Goe pnof epal MINIS 4 ' OF F NANCE WORLD BANK RECEPTION OFFICIAL DOCUMENT SINGHADURBAR KATHMANDU. NEPAL 2 June 2016 Mr. Jim Jong Kim President The World Bank 1818 H Street N.W. Washington DC 20433 United States of America. Dear Mr. Kim: RE: LETTER OF DEVELOPMEN POLICY I. The Government of Nepal is committed to pursuinj a medium term program to reform the financial sector in Nepal. A stable financial sector is c 'tical to enhance economic growth and for sound financial governance. For this the Governm nt is undertaking major reforms in the financial sector. 2. Following the liquidity crisis that threatened finan al sector stability in Nepal in mid- 2011, the Government articulated a program of financial ,ector reforms with the objective of ensuring the stability of the financial system, overhauling t ie regulation and supervision of the banking and financial institutions, limiting Government :ontrol and ownership of financial institutions, placing the financial sector safety net on a firr i footing, and laying the ground for further reform programs designed to broaden and deepen ccess to financial services for both business and individuals. 3. The first phase of reforms (from early 2012 to mid- 2013) was carried out in a relatively unstable political climate. The reform program gained mor ientum with the second phase (from mid-2013 to mid-2015) despite the adverse impact to he financial sector caused by the earthquakes in April/May of 2015.The on-going reform i the third phase (mid-2015 to mid- 2016). We have continued to implement major reforms ti 1 date with support from the World Bank, the United Kingdom Department for Interna ional Development (DFID), the International Monetary Fund (IMF) and other Developmen Partners. 4. In the initial years of the reform program, we w re able to set up a financial sector safety net by establishing the Deposit Guarantee Fu d (DGF) and embarked on the restructuring and recapitalization of two large state-control ed commercial banks, Rastriya Govir t epal MINISTRW*F4 NANCE SIN\GHADURBAR~ KATHMANDU NEPAL Banijya Bank (RBB) and Nepal Bank Limited (NBL). Bot RBB and NBL insolvent for more than a decade, now meet the statutory capital requirement d are amongst the highest earning commercial banks in the country. Following the drafting of xtensive amendments to the Nepal Rastra Bank (NRB) Act (NRBA Bill) and the Bank and inancial Institutions Act (BAFIA), and a new Deposit and Credit Guarantee Fund Bill ( GF Bill), these bills have been submitted to the Parliament for approval. These three bill propose to strengthen the NRB's resolution powers, to improve governance of financial inst tutions and to place the DGF on a firm legal foundation.These reforms were supported b two Development Policy Credit operations, which were approved by the World Bank's B rd of Executive Directors in June 2013 and June 2015 respectively. Other reform activities t t were completed during these two phases (2012 - 2014) include the following: * The diagnostic of the banking system covering 27 of the 54 financial institutions, of a program of 54 in-depth Special Inspections of all e-risk and systemic banks has been completed. The NRB also initiated appropriate prompt corrective action and resolution enforcement measures; * Throughout the reform phases, the NRB has main ined its moratorium on licensing of new banks and financial institutions (BFIs), and i 2014 also issued a new bylaw on acquisitions to facilitate further consolidation of the anking system; * In 2014, the Parliament approved and enacted o dinances covering key AML/CFT measures: the Mutual Legal Assistance Act, the xtradition Act, and the Organized Crime Act. Along with the already enacted Asset oney) Laundering Prevention Act (2008). These legislations provide a legal fr ework in line with international standards, and Nepal is no longer "grey-listed" by TF; * In 2014, NRB Board approved the National Payme ts System Development Strategy; * In 2015, Ministry of Finance completed and app oved a long term Financial Sector Development Strategy (FSDS) based on wide cons Itations; 5. The Government of Nepal is making rapid p ogress towards implementing the medium-term strategy for reforming the financial sector an, has been able to refine policies and strategies using the information and recommendations pro ided by Nepal's participation in the Financial Sector Assessment Program (FSAP) in 2014. Tht Government's on-going program Goqr t of Nepal MINISfArbnF NANCE SINGHADURBAR KATHMANDU NEPAL for the financial sector focuses on reforms designed to 1chieve two over-arching policy objectives; (i) to ensure the stability of the financial sysl em by improving the quality of regulation, supervision, and transparency to levels closer to international norms; and, (ii) to start improving access to formal financial services. These objectives will be maintained and also supplemented by measures designed to support the rec very of the financial sector from the impact of the earthquake and the trade disruptions, and put in place needed measures to ensure the operational resilience of the sector in the face of n tural disasters. 6. The reforms under our medium term strategy unde the third phase which we have completed since the mid-2015, include the following: * Taking further steps to complete the restructuring a id divestiture of state-controlled commercial banks by: in the case of RBB, recapitaliza on to above the minimum capital adequacy ratio of 10 percent; and, in the case of NB , recapitalization to 9.55 percent capital adequacy and initiation of divesting Governmer t owned shares in NBL to a bank strategic investor; * Completion in December 2015 of the second and fi -al phase of a diagnostic of the banking system, thereby representing about 70 perce it of banking system assets of a program of 54 in-depth Special Inspections of all at-r ik and systemic banks. The NRB has initiated appropriate prompt corrective action or resolution enforcement measures (including recapitalization, merger, and closure) for all undercapitalized financial institutions; * In December 2015, a quick diagnostics of the BFIs to asess the impact of the earthquake disaster on their assets was carried out; * In 2015 and in 2016, the Government responded to the queries/comments raised on NRBA Bill, DCGF Bill and BAFIA Bill by the parlia entary sub-committee as part of deliberation process and the remaining NRBA Bill is not be tabled in the ongoing parliamentary session and Finance Committee has alreE dy tabled two out of three Bills in the full House for approval. The bills, once enacted, Ere expected to (i) strengthen the governance of financial institutions, and give supervi ors stronger legal tools for bank resolution; (ii) put in place a fully-functioning financial sector safety; and (iii) improve the governance of state-controlled financial institution and establish fit and proper requirements and minimum qualifications. R nc+rA)lIqOqir+nn -) ?1174)A) 11Al1OZ G#q At of epal MINISTn"OF F NANCE KATH~MANDU NEPAL 7. In 2016-18 we intend to implement the remaining major reform agendas to strengthen the financial sector and support its recovery from the doublb impacts of the 2015 earthquake and trade disruptions (September 2015 to January 2016), with an increasing emphasis on deepening and broadening financial access. The reform st ps will include: (i) initiation for publishing international tender for the divestiture of G vernment's stake in NBL; (ii) Completion of in-depth diagnostic of the insurance sector to identify institution level risks and implementation of corrective action or resolution program for undercapitalized insurance companies. (iii) undertake steps to improve the superVisory capacity of the financial cooperatives regulator; (iv) issue enabling regulations consistent with the NRB Act Amendments; (v) implement and operationalize a superviso information system by the NRB; (vi) approve DCGF's regulation that covers its relationsh with BFls, guaranteed deposit verification process, BFI reporting, payout and reimburse nt of guaranteed deposits and a deposit guarantee fund investment policy; (vii) execute atngements to provide back-up funding,liquidity and credit line facility to DCGF; (viii) apr rove Payment System Act by the cabinet for submission to the parliament; (ix) approve a new nsurance Act by the cabinet ready for submission to the Parliament; and (x) issuance of NFRS complaint regulations and reporting requirements for BFIs and issuance of rules an by-laws for the newly enacted BAFIA by the NRB. Finally, we would like to reiterate the commitment of the Covernment of Nepal to all these reforms, and we trust that this request for World Bank support for their implementation will receive your favorable consideration. Yours sincerely, Bishnu rasad Paudel Sh ba Raj Shrestha Minister of Finance Offidiating Governor Nepal Rastra Bank