Report No. PID10514

Project Name -Financial Sector Strengthening

Region Africa Regional Office

Sector Financial Sector Development

Project ID UGPE74649 Public Disclosure Authorized Borrower(s) GOVERNMENT OF UGANDA

Implementing Agency Address BANK OF UGANDA

Environment Category C

Date PID Prepared July 10, 2001

Projected Appraisal Date January 22, 2002

Projected Board Date July 2, 2002

Public Disclosure Authorized 1. Country and Sector Background Introduction. Over the last decade, the Government of Uganda has taken measures to improve the mobilization and allocation of financial resources and foster monetary deepening through liberalized policies, and improved formulation and execution of . The first stage of these reforms was supported under the Financial Sector Adjustment Credit (FSAC) and SAC III. They included improvement of the regulatory environment for financial institutions, including the passage of legislation for deposit-taking institutions and insurance companies, restructuring and privatization of weak financial institutions and capacity building for oversight authorities.The Government has recently embarked upon a second stage of financial sector reform. This stage was supposed to have been supported by the Financial Markets Assistance Project which was approved by the Board in May 1999. However, the Project Public Disclosure Authorized lapsed on March 31, 2001 without becoming effective after the Uganda Parliament had queried the rationale for borrowing IDA funds to re-privatize the Uganda Commercial Bank Limited (UCBL). Under the second stage, the reforms are focused on the further deepening and development of the financial sector through: (i) strengthening the regulation, supervision and operations of deposit-taking institutions; (ii) ensuring increased access to formal financial services, especially by rural savers and micro entrepreneurs; (iii) developing insurance and contractual saving institutions as well as their oversight; and (iv) strengthening financial infrastructure. Structure of the Financial Sector. Most of the material in this Section is taken from the April 2001 Uganda FSAP report.. The financial system in Uganda consists of 17 commercial banks, 6 non-bank credit institutions, 3 development banks, one post office savings bank, around 450 cooperative savings and credit societies, 35 microfinance institutions, 18 insurance companies, and 13 securities Public Disclosure Authorized brokers and dealers. Commercial banks dominate the financial system, accounting for 80 percent of system assets (Table 1). They include one state-owned bank, five large foreign banks, and eleven privately-owned banks (some with partial or full foreign ownership). The banking sector is characterized by the large share of foreign ownership and high concentration. The largest 5 banks in the system--four of which are foreign-owned--account for 74 percent of total sector assets. Foreigners account for 63 percent of paid-in capital in the sector, and the loans and deposits of the five largest foreign banks represent 65 and 60 percent of the total loand and deposits, respectively (Table 4). The second largest bank in the sector--the state-owned Uganda Commercial Bank Limited (UCBL)-- plays a limited role in financial intermediation because of the restrictions on its lending as part of a rehabilitation program administered under the conservatorship of the . Non-bank financial institutions also play only a minor role in intermediating domestic savings and foreign capital inflowsTable 1. Financial System StructureIn general, the financial system in Uganda plays a limited role in financing investment and growth, with the outstanding stock of loans only one-half the annual flow of external grants and loans. Banks have displayed a strong preference for liquid, low risk assets. A key source of balance sheet growth, foreign currency deposits, has not financed domestic investment in Uganda, but instead either has been invested in treasury bills or placed abroad. The share of assets invested in treasury bills more than doubled to 14 percent between 1995 and 2000. By contrast, the share of loans fell from 42 percent to 26 percent over the same period. Total system assets stood at 26 percent of GDP in 2000, only a quarter of which were loans to the private sector. Moreover, the bulk of private sector credit is concentrated in the urban area, with very low penetration into rural areas. Despite agriculture's substantial contribution to output (40 percent of GDP), only 10 percent of system bank credit is extended to the sector. The banking sector is not financing real investment and economic activity that could potentially generate greater demand for credit in the future.Uganda Commercial Bank Limited (UCBL). UCBL is a state-owned institution and is the second largest bank in the country with 19.5 percent of banking system assets as at end December 2000. However, it has the largest branch network of 67 branches. Its restructuring and privatization was started in 1992 when it accounted for about 50 percent of the total loans and deposits in the banking sector and had 189 branches throughout the country. The privatization process culminated into the sale of 49 percent of UCBL's shareholding to a Malaysian company in October 1997. The sale transaction was subsequently annulled in November 1998 following a breach of the sale contract by the new shareholder. The Government repossessed all the shares in UCBL but the central bank (Bank of Uganda) took over the management of the bank in April 1999 owing to its precarious financial condition. The Government has agreed to re-privatize the UCBL and Bank of Uganda (BOU) is currently looking for potential buyers of the bank.As one of the restrictions imposed on UCBL operations under the central bank intervention, the bank is prohibited from making new loans, with the exception of a select few existing customers. The bank invests the bulk of its loanable funds in government securities, which currently account for 48 percent of its total assets. UCBL accounts for only 7 percent of sector loans, despite its 21 percent market share in deposits. Restrictions on the bank's extension of new loans--which is appropriate from a prudential perspective given its poor lending history--deprives the economy of a substantial portion of the savings mobilized by the banking sector. UCBL's disproportionate presence in the treasury bill auction market complicates monetary management, increases sterilization costs, and contributes to the high level and volatility of interest rates. Interest rate volatility, in turn, undermines the central bank's signaling capacity and credibility. Earnings from high-interest treasury bills have restored UCBL to profitability and to capital adequacy, but the long-term viability of the bank remains in

-2 - question, as the current structure of its balance sheet is both unsustainable and undesirable. The planned privatization of the bank will, in principle, normalize UCB's balance-sheet structure and rectify the problems associated with it over time. However, considerable uncertainty remains over the speed with which the bank can be privatized given its limited operational restructuring to date and the short supply of bankable households and projects. Another issue over which there is uncertainty with regard to the UCBL privatization is the extent to which the new buyer will keep all UCBL's branches open. This has critical implications for access to basic financial services especially in those rural areas and upcountry towns where UCBL is the only bank present. A 1996 study by DFC Consultants had identified 18 UCBL branches that were essential in the rural areas. This study may need to be updated in light of the fact that the Cooperative Bank, which had the second largest branch network to UCBL, has since been closed. Continued operation of the bulk of UCBL's upcountry branch network (by UCBL or by other banks) is critical to the successful implementation of the Government's rural development and poverty reduction programs. Regulation, Supervision and Operations of Deposit-taking Institutions. The Government's strategy to improve the soundness of the financial system included the passage of the Bank of Uganda Statute 1993, the Financial Institutions Statute 1993, the Insurance Statute 1996, and the recruitment and training of staff of the BOU Bank Supervision Department. Off-site and on-site supervision of commercial banks was strengthened through technical support under FSAC and non-performing loans of UCBL and Uganda Development Bank were transferred to the Non-Performing Assets Recovery Trust (NPART) as a way of enforcing credit discipline. The Bank of Uganda intervened and closed 4 commercial banks between 1998 and 2000, in addition to taking over the management of UCBL. Despite the important strides taken in improving banking soundness in recent years, several small banks still exhibit signs of weakness in the form of poor asset quality, insider lending above prudential limits, and high cost of funds. These banks warrant close scrutiny by the supervisory authorities and need to be subject to strict prudential enforcement.Much remains to be done to strengthen the supervision of commercial banks and other non-bank financial institutions. The number of bank examiners (currently ) needs to be increased for them to adequately effect off-site examinations of at least once a year for each of the deposit taking institutions. Existing staff need further training in specialized fields while the new staff need immediate generalized training. A new Financial Institutions Bill, 2000 addressing the weaknesses in the 1993 Statute has been drafted and needs to be presented to Parliament for enactment and subsequent operationalization.Insurance and Contractual Savings Reform and Regulation. Insurance and contractual savings institutions which have the potential for savings mobilization and acting as a source of funds for the critically lacking term finance have attracted the attention of the Government. Eighty six percent of bank loans are short term in nature and only six percent of loans outstanding have maturity greater than 3 years. A high priority is being given to the improvement of the environment conducive to the development of insurance and other contractual institutions. Non-life insurance is an important financial sector service, essential for economic growth in general and the development of the private sector in particular. The Insurance Statute 1996 caters for the establishment of an Insurance Commission to regulate and oversee the operations of the insurance industry. The commission has been established and is operational. However, its capacity is still weak

-3 - and needs to be strengthened. Uganda's private pension systems generally, and the National Social Security Fund (NSSF) in particular, are somewhat dysfunctional both in failing to protect the post-retirement futures of Ugandan employees adequately and failing to preserve the long term nature of their funds in the economy. The pension system is dominated by NSSF whose performance is less than adequate primarily due to administrative inefficiency and poor investment practices. Over the last ten years, it has been declaring dividends substantially higher than its income leading it to a potentially negative net worth of UShs 8 billion as of end June 2000. Out of an estimated labor force of 6 million, less than 500,000 workers participate in pension schemes. Participation (especially in NSSF) is widely viewed as atx and not a benefit and thus enforcing contribution requirements is costly. This has severely affected the accumulation of long term capital which is essential for increased investment levels in the economy. Money and Debt Markets. Although Uganda has taken significant steps to improve monetary management, the lack of a secondary market for T-bills--the main monetary instrument used by BOU--hampers the effectiveness of indirect tools of monetary control. In addition, the inter-bank market is very thin with annual turnover less than 0.3w of total deposit liabilities. Banks consequently hold large excess reserves. Treasury and liquidity management in Ugandan banks is still in the formative stage and this contributes to the underdevelopment of the money market in general, especially the absence of private money market instruments. It also partly accounts for the observed lack of liquidity in both the T-bill and inter-bank market. Other Sector Issues. Uganda has a fairly developed and diversified micro-finance industry involving licensed financial institutions, numerous NGO-type organizations, both international and domestic, and cooperatives. Most of the investment into the sector, which has been substantial, has come from donor organizations, mainly bi-lateral and multi-lateral aid agencies including ADB, DANIDA, DFID, European Union, German Aid, IFAD, USAID, World Bank and others. The micro-finance organizations are for the most part relatively weak financially, have a small presence in rural areas and can not expand too quickly without significantly increasing risk. A new Microfinance Act has been drafted by the BOU after extensive consultations with various stakeholders in the industry, including MFIs and donors. The Government and BOU would like to encourage the broader distribution and availability of financial services while subjecting deposit takers to an appropriate regime of prudential regulation.The cooperatives sector is another option that would help bridge the gap of access to financial services if it were strengthened. There are two umbrella organizations for cooperatives in Uganda, the Uganda Cooperative Alliance (UCA) and the Uganda Cooperative Savings and Credit Union (UCSCU). Both of these organizations include Savings and Credit Cooperative Organizations (SACCOs) among their membership. UCA reports that there are more than 700 SACCOs in the country but that most of them are dysfunctional. Reportedly, the majority of SACCOs are work-based organizations located in urban areas or district centers whose members are salaried employees motivated to join SACCOs by the potential access to credit which they offer. Where they do occur in the rural areas, SACCOs are more often formed within villages with the common bond being determined by residence in the community rather than by employment. Both umbrella organizations have recently initiated pilot projects aimed at revitalizing the sector by working with a few model SACCOs with the objective of expanding coverage over time.Uganda has made considerable progress in updating its banking and central banking

- 4 - legislation. The Bank of Uganda Act 1966 and the Banking Act 1969 were amended in 1993 and replaced with the Bank of Uganda Statute 1993 and the Financial Institutions Statute 1993, respectively. The latter is currently being revised to strengthen the enforcement powers of the Bank of Uganda, taking into account lessons learned from the recent closures of insolvent banks. The new Financial Institutions Bill 2000 addresses issues of corporate governance, prompt corrective action, graduated licensing, financial criminal penalties, bank insolvency, money laundering and transparency, and improved disclosure requirements. With the imminent enactment of this Bill and the Microfinance Bill 2000, Uganda will have in place a sound and comprehensive legal framework to govern its financial sector. Progress has also been made in improving the legal framework governing the commercial sector although much remains to be done to update the Companies Act, the Bankruptcy Act and other legislation necessary to provide for an efficient private sector environment. Collateral and contract enforcement mechanisms and institutions are still weak and improvements are needed in the regulations governing the capital markets and insurance sectors.

2. Objectives The objective of the Project is to increase the soundness and competitiveness of the financial sector and improve access to financial services by the general population. This is aimed at supporting broad-based private sector growth. The Government acknowledges that an efficient and effective financial sector is one of the critical ingredients in its strategy to reduce poverty through accelerated growth. The Project will achieve its objective by: (i) strengthening the regulation, supervision and operations of deposit-taking institutions; (ii) ensuring increased access to formal financial services, especially by rural savers and micro entrepreneurs; (iii) developing insurance and contractual saving institutions as well as their oversight; and (iv) strengthening financial infrastructure.

3. Rationale for Bank's Involvement Unusually for financial sector operations, there is a high degree of bilateral and multilateral donor activity in Uganda. However there are three important areas where the Bank will add value beyond what is being done by others. These are as follows:-First, because the Bank's support will run over a project cycle of four years, we will be able to monitor the effectiveness of the supervision efforts over that time frame. This is in contrast to some of the other interventions which are target specific activities of short duration thereby making it impossible to assess impact over the medium term.Second, no other donor is willing to provide support for fundamental institutional reform of state-owned financial institutions including banks and the pension funds. We have considerable experience in this field both in Africa and the rest of the world and place a high priority on it as an essential success factor for Financial Sector Development.Third, we have knowledge and experience in making rural banking in Africa financially sustainable which other donors do not. We are therefore uniquely qualified to support the Bank of Uganda in establishing a new rural bank out of the remnant of UCBL so as to ensure the continued provision of financial services in the rural areas.

4. Description

-5- Increasing the Efficiency and Competitiveness

Increasing the soundness of the financial system Improving the Capacity of the Department of Banking Supervision. The Project will support the training of the more senior examiners to acquire sophisticated techniques in off-site and on-site examinations. Technical assistance will also be provided to ensure hands-on training to BSD staff in, inter alia, loan evaluation and provisioning, evaluation of lending concentration, foreign exchange risk valuation, liquidity risk assessment, and contingent risk management.

The Project will also support the drafting of legislation to better define BOU roles and responsibilities in regulating non-bank deposit-taking institutions including merchant banks, building societies, leasing companies (which mobilize deposits) and the Post Bank of Uganda. It will also support hands-on training for examiners placed in the non-bank examination unit.

Improving the Supervision of Commercial Banks and NBFIs. The Project will support the setting up of a monitoring system for the performance of the BSD in supervising the financial system Progress in performance will be measured against baseline benchmarks and agreed annual targets.

Improving Supervision and Regulation of the Insurance Industry. Support to strengthen the capacity of the Insurance Commission, consistent with its institutional development plan, will be provided. The Project will also provide support for the drafting of regulations necessary to implement the Insurance Statute 1996. A monitoring system for the performance of the Commission in supervising the insurance industry will be developed as part of the implementation support arrangements.

Review of the Structure and Regulation of Pension System. The Project will support a study of the pension sector to identify the weaknesses in the current system and to suggest reform and restructuring strategies and policies that will ensure the liberalization of the sector and increase its coverage and effectiveness. The Project will also support the implementation of the recommendations of the sectoral study, including drafting of legislation for a pension oversight authority.

Increasing the Efficiency and Competitiveness

Restructuring and Privatization of Weak Banks. The Project will finance a diagnostic review of PBU and also support the proposed PBU privatisation. The Project will also finance a diagnostic study of HFCU to identify ways to improve its performance in providing medium and long term investment funding. It will also support the necessary measures for HFCU's restructuring and privatisation.

Improved Collection of UCBL and UDB Non-performing Loans by NPART. The Project will finance the contract of the Trust Administrator to enable NPART continue its process of recovering loans of UCB, as well as recovering loans transferred from UDB.

Assessment of Regional Integration of Capital Markets. The Project will

- 6 - provide support to the CMA in its Regionalization initiatives. A monitoring system for the performance of the CMA in supervising the securities market will be developed as part of the implementation support arrangements. Establishing a Secondary Market for Treasury Bills. The Project will support advisors to assist in developing a secondary market for T-bills, including measures such as the development of a primary dealer system as well as establishing a retail market outside banks. The support will include advisory services focusing on techniques of making the inter-bank market more active and liquid, such as reducing the current high degree of segmentation in the market.

Training in Treasury and Liquidity Management. The Project will provide support to the Uganda Institute of Bankers (UIB) to develop and implement a basic course in treasury and liquidity management for commercial banks and also provide relevant training materials.

Increasing Access to financial Services

Establishment of a Rural Financial Services Bank. The Project will support measures to transform the leftover rural UCBL branches into a rural bank to continue playing the essential role of mobilizing rural savings (and providing depository services), providing payments services particularly in district capitals, and in providing essential banking services to micro-finance institutions.

Capacity Building in MFI Best Practice. The Project will support the development of MFI best practices so that the existing institutions can progressively reach conditions of financial sustainability and the subsequent expansion of their outreach. It will also support the drafting of regulations for the implementation of the Microfinance Act.

Availability of Term Finance. The Project will provide resources to review the options for transforming UDB into an institution that can offer term lending to small scale investors. A Housing Finance study will also be conducted to explore securitization of mortgages and/or provision of liquidity support facilities to catalyze commercial bank lending for housing.

Improved Management of SACCOs. The Project will support the two pilot programs by UCSCU and UCA aimed at revitalizing the growth and improving performance of the SACCOs sector.

Financial Infrastructure Strengthening

Strengthening the Legal Framework. The Project will provide resources for the drafting of the NBFI law and operationalization of the Microfinance law.

Increasing Efficiency of Commercial Courts. The Project will provide support to activities meant to address some of these problems which include unnecessary delays, unpredictability, inefficiency, absence of modern technology, poor library and research facilities, poor management skills in case handling and record keeping, and the fact that few judges and magistrates have specialized experience and skills in business and

- 7- commercial law matters.

Strengthening and Expanding the Reach of the Payments System

Project Management Unallocated

5. Financing Total ( US$m) BORROWER Total Project Cost 13.0

6. Implementation Implementation Period:4 years, December 2002 to December 2006Executing Agencies:BOU, Ministry of Finance, UCBL, Insurance Commission, NPART, Uganda Institute of Bankers, and CMAProject Coordination:Coordinator, Deputy Governor's Office, BOUProject Execution and Coordination. Overall responsibility for the implementation and coordination of the Project will be entrusted to the Deputy Governor's office in BOU. The designated officials in this office will have the responsibility for ensuring policy consistency across beneficiaries of the Project, coordinating implementation and ensuring adequate financial management (procurement, disbursement, accounting and audit) and general administration (monitoring the implementation plan and reporting). Each project component would be implemented by a designated agency and responsible individual accountable for the execution of project activities and timely delivery of outputs as defined and agreed under the Project Implementation Plan (PIP). The PIP will be prepared by the Borrower and finalized and adopted prior to credit effectiveness.

7. Sustainability This Project supports a process that is aimed at achieving a sustainable result, namely a sound and efficient financial system. Such sustainability will depend ultimately on the ability of regulators to oversee prudent risk-taking and institutionalize such a process, as well as sustainable macro-economic policies which can shield Uganda from severe economic turbulence.

8. Lessons learned from past operations in the country/sector Corporate Governance. When restructuring financial institutions in Africa, corporate governance is the key issue for success and must be addressed if the sector is to become both efficient and sound. The preferred means of improving governance is by selling a majority stake to a reputable strategic investor who will bring much-needed improvements in technology, operational procedures and Human Resource Development. Such an outcome is not always attainable and so fall-back options are often necessary. When required, such options need to be evaluated primarily on their impact on the governance of the institution.Rural Banking. Rural bank branch networks provide the essential infrastructure necessary to maintain and promote access to financial services in rural areas. However, it is the rural branches that are most at risk in a divestiture process. We know that rural banking can be made profitable if a non-traditional business model is adopted thereby protecting and maintaining rural access to financial services on a sustainable basis. The Project thus intends to support the restructuring of any rural branch network that is not taken

- 8 - over by a reputable buyer as part of the UCBL divestiture.Capacity Building. The value of capacity building support to financial sector regulators has been limited in the absence of a clear focus on measuring the impact of such regulators over the medium term. This is because improved capability to identify problems often does not lead into imposition of effective remedial measures. The project will therefore place a high priority on regularly monitoring the effectiveness of supervision activities across the financial sector.Political Obstacles. Financial sector reform is politically difficult and the Uganda Parliament, while demonstrating a desire to see the financial sector strengthened (e.g. by commissioning the recent Judicial Enquiry into the Closure of Banks), was reluctant to approve the previous financial sector project (the FINMAP). As part of the Project preparation activities, the team will therefore seek to engage actively with a broad range of stakeholders including key representatives from Parliament.Baseline Country Knowledge. Our knowledge of the Ugandan Financial Sector is excellent both as a result of the preparation work that went into the previous project and because of the joint World Bank/IMF Financial Sector Assessment Program (FSAP) mission that was undertaken in April/May 2001. A follow-up mission will take place in July 2001 to further define actions that can be taken to tackle specific problems and issues identified during the FSAP mission. The Project is tapping into this knowledge in order to optimize the Project's relevance and effectiveness in addressing Uganda's key financial sector needs.

9. Program of Targeted Intervention (PTI) N

10. Environment Aspects (including any public consultation) Issues Environmental Assessment. a. Environmental issues: noneb. Environmental Category [ I A [ I B [ I C (To be determined based on a review by the Environmental Specialist)c. Justification/Rationale for category rating:

11. Contact Point:

Task Manager Antony Thompson The World Bank 1818 H Street, NW Washington D.C. 20433 Telephone: 202-473-2252 Fax: 202-47385-75

12. For information on other project related documents 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

Note: This is information on an evolving project. Certain components may not be necessarily included in the final project.

-9- This PID was processed by the InfoShop during the week ending July 13, 2001.

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