Documentof The World Bank ReportNo: 27417 FOR OFFICIAL USE ONLY PROJECTAPPRAISAL DOCUMENT ON A PROPOSEDIDA CREDIT SDR 47.6 MILLION INTHEAMOUNT OF(USD$68.5 MILLIONEQUIVALENT) AND PROPOSEDIDA GRANT OF SDR 4.9 MILLION INTHEAMOUNT OF(US $7.0MILLIONEQUIVALENT) TO THE HIS MAJESTY'S GOVERNMENT OF NEPAL FORA FINANCIAL SECTORRESTRUCTURINGPROJECT January22,2004 Financeand Private Sector Development SouthAsia RegionalOffice This document has a restricted distributionand maybe usedbyrecipients only inthe performance o ftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (Exchange Rate Effective November 28,2003) Currency Unit = Nepalese rupee lrupee = US$O.O129 US$ = SDR0.6946 FISCAL YEAR July 15 - July 14 ABBREVIATIONS AND ACRONYMS ADB Asian DevelopmentBank ADBN Agricultural DevelopmentBank o f Nepal CEO Chief Executive Officer CFG Corporate and Financial Governance CIAA Commission for the Investigation o f the Abuse o f Authority CRR Cash Reserve Requirement CST Coordination Support Team (inNRB) DFID Department for InternationalDevelopment DRT Debt Recovery Tribunal FMR FinancialMonitoringReport FSSS Financial Sector Strategy Statement FSTA Financial Sector Technical Assistance Project GDP Gross Domestic Product HMGN HisMajesty's Government o fNepal HR Human Resources I A S InternationalAccounting Standards I C A N Institute o f Chartered Accountants o f Nepal IDA InternationalDevelopment Association IMF InternationalMonetary Fund ICT Information Communications Technology IT Information Technology MOF MinistryofFinance NF3L Nepal Bank Limited NEPSE Nepal Stock Exchange NIDC Nepal IndustrialDevelopment Corporation NPA Non-PerformingAssets NPL Non-Performing Loans NRB Nepal Rastra Bank (the central bank) PRGF Poverty Reduction and GrowthFacility PSRC Poverty Strategy Reduction Credit RBB Rastriya Banijya Bank SLR Statutory Liquidity Requirement TA Technical Assistance VRS Voluntary Retirement Scheme - Vice President: Praful C. Pate1 Country Director: Kenichi Ohashi Sector Director: Joseph Del Mar Pemia Task Team Leader: Simon C. Bell FOROFFICIAL USEONLY PAD Cover Sheet Kingdom of Nepal Financial Sector Restructuring Project PROJECT APPRAISAL DOCUMENT South Asia Region Finance and Private Sector oevelopment Unit Project ID:PO84219 Restructuring and Privatization This document hasa restricteddistribution andmay be used by recipients only in the performance of their official duties. I t s contents may not be otherwise disclosed without World Bank authorization. Project development objective Re$ PAD B.2, TechnicalAnnex 3 The objective o f this operation i s to support the continuing efforts o f HMGNto improve the operation o f the financial sector inorder to ensure continued macroeconomic stability and promote private sector-led economic growth. Project description [one-sentence summary of each component] Re$ PAD B.3.a, TechnicalAnnex 4 Support to Voluntary Retirement Schemes (VRS) inRastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL),Hiringo f Sales Advisors to privatizedthese two banks, Phase I1o f on- going Nepal Rastra Bank (central bank -NRB)restructuring, and on-going Management Team Support inthe two large commercialbanks (RBB andNBL). Which safeguard policies are triggered, ifany?Re$ PAD D.6, TechnicalAnnex 10 None Significant, non-standard conditions, if any, for: Re$ PAD C.7 Boardpresentation: None Loadcredit effectiveness: None Covenants applicable to project implementation: None NEPAL FinancialSector RestructuringProject CONTENTS Page A. STRATEGIC CONTEXT AND RATIONALE ....................................................................... 1 1. Country and sector issues............................................................................................................. 1 2. Rationale for Bank involvement .................................................................................................. 4 3. Higher level objectives to which the project contributes ............................................................. 5 B. PROJECT DESCRIPTION....................................................................................................... 5 1. Lending instrument ...................................................................................................................... 5 2. Project development objective and key indicators....................................................................... 5 3. Project components...................................................................................................................... 6 4. Lessons learned and reflected inthe project design..................................................................... 7 5. Alternatives considered andreasons for rejection ....................................................................... 8 C. IMPLEMENTATION............................................................................................................... 8 1. Partnership arrangements ............................................................................................................. 8 2. Institutionaland implementation arrangements ........................................................................... 9 3. Procurement ................................................................................................................................. 9 4. Monitoring and evaluation o f outcomeshesults......................................................................... 10 5. Sustainability ............................................................................................................................. 10 6. Critical risksand possible controversial aspects........................................................................ 10 7. Loadcredit conditions and covenants........................................................................................ 12 D. APPRAISAL SUMMARY..................................................................................................... 12 1. Economic and financial analyses .............................................................................................. -12 2. Technical.................................................................................................................................... 12 3. Fiduciary .................................................................................................................................... 13 4. Social ......................................................................................................................................... 13 5. Environment.............................................................................................................................. -13 6. Safeguard policies...................................................................................................................... 13 7. Policy Exceptions and Readiness............................................................................................... 14 Annex 1: Country and Sector or Program Background................................................................ 15 Annex 2: Major RelatedProjects Financedby the Bank and/or other Agencies ......................... 23 Annex 3: Results Framework andMonitoring ............................................................................. 25 Annex 4: Detailed Project Description......................................................................................... 29 Annex 5: Project Costs ................................................................................................................. 32 Annex 6: Implementation Arrangements...................................................................................... 33 Annex 7: Financial Management andDisbursementArrangements ............................................ 35 Annex 8: Procurement.................................................................................................................. 39 Annex 9: Economic andFinancial Analysis ................................................................................. 42 Annex 10: SafeguardPolicy Issues .............................................................................................. 44 Annex 11: Project Preparation and Supervision........................................................................... 46 Annex 12: Documents inthe Project File..................................................................................... 47 Annex 12A: Letter of Financial Policies ...................................................................................... 48 Annex 13: Statementof Loans and Credits .................................................................................. 53 Annex 14: Country at a Glance..................................................................................................... 54 A. STRATEGIC CONTEXT AND RATIONALE 1. Countryandsector issues Country Background. Nepalis one ofthe world's poorest countries, with an annual per capita income o f about US$240 with many indicators showing a very poor quality o f life. Progress inthe fight against poverty has been hampered by a number o f factors, including a succession o f unstable Governments. More recently, the challenge has intensifiedwith the escalation o f the insurgency and lingering instability inthe Government. Security concerns have beenheightenedbythe August 2003 collapse o fthe ceasefire agreed with insurgents operating inthe country and there i s a fear o f wider civil disturbance. Together with the global economic slowdown that has adversely impactedNepal's trade-dependant economy, these domestic events have led to a sharp downturn ineconomic activity. Relatedto this i s potential fiscal stress, as public spending has been obliged to accommodate increased security demands. Meanwhile, there i s widespread belief that the insurgency i s fundamentally a challenge to a state that has not proved itself effective indealingwith Nepal's development agenda. FinancialSector Background. Nepalhas 17commercialbanks -comprisingthe two large banksNepal Bank Limited (NBL)and Rastriya Banijya Bank (RBB) inwhich the government has a dominant shareholding; 6 Joint Venture Banks, which are mixedNepalilforeign owned (foreign ownership i s constrained to 67 percent); and 9 local (100 percent Nepali) banks. It also has 2 large development banks -theAgriculturalDevelopmentBankofNepal(ADBIN)andtheNepalIndustrialDevelopment Corporation (NIDC) which also undertake some commercial banking activities. The system also operates with 54 finance companies, 13 insurance companies, numerous micro-finance institutions, 7 Grameen Replicator Banks, 35 financial cooperatives, 25 financial Non-Government Organizations (NGOs), and a stock exchange. The two largest commercialbanks -RBB and NBL- account for around 50 percent o f total banking system assets, and are in a very precarious financial position. Political intervention, weak management, poor financial information systems, and a deeply entrenched culture of non-repayment o f loans have resultedina rapid deterioration o f their financial health. RBB, which represents 27 percent o f commercial banking system assets, i s estimated to have 71percent non-performing loans. Although in slightlybetter financial condition, NBLhas similar problems including around 59 percent non- performing loans (NPLs). This could have serious ramifications for the Government interms o f systemic riskand couldprove to be a severe financial strain on an already delicate budget should either o fthese two banks face a crisis o f confidence with concomitant adverse macroeconomic implications. The 2003 unauditedaccounts for RBB and NBL indicate that these two banks had estimated accumulated deficits, as o f mid-2003, o f approximately $435 million - equivalent to around 7 percent o f GDP. BothNBL and RBBhave made significantprogress inreducingtheir operating losses since professional management teams assumed control o f their operations in2002 (supported by a World Bank Phase IFinancial Sector Technical Assistance (FSTA) credit). In addition, the two large development banks have deteriorated incomparable fashion to that o f RBB and NBL. The financial positionsofADBINandNIDC are currently intheprocessofbeing appraisedbythe Asian Development Bank (ADB)- and a work out plan i s being developed. Ingeneral, Nepal's financial system suffers from the followingproblems: (a) The Government'sRole. HisMajesty's Government o fNepal (HMGN)plays a large direct role inthe financial sector. Fromownershipofkey financial institutionssuch as RBB,ADB/N,the Grameen banks, the largest insurance company, the stock exchange, the largest investmentcompany, and, until recently, Nepal Bank Limited (where it remains the largest single shareholder); to significant influence over the Joint Venture Banks; the Government's involvement i s evident inalmost every aspect o f 1 financial sector activity. This has resulted in strong political interference inbanlung activities which, in turn,has resultedinnon-repayment o floans, andpoor financialhealththroughout the system. (b) NepalRastraBank(NRB)-the CentralBank. UntilJanuary 2002, when anew Act was approved, the NRB fell under the authority o f the Ministryo f Finance. This historical lack o f autonomy hinderedthe NRB's ability to supervise andregulate the banking system. Political influence inRBB and NBL-andtheir dominanceinthebanlungsystem-alsoplacedthesebanks outside the influenceand control o f the central bank. Although still requiring further modification in several areas, the 2002 Nepal Rastra Bank Act provides the NRB with basic autonomy. The authority o f NRB over the banking system has been further establishedby the recent Cabinet approval o f the Banking and Financial Institutions Ordinance. Improved banking regulations also provide the regulatory basis for NRBto move the system closer to international banking norms while permitting the bank supervisors to deal expeditiously with errant banks. The NRB i s supported inthis endeavor through a substantive program o f capacity building from a resident team o f international banking experts supported by IDA under the FSTA. (c) RastriyaBanijyaBank(RBB) is 100percent Government owned. Itis the biggest ofNepal's commercial banks with deposits o f approximatelyRs 40 billion- 25 percent o f the Nepali banking system. RBB i s technically insolvent with highlevels o f non-performing assets ("As) -andhadan estimated negative net worth of US$335 million as o f July 2003. A professional management team took over the bank inearly 2003 -the new CEO, recruitedon a fixed-term contract, joined the bank on January 16th2003, followed by the rest o f the team inlate February 2003. Invariance to the original concept, each member o f the management team has been hired individually. Due to the on-going insurgency, branches have been reducedfi-om more than 200 to around 130 nationwide and the total number o f staff inthe bank i s beingreduced from 5,522 to a target figure close to 3,200 through a Voluntary Retirement Scheme (VRS) launched in September 2003. At the same time a process o f computerization i s underway and some 42 branches are expected to operate with an online system. RBB continues to suffer from a highpercentage o f non-performing loans although performance inthis fieldis improvingunder the guidance ofthe new managementteam. (d) NepalBankLimited(NBL). The financial conditiono fNBLhas also been significantly impaired, butnot to the same extent as RBB. NBLi s the oldest bank inNepal (established in 1935) - it is also the second largest bank with deposits o f Rs 35 billion. Originally, the Government owned the entire bank but its shareholding was sold down throughout the 1990s to reach41 percent. The Govemment's policy o f successively selling shares to the general public has, however, left the bank without a strategic banking partner - and, meanwhile, the connected lending activities o f the newprivate owners are thought to have further compromised its operations. Incommon with RBBit has suffered from weak management, political interference, and a lack o f financial controls. UsingWorld Bank assistance, HMGNdecided to bringinprofessional management fromthe Bank o f Scotland to take over the day-do-day runningo fNBL inAugust 2002. Initial main areas o f focus for the new management team have included, producing credible audited accounts for 2001 and 2002, designing and developing a minimumInformationTechnology (IT) platform for the bank, developing appropriate humanresource policies for the staff, strengthening its treasury management function, identifying non- performing loans, and establishing a loan recovery unit to deal with these NPLs. The ManagementTeam i s also restructuring the bank by reducing staffing levels by almost 50 percent; rationalizingthe branch network; recoveringon non-performing loans; and requesting delisting fi-om the Nepal Stock Exchange (NEPSE). (e) The AgriculturalDevelopmentBankof Nepal(ADBN. The financial and operational situation o f the ADB/N, the thirdbiggest bank inNepal, i s also extremely poor. The ADB/Nwill require 2 restructuring, system development, changes ingovernance arrangements, and a review o f its ultimate role and ownership arrangements. Reform inthis bank i s being supported by the ADB. Close coordination between IDA and the ADB means that reforms made inFU3B and NBLare likely to be replicatedin ADB/Nto ensure a consistency of approach. (f) A Weak andFragmentedLegalFinancialEnvironment. Although recent progress inthis area i s noteworthy, Nepal has historically suffered from a proliferationo f bothlaws and regulations that are institutionally rather than hnctionally focused. This has created a fragmented legal environment. The NepalRastraBankAct, now superseded by a January 2002 Act, was seriously outdated and deficient withrespect to issues o f central bank autonomy, accountability, and governance. The new legislation strengthens its independence and supervisory role. e The 1974 CommercialBankAct was also defective and it didnot cover all deposit-taking institutions. A proliferation o f laws covering various classes o f deposit-taking institutions permitted legal arbitrage. NRB has drafted a new omnibus Bankmg and Depository Institutions Act that was approved by Cabinet inlate 2003. e AncillaryLaws. New legislationis also requiredinsuch areas as Secure Transactions, Insolvency, and a new Company Law, etc. (g) A Weak andFragmentedAccountingandAuditingEnvironment. A weak accounting and auditing tradition has meant that the timeliness and reliability o f financial data from banks i s poor. Corporate accounting i s also weak, making lending decisions difficult for the banks. The overall strengthening o f accounting and auditing i s therefore essential. The progress made, inthis respect, within the two largest commercial banks by the newly institutedmanagement teams, i s noteworthy. (h) Competitioninthe BankingSector. Reform o fthe state-owned banking sector is designed to reduce fragmentation and support efficient intermediationo f funds within the financial sector. This will increase competitivepressures and provide more efficient and cost-effective solutions to the public. (i) Other Issues. The financial sector environment also needs to be strengthenedinseveral other important areas. Credit information systems needto be made more reliable and effective; the Nepal Stock Exchange requires urgent reform; and access to finance for many millions o f rural Nepalis needs to be addressed. (j) Government Strategy. Over the past few years, the Governmenthas undertaken general reform measures inthe financial sector. These include interest rate deregulation, the phase out o f Statutory LiquidityRequirements (SLR), reduction inCashReserveRequirement(CRR), introductiono fmodem bank regulations, and foreign exchange liberalization. However, much remains to be done, particularly withrespect to institutional reform. To help establish a mediumterm framework, the Government formulated a Financial Sector Strategy Statement (FSSS) that consolidates its thinkingand develops a comprehensive and interlinked reformprogram. This FSSS has been adopted as official Government policy and was publicly released and published inthe Nepali and Englishpress at the end o f 2000. The main elements o fthe FSSS include: e Reducing the role o f the Government inthe financial sector as a direct owner o f financial institutionswhile strengthening its role as a supervisor and regulator; e Requiring strong corporate governance by ensuring that banks (inparticular the two largest commercial banks) are owned and managed by "fit andproper" private investors; 3 0 Strengthening the role o f Nepal Rastra Bankby drafting a new central bank Act to provide autonomy inthe conduct ofmonetarypolicy, banking system regulation and supervision, and the licensing o f banks and nonbanks; 0 Improvingexisting banking and financial legislation andjudicial processes for enforcing financial contracts; 0 Improving auditing and accountancy standards within the banking sector; and 0 Promoting financial discipline through adequate disclosure and competition. To date, the Government o fNepal has demonstrated a seriousness and commitment to banking reform and has not wavered inmoving ahead with the difficult agenda. Actions taken so far provide IDA with comfort that the Government i s willing to transparently and decisively address the issues at hand. 2. Rationale for Bank involvement The objective o f this operation i s to support the efforts o f HMGNto improve the financial sector inorder to ensure continued macroeconomic stability and promote private sector-led economic growth. This represents the secondphase o f a larger financial sector reform effort -whichbeganwith the FSTA. Assuming on-going commitment to reform, this would leadultimately to athirdphase involving bank privatization. Phase Iinvolvedbringinginthree management consultant teams to: restructure andre- engineer the central bank; and reform the two large commercial banks (Rastriya Banijya Bank and Nepal Bank Limited). This secondphase will assist in(i) right-sizing the two commercial banks through the implementation o f Voluntary Retirement Schemes (VRS) to reduce operating costs and make them viable for privatization; (ii) bringingina Sales Advisor to assist inthe privatization; (iii) providing further assistance to a second phase o f Central Bank re-engineering; and (iv) supporting the continuation o f professional management team support up untilthe point o f bank privatization. Phase I11(not included in thisproject) would involve support for financial re-engineering o fthe banks (re-capitalization) at the point o f sale after satisfactory changes in governance arrangements and cost restructuringhave taken place. The operation supports the Nepal Country Assistance Strategy (CAS) 2004-2007 (Report No. 26509- NEP) outcomes inthe financial sector as well as governance objectives. Improvement inthe banking sector i s one o fthe key growth-enhancing structural reforms that Nepal must undertake inorder to stimulate a more pro-poor and inclusive growth process. The CAS recognizes that a strong financial system i s critical for private sector development. On-going progress with respect to banking reform i s a keytrigger for Nepal to remain inabase case lending scenario. Borrower commitment to financial sector reformi s evidenced by the medium term vision laid out inthe Financial Sector Strategy Statement and reaffirmed inthe Letter o fFinancial Policy (December 9, 2003). Itis further demonstrated bythe hiringo fmanagement teams to implementreforminthe commercial banks and the free hand that they have been given to deal with defaulting borrowers. The project elements are inline with the analyticalwork undertaken on Nepal's financial sector. The Financial Sector Study (October 2002) recommends a human resource re-engineering exercise within the two largest commercial banks and the implementation o f a VRS scheme to right-size staffing levels -to prepare the banks for privatization. This i s an important next step inthe on-going movement towards privatization. A main lesson from previous Bank assisted projects i s that implementationprogress i s generally faster when project components have been fully developed prior to project approval. With the VRS schemes already designed and ready to go, this has been taken care o f inthe current operation. 4 3. Higher level objectivesto which the projectcontributes The project i s important indealing with the critical situation within the banks. Serious losses have been incurred which will ultimately have to be recognized by the owners o f the banks and paid for with taxpayers money, With a need for fiscal resources to be increasingly devoted to poverty needs inthe fields o f education, health, rural water, and enhanced infrastructure -it i s crucial that the losses inthese banks be stemmed. Consequently, the on-goingbank reformprocess also has many important indirect poverty alleviation implications over the mediumterm. The project is also important inestablishing a better intermediationfunction withinthe banking system so that funds can flow to their most productive economic use -thereby benefitingthe entire economy in terms o fmore rational investment decisions, more sustained employment opportunities, increased production and exports - and ultimately enhanced growth. B. PROJECTDESCRIPTION 1. Lendinginstrument The project i s to be supported through an IDA Credit and Grant. An Investment operation was chosen as the bulko fthe funds are to be passed on to two commercial entities, RBB and NBL. Onthe basis o f financial data providedby the two banks, the amounts disbursed under the loan will be quickly recovered through lower operating costs -the paybackperiod for the VRS schemes i s inthe region o f two to three years -hence the return on the investment i s healthy. The grant component was included to ensure compliance with HMGN'sForeign Aid Policy (2002) which, in Sections 7.4 through 7.6,specifies that grant funds should be usedfor technical assistance inprojects. 2. Projectdevelopmentobjectiveand key indicators The main objective o f the project i s to support the on-going efforts to develop a healthier financial sector inNepal whichintermediates fundsmore efficiently and effectively to the benefit ofall segments of society and ina manner which supports private sector development, increased investment, and faster growth. These objectives will be achieved via a two pronged approach. The first entails further strengthening o f the central bank o f Nepal (Nepal Rastra Bank) through an on going program o f bank supervision strengthening; accounting and auditing development; human resource re-engineering; information technology upgradation; and other support. The objective i s to also further enhance the professional status o fthe central bank and its capacity to oversee the development o f a prudently operated financial sector inline with its own medium term vision as enunciated inthe FSSS. Key indicators will be a greatly enhanced capacity to supervise banks to international standards; ability to produce its own accounts to international accounting standards (IAS); a small butmore efficient workforce which i s appropriately incentivized and which operates in aprofessional manner; and a fully computerized general ledger to improve management information systems withinthe bank. The second prong involves a deepening o f the reformprocess within the two large banks so as to improve their operational capacity and ensure that they operate on a more commercially orientedbasis. This will permit their ultimate sale to "fit and proper" bank owners inthe private sector. The development objective o f this component i s to substantially improve their operating capacity and commercial viability; to move them as swiftly as possible into the private sector; and thereafter, develop the government's oversight and supervisory capacity over them and other banking institutions. Key indicators will be the ability to attract "fit and proper" buyers to purchase these restructured banks - and to ultimately privatize the institutions. 5 3. Projectcomponents The project has four main components (Table below). Voluntary Retirement Schemes (VRS). The largest component is designed to support the VRS inRBB and NE3Linan effort to reduce their costs and ultimately assist inmaking them more saleable/privatizable institutions. The two main components o f highcost inthese banks have been identified as non- performing loans and staff costs. The first o f these i s actively being dealt with by the new Managers in these banks while the VRS will be supported under this project. The management teams each have a Human Resource advisor who, as part o f their terms o freference, have identified redundant staff and have designed VRS schemes. The launching o f these schemes inthe two banks was announced inSeptember 2003 and the first o f the retirees will leave the banks by the endo f 2003. Hence, this component is fully designed and well under implementation. Hiringof SalesAdvisors. The hiring o fthe Sales (Privatization) Advisors will not happenuntilayear or so into the project when the banks are ina better financial condition and are therefore more viable privatization candidates. These Advisors will undertake proper due diligence, prepare a prospectus for the banks, and then undertake a road show to bringthem to the point o f sale to "fit and proper" private sector buyers as rapidly as possible. This component (US$ 3.0 million) will be financed usingthe IDA Grant component. Phase11:On-goingNepalRastra Bank Re-engineering. The Financial Sector Technical Assistance Project has commenced a process o f re-engineering within the central bank. However, reform, revitalization, and professionalization are complicated, long-term tasks. Greatly enhancing the capacity o fNRBto oversee a prudently operated banking system i s a prime objective o fthe series o freforms being undertaken within the sector. Whereas the Phase Ireforms inbanking supervision have focused on developing an appropriate off-site reporting system and a minimalist amount o f on-site bank supervisory assistance, the Phase I1reforms will assist inaugmenting the on-site supervisory capacities to oversee the commercial banks. The accounting component will assist NRB inmeeting the IMF's Safeguard Assessment milestones, including the productiono f an international audit o f the bank's accounts to IAS. The Human Resources (HR) reforms will buildupon the newly introduced HRpolicies, recent efforts by the central bank to reduce overall staffing levels, and the development o f a new training planto help move NRBtowards the establishment o f a more professionallymanaged staffing cadre. The Information Technology (IT) component i s new (not covered inthe Phase Ireforms) but i s critically required as part o fthe modernizationprocess within the bank. The technical assistance components (around US$4.0 million) o f the NRB Re-engineering will also be financed usingan IDA Grant. ManagementTeam Support. It is agreed, that the two banks may not be privatizedby the time that the current three year term o f the existing Management Teams expire (two years with a possible one-year extension). It i s equally recognizedthat the banks should not revert to old management practices. It i s 6 therefore necessary to include fundingfor a contingency to cover the costs o f continuing management team support up untilthe point o f privatization. It i s felt, however, that the pre-privatizationrestructuring process will take longer than three years. These components were establishedbasedupon the experience inother comparable projects (such as the PakistanBanking Sector Restructuring and Privatization Project). This experience has shown that, while the agreed objective for banking sector restructuring worldwide i s to transfer ownership to "fit and proper" private sector owners (ideally international banks), this i s difficult to achieve inSouth Asia. Experience inthe region has indicatedthat private sector buyers, particularly o f the caliber and reputation that one would like to attract, do not wish to be bogged down inthe process o f reducing staff numbers and closing branches. Buyers have also indicatedthat a necessary prior condition i s to have credible accounts and a basic computerized core banlung solution system inplace. Also core ina successful systemic revitalizationof the banking sector i s a concerted and lasting improvement inthe quality andreach o f banking supervision exercisedby the regulator to oversee the newly private banks. A substantive element o f restructuringo f the NRB and training o f staff was included inthe FSTA, however, given the importance, additional funds have been dedicated to this endinthis project. 4. Lessons learned and reflected in the project design The OED Performance Audit Report for the Second Structural Adjustment Credit (Credit 2046-NEP), M a y 17, 1995, concluded that: "The basic cause o fthe weakness o f the financial sector design [inthat project] was: (a) Lack o f commitment by the Government to change its basic attitude towards the state-owned banks, including a much stronger emphasis on commercial orientationand on preparationfor eventual privatization; (b) Absence o f an Action Program didnot require the Government to introduce drastic changes inthe managerial culture to ensure that managers were professionals with autonomy and accountability; and (c) Lack o f specific fundamental reforms needed to achieve a major improvement in financial and operational performance o f the banks." The current operation has dealt with these lessons by not proceeding with IDA financing untilthere has been upfront action by the Government to carry out fundamental reforms inbanking supervision generally and inthe governance arrangements within the state-owned, inparticular- starting with the placement o f external management teams inthe two banks. The development of an overarching framework for financial sector reform- as encapsulated inthe FSSS -has also helpedensure consistency and commitment. Inaddition, the three-phase approach has been designed to build upon the strong foundations o f the FSTA and has allowed HMGNample opportunity to demonstrate commitment to reform and willingness to confront difficult issues. The Letter o f Financial Policies (see Annex 12) are key recent steps that have been taken to strengthen the legal framework and also provides further evidence o f the Government's strong commitment to reform inthis sector. Inaddition, generic lessons learnedfrompreviousprojectsinthe financial sector include: (a) Sustainable banking sector reforms require that the autonomy and technical skills of the regulator be enhanced. Under the FSTA, steps havebeen taken to enhance the bank supervisory slulls o f NRB so that it can become increasinglyprofessional and autonomous; (b) The legal framework is critical to ensure successful implementation. The FSTA has supported the revision and modernization o f key banking legislation. A new NRB Act, a new Banking and Financial Institutions Ordinance, the establishment o f a Debt Recovery Tribunal, and a Blacklisting directive. 7 Sequencingis important for successful financial sector reform. Partial strengthening o fthe CentralBank, has already been carried out as a precursor to this project, and continues to be a highpriority withinthe programo f commercialbanlungreform; Reforms should focus on a limitednumberof key activities. This project will support a purposely limited agenda o f focused activities; Forcingreformsfromoutsideis not sustainable. Strongborrower commitment produces the greatest chance o f success - a commitment evidenced by the FSSS, the appointment o f the management teams inthe banks, and the on-going close liaisonbetween NRB and the MoF; Re-capitalizingcommercialbankswithout fundamentalreformsinownership and governancestructuresis not likelyto besuccessful. Any injection o fcapitalinto RBB and NE3Lwill only be supported at the point ofprivatizatiodliquidation or some other acceptable change ingovernance arrangements inthese banks; Project componentswhich havebeenpre-designedand are already under implementationhave the greatest chances o f success. Inthis respect, the VRS -the largest monetary component o f the proposed project -has been completelypre-designed to a level acceptable to the World Bank, and i s currently being operationalized. Projectimplementationinitiallysuffers due to slow procurementand disbursement. Inthe past, under the FSTA, NRE!didnot have experience handlingBank procurement. This has been mitigatedby the recruitment o f a Procurement Expert. 5. Alternativesconsideredandreasons for rejection An alternative approach to dealingwithNepal's financial sector problemscouldbe to pursue abroader financial sector reform agenda on a wide range o f fronts to a large array o f institutions -particularly some o f the other weak (but significantly smaller) privately-owned commercial banks and the two development finance institutions. However, given the primacy o f the problems inthe Central Bank and the two largest commercial banks, incombination with the Government's own limitedimplementation capacity, the project team decided to focus on a narrower agenda o f issues. This limited and more focused agenda i s likely to have the biggest impact. Another option would have been to press for the immediate closure o f one o f the two troubled banks - or for their merger. While the prospect for closure o f at least one o fthe two banks has purposefully been retained within the program design, it has been recognized that given the severely challenged political circumstances inthe country, it would be unrealistic to insist uponthis requirement. Ithas been ensured, however, that the ability o f either bank to extend lending operations has been severely curtailed. The possibility o f processing the project as an adjustment operation was also considered. However, it was determined that an investment operation would achieve the objectives o f the project better as disbursement would be tied strictly to full implementation o f the reformmeasures. Inaddition, there was an important need for on-going technical assistance to ensure smooth implementation o f the project - such as the sales advisors and the NRE!re-engineering technical support -which were better suited to an investment operation. C. IMPLEMENTATION 1. Partnershiparrangements The Department for InternationalDevelopment o f the UK (DFLD) i s a co-financier o f the on-going FSTA (through a grant o f USSlO.0 million). While not financing the Phase I1operation, DFIDhas been closely involved in all the design o f the current project and has contributed significantly to certain elements. The Bank i s also working extremely closely with the IMF on the financial sector reform agenda -which features prominently inthe Poverty Reduction and GrowthFacility (PRGF). Close cooperation with the 8 ADB has also beendevelopedto ensure that the development bankreforms are carried out ina consistent manner. 2. Institutionalandimplementationarrangements Nepal Rastra Bank will be responsible for the implementationo f the project. This agency has been selected due to its success inthis capacity inthe FSTA, and its established (albeit limited) cadre o f competent and committed reformers and its central role within the Nepalese financial sector. As institutional and implementation arrangements for the predecessor project have already been developed withinNRBthese will continue to be usedto oversee the implementationofthe current operation. FinancialManagement (FM). The Coordinationand Support Team (CST), inthe NRB,under the direct supervision o f an executive director will be responsible for overall financial management activities under the project. There are experienced FMstaff inthe CST and additional staff will be appointed to support the FMwork under the proposed project. Utilization o f IDA'S share o f eligible expenditure will be undertaken through a Special Deposit Account (SA), opened byNRB, under terms and conditions acceptable to IDA. The Executive Director (ED) will continue to work as CST coordinator inthe new project and will be authorized to issue checks, make payment requests to the CST, and withdraw funds from the IDA financing. The SA will be managed under the joint signature o f the ED and the FMexpert with a provision for an alternate signature of another Assistant Director (finance). For counterpart funding, HMGNwill ensure the timely release o f funds to the CST through a separate project bank account. The weakness identifiedinthe FMassessment have been addressedby an agreed time bound action plan. 3. Procurement The procurement consultant currently contracted for the CST has sufficient skills for procuringgoods and some hands-on experience with consultant selection contracts and IT procurement. However, the skills of the staff supervising the consultant inareas such as consultant selection, contract administration (especially o f consultant contracts) and overall project procurement monitoring may need upgrading. This is important given that Phase I1calls for many significant novel consultant contracts whose selection procedures, documents, etc. need to be carefully designed. NRB may consider solutions - such as sending the CST staff for specialized training inconsultant selection and contract administration. Continuation o fthe current Phase Iinto the proposed Phase I1entails the procurement related actions described below. 0 ContinuedManagement Support: It is vital to have experiencedmanagement teams inthe two banks untilthe process o fprivatization i s completed. Consequently, it i s suggested that on completion o f the current contracts funded from the on-going FSTA in 2005 and 2006, a new management contract be negotiated on a sole-source basis subject to justification or on a competitive basis, for the duration o f the proposed second phase (upto the point o f privatization). 0 Procurementof computers,IT systems: As a part of the NRBre-engineering component NRB needs to acquire hardware, software and networking for the development o f its IT system. DuringPhase I, CST at the Central Bank, withthe guidance and assistance o fthe IT experts in the the two management teams, successfully carried out an IT procurement for RBB and NBL. Thus it is consideredthat NRBhas the capacity to undertake itsremaining ITprocurement needs. While simple purchases such as computers and printers for Banking Supervision shall be procuredthrough NCB, given the estimated cost and complexity o f the items, procurement o f the ITplatform will be carriedout usingICBprocedures. 9 0 Hiring of sales/privatization advisors: This is a large and complex contract and hence QBS - or QCBS with a 70-30 split inthe technical/financial evaluation i s anticipated. 4. Monitoring and evaluation of outcomeshesults Short to medium-term success will be realizedwhen improved capabilities inRBB and NBLbegin to exert competitive pressures for better banking services. The long-term success o f the project will be realized, however, only when both RBB and NBLhave been sold to fit and proper private sector owners. The price achieved for the banks will not be a factor in determining success, but the quality o f the buyer will be important. This aspect will be monitored ina transparent fashion by the NRB and by the privatization advisers recruitedunder the project. Separate indicators have been established and will be separately monitored for the IDA Grant component (Please refer Annex 3). Giventhe country's economic constraints, MoF's ForeignAid Policy does not espouse taking a loan to finance TA components involving hiringo f intemational consultants. However, it i s essential that Sales Advisors for privatization (component two) and Consultants for Phase I1NRBRe-engineering (component three) be o f intemational caliber and hence, we have proposed to finance these components by IDA Grant. 5. Sustainability HMGNhas already demonstratedits commitment to take hardpoliticaldecisions inthe face ofthe need to stem the growth o f non-performing assets within the two state controlled banks and the banking sector as a whole. Working closely in accordance with the conditionality established for the IMF's PRGF the govemment has already undertaken far reachinglegislative and regulatory reforms. One factor which will be critical to the continued success o f the project will be for NRB to take necessary steps, as per the proposed amendment o f Section 86 o f its Act, to deal with the existing private sector shareholders. Steps to this end are currently inprogress - including the December de-listing o f NBL shares from the Nepal Stock Exchange and an amendment to the Nepal Rastra Bank Act to give it greater powers over troubled banks. It will also be critical to ensure that legislationpassed by ordinance i s not subsequently revoked. Close coordinationwith the IMF, DFID,the ADB, and the rest o f the donor community will also help ensure that the reforms implementedwill remain inplace regardless o f changes in govemment (inthat donor funding i s indispensable to support on-going development programs). Additional steps, including enhancedreporting of the reform efforts and holding regular meetings with stakeholders, are under way to ensure that there i s sufficient popular support for the reforms beingimplemented and that the value o f these measures i s broadly understood across the political spectrum. 6. Critical risks and possible controversial aspects The project is susceptibleto the followingkey risks: Risks RiskMitigationMeasures RiskRating with Mitigation Political Given the fragile security - The Bank has attempted to maintain good lines o f situation and continuing political communication with politicians across the spectrum. uncertainty, there i s a possibility that No single political group, including those o f the far left the reformprocess may be stymied or has indicated opposition to the restructuring o f the M reversed. At the extreme, the situation distressed banks. may deteriorate so as to severely Overall political support is likely to continue since the underminegovernment institutions. project reflects HMGNIMoF's priorities on banking 10 Risks RiskMitigationMeasures RiskRating with Mitigation reform and i s strongly supportedby high level civil servants. Bureaucratic or political interference ir Appropriate recruitment and training procedures for institutional change related to increase( project personnel would be established, coupled with transparency, stakeholder participation. incentives to reward good performance. M and decision making. Assurances are being sought from HMGNthat qualified key personnel will remain inplace during the lifetime o f the project. Agitation from local advocacy groups Efforts have beenmade to actively involve all (labor unions, etc.). stakeholders, across all levels o f employees, to generate support and ownership. Ensuring that project design and implementation S adequately reflect people's needs; that transparency and accountability are addressed; and that interventions and outcomes benefit workers. The VRS may fail. Inthe face o f This component has already commenced and results limited alternative employment from the First Phase implementation indicate that opportunities ina weak economy, bank around 50 percent o f the designated staff have employees may be unwilling to accept accepted the VRS. A Second Phase i s expected to net M VRS terms - ultimately frustrating the the remaining targeted excess staff. privatization o f the banks. Lack o f support from local and nationa HMGNwill engage indialogue about soundbanking government elites. practices. A multi-sector partnership betweenthe government, private banking sector, and media, and others i s required to facilitate public accountability M measures to help build public pressure for more sustainable corporate practice. Defaulters and other vested interests. HMGNhas demonstrated increasedwillingness to The process ofreformhurtsmany confront vested interest groups. The recent influential groups -particularly those establishment o f the Debt Recovery Tribunals and the who have habitually defaulted to the new Blacklisting Directive are further evidence o f a S government banks or have benefited commitment to fundamental reforms and a willingness from poor standards o f governance. to face up to vested interests. Private shareholders o f NBLmay be Trading o fNBL shares has been suspended with a disruptive, NBL is only 41 percent commitment to de-list from the Nepal Stock Exchange owned by HMGN. (NEPSE). NRB has committed to take full control o f S NBLusingenhancedpowers inthe NRBAct. VRS Adverse Selection. There i s a risl The management o f both banks maintain that the level that severance packages may encouragc o f overstaffing i s so high and the level o f expertise so good performing staff to leave and low that targeting is not required(although some staff mediocre staff to remain in the banks. will be encouraged to stay). The scheme i s also at the mutual consent o f both parties - hence bank M management can rehse an application from a particularly good performing staff member. 11 Risks RiskMitigationMeasures RiskRating with Mitigation i VRS Overpayment. Retrenchment Both RBB and NBLhave conducted personnel reviews rograms should first exhaust to ensure that employees who have been improperly ossibilities for disciplinary actions and hired (e.g. with forged education certificates) may not he elimination o f payroll fraud arising participate inthe VRS. Based on this, both banks have M from ghost workers and improper suspended a number o f employees. iring. oral Hazard. An important concern lfor the Bank is to ensure that workers I staff for the workers who accept the VRS. A survey ofl ho have received severance packages all employees who leave the two institutions i s rehiredby the same enterprise 01 included inthe project. The Government has also ifitremains inthe public sector signed a Letter o f Financial Sector Policy indicating M the extent monitorable, by other that it will privatize these banks at the end o f the bublic sector institutions. I restructuridg process. I RiskRating ;H(HighRisk),S (Substantial Risk), M(Modest Risk),N(Negligible Risk) 7. Loadcredit conditions and covenants There i s no conditionality pertainingto this financing. Nonetheless, the understanding between the World Bank and HMGN, and as laid out inthe Letter o fFinancial Policies, i s that Nepal Rastra Bank will continue to exert full control over Nepal Bank Limitedunder Section 86 o f the NRB Act untilthe bank i s privatized. HMGNwill also ensure that the existing shareholders o f NBL do not benefit from the restructuringexercise and do not impede the restructuring process. The Govemment will ensure this by maintainingthe suspension o f trading o f NBL shares untilprivatizationand ensure that the shares are delisted from NEPSE by the end o f 2003; by writing down the capital o f NBLprior to privatization; by divesting the shares of current shareholders to "fit and proper" persons; and ifwriting down capital i s not possible -by moving with the process o f vesting NBLto a fit and proper institution. D. APPRAISAL SUMMARY 1. Economic andfinancial analyses Analysis undertaken by the Management Teams inbothRBB and NBLindicate that the payback period from implementing the VRS i s about two years. This indicates an extremely good retum on the investment from this credit -ranging from 48 to 59 percent per annum. These analyses are inline with work undertaken on the cost-benefit experiences with VRS schemes inother banks inSouth Asia (Sri Lanka, India, Palustan, Bangladesh) - and with VRS schemes instate-owned enterprises inthe region. The 8-10 year payout to these bank workers appears to be large -but i s also consistent with other experiences in South Asian public sector institutions which indicate that payouts are high, but payback periods are extremely low. 2. Technical Most o f the technical design work for the project has been undertaken by experts working inthe ManagementTeams inthe two commercial banks, or by the re-engineering team operating inthe central bank. These long term, experienced professionals have ensured the utmost care indesigning the best possible technical solutions to the problems at hand. 12 3. Fiduciary The proposed project has strengths inthe area o f financial management. The existing Financial Managementexpert has familiarized himself with the World Bank's FMpolicy and procedures and he will continue worlung inthe new project. Moreover, the need for additional support, inthe form o fa finance officer, has been identified- and he/she will be inplace by March 31,2004. The highlevel commitment o fthe government and N R B ' s senior management to various reform activities will greatly contribute to addressing any potential problems arising duringproject implementation. A weakness is the inadequate logistical and other administrative support to the CST. The CST is operating ina constrained environment with insufficient staff. Financial information i s maintainedin spreadsheets, but there i s scope for computerization o f accounts to keep track o f project expenditures, compilation, and reporting -but this will require additional staffing support. The CST plans to be upgraded with additional computer equipment under the current Project. The other FMstaff are also well conversant with the World Bank's FMpolicies and procedures. Overall, the FMarrangements for the project are adequate at the initial stage o f project implementation. However, these needto be further improved inthe areas indicatedinthe FMassessment to ensure a satisfactory FMsystem throughout the project implementationperiod. Annex 7 includes a detailed FMassessment-with an Action Plan. 4. Social The social implications o fthe implementation o f the V R S inthe banks could be considerable. While there are no safeguardissues anticipated, there are likely to be important social impacts on the lives o f those who choose voluntary retirement. These will vary according to the personal circumstances o f individual employees. While the full range o f risks have yet to be determined, some potential risks include: (i) inability o f employees to re-enter and compete inthe limitedjob market, either within a the reasonable timeframe, or ina sustainable manner; (ii) as most Nepalis still live inajoint family system there will be socio-economic ramifications on a population exceeding the estimated 4,700 employees who may choose to participate inthe VRS scheme'; and (iii) many o f the more standard approaches to re- training may not be an appropriate inthe local cultural context. For this reason, all initiatives taken to mitigate potential adverse impacts have been developed keeping local circumstances in mind. The project team i s working closely with DFIDto undertake an Exit Survey o f the workers leaving the banks. The purpose o f this Exit Survey will be to understand notjust the economic, but also the socio-cultural ramifications o f the project's affected population. This will then be followed by regular Social Traclung Surveys on a sub-set o f retirees -undertaken every six months. These tracking methodologies will permit the government, the banks, and the World Bank to have on-going feedback on the social impact o f the implementation o f the VRS and to adjust policies accordingly. Inaddition, the project team has met with focus groups consisting o fbank workers who have applied for the VRS - and the unions which represent them - and have discussed their future needs ina post-retirement era. 5. Environment There are no environmental issues arising from this project. 6. Safeguard policies Safeguard Policies Triggered by the Project Yes N o Environmental Assessment (OPBP/GP 4.01) [I [XI Natural Habitats (OPBP 4.04) [I [XI 'While the situation varies according to household, gender relations inNepal often entail a male family head who has primary economic responsibly for his immediate as well as extended family members (that may include elderly parents, cousins, and widows). It is not knownat this time the extent to which this is a pertinent issue or not. 13 Pest Management (OP 4.09) [I [XI CulturalProperty (OPN 11.03, beingrevised as OP 4.11) [I [XI InvoluntaryResettlement (OP/BP 4.12) [I [XI Indigenous Peoples (OD 4.20, being revised as OP 4.10) [I [XI Forests (OP/BP 4.36) -[ 1 [XI Safety o f Dams (OP/BP 4.37) [I [XI Projects inDisputedAreas (OP/BP/GP 7.60)* [I [XI Projects on International Waterways (OP/BP/GP 7.50) [I [XI 7. Policy Exceptions and Readiness (a) Exceptions. Two exceptions to normal Bankpolicy have been agreed for the current project. The first o f these i s the application o f 35 percent retroactive financing - above the normal 10percent generally applied. This has been discussed and supported by Bank management. This exception i s necessary to meet the VRS costs which are currently being incurred inadvance o fproject approval and i s designed to support the current momentum for change which exists within the financial sector reform process. The second issue (not really an exception) which i s also approved by Bank management -i s financing o f the VRS within NBL (legally a private sector institution), on the basis that this institutioni s effectively controlled by the Govemment (the central bank has replaced both the Board and the Management o f this bank). The policy on VRS payments refers to control rather than ownership and Nepal Bank Limitedmeets the test o fpublic control through the management and board. Inaddition, however, NRB i s puttinginplace a series o fmeasures which will ultimately lead to the legal assumption o f this bank. These measures include suspension o ftrading o f NBL shares on the stock exchange; delisting o fthe shares from the exchange; amending the central bank act to provide it with greater powers to deal with a troubled bank; writing down the capital o fNBLprior to privatization; and by ultimately divestingthe shares o f current shareholders to "fit andproper" persons. Ifwriting down the capital proves legally challenging, then NRB will altematively move ahead with the process o f vesting NBLto a fit and proper institution. @) Readiness. The requirement for larger than normal amounts o fretroactive financing supports the propositionthat the project already has an in-builtmomentum which the World Bank i s eager to support. The VRS has been designed and i s already being implementedinadvance o f project approval. Other components are also at an advanced stage o fpreparation and will be ready for implementation immediately upon effectiveness. The NRBcomponents will follow on from the work already on-going withinNRB.Consequently, the project is ready for immediate implementation and initial disbursements should be highto cover payments made inadvance o fproject effectiveness. 'By supporting theproposedproject, the Bank does not intend toprejudice thefinal determination of theparties` claims on the disputed areas 14 Annex 1:Country andSector or ProgramBackground NEPAL: FinancialSector RestructuringProject Country Background. Nepalremains one o fthe world's poorest countries, with an annual per capita income o f about US$240 with many indicators showing a bleak quality o f life. Progress inthe fight against poverty has beenhamperedby a number o f factors, including a succession o f unstable Governments. More recently, the challenge has intensified with the continuing insurgency and lingering instability inthe Government. Security concerns have been heightenedby the August 2003 collapse o f the ceasefire agreed withthe insurgentsand there i s a fear o f wider civil disturbance. Together with the global economic slowdown that has affected Nepal's trade-dependant economy harshly, these domestic events have ledto a sharp downturn ineconomic activities. Related to this i s potential fiscal stress, as public spending i s up on account o f security needs. Meanwhile, there i s widespread belief that the insurgency i s fundamentally a challenge to a state that has not proved itself to be effective. FinancialSector Background. Nepalhas 17 commercialbanks, 2 large banks (RBB andNBL)which dominate the sector; 6 Joint Venture Banks, which are mixedNepaWforeignowned (this group being constrained to a maximum 67 percent foreign ownership); and 9 local banks. Inaddition, the sector also includes 2 large development banks -the Agricultural Development Bank o f Nepal (ADB/N) and the Nepal IndustrialDevelopment Corporation (NIDC), 54 finance companies, 13 insurance companies, numerous micro-finance institutions, 7 Grameen Replicator Banks, 35 financial cooperatives, 25 financial Non-Government Organizations (NGO's), and a stock exchange. The two largest commercial banks - Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL)- account for around 50 percent of total banking system assets, and are ina very precarious financial position. Political intervention, weak management, poor financial information systems, and a deeply entrenched culture o fnon-repayment o f loans have resulted ina rapid deterioration of their financial health. RBB, which represents 27 percent o f commercial banking system assets, i s estimated to have 71 per cent non-performing loans. Although in slightlybetter financial condition, NBLhas similar problems including around 59 percent non-performing loans. This could have serious ramifications for the Government interms o f systemic risk and could prove to be a severe financial strain on an already delicate budget should either o fthese two banks face a crisis o f confidence with concomitant adverse macroeconomic implications. The 2003 unaudited accounts for RBB andNBLindicate that these two banks had estimated accumulated deficits, as o f mid- 2003, o f approximately $435 million - equivalent to around 7 percent o f GDP. BothNBL and RBB have made significant progress inreducingtheir operating losses since professional management teams assumed control o f their operations inmidand late 2002 respectively (supported by a World Bank Phase I Financial Sector Technical Assistance (FSTA) credit). It i s understood that the financial condition o f the two large development banks has deteriorated ina fashion comparable to that o f RBB and NBL. The financial position o f ADB/Nand NIDC is currently in the process o f being appraisedby the Asian Development Bank (ADB) and a restructuringplan for these institutions will be put inplace, intime, supported by the ADB. Ingeneral, Nepal's financial system suffers fromthe followingproblems that are alsorecognizedbythe Government: (a) The Government'sRole. His Majesty's Governmento fNepal (HMGN) plays a large direct role inthe financial sector. Fromownershipofkey financial institutionssuchas RBB,ADBN, the Grameen banks, the largest insurance company, the stock exchange, the largest investment company, and, until recently, Nepal Bank Limited (where it remains the largest single shareholder); to significant influence over the Joint Venture Banks (where, untilrecently, the government nominated a director for each bank); the Government's involvement i s evident inalmost every aspect o f financial sector activity. This has 15 resulted instrong political interference inbanlung activities which, inturn, has resulted innon-repayment o f loans, and poor financial health throughout the system. (b) NepalRastraBank (NRB) -theCentralBank. UntilJanuary 2002, when a newNRBAct was approved, the NRB fell under the authority o f the Ministryo f Finance. This historical lack o f autonomy hinderedthe NRB's ability to supervise and regulate the banking system adequately. Political influence inRBBandNBL-as well as their sheer dominance withinthe banking system-placedthesebanks outside the influence and control o f the central banking authorities. Although still requiring significant development in several material areas, the 2002 Nepal Rastra Bank Act provides the NRBwithbasic autonomy. The full authority o f the NRB over the entire banking system has been further establishedby the recent Cabinet approval o f the Banking and Financial Institutions Ordinance. Improvedbanking regulations, now being implemented, have also providedthe regulatorybasis for NRBto move the system closer to international banking norms while permitting the bank supervisors to deal expeditiously with errant banks. The NRB i s supported inthis endeavor through a substantive program o f capacity building from a resident team o f international banking experts supported under the Financial Sector Technical Assistance Project. (c) RastriyaBanijyaBank(RBB) is 100percent Government owned. RBBis the biggestof Nepal's commercial banks with deposits o f approximately Rs 40 billionrepresenting some 25 percent o f the Nepali banlung system. RBB i s technically insolvent with highlevels o f non-performing assets (NPAs). RBBhadanegative net worth estimated inthe regionofUS$300 million as o fJuly 2003. The professional management team supported under the IDAFSTA Project commenced work inthe bank in early 2003 - the new CEO, recruited on a fixed-term contract, joined the bank on January 16* 2003 but it was not until late February 2003 that the rest o f the team followed him. Invariance to the original concept, eachmember o f the management team has been hired individually. As a consequence o fthe on-going insurgency, the number o fbranches has been reduced from more than 200 to around 130 nationwide and the total number o f staff inthe bank is being reduced from 5,522 to a target figure close to 3,200 through a Voluntary Retirement Scheme (VRS) launched in September 2003. At the same time aprocess o f computerizationis underway and some 42 branches are beingbrought online usingthe IBIS core banking solutions system. RBB continues to suffer from a highpercentage o f non-performing loans although performance inthis field i s improving under the guidance o f the new management team. (d) NepalBankLimited(NBL). The financial conditiono fNBLhas also been significantly impaired, but not to the same extent as RBB. NBLi s the second largest bank inNepal with deposits o f Rs 35 billion. It is also the oldest bank inNepal, establishedin 1935. Originally, the Government owned the entire bank but the government's shareholding was sold down throughout the 1990s to reach 41 percent. This disinvestment by HMGNwas carried out with the objective o freducingpolitical interference inNBL's management and promoting private sector participationinthe bank so that it could operate ina more commercial and business-like manner. The Government's policy o f successively selling shares to the general public has, however, left the bank without a single strategic partner with a strong background incommercial banking and international linkages with the global economy. Connected lending activities by the new private owners are thought to have further compromisedits operations. Since the mid-1980s when the banking sector was opened up to foreign competition, NBLhas been losing out to the newly establishedjoint venture banks. NBL's profitability has correspondingly declined. The main reasons for this decline inprofitability have been: (i) a deposit mix which involves a disproportionately large share o f high-cost funds (ii) a large branchnetwork comprising various rural and other non-profitablebranches throughout the country, (iii) staffing levels which are inexcess o f actual 16 requirements, (iv) low recovery rates on loans, (v) manual accounting systems and inadequate automationcompared to the size o f operations, (vi) poor service delivery, and (vii) not being able to respond to market demandtrends Making use o f the support made available under the FSTA Project, HMGNdecided to bringin professional management to take over control o f the bank. The Bank o f Scotland management team took over the day-do-day runningo f NI3L inAugust 2002. Initial main areas o f focus for the new management team have included, producing credible audited accounts for 2001 and 2002, designing and developing a minimumInformation Technology (IT) platform for the bank, developingappropriate humanresource policies for the staff, strengthening its treasury management function, and identifyingnon-performing loans (NPLs) and establishing a loanrecovery unit to deal with these NPLs. Through a voluntary retirement scheme, NBLi s inthe process o f reducingits payroll from 5,270 to a new total o f around 3,000 employees. As with RBB, the branch network luns nationwide and i s being rationalizedto a total modestly inexcess o f 100branches, 44 o f which arejust now coming online. The management team has achievedreasonable success inthe recovery o fnon-performing loans - and expectations on recoveries inthe current year are expected to be even more favorable. HMGNhas agreed to reestablish control o f the bank to expedite the restructuring process and the process o f de-listing the bank from the Nepal Stock Exchange i s under way as a first step to this end. (e) The Agricultural DevelopmentBank of Nepal(ADB/N). The financial andoperational situation o f the ADB/N, the thirdbiggest bank inNepal, i s also extremely poor. The ADB/Nwill require restructuring, system development, changes in governance arrangements, and a review o f its ultimate role and ownership arrangements. Reforminthis bank i s being supported by the Asian Development Bank. Close coordination between IDA and the ADB means that reforms made inRBB and NJ3L are likely to be replicatedinADB/Nto ensure a consistency o f approach. (f) A Weak and FragmentedLegalFinancial Environment. Although recent progress inthis area i s noteworthy, Nepal has historically suffered fi-om a proliferation o f both laws and regulations that are institutionally rather than functionally focused. This has created a fi-agmented legal environment. 0 The NepalRastra Bank Act, now superseded by a January 2002 Act, was seriously outdated and deficient with respect to issues o f central bank autonomy, accountability, and governance. N o w that new legislation has been approved, the challenge will be to ensure that NRB can effectively enforce the provisions enshrined inthe new legal and regulatory environment. The 1974 CommercialBank Act is also defective. Most importantly, the act does not cover all deposit-taking institutions. Other nonbank deposit-taking institutions are governed by their own laws (e.g., the Agricultural Development Bank Act o f 1967). A proliferation o f laws covering various classes o f deposit-takmg institutionshas permitted legal arbitrage. NRB has recently completed drafting a new Banking and Financial Institutions Act that covers all major deposit- taking institutions. This Act was approved by the Cabinet inOctober 2003. Ancillary Laws. Once the above two keypieces o f legislation are fully inplace, it will be important to ensure that other ancillary laws are developed in support o f a modem banking system. New legislation i s required insuch areas as Secure Transactions, Insolvency, and a new Company Act. (g) A Weak and FragmentedAccounting and Auditing Environment. A weak accounting and auditing tradition has meant that the timeliness and reliability o f financial data (particularly from the largest banks) i s extremely poor. Corporate sector accounting i s also weak, making lending decisions 17 difficult for the banks. IfNepal's financial system i s to operate ina prudentially sound and efficient manner, strengthening o f accounting and auditing i s essential. The recent progress made, inthis respect, withinthe two largest commercialbanks bythe newly institutedmanagementteams, is noteworthy. (h) Competitioninthe BankingSector. Reformo fthe state-owned banking sector isbeing designed to reduce fi-agmentation and support the more efficient intermediationo f funds withinthe banks and nonbanks. This will increase competitive pressures and thereby provide more efficient and cost-effective solutions to the banking public. (i) OtherIssues. Inadditiontotheabove, thefinancialsectorenvironmentneedstobestrengthened inseveral fundamental ways. For example, credit information systemshavenotbeeneffectivetools against non-performing borrowers; capacity buildinginthe sector remains very weak; the general public's low level o f financial sophistication means that it does not serve as an effective check and balance within the system; the Nepal Stock Exchange remains a weak and ineffectual institutionwithin the financial system; and access to finance for many millions o f rural Nepalis still remains a critical lacuna. These weaknesses also require attention, and call for urgent reformand modernization. Nepalneeds to create the preconditions fgr the development o f an efficient banking system that i s capable o f developingnew financing mechanisms and instrumentsto meet private sector needs. Without such reforms, the prospects for faster growth and ultimately poverty reductionwill be constrained. However, financial sector development i s a long and complex process that will take many years, particularly given the very low starting point inNepal. (j) GovernmentStrategy. Over the past few years, the Government has undertaken generalreform measures inthe financial sector. These include interest rate deregulation, the phase out o f Statutory LiquidityRequirements (SLR), reductioninthe CashReserveRequirement (CRR); introductiono f modem banking regulations, capital market reforms, and foreign exchange liberalization. However, much still remains to be done, particularly with respect to institutional reform. To help establish a fi-amework for the way forward, the Government formulated a Financial Sector Strategy Statement (FSSS) that consolidates its thinkingand develops a comprehensive and interlinkedreformprogram. The FSSS has been discussed widely within Nepal - withinthe private sector and the financial sector - and it has been adopted as Government policy. The FSSS was publicly releasedand published inthe Nepali and English press at the end o f 2000. The desire for reforminthe financial sector i s further reflected by the fact that the Governmenthas asked for, and secured, World Bank, IMF, and UK Department for Intemational Development (DFID) assistance to proceedwith the reform agenda. Initial support has been provided through the Financial Sector Technical Assistance credit, withjoint IDA-DFIDfinancing. The main elements o f the FSSS sector strategy include (some o f which has already been implemented): 0 Reducingthe role o f the Government inthe financial sector as a direct owner o f financial institutions while strengthening its role as a supervisor and regulator o f banks and financial institutions; 0 Requiring strong corporate governance by ensuring that banks (inparticular the two largest commercial banks) are owned and managedby "fit andproper" private investors; 0 Strengthening the role o fNepal Rastra Bank inthe overall financial system by drafting a new central banking Act to provide sufficient autonomy inthe conduct o f monetary policy, banking system regulation and supervision, and the licensing o f banks and nonbanks; 0 Improving existingbanking and financial legislation andjudicial processes for enforcing financial contracts; 0 Improving auditing and accountancy standards within the banking sector; and 0 Promoting financial discipline through adequate disclosure and competition. 18 The reforms inthe financial sector, particularly with respect to the state-owned banks, require strong political commitment. As inmany countries, bank restructuring issues are difficult. To date, the Govemment o f Nepal has demonstrated a seriousness and commitment to the banking reform agenda and has not wavered inmoving ahead with the difficult agenda at hand. Actions taken so far provide the World Bank with comfort that the Govemment i s willing to transparently and decisively address the issues at hand. PROGRESSUNDERTHE FINANCIAL SECTORTECHNICAL ASSISTANCECREDIT The FSTA, approved inDecember 2002, has three essential components. The first i s a Re-engineering Team which has been placed into Nepal Rastra Bank, the second i s a professional Management Team in Rastriya Banijya Bank, and the thirdi s a professional Management Team inNepal Bank Limited. The NBLteamhasbeeninplace the longest (mid-2002) while the teams inNRBandRBBcommenced work inearly 2003. The re-engineering team inNepal RastraBank is considered extremely important as it is working on professionalizingthe central bank and gettingthe bank to focus more on its core centralbanking functions. Inthis process, the NRB,by its own volition, has reducedstaffing levels from around 2,400 to a current level o funder 1,800. However, with only around 380 professional staff inthe bank, it still remains highly overstaffed with under-slulled personnel. NepalRastraBank. The Nepal RastraBankRe-engineering Team financed by the FSTA comprises: HumanResourceSupport. A HumanResources expert has beenplacedinthe bank inan effort to help with designing appropriate Voluntary Retirement Schemes to reduce staffing levels to more appropriate levels; to assist inthe outsourcing o fnon-core functions from the bank; to draft a new set o f "international best practice" HRpolicies for the staff which reward performance over time in grade; to draft job descriptions; to design a new salary and compensation package; and to help develop a more appropriate organization structure for the central bank. Most o fthese activities are on track. AccountingSupport. A team o f accountants has beenputinplaceto assist indrafting anew accounting manual for the central bank and to assist the Accounting Departmentbringthe accounts o fthe bank up to InternationalAccounting Standards. There are also issues o f timeliness o f accounts with which the team i s also assisting. BankingSupervisionSupport. The project also supports an On Site and an Off Site Bank Examiner to assist the Bank Inspections Departments (Bank and Non-Bank) bringtheir capacities closer to internationallevels. While the FSTA project has focused on RBB andNBLthere i s also a needto ensure that the other commercialbanks inthe system are operating prudently and inline with establishednorms. Developing the bank supervisory capacity o fNRB,however, is considered to be a longer term endeavor and additional substantive assistance will be provided underthe current operation. Oversight ofthe Two Management Team Contracts. Inthe absence o f a capacity to take over the two large troubled banks (RBB and NBL)as a conservator, the Nepal Rastra Bankhas employed the services o f two professional management teams. However, given limited capacities withinNRB,it also requires assistance inoverseeing the work o fthese two management teams. The experienced banker inthis position i s meant to provide the liaison and oversee the work o f the two professional management teams; to ensure that they meet their agreed performance 19 benchmarks; that they report on a timely basis; and undertake all contractual agreements as required. This support to NRB i s designed to assist the central authorities oversee these two contracts ina rigorous and professional manner. Some o f the notable milestones that have been achieved are cabinet approval o f Banlung and Financial Institutions Act and amendment o fNRBAct that empowers the CentralBank to take action against troubled banks; development o f a stronger blacklisting mechanism and better equipped Credit Information Bureau; formation o f a DebtRecovery Tribunal; formulation o f a two-year program o f on- site supervision o f commercial banks; production o fNRB accounts as per statutory requirement; adoption o f a new organization structure and a revisedHRPolicy; and reduction in staffing from 2,400 to around 1,700. Rastriya Banijya Bank and NepalBank Limited. The two management teams include eight professionals -roughly split 50/50 between foreigners and Nepalis. The positionsheld inboth institutions are (a) Chief Executive Officer; (b) Chief Credit Officer; (c) LoanRecovery Officer; (d) Chief HumanResources Officer; (e) Chief Information Technology Officer; (0Chief o f Treasury; (g) Chief Audit Officer; (h) Chiefo fInternal Audit; and (i) ofBranchOperations. The follow describes some Chief o f the progress made withinthese two banks with respect to the restructuring process. (a) Financial Health of the Banks. Under the stewardship o fthe two management teams both banks have made significant progress inimproving their financial position as well as reducing operating losses. Froma loss inexcess o f Rs 3.0 billion in2001/02, NBLhas managed to reduce losses to Rs 281million in2002/03 -remarkable by any standard. NBL i s confident that they can make an operating profit in2003/04. Its costlincome ratio improved from 455 percent in 2001/02 to 125 percent in2002/03. Whilst the NPA level remains high(58 percent as o f July 2003), it has recovered Rs 2.7 billion worth o f non-performing assets, as cash recoveries, since taking over the management and has created adequate provisions to cover loan losses. However, total net worth i s still negative Rs 10billion ($135 million). Similarly RBB's operating loss has been reducedfkom Rs 7 billion to Rs 4.8 billion over the same period. Although RBB'sNPA level remains higher (71 percent as o f July 2003), it has recovered Rs2.0 billion o f non-performing assets since the change o f management. It still has a large negative worth o f Rs 22.4 billion ($300 million). The combined capital shortfall o f the two banks i s Rs 32.4 billion ($435 million) - inline with previous upper estimates. As inthe case o f NBL,RBB has createdadequateprovisionsto cover loanlosses andits costhcomeratio improved from a negative number (-433 percent) to a positive number (+1,740 percent). However, it i s understood that the two banks have witnessed a slow down inrecoveries over the past two months - as easier loans are recovered and the harder recoveries become "the norm". @) NPAs, Debt RecoveryProcedures,and Blacklisting. Highlevels o fNPAs continue to be o f concern despite the progress that has been made with loanrecoveries. Unless the recently established Debt Recovery Tribunals (DRT) are made more effective intheir approach and blacklisting regulations are adhered to infull spirit, it would be unreasonable to expect significant improvement inNPA levels. Further strengthening of the DRT and possible modifications o f the Blacklisting Directive are likely to be necessary ifthese institutions/instruments are to be rendered effective. Inaddition, the banks mustbe encouraged to take cases to the DRT-to assess their functioning and to indicate where more assistance may be required to strengthen their functionality. The publishingo f defaulter's names inthe newspapers i s a recent innovation which has also had some beneficial impacts interms o f improving recoveries. 20 (c) Accounts for 2002/03 for bothbanks are nearingcompletionand are expected to be submitted in December 2003, five months from the report date -incompliance with NRB guidelines. This i s a considerable achievement considering that RBBhadnot produced any published accounts for the past seven years and NBLhadnot produced accounts for the past three. (d) InformationTechnology. Bothbanks are inthe process of establishinga minimalist Information Technology platform. An almost complete absence o f computers inthese two banks means that data collection and Management Information Systems are extremely weak. NBLi s well advanced inprocuring such a system and hopes to commence installation inearly 2004. RBB i s inthe process ofevaluating bidsand hopes that aselection andrapidinstallationcantake place thereafter. Ithas been decided to only introduce a minimalist platform as the new buyers o f the banks may well wish to install their own hardware and software systems. (e) Voluntary Retirement Schemes-StaffRight Sizing. Bothbanks announcedtheir VRS schemes in September 2003 and closed them inthe early part o fNovember. Under pressure from the labor unions, the management teams (in consultation with the central bank), agreed to improve the severance package paid to employees duringthe last week that the schemes were open. InRBB,o f the eligible 1,5 15 workers (at endDecember 2002), 150hadretired as per the bank's normal retirement policy - and o fthe 1,350 remaining, the bank receivedapplications from 1,244. This represents a highly satisfactory take-up o f 92 percent. RBBplans to introduce a second phase VRS next year so as to affect further reductions in staffing levels. This second phase will apply to staff with 15-19 years of service - 1,578 staffers. Around 1,140 are expected to participate in the scheme duringthe secondphase, bringingthe total number o fretirees to 2,384 which represents 77 percent o f the total eligible employees o f 3,093. The cost estimate for RBB's VRS i s Rs 2,594 million ($35.0 million) - which does not include the payment that RBBmust make to its employees under its provident fund scheme upon termination o ftheir service -Rs 179 million. Also excluded i s the payment that RBB must make to its employees for unusedhome leave (up to120 days) and sick leave (15 days per year) which can be commutedto cash upon termination o f service -Rs 100 million. Including these two elements, the cost o f the severance package increases to Rs 2,873 million ($38.8 million). These latter two components will be covered by HMGNrather than the World Bank. InNBL,ofthe 2,561 eligible employees with20 or moreyears ofservice, 1,458 submitted applications. Inview o f a lower than anticipated number o f employees talung up the VRS, NBL decided to conduct a second phase VRS targeting staff with 15-19 years o f service (2,131). A total o f 853 are expected to participate inthe scheme during the secondphase, bringingthe total number o fretirees to 2,3 11. The cost estimate o fNBL's VRS stands at Rs 1,594 million ($21.5 million). This calculation does not include the payment that NBLmust make to its employees under the provident fund scheme upon termination o f service - Rs 366 million. It also excludedis the paymentthat NBL must make to its employees for unusedhome leave (upto150 days) and sick leave (12 days per year) which can be commuted to cash upontermination o f their service -Rs 77 million. Including the two cost elements, the cost o f the severance package increases to Rs 2,037 million ($27.5 million). Again, the World Bank will not cover these latter two elements which will also become the Borrower's contributionto the project. The following table compares the two Voluntary Retirement Schemes inthe two banks. 21 VOLUNTARY RETIREMENTSCHEMES InRastriyaBanijyaBank andNepalBank Limited NepalBank Ltd. Rastriya Banijya TOTAL Bank Current Staff Strength 5,270 5,522 10,792 RequiredStaff Level 2,959 3,200 6,159 VRS target 2,311 2,384 4,695 Eligiblefor VRS 2,561 3,093 5,654 Total VRS Cost Rs 2,037 mill Rs 2,873 mill Rs 4,910 mill ($27.5 mill) ($38.8 mill) ($66.4 mill) PhaseI-No. o f staff 1,450 staff 1,200 staff 2,650 staff PhaseI- Cost Rs 1,528 mill Rs 1,645 mill Rs 3,172 mill PhaseI1-No. o f staff 861 staff 1,184 staff 2,045 staff PhaseI1- Cost Rs 509 mill Rs 1,229 mill Rs 1,738 mill Average Cost per Employee Rs 881K Rs 1,205K Rs 1,046K ($11,911) ($16,287) ($14,133) Annual Savings after VRS Rs 197mill Rs 248 mill Rs 445mill($6.0mill) ($2.7 mill) ($3.3mill) Staff Expense (FY 2002103) Rs 1,006 mill Rs 787mill Rs 1,793 mill($24.2 ($13.6 mill) ($10.6 mill) mill) Eligible Age Open Open Eligibility service (years) >15 >15 ImpltmentationProcess Two Phases: Two Phases: Phase I: >20 years Phase I:>20 years or or more o f service more o f service Phase11: 15 - 19 Phase 11: 15 19 - years o f service. years o f service. Equivalent months'pay 100.2 130.6 (Average) Cost Structure (Average) Gratuity: 33.7 % Pension: 48.2% Retirement : 24.5% Insurance: 23.4% Incentive : 20.0% Incentive: 18.7 % Provident Fund: Provident Fund: 5.5% 18% Leave Encash: 4.2% Leave Encash: 3.8% Exclusion No particular No particular positions specified positions specified Mode o f Payment One-time lump sum One-time lump sum except for pension portion. E t afrom Nepal Rastra Bank exclu ?sCosts associated wi encashment. 22 Annex 2: Major RelatedProjectsFinancedby the Bank and/or other Agencies NEPAL: FinancialSector RestructuringProject The on-going FSTA project (co-financed by DFID)was approved by the Board on December 19,2002. This project i s the first phase (Phase I)f three sequential phases designed to implement a comprehensive o financial sector reformprogram. This sequential approach has been endorsedby the International Monetary Fund(IMF), the Department for InternationalDevelopment (DFID) U.K.,and the Asian Development Bank (ADB). Ofthe total FSTA financing o fUS$30.1 million, IDA has extended a credit o f US$16.0 million and DFIDhas provided a grant o f US$lO.O million, while the remaining fundingi s from the Government o fNepal. Specifically, the project focuses on (i) to restructure and re-engineer the Central Bank (Nepal helping Rastra Bank -NRB), so that it can effectively perform its key central banking functions; (ii) commencing commercial banking reform inthe two large ailing commercial banks that dominate the sector Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL)-by introducingstronger external bank management that protects the financial integrity o f the two banks and takes on a conservator role to prepare the banks for the next steps o frestructuring; and (iii) supporting a better environment for financial sector reform inareas such as enhanced credit information, better financial news reporting, andbetter training for staff infinancial institutions. The latest ImplementationPerformance and Development Outcome ratings as per the Project Supervision Report dated July 25,2003 are given below: Summary Ratings: Last Now Compliance with Agreed S S Achievement o f PDO S S Procurement Schedules Implementation Progress S S Quality and Reliability S S o f Procurement Admin. Other Ratings: Safeguard Mgt Performance S S FinancialManagement S S Other Legal Covenants S S Financial Performance S S WID Impact NA NA Project Management S S Monitoring& Evaluation S S Asian DevelopmentBanklendingfor the development o fNepal's financial sector has traditionally focused on rural finance -mainly through the Agriculture Development Bank o fNepal (ADBN)- and micro finance. The ADB has recently completed a diagnostic o f the ADBN (and the NIDC) and intends to implement a program o f restructuringwithin these two institutions, similar to the one supported by the World Bank inRBBand NBL. On-going ADB technical assistance inthe sector supports the reform process bybuildingthe accounting and auditingprofessionthrough the strengthening o f the Institute o f Chartered Accountants o fNepal (ICAN), reform o f company law, development o f legislation for insolvency and secured transactions, and creating a focal point withinthe Ministryo f Finance (MoF) to sustain the momentum and augment capacity for financial sector reform. ADB's support is through the on-going Corporate &FinancialGovernance (CFG) Projectthat aims to improve transparency, accountability and basic financial sector infrastructure, comprising (i) strengthening the legal and regulatory framework, accounting standards and sector policies; (ii) supporting key sector regulatory and supervisory institutions; (iii) enhancing the capacity o f the legal and judicial system for proper enforcement and dispute resolution; and (iv) improving the environment for I C T infrastructure for payments, information disclosure, and financial service delivery. Inaddition, the 23 project will initiate work on developing selected market participants to play a better role inthe financial system. To cover these assistance areas, the project blends loans (US$7.6 million) and technical assistance (TA) grant funds (US$6.0 million) focusing on governance inthe corporate sector as well as non-bank financial institutions, including rural finance and capitalmarkets. 24 Annex 3: ResultsFrameworkandMonitoring NEPAL: FinancialSector RestructuringProject ResultsFramework UseofOutcome Information To improve corporate Improve regulatory governance through provision of c o k p t i o n i s suspected, referredto the regime. management support to the two Commission for the Investigationo f the large commercial banks. Abuse o f Authority (CIAA). Establishment and commenced operation o f Debt Recovery Tribunals and Appellate Tribunal. Enforcement o f the Blacklisting Directive. To improve market structure by Retrenchment o f staff o fNBL and RBBby Prepare the two banks reducingthe state-owned 40 percent and rationalization o fbranch for privatization. segment o f the banking system. networks to reduce cost structure. Outsourcingo f non-core activities. RBBand NBLprivatized. To sustain and deepen the Enhanced Supervisory and Regulatory To takeprompt banlungreforms. Capacity at NRB. corrective action with respect to troubled banks. Indicators in bold italics will befinanced by thegrant. Other indicators will befinancedfrom ~~ the credit. ComponentsFundedby IDA Credit RBBandNBL. to less than 20 percent. reduction measures. central banking responsibilities. 25 further deterioration in asset quality of management teams. existingportfolio. ImprovedOperatingResults with a positive cash flow. More than 50 percent o f the customers to have access to branches that operates with on-line system. Production of Quarterly Financialswithin one month and audited Annual Financials within five months. Better, cheaper, andor more diversified range o f banking services. Components Fundedby IDA G nt Component Two: Sales Advisors Assistance inthe ultimate Negotiationsfor sale of NBL and RBB To ensure that banks privatization of the two commenced withpre-qualijied strategic are sold to "Fit and commercial banks. investors. Proper ''Bankers. ComponentThree: PhaseI1of NRBRe-engineering More efficient discharge of Reduction in Non-Professional to Design the Third central bankingresponsibilities. Professional Staff Ratio to 2:l. Phase of NRB Re- engineering. Adoption of revised organization structure and revised HR Policies. Merit-based over Seniority-Based Promotion. On-Site bank supervision reports that are of international standardproduced within a quarter after completion of bank examination and a cycle not exceeding two yearsfor each commercial bank. Prompt action taken against troubled banks that do not meet statutory and regulatory requirements. NRBAccounts produced to international accounting standards within the statutory timeframe. External audit of NRB by an International Firm for FY 2003. 26 2z d 4u 2z X X X X X X X X X X X X X X X X X X X X X X X X X X X X X x X X X X X Annex 4: DetailedProjectDescription NEPAL: FinancialSector RestructuringProject The proposed project includes four project components. Project Component 1-US$ 56.5 million VOLUNTARY RETIREMENT SCHEME (VRS). The performance o fNBLand RBBhas partly been constrainedby costs exceeding income, with highstaff expenses a main contributing factor. It i s therefore critical that these banks down-size to more sustainable levels. The project would assist the restructuringefforts inthe two banks that would lay the foundation for them becomingprivatizable assets. On September 15 and 17,2003, respectively, RastriyaBanijya Bank (RBB) andNepal Bank Limited (NBL)-withagreement fromthe Ministryof.FinanceandNepalRastraBank (NRB)-announcedtheir respective VRS schemes. Whilst the schemes were open for up to a month, the management o f these two banks agreed (with the Labor Unions o frespective banks) to extend the application deadline by another three weeks to a month to accommodate the Tihar festival holiday period inlate October. The staff who have already submittedtheir applications should be able to start retiring from the banks as early as December 2003. Some staff will, however, be requestedto stagger their departure dates so as to ensure a smooth transition for these institutions. Out o f 5,522 staff, RBB expects to retire 2,384 staffwith an average payout to staff o f US$ 16,287. NBL (with 5,270 staff) has targeted 2,311 stafffor retirement at a cost o fUS$ 11,911 per employee. The difference inthe average payouts between the two banks represents different age and time-in-position employee profiles inthe two banks rather than a fundamental difference betweenthe schemes being offered. The average payout per employee represents 100 months salary for NBLand 130 for RBB. However, the actual incentive (over and above requiredpayouts) inthe VRS package i s only 20 percent in NBLand 19percentinRBB. The total cash outlay for theVRS operation for the two banks is estimated to be US$ 66.3 million out o f which the World Bank with financ.e US$ 56.5 million. RBBhas plannedthe VRS operation intwo phases with the first phase targeted at those who havehad more than 20 years o f service followed by those with between 15-19 years of service. Although NBL originally targeted only those with more than 20 years o f service, it i s now highlylikely that those staff with 15 to 19years o f service (and even less), will also betargeted ina secondphase. ProjectComponent2 -US$3.0 million [ofwhich US$3.0 millionis anIDA Grant] HIRING OF SALESADVISORS: The thirdcomponent o fthe proposedproject involves the hiringof a Sales Advisor (Privatization Advisor) to help sell the banks to "fit and proper" owners towards the end o f the bank restructuring process. This could happen sooner or later depending upon the progress made by the management teams inrestructuringthe two banks andor the potential interest by outside parties in purchasing the institutions. Inall likelihood, however, the Sales Advisor would not be recruited for one to two years after significant progress hadbeen made with the restructuringprocess. Their role would be to prepare a sales prospectus for the banks, undertake a road show to sell these institutions and take them through to the point o f privatization. ProjectComponent3 -USS8.0 million [ofwhich USS4.0 millionis anIDA Grant] SECONDPHASEOF NEPALRASTRABANK (NRB) RE-ENGINEERING: The CentralBank o f Nepal, continues to be a weak institution requiring strengthening o f all its core functions. NRE3 has 29 requested continued support for its on-going re-engineering to buildupon the progress made to date under the FSTA credit. This assistance will be provided inthe following areas: (i) humanresource re- engineering; (ii)accounting support; (iii) supervision and regulation; and (iv) Information bank Technology (IT) up-gradation. (a) HumanResourceRe-engineering. Humanresource re-engineering is at the heart o f institutional reforminNRB. Ofprime importance i s the adoption o f a new organizational structure within the bank. Considerable progress has been made inthis regardand a new simplified structure i s to be adopted in early 2004. However, the bank will require on-going support to assist it inimplementing its new HRpolicies which emphasize merit-based advancement over the time-in-grade criteriatypically used in South Asian public sector institutions. Further development o f the training plan and its implementationwill become an important focus o fthe Phase I1program o f support. (b) AccountingSupport. The NRB is making goodprogress inadoptingInternational Accounting Standards (IAS). Two key actions required for the immediate future are revision o fthe Accounting Manual to reflect U S , and the external audit o f the NRBby a well recognized international accountancy firm. These activities will be supported under the Phase I1project. (c) BankSupervisionandRegulation. The bank supervision department is makinggoodprogress inundertakingon-site examinations ofthe 15 commercialbanks-not includingRBBandNBL. In2001/02, HimalayanBankwas examinedbyNRB. In2002/03, LaxmiBank,NepalInvestment Bank, Everest Bank, Nepal Industrial and Commerce Bank, Standard Chartered Bank, Bank o f Kathmandu, and Siddarth Bank were examined. In2003/04 the plan i s to examine Nepal Bank Limited, RastriyaBanijya Bank, Nabil Bank, Nepal SBI Bank, Nepal Bangladesh Bank, Nepal Credit and Commerce Bank, LumbiniBank, Macchapuchere Bank, and Kumari Bank. However, this ambitious schedule o fbank examinations is hamperedbyyoung andinexperiencedbank examiners who have to be nurturedby their more experienced colleagues. With three bank examination teams out at any one time, and with approximately two experiencedNepali bank examiners ineach team o f six, both the bank examination report and the training component o f these exams i s severely hampered. As a result, examinations take an unduly long time to complete and the reports take several months to reachthe Board o fNRB where they can further wait for a further two to three months before they are discussed. The end results are long delays and out-of date reporting. A final problem lays with a lack o f follow up on actions where deficiencies ina particular bank are uncovered by the examiners. The Phase I1project will provide enhancedtechnical and physical support for the work o f the department inthe form o f additional desk top computers, lap top computers for on-site examiners, intemational experts to assist with on-the-job training (for the complete two year examination cycle o f all the commercial banks), and classroom training inareas relatedto bank supervision, computing, and English(report writing). (d) InformationTechnologyUp-Gradation.A lack o f computerizationindepartments frombank supervision, to accounting, to banking operations, has hampered the efficient functioning o f the central bank. Operatingwith DOS based systems and an IT department which i s developing its own software rather than purchasing customized software offthe shelf, the bankrequires serious investment inup-dated IT systems, including the purchase o f a computerized General Ledger system for the institution. An IT Specialist i s being recruited to assist indesigning this component with fundingfrom the FSTA project. This subcomponent will be financed by an IDA Credit. 30 The costing o f components for the Phase I1Nepal Rastra Bank re-engineering i s therefore based on the following cost table ProjectComponent 4 -US$6.0 million MANAGEMENT TEAM SUPPORT: This component providesfundingfor continuous Management Team support (at NBLand FU3B) prior to their privatization. Whereas the Management Teams are currently working on a two year plus one (2+l) contract, privatization could feasibly take longer than this to achieve. Reverting to poor management before privatization would result ina loss o f the good investment which has taken place so far inthese banks. Consequently, this component i s intended to maintain the banks under full profession management from the end o fthe third year o f the Management Team contracts through to full privatization without any breaks. 31 Annex 5: ProjectCosts NEPAL: FinancialSector RestructuringProject ~ Local Foreign Total Project Cost By Component andor Activity TTC Qm;ll;fi.\n 1 rylllllllull US $million U S $million Voluntary Retirement Scheme 56.50 0.00 56.50 Hiringof SalesAdvisors 0.00 3-00 3.OO NRE3 Re-engineering (Phase 11) 1.00 7.00 8.00 On-going Management Team Support 0.00 6.00 6.00 Total Baseline Cost 57.50 16.00 73.50 Physical Contingencies 0.00 1.20 1.20 Price Contingencies 0.00 0.80 0.80 TotalProject Costs 57.50 18.00 75.50 Interest duringconstruction Front-endFee TotalFinancingRequired 57.50 18.00 75.50 32 Annex 6: ImplementationArrangements NEPAL: FinancialSector RestructuringProject The Coordination and Support Team (CST) that has been formed within Nepal Rastra Bank inthe Bank and Non-Bank Financial InstitutionRegulations Department, under the FSTA, will continue to administer this project. The ExecutiveDirectoro fthis department heads the CST andprovides overall guidance and leadership on matters o f project implementation. The CST i s supported by a dedicated Financial Management Specialist who i s a qualified professional accountant and by a dedicated Procurement Specialist. The CST i s also supported by adequate ancillary staff and facilities. Operatingcosts o f the CST will be funded under the FSTA on a declining cost basis over the project implementationperiod. These operating costs include communications, office supplies and materials, incremental staff costs, and other expenses which will bejointly financed by the IDA Credit and the DFID Grant. Staff salaries are excluded (except for the consultant procurement officer). The restructuringmeasures will be coordinatedby the Ministryo f Finance (MoF) and Nepal Rastra Bank (NRE3). RastriyaBanijya Bank (RBB) andNepal Bank Limited (NBL)will be responsible for the design and implementation o f their respective Voluntary Retirement Schemes (VRS) -which i s the main expenditure under the project. NRBandthe MoFwill beresponsible for implementingthe requiredstepsto bringthe two banks to the point o f sale and for identifying bona fide strategic investors inparallel with the restructuringexercise currently being undertaken by the professional management teams. The NRB and MOF will be assisted by the Sales Advisor engaged under the Project to implementthe individual sale transactions. The MOF will coordinate the selection process withNRB,the bank regulator and supervisor, to ensure that the process results inthe selection o f qualifiedbuyers who have the required integrity, capital, banking expertise, technology, and management. The NRB will be responsible for clearing potential buyers and their proposed management teams inaccordance with established selection criteria and banking regulations. The MOF will also be responsible for taking steps to amend Article 86 o fthe Nepal RastraBank Act to provide NRB sufficient powers to rehabilitate and restructure the institution and for coordinatingwith the Securities Board and the Nepal Stock Exchange to arrange for NBL shares to be de-listed from the stock exchange. The NRB will be responsible for designing a program o f on-going re-engineering o f the central bank to builduponthe progress made to date underthe FSTA. The NRBwill be assistedby experts in the areas o f human resource, accounting, bank supervision and regulation, and information technology. The M o F and NRB will be the implementingagencies for the restructuring and other policy reforms supported by the proposed project. The ICC/Bank o f Scotland i s expected to provide management support for NBLand the team o f individual consultants for RBB duringthe remainder o ftheir term (two- year term with an option for one-year extension). Continued management support beyond the three year period will be overseen by NRB. The project will be implemented over a five-year period (2004-2008) with the bulk o f loan proceeds (US$56.5 million or close to 75 percent) disbursed in2004 and 2005 to finance the VRS o f the two banks. The costs o f Sales Advisors, Phase I1NRB re-engineering, and the on-going Management Team support will be spread over a four-to-five year period. WhilstNRBwas the only implementingagency for FSTA, MoF andNBL/RBBare active participants. 33 For the proposedproject, all these agencies -NRB, MoF, and RBB/NBL will have implementation responsibilities. 34 Annex 7: FinancialManagementandDisbursementArrangements NEPAL: FinancialSector RestructuringProject(Phase I1Reforms) Summary of ProjectDescription: The proposedcredit is a secondphaseproject o fthe on-going Financial Sector ReformProject (Phase I). The project implementation arrangements under the current project will continue inthe next phase. The financial management (FM) assessment has been carried out aiming at (i) reviewing current project FMarrangements, including weaknesses, and (ii) proposing arrangements for improved financial management. One o f the key objectives o f the proposedproject i s to provide further assistance to improve N R B ' s accounting, reporting and auditing standards and make them I A S compliant within a reasonable time-frame. The project activities are grouped under four broad components. The details o f the components and their sub-components are described inAnnex 4 o f the PAD. CountryIssues: The IMF's SafeguardAssessment o fthe financial sector identifiedinstitutional weaknesses inthe area o f financial management and the IMF has been working with NRBtowards improving financial management through an agreed actionplan. The ongoing project includes a component which has been addressingN R B ' s current weaknesses inthe area o f accounting, reporting, extemalhnternal audit and training. The proposed IDA grant will further compliment the on-going FM reforms inNRB and would further strengthen its FMcapacity inline with international standards. The component for Phase I1NRBre-engineering includes a revision o f the Accounting Manual to reflect I A S requirements, extemal audit by an internationallyreputed audit firm, installation o f a computerized accounting system, and training. These actions will greatly contribute towards improving overall FM systemwithinthe NRB. Adequacy ofFMarrangements: The CST under the direct supervision o f an Executive Director within NRBhas been functioningwell inthe on-going project. The CST will be further expanded inthe proposed project with additional staff and logistics. Financial Administration Rules o f the NRB are adequate to ensure appropriate controls over project transactions. The duties and responsibilities o fthe CST are segregated properly so as to ensure that financial transactions are initiated, approved and executed at different levels. The FMstaff are well conversant with the Bank's FMpolicies and procedures. Overall, the FMarrangements for the project are adequate for the initial stage o f project implementation. However, these needto be further improved inthe areas indicatedbelow to ensure a satisfactory FM system throughout the entire project implementation period. RiskAnalysis: Froma financial managementperspective, there is lowriskaffecting the project. This is because a large portion (almost 75 percent) o f the credit proceeds would be utilized to reimburse NBL and RBB for Voluntary Retirement Schemes (VRS). N R B ' s appointment o f a full time Procurement Specialist and FMexpert inthe CST has greatly contributed towards avoiding any potential risk inthe procurement o f consultancy services and performing the ex-ante audit functions efficiently and effectively. Further, implementation experience gathered through the on-going Phase Iproject has provided adequate knowledge and skills inmanagingIDA funded credits. Strengths: The proposedproject aims to buildonthe successeso fthe current project and will have the following strengths inthe area o f financial management: (i) the existing FMexpert, who has familiarized himselfwiththe World Bank's FMpolicy andprocedures, will continue to work inthe newproject. Moreover, the need for additional support has been identified and it has been agreedthat these staff will be put inplace by March 31,2004; and (ii) highlevel commitment o fthe government andNRB's the management to various reforminitiatives will greatly contribute to addressing any potentialproblems which may arise duringproject implementation. 35 Weakness andResolution: An importantweakness is poor logistic and other administiative support to the CST. The CST staff are operating ina constrained environment interms o f staffing resources. Financial information i s maintained in spreadsheets, but there i s scope for computerization o f accounts to keep track o f project expenditures, compilation and reporting - with additional staff. It i s recommended that this be addressed by the appointment o f additional staff. The CST i s also planning to upgrade its computer facilities under the current project. The Finance Officer will be appointed by March 2004. FundsFlow: To utilize IDA'Sshare o feligible expenditures, NRBwill open a Special Deposit Account (SA) under terms and conditions acceptable to IDA. The Executive Director (ED) o fthe NRB and Financial Institutions Regulations Department will continue to work as the Coordinator inthe new project and will continue to be the authorizing authority for checks, making payment request to CST, and the withdrawal o f funds from the IDA creditlgrant. The SA will be managed under the joint signature o f the EDand anFMexpert with aprovision for an alternate signature o f another Assistant Director (finance). With regardto VRS payments, NBLand RBBhave aproper system inplace to properlymonitor the eligibility o f VRS payments and maintainrecords thereof in their system. NRB has agreed to a reporting format with NBL and RBB. NBLand RBB will maintain all supportingdocuments related to VRS payments and they will be maintainedwithin the respective accounting departments o fthe two commercial banks. These documents will be made available upon demand to NRB, external auditors and other concerned authorities including World Bank supervision missions. Reporting formats have also been agreed with NRB, and the two commercialbanks will prepare a summary statement o f all VRS payments which will be completed by the Accounts Departments o f the respective banks, certifiedby the Chief Financial Officers, and the Heads o f the Internal Audit Departments. VRS payments will be based on policy documents approved by the concerned authorities o fthe two commercialbanks and the resolution o f the management committee approving claims for amounts paid under the VRS. HMGNwill ensure timelyrelease of counterpart fundsto the CST througha separateprojectbank account. Transaction baseddisbursement procedures will be applicable for withdrawal o f funds from the creditlgrant. Budgeting,Accounting andInternalControls: Project planning andbudgetingwill follow HMGN's existing planning and budgeting system, which i s adequate for the new project. This has already been reviewed duringthe on-going project preparation and i s outlined inthe PAD. Cash based accounting systems will be followed. The accounting policies and procedures will be the same as for the on-going project and will be governed by the existing accounting procedures outlined inthe Financial Administration Rules o f the NRB. Separate books/records (cash and bank-book, General Ledger, Fixed Assets register, Bank Reconciliation, etc) for the project would be maintained byNRB. The accounts will continue to be maintained on computer spreadsheets which i s adequate to keep track o f project financial transactions. Approval authority and proper segregation o f duties inthe CST has been functioning well in the on-going project. The same delegation o f financial powers and approval authorities will be followed for the new project and will further strengthen with the appointment o f a finance officer. FinancialReportingandMonitoring: The CST will be responsible for summarizingfinancial transactions, maintaining supporting papers and preparingtimely consolidated Financial Statements on a monthly basis. A set o f customized formats o f project Financial Monitoring Reports (FMRs) were agreed inthe on-going project. The first set o f reports were receivedinDecember 2003. NRB will propose formats to report project progress based on the existing agreed reporting formats. FMRs will be submitted on a trimester basis within 45 days o f the end o f each trimester. It has been agreed that a set o f customizedreports for the proposed project will be submitted to IDA and will be finalized based on IDA'Scomments by January 31,2004. 36 ExternalAudit: The first audit report ofthe on-goingproject, and for NRB, are for FY2002/03 and are due on January 15,2004. NRB was notified o fthe need for the audit reports by the due date - including beingnotified o f the implications o f delays that could lead to delays inproject processing o f the current operation. The option o fNRB's audited financial statement being mergedwith identifiable information on IDA funds, under an agreed Terms o fReference (TOR), was explored. It was concluded that NRBi s not yet ready to merge project financial data into its financial statements and it would prefer to have project financial statements auditedby a private audit firm appointed by the Auditor General (AG), acceptable to IDA. The audit TOR, which has beenagreed inthe on-going project, will be followed for the proposed project and the audit report will be submitted to the Bank within six months o f the end o f each fiscal year. Inaddition, N R B ' s statutory auditor will carry out an annual audit o f its financial statements. A copy o f such audit reports will be submitted to IDA by January 15 o f each fiscal year. The following audit reports would be monitoredinthe Audit Report Compliance system (ARCS): Implementing Audit Auditors Audit DueDate Agency NRB Project Financial Private Sector Audit Firm 6 months after the end Statements appointed by the ,Auditor o f fiscal year (January General (AG) 15'h) NRB Entity(NRB) Financial Private Sector Audit Firm 6 months after the end Statements appointed by the Auditor o f fiscal year (January General (AG) 15') Actions Responsibility Completiondate 1. Appointment of Support Staff inthe CST NRB March 31, 2004 2. Upgradation o f Computer Hardware/ NRB December 3 1,2004 Software in CST to move to a computerized information system 3. Finalization o f FMRs formats and contents IDAandNRB January 31,2004 4. Appointment o fprivate audit firm OAG M a y 15" o f every year accentable to IDA SupervisionPlan: The initial supervision focus will be onthe progress o fimplementation o fthe agreed actions, and facilitating NRB inmaintaining sound Financial Management arrangements throughout the project implementationperiod. Disbursement Allocationof credit/grantproceeds (TableC): Disbursement underthe proposed crediugrant will be made as indicated inTable C, which indicates the percentage o f financing for different categories o f expenditures o f the project. It i s expected that IDA funds will be disbursed over a period o f five years. The fiscal year disbursement estimate i s provided on page one (the Project Summary) o f the PAD. The Closing Date o f the credit/grant i s March 2009. 37 Allocation of CreditProceeds ExpenditureCategory Amount inUS $ Million FinancingPercentage 1. Voluntary Retirement 56.5 100% o f disbursed amount Scheme 2. Consulting Services 13.0 85% 3. Goods 4.0 100%o f foreign expenditures and 85% o f local expenditures Unallocated 2.0 Use of Statement of Expenditures(SOEs): IDA will require full documentation for all prior review cases where contracts exceed the equivalent of: (a) U S $200,000 for goods; (b) U S $100,000 for services contracts with firms; and (c) U S $25,000 for individuals. Expenditures below the above thresholds and all expenditures under voluntary retirement schemes (VRS), will be claimed on SOEs. Duringthe initial supervision by IDA, the mission will closely review the SOE claims to ensure that the funds are utilized for the intended purposes. Any deviations noticed duringsuch reviews would be noted for remedy and improvement. SpecialAccount: For utilization o fIDA'S share o fproject expenditures, NRE3may open andmaintaina Special Deposit Account inU S dollars under terms and conditions acceptable to IDA. The authorized allocationto the Special Deposit Account will be limited to 3 to 4 months estimated expenditure o f IDA'S share o f the proposed project. The authorized allocationwill be limitedto $4,000,000. At the start o f the project, the initial deposit will be limitedto $2,000,000. The remaining $2,000,000 o f the authorized allocationmay be withdrawn once the total withdrawal from the creditlgrant reaches SDR 5,000,000. RetroactiveFinancing: Inorder to expedite project implementation, there is aneedfor retroactive financing in excess o f the current 10percent authorized limit which has requiredRegional Vice President (RVP) and Managing Director (MD)approval. Bank reimbursement from the proceeds o f the IDA credit will be made for VRS payments undertaken inadvance o f the anticipated Boarddate. Inorder to be eligible for retroactive financing, procedures for procurement, the use o f consultants, processing and clearance, are subject to Bank's Procurement and Consultants Guidelines. Inaddition, documentation requirements for expenditures claimed under retroactive financing are the same as those for disbursements against payments made after the Financing Agreement i s signed and effective. 38 Annex 8: Procurement NEPAL: FinancialSector RestructuringProject Table A: Project Costs by Procurement Arrangements (US$ million equivalent) Procurement Method Expenditure Category ICB NCB Other' N.B.F. Total Cost 1. Works 0.00 0.00 0.00 0.00 0.00 2. Goods 3.83 0.17 0.00 0.00 4.00' 3. Services 0.00 0.00 13.003 0.00 13.00 4. Miscellaneous4 0.00 0.00 56.50 0.00 56.50 5. Unallocated' 0.00 0.00 2.00 0.00 2.00 Total 3.83 0.17 71.50 0.00 75.50 ' Includes consultant selection arrangements and VRS payments, Computer purchases and ITupgrading for NRB. This comprises consultancy services for NRJ3reengineering, managementteam support and sales advisors, Voluntary Retirement Schemes - $ 56.5 million Unallocatedamount could go into ExternalAudit and IT Platform shortfall bothunder NRB re-engineering or possible shortfall inFSTA budget for payment to Management Team for Year 3 , 39 Table A1: Consultant Selection Arrangements (optional) (US$ million equivalent) SelectionMethod Consultant Services QCBS QBS SFB LCS CQ Other N.B.F. Total Expenditure Category A. Firms 6.18 0.00 0.00 0.00 0.00 6.00 0.00 12.18 B.Individuals 0.82 0.00 0.00 0.00 0.00 0.00 0.00 0.82 Total 7.00 0.00 0.00 0.00 0.00 6.00 0.00 13.00 Note: Other refers to sole sourcing. Table B: Thresholds for Procurement Methods andPrior Review' Contract Value ContractsSubject to Expenditure Category Threshold ProcurementMethod Prior Review (US$ thousands) (US$millions) 1.Works NA 2. Goods a) <200,000 NCB 0.00 b) >200,000 ICB 4.00 3. Services A. Firms: a) < 100,000 QCBS,CQ, Other 0.00 b) > 100,000 QCBS 7.15 LC, SFB, Other 7.25 B.Individuals: CQ, Other 0.10 >25,000 Thresholds generally differ by country and project. Consult OD 11.04 "Review o f Procurement Documentation" and contact the RegionalProcurement Adviser for guidance. Total value o f contracts subject to prior review: {US$ 18.5 million} Overall Procurement Risk Assessment: {Average} Frequency of procurement supervision missions proposed: One every {four} months (includes special procurement supervision for post-review/audits) 40 Table C: Allocation of Credit Proceeds Expenditure Category Amount inUS$ million FinancingPercentage Goods 3-62 100% Services 13.38 85% Miscellaneous (VRS) 56.50 100% Unallocated 2.00 85% Total Project Costs 75.50 Interest during construction Front-endFee Use of statements of expenditures (SOEs): {if applicable} Special Account: {ifapplicable} 41 Annex 9: EconomicandFinancialAnalysis NEPAL: FinancialSector RestructuringProject Nepal Bank Limited ----- 1999 2000 2001 2002 2003 StaffExpense(Rs. mil) 763 1,048 871 1,228 1,005 Annual Savings after VRS (Rs.mil) 244 Cost (Incentive) of VRS - (20.1 % ofRs. 2,037 mn) 409 IRR(10 year period) - % 59% Payback(years) 1.68 NE3Lmanagementhopestoreduce staffexpenses from25 percent oftotal operating expenseto 16percent annually iftheir VRS plan i s successful. This translates to annual saving inoperating costs o f Rs 244 million. Whilst the total cost o f VRS i s Rs 2,037 million, the incentive portion built into the scheme i s only 20.1percent o f the total, i.e. Rs 409 million, which i s the figure used as the investment cost for the project. This results ininternalrate o freturn o f 59 percent with a payback periodof 1.68years. Given that data on future cash flows are not available, annual savings and investment cost (taking into cognizance the possibility of an increase inincentive costs) have been sensitized under different scenarios, viz: IRR& PavbackPeriod Increase InvestmentCostby ReduceAnnual Savingsby/ 5yo 10% 15% 20% 10% 53% (1.86) 48% (2.05) 46% (2.14) 44% (2.23) 20% 47% (2.10) 42% (2.30) 40% (2.41) 38% (2.51) 30% 40% (2.39) 36% (2.63) 34% (2.75) 33% (2.87) 40% 34% (2.79) 30% (3.07) 29% (3.21) 27% (3.35) Even ifprojectedcash flow i s sensitized with 40 per cent reduction inannual savings and increase in investment cost by 20 percent, N B L ' s IRRremains satisfactory at 27 percent (with a payback o f 3.4 years). RastrivaBaniiva Bank ----- 1999 2000 2001 2002 2003 StaffExpense (NPR mil) 560 1,279 1,385 759 3,258 Annual Savingsafter VRS (NPRmil) 264 Cost (Incentive) of VRS - (18.7 % ofNPR2873 mn) 537 IRR(10 year period) - YO 48% Payback(years) 2.03 Note - Staffexpenses in 2000, 2001 and 2003 includesprovision madefor Provident Fund and other staffbenefts. Based on estimates provided by RBBmanagement, projectedannual savings are Rs 264 million after implementingtheir VRS (both phases). Investmenti s estimated at Rs 537 million, i.e. the incentive 42 portion from the total VRS cost o f Rs 2,837 million. This yields an IRRo f 48 percent with a pay back period o f slightly more than 2 years. As information on RBB's future cash flow is not available, annual savings and investment cost havebeen sensitized under various scenarios inline with NBL,viz: IRR& PavbackPeriod Increase Investment Cost by Reduce Annual Savings bd 5yo 10% 15% 20% 10% 41% (2.37) 39% (2.49) 37% (2.60) 35% (2.71) 20% 36% (2.67) 34% (2.80) 32% (2.92) 30% (3.05) 30% 30% (3.05) 29% (3.20) 27% (3.34) 26% (3.49) 40% 25% (3.56) 24% (3.73) 22% (3.90) 21% (4.07) Hence, under a worst case scenario - a 40 percent reduction inprojected annual savings and a 20 per cent increase ininvestment cost -results inan IRRo f 21 percent (payback o f 4 years). Due to the lack o f data, the above calculations didnot take into account the indirect costs o f the VRS including the cost o f outsourcing, and the cost o fnew hires. Similarly, indirect benefits such as subsidies on staff loans, and the overhead costs o f displaced staff have not been factored in. Hence, sensitivity analysis was done under various adverse conditions as shown above which still results insatisfactory returns to the investment. The retum to the Bank's investment operation are quantifiable benefits interms o f cost savings as shown above and the unquantifiablebenefits interms o f increased efficiency o f the banking system through lower lending spread and wider choice o f banking services. 43 Annex 10: SafeguardPolicyIssues NEPAL: FinancialSector RestructuringProject N o World Bank Safeguardpolicies have been triggeredby this project -therefore issues pertaining to the identification and minimization o f safeguards do not apply. This Annex does, however, cover social safeguard issues considered by the project team inthe preparation o f this project. Social andSafeguardIssues Introduction As part o fthe FinancialSector Technical Restructuring Program (FSRP - Phase 11)inNepal, aVoluntary Retirement Scheme (VRS) i s to be implementedintwo commercial banks -Nepal Bank Limited (NBL) and RastriyaBanijya Bank (RBB). The project team originally built ina training and counseling component inan effort to meet the genuine retraining needs o f these retiredstaff and to address potential criticisms arising from the implementationo f the VRS which could pose a reputationrisk for the Bank. The inclusion o f this component was also promptedby the desire to meet Bank safeguardrequirements. The team felt that there was a real or perceived harmresultingfrom the retrenchment o f workers at the two banks. The VRS component has been developed ina participatory process that involves all stakeholders (including the affected parties or their representatives) and, as a result o f this undertaking, has established that there i s only minimal demand for training and counseling at the current time. Formal and open consultations were held with all affected parties - and a social assessment o f the training and counseling component was carried out with the conclusion that it was not needed. Extensive discussions were held with the unions, focus groups and others -by the Management Teams inthe banks, the Appraisal Missionteam members, and a social consultancy consultant -to ascertain interest. It was clear that there i s very little interest from the workers or the Government inthese activities. The team has, nonetheless, undertaken extensive due diligence on this issue. What hasbeendone? At the early stage o f project conceptualization, itwas thought that there couldbe considerable social implications associated with the implementation o f the VRS. It was recognized early on that althoughno safeguards issues were triggered, there was nonetheless concem about the likely negative social impact on those workers that chose early retirement without proper planning. Includedinthe range o f social risks were: (1) the inability o f employees to re-enter and compete within the labor market; and (2) the risk o f lower level o f bank employees being forced into poverty as a result o f their choosing early retirement. With this inmind, a training and counseling component was developed to mitigate the potential adverse impacts listed above. Detailsof the Training andCounselingComponent A detailed training and counseling component was developed to support the approximately4,700 retiring staff from these banks. This program had three main objectives: (1) to promote income generation activities for the worker or hisher family members; (2) to assist workers in designing their investment strategies for their lump sum severance pay; and (3) to provide networhng and general empowerment training to worker and family members. The plan was to provide assistance to staff expected to retire 44 underthe VRS package inNBLand RBB. This component was thereby designedas an added social safety net for workers who take up the VRS package. Conduct of Social Assessment A focus group discussion with employees comprising Officer andAssistant o fthe accounts, Banking Business, General Service, and Internal Audit departments was held inOctober 2003 at the RBB headquarters inKathmandu, Nepal. An additional focus group discussion with RBB employees consisting o fthe HeadAssistant, Assistant Officer, Senior RecordKeeper, Assistant Manager, Assistant Manager, and Deputy Manager was held on inNovember 2003 at the RBB office headquarters. Intotal, six focus group discussions were conducted with approximately 60 employees from bothbanks in October and inNovember 2003. Consultations were also held with representatives o f the unions and o f the civil society including the NGOs, international donor community and government agencies concerned with workers' welfare. Why was this training and social component abandoned? After undertakingconsiderable due diligence initially inOctober 2003, and then again inNovember 2003 as part o f the appraisal mission, several areas o f concem arose which resultedinthe decision by the project team to drop the training and counseling component o f the project. The reasons included: (1) the lack o f government buy-infor the component which raised the issue o f whether the project team was being truly "client responsive"; (2) the absence o f an effective on-the-ground agency with the ability to handle the complexity o f this component; and (3) the absence o f support by bilateral partners and international NGOs (DFID and GTZ) for this component. Most importantly, the retirees themselves, many with secondjobs while working for the bank, are not considered the poor or the vulnerable groups inNepalese society. ByNepalese standards, the employees ofthese two public sector banks arerelatively well offby many standards and, duringmeetings with and without union representation, RBB and NBL employees didnot view the training and counseling component as especially pertinent to their lives. Social Tracking and Exit Surveys Nonetheless, inan effort to learn about the effects o f retrenchment and discontinuationo f employment in Nepal, two surveys will be carried out as part o f this project. An exithetraining survey will provide vital information on the attributes and profile o f all staffretiring from NBLand RBB. A second, more long term, tracking survey will be conducted among a smaller sub-sample o f these retiring workers to track their progress intheir post- retirement lives so that future programs can be adequately adaptedto meet the special needs o f this sub-group o fretiring ex-state owned enterprise workers. The Bank has been in contact with DFIDconcerningthe ExiURetraining Survey and the subsequent traclung survey and there i s an agreement inprincipal that the UK Government will fundthis survey work. The project team has identified MARGNepal, a subsidiary o f ACNielsen based inKathmandu, as the most appropriate research agency to conduct and analyze both surveys. MARGNepal i s a large multidisciplinary research and consultancy agency which i s registered with the Ministry o f Commerce (Nepal) and with the Bank inthe South Asia region. MARGi s experienced with handling large studies in urban and rural settings, ina wide range o f subject areas (health practices, corruption, poverty alleviation opinion polls) for agencies such as the UnitedNations, DFID, and Transparency International 45 Annex 11:ProjectPreparationand Supervision NEPAL: FinancialSector RestructuringProject Planned Actual PCNreview 09/15/03 9/03/2003 InitialPID to PIC 10/30/03 InitialISDS to PIC 10/25/03 10/21/2003 Appraisa1 11/10/03 11/10/2003 Negotiations 01/15/04 BoardRVP approval 03/16/04 02/24/2004 Planned date o f effectiveness 05/31/04 Planned date o fmid-termreview 09/10//06 09/10/2006 Plannedclosing date 0346/09 03/16/2009 Keyinstitutionsresponsible for preparation ofthe project: World Bank, IDA InternationalMonetary Fund, IMF Department o f InternationalDevelopment, DFID(UK) Bank staff and consultants who worked on the project included: Name Title Unit Simon Bell Sector Manager SASFP Sabin Raj Shrestha Financial Sector Specialist SASFP Juan Costain Lead Fin. Sector Specialist SASFP Kiatchai Sophastienphong Sr. Financial Sector Specialist SASFP Nagavalli Annamalai Lead Counsel LEGPS Kiran Baral Sr. Procurement Officer s m s Suraiya Zannath Sr. Fin.Mgmt. Specialist SARFM Bigyan Pradhan Sr. Fin.Mgmt. Specialist SARFM Nina Bhatt Project Safeguard Specialist SDV Caroline Fawcett Consultant IMPAQInternational, L L C Margaret Murray Executive Assistant SASFP Bank funds expended to date on project preparation: 1. Bankresources: 150.0 K 2. Trust funds: 0.0 3. Total: 150.0 K EstimatedApproval and Supervisioncosts: 1, Remainingcosts to approval: 35.0 K Estimated annual supervision cost: 75.0 K 46 Annex 12: Documentsinthe ProjectFile NEPAL: FinancialSector RestructuringProject A. Government Documents -Original Signed Letter o f FinancialPolicies from the Minister o f Finance inNepal. -Financial Sector Strategy Statement (FSSS) B. Bank Staff Assessments -Bank's Financial Sector Study -Financial Management Assessment o f Nepal Rastra Bank -Procurement Assessment o f Nepal Rastra Bank C. Other -various Management Team reports for Rastriya Banijya Bank and Nepal Bank Limited. 47 Annex 12A:Letter of FinancialPolicies Dr. PrakashchandraLohani %%&ber 9,2003 Ministry of Finance Mr.PrafulPatel, Vice President, South Asia Region The World Bank 1818 H Street, N.W., Washington, D.C., 20433 UNITED STATES OF AMERICA Dear Mr.Patel, Letter of Financial Policies -Financial Sector Restructuring in Nepal HisMajesty's Government o fNepal (HMGN)has embarkedona comprehensiveprogramoffinancial sector reform and The World Bank and the UK Department for IntemationalDevelopment (DFID) have provided important financial support to the f i s t phase o f this reform through the Financial Sector Technical Assistance (FSTA) Project. Under this project, the government has placed two professional management teams into the two largest banks inNepal - Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL)- to restructure these institutions and ultimately prepare them for privatization. Progress inRBB andNBL. Initialindications are that goodprogress isbeingmade inthese two banks. For example, non-performing loan recoveries have reached more than Rs2.0billion inRBB and well over Rs2.5 billioninNBL. Bothbanks are now producing financial accounts on a regular quarterly basis. Externally audited accounts are expected to be produced for 2002/03 within the five monthtime frame stipulated byNepal Rastra Bank (NRB). Bothbanks are inthe process o finstallingabasic ITplatformto improve their managementinformation systems and their accounting functions and Treasury management has been tightened inthe two banks. Bothbanks managed to reduce their losses o n current year operations compared to last financial year. These banks are being restructured inways that would not have been possible two years ago. Inthis, we are grateful for the ongoing support o f the World Bank and DFID. Voluntary RetirementSchemes inthe two CommercialBanks. However, before additional substantive progress can be made inmoving these banks towards privatization, further efficiency gains will need to be undertaken. The most evident area where productivity needs to be achieved i s with respect to staffing. The human resource managers inthese two banks have estimated that the banks are between 40 to 50 percent overstaffed and that it i s necessary to shed 5,500 staff from these banks. Only once the staffing levels are reduced to numbers which are viable inthe longer term will it be practicalto undertake the training and the upgrading necessary to improve 48 service and efficiency. This process i s also expectedto acheve substantive gains with respect to cutting administrative costs - enhancing the ability to ultimately privatize these banks. As you are aware, supporting the Voluntary Retirement Schemes (VRS) inthese two banks i s a major focus o f the proposed Financial Sector Restructuring Programthat we have now embarked upon - again with proposed support from the World Bank. NepalBankLimited. Inmoving ahead with the VRS we are cognizant o fthe fact that NepalBank Limitedi s a privately (59.1 percent) owned bank - even though His Majesty's Government i s the single largest shareholder. As part o f the FSTA, the private sector board o f the bank was replaced by a board o f officials designated by the central bank and a new Management Team was installed - effectively placing the bank under NRB's control. Given these serious problems -plus the steep negative net worth o f the bank (conservatively estimated at around $150 million) - there is a need to take over full control o f this bank to protect the interests o f depositors, and to facilitate the ultimate objective o f turningthis bank over to new "fit and proper" owners once the bank has been restructured. T o bringabout this change inownership, it is the intention o f HMGNto amend Article 86 o f the NRB Act to provide NRB sufficient powers to, not only assume control o fNBL, as it has already done, but also rehabilitate and restructure the latter through asset and liability transfers. This arrangement i s specifically designed to address the issue o f troubled banks such as NBLwhich have private sector shareholders. To this end, HMGN intends to have this amendment approved by the Cabinet by December 2003. Inaddition, ithasbeena consideredview o fthe Government as well as the Central Bankthat, giventhe significant negative net worth o f the NBL, the continuation o f its listing inthe stock exchange could facilitate the trading o f shares at prices likely to prove to be unsustainable, to the ultimate detriment o f potential investors. Consequently, initiatives have recently been taken through appropriate measures, currently inthe form o f suspension o f share trading, to de-list NBL shares from the stock exchange. The government wants to assure you that the suspension will continue untilthe de-listingprocess will be completed. The government expects to complete this process by December 2003, taking into account all necessary, including legal and financial implications o f the move. RastriyaBanijya Bank. Issues relatingto ownership do not exist with RBBas it is a 100percent government owned bank. HMGNwill therefore be able to dispose o f the assets o f the bank inany way inwhich it sees fit. Nonetheless, inbothbanks, there will be the customary problems associated with VRS schemes, notably, questions o f adverse selection, revolving door policies, and concem that changes ingovernance arrangements (Le. privatization) may not ultimately be acheved. Inthis respect we are working with the HR specialists on the two Management Teams to reduce the staff complement o f these banks to a much lower level; ensure that acceptance o f the VRS i s only with the agreement o fbothparties - the bank and the individual (to avoid adverse selection); and to move towards rapidprivatization to ensure that satisfactory long t e r m governance arrangements are put into place withinthese two banks as soon as possible. The "End Game" for the Two LargeBanks. Over the past twelve months, there has beenconsiderable discussion o f the "End Game" with respect to these banks. We have discussed with World Bank and Intemational Monetary Fundofficials many possible options including liquidation, merging the banks, privatizing the banks as separate entities, and splittingtheir functions and combining them with other financial institutions. However, we 49 have decided to remain with the original plan laid out inGovernment's Financial Sector Strategy statement (FSSS) o f November 2000 which clearly states that the two banks will be ultimately privatized-to "fit and proper" bankers -astwoseparateentities. Itisourintentiontomovetowardsprivatizationasrapidlyaspossibleandhencewehave decided to recruit a Sales Advisor to advise on the privatization as part o f the proposed Phase I1financial sector reform operation supported by the World Bank. Therefore, the HMGN's end game with respect to RBB and NBL i s rapid privatizationo f these banks to fit and proper buyers, as separate banking entities, inas short a time period as possible -preferably before the endo f 2006. Retrainingand Counseling. The government wants to see that bank staffwho accept the voluntary retirement packages are given as much support as possible inmaking smooth the transition from working life inthe banking sector to retirement, self employment, or some other productive economic activity, by counseling these workers, providing training to them or their family members, who can help earn alternative sources o f household income. We therefore request that this component o fthe proposed Phase I1package o f the financial sector reform be exclusively grant-funded with the support o f the World Bank or any other development partner. HiringSalesAdvisors. Hiring Sales Advisors for the two banks i s an integral component o four planto reach the end game o f separate privatization. Again we welcome World Bank support to hire this expertise, prepare sales memoranda for the two restructured institutions, undertake a road show for their sale, and ultimately take the banks through to the point o f privatization. It i s our intention to have completed this process by the end o f 2006 - with a view that one bank could be sold some time earlier. On-goingManagementTeam Support. We also wishto maintain the banks under professional management arrangements up to the point o f privatization. The current management teams will almost certainly have their contracts extended for a thirdyear - although the composition o f the teams may change. However, given the uncertainties surrounding the restructuring program and the timing o f the privatizationprocess itself, it may be necessary to keep these Management Teams, or an acceptable alternative, engaged beyond a thud year. Inthis light, we welcome the proposed World Bank assistance to cover the costs o f such Management Team support up untilthe point o f privatization. NepalRastraBank. The most critical institutionwith respect to our nation's financial sector is the central bank itself, i.e. Nepal Rastra Bank. The support provided under the FSTA project has been instrumental inhelping commence the process o f re-engineering the human resources, the accounting, and the bank supervisory functions o f the bank. We now feel that it i s important to broaden and deepen these initial gains. W e therefore view a second phase o f NRBre-engineering as being important inconsolidating the gains already achieved with respect to NRB and widening these further to the other banks and finance companies operating within the economy. Iwould like to emphasize some areas where we have agreed that World Bank support will be required withinNRB: Human Resource Reform. First, the compete restructuring o f the HumanResources function i s critical to providing appropriate incentives to staff and to ultimately turningthe bank into a fully professional world class institution. To this end, the NRB is taking steps to energize this important function. The bank has reduced its staffing numbers from 2,500 to 1,700. Inour view the bank i s still substantially over-staffed and needs to reduce staffing to a level somewhat lower than 1,000 with further reductions once the IT platform has beenput inplace. The bank i s embarking upon a VRS scheme under which it intends to retrench staff who are currently involved in 50 functional areas which are to be outsourced- mainly non-core central banlung activities (gardening, security, drivers, cleaners, canteen, etc), as well as lower level administrative jobs where the bank is currently overstaffed. This will be further supported by the introduction o f a new organizational structure from January 1, 2004 (agreed with IDA and the IMF)and new humanresource policies relatedto recruitment, promotion, transfer, performance management, and retirement. Incombinationwith a continuation o f the existing no-transfer rule on staff inkey departments and on-going HR support under the follow up financial sector operation, we expect to witness a strong movement inthe desired direction for Nepal Rastra Bank over the next several years. Establishing a leaner, more professional central bank also permits the Ministryto put forward a stronger case for the salary decompression which is required inNRB for attracting and retaining the rightprofessional talent inthe institution. Banking Supervision. The progress achieved within bank supervision inNRB over the past three years, now needs to be consolidated and deepened. T o this end, the NRB has established a two-year cycle o f on site bank examinations for all 17 commercialbanks inthe country. Under the Financial Sector Restructuring Project, we anticipate that substantive professional support will provide the necessary training and quality assurance required for these on-site bank exams. Computing assistance for the bank supervision and operations department will also assist inthisprocess. StrengtheningNRB's supervisory andregulatory role is key to the success o fthe overallfinancial reform agenda. Equally important will be follow up actions resulting from the recommendations o f these consolidated on-site bank examination reports, which HMGNwill be pursuingwith the full force o f the law. Auditing and Accounting. Inline with agreements with IDA and the IMF,Nepal Rastra Bank will be adopting an accounting manual w h c h meets International Accounting Standards and will itselfbe externally audited to I A S in2002/03 and 2003/04 by an international firmexperienced incentral bank audit. T o assist inthis process, we welcome the on-going IDA support under the FSTA Project to assist the central bank inmeeting these important goals. Information Technology. The central bank requires a significant upgrading o f its IT platform. It currently operates with very little computing power and without a computerized General Ledger. We are pleasedto note the support o f IDA inagreeing to finance the development o f an institution wide IT Strategy for the bank, the hardware (including a computerized general ledger system), the software, and the staff training requirements for this function. Itis only with a substantially enhancedcomputerized capacity that the centralbank will be able to achieve its full potential with respect to the vision that HMGNnow has for the bank. Other Support. Iwould also like to request that the World Bank operation retain some flexibility to finance other pertinent areas o f support withinNepal Rastra Bank - as the need arises. This will be particularly important in helping us meet our medium term objectives o f establishing a first class central over the next three to five years. PublicAwareness and Public Concerns. Iampleasedto note that the generalpublic has become increasingly aware o f the issues surrounding the financial sector reform inNepal. The maturityo f the public debate on these issues has been encouraging. Nonetheless, as we move forward, Ianticipate that various vested interests will apply pressure inthe media and beyond inan effort to protect the economic rents that they have managed to extract from the system. T o this end, anup-scaling o f the public awareness component o f the Phase IFSTA project will be important and we look to NRB and IDA inassisting us inpublicizing the reformmessage adequately and at an appropriate level to reach the general public inNepal. We are firmly o f the view that a well-informed public i s a crucial ingredient o f success inthe overall reform agenda. 51 In Conclusion. Itrust that the progress that we have acheved over the past two years clearly demonstrates HMGN'ssupport for the financial sector reformagenda. The way forward is focused onthree very clear and tangible objectives: (a) the separate privatizationo f RBB and NEiLto "fit and proper" buyers within the next three years; (b) an intensification o f the consolidated supervision o f all the commercial banks inNepal (including follow through o n appropriate remedial actions); and (c) a further streamlining and professionalization o f the central bank with a particular focus on on-going HRreform, strengtheningo f auditing and accounting capacities, considerably enhanced support for on-site bank examination, and an important capacitization o f the IT function. As such, we envisage that the World Bank Phase I1Financial Sector Reformproject will provide $77.0 million for support in these areas. Iamencouragedaboutthewayforwardforourfinancialsectorreformagendaandamgratefulforthe support that the IDA, the IMF and DFIDhave lent to our efforts. Our vision is o f a fundamentally rejuvenated and modernizedfinancial sector -providing support for the better overall economic health o f the economy, for the benefit o f all Nepalis. Yours Sincerely, Dr.PrakashChandra Lohani Minister o f Finance, HisMajesty's Government o f Nepal cc International Monetary Fund; (IMF) Department for International Development (DFID 52 Annex 13: Statementof Loans and Credits NEPAL: FinancialSector RestructuringProject Difference between expected and actual Original Amount in US$Millions disbursements ProjectID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm. Rev'd ~~~ PO10516 1997 Rural Water Supply and Sanitation 0.00 18.28 0.00 0.00 1.55 0.59 3.37 1.74 PO10530 1998 IrrigationSector Development 0.00 79.77 0.00 0.00 8.01 5.22 14.64 3.77 PO40612 1999 Basic and PrimaryEducationI1 0.00 12.50 0.00 0.00 0.00 0.52 0.81 -0.63 PO45052 2000 RoadMaintenanceand Development 0.00 54.50 0.00 0.00 0.00 33.13 49.43 9.40 PO50671 2002 TelecommunicationsSector Reform 0.00 22.56 0.00 0.00 0.00 23.24 11.30 0.22 PO82646 2003 Community School Support Project LIL 0.00 5.00 0.00 0.00 0.00 4.95 0.13 0.00 PO71291 2003 Financial Sector Technical Assistance 0.00 16.00 0.00 0.00 0.00 14.26 -2.75 0.00 PO43311 2003 Power DevelopmentProject 0.00 75.60 0.00 0.00 0.00 78.46 3.00 0.00 PO74686 2004 PovertyReductionSupport Project 0.00 70.00 0.00 0.00 0.00 74.17 0.00 0.00 Total: 0.00 354.21 0.00 0.00 9.56 235.54 79.93 14.51 NEPAL STATEMENT OF IFC's HeldandDisbursedPortfolio InMillionsofUS Dollars Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic. Loan Equity Quasi Partic. 1994 Himal Power 23.40 0.00 3.40 0.00 23.40 0.00 3.40 0.00 1996 BhoteKoshi 17.96 2.95 0.00 26.90 17.96 2.95 0.00 26.90 1998 Jomsom Resort 4.00 0.00 0.00 0.00 4.00 0.00 0.00 0.00 2001 ILFC -Nepal 0.00 0.29 0.00 0.00 0.00 0.30 0.00 0.00 Total portfolio: 45.36 3.24 3.40 26.90 45.36 3.25 3.40 26.90 Approvals PendingCommitment ~ FY Approval Company Loan Equity Quasi Partic. Total pendingcommitment: 0.00 0.00 0.00 0.00 53 Annex 14: Countryat a Glance NEPAL: FinancialSector RestructuringProject POVERTYand SOCIAL South LOW. Nepal Asia income Developmentdiamond' 2003 Population,mid-year(million) 24.2 1,401 2,495 GNi per capita (Atlas method, US$J 240 460 Lifeexpectancy 430 GDP per capita (US$) 238 GNI (Atlas method, US$ billion) 5.7 40 1,072 T Average annual growth, 199743 Population(%) 2.2 1.8 1.9 3NI Laborforce (%) 2.6 2.3 2.3 ier Most recent estimate (latest year available, 1997-03) :apita Poverty(% ofpopulationbelownationalpovertyline, 1996) 42 Urbanpopulation(% of totalpopulation) 13 28 30 Life expectancyat birth (years) 60 63 59 1 Infantmortality(per 1,000live birlhsl 66 71 81 Child malnutrition(% ofchildrenunder5) 48 Access to improvedwater source Accessto an improvedwater source (% ofpopulation) 88 84 76 illiteracy(% ofpopulation age 15+) 55 44 37 Grossprimaryenrollment I%ofschool-agepopulation) 118 97 95 -Nepal Low-incomegroup Male 128 108 103 Female 108 89 87 KEY ECONOMIC RATIOSand LONG-TERMTRENDS 1983 1993 2002 2003 Economicratios. GDP (US$ billions) 2.4 3.7 5.5 5.7 (in percent) Grossdomestic investmenVGDP 19.6 22.6 24.6 26.1 Trade Exportsof goods and ServicedGDP 10.2 18.4 16.1 14.6 Gross domestic savings/GDP 8.5 12.2 11.8 11.3 T Gross nationalsavings/GDP 10.7 14.5 25.7 25.6 Current accountbalanceiGDP -7.4 -8.1 2.6 -0.9 Interestpayments on externaldebtlGDP 0.2 0.8 0.4 0.4 Total external debVGDP 18.5 54.9 52.9 51.8 Total debt service/exports 6.5 8.8 4.6 5.2 I 1 Present value of debffGDP(2001) 28.1 Present value of debffexports(2001) 74.0 I Indebtedness 1983-93 1993-03 2002 2003 2003-07 (average annualgrowth) 1 GDP 5.1 4.3 -0.5 2.3 4.8 -Nepal Low-incomegroup GDP per capita 2.7 2.0 -2.7 0.1 2.2 STRUCTUREof the ECONOMY 1983 lSs3 2o02 fig< (% of GDP) Growthof GDp (*A) Agriculture 60.3 41.3 39.6 Industry 12.8 20.2 20.9 Manufacturing 4.6 8.6 8.1 Services 26.9 38.4 39.5 39.7 Privateconsumption 81.3 79.3 78.1 78.2 -2 General govemmentconsumption 10.1 8.5 10.0 10.5 Imports of goods and services 21.3 28.8 28.8 29.3 ' O ' G D P 1983-93 1993-03 2002 2003 (average annualgrowth) Agriculture 3.4 3.3 2.2 2.1 Industry 9.2 4.9 -3.3 2.3 Manufacturing 10.1 4.2 -10.0 0.4 Services 4.7 5.5 -1.4 2.7 Note:2003=2002/03. * The diamonds show four keyindicatorsin the country(in bold)comparedwith its income-groupaverage.If data are missing,the diamond will be incomplete. 54 PRICES and GOVERNMENT FINANCE I 1983 1993 2002 2003 lnflatlon (%) Domestic prices I (% change) l5T Consumer prices 14.0 9.9 2.9 4.7 1,I Implicit GDP deflator 12.3 11.2 3.2 3.5 .] Governmentfinance (% of GDP, includes current grants) Current revenue 11.5 12.3 i O' 98 99 00 02 Current budget balance -0.1 -4.0 -GDP deflator ' O ' C P I Overall surplusldeficit -5.7 -4.0 TRADE I 1983 I993 2001 2003 (US$ millionsl Exportand Import levels (US0 mill.) Total exports (fob) 82 379 942 782 12,010T Food 65 Pulses 56 Manufactures 256 Total imports (cif) 457 860 1,773 1,707 Food 101 81 97 98 99 00 01 02 Fueland energy 84 338 Capital goods 169 312 Exports w Imports BALANCEof PAYMENTS 1983 1993 2002 2003 (US$ millions) Currentaccount balance to GDP (%) Exports of goods and services 249 675 1,060 949 lo T Imports of goods and services 483 1,053 1,687 1,821 Resource balance -233 -378 -626 -872 Net income 12 8 -7 -6 Net current transfers 36 75 777 825 Current account balance -185 -295 143 -53 Official transfers 4 77 143 161 Financing items (net) 137 380 -323 -143 Changes in net reserves (-=increase) 44 -162 36 -123 1.5 1 Memo: Reserves including gold (US$millions) 571 1,055 1,184 Conversion rate (DEC, local/US$) 13.8 48.0 75.9 77.8 EXTERNAL DEBT and RESOURCEFLOWS 1983 I993 2002 2003 /US$ millions) Comporltlonof 2002 debt (US0mlll.) Total debt outstanding and disbursed 453 2,010 2,933 2,975 IBRD 0 0 0 0 ~~5 G 3 6 IDA 172 832 1,156 1,185 Total debt service 20 69 88 96 IBRD 0 0 0 0 IDA 2 10 26 30 Composition of net resource flows Official grants 94 77 143 161 Official creditors 68 156 4 Private creditors I -10 0 0 Foreign direct investment -1 6 -4 -2 Portfolio equity 0 0 0 0 World Bank program Commitments 45 0 23 97 A. IBRD E Bilateral - Disbursements 31 69 38 27 B IDA - D Othermultilateral . F Private - Principal repayments 0 4 18 21 C. IMF G. Short-term Net flows 31 66 20 6 Interest payments 1 6 8 9 Net transfers 29 60 12 -3 Development Economics 10/7/03 wb16511 55 M:\MMurrayWepalWestructunngProjProjectAppraisalDocument,January 12,2004.doc January 14,2004 558 PM 56 MAP SECTION