Page 1 PROJECT INFORMATION DOCUMENT (PID) TECHNICAL DISCUSSION STAGE Report No.: AB420 Project Name Financial Sector Restructuring Project Region SOUTH ASIA Sector Banking (100%) Project ID P084219 Borrower(s) HIS MAJESTY'S GOVERNMENT OF NEPAL Implementing Agency His Majesty's Government of Nepal (HMGN) Nepal Rastra Bank (NRB) Tel: 977-1-4410-386 Fax: 977-1-4410-159 nrbgov@mos.co.np Environment Category [ ] A [ ] B [X] C [ ] FI [ ] Safeguard Classification [ ] S 1 [ ] S 2 [X] S 3 [ ] S F [ ] Date PID Prepared December 19, 2003 Date of Appraisal Authorization November 10, 2003 Date of Board Approval February 24, 2004 1. Country and Sector Background Country Background. Nepal is one of the world’s poorest countries, with an annual per capita income of about US$250 with many indicators showing a very poor quality of life. Progress in the fight against poverty has been hampered by a number of factors, including a succession of unstable Governments. More recently, the challenge has intensified with the escalation of the insurgency, the imposition of a state of emergency and lingering instability in the Government. Security concerns have been heightened by the August 2003 collapse of the ceasefire agreed with insurgents operating in the country and there is a fear of wider civil disturbance. Together with the global economic slowdown that has adversely impacted Nepal’s trade-dependant economy, these domestic events have led to a sharp downturn in economic activity. Related to this is potential fiscal stress, as public spending has been obliged to accommodate increased security demands. Meanwhile, there is widespread belief that the insurgency is fundamentally a challenge to a state that has not proved itself effective in dealing with Nepal’s development agenda. Financial Sector Background. Nepal has 17 commercial banks – comprising the two large banks Nepal Bank Limited (NBL) and Rastriya Banijya Bank (RBB) in which the government has a dominant shareholding; 6 Joint Venture Banks, which are mixed Nepali/foreign owned (foreign ownership is restricted to 67 percent); and 9 local (100 percent Nepali) banks. It also has 2 large development banks – the Agricultural Development Bank of Nepal (ADB/N) and the Nepal Industrial Development 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 (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 in a very precarious financial position. Political intervention, weak management, poor financial information systems, and a deeply entrenched culture of non-repayment of loans have resulted in a rapid deterioration of their financial health. RBB, which represents 27 percent of commercial banking system assets, is Page 2 estimated to have 71 per cent non-performing loans. Although in slightly better financial condition, NBL has similar problems including around 59 percent non-performing loans. This could have serious ramifications for the Government in terms of systemic risk and could prove to be a severe financial strain on an already delicate budget should either of these two banks face a crisis of confidence with concomitant adverse macroeconomic implications. The 2003 unaudited accounts for RBB and NBL indicate that these two banks had estimated accumulated deficits, as of mid-2003, of approximately $435 million – equivalent to around 7 percent of GDP. Both NBL and RBB have made significant progress in reducing their operating losses since professional management teams assumed control of their operations in 2002 (supported by a World Bank Phase I Financial Sector Technical Assistance (FSTA) credit). In addition, the two large development banks have deteriorated in comparable fashion to that of RBB and NBL. The financial position of ADB/N and NIDC is currently in the process of being appraised by the Asian Development Bank (ADB) – and a work out plan is being developed. In general, Nepal’s financial system suffers from the following problems: (a) The Government's Role. His Majesty's Government of Nepal (HMGN) plays a large direct role in the financial sector. From ownership of key financial institutions such as 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; the Government's involvement is evident in almost every aspect of financial sector activity. This has resulted in strong political interference in banking activities which, in turn, has resulted in non-repayment of loans, and poor financial health throughout the system. (b) Nepal Rastra Bank (NRB) - the Central Bank. Until January 2002, when a new Act was approved, the NRB fell under the authority of the Ministry of Finance. This historical lack of autonomy hindered the NRB's ability to supervise and regulate the banking system. Political influence in RBB and NBL – and their dominance in the banking system – also placed these banks outside the influence and control of 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 of NRB over the banking system has been further established by the recent Cabinet approval of the Banking and Financial Institutions Ordinance. Improved banking regulations also provide the regulatory basis for NRB to move the system closer to international banking norms while permitting the bank supervisors to deal expeditiously with errant banks. The NRB is supported in this endeavor through a substantive program of capacity building from a resident team of international banking experts supported by IDA under the FSTA. (c) Rastriya Banijya Bank (RBB) is 100 percent Government owned. It is the biggest of Nepal’s commercial banks with deposits of approximately Rs 40 billion – 25 percent of the Nepali banking system. RBB is technically insolvent with high levels of non-performing assets (NPAs) – and had an estimated negative net worth of US$335 million as of July 2003. A professional management team took over the bank in early 2003 – the new CEO, recruited on a fixed-term contract, joined the bank on January 16 th 2003, followed by the rest of the team in late February 2003. In variance to the original concept, each member of the management team has been hired individually. Due to the on-going insurgency, branches have been reduced from more than 200 to around 130 nationwide and the total number of staff in the 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 a process of computerization is underway and some 42 branches are expected to operate with an online system. RBB continues to suffer from a high percentage of non-performing loans although performance in this field is improving under the guidance of the new management team. Page 3 (d) Nepal Bank Limited (NBL). The financial condition of NBL has also been significantly impaired, but not to the same extent as RBB. NBL is the oldest bank in Nepal (established in 1935) – it is also the second largest bank with deposits of Rs 35 billion. Originally, the Government owned the entire bank but its shareholding was sold down throughout the 1990s to reach 41 percent. The Government’s policy of successively selling shares to the general public has, however, left the bank without a strategic banking partner – and, meanwhile, the connected lending activities of the new private owners are thought to have further compromised its operations. In common with RBB it has suffered from weak management, political interference, and a lack of financial controls. Using World Bank assistance, HMGN decided to bring in professional management from the Bank of Scotland to take over the day-do-day running of NBL in August 2002. Initial main areas of focus for the new management team have included, producing credible audited accounts for 2001 and 2002, designing and developing a minimum Information Technology (IT) platform for the bank, developing appropriate human resource policies for the staff, strengthening its treasury management function, and identifying non-performing loans (NPLs) and establishing a loan recovery unit to deal with these NPLs. The Management Team is also restructuring the bank by reducing staffing levels by almost 50 percent; rationalizing the branch network; recovering on non-performing loans; and requesting delisting from the Nepal Stock Exchange (NEPSE). (e) The Agricultural Development Bank of Nepal (ADB/N). The financial and operational situation of the ADB/N, the third biggest bank in Nepal, is also extremely poor. The ADB/N will require restructuring, system development, changes in governance arrangements, and a review of its ultimate role and ownership arrangements. Reform in this bank is being supported by the Asian Development Bank. Close coordination between IDA and the ADB means that reforms made in RBB and NBL are likely to be replicated in ADB/N to ensure a consistency of approach. (f) A Weak and Fragmented Legal Financial Environment. Although recent progress in this area is noteworthy, Nepal has historically suffered from a proliferation of both laws and regulations that are institutionally rather than functionally focused. This has created a fragmented legal environment. \01\02 The Nepal Rastra Bank Act, now superseded by a January 2002 Act, was seriously outdated and deficient with respect to issues of central bank autonomy, accountability, and governance. The new legislation strengthens its independence and supervisory role. \01\02 The 1974 Commercial Bank Act was also defective and it did not cover all deposit-taking institutions. A proliferation of laws covering various classes of deposit-taking institutions permitted legal arbitrage. NRB has drafted a new omnibus Banking and Depository Institutions Act that was approved by Cabinet in late 2003. \01\02 Ancillary Laws. New legislation is also required in such areas as Secure Transactions, Insolvency, and a new Company Law, etc. (g) A Weak and Fragmented Accounting and Auditing Environment. A weak accounting and auditing tradition has meant that the timeliness and reliability of financial data from banks is poor. Corporate accounting is also weak, making lending decisions difficult for the banks. The overall strengthening of accounting and auditing is therefore essential. The progress made, in this respect, within the two largest commercial banks by the newly instituted management teams, is noteworthy. (h) Competition in the Banking Sector. Reform of the state-owned banking sector is designed to reduce fragmentation and support efficient intermediation of funds within the financial sector. This will increase competitive pressures and provide more efficient and cost-effective solutions to the public. Page 4 (i) Other Issues. The financial sector environment also needs to be strengthened in several other important areas. Credit information systems need to be made more reliable and effective; the Nepal Stock Exchange requires urgent reform; and access to finance for many millions of rural Nepalis needs to be addressed. (j) Government Strategy. Over the past few years, the Government has undertaken general reform measures in the financial sector. These include interest rate deregulation, the phase out of Statutory Liquidity Requirements (SLR), reduction in Cash Reserve Requirement (CRR), introduction of modern bank regulations, and foreign exchange liberalization. However, much remains to be done, particularly with respect to institutional reform. To help establish a medium term framework, the Government formulated a Financial Sector Strategy Statement (FSSS) that consolidates its thinking and develops a comprehensive and interlinked reform program. This FSSS has been adopted as official Government policy and was publicly released and published in the Nepali and English press at the end of 2000. The main elements of the FSSS include: \01\02 Reducing the role of the Government in the financial sector as a direct owner of financial institutions while strengthening its role as a supervisor and regulator; \01\02 Requiring strong corporate governance by ensuring that banks (in particular the two largest commercial banks) are owned and managed by “fit and proper” private investors; \01\02 Strengthening the role of Nepal Rastra Bank by drafting a new central bank Act to provide autonomy in the conduct of monetary policy, banking system regulation and supervision, and the licensing of banks and nonbanks; \01\02 Improving existing banking and financial legislation and judicial processes for enforcing financial contracts; \01\02 Improving auditing and accountancy standards within the banking sector; and \01\02 Promoting financial discipline through adequate disclosure and competition. To date, the Government of Nepal has demonstrated a seriousness and commitment to banking reform and has not wavered in moving ahead with the difficult agenda. Actions taken so far provide IDA with comfort that the Government is willing to transparently and decisively address the issues at hand. 2. Objectives of the Project The project is important in dealing with the critical situation within the banks. Already serious losses have been incurred which will ultimately have to be recognized by the owners of the banks and paid for with tax payers money. With an important need for fiscal resources to be increasingly devoted to important poverty alleviation needs in the fields of education, health, rural water, enhanced infrastructure, and so on – it is crucial that the losses in these banks be stemmed once and for all. Consequently, the banking system reform process – which is now proceeding well – is viewed as having important poverty alleviation impacts over the medium term. The project is also important in establishing a better intermediation function within the banking system so that funds can flow to their most productive economic use – thereby benefiting the entire economy in terms of more rational investment decisions, most sustained employment opportunities, increased production and exports – and ultimately enhanced growth for the betterment of all. 3. Rationale for Bank Involvement Page 5 The objective of this operation is to support the efforts of HMGN to improve the financial sector in order to ensure continued macroeconomic stability and promote private sector-led economic growth. This represents the second phase of a larger financial sector reform effort – which began with the FSTA. Assuming on-going commitment to reform, this would lead ultimately to a third phase involving bank privatization. Phase I involved bringing in three management consultant teams to: restructure and re- engineer the central bank; and reform the two large commercial banks (Rastriya Banijya Bank and Nepal Bank Limited). This second phase of the operation will assist in (i) right-sizing the two commercial banks through the implementation of Voluntary Retirement Schemes (VRS) to reduce operating costs and make them viable for privatization; (ii) bringing in Sales Advisors to assist in the privatization; (iii) providing further assistance to a second phase of Central Bank re-engineering; and (iv) supporting the continuation of professional management team support up until the point of bank privatization. Phase III (not included in this project) would involve support for financial re-engineering of the banks (re- capitalization) at the point of sale after satisfactory changes in governance arrangements and cost restructuring have taken place. The operation supports CAS (FY 04-07) outcomes in the financial sector as well as governance objectives. Improvement in the banking sector is one of the key growth-enhancing structural reforms that Nepal must undertake in order to stimulate a more pro-poor and inclusive growth process. The CAS recognizes that a strong financial system is critical for private sector development. On-going progress with respect to banking reform is a key trigger for Nepal to remain in a base case lending scenario. Borrower commitment to financial sector reform is evidenced by the medium term vision laid out in the Financial Sector Strategy Statement and reaffirmed in the Letter of Financial Policy (December 9, 2003). It is further demonstrated by the hiring of management teams to implement reform in the commercial banks and the free hand that they have been given deal with defaulting borrowers. The project elements are in line with the analytical work 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 of a VRS scheme to right-size staffing levels – to prepare the banks for privatization. This is an important next step in the on-going movement towards privatization. A main lesson from previous Bank assisted projects is that implementation progress is 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 of in the current operation. 4. Description a. The project has four main components (Table below). Bank- financing (USSM) Component) Indicative Costs (US$M) % of Total Credit Grant Total % of Bank- financing VRS in RBB and NBL 66.3 77.7 56.5 0.0 56.5 74.8 Hiring of Sales Advisors 3.0 3.5 0.0 3.0 3.0 4.0 Phase II: NRB Re-engineering 8.0 9.4 4.0 4.0 8.0 10.6 On-going Management Team Support 6.0 7.0 6.0 0.0 6.0 7.9 Unallocated 2.0 2.3 2.0 0.0 2.0 2.6 TOTAL 85.3 100.0 68.5 7.0 75.5 100.0 Page 6 Voluntary Retirement Schemes (VRS). The largest component is designed to support the VRS in RBB and NBL in an effort to reduce their costs and ultimately assist in making them more amenable to sale and privatization . The two main components of high cost in these banks have been identified as non- performing loans and staff costs. The first of these is actively being dealt with by the new Managers in these banks while the VRS will be supported under this project. The management teams each has a Human Resource advisor who, as part of his terms of reference, has identified redundant staff and has designed VRS schemes. The launching of these schemes in the two banks was announced in September 2003 and the first batch of the retirees will leave the banks by the end of the calendar year. Hence, this component is fully designed and well under implementation. Hiring of Sales Advisors. The hiring of the Sales (Privatization) Advisors will not happen until a year or so into the project when the banks are in a 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 bring them to the point of sale to “fit and proper” private sector buyers as rapidly as possible. This component (US$ 3.0 million) will be financed using the IDA Grant component. Phase II: On-going Nepal Rastra Bank Re-engineering. The Financial Sector Technical Assistance Project has commenced a process of re-engineering within the central bank. However, reform, revitalization, and professionalism are complicated, long-term tasks. Greatly enhancing the capacity of NRB to oversee a prudently operated banking system is a prime objective of the series of reforms being undertaken within the sector. Whereas the Phase I reforms in banking supervision have focused on developing an appropriate off-site reporting system and a minimalist amount of on-site bank supervisory assistance, the Phase II reforms will assist in augmenting the on-site supervisory capacities to oversee the commercial banks. The accounting component will assist NRB in meeting the IMF’s Safeguard Assessment milestones, including the production of an international audit of the bank’s accounts to IAS. The HR reforms will build upon the newly introduced HR policies, recent efforts by the central bank to reduce overall staffing levels, and the development of a new training plan to help move NRB towards the establishment of a more professionally managed staffing cadre. The Information Technology (IT) component is new (not covered in the Phase I reforms) but is critically required as part of the modernization process within the bank. The technical assistance sub-components (around US$ 4.0 mn) of the NRB Re-engineering will also be financed using an IDA Grant. Management Team Support. It is agreed, that the two banks may not be privatized by the time that the current year term of the existing Management Teams expire (two years with a possible one-year extension). It is equally recognized that the banks should not revert to old management practices. It is therefore necessary to include funding for the costs of continuing management team support up up to the point of privatization. It is felt, however, that the pre-privatization restructuring process will take longer than three years. These components were established based upon the experience in other comparable projects (such as the Pakistan Banking Sector Restructuring and Privatization Project). This experience has shown that, while the agreed objective for banking sector restructuring worldwide is to transfer ownership to “fit and proper” private sector owners (ideally international banks), this is difficult to achieve in South Asia. Experience in the region has indicated that private sector buyers, particularly of the caliber and reputation that one would like to attract, do not wish to be bogged down in the process of reducing staff numbers and closing branches. Buyers have also indicated that a necessary prior condition is to have credible accounts and a basic computerized core banking solution system in place. Equally important for a successful systemic revitalization of the banking sector is a concerted and lasting improvement in the quality and reach of banking supervision exercised by the regulator to oversee the newly private banks. A substantive Page 7 element of restructuring of the NRB and training of staff was included in the FSTA, however, given the importance, additional funds have been dedicated to this end in this project. 5. Financing Source: ($m.) BORROWER/RECEPIENT 9.8 INTERNATIONAL DEVELOPMENT ASSOCIATION 75.5 Total 85.3 6. Implementation The Nepal Rastra Bank will be responsible for the implementation of the project. This agency has been selected due to its success in this capacity under the Financial Sector Technical Assistance Project, and its established (albeit limited) cadre of competent and committed reformers and its central role within the Nepalese financial sector. As institutional and implementation arrangements for the predecessor FSTA have already been developed within NRB through the Coordination Support Team (CST) – these will also be utilized to oversee the implementation of the current operation. 7. Sustainability HMGN has already demonstrated its commitment to take hard political decisions in the face of the need to take decisive action to stem the growth of 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 government has already undertaken far reaching legislative and regulatory reforms. One factor which will be critical to the continued success of the project will be for NRB to take necessary steps, as per the proposed amendment of Section 86 of its Act, to deal with the existing private sector shareholders. Steps to this end are currently in progress – including the December de-listing of 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 legislation passed by ordinance is not subsequently revoked. Close coordination with the IMF, DFID, the ADB, and the donor community will also help ensure that the reforms implemented will remain in place regardless of changes in government (in that donor funding is indispensable to support on-going development programs). Additional steps, including enhanced reporting of the reform efforts and holding regular meetings with stakeholders, are under way to ensure that there is sufficient popular support for the reforms being implemented and that the value of these measures is broadly understood across the political spectrum. 8. Lessons Learned and Reflected in the Project Design The OED Performance Audit Report for the Second Structural Adjustment Credit (Credit 2046-NEP), May 17, 1995, concluded that: “The basic cause of the weakness of the financial sector design [in that project] was: i. Lack of commitment by the Government to change its basic attitude towards the state-owned banks, including a much stronger emphasis on commercial orientation and on preparation for eventual privatization; ii. Absence of an Action Program did not require the Government to introduce drastic changes in the managerial culture to ensure that managers were professionals with autonomy and accountability; and Page 8 iii. Lack of specific fundamental reforms needed to achieve a major improvement in financial and operational performance of the banks.” The current operation has dealt with these lessons by not proceeding with IDA financing until there have been upfront actions by the Government to carry out fundamental reforms in banking supervision generally and in the governance arrangements within the state-owned, in particular – starting with the placement of external management teams in the two banks. The development of an overarching framework for financial sector reform – as encapsulated in the FSSS – has also helped ensure consistency and commitment. In addition, the three-phase approach has been designed to build upon the strong foundations of the FSTA and has allowed HMGN ample opportunity to demonstrate commitment to reform and willingness to confront difficult issues. The Letter of Financial Policies (see Annex 12) also provides further evidence of the Government’s strong commitment to reform in this sector. 9. Safeguard Policies Not applicable. 10. List of Factual Technical Documents A. Government Documents -Original Signed Letter of Financial Policies from the Minister of Finance in Nepal. -Financial Sector Strategy Statement (FSSS) B. Bank Staff Assessments -Bank's Financial Sector Study -Financial Management Assessment of Nepal Rastra Bank -Procurement Assessment of Nepal Rastra Bank C. Other -various Management Team reports for Rastriya Banijya Bank and Nepal Bank Limited 11. Contact point Contact: Simon C. Bell Title: Sector Manager Tel: (202) 473-4931 Fax: (202) 522-1143 Email: Sbell2@worldbank.org 12. For more information contact: The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Web: http://www.worldbank.org/infoshop