Report No. PID10469

Project Name NEPAL-Financial Sector Technical (@) Assistance Project

Region South Asia Regional Office

Sector Banking (100%)

Public Disclosure Authorized Project ID P071291

Borrower(s) THE KINGDOM OF NEPAL

Implementing Agency Address NEPAL RASTRA BANK Address: Nepal Rastra Bank, Baluwatar, Kathmandu, NEPAL Contact Person: Governor, Nepal Ratsra Bank Tel: 977-1-410386 Fax: 977-1-410159 Email: [email protected] -

Public Disclosure Authorized another email - [email protected]

Ministry of Finance Address: Ministry of Finance, Bag Dubar, Kathmandu, NEPAL Contact Person: Secretary, Ministry of Finance Tel: 977-1-259880 Fax: 977-1-259891 Email: [email protected]

Environment Category C

Date PID Prepared November 14, 2002 Public Disclosure Authorized

Auth Appr/Negs Date January 22, 2002

Bank Approval Date December 19, 2002

1. Country and Sector Background Financial Sector Background. Nepal has 15 commercial banks -- RBB, NBL, 9 Joint Venture Banks (JVB's), which are mixed public/privately owned, and 4 local banks. In addition, the sector also includes 2 large development banks (the Agricultural Development Bank of Nepal (ADB/N) and the Nepal Industrial Development Corporation (NIDC)), 48 finance companies, 13 insurance companies, numerous microfinance institutions, 7 Grameen Replicator Banks, 35 financial cooperatives, 25 financial Non-Government Organizations (NGO's), and a stock exchange. The two large banks -- RBB and NBL -- account for around 50 percent of total banking system assets, Public Disclosure Authorized and are in a very precarious financial position. Political intervention, weak management, disruptive unions, poor financial information systems, and a deeply entrenched culture of non-repayment of loans has resulted in a rapid deterioration of their financial health.

RBB, which represents 27 percent of commercial banking system assets, is estimated to have a large negative net worth and therefore a capital base that is well below the levels required by generally accepted international norms. Although in slightly better financial condition, NBL has similar problems including a high negative net worth. 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. A 2000 review of RBB and NBL indicated that these banks together had estimated losses, as of mid-1998, as much as $426 million -- equivalent to around 46 percent of the Government budget or about 8.6 percent of GDP. The situation in these two banks has inevitably deteriorated considerably since this date.

In general, Nepal's financial system suffers from the following problems that are also recognized by the Government:

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 insurance industry, and, until recently, the Nepal Bank Limited (where it is still the largest single shareholder); to significant influence over the Joint Venture Banks; the Government's hand is evident in almost every aspect of financial sector activity. This has resulted in strong political interference in banking activities. This, in turn, has resulted in a weak banking culture, non-repayment of loans, and poor financial health throughout the system. Nepal Rastra Bank -- the Central Bank. Until January 2002, when a new NRB Act was approved, the NRB fell under the authority of the Ministry of Finance. This historical lack of autonomy has hindered the NRB's ability to supervise and regulate the banking system adequately. Political influence in the RBB and NBL -- as well as their sheer dominance within the banking system -- placed these banks outside the influence and control of the central banking authorities. Although it may take time to become fully operational, the new 2002 Act provides the NRB with sufficient autonomy and full authority over the entire banking system. Recently approved banking regulations will 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. For the immediate future, the NRB's challenge will be to enforce the rules that have now been established. The Government and the NRB need to reorient their activities away from being active participants (as owners and operators) in the financial sector to increasingly focus on becoming more effective regulators and supervisors.

Rastriya Banijya Bank (RBB) is 100 percent Government owned. As the largest commercial bank, with more than 200 branches, RBB has an important role to play in the economy. However, burdened by political demands, an active and disruptive union movement, management weaknesses, poor accounting and auditing functions, and high levels of non-performing assets, RBB has reached a particularly parlous financial state. A recent audit points to a high negative net worth, weak internal systems, poor internal financial management, and shabby operating methods. At the request of the government, a diagnostic review of the RBB and NBL was carried out by KPMG/Barents in 1999/2000. This study's major findings confirm that (a) the banks' management is basically dysfunctional; (b)

-2 - there are no reliable data available on the loan portfolio; (c) financial accounting is primitive and not according to international standards (accounts are virtually all manual and annual statements have not been produced for over six years); (d) business strategies are not in place; (e) human resource policy is weak and counterproductive; (f) management information systems and record keeping are very basic; and (g) governance and management are highly politically driven and lacking a commercial focus. This work was financially supported under a Policy and Human Resources Development Fund (PHRD) grant (TF 025473) for both RBB and NBL.

The Nepal Bank Limited (NBL). While in somewhat better financial condition, NBL is still a weak institution. Its dominant role in the financial sector creates scope for inefficiency and a low level of banking competition. Over the 1990s, the Government reduced its stake in NBL by selling parcels of shares to the private sector. The Government has reduced its shareholding to a minority 41 percent, although it remains the single biggest shareholder in the bank. This disinvestment by HMGN was carried out with the objective of reducing political interference in NBL's management and promoting private sector participation in the bank so that it could operate in a more commercial and business-like manner. The Government's policy of successively selling shares to the general public has, however, left the bank without a single strategic partner with a strong background in commercial banking and international linkages with the global economy. Insider dealings and other inappropriate activities by the new private owners are thought to have further compromised its operations. As such, it also has many of the same problems as RBB (see above) as identified in the KPMG diagnostic.

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 poor. The ADB/N will require restructuring, system development, changes in governance arrangements, and a review of its ultimate role and ownership arrangements. This bank is being dealt with by the Asian Development Bank. Close coordination between IDA and the ADB mean that actions taken in RBB and NBL are likely to be applied to ADB/N to ensure a consistency of approach. A Weak and Fragmented Legal Financial Environment. Nepal has a proliferation of both laws and regulations that are institutionally rather than functionally focused. This has created a fragmented legal environment. 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. Now that new legislation has been approved, the challenge will be to ensure that NRB can effectively enforce the provisions of the new legal and regulatory environment. The 1974 Commercial Bank Act is also defective. Most importantly, the act does not cover all deposit-taking institutions. Other nonbank deposit-taking institutions are governed by their own laws -- the Development Bank Act of 1996, the Agricultural Development Bank Act of 1967, and so on. A proliferation of laws covering various classes of deposit-taking institutions has permitted legal arbitrage. NRB has recently completed drafting a new Banking and Financial Institutions Act that covers all major deposit-taking institutions. This Act is expected to become law in 2003. Ancillary Laws. Once the above two key pieces of legislation have been

- 3- amended, it will be important to ensure that other ancillary laws are developed in support of a modern banking system. New legislation is required in such areas as collateral, credit activity, bankruptcy law, and so on.

A Weak and Fragmented Accounting and Auditing Environment. A weak accounting and auditing tradition has meant that the timeliness and reliability of financial data (particularly from the largest banks) is extremely poor. Corporate sector accounting is also weak, making lending decisions difficult for the banks. If Nepal's financial system is to operate in a prudentially sound and efficient manner, strengthening of accounting and auditing is essential. Competition in the Banking Sector. Reform of the state-owned banking sector should be designed to reduce fragmentation and support the more efficient intermediation of funds within the banks and nonbanks. This would increase competitive pressures and thereby provide more efficient and cost-effective solutions to the banking public. Market-oriented approaches also need to be developed to enhance competitive pressures. These are preferable to mandated efforts such as those developed to control interest rate spreads and priority and deprived sector lending.

Other Issues. In addition to the above, the financial sector environment needs to be strengthened in several fundamental ways. For example, credit information systems have not been effective tools against non-performing borrowers; capacity building in the sector remains very weak; and the general public's low level of financial sophistication means that it does not serve as an effective check and balance within the system. These weaknesses also require attention.

These issues call for urgent reform and modernization. Nepal needs to create the preconditions for the development of an efficient banking system that is capable of developing new financing mechanisms and instruments to meet private sector needs. Without such reforms, the prospects for faster growth and ultimately poverty reduction will be constrained. However, financial sector development is a long and complex process that will take many years, particularly given the very low starting point in Nepal. The proposed program will start this process and deal with only the most serious of these problems -- specifically central banking, the two largest banks, and strengthening the financial environment.

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), introduction of modern banking regulations, capital market reforms, and foreign exchange liberalization. However, much remains to be done, particularly with respect to institutional reform. To help establish a framework for the way forward, the Government has formulated a Financial Sector Strategy Statement (FSSS) that consolidates its thinking and develops a comprehensive and interlinked reform program. The FSSS has been discussed widely within Nepal -- within the private sector and the financial sector -- and it has been adopted as Government policy. The FSSS was publicly released and published in the Nepali and

- 4 - English press at the end of 2000. The desire for reform in the financial sector is further reflected by the fact that the Government has asked for World Bank, IMF, and Department for International Development (DFID) assistance to proceed with the reform agenda. Initial support has been provided through a PHRD grant and a Project Preparation Facility (PPF). The main elements of the HMGN's FSSS sector strategy include: Reduce 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 of banks and financial institutions; Require strong corporate governance by ensuring that banks (in particular the two largest commercial banks) are owned and managed by "fit and proper" private investors; Strengthen the role of Nepal Rastra Bank in the overall financial system by drafting a new Act to provide sufficient autonomy in the conduct of monetary policy, banking system regulation and supervision, and the licensing of banks and nonbanks; Improve existing banking and financial legislation and judicial processes for enforcing financial contracts; Improve auditing and accountancy standards within the banking sector; and Promote financial discipline through adequate disclosure and competition.

The reforms in the financial sector, particularly with respect to the state-owned banks, require strong political commitment. As in many countries, bank restructuring issues are likely to be difficult for the Government when the time comes for action. For example, although liquidation of RBB is one of the options that will be considered, this may not be politically acceptable. Even privatizing the bank to good foreign-banking interests or splitting its activities into several distinct components may prove difficult to implement (given its poor financial health, its long public-sector association, and the weak state of the Nepali economy). Nonetheless, fundamental reform is required and strong political commitment will be necessary if the reform measures are to be carried through to a point where they make a lasting and irreversible contribution to overall economic development. Government commitment to reform, to date, has been demonstrated by its contracting of KPMG to assess future options for RBB and NBL; the installation of a professional management team in NBL in July 2002 and a CEO in RBB in late 2002; development of a modern legal and regulatory environment for banking; and the issuance of an overarching Government policy on financial sector reform. These activities provide the World Bank with comfort that the Government is willing to transparently assess the condition of the banks and to develop credible corrective action plans.

2. Objectives The overarching objective of the Reform Program in the Financial Sector is to support the renewed efforts of His Majesty's Government of Nepal (HMGN) to improve the sector in order to bring macroeconomic stability and promote private-sector-led economic growth. The proposed Financial Sector Technical Assistance Project is the first major step in this process and focuses on three broad objectives (a) helping to restructure and re-engineer the Central Bank (Nepal Rastra Bank - NRB), so that it can effectively perform its key central banking functions; (b) commencing commercial banking reform in the two large ailing commercial banks that dominate the sector (Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL)) -- by introducing stronger bank management that protects the

- 5- financial integrity of the two banks and would take on a conservator role to prepare the banks for the next steps of restructuring; and (c) supporting a better environment for financial sector reform in areas such as enhanced credit information, better financial news reporting, and better training for staff in financial institutions. These actions will help create a more prudently operated and commercially viable commercial banking system that is overseen by a modern, effective, and technically competent central bank. If sufficient progress is made during this first phase of reform, then subsequent IDA support would focus on more longer term objectives. These include further deepening and broadening of the sector, supporting worker retrenchment in the banks, bank privatization and/or liquidation, and helping to cover the financial losses in the large publically owned banks.

It is anticipated that IDA's support for the overall financial sector reform program will be in the form of several, sequential projects. The first of these -- the Financial Sector Technical Assistance Project -- is centered around the re-engineering of Nepal Rastra Bank (particularly in its core central banking functions; supervision, monetary policy, banking legislation, accounting and auditing, information technology, human resources, and training); reform of the two large commercial banks -- RBB and NBL (through the recruitment of Management Teams to put these two banks in conservatorship on behalf of the central bank); and support for capacity building in the financial sector (through support for training, financial journalism, and a credit information bureau). This project will finance a range of activities that are necessary to prepare for a major reform operation. This initial phase will also serve to demonstrate and confirm broad-based commitment to undertake difficult reforms. This sequential approach to financial sector reform has been endorsed by colleagues in the International Monetary Fund (IMF), the Department for International Development (DFID) U.K., and the Asian Development Bank (ADB).

The Financial Sector Reform Program is also important in terms of enhancing poverty alleviation. It is expected to (a) support private-sector-led economic growth and job creation; and (b) reduce the number of nonperforming loans made through the banking system to the politically powerful elite in Kathmandu. As the large non-recoverable losses in the banking system will have to ultimately be borne by the Government -- this represents a transfer of resources from the tax payer in Nepal to the urban rich (who represent some of the largest defaulting borrowers in the banking system). A more efficient intermediation of funds should also result in a better allocation of financial resources and hence stronger economic growth.

3. Rationale for Bank's Involvement The Bank has a growing background in the area of financial sector reform operations which will be useful in the implementation of the proposed Nepal program. The Bank is also a significant source of development assistance in Nepal and -- in concert with the IMF, DFID, and the ADB -- will be able to present a strong case for making the appropriate decisions and tough choices.

In this regard, project preparation and appraisal has coincided with IMF and DFID missions which has provided an opportunity for close

- 6 - collaboration. Financial sector reform (along with fiscal reform) are also central tenets of the IMF's support program for Nepal.

DFID's contribution of US$ 10 million equivalent for this joint project will reinforce IDA's efforts and will establish a track record of cooperation between our two agencies in the area of financial sector reform -- for the next phase of the reform effort.

4. Description The project has three main components (Table below). Based on its cofinancing agreement, DFID will provide US$10.0 million equivalent in the form of joint financing for this project. The respective DFID shares for the three components will be: US$1.56 million for re-engineering of NRB; US$8.10 million for restructuring of RBB and NBL; and US$0.34 million for capacity building in the financial sector. The balance of US$4.1 million will be provided by HMGN.

Re-engineering Nepal Rastra Bank Restructuring the Two Big Banks (RBB and NBL)

Capacity Building in the Financial Sector

5. Financing Total ( US$m) BORROWER $4.10 IBRD IDA $16.00 UK: BRITISH DEPARTMENT FOR INTERNATIONAL DEVELOPMENT (DFID) $10.00 Total Project Cost $30.10

6. Implementation A Coordination and Support Team (CST) has been formed within Nepal Rastra Bank under the Banking Operations Department to administer this project. The Executive Director of the Banking Operations Department heads the CST and provides overall guidance and leadership on matters of project implementation. The CST is supported by a dedicated Financial Management Specialist who is a qualified professional accountant and by a dedicated Procurement Specialist. The CST is also supported by adequate ancillary staff and facilities. The operating costs of the CST will be funded under the project on a declining cost basis over the project implementation period. These operating costs include communications, office supplies and materials, incremental staff costs, and other expenses which will be jointly financed by the IDA Credit and the DFID Grant. Staff salaries are excluded.

Financial Management (also see Section E - Summary Project Analysis and Annex 6) A financial management capacity assessment of the implementing agency, Nepal Rastra Bank, was carried out by World Bank financial management specialists during appraisal. The project has adequate financial management arrangements in place to account for and report on project expenditures. To mitigate potential financial management risks and to strengthen the financial management capabilities of NRB, a financial management improvement component has been designed and built into the project to ensure that noted deficiencies are appropriately addressed. Terms of reference for consultancy services to help improve

-7 - the accounting capacity of NRB have been agreed and advertised in the local and international press (including the UN Development Business). The proposed consultancy services are expected to be carried out in three phases. The first phase is a diagnostic and planning phase and will identify the areas that need improvement resulting in the development of a time-bound action plan to address any weaknesses. The second phase will implement the agreed actions. The third phase will include intensive training for NRB staff and a follow-up evaluation of the impact of the financial management improvement program. These steps will build on the good initiatives that are already underway within NRB to ensure the establishment of a robust financial management system. Annual project financial statements, SOE's, and special account statements will be audited by the Office of the Auditor General and submitted to IDA within six months after the end of the fiscal year. NRB entity financial statements will be audited by a certified private auditor who will be appointed by the Auditor General and submitted to IDA within six months after the end of the fiscal year.

7. Sustainability The sustainability of the financial reform program will depend upon the commitment of the Government to take hard political decisions on governance issues in the two large banks. Given the politicization of these institutions, it may prove difficult to ensure the proper commitment to lasting restructuring (and ultimately privatization or liquidation) that is required. Nonetheless, some actions demonstrating government commitment have already been taken upfront, and the project team feels that the program has a significantly enhanced chance of success as a result. The Financial Sector Strategy Statement is thorough and sound in its approach to fundamental financial sector reform, and it reflects an appropriate set of policies. An expert management team has also taken over the management of NBL and a Chief Executive Officer has been selected to take over RBB -- in all their key functions. Overcoming the political resistance to the introduction of external management teams already demonstrates considerable resolve on the part of the government and increases the likelihood of sustainability of the reform process.

Sustainability could be adversely impacted by political uncertainly within Nepal. Weak coalitions and frequent changes in Governments, which seek to curry political favor with their electorate, may result in a policy reversal. Close cooperation with the IMF, the ADB, DFID and the rest of the donor community will also be important to ensure that adequate pressure is brought to bear against any perceived reversal in policy gains.

8. Lessons learned from past operations in the country/sector 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 (iii) Lack of specific fundamental reforms needed to achieve a major

- 8 - 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 has been upfront commitment and action by the Government to carry out fundamental reforms in banking supervision generally and in the governance arrangements within the state owned bank RBB and in NBL, 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 Financial Sector Strategy Statement -- will also help ensure consistency and commitment.

In addition, generic lessons learned from previous projects in the financial sector include:

(a) Sustainable banking sector reforms require that the autonomy and technical skills of the regulator be enhanced. This project aims to enhance the bank supervisory technical skill of NRB so that it can become increasingly more professional and autonomous; (b) Legal framework reforms are critical to ensure successful implementation. This project has supported the revision and modernization of key banking legislation. A new NRB Act, providing the Central Bank with significantly more autonomy, was approved in January 2002. A new Banking and Financial Institutions Act is currently under discussion within the banking community. Further legal reforms, including measures for debt recovery, and registration and prioritization of liens, are also envisaged in the immediate future; (c) Sequencing is important for successful financial sector reform. Strengthening the Central Bank, as anticipated under this project, is a high priority and should be carried out with a program of initial commercial banking reform; (d) Reforms should include rationalization of processes and procedures and should be backed by vigorous enforcement. The project will deal with procedures in the Central Bank and will provide assistance to ensure strict enforcement of prudential regulations and legal requirements; (e) Reforms should focus on a limited number of key activities. This project will support a purposely limited agenda of focused activities; (f) Forcing reforms from outside is not sustainable. Strong borrower commitment will produce the greatest chance of success. This commitment appears to be in place as evidenced by the development of the Financial Sector Strategy Statement, the appointment of a professional management team in NBL and a professional CEO in RBB, and the ongoing close liaison between NRB and the Ministry of Finance on all aspects of the financial reform process; and (g) Re-capitalizing commercial banks without fundamental reforms in the ownership and governance structures of the banks is not likely to be successful. Any injection of capital into RBB and NBL will only be supported at the point of privatization/liquidation or some other acceptable change in governance arrangements within these banks.

9. Environment Aspects (including any public consultation) Issues : The project is rated C for the environmental impact. No environmental impact is expected under this project.

10. Contact Point:

9 Team Leader Simon C. Bell The World Bank 1818 H Street, NW Washington D.C. 20433 Telephone: 202-473 4931 Fax: 202-522 1145

11. 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.

This PID was processed by the InfoShop during the week ending November 22, 2002.

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