Extended Annual Review Report

Project Number: 48302-001 Loan Number: 3229 September 2018

Senior Loan Hatton National Bank Supporting Infrastructure Development (Sri Lanka)

This is an abbreviated version of the document that excludes commercially sensitive and confidential business information that is subject to exceptions to disclosure set forth in ADB’s Public Communications Policy 2011.

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CURRENCY EQUIVALENTS Currency Unit – Sri Lanka Rupee (SLRs)

At Appraisal At Project Review 1 October 2014 31 May 2018 SLRs1.00 = $0.0077 $0.0063 $1.00 = SLRs130.3550 SLRs158.0300

ABBREVIATIONS

ADB – Asian Development Bank CASA – current and savings accounts CBSL – Central Bank of Sri Lanka CDB – China Development Bank DEG – Deutsche Investitions-und Entwicklungsgesellschaft DMF – design and monitoring framework E&S – environmental and social ESHS – environment, social, health, and safety ESMS – environmental and social management system FMO – Nederlandse Financierings Maatschappij Voor Ontwikkelingslanden (Netherlands Development Finance Company) IMF – International Monetary Fund HNB – Hatton National Bank LCB – licensed commercial bank LIBOR – London interbank offered rate NPLs – nonperforming loans PROPARCO – Promotion et Participation pour la Coopération Économique SMEs – small and medium-sized enterprises XARR – extended annual review report

NOTES (i) The fiscal year (FY) of the Government of Sri Lanka ends on 31 December. “FY” before a calendar year denotes the year in which the fiscal year ends, e.g., FY2016 ends on 31 December 2016. (ii) In this report, “$” refers to United States dollars.

Vice-President Diwakar Gupta, Private Sector and Cofinancing Operations Director General Michael Barrow, Private Sector Operations Department (PSOD) Director Craig Lee Roberts, Portfolio Management Division, PSOD

Team leader Manohari Gunawardhena, Investment Specialist, PSOD Team member Debby Anne Francisco, Project Analyst, PSOD Melissa Manguiat, Senior Safeguards Officer, PSOD Viswanathan Ramasubramanian, Senior Safeguards Specialist, PSOD

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgment as to the legal or other status of any territory or area.

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CONTENTS

Page

BASIC DATA i

EXECUTIVE SUMMARY ii I. THE PROJECT 6 A. Project Background 6 B. Key Features 7 C. Progress Highlights 8 II. EVALUATION 8 A. Project Rationale and Objectives 8 B. Development Results 9 C. ADB Additionality 12 D. ADB Investment Profitability 13 E. ADB Work Quality 13 F. Overall Evaluation 14 III. ISSUES, LESSONS AND RECOMMENDED FOLLOW-UP ACTIONS 14 A. Issues and Lessons 14 B. Recommended Follow-Up Actions 15

BASIC DATA Senior Loan: Hatton National Bank Supporting Infrastructure Development (Loan No. 3229—Sri Lanka) As per ADB Loan Documents Actual Key Project Data ($ million) ($ million) Loan number 3104 Total project cost: ADB Investment A Loan 75.0 75.0 B Loan 25.0 25.0 Total investment: Committed 100.0 100.0 Disbursed 100.0 100.0 Outstanding 88.8 88.8 Key Dates Concept clearance approval 2014 30 June 2014 Board approval 2014 4 December 2014 Loan agreement 2015 27 March 2015 Loan effectiveness 2015 27 March 2015 First disbursement 2016 5 May 2016 Loan maturity 2022 27 March 2022 Project Administration and Monitoring Number of Missions No. of Person-Days Due diligence mission 3 53 Signing of loan documents 1 1 Project administration 1 3 XARR mission 1 6 ADB = Asian Development Bank, XARR = extended annual review report.

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EXECUTIVE SUMMARY

In December 2015, the Board of Directors of the Asian Development Bank (ADB) approved a senior loan of $100 million, including an A loan of $75 million and a B loan of $25 million, to Hatton National Bank (HNB) for on-lending to support infrastructure development in Sri Lanka. The B loan was arranged with the Netherlands Development Finance Company (FMO). In August 2016, ADB approved an equity investment of $40 million which was subsequently cancelled. This extended annual review report (XARR) is on the A loan and B loan given to HNB.

Sri Lanka experienced rapid economic growth in the years following the end of the conflict in 2009. At the same time, the country faced massive infrastructure needs, including reconstruction of post-conflict areas. Infrastructure development was a key priority for the Government of Sri Lanka and the ADB Country Partnership Strategy for Sri Lanka. ADB was actively involved in infrastructure financing through its sovereign-lending operations and sought to complement these efforts by harnessing the resources and expertise of private sector financial intermediaries. HNB was one of the largest and oldest private commercial banks in Sri Lanka. It had been active in infrastructure lending since 1975 and was keen to expand this activity to diversify its portfolio and participate in a key growth area for the country.

In the years following project approval, Sri Lanka saw rising fiscal and external deficits, leading to slower growth, higher inflation, and currency depreciation. Despite these obstacles, the project was implemented successfully. Key drivers for economic growth in Sri Lanka include infrastructure development and increased private sector output. Investments in social infrastructure like health and education generate important social and inclusion benefits, in addition to boosting the human capital and long-term growth potential of the economy.

The contribution of the project to private sector development and ADB strategic development objectives is rated satisfactory. The project has met or is on target to meet all key output, outcome, and impact indicators set at appraisal. HNB achieved continued growth in its infrastructure portfolio, which accounts for approximately 8% of its loan portfolio, and the projects financed meet key needs in the transport, energy, water, irrigation, health, and education sectors. HNB also made special efforts to support infrastructure needs in post-conflict areas by providing financing for solar power and for upgrading a private hospital in the northern part of the country and the rail and road networks.

The business success of the project is rated satisfactory. HNB’s infrastructure loan portfolio increased from about $250 million at appraisal to $328 million as of 31 December 2017. The bank had good return-on-equity (16.43%) and return-on-asset (1.84) metrics as of the first quarter of 2018, with an excellent cost-to-income ratio of 36% as well. Total assets stood at $6.2 billion. The United Kingdom’s Banker Magazine named HNB Sri Lanka’s “bank of the year” for 2017.

The economic performance is rated satisfactory. The economic impact of the project mirrors the business success of HNB, which it has achieved without significantly distorting the markets served. The project has contributed to funding both government and private sector infrastructure projects in key economic growth areas.

The environmental, social, health, and safety performance of HNB is rated satisfactory. ADB’s loan was categorized as financial intermediary (FI), with the use of proceeds to be directed to non-category A projects for environment, involuntary resettlement, and indigenous peoples. In 2012, HNB had established an environmental and social risk management system (ESMS) consistent with International Finance Corporation performance standards. In 2014, ADB’s due diligence for the transaction confirmed that HNB’s ESMS was adequate to address environmental

and social impacts associated with Category B projects, and recommended enhancements to bring the ESMS in line with ADB’s Safeguard Policy Statement (2009) prior to the first loan disbursement. HNB has utilized ADB loan proceeds to support corporate loans given to infrastructure investments for both private sector clients and government agencies. HNB carries out screening for environment and social impacts and ensures compliance with ESMS requirements. After screening each subproject, HNB determines the subproject categorization and eligibility for ADB’s funding. Government-funded projects usually involve additional support from commercial banks; in these cases, HNB’s influence to enforce ESMS implementation is limited. ADB ’s safeguards specialist conducted site visits to HNB-financed road projects in 2016, which were funded from the ADB loan, and noted no significant safeguard issues on the projects visited. ADB also engaged an external consultant in 2017 to review HNB’s environmental and social performance. The safeguards specialist found that the subprojects were compliant with national environmental and social regulations, and that periodic environmental and social (E&S) monitoring had been carried out consistently and was aligned with the ESMS.

ADB investment profitability is rated satisfactory. Pricing was in line with ADB policies, and the client reported that ADB charged a slightly higher interest than loans of comparable maturities from bilateral sources. The loan is current, has not had any payment delays, and is expected to be fully repaid on time. The quality of ADB work is rated satisfactory, based on satisfactory appraisal and supervision work. The project represents an innovative effort to address key development needs of the country through a private financial intermediary. The selection of HNB was based on its established track record and demonstrated interest in serving the target market. The design and monitoring framework (DMF) was well-articulated and set meaningful and measurable targets. ADB’s senior loan project with HNB is rated successful overall, based on the satisfactory performance across all evaluation dimensions.

An important lesson of the project is that targeting infrastructure through private financial intermediaries is feasible and can be a useful complement to government funding. It can boost private sector financial intermediation and help ADB support smaller-scale projects that it could not effectively reach otherwise. ADB could look to replicate this approach in other markets, especially where government capacity to meet infrastructure needs is limited and where suitable private financial intermediaries can be found.

ADB could consider providing technical assistance to help assess the technical and economic feasibility of emerging opportunities in infrastructure, for example in areas like clean energy, waste management, and private education.

I. THE PROJECT

A. Project Background

1. In December 2015, the Board of Directors of the Asian Development Bank (ADB) approved a loan of $100 million to Hatton National Bank (HNB) for on-lending to infrastructure development in Sri Lanka.1 The approval was for an A loan of up to $75 million and a B loan of up to $25 million.2

2. Sri Lanka was undergoing a period of rapid growth following the end of the conflict in 2009.

1 ADB. 2015. Report and Recommendation of the President to the Board of Directors: Proposed Senior Loan to Hatton National Bank for Supporting Infrastructure Development. Manila. 2 An equity investment of $40 million in HNB was approved subsequently but did not materialize.

Appendix 4 7

It faced massive infrastructure needs because of the relatively poor state of existing infrastructure after years of underinvestment, especially in post-conflict areas, and the strong growth of the economy. Supporting infrastructure development was a key priority of the ADB country partnership strategy for Sri Lanka, 2012–2016 and ADB’s country operations review.3 It also matched the development plans and priorities of the Government of Sri Lanka.4 ADB was already actively involved in financing infrastructure through its sovereign-lending operations. It sought to complement these efforts by harnessing the resources and expertise of private sector financial intermediaries to support infrastructure projects in both the public and private sectors, including smaller-scale projects that ADB could not effectively reach directly.

3. The government and the Central Bank of Sri Lanka (CBSL) were also pursuing ambitious financial sector reforms at the time of project appraisal.5 The Sri Lankan financial sector was characterized by a large number of smaller-sized banks, with a high bank-to-population ratio compared with countries with similar conditions and income levels. 6 A key objective of the financial sector road map articulated by the CBSL in January 2014 was to accelerate consolidation of the banking sector around a smaller number of systemically important institutions with market-leading governance and management practices. ADB supported these reforms through financial and advisory assistance, from both its sovereign and nonsovereign windows.7

4. HNB was one of the largest and oldest private commercial banks in Sri Lanka. It had an extensive network comprising 250 branches, including a long-standing presence in the Northern and Eastern provinces, and a strong franchise. While primarily a retail and commercial bank, HNB had been active in infrastructure lending since 1975 and built strong expertise in this sector. It was a participating financial intermediary in several multilateral development bank–financed projects targeting infrastructure as well as other areas.8 HNB had also received support from three bilateral institutions, including Promotion et Participation pour la Coopération Économique (PROPARCO) of France, the China Development Bank (CDB), and the German Development Corporation (DEG). HNB was keen to expand its infrastructure lending to diversify its activities and participate in a key growth area for the country.

B. Key Features

5. ADB provided a $75 million senior loan with 7 years maturity with a 3 years grace period. A $25 million B loan with the same conditions was arranged with the Netherlands Development Finance Company (FMO). Both loans were fully disbursed in May 2015. The $75 million loan was covered by a risk transfer agreement from ACE European Group Ltd., signed on 28 May 2015.

6. ADB also separately approved a $40 million equity investment in HNB which was subsequently cancelled. It does not form a part of the discussion for this XARR.

3 ADB 2012. Country Partnership Strategy: Sri Lanka, 2012–2016. Manila. 4 ADB. 2015. Interim Country Partnership Strategy: Sri Lanka, 2015–2016. Manila. 5 Moody’s. 2014. Sri Lanka’s Plan to Consolidate Non-Bank Financial Institutions is Credit Positive. Asia Pacific Weekly. 27 January. Colombo. 6 The banking sector comprised 24 licensed commercial banks (LCBs) and nine licensed specialized banks. As of the end of 2013, LCBs accounted for 48.7% of total financial system assets and 69.9% of banking sector assets. The two largest LCBs and the largest licensed specialized bank are state-owned. 7 ADB private sector operations supported government reform plans by working with leading institutions that were likely to continue in operation, providing them with both financial and advisory support to strengthen their capacities. 8 For example, the World Bank Energy Services Delivery Project (1997–2002), the World Bank Renewable Energy for Rural Economic Development Scheme (2003–2008), and the Post Tsunami Credit Line of the European Investment Bank.

7. The project was structured as a nonguaranteed senior loan, with delegation of authority to HNB to select subprojects meeting ADB social and environmental criteria in all relevant infrastructure subsectors: roads, water, irrigation, sewerage, hospitals, hydropower, solar, wind, etc. HNB was to provide periodic reports outlining its financial performance, accomplishments in reaching target segments and goals, and compliance with environmental and social conditions.

C. Progress Highlights

8. The Sri Lankan economy suffered macroeconomic difficulties, including growing fiscal and external deficits, in the years following project approval, which led to somewhat slower growth, higher inflation, and more rapid currency depreciation than anticipated. Nevertheless, the project was largely implemented as planned. HNB’s total loan portfolio grew from about $2.8 billion at the end of fiscal year (FY) 2013 to $4.2 billion at the end of FY2017, and the infrastructure portfolio increased from about $250 million at appraisal to $328 million as of 31 December 2017. The bank maintained sound financial condition and profitability, while an International Monetary Fund (IMF) program that seeks to redress key macroeconomic imbalances is helping to improve the overall economy.9

9. The bulk of infrastructure lending has gone to the public sector, in particular for roads as well as water supply, irrigation, health care, and energy. Some projects with public sector financing have received parallel support in the form of nongovernment guaranteed loans to private sector contractors. Private sector loans accounted for about 17% of total infrastructure lending, principally for mini-hydropower and solar power, as well as for private contractor financing for government projects as outlined above. Typical tenors are 12–15 years for government loans and 8–10 years for private sector loans. The repayment performance over the entire portfolio has been excellent, with no nonperforming loans reported. Recent efforts target projects in new sectors, such as clean energy (biomass and waste-to-energy), private education, hospital waste disposal, etc.). The dollar denomination of the ADB loan seems not to have posed any problems to HNB, as it had sufficient dollar-denominated assets on its book to absorb the exchange risk. The ADB loan thus effectively freed SLR resources for lending to local infrastructure projects.

II. EVALUATION

A. Project Rationale and Objectives

10. The project targeted two key elements of the ADB Strategy 2020, ADB’s Midterm Review in 2014 and country partnership strategy, as well as the government’s development plans and priorities: infrastructure development and financial sector development.10 At the time of loan approval, Sri Lanka faced massive infrastructure requirements because of strong economic growth coupled with low levels of domestic savings and limited government resources. The country had a large savings–investment gap, reflected in high loan-to-demand ratios on the balance sheets of local banks. It needed to attract external financing to meet infrastructure needs,

9 The Extended Fund Facility (EFF) was established to provide support of comprehensive programs that include policies of the scope and character required to correct structural imbalances over an extended period. http://www.imf.org/en/about/factsheets/sheets/2016/08/01/20/56/extended-fund-facility. 10 ADB. 2008. Strategy 2020: The Long-Term Strategic Framework of the Asian Development Bank, 2008–2020. Manila. ADB. 2014. Midterm Review of Strategy 2020: Meeting the Challenges of a Transforming Asia and Pacific. Manila. ADB. 2016. Country Partnership Strategy: Viet Nam, 2016–2020—Fostering More Inclusive and Environmentally Sustainable Growth. Manila.

Appendix 4 9 in particular the longer maturities needed by infrastructure projects.

11. HNB is the oldest and second largest private commercial bank in Sri Lanka. 11 While primarily a retail and commercial bank, it has traditionally been a key lender to infrastructure, including in the Northern and Eastern provinces which faced large post-conflict reconstruction demands. HNB was the main private bank active in the infrastructure market, along with the two big state-owned banks. It saw an opportunity to participate in the ambitious infrastructure development plans of the country, thereby diversifying its activities, adding relatively safe long- term assets to its portfolio, and supporting national development priorities. However, HNB had limited access to international financial markets, especially for the longer maturities needed for infrastructure.

12. HNB obtained an international credit rating of B+ in 2013; the rating was limited by the country ceiling and is reported to have been 2 notches higher otherwise. Funding from international commercial lenders was limited to up to 3–5 years maturity. Eurobond issues were difficult to arrange, costly, and required a minimum size of $250 million, which HNB found hard to deploy in the context of the Sri Lankan market. The local deposit base was predominantly short- term; HNB could float debentures on the local capital market, but maturities rarely exceeded 5 years and interest rates were highly volatile and unpredictable. The ADB loan was designed to provide HNB with the long-term resources needed to finance its infrastructure plans, and through the added credibility it provided, help HNB access additional commercial financing from international sources. The objectives are considered to be relevant and were largely met by the project.

13. The project is also consonant with government plans for the financial sector, including boosting private sector participation in credit and attracting private financing to infrastructure development. ADB’s loan to HNB also supports the CBSL’s plan to consolidate the banking sector around a smaller number of relatively large financial institutions, capable of reaping economies of scale and participating in large-scale projects.

B. Development Results

14. The development impact of the project is rated satisfactory.

i. Contribution to Private Sector Development and ADB’s Strategic Development Objectives

15. The contribution of the project to private sector development and ADB strategic development objectives is rated satisfactory. The project has substantially met or is on target to meet all key output, outcome, and impact indicators defined in the DMF.

16. The DMF figures illustrate that the project has generated the expected impact for HNB as well as for the wider economy. HNB has achieved continued growth in its infrastructure portfolio, covering a wide range of subsectors including transport, energy, and water in both the public and private sectors. HNB’s specialized project finance unit, established to assess infrastructure proposals, has seen its expertise grow through its involvement in a wide range of projects, making HNB a market leader as well as role model for successful infrastructure lending in the country.

17. In 2015 to 2017, HNB experienced a slight slowdown in infrastructure lending because of

11 Footnote 1

the unsettled macroeconomic situation and political uncertainty in the country. HNB also has set internal caps for its infrastructure portfolio in relation to capital and loan book.; it came close to the capital ceiling, though this will be lifted after the rights issue in July 2017.12

18. HNB expects continued growth in its infrastructure lending, which it views as a core addition to its SME, corporate, and retail banking activities. Infrastructure development is expected to be a key growth area for the country in the coming years. Major projects include the large-scale Colombo Port City project (a $6 billion investment mainly funded by the People’s Republic of China (PRC) on reclaiming part of the ocean and building a modern city) and projects in clean energy, waste management, private education, and health care. HNB’s looking to diversify its future lending and explore new areas.

19. The project also has had a tangible demonstration impact beyond HNB, in particular on other financial institutions attracted to the market by the strong growth and excellent repayment record achieved by HNB and other banks in this area. This had led to more competition in the market for infrastructure financing. Financing is now often syndicated, reflecting both a greater demand for funds and a rising willingness of other commercial banks to participate. This should make it easier for future infrastructure projects in Sri Lanka to access finance.

20. The subprojects financed under the project meet key infrastructure needs in transport, energy, water, irrigation, health, and education. It is expected that they will generate large indirect benefits for the economy in terms of on economic growth, social development, and environmental sustainability (see the “Economic Performance” section below).

21. HNB also had a special impact in post-conflict areas by supporting key infrastructure needs such as a private hospital in Jaffna, the capital city the Northern Province and upgrading of rail and road network and solar power in the same region These infrastructure projects are playing a major role in rebuilding access to basic services in the Northern and Eastern provinces, improving connectivity with other parts of the country, and reducing disparities in income and access to services.

ii. Economic Performance

22. The economic performance of the project is rated satisfactory. The economic impact of the project mirrors the business success of HNB, which it has managed to achieve without benefiting from artificial market distortions. Financial markets in Sri Lanka are competitive and generally well regulated; state-owned banks may benefit from a somewhat artificially lower cost of capital, but this seems not to have led to major distortions in credit markets and interest rates.

23. In the years following project approval, the Sri Lankan economy suffered macroeconomic difficulties, including growing fiscal and external deficits, leading to somewhat slower growth, higher inflation, and more rapid currency depreciation than anticipated. Nevertheless, the project was largely implemented as planned. HNB’s total loan portfolio grew from about $2.8 billion at the end of FY2013 to $4.2 billion at the end of FY2017, and the infrastructure portfolio increased from about $250 million at appraisal to $328 million at end of FY2017. The bank maintained sound financial condition and profitability, while the overall economy is undergoing an IMF program that seeks to redress key macroeconomic imbalances (refer paragraph 8).

24. Infrastructure can be subject to natural monopolies, but services are either free (e.g.,

12 HNB issued up to 70,082,228 new ordinary shares by way of a rights issue in July 2017.

Appendix 4 11 public sector roads), subject to market competition (e.g., private hospitals), or covered by negotiated purchase agreements (e.g., private power). The Ceylon Electricity Board has recently begun to introduce competitive bidding for selected private power projects.

25. HNB is expected to continue serving the infrastructure market based on its excellent track record, accumulated expertise, market leading position, amid the government development plans and resultant growth opportunities in the country. Internal capital limits of the bank are not expected to be a constraint since the rights issue in July 2017 increased the capital of HNB. Infrastructure is viewed by the bank not only as a growth driver, but also a key corporate social responsibility (CSR) area (refer paragraph 18 for growth opportunities).

iii. Environment, Social, Health, and Safety Performance

26. The environmental, social, health, and safety performance of the project is rated satisfactory. In compliance with ADB’s Safeguard Policy Statement (2009), ADB’s loan was categorized as financial intermediary (FI) for all three safeguard categories: environment, involuntary resettlement, and indigenous peoples. The proceeds from the ADB loan were to be directed to projects that are not categorized A for any of the three safeguard categories. HNB established an environmental and social risk management system (ESMS) consistent with International Finance Corporation performance standards in 2012—before ADB approved the project in 2014. ADB’s due diligence for the transaction confirmed that HNB’s ESMS was adequate to address environmental and social impacts associated with Category B projects, and recommended enhancements to the ESMS to bring it into compliance with the Safeguard Policy Statement. The proposed ESMS enhancements included: (i) completely aligning HNB’s exclusion list with ADB’s Prohibited Investment Activity List;13 (ii) incorporating environment, involuntary resettlement, and indigenous people’s impacts in the loan forms; (iii) providing separate categorization forms for involuntary resettlement and indigenous peoples; and (iv) obtaining the commitment of senior HNB management to implement the enhanced ESMS. HNB carried out these ESMS enhancements in advance of disbursement of the ADB loan.

27. HNB has used the ADB loan proceeds to provide corporate loans supporting infrastructure investments by both private sector clients and government agencies. For its lending to private sector clients, HNB carries out screening for environment and social impacts and ensures that ESMS requirements as well as national compliance requirements are adhered to. HNB management has been particularly careful to avoid potential negative impacts—and negative publicity–—that might result from projects that it finances. For instance, the bank rejected a proposal for an automated laundry project serving hotels in Colombo because it did not include plans for proper effluent treatment; and it convinced the sponsor of a biomass project to ensure that informal suppliers did not burn grasslands or employ child labor. HNB plays a vital role in infrastructure development in Sri Lanka by providing financing for major infrastructure projects implemented by government agencies in roads, urban water supply and sanitation, energy, and irrigation. For government-funded projects, HNB has been limited in ensuring effective implementation of ESMS requirements because (i) HNB was one of the several commercial banks supporting government projects, and not all participating banks are required to adhere to ESMS norms; and (ii) HNB is a private bank. However, the government funded projects financed from ADB loans were directed to non-Category A projects, that are required to comply with statutory environmental and social regulations, which are equivalent with the ESMS requirements for Category B projects. Based on site visits and discussions during ADB’s annual mission in 2016, road-strengthening projects implemented by the Roads Development Authority and financed by

13 https://www.adb.org/sites/default/files/linked-documents/48015-002-sd-01.pdf

HNB using ADB funds had no high-risk outstanding safeguard issues.

28. In 2017, ADB engaged an external consultant and tasked to review HNB’s E&S performance against its ESMS. Sample Category B projects (e.g. solar power, road renovation projects) were visited and, annual E&S reports were reviewed. The consultant reported the subprojects reviewed were compliant with statutory E&S requirements and is in accordance with the ESMS.

29. HNB regularly submits safeguard monitoring reports, which confirm that it has been implementing environmental and social management measures and health and safety programs in projects funded from ADB loans. The capacity of HNB to manage environmental and social impacts arising in category B projects was found to be adequate.

30. The project was categorized as some gender elements, and HNB’s performance on its gender measures is rated satisfactory. HNB confirmed in its annual environmental and social performance reports that projects taken up with ADB funds comply with national labor requirements and ADB social protection requirements. HNB’s compliance with ADB social protection requirements is therefore rated satisfactory.

iv. Business Success

31. The business success of the project is rated satisfactory. HNB is the fifth largest company by market capitalization (FY2014: 11th ranked) on the Colombo Stock Exchange (SLRs116.5 billion). It is considered a systemically important bank in Sri Lanka.14 HNB’s distribution network consists of 251 branches and 685 ATMs.

32. HNB grew at a compound annual growth rate of 19% in terms of total assets and 17% in terms of loan assets during FY2014–FY2017. Its deposit base increased at a compound annual growth rate of 19%, while capital remained robust at tier 1 at 13.7% and total capital at 17%. The bank’s strong profitability (return on equity 17.8% and return on assets 1.8% in FY2017) and robust capital enables the growth in the infrastructure portfolio which has an increased risk profile compared to other loans.

C. ADB Additionality

33. ADB additionality is rated satisfactory. Financing of suitable tenor and size was not available from commercial sources for HNB at the time of project appraisal. On a macroeconomic level, the country also faced a large financing gap and needed external resources to support its ambitious infrastructure development plans.

34. The tenor of infrastructure loans tends to be long, ranging from 8 to 15 years on average, and the overall balance sheet of HNB at the time of project appraisal showed a significant maturity gap, with long-term loans (not only for infrastructure but also corporate and retail) exceeding short-term deposits.15 Local currency debentures were generally limited to maturities of up to 5 years. International commercial financing was limited in scope and of even shorter tenor. Only multilateral development banks could provide the long maturities needed for expanded infrastructure funding.

14 https://www.cbsl.gov.lk/en/financial-system/financial-system-stability/banking-sector 15 Footnote 1.

Appendix 4 13

35. HNB had three bilateral backers at the time ADB approved the loan: PROPARCO of France, DEG of Germany, and PRC’s CDB. It could have tried to attract more funds from these existing backers or from new sources, but this would have been difficult. More importantly, ADB involvement lent HNB a measure of prestige and credibility in international markets that helped the bank access additional international funding. Several international commercial lenders approached HNB after the ADB loan approval.

36. The ADB project also raised $25 million in co-financing from FMO in the form of a B loan. While this cannot be attributed to the ADB project alone, the ADB project clearly played a role in enhancing the confidence of other lenders to HNB.

37. This was the first ADB project that sought to address Sri Lanka’s infrastructure needs through a private financial intermediary. Build-operate-transfer and similar structures are rare in Sri Lanka. Public sector financing is inherently constrained by the weak revenue-generation capacity of the government, coupled with large competing demands for government resources (free education and health care are universally available in Sri Lanka). The reconstruction of post- conflict areas posed additional challenges. This made the additional funding provided through the ADB loan even more important for meeting the country’s infrastructure needs.

D. ADB Investment Profitability

38. ADB investment profitability is rated satisfactory. Pricing was in line with ADB policies and cleared by the Office of Risk Management. The loan is current, has not had any payment delays, and is expected to be repaid in full and on time.

39. The project also involved relatively light supervision compared with other financial intermediation loans where ADB has been involved in the review or approval of select subprojects. The delegation of authority to HNB is deemed appropriate and has reduced the administrative cost for both ADB and the borrower.

E. ADB Work Quality

40. The overall quality of ADB work is rated satisfactory based on the two subcategories as reviewed above.

1. Screening, Appraisal, and Structuring of the Project

41. ADB’s work in screening, appraisal, and structuring is rated satisfactory. The project represents an innovative effort to address key development needs of Sir Lanka through a private financial intermediary. Selection of HNB was based on its established track record, strong capacity, and demonstrated interest in serving the target market. ADB’s analysis of the market, sponsor, and risks was extensive and thorough. The DMF was well-articulated and set meaningful and measurable targets. As noted above, the structure of the project—involving full delegation of sub loan approval to the client—is considered appropriate and effective.

2. Monitoring and Supervision

42. ADB’s monitoring and supervision of HNB is rated satisfactory. ADB kept itself fully apprised of project progress and borrower condition. A covenant breach on the liquidity ratio was promptly identified and addressed. Submission of some reports was delayed, but these delays were promptly and effectively addressed in collaboration with HNB.

43. The client is pleased with the relationship and assistance provided by ADB. They feel that the approval took slightly longer than they may have liked but recognize that this is to be expected given the nature of ADB as a multilateral development bank. They also expressed the wish that interest rates could be somewhat lower and maturities longer in the future.

F. Overall Evaluation

44. ADB’s senior loan project with HNB is rated successful overall, based on the satisfactory performance across all evaluation dimensions (see Table 1):

Table 1: Evaluation of ADB’s Senior Loan to Hatton National Bank Less than Item Unsatisfactory Satisfactory Satisfactory Excellent Development Results √ (i) Contribution to private sector development and ADB’s strategic √ development objectives (ii) Economic performance √ (iii) Environmental, social, health, and √ safety performance (iv) Business success √ ADB Additionality √ ADB Investment Profitability √ ADB Work Quality √ (i) Screening, appraisal, and structuring √ (ii) Monitoring and supervision √ Overall Rating Successful ADB = Asian Development Bank. Source: Asian Development Bank.

III. ISSUES, LESSONS AND RECOMMENDED FOLLOW-UP ACTIONS

A. Issues and Lessons

45. Targeting infrastructure development through private financial intermediaries is feasible and can be a useful complement to government funding under appropriate circumstances. It can boost private sector financial intermediation and help ADB support smaller-scale projects that it could not effectively reach otherwise. ADB could look to replicate this approach in other markets, especially where government capacity to meet infrastructure needs is limited and where suitable private financial intermediaries can be found.

46. Supporting an established and well-managed institution like HNB in efforts that are of high strategic importance for the government and for ADB, and where appropriate funding is not readily available from the market, is a good use of ADB resources.

47. Leaving the selection and appraisal of individual subprojects to the participating financial institution, where the financial institution has a strong general level of expertise and specific experience in the target sector, is appropriate. ADB generally requires the submission of periodic reports on the use of its funds—including types of projects financed; development targets reached; and financial and environmental, social, health, and safety performance. This provides

Appendix 4 15 sufficient information to assess the impact of the project and propose remedial actions where needed.

B. Recommended Follow-Up Actions

48. ADB should consider providing technical assistance to help assess the technical and economic feasibility of emerging opportunities in infrastructure in Sri Lanka, especially in innovative areas such as clean energy, waste disposal, and private education. This could be especially relevant in combination with additional financing from ADB. ADB could also consider providing assistance to HNB to enhance its micro-SME lending program.

49. ADB should consider providing loans with longer tenors of up to 10–12 years in the future. This could include loans for micro, small and medium-sized enterprises, clean energy, private education, and health care. Industries with high growth potential, such as information and communications technology (ICT), business process outsourcing (BPO), agribusiness, and tourism, could also be targeted.