86083 ELEMENTS TO CONSIDER WHEN ESTABLISHING THE ENVISAGED 1 DEVELOPMENT BANK OF MOZAMBIQUE POLICY NOTE JANUARY 2014 THE WORLD BANK POVERTY REDUCTION AND ECONOMIC MANAGEMENT VICE PRESIDENCY AFRICA REGION 1 This note has been prepared by Carlos Leonardo Vicente, Senior Financial Specialist in the Financial Architecture and Banking Systems Unit. Feedback and support was provided by Enrique Blanco Armas (AFTP1). Comments were provided by Kobi Bentley, Economic Advisor, DFID Mozambique, Jose de Luna Martinez, Senior Financial Economist in FFSAB and Mazen Bouri, Senior Private Sector Development Specialist in AFTFE. The team would like to acknowledge the financing provided by DFID for this work under the programmatic AAA 'Enhancing macroeconomic and fiscal policy making for inclusive growth in a resource-rich setting'. ABBREVIATION AND ACRONYMS AGRA Alliance for a Green Revolution in Africa BCM Banco Comercial de Moçambique BCI Banco Comercial de Investimentos BDC Business Development Bank of Canda BdM Banco de Moçambique BIM Banco International de Moçambique BNDES Banco Nacional de Desenvolvimento Económico e Social BNI Banco Nacional de Investimento BPD Banco Popular de Desenvolvimento CEO Chief Executive Officer CFD French Development Fund CIP Centro de Integridade Pública DBSA Development Bank of Southern Africa DNEAP Direcção Nacional de Estudos e Análise de Políticas FDI Foreign Direct Investment GAPI Gabinete para Apoio a Pequenos Projectos de Investimento GDP Gross Domestic Product GoM Government of Mozambique IGEPE Instituto de Gestao de Participações do Estado INE Instituto Nacional de Estatistica INSS National Social Security Institute MDB Mozambique Development Bank MPD Ministério de Planifacação e Desenvolvimento MTN New Mozambican Metical NAFIN Nacional Financiera NGO Non-Government Organization NPL Non-performing Loan OECD Organization for Economic Co-operation and Development ROE Return on Equity SME Small and Medium Enterprise USAID United States Agency for International Development VAT Value Added Tax Contents SUMÁRIO EXECUTIVO .................................................................................................................................... i EXECUTIVE SUMMARY ................................................................................................................................. iv I. INTRODUCTION ..................................................................................................................................... 1 II. visible progress in the financial sector .................................................................................................. 1 A. Structure and performance .............................................................................................................. 1 B. Outreach and access to finance ........................................................................................................ 3 C. Remaining market gaps .................................................................................................................... 5 III. The ROLE of a development bank ..................................................................................................... 9 A. International experience....................................................................................................................... 9 B. Limitations of development banks ..................................................................................................... 10 C. The Development Bank of Mozambique ............................................................................................ 10 IV. Elements to consider when setting the development bank ........................................................... 11 A. Ownership ....................................................................................................................................... 12 B. Policy mandate................................................................................................................................ 12 C. Funding ........................................................................................................................................... 16 D. Lending model................................................................................................................................. 18 E. Pricing of products and services ..................................................................................................... 19 F. Regulation and supervision ............................................................................................................. 20 G. Corporate governance .................................................................................................................... 21 H. Transparency and disclosure .......................................................................................................... 24 V. CONCLUSIONS AND RECOMMENDATIONS ......................................................................................... 24 References .................................................................................................................................................. 28 Appendix A. ................................................................................................................................................. 29 Figures Figure 1: Financial Depth Trends (in percent) .............................................................................................. 2 Figure 2: Non-Performing Loans (in percent) .............................................................................................. 2 Figure 3: Bank Concentration and Profitability ............................................................................................ 3 Figure 4: Bank lending to agriculture ........................................................................................................... 7 Tables Table 1: Use Financial Instruments by Firm Type, in percent ...................................................................... 4 i SUMÁRIO EXECUTIVO O sector financeiro Moçambicano tem experimentado um progresso significativo. As reformas implementadas desde finais de década de 90 – incluindo a privatização dos bancos estatais, o fortalecimento da independência e da capacidade reguladora do Banco Central, e a introdução de um quadro regulamentar moderno – conduziram ao aumento do número de instituições financeiras e maior estabilidade e profundidade financeira. A percentagem de activos financeiros detidos pelo estado reduziu significativamente e foram introduzidos novos serviços e produtos financeiros. A solvência bancária também aumentou, com o rácio de solvabilidade tendo aumentado de 14 por cento em 2002 para 17, 9 per cento em 2012. O crédito mal parado diminuiu de forma drástica e tanto os depósitos internos em relação ao Produto Interno Bruto (PIB) bem como o crédito privado em relação ao PIB aumentaram desde 2004. A abrangência do sector financeiro, embora continue limitada, tem apresentado sinais encorajadores. O número de agencias bancárias aumentou de 228 em 2005 para 529 em 2012 mas existem disparidades entre a capital do país, Maputo, e o resto do país bem como entre as zonas urbanas e rurais. Inquéritos recentes mostram um aumento no acesso aos serviços financeiros por parte das Pequenas e Médias Empresas (PMEs), conforme demonstrado pela maior utilização dos empréstimos bancários e dos descobertos bancários. Contudo, o acesso global aos serviços financeiros continua baixo. A grande maioria das empresas em Moçambique considera o acesso limitado aos serviços financeiros como o principal constrangimento para os seus negócios. Ademais, Moçambique tem uma das piores classificações em termos de quadro jurídico e apoio institucional para a obtenção de crédito. A falta de financiamento de longo prazo e para o sector agrícola e PMEs tem sido muitas vezes apontada como uma lacuna que requer uma solução urgente. O Governo de Moçambique (GdM) está a considerar a hipótese de criação de um banco de desenvolvimento que iria providenciar financiamento de longo prazo e outras soluções financeiras para as empresas, incluindo as PMEs. A proposta de estratégia nacional de desenvolvimento recentemente partilhada propõe a criação do um Banco de Desenvolvimento de Moçambique (MDB) o qual iria financiar o investimento produtivo e acelerar o processo de industrialização. O Banco iria também gerir o fundo nacional de investimento e operacionalizar um fundo de garantia de crédito e um fundo de equalização da taxa de juros. Os três fundos iriam receber dotações orçamentais, incluindo os recursos que actualmente são disponibilizados para fundos de fomento. Em termos mais amplos, o MDB é visto como um instrumento para promover a diversificação da economia Moçambicana, garantindo que parte dos recursos fiscais gerados pelos recursos naturais são canalizados para o sector não transaccionável, em particular para as PMEs com potencial para a geração de postos de trabalho. i Embora o MDB ofereça uma oportunidade de diminuir os constrangimentos financeiros enfrentados pelas empresas, existem limitações e riscos associados ao mesmo. A experiência internacional monstra que os bancos de desenvolvimento são normalmente alvo de ingerência política a qual compromete a sua sustentabilidade. Quando os bancos de desenvolvimento vão à falência, estes tendem a impor prejuízos aos contribuintes visto que os governos intervêm para cobrir os passivos dos bancos durante o processo de liquidação ou antes da privatização. Os bancos de desenvolvimento não podem resolver todos os constrangimentos que limitam o acesso aos serviços financeiros. Esses constrangimentos reflectem uma interacção de múltiplos factores, incluindo o fraco ambiente de negócios, a falta de infra-estrutura de informação de crédito, conhecimentos de gestão limitados no seio dos mutuantes, etc. As recomendações que se seguem podem ajudar o Governo de Moçambique (GdM) a aumentar as possibilidades de sucesso do MDB:  Paralelamente com a possível criação do MDB, continuar a implementação de reformas com vista a promover um sistema financeiro privado competitivo, diversificado e capaz de resolver de forma sustentável os actuais constrangimentos de acesso ao financiamento;  Criar o MDB através de uma lei própria com vista a facilitar a inclusão de requisitos específicos, incluindo o mandato, disposições de governação corporativa, quadro regulamentar e de supervisão, e requisitos de sustentabilidade financeira;  Garantir que as actividades do MDB estimulam e não comprometem os recentes progressos na abrangência dos serviços financeiros. De forma mais específica, exigir que o MDB actue de forma complementar e que reporte anualmente sobre o seu desempenho. Por outro lado, garantir que o governo mantém uma participação social maioritária no Banco ao mesmo tempo que permite a participação de outros accionistas;  Atribuir ao MDB a flexibilidade para oferecer produtos e serviços que satisfaçam as necessidades do grupo ou segmento de mercado alvo e alinhar esses produtos e serviços às lacunas existentes – acesso limitado a serviços financeiros de longo prazo e para as PMEs e agricultura;  Exigir que o MDB seja financeiramente sustentável mediante o alcance de uma taxa de retorno mínima;  Rever o mandato do MDB de cinco em cinco anos com vista a garantir que o mesmo continue relevante; ao mesmo tempo, garantir a responsabilização do MDB pelo alcance dos seus objectivos estipulados;  Assegurar uma capitalização adequada do MDB, com acesso regular a um fluxo de financiamento de longo prazo; proibir o Banco de captar depósitos; ii  Exigir que o MDB opere como uma instituição financeira de segunda linha, disponibilizando os seus empréstimos através de instituições financeiras privadas; permitir operações de primeira linha ou concessão directa de empréstimos a grandes projectos, preferencialmente mediante a constituição de sindicatos com outros bancos e a utilização de esquemas de garantia de empréstimos devidamente desenhados com vista a encorajar a concessão de empréstimos a mutuantes de maior risco (especialmente PMEs);  Garantir que o MDB pratica preços comerciais, isto é, as suas taxas de juros cobrem os seus custos de financiamento, custos operacionais, e risco de crédito. Qualquer concessão de subsídios deve ser temporária, devidamente justificada, quantificada, e inscrita no Orçamento do Estado e nos relatórios do MDB;  Tomar precauções na elaboração do esquema de equalização das taxas de juros dado o seu potencial para criar o risco moral e incentivar os bancos para expandir a carteira de crédito de forma excessiva. Por outro lado, e por forma a evitar a acumulação de passivos contingentes por parte do governo, quaisquer subsídios não devem exceder os recursos alocados no Orçamento do Estado;  Colocar o MDB sob a supervisão do banco central e exigir que o mesmo cumpra com as mesmas normas prudenciais aplicáveis a instituições financeiras similares;  Comprometer-se na aplicação das mais elevadas normas de governação corporativa tendo em vista garantir que o MDB opera de forma independente e sem interferências políticas indevidas;  Garantir que o Conselho de Administração é dominado por membros qualificados, não executivos, e que não estejam ligados directamente ao governo; evitar a nomeação de funcionários governamentais para o Conselho de Administração;  Identificar de forma clara a instituição que irá representar o governo no MDB, a qual irá exercer os seus direitos e responsabilidades de propriedade e que será a única ligação entre o MDB e o governo;  Nomear um conselho de gestão profissional e dotá-lo de autonomia administrativa incluindo na tomada de decisões sobre a concessão de empréstimos e garantia do seu reembolso;  Assegurar a responsabilização a todos os níveis mediante a prestação regular de contas e avaliação de desempenho. Em especial, exigir que o governo ou o seu representante submeta o plano de actividades, orçamento e relatório anual do MDB à Assembleia da República, e efectue uma apresentação à comissão parlamentar de tutela sobre o desempenho do MDB;  Garantir níveis elevados de transparência e divulgação mediante a publicação de informação relevante sobre as operações e governação corporativa do MDB e aprovar um quadro apropriado para reportar sobre o seu impacto no desenvolvimento do país. iii EXECUTIVE SUMMARY The Mozambican financial sector has witnessed dramatic progress. The reforms implemented since late 1990s – including the privatization of state-owned banks, the strengthening of the independence and regulatory capacity of the central bank, and the introduction of a modern regulatory framework – have led to an increase in the number of financial institutions and more financial stability and deepening. The share of state-owned banks in the financial sector has reduced significantly and new products and services have been introduced. Bank solvency has also improved, with reported regulatory capital ratio rising from 14 percent in 2002 to 17.9 percent in 2012. Non-performing loans (NPLs fell dramatically and both domestic deposits to GDP and private credit to GDP have increased since 2004. The outreach of the financial sector, although still limited, has shown encouraging trends. The total number of bank branches increased from 228 in 2005 to 529 in 2012 but there are disparities between the capital Maputo and the rest of the country and between urban and rural areas. Recent surveys point to an increase in access to finance by manufacturing SMEs as evidenced by more use of bank loans and overdraft facilities. However, overall access to finance remains low. The vast majority of firms in Mozambique identify limited access to finance as a key business constraint and Mozambique ranks near the bottom in terms of the legal and institutional strength for getting credit. Lack of agricultural, long-term, and SME financing are often cited as the main financing gaps requiring urgent solution. The Government of Mozambique (GoM) is considering establishing a development bank which would provide long-term financing and other financial solutions to firms, including SMEs. The draft national development strategy recently circulated, proposes the establishment of the Mozambique Development Bank (MDB) which would provide finance to productive investment and accelerate the process of industrialization. It would also manage a national investment fund and operate a credit guarantee fund and interest rate equalization fund. The three funds would receive budget allocations, including the resources currently going to investment promotion funds. More broadly, the MDB is viewed as an instrument to promote the diversification of the Mozambican economy by ensuring that part of the fiscal resources generated by the natural resource sector are channeled to the non-tradable sector, particularly to SMEs with potential to generate jobs. While the MDB offers an opportunity to lessen the financing constraints faced by firms in Mozambique, there are limitations and risks associated with it. First, international experience shows that development banks are often targets of political intrusion which compromise their iv sustainability. When they fail, they tend to impose losses on taxpayers as governments step-in to pay their liabilities during liquidation or before privatization. Second, development banks cannot fix all the constraints limiting access to finance. These constraints reflect an interaction of multiple factors including a poor business environment, lack of information infrastructure, limited managerial skills among borrowers, etc. The following recommendations could help the GoM increase the MDB’s chances of success:  In tandem with a possible establishment of the MDB, continue to implement reforms that promote a competitive and diversified private sector-led financial system able to sustainably solve existing financing gaps.  Establish the MDB under its own law in order to facilitate the inclusion of specific requirements, including the mandate, corporate governance provisions, regulatory and supervisory framework, and financial sustainability requirement.  Ensure that the activities of the MDB enhance and not undermine the recent progress in the outreach of the financial sector. More specifically, require the MDB to act complementarily and to report annually on its complementary role. In addition, ensure that the government retains a controlling ownership interest in the bank while allowing the participation of other shareholders.  Give the MDB flexibility to offer products and services that meet the needs of the target sector or market segment and align those products and services with existing gaps – limited access to long-term, SME, and agricultural finance.  Require the MDB to be financially sustainable by achieving a minimum rate of return.  Review the MDB’s policy mandate every five years to ensure that it remains relevant while holding the MDB accountable for the delivery of its policy objectives.  Ensure that the MDB is adequately capitalized, with access to a regular funding stream; restrict it from taking deposits.  Require the MDB to operate as a second-tier development finance institution, conducting its lending through private financial institutions; allow first-tier or direct lending operations to large projects, preferably in syndication with other banks and use a properly designed credit guarantee scheme to encourage lending to riskier borrowers (particularly SMEs). v  Ensure that the MDB prices its products on commercial basis, that is, its lending rates and charges cover its cost of funding, operational costs, and credit risk. Any provision of subsides should be properly justified, quantified, temporary, and disclosed in the state budget and MDB’s reports.  Exercise caution in the design of the interest rate equalization scheme given its potential to create moral hazard and give banks incentives to excessively expand lending. In addition, any subsidies should not exceed the resources allocated in the state budget in order to prevent the accumulation of contingent liabilities by the government.  Place the MDB under the supervision of central bank and require it to comply with the same prudential standards applying to similar financial institutions.  Commit to higher standards of corporate governance with the view to ensure that the MDB operates independently and without undue political interference.  Ensure that the board is dominated by qualified, non-executive board members that are not directly affiliated with the government; avoid appointing government officials as board members.  Clearly identify a shareholder representative who on behalf of the government and the state will exercise ownership rights and responsibilities and be the single link between the MDB and the government.  Appoint a professional management and provide it with operational autonomy including to make credit allocation and collection decisions.  Ensure accountability at all levels through regular reporting and performance assessments. In particular, require the shareholder representative or the government to submit MDB’s corporate plan, budget, and annual report to parliament and to make an annual presentation to a designated parliamentary committee on the performance of the MDB.  Ensure high standards of transparency and disclosure by publishing relevant information about the operations and governance of the MDB and put in place a framework to report on its development impact. vi I. INTRODUCTION 1. This note identifies elements to consider when establishing and operating the proposed Development Bank of Mozambique (MDB). It is motivated by the recently circulated draft National Development Strategy which calls for the creation of a development bank to promote economic development by mobilizing and allocating financial resources for long-term investment. The note neither endorses nor opposes the establishment of the proposed development bank in Mozambique. 2. The note argues that the establishment of the development bank should be preceded by an in-depth diagnostic of existing financing gaps and its design and operation should conform to best practices. More specifically, the bank should have a clear policy mandate, including a well-identified target sector or market segment; sound corporate governance, particularly independent and professional board and management able to operate free of undue political interference; sound risk management; and adequate funding, regulation and supervision. It should contribute to recent progress in the expansion of financial services by complementing private financial institutions through focus on market gaps – including lack of long-term and SME financing. 3. The note is organized as follows: following this introduction, Section II highlights recent progress in outreach and access to finance in Mozambique and identifies three market gaps – limited availability of long-term finance, agricultural finance, and SME finance – which are often cited as reasons for government intervention; Section III assesses a potential role for the development bank in addressing these gaps; Section IV discusses elements to consider when establishing and operating such development bank; and section V concludes. II. VISIBLE PROGRESS IN THE FINANCIAL SECTOR A. Structure and performance 4. The Government of Mozambique (GoM) has implemented a series of financial sector reforms since late 1990s. The privatization of state owned banks – which had become a burden on public finances and a source of banking sector vulnerability – was completed in 2001; the financial institutions law was successively revised to accommodate new types of financial institutions and products; and the independence and powers of the central bank (Banco de Moçambique (BdM)) were strengthened along with the banking supervision and regulation capacity. The payment system was upgraded through the introduction of electronic clearing for checks, electronic transfer of government funds, and real time gross settlement system. 1 5. The above reforms have transformed the structure of the financial sector. The banking sector has witnessed the most dramatic progress. The number of commercial banks increased from 12 in 2000 to 18 in 2013 and new types of financial institutions (e.g., microbanks and credit cooperatives) have emerged. The privatization of state-owned banks and entrance of new private banks significantly reduced the share of banking assets owned by the state. Nonetheless, the state and its agencies still own 26 percent of Millennium BIM – the largest bank in the system, and in December 2012, Banco Nacional de Investimento (BNI) became a 100 percent state-owned after the GoM acquired the participation of the Portuguese government in the bank2. The pool of products and services offered to consumers has continued to expand, the latest addition being electronic banking and electronic money. Figure 1: Financial Depth Trends (in percent) Figure 2: Non-Performing Loans (in percent) 70 25 Domestic Bank Deposits to GDP 60 Private Credit to GDP 20 50 15 40 30 10 20 5 10 0 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: FinStats, World Bank 6. The banking sector became deeper and stable. Bank solvency has improved, with reported regulatory capital ratio rising from 14 percent in 2002 to 17.9 percent in 2012. Both domestic deposits to GDP and private credit to GDP have increased since 2004, despite stagnating in 2011 as a result of BdM’s monetary policy tightening (Figure 1). Non-performing loans (NPLs) fell dramatically between 2002 and 2004 (Figure 2) following the cleanup of the balance sheets and privatization of state owned banks – notably Banco Comercial de Moçambique (BCM) and Banco Popular de Desenvolvimento (BPD)/Banco Austral. NPLs have 2 BNI was established in 2010 by the governments of Mozambique and Portugal as an investment and development bank to focus on large infrastructure projects. The initial shareholding structure was 49.5 percent for the Government of Mozambique, 49.5 for the government of Portugal through state-owned bank Caixa Geral de Depósitos, and 1 percent for BCI-Fomento (owned by Caixa Geral). The capital of BNI was initially set at US$500 million but the shareholders were only able to pay-in US$70 million. As of June 2013, BNI had approximately US$ 80 million in assets, of which 54 percent were government securities. 2 remained consistently below 5 percent since 2005, although they have been rising slowly since 2011. 7. Despite the entrance of new banks, the system remains highly concentrated. The three largest banks owned 85 percent of the total assets of the banking system in 2011, down from 100 percent in 2004. The average profitability of the banking system as measured by the average return on equity (ROE) has declined from 61 percent in 2004 to 23 percent in 2011, but it remains somewhat higher than the Sub-Saharan Africa average (Figure 3). Figure 3: Bank Concentration and Profitability 3 Bank Asset Concentration (in percent) Return on Equity in (in percent) 120 70 100 60 50 80 40 60 30 40 20 20 10 0 0 2004 2005 2006 2007 2008 2009 2010 2011 2004 2005 2006 2007 2008 2009 2010 2011 Mozambique Angola Kenya Mozambique Angola Kenya South Africa Zambia SSA Average South Africa Zambia SSA Average Source: FinStats, World Bank B. Outreach and access to finance 8. While the outreach of the banking sector remains low and unbalanced, recent progress is encouraging. The total number of bank branches increased from 228 in 2005 to 529 in 2012. As a result, the number of bank branches per 100,000 adults nearly doubled from 2.2 to 4.1 while the number of branches per square kilometer increased from 0.29 to 0.663. However, the difference between Maputo and the rest of the country as well as between urban and rural areas is significant. For instance, in 2012, the number of branches per 100,000 adults in urban areas (13.8) was ten times higher than in rural areas (1.3). Similarly, the levels of financial inclusion show tremendous disparities, with Maputo city enjoying an index of financial inclusion that is seven times the national average (BdM 2013). 3 But these figures are low in absolute terms and compare unfavorably with those of selected peer countries (including South Africa, Kenya, and Angola) as well with the average of Sub-Saharan Africa. 3 9. Access to finance appears to be slowly improving, albeit from a lower base. According to the 2012 survey of manufacturing firms (DNEAP 2013), the use of financial services increased among a group of 180 SMEs surveyed in 2006 and 2012 (Table 1) 4 . For example, 17.8 percent of firms report using bank overdrafts in 2012, compared to 15 percent in 2006; the same percentage (17.8) reports having a bank loan in 2012, compared to only 12.8 percent in 2006. The improvement is not confined to Maputo as more firms in Beira and Nampula provinces report an increase in the use of bank loans and overdraft facilities. As expected, usage increases with firm size and with the availability of audited accounts (column ‘Audit’ in Table 1); formal firms report more usage than their informal counterparts. Table 1: Use Financial Instruments by Firm Type, in percent Source: 2012 Survey of Mozambican Manufacturing Firms (DNEAP, 2013) 10. According to DNEAP’s survey, the two largest commercial banks and microfinance banks are responsible for most of this improvement in lending. Millennium BIM and BCI- Fomento, the two largest commercial banks and the main drivers of the geographical expansion of the branch network in Mozambique, are reported as the providers of banks loans by 21 and 9 percent of the surveyed firms, respectively. Microfinance banks have also contributed to the improvement in lending, such as Socremo (20 percent), ProCredit (16 percent) and Banco Tchuma (7 percent) – all microfinance banks that entered the market in the last few years and introduced innovative lending technologies. 4 This is consistent with the increase of the volume of lending going to the manufacturing sector (industry) from MZN 4,746 million in 2006 to MZN 8,906 in 2012, according to BdM’s data. However, during the same period, the share of manufacturing lending declined from 13.1 to 8.7 percent. 4 C. Remaining market gaps 11. Despite the progress, access to finance is still low and perceived as the biggest constraint to firm growth. The 2014 World Bank Doing Business Report ranks Mozambique 130 out of 189 economies in terms of the legal and institutional strength for getting credit 5. Moreover, 54.6 and 53.8 percent of manufacturing firms identified access to foreign credit and domestic credit, respectively, as the top two business constraints (DNEAP 2012). Similarly, 45.7 of firms surveyed for the 2009 World Bank investment climate assessment identified access to finance as a major or severe business constraint. 12. There are three main financing gaps that are often mentioned as compelling reasons for government intervention through a development bank. These include limited supply of long-term financing and limited credit to agriculture and SMEs. These gaps have been documented in several diagnostics (e.g., investment climate assessments, SME surveys, banking sector studies, etc.). 13. Nonetheless, there may be a need to undertake further assessments to better tailor the MDB’s lending programs to the actual needs of the target sector/market segment. For instance, there is a need to understand with some level of detail the sectoral needs and the product/instrument gaps, identify the ongoing and planned reforms and projects that aim to tackle some of the more structural constraints in accessing finance, and decide how the MDB can complement such reforms and projects. Such projects (e.g., UK’s project on access to finance developed in collaboration with the WB, IFC and other donors) could address some of the gaps (e.g., business development services) while offering the MDB the opportunity to play a delivery role. Medium and long-term finance gap 14. Lack of long-term finance is perceived as an impediment to productive investment, particularly by local firms without access to international financial markets. No comprehensive data is available on the distribution of bank loans by maturities. However, the average maturity of bank loans has increased particularly due to an increase in mortgage and commercial real estate lending. The share of medium to long term loans (more than one year) in the combined loan portfolio of the three largest banks (Millennium BIM, BCI-Fomento and Standard Bank) was approximately 70 percent in 2010 through 20126. While this does not tell much about the maturity distribution and the sectoral/borrower concentration of these medium to long-term loans, they account for a much larger percentage in Mozambique compared to less 5 The legal and institutional strength for getting credit assesses the legal framework for movable collateral as well as credit information systems and infrastructure. 6 BCI-Fomento’s annual report shows that 47 percent of the bank’s portfolio value in 2012 had a maturity of more than 5 years. 5 than 50 percent in Africa (Beck et al 2011). Nonetheless, there is a perception that the maturities of the loans currently provided are short to meet the investment needs of Mozambican companies, particularly those that need to invest in projects with long gestation periods including infrastructure and mining. 15. Reasons for limited supply of long-term finance are diverse. They include:  Short-term maturity of bank liabilities. Demand deposits account for the bulk of funding of the Mozambican banks. Bond issuance is not common7. Although banks can still engage in maturity transformation – using short-term deposits to extend loans – they tend to refrain from doing so in order to avoid maturity mismatches. This is particularly the case if they lack risk management capabilities to handle long-term lending.  Smaller and underdeveloped capital markets. Pension funds and insurance companies are typically the main suppliers of long-term finance as they try to hold assets with duration that match their long-term liabilities. Life insurance premiums account for less than 0.5 percent of GDP and the pension sector is dominated by the Instituto Nacional de Segurança Social (INSS), a state-run Pay-As-You-Go system. Still, the underdevelopment of capital markets limits the ability of insurance companies and pensions funds to channel their limited funds to productive investment while earning a stream of returns that suit their long-term liabilities. Moreover, only a very small number of large companies (telecoms and banks) have sporadic access to the bond market. Equity issuance at the Mozambique Stock Exchange is rare and secondary market trading of securities almost inexistent.  Institutional factors. There are also institutional and demand-side factors that constrain long-term lending. Banks use short-term lending to control borrowers given pervasive asymmetric information problems due to the absence of sound credit information infrastructure, reliable financial reporting, and stronger contract enforcement mechanisms. 16. A problem closely related to the lack of long-term finance is the smaller size of local commercial banks which limits their ability to finance big ticket projects. The largest bank, Millennium BIM, had equity of US$ 436 million in 2012, meaning that it cannot take a single exposure of more than US$ 106 million. Thus, it is argued that local banks lack the scale to finance the participation of local companies in capital-intensive sectors such as mining and infrastructure. 7 Demand deposits make two-thirds of total deposits and this share has remained largely unchanged for the last six years. 6 17. Foreign Direct Investment (FDI), foreign borrowing, and official development assistance have been filling the long-term finance gap. FDI almost quadrupled between 2010 and 2012, but it is concentrated in the extractive industries sector. After picking at about US$5.2 billion in 2012, it is expected to reach US$4.7 billion in 2013 and to remain over US$4 billion yearly for the next few years. In recent years, official development assistance and external borrowing have financed nearly all the large public investment projects. Agricultural finance gap 18. Notwithstanding its economic importance, banks have stayed away from agriculture. The agricultural sector employs 78 percent of the economically active population and generates 23 percent of GDP. But the share of bank credit going to the sector has fallen from 19 percent in 2000 to 5 percent in 2012 (Figure 4). Moreover, according to the 2009-2010 agricultural census, only 2.4 percent of farmers had access to any type of credit. Access among small farmers was the lowest at 2 percent, compared to 7 and 15.2 percent among medium and big farmers respectively. Input suppliers were the top credit providers (to 41.5 percent of farmers that received any credit); commercial banks were providers to only 3.7 percent. Figure 4: Bank lending to agriculture 7,000 25 Loans to agriculture in million MZN Agriculture share in percent, right 6,000 20 5,000 15 4,000 3,000 10 2,000 5 1,000 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: BdM; World Bank Staff Calculations 19. Banks perceive agricultural lending as highly risky, particularly due to a higher probability of crop failure as result of unpredictable weather. Only a small percentage of agricultural land in Mozambique has any type of water management infrastructure, making production vulnerable to floods and droughts. Access to extensions services is also limited. 20. In addition, many banks lack the branch network required to service the sector. The majority of agricultural activity takes places in rural areas with no presence of financial 7 institutions. In 2012, only 134 out of the 529 bank branches were located in non-urban areas and only 63 of the 128 districts had at least one bank branch. But even if banks were present everywhere, the majority of rural enterprises and smallholder activities would still not be bankable due to their small scale and lack of collateral, including the difficulty to use land titles as collateral in rural areas. 21. Nonetheless, some banks have increased their attention to agriculture. Banco Terra was established to focus on agricultural lending but it appears to have had mixed success so far. Standard Bank has established a specialized agri-finance department and has tried to leverage its partnership with Alliance for a Green Revolution in Africa (AGRA). Bank Pro-credit reported a 42 percent growth of its agricultural portfolio in 2011 as it expanded to the north of the country. Finally, GAPI8 has continued to mobilize donor credit lines to finance agro-processing SMEs in the north and has been setting up and funding rural micro-banks and cooperatives that finance production and trading activities at the local level. Finally, GAPI, the embassy of Denmark, and the Ministry of Agriculture recently established a US$ 12 million guarantee scheme to encourage lending to firms in the agro-processing value chain. SME finance gap 22. With overall access to finance very low in Mozambique, it is not surprising that SMEs’ access is even lower. Nonetheless, assessing the extent of SME financing gap and progress made in addressing it is hampered by lack of data. Aggregate credit data are not disaggregated by the size of the borrowers and commercial banks rarely disclose their lending to SMEs. In addition, the newly issued definition of SMEs (Decree 44/2011)9 is not yet consistently applied among banks and government entities. Banks use their own definitions, usually depending on the amount of the loan and the way the exposures are managed. 23. Microfinance banks are the key providers of SME financing. The four microfinance banks – Procredit, Socremo, Banco Tchuma, and Banco Oportunidades – have gradually moved from micro to SME lending as they shifted their strategies into universal banking models. For example, Procredit reported in 2011 that it shifted away from loans under USD 2,000 to lending to small enterprises. Total lending by these banks has continued to grow. Other players in SME lending include GAPI, Banco Terra, and more recently Banc ABC. 8 GAPI is a US$ 33 million asset development finance institution owned by the GoM, Mozambican private investors (GAPI staff), and two NGOs (Mozambique Red Cross and Community Development Foundation). It offers financing, business development services, and guarantees. A larger share of its funding comes from international development agencies. 9 Decree 44/2011 defines SMEs as companies with up to 100 employees and with no more than MTN 29.9 million (or $1 million) turnover. In 2009, SMEs were estimated to comprise 99 percent of the 26,000 enterprises that existed at that time (INE 2009). 8 24. The Government also operates investment promotion funds which lend to multiple sectors and market segments. The main ones are the Fundo de Fomento Pesqueiro (Fisheries), Fundo de Desenvolvimento Agrário (Agriculture), Fundo de Desenvolvimento Distrital (local/district development), and Fundo de Promoção à Pequena Indústria (manufacturing). They are spread out across several ministries and operate in an uncoordinated manner, increasing the administrative costs of managing them. There is no readily available information on their portfolio allocations but they seem to be affected by a number of challenges, including low repayment rates arising from a deficient selection of borrowers10. As discussed later, some of these funds might be incorporated into the new development bank. 25. Different types of SMEs will have different constraints to accessing finance and interventions to address these constraints should therefore be different. There are likely to be three cohorts of SMEs: the first, comprising those that are already accessing credit from the banking system but at higher cost and shorter maturities; the second, made of near-bankable SMEs unable to access credit because they are perceived to be too risky – for instance because they lack credit history or collateral; the third cohort may include very small SMEs at an early development stage and facing all other typical constraints, including lack of basic accounting information, management skills, business plans, etc. Each cohort has specific needs, and in order to be effective, government intervention needs to be tailored accordingly. For example, the second cohort can benefit from risk mitigation instruments such as credit guarantees while the third would require a comprehensive package of business development services. III. THE ROLE OF A DEVELOPMENT BANK A. International experience 26. An immediate question is whether a development bank can be a tool to address the market gaps identified in the previous section. International experience shows that countries have established development banks to address all sort of market failures, including the three discussed. In fact, the World Bank global survey of development banks (De Luna Martinez and Vicente 2012) shows that 92 percent of development banks target SMEs, 90 percent offer long- term loans (the top product offering), and 83 percent lend to agribusiness. Development banks often take a long-term view, particularly if they are funded by sources other than short-term deposits. The Brazilian development bank (BNDES) is a development bank with far-reaching impact on the economy, targeting small to large business across all sector of the economy, including sports, culture, and environment, focusing on long-term financing. 10 See Orre and Forquilha (2012) and CIP (2012) for a discussion on the performance of the Fundo de Desenvolvimento Distrital. 9 27. But international experiences also show that it is not easy to establish a successful development bank. The majority of development banks in the world are not successful, mainly because they are unable to balance financial sustainability with the delivery of their development mandate. They drift away from their policy mandates, compete with the private sector, and distort the credit culture by failing to enforce loan agreements. The failure of state-owned banks (as is the case with private banks) also imposes direct costs on taxpayers. For example, the recapitalization of state-owned banks prior to privatization reached more than 10 percent of GDP in Albania, Czech Republic, and Turkey between 1991 and 2002 (Sherif 2004). In Mozambique, the recapitalization of then state-owned BCM and BPD was substantial, reaching 2.9 percent of GDP in 2001. Earlier recapitalizations of BCM were 7 percent of GDP in 1993 and 4 percent in 1994. B. Limitations of development banks 28. Development banks are not a panacea – the causes of market failure are complex and require other types of policy interventions. Lack of finance for agriculture and SMEs is a result of many other factors beyond the control of a development bank. As discussed, lending to agriculture is constrained by the high probability of crop failure due to lack of agricultural infrastructure; SMEs face own constraints including poor managerial skills; and borrowers in general cannot easily establish their track record in the absence of credit information infrastructure. Adding to this, the overall business environment in Mozambique is still challenging as demonstrated by Mozambique’s position in Doing Business. The physical infrastructure is deficient, contract and collateral enforcement is poor, and the quality of accounting information is substandard. The development bank cannot solve all these problems; on the contrary, these problems could affect the bank’s performance. 29. This suggests that the establishment of a development bank should not come at the cost of ongoing reforms. A competitive, diversified, and sound private sector-led financial system is better positioned to sustainably solve existing financing gaps. In this context, there is a need to accelerate the ongoing establishment of a regulatory framework for private credit bureaus and secured transactions (including movable collateral registries) which could be a game changer in reducing informational and collateral constraints for access to finance, particularly by SMEs. The same can be said about ongoing efforts to develop government debt markets, making them efficient in acting as benchmarks for the pricing of long-term debt and supporting the development of capital markets which would be an alternative source of long-term funding for firms. C. The Development Bank of Mozambique 10 30. The idea of establishing a development bank in Mozambique is not new . The Nation’s Vision and Strategies – Agenda 2025 (Committee of Counsellors 2003) calls for the establishment of a development bank which would provide financing for productive investment amid the reluctance of private banks to provide this type of financing. It also calls for the establishment of credit guarantee schemes, lines of credit, and venture capital funds. Box 1 in Appendix A fully reproduces the description of the development bank contained in Agenda 2025. 31. Calls for the establishment of a development bank have been renewed by the recent discoveries of natural resources. In this context, a development bank is viewed as an instrument to promote the diversification of the economy by ensuring that part of the fiscal revenues generated by the natural resources sector are channeled to the non-tradable sector, particularly to SMEs with potential to generate jobs. A separate policy note being produced to discuss options for managing natural resource revenues discusses the role that a development bank could have (World Bank, 2014). 32. The draft national development strategy– which aims to ensure the implementation of Agenda 2025– identifies the establishment of the Mozambique Development Bank (MDB) as a key policy intervention to increase financing for productive investment and accelerate the process of industrialization. According to the draft strategy (MPD 2013), the main financing gap to be filled by the MDB is the lack of long-term financing, deemed to be arising from limited savings and the inability of the private banking system to supply credit. The MDB would manage a national investment fund which would receive budget allocations, including the resources currently going to investment promotion funds. The strategy suggests that the MDB would operate at both retail and wholesale levels – this is a departure from the Agenda 2025 which foresaw wholesale-only development bank. 33. The MDB would also operate a guarantee fund and an interest rate equalization fund. The guarantee fund would cover a portion of the loans granted by commercial banks, therefore reducing the credit risk and the required level of collateral. The interest rate equalization fund would cover the difference between “the interest rate required to make investments viable” and market rate charged by commercial banks. Implicit is the notion that part of the development bank lending would be subsidized. Both funds would receive annual budget allocations. IV. ELEMENTS TO CONSIDER WHEN SETTING THE DEVELOPMENT BANK 34. As shown in section II, there are encouraging trends pointing to an increasing access to finance and outreach of the Mozambican financial sector. The MDB should enhance these 11 trends and not undermine them. In order to increase its chances of success, it would need to embrace best practices, including having a clear mandate, complementing the private sector, adopting the right delivery model, be properly funded, transparently governed, and required to be financially sustainable. This section discusses how these best practices could be incorporated into the design of the MDB. A. Ownership 35. The government should retain controlling interest in the MDB, but consideration should be given to a possible participation of other shareholders (particularly international development agencies). Public control of development banks ensures focus on development objectives. As the World Bank global survey of development banks shows, the majority of development banks (74 percent) are fully owned by their domestic governments. The remaining 26 percent are partially owned by foreign governments, international development agencies, or private sector11. This partial ownership enhances corporate governance and facilitates technology transfer, ultimately bringing value to the development bank. This is particularly the case if these shareholders are selected strategically and they share the same goals as the government. GAPI’s example illustrates that it is possible to operate a viable public-private partnership in Mozambique that focuses on development finance. 36. The development bank needs to have a clear legal form. The majority of development banks in the world have been established under a special law or decree. Such laws provide legal cover to the bank, stipulating its mandate and the governance structure. Still, development banks can be established under the banking or the companies’ law. But the special law has the advantage of allowing the inclusion of provisions or requirements that are specific to development banks as public policy institutions (see the discussion on the policy mandate). Another advantage – unique for Mozambique – is that the process of passing the law would facilitate a debate which could build a national consensus about the role of the development bank. B. Policy mandate 37. The MDB should operate under a clear and specific policy mandate. Such mandate should specify the target sector/market segment, products and services, positioning or cooperation with the private sector, and self-sustainability criteria. It should also require the bank to undergo a periodic review of its mandate and to be accountable to the Parliament for its performance. Ideally, these specifications and requirements should be spelled out in the law of 11 An example of a development bank partially owned by international development institutions is the Rwanda Development Bank. 12 the MDB as it is the case with more successful development banks, such as the Business Development Bank of Canada (BDC). Target sector or market segment 38. The market failure that the MDB will fill needs to be clearly identified and articulated. As discussed above, there appears to be a gap or market failure in the provision of credit to SMEs and agriculture as well as long-term finance. However, there is a need to better understand the current situation by looking at both at supply and demand factors driving this limited access. For instance, it is not enough to prove that SMEs are not getting enough financing or that the cost of credit is too high. In order to be confident that development bank is the right instrument to tackle a particular market failure and tailor its operations and instruments accordingly, one needs to better understand the root causes of limited access and high cost of credit. Positioning 39. The MDB should act as a gap-filler, meaning that it should be expected to serve sectors and market segments that private banks are unwilling or unable to serve. It should not compete with the private financial institutions nor try to substitute for them; rather, it should complement them by operating within its target sector/market segment as stipulated by its mandate. To ensure that this is the case, the MDB should be required by its law to act complementarily and to report annually on its complementary role (for example, by disclosing the volume of its syndicated lending with private financial institutions or the number of mutually referred deals). Restricting the scope of the MDB’s retail/direct operations would reduce the risk of competition with the private sector. 40. The key principle is that the MDB should operate at the risk frontier. In other words, it should take marginally more risk than commercial banks, either by lending at relatively longer maturities or to clients that commercial banks would regard as too risky. But in order to this, the MDB would need sophisticated risk management capacities to ensure that it not taking excessive risk and exposing itself to unsustainable losses. Products and services 41. The mandate also needs to broadly specify what products the MDB will offer to its target sector. The bank should be given flexibility to offer a diversified set of products and to tailor them to the needs of the target sector or market segment. Nonetheless, in order to minimize the risk of competition with private financial institutions, the MDB should not offer short-term products – overdrafts, lines of credit, etc. – that are usually the province of commercial banks. 13 42. Such products and services also need to be in line with the market failure that the MDB will be expected to address. Based on the brief characterization of financing gaps provided in section II, it appears that:  Lending should be primarily medium to long-term. This would address the long-term financing gap by complementing commercial bank’s short-term financing; in essence, it would increase the supply of funding for working capital and acquisition of loan term assets. Short-term funding programs for SMEs could be offered, but only through financial intermediaries (see the discussion on the lending model).  There is a valid rationale for using a credit guarantee scheme to induce more lending by leveraging existing bank liquidity12. A credit guarantee scheme could mitigate the agricultural and SME financing gaps – particularly for borrowers with limited collateral – by reducing financial institution’s exposure to loss in the event of borrower’s default. By leaving credit appraisal in the hands of private financial institutions, guarantees allow these institutions to refine their risks management skills and to learn about the payment behavior of borrowers.  However, such scheme would need to be carefully designed in order to ensure additionality and limit moral hazard while remaining attractive to private financial institutions. This would require two things. First, proper pricing of guarantees to ensure that banks have no incentives to request coverage for low risk borrowers. Second, adequate level of risk sharing to reduce moral hazard. Moreover, the design would have to incorporate lessons of limited success of other guarantee schemes, including those sponsored by USAID, AGRA/Standard bank, and the French Development Fund (CFD). Finally, the scheme would need to complement the existing US$ 12 million scheme operated by GAPI.  The development bank could provide innovative public goods, including financial infrastructure and coordination services. The Mexican development bank Nacional Financiera (NAFIN) operates a reverse factoring program and an online platform (cadenas productivas) which links banks, large buyers, and suppliers (Klapper 2006). The platform allows suppliers to place their account receivables (invoices) and have banks compete to discount these invoices. More than allowing suppliers to turn their account receivables into cash, the platform facilitates a flow of information among the three parties involved, stimulating additional lending and borrowing opportunities. This type of 12 The Mozambican banking sector is liquid as demonstrated by a ratio of liquid assets to total liabilities of 33.4 percent in 2012 and a loan to deposit ratio of 70 percent. Nonetheless, loan to deposit ratios have been increasing in recent years in line with increased intermediation. 14 infrastructure holds some potential in Mozambique given the emergence of large and reputable buyers. Account receivables from the public sector (maybe including VAT reimbursements) could also be factored. The MDB could also facilitate the financing of large projects by acting as a project originator and leading loan syndications. With regard to agriculture, the MDB could take a lead in the development of innovative financing products such as mobile payments, index based insurance, and warehouse receipts.  While the product offering could also include advisory services, the MDB should not offer these services directly, except to smaller financial intermediaries. Many development banks, particularly those operating a retail model, offer consulting, training, and other capacity building services to their clients. Many banks use external providers. However, few banks are able to recover the costs associated with the delivery of these services. The MDB should act as a referral to advisory services already offered by government institutions (such as the Institute for the Promotion of Small and Medium Enterprises) and donor funded programs. Nonetheless, the MDB could still directly provide capacity building to smaller financial intermediaries who are willing to expand their lending to SMEs. Efficiency and sustainability requirement 43. In order to be successful, the MDB would have to operate as a commercial entity and earn a profit that allows it to be sustainable over time. At a minimum, such profit should ensure that the capital of the bank remains constant in real terms. Following international practice, this can be accomplished by requiring the development bank to earn a medium-term rate of return not lower than the inflation rate (e.g., NAFIN in Mexico) or the government’s long-term borrowing cost (BDC) 13 . This requirement should not be mistaken with profit maximization. The goal of a development bank is to maximize social impact, not profitability. But in order to maximize social impact, it must be profitable unless it relies on government transfers. Review of the policy mandate. 44. The law of the MDB should make provisions for a regular review of the policy mandate. Market gaps are dynamic and the mandate of the bank will need to adapt accordingly. Thus, regular review of the mandate would ensure that it remains relevant while holding the bank accountable in achieving desired results14. The frequency of the review could be five years. 13 As a result of the ongoing restructuring process, the Development Bank of Southern Africa will have a specific sustainability requirement. 14 Mandate reviews are typically led by the government entity in charge of the ownership function (shareholder representative). The reviews are supported by external experts and involve extensive consultations with key stakeholders and market participants (for instance, private commercial banks and their membership organizations). 15 Box 1: The policy mandate of the Business Development Bank of Canada (excerpts from the law of the BDC) The current mandate of the BDC is outlined in its law enacted by the parliament in 1995. The BDC succeeded the Federal Business Development Bank (1975-1995) and the Industrial Development Bank (1944-1975). Purpose: the purpose of the Bank is to support Canadian entrepreneurship by providing financial and management services and by issuing securities or otherwise raising funds or capital in support of those services Target sector: in carrying out its activities, the Bank must give particular consideration to the needs of small-sized enterprises. Positioning: The loans, investments and guarantees are to fill out or complete services available from commercial financial institutions. Products and services: The loans, investments, and guarantees may be made or given directly, through arrangements with other financial institutions or by the Bank as a member of a financing syndicate; the Bank may provide …business planning services; management counseling and training, including seminars, conferences and meetings; and information. Currently, BDC provides financing, subordinated financing, venture capital, and consulting. Review of mandate: Five years after this Act [law of the BDC] comes into force, and every ten years afterward, the Designated Minister must have a review of the provisions and operation of this Act undertaken in consultation with the Minister of Finance. Sustainability: BDC is required to achieve a return on equity that exceeds its cost of capital. Currently, this requirement is not set in the law but in the Treasury Board Guidelines. C. Funding 45. Development banks use multiple funding sources. These include deposits from the public, loans from domestic and international financial institutions, debt issuance in domestic and international capital markets, budget transfers, and net worth (capital and retained earnings). Their debt is often guaranteed by the state, allowing them to borrow at a relatively lower cost. The global survey found that 59 percent of the surveyed developments banks did not take deposits from the public, 89 percent were allowed to borrow from other institutions or issue debt in local markets, 40 percent received transfers from the government, and 64 percent enjoyed state guarantees. In addition, the survey found that all deposit-taking development banks were retail lenders. 46. The MDB will have to have sufficient scale through adequate capitalization. Mozambique already has a considerable number of banks but their individual size is small relative to the financing needs of emerging projects in natural resources and infrastructure. 16 Adding a smaller state-owned institution will not make much difference to large infrastructure projects. As the experience with the capitalization of BNI has demonstrated, it will be challenging to secure enough capital (say US$ 500 million) for the bank. A possible alternative would be to start with a smaller development bank and grow it gradually. Such bank could concentrate on SMEs, using credit guarantees to leverage the resources of private financial institutions. Another alternative would be to reach out to international investors and financiers. But this is not an easy solution given the reservations that many have about the success of a development bank in Mozambique. Perhaps it would help to approach investors with a clear plan about how the development bank will work and what governance safeguards will be put in place to limit political interference and mismanagement. 47. In addition to be well-capitalized, the MDB would need to secure a stable stream of long-term financing. International experiences (Box 2) shows that development banks that are successful in long-term lending tend to have access to stable and long-term funding, including access to capital markets, earmarked funding (e.g., from social security), and borrowing from the government. The BDC and the BNDES borrow directly from their national treasuries, particularly since the onset of the global financial crisis. The DBSA, on the contrary, relies more on the issuance of bonds guaranteed by the government. Box 2: Sources of funding of the BNDES and DBSA In 2012, BNDES’ main funding sources included direct borrowing from the national Treasury (52.6%), workers assistance fund and PIS-PASEP payroll tax (27.2%), net worth (7.2%), and foreign sources (3.3%). The Development Bank of Southern Africa (DBSA) is a development finance institution fully owned by the Government of South Africa. The DBSA funds itself mainly through issuance of long-term domestic bonds (including bonds with 16 and 20 year maturities). As of March 2011, DBSA’s funding sources were distributed as follows: domestic capital markets (66.1%), international capital markets (7.1%), domestic money markets (10.3%), bilateral (8.3%), supranational (7.4%), and other (0.8%). Source: BNDES and DBSA’s annual reports 48. The MDB should not take deposits from the public. As argued above, the mandate and products of a development bank must reflect the market failures that it is expected to address. While savers in rural Mozambique still lack formal saving opportunities, the expanding branch network and the emergency of micro banks and savings associations shows the willingness and ability of private financial institutions to offer savings products to increasingly more people. Thus, deposit-taking by the MDB does not appear to be justified15. The law of the MDB should explicitly prohibit it from taking deposits. 15 Moreover, in order to mobilize savings the MDB would have to a build an extensive branch network in rural areas. 17 49. The idea of bringing various investment promotion funds currently managed by different government agencies under the management of the MDB would be a move in the right direction. This would ensure a strategic allocation of these funds and generate economies of scale. But for this to be effective, the allocation procedures and target groups/sectors of these funds would have to be revisited. Otherwise, the development bank would be fragmented as it tries to serve the different constituencies and objectives currently served by the funds. More importantly, these constituencies would have to stop treating loans as gifts. D. Lending model 50. There are two lending models for development banks – retail lending (first tier) and wholesale lending (second-tier). Under the wholesale model, development banks lend through other financial intermediaries while under the retail model they lend directly to final borrowers using their own branch network. The wholesale model is usually preferable because it ensures that the development banks complement rather than substitute the private financial institutions. It also allows the development banks to operate with a lean structure. Examples of wholesale development include Kreditanstalt fuer Wiederaufbau (KfW) of Germany, Corporación Financieras de Desarrollo S.A. (Cofide) of Peru, and the National Bank for Agriculture and Rural Development (NABARD) of India. Wholesale development banks tend to perform better than their retail counterparts because they only take the financial intermediary credit risk – the borrower’s credit risk is borne by private financial intermediaries. 51. Nonetheless, the second-tier model has some disadvantages. Firstly, by not dealing directly with borrowers, the development has no direct control on credit allocation. Secondly, the development bank does not directly learn about the needs of the target sector, limiting its ability to provide feedback to the government and influence policy and strategies. 52. Many development banks operate both at retail and wholesale level (mixed model). According to the survey, 52 percent of development banks were simultaneously retailers and wholesalers, compared to 12 percent that were wholesalers-only and 36 percent retailers-only. 53. The MDB should operate as a second-tier development finance institution. Under this model, the MDB would be able to keep a leaner organizational structure by leveraging the expanding branch network of existing financial intuitions (including that of GAPI). It would rely on financial intermediaries’ skills and experience to appraise borrowers, reducing potential pressure on itself to lend to excessively risky borrowers. Concerns about possible competition with private financial institutions would also be minimized. Retail lending could be allowed only for big ticket projects or loan syndications with private financial institutions. This model requires that the MDB puts in place a monitoring and evaluation system that captures the additionality, and if possible, the development impact of its indirect lending. 18 54. Despite relying on profit maximizing financial intermediaries a second-tier model could still contribute to the lessening of financing gaps identified in section II. Assuming minimal institutional and demand-side constraints, the provision of long-term funding to financial intermediaries, everything else equal, would increase their ability to lengthen maturities. Thus, bankable borrowers would be able to access long-term loans and possibly at relatively lower cost and flexible terms16 depending on the MDB’s ability to mobilize cheaper funding. Those borrowers that are deemed too risky – either because they lack credit history or collateral – including SMEs and agricultural borrowers, could count on the support of the credit guarantee scheme. E. Pricing of products and services 55. The MDB should price its products on a commercial basis. This means that its lending rates should recover its cost of funding and cover operational costs and the credit risk involved in both wholesale and retail lending. The MDB may still be able to lend at below average interest rates if it secures its funding at below market rates or if the GoM as the shareholder implicitly accepts a lower rate of return (as is typically the case). Lending at below market rates should not be the result of risk underpricing or non-recovery of operational costs as this would render the operations of the MDB unsustainable. Following the example of the BNDES, the MDB should disclose its pricing formula. 56. Any provision of subsides should be properly justified, temporary, and transparent. A stronger case for the provision of subsidies to certain groups or sectors should be done through proper cost benefit analysis (at program level), including the quantification of gains and internalization of the opportunity costs of public funds. Subsidies should also be provided for a limited period of time and criteria for lifting them should also be set up front. The cost of such subsidies should be included and discussed in the state budget. Cross-subsidization, if any, should also be made transparent through proper disclosure in the MDB’s reports. 57. Caution should be exercised when designing the interest rate equalization scheme. If the promise of interest rate compensation is credible and the difference between the subsidized and the market interest rate is high, banks will have the incentive to expand compensated lending. This incentive increases if compensated loans are covered by the credit guarantee scheme. The result could be excessive credit growth and accumulation of contingent liabilities by the state. In order to avoid this outcome, a limited allocation for subsidies (interest rate compensation amounts) should be included in the state budget and the volume of compensated lending capped at the level allowed by the subsidies foreseen in the state budget. 16 Flexible terms could include grace periods and tailored repayment schedules. 19 Box 3: Credit guarantees and interest rate equalization in Belarus The financial sector in Belarus is dominated by four public banks which accounted for 65% of the banking system assets in 2011. They also accounted for two-thirds of total deposits and provided 60 percent of total credit. Their dominance was particularly higher in sectors targeted by government programs, including agriculture, housing, and manufacturing. Bank lending is highly influenced by the government through its lending programs. Lending under government programs (LGP) is a well-established practice through which the government directs subsidized credit to some sectors, groups, and projects. LGP targets are set in presidential and ministerial decrees. In theory, LGP is “recommended” but the public banks do not have sufficient autonomy to disregard a decree from the President or the Council of Ministers. Nonetheless, LGP is attractive for banks because it allows them to expand their lending portfolio and is usually 100 percent guaranteed by the central and local governments. The public banks finance government programs using three sources: (i) resources allocated in the State budget, which are placed with them as low cost deposits; (ii) central bank funding; and (iii) own resources (deposits from customers and capital injections from the government). Banks are entitled to interest rate compensation if they grant loans using their own resources, but no compensation is provided if they use government deposits. In some cases, the interest rate compensation is provided directly to the borrower by the Treasury. In both cases, the compensation is calculated as the difference between the market interest rate and the subsidized rate established under a particular government program. LGP has imposed challenges on the public banks. Firstly, banks have recorded losses due to high levels of non-performing loans in their non-guaranteed portfolios. Secondly, they have faced liquidity shortages because the volume of government lending targets exceeded the resources allocated in the State budget. Thirdly, liquidity shortages were addressed through monetary financing by the central bank, fuelling excessive aggregate demand with negative consequences on price stability and current account balance. LGP has also imposed significant costs on the economy of Belarus. The claim rate – the claimed guarantees as percentage of outstanding guarantees – increased from 3 percent in 2009 to 9 percent in 2011. In 2011, bank recapitalization totaled BYR 14.5 trillion or 5.3 percent of GDP, and according to the IMF, annual bank recapitalization averaged 1 percent of GDP during 2007-10. LGP has also distorted the competitive environment because private banks have been kept out of these programs. Finally, the subsidization of interest rates and the issuance of full, cost-free, credit guarantees have distorted incentives for prudent risk management and undermined the credit culture. F. Regulation and supervision 58. The MDB should be supervised by BdM and be subject to the same standards applying to commercial banks/investment funds. This would contribute to its efficiency and sustainability by making sure that it adheres to international best practices on loan underwriting, classification, and provisioning; risk management; anti-money laundering; maximum exposures; management of related party exposures; etc. And by being required to be adequately capitalized, the bank would project financial strength to the market and therefore access funding at a lower cost. 20 G. Corporate governance 59. According to the OECD (2009), “corporate governance is one key element in improving economic efficiency and growth as well as enhancing investor confidence. It is defined as a set of relationships between a company’s management, its board, its shareholders and other stakeholders”. It provides the structure for setting corporate objectives, allocating resources, and monitoring performance. It also provides management with the incentives to pursue objectives that are compatible with the interest of the company. 60. Poor corporate governance is regarded as the single most important factor explaining the failure of development banks around the world. While development banks are established to pursue noble goals, experience shows that as soon as they are established, they tend to quickly pursue objectives beyond their mandates. In some cases, they are captured by powerful groups who see them as a source of free money. Indeed, the failure of BPD in Mozambique fits this description very well. Sometimes development banks fail because their mandates are not clear and the state as the owner has given up its ownership responsibilities. 61. The success of the MDB would require a strong commitment to sound corporate governance practices. At the core is to ensure that the bank operates independently and serves the public interests for which it was established and not the interests of certain groups. If this commitment to public interest is not secured, recent history in Mozambique suggests that the country and its taxpayers might be better off without a development bank. Building on international best practices (OECD 2004; Scott 2007), the following paragraphs outline key elements to consider when designing the governance framework for the MDB17. 62. The law of the MDB should provide the foundation for good governance by stipulating a clear mandate and key governance provisions. It should outline clear expectations about the development bank: what will the bank do and why (target sector/market gap) and how (instruments and products, positioning, and sustainability). The law should prescribe a governance structure, including the roles and responsibilities of the shareholders, chairperson, management, regulators, auditors, and others. Moreover, it should unequivocally identify the BdM as the supervisor and regulator. Taken together, these elements act as the statutory protection against political intervention. 63. The MDB should enjoy a high degree of independence, including the ability to resist undue political influence. While this is hard to ensure in practice, particularly in a weak governance environment, the following could reduce political interference in the affairs of the bank: 17 For detailed discussion of corporate governance in state-owned financial institutions see Scott (2007) and the Association of African Development Finance Institutions (2009). 21  Identifying a shareholder representative. According to Gutierrez et al (2009), the existence of an identifiable shareholder representative reduces the likelihood that any government official or minister will claim to have the right to call the development bank to seek support for a particular program. The Minister of Finance should act as the shareholder representative on behalf of the GoM/state and he/she could delegate his/her ownership responsibilities and rights to a specific department or entity (such as the Treasury Directorate or the state holding company IGEPE). Among other responsibilities, the shareholder representative should provide policy guidance to the MDB, ensure that it operates according to its mandate, review and approve corporate plans and reports, monitor performance, review and assess the bank’s policy mandate, appoint or ensure the appointment of the bank’s statutory boards, and ensure coordination between various state-owned development finance institutions (e.g., between the MDB and GAPI).  Appointing an independent board. The Board is expected to act in the best interest of the development bank and its owners. It should be dominated by non-executive directors selected based on the value they bring to the board as demonstrated by the skills and experience they possess. In line with the current practice in the Mozambican private banking sector, consideration should be given to the separation of the roles of CEO and chairperson. Appointment of senior government officials and staff of the shareholder representative should be avoided because those appointees are often viewed as direct representatives of the shareholder in the board. Boards are accountable to the shareholder for achieving corporate objectives, and this accountability breaks down if the same people who should hold the board accountable are part of that same board. Moreover, by virtue of their careers as public servants, government officials often lack the bank-related skills and experience necessary to be effective board members of a development bank.  Ensuring that the board has the right mix of skills. The board should be fully competent to discharge its stewardship responsibilities which include approving the strategic direction of the development bank and its corporate plan; ensuring the adequacy of the bank’s systems to identify, measure, and manage risk; approving management’s succession planning and the appointment of top managers; monitoring performance; and ensuring the integrity of the information systems and the information generated. Therefore, the board should include members with extensive banking and management experience, for instance in risk management, investments, accounting, human resources, public policy formulation, etc. Current board members should play a role in the appointment of new board members, for example, by identifying skill gaps in the board and making recommendations to the shareholder representative. Finally, board members and senior managers should be subject to fit and proper tests by the BdM. 22  Appointing professional and accountable management. The MDB should be managed as a private business, with due regard to efficiency and economic profitability – defined as the attainment of policy goals in a sustainable manner. For this to happen, the management team must be as competent as it would be in a private bank. In fact, because the MDB would take more than average risk, its management should be especially qualified in managing risk. The board should play a more active role in the selection of the CEO – ideally, the board should have the authority to hire and fire the CEO of the MDB. This way, the CEO would be directly accountable to the board for the management and performance of the MDB. If this is not feasible, the board should at least lead the appointment process including the identification, shortlisting, and recommendation of two or three candidates for final appointment by the shareholder representative.  Giving management operational autonomy. Management should be free to make operational decisions within the scope of the bank’s mandate and board oversight. For instance, it should have the autonomy to decide to whom to lend and under what conditions. It should also have the autonomy to enforce the terms of the loan, including foreclosing delinquent borrowers.  Ensuring the chairperson is the only interlocutor between management and the shareholder representative. Government officials and the shareholder representative should not have direct contact with the management of the MDB. The shareholder representative should communicate with the MDB through the chairperson. 64. There is also the need to ensure the accountability of the board. The board should be accountable to the shareholder representative for the overall performance of the MDB. A performance contract/shareholder compact which includes targets and indicators should be signed between the shareholder representative and the board of the MDB. This contract would form the basis for evaluating board performance18. In addition, procedures should also be put in place to individually evaluate the performance of the chairperson, board members, and the CEO. 65. The shareholder representative should be direct or indirectly accountable to the parliament which is the ultimate representative of the taxpayers. The shareholder representative should table MDB’s corporate plan, budget, and annual report in parliament and make an annual presentation to a designated parliamentary committee on the performance of the MDB. Additional reporting on the performance of the bank by the government should take place during the approval of the annual state budget and the annual Q&A session between the government and parliament. 18 The DBSA signs an annual performance contract with the Minister of Finance (Scott 2009). 23 66. Finally, prudential supervision by BdM and the adoption of a second-tier model should enhance the independence of the MDB. The management of the MDB can invoke the need to comply with BdM’s prudential requirements as a reason not to engage in politically- driven lending activities. Similarly, adopting a second-tier model reduces political pressure to lend to certain groups since credit allocation decisions and enforcement of loan contracts would be left in the hands of private financial institutions. H. Transparency and disclosure 67. The MDB would need to adhere to high standards of transparency and disclosure. Its accounting, auditing and transparency standards should match those of other banks. More specifically, the MDB should have a qualified and independent board-level audit committee and a strong internal audit function. It should be audited by a reputable external auditor approved by the shareholder representative and the BdM (if applicable). It should publish its management report and accompanying audited financial statements with all explanatory notes; disclose board structure, including names and qualifications of board members and their current employment; and management structure. Moreover, procedures to prevent and handle conflicts of interest should be put in place including those regarding to related part transactions (for instance, transactions concerning senior managers or board members should be approved by the board and then disclosed). 68. As a development bank, the MDB should also put in place a framework to measure development impact and sustainability. Reporting financial performance, although important, is not enough for a development bank. It also needs to set measurable policy targets, monitor and report them in its annual report. Given the difficulty of measuring development impact directly, development banks have relied on proxy indicators to approximate their catalytic role and development impact. Such indicators include: number of target clients served (e.g., SMEs), number of first borrowers/startups, average loan maturity, number of jobs generated by firms in the portfolio, increase in sales, etc. Thus, the MDB would have to put in place a monitoring system that captures the outcomes of both its retail and wholesale lending. V. CONCLUSIONS AND RECOMMENDATIONS 69. The Mozambican financial sector has witnessed important progress. The number of commercial banks has increased, the share of state-owned banks in the financial sector has reduced significantly, new products and services have been introduced. Bank solvency has also improved, with reported regulatory capital ratio rising from 14 percent in 2002 to 17.9 percent in 2012. Both domestic deposits to GDP and private credit to GDP have increased since 2004 while NPLs fell dramatically. The outreach of the financial sector, although still limited, has 24 shown encouraging signs and recent surveys suggest an increase in access to finance by manufacturing SMEs. 70. However, overall access to finance remains low. The vast majority of firms in Mozambique identify limited access to finance as a key business constraint and Mozambique ranks near the bottom in terms of the legal and institutional strength for getting credit. Lack of agricultural, long-term, and SME financing are often cited as the main financing gaps requiring urgent solution. 71. The MDB is being discussed by GoM as a tool to increase access to finance. It would finance productive investment and accelerate the process of industrialization. It would manage a national investment fund and operate a guarantee fund and interest rate equalization fund. 72. The following recommendations could help the GoM increase the MDB’s probability of success:  In tandem with a possible establishment of the MDB, continue to implement reforms that promote a competitive and diversified private sector-led financial system able to sustainably solve existing financing gaps.  Establish the MDB under its own law in order to facilitate the inclusion of specific requirements, including the mandate, corporate governance provisions, regulatory and supervisory framework, and financial sustainability requirement.  Ensure that the activities of the MDB enhance and not undermine the recent progress in the outreach of the financial sector. More specifically, require the MDB to act complementarily and to report annually on its complementary role. In addition, ensure that the government retains a controlling ownership interest in the bank while allowing the participation of other shareholders.  Give the MDB flexibility to offer products and services that meet the needs of the target sector or market segment and align those products and services with existing gaps – limited access to long-term, SME, and agricultural finance.  Require the MDB to be financially sustainable by achieving a minimum rate of return.  Review the MDB’s policy mandate every five years to ensure that it remains relevant while holding the MDB accountable for the delivery of its policy objectives. 25  Ensure that the MDB is adequately capitalized, with access to a regular funding stream; restrict it from taking deposits.  Require the MDB to operate as a second-tier development finance institution, conducting its lending through private financial institutions; allow first-tier or direct lending operations to large projects, preferably in syndication with other banks and use a properly designed credit guarantee scheme to encourage lending to riskier borrowers (particularly SMEs).  Ensure that the MDB prices its products on commercial basis, that is, its lending rates and charges cover its cost of funding, operational costs, and credit risk. Any provision of subsides should be properly justified, quantified, temporary, and disclosed in the state budget and MDB’s reports.  Exercise caution in the design of the interest rate equalization scheme given its potential to create moral hazard and give banks incentives to excessively expand lending. In addition, any subsidies should not exceed the resources allocated in the state budget in order to prevent the accumulation of contingent liabilities by the government.  Place the MDB under the supervision of the central bank and require it to comply with the same prudential standards applying to similar financial institutions.  Commit to higher standards of corporate governance with the view to ensure that the MDB operates independently and without undue political interference.  Ensure that the board is dominated by qualified, non-executive board members that are not directly affiliated with the government; avoid appointing government officials as board members.  Clearly identify a shareholder representative who on behalf of the government and the state will exercise ownership rights and responsibilities and be the single link between the MDB and the government.  Appoint a professional management and provide it with operational autonomy including to make credit allocation and collection decisions.  Ensure accountability at all levels through regular reporting and performance assessments. In particular, require the shareholder representative or the government to submit MDB’s corporate plan, budget, and annual report to parliament and to make an annual presentation to a designated parliamentary committee on the performance of the MDB. 26  Ensure high standards of transparency and disclosure by publishing relevant information about the operations and governance of the MDB and put in place a framework to report on its development impact. 27 References Association of African Development Finance Institutions. (2009). Prudential Standards, Guidelines and Rating System for African Development Banks. AADFI. Banco de Moçambique. (2013). Desafios da Inclusão Financeira em Moçambique: Uma Abordagem do Lado da Oferta. Maputo: Banco de Moçambique. Beck, T., Maimbo, S. M., Faye, I., & Triki, T. (2011). Financing Africa Through the Crisis and Beyond. Washington DC: The World Bank. CIP. (2012). O Distrito como Polo de Desenvolvimento: Um Olhar da Sociedade Civil. Maputo: CIP. Committee of Counsellors. (2003). Agenda 2025: Nation's Vision and Strategies. Maputo: EloGráfico. De Luna-Martinez, J., & Vicente, C. (2012). Global Survey of Development Banks. Washington DC: World Bank. DNEAP. (2013). 2012 Survey of Mozambican Manufacturing Firms. Maputo: MPD. Gutierrez, E., Rudolph, H. P., Homa, T., & Beneit, E. B. (2011). Development Banks: Roles and Mechanisms to Increase their Efficiency. Washington DC: The World Bank. Instituto Nacional de Estatisticas. (2012). Estatísticas das Empresas 2009. Maputo: INE. Klapper, L. (2006). Financing for SMEs: The Role of Factoring. Washington DC: World Bank. MPD. (2013). Estratégia Nacional de Desenvolvimento (esboço em progresso). Maputo: MPD. OECD. (2004). OECD Principles of Corporate Governance. Paris: OECD. Orre, A., & Forquilha, S. C. (2012). Uma Iniciativa Condenada ao Sucesso: O Fundo Distrital dos 7 Milhoes e Suas Consequencias para a Governaçao em Moçambique. In B. Weimer, Moçambique: Descentralizar O Centralismo. Economia Política, Recursos e Resultados (pp. 168-194). Maputo: COMPRESS.dsl. Scott, D. H. (2007). Strengthening the Governance and Performance of State-Owned Financial Institutions. Washington DC: The World Bank. Sherif, K. (2004). Fiscal Costs of State-Owned Banks in Selected Economies of Central and Eastern Europe. In K. Liebscher, J. Christl, P. Mooslechner , & D. Ritzberger-Grünwald, The Economic Potential of a Larger Europe (pp. 203-216). Cheltenham: Edward Elgar. World Bank. (2014). Generating Sustainable Wealth from Mozambique's Natural Resources Boom. Washington DC: The World Bank. 28 Appendix A. Box A-1: Development Bank (extract from Nation’s Vision and Strategies (Agenda 2025)) The establishment of a Development Bank may play a crucial role in economic development in Mozambique. - The economic agents (entrepreneurial and household sector) need to have access to concessionary funds at preferential interest rates to complement their own funds and to facilitate modernization and expansion, and consequently the medium- and long-term productive investment the current banking system is not able to provide; - Such a bank, directed to productive investment, ought to be managed with high standards of rigor and professionalism, and should develop partnerships between the public and private sector, as well as other partners; - The development bank may play an important role in the provision of capital, in concessionary terms, for training, purchasing equipment and know-how, for preparing market (internal and external) studies and research, research and innovation activities for development, thus assisting farmers and industry people to reduce costs and market risks. Such bank may have an important role in the promotion of national products in internal and external markets, and support rural development projects, small irrigation schemes, family-size industrial units for processing agricultural products, rural extension programs for disseminating technologies and knowledge, rural marketing and transport. The medium- and long-term credit the bank should specialize on could stimulate investment in new technologies, in innovation, in research and company development programs, and would stimulate productivity. This institution may be determinant for peasant families, who will become more important for poverty relief and creating their own wealth; - Credit from this bank should be mostly targeted to public and private infrastructures under public and private partnership, covering the productive sectors with more competitive advantages, as a way of favoring those sectors: agriculture, agro-industry, fisheries, tourism, mineral resources, and export sectors. - Rural development is the most important strategy for Mozambique, as it may benefit more than 70% of the population. A development bank would take up a leading role in such a strategy; - Operating in a high-risk sector, the capital/asset ratio and credit provision requirements should be stricter than those in commercial banks; - This development bank would gather the various funds already established to promote development actions, as well as the counterpart funds from debt relief (HIPC) that are to be used in the fight against poverty. The promotion of development projects is the most consistent and sustainable strategy for eliminating poverty, simultaneously ensuring a more professionalized management and cost reduction of financial intervention. - The development bank would act as a second level entity, allowing overcoming imperfections in the financial markets, which severely limit the availability of funds for development, thus sharing resources, risks and benefits with commercial banks. Source: Agenda 2025 29