ICRR 13377 Report Number : ICRR13377 IEG ICR Review Independent Evaluation Group 1. Project Data: Date Posted : 05/24/2010 PROJ ID : P084219 Appraisal Actual Project Name : Second Financial US$M ): Project Costs (US$M): 75.5 57.91 Sector Restructuring Project Country : Nepal Loan/ US$M): Loan /Credit (US$M): 75.5 57.91 Sector Board : FPD Cofinancing (US$M): US$M ): Sector (s): Banking (100%) Theme (s): State enterprise/bank restructuring and privatization (67% - P) Standards and financial reporting (33% - S) L/C Number : C3864; CH074 Board Approval Date : 02/24/2004 Partners involved : Closing Date : 09/30/2009 09/30/2009 Evaluator : Panel Reviewer : Group Manager : Group : Valeriano F. Garcia Jorge Garcia-Garcia Ismail Arslan IEGCR 2. Project Objectives and Components: a. Objectives: The overarching objectives of the operation were to support the on-going efforts to improve the financial sector in Nepal which intermediates funds more efficiently and effectively to the benefit of all segments of society in a manner which supports private sector development, increased investment, and faster growth. The specific objectives were to: Improve corporate governance through provision of management support to the two large commercial banks. Improve market structure by reducing the state-owned segment of the banking system. Sustain and deepen the banking reforms. b.Were the project objectives/key associated outcome targets revised during implementation? No c. Components (or Key Conditions in the case of DPLs, as appropriate): The project had four major components: 1. Voluntary Retirement Scheme (VRS) Regarding the two State Owned Banks that were to be readied for privatization the component envisaged a significant reduction in their personnel . The target was reducing staff by more than 40 percent, focusing first on those who have had more than 20 years of service followed by those in the 15-19 years bracket to achieve the target of retiring roughly 4,700 staff (appraisal $56.5 million; actual $53.63 million) 2. Hiring of Sales Advisors (funded from IDA grant). It sought to assist in the ultimate sale of the two State Owned banks ensuring that, at the end of the readiness process, they are sold to "fit and proper" investors. The advisors would undertake due diligence, prepare prospectus and lead a road show to bring the targeted banks to their point of sale to fit and proper private sector investors; (appraisal $3.00 million; actual $ 0.00 million.) 3. Second Phase of Nepal Rastra Bank (NRB, Central Bank) Re-engineering It supported strengthening the Central Bank through the following sub-components: (a) Human Resource Re -engineering . It supported restructuring the Human Resource Department (HRD) and policies resulting in the implementation of merit -based advancement; a time-in-grade criteria and developing a structured training plan; (b) Accounting Support . It supported modernizing the Accounting Department to assist the Central Bank in meeting the IMF’s Safeguard Assessment milestones; also to help the Bank in producing an international audit of the bank’s accounts to international accounting standards (IAS). (c) Bank supervision and regulation . It supported the work of the bank supervision department in the form of additional desk top computers, lap top computers for on-site examiners, international experts to assist with on-the-job training (for the complete two year examination cycles of all the commercial banks), and classroom training in areas related to bank supervision, computing, and English (report writing). (d) Upgrading the Bank ’s Information Technology (IT) IT). It supported doing so through the following sub-components: (i) developing a Management Information System (MIS); (ii) developing a computerized General Ledger system (GL) system; (iii) provisioning additional computers and software for on-site examiners and international experts to assist with on -the-job training in areas related to bank supervision and regulation (total for component at appraisal $8.00 million; actual $0.28 million). 4. On-Going Management Support Team It supported the continuation of the management team in charge of bringing the banks to point of privatization. A significant expected outcome was the reduction in the non-performing loans ratio by 50 percent.(appraisal $6.00 million; actual $3.85 million) d. Comments on Project Cost, Financing, Borrower Contribution, and Dates: IDA agreed (on June 4, 2004) to make available to the borrower SDR 47,600,000 (Credit) and SDR 4,900,000 (Grant). The loan became effective on July 25, 2004. On June 5, 2008 the government requested closure of the FSRP and restructuring of the FSTA project to include some of the key activities envisaged in the former loan . To this end undisbursed funds totaling SDR 8,566,000 of IDA credit and SDR 4,531,000 of IDA grant were cancelled. 3. Relevance of Objectives & Design: The objectives of the loan were very relevant to the development of a healthy and growth enhancing financial sector. They addressed the major fault lines of the system namely the Central Bank and the two major State Owned banks. The Central Bank depended on the ministry of finance and had limited autonomy. It was institutionally weak and lacked the capacity to adequately regulate and oversee the banking system. The financial system was shallow and dominated by two public banks (NBL and RBB) which comprised a large share of total banking assets (more than 50 percent.) The Bank strategy fitted in the country context and its culture of slow changes and improvement made one-step-at-a time only. However, the country context also included high instability which meant that government commitments could easily change. The project design was relevant and embedded in the country’s slow-change cultural context and consisted in a two prong strategy: the first was the institutional strengthening of the Central Bank and the second was the downsizing and privatization of the two largest commercial banks . By all accounts those banks were not only bankrupt but also involved in questionable lending practices (bordering with outright corruption.) One of those banks (RBB) had about 71 percent of its loans in non-performing status while the other bank (NBL) had non-performing loans close to 60 percent of its total loans. While best international practices unequivocally indicate that under these circumstances banks should be: (a) swiftly liquidated and whatever assets are left should be used to pay severance and depositors, or (b) broken into a "bad" bank and a "good" bank, privatizing the former and liquidating the later, the project was designed under a different paradigm . Such design took into account the relevance of one of the country’s most significant characteristics : changes are made, but very slow. However, by taking this time-intense approach in its design the project disregarded the other significant characteristic : changing commitments and great political instability . Thus in an effort to customize the project design to the cultural demands of the country, the privatization strategy for the public banks did not follow best international practices for bankrupt (and corrupt prone) banks. The alternative path was rejected under the presumption that outright liquidation would have been politically challenging . Political instability, however, ended -up being the Achilles' heel of the loan design: according to the ICR "at the time of project inception, the key policy makers in the GON had full commitment to reduce the government ownership and control from the two banks." With the benefit of hindsight this means that a golden opportunity may have been missed to address the issue of the two large insolvent banks in the way indicated by best international practices . Summing up, this review finds that the relevance of objectives was very high but the relevance of design was modest. 4. Achievement of Objectives (Efficacy): 1. To improve corporate governance in the banking sector The PAD defined three outcomes indicators for this objective . For the first one it was established that high profile non-repayment cases, in which corruption is suspected, would be referred to the Commission for the Investigation of the Abuse of Authority (CIAA). Of the at least five high profile default cases in which against them was taken and resolved by CIAA, only one was forwarded to CIAA, but no legal action was taken and the case was finally dropped . The second indicator was to establish a debt recovery tribunal (DRT) that would enforce decisions according to set guidelines : 150 days for turnaround and 90 days to resolve appeals. The DRT enforced decisions slowly and in an unsatisfactory manner, and failed to meet the turnaround and appeal timelines . The third indicator was to enforce the "Blacklisting Directive " but its enforcement was not satisfactory. Efficacy in achieving this objective was negligible . 2. To improve the structure of the financial markets The PAD defined three outcome indicators for this objective . In the first one it was expected a retrenching of staff of both NBL and RBB by 40 percent and rationalization of branch network to reduce cost structure. While the staff in the NBL was reduced by 45 percent (from 5,270 to 2,900) and in RBB by 48 percent (from 5,222 to 2,862), NBL increased by 138 its branch network and RBB reduced it by 123. The ICR notes that despite the reduction in staff, staff costs in both banks almost doubled as a result of the rise in civil service pay made in 2009. The second outcome indicator, outsourcing of non-core activities, was not achieved. The third outcome indicator, privatize NBL and RBB, was not achieved as the government failed to decide what to do with the two banks. Efficacy in achieving this objective was modest . 3. To strengthen the oversight capacity of the Central Bank Regarding bank supervision, NRB on-site and off-site supervision capabilities improved during the project but the bank supervision sub-component remained stalled. After a CIAA charge against the Governor the Central Bank staff became demoralized and did not proceed with any further procurement. The hiring of a new HR advisor to assist in the streamlining of recruitment, training, transfers and promotion did not take place. The IT component did not make any progress through the project. This activity was transferred to the FSTA. Efficacy in achieving this objective was negligible . 5. Efficiency (not applicable to DPLs): This type of project is not apt for calculating specific numbers in relation to ERRs or FRR . However on a qualitative basis the project was moderately efficient because its main objectives were only partially achieved. ERR )/Financial Rate of Return (FRR) a. If available, enter the Economic Rate of Return (ERR) FRR ) at appraisal and the re- re -estimated value at evaluation : Rate Available? Point Value Coverage/Scope* Appraisal % % ICR estimate % % * Refers to percent of total project cost for which ERR/FRR was calculated. 6. Outcome: The FSRP sought very relevant objectives but its efficacy was limited . a. Outcome Rating : Unsatisfactory 7. Rationale for Risk to Development Outcome Rating: While the PDO were not entirely achieved there was progress in downsizing both, the NBL and RBB while their NPL was substantially reduced . a. Risk to Development Outcome Rating : Significant 8. Assessment of Bank Performance: The initial design of the loan was not appropriate to fully achieve the PDO . Such design was time-intense and necessarily bound to take a long time to implement . In the context of fluid political conditions, typical of Nepal, the winds changed and new political realities changed previous commitments not favoring the achievement of the PDO. Once the project became effective the Bank pursued closely its progress and carried out due dialogue with all stakeholders . The ISR reports show that the Bank was keenly aware of the extremely difficult problems facing the progress of the loan (for example ISR 11/26/2006.) However, only the final ISR rated the PDO as Unsatisfactory. at -Entry :Unsatisfactory a. Ensuring Quality -at- b. Quality of Supervision :Moderately Satisfactory c. Overall Bank Performance :Moderately Satisfactory 9. Assessment of Borrower Performance: The Government worked with the Bank in the design of the loan and agreed to its targets, intermediate steps, and time-line. Evidently the government, along with the Bank, miscalculated the reform effort in the context of a fluid political environment . The government did not honor its commitments as signed in the Letter of Financial Development dated December 9, 2003 regarding the ultimate resolution of NBL and RBB, putting into risk the gains achieved in the restructuring of both banks. In general the government did not do enough to assure that the implementing agency, which was under its aegis, complied with the loan ’s road map. a. Government Performance :Moderately Unsatisfactory b. Implementing Agency Performance :Moderately Unsatisfactory c. Overall Borrower Performance :Moderately Unsatisfactory 10. M&E Design, Implementation, & Utilization: Bank M&E: The Bank design of its M&E was appropriate and in line with standard Bank procedures for these operations and included a mid-term review by mid 2007. The implementation was achieved by timely bi-annual ISR; The utilization of these reports was dependent on the problem flagged. However, during 2004-2007 the ISR rated the PDO “S� and most of the IP as “S or MS". Only by end 2007 both indicators were rated “Moderately Unsatisfactory�. It was surely earlier in the process that IP had been lagging and signals of failing DO were not timely and properly evaluated and urgently flagged. This may have prevented the senior management from utilizing the ISR early enough in the process to look for changes or put more pressure on implementation . Government M&E In its design M&E was not followed at the project level. This flaw prevented close follow-up, implementation and utilization. Also, there were frequent changes in project coordinators and other staff and consequently institutional memory, drive and skills were lost at the Coordination Support Team (CST) level. In summary while the Bank's monitoring was appropriate, its evaluation was faulty and prevented its timely use by senior management. The borrower's M&E design was flawed, and had little room to use it for proper implementation or utilization . a. M&E Quality Rating : Modest 11. Other Issues (Safeguards, Fiduciary, Unintended Positive and Negative Impacts): 12. Ratings : 12. ICR IEG Review Reason for Disagreement /Comments Outcome : Unsatisfactory Unsatisfactory Risk to Development Significant Significant Outcome : Bank Performance : Moderately Moderately Satisfactory Satisfactory Borrower Performance : Moderately Moderately Unsatisfactory Unsatisfactory 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. - The "Reason for Disagreement/Comments" column could cross-reference other sections of the ICR Review, as appropriate . 13. Lessons: In politically volatile countries, when there is a window of opportunity to implement substantial policy changes, the time-line of the whole operation should not involve several years . As the political tide changes, a long to implement operation poses the risks of commitment reversal . 14. Assessment Recommended? Yes No 15. Comments on Quality of ICR: The ICR presents a very good description of the project design, implementation and lack of achievement. However it does not emphasizes the "quality at entry" issue -which was the Achilles heel of this loan. Also it does not emphasizes the until very late ISR reports rated PDO as satisfactory when at the end none of the main objectives were achieved. a.Quality of ICR Rating : Satisfactory