003 whereas before that they were losing US$ 80 million annually. The difference between these is over US$ 1 billion. Total expenditures for both projects were approximately US$ 78 million. Thus, while the net worth of the two banks remains negative the deficit has declined substantially reducing the eventual fiscal cost of re -capitalizing the banks. Rating for efficiency is substantial . ERR )/Financial Rate of Return (FRR) a. If available, enter the Economic Rate of Return (ERR) FRR ) at appraisal and the re- re -estimated value at evaluation : Rate Available? Point Value Coverage/Scope* Appraisal No ICR estimate No * Refers to percent of total project cost for which ERR/FRR was calculated. 6. Outcome: The objectives of modernizing the central bank and restructuring two large, failing, commercial banks were substantially relevant to reforming Nepal's financial sector . However, despite building on extensive diagnostic work the design was only modestly relevant – overly ambitious, poorly focused, and with a confusing results framework. The project was restructured four times as it went progressively off track, including a six year extension of the closing date, which did little to streamline the design . Despite initial success in restructuring the two commercial banks, ultimately the project ’s achievements were modest and remain significantly at risk . Considering these factors, the project is rated as Moderately Unsatisfactory . a. Outcome Rating : Moderately Unsatisfactory 7. Rationale for Risk to Development Outcome Rating: Despite a significant improvement in the performance of NBL and RBB, both banks still have a negative net worth and remain fragile and there is a significant risk they will revert to their previous management practices without a change in ownership. A rapid increase in staff costs is indicative, following a costly and protracted VRS that was partially funded under the FSRP . The ICR did not consider risks to the other two components, since the project's achievements there were so limited . a. Risk to Development Outcome Rating : Significant 8. Assessment of Bank Performance: a. Quality at entry: During preparation, the bank paid considerable attention to the scope of the project as well as to the Government's implementation capacity and commitment to reform, but then disregarded the obvious implications of its analysis. The second component focusing on restructuring of the RBB and NBL was specified narrowly and explicitly, and largely achieved its objectives although, as noted above, failed to complete the job. The first component dealing with restructuring of the central bank ran into more difficulties . The project comprised a wide range of loosely connected tasks, touching on almost every aspect of the NRB ’ s operation, from the legal framework, to HR management, supervisory capacity, training, research, and IT . A narrower focus and less emphasis on fundamentally reengineering the central bank, and less reliance on the Government’s procurement capacity might have led to greater success . at -Entry Rating : Quality -at- Moderately Unsatisfactory b. Quality of supervision: The Bank conducted regular supervision of the project from the Country Office in Nepal as well as periodic supervision missions, and a Mid Term Review in 2006. A few supervision missions were conducted jointly with DFID. Implementation Status and Results reports were detailed and informative . Project counterparts and donors credited the Bank's technical support and guidance for smooth implementation of project activities (ICR, p. 21). During the initial years of implementation, senior Bank management also engaged in active dialogue with the country's financial sector stakeholders including the Ministry of Finance and the Central Bank . However, the ICR notes that this engagement was not sustained after changes in both senior management at the Bank and the Government. As the political situation and the Government's commitment to reform deteriorated, and especially after corruption charges were brought against the Governor of the NRB, the project stalled . The project team and even Bank senior management (at the vice president level) were unsuccessful in getting the project back on track . The ICR argues that the initial project extension made sense at a time when the FSTAP was progressing well, but that later extensions and restructurings are more difficult to justify . In four years, 2007-11, the project disbursed just US$0.1 7 million and achieved very little progress toward the PDOs . Thus, it should have been either fundamentally restructured or closed earlier . Quality of Supervision Rating : Moderately Unsatisfactory Overall Bank Performance Rating : Moderately Unsatisfactory 9. Assessment of Borrower Performance: a. Government Performance: The Government was initially very supportive of the project during preparation and appraisal, applying for two PPFs, publishing a Financial Sector Strategy Paper which aligned closely to the FSRP, passing the NRB Act and appointing the NBL management team prior to effectiveness . Subsequently, however, due to a deteriorating political environment and changing priorities, its commitment wavered . Delays is in procurement were partly the result of a corruption case brought against the Governor, however the government showed little interest in working around the ostacles by using donor funds and procedures for procurement. Progress stalled on reengineering of NRB, including finalization of the BFIA, and hiring a bank restructuring advisor for a final resolution of NBL and RBB . Government Performance Rating Moderately Unsatisfactory b. Implementing Agency Performance: Due to procurement issues at the CST, elements of the project were delayed, including the hiring of bank supervisors and other experts, automation of credit information functions, capacity building, carrying out a diagnostic study of NBL, and the appointment of replacement management teams at RBB and NBL . These delays contributed to the failure to achieve the PDOs . Implementing Agency Performance Rating : Moderately Unsatisfactory Overall Borrower Performance Rating : Moderately Unsatisfactory 10. M&E Design, Implementation, & Utilization: a. M&E Design: The M&E design was flawed by a weak and imprecise results framework . None of the indicators were quantitative, and no baseline data were collected . Impressionistic results were conscientiously described in ISRs, but the results framework conveyed little sense of how much progress was being made, or what remedial actions might have been appropriate . b. M&E Implementation: M&E was regularly conducted through implementation support missions and a MTR conducted in September 2006. Aides Memoires were shared with other stakeholders and served as a basis for dialogue seeking to expedite implementation and reinforce the Government's commitment towards the project's objectives . At the same time, however, absence of a strong MIS within CST prevented the smooth flow of information and data collection. Project supervision by NRB, and the Government was inadequate . c. M&E Utilization: ISRs regularly reported on the results framework and conveyed a realistic sense of the project's status. This was useful at the time of the first restructuring, but subsequently when the project went off track due to a change in the Government’s priorities, the M&E process was unable to get things back on track, either because the government was not much involved in the M&E process, or because its priorities had changed irreversibly. M&E Quality Rating : Modest 11. Other Issues a. Safeguards: No issues raised b. Fiduciary Compliance: No issues raised c. Unintended Impacts (positive or negative): None d. Other: 12. 12. Ratings : ICR IEG Review Reason for Disagreement /Comments Outcome : Moderately Moderately The restructuring of the RBB and NBL Unsatisfactory Unsatisfactory is a significant achievement. However, it is at risk because progress toward a final resolution has stalled. Should the government proceed in time to this step, MU would certainly understate the project's value. Risk to Development Significant Significant Outcome : Bank Performance : Moderately Moderately Unsatisfactory Unsatisfactory Borrower Performance : Moderately Moderately Unsatisfactory Unsatisfactory Quality of ICR : Satisfactory NOTES: NOTES - When insufficient information is provided by the Bank for IEG to arrive at a clear rating, IEG will downgrade the relevant ratings as warranted beginning July 1, 2006. - The "Reason for Disagreement/Comments" column could cross-reference other sections of the ICR Review, as appropriate. 13. Lessons: The ICR draws some clear lessons about projects such as the FSTAP depending on a sustained commitment and the difficulty of maintaining this over a long period . Especially in fragile states and conflict prone environments, the window is likely to be narrow . Thus, a more focused project aimed at restructuring and resolving the RBB and NBL -- the most critical problem from a fiscal standpoint -- would have been preferable. The ICR also argues that the project should have been closed much sooner as the Government's commitment ebbed. However, this conclusion is more obvious in hindsight than it would have been at the time . It provided a platform for the Bank to remain engaged on financial sector issues and there was little financial or reputational risk to the Bank since the project was relatively dormant and disbursed little money . It is only the somewhat arcane internal procedures for allocating BB that made keeping the project open problematic . Moreover, the project was closed reasonably soon after its performance was downgraded . 14. Assessment Recommended? Yes No 15. Comments on Quality of ICR: This was a complicated and increasingly troubled project, which was restructured four times in a four year period, 2007-11, adding and removing actions and objectives and extending the closing date . The ICR is honest and forthright and it does a reasonably good job of presenting the facts, though it might have attempted a more critical analysis of why and how the project succeeded and failed . a.Quality of ICR Rating : Satisfactory