Document of The World Bank FOR OFFICIAL USE ONLY Report No: PAD1122 INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVLOPMENT PROJECT APPRAISAL DOCUMENT ON A PROPOSED LOAN IN THE AMOUNT OF US$93 MILLION TO THE LAND AND AGRICULTURAL DEVELOPMENT BANK OF SOUTH AFRICA WITH THE GUARANTEE OF THE REPUBLIC OF SOUTH AFRICA FOR A LAND BANK FINANCIAL INTERMEDIATION LOAN DECEMBER 29, 2016 Finance and Markets Global Practice Africa Region This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document will be made publicly available in accordance with the Bank’s policy on Access to Information. CURRENCY EQUIVALENTS (Exchange Rate Effective October, 30 2016) Currency Unit = South African Rand ZAR 13.47 = US$1 SDR 0.73 = US$1 FISCAL YEAR January 1 – December 31 ABBREVIATIONS AND ACRONYMS AES Agricultural and Environmental Services AFC Agricultural Finance Center AFS Annual Financial Statements AfDB African Development Bank AG Auditor-General of South Africa B&CB Business and Corporate Banking BBBEE Broad-Based Black Economic Empowerment CASP Comprehensive Agricultural Support Program CB Corporate Banking CDB Commercial Development Banking CEO Chief Executive Officer CFO Chief Financing Officer COO Chief Operating Officer DAFF Department of Agriculture, Forestry and Fisheries DBSA Development Bank of Southern Africa DFI Development Finance Institution DRDLR Department of Rural Development and Land Reform EIA Environmental Impact Assessment ERR Economic Rate of Return ESMS Environmental and Social Management System FIL Financial Intermediary Loan FM Financial Management FSDRP Financial Sector Development and Reform Program GDP Gross Domestic Product GRS Grievance Redress Service IBRD International Bank for Reconstruction and Development IDA International Development Association IFAC International Federation of Accountants IFRS International Financial Reporting Standards IPF Investment Project Financing ISP Implementation Support Plan ISR Implementation Status and Results Report JSE Johannesburg Stock Exchange LOC Line of Credit LRAD Land Redistribution for Agricultural Development MAFISA Micro Agricultural Financial Institution of South Africa NCR National Credit Regulator NDP National Development Plan NGO Non-government organization NIM Net Interest Margin NPF New Procurement Framework NPL Non-Performing Loans NPV Net Present Value NT National Treasury PDO Project Development Objective PFI Participating Financial Intermediary PLAS Proactive Land Acquisition Strategy PS Performance Standards RCB Retail Commercial Banking REM Retail Emerging Markets ROAA Return on Average Assets ROAE Return on Average Equity SAP Systems, Applications and Products SARB South African Reserve Bank SLAG Settlement/Land Acquisition Grant SME Small and medium enterprise S&P Standard & Poor US$ United States Dollars VCF Value Chain Financing WB World Bank WBG World Bank Group ZAR South African Rand Regional Vice President: Makhtar Diop Country Director: Ivan Velev (Acting) Senior Global Practice Director: Gloria M. Grandolini Practice Manager: Alejandro Alvarez de la Campa Task Team Leaders: Gunhild Berg/Uzma Khalil SOUTH AFRICA Land Bank Financial Intermediation Project TABLE OF CONTENTS Page I. STRATEGIC CONTEXT .................................................................................................1 A. Country Context ............................................................................................................ 1 B. Sectoral and Institutional Context ................................................................................. 4 C. Higher Level Objectives to which the Project Contributes .......................................... 9 II. PROJECT DEVELOPMENT OBJECTIVES ..............................................................11 A. PDO............................................................................................................................. 11 B. Project Beneficiaries ................................................................................................... 11 C. PDO Level Results Indicators ..................................................................................... 12 III. PROJECT DESCRIPTION ............................................................................................13 A. Project Components .................................................................................................... 13 B. Project Financing ........................................................................................................ 18 C. Project Cost and Financing ......................................................................................... 18 D. Lessons Learned and Reflected in the Project Design ................................................ 18 IV. IMPLEMENTATION .....................................................................................................20 A. Institutional and Implementation Arrangements ........................................................ 20 B. Results Monitoring and Evaluation ............................................................................ 21 C. Sustainability............................................................................................................... 21 V. KEY RISKS AND MITIGATION MEASURES ..........................................................22 A. Overall Risk Rating and Explanation of Key Risks.................................................... 22 VI. APPRAISAL SUMMARY ..............................................................................................22 A. Economic and Financial Analysis ............................................................................... 22 Financial Analysis ............................................................................................................. 22 B. Technical ..................................................................................................................... 23 C. Financial Management ................................................................................................ 23 D. Procurement ................................................................................................................ 24 E. Social and Environment (including Safeguards) ........................................................ 24 F. World Bank Grievance Redress .................................................................................. 26 Annex 1: Results Framework and Monitoring .........................................................................27 Annex 2: Detailed Project Description .......................................................................................31 Annex 3: Assessment of Land Bank ...........................................................................................41 Annex 4: Implementation Arrangements ..................................................................................52 Annex 5: Implementation Support Plan ....................................................................................62 Annex 6: Economic and Financial Analysis ..............................................................................65 Annex 7: Financial Sector, Agricultural Financing and Extension Services Overview ........71 Annex 8: PFI Due Diligence Criteria and Summary ................................................................87 PAD DATA SHEET South Africa Land Bank Financial Intermediation Project (P150008) PROJECT APPRAISAL DOCUMENT AFRICA Finance and Markets Global Practice Report No.: PAD1122 Basic Information Project ID EA Category Team Leader(s) P150008 F - Financial Intermediary Gunhild Berg, Uzma Khalil Assessment Lending Instrument Fragile and/or Capacity Constraints [ ] Investment Project Financing Financial Intermediaries [ X ] Series of Projects [ ] Project Implementation Start Date Project Implementation End Date 23-Jan-2017 1-Apr-2022 Expected Effectiveness Date Expected Closing Date 31-May-2017 31-Mar-2022 Joint IFC No Practice Senior Global Practice Country Director Regional Vice President Manager/Manager Director Alejandro Alvarez de Gloria M. Grandolini Ivan Velev Makhtar Diop la Campa Borrower: Land and Agricultural Development Bank of South Africa Responsible Agency: Land and Agricultural Development Bank of South Africa Contact: Bennie van Rooy Title: Chief Financial Officer Telephone No.: 27-83380-0672 Email: bvanrooy@landbank.co.za i Project Financing Data(in USD Million) [X] Loan [ ] IDA Grant [ ] Guarantee [ ] Credit [ ] Grant [ ] Other Total Project Cost: 93.00 Total Bank Financing: 93.00 Financing Gap: 0.00 Financing Source Amount Borrower 0.00 International Bank for Reconstruction and 93.00 Development Total 93.00 Expected Disbursements (in USD Million) Fiscal 2017 2018 2019 2020 2021 2022 Year Annual 18.60 27.90 18.60 18.60 9.30 0.00 Cumulati 18.60 46.50 65.10 83.70 93.00 93.00 ve Institutional Data Practice Area (Lead) Finance & Markets Contributing Practice Areas Cross Cutting Topics [ ] Climate Change [ ] Fragile, Conflict & Violence [ ] Gender [ ] Jobs [ ] Public Private Partnership Sectors / Climate Change Sector (Maximum 5 and total % must equal 100) Major Sector Sector % Adaptation Mitigation Co-benefits % Co-benefits % Finance General finance sector 30 Agriculture, fishing, and forestry General agriculture, 20 fishing and forestry sector Finance SME Finance 50 ii Total 100 I certify that there is no Adaptation and Mitigation Climate Change Co-benefits information applicable to this project. Themes Theme (Maximum 5 and total % must equal 100) Major theme Theme % Rural development Rural markets 50 Financial and private sector development Other Financial Sector Development 50 Total 100 Proposed Development Objective(s) The project’s development objective is to sustainably scale up Land Bank’s financing, specifically to benefit emerging farmers. Components Component Name Cost (USD Millions) Line of Credit for Agricultural Financing 93 Systematic Operations Risk- Rating Tool (SORT) Risk Category Rating 1. Political and Governance Moderate 2. Macroeconomic Moderate 3. Sector Strategies and Policies Moderate 4. Technical Design of Project or Program Moderate 5. Institutional Capacity for Implementation and Sustainability Moderate 6. Fiduciary Low 7. Environment and Social Moderate 8. Stakeholders Moderate 9. Other OVERALL Moderate Compliance Policy Does the project depart from the CAS in content or in other significant Yes [ ] No [ X ] respects? Does the project require any waivers of Bank policies? Yes [ ] No [ X ] Have these been approved by Bank management? Yes [ ] No [ ] iii Is approval for any policy waiver sought from the Board? Yes [ ] No [ X ] Does the project meet the Regional criteria for readiness for implementation? Yes [ X ] No [ ] The project will have impacts that will be managed in a manner consistent with the following World Bank Performance Standards: Performance Standards Yes No PS 1: Assessment and Management of Environmental and Social Risks X and Impacts PS 2: Labor and Working Conditions X PS 3: Resource Efficiency and Pollution Prevention X PS 4: Community Health, Safety, and Security X PS 5: Land Acquisition and Involuntary Resettlement X PS 6: Biodiversity Conservation and Sustainable Management of Living X Natural Resources PS 7: Indigenous Peoples X PS 8: Cultural Heritage X Legal Covenants Name Recurrent Due Date Frequency Description of Covenant Conditions Source Of Fund Name Type IBRD Guarantee Agreement, refer Article V (5.01) of Effectiveness Loan Agreement Description of Condition: The Additional Condition of Effectiveness consists of the following, namely, that the Guarantee Agreement has been executed and delivered and all conditions precedent to its effectiveness (other than the effectiveness of this Agreement), have been fulfilled. Source Of Fund Name Type IBRD Front-end Fee, refer Schedule 2, Section III B Disbursement 1 (a) of Loan Agreement Description of Condition: Notwithstanding the provisions of Part A of this Section, no withdrawal shall be made (a) from the Loan Account until the Bank has received payment in full of the Front-end Fee. Source Of Fund Name Type IBRD Retroactive Financing, refer Schedule 2, Disbursement iv Section III B 1 (b) of Loan Agreement Description of Condition: Notwithstanding the provisions of Part A of this Section, no withdrawal shall be made (b) prior to the date of this Agreement, except that withdrawal up to an aggregate amount not to exceed eighteen million six hundred thousand (US$18,600,000) may be made for payments made prior to this date but on or after April 1, 2016 for Eligible under Category (1). Team Composition Bank Staff Name Role Title Specialization Unit Gunhild Berg Team Leader Senior Financial Financial Sector GFM01 Sector Specialist Uzma Khalil Team Leader(ADM Senior Financial Financial Sector GFM01 Responsible) Sector Specialist Chitambala John Procurement Senior Procurement Procurement GGO01 Sikazwe Specialist Specialist Tandile Gugu Zizile Financial Financial Financial GGO26 Msiwa Management Management Management Specialist Specialist Ayanda Mavundla Team Member Financial Sector Financial Sector GFM01 Specialist Christiaan Johannes Team Member Finance Officer Disbursement WFALA Nieuwoudt David J. Nielson Team Member Lead Agriculture Agriculture GFA05 Services Specialist Dorothe Singer Team Member Economist Research DECFP Edith Ruguru Mwenda Counsel Senior Counsel Legal LEGAM Elizabeth Chacko Team Member Consultant Financial Sector GFM01 Ioannis John Balafoutis Team Member Lead Financial Treasury FABBK Officer/Debt Capital Markets & CBP Jemima Harlley Team Member Program Assistant Administrative AFCS1 Kisa Mfalila Safeguards Senior Environment GEN01 Specialist Environmental Safeguards Specialist Lalit Raina Team Member Adviser Financial Sector GFM03 Magalie Pradel Team Member Program Assistant Administrative GFM01 Paula F. Lytle Safeguards Senior Social Social Safeguards GSU07 Specialist Development Specialist v Maria Eileen Pagura Team Member Consultant Agriculture GFM01 Extended Team Name Title Office Phone Location Locations Country First Location Planned Actual Comments Administrative Division South Africa vi I. STRATEGIC CONTEXT 1. The Government of South Africa is pursuing an ambitious policy agenda to support rural development and achieve a reduction in poverty and inequality. To attain this goal, South Africa’s National Development Plan (NDP) focuses on agricultural development and successful land reform as two of its top priorities. As a leading development finance institution in the rural and agricultural sector, the Land and Agricultural Development Bank of South Africa (henceforth Land Bank) is a key provider of agricultural financing, including to historically disadvantaged emerging farmers. The Land Bank plays an important role in contributing to poverty reduction and reducing income inequality. The proposed project aims to address market failures in the provision of agricultural financing, access to finance for historically disadvantaged emerging farmers, and limited availability of medium to long-term financing in South Africa. The project will contribute to these broad objectives by supporting Land Bank with long-term financing. It will help the Land Bank refocus its operations to sustainably scale up lending to emerging farmers through wholesale channels along with extension services and through direct lending channels to facilitate emerging farmers’ integration into established value chains. By targeting farmers and farm workers who are considerably poorer than other income earners in South Africa, the project will contribute to poverty reduction and income equality. A. Country Context 2. More than twenty years after the end of apartheid, unemployment, poverty and inequality remain important development challenges in South Africa, despite substantial progress in overcoming the legacy of the past. While total employment increased from 9 million in 1996 to 16 million in 20151, the unemployment rate has stayed stubbornly high in the range of 20-26 percent. In 2015 approximately 5.4 million South Africans were unemployed, of which about 40 percent were new entrants.2 A 30 percent increase in per capita Gross Domestic Product (GDP) since the late 1990s and a sharp expansion of the social grant coverage enabled a significant decline in the poverty rate—from 43.5 percent of the population living below ZAR 219 (inflation-adjusted)3 a month in 2000 to 36.7 percent (or 18.3 million people) living below ZAR 501 in 2015.4 Nevertheless, pockets of poverty remain deeply entrenched, mostly among the historically disadvantaged population. With a relatively stagnant income Gini coefficient of around 0.69 in 2011 (versus 0.72 in 2006 and expenditure Gini of 0.634 in 2015 (versus 0.67 in 2006), South Africa has one of the highest inequality rates in the world. Land distribution, in particular, is one of the most unequal in the world.5 Threatening progress in poverty alleviation is the impact of the drought on agriculture and the widening gap between those with and without jobs.6 3. Recent developments in economic activity are not indicative of major improvements in growth or employment. South Africa’s annual GDP is estimated to have increased by 1.3 1 Bulletin of Statistics, March 2016, Statistics of South Africa. 2 WBG South Africa Economic Update, February 2016. 3 Methodological report on rebasing of national poverty lines and development of pilot provincial poverty lines, Statistics South Africa. Refers to population living below the National Lower Bound Poverty Line, those who can purchase both adequate food and non-food items but must sacrifice food in order to obtain the non-food items. 2000 and 2011 data is from IES survey. 2011 data is based on rebased methodology. 4 WBG South Africa Economic Update, February 2016. 5 South Africa CPS FY2014-17. 6 WBG South Africa Economic Update, February 2016. 1 percent in 20157, compared to 1.5 percent in 2014 and 2.2 percent in 2013, a result of depressed global conditions, as well as labor unrest and electricity shortages which compounded structural constraints.8 This weak growth is well-below the projected 5 percent growth needed to drive down unemployment. Inflation was relatively subdued in 2015 amid lower food and fuel prices (5.2 percent as of December 2015, up from 4.8 percent in November). However the Reserve Bank increased the repurchase rate by a total of 125 basis points from start 2015 to end March 2016 due to a deterioration of the inflation outlook as a result of the effects from rising food prices due to the drought, the risk of a higher pass-through from the sharp depreciation of the rand (depreciated by more than 30 percent against the dollar in 2015 and continued to weaken in January 2016, before showing a subsequent moderate recovery) and subdued global growth.9 4. A weaker growth environment will pose a challenge in the management of the fiscal deficit, which in turn increases the sovereign credit risk. In an effort to mitigate sovereign credit risk, the National Budget Speech of February 2016 announced a strong fiscal adjustment effort, bringing the fiscal deficit from 3.9 percent of GDP for 2015/16 to 2.8 percent by 2017/18. The original target of the 2015 budget had been 2.5 percent, however deterioration in the growth outlook rendered the target unrealistic. In December 2015, Fitch and Standard and Poor’s (S&P) downgraded South Africa’s creditworthiness rating to BBB-, one notch above speculative grade, and S&P placed its rating on negative watch. The turmoil in markets experienced in December 2015 when a weakening in the government’s commitment to fiscal discipline was perceived, hints at the potential fallout from a further ratings downgrade.10 5. A substantial reduction in poverty and inequality will be hard to achieve without a major success in rural development. As stated by South Africa’s National Development Plan (NDP)11, the main challenge for rural development in South Africa is to “combat the marginalization of the poor”. While the rural share of poverty fell from 70 percent in 1993 to 58.3 percent in 2011,12 partly due to migration of the poor to townships and informal settlements around urban centers, rural areas remain characterized by greater poverty and inequality than urban areas. The contraction in agricultural production at double-digit rates in the first three quarters of 2015, as extreme weather conditions related to El Nino led to the most severe drought in almost 20 years, pushed an estimated 50,000 South Africans into poverty.13 6. Agriculture development and successful land reform are key pillars of the strategy laid out by the NDP for integrated and inclusive rural development. South Africa’s agriculture sector is characterized by dualism: a modern, market-oriented capital intensive farming sector consisting of a small number of large commercial farms (around 40,000 farming units14) and a large number of subsistence and small-scale or emerging farms, many in the former homeland areas. In addition, there is growing consolidation in the industry with a number of mergers taking place and the acquisition of smaller players.15 While improving economies of 7 National Budget Speech, February 2016. 8 WBG South Africa Economic Update 2015. 9 Statement of the Monetary Policy Committee, March 2016. 10 Ibid 11 National Development Plan, p.195. 12 Poverty Trends in South Africa, An examination of absolute poverty 2006 – 2011, Statistics South Africa. 13 WBG South Africa Economic Update, February 2016. 14 Department of Agriculture, Forestry and Fisheries (DAFF): Abstract of Agricultural Statistics, 2010. 15 Examples include the merger of AFGRI and Senwes retail businesses to become Hinterland, OCEANA’s acquisition of Foodcorp’s fishing business, Rainbow’s acquisition of 64 percent of Foodcorp as well as a stake in Zambia’s Zambeef, among others. 2 scale, this consolidation may also lead to lower competition in the market. Around 2006, over 80 percent of South African farmers worked on a piece of land of one hectare or smaller, and another 11 percent on one to five hectares. Only 3 percent had access to land of larger than 20 hectares.16 It is estimated that there are 2.5 – 3.5 million households engaged in subsistence farming, about 350,000 – 700,000 who can be classified as emerging farmers, producing part of their output for the market, and between 11,000 – 15,000 small to medium scale farmers who are commercially oriented.17 7. The progress of land reform has been slow and a large number of land reform beneficiaries are not using the land productively. The government committed itself to transfer 30 percent of the 82 million hectares of agricultural land owned by whites in 1994 to historically disadvantaged farmers by 2014, a total of 24.5 million hectares, through both land restitution and land redistribution. According to the Twenty Year Review published by the Presidency, only 9.4 million hectares have been redistributed since 1994 through both land restitution and redistribution.18 Achieving the objective of “productive use” of redistributed and restituted land requires even greater efforts and innovation. Land reform in South Africa to date has involved the transfer of relatively large commercial farms in their entirety to groups of beneficiaries. Land reform beneficiaries are typically resource-poor, risk-averse, and inexperienced historically disadvantaged farmers. Support provided to them after their takeover of the land, that is post- settlement support, has been inadequate. Land reform beneficiaries have experienced numerous problems accessing services, such as credit, training, technology extension, transport, plowing services, veterinary services, and marketing services. The well-developed agribusiness sector that services large-scale commercial agriculture has not been seen extending its operations to emerging farmers who, in most cases, would be cash-strapped and incapable of paying for such services anyway.19As a consequence, there is limited integration of small farmers into the value chain. 8. Support for small-scale farmers is equally crucial to job creation. Employment in the formal agriculture sector declined from 1.1 million in 1992 to 739,000 in 201420 despite output growth. Nevertheless, the NDP believes that with successful rural development and land reform the agriculture sector has the potential to create 1 million new jobs 21 by 2030. The NDP counts on small-scale/ emerging farmers for over 35 percent of the job creation target, in addition to a 10 percent share from subsistence farmers, a 10 percent share expected from better use of the land that has already been redistributed or restituted to land reform beneficiaries, and a 30 percent share from expansion of labor intensive commercial farming. 16 National Development Plan, p.199. 17 DAFF: Abstract of Agricultural Statistics, 2012; FinScope, 2010; FinMark Trust: The Status of Agricultural and Rural Financial Services in South Africa, 2013; Center for Inclusive Banking at the University of Pretoria: The Microfinance Review, 2013. 18 The Presidency, Twenty Year Review, p.64. 19 Edward Lahiff and Guo Li. 2012. “Land Redistribution in South Africa -- A Critical Review”, pp.14-17. 20 The Presidency, Twenty Year Review, p.65. Several factors have undermined the growth of agricultural jobs. These include higher levels of mechanization, driven partly by a desire to compete internationally. The necessary introduction of rights for resident farm workers, including security of tenure, has resulted in one of the most intense migration patterns in South Africa’s history. Close to a million people were uprooted from commercial farms between 1994 and 2003, destroying jobs and undermining household food security. See “Economic Diagnostic” prepared for the NDP, p13. 21 National Development Plan, p.197. 3 B. Sectoral and Institutional Context 9. South Africa’s financial sector is the most developed in Sub -Saharan Africa and is significantly larger and more diversified compared to regional and income-group peers. It is supported by an elaborate legal and financial infrastructure and a generally effective regulatory framework. South Africa’s financial system totaled approximately ZAR 10 trillion in assets as of year-end 2014 (US$ equivalent of 1,026 billion). As of end 2014, the banking sector constitutes almost 40 percent of the financial system assets, with pension funds and long-term insurers each contributing roughly 35 and 18 percent, respectively (see Annex 7 for a more detailed description of the financial sector). 10. The banking sector is highly concentrated, but at the same time commercially driven and professional. The ‘big four’ banks in South Africa, two of which are foreign owned22, account for over 83 percent of total banking assets. This concentrated ownership structure has led to limited competition and distorted incentives for these banks to serve the lower end of the market, especially micro, small, and medium-sized enterprises and the low- income population. Nevertheless, the banking system generally is highly professional and commercially driven, and does not suffer from distortionary policies. Provision of agricultural finance and support 11. One of the main challenges for rural and agriculture development is affordable access to working capital for emerging farmers and medium to long-term finance for small and medium-sized agricultural enterprises. While the financial services needs of the large commercial farms are generally well catered for by the private sector, farmers in rural areas experience many of the challenges faced by their peers in other African countries, ranging from difficulties in accessing markets, poor infrastructure, and little or no physical assets that could be used as collateral for accessing financing. With few exceptions, emerging and small-scale farmers are unable to use the land that they farm on as collateral given that the state owns most of the land in the former homelands. FinScope’s 2010 Small Business Survey estimates that of the roughly 700,000 emerging and small commercial farmers, only 5.6 percent used formal credit services and only 2.5 percent from a bank. In contrast, nearly half of those farmers used formal savings and/ or payments services and about 30 percent formal insurance. 12. Without adequate collateral, rural farmers face challenges in accessing credit from traditional commercial banks. While the ‘big four’ commercial banks have made efforts to become more inclusive, their business models and cost structure do not lend themselves to serving the agricultural sector. Some banks are funding value chain off-take agreements23 with large processors and retailers for on-lending to smaller farmers, but such lending is small compared to the overall loan book of commercial banks. According to the Department of Agriculture, Forestry and Fisheries (DAFF), total farming debt amounted to ZAR 116,576 million in 2014, out of which ZAR 66,345 million was from commercial banks and ZAR 30,580 22 One is majority and the other one minority foreign-owned. 23 Off-take agreements are agreements between a producer and a buyer to purchase/sell portions of the producer's future production. 4 million from the Land Bank.24 Compared to total commercial bank loans and advances of ZAR 2,967 billion,25 agricultural lending amounts to about 1 percent of their total loan book. 13. A wide range of programs have been implemented by the government to provide financial support to land reform beneficiaries and small-scale farmers. In 1994 the government introduced the Settlement/Land Acquisition Grant (SLAG) to enable individuals and groups to finance the purchase of land from a willing seller. Until 2000, redistribution policy centered on the provision of a grant of ZAR 16,000 to qualifying households with an income of less than ZAR 1,500 a month. In 2001 the Land Redistribution for Agricultural Development (LRAD) Grant was introduced to establish and promote emerging farmers. LRAD offered higher grants, paid to individuals rather than to households, and made greater use of loan financing through institutions such as Land Bank to supplement the grant. A few years later, the slow pace of land reform led to the introduction of the Proactive Land Acquisition Strategy (PLAS) in 2005-06. The use of grants for land acquisition was discontinued, and the focus was shifted to the acquisition of strategically located land through PLAS by the state. Since its inception, PLAS has become the biggest single program area within redistribution, in terms of both budget and land area.26 14. There are also initiatives designed to provide post-settlement support to land reform beneficiaries. The LRAD policy for example sets out to close the post-settlement support gap that prevailed under SLAG. In addition, the Comprehensive Farmer Support Program (CFSP) provides two grants, one for capacity building and one for on-farm infrastructure. In order to access on-farm infrastructure grants ranging from a minimum of ZAR 5,000 to a maximum of ZAR 100,000, beneficiaries must make an ‘own contribution’ along a sliding scale similar to that of the LRAD grant program. It is a once-off support package designed for LRAD beneficiaries.27 The Comprehensive Agricultural Support Program (CASP) supported by DAFF offers grants to support short-term operating expenses and small operating needs such as machinery. These grants are managed at the provincial level and come from funds that are transferred from the national to the provincial level. Combined land acquisition grants, both for redistribution and restitution, totaled ZAR 13.6 billion between 2008 and 201228 while grants for movable equipment and fixed improvements amounted to ZAR 13.4 billion between 2004 and 2012 (DAFF). Borrowing for working capital needs to operate and expand farms has been one of the most acute challenges for emerging and small farmers as well as land reform beneficiaries due to the reasons mentioned above. 15. Value chain integration is an opportunity to address significant skills and financing gaps of emerging farmers. In South Africa, there is a growing recognition in government and the private sector that value chain integration may be an effective way of building up a new class of commercial emerging farmers. Drawing on the successful experiences in the sugar, poultry, cotton, tobacco and forestry sectors, the government and private sector are joining forces to scale up efforts in these and other sectors. A new area opening for value chain integration is in the supply of fresh fruits and vegetables to retail supermarkets. With new Broad Based Black Economic Empowerment (BBBEE) procurement policies government is encouraging the private 24 DAFF: Abstract of Agricultural Statistics, 2015. 25 SARB Selected South African banking sector trends December 2014. 26 The Presidency, Twenty Year Review, pp.63-4. Edward Lahiff and Guo Li. 2012. “Land Redistribution in South Africa -- A Critical Review”, pp.8-12. 27 Peters Jacob. 2003. “Evaluating land and agrarian reform in South Africa”. 28 National Treasury: Medium-term Budget Policy Statement, 2008-12. 5 sector to get involved. For example, Walmart-Massmart has established a supplier fund to support emerging farmer integration into their supply chain. 29 The South African Poultry Association through the creation of the Developing Poultry Farmers Organization (DPFO) facilitates technical and financial assistance to access contracts with egg and poultry businesses.30 Land Bank 16. In addition to government grants, financing from Land Bank has been expected to play a critical role in land reform and agriculture development. Land Bank was established in 1912 and is governed by the Land and Agricultural Development Bank Act of 2002. Land Bank was given a mandate of 11 aspects, which fall into five broader areas: (i) access of the historically disadvantaged population to land; (ii) agriculture productivity, growth and job creation; (iii) gender equity; (iv) environmental sustainability; and (v) food security. The NDP published in 2011 continues to call for a key role of Land Bank in providing financial support to land reform beneficiaries and to help them overcome difficulties in entry into commercial farming31 (see Annex 3 for detailed assessment of Land Bank). 17. As the leading development financial institution in the rural and agriculture sector in South Africa, Land Bank had an approximately 29 percent market share in agricultural financing as of July 2015. The bank32 has achieved a significant turnaround during the past five years. It is now on a sustainable trajectory with profits of ZAR 420 million in 2014/15 (up 61 percent from 2013/14), and a Return on Average Assets of 1.12 percent and a Return on Average Equity of 6.78 percent. Total assets stood at ZAR 39.4 billion in 2014/15 with a performing loan book of ZAR 36 billion. Non-performing loans (NPLs) under Land Bank methodology were at 3.72 percent in 2014/15 and the cost-to-income ratio was 54.9 percent. Fitch Ratings upgraded Land Bank from AA to AA+ in January 2014. The rating was maintained at AA+ in December 2015. Moody’s Investor Services has assigned Land Bank a credit rating of Aa1.za in May 2016. The bank does not take general deposits and funds itself mainly through the debt and capital markets, issuing instruments such as promissory notes. 18. Land Bank is fully owned by the South African government and supervised by the National Treasury.33 It follows prudential guidelines as issued by its Board of Directors. It is consequently not prudentially supervised by the South African Reserve Bank (SARB). The bank is audited by the Auditor General. Land Bank is engaged in both wholesale lending through intermediaries as well as direct lending. Intermediaries are mainly credit providers, cooperatives, or agri-businesses. 19. In 2015, Land Bank adopted a new strategy following the completion of its organizational review. The review was undertaken following conditions set by NT pursuant to 29 “Smallholders and agrifood value chains in South Africa – Emerging practices, emerging challenges,” 2013. PLAAS, Institute for Poverty, Land and Agrarian Studies, School of Government, University of the Western Cape, pp.1-4. 30 “A Profile of the South African Egg Industry Market Value Chain,” 2014. Department of Agriculture, Forestry and Fisheries, Republic of South Africa, pp.22-24. 31 National Development Plan, p.200. 32 Source of financial information is Land Bank’s 2014 and 2015 Annual Report. Per the report, Land Bank Group includes REM, RCB, B&CB, LDFU, and LBLIC. Land Bank only includes REM, RCB, B&CB and Group Capital. 33 In 2008, the administrative and supervisory powers over Land Bank were transferred from the Minister of Agriculture and Land Affairs to the Minister of Finance. 6 the issue of a government guarantee, aimed at enabling the Land Bank to raise longer term funding. The review was completed in August 2015, and subsequently an implementation plan was approved by the Land Bank Board. Land Bank has started implementing the new strategy and key changes are planned to be put in place over a two-year period in line with the priorities of Land Bank. The changes focus on: (i) a strategy to optimize the retail commercial banking segment of Land Bank, the long-term viability of which was a concern owing to loan losses and significant operational costs; (ii) new initiatives to potentially expand the development portfolio of Land Bank for emerging farmers34 in a sustainable and commercially viable manner by adopting a project finance approach in partnership with large corporates and intermediaries to integrate the emerging farmers into established value chains; and (iii) steps to align Land Bank financial soundness indicators, credit appraisal processes and risk management practices with international banking standards. 20. Following the adoption of this new strategy, Land Bank has two main business lines: Corporate Banking (CB) and Commercial Development Banking (CDB).35 The new CDB business line is a combination of previous Retail Emerging Markets (REM) and Retail Commercial Banking (RCB) business lines. In 2014/15, CB accounted for 83.6 percent of the bank’s loan book and CDB accounted for 16.4 percent, of which 1.3 percent was composed of loans provided under REM.36 21. Under CDB, the wholesale finance facility continues to focus on lending to emerging farmers for development purposes. Farmers supported under this facility typically have no or limited access to commercial funding and little or no collateral, but can be commercially sustainable and viable with financing and technical support. Subsistence farmers are not supported under CDB. Lending is based on cash-flows and non-financial support (end to end on- farm support) is provided by Land Bank intermediaries and agricultural specialists based in Land Bank branches.37 The wholesale lending to emerging farmers offers production financing, installment sale finance, and medium-term loans. The total wholesale finance portfolio to emerging farmers amounted to ZAR 489 million in 2014/15 (increase of ZAR 97 million in that year). 22. Intensive and high-quality extensions services under the wholesale finance facility to emerging farmers are effectively provided by Land Bank’s intermediaries. These intermediaries have a comparative advantage in providing these services due to their close interaction with the beneficiaries. The non-financial complementary services, especially extension services, are critical for emerging farmers to develop (see Annex 7 for a summary of extension services provided in South Africa). The costs for the extension services are embedded in the overall cost structure under wholesale finance facility and are borne by the intermediaries.38 While the provision of extension services is costly, especially for new emerging farmers, intermediaries can generate profits from these clients over time due to the long-run and comprehensive nature of engagement between intermediaries and their clients. The current 34 In addition to existing wholesale lending currently provided under REM. 35 The new Corporate Banking unit is the former Business and Commercial Banking unit. . 36 Information in Land Bank’s 2015 Annual Report is disaggregated by former three business lines i.e. B&CB, RCB and REM. For the purpose of analysis in this section, the financial information for RCB and REM is consolidated where appropriate. 37 These refer to the existing branches and Agricultural Finance Centers. 38 This means that intermediaries are shouldering the costs of providing required extension services instead of Land Bank, partly justifying the lower-cost financing they are receiving. 7 model of providing extension services is considered to be of high quality according to the assessment carried out during project preparation. 23. Under CDB, the RCB business line which was exclusively focused on direct retail lending to medium scale farmers, through 27 Agriculture Finance Centers (AFCs), has been significantly restructured to improve its long term sustainability. RCB was loss- making due to high operating costs of the large branch network and had NPLs of 11 percent in 2014/15. RCB was losing clients to commercial banks and agricultural enterprises who started to lend in that space and could offer a wider range of products. The competitiveness and long-term viability of RCB was therefore questionable. The new strategy aims at consolidating the branch network into 9 provincial offices in strategically important geographical locations which will also result in significant staff reduction. Importantly, the consolidated branch network’s role will specifically focus on facilitating effective partnerships in their respective regions with corporate retailers, emerging farmers, government programs, as well as technical and financial intermediaries to leverage on high impact and high value chain finance deals. 24. Importantly, as part of the new strategy, Land Bank aims to scale up financing support to emerging farmers in a sustainable and commercially viable manner through their integration in established value chains. The approach is anchored in identifying high- potential value chain projects in a given geographic region and securing buy-in from large agriculture corporates or technical partners to assist in supporting emerging farmers’ integration into the chain. The agriculture corporates will provide technical support (directly or indirectly) to the emerging farmers, building up their capacity to be sustainable suppliers to the chain. Land Bank has identified selected potential value chain projects and agriculture corporates to partner with in the grains, winery, horticulture and livestock sectors for this type of financing. 25. The CB business line is the corporate part of the bank and the most viable business line. The CB business line involves both direct and wholesale lending. Lending takes place primarily through intermediaries (cooperatives and agri-businesses). CB operates through two offices in Pretoria and Cape Town. The total portfolio of CB amounted to ZAR 31 billion in 2014/15. While CB targets commercial farmers, the workers employed on these farms tend to be part of the low-income population. 26. Land Bank aims at increasing its developmental focus in both CB and CDB business lines by strengthening its wholesale business as well as its direct lending to emerging farmers. Both business lines contain a development portfolio with “development” referring to a focus on supporting the historically disadvantaged population in line with Broad-Based Black Economic Empowerment (BBBEE).39 International experience with development banks suggests that wholesale lending is more likely to be successful than retail lending. The key reason is that wholesale lending does not require a large branch network which is costly to build and maintain but rather leverages the networks already built by other financial service providers. Wholesale lending is also more market enabling and does not aim at competing with the private sector. Direct lending via value chain financing leverages the corporate partner’s ability to provide technical support to the borrower, building up their capacity to be sustainable suppliers to the chain. As such, emerging farmers in this scheme have the potential to increase their revenues and thus a greater likelihood of fulfilling debt obligations to the bank. The project will therefore focus on supporting Land Bank in scaling up its wholesale portfolio as well as expanding direct 39 http://www.economic.gov.za/about-us/programmes/economic-policy-development/b-bbee. 8 lending through LB’s new approach of integrating emerging farmers into established value chains. Using long-term financing to fill existing funding gaps will additionally help Land Bank meet its investment needs as well as improve its asset liability management. 27. Land Bank is making an important contribution to job creation. Land Bank estimates that the impact of its loan disbursements on employment opportunities in South Africa was close to 400,000 in 2013-2014.40 This estimate is comprised of over 23,000 new employment opportunities generated and over 370,000 jobs maintained during the year. One employment opportunity constitutes 240 days worked per year. The estimated new jobs created are arising out of the medium and long-term loans Land Bank is providing. C. Higher Level Objectives to which the Project Contributes 28. Through the role of Land Bank in rural and agricultural development, the project is strongly linked to the government’s objectives of eliminating poverty, reducing inequality and improving job creation. The goals of the NDP are fully aligned with the twin goals of the World Bank to eradicate extreme poverty and increase shared prosperity. The operation has been requested by National Treasury and Land Bank and carefully calibrated to their specific needs. 29. The project will contribute to poverty reduction by targeting farmers and farm workers who are considerably poorer than other income earners. According to South African household data (Table 1), an approximation for those working as farmers and farm workers shows that this group is twice as poor as other workers, receives about 53 percent less income, and lives in households with consumption per capita about 54 percent lower than other workers. The difference holds for international as well as national poverty lines. The group is also predominantly black. The project will support Land Bank in providing financing to those farmers and farm workers, which will contribute to poverty reduction. Table 1: Poverty Characteristics of Farmers in South Africa Poverty Rates Share of Average Population $1.25 a day $2.5 a day National Low National Med National Upper Blacks Consumption Total Economy 50,175,588 0.12 0.36 0.22 0.37 0.54 0.79 21,472 Farmers (all) 465,360 0.10 0.32 0.18 0.33 0.52 0.92 20,447 Other Wage Earners 11,524,933 0.04 0.16 0.08 0.17 0.31 0.68 34,870 Other groups (non-wage, including social grant beneficiaries) 38,185,295 0.14 0.42 0.26 0.43 0.61 0.83 17,441 Source: World Bank calculations based on Income and Expenditures of South Africa Metadata, Statistics of South Africa. Notes: Farmers (all) is an approximation of the universe of farmers. Other wage earners includes those with gainful employment outside of farming, and ‘other groups’ includes non-wage earners including social grant and pension recipients. The national poverty lines are defined as ZAR335, ZAR 501 and ZAR 779 per capita per month respectively. The lowest poverty line sets a monetary value below which an individual is not able to attain a basic minimum nutritional requirement. 30. Through supporting Land Bank’s growth and development plan, the project will support job creation in the agricultural sector in South Africa. Based on Land Bank’s estimates, the bank is playing an important role in job creation and job maintenance in South Africa. Jobs are not only created for emerging farmers under the CDB business line but also for poor farm workers who are employed on commercial farms supported under CB. Given that the project will provide long-term funds to Land Bank, which the bank estimates to contribute most 40 Land Bank Annual Report 2013-2014. 9 to job creation and which the bank will on-lend to farmers through its intermediaries, the project will have a direct contribution to job creation in the agricultural sector of South Africa. 31. The project will address market failures in the provision of agricultural financing and limited access to finance for previously disadvantaged emerging farmers. Commercial bank financing for agriculture amounts to 1 percent of commercial bank’s loan book (ZAR 2,753 billion) which is low compared to farmers reported demand. In addition, financing from commercial banks can typically not be accessed by emerging farmers due to a lack of adequate collateral. The CDB business Land Bank is designed to specifically provide financing to emerging farmers, who do not have collateral as security, so that these farmers can later become commercially viable. In addition, the CB business line also has a large developmental portfolio in line with BBBEE and indirectly supports poor farm workers employed on the commercial farms supported under CB. The project will support Land Bank in addressing these market gaps by providing additional resources to specifically finance emerging farmers in a sustainable manner. 32. Moreover, the project will support Land Bank in piloting its new approach to scale up financing for emerging farmers by facilitating their integration into established value chains. The emerging farmers lack financing and operate largely outside of the established agriculture value chains. However, partnerships with corporates and technical partners operating in the same value chain have demonstrated the potential for addressing farmers’ skills and financing gaps by sustainably integrating emerging farmers into established value chains. This project will support Land Bank’s initiative to finance such projects, by directly lending to emerging farmers within a structured value chain project. 33. The project will also address the limited availability of medium to long-term financing for Land Bank. Currently, Land Bank predominantly relies on short-term funding sources for lending to the agricultural sector due to limited availability of medium and long-term financing. The availability of long-term financing under the project will help Land Bank in improving its asset-liability management and deepening its financial intermediation capacity. 34. The project will complement the active WBG engagement with the government on achieving its rural development and financial inclusion objectives. Under the reimbursable advisory services program agreed with the Department of Rural Development and Land Reform (DRDLR) in 2010, the World Bank is providing knowledge advisory services to support the development and implementation of the Comprehensive Rural Development Program that will also help government in addressing some of the challenges faced in the implementation of the land reform program. A US$4 million multi-donor World Bank executed Trust Fund launched in 2014, the Financial Sector Development and Reform Program (FSDRP), provides analytical and advisory services to the South African government on a range of initiatives aimed at expanding financial inclusion and strengthening financial stability. Among the activities in the financial inclusion space are advice on the establishment of a credit information service for SMEs and a movable collateral registry, a review of government support schemes aimed at expanding SME finance, a strengthening of the retail payments landscape including agency and mobile banking, and advice on personal insolvency and an enhanced consumer protection framework. The WBG also delivered a diagnostic report on the possibility of public private partnerships for agricultural insurance to the National Treasury in 2016 and is currently discussing possibilities to provide support on this area going forward. Moreover, IFC is engaged with private financial institutions 10 to enhance private sector access to funding through short-term liquidity support and longer-term foreign currency funding. 35. The operation is fully aligned with the Country Partnership Strategy (CPS) for South Africa for the period of FY2014-1741 and the Twin Goals of the World Bank Group to eradicate extreme poverty and increase shared prosperity. The project is expected to contribute to all three pillars of the CPS. First of all, it supports the reduction of inequality by increasing access to finance for the historically disadvantaged population, specifically to benefit emerging farmers. Secondly, it catalyzes private investment in rural development and agriculture through financing solutions provided by Land Bank. Thirdly, it helps strengthening institutional capacity of Land Bank on agricultural financing as well as asset-liability management, and the capacity of its intermediaries. II. PROJECT DEVELOPMENT OBJECTIVES A. PDO 36. The project’s development objective is to sustainably scale up Land Bank’s financing, specifically to benefit emerging farmers. The PDO will be achieved by providing long-term financing for Land Bank. This will facilitate a broader and deeper financial intermediation by Land Bank and diversify its funding sources away from government. B. Project Beneficiaries 37. Project beneficiaries will be the target beneficiaries under CDB and CB business lines as detailed in the respective credit policies. The wholesale finance facility under CDB focuses on historically disadvantaged South Africans in primary agriculture fulfilling certain criteria, such as a maximum asset size of ZAR 3 million, access to land, farming on a full-time basis, difficulties in accessing traditional financing due to a lack of security, and existing off-take agreements or contracts in place. CB clients are either historically disadvantaged or other clients engaged in primary and secondary agriculture. According to the CB credit policy, they must be solvent, have viable business plans, and adequate security, among others. Indirectly, the project will benefit the poor farm workers employed in the commercial farms supported by CB. Under Land Bank’s new approach to scale up financing support to emerging farmers in a commercially viable manner through integrated value chain finance projects (or partnerships), the target beneficiaries are groups of historically disadvantaged emerging farmers in the form of an agri- business, cooperative or other forms of partnerships and engaged in primary and secondary agriculture. The beneficiaries will benefit from the financing provided by Land Bank for investment and working capital loans. In addition, participating financial intermediaries (PFIs) will benefit from the longer-term funding provided through the project. 38. The target beneficiaries are farmers under CDB and emerging farmers under CB who are more likely to be poor than other income earners. As shown in Table 1 above, the target beneficiaries are twice as poor as other workers and receive about 53 percent less income. By supporting those farmers and emerging farmers through financing, Land Bank and the project will contribute to poverty reduction and income equality, subject to high quality extension services and the infrastructure required for successful farming being in place as well. 41 Country Partnership Strategy (CPS) for South Africa for period of FY2014-14, Report No. 77006-ZA, October 17, 2013. 11 C. PDO Level Results Indicators 39. The achievement of the objectives and outcomes of this project will be measured through the following PDO results indicators:  Volume of wholesale loans disbursed under the project (amount US$).  Volume of direct value chain loans disbursed under the project (amount US$).  Number of direct project beneficiaries.  Total NPL rate under the credit line (%). Intermediate results indicators will be as follows:  Increase in outstanding loan portfolio of Land Bank (%).  Increase in CB outstanding loan portfolio of Land Bank (%).  Increase in REM outstanding loan portfolio of Land Bank (%).  NPL rate for Land Bank (%).  Land Bank liabilities that are long-term (over 1 year) (%).  Return on Average Equity (%).  Land Bank Return on Assets/ Equity (%). Figure 1: Project Level Result Chain Project level Results Chain Input Activity Output Outcomes Primary 1) Expand LB’s wholesale lending US$93 MM LoC WBG disburses to business through increased LB disburses lending to PFIs from WBG LB 2) Support value chain financing partnerships Commercial Commercial Corporate Corporate Development Development Secondary 1) Demonstration effect PFIs increase lending (to commercial and emerging farmers) and extension services (to emerging WBG Complimentary Engagements farmers) 2) Integrate emerging farmers into 1) RAS on land Reform value chains 2) Assessment of extension services in South Africa 3) FSDRP on financial inclusion, incl. e.g. credit bureaus, collateral registries, and SME finance Tertiary 4) IFC investments 1) Increase access to medium and long-term finance for commercial and emerging farmers 2) Promote job creation and income generation 40. The indicators primarily focus on measuring the change in Land Bank’s business model towards wholesale financing and increasing its developmental impact through increased lending to emerging farmers. As the PDO is targeted at changing the behavior of Land Bank, and ultimately the use of wholesale financing as a mechanism to affect agricultural 12 financing in the longer-term, the indicators above measure how the project will contribute to Land Bank’s overall portfolio and its asset-liability management framework. While it is anticipated that the project will benefit the CDB and CB target customers, it would not be prudent to measure beneficiary level impact in this project because the link between the project and these beneficiaries is not direct. III. PROJECT DESCRIPTION A. Project Components 41. The project is a financial intermediary loan (FIL) of US$93 million to Land Bank as the borrower and implementing agency with a guarantee of the Republic of South Africa. The project has one component: a Line of Credit (LOC) for Agricultural Financing in the amount of US$93 million. Component 1: Line of Credit for Agricultural Financing (US$93 million) 42. The objectives of the LOC component are to:  Support Land Bank in refocusing its operations on wholesale lending. As explained in section I.B., Land Bank uses both wholesale and direct lending under the Corporate Banking (CB) and Commercial Development Banking (CDB) business lines. Given Land Bank’s limited branch network and based on international best practices for Development Finance Institutions (DFIs), wholesale lending is more sustainable because it helps Land Bank leverage a network of financial intermediaries without incurring significant operating costs. In addition, wholesale lending allows Land Bank to play a market enabling role because it permits agricultural borrowers to build credit history with financial intermediaries and improve their financial records for commercial loans, thus improving their ability to gain access to credit. The LOC will help Land Bank in expanding wholesale lending to both commercial and emerging farmers under the CB and CDB business lines respectively. Through supporting the CB business line, the LOC will support employment generation for poor farm workers employed on the commercial farms supported. The CB business line also contains a large and growing developmental portfolio in line with BBBEE, therefore making an important contribution to the NDP and Land Bank’s development goals.  Support Land Bank’s new approach to help integrate emerging farmers into established value chains. Based on the outcomes of its organizational review, Land Bank decided to scale up financing support to emerging farmers in a sustainable and commercially viable manner through partnerships with large agriculture corporates that emphasize integrating emerging farmers in established value chains. The approach is anchored in identifying high-potential value chain projects in a given geographic region and securing buy-in from large agriculture corporates or technical partners to assist in supporting emerging farmers’ integration into the chain. The agriculture corporates will provide technical support (directly or indirectly) to the emerging farmers, building up their capacity to be sustainable suppliers to the chain. Land Bank has identified potential value chain projects and agriculture corporates to partner with in the grains, winery, horticulture and livestock sectors for this type of financing. The success of these initiatives is expected to have a demonstrative effect in the medium term helping to bring in commercial banks’ financing for such initiatives and agriculture in general which is currently very limited. 13 Box 1: Trends in Development Finance Institution Practices Based on the Global Survey of Development Banks (World Bank Policy Research Working Paper 5969, 2012), a survey of 90 DFIs across the World, several trends for the DFI sector can be identified (although there are obviously counterexamples for each trend). The survey included a range of DFIs across all regions and with different mandates. Out of the DFIs with a specific mandate, the majority were focused on agricultural activities. Some of the main trends based on the survey are:  While the majority of DFIs are entirely government-owned, mixed public-private capital structures are becoming more common;  DFIs still serve as the largest source of long-term credit for agriculture, housing, and infrastructure in emerging economies;  The majority of DFIs are not accepting deposits from the general public, but raise funding from the wholesale and capital market. This allows DFIs to focus on their lending operations, avoid direct competition with the private sector, and limit the potential exposure of taxpayers to losses. In addition, governments tend to move away from direct budget transfers, preferring to guarantee the debt and liabilities of the institution;  The credit model used by DFIs is trending away from mixed wholesale/ retail towards a wholesale-only model;  Governments seek to make DFIs self-sustaining and insulate them from political interference. Only half of all DFIs offer credit at subsidized interest rates;  The trend is for DFIs to be profitable and have non-performing loan (NPL) ratios of below 5 percent, reflecting greater wholesale credit activity (all wholesale-DFIs had NPL ratios below 5 percent), better governance, professionalization of management, and stronger risk management practices; and  Regulation and supervision of DFIs is being strengthened, with the favored model now to require DFIs to comply with commercial banking regulations. The clear majority of DFIs are regulated and supervised by the same authority that supervises private commercial banks. 43. To achieve the above objectives, Land Bank will provide both wholesale finance to participating PFIs for on-lending to commercial and emerging farmers and direct financing, in partnership with large agriculture corporates, to emerging farmers to support their integration in established value chains. It will do so through two main financing windows: Window 1: Wholesale finance to commercial and emerging farmers. This window will provide a wholesale line of credit to Land Bank. Land Bank will on-lend the funds to participating financial intermediaries (PFIs) which comply with eligibility criteria agreed with the World Bank. The PFIs will on-lend funds to eligible agriculture enterprises, commercial and emerging farmers, communal property associations and other eligible borrowers supported under the Land Bank’s CB and CDB business lines. Currently, the wholesale line under CDB primarily focuses on lending to emerging farmers, however, over the life of the project this may change to include other wholesale loans under CDB. Window 2: Financing to integrate emerging farmers into established value chains. This window will provide a line of credit to Land Bank to finance direct lending to emerging farmers for integrated value chain finance. For direct lending to value chain finance/development projects, Land Bank will finance eligible emerging farmers and agriculture enterprises in collaboration with large agriculture corporates and/or technical partners in a targeted value chain. 14 44. It is expected that 70 percent of LOC funds will be used to support wholesale lending and 30 percent will be used for direct lending to emerging farmers for their integration in established value chains. However, this ratio will be kept flexible in both directions to allow for adjustments based on market and portfolio developments in the bank’s CB and CDB business lines. 45. Consistent with Land Bank’s pricing policies, the interest rates to intermediaries in wholesale financing and for borrowers through direct financing will be determined by the customer segment.  Window 1: Commercial farmers under CB. Land Bank will on-lend funds to PFIs at interest rates that take into account at minimum Land Bank’s cost of funding, operating costs and an appropriate credit risk margin.  Window 1: Emerging farmers under CDB. For these farmers, Land Bank will on-lend funds to intermediaries at interest rates that will allow the bank to at least cover its average costs of funds.  Window 2: Emerging farmers in established value chains. The pricing for direct lending by Land Bank to integrate emerging farmers in established value chains will be market- based. Land Bank aims to implement the new approach to scale-up financing for emerging farmers in a commercially viable and sustainable manner. Thus, pricing for this financing will cover Land Bank’s cost of funding, operating costs and an appropriate credit risk margin. 46. The interest rates to final borrowers will be market-based to ensure sustainability and avoid creating interest rate distortions in the market. The PFIs for both commercial and emerging farmers will be able to freely set their interest rates, which are expected to cover at least the cost of funding, operational costs and an appropriate credit risk premium based on the credit assessment of the borrower. 47. The lower interest rates for emerging farmers under wholesale finance facility will allow Land Bank and the PFIs to finance clients that would otherwise be excluded from formal sector financing. While on-lending for emerging farmers will initially be at average cost of funds, these farmers are expected to be able to graduate to commercial funding after a period of five years, underlining the sustainability of the program. Moreover, Land Bank is currently reviewing its wholesale finance facility to emerging farmers pricing policy to allow Land Bank to at least break-even on pricing by covering at least its average cost of funds and operating costs. In addition, interest rates for emerging farmers under CDB will be subject to continuous review to ensure that the objectives of the program are achieved while ensuring Land Bank’s sustainability. 48. To meet its wholesale lending objectives under CB and CDB business lines, Land Bank is currently engaged with a broad range of intermediaries. Those include agricultural cooperatives, large agricultural companies, and credit providers. These intermediaries have a credit provider license and are supervised under the National Credit Act by the National Credit Regulator. The intermediaries are primarily providing credit to their clients with whom they have existing business relationships in the form of input supplies contracts, off-take agreements etc. and provide technical advisory services specifically to emerging farmers. Currently, Land Bank 15 is working with ten intermediaries who are engaged under both CB and CDB. In addition, additional intermediaries in the pipeline are expected to operate for both CB and CDB. These intermediaries are providing financing for sugar cane, grain, citrus, fruits, vegetables and livestock. The intermediaries are geographically spread across all provinces. 49. In addition to financing, the intermediaries provide intensive and high-quality extension services, particularly to emerging farmers. Since Land Bank’s intermediaries have been engaged in agricultural activities for the past several decades, they have developed a unique comparative advantage in providing extension services to farmers specifically tailored to their individual needs. These extension services include training, skills development and mentoring of smallholder beneficiaries and range from hands-on advice on crop selection, plantation, inputs needs and harvesting to training on agriculture marketing, business planning etc. For the wholesale finance facility to emerging farmers, these extension services are embedded in the financing, recognizing the fact that emerging farmers need financing as well as technical assistance to succeed. A review of extension services in South Africa found that these programs have proved successful in establishing commercially successful emerging farmers (see Annex 7 for more details). 50. While all interested PFIs of Land Bank will ultimately be appraised, Land Bank and the World Bank initially selected six intermediaries that are operating in both the CB and CDB business line and assessed them against the eligibility criteria. The eligibility criteria took into consideration Land Bank’s selection criteria for intermediaries and the recommendations on financial intermediary financing under the World Bank’s Operational Policy OP10. The OP10 policy requires an assurance that all PFIs in a World Bank financed LOC are viable financial institutions determined by: (a) adequate profitability, capital, and portfolio quality as confirmed by audited financial statements; (b) acceptable level of loan collections; (c) appropriate capacity, including staffing, for carrying out subproject appraisal (including environmental assessment) and for supervising subproject implementation; (d) capacity to mobilize domestic resources; (e) adequate managerial autonomy and commercially oriented governance; and (f) appropriate prudential policies, administrative structure, and business procedures. Annex 8 contains the detailed eligibility criteria for PFI participation in the LOC. Land Bank will enter into Sub-Loan Agreements (SLA) with the selected PFIs, which will specify terms and conditions on the use of the LOC as agreed between Land Bank and IBRD. PFIs will not be obliged to draw on the available funding, and interest costs and other fees will only be charged upon accessing the LOC. 51. Based on the assessment, two intermediaries fully meet the eligibility criteria and three generally meet the criteria for participation in LOC. Of the six intermediaries appraised during preparation, two intermediaries fully meet the eligibility criteria; two intermediaries generally meet the eligibility criteria except for capital structure; and one intermediary generally meets the eligibility criteria, however it needs to improve the quality of its loan portfolio and cash flows going forward. One intermediary does not meet the eligibility criteria at this moment, however it can participate as intermediary once the issues identified in the due diligence are resolved. Annex 8 describes the eligibility criteria in more detail. 52. The available LOC funding will be used based on a drawdown mechanism. Once PFIs are approved for funding from Land Bank, they receive a drawdown facility of the approved amount with a fixed maturity, for example five years, which they can use to finance projects complying with the agreed eligibility requirements. Loans to final beneficiaries will be 16 provided by PFIs from the drawdown facility up to the amount and maturity approved. Land Bank will receive funding from the LOC based on the submission of internally approved drawdown facilities for intermediaries in line with the eligibility criteria or the submission of interim financial reports. There will be a limit of 25 percent of the LOC facility per intermediary to encourage the participation of several PFIs in the project. In case a PFI is unable to utilize the facility, the unutilized amount can be allocated to other PFIs. PFIs will need to comply with the ongoing eligibility criteria during their participation in the LOC (see Annex 8). The repayments will be collected in a revolving fund and will be used to provide funding for new sub-loans. 53. Specific criteria for the sub-loans to final borrowers as well as eligible borrowers were agreed between Land Bank and the World Bank. The sub-loans to final borrowers under the CDB and CB business line will follow Land Bank criteria as well as additional criteria agreed between Land Bank and IBRD, aimed at meeting the project objectives. The final borrowers under the LOC will be primarily those supported under Land Bank’s CDB and CB business lines and complying with the respective eligibility criteria, described in Annex 2. 54. For direct lending to emerging farmers, Land Bank will work with a number of corporate and technical partners to facilitate capacity development and value chain integration. The project will support Land Bank’s new development lending initiative which provides direct loans to emerging farmers that are part of a larger value chain integration project. The emphasis is on emerging farmer sustainability through targeted technical assistance within a specific value chain. These interventions can take different forms depending on the specificity of the value chain. Land Bank is considering a number of value chain financing projects in the grains, winery, horticulture and livestock sectors. As foreseen in its approved restructuring, Land Bank will hire additional staff with VCF/project finance expertise to develop and scale up this initiative. For illustrative examples of different value chain financing modalities see Annex 2. 55. The technical assistance needs of Land Bank and beneficiaries are being met through different sources outside the proposed project. Land Bank needs to further strengthen its institutional model and development impact while ensuring sustainability. Currently, Land Bank is receiving substantial funding from the African Development Bank (AfDB) to help address current and potential technical assistance needs. These funds are still partially unutilized and have been used to date to develop Land Bank’s Environmental and Social Management System (ESMS) which was a recommendation by the team during preparation. Additionally, Land Bank is committed to using its own internal resources for further institutional strengthening and aligning its risk management practices with international standards. Following the completion of the organizational review, Land Bank has engaged external experts to improve its business procedures and risk management models. The support already provided to Land Bank is deemed sufficient based on Land Bank’s current capacity. 56. The technical assistance needs of emerging farmers under the wholesale finance facility to emerging farmers are met by Land Bank’s intermediaries. As specified earlier, intermediaries are effectively providing targeted extension services to emerging farmers. For the wholesale finance facility to emerging farmers, these extensions services are embedded in the financing provided by intermediaries. Moreover for direct lending, as foreseen in its approved restructuring plan, Land Bank will hire additional staff with VCF/project finance expertise to develop and scale up this initiative. The project, therefore, does not include a separate technical assistance component. 17 B. Project Financing 57. The project will be financed through Investment Project Financing (IPF) in the amount of US$93 million on IBRD terms, to be implemented over five years. 58. The loan to Land Bank will be converted from US$ into local currency. Land Bank has indicated a preference for long-term funding (an amortizing loan with a final maturity of 25 years with 4 years grace period) in ZAR based on a variable spread over a floating Jibar 3 month rate. IBRD financing in ZAR can be made available to Land Bank through the currency conversion options embedded in the loan, subject to the availability of a liquid swap market in ZAR at the time of disbursement. Indicative pricing based on market conditions at that time has been discussed with Land Bank, along with an explanation of the conversion options. C. Project Cost and Financing IBRD or IDA Project Components Project cost % Financing Financing 1. Line of Credit for Agricultural Financing US$93 million IBRD 100% Total Costs Total Project Costs US$93 million IBRD 100% Front-End Fees Total Financing Required US$93 million D. Lessons Learned and Reflected in the Project Design 59. International experience related to development finance institutions shows that a wholesale model leads to a better performance compared to a focus on retail lending. In a wholesale-only model the DFI provides incentives to private sector financial intermediaries to enter new markets or expand services to existing markets by providing funding, other financial products, and linked technical assistance which increases the attractiveness of these markets and/or makes bank credit feasible, for example, by providing term funds to allow longer-term funding for investment projects. Under the wholesale lending approach, DFIs tend to have lower operating costs because the PFIs select and assess the loan applications of end-customers. Through PFIs, DFIs can reach a larger number of end-customers and cover more locations without incurring high operating costs. The model also promotes the growth of PFIs, which become extensions of the DFI, and helps reach under-served sectors and clients. Furthermore, credit risk is partially absorbed by the PFIs. 60. Operating a DFI on a retail basis has numerous disadvantages. First, a retail-oriented DFI has to have an extensive retail infrastructure which entails significant capital and ongoing operational costs for the establishment, staffing and operation of a branch network and attendant back office costs. Second, DFIs following a retail-model are often perceived as an arm of the government by clients, potentially leading to worse repayment discipline and therewith potentially large contingent fiscal liabilities. Third, if the DFI has access to deposit funding, discipline in terms of transparency, governance requirements, and performance is required to not endanger deposits. In addition, compliance costs with prudential regulations would increase because any DFI taking deposits should be regulated and supervised similarly as commercial 18 banks. Finally, credit risk exposure and credit losses of the DFI can increase in a retail model as a result of its direct credit exposure to end-users without the insulation provided by wholesale lending to other institutions (where the capital of the retail borrower stands between the DFI and any losses). The focus of this project on financing wholesale lending by Land Bank to its CB and CDB business lines is therefore supported by international experience. 61. LOCs should be based on commercial principles. DFIs that are fully operationally and financially self-sustaining perform better. For example, the Development Bank of Southern Africa (DBSA) needed to be recapitalized in 2011 because of political pressure to work more with poorer segments of society and to take on more risk at subsidized rates beyond its financial capacity. The DBSA case demonstrates that rather than encouraging the dilution of DBSA’s mandate, the authorities would have been better advised to provide subsidies to those municipalities that were unable to afford the market-conforming financing otherwise available from DBSA. The project fully incorporates commercial principles. 62. Experience based on other World Bank financed LOCs shows that the LOC terms should allow for flexibility. The Turkey Access to Finance for SMEs Project (P082822) was designed to allow for operational adjustments as needed to ensure effective implementation. The loan terms were flexible and they could be granted for working-capital and investment purposes. There were also no restrictions on eligible sectors because historical experience suggests that unviable projects receive financing merely by virtue of the sector requirements. The Land Bank FIL will support investment and working capital loans, and the allocation of funds between the CB and CDB business lines will remain flexible to accommodate market and portfolio developments. 63. Evidence from other countries reveals how the authorities have grappled with avoiding situations where DFIs ‘crowd out’ the private sector and thereby impair their impact. To avoid cross-subsidization and crowding out the Mexican DFIs have moved away from lending at subsidized interest rates to lending on market-conforming terms. NAFIN’s second-tier lending model was based on granting credit at longer maturities and lower costs than typically available in the Mexican market, reflecting its ability to raise capital at sovereign interest rates. With the reduction of the spread between sovereign interest rates and inter-bank rates, these subsidized rates became less attractive, eventually leading NAFIN to create an innovative program that increases demand for its funding without having to rely on interest rate subsidies. FIRA’s initial practice of providing directed credit at lower -than-market rates and subsidized credit guarantees was marked by high administrative costs, widespread strategic defaults induced by debt-forgiveness programs, and failure to reach the intended clientele, resulting in significant fiscal costs. Its strategy has shifted to establishing partnerships between large agribusiness companies and primary producers, and in the process creating new financial and risk management instruments attractive to private-sector financial intermediaries. In Brazil, long-term loans are subsidized by the Treasury as a result of BNDES refinancing itself with the government at a directed long-term rate which is lower than the corresponding yield on government bond issues. Such subsidies eventually impact the federal public debt and have given rise to concerns due to ‘crowding out’ of commercial banks. The fear is that favored borrowers which already have access to the credit markets have turned to BNDES solely to reduce their financing costs, and that there is low impact associated with BNDES’s lending (i.e. the private market would in any case have funded these companies if BNDES had not). In recent years, BNDES has ramped up schemes supporting access to finance for SMEs which do not involve subsidized lending. 19 64. Experience from other WBG projects suggests that projects should build on existing supply chain relationships if possible or encourage new relationships to develop. The productive partnership model, which has been implemented in countries such as Papua New Guinea, Bolivia, and Colombia, has primarily served to facilitate or strengthen value chain relationships between farmers and agribusinesses with complementary products and services through the extension of short-term in-kind credit and relevant technical assistance. In these instances, the relationships and services did not exist or were limited in nature and needed external support to scale up. In contrast, Land Bank already works with a number of PFIs that have long-standing relationships with commercial and emerging farmers through which targeted technical assistance and credit is extended for inputs and machinery. In South Africa, these private-sector led relationships have proven to be more beneficial for farmers (refer to Annex 7) than similar government-led grant programs. In addition, the focus in this project is more on the extension of long-term credit compared to the productive partnership model. 65. The experience with the AfDB line of credit to Land Bank indicates a high demand for funds with 50 percent disbursement since 2013, yet disbursement under the REM business line has been slow. Due to the high risk and extensive need for technical support to emerging famers in addition to financing, the growth of the REM portfolio has been slow, especially in its initial stages. While growth is expected to be stronger now that an initial portfolio and experience has been built, expanding the REM portfolio sustainably has remained challenging. It is expected that Land Bank’s new approach to facilitate integration of emerging farmers in established value chains in a commercially viable manner may help in opening new opportunities to expand support to emerging farmers. In addition, a significant amount of AfDB funds for technical assistance (US$1 million) remain available to meet Land Bank’s institutional needs. IV. IMPLEMENTATION A. Institutional and Implementation Arrangements 66. The IBRD loan of US$93 million consists of one component: Line of Credit for Agricultural Financing (US$93 million). 67. The loan will be extended to Land Bank as the borrower and implementing agency with a guarantee of the Republic of South Africa. Land Bank will use the funds under the LOC component for on-lending to PFIs. The arrangement will be governed by the following formal agreements: (i) loan agreement between IBRD and Land Bank, (ii) guarantee agreement between IBRD and the Republic of South Africa, and (iii) Sub-Loan Agreements between Land Bank and PFIs. Land Bank will pay a guarantee fee to National Treasury. The envisaged flow of funds under the LOC component is depicted in Figure 2. Figure 2: Flow of Funds 20 68. Land Bank will be responsible for project implementation and monitoring. The Chief Financial Officer has been designated as the primary counterpart for the project in Land Bank. He will be supported by the respective operational teams to monitor project implementation and report to the World Bank. Dedicated staff in Land Bank has been identified for managing all aspects of the project, including reporting on implementation progress and monitoring and evaluation, ensuring compliance with environmental and social safeguards as well as with financial management and procurement arrangements. Extensive supervision by the World Bank team is planned during project implementation to support Land Bank and the PFIs. Detailed implementation arrangements are described in Annex 4. B. Results Monitoring and Evaluation 69. Land Bank will monitor and evaluate progress against the proposed indicators through regular reports. Land Bank will report on the PDO and intermediate indicators as set out in Annex 1 on a semi-annual basis. The data will come from Land Bank’s internal reports and from information provided by the PFIs. Land Bank will prepare quarterly Interim Financial Reports for the project. The specific reporting templates will be defined in the Project’s Operational Manual. Land Bank’s financial performance will be audited annually by the Auditor General. C. Sustainability 70. The sustainability of the project will be ensured by Land Bank’s as well as the government’s commitment to increase financing for the agricultural sector, and specifically to emerging farmers. Achieving the NDP’s job creation and poverty reduction goals will not be possible without substantial progress in rural and agricultural development. The government’s commitment to the sector and the importance of affordable access to financing for emerging farmers to succeed will ensure that the project’s objectives will remain at the center of the government’s reform agenda. In addition, while the World Bank can play a catalytic role by providing Land Bank with medium-term financing, which is scarce and costly at this stage, it is expected that in the future, Land Bank will be able to secure such funding directly from the market. This will ensure sustainability of the operation in the longer term. In addition, it is expected that the emerging farmers financed by Land Bank will transition to commercial farming over the course of about five years, further supporting sustainability of the project and Land Bank overall. 21 V. KEY RISKS AND MITIGATION MEASURES A. Overall Risk Rating and Explanation of Key Risks 71. The overall project implementation risk is Moderate primarily due to potentially conflicting interests among stakeholders, Land Bank’s internal governance, a new lending engagement in South Africa after a considerable time, and the scope of Land Bank’s and the PFI’s capacity. As a fully government-owned institution, Land Bank can be mandated by the government to support specific industries and companies, which may affect the sustainability of the bank. However, in 2009 the supervision of Land Bank was transferred to National Treasury and since then Land Bank has implemented a comprehensive strategy to put the bank on a sustainable path. The strategy is further enhanced by the recent organizational review undertaken and being implemented by Land Bank. Furthermore, the project is designed to mitigate governance risks through the inclusion of specific eligibility criteria for sub-loans to ensure appropriate fund utilization. However, due to recent political upheaval in South Africa, including at National Treasury, there could be implications for the oversight over Land Bank in the long term. PFIs who on-lend through Window 1 will make credit decisions based on their own credit risk assessment and commercial considerations. The direct financing by Land Bank through Window 2 will only be in partnership with corporate and/or technical partners where there is a clear business case to support targeted value chains. The project signifies a new lending engagement in South Africa after a considerable time in a new sector which poses challenges regarding the understanding of WBG’s policies, procedures and fiduciary arrangements. The project responds to specific client demand and NT’s strong interest in the project. During implementation the World Bank team will work closely with government institutions and Land Bank to strengthen the understanding of WBG fiduciary arrangements. Moreover, the project complements the active WBG engagement with the government on achieving its rural development and financial inclusion objectives through the reimbursable advisory services program on rural development and the World Bank executed Trust Fund on the Financial Sector Development and Reform Program, which will help in continuing the policy dialogue on key reforms. In regards to capacity, Land Bank is a new WBG client and not familiar with the WBG’s fiduciary arrangements. These arrangements could place a higher burden on Land Bank’s normal operating procedures. By extension, the WBG’s fiduciary requirements could also place a higher burden on the PFIs capacity to disburse the funds. In addition, PFIs could face challenges to scale-up their financing and/ or advisory support in line with the needs of the project or there could be inadequate demand for the services at the price at which it is offered. Land Bank’s ongoing effort to align its mandate with the objectives of the NDP, progress in implementing key changes following the organizational review, well-developed lending criteria, and a thorough due diligence of the PFIs including estimates for absorptive capacity are the key measures incorporated in the project design to reduce the probability and impact of these risks. VI. APPRAISAL SUMMARY A. Economic and Financial Analysis Financial Analysis 72. The financial analysis projects that Land Bank will grow its loan book considerably through 2020. The strongest growth is expected in the development portfolio. The development 22 portfolio provides financing to the disadvantaged population in line with Broad-Based Black Economic Empowerment (BBBEE) and emerging farmers and is represented in both the CB and CDB business lines (see Annex 3 for a detailed analysis of Land Bank’s financial performance as well as Annex 6). Economic Analysis 73. This economic analysis aims to assess the contributions of both the CDB and CB business lines to job creation and income generation, among others. In particular, the economic analysis aims to quantify the costs and benefits that accrue from providing a line of credit for agricultural financing, separately for the CDB and CB business lines. The Net Present Value (NPV) and Economic Rate of Return (ERR) are calculated for each business line with a number of sensitivity checks. The analysis is based on data and assumptions provided by Land Bank and expert opinion. Further details on the methodology, assumptions, and data used in the economic analysis are provided in Annex 6. 74. Overall, the ERR of the line of credit component of the project is expected to be 31 percent. The NPV is expected to be approximately ZAR 317 million assuming a discount rate of 10 percent (ZAR 248 million assuming a discount rate of 12 percent) as shown in Table 1. The positive valuation indicates that the returns on investment exceed the returns that could be otherwise earned by World Bank financing. As such, the improvements in the income of end- borrowers and the monetized value of jobs created, net of interest costs paid by end-borrowers, outweigh the cost of investment under this component. B. Technical 75. The technical design of the project is closely linked to the NDP which highlights agricultural development and successful land reform as key pillars of the strategy for integrated and inclusive rural development. Importantly, the design incorporates World Bank technical expertise and international good practices on financing through DFIs using wholesale mechanisms. The LOC is based on commercial principles and includes flexible terms to adjust to changing needs of the project. The project design is based on extensive consultations with Land Bank, NT and other relevant stakeholders. The project builds on lessons learned from the implementation of previous LOC projects. C. Financial Management 76. Land Bank’s financial management (FM) system will be used for the implementation of the project, with the already laid down oversight arrangements by National Treasury and the Land Bank Board. The Systems Applications & Products (SAP) accounting system is capable of producing periodic reports for monitoring the financial aspects of the project. Reliance can be placed on the oversight functions of the organization, namely, the internal audit function. The reviews are carried out independently and objectively. The internal audit function plays an oversight function in the disbursement of the loans to ensure that policies are implemented as intended. 77. Land Bank will maintain a Rand designated account for the implementation of the Bank financed component. Disbursements into the designated account will be based on interim financial reports. Disbursements and oversight on the intermediaries will be done based on Land Bank’s credit policy. 23 78. The annual financial statements will be audited by the office of the Auditor General. The audit will be undertaken in accordance with international standards on auditing promulgated by the International Federation of Accounts (IFAC) and audit reports will be submitted to the World Bank within six months after the financial year-end, 30 September each year. The FM arrangements meet the Bank’s minimum requirements under OP/BP 10.00 Financial Management. D. Procurement 79. The South Africa Land Bank Financial Intermediation Loan (FIL) received World Bank management clearance on March 14, 2016 to proceed as an early adopter of the World Bank’s New Procurement Framework (NPF). Specifically, the operation is a FIL where the final recipients of loan funds are private sector enterprises to which the New Procurement Framework does not apply as per Section I.1 of the World Bank Policy, “Procurement in IPF and Other Operational Procurement Matters”. Independent oversight for providing assurance that funds have been used for the intended purpose will rely on the external audit conducted by the Auditor General of South Africa. The Sub-Loan Agreements (SLAs) between Land Bank and the PFIs will include the World Bank’s audit rights and the Anti- Corruption Guidelines of January 2011, which will also be made applicable to all beneficiaries of the sub-loans. The World Bank is not required to have any new implementing rules and/or documents and neither will the World Bank be required to provide any additional resources for implementation support and monitoring. Land Bank in turn is not required to have any additional capacity to apply the NPF. E. Social and Environment (including Safeguards) 80. The project has been categorized as a Financial Intermediary Loan (FI-2) with moderate environmental and social risks and impacts according to the World Bank’s Performance Standards (PS) for the Private Sector Projects (OP/BP 4.03). The Project has been categorized as a Financial Intermediary Loan (FI-2) according to the World Bank’s Performance Standards for the Private Sector Projects (OP/BP 4.03). Project activities to be supported by the FIL will mainly focus on agriculture and agri-business which involves the cultivation of sugarcane, citrus-fruits, grain and processing of food products which are likely to generate minimal environmental and social risks and impacts that are site-specific, largely reversible and can be readily addressed through mitigation measures. The specific nature, scope and location of the agriculture and agri-business activities will be known during implementation when the PFIs receive loan applications from the beneficiaries. Land Bank will be required to manage the environmental and social risks of the FIL-supported activities consistent with the requirements of the OP/BP 4.03 and applicable national environmental and social laws and regulations, while the PFIs will have the responsibility of screening loan applications for environmental and social risks and impacts and manage the risks and impacts in a manner consistent with the procedures stipulated in the Environmental and Social Management System. 81. The following World Bank Performance Standards have been applied: PS1: Assessment and Management of Environmental and Social Risks and Impacts, PS2: Labor and Working Conditions, PS3: Resource Efficiency and Pollution Prevention, PS4: Community Health, Safety and Security, and PS5: Land Acquisition and Involuntary Resettlement. PSI, PS3 and PS4 are applied because of the inherent nature of environmental and social impacts associated with agriculture and agri-business operations which will likely generate point and 24 non-point source pollution from run off emanating from the use of pesticides/herbicides in controlling weed infestation on farms and potential increased use of fertilizer to increase crop productivity, effluent discharges and solid waste generated from agro-processing activities, noise and air emissions from agro-processing facilities, occupational health and safety of workers due to lack of or in-use of Personal Protective Equipment (PPE), soil erosion from poor or lack of proper site drainage, and contamination of water (both surface and ground water) from oil spills. PS1 is applied to prevent and manage the potential environmental risks and impacts. Beneficiaries of the sub-loans will be required to carry out environmental and social assessments equivalent to the level of risk assessed by the PFIs and prepare appropriate safeguard instruments to mitigate the impacts in compliance with the World Bank’s PSs and national environmental laws and regulations. PS2 is applied as beneficiaries to the loan will engage in agriculture and agro-processing activities which should comply with national laws on worker health and safety. PS3 is applied to ensure proper management and appropriate application of fertilizers as well as availability of well-established pest mitigation measures through Pest Management Plans. PS4 is applied to ensure that effective protection is ensured against risks emanating from agro- processes, gas releases from agro-processing facilities, chemical hazards, fire and explosions, and that community relations are maintained. PS5 is applied because although Land Bank will not finance the acquisition of land under the project, intensification of agriculture on existing holdings could result in land tenants’ relocation within a specific property. Based on feedback during field visits, the likelihood of such on-farm relocations is low. 82. Land Bank has established procedures for collecting a range of detailed data on financial intermediary performance. Information collected at the various levels incorporates social indicators, including detailed information on the number of emerging farmers, their assets, racial demographics of the work force, status, ownership, and amount of land (including differentiation among usage). Land Bank also requires licenses such as: water use licenses, environmental impact assessments, and land title. With the development of an Operational Manual, which includes an Environmental and Social Annex, this data collection can be systematized into monitoring on social and environmental safeguards and social sustainability with some modifications to existing practices. The consolidated monitoring and evaluation reports track metrics related to the mentoring programs designed to build capacity of emerging farmers. Indicators used are: number of farmers receiving financial and technical mentorship, attending training programs, and participating in other skills building activities. 83. The sub-loans to be financed under the project will be subjected by the PFIs to an environmental and social screening process using procedures described in the Environmental and Social Operational Manual.42 This will ensure that the environmental and social risks of the sub-projects are adequately screened and appropriate mitigation measures are developed to avoid, minimize or offset any risks and impacts likely to occur during implementation. The Environmental and Social Operational Manual will guide the PFIs in the screening process. Land Bank will be responsible for providing overall oversight and monitoring to ensure that the screening process at the PFIs is adequately carried out and appropriate environmental and social measures are carried out by the beneficiaries. 84. Land Bank has a commitment to environmental management through the corporate Environmental and Social Management System which was approved by the Land Bank 42 The ESOM will establish procedures to operationalize the Land Bank’s ESMS and provide guidance to the PIFs on screening and mitigating environmental and social risks to ensure compliance with the World Bank PSs. 25 Board in 2015, and through the credit application review and monitoring processes. During project preparation, the World Bank assessed the capacity and knowledge of Land Bank to implement the Environmental and Social Management System (environmental screening, assessment, mitigation, review, monitoring and reporting) across the PFIs. The assessment also took note of Land Bank’s effectiveness in implementing, monitoring and reporting in relation to its corporate Environmental and Social Management System. The assessment looked at any potential gaps between Land Bank’s ESMS and the World Bank’s PSs. Land Bank has an environmental and social coordinator who oversees the implementation of the sub-projects. The overall capacity and knowledge related to the application of World Bank Performance Standards is generally good and based on the team’s assessment, Land Bank’s Environmental and Social Management System is adequate. Technical assistance to strengthen the capacity will be provided through the AfDB loan. F. World Bank Grievance Redress 85. Under the project, the communities and individuals who believe that they are adversely affected by a World Bank (WB) supported project may submit complaints to existing project-level grievance redress mechanisms or the WB’s Grievance Redress Service (GRS). The GRS ensures that complaints received are promptly reviewed in order to address project-related concerns. Project affected communities and individuals may submit their complaint to the WB’s independent Inspection Panel which determines whether harm occurred, or could occur, as a result of WB non-compliance with its policies and procedures. Complaints may be submitted at any time after concerns have been brought directly to the World Bank's attention, and Bank Management has been given an opportunity to respond. For information on how to submit complaints to the World Bank’s corporate Grievance Redress Service (GRS), please visit http://www.worldbank.org/GRS. For information on how to submit complaints to the World Bank Inspection Panel, please visit www.inspectionpanel.org. 26 Annex 1: Results Framework and Monitoring Country: Republic of South Africa Project Name: Land Bank Financial Intermediation Project (P150008) . Results Framework Project Development Objectives PDO Statement The project’s development objective is to sustainably scale up Land Bank’s financing, specifically to benefit emerging farmer s. Project Development Objective Indicators Cumulative Target Values Indicator Name Baseline YR1 YR2 YR3 YR4 YR5 Volume of wholesale loans disbursed under the project. 0 18,600,000 39,525,000 44,175,000 55,800,000 65,100,000 (Amount(USD)) Volume of direct value chain loans disbursed under the project. 0 0 6,975,000 20,925,000 27,900,000 27,900,000 (Amount(USD)) Direct project beneficiaries. 0 22 198 528 858 1100 (Number) Total NPL rate under the credit line. N/A <10 <10 <10 <10 <10 (Percentage) Intermediate Results Indicators Cumulative Target Values Indicator Name Baseline YR1 YR2 YR3 YR4 YR5 Increase in outstanding loan portfolio of 37,796,688,000 1.50 10.00 10.00 10.00 10.00 27 Land Bank. (Percentage) Increase in CB outstanding loan portfolio. 31,607,333,000 1.50 10.00 10.00 10.00 10.00 (Percentage - Sub-Type: Breakdown) Increase in REM outstanding loan portfolio. 489,051,000 10.00 25.00 25.00 25.00 20.00 (Percentage - Sub-Type: Breakdown) Total NPL rate for Land Bank. 3.72 <10 <10 <10 <10 <10 (Percentage) Land Bank liabilities that are long-term (over 1 year). 31 33 35 37 40 40 (Percentage) Return on Average Assets. 1.12 1.12 1.12 1.12 1.12 1.12 (Percentage) Return on Average Equity. 6.78 6.78 6.78 6.78 6.78 6.78 (Percentage) Indicator Description Project Development Objective Indicators Responsibility for Data Indicator Name Description (indicator definition etc.) Frequency Data Source / Methodology Collection Volume of wholesale loans Volume of wholesale loans disbursed Semi-Annual Land Bank Land Bank disbursed under the project. under the project for REM and CB. (minimum) Volume of direct value Volume of direct value chain loans Semi-Annual Land Bank Land Bank chain loans disbursed under disbursed under the project. the project. (minimum) Direct project beneficiaries. Number of beneficiaries, as defined by Annual Land Bank Land Bank (minimum) Land Bank. The estimate includes the borrowing farmers as well as the on-farm 28 workers.43 Total NPL rate under the NPLs = loans more than 90 days past due / Semi-Annual Land Bank Land Bank credit line. (maximum) gross loans. Indicator values are not cumulative. Intermediate Results Indicators Responsibility for Data Indicator Name Description (indicator definition etc.) Frequency Data Source / Methodology Collection Increase in outstanding loan Increase in Land Bank’s total (CB and Annual Audited financial Land Bank portfolio of Land Bank. CDB) outstanding loan portfolio. Baseline statements (minimum) in ZAR. Increase in CB outstanding Increase in CB outstanding loan portfolio. Annual Audited financial Land Bank loan portfolio. (minimum) CB includes Growth – Corporate, Agro- statements processing, Corporate Direct, Intermediary SLA, and Intermediary Non-SLA. Baseline in ZAR. Increase in REM Increase in total REM outstanding loan Annual Audited financial Land Bank outstanding loan portfolio. portfolio. Baseline in ZAR. statements (minimum) Total NPL rate for Land NPL rate based on Land Bank’s definition. Annual Audited financial Land Bank Bank. (maximum) Indicator values are not cumulative. statements Land Bank liabilities that All liabilities over 1 year relative to total Annual Audited financial Land Bank are long-term (over 1 year). liabilities statements and Land Bank (Percentage) (minimum) management information system Return on Average Assets. Total comprehensive income for the year / Annual Audited financial Land Bank (minimum) [(Latest reporting year Total Assets + statements Previous year Total Assets) / 2]. Indicator values are not cumulative. 43 Of note, the number of on-farm workers depends crucially on the type of farming as some activities are more labor-intensive than others. In addition, larger farms are more mechanized and therefore require less on-farm workers than smaller, emerging farms. 29 Return on Average Equity. Total comprehensive income for the year / Annual Audited financial Land Bank (minimum) [(Latest reporting year Capital and statements Reserves + Previous year Capital and Reserves) / 2]. Indicator values are not cumulative. 30 Annex 2: Detailed Project Description REPUBLIC OF SOUTH AFRICA: Land Bank Financial Intermediation Project 1. The project will sustainably scale up Land Bank’s financing, specifically to benefit emerging farmers. This will be achieved by providing long-term financing for Land Bank, which will facilitate a broader and deeper financial intermediation by Land Bank and diversify its funding sources away from government. 2. The project will address market failures in the provision of agricultural financing, access to finance for previously disadvantaged emerging farmers, and limited availability of medium to long-term financing. Commercial bank financing for agriculture amounts to 1 percent of commercial banks’ loan book (ZAR 2,753 billion) which is low compared to farmers reported demand. In addition, financing from commercial banks can typically not be accessed by emerging farmers due to a lack of adequate collateral. The project will support Land Bank in addressing these market gaps by providing additional resources to specifically finance emerging farmers in a sustainable manner. In addition, Land Bank predominantly relies on short-term funding sources for lending to the agricultural sector due to limited availability of medium and long-term financing. The availability of long-term financing under the project will help Land Bank in improving its asset-liability management and deepening its financial intermediation capacity. 3. Moreover, the project will support Land Bank in piloting its new approach to scale up financing for emerging farmers by facilitating their integration into established value chains. South Africa’s agriculture sector is characterized by dualism: a modern, market-oriented capital intensive farming sector consisting of a small number of large commercial farms (around 40,000 farming units44) and a large number of subsistence and small-scale or emerging farms, many in the former homeland areas. Recent government policies and programs on land reform, such as restitution, tenure reform and AgriBEE, have assisted historically disadvantaged emerging farmers’ access to land, credit and technical assistance. In spite of these programs, large knowledge and skills gaps persist and emerging farmers lack financing and operate largely outside of the established agriculture value chains. However, partnerships with corporates and technical partners operating in the same value chain have demonstrated the potential for sustainably integrating emerging farmers into established value chains. This project will support Land Bank’s initiative to finance such projects, by directly lending to emerging farmers within a structured value chain project. 4. The project is a financial intermediary loan (FIL) of US$93 million to Land Bank as the borrower and implementing agency with a guarantee of the Republic of South Africa. The project has one component: a Line of Credit for Agricultural Financing in the amount of US$93 million. 44 Department of Agriculture, Forestry and Fisheries (DAFF): Abstract of Agricultural Statistics, 2010. 31 Component 1: Line of Credit for Agricultural Financing (US$93 million). 5. The objectives of the LOC component are to:  Support Land Bank in refocusing its operations on wholesale lending. As explained in section I.B., Land Bank uses both wholesale and direct lending under the Corporate banking (CB) and Commercial Development banking (CDB) business lines. Given Land Bank’s limited branch network and based on international best practices for Development Finance Institutions (DFIs), wholesale lending is more sustainable because it helps Land Bank leverage a network of financial intermediaries without incurring significant operating costs. In addition, wholesale lending allows Land Bank to play a market enabling role because it permits agricultural borrowers to build credit history with financial intermediaries and improve their financial records for commercial loans, thus improving their ability to gain access to credit. The LOC will help Land Bank in expanding wholesale lending to both commercial and emerging farmers under the CB and CDB business lines respectively. Through supporting the CB business line, the LOC will support employment generation for poor farm workers employed on the commercial farms supported. The CB business line also contains a large and growing developmental portfolio in line with BBBEE, therefore making an important contribution to the NDP and Land Bank’s development goals.  Support Land Bank’s new approach to help integrate emerging farmers into established value chains. Based on the outcomes of its organizational review, Land Bank decided to scale up financing support to emerging farmers in a sustainable and commercially viable manner through partnerships with large agriculture corporates that emphasize integrating emerging farmers in established value chains. The approach is anchored in identifying high-potential value chain projects in a given geographic region and securing buy-in from large agriculture corporates or technical partners to assist in supporting emerging farmers’ integration into the chain. The agriculture corporates will provide technical support (directly or indirectly) to the emerging farmers, building up their capacity to be sustainable suppliers to the chain. Land Bank has identified potential value chain projects and agriculture corporates to partner with in the grains, winery, horticulture and livestock sectors for this type of financing. The success of these initiatives is expected to have a demonstrative effect in the medium term helping to bring in commercial banks’ financing for such initiatives and agriculture in general which is currently very limited. 32 Box 1: Trends in Development Finance Institution Practices Based on the Global Survey of Development Banks (World Bank Policy Research Working Paper 5969, 2012), a survey of 90 DFIs across the World, several trends for the DFI sector can be identified (although there are obviously counterexamples for each trend). The survey included a range of DFIs across all regions and with different mandates. Out of the DFIs with a specific mandate, the majority were focused on agricultural activities. Some of the main trends based on the survey are:  While the majority of DFIs are entirely government-owned, mixed public-private capital structures are becoming more common;  DFIs still serve as the largest source of long-term credit for agriculture, housing, and infrastructure in emerging economies;  The majority of DFIs are not accepting deposits from the general public, but raise funding from the wholesale and capital market. This allows DFIs to focus on their lending operations, avoid direct competition with the private sector, and limit the potential exposure of taxpayers to losses. In addition, governments tend to move away from direct budget transfers, preferring to guarantee the debt and liabilities of the institution;  The credit model used by DFIs is trending away from mixed wholesale/ retail towards a wholesale- only model;  Governments seek to make DFIs self-sustaining and insulate them from political interference. Only half of all DFIs offer credit at subsidized interest rates;  The trend is for DFIs to be profitable and have non-performing loan (NPL) ratios of below 5 percent, reflecting greater wholesale credit activity (all wholesale-DFIs had NPL ratios below 5 percent), better governance, professionalization of management, and stronger risk management practices; and  Regulation and supervision of DFIs is being strengthened, with the favored model now to require DFIs to comply with commercial banking regulations. The clear majority of DFIs are regulated and supervised by the same authority that supervises private commercial banks. 6. To achieve the above objectives, Land Bank will provide both wholesale finance to participating PFIs for on-lending to commercial and emerging farmers and direct financing, in partnership with large agriculture corporates, to emerging farmers to support their integration in established value chains. It will do so through two main financing windows: Window 1: Wholesale finance to commercial and emerging farmers. This window will provide a wholesale line of credit to Land Bank. Land Bank will on-lend the funds to participating financial intermediaries (PFIs) which comply with eligibility criteria agreed with the World Bank. The PFIs will on-lend funds to eligible agriculture enterprises, commercial and emerging farmers, communal property associations and other eligible borrowers supported under the Land Bank’s CB and CDB business lines. Currently, the wholesale line under CDB primarily includes the emerging farmer’s portfolio, however, over the life of the project this may change to include other wholesale loans under CDB. Window 2: Financing to integrate emerging farmers into established value chains. This window will provide a line of credit to Land Bank to finance direct lending to emerging farmers for integrated value chain finance. For direct lending to value chain finance/development projects, Land Bank will finance eligible emerging farmers and agriculture enterprises in collaboration with large agriculture corporates and/or technical partners in a targeted value chain. 33 7. It is expected that 70 percent of LOC funds will be used to support wholesale lending and 30 percent will be used for direct lending to emerging farmers for their integration in established value chains. However, this ratio will be kept flexible in both directions to allow for adjustments based on market and portfolio developments in the Land Bank’s CB and CDB business lines. 8. The below figure presents the project design and implementation arrangements: Figure 1: Project Design Pricing 9. Consistent with Land Bank’s pricing policies, the interest rates to intermediaries in wholesale financing and for borrowers through direct financing will be determined by the customer segment.  Window 1: Commercial farmers under CB. Land Bank will on-lend funds to PFIs at interest rates that take into account at minimum Land Bank’s cost of funding, operating costs and an appropriate credit risk margin.  Window 1: Emerging farmers under CDB. For these farmers, Land Bank will on- lend funds to intermediaries at interest rates that will allow the bank to at least cover its average costs of funds.  Window 2: Emerging farmers in established value chains. The pricing for direct lending by Land Bank to integrate emerging farmers in established value chains will be market-based. Land Bank aims to implement the new approach to scale-up financing for emerging farmers in a commercially viable and sustainable manner. Thus, pricing for this financing will cover Land Bank’s cost of funding, operating costs and an appropriate credit risk margin. 34 10. The interest rates to final borrowers will be market-based to ensure sustainability and avoid creating interest rate distortions in the market. The PFIs for both commercial and emerging farmers will be able to freely set their interest rates, which are expected to cover at least the cost of funding, operational costs and an appropriate credit risk premium based on the credit assessment of the borrower. At the same time, Land Bank will discuss appropriate margins with the PFIs to ensure that any interest advantages are passed on to the final borrowers. 11. The lower interest rates for emerging farmers under CDB will allow Land Bank and the PFIs to finance clients that would otherwise be excluded from formal sector financing. While on-lending for emerging farmers will initially be at average cost of funds, these farmers are expected to be able to graduate to commercial funding after a period of five years, underlining the sustainability of the program. Moreover, Land Bank is currently reviewing its wholesale finance facility to emerging farmers pricing policy to allow Land Bank to breakeven on pricing by covering at least its average cost of funds and operating costs. In addition, interest rates for emerging farmers under the wholesale finance facility will be subject to continuous review to ensure that the objectives of the program are achieved. Figure 2 shows Land Bank’s previous and new pricing structure for the wholesale finance facility for emerging farmers. Figure 2: Changes in REM pricing 35 12. The PFIs will assume full credit risk for all final borrowers and sub-loans that they have financed under CB. For the wholesale finance facility to emerging farmers, Land Bank currently shares credit risk with the PFIs. The agreement is such that for the first 5 percent of non-performing loans, Land Bank takes 50 percent of the loss, between 5 and 10 percent, Land Bank takes 30 percent of the loss, and above 10 percent, Land Bank does not share in the loss. This arrangement will be reviewed during project implementation in case it should no longer be required. Eligibility Criteria for PFIs 13. To meet its wholesale lending objectives under CB and CDB, Land Bank is currently engaged with a broad range of intermediaries. Those include agricultural cooperatives, large agricultural companies, and credit providers. These intermediaries have a credit provider license and are supervised under the National Credit Act by the National Credit Regulator. The intermediaries are primarily providing credit to their clients with whom they have existing business relationships in the form of input supplies contracts, off- take agreements etc. and provide technical advisory services specifically to emerging farmers. Currently, Land Bank is working with ten intermediaries who are engaged under both CB and CDB. In addition, additional intermediaries in the pipeline are expected to operate for both CB and CDB. These intermediaries are providing financing for sugar cane, grain, citrus, fruits, vegetables and livestock. The intermediaries are geographically spread across all provinces. 14. In addition to financing, the intermediaries provide intensive and high quality extension services, particularly to emerging farmers. Since Land Bank’s intermediaries have been engaged in agricultural activities for the past several decades, they have developed a unique comparative advantage in providing extension services to farmers specifically tailored to their individual needs. These extension services include training, skills development and mentoring of smallholder beneficiaries and range from hands-on advice on crop selection, plantation, inputs needs and harvesting to training on agriculture marketing, business planning etc. For the wholesale finance facility to emerging farmers, these extension services are embedded in the financing, recognizing the fact that emerging farmers need financing as well as technical assistance to succeed. A review of extension services in South Africa found that these programs have proved successful in establishing commercially successful emerging farmers (see Annex 7 for more details). 15. While all interested PFIs of Land Bank will ultimately be appraised, Land Bank and the World Bank initially selected six intermediaries that are operating in both the CB and CDB sub-business line under CDB and assessed them against the eligibility criteria. The eligibility criteria took into consideration Land Bank’s selection criteria for intermediaries and the recommendations on financial intermediary financing under the World Bank’s Operational Policy OP10. The OP10 policy requires an assurance that all PFIs in a World Bank financed LOC are viable financial institutions determined by: (a) adequate profitability, capital, and portfolio quality as confirmed by audited financial statements; (b) acceptable level of loan collections; (c) appropriate capacity, including staffing, for carrying out subproject appraisal (including environmental assessment) and for supervising subproject implementation; (d) capacity to mobilize domestic resources; (e) adequate managerial autonomy and commercially oriented governance; and (f) appropriate prudential policies, administrative structure, and business procedures. Annex 8 contains the detailed eligibility 36 criteria for PFI participation in the LOC. Land Bank will enter into Sub-Loan Agreements (SLA) with the selected PFIs, which will specify terms and conditions on the use of the LOC as agreed between Land Bank and IBRD. PFIs will not be obliged to draw on the available funding, and interest costs and other fees will only be charged upon accessing the LOC. 16. The available LOC funding will be used based on a drawdown mechanism. Once PFIs are approved for funding from Land Bank, they receive a drawdown facility of the approved amount with a fixed maturity, e.g. five years, which they can use to finance projects complying with the agreed eligibility requirements. Loans to final beneficiaries will be provided by PFIs from the drawdown facility up to the amount and maturity approved. Land Bank will receive funding from the LOC based on the submission of internally approved drawdown facilities for intermediaries in line with the eligibility criteria. There will be a limit of 25 percent of LOC facility per intermediary to encourage the participation of several PFIs in the project. In case a PFI is unable to utilize the facility, the unutilized amount can be allocated to other PFIs. PFIs will need to comply with the ongoing eligibility criteria during their participation in the LOC (see Annex 8). The repayments will be collected in a revolving fund and will be used to provide funding for new sub-loans. 17. Land Bank will be responsible for the supervision of credit lines provided under the project. This includes assessing and monitoring PFI compliance with eligibility criteria, supervision of withdrawal applications and sub-loans, and reporting on the credit line implementation progress. It also involves reviewing PFI’s audited financial statements on an annual basis, reviewing PFI loan books, and periodic on-site supervision and monitoring. The PFIs will be expected to report on their sub-loan portfolio and key financial and performance indicators to Land Bank on a semi-annual basis to facilitate the monitoring and supervision process. Direct lending to integrate emerging farmers into established value chains 18. For direct lending to emerging farmers, Land Bank will work with a number of corporate and technical partners to facilitate capacity development and value chain integration. The project will support Land Bank’s new development lending initiative which provides direct loans to emerging farmers that are part of a larger value chain integration project. The emphasis is on emerging farmer sustainability through targeted technical assistance within a specific value chain. These interventions can take different forms depending on the specificity of the value chain. For example, Land Bank is interested in partnering with a large wine exporter that has expressed an interest in bringing in emerging farmers to expand their wine production and bottling capacity. In this scenario, Land Bank would finance this project, ensuring medium to long-term financing to the farmers to establish new vineyards and the bottling plant. The wine exporter would be part-owner in the bottling facility and ensure the specific technical guidance for vineyard set up and bottling plant building and management. Other equity investors would be invited to invest in the project. A second scenario, a more traditional value chain financing model, would involve partnering with a large corporate food retailer that is interested sourcing fruits and vegetables from new emerging farmers. In this case, the food retailer would provide the extension services to the emerging farmers ensuring that they meet their quality specifications for purchase. Land Bank would provide working capital and investment loans to the farmers backed by the retailer’s contracts. As foreseen in its approved restructuring, Land Bank will 37 hire additional staff with VCF/project finance expertise to develop and scale up this initiative. Eligibility Criteria for Sub-loans, Sub-borrowers and Direct lending 19. Under window 1, the sub-loans to final borrowers under the CB and CDB business line will follow Land Bank criteria as well as the following additional criteria to meet the project objectives:  The sub-loans will finance investment and working capital loans. Land Bank will not support sub-projects under this project through equity participation or other financial instruments;  Sub-projects will be targeted towards the agriculture sector and agribusinesses;  The sub-loan will be denominated in South Africa Rand;  Limits on Sub-Loan Amounts. Not more than ZAR 5 million of IBRD loan proceeds should be directed towards a single beneficiary or group of related borrowers under the wholesale finance facility to emerging farmers. The limit on sub-loan amounts will be ZAR 75 million for CB and CDB;  Maturities of investment loans would be up to maximum ten years, with grace period determined by the PFI. Maturities of working capital loans would be up to four years;  PFIs will assume full credit risk for all final borrowers and sub-loans that they have financed under CB and CDB. For the wholesale finance facility to emerging farmers, Land Bank will share the credit risk with the PFIs according to its credit policies;  Interest rates will be freely determined by the PFIs; and  Goods and works on the IBRD's negative list will not be eligible for financing. 20. Under window 2, the loans will follow Land Bank criteria as well as the following additional criteria to meet project objectives:  The IBRD loan proceeds will finance investment and working capital loans. Land Bank will not support value chain financing (VCF)/development projects under this project through equity participation or other financial instruments;  The loans will be used for growth and developmental purposes with the aim of integrating emerging farmers into structured and well-established value chains;  Partners within the VCF/developmental projects shall be secured with service level agreements outlining the conditions of partner contributions prior to the granting of Land Bank loans;  Not more than ZAR 100 million of IBRD loan proceeds should be allocated to one VCF/development project;  Maturities of investment loans would be up to maximum ten years, with grace period determined by the Land Bank. Maturities of working capital loans would be up to four years;  Interest rates will be determined by Land Bank to cover Land Bank’s cost of funding, operating costs and an appropriate credit risk margin.  Goods and works on the IBRD's negative list will not be eligible for financing. 21. The final borrowers under the LOC will be primarily those supported under Land Bank’s CB and CDB business lines. The eligibility criteria for final borrowers under 38 the wholesale finance facility to emerging farmers will meet Land Bank criteria (see Box 2) and include the following:  Private companies (defined as more than 50 percent private ownership or private control), communal associations providing goods and services in the agriculture sector;  Final borrower, after receipt of the sub-loan, should generate enough cash during the pay-back period of the sub-loan to maintain a sufficient debt service coverage ratio;  Final borrower must maintain a reasonable level of debt to equity ratio throughout the payback period of the sub-loan;  Final borrowers and sub-projects will be physically located within South Africa. Box 2: Land Bank criteria for borrowers financed under the wholesale finance facility to emerging farmers (previously REM) To be eligible to borrow under the wholesale finance facility to emerging farmers, borrowers must fulfil the following criteria according to Land Bank’s credit policy:  Black, historically disadvantaged South African citizens or a juristic person in which 100 percent of the shareholding or members’ interest is held by black, historically disadvantaged South African citizens;  Farm on a full-time basis (if the client does not farm on a full-time basis, a full-time manager is mandatory);  Active in primary agriculture;  Total assets must not exceed South African Rand 3 million prior to assistance at current market value;  Located in priority areas determined by government priority or the Bank’s own concentration limits;  Unable to secure traditional finance due to a lack of traditional forms of security;  Have access to either own, family owned, communal or leased land for the duration of the loan;  Lack managerial, financial, and/or agricultural skills;  Have the ability to produce crop that, together with alternative sources of income, will cover living expenses, loan repayments and build up capital;  Have an off-take agreement in place or are contract farmers;  Involved in a project where all participants have a meaningful share of the risk;  The applicant or directors, members or trustees if it is a legal entity must have practical farming experience, are adequately motivated to farm, will be actively involved in the venture and have acceptable technical support for the venture;  The area in which the farming enterprise is situated must show a significant degree of social cohesion; and  Can be assisted with acquisition of land through lease agreement based on business plan. 22. Requirements for borrowers under CB as stipulated by Land Bank’s credit policies are as follows:  Be a small, medium or large business focused on secondary agriculture that is a: o Manufacturer of agricultural intermediary goods; o Manufacturer or processor of agricultural commodities, or an entity trading in agricultural goods or commodities either on wholesale or retail level; o Traditional agribusiness that focus on production support and market entry; or o Agricultural cooperative.  Have a solvent balance sheet;  Have a viable business plan that is sustainable and realistic;  Be able to adequately secure or mitigate exposure. 39 23. To ensure smooth implementation of the LOC, IBRD will undertake prior review of two sub-loans for each PFI. During project implementation, IBRD together with Land Bank will prior review two sub-loans for each PFI to ensure that PFIs are adequately complying with the LOC eligibility criteria. In addition, IBRD will prior review one loan under direct financing by Land Bank. The details on prior review will be specified in the Operational Manual. The prior review will help address any initial gaps that PFIs may have in applying the LOC criteria and will help manage risks. 24. The technical assistance needs of Land Bank and beneficiaries are being met through different sources outside the proposed project. Land Bank needs to further strengthen its institutional model and development impact while ensuring sustainability. Currently, Land Bank is receiving substantial funding from the African Development Bank (AfDB) to help address current and potential technical assistance needs. These funds are still partially unutilized and have been used to date to develop Land Bank’s Environmental and Social Management System (ESMS) which was a recommendation by the team during preparation. Additionally, Land Bank is committed to using its own internal resources for further institutional strengthening and aligning its risk management practices with international standards. Following the completion of the organizational review, Land Bank has engaged external experts to improve its business procedures and risk management models. The support already provided to Land Bank is deemed sufficient based on Land Bank’s current capacity. 25. The technical assistance needs of emerging farmers under the wholesale finance facility are met by Land Bank’s intermediaries. As specified earlier, intermediaries are effectively providing targeted extension services to emerging farmers. For the wholesale finance facility to emerging farmers, these extensions services are embedded in the financing provided by intermediaries. Moreover for direct lending, as foreseen in its approved restructuring plan, Land Bank will hire additional staff with VCF/project finance expertise to develop and scale up this initiative. The project, therefore, does not include a separate technical assistance component. 40 Annex 3: Assessment of Land Bank REPUBLIC OF SOUTH AFRICA: Land Bank Financial Intermediation Project 1. The World Bank Operational Policy OP 10 requires an assurance that all financial institutions and participating financial intermediaries (PFIs) in a World Bank financed credit line are viable financial institutions determined by: (a) adequate profitability, capital, and portfolio quality as confirmed by audited financial statements acceptable to IBRD; (b) acceptable level of loan collections; (c) appropriate capacity, including staffing, for carrying out subproject appraisal (including environmental assessment) and for supervising subproject implementation; (d) capacity to mobilize domestic resources; (e) adequate managerial autonomy and commercially oriented governance; and (f) appropriate prudential policies, administrative structure, and business procedures. 2. Land Bank is the borrower and implementing agency under the project. For the current project, the World Bank performed its financial due diligence of Land Bank in accordance with the established criteria set by OP 10 and confirmed its compliance with the criteria. Unless otherwise stated, the financial analysis in this review is based on Land Bank IFRS statements audited by the Auditor-General (AG) of South Africa. For the 2015, 2014 and 2013 IFRS statements, the AG has provided an unqualified opinion. Overview of Land Bank 3. Land Bank was established in 1912 and is governed by the Land and Agricultural Development Bank Act of 2002. Land Bank was given a mandate of 11 aspects, which fall into five broader areas: (i) access of the historically disadvantaged population to land, (ii) agriculture productivity, growth and job creation; (iii) gender equity; (iv) environmental sustainability; and (v) food security. The NDP published in 2011 continues to call for a key role of Land Bank in providing financial support to land reform beneficiaries and to help them overcome difficulties in entry into commercial farming.45 4. Land Bank is a non-deposit taking institution fully owned by the South African Government and supervised by the National Treasury.46 Currently key development finance institutions in South Africa are supervised by National Treasury.47 Thus, Land Bank follows prudential guidelines as issued by its Board of Directors. It is consequently not prudentially supervised by the South African Reserve Bank (SARB). The bank is audited by the Auditor General of South Africa. 5. As the leading development financial institution in the rural and agriculture sector in South Africa, Land Bank had an approximately 29 percent market share in agricultural financing as of July 2015. The bank48 has achieved a significant turnaround during the past five years. It is now on a sustainable trajectory with profits of ZAR 420 million in 2014/15 45 National Development Plan, p 200. 46 In 2008, the administrative and supervisory powers over the Land Bank were transferred from the Minister of Agriculture and Land Affairs to the Minister of Finance . 47 These include the Development Bank of Southern Africa (DBSA), the Public Investment Corporation (PIC) and the Land Bank. 48 Source of financial information is Land Bank’s 2014 and 2015 Annual Report. Per the report, Land Bank Group includes REM, RCB, B&CB, LDFU, and LBLIC. Land Bank only includes REM, RCB, B&CB and Group Capital. 41 (up 61 percent from 2013/14), and a Return on Average Assets of 1.12 percent and a Return on Average Equity of 6.78 percent. Total assets stood at ZAR 39.4 billion in 2014/15 with a performing loan book of ZAR 36 billion. Non-performing loans (NPLs) under Land Bank methodology were at 3.72 percent in 2014/15 and the cost-to-income ratio was 54.9 percent. Fitch Ratings upgraded Land Bank from AA to AA+ in January 2014. The rating was maintained at AA+ in December 2015. Moody’s Investor Services has assigned Land Bank a credit rating of Aa1.za in May 2016. The bank does not take general deposits and funds itself mainly through the debt and capital markets, issuing instruments such as promissory notes. Land Bank Business Model 6. Land Bank is engaged in both wholesale lending through intermediaries as well as direct lending. Intermediaries are mainly credit providers, cooperatives, or agri-businesses. In 2015, Land Bank undertook an organizational review following conditions set by NT pursuant to the issue of a government guarantee, aimed at enabling the Land Bank to raise longer term funding. The review focused on identifying opportunities for (i) optimizing operational efficiencies and cost reduction; (ii) developing an appropriate funding model for an agricultural DFI; and (iii) improving sustainability of Land Bank’s capital base. The review was completed in August 2015 and subsequently an implementation plan was approved by Land Bank’s Board. 7. The new strategy adopted by Land Bank, based on the outcomes of organizational review, envisions following four strategic pillars to further align Land Bank mandate with the development objectives of South African agriculture sector as laid down in the NDP: (i) Sector growth support to accelerate growth in high-potential regions and crops by targeting emerging commercial farmers that require financing for new farm development, expansion projects and acquisitions. (ii) Supply chain development focusing on agro-processing by targeting agro enterprises that require capital expansion and commercial farmers moving up the value chain. (iii) Production expansion and intensification to support next generation farming by targeting established commercial farmers with potential for expansion or yield improvement. (iv) Agri-Innovation to spur agri-innovation by targeting enterprises with evolutionary agri-technology or products. 8. Land Bank has started implementing the new strategy and key changes are planned over a two-year period in line with the priorities of Land Bank. Key changes focus on: (i) a strategy to optimize the retail commercial banking segment of Land Bank the long term viability of which was a concern owing to loan losses and significantly high operational costs; (ii) new initiatives to potentially expand the development portfolio of Land Bank for emerging farmers49 in a sustainable and commercially viable manner by adopting a project finance approach in partnership with large corporates and intermediaries to integrate the emerging farmers into established value chains; and (iii) steps to align Land Bank financial soundness indicators, credit appraisal processes and risk management practices with international standards. 49 In addition to existing wholesale lending. 42 9. Following the adoption of this new strategy, Land Bank has two main business lines: Corporate Banking (CB) and Commercial Development Banking (CDB).50 The new CDB business line is a combination of previous Retail Emerging Markets (REM) and Retail Commercial Banking (RCB) business lines. In 2014/15, CB accounted for 83.6 percent of the bank’s loan book and CDB accounted for 16.4 percent, of which 1.3 percent was composed of loans provided under REM51. 10. Under CDB, the wholesale finance facility continues to focus on lending to emerging farmers for development purposes. Farmers supported under this facility typically have no or limited access to commercial funding and little or no collateral, but can be commercially sustainable and viable with financing support. Subsistence farmers are not supported under REM. Lending is based on cash-flows and non-financial support (end to end on-farm support) is provided by Land Bank intermediaries and agricultural specialists based in Land Bank branches. The wholesale finance facility to emerging farmers offers production financing, installment sale finance, and medium-term loans. The total wholesale finance facility portfolio to emerging farmers amounted to ZAR 489 million in 2014/15 (increase of ZAR 97 million in that year). 11. Under CDB, the RCB business line which was exclusively focused on direct lending to medium scale farmers, through 27 Agriculture Finance Centers (AFCs), has been significantly restructured to improve its long term sustainability. RCB was loss-making due to high operating costs of the large branch network and had NPLs of 11 percent in 2014/15. RCB was losing clients to commercial banks and agricultural enterprises who started to lend in that space and could offer a wider range of products. The competitiveness and long-term viability of RCB was therefore questionable. The new strategy aims at consolidating the branch network into 9 provincial offices in strategically important geographical locations which will also result in a reduction in operating costs. Importantly, the consolidated branch network’s role will specifically focus on facilitating effective partnerships in their respective regions with corporate retailers, emerging farmers, government programs, as well as technical and financial intermediaries to leverage on high impact and high value chain finance deals. 12. Importantly, as part of the new strategy, Land Bank has decided to scale up financing support to emerging farmers in a sustainable and commercially viable manner through partnerships with large agriculture corporates that emphasize integrating emerging farmers in established value chains. The approach is anchored in identifying high-potential value chain projects in a given geographic region and securing buy-in from large agriculture corporates or technical partners to assist in supporting emerging farmers’ integration into the chain. The agriculture corporates will provide technical support (directly or indirectly) to the emerging farmers, building up their capacity to be sustainable suppliers to the chain. Land Bank has identified potential value chain projects and agriculture corporates to partner with in the grains, winery, horticulture and livestock sectors for this type of financing. 50 The new Corporate Banking unit is the former Business and Commercial Banking unit. 51 Information in Land Bank’s 2015 Annual Report is disaggregated by former three business lines i.e. B&CB, RCB and REM. For the purpose of analysis in this section, the financial information for RCB and REM is consolidated where appropriate. 43 13. The CB business line (formerly B&CB) is the corporate part of the bank and the most viable business line. The CB business line involves both direct and wholesale lending. Lending takes place primarily through intermediaries (cooperatives and agri-businesses). CB operates through two offices in Pretoria and Cape Town. The total portfolio of CB amounted to ZAR 31 billion in 2014/15. 14. Under the CB business line, Land Bank on-lends funds to its intermediaries at market related rates while under wholesale finance facility to emerging farmers under CDB, Land Bank has decided to on-lend funds to intermediaries at subsidized interest rates (though Land Bank at least covers its average costs of funds). Land Bank is currently reviewing its wholesale finance facility to emerging farmers pricing policy to allow Land Bank to breakeven on pricing by covering at least its average cost of funds and operating costs. Upon graduation from the program, which Land Bank expects to be within five years from the first engagement with the emerging farmer, it is expected that these clients will be able to pay market rates. 15. Both business lines contain a development portfolio with “development” referring to a focus on supporting historically disadvantaged population in line with Broad-Based Black Economic Empowerment (BBBEE). The total development portfolio of CDB is projected at 1.4 billion in 2016. Capital Adequacy, Portfolio Quality and Profitability Table 1: Overview of Land Bank Financial Performance as of end March 2015 1 Group Bank Return on Average Assets (ROAA) 0.76 1.12 Return on Average Equity (ROAE) 4.05 6.78 Cost to Income Ratio 56.11 54.93 52 Non-performing loan (NPL) ratio 3.72 3.72 53 Short-term liabilities / total financial liabilities 69.25 69.17 Short-term assets / total financial assets 36.11 36.60 Capital Adequacy (capital to total liabilities) 23.13 20.34 Capital Adequacy including Govt. Guarantee 39.83 37.13 1 Land Bank Group includes Land Bank, Land Bank Insurance Limited and Land Bank Life Insurance Company Limited. Capital 16. Land Bank’s capital consists of contributions made by the South African government from the budget. National Treasury has injected capital to the tune of ZAR 3.5 billion since 2009. In the absence of any statutory regulation prescribing the minimum level of capital adequacy ratio54 maintained by Land Bank, the bank uses a 20 percent benchmark which is informed by National Treasury’s guarantee conditions. As of March 2015, Land Bank has a capital to total asset ratio of 16.9 percent and capital adequacy ratio (total equity to total liabilities and guarantee) of 37.1 percent (25.9 percent in 2014). The increase is primarily due 52 NPLs are based on Land Bank methodology. 53 Short-term is defined as 12 months or less. 54 CAR calculation is based on National Treasury requirements for the guarantee and is calculated by summing total equity and dividing by total liabilities and the amount of guarantee. 44 to a guarantee of ZAR 4 billion provided by National Treasury. It is expected that a further increase in capital will likely be met through retained earnings. Importantly, following the organizational review, Land Bank is taking steps to align Land Bank financial soundness indicators including capital adequacy with international standards. From FY2016, Land Bank will adopt a minimum capital adequacy ratio based on the Basel II standardized approach framework. Portfolio Quality 17. There are three particularly noteworthy aspects as regards the assets side of Land Bank’s balance sheet: (i) a relatively high level of loans (93.1 percent of total assets) due to significant growth in the loan portfolio since 2011; (ii) declining but adequate levels of cash on hand and cash equivalents (3.5 percent of total assets) and (iii) a relatively small and stable level of investments (1.4 percent of total assets). Table 2: Land Bank Asset Composition (in %) 2012 2013 2014 2015 Loans as % of total assets 89.0 90.8 93.4 93.1 Cash on hand and due from credit 7.4 5.6 3.4 3.5 institutions as % of total assets Investments as % of total assets 1.0 1.0 1.0 1.4 18. Land Bank’s loan portfolio grew by about 10.3 percent, 22.3 percent, 24.1 percent and 45 percent during 2015, 2014, 2013 and 2012 respectively in line with the bank’s turnaround strategy. About 87 percent of the growth in the loan book in 2015 is attributed to the CB business line. The loan portfolio has performed relatively well compared to prior years when the bank was dealing with a legacy of high NPLs. NPLs (defined under Land Bank methodology- see Box 1 below) remain below 5 percent compared to the peak of 22.5 percent in 2009; this is due to consistent efforts to clean up the bank’s balance sheet as part of a strategy adopted in 2009 and partly due to recent significant growth in the loan portfolio. Of note, NPLs are highest in the bank’s previous RCB business line at 11 percent in 2015 though lower from 12 percent in 2014. The bank regularly monitors past due loans for all business segments to recognize early problems in the portfolio.55 In order to standardize its NPL definition and methodology, Land Bank adopted IFRS 9 – Financial Instruments in April 2015 under which all accounts past due by more than 90 days are classified as NPLs. Due to this change NPLs are projected to grow to 10 percent by 2019. 55 The information on restructured/ renegotiated loans is not available. 45 Box 1: Land Bank’s new and previous NPL methodology New NPL methodology With the adoption of IFRS 9 from April 01, 2015, the Bank now classifies its loans in three distinct stages: - Stage 1: Performing loans (typically loans that are current, or overdue for less than 30 days) - Stage 2: Under-performing loans (typically loans that are past due for more than 30 days); and - Stage 3: Non-performing loans (typically loans that are past due for more than 90 days). Previous NPL methodology NPLs are accounts downgraded in terms of Land Bank’s Asset Quality Classification Policy as follows: - Retail accounts impaired for more than 24 months; - B & CB accounts impaired for more than 6 months; - Retail accounts in arrears by at least two (2) annual contractual instalments; - Retail and B & CB accounts displaying a balance past the final due date; and - Accounts with the following Arrears Management Classification (AMS) categories: I. Legal II. Debt collection III. Insolvency IV. Pre-legal with AMS classification: –Debt collection –Deceased –Write-off or unprocessed. 19. The current provisioning coverage for NPLs is moderate with an absolute decline in provision levels compared to previous years, partly due to an absolute decline in the level of NPLs. The bank’s capital at risk (i.e. NPLs net of provision to capital) is moderate at 6.8 percent with significant improvement from 28 percent in 2011 due to the decline in NPLs and injection of capital by NT. Table 3: Land Bank – Analysis of NPLs, Renegotiated Loans and Provision (in %) 2011 2012 2013 2014 2015 NPLs to gross loans 11.1 6.4 4.9 3.21 3.72 Provisions to gross loans 3.9 1.7 2.0 1.6 2.5 Provisions to NPLs 35.0 39.7 41.2 51.3 67.8 Specific Provisions to NPLs 30 27 30 38.0 41.0 NPLs net of provision to capital 28.2 17.8 15.6 9.3 6.80 (negative value implies NPLs are more than 100% covered by provisions) Note: NPLs are based on Land Bank methodology and do not include LDFU loans. 20. Land Bank has single party exposure limits for each business segment (see Box 2 below). As at end March 2014, the bank has one client under CB for which the highest single exposure is 47.1 percent, which is above the maximum limit of 25 percent of capital defined by Land Bank’s credit risk policy. However, this client is categorized as a strategic partner and the breach in limit was approved by the Land Bank Board.56 Besides, the top 20 56 Land Bank revised its Credit Concentration Policy in May 2014 to define exposure limits in excess of 25 percent of capital for strategic partner loans wherein strategic partner is defined as partner that contributes/enables Land Bank to achieve its strategic commercial and development objectives. The change in 46 borrowers under CB account for 50.2 percent of the total CB loan portfolio, representing a relatively high concentration. However, this concentration is also partly attributed to the wholesale nature of lending under CB. Box 2: Land Bank Single Party Exposure Limits REM Single obligor R3 million Project Finance R5 million CDB Single borrower and/or group of related borrowers may not exceed 10 percent of the Bank’s capital and reserves calculated as of the end of each calendar quarter or R150 million (the lesser will apply). B&CB The aggregate of all loans and/or commitments extended by the Bank’s Business & Corporate Banking Division, to a single borrower and/or group of borrowers may not exceed 25 percent of the Bank’s capital and reserves calculated as of the end of each calendar quarter. Profitability 21. As shown below, earnings are positive and have improved significantly compared to losses in 2009. The bank’s cost to income ratio has improved significantly. The recent decline in the cost to income ratio is primarily due to a 6.5 percent decrease in staff costs and increase in interest income owing to rapid growth in the loan portfolio. The bank is currently reviewing its overall strategy to further reduce its operating costs. Although Land Bank does not have a mandate to maximize profitability, a positive net interest margin contributes to its sustainability. Table 4: Land Bank – Analysis of Profitability (in %) 2012 2013 2014 2015 ROAA 1.00 0.57 0.80 1.12 ROAE 4.76 3.08 4.77 6.78 NIM57 3.25 2.95 2.92 2.82 Cost to Income58 77.33 67.71 59.5 54.93 policy is also motivated by the ongoing consolidation in South Africa’s agriculture sector through mergers and acquisitions among large corporates. 57 Net interest income/average total assets. 58 Operating cost to operating income. 47 Funding 22. Land Bank is a non-deposit taking institution that funds its operations predominantly through short-term funding sources for lending to the agricultural sector due to limited availability of medium and long-term financing. As shown below, short-term promissory notes accounted for 40.5 percent of the bank’s liability structure in 2015 (reduced from 69.2 percent in 2013). As highlighted in table 2, there is a refinancing risk since short-term liabilities account for approximately 69 percent of total financial liabilities, however this ratio has improved compared to 75 percent in 2014. In 2013, the bank also received a ZAR 1 billion credit line from the AfDB to fund its lending portfolio. In addition in March 2015, National Treasury provided a ZAR 4 billion government guarantee to Land Bank to obtain funding from the financial market with an appropriate tenor to help lengthen the maturity profile of Land Bank’s financial liabilities. Under this project, Land Bank is looking to diversify its funding base and to increase the maturity profile of its liabilities. 48 Figure 1: Land Bank Liabilities Structure Credit appraisal and monitoring, risk management and internal control 23. Land Bank has detailed policies and procedures for credit appraisal and monitoring. The bank has a Board Credit Risk Committee, a Credit Risk Management Committee and Retail Credit Committees each of which have their specified mandates and approve credit up to certain thresholds. Box 3: Land Bank Credit Approval Limits Up to ZAR 20 million Commercial Credit Committee Between ZAR 20 million and ZAR 250 million CRMC Between ZAR 250 million and ZAR 1billion Board Credit and Investment Committee Above ZAR 1 billion Board 24. The credit analysis process includes an internal rating system of nine grades to guide decision-making, pricing, and monitoring on an individual and portfolio basis. The bank has a Credit Risk Monitoring Committee which monitors the credit risk taking activities and overall credit risk management. The bank also has a credit risk monitoring department which monitors the implementation of credit risk policies at committee levels and within each business segment. Though the bank has detailed policies and procedures for credit appraisal, the application of these procedures can be strengthened further to ensure consistency in credit evaluation processes across different clients. Under the new strategy, Land Bank is strengthening its credit appraisal and credit risk processes in line with international standards. 25. Land Bank uses an enterprise risk management framework to set the risk management strategy across the organization. Following the organizational review, Land Bank is in the process of strengthening the risk management function to allow for better segregation between operations and portfolio monitoring. The risk function will be spread across the risk department and investment management services (including client contract administration, portfolio performance management, workout and restructuring). The bank has a risk management department that is headed by the Executive Manager, Risk and monitors credit risk, compliance risk, liquidity/market risk, operational risk and systems risk across the bank. 26. Land Bank’s internal controls appear to be well managed, based on a presentation by the head of the internal audit department and a review of the bank’s management letters for 2013. The internal audit department consists of 12 staff including the head of internal audit 49 and possesses relevant qualifications and experience in internal audit, IT audit and forensic investigation. The head of internal audit reports to the Audit Committee which consists of independent directors. The internal audit department has a well-developed annual audit plan and a three year plan approved by the audit committee. Managerial Autonomy and Governance 27. Land Bank is fully owned by the South African Government. It is supervised by National Treasury and follows prudential guidelines as issued by its Board of Directors. It is consequently not prudentially supervised by the SARB. The bank is audited by the Auditor General. The Board has 12 members (10 non-executive directors, the Chief Executive Officer (CEO), and the Chief Financial Officer (CFO)) and is appointed by the Minister of Finance. In addition to the Board, five committees chaired by non-executive directors sat in 2014/15: Audit, Risk, Credit, ALCO and Human Resources and Remuneration. The bank has units providing typical business and corporate support functions including, among others, strategy, treasury, risk, IT, and legal. 28. Being a fully government-owned institution, Land Bank can be mandated by the government to support specific industries and companies, which may affect the sustainability of the bank. This was evidenced by the Department of Agriculture’s support for the REM business line, which was not sustainable from Land Bank’s perspective. However, in 2009 the supervision of Land Bank was transferred to National Treasury and since then Land Bank has implemented a comprehensive strategy that has put the bank on a sustainable path. Furthermore, the government and Land Bank are undertaking a strategic review of Land Bank’s future direction. Questions of strategic importance that may need to be addressed are the comparative advantage of wholesale versus retail lending, the long-term sustainability of currently unprofitable business lines, and the balancing between financial sustainability and achieving development impact. 29. Land Bank’s middle and senior management team make a positive impression.59 The individuals with whom the due diligence team met have relevant expertise and are familiar with international banking practices. The bank is making noteworthy progress in implementing international practices; this process is primarily led by management team members and middle management who have relevant industry and development finance experience. Prudential Policies, Administrative Structure and Business Procedures 30. National Treasury supervises key development finance institutions60 in South Africa including Land Bank. The supervisory approach differs markedly from SARB which adopted the Basel III supervisory framework in January 2013 in accordance with the reform agenda of international standard setting bodies such as the Group of Twenty (G-20) Forum, the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (Basel Committee). The main quantitative prudential criteria followed by Land Bank include a minimum capital adequacy ratio of 20 percent defined under Land Bank methodology as sum 59 The three members of the management board with whom the due diligence team met were the CEO, the CFO and the COO. 60 These include the Development Bank of Southern Africa, the Public Investment Corporation and Land Bank. 50 of total equity to total liabilities and the amount of guarantee by National Treasury. Additional criteria include a minimum liquidity ratio of 7.5 percent defined as liquid assets to short-term debt, a single party exposure limit of 25 percent of total capital, etc. As part of new strategy, in 2016 Land Bank has aligned its capital adequacy, liquidity, NPLs methodology and risk management functions with Basel II framework. 31. Since Land Bank is not governed by SARB’s commercial banking laws and regulations and is not subject to external regulatory oversight by the SARB, the main principles and areas of Land Bank activities are set out under the aforementioned Land Bank Act and the by-laws. In addition, Land Bank is a registered credit provider under the National Credit Act and follows the requirements set out by National Credit Regulator. Land Bank has detailed procedures relating to credit appraisal and monitoring, risk management and internal controls. 51 Annex 4: Implementation Arrangements REPUBLIC OF SOUTH AFRICA: Land Bank Financial Intermediation Project Project Institutional and Implementation Arrangements Project administration mechanisms 1. Land Bank will be responsible for project implementation and monitoring. The Chief Financial Officer has been designated as the primary counterpart for the project in Land Bank. He will be supported by a dedicated staff to manage the day-to-day coordination with the World Bank team. They will interact with the Chief Operating Officer and the respective operational teams to monitor project implementation and report to the World Bank. Dedicated staff in Land Bank have been identified for managing all aspects of the project, including reporting on implementation progress and monitoring and evaluation, ensuring compliance with environmental and social safeguards as well as with financial management and procurement arrangements. Extensive supervision by the World Bank team is planned during project implementation to support Land Bank and the PFIs. Figure 1 describes the project administration arrangements. Figure 1: Project Administration Arrangements Land Bank: CFO Designated staff Operational Fiduciary Head of Commercial Procurement Environmental / Social Development Banking Head of Corporate Financial Management Banking 52 Financial Management, Disbursements and Procurement Financial Management 2. The World Bank’s financial management team conducted a financial management assessment of Land Bank, the implementing entity of the project. The objective of the assessment was to determine whether the financial management arrangements: (a) are capable of correctly and completely recording all transactions and balances relating to the project; (b) will facilitate the preparation of regular, accurate, reliable, and timely financial statements; (c) will safeguard the project entity assets; and (d) will be subjected to auditing arrangements acceptable to the World Bank. The assessment complied with the Financial Management Manual for World Bank-Financed Investment Operations that was issued (retrofitted) on February 4, 2015 and the Africa Region Financial Management (AFTFM) Financial Management Assessment and Risk Rating Principles. 3. The conclusion of the assessment is that the financial management arrangements meet the World Bank’s minimum requirements under OP/BP10.00. The overall residual risk rating for Land Bank is Low. Project Description 4. The project is a financial intermediary loan of US$ 93 million to Land Bank and is meant to scale up financing, specifically to emerging farmers. This will be achieved by providing long-term financing for Land Bank, which will facilitate a broader and deeper financial intermediation by Land Bank and diversify its funding sources away from government. The project will address market failures in the provision of agricultural financing, access to finance for previously disadvantaged emerging farmers, and limited availability of medium to long-term financing. The project has one component: a Line of Credit for Agricultural Financing in the amount of US$ 93 million. 5. For the FM implementation of the project, Land Bank will use its existing FM system with appropriate oversight by the Board and the National Treasury. 6. The following table shows the identified FM risks and the proposed mitigation measures. The Risk Mitigation Assessment Risk Ratings are: H (High), S (Substantial), M (Moderate), L (Low). Table 1. Financial Management Risk Assessment and Mitigation Description of Risk Risk Mitigation Measures Condition of Residual incorporated in Project Effectiveness Risk/ (Risk) Implementation (Yes/No) rating INHERENT RISKS Country Level There is no perceived risk. No Low SA’s institutional and regulatory framework is robust, transparent, with a system of accountability and judicial independence. 53 Description of Risk Risk Mitigation Measures Condition of Residual incorporated in Project Effectiveness Risk/ (Risk) Implementation (Yes/No) rating Entity Level The entity is not familiar with and The World Bank will conduct a No Low therefore has limited knowledge of the comprehensive training on the FM World Bank’s FM and Disbursement and Disbursement policies and policies and procedures. procedures by effectiveness of the Loan Agreement. Project Level Due to the nature of the lending The entity has rigorous credit No Low operation, there is a risk of policies that led to low write-offs of irrecoverable debts. debts. Overall Inherent Risk Residual Risk: Low CONTROL RISK Budgeting There is no perceived risk. No Low The entity has a comprehensive budgeting process. Accounting and financial reporting No identified risk at this stage. No Low Land Bank prepares monthly financial statements which are reviewed and approved by appropriate governance committees. The entity uses the SAP accounting software, which is capable of producing the required financial reports. The Finance unit is staffed with professionally qualified accountants as the heads of different units. Internal Control No identified risk at this stage. No Low The entity has an effective Internal Audit Unit, whose Head has unrestricted access to the Chairman of the Audit Committee. Furthermore, the reviews of the audit reports have revealed a healthy control environment. Funds Flow There is a risk of no timely This is mitigated by the sound credit No Low disbursements to the beneficiaries as a policies and its adherence to them. result of likely delays in the credit Furthermore, the internal audit approval process. attends the adherence to the policies. Auditing No specific audit risk. PFMA requires No Low Land Bank to produce and submit annual audited financial statements by the 31 May of each year. Overall Control Risk Low Overall Risk Low 54 7. Strengths. The entity has matured FM systems that can manage any operation. The oversight function played by the different governance committees, the Board, and the government can be relied upon. 8. Weaknesses. It is the first time that the entity will be involved in the implementation of a World Bank financed project and hence there is no familiarity with the World Bank’s fiduciary guidelines. 9. Budgeting. The budgeting process starts at six months into the next financial year by distribution of the budget guidelines to all business units. The guidelines provide guidance on the key assumptions to be used on the budgeting process. For the loan books, projections for the next two financial years (2016/17 and 2017/18) are prepared based on the forecast loan book of the current financial year end (2015). The loan book projections are informed by Land Bank’s growth strategy as agreed by the Executive Committee and the Board. This growth is measured based on the net performing loan book taking into account the projected payouts, planned disbursements and new business opportunities. The rest of the organization follows a zero base budgeting process. The budgeting review and verification process is done by the Finance Unit together with all related business units before it is presented to Exco for approval. Once the Exco approves the budget it is presented to the Audit Committee, and then forwarded to the Board for approval. The budget is subsequently submitted to the National Treasury together with the three year plan. The sampled intermediaries also have adequate budgeting arrangements. 10. Accounting. The financial management responsibility rests with the Chief Financial Officer. The entity will use its own computerized accounting software called SAP to record and report on the use of the loan proceeds. SAP is reputable and sophisticated software and reliance can be placed on it. The visited intermediaries also have reliable computerized accounting software. The Finance Unit has competent staff to handle the FM function with appropriate segregation of duties. The senior managers are qualified chartered accountants. 11. Internal Control. Due diligence on lending to PFIs will be governed by the entity’s credit management framework which includes amongst the policies: a credit policy, risk grading policy, risk appetite policy, arrear management policy, and bad debt recovery policy. These policies spell out the processes followed in evaluating and approving the applications, monitoring mechanisms on active loans, and reporting and further disbursing to the intermediaries. 12. Internal Audit. The internal audit department is headed by the Head Internal Audit, who is a qualified chartered accountant. The Head Internal Audit reports to the Board functionally, through the Internal Audit Committee, and to the CEO administratively. The internal audit executes its functions through the approved annual plans. Review of the internal audit reports for the year under review (2014/2015) indicated that reliance can be placed on the internal audit as well as the internal control environment. The last independent quality assessment review carried out by The Institute of Internal Auditors was in 2013 and the organization received “GC” (General Conforms). The internal audit also attends the evaluation and award process for the loans as an observer. 55 13. Financial Reporting. The project will produce and submit unaudited interim financial reports (IFRs) to the World Bank on a quarterly basis. These reports are designed to provide sufficiently detailed information and will include:  A narrative summary of the project implementation highlights  Sources and uses of funds by disbursement categories  The Designated Account Activity statement Land Bank’s accounting system is capable of producing the quarterly reports. The assessment noted that the organization produces monthly management accounts for the Exco and quarterly report for submission to the National Treasury. 14. Auditing arrangements. The Public Financial Management Act of South Africa stipulates that Land Bank prepares and submits the Annual Financial Statements (AFS) to the National Treasury and the Office of the Auditor General by May 31st each year. The AFS are supported by a comprehensive operational and performance information report. The AFS are prepared in accordance with International Financial Reporting Standards (IFRS) and the audit is conducted with the International Standards on Auditing. Land Bank has received unqualified audit reports in the year ended 2013, 2014, and 2015. The review of the management letters, performance information and internal audit reports gave assurance that reliance can be placed on the governance processes. 15. Land Bank’s audited financial statements will be acceptable to the Bank without a requirement for a separate audit report for the project. Land Bank will prepare the audit terms of reference in consultation with the World Bank to ensure adequate coverage of the scope of the audit and confirm that the World Bank’s fund have been used for the intended purposes. The audit report will be submitted to the World Bank within six months of the end of the financial year, namely, September 30 each year. The submission will include the auditors’ report, management letter, and management responses thereto as an attachment to the annual financial statements. 16. Office of the Auditor General. Reliance can be placed on the office of the Auditor General. Audits are carried out based on International Standards on Auditing and the office observes standards set in INTOSAI (International Organization of Supreme Audit Institutions). Audit reports undergo rigorous processes before they are issued to the public. The report is presented to the audit committee which is comprised of qualified independent members for review and endorsement. 17. Governance and Accountability. Land Bank’s governance arrangements and the oversight provided by the government through the National Treasury, various government departments, parliament through the portfolio committees and as well as the general public are considered adequate for the implementation of the project. The organization has a “tip-off and anonymous” (whistle blowing) policy to encourage staff and the public at large to report on suspected irregularities. 18. Overall conclusion. Based on the proposal to use Land Bank’s FM system for accounting and reporting on the project’s use of funds, the overall conclusion of the assessment of the system is that the proposed FM arrangements meet the World Bank’s minimum requirements for financial management under OP 10.00. 56 Disbursements 19. Funds flow and disbursement arrangements. Upon the signing of the Loan Agreement, the World Bank will open a Loan account in its books, in the name of the lender for the signed amount of US$93 million. Funds will flow from the World Bank Loan Account through the World Bank’s Treasury upon the request from the borrower into a Rand denominated Designated Account (DA) maintained by Land Bank at a preapproved commercial or financial institution acceptable to the World Bank. Land Bank will disburse through this account to the approved intermediaries. 20. Disbursement arrangements. The project will use the Advance Disbursement method whereby withdrawals from the loan account will be deposited in the DA for payment of the World Bank financed eligible expenditures. Disbursements from the loan account will be based on quarterly IFRs which will contain a 2 quarterly forecast to indicate the approved amount to be drawn down from the loan account. (i) Upon effectiveness of the loan agreement and the submission of a withdrawal application, signed electronically by the authorized signatories whom would have been formally mandated to sign applications, the World Bank will disburse an amount equivalent to six months expenditures into the DA based on the prior approved cash flow forecast in the IFR. Subsequent disbursements will be based on three or six months estimated expenditures, taking into account the balance in the DA at the end of each quarterly reporting period. The reimbursement disbursement method can be an alternate should the entity use its own funds to pay World Bank eligible expenditures as well as the use of the direct payment method of disbursement whereby the World Bank will pay directly to a third party. (ii) Retroactive financing of an amount not exceeding 20 percent of the total loan amount could be made for eligible expenditures under the Project. Such financing covers a period of a date not exceeding 12 months prior to the signing of the loan agreement. Payment for retroactive financing is for activities that comply with the World Bank guidelines and procedures for the Project, including fiduciary arrangements (for procurement, financial management, anti-corruption, social and environmental safeguards), and other criteria and arrangements agreed to with the Bank. If the existing agreements between Land Bank and eligible PFIs do not include the requirements agreed with the Bank, Land Bank agrees to incorporate the new requirements through an addendum to the pre-existing agreements. (iii) On-lending to the intermediaries will be based on the organization’s credit policy whereby applications will be received, assessed and approved. (iv) The use of funds in the DA for eligible expenditures will be reported on in the quarterly IFR’s together with the submission of the authorized Applications for Withdrawal. At this stage the expenditures will be recorded in the World Bank’s loan account as utilized. Unutilized funds at the end of the project will have to be returned by the Borrower to the World Bank’s loan account and will therefore not form part of the final loan amount to be repaid. Procurement 57 21. The South Africa Land Bank Financial Intermediation Loan (FIL) received World Bank management’s clearance on March 14, 2016 to proceed as an early adopter of the World Bank’s New Procurement Framework (NPF). Specifically, the operation is a FIL where the final recipients of loan funds are private sector enterprises to which the New Procurement Framework does not apply as per Section I.1 of the World Bank Policy, “Procurement in IPF and Other Operational Procurement Matters”. Independent oversight for providing assurance that funds have been used for the intended purpose will rely on the external audit conducted by the Auditor General of South Africa. The Sub-Loan Agreements (SLAs) between Land Bank and the PFIs will include the World Bank’s audit rights and the Anti-Corruption Guidelines of January 2011, which will also be made applicable to all beneficiaries of the sub-loans. Environmental and Social (including safeguards) 22. In line with OP/BP 4.03 World Bank’s Performance Standards for the Private Sector Projects, the Project is classified as F1-2 implying that the environmental and social risks and impacts generated from implementing the sub-loans are moderate. The World Bank’s Performance Standards for the Private Sector Projects will apply and would prevail in case the national environmental policies are not consistent with the World Bank PSs. The Performance Standards that are applicable to the Project include, PS1: Assessment and Management of Environmental and Social Risks and Impacts, PS2: Labor and Working Conditions, PS3: Resource Efficiency and Pollution Prevention, PS4: Community Health, Safety and Security, and PS5: Land Acquisition and Involuntary Resettlement. PS1 and PS3 are applied because of Land Bank’s involvement in financing agricultural activities that could potentially have harmful consequences on the environment, including through pollution. PS2 and PS4 are applied to Land Bank and its intermediaries to ensure that the labor and working conditions as well as the health, safety and security standards are adequate. PS5 applies because Land Bank is financing projects of land reform beneficiaries even though Land Bank is not supporting land acquisition under the REM program. Environmental 23. Environmental risks and impacts inherent to the agriculture and agribusiness industry are largely related to effluent discharges from use of pesticides/herbicides in controlling weed infestation, use of fertilizer to increase crop productivity, pollution of soil and water resources from runoff, occupational health and safety of workers, efficient use of water and energy resources, solid waste disposal, and noise and air emission from industrial facilities. Institutional Framework 24. Land Bank has a commitment to environmental and social management through the Environmental and Social Management System which was approved by the Land Bank Board in 2015, and through the credit application review and monitoring processes. The Environmental and Social Management System (ESMS) is anchored in the national environmental and social laws and regulations, particularly the National Environmental Management Act (Act 107 of 198). The World Bank’s due diligence assessed the capacity and knowledge of Land Bank to implement the Environmental and Social Management System (environmental screening, assessment, mitigation, review, monitoring and reporting) 58 across the PFIs, and the effectiveness in implementing, monitoring and reporting according to its ESMS. Furthermore, the World Bank assessed the screening occurring in the context of loan applications on land status and various social indicators. The assessment also reviewed any potential gaps between Land Bank’s ESMS and the World Bank’s PSs. Land Bank has an environmental and social coordinator who oversees the implementation of the sub- projects. The overall capacity and knowledge related to the application of World Bank Performance Standards is generally good and based on the team’s assessment, Land Bank’s Environmental and Social Management System is adequate. Technical assistance will be provided to strengthen the capacity and knowledge of Land Bank through the existing AfDB loan. 25. Screening for environmental risks and impacts is carried out by the Land Bank during the credit approval process. Mitigation measures to address the risks and impacts are also identified through this process. Compliance monitoring and enforcement is carried out by the Department of Environmental Affairs, Department of Water Affairs and the Department of Agriculture following their respective mandates in accordance with the EIA licenses, Water Licenses and Soil Conservation Act. Land Bank has staff in the field who report on other aspects of compliance with loans, including provision of detailed information on the limiting factors on agricultural productivity, and on livelihoods. Compliance monitoring and enforcement is carried out by the Department of Environmental Affairs, Department of Agriculture, and the Department of Water Affairs. The main impediment to effective and meaningful implementation and enforcement of the environmental and environmental related laws are due to the fragmentation among regularity institutions and licensing agencies to the effect that no single institution can take enforcement actions effectively. The Environmental and Social Operational Manual will guide Land Bank in screening, monitoring and reporting of the sub-loans. Implementation of the Environmental and Social Management System 26. PFIs will use procedures included in the Environmental and Social Operational Manual in reviewing and appraising the sub-loans, and to inform the beneficiaries of environmental requirements for sub-loan appraisal, so that the subprojects can be implemented in an environmentally sound manner. The procedures and requirements will incorporate the Republic of South Africa regulatory requirements for Environmental Review and the World Bank’s Performance Standards for Private Sector. The procedures will primarily comprise of Environmental Screening, Environmental Impact Assessment, and Environmental Mitigation where necessary. The Environmental Screening will be carried out by the PFIs at an early stage in their sub-loan review procedures to determine the appropriate environmental risk category for the enterprises, and may require the contracting of external expertise in carrying out the appropriate E&S instrument depending on the level of risk and impact of the sub-loan on the environment. Following screening, an Environmental Impact Assessment (EIA) in line with the environmental classification of the sub-project may be recommended. 27. The beneficiaries will be responsible for carrying out any environmental analysis and for confirming that the proposed sub-projects comply with the national environmental laws and regulations, and the World Bank’s Performance Standards for the Private Sector, and for obtaining the necessary clearance from the appropriate licensing authorities. Once the analysis is performed and recommendations incorporated into the sub-project, the PFI will 59 appraise the proposed sub-loan package which would include, where appropriate, an environmental mitigation plan. The implementation of the mitigation plan will be monitored by the PFI. The overall review process will be monitored by Land Bank. Social 28. Land Bank has established procedures for collecting a range of detailed data on financial intermediary performance. This data collection could be systematized into monitoring on social safeguards and social sustainability with some modifications to existing practices. 29. A review of documentation filed by the intermediaries indicates a number of social dimensions on which information is collected. Submission memos for loans include detailed information on the number of emerging farmers, their assets, racial demographics of commercial firms’ work force (including breakdown between employees and management), status, ownership, and amount of land (including differentiation among usage). 30. The consolidated monitoring and evaluation reports track metrics related to the mentoring programs designed to build capacity of emerging farmers. Indicators used are: number of farmers receiving financial and technical mentorship, attending training programs, and participating in other skills building activities. On the grassroots level, approximately thirty Agricultural and Environmental Services (AES) officers monitor performance of farmers who are loan recipients and provide detailed reporting on land use, other debts, farm income, etc. The AES officers are the first interface between the farmer and the financial system. Land Bank utilizes a Production Value and Inspection Report (known as Form 90). This report could be readily adapted to incorporate reporting on environmental and social safeguards. 31. Site visits were conducted during preparation to the six Land Bank financial intermediaries that were appraised during project preparation. An additional site visit was conducted to a prospective Land Bank client which can be considered based on its operations as a typical example of a Land Bank client, although they do not provide credit to their clients/ beneficiaries. The site visits demonstrated the extent to which the intermediaries work closely with their clients. Support includes: provision of extension services, mentoring (as mentioned above), community social programs, and local infrastructure. During the site visit, stakeholders demonstrated detailed anecdotal knowledge of the success or failure of various emerging farmers in the vicinity. The REM program does not finance acquisition of land, though intensification of use is supported. REM program participants lease their land. 32. The AES officers in the field work closely with colleagues in the Department of Water Affairs, Department of Environmental Affairs, Department of Agriculture and Department of Rural Development and Land Reform. Land Bank requires licenses such as: water use licenses, environmental impact assessments, and land title. In practice and in the field, AES officers’ normal inspection of farms may identify compliance issues to other colleagues with responsibility for enforcement, although Land Bank staff has no authority or jurisdiction in those areas. Enhancements in implementation of the safeguard guidelines adopted by Land Bank could build upon these existing practices with a formalized referral system to appropriate authority. 60 33. Information collected by Land Bank at the various levels incorporates social indicators, but these indicators are not tracked or analyzed systematically from the earliest point of entry to ongoing monitoring. There is an opportunity to use this information to measure the success of various interventions intended to improve livelihoods of emerging farmers as well as to monitor land usage more generally. Integrating social impact and social safeguards indicators into an overall M&E system will be addressed through an integrated Operational Manual for the project. Monitoring & Evaluation 34. Land Bank will monitor and evaluate progress against the proposed indicators through regular reports. Land Bank will report on the PDO and intermediate indicators as set out in Annex 1 on a semi-annual basis. The data will come from Land Bank’s internal reports and from information provided by the PFIs. The specific reporting templates will be defined in the Project’s Operational Manual. Land Bank’s financial performance will be audited annually by the Auditor General. 61 Annex 5: Implementation Support Plan REPUBLIC OF SOUTH AFRICA: Land Bank Financial Intermediation Project Strategy and Approach for Implementation Support 1. This implementation support plan (ISP) describes how the World Bank will support the risk mitigation measures and provide the technical advice necessary to help the client achieve the PDO. This ISP also identifies the minimum requirements to meet the World Bank’s fiduciary obligations. It has been developed based on the nature of the project and its risk profile. Formal implementation support visits and field visits will be carried out semi-annually and focus on the areas detailed below. Given that Land Bank is a new client and that the PFIs are not familiar with World Bank procedures, supervision will be intensive in the first years of implementation and go beyond the two formal implementation support visits as needed. This will be facilitated through leveraging synergies with supervision visits to other projects under implementation in South Africa and the sub-region. 2. There will be strong coordination between the Land Bank and the World Bank, the borrower and the implementing agency. The World Bank task team will bring a comprehensive set of instruments and expertise to advice on project activities. It will work closely with Land Bank to ensure project success. The team plans two implementation support visits on average per year to South Africa as well as additional visits facilitated by leveraging synergies with supervision visits to other projects under implementation in South Africa and the sub-region, as well as ongoing dialogue via video and audio conferences and email. 3. In addition to implementation support visits and ongoing engagement, the World Bank project team will carefully monitor the progress of project implementation and achievement of results via formal and informal reporting channels. Formal reporting channels include Implementation Status and Results reports (ISRs), and results monitoring reports supplied by Land Bank (more detail in Monitoring and Evaluation below). Informal channels include interaction with direct beneficiaries of the project, reports from local media, and country economic analysis. 4. The project team will also take a flexible approach to ensure that it meets client needs as circumstances evolve. The World Bank will continue a close policy dialogue with the implementing agency, NT, DAFF, DRDLR, and other stakeholders. 5. Financial Management. The World Bank will conduct risk-based financial management supervision, initially after every six months (as part of implementation support visits), and later at appropriate intervals based on assessed risk. During project implementation, the World Bank will supervise the project’s FM arrangements in the following ways: i) review the project’s quarterly unaudited interim financial reports, the internal audit reports, the annual audited financial statements complemented by the operational and performance information report , the auditor’s report, and remedial actions recommended in the auditor’s management letters; ii) during the World Bank’s onsite implementation support visits, review project accounting and internal control systems, budgeting and financial planning arrangements, and disbursement management and financial flows, as applicable; and iii) at other times when applicable, participate in discussions with the client, checking that payments are done strictly in accordance with contract provisions, and look into any areas requiring attention. 62 6. Procurement. The operation is a FIL where the final recipients of loan funds are private sector enterprises to which the New Procurement Framework does not apply as per Section I.1 of the Bank Policy, “Procurement in IPF and Other Operational Procurement Matters”. Independent oversight for providing assurance that funds have been used for the intended purpose will rely on the external audit conducted by the Auditor General of South Africa. There will be no procurement implementation support missions. 7. Safeguards. During project implementation, the World Bank will semi-annually supervise the project’s environmental and social safeguard arrangements in the following ways: 1) review of Land Bank’s Form 90 (Production Value and Inspection Report), documentation submitted by intermediaries on social dimensions, reports from Land Bank’s AES officers from on-site visits, and any environmental reports from the Department of Environmental Affairs, Department of Agriculture, and the Department of Water Affairs, and 2) assess compliance with the Operational Manual. The World Bank will also seek updates on the support from AfDB targeted at further strengthening Land Bank’s environmental and social management capacity. 8. Monitoring and Evaluation. The indicators primarily focus on measuring behavior change at Land Bank, not at the beneficiary-level. The World Bank will review the updated result framework submitted semi-annually by Land Bank as part of progress reports. The team leader will discuss the progress and deviations with Land Bank to identify any areas where additional help from the World Bank is needed. Land Bank and World Bank will also use results data to build awareness of project results among key beneficiaries and counterparts. An impact evaluation would be the primary tool to collect beneficiary-level data and evaluate outcomes. However, such an evaluation is not incorporated into this project. The results framework evaluates the changes within Land Bank as a result of the project. 9. The tables below detail the key areas of focus of the implementation support activities for the first 48 months of the project’s implementation. These have been determined based on conversations with the client and an understanding of the priority activities to be implemented during the first year of the project. Future updates will be based on progress on project activities, timing of major new activities, and the expertise required to address any issues that arise, among other things. 63 Implementation Support Plan Time Focus Skills Needed Resource Partner Role Estimate Year 1 Project/Task TTL / Financial Sector 12 weeks CFO Management Specialist (HQ) Implementation Support Financial Sector Specialist 8 weeks CFO (Pretoria) Financial Management Financial Management 2 weeks Financial Management Supervision Specialist (Pretoria) Performance Standards Environmental & Social 2 weeks Economic Research & Supervision Specialists (HQ + Pretoria) Business Intelligence Dept (Environmental & Social focused- team member) Agriculture Value Chain GFADR 1 week CFO Specialists (2) (each) Treasury transactions for Treasury Specialist 1 week Treasury conversion to ZAR (HQ) Years 2 Project/Task TTL / Financial Sector 24 weeks CFO –5 Management Specialist (HQ) Implementation Support Financial Sector Specialist 16 weeks CFO (Pretoria) Financial Management Financial Management 4 weeks Financial Management Supervision Specialist (Pretoria) Performance Standards Environmental & Social 4 weeks Economic Research & Supervision Specialists (HQ + Pretoria) Business Intelligence Agriculture Value Chain GFADR 3 week CFO Specialists (2) (each) Treasury transactions for Treasury Specialist 3 week Treasury conversion to ZAR (HQ) Skills Mix Required (over 60 month period) Skills Needed Number of Staff Number of Trips Comments Weeks TTL/Financial Sector 36 10 Based in HQ Specialist Financial Sector Specialist 24 0 Based in Pretoria Financial Management 6 0 Based in Pretoria Specialist (Pretoria) Environmental Specialist 6 0 Based in Pretoria Social Specialist 6 10 Based in HQ Agriculture Specialist (2) 8 (total) 6 (total) Based in HQ Treasury 4 1 Based in HQ Name Institution/Country Role Land Bank Development Bank / South Africa Borrower and Implementing Agency 64 Annex 6: Economic and Financial Analysis REPULIC OF SOUTH AFRICA: Land Bank Financial Intermediation Project A. Financial Analysis 1. The financial analysis projects that Land Bank will grow its loan book considerably through 2020. The strongest growth is expected in the development portfolio. The development portfolio provides financing to the disadvantaged population in line with Broad-Based Black Economic Empowerment (BBBEE) and emerging farmers and is represented in both the CB and CDB business lines. 2. Based on Land Bank’s decision to at least cover its costs of funds for new wholesale loans to emerging farmers under CDB, it is projected that Land Bank can significantly improve the financial sustainability of the wholesale finance facility to emerging farmers on a cost-recovery basis by 2020. By realigning its operations around four strategic pillars, and charging average cost of funds (currently at 7.5 percent) on new loans, Land Bank is projected to break even on its wholesale finance facility to emerging farmers by FY2020 with regard to recovering its average cost of funds. However, even under the new scenario, the previous REM business line will not recover its operational expenses or charge credit risk premiums unless the pricing policy is revised further.61 Given that the previous REM portfolio is small at this stage compared to the overall loan portfolio and will remain so, even with its projected growth through 2020, this will have limited impact on the overall financial sustainability of Land Bank. B. Economic Analysis 3. The project objective is to sustainably scale up Land Bank’s financing, specifically to benefit emerging farmers. The project has one component: a line of credit for agricultural financing in the amount of US$93 million, with 70 percent of the funding intended for wholesale lending (about US$65 million) and 30 percent for direct lending (about US$28 million) although the ratios will be kept flexible. 4. The economic analysis aims to assess the contributions of wholesale lending under the CB and CDB business lines to job creation and income generation.62 In particular, the economic analysis aims to quantify the costs and benefits that accrue from providing a line of credit for agricultural financing by calculating the Net Present Value (NPV) and Economic Rate of Return (ERR). The analysis is based on Land Bank data and information, including for the estimates on job creation and income generation which Land Bank estimates based on its beneficiary information. 5. The economic analysis does not assess the contribution of direct lending. Given this is a new line of business, no sufficient data exists on which to base the analysis. A potential analysis is further complicated by the fact that likely only a small number of projects will be financed in this window and the contributions to job creation and income generation will depend on the exact project. The analytical model 61 The net loss ratio for the REM business line is assumed to be 2 percent. 62 For ease of calculation, the economic analysis assumes a loan amount of US$95 million. 65 6. The model considers the net cost and benefits of agricultural financing due to the World Bank’s line of credit for wholesale agricultural financing. While Land Bank plans to significantly grow its loan book, particularly the development loan portfolio, this analysis is limited to the net cost and benefits arising directly from the US$65 million line of credit for wholesale lending under this project. For simplicity, a disbursement equivalent to US$65 million in ZAR is assumed, with the equivalent in ZAR of US$13 million being disbursed in each of the first five years. All calculations are in ZAR. For ease of conversion and comparison, an exchange rate of US$1 = ZAR 15 is assumed.63 Given the structure of the loan, the economic analysis considers the net cost and benefits over 15 years, the life of the loan. The economic analysis assumes that 80 percent of the disbursement (about US$ 52 million) will go to farmers in the CB business line and 20 percent (about US$ 13 million) to farmers in the wholesale finance facility to emerging farmers under the CDB business lines. Both components undergo the same step-by- step process and for the overall results, the two components are added up. To arrive at the cash- flow for a given year, net revenues minus net costs are calculated. The size of the cash-flow is calculated according to the parameters explained in the text and reported in Tables 2 and 3. 7. The cost component of the analysis considers the net cost for Land Bank in extending wholesale loans to PFIs which on-lend to end-borrowers. In particular, the cost component models the cost of the World Bank line of credit to Land Bank while taking into consideration the interest and fees Land Bank earns from extending wholesale loans to PFIs as well as any net losses Land Bank incurs on its loans. Specifically, total net costs for each year are calculated as follows (categories in parenthesis represent income and reduce net costs): Interest due to World Bank from Land Bank + Guarantee fee due to National Treasury from Land Bank + (Fees earned by Land Bank from PFIs) + (Interest earned by Land Bank from PFIs) + Net loss to Land Bank = Total net costs 8. The benefit component of the analysis considers the net benefits arising from the loan to income generation, job creation, and tax revenue while accounting for the interest payments made by the end-borrowers. The net benefits are calculated based on the estimated difference in cash flow to beneficiaries, i.e. both the end-borrowers of the loan and the monetized value of the new jobs created. As a result of the project, individual farmers, the end-borrowers of the funds, will be able to expand their production and/or improve their productivity. This revenue additionality due to the loan, compared to the counterfactual of no loan, translates into an increase in value added and creates additional jobs for a specified number of years after which the loan has been granted to the end-borrower. 64 In particular, total net benefits for each year are calculated as follows (categories in parenthesis represent an expense and reduce net benefits): Additional value-added for end-borrower of loan after taxes + Tax income 63 The end 2015 exchange rate is US$1 = ZAR 15.48. 64 The net increase in value added to the end-borrower depends on the interest rate charged relative to the revenue additionality. And while the revenue additionality for the end-borrowers ends after the specified number of years, the level of revenue for end-borrowers is assumed to be permanently higher. 66 + Monetized value of jobs created + (Interest payments by end-borrower of loan) = Total net revenues 9. Total net revenue is calculated at the individual farmer level and summed up over the number of farmers receiving a loan in each year to arrive at the aggregated numbers for each year. The number of farmers receiving a loan depends on the overall allocation of money to the CB and CDB business line and the average loan size and specified number of years for repayment. Loans are extended to end-borrowers on a rolling basis. Tax income and the monetized value of jobs created are a function of the additional revenue to the end-borrower (tax income = tax base times tax rate times revenue additionality; monetized value of jobs created = jobs created per ZAR times revenue additionality). Revenue additionality to the end-borrower in each year is calculated as follows: revenue with loan minus revenue without loan (the counterfactual; different growth rates in revenue with and without loan for specified number of years). Value-added additionality is calculated as the difference in revenue with loan multiplied by (1 minus average cost fraction; i.e. percent that will result in value added) and revenue without loan multiplied by (1 minus average cost fraction). Taxes are subtracted from the additional value added to arrive as value added for end-borrower of loan after taxes. Interest payments by end borrowers of the loan are equal to the size of the loan times the interest rate. 10. According to the economic analysis, the ERR of this component is expected to be 31 percent. The NPV is expected to be approximately ZAR 317 million (US$20.4 million) assuming a discount rate of 10 percent (ZAR 248 million or US$16.0 million assuming a discount rate of 12 percent) as shown in Table 1. The positive valuation indicates that the returns on investment exceed the returns that could be otherwise earned by World Bank financing. As such, the improvements in the income of end-borrowers and the monetized value of jobs created, net of interest costs paid by end-borrowers, outweigh the cost of investment under this component. Table 1: Economic Analysis NPV (10% discount rate) ZAR 317 million NPV (12% discount rate) ZAR 248 million ERR 31% 11. The number of jobs created by this subcomponent is estimated to be 8,086 over 15 years. 12. The economic analysis of the line of credit is based on the following assumptions. The assumptions for the cost component of the analysis are summarized in Table 2 and the assumptions for the benefit component in Table 3.  Data and assumptions on the characteristics of the average CB and CDB farmer are estimates based on existing Land Bank data and supplemented with expert opinion. In many cases, numbers were adjusted downwards to arrive at more conservative estimates. 67  The average annual revenue growth without a loan is assumed to be 6 percent, in line with South Africa’s current CPI-based inflation. Wage growth is assumed to be 8 percent based on the fact that minimum farmworker wage legislation mandates increases in the minimum farmworker wage of at least CPI plus 1.5 percent per year.  The average annual additional growth increase due to the loan is based on the assumption that farmers will need to earn at least the cost of the loan to justify the expense of the loan. It is furthermore assumed that the growth rate increase of CDB farmers is higher than for CB farmers since they are starting from a smaller base. Table 2: Cost Component Assumptions CDB CB (ZAR 150 (ZAR 600 million) million) Interest rate due to World Bank by Land Bank (% of loan) 65 7.75% 7.75% Guarantee fee due to National Treasury by Land Bank (% of loan) 0.33% 0.33% Interest rate charged to PFIs by Land Bank (% of loan) 7.50% 8.75% Fees charged to PFIs by Land Bank (% of loan) 1.00% 0.50% Net loss ratio (% of loan) 2.00% 1.00% Table 3: Benefit Component Assumptions66 CDB CB Average loan size ZAR 2,000,000 ZAR 10,000,000 Average annual revenue ZAR 1,500,000 ZAR 10,000,000 Average costs (% of revenue) 90% 80% Average annual growth without loan 6.0% 6.0% Average annual additional growth increase due to loan 13.0% 11.0% Number of years that see additional growth increase due to loan 5 5 Tax base (% of end-borrowers) 20% 20% Tax rate 29% 29% Average number of employees per end-borrower (FTE) 30 5 Average annual salary per employee ZAR 25,000 ZAR 36,000 Average annual growth in wages 8% 8% Jobs created per ZAR increase in revenue 0.0000050 0.0000005 Interest rate charged to end-borrowers by PFIs (% of loan) – base case 11.50% 10.75% 65 Based on current market rates and the assumption that Land Bank will select the option of financing based on a 3- month Jibar plus spread. 66 Assumptions based on Land Bank estimates from beneficiary information. 68 13. A sensitivity analysis tests the robustness of the economic analysis with regard to changes in key assumptions. The findings of the sensitivity analysis are summarized in Box 1 and assume that the variable in question changes while the values of all other variables remain unchanged. Box 1: Sensitivity Analysis for Key Assumptions 1. Additional sales growth due to loan  a 2 percentage point increase (decrease) results in an increase (decrease) of the ERR to 46% (16%) 2. Wage growth  a 2 percentage point increase (decrease) results in an increase (decrease) of the ERR to 32% (31%) 3. Net loss ratio  a doubling of the ratio to 2% for CB and 4% for CDB results in a decrease of the ERR to 24%  14. The sensitivity analysis reveals that the major impact on the ERR for this subcomponent under the base case scenario comes from the additional sales growth assumption. Changes in sales growth additionally affect the increase in income for each end- borrower as well as the number of jobs created as a result of it. The doubling of the net loss ratio also has a potentially significant effect while changes in wage growth have a limited effect. C. Rationale for public financing 15. Access to financial services is consistently raised as a critical constraint by the private sector in South Africa, particularly in agriculture. The project addresses the following market failures, justifying public financing, as follows: i. Agricultural lending amounts to about 1 percent of commercial bank’s total loan book of ZAR 2,970 billion67. Commercial bank financing for agriculture is therefore comparatively low while farmer’s demand for affordable financing appears to be large. The resulting financing gap justifies public financing given that it will play a critical role in expanding financing for agricultural development and help them become more sustainable, grow and create jobs. ii. Without adequate collateral, emerging farmers face challenges in accessing credit from traditional commercial banks. The Land Bank’s development portfolio is designed to specifically provide financing to disadvantaged population in line with Broad-Based Black Economic Empowerment (BBBEE) and emerging farmers who do not have collateral as security so that these farmers can later become commercially viable. iii. Land Bank predominantly relies on short-term funding sources for lending to the agricultural sector due to limited availability of medium and long-term financing. The availability of long-term financing under the project will help Land Bank in improving its asset-liability management and deepening its financial intermediation capacity. D. World Bank’s value added 67 DAFF: Abstract of Agricultural Statistics, 2014. 69 16. The World Bank has significant international experience helping development banks to achieve their developmental objectives in a sustainable manner. In particular the World Bank has helped development banks in establishing/expanding their wholesale financing mechanism, which is one of the focus areas under this project. With the support of the World Bank, Land Bank will be able to access long-term funds which will reduce its reliance on government funding sources and will help Land Bank in deepening its financial intermediation capacity. In addition, the project will help Land Bank increase financing for its development portfolio which supports disadvantaged population in line with Broad-Based Black Economic Empowerment (BBBEE) and emerging farmers and land reform beneficiaries. Under the project all financing will be channeled to the development portion of Land Bank’s portfolio. 70 Annex 7: Financial Sector, Agricultural Financing and Extension Services Overview REPUBLIC OF SOUTH AFRICA: Land Bank Financial Intermediation Project Financial Sector Overview 1. South Africa has an advanced and diversified financial sector, comparable to those in developed countries. The sector includes a sophisticated banking sector, well-established capital markets, and one of the deepest insurance and pension markets in the world. As of end 2014, total assets of financial institutions constitute approximately 292 percent of GDP. The banking sector constitutes approximately 36 percent of the financial system assets, with pension funds and long-term insurers contributing 35 and 18 percent, respectively.68 Table 1: Snapshot of financial institutions in South Africa Dec. 2011 Dec. 2012 Dec. 2013 Dec. 2014 Assets R 8.18 tn R 9.25 tn R 10.25 tn R 11.76 tn Of which…: Banks 3.43 tn 3.68 tn 3.87 tn 4.18 tn Long-term insurers 1.80 tn 2.06 tn 2.31 tn 2.27 tn Pension funds (public & 2.86 tn 3.34 tn 3.77 tn 4.20 tn private) Sources: SARB Bulletin, Bloomberg, BIS, Haver, World Bank, South Africa FSAP Dec 2014. 2. As shown in Figure 1, the ability of the financial sector to channel funds to the private sector (ratio of private sector credit to GDP), is markedly higher than in peer countries and is the highest in the region. Domestic bank deposits/GDP, on the other hand, is only modestly higher compared to the peer countries but remains significantly higher than the region. Figure 1: Domestic Bank Deposits and Private Credit / GDP comparison69 Domestic Bank Deposits / GDP (%) Private Credit / GDP (%) 80.0 100.0 80.0 60.0 60.0 40.0 40.0 20.0 20.0 0.0 0.0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Value Observed Regional Average Value Observed Regional Average Income Group Average Expected median Income Group Average Expected median Peer Group Average Peer Group Average 68 South Africa FSAP Report December 2014. 69 The expected median is a result of a regression framework that takes specific country characteristics into account to arrive at predicted values for a certain level of development. The ‘peer countries average’ is composed of values for Kenya, Brazil, Nigeria, Angola and Mozambique. Source: Finstats 2015 database. 71 3. As shown in Figure 2, credit growth in South Africa has gradually increased over the past five years, from 1.8 percent in 2010, to an average of 7.8 percent in the first ten months of 2015, having declined from 8.4 percent in 2014. Whist corporate sector borrowing registered firm growth in 2015, household borrowing remained subdued and concentrated in the mortgage market. Figure 2: Total loans and advances to the private sector Source: SARB Quarterly Bulletin December 2015 Banking Overview 4. Commercial banks dominate the South African financial system, with assets amounting to ZAR 4,179 billion as of December 31, 201470. Loans and advances were the largest portion of banking-sector assets and amounted to ZAR 3,156 billion as at December 31, 2014 up from ZAR 2,898 billion in 2013. As of the end of January 2015, 17 banks were registered with the South African Reserve Bank (down from 30 at year-end 2002), of which ten are local banks and six foreign. Furthermore, 3 mutual banks, 2 co-operative banks, 14 branches of international banks and 40 representative offices operate in South Africa.71 5. The banking sector is dominated by four major financial conglomerates. These groups have extensive interest in primarily banking, asset management, insurance and securities. The insurance industry is also dominated by four large conglomerates with the same characteristics. These internationally active conglomerates are listed on either the Johannesburg Stock Exchange, the London Stock Exchange or have a dual listing. The banking operations of the conglomerates are structured under a bank controlling company. Interests in the other sectors such as insurance, asset management and securities are also structured under the bank controlling company, but legislation provides that the activities of the bank controlling company should be predominantly in the business of banking. 6. Asset concentration in the South African banking industry is high. Four banks (Standard Bank, Absa Bank, FirstRand Bank and Nedbank), two of which are foreign owned, account for over 80 percent of total banking assets as of end 2014. These big four expanded internationally, 70 SARB. Banking Supervision Department Annual Report, 2014. 71 SARB. Quarterly Bulletin, March 2015. 72 especially in the SADC region, where they acquired substantial market shares. To address the issue of concentration, the Competition Commission launched a Banking Enquiry in 2006 that resulted in recommendations to address problems of restrictive interbank arrangements, barriers to entry in the payments systems and measures of consumer protection. 7. Overall, the South African financial sector remains sound, though recent developments have highlighted vulnerabilities in the system. In addition, the financial system continues to feel some of the consequences of the global financial crisis. In August 2014, the sixth-largest bank in South Africa, African Bank Limited, which focused on unsecured consumer lending, failed and had to be resolved. Following the bank failure, all major South Africa banks received a rating downgrade. The wholesale funding market has not been seriously affected in the aftermath of the failure though funding costs have increased. Recently the four largest banks were further downgraded on the back of the sovereign debt downgrade to a notch above junk grade. 8. It is expected that NPLs in unsecured lending will increase over the coming year because of rising interest rates, a continuously weakening economy, high unemployment (25.5 percent as of the third quarter 2015, youth unemployment of 49.9 percent72), and the high level of household debt which will increase pressure on households’ debt repayments. 9. South Africa's financial system has been affected by the US Federal Reserve Bank's tapering of Quantitative Easing (QE) post financial crisis. The expectation of tapering of QE and then the actual tapering that started in January 2014 resulted in significant outflows from bond and equity markets. Amplifying the impact of QE tapering in South Africa is the prevalence of significant domestic risks as noted above. Because of its wide current account deficit, South Africa is dependent on portfolio inflows, the cost of which have increased as a result of global conditions. Yields on ten-year government bonds increased by about 200 basis points (bps). The South African Rand has also been affected by these latest developments with a depreciation of almost 23 percent from January to December 2015. SARB tested the resilience of banks against a possible increase in sovereign yields in 2014 and noted that banks appear to be sufficiently resilient to withstand a 500bps increase in yields without having to raise additional capital or increase liquidity buffers in its Financial Stability Review. The Monetary Policy Committee raised the benchmark interest rate in several steps in 2014 and 2015; it currently stands at 6.25 percent, due to rising inflation and the weakening of the Rand. Given the worsening economic fundamentals, the hike in interest rates could also affect credit quality going forward. 10. Regulatory capital over risk weighted assets was at 14.7 percent at end 2014 (15.6 percent in 2013). Tier 1 capital to risk weighted assets was 11.92 percent in 2014 (12.4 percent in 2013). Despite a more challenging economic environment, banks remain profitable (albeit showing some pressure) with the RoA at 1.06 percent and the RoE at 14.5 percent at end 2014 (1.1 percent and 14.7 percent in 2013). 11. The percentage of NPLs to gross loans has decreased from 5.9 percent in 2009, at the height of the global and domestic economic downturn, to 3.3 percent at end 2014. Provisions relative to NPLs increased to 49 percent at end 2014, which is relatively low in international comparisons. 72 SARB quarterly bulletin December 2015 73 Table A2: Financial Stability Indicators 2011 2012 2013 2014 Asset Quality NPL’s to Gross Loan Portfolio 4.7% 4.0% 3.7% 3.3% Provisions to NPL’s 34.9% 40.3% 45.7% 48.9% Profitability ROA 1.1% 1.3% 1.1% 1.1% ROE 15.8% 17.7% 14.8% 14.5% Cost-to-income 54.9% 52.9% 53.5% 54.4% Net interest income ratio 3.7% 3.8% 3.9% 3.8% Capital Adequacy Regulatory Capital to Risk-Weighted 14.9% 15.9% 15.6% 14.7% Assets Liquidity Liquid Assets / Deposits & Short-Term 12.7% 12.1% 12.3% 12.2% Funding Source: SARB Banking Supervision Annual Report 2014 Liquid Assets = cash + balances at central bank + short-term negotiable securities; Deposits & ST Funding = current accounts, savings deposits, call deposits, fixed and notice deposits, negotiable CDs 12. Through a combination of market-friendly interventions by the public and private sectors, the “banked” population in South Africa has grown from about 25 percent in 1994 to 77 percent in 2015, up from 67 percent in 2012 and remaining flat at 75 percent in 2013 and 2014 (FinScope 2015). Financial inclusion improved modestly from 2014 to 2015 (from 86 percent to 87 percent). This increase is mostly attributed to an increase in banking, which was prompted by continued implementation of the South African Social Security Agency grant program. Additionally, the Mzansi account initiative initiated the opening of 6 million new accounts amongst the low income population. That said, the results of this initiative have been mixed as most banks involved reported losses on the accounts due to low usage and high dormancy. Significant challenges persist in expanding access: it remains far easier to open a bank account for salaried South Africans compared to non-salaried individuals. Furthermore, consumer indebtedness remains high, with approximately 9.5 million consumers in arrears of three months or more. These indebted consumers tend to be higher income earners; there is little evidence that they are concentrated in a specific sector. At the same time, lending to SMEs remains low, the availability of savings and insurance products is still relatively limited, and the uptake of the mobile banking and payment products in the country also remains very low. Insurance and Pensions Overview 13. The insurance sector in South Africa, while smaller than the banking sector, plays an important role in credit intermediation. Insurance penetration – measured as premiums to GDP – is among the highest globally at an estimated 15 percent of GDP as of 2013. Premiums and underwriting profits have increased over the past two years with the latter being positively impacted by a reduction in claims. Insurers earned an investment return of 16 percent in 2013,73 which is slightly higher than the previous year. According to the Association for Savings and Investment South Africa, the life insurance (long-term) industry held record assets of ZAR 2.2 trillion at the end of 2014, an increase of 10 percent from ZAR 2.2 trillion at the end of 2013. The long-term sector reported an overall premium growth of 14.6 percent in 2013.74 There 73 SARB. Financial Stability Report, March 2014. 74 Ibid. 74 are 79 life insurance licensees holding these assets, but like the banking sector, the insurance market is essentially dominated by four players: Old Mutual, Sanlam, Liberty and Momentum in the form of MMI Holdings. The short-term (non-life) insurance sector also posted positive results in 2010 and 2011, after sharp declines in 2008 and 2009. Gross premiums for the short- term (non-life) insurance sector also increased similar amounts (8.5 percent) in 2012 and 2013, while underwriting results decreased by 4 percent in 2013 (6 percent in 2012).75 14. In the pension sector, the institutional investor base is well developed in South Africa, with pension assets at 110 percent of GDP in 2013. During the 2012 financial year, membership in retirement funds increased to 15 million members and total assets exceeded ZAR 2 trillion. The retirement fund sector covers most employees in the formal sector through occupational retirement fund arrangements (“quasi-mandatory”), pension funds, provident funds, umbrella funds, retirement annuity funds and preservation funds. Voluntary retirement savings are supported by tax incentives, largely limited to middle and upper income workers and cover over 60 percent of workers in the formal sector. Equity Markets Overview 15. The market capitalization/GDP of the Johannesburg Stock Exchange (JSE) exceeds that of major emerging stock markets, such as Russia or China, and reached 160 percent of GDP in 2012.76 The market capitalization of all listed securities amounted to ZAR 11.5 billion77 as of October 2014. This ranks the JSE among the 20 largest stock exchanges in the world in terms of market capitalization. A total of 427 companies were listed on the South African stock market as of July 2014. Liquidity, measured on the basis of equity turnover as a percentage of market capitalization, amounted to 46 percent for the year ended on March 31, 2012. Stock exchange performance was seriously hampered by the financial crisis as it is largely driven by commodities. Predominant players on the bond market are the central government and to a lesser extent municipalities. Non-government issuers also issue bonds as well as parastatals, corporations, commercial banks, mortgage houses and asset finance houses. Overview of Agricultural Finance Suppliers and Customers 16. “Agricultural finance refers to financial services, including savings, transfers, insurance and loans, potentially needed by the agricultural sector, meaning farming and farm-related activities including input supply, processing, wholesaling, and marketing. Most of these activities are conducted in rural areas, but large processing facilities and agribusinesses, as well as (many) largely subsistence-level smallholders, are also located in urban and peri-urban areas.”78 Demand Side of Agricultural Finance 17. In South Africa, the users of agricultural finance include large scale, exclusively commercial farming (about 40,000 farming units as of 200779) and small scale, predominantly 75 Ibid. 76 Economist Intelligence Unit. “South Africa Financial Services Industry Report,” July 2014. 77 SARB Quarterly Bulletin December 2014 78 ‘Policy Brief on Agricultural Finance in Africa’, Making Finance Work for Africa, March 2012. 79 DAFF: Abstract of Agricultural Statistics, 2010. p.5. 75 non-commercial farming. The former group’s financing needs are generally well-serviced, unlike the needs of the small scale farmers. The small scale farmers can be further sub-divided into three groups: (a) non-commercial smallholders (‘subsistence farmers’): They represent approximately 65 – 85 percent of producers, or 2.5 – 3.5 million. They are usually the largest percentage of producers. These farmers, typically, produce only staples for their own consumption, have very limited access to land and external inputs/services, are the poorest and most vulnerable, and are heavily dependent on off-farm income. (b) smallholders in loose value chains (‘emergent farmers’): They represent approximately 10 – 20 percent of producers, or 350,000 – 700,000. This group is smaller but still represents a significant, percentage of producers. These farmers generally produce some surplus staples and non-staples (‘cash crops’), market opportunistically, have greater (but still limited) access to land and external inputs/services than subsistence farmers, and are also less poor and vulnerable, but still substantially, dependent on off-farm income. (c) commercial smallholders in tight value chains (‘small scale commercial farmers’): This subset of farmers is a relatively small minority of producers, of less than 1 percent of producers, or about 11,000 – 15,000. They are mostly in the cane sugar industry, but also in cotton and some other sub-sectors, including livestock/poultry, annual grain/oilseed crops and horticulture (fruit, wine and vegetables). They produce mainly non-staples for marketing through agreed buyer(s), have greater access to land and external inputs/services than other smallholders; and are the least poor, vulnerable and dependent on off-farm income. 18. As Figure 3 illustrates, approximately half of the country’s small farmers are found in KwaZulu-Natal, the Free State, and Gauteng (51 percent cumulatively), with the Eastern Cape and North-West contributing a further 29 percent and the other four provinces the remaining 20 percent. Figure 3: Distribution by province of ‘emergent’ and ‘small commercial’ farmers, South Africa, 2010 Geographical distribution W.Cape E.Cape N.West 3% 15% N.Cape 14% Free State 4% 17% Mpumalanga Gauteng 9% 17% Limpopo KZN 4% 17% E.Cape Free State Gauteng KZN Limpopo Mpumalanga N.Cape N.West W.Cape Source: FinScope Small Business Survey 2010 19. According FinScope’s 2010 Small Business Survey, 53.4 percent urban small farmers used banks’ services versus 38.4 percent of their rural counterparts. Nearly half of small farmers used formal savings and/or transmission services and about 30 percent formal insurance services, but only a small percentage used formal credit services (5.6 percent), only 2.5 percent from a bank. Similar to micro and small enterprises, family and friends were the most frequently tapped 76 source of credit. Informal savings and credit groups more often served as a vehicle for saving the funds required for annual agricultural inputs than as a source of loans for this purpose. 20. The table below highlights the main needs of these farmers. (Brackets indicate where the demand for a service category by subsistence farmers is possible, but unlikely to be widespread.) Table 3: Typical financial services by farmer profile80 Service Financial goal Subsistence Emergent Small scale category farmers farmers commercial farmers Savings Have money to pay for farming X X X inputs at right time Large purchases, investments in (X) X X fixed/movable assets Credit Have money to pay for farming (X) X X inputs at right time Large purchases, investments in (X) X X fixed/movable assets Transmission Receipt of harvest X X payments/payments from clients Payments to input suppliers (X) X X Insurance Crop/livestock insurance X X Fixed/movable asset insurance X X 21. These small-scale farmers face a number of challenges securing adequate financing to grow their businesses. The key challenges include: (a) Lack of collateral security: Small farmers in informal rural areas and land reform beneficiaries are restricted from using the land that they farm as collateral for bank loans. This makes lending more difficult because acceptable alternative sources of physical or financial security (per the banks’ definitions) are generally limited or absent. (b) High costs to users of formal financial services: The “costs of financial services” usually refer to direct transaction and interest charges. The “cost of finance” was ranked fourth among the obstacles to growth by small farmers in the Tipoy 201081 survey. In addition to these costs, farmers in low-income rural communities, who are relatively far from formal financial institution and poorly educated, are also subject to economic costs (i.e., opportunity, agency), regulatory and compliance costs (i.e., Know Your Customer requirements), social/cultural costs (i.e., being part of a network to improve access), and psychological costs (i.e., stress of debt). (c) Financial literacy:82 The low-income community has limited familiarity with formal financial products and sources for formal help, which can restrict the ability of small producers to bargain with large up- and downstream value chain players. 80 FinMark Trust. “The Status of Agricultural and Rural Financial Services in South Africa. ” March 2013. 81 Tipoy, C.K. (2010), Small Farmers in South Africa, Centre for Inclusive Banking in South Africa. 82 Financial literacy is typically defined as the combination of consumers’/ investors’ understanding of formal financial products and concepts and their ability and confidence to appreciate financial risks and opportunities, to 77 Supply side of agricultural finance 22. At the policy level, there is no comprehensive strategy or specific laws / regulations on agricultural finance other than the Land and Agricultural Development Bank Act, which governs Land Bank. There is also no single coordinating body advocating on behalf of agricultural finance. Instead, the government delivers grants for specific purposes through different agencies, which at times counteract one another because the agencies have their own strategies and objectives. The main national government-sponsored grant programs are for: a) land acquisition (administered by DRDLR), b) moveable equipment and fixed improvement (CASP grant administered by DAFF), and c) working capital (MAFISA program administered by DAFF). Although DAFF reported in 2010 to have assisted approximately 11,000 small farmers and land reform beneficiaries, there is little evidence that any of the government institutions have successfully reached large numbers of targeted clients. 23. Despite the absence of a coordinated policy framework and champion entity for agricultural finance, there are a different options available for financing farmers, namely agricultural-focused government institutions (i.e., AgriSETA, DRDLR, and DAFF), government- sponsored credit guarantee schemes (i.e., Khula Credit Guarantee Scheme), national and provincial wholesale development finance institutions, commercial financial institutions, formal micro-finance institutions (MFIs), informal MFIs (i.e., rotating savings and credit associations, village savings and loans associations), cooperative banks/financial services cooperatives, and agricultural cooperatives. However, the vast majority of these suppliers are not specifically dedicated to the rural or agricultural sector with the exception of a select few (i.e., AgriSETA, Land Bank). Therefore, the breadth and depth of the products and services available for farmer’s specific needs remains limited and they are not targeted to small-scale farmers. Table 483 provides an overview of the various suppliers available to farmers. The table is meant to highlight the prominent suppliers of finance, not to be an exhaustive list. 24. Total farming debt as of end of 2014 is ZAR 116, 576 million, of which 57 percent or ZAR 66,345 million was from commercial banks, 26 percent or ZAR 30,580 million was from Land Bank, and the remaining 17 percent was from agricultural cooperatives, DAFF, private citizens, other financial institutions, and other debt sources.84 State grants for land totaled ZAR 13.6 billion from 2008 – 2012 and ZAR 3.4 billion for fixed improvements and moveable equipment from 2004 – 2012.85 DAFF is the largest lender of working capital through the MAFISA program. The annual value of these loans has averaged approximately ZAR 900 million in recent years. The total value of annual lending to the land reform beneficiaries and small farmers by other DFIs and commercial banks is not known but estimated to be half the value of the MAFISA loans. 25. Furthermore, the stark shortage of working capital for small scale farmers is more obvious when compared to commercial farmers. On average, commercial farmers borrow 40 percent of the combined value of their farms’ land, fixed improvements and moveable equipment make informed choices, to know where to go for help and to take other effective actions to improve their financial well-being (Messy, F. and Monitcone., 2012., The Status of Financial Education in Africa, OECD Working Papers), such as keeping adequate financial records and being able to analyze and deduce business strategy from such records. 83 FinMark Trust. “The Status of Agricultural and Rural Financial Services in South Africa. ” March 2013. 84 DAFF: Abstract of Agricultural Statistics, 2015. 85 Center for Inclusive Business at the University of Pretoria: The Microfinance Review, 2013. 78 for annual inputs. In contrast, the small scale farmers borrow less than ZAR 1.5 billion, which is less than 10 percent of the ZAR 18 billion that the state has spent acquiring land, fixed, and moveable assets for historically disadvantaged farmers. 79 Table 4: Major micro-level financial service providers in South Africa and services offered Products & services available to Personal loans for enterprise Short term production loans customers  Branchless banking solution ST household insurance inc Medium term Agric Loans Medium term Agric loans Personal loans mainly for Savings account/ service Cash handling capability Transactional capability Fixed Deposit account Long term loans (land) Finance for secondary Transactional account (e.g agro processing) Agri-asset insurance business (stock, etc) Credit life insurance Wholesale finance (Moveable assets) Funeral insurance (loan linked card) Crop insurance Equity Finance (mobile, POS) consumption (Orchards) purposes sectors Grants Institutions  Commercial Banks Absa Bank & Insurance Company                  Standard Bank            First National Bank            Nedbank              Capitec Bank        African Bank      Co-operative Banks Ditsobotla Co-operative Bank     Government DFIs Land Bank     Khula (now part of SEFA)     SAMAF (now part of SEFA)   National Empowerment Fund    Industrial Development Corporation (now part of SEFA)   Development Bank of Southern Africa Small Enterprise Finance Agency (SEFA)     Post Bank (South African Post Office)     Ithala (provincial)       CASIDRA (provincial)   Mpumalanga Economic Growth Agency (MEGA) (provincial)     Insurance companies Santam    Mutual & Federal    Zurich   Hollard    Momentum    Developmental Microfinance Institutions Small Enterprise Foundation    Marang   Women’s Development Business   Off-takers/ buyers Pick ‘n Pay (and Ackerman Foundation)   Registered Credit providers (4,000)  Informal services Stokvels/ROSCAS/ASCAS  Financial Service Co-operatives  Family and friends    Burial societies  Mashonisas/loan sharks   80 Overview of Agricultural Extension Services86 26. Agricultural extension services in South Africa have a long history dating back to 1902. In the earliest form, foreign scientists were imported into South Africa to provide technical support services to the farmers without any central coordination. Over time it evolved to be more home-grown and include demonstration trains, study tours, one-on-one advisory services, financing schemes and scientific research. The responsibility for these services also changed numerous times. Responsible agencies have included the Department of Agriculture, Agricultural Development Institutions, the National Department of Education, the Department of Lands, the Department of Credit and Land Tenure, the Department of Native Affairs, and most recently, the Ministry of Rural Development and Land Affairs. 27. The effectiveness of the services have been mixed and poorly managed over the last 113 years. According to the Department of Agriculture’s 2008 report, “The state of extension and advisory service within the agricultural Public Service: A Need for Recovery” the “capacity of provinces to deliver quality extension services to farmers varies and to some it is already suffocating.” The report provides a sober assessment of the state of the South Africa’s extension services.87 28. In 2007, the largest proportion of extension officials are from Limpopo Province which constitutes 30 percent of the total followed by Eastern Cape Province at 28 percent and KwaZulu Natal at 16 percent. The Gauteng and Northern Cape Provinces have the smallest number of appointed extension personnel, less than 2 percent of the total staff pool. Only 427 out of the 2,155 staff (20 percent) have a degree or higher qualification. About 1,728 out of 2,155 (80 percent) of the extension personnel have a diploma qualification. Overall 8 out of 10 are insufficiently qualified to operate as Agricultural Advisors or Subject Matter Experts, which only require bachelor’s degrees in agriculture to work at the provincial or national level. Only Gauteng and Free State Provinces have a good percentage of officials with degree qualifications and higher. The Eastern Cape and KwaZulu Natal has the lowest percentage of extension officials with degree qualifications and higher. In 6 out of 9 provinces, female extension officials are more educated than their male counterparts. It is only in Free State, Gauteng and Western Cape where male officials are more educated than their female counterparts. 29. According to the report, very few extension officials have been exposed to formal skills programs which are crucial to the delivery of product and services to farmers. Of the total pool of 2,155, only 204 (9 percent) had completed training in communication, 238 (11 percent) had completed project management, 140 (6 percent) had completed computer training and 143 (7 percent) had completed training related to people management and empowerment. Less than 25 percent of extension staff were exposed to technical training programs since joining public service. 30. Table 5 presents the projected ratio of extension personnel to farmers based on extrapolated farmer populations. The table illustrates that each of the provinces are severally 86 This section is a summary of a World Bank background note on “Review of Agriculture Advisory Service in South Africa” (April 2015). 87 This report flows from the Extension indaba (important conference held by the izinDuna, or principal men, of the Zulu or Xhosa peoples of South Africa) held earlier in 2008. 81 understaffed by the more conservative measure of 1 extension officer to 250 farmers. Currently the Eastern Cape, KwaZulu Natal, Limpopo and Mpumalanga have the highest shortfall of extension personnel given the number of communal farmers in these provinces as well as projects emerging as a result of the land reform program through CASP and other initiatives. Per the 1:500 ratio, the Free State, Gauteng, and North West Provinces are sufficiently staffed. These are also the provinces with more highly qualified staff. Table 5: Projected staffing needs Province Current No. of extension Suggested number based on different ratios officials 1: 500 1: 250 Eastern Cape 623 1 344 2 688 Free State 70 52 103 Gauteng 29 19 38 KwaZulu Natal 360 710 1 419 Limpopo 666 1181 2 361 Mpumalanga 189 337 675 Northern Cape 23 26 52 North West 137 129 257 Western Cape 58 61 123 Total 2 155 3 559 7 706 31. Figure 4 shows the trend in government expenditure on farmer support, extension (included in farmer support and development expenditure) and the land reform for rural development programs of government since 2004/5. Average expenditure on farmer support and development over the past five years was ZAR 4,405 million per year with extension services representing roughly 55 percent. The expenditure by the Department of Land Affairs on the Land Reform for Agriculture program is roughly the same as the combined expenditure on extension by DAFF and the provincial departments (after accounting for conditional grant transfers between DAFF and the provincial departments). The expenditure on extension translates to a spending intensity ratio of about ZAR 47,000 (2010 values88) per commercial farmer, or ZAR 4,000 (2010 values) per farm worker. 88 2010 Year-end exchange rate US$1 = ZAR 6.58 82 Figure 4: Government expenditure on extension and farmer support 5,000 R million (2010) 4,500 4,000 3,500 3,000 2,500 2,000 1,500 Farmer Support and Development 1,000 Extension 500 Land reform 0 Source: RSA 2004-2014 Extension Service Providers 32. Currently, there are four sources of extension service providers. I. Universities: There are nine universities that have faculties of agriculture in South Africa, only three of which have programs dedicated to extension training. The total researcher capacity in Full-time Equivalent staff was reported to be 140 persons, or 18 percent of the total researcher capacity in agricultural sciences in the country (Flaherty et al, 2010). Another five Universities of Technology offer agricultural training; mainly focused on agricultural production and management qualifications. There are 12 agricultural colleges, nine of which offer higher education qualifications. These qualifications are generally production related three-year diplomas in agriculture. Most colleges are also involved in farmer training. With the exception of Grootfontein (which is managed by DAFF), the agricultural colleges are managed by their respective Provincial Departments of Agriculture. Under the competitive funding base for agricultural research in the country many faculties of agriculture have developed centers of excellence in particular fields in competition to the services traditionally provided by the Agricultural Research Council. These centers of excellence at the faculties of agriculture serve as a potential source of support to farmer settlement either through training or outright service provision. II. State funded agencies: In S. Worth’s 2012 paper on extension services89, he identified three state-funded agencies: Agri-TV, the Agricultural Research Council, and the Agri- business Development Agency (Kwazulu Natal). The Agricultural Research Council supports small holder agriculture but is seriously understaffed (operating with only 443 researchers versus the recommended 750). A number of development agencies exist at the national and provincial levels, however, information (capacity and number) on these agencies is very limited. 89 Agricultural Extension In South Africa: Status Quo report: Discussion Document. 83 III. Private Sector Extension Services: According to Worth (2012) one of the implicit behaviors among farmers when they reach a state of self-reliance or where their knowledge and skills in their particular field outstrip those available from the State, they become willing to fund research and extension specific to their primary production focus. This behavior manifests itself collectively and commodity-based agricultural support organizations are created. Experts at universities or the government have transitioned to set up private consulting and/or services providing this support. They offer a wide range of agricultural related services including technical production advice, marketing, infrastructure development (e.g. irrigation), business management and research. Within this larger group are commodity organizations, organized agriculture organizations, non- government organizations, and private consultants.  Commodity: Approximately 33 commodity organizations currently exist in South Africa. Generically these services include producer representation, industry promotion, information sharing, quality assurance, industry transformation, research (either directing, funding, or conducting), extension, production support, industry development, institutional capacity building. These services are largely funded through membership fees, proceeds from trust funds and through levy income. Some of these organizations have well established farmer support programs aimed at new entrants to farming and have become preferred service providers to departmental farmer settlement programs. With sufficient funding, many private-sector firms can organize, manage and deliver extension services more efficiently than government agencies.  Organized Agriculture: There are only two institutions that exist within this sphere: AgriSA the Transvaal Agricultural Union and NAFU. These organizations serve as the mouthpiece for farmers at the national level, with the purpose of ensuring the best possible financial and social position for the farmer within the national economy.  Non-Government Organizations (NGO): There are 16 NGO’s focusing on agriculture, 23 on rural development, and 10 that deal with land issues. The services provided by these institutions generally range from skills development to legal support.  Private consultants: Worth identified 29 private sector consultants consisting of individuals, associations and companies. The scope of their services is diverse, ranging from input supply to agricultural and rural development support. IV. Agri-business & banks: Another source of support to farmers is commercial banks and agri-business industries. Commercial banks have well-established agricultural divisions dedicated to provide financial support to commercial farmers, but obviously at commercial principles. Although banks do not promote themselves as extension service providers, they do possess the potential to assist in the provision of access to technical support to their clients. The Agribusiness sector provides technical support services to commercial farmers with supply contracts in the interest of securing produce of the appropriate quality, etc., and in so doing serve as another source of technical support available to farmers, albeit to more skilled farmers, but in many cases not exclusively so. All the major commercial banks have an agricultural division specializing in tailor made financial services to the farming community. These include specialist services from agricultural economists and advisors including support in the development of business 84 plans, insurance services and grain trading on Safex. They assist in linking their clients with service providers at co-operatives, commodity organizations and input suppliers in this respect. They are also involved with joint venture finance for developing agriculture, where they administrate the financial scheme of assistance to the project, whilst the mentorship, training and management is provided through a subsidiary. Land Bank Support to Emerging Farmers 33. Land Bank falls within the last category of agribusinesses and banks. Land Bank’s mandate was reformulated in 2002 to effect a change in the patterns of land ownership, by promoting greater participation in the agricultural sector by historically disadvantaged persons and an increase in ownership of agricultural land by such persons, through the provision of appropriate financial services. Land Bank outsources the provision of technical support to third parties preferring not to have the in-house capacity to do so. 34. The REM program of Land Bank is one of several public programs that provide financing to emerging farmers. Two such programs belong to DAFF. One of these, MAFISA, is very similar to the REM program. It offers short term credit to emerging farmers on terms similar to those offered under REM. MAFISA originally provided wholesale financing through nine intermediaries, which has decreased to three. Established with an endowment of ZAR 1 billion in 2004, MAFISA has provided loans to approximately 5,000 disadvantaged farmers — most somewhat smaller than REM’s typical client, but still in the category of emerging farmers. Some of the MAFISA endowment has been returned to NT and the remaining funds have been relocated to the Land Bank. Because REM and MAFISA are so similar, and because Land Bank has greater capacity to manage such a program, many observers believe that the two programs should be merged into one program under the Land Bank. A second program of DAFF offers grants to support short-term operating expenses and small operating needs such as machinery. These grants are managed at the provincial level and come from funds that are transferred from the national to provincial level under CASP. 35. Land Bank gives low, medium and high-risk clients access to a full range of long, medium and short-term loans to meet all financial needs, including land and equipment purchases, asset improvement and production credit. A series of tailor made programs and products have been developed specific to the needs of previously-disadvantaged people in the sector. The development of the requisite business plan needed to apply for a loan is done through intermediaries (i.e., co-operatives, commodity organizations, NGOs, private consultants, etc.). The experience with this arrangement has been positive. 36. Since Land Bank has no in-house technical support capacity, technical support to farmers from intermediaries includes training, skills development and mentoring of smallholder beneficiaries. The commodity organizations, many of which fund their operations from trust funds and funding sourced from the programs of DAFF and the Department of Rural Development and Land Affairs, have proved successful in establishing commercially successful historically disadvantaged farmers. There are several examples of such successful small farmer development programs in South Africa. While the number of clients served by Land Bank through this approach is currently small, it is the most cost effective way of providing the technical support under this scenario. The technical support provided by the intermediaries is of high quality compared to other available programs, but it is cost-intensive. If the number of 85 clients were to grow significantly the burden on the financial resources of the intermediary services of the commodity organizations specifically may become unsustainable absent an increase in support from government programs. Consolidating government support for extension services 37. The existence of the somewhat parallel efforts of government departments has led to fragmentation of effort and inefficiency and has caused frictions and problems in implementation. The current setup between national and provincial departments of agriculture does not lend itself to effective central coordination of the available capacity in government and an institutional solution needs to be created to fill this void. A mechanism was developed in 2004 to coordinate the support for these various programs (and an operational manual for such coordination was developed and agreed) but it has never been implemented. 38. Consolidating the financial support initiatives of DAFF and DRDLR would circumvent these problems. The existence of an efficient public service extension service would go a long way to assist Land Bank. It is clear that the extension services capacity provided by government faces enormous challenges in providing adequate support to farmers. In the meantime, the current model of utilizing the intermediaries is the best approach that Land Bank could use. 86 Annex 8: PFI Due Diligence Criteria and Summary REPUBLIC OF SOUTH AFRICA: Land Bank Financial Intermediation Project 1. The World Bank Operational Policy OP10 requires an assurance that all financial institutions and participating financial intermediaries (PFIs) in a World Bank financed credit line are viable financial institutions determined by: (a) adequate profitability, capital, and portfolio quality as confirmed by audited financial statements acceptable to IBRD; (b) acceptable level of loan collections; (c) appropriate capacity, including staffing, for carrying out subproject appraisal (including environmental assessment) and for supervising subproject implementation; (d) capacity to mobilize domestic resources; (e) adequate managerial autonomy and commercially oriented governance; and (f) appropriate prudential policies, administrative structure, and business procedures. 2. The success of a credit line operation critically depends on the effectiveness and quality of the participating financial intermediaries (PFIs). Strong and capable PFIs, which are in a stable financial condition with proper capacity to appraise and carry the credit risk, are more likely to deliver funds effectively and efficiently to viable subprojects, which are consistent with project objectives. Due Diligence Eligibility Criteria 3. The eligibility criteria assessed in the due diligence process follow the general guidance provided under World Bank Operational Policy OP10 and Land Bank selection criteria for intermediaries. The potential PFIs under the project are agricultural cooperatives, large agricultural companies, and credit providers that have a credit provider license, are supervised under the National Credit Act by the National Credit Regulator (NCR) of South Africa and maintain externally audited financial accounts based on IFRS. The following specific eligibility criteria are developed to take into consideration the peculiar nature of the potential PFIs while following the general guidance under OP10. - Good governance and management quality – commercially oriented governance; experienced management and good practices; existence and effectiveness of business and risk related committees. - Adequate Capital structure and leverage – quality of capital; acceptable level of leverage and debt service coverage. - Appropriate Asset Structure and profitability -- including acceptable risk profile; type and diversification of asset structure; well diversified and stable earnings; level and growth trends of operating costs and expenses should be well managed. - Adequate Liquidity and funding structure – appropriate liquidity levels. Good funding structure without heavy concentration and capacity to mobilize domestic resources. - Adequate Credit appraisal and monitoring capacity and lending portfolio quality – appropriate credit appraisal process and well defined procedures; policies/effectiveness of loan underwriting; adequate staffing for carrying out subproject appraisals and for 87 supervising subprojects implementation that would meet the requirements for effective participation in the Credit Line; asset/loan classification and provisioning practices; level and severity of non-performing loans; timely identification and collection of problem loans. - Appropriate financial risk management and internal controls – adequate organization and institutional capacity for its specific risk profile; well defined and prudent policies and written procedures and effective execution for management of all types of financial risks (liquidity, credit, currency, interest rate and market risk). - Appropriate internal audit function – organization of internal audit; quality of reporting and responsiveness to audit suggestions; follow-up on any noted issues. - Compliance with NCR regulations and other applicable laws and regulations. The National Credit Regulator (NCR) was established as regulator under the National Credit Act 34 of 2005 (the Act) and is responsible for the regulation of the South African credit industry. The NCR is tasked with the registration of credit providers, credit bureaus and debt counsellors; and enforcement of compliance with the Act. The regulations issued by the NCR for credit providers primarily relate to ensuring adequate financial consumer protection and submission of audited annual financial statements by credit providers. The NCR regulations do not prescribe any prudential limits for the supervision of credit providers. Therefore, to ensure the financial soundness of PFIs, the due diligence criteria define specific financial performance criteria described below that PFIs need to comply with on an ongoing basis. Ongoing Eligibility Criteria 4. In addition, each PFI will be required to demonstrate ongoing compliance with the following financial performance indicators throughout its participation in the line of credit. On-going Financial Performance Criteria90 Average total asset to average total equity (equity multiplier)1 Interest coverage ratio (EBITDA to Interest expense) Non-performing loans more than 90 days past due to total loans Liquidity ratio defined as current assets to current liabilities Maximum exposure to one borrower or group of related borrowers by intermediary relative to total equity Maximum exposure to intermediary related parties relative to total equity 1. Due to recent changes in business models for some of Land Bank intermediaries such as Unigrow and Akwandze in which the lending is undertaken by a subsidiary that is structured as a financing entity, the corporate leverage ratio criteria based on total debt to equity may not reflect the business model appropriately. For these intermediaries total capital to total assets or average total assets to average total capital will be used. 90 Values are defined in the Operational Manual. 88 5. In addition to the above eligibility criteria, the LOC has well-defined sub-loan eligibility criteria. These criteria include a limit on maximum loan sizes to a single sub- borrower or group of related borrowers to ensure that credit risk is diversified across a large number of sub-borrowers. The LOC also limits lending to related parties by PFIs. 6. Given the need to support Land Bank in expanding its wholesale lending to commercial and emerging farmers, an intermediary that is not fully meeting the eligibility criteria may be accepted as a PFI providing that it is willing to sign the Memorandum of Understanding (MOU) in which it will commit to an agreed Action Plan91 that will bring it in full compliance in an agreed time. Also some of Land Bank’s intermediaries have established fully-owned subsidiaries to undertake financial services on behalf of the Group. In these cases, guarantees may also be provided by the parent company if the subsidiary is not fully meeting the eligibility criteria, in particular regarding the capital structure. Land Bank in the process of its annual credit review and the World Bank during supervision missions will do regular check-ups to make sure that the PFI is making the expected progress in the agreed timeframe. 7. Land Bank and the World Bank initially selected six intermediaries that are operating in both the corporate banking and REM sub-business lines and assessed them against the eligibility criteria. Akwandze, Humansdorp, Lona Citrus, TWK, GWK and Unigrow Financial Services (fully owned subsidiary of Afgri Group) were selected to start the due diligence assessment and the World Bank team appraised these PFIs during project preparation. Additional PFIs interested in the LOC will be appraised during project implementation. 8. The appraisal of TWK, Lona Citrus, Unigrow, Akwandze, GWK and Humansdorp included a detailed assessment of whether the potential intermediary meets the eligibility criteria (as specified above). The due diligence review process included:  Interviews with senior management regarding the intermediary organization, business strategy, ownership and governance structure.  Interviews with senior management on the intermediary’s financial condition and profitability, including a review of related policy documents of the intermediary.  Review of externally audited financial statements as of 2012, 2013, 2014 and 2015.  Interviews with senior management on lending policies, procedures and practices and internal controls. 9. Based on the assessment, two intermediaries fully meet the eligibility criteria and three generally meet the criteria. Two intermediaries generally meet the eligibility criteria except for capital structure; and one intermediary generally meets the eligibility criteria, however it needs to improve the quality of its loan portfolio and cash flows going forward. One 91 For example, an intermediary with a capital structure in which the total asset to total equity ratio is more than the agreed maximum, the PFI would be asked to commit to improving the capital structure in the agreed time frame and/or where applicable guarantee is provided by the parent company. An intermediary that has high credit concentration will be asked to diversify the credit portfolio in the agreed time frame. An intermediary with an NPL level considered too high will be asked to reduce the level of impaired loans to less than eight percent in the agreed time frame. Some minor, but important, improvements related to risk management functions could also be subject of an MOU. 89 intermediary does not meet the eligibility criteria at this moment, however it can participate as intermediary once the issues identified in the due diligence are resolved. 90