ICRR 12465 Report Number : ICRR12465 IEG ICR Review Independent Evaluation Group 1. Project Data: Date Posted : 09/14/2006 PROJ ID :P074655 Appraisal Actual Project Name :Mx Rural Finance Project Costs US$805.06 US$805.06 Development Structural US$M ) (US$M) Adjustment Loan (Project) Country :Mexico Loan /Credit (US$M) Loan/ US$M ) US$506.06 US$506.06 Sector (s):Board: ): FSP - Micro- and US$M) Cofinancing (US$M ) SME finance (80%), Banking (20%) L/C Number :L7180 FY ) Board Approval (FY) 03 Partners involved : Closing Date 12/31/2005 12/19/2005 Evaluator : Panel Reviewer : Division Manager : Division : Marcelo J. Bueno Kris Hallberg Lily L. Chu IEGCR 2. Project Objectives and Components a. Objectives The Project had a dual objective : (i) support the liquidation of Banrural, and in its place, (ii) create the Financiera Rural (FR), a non-bank decentralized financial institution charged with promoting the development of rural financial markets, and lending to small and medium -sized rural producers directly or via rural financial intermediaries . In addition, the Project was designed to buttress several key overarching development objectives of the Government of Mexico, namely: (a) the federal government's program to reform the banking sector and the macro -objective of reducing the fiscal drain of loss -making banks, (b) the provision of access to financial markets to groups not served by commercial banks, (c) the provision of prudent lending to the rural sector thereby stimulating output growth and employment generation, and the (d) financial performance of the banking sector objective of improving the financial performance of FR as compared to Banrural in terms of outreach and market coverage, portfolio quality, yields, and financial efficiency. b. Components (or Key Conditions in the case of Adjustment Loans ): The Project components included : 1. One general condition that the Borrower had to meet throughout the life of the SAL, and that was to maintain a sound macro -economic framework consistent with the policy objectives described in the Letter of Sectoral Development policy. Other Project components and key conditions were directly linked to 3 Tranche release conditionalities : 2. The First Tranche release conditionality was for the Liquidation of Banrura l, the funds of which were disbursed upon loan effectiveness. Prior actions for compliance with the conditionality included the : (i) setting-up of the legal framework to liquidate Banrural, establish a well -managed and financially viable FR, and allocate an adequate amount of budgetary resources to achieve both objectives; (ii) approval by the Ministry of Finance (SHCP) of procedures for liquidating the Banrural system; and (iii) actions by the Board of FR and SHCP necessary and sufficient to establish FR as a new rural finance institution, and to set it up on the right business course toward financial sustainability compatible with new private primary lenders entering into the rural sector; 3. The Second Tranche release conditionality was for the Creation of Financiera Rural FR) which included 2 sets (FR) of prior government actions: (i) confirmation by the banks under the Banrural system that they had ceased to operate as banking institutions following the revocation of their banking licenses; and (ii) confirmation that the FR was meeting key operational standards satisfactory to the Bank including : (a) FR Board approval of a Strategic Plan and operating manuals on credit, debt recoveries, and credit scoring, (b) certification by external financial auditors that FR was in compliance with key prudential regulations issued by the National Bank and Securities Commission (CNBV), and (c) certification by the FR external auditors that subsidies and transfers received by FR were declared and identified in the periodic reports to Congress; and 4. The Third Tranche release conditionality was for assurances that FR continued to operate satisfactorily and that it was on a financially sustainable path . Along this line, FR's external auditor certified that : (i) for a 6-month period, FR's net income had been Zero or positive as defined by previously agreed pro -forma financial statements; (ii) any subsidies and transfers received by FR had been clearly declared and identified in the periodic reports submitted to Congress; (iii) FR was consistently applying its Credit Manual; (iv) FR was in compliance with key prudential regulations, including norms for risk classification and loan loss provisioning; (v) FR had submitted to the Bank detailed cost accounting figures showing the actual cost of lending and non -lending operations; and (vi) FR's management information system (MIS) was being implemented in accordance with its Board -approved Strategic Plan. c. Comments on Project Cost, Financing, Borrower Contribution, and Dates No discussion on Project Cost, financing, and Borrower contribution was presented in the ICR, except the mention of the actual Bank Loan of US$505.06 million (Section 3 Assessment of Development Objective and Design, and of Quality of Entry). The US$505.06 included a front-end fee of 1.0% of the loan amount based on the loan agreement of US$500,009,400. Of this amount, the Borrower was entitled to withdraw the amount of US$ 500.00 million in support of the Project as originally proposed in the Program Document of May 16, 2003. The US$500.00 million Structural Adjustment Loan was to be a three -tranche operations of US$200 for the first tranche, and US$150 million and US$150 million for the second and third tranches, respectively . All three tranche funding were released based on satisfactory and timely compliance with the tranche release conditionalities as agreed . Under simplified FSAL procedures, the Borrower opened and maintained a US$ account in the Bank of Mexico (BOM). As Project funds were released under the Project's tranche release requirements, the Borrower submitted a simplified withdrawal application against which the Bank disbursed the loan proceeds in the Deposit Account for the Borrower's use . No Trust Funds were associated with this Project . 3. Relevance of Objectives & Design : The Project objectives and design (i.e. maintaining a sound macro-economic framework throughout the project timeframe) of the liquidation of Banrural, the creation of FR in Banrural's place, and the continued satisfactory operations of the latter, were consistent with the recommendations in the FSAP and were relevant in several areas of rural market reforms in Mexico: (i) it was consistent with the Bank's strategy for banking sector reforms established in the 04/2003 CAS; (ii) it supported a policy of sustainable institutional reforms in rural finance; (iii) it supported an important step in Mexico's program for the restructuring of its government -owned development banks; (iv) it built upon the Bank's financial sector restructuring facilities and initiatives of 1995, 1999, and 2001; (v) it provided credit access to the rural sector and helped develop rural financial markets, an important step toward solving the lack of funds for rural producers, and (vi) it complemented the IDB's support for Mexico's rural financial reforms and government actions in rural finance while focusing on liquidation and start -up operations of Banrural and FR, respectively. It should be noted, however, that the creation of a development institution for specialized credit is not a first -best solution. As the PAD notes, the markets have refrained from providing such credit for valid reasons, including, inter alia, a desire to strengthen bank balance sheets through more cautious lending, limitations on credit information on borrowers, and high transactions costs . Given that the government has deemed that rural credit is a priority for a number of reasons (reducing poverty and income inequality ), and has decided it is worth allocating budget support, it was a reasonable second-best solution to create a non -bank development institution. It should also be noted, however, that this solution would likely not be workable in many environments . Mexico has demonstrated a sustained commitment towards cleaning up its banking sector and removing state influence from lending decisions . In a different environment, this project structure could easily lead to a highly unsatisfactory outcome . 4. Achievement of Objectives (Efficacy) : Overall, the Borrower with the assistance of the Bank through the Project has made major reform in -roads in the rural financial market and in the restructuring of the financial sector, in general . The matrix of policy actions sharply focused on achieving the dual objective of the Project i .e. the liquidation Banrural and the creation of FR in its place, along with the policy actions which were considered essential pre -conditions for achieving the Project objectives . While no mention was made in the ICR of whether an adequate macro -economic framework was maintained during the Project life, several indications, however, pointed to improvements in this area : (i) the May 2006 FSAP reached conclusions on the substantial progress achieved in reforming the system of development banks, and (ii) the improvement in Mexico's macro-economic environment has been the result of favorable international economic conditions leading to direct foreign investments in the agricultural sector . The efficacy of the Project was based on four major initiatives: 1. The foundation for the creation of the legal, regulatory, and budgetary framework to fund the liquidation of Banrural and to provide the initial capitalization for establishing FR was created . In a highly politicized financial sector environment, the creation of organic legislation for the liquidation of a long -imbedded but insolvent government financial institution along with the budgetary impact of the same and the creation of one in its place was a major initiative without which the Project's dual objective could have been achieved . 2. Banrural was liquidated. With this, fiscal losses associated with the financial intermediation activities of the Banrural system, a composite of 13 independently operated financial intermediaries with some 207 branches across Mexico had been identified for elimination . The liquidation of Banrural also led to ending the heavy fiscal burden, moral hazard, and market distortions it had created in the rural and agricultural sectors of the economy . The liquidation of Banrural meant that the government opted for the final solution after several failed attempts and US$ 3.0 billion during 1995-2000 to rescue the bank's continued failed financial position . The potential worsening financial and operational performance of Banrural along with the growing fiscal problem was not to be tolerated . 3. FR, in place of Banrural, was created and was well capitalized . Based on a "development agency model" as recommended by the Mexico 2001 FSAP, FR served as the reform strategy of separating subsidies from finance and transforming development banks into development agencies funded through budgetary allocations with social objectives as providing access to the financial markets and those unserved by commercial banks . Its dual objective of providing credit to SME in fisheries and agribusiness via rural financial intermediaries, and to promote the development of rural financial markets and provide TA to new entrants into the sector and intermediate in FR's market niche were well assigned in its organic law . Its financial performance was reported periodically to Congress including any deviation from its mandate to maintain, in real terms, the value of its capital endowment earmarked for lending, along with any subsidies provided to it by other government agencies . Its net worth increased significantly in real terms over the last three years of its operations accounting for an ROA and ROE of 2.1% and 2.2%, respectively in 2005 along with a robust asset and operating efficiency level . Concerns that FR would be duplicating FIRA's role in providing state intervention in rural financing were recognized at the time of the Project design and measures were made to coordinate the market activities of both FR and FIRA . In addition, a mitigating measure by the government was to level the playing field by partially adjusting FIRA's subsidized interest rates upward (to coincide with FR's market rates) to avoid undesirable rate arbitrage in those market segments where FR and FIRA had common clients . 4. The periodic reports to Congress served as the supervisory and regulatory oversight over FR in order to help maintain its financial discipline. The oversight was to make sure that FR continued to operate satisfactorily and that it was on a financially sustainable path . After 6 months of operations, external auditors certified FR's net income to be Zero or positive as defined by previously agreed financial statements . On 11/2005, it was further certified that FR had met its objective of becoming a financially sound non -bank financial institution, charged with promoting the development of the rural financial markets and providing credit for rural development activities . 5. Efficiency : The Project was efficient in that it facilitated : (i) the timely closure of the Banrural system as scheduled in mid -2003, halting a huge fiscal problem from getting worse . More importantly, from a development perspective, the exit of Banrural put an end to the serious moral hazard that it created by fostering a non -payment culture through its loan servicing and collection operations . This was a major achievement in the development objective of the Project; (ii) the effective creation and on -going operations of FR exceeded all its major relevant development objectives and was likely to have a substantial impact on rural finance, development banking policy, and public institutional development; and (iii) a more focused financial intermediation process through FR than Banrural ever was, i .e. with larger credit volumes to a larger segment of the rural financial markets were made available while keeping credit risk at bay . In addition, gains in efficiency were realized through FR's promotional and advisory services, and financial performance by expanding its lending portfolio and market coverage and the effective targeting of 2 areas for progress which was highlighted in the CAS, namely, the improvements in the efficiency and transparency of the financial sector, and the fostering of productivity and efficiency in the rural sector . 6. M&E Design, Implementation, & Utilization: Monitoring and evaluation was adequate and effective .The Benchmarks and information on performance indicators which were provided on a 6-month basis including the (i) Outreach Indicators (e.g. loan size and distribution, municipalities and localities served, active first -tier and second-tier clients, percent of women served, clients by income level and by export crops ), (ii) Portfolio Quality/Yield Indicators (e.g. loan classification, losses and write -offs, restructured loans, interest subsidized loan, and portfolio yields ), and (iii) Efficiency Indicators (.e.g. operating costs, and explicit and implicit subsidies ) made the monitoring and on-going evaluation of the Project effective and valuable. Loan disbursements and financial management were made under simplified FSAL procedures, while the Project's deposit account, audited by auditors acceptable to the Bank, was found to be satisfactory . Submission to the Bank by the Borrower of progress reports on policy actions related to the respective tranches were complied with prior to all tranche releases. 7. Other (Safeguards, Fiduciary, Unintended Impacts--Positive & Negative): The Bank's consistent interest and assistance in support of Mexico's broad ranging financial reforms and its efforts in increasing the country's competitiveness had a positive impact on the design and implementation of the Project . The Project benefitted from the clear and market -friendly guidelines by the Fox Administration for reforming the public development banking system. In addition, the Project also gained with the high level and strong political will behind the actions to liquidate the Banrural system, create FR, and secure a large amount of budgetary resources to finance the transformation of the rural financial system . Last but not least was the quality and professionalism of FR's staff which had a decisive impact on the Project's implementation . 8. Ratings : ICR ICR Review Reason for Disagreement /Comments Outcome : Highly Satisfactory Highly Satisfactory While this project is highly satisfactory, care must be taken to not generalize from this project. As noted in Section 3, a creation of a development institution such as FR, while acceptable in this environment, would likely not be workable in many countries. Mexico has demonstrated a sustained commitment towards cleaning up its banking sector and removing state influence from lending decisions. In a different environment, this project structure could easily lead to a highly unsatisfactory outcome . Institutional Dev .: High High Sustainability : Likely Likely Likely, unless the government delineates the roles of FIRA and FR particularly when FR is transformed into a second -tier lender which FIRA is now. As noted above, there are also risks involved in development institutions; if the political environment changes, this type of institution could result in serious economic distortions. Bank Performance : Satisfactory Satisfactory Although the Bank's performance was Highly Satisfactory on the lending side, it was not as robust in its supervision role . Borrower Perf .: Highly Satisfactory Highly Satisfactory Borrower performance was highly satisfactory and consistent during Project preparation, performance of Government during implementation, and in the performance of the Implementing Agency Quality of ICR : Satisfactory NOTES: NOTES - When insufficient information is provided by the Bank for IEG to arrive at a clear rating, IEG will downgrade the relevant ratings as warranted beginning July 1, 2006. - ICR rating values flagged with ' * ' don't comply with OP/BP 13.55, but are listed for completeness . 9. Lessons: For similar adjustment operations, three key lessons can be drawn from the design, implementation, and Bank and borrower performance, all of which can make an important difference in the outcome of an operation : (i) front-loading of conditionalities and the use of a structural adjustments can be effective and flexible modalities to set and sequence the appropriate policy actions and to effectively monitor the implementation of a project; and (ii) the strength and sustainability of institutions depend on the legal and legislative framework under which it was created, the quality of their staff and management, and the observance of operations with their operating policies and procedures. 10. Assessment Recommended? Yes No Why? 11. Comments on Quality of ICR: The quality of the ICR is satisfactory providing a detailed and relatively comprehensive summary of the objectives, rationale for the Project, compliance with the conditionalities, and the effective monitoring and implementation of the project components. Several issues, however, are worth pointing out : (i) linkages to the CAS and FSAP however, could have been more specific in order to be able to isolate the relative impact of this project versus other Bank loans and initiatives in rural and agricultural reforms and bank restructuring (e.g. First and Second Bank Restructuring Facility Loans); (ii) as FR's long-term objective is to be transformed into a second -tier financial institution, hardly any analysis along with the lack of discussion was advanced in the ICR regarding over -laps and duplication of activities with FIRA and their future respective roles in the rural markets . Lack of preparation for FR's eventual role as a send-tier lender will be a problem in the not too distant future; (iii) no discussion was advanced on whether the Mexican authorities would have had the political will to move ahead on such a project had not the Bank participated in the initiative via the loan; and (iv) lastly, there was no discussion of the Project and its linkage with poverty reduction having advanced the rationale for the Project as having a bearing on the same by deepening the financial sector, increasing long-term growth and by broadening access to financial services to underserved groups .