Document o f The World Bank

ReportNo: 27417 FOR OFFICIAL USE ONLY

PROJECT APPRAISAL DOCUMENT

ON A

PROPOSED IDA CREDIT

SDR 47.6 MILLION IN THE AMOUNT OF (USD $68.5 MILLION EQUIVALENT)

AND

PROPOSED IDA GRANT OF SDR 4.9 MILLION IN THE AMOUNT OF (US $7.0 MILLION EQUIVALENT)

TO THE

H I S MAJESTY'S GOVERNMENT OF NEPAL

FOR A

FINANCIAL SECTOR RESTRUCTURING PROJECT

January 22,2004

Finance and Private Sector Development South Asia Regional Office

This document has a restricted distribution and may be used by recipients on l y in the performance o f their off icial duties. I t s contents may not otherwise be disclosed without W o r l d Bank authorization.

CURRENCY EQUIVALENTS

- Vice President: Praful C. Pate1

Country Director: Kenichi Ohashi Sector Director:

Task Team Leader: Joseph D e l M a r Pemia Simon C. B e l l

(Exchange Rate Effective November 28,2003)

Currency Unit = Nepalese rupee l r u p e e = US$O.O129

US$ = SDR0.6946

ADB ADBN CEO CFG CIAA CRR CST DFID DRT FMR FSSS F S T A GDP HMGN HR I A S I C A N IDA IMF I C T IT MOF NF3L NEPSE N I D C NPA NPL NRB PRGF PSRC RBB SLR TA VRS

F ISCAL YEAR July 15 - July 14

ABBREVIATIONS AND A C R O N Y M S

Asian Development Bank Agricultural Development Bank o f Nepal Chief Executive Officer Corporate and Financial Governance Commission for the Investigation o f the Abuse o f Authority Cash Reserve Requirement Coordination Support Team (in NRB) Department for International Development Debt Recovery Tribunal Financial Monitor ing Report Financial Sector Strategy Statement Financial Sector Technical Assistance Project Gross Domestic Product His Majesty’s Government o f Nepal Human Resources International Accounting Standards Institute o f Chartered Accountants o f Nepal International Development Association International Monetary Fund Information Communications Technology Information Technology Ministry o f Finance Nepal Bank Limited Nepal Stock Exchange Nepal Industrial Development Corporation Non-Performing Assets Non-Performing Loans Nepal Rastra Bank (the central bank) Poverty Reduction and Growth Facil ity Poverty Strategy Reduction Credit Rastriya Banijya Bank Statutory Liquidity Requirement Technical Assistance Voluntary Retirement Scheme

FOR OFFICIAL USE ONLY PAD Cover Sheet Kingdom o f Nepal

Financial Sector Restructuring Project

PROJECT APPRAISAL DOCUMENT

South Asia Region

Finance and Private Sector oevelopment Uni t

Project ID: PO84219 Restructuring and Privatization

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. I t s contents may n o t be otherwise disclosed without W o r l d Bank authorization.

Project development objective Re$ PAD B.2, Technical Annex 3 The objective o f this operation i s to support the continuing efforts o f HMGN to improve the operation o f the financial sector in order to ensure continued macroeconomic stability and promote private sector-led economic growth. Project description [one-sentence summary of each component] Re$ PAD B.3.a, Technical Annex 4 Support to Voluntary Retirement Schemes (VRS) in Rastriya Banijya Bank (RBB) and Nepal Bank L imi ted (NBL), Hiring o f Sales Advisors to privatized these two banks, Phase I1 o f on- going Nepal Rastra Bank (central bank - NRB) restructuring, and on-going Management Team Support in the two large commercial banks (RBB and NBL). Which safeguard policies are triggered, if any? Re$ PAD D. 6, Technical Annex 10 None

Significant, non-standard conditions, if any, for: Re$ PAD C. 7 Board presentation: None

Loadcredit effectiveness: None

Covenants applicable to project implementation: None

NEPAL Financial Sector Restructuring Project

CONTENTS

Page A . STRATEGIC CONTEXT AND RATIONALE ....................................................................... 1

1 . Country and sector issues ............................................................................................................. 1 2 . Rationale for Bank involvement .................................................................................................. 4 3 . Higher level objectives to which the project contributes ............................................................. 5

B . PROJECT DESCRIPTION ....................................................................................................... 5 1 . Lending instrument ...................................................................................................................... 5 2 . Project development objective and key indicators ....................................................................... 5 3 . Project components ...................................................................................................................... 6 4 . Lessons learned and reflected in the project design ..................................................................... 7 5 . Alternatives considered and reasons for rejection ....................................................................... 8

C . IMPLEMENTATION ............................................................................................................... 8 1 . Partnership arrangements ............................................................................................................. 8 2 . Institutional and implementation arrangements ........................................................................... 9 3 . Procurement ................................................................................................................................. 9 4 . Monitor ing and evaluation o f outcomeshesults ......................................................................... 10 5 . Sustainability ............................................................................................................................. 10 6 . Crit ical risks and possible controversial aspects ........................................................................ 10 7 . Loadcredi t conditions and covenants ........................................................................................ 12

D . APPRAISAL SUMMARY ..................................................................................................... 12 1 . Economic and financial analyses .............................................................................................. -12 2 . Technical .................................................................................................................................... 12 3 . Fiduciary .................................................................................................................................... 13 4 . Social ......................................................................................................................................... 13 5 . Environment .............................................................................................................................. -13 6 . Safeguard policies ...................................................................................................................... 13 7 . Policy Exceptions and Readiness ............................................................................................... 14

Annex 1: Country and Sector or Program Background ................................................................ 15 Annex 2: Major Related Projects Financed by the Bank and/or other Agencies ......................... 23 Annex 3: Results Framework and Monitoring ............................................................................. 25 Annex 4: Detailed Project Description ......................................................................................... 29 Annex 5: Project Costs ................................................................................................................. 32 Annex 6: Implementation Arrangements ...................................................................................... 33 Annex 7: Financial Management and Disbursement Arrangements ............................................ 35

Annex 9: Economic and Financial Analysis ................................................................................. 42 Annex 10: Safeguard Policy Issues .............................................................................................. 44 Annex 1 1 : Project Preparation and Supervision ........................................................................... 46 Annex 12: Documents in the Project F i l e ..................................................................................... 47 Annex 12A: Letter o f Financial Policies ...................................................................................... 48 Annex 13: Statement o f Loans and Credits .................................................................................. 53 Annex 14: Country at a Glance ..................................................................................................... 54

Annex 8: Procurement .................................................................................................................. 39

A. STRATEGIC CONTEXT AND RATIONALE 1. Country and sector issues

Country Background. Nepal i s one o f the world’s poorest countries, with an annual per capita income o f about US$240 with many indicators showing a very poor quality o f l i fe. Progress in the fight against poverty has been hampered by a number o f factors, including a succession o f unstable Governments. More recently, the challenge has intensified with the escalation o f the insurgency and lingering instability in the Government. Security concerns have been heightened by the August 2003 collapse o f the ceasefire agreed with insurgents operating in the country and there i s a fear o f wider c iv i l disturbance. Together with the global economic slowdown that has adversely impacted Nepal’s trade-dependant economy, these domestic events have led to a sharp downturn in economic activity. Related to this i s potential fiscal stress, as public spending has been obliged to accommodate increased security demands. Meanwhile, there i s widespread belief that the insurgency i s fundamentally a challenge to a state that has not proved itself effective in dealing with Nepal’s development agenda.

Financial Sector Background. Nepal has 17 commercial banks - comprising the two large banks Nepal Bank L imi ted (NBL) and Rastriya Banijya Bank (RBB) in which the government has a dominant shareholding; 6 Joint Venture Banks, which are mixed Nepalilforeign owned (foreign ownership i s constrained to 67 percent); and 9 local (100 percent Nepali) banks. I t also has 2 large development banks - the Agricultural Development Bank o f Nepal (ADBIN) and the Nepal Industrial Development Corporation (NIDC) which also undertake some commercial banking activities. The system also operates with 54 finance companies, 13 insurance companies, numerous micro-finance institutions, 7 Grameen Replicator Banks, 35 financial cooperatives, 25 financial Non-Government Organizations (NGOs), and a stock exchange. The two largest commercial banks - RBB and NBL - account for around 50 percent o f total banking system assets, and are in a very precarious financial position. Political intervention, weak management, poor financial information systems, and a deeply entrenched culture o f non-repayment o f loans have resulted in a rapid deterioration o f their financial health. RBB, which represents 27 percent o f commercial banking system assets, i s estimated to have 7 1 percent non-performing loans. Although in slightly better financial condition, NBL has similar problems including around 59 percent non- performing loans (NPLs). This could have serious ramifications for the Government in terms o f systemic risk and could prove to be a severe financial strain on an already delicate budget should either o f these two banks face a crisis o f confidence with concomitant adverse macroeconomic implications. The 2003 unaudited accounts for RBB and NBL indicate that these two banks had estimated accumulated deficits, as o f mid-2003, o f approximately $435 mi l l ion - equivalent to around 7 percent o f GDP. B o t h NBL and RBB have made significant progress in reducing their operating losses since professional management teams assumed control o f their operations in 2002 (supported by a Wor ld Bank Phase I Financial Sector Technical Assistance (FSTA) credit).

In addition, the two large development banks have deteriorated in comparable fashion to that o f RBB and NBL. The financial positions o f ADBIN and N I D C are currently in the process o f being appraised by the Asian Development Bank (ADB) - and a work out plan i s being developed.

In general, Nepal’s financial system suffers f rom the fol lowing problems:

(a) The Government’s Role. His Majesty’s Government o f Nepal (HMGN) plays a large direct ro le in the financial sector. F rom ownership o f key financial institutions such as RBB, ADB/N, the Grameen banks, the largest insurance company, the stock exchange, the largest investment company, and, until recently, Nepal Bank L imi ted (where i t remains the largest single shareholder); to significant influence over the Joint Venture Banks; the Government’s involvement i s evident in almost every aspect o f

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financial sector activity. This has resulted in strong polit ical interference in banlung activities which, in turn, has resulted in non-repayment o f loans, and poor financial health throughout the system.

(b) approved, the NRB f e l l under the authority o f the Ministry o f Finance. This historical lack o f autonomy hindered the N R B ' s ability to supervise and regulate the banking system. Political influence in RBB and NBL - and their dominance in the banlung system - also placed these banks outside the influence and control o f the central bank. Although s t i l l requiring further modification in several areas, the 2002 Nepal Rastra Bank A c t provides the NRB with basic autonomy. The authority o f NRB over the banking system has been further established by the recent Cabinet approval o f the Banking and Financial Institutions Ordinance. Improved banking regulations also provide the regulatory basis for NRB to move the system closer to international banking norms whi le permitting the bank supervisors to deal expeditiously with errant banks. The NRB i s supported in this endeavor through a substantive program o f capacity building f rom a resident team o f international banking experts supported by IDA under the FSTA.

Nepal Rastra Bank (NRB) - the Central Bank. Until January 2002, when a new Ac t was

(c) commercial banks with deposits o f approximately Rs 40 b i l l ion - 25 percent o f the Nepali banking system. RBB i s technically insolvent with high levels o f non-performing assets ("As) - and had an estimated negative net worth o f US$335 mi l l ion as o f July 2003. A professional management team took over the bank in early 2003 - the new CEO, recruited o n a fixed-term contract, jo ined the bank o n January 16th 2003, followed by the rest o f the team in late February 2003. In variance to the original concept, each member o f the management team has been hired individually.

Rastriya Banijya Bank (RBB) i s 100 percent Government owned. I t i s the biggest o f Nepal's

Due to the on-going insurgency, branches have been reduced fi-om more than 200 to around 130 nationwide and the total number o f staff in the bank i s being reduced f rom 5,522 to a target figure close to 3,200 through a Voluntary Retirement Scheme (VRS) launched in September 2003. At the same time a process o f computerization i s underway and some 42 branches are expected to operate with an online system. RBB continues to suffer f rom a high percentage o f non-performing loans although performance in this f ie ld i s improving under the guidance o f the new management team.

(d) Nepal Bank Limited (NBL). The financial condition o f NBL has also been significantly impaired, but not to the same extent as RBB. NBL i s the oldest bank in Nepal (established in 1935) - it i s also the second largest bank with deposits o f Rs 35 bil l ion. Originally, the Government owned the entire bank but i t s shareholding was sold down throughout the 1990s to reach 41 percent. The Govemment's pol icy o f successively selling shares to the general public has, however, lef t the bank without a strategic banking partner - and, meanwhile, the connected lending activities o f the new private owners are thought to have further compromised i t s operations. In common with RBB it has suffered f rom weak management, political interference, and a lack o f financial controls.

Using Wor ld Bank assistance, HMGN decided to bring in professional management f rom the Bank o f Scotland to take over the day-do-day running o f NBL in August 2002. In i t ia l main areas o f focus for the new management team have included, producing credible audited accounts for 200 1 and 2002, designing and developing a minimum Information Technology (IT) platform for the bank, developing appropriate human resource policies for the staff, strengthening i t s treasury management function, identifying non- performing loans, and establishing a loan recovery unit to deal with these NPLs. The Management Team i s also restructuring the bank by reducing staffing levels by almost 50 percent; rationalizing the branch network; recovering o n non-performing loans; and requesting delisting fi-om the Nepal Stock Exchange (NEPSE).

(e) The Agricultural Development Bank of Nepal (ADBN. The financial and operational situation o f the ADB/N, the third biggest bank in Nepal, i s also extremely poor. The ADB/N will require

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restructuring, system development, changes in governance arrangements, and a review o f i t s ultimate role and ownership arrangements. Reform in this bank i s being supported by the ADB. Close coordination between IDA and the ADB means that reforms made in FU3B and NBL are l ikely to be replicated in ADB/N to ensure a consistency o f approach.

(f) i s noteworthy, Nepal has historically suffered from a proliferation o f both laws and regulations that are institutionally rather than hnct ional ly focused. This has created a fragmented legal environment.

A Weak and Fragmented Legal Financial Environment. Although recent progress in this area

The Nepal Rastra Bank Act, now superseded by a January 2002 Act, was seriously outdated and deficient with respect to issues o f central bank autonomy, accountability, and governance. The new legislation strengthens i t s independence and supervisory role.

e The 1974 Commercial Bank Act was also defective and it did not cover a l l deposit-taking institutions. A proliferation o f laws covering various classes o f deposit-taking institutions permitted legal arbitrage. NRB has drafted a new omnibus Bankmg and Depository Institutions A c t that was approved by Cabinet in late 2003.

e Ancillary Laws. N e w legislation i s also required in such areas as Secure Transactions, Insolvency, and a new Company Law, etc.

(g) auditing tradition has meant that the timeliness and reliability o f financial data f rom banks i s poor. Corporate accounting i s also weak, making lending decisions diff icult for the banks. The overall strengthening o f accounting and auditing i s therefore essential. The progress made, in this respect, within the two largest commercial banks by the newly instituted management teams, i s noteworthy.

A Weak and Fragmented Accounting and Auditing Environment. A weak accounting and

(h) Competition in the Banking Sector. Reform o f the state-owned banking sector i s designed to reduce fragmentation and support efficient intermediation o f funds within the financial sector. This will increase competitive pressures and provide more efficient and cost-effective solutions to the public.

(i) important areas. Credit information systems need to be made more reliable and effective; the Nepal Stock Exchange requires urgent reform; and access to finance for many mi l l ions o f rural Nepalis needs to be addressed.

Other Issues. The financial sector environment also needs to be strengthened in several other

(j) measures in the financial sector. These include interest rate deregulation, the phase out o f Statutory Liquidity Requirements (SLR), reduction in Cash Reserve Requirement (CRR), introduction o f modem bank regulations, and foreign exchange liberalization. However, much remains to be done, particularly with respect to institutional reform. T o help establish a medium term framework, the Government formulated a Financial Sector Strategy Statement (FSSS) that consolidates i t s thinking and develops a comprehensive and interlinked reform program. This FSSS has been adopted as official Government policy and was publicly released and published in the Nepali and English press at the end o f 2000. The main elements o f the FSSS include:

Government Strategy. Over the past few years, the Government has undertaken general reform

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Reducing the role o f the Government in the financial sector as a direct owner o f financial institutions while strengthening i t s role as a supervisor and regulator; Requiring strong corporate governance by ensuring that banks (in particular the two largest commercial banks) are owned and managed by “fit and proper” private investors;

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0 Strengthening the role o f Nepal Rastra Bank by drafting a new central bank Ac t to provide autonomy in the conduct o f monetary policy, banking system regulation and supervision, and the licensing o f banks and nonbanks; Improving existing banking and financial legislation and judicial processes for enforcing financial contracts; Improving auditing and accountancy standards within the banking sector; and Promoting financial discipline through adequate disclosure and competition.

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T o date, the Government o f Nepal has demonstrated a seriousness and commitment to banking reform and has not wavered in moving ahead with the diff icult agenda. Actions taken so far provide IDA with comfort that the Government i s willing to transparently and decisively address the issues at hand.

2. Rationale for Bank involvement The objective o f this operation i s to support the efforts o f HMGN to improve the financial sector in order to ensure continued macroeconomic stability and promote private sector-led economic growth. This represents the second phase o f a larger financial sector reform effort - which began with the FSTA. Assuming on-going commitment to reform, this would lead ultimately to a third phase involving bank privatization. Phase I involved bringing in three management consultant teams to: restructure and re- engineer the central bank; and reform the two large commercial banks (Rastriya Banijya Bank and Nepal Bank Limited). This second phase will assist in (i) right-sizing the two commercial banks through the implementation o f Voluntary Retirement Schemes (VRS) to reduce operating costs and make them viable for privatization; (ii) bringing in a Sales Advisor to assist in the privatization; (iii) providing further assistance to a second phase o f Central Bank re-engineering; and (iv) supporting the continuation o f professional management team support up until the point o f bank privatization. Phase I11 (not included in this project) would involve support for financial re-engineering o f the banks (re-capitalization) at the point o f sale after satisfactory changes in governance arrangements and cost restructuring have taken place.

The operation supports the Nepal Country Assistance Strategy (CAS) 2004-2007 (Report No . 26509- NEP) outcomes in the financial sector as wel l as governance objectives. Improvement in the banking sector i s one o f the key growth-enhancing structural reforms that Nepal must undertake in order to stimulate a more pro-poor and inclusive growth process. The CAS recognizes that a strong financial system i s critical for private sector development. On-going progress with respect to banking reform i s a key trigger for Nepal to remain in a base case lending scenario.

Borrower commitment to financial sector reform i s evidenced by the medium term vision la id out in the Financial Sector Strategy Statement and reaffirmed in the Letter o f Financial Policy (December 9, 2003). I t i s further demonstrated by the hiring o f management teams to implement reform in the commercial banks and the free hand that they have been given to deal with defaulting borrowers.

The project elements are in line with the analytical work undertaken o n Nepal’s financial sector. The Financial Sector Study (October 2002) recommends a human resource re-engineering exercise within the two largest commercial banks and the implementation o f a V R S scheme to right-size staffing levels - t o prepare the banks for privatization. This i s an important next step in the on-going movement towards privatization. A main lesson from previous Bank assisted projects i s that implementation progress i s generally faster when project components have been fully developed pr ior to project approval. With the VRS schemes already designed and ready to go, this has been taken care o f in the current operation.

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3. Higher level objectives to which the project contributes The project i s important in dealing with the critical situation within the banks. Serious losses have been incurred which will ultimately have to be recognized by the owners o f the banks and paid for with taxpayers money, With a need for fiscal resources to be increasingly devoted to poverty needs in the fields o f education, health, rural water, and enhanced infrastructure - it i s crucial that the losses in these banks be stemmed. Consequently, the on-going bank reform process also has many important indirect poverty alleviation implications over the medium term.

The project i s also important in establishing a better intermediation function within the banking system so that funds can f low to their most productive economic use -thereby benefiting the entire economy in terms o f more rational investment decisions, more sustained employment opportunities, increased production and exports - and ultimately enhanced growth.

B. PROJECT DESCRIPTION 1. Lending instrument The project i s to be supported through an IDA Credit and Grant. An Investment operation was chosen as the bulk o f the funds are to be passed on to two commercial entities, RBB and NBL. On the basis o f financial data provided by the two banks, the amounts disbursed under the loan will be quickly recovered through lower operating costs - the payback period for the VRS schemes i s in the region o f two to three years - hence the return o n the investment i s healthy. The grant component was included to ensure compliance with HMGN’s Foreign Aid Policy (2002) which, in Sections 7.4 through 7.6, specifies that grant funds should be used for technical assistance in projects.

2. Project development objective and key indicators The main objective o f the project i s to support the on-going efforts to develop a healthier financial sector in Nepal which intermediates funds more efficiently and effectively to the benefit o f a l l segments o f society and in a manner which supports private sector development, increased investment, and faster growth. These objectives will be achieved via a two pronged approach.

The f i rst entails further strengthening o f the central bank o f Nepal (Nepal Rastra Bank) through an o n going program o f bank supervision strengthening; accounting and auditing development; human resource re-engineering; information technology upgradation; and other support. The objective i s to also further enhance the professional status o f the central bank and i t s capacity to oversee the development o f a prudently operated financial sector in line with i t s own medium term vision as enunciated in the FSSS. K e y indicators will be a greatly enhanced capacity to supervise banks to international standards; abil ity to produce i t s own accounts to international accounting standards (IAS); a small but more efficient workforce which i s appropriately incentivized and which operates in a professional manner; and a fully computerized general ledger to improve management information systems within the bank.

The second prong involves a deepening o f the reform process within the two large banks so as to improve their operational capacity and ensure that they operate o n a more commercially oriented basis. This will permit their ultimate sale to “fit and proper” bank owners in the private sector. The development objective o f this component i s to substantially improve their operating capacity and commercial viability; to move them as swiftly as possible into the private sector; and thereafter, develop the government’s oversight and supervisory capacity over them and other banking institutions. K e y indicators will be the abil ity to attract “fit and proper” buyers to purchase these restructured banks - and to ultimately privatize the institutions.

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3. Project components

The project has four main components (Table below).

Voluntary Retirement Schemes (VRS). The largest component i s designed to support the VRS in RBB and NE3L in an effort to reduce their costs and ultimately assist in making them more saleable/privatizable institutions. The two main components o f high cost in these banks have been identified as non- performing loans and staff costs. The f i r s t o f these i s actively being dealt with by the new Managers in these banks while the VRS wil l be supported under this project. The management teams each have a Human Resource advisor who, as part o f their terms o f reference, have identified redundant staff and have designed VRS schemes. The launching o f these schemes in the two banks was announced in September 2003 and the f i rst o f the retirees will leave the banks by the end o f 2003. Hence, this component i s fully designed and wel l under implementation.

Hiring of Sales Advisors. The hiring o f the Sales (Privatization) Advisors wil l not happen until a year or so into the project when the banks are in a better financial condition and are therefore more viable privatization candidates. These Advisors will undertake proper due diligence, prepare a prospectus for the banks, and then undertake a road show to bring them to the point o f sale to “fit and proper” private sector buyers as rapidly as possible. This component (US$ 3.0 mill ion) will be financed using the IDA Grant component.

Phase 11: On-going Nepal Rastra Bank Re-engineering. The Financial Sector Technical Assistance Project has commenced a process o f re-engineering within the central bank. However, reform, revitalization, and professionalization are complicated, long-term tasks. Greatly enhancing the capacity o f NRB to oversee a prudently operated banking system i s a prime objective o f the series o f reforms being undertaken within the sector. Whereas the Phase I reforms in banking supervision have focused on developing an appropriate off-site reporting system and a minimalist amount o f on-site bank supervisory assistance, the Phase I1 reforms will assist in augmenting the on-site supervisory capacities to oversee the commercial banks. The accounting component will assist NRB in meeting the IMF’s Safeguard Assessment milestones, including the production o f an international audit o f the bank’s accounts to I A S . The Human Resources (HR) reforms will build upon the newly introduced HR policies, recent efforts by the central bank to reduce overall staffing levels, and the development o f a new training plan to help move NRB towards the establishment o f a more professionally managed staffing cadre. The Information Technology (IT) component i s new (not covered in the Phase I reforms) but i s critically required as part o f the modernization process within the bank. The technical assistance components (around US$4.0 mill ion) o f the NRB Re-engineering will also be financed using an IDA Grant.

Management Team Support. I t i s agreed, that the two banks may not be privatized by the time that the current three year term o f the existing Management Teams expire (two years with a possible one-year extension). It i s equally recognized that the banks should not revert to o ld management practices. I t i s

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therefore necessary to include funding for a contingency to cover the costs o f continuing management team support up until the point o f privatization. I t i s felt, however, that the pre-privatization restructuring process will take longer than three years.

These components were established based upon the experience in other comparable projects (such as the Pakistan Banking Sector Restructuring and Privatization Project). This experience has shown that, while the agreed objective for banking sector restructuring worldwide i s to transfer ownership to “fit and proper” private sector owners (ideally international banks), this i s diff icult to achieve in South Asia. Experience in the region has indicated that private sector buyers, particularly o f the caliber and reputation that one would l ike to attract, do not wish to be bogged down in the process o f reducing staff numbers and closing branches. Buyers have also indicated that a necessary prior condition i s to have credible accounts and a basic computerized core banlung solution system in place. Also core in a successful systemic revitalization o f the banking sector i s a concerted and lasting improvement in the quality and reach o f banking supervision exercised by the regulator to oversee the newly private banks. A substantive element o f restructuring o f the NRB and training o f staff was included in the FSTA, however, given the importance, additional funds have been dedicated to this end in this project.

4. Lessons learned and reflected in the project design The OED Performance Audit Report for the Second Structural Adjustment Credit (Credit 2046-NEP), M a y 17, 1995, concluded that: “The basic cause o f the weakness o f the financial sector design [in that project] was:

(a) Lack o f commitment by the Government to change i t s basic attitude towards the state-owned banks, including a much stronger emphasis o n commercial orientation and o n preparation for eventual privatization; Absence o f an Act ion 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 Lack o f specific fundamental reforms needed to achieve a major improvement in financial and operational performance o f the banks.”

(b)

(c)

The current operation has dealt with these lessons by not proceeding with IDA financing until there has been upfront action by the Government to carry out fundamental reforms in banking supervision generally and in the governance arrangements within the state-owned, in particular - starting with the placement o f external management teams in the two banks. The development o f an overarching framework for financial sector reform - as encapsulated in the FSSS - has also helped ensure consistency and commitment. In addition, the three-phase approach has been designed to build upon the strong foundations o f the FSTA and has allowed HMGN ample opportunity to demonstrate commitment to reform and willingness to confront diff icult issues. The Letter o f Financial Policies (see Annex 12) are key recent steps that have been taken to strengthen the legal framework and also provides further evidence o f the Government’s strong commitment to reform in this sector.

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

(a) Sustainable banking sector reforms require that the autonomy and technical s k i l l s o f the regulator be enhanced. Under the FSTA, steps have been taken to enhance the bank supervisory s l u l l s o f NRB so that it can become increasingly professional and autonomous; The legal framework i s critical to ensure successful implementation. The F S T A has supported the revision and modernization o f key banking legislation. A new NRB Act, a new Banking and Financial Institutions Ordinance, the establishment o f a Debt Recovery Tribunal, and a Blacklisting directive.

(b)

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Sequencing i s important for successful financial sector reform. Partial strengthening o f the Central Bank, has already been carried out as a precursor to this project, and continues to be a high priority within the program o f commercial banlung reform; Reforms should focus on a limited number of key activities. This project will support a purposely l imi ted agenda o f focused activities; Forcing reforms from outside i s not sustainable. Strong borrower commitment produces the greatest chance o f success - a commitment evidenced by the FSSS, the appointment o f the management teams in the banks, and the on-going close liaison between NRB and the MoF; Re-capitalizing commercial banks without fundamental reforms in ownership and governance structures i s not likely to be successful. Any injection o f capital into RBB and NE3L will only be supported at the point o f privatizatiodliquidation or some other acceptable change in governance arrangements in these banks; Project components which have been pre-designed and are already under implementation have the greatest chances o f success. In this respect, the VRS - the largest monetary component o f the proposed project - has been completely pre-designed to a level acceptable to the Wor ld Bank, and i s currently being operationalized. Project implementation initially suffers due to slow procurement and disbursement. In the past, under the FSTA, NRE! did not have experience handling Bank procurement. This has been mitigated by the recruitment o f a Procurement Expert.

5. Alternatives considered and reasons for rejection An alternative approach to dealing with Nepal’s financial sector problems could be to pursue a broader financial sector reform agenda on a wide range o f fronts to a large array o f institutions - particularly some o f the other weak (but significantly smaller) privately-owned commercial banks and the two development finance institutions. However, given the primacy o f the problems in the Central Bank and the two largest commercial banks, in combination with the Government’s own l imi ted implementation capacity, the project team decided to focus o n a narrower agenda o f issues. This l imi ted and more focused agenda i s l ikely to have the biggest impact.

Another option would have been to press for the immediate closure o f one o f the two troubled banks - or for their merger. Whi le the prospect for closure o f at least one o f the two banks has purposefully been retained within the program design, i t has been recognized that given the severely challenged political circumstances in the country, i t would be unrealistic to insist upon this requirement. I t has been ensured, however, that the abil ity o f either bank to extend lending operations has been severely curtailed.

The possibility o f processing the project as an adjustment operation was also considered. However, i t was determined that an investment operation would achieve the objectives o f the project better as disbursement would be tied strictly to full implementation o f the reform measures. In addition, there was an important need for on-going technical assistance to ensure smooth implementation o f the project - such as the sales advisors and the NRE! re-engineering technical support - which were better suited to an investment operation.

C. IMPLEMENTATION

1. Partnership arrangements The Department for International Development o f the UK (DFLD) i s a co-financier o f the on-going F S T A (through a grant o f USSlO.0 mill ion). Whi le not financing the Phase I1 operation, DFID has been closely involved in al l the design o f the current project and has contributed significantly to certain elements. The Bank i s also working extremely closely with the IMF o n the financial sector reform agenda - which features prominently in the Poverty Reduction and Growth Facil ity (PRGF). Close cooperation with the

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ADB has also been developed to ensure that the development bank reforms are carried out in a consistent manner.

2. Institutional and implementation arrangements Nepal Rastra Bank will be responsible for the implementation o f the project. This agency has been selected due to i t s success in this capacity in the FSTA, and i t s established (albeit limited) cadre o f competent and committed reformers and i ts central role within the Nepalese financial sector. As institutional and implementation arrangements for the predecessor project have already been developed within NRB these will continue to be used to oversee the implementation o f the current operation.

Financial Management (FM). The Coordination and Support Team (CST), in the NRB, under the direct supervision o f an executive director will be responsible for overall financial management activities under the project. There are experienced FM staff in the CST and additional staff will be appointed to support the FM work under the proposed project. Uti l ization o f IDA’S share o f eligible expenditure will be undertaken through a Special Deposit Account (SA), opened by NRB, under terms and conditions acceptable to IDA. The Executive Director (ED) will continue to work as CST coordinator in the new project and will be authorized to issue checks, make payment requests to the CST, and withdraw funds f rom the IDA financing. The SA will be managed under the jo in t signature o f the ED and the FM expert with a provision for an alternate signature o f another Assistant Director (finance).

For counterpart funding, HMGN will ensure the timely release o f funds to the CST through a separate project bank account. The weakness identified in the FM assessment have been addressed by an agreed time bound action plan.

3. Procurement The procurement consultant currently contracted for the CST has sufficient ski l ls for procuring goods and some hands-on experience with consultant selection contracts and IT procurement. However, the sk i l l s of the staff supervising the consultant in areas such as consultant selection, contract administration (especially o f consultant contracts) and overall project procurement monitoring may need upgrading. This i s important given that Phase I1 calls for many significant novel consultant contracts whose selection procedures, documents, etc. need to be carefully designed. NRB may consider solutions - such as sending the CST staff for specialized training in consultant selection and contract administration.

Continuation o f the current Phase I into the proposed Phase I1 entails the procurement related actions described below.

0 Continued Management Support: I t i s vital to have experienced management teams in the two banks until the process o f privatization i s completed. Consequently, i t i s suggested that on completion o f the current contracts funded f rom the on-going F S T A in 2005 and 2006, a new management contract be negotiated on a sole-source basis subject to justification or o n a competitive basis, for the duration o f the proposed second phase (up to the point o f privatization).

0 Procurement of computers, I T systems: As a part of the NRB re-engineering component NRB needs to acquire hardware, software and networking for the development o f i t s IT system. During Phase I, the CST at the Central Bank, with the guidance and assistance o f the IT experts in the two management teams, successfully carried out an IT procurement for RBB and NBL. Thus it i s considered that NRB has the capacity to undertake i t s remaining IT procurement needs. Whi le simple purchases such as computers and printers for Banking Supervision shall be procured through NCB, given the estimated cost and complexity o f the items, procurement o f the IT platform will be carried out using I C B procedures.

9

0 Hiring o f sales/privatization advisors: This i s a large and complex contract - and hence QBS or QCBS with a 70-30 split in the technical/financial evaluation i s anticipated.

Risks Risk Mitigation Measures Risk Rating with

Mitigation Political - Given the fragile security situation and continuing pol i t ical uncertainty, there i s a possibil i ty that

reversed. At the extreme, the situation m a y deteriorate so as to severely undermine government institutions.

The Bank has attempted to maintain good lines o f communication with politicians across the spectrum. N o single pol i t ical group, including those o f the far left

distressed banks. Overall pol i t ical support i s l ike ly to continue since the project reflects HMGNIMoF ’s priorit ies o n banking

the reform process may be stymied or has indicated opposition to the restructuring o f the M

4. Monitor ing and evaluation o f outcomeshesults Short to medium-term success wil l be realized when improved capabilities in RBB and NBL begin to exert competitive pressures for better banking services. The long-term success o f the project wi l l be realized, however, only when both RBB and NBL have been sold to fit and proper private sector owners. The price achieved for the banks will not be a factor in determining success, but the quality o f the buyer will be important. This aspect will be monitored in a transparent fashion by the NRB and by the privatization advisers recruited under the project. Separate indicators have been established and will be separately monitored for the IDA Grant component (Please refer Annex 3).

Given the country’s economic constraints, MoF’s Foreign Aid Policy does not espouse taking a loan to finance TA components involving hiring o f intemational consultants. However, i t i s essential that Sales Advisors for privatization (component two) and Consultants for Phase I1 NRB Re-engineering (component three) be o f intemational caliber and hence, we have proposed to finance these components by IDA Grant.

5. Sustainability HMGN has already demonstrated i ts commitment to take hard polit ical decisions in the face o f the need to stem the growth o f non-performing assets within the two state controlled banks and the banking sector as a whole. Working closely in accordance with the conditionality established for the IMF’s PRGF the govemment has already undertaken far reaching legislative and regulatory reforms.

One factor which will be critical to the continued success o f the project will be for NRB to take necessary steps, as per the proposed amendment o f Section 86 o f i t s Act, to deal with the existing private sector shareholders. Steps to this end are currently in progress - including the December de-listing o f NBL shares f rom the Nepal Stock Exchange and an amendment to the Nepal Rastra Bank Ac t to give it greater powers over troubled banks. I t will also be critical to ensure that legislation passed by ordinance i s not subsequently revoked.

Close coordination with the IMF, DFID, the ADB, and the rest o f the donor community will also help ensure that the reforms implemented will remain in place regardless o f changes in govemment (in that donor funding i s indispensable to support on-going development programs). Additional steps, including enhanced reporting of the reform efforts and holding regular meetings with stakeholders, are under way to ensure that there i s sufficient popular support for the reforms being implemented and that the value o f these measures i s broadly understood across the polit ical spectrum.

6. Cri t ical risks and possible controversial aspects The project i s susceptible to the fol lowing key risks:

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Risks

Bureaucratic or pol i t ical interference ir institutional change related to increase( transparency, stakeholder participation. and decision making.

Agitat ion f r o m local advocacy groups (labor unions, etc.).

The VRS may fail. In the face o f limited alternative employment opportunities in a weak economy, bank employees may be unwi l l ing to accept V R S terms - ultimately frustrating the privatization o f the banks.

Lack o f support f rom local and nationa government el i tes.

Defaulters and other vested interests. The process o f re form hurts many influential groups - particularly those who have habitually defaulted to the government banks or have benefited f rom poor standards o f governance.

Private shareholders o f NBL may be disruptive, NBL i s only 41 percent owned by HMGN.

VRS Adverse Selection. There i s a r i s l that severance packages may encouragc good performing staff to leave and mediocre staff to remain in the banks.

Risk Mitigation Measures

reform and i s strongly supported by h igh level c i v i l servants.

Appropriate recruitment and training procedures for project personnel would be established, coupled with incentives to reward good performance. Assurances are being sought f r o m HMGN that qualified key personnel wi l l remain in place during the lifetime o f the project. Efforts have been made to actively involve a l l stakeholders, across a l l levels o f employees, to generate support and ownership. Ensuring that project design and implementation adequately reflect people’s needs; that transparency and accountability are addressed; and that interventions and outcomes benefit workers.

This component has already commenced and results f r o m the First Phase implementation indicate that around 50 percent o f the designated staff have accepted the VRS. A Second Phase i s expected to net the remaining targeted excess staff.

HMGN will engage in dialogue about sound banking practices. A multi-sector partnership between the government, private banking sector, and media, and others i s required to facilitate publ ic accountability measures to help build public pressure for more sustainable corporate practice.

HMGN has demonstrated increased willingness to confront vested interest groups. The recent establishment o f the Debt Recovery Tribunals and the new Blacklisting Directive are further evidence o f a commitment to fundamental reforms and a willingness to face up to vested interests.

Trading o f NBL shares has been suspended with a commitment to de-list f r o m the Nepal Stock Exchange (NEPSE). NRB has committed to take full control o f NBL using enhanced powers in the NRB Act.

The management o f both banks maintain that the level o f overstaffing i s so h igh and the level o f expertise so l o w that targeting i s not required (although some staff wi l l be encouraged to stay). The scheme i s also at the mutual consent o f both parties - hence bank management can rehse an application f r o m a particularly good performing staff member.

Risk Rating with

Mitigation

M

S

M

M

S

S

M

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Risks Risk M i t i g a t i o n Measures Risk R a t i n g with

M i t i g a t i o n V R S Overpayment. Retrenchment Bo th RBB and NBL have conducted personnel reviews

rograms should first exhaust ossibilities for disciplinary actions and

he elimination o f payro l l fraud arising f r o m ghost workers and improper iring. i oral Hazard. An important concern

lfor the Bank i s to ensure that workers

to ensure that employees who have been improperly hired (e.g. with forged education certificates) may not participate in the VRS. Based o n this, both banks have suspended a number o f employees.

I staff for the workers who accept the VRS. A survey ofl

bubl ic sector institutions.

ho have received severance packages rehired by the same enterprise 01

if it remains in the public sector the extent monitorable, by other

I restructuridg process. I

M

a l l employees who leave the two institutions i s included in the project. The Government has also

that it wi l l privatize these banks at the end o f the signed a Letter o f Financial Sector Pol icy indicating M

Risk Rating ; H (High Risk), S (Substantial Risk), M (Modest Risk), N (Negligible Risk)

7. Loadcredit conditions and covenants There i s n o conditionality pertaining to this financing. Nonetheless, the understanding between the Wor ld Bank and HMGN, and as la id out in the Letter o f Financial Policies, i s that Nepal Rastra Bank will continue to exert full control over Nepal Bank L imi ted under Section 86 o f the NRB A c t until the bank i s privatized. HMGN will also ensure that the existing shareholders o f NBL do not benefit f rom the restructuring exercise and do not impede the restructuring process. The Govemment will ensure this by maintaining the suspension o f trading o f NBL shares until privatization and ensure that the shares are delisted f rom NEPSE by the end o f 2003; by writing down the capital o f NBL prior to privatization; by divesting the shares o f current shareholders to “fit and proper” persons; and if writing down capital i s not possible - by moving with the process o f vesting NBL to a fit and proper institution.

D. APPRAISAL S U M M A R Y

1. Economic and financial analyses Analysis undertaken by the Management Teams in both RBB and NBL indicate that the payback period f rom implementing the VRS i s about two years. This indicates an extremely good retum on the investment f rom this credit - ranging f rom 48 to 59 percent per annum. These analyses are in l ine with work undertaken o n the cost-benefit experiences with VRS schemes in other banks in South Asia (Sri Lanka, India, Palustan, Bangladesh) - and with VRS schemes in state-owned enterprises in the region. The 8-10 year payout to these bank workers appears to be large -but i s also consistent with other experiences in South Asian public sector institutions which indicate that payouts are high, but payback periods are extremely low.

2. Technical Most o f the technical design work for the project has been undertaken by experts working in the Management Teams in the two commercial banks, or by the re-engineering team operating in the central bank. These long term, experienced professionals have ensured the utmost care in designing the best possible technical solutions to the problems at hand.

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3. Fiduciary The proposed project has strengths in the area o f financial management. The existing Financial Management expert has familiarized himself with the Wor ld Bank’s FM policy and procedures and he will continue worlung in the new project. Moreover, the need for additional support, in the form o f a finance officer, has been identified - and he/she will be in place by March 3 1,2004. The high level commitment o f the government and N R B ’ s senior management to various reform activities will greatly contribute to addressing any potential problems arising during project implementation.

A weakness i s the inadequate logistical and other administrative support to the CST. The CST i s operating in a constrained environment with insufficient staff. Financial information i s maintained in spreadsheets, but there i s scope for computerization o f accounts to keep track o f project expenditures, compilation, and reporting -but this will require additional staffing support. The CST plans to be upgraded with additional computer equipment under the current Project. The other FM staff are also well conversant with the Wor ld Bank’s FM policies and procedures. Overall, the FM arrangements for the project are adequate at the init ial stage o f project implementation. However, these need to be further improved in the areas indicated in the FM assessment to ensure a satisfactory FM system throughout the project implementation period. Annex 7 includes a detailed FM assessment - with an Act ion Plan.

4. Social The social implications o f the implementation o f the V R S in the banks could be considerable. Whi le there are n o safeguard issues anticipated, there are l ikely to be important social impacts on the lives o f those who choose voluntary retirement. These will vary according to the personal circumstances o f individual employees. Whi le the full range o f r i sks have yet to be determined, some potential r isks include: (i) the inabil ity o f employees to re-enter and compete in the l imi ted j o b market, either within a reasonable timeframe, or in a sustainable manner; (ii) as most Nepalis s t i l l l ive in a jo in t family system there will be socio-economic ramifications on a population exceeding the estimated 4,700 employees who may choose to participate in the VRS scheme’; and (iii) many o f the more standard approaches to re- training may not be an appropriate in the local cultural context. For this reason, a l l initiatives taken to mitigate potential adverse impacts have been developed keeping local circumstances in mind. The project team i s working closely with DFID to undertake an Ex i t Survey o f the workers leaving the banks. The purpose o f this Exit Survey will be to understand not just the economic, but also the socio-cultural ramifications o f the project’s affected population. This will then be followed by regular Social Traclung Surveys o n a sub-set o f retirees - undertaken every six months. These tracking methodologies will permit the government, the banks, and the Wor ld Bank to have on-going feedback o n the social impact o f the implementation o f the VRS and to adjust policies accordingly. In addition, the project team has met with focus groups consisting o f bank workers who have applied for the VRS - and the unions which represent them - and have discussed their future needs in a post-retirement era.

5. Environment There are n o environmental issues arising f rom this project.

6. Safeguard policies

Safeguard Policies Triggered by the Project Y e s N o Envi ronmenta l Assessment (OPBP/GP 4.01) [I [XI Na tu ra l Habi tats (OPBP 4.04) [I [XI

’ Whi le the situation varies according to household, gender relations in Nepal often entail a male fami ly head who has primary economic responsibly for his immediate as we l l as extended fami ly members (that may include elderly parents, cousins, and widows). I t i s not known at this t ime the extent to wh ich this is a pertinent issue o r not.

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Pest Management (OP 4.09) [I [XI Cultural Proper ty (OPN 11.03, be ing revised as OP 4.1 1) [XI Invo lun ta ry Resettlement (OP/BP 4.12) [I [XI Indigenous Peoples (OD 4.20, b e i n g revised as OP 4.10) [XI Forests (OP/BP 4.36) -[ 1 [XI Safety o f Dams (OP/BP 4.37) [I [XI Projects in D ispu ted Areas (OP/BP/GP 7.60)* [I [XI Projects on Internat ional Waterways (OP/BP/GP 7.50) [I [XI

[I

[I

7. Policy Exceptions and Readiness

(a) Exceptions. T w o exceptions to normal Bank pol icy have been agreed for the current project. The f i rst o f these i s the application o f 35 percent retroactive financing - above the normal 10 percent generally applied. This has been discussed and supported by Bank management. This exception i s necessary to meet the VRS costs which are currently being incurred in advance o f project approval and i s designed to support the current momentum for change which exists within the financial sector reform process. The second issue (not really an exception) which i s also approved by Bank management - i s financing o f the VRS within NBL (legally a private sector institution), o n the basis that this institution i s effectively controlled by the Govemment (the central bank has replaced both the Board and the Management o f this bank). The pol icy on VRS payments refers to control rather than ownership and Nepal Bank L imi ted meets the test o f public control through the management and board. In addition, however, NRB i s putting in place a series o f measures which will ultimately lead to the legal assumption o f this bank. These measures include suspension o f trading o f NBL shares o n the stock exchange; delisting o f the shares f rom the exchange; amending the central bank act to provide it with greater powers to deal with a troubled bank; writing down the capital o f NBL prior to privatization; and by ultimately divesting the shares o f current shareholders to “fit and proper” persons. If writing down the capital proves legally challenging, then NRB will altematively move ahead with the process o f vesting NBL to a fit and proper institution.

@) proposition that the project already has an in-built momentum which the Wor ld Bank i s eager to support. The VRS has been designed and i s already being implemented in advance o f project approval. Other components are also at an advanced stage o f preparation and will be ready for implementation immediately upon effectiveness. The NRB components will fo l low on from the work already on-going within NRB. Consequently, the project i s ready for immediate implementation and init ial disbursements should be high to cover payments made in advance o f project effectiveness.

Readiness. The requirement for larger than normal amounts o f retroactive financing supports the

’ By supporting the proposedproject, the Bank does not intend to prejudice the f inal determination of the parties‘ claims on the disputed areas

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Annex 1: Country and Sector o r Program Background NEPAL: Financial Sector Restructuring Project

Country Background. Nepal remains one o f the world’s poorest countries, with an annual per capita income o f about US$240 with many indicators showing a bleak quality o f l i fe. Progress in the fight against poverty has been hampered by a number o f factors, including a succession o f unstable Governments. More recently, the challenge has intensified with the continuing insurgency and lingering instability in the Government. Security concerns have been heightened by the August 2003 collapse o f the ceasefire agreed with the insurgents and there i s a fear o f wider c iv i l disturbance. Together with the global economic slowdown that has affected Nepal’s trade-dependant economy harshly, these domestic events have led to a sharp downturn in economic activities. Related to this i s potential fiscal stress, as public spending i s up on account o f security needs. Meanwhile, there i s widespread bel ief that the insurgency i s fundamentally a challenge to a state that has not proved itself to be effective.

Financial Sector Background. Nepal has 17 commercial banks, 2 large banks (RBB and NBL) which dominate the sector; 6 Joint Venture Banks, which are mixed NepaWforeign owned (this group being constrained to a maximum 67 percent foreign ownership); and 9 local banks. In addition, the sector also includes 2 large development banks - the Agricultural Development Bank o f Nepal (ADB/N) and the Nepal Industrial Development Corporation (NIDC), 54 finance companies, 13 insurance companies, numerous micro-finance institutions, 7 Grameen Replicator Banks, 35 financial cooperatives, 25 financial Non-Government Organizations (NGO’s), and a stock exchange. The two largest commercial banks - Rastriya Banijya Bank (RBB) and Nepal Bank L imi ted (NBL) - account for around 50 percent o f total banking system assets, and are in a very precarious financial position. Political intervention, weak management, poor financial information systems, and a deeply entrenched culture o f non-repayment o f loans have resulted in a rapid deterioration o f their financial health. RBB, which represents 27 percent o f commercial banking system assets, i s estimated to have 71 per cent non-performing loans. Although in slightly better financial condition, NBL has similar problems including around 59 percent non-performing loans. This could have serious ramifications for the Government in terms o f systemic risk and could prove to be a severe financial strain on an already delicate budget should either o f these two banks face a crisis o f confidence with concomitant adverse macroeconomic implications. The 2003 unaudited accounts for RBB and NBL indicate that these two banks had estimated accumulated deficits, as o f mid- 2003, o f approximately $435 mi l l ion - equivalent to around 7 percent o f GDP. Bo th NBL and RBB have made significant progress in reducing their operating losses since professional management teams assumed control o f their operations in mid and late 2002 respectively (supported by a W o r l d Bank Phase I Financial Sector Technical Assistance (FSTA) credit).

I t i s understood that the financial condition o f the two large development banks has deteriorated in a fashion comparable to that o f RBB and NBL. The financial position o f ADB/N and NIDC is currently in the process o f being appraised by the Asian Development Bank (ADB) and a restructuring plan for these institutions will be put in place, in time, supported by the ADB.

In general, Nepal’s financial system suffers f rom the fol lowing problems that are also recognized by the Government:

(a) in the financial sector. From ownership o f key financial institutions such as RBB, ADBN, the Grameen banks, the largest insurance company, the stock exchange, the largest investment company, and, until recently, Nepal Bank Limited (where it remains the largest single shareholder); to significant influence over the Joint Venture Banks (where, until recently, the government nominated a director for each bank); the Government’s involvement i s evident in almost every aspect o f financial sector activity. This has

The Government’s Role. H i s Majesty’s Government o f Nepal (HMGN) plays a large direct role

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resulted in strong polit ical interference in banlung activities which, in turn, has resulted in non-repayment o f loans, and poor financial health throughout the system.

(b) Nepal Rastra Bank (NRB) -the Central Bank. Until January 2002, when a new NRB Ac t was approved, the NRB fell under the authority o f the Ministry o f Finance. T h i s historical lack o f autonomy hindered the N R B ’ s abil ity to supervise and regulate the banking system adequately. Political influence in RBB and NBL - as wel l as their sheer dominance within the banking system - placed these banks outside the influence and control o f the central banking authorities. Although s t i l l requiring significant development in several material areas, the 2002 Nepal Rastra Bank A c t provides the NRB with basic autonomy. The full authority o f the NRB over the entire banking system has been further established by the recent Cabinet approval o f the Banking and Financial Institutions Ordinance. Improved banking regulations, now being implemented, have also provided the regulatory basis for NRB to move the system closer to international banking norms while permitting the bank supervisors to deal expeditiously with errant banks. The NRB i s supported in this endeavor through a substantive program o f capacity building f rom a resident team o f international banking experts supported under the Financial Sector Technical Assistance Project.

(c) Rastriya Banijya Bank (RBB) i s 100 percent Government owned. RBB i s the biggest o f Nepal’s commercial banks with deposits o f approximately Rs 40 b i l l ion representing some 25 percent o f the Nepali banlung system. RBB i s technically insolvent with high levels o f non-performing assets (NPAs). RBB had a negative net worth estimated in the region o f US$300 mi l l ion as o f July 2003. The professional management team supported under the IDA F S T A Project commenced work in the bank in early 2003 - the new CEO, recruited o n a fixed-term contract, joined the bank o n January 16* 2003 but it was not until late February 2003 that the rest o f the team followed him. In variance to the original concept, each member o f the management team has been hired individually.

As a consequence o f the on-going insurgency, the number o f branches has been reduced f rom more than 200 to around 130 nationwide and the total number o f staff in the bank i s being reduced f rom 5,522 to a target figure close to 3,200 through a Voluntary Retirement Scheme (VRS) launched in September 2003. At the same time a process o f computerization i s underway and some 42 branches are being brought online using the IB IS core banking solutions system. RBB continues to suffer f rom a high percentage o f non-performing loans although performance in this field i s improving under the guidance o f the new management team.

(d) Nepal Bank Limited (NBL). The financial condition o f NBL has also been significantly impaired, but not to the same extent as RBB. NBL i s the second largest bank in Nepal with deposits o f Rs 35 bil l ion. I t i s also the oldest bank in Nepal, established in 1935. Originally, the Government owned the entire bank but the government’s shareholding was sold down throughout the 1990s to reach 41 percent. This disinvestment by HMGN was carried out with the objective o f reducing polit ical interference in N B L ’ s management and promoting private sector participation in the bank so that i t could operate in a more commercial and business-like manner. The Government’s pol icy o f successively selling shares to the general public has, however, lef t the bank without a single strategic partner with a strong background in commercial banking and international linkages with the global economy. Connected lending activities by the new private owners are thought to have further compromised i t s operations.

Since the mid-1980s when the banking sector was opened up to foreign competition, NBL has been losing out to the newly established jo in t venture banks. N B L ’ s profitabil ity has correspondingly declined. The main reasons for this decline in profitabil ity have been: (i) a deposit mix which involves a disproportionately large share o f high-cost funds (ii) a large branch network comprising various rural and other non-profitable branches throughout the country, (iii) staffing levels which are in excess o f actual

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requirements, (iv) l o w recovery rates on loans, (v) manual accounting systems and inadequate automation compared to the size o f operations, (vi) poor service delivery, and (vii) not being able to respond to market demandtrends

Making use o f the support made available under the F S T A Project, HMGN decided to bring in professional management to take over control o f the bank. The Bank o f Scotland management team took over the day-do-day running o f NI3L in August 2002. In i t ia l main areas o f focus for the new management team have included, producing credible audited accounts for 2001 and 2002, designing and developing a minimum Information Technology (IT) platform for the bank, developing appropriate human resource policies for the staff, strengthening i t s treasury management function, and identifying non-performing loans (NPLs) and establishing a loan recovery unit to deal with these NPLs.

Through a voluntary retirement scheme, NBL i s in the process o f reducing i t s payroll f rom 5,270 to a new total o f around 3,000 employees. As with RBB, the branch network l u n s nationwide and i s being rationalized to a total modestly in excess o f 100 branches, 44 o f which are just now coming online. The management team has achieved reasonable success in the recovery o f non-performing loans - and expectations o n recoveries in the current year are expected to be even more favorable. HMGN has agreed to reestablish control o f the bank to expedite the restructuring process and the process o f de-listing the bank f rom the Nepal Stock Exchange i s under way as a f i rst step to this end.

(e) The Agricultural Development Bank of Nepal (ADB/N). The financial and operational situation o f the ADB/N, the third biggest bank in Nepal, i s also extremely poor. The ADB/N will require restructuring, system development, changes in governance arrangements, and a review o f i t s ultimate role and ownership arrangements. Reform in this bank i s being supported by the Asian Development Bank. Close coordination between IDA and the ADB means that reforms made in RBB and NJ3L are l ikely to be replicated in ADB/N to ensure a consistency o f approach.

( f ) i s noteworthy, Nepal has historically suffered fi-om a proliferation o f both laws and regulations that are institutionally rather than functionally focused. This has created a fi-agmented legal environment.

A Weak and Fragmented Legal Financial Environment. Although recent progress in this area

0 The Nepal Rastra Bank Act, n o w superseded by a January 2002 Act, was seriously outdated and deficient with respect to issues o f central bank autonomy, accountability, and governance. N o w that new legislation has been approved, the challenge will be to ensure that NRB can effectively enforce the provisions enshrined in the new legal and regulatory environment.

The 1974 Commercial Bank Act i s also defective. Mos t importantly, the act does not cover a l l deposit-taking institutions. Other nonbank deposit-taking institutions are governed by their own laws (e.g., the Agricultural Development Bank A c t o f 1967). A proliferation o f laws covering various classes o f deposit-takmg institutions has permitted legal arbitrage. NRB has recently completed drafting a new Banking and Financial Institutions A c t that covers al l major deposit- taking institutions. This A c t was approved by the Cabinet in October 2003.

Ancillary Laws. Once the above two key pieces o f legislation are fully in place, it will be important to ensure that other ancillary laws are developed in support o f a modem banking system. N e w legislation i s required in such areas as Secure Transactions, Insolvency, and a new Company Act.

(g) auditing tradition has meant that the timeliness and reliabil i ty o f financial data (particularly f rom the largest banks) i s extremely poor. Corporate sector accounting i s also weak, making lending decisions

A Weak and Fragmented Accounting and Auditing Environment. A weak accounting and

17

diff icult for the banks. If Nepal’s financial system i s to operate in a prudentially sound and efficient manner, strengthening o f accounting and auditing i s essential. The recent progress made, in this respect, within the two largest commercial banks by the newly instituted management teams, i s noteworthy.

(h) Competition in the Banking Sector. Reform o f the state-owned banking sector i s being designed to reduce fi-agmentation and support the more efficient intermediation o f funds within the banks and nonbanks. This will increase competitive pressures and thereby provide more efficient and cost-effective solutions to the banking public.

(i) 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; the general public’s l o w level o f financial sophistication means that i t does not serve as an effective check and balance within the system; the Nepal Stock Exchange remains a weak and ineffectual institution within the financial system; and access to finance for many mill ions o f rural Nepalis s t i l l remains a critical lacuna. These weaknesses also require attention, and call for urgent reform and modernization. Nepal needs to create the preconditions fgr the development o f an efficient banking system that i s capable o f 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 i s a long and complex process that will take many years, particularly given the very l o w starting point in Nepal.

(j) measures in the financial sector. These include interest rate deregulation, the phase out o f Statutory Liquidity Requirements (SLR), reduction in the Cash Reserve Requirement (CRR); introduction o f modem banking regulations, capital market reforms, and foreign exchange liberalization. However, much s t i l l remains to be done, particularly with respect to institutional reform. To help establish a fi-amework for the way forward, the Government formulated a Financial Sector Strategy Statement (FSSS) that consolidates i t s 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 English press at the end o f 2000. The desire for reform in the financial sector i s further reflected by the fact that the Government has asked for, and secured, Wor ld Bank, IMF, and UK Department for Intemational Development (DFID) assistance to proceed with the reform agenda. In i t ia l support has been provided through the Financial Sector Technical Assistance credit, with jo int IDA-DFID financing.

Government Strategy. Over the past few years, the Government has undertaken general reform

The main elements o f the FSSS sector strategy include (some o f which has already been implemented):

0 Reducing the role o f the Government in the financial sector as a direct owner o f financial institutions while strengthening i t s ro le as a supervisor and regulator o f banks and financial institutions; Requiring strong corporate governance by ensuring that banks (in particular the two largest commercial banks) are owned and managed by “fit and proper” private investors; Strengthening the role o f Nepal Rastra Bank in the overall financial system by drafting a new central banking A c t to provide sufficient autonomy in the conduct o f monetary policy, banking system regulation and supervision, and the licensing o f banks and nonbanks; Improving existing banking and financial legislation and judicial processes for enforcing financial contracts; Improving auditing and accountancy standards within the banking sector; and Promoting financial discipline through adequate disclosure and competition.

0

0

0

0

0

18

The reforms in the financial sector, particularly with respect to the state-owned banks, require strong polit ical commitment. As in many countries, bank restructuring issues are difficult. T o date, the Govemment o f Nepal has demonstrated a seriousness and commitment to the banking reform agenda and has not wavered in moving ahead with the diff icult agenda at hand. Actions taken so far provide the Wor ld Bank with comfort that the Govemment i s willing to transparently and decisively address the issues at hand.

PROGRESS UNDER THE FINANCIAL SECTOR TECHNICAL ASSISTANCE CREDIT

The FSTA, approved in December 2002, has three essential components. The f i rs t i s a Re-engineering Team which has been placed into Nepal Rastra Bank, the second i s a professional Management Team in Rastriya Banijya Bank, and the third i s a professional Management Team in Nepal Bank Limited. The NBL team has been in place the longest (mid-2002) while the teams in NRB and RBB commenced work in early 2003.

The re-engineering team in Nepal Rastra Bank i s considered extremely important as i t i s working o n professionalizing the central bank and getting the bank to focus more o n i t s core central banking functions. In this process, the NRB, by i t s own volition, has reduced staffing levels f rom around 2,400 to a current level o f under 1,800. However, with only around 380 professional staff in the bank, it s t i l l remains highly overstaffed with under-slulled personnel.

Nepal Rastra Bank. The Nepal Rastra Bank Re-engineering Team financed by the F S T A comprises:

Human Resource Support. A Human Resources expert has been placed in the bank in an effort to help with designing appropriate Voluntary Retirement Schemes to reduce staffing levels to more appropriate levels; to assist in the outsourcing o f non-core functions f rom the bank; to draft a new set o f “international best practice” HR policies for the staff which reward performance over time in grade; to draft j o b descriptions; to design a new salary and compensation package; and to help develop a more appropriate organization structure for the central bank. Most o f these activities are o n track.

Accounting Support. A team o f accountants has been put in place to assist in drafting a new accounting manual for the central bank and to assist the Accounting Department bring the accounts o f the bank up to International Accounting Standards. There are also issues o f timeliness o f accounts with which the team i s also assisting.

Banking Supervision Support. The project also supports an On Site and an Off Site Bank Examiner to assist the Bank Inspections Departments (Bank and Non-Bank) bring their capacities closer to international levels. Whi le the F S T A project has focused o n RBB and NBL there i s also a need to ensure that the other commercial banks in the system are operating prudently and in l ine with established norms. Developing the bank supervisory capacity o f NRB, however, i s considered to be a longer term endeavor and additional substantive assistance will be provided under the current operation.

Oversight o f the Two Management Team Contracts. In the absence o f a capacity to take over the two large troubled banks (RBB and NBL) as a conservator, the Nepal Rastra Bank has employed the services o f two professional management teams. However, given l imited capacities within NRB, it also requires assistance in overseeing the work o f these two management teams. The experienced banker in this position i s meant to provide the liaison and oversee the work o f the two professional management teams; to ensure that they meet their agreed performance

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benchmarks; that they report on a timely basis; and undertake al l contractual agreements as required. This support to NRB i s designed to assist the central authorities oversee these two contracts in a rigorous and professional manner.

Some o f the notable milestones that have been achieved are cabinet approval o f Banlung and Financial Institutions A c t and amendment o f NRB Ac t that empowers the Central Bank to take action against troubled banks; development o f a stronger blacklisting mechanism and better equipped Credit Information Bureau; formation o f a Debt Recovery Tribunal; formulation o f a two-year program o f on- site supervision o f commercial banks; production o f NRB accounts as per statutory requirement; adoption o f a new organization structure and a revised HR Policy; and reduction in staffing f rom 2,400 to around 1,700.

Rastriya Banijya Bank and Nepal Bank Limited. The two management teams include eight professionals - roughly split 50/50 between foreigners and Nepalis. The positions held in both institutions are (a) Chief Executive Officer; (b) Chief Credit Officer; (c) Loan Recovery Officer; (d) Chief Human Resources Officer; (e) Chief Information Technology Officer; (0 Chief o f Treasury; (g) Chief Audit Officer; (h) Chief o f Internal Audit; and (i) Chief o f Branch Operations. The fol low describes some o f the progress made within these two banks with respect to the restructuring process.

(a) Financial Health o f the Banks. Under the stewardship o f the two management teams both banks have made significant progress in improving their financial position as wel l as reducing operating losses. F rom a loss in excess o f Rs 3.0 b i l l ion in 2001/02, NBL has managed to reduce losses to Rs 28 1 mi l l ion in 2002/03 - remarkable by any standard. NBL i s confident that they can make an operating prof i t in 2003/04. I t s costlincome ratio improved f rom 455 percent in 2001/02 to 125 percent in 2002/03. Whilst the NPA level remains high (58 percent as o f July 2003), i t has recovered Rs 2.7 b i l l ion worth o f non-performing assets, as cash recoveries, since taking over the management and has created adequate provisions to cover loan losses. However, total net worth i s sti l l negative Rs 10 b i l l ion ($135 million).

Similarly RBB’s operating loss has been reduced fkom Rs 7 b i l l ion to Rs 4.8 b i l l ion over the same period. Although RBB’s NPA level remains higher (71 percent as o f July 2003), i t has recovered Rs 2.0 b i l l ion o f non-performing assets since the change o f management. It s t i l l has a large negative worth o f Rs 22.4 b i l l ion ($300 million). The combined capital shortfall o f the two banks i s Rs 32.4 b i l l ion ($435 mill ion) - in l ine with previous upper estimates. As in the case o f NBL, RBB has created adequate provisions to cover loan losses and i t s costhcome ratio improved f rom a negative number (-433 percent) to a positive number (+1,740 percent).

However, i t i s understood that the two banks have witnessed a slow down in recoveries over the past two months - as easier loans are recovered and the harder recoveries become “the norm”.

@) NPAs, Debt Recovery Procedures, and Blacklisting. High levels o f NPAs continue to be o f concern despite the progress that has been made with loan recoveries. Unless the recently established Debt Recovery Tribunals (DRT) are made more effective in their approach and blacklisting regulations are adhered to in full spirit, i t would be unreasonable to expect significant improvement in NPA levels. Further strengthening o f the DRT and possible modifications o f the Blacklisting Directive are l ikely to be necessary if these institutions/instruments are to be rendered effective. In addition, the banks must be encouraged to take cases to the DRT - t o assess their functioning and to indicate where more assistance may be required to strengthen their functionality. The publishing o f defaulter’s names in the newspapers i s a recent innovation which has also had some beneficial impacts in terms o f improving recoveries.

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(c) Accounts for 2002/03 for both banks are nearing completion and are expected to be submitted in December 2003, five months f rom the report date - in compliance with NRB guidelines. This i s a considerable achievement considering that RBB had not produced any published accounts for the past seven years and NBL had not produced accounts for the past three.

(d) Information Technology. B o t h banks are in the process o f establishing a minimalist Information Technology platform. An almost complete absence o f computers in these two banks means that data collection and Management Information Systems are extremely weak. NBL i s wel l advanced in procuring such a system and hopes to commence installation in early 2004. RBB i s in the process o f evaluating bids and hopes that a selection and rapid installation can take place thereafter. I t has been decided to only introduce a minimalist platform as the new buyers o f the banks may well wish to install their own hardware and software systems.

(e) Voluntary Retirement Schemes - Staff Right Sizing. Both banks announced their VRS schemes in September 2003 and closed them in the early part o f November. Under pressure f rom the labor unions, the management teams (in consultation with the central bank), agreed to improve the severance package paid to employees during the last week that the schemes were open. In RBB, o f the eligible 1,5 15 workers (at end December 2002), 150 had retired as per the bank’s normal retirement pol icy - and o f the 1,350 remaining, the bank received applications f rom 1,244. This represents a highly satisfactory take-up o f 92 percent. RBB plans to introduce a second phase VRS next year so as to affect further reductions in staffing levels. T h i s second phase will apply to staff with 15-19 years o f service - 1,578 staffers. Around 1,140 are expected to participate in the scheme during the second phase, bringing the total number o f retirees to 2,384 which represents 77 percent o f the total eligible employees o f 3,093.

The cost estimate for RBB’s VRS i s Rs 2,594 mi l l ion ($35.0 mill ion) - which does not include the payment that RBB must make to i t s employees under i t s provident fund scheme upon termination o f their service - Rs 179 mi l l ion. Also excluded i s the payment that RBB must make to i t s employees for unused home leave (up to 120 days) and sick leave (1 5 days per year) which can be commuted to cash upon termination o f service - Rs 100 mi l l ion. Including these two elements, the cost o f the severance package increases to Rs 2,873 m i l l i on ($38.8 mill ion). These latter two components will be covered by HMGN rather than the Wor ld Bank.

In NBL, o f the 2,561 eligible employees with 20 or more years o f service, 1,458 submitted applications. In view o f a lower than anticipated number o f employees talung up the VRS, NBL decided to conduct a second phase VRS targeting staff with 15-19 years o f service (2,131). A total o f 853 are expected to participate in the scheme during the second phase, bringing the total number o f retirees to 2,3 11.

The cost estimate o f N B L ’ s VRS stands at Rs 1,594 mi l l ion ($21.5 mill ion). This calculation does not include the payment that NBL must make to i t s employees under the provident fund scheme upon termination o f service - Rs 366 mill ion. I t also excluded i s the payment that NBL must make to i t s employees for unused home leave (up to150 days) and sick leave (12 days per year) which can be commuted to cash upon termination o f their service - Rs 77 mi l l ion. Including the two cost elements, the cost o f the severance package increases to Rs 2,037 mi l l ion ($27.5 million). Again, the Wor ld Bank will not cover these latter two elements which will also become the Borrower’s contribution to the project.

The following table compares the two Voluntary Retirement Schemes in the two banks.

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VOLUNTARY RETIREMENT SCHEMES In Rastriya Banijya Bank and Nepal Bank Limited

Current Staff Strength Required Staff Level VRS target Eligible fo r V R S Total VRS Cost

Phase I -No. o f staff Phase I - Cost

Phase I1 - No. o f staff Phase I1 - Cost

Average Cost per Employee

Annual Savings after VRS

Staff Expense (FY 2002103)

Eligible Age Eligibility service (years) Impltmentation Process

Equivalent months’ pay (Average) Cost Structure (Average)

Exclusion

Mode o f Payment

E t a from Nepal Rastra Bank exclu encashment.

Nepal Bank Ltd.

5,270 2,959 2,311 2,561

Rs 2,037 mill ($27.5 mill)

1,450 staff Rs 1,528 mill

861 staff Rs 509 mill

Rs 881 K ($1 1,911) Rs 197mill ($2.7 mill)

Rs 1,006 mill ($13.6 mill)

Open >15

Two Phases: Phase I: > 20 years or more o f service Phase 11: 15 - 19 years o f service.

100.2

Gratuity: 33.7 % Retirement : 24.5% Incentive : 20.0% Provident Fund:

18% Leave Encash: 3.8%

N o particular positions specified One-time lump sum

?s Costs associated wi

Rastriya Banijya Bank 5,522 3,200 2,384 3,093

Rs 2,873 mill ($38.8 mill)

1,200 staff Rs 1,645 mill

1,184 staff Rs 1,229 mill

Rs 1,205K ($16,287)

Rs 248 mill ($3.3mill) Rs 787mill ($10.6 mill)

Open >15

Two Phases: Phase I: > 20 years or

more o f service Phase 11: 15 - 19 years o f service.

130.6

Pension: 48.2% Insurance: 23.4% Incentive: 18.7 %

Provident Fund: 5.5% Leave Encash: 4.2%

N o particular positions specified One-time lump sum except for pension

TOTAL

10,792 6,159 4,695 5,654

Rs 4,910 mill ($66.4 mill)

2,650 staff Rs 3,172 mill

2,045 staff Rs 1,738 mill

Rs 1,046K ($14,133)

Rs 445mill($6.0mill)

Rs 1,793 mill ($24.2 mill)

portion.

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Annex 2: Major Related Projects Financed by the Bank and/or other Agencies NEPAL: Financial Sector Restructuring Project

Summary Ratings: Last Now

Implementation Progress S S

Other Ratings: Financial Management S S

Project Management S S

Achievement o f PDO S S

Financial Performance S S

The on-going F S T A project (co-financed by DFID) was approved by the Board o n December 19,2002. This project i s the f irst phase (Phase I) o f three sequential phases designed to implement a comprehensive financial sector reform program. This sequential approach has been endorsed by the International Monetary Fund (IMF), the Department for International Development (DFID) U.K., and the Asian Development Bank (ADB). Of the total F S T A financing o f US$30.1 million, IDA has extended a credit o f US$16.0 mi l l ion and DFID has provided a grant o f US$lO.O mill ion, whi le the remaining funding i s f rom the Government o f Nepal.

Compliance with Agreed S S

Quality and Reliability S S

Safeguard Mgt Performance S S Other Legal Covenants S S

Monitor ing & Evaluation S S

Procurement Schedules

o f Procurement Admin.

WID Impact NA NA

Specifically, the project focuses on (i) helping to restructure and re-engineer the Central Bank (Nepal Rastra Bank - NRB), so that it can effectively perform i t s key central banking functions; (ii) commencing commercial banking reform in the two large ail ing commercial banks that dominate the sector Rastriya Banijya Bank (RBB) and Nepal Bank L imi ted (NBL) -by introducing stronger external bank management that protects the financial integrity o f the two banks and takes on a conservator role to prepare the banks for the next steps o f restructuring; and (iii) 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.

The latest Implementation Performance and Development Outcome ratings as per the Project Supervision Report dated July 25,2003 are given below:

Asian Development Bank lending for the development o f Nepal’s financial sector has traditionally focused o n rural finance - mainly through the Agriculture Development Bank o f Nepal (ADBN) - and micro finance. The ADB has recently completed a diagnostic o f the ADBN (and the NIDC) and intends to implement a program o f restructuring within these two institutions, similar to the one supported by the Wor ld Bank in RBB and NBL. On-going ADB technical assistance in the sector supports the reform process by building the accounting and auditing profession through the strengthening o f the Institute o f Chartered Accountants o f Nepal (ICAN), reform o f company law, development o f legislation for insolvency and secured transactions, and creating a focal point within the Ministry o f Finance (MoF) to sustain the momentum and augment capacity for financial sector reform.

ADB’s support i s through the on-going Corporate & Financial Governance (CFG) Project that aims to improve transparency, accountability and basic financial sector infrastructure, comprising (i) strengthening the legal and regulatory framework, accounting standards and sector policies; (ii) supporting key sector regulatory and supervisory institutions; (iii) enhancing the capacity o f the legal and judic ia l system for proper enforcement and dispute resolution; and (iv) improving the environment for I C T infrastructure for payments, information disclosure, and financial service delivery. In addition, the

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project will initiate work o n developing selected market participants to p lay a better role in the financial system. To cover these assistance areas, the project blends loans (US$7.6 mill ion) and technical assistance (TA) grant funds (US$6.0 million) focusing on governance in the corporate sector as well as non-bank financial institutions, including rural finance and capital markets.

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Annex 3: Results Framework and Monitoring NEPAL: Financial Sector Restructuring Project

To improve corporate governance through provision o f management support to the two large commercial banks.

To improve market structure by reducing the state-owned segment o f the banking system.

T o sustain and deepen the banlung reforms.

Results Framework

c o k p t i o n i s suspected, referred to the Commission for the Investigation o f the Abuse o f Authority (CIAA).

Establishment and commenced operation o f Debt Recovery Tribunals and Appellate Tribunal.

Enforcement o f the Blacklisting Directive.

Retrenchment o f staff o f NBL and RBB by 40 percent and rationalization o f branch networks to reduce cost structure.

Outsourcing o f non-core activities.

RBB and NBL privatized. Enhanced Supervisory and Regulato ry Capacity at NRB.

Use of Outcome Information

Improve regulatory regime.

Prepare the two banks for privatization.

To take prompt corrective action with respect to troubled banks.

~~

Indicators in bold italics wi l l be financed by the grant. Other indicators wi l l be financedfrom the credit.

Components Funded by IDA Credit

RBB and NBL. to less than 20 percent. reduction measures.

central banking responsibilities.

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Components Funded by IDA G

Component Two: Sales Advisors Assistance in the ultimate privatization o f the two commercial banks. Component Three: Phase I1 of NRB Re-engineering More efficient discharge o f central banking responsibilities.

further deterioration in asset quality o f existing portfolio.

Improved Operating Results with a positive cash flow.

More than 50 percent o f the customers to have access to branches that operates with on-line system.

Production o f Quarterly Financials within one month and audited Annual Financials within five months.

Better, cheaper, andor more diversified range o f banking services.

nt

Negotiations for sale of NBL and RBB commenced with pre-qualijied strategic investors.

Reduction in Non-Professional to Professional Staff Ratio to 2 : l .

Adoption of revised organization structure and revised HR Policies. Merit-based over Seniority-Based Promotion.

On-Site bank supervision reports that are of international standard produced within a quarter after completion of bank examination and a cycle not exceeding two years for each commercial bank.

Prompt action taken against troubled banks that do not meet statutory and regulatory requirements.

NRB Accounts produced to international accounting standards within the statutory timeframe. External audit of NRB by an International Firm for FY 2003.

management teams.

To ensure that banks are sold to “Fit and Proper ’’ Bankers.

Design the Third Phase of NRB Re- engineering.

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d u 4 2 z 2 z

X X X

X X X X

X X X X

X X X X X X

X X X X X X

X

X

X

X

X

X

x

X

X

X

X

X

Annex 4: Detailed Project Description

NEPAL: Financial Sector Restructuring Project

The proposed project includes four project components.

Project Component 1 - US$ 56.5 million

VOLUNTARY RETIREMENT SCHEME (VRS). The performance o f NBL and RBB has partly been constrained by costs exceeding income, with high staff expenses a main contributing factor. I t i s therefore critical that these banks down-size to more sustainable levels. The project would assist the restructuring efforts in the two banks that would lay the foundation for them becoming privatizable assets.

On September 15 and 17,2003, respectively, Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL) - with agreement f rom the Ministry o f .Finance and Nepal Rastra Bank (NRB) - announced their respective VRS schemes. W h i l s t the schemes were open for up to a month, the management o f these two banks agreed (with the Labor Unions o f respective banks) to extend the application deadline by another three weeks to a month to accommodate the Tihar festival holiday period in late October. The staff who have already submitted their applications should be able to start retiring f rom the banks as early as December 2003. Some staff will, however, be requested to stagger their departure dates so as to ensure a smooth transition for these institutions.

Out o f 5,522 staff, RBB expects to retire 2,384 staff with an average payout to staff o f US$ 16,287. NBL (with 5,270 staff) has targeted 2,311 staff for retirement at a cost o f US$ 11,911 per employee. The difference in the average payouts between the two banks represents different age and time-in-position employee profiles in the two banks rather than a fundamental difference between the schemes being offered. The average payout per employee represents 100 months salary for NBL and 130 for RBB. However, the actual incentive (over and above required payouts) in the VRS package i s only 20 percent in NBL and 19 percent in RBB. The total cash outlay for the VRS operation for the two banks i s estimated to be US$ 66.3 mi l l ion out o f which the Wor ld Bank with financ.e US$ 56.5 mi l l ion.

RBB has planned the VRS operation in two phases with the f i rst phase targeted at those who have had more than 20 years o f service followed by those with between 15-19 years o f service. Although NBL originally targeted only those with more than 20 years o f service, i t i s n o w highly l ikely that those staff with 15 to 19 years o f service (and even less), will also be targeted in a second phase.

Project Component 2 - US$3.0 million [of which US$3.0 million i s an IDA Grant]

HIRING OF SALES ADVISORS: The third component o f the proposed project involves the hiring o f a Sales Advisor (Privatization Advisor) to help sell the banks to “fit and proper” owners towards the end o f the bank restructuring process. This could happen sooner or later depending upon the progress made by the management teams in restructuring the two banks andor the potential interest by outside parties in purchasing the institutions. In a l l likelihood, however, the Sales Advisor would not be recruited for one to two years after significant progress had been made with the restructuring process. Their role would be to prepare a sales prospectus for the banks, undertake a road show to sell these institutions and take them through to the point o f privatization.

Project Component 3 - USS8.0 million [of which USS4.0 million i s an IDA Grant]

SECOND PHASE OF NEPAL RASTRA BANK (NRB) RE-ENGINEERING: The Central Bank o f Nepal, continues to be a weak institution requiring strengthening o f a l l i t s core functions. NRE3 has

29

requested continued support for i t s on-going re-engineering to build upon the progress made to date under the F S T A credit. This assistance will be provided in the fol lowing areas: (i) human resource re- engineering; (ii) accounting support; (iii) bank supervision and regulation; and (iv) Information Technology (IT) up-gradation.

(a) Human Resource Re-engineering. Human resource re-engineering i s at the heart o f institutional reform in NRB. Of prime importance i s the adoption o f a new organizational structure within the bank. Considerable progress has been made in this regard and a new simplified structure i s to be adopted in early 2004. However, the bank will require on-going support to assist i t in implementing i t s new HR policies which emphasize merit-based advancement over the time-in-grade criteria typically used in South Asian public sector institutions. Further development o f the training plan and i t s implementation will become an important focus o f the Phase I1 program o f support.

(b) Accounting Support. The NRB i s making good progress in adopting International Accounting Standards (IAS). T w o key actions required for the immediate future are revision o f the Accounting Manual to reflect U S , and the external audit o f the NRB by a wel l recognized international accountancy firm. These activities will be supported under the Phase I1 project.

(c) Bank Supervision and Regulation. The bank supervision department i s making good progress in undertaking on-site examinations o f the 15 commercial banks - not including RBB and NBL. In 2001/02, Himalayan Bank was examined by NRB. In 2002/03, L a x m i Bank, Nepal Investment Bank, Everest Bank, Nepal Industrial and Commerce Bank, Standard Chartered Bank, Bank o f Kathmandu, and Siddarth Bank were examined. In 2003/04 the plan i s to examine Nepal Bank Limited, Rastriya Banijya Bank, Nabi l Bank, Nepal S B I Bank, Nepal Bangladesh Bank, Nepal Credit and Commerce Bank, Lumbini Bank, Macchapuchere Bank, and Kumari Bank. However, this ambitious schedule o f bank examinations i s hampered by young and inexperienced bank examiners who have to be nurtured by their more experienced colleagues. With three bank examination teams out at any one time, and with approximately two experienced Nepali bank examiners in each team o f six, both the bank examination report and the training component o f these exams i s severely hampered. As a result, examinations take an unduly long time to complete and the reports take several months to reach the Board o f NRB where they can further wait for a further two to three months before they are discussed. The end results are long delays and out-of date reporting. A final problem lays with a lack o f fo l low up on actions where deficiencies in a particular bank are uncovered by the examiners.

The Phase I1 project will provide enhanced technical and physical support for the work o f the department in the form o f additional desk top computers, lap top computers for on-site examiners, intemational experts to assist with on-the-job training (for the complete two year examination cycle o f a l l the commercial banks), and classroom training in areas related to bank supervision, computing, and English (report writing).

(d) Information Technology Up-Gradation. A lack o f computerization in departments f rom bank supervision, to accounting, to banking operations, has hampered the efficient functioning o f the central bank. Operating with DOS based systems and an IT department which i s developing i t s own software rather than purchasing customized software o f f the shelf, the bank requires serious investment in up-dated IT systems, including the purchase o f a computerized General Ledger system for the institution. An I T Specialist i s being recruited to assist in designing this component with funding from the F S T A project. This subcomponent will be financed by an IDA Credit.

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The costing o f components for the Phase I1 Nepal Rastra Bank re-engineering i s therefore based on the fol lowing cost table

Project Component 4 - US$6.0 million

MANAGEMENT TEAM SUPPORT: This component provides funding for continuous Management Team support (at NBL and FU3B) pr ior to their privatization. Whereas the Management Teams are currently working o n a two year plus one (2+l) contract, privatization could feasibly take longer than this to achieve. Reverting to poor management before privatization would result in a loss o f the good investment which has taken place so far in these banks. Consequently, this component i s intended to maintain the banks under full profession management f rom the end o f the third year o f the Management Team contracts through to full privatization without any breaks.

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Annex 5: Project Costs NEPAL: Financial Sector Restructuring Project

~

Foreign Total Project Cost By Component andor Act iv i ty

Voluntary Retirement Scheme 56.50 0.00 56.50 rylllllllull US $mil l ion U S $mill ion

Local TTC Qm;ll;fi.\n 1

Hiring o f Sales Advisors NRE3 Re-engineering (Phase 11) On-going Management Team Support

0.00 3 -00 3 .OO 1.00 7.00 8.00 0.00 6.00 6.00

Total Baseline Cost 57.50 16.00 73.50 Physical Contingencies 0.00 1.20 1.20 Price Contingencies 0.00 0.80 0.80

Total Project Costs 57.50 18.00 75.50 Interest during construction

Front-end Fee Total Financing Required 57.50 18.00 75.50

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Annex 6: Implementation Arrangements NEPAL: Financial Sector Restructuring Project

The Coordination and Support Team (CST) that has been formed within Nepal Rastra Bank in the Bank and Non-Bank Financial Institution Regulations Department, under the FSTA, will continue to administer this project. The Executive Director o f this department heads the CST and provides overall guidance and leadership on matters o f project implementation. The CST i s supported by a dedicated Financial Management Specialist who i s a qualified professional accountant and by a dedicated Procurement Specialist. The CST i s also supported by adequate ancillary staff and facilities. Operating costs o f the CST will be funded under the FSTA 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 jo int ly financed by the IDA Credit and the DFID Grant. Staff salaries are excluded (except for the consultant procurement officer).

The restructuring measures will be coordinated by the Ministry o f Finance (MoF) and Nepal Rastra Bank (NRE3). Rastriya Banijya Bank (RBB) and Nepal Bank L imi ted (NBL) will be responsible for the design and implementation o f their respective Voluntary Retirement Schemes (VRS) - which i s the main expenditure under the project.

NRB and the M o F will be responsible for implementing the required steps to bring the two banks to the point o f sale and for identifying bona fide strategic investors in parallel with the restructuring exercise currently being undertaken by the professional management teams. The NRB and MOF will be assisted by the Sales Advisor engaged under the Project to implement the individual sale transactions. The MOF will coordinate the selection process with NRB, the bank regulator and supervisor, to ensure that the process results in the selection o f qualified buyers who have the required integrity, capital, banking expertise, technology, and management. The NRB will be responsible for clearing potential buyers and their proposed management teams in accordance with established selection criteria and banking regulations.

The MOF will also be responsible for taking steps to amend Article 86 o f the Nepal Rastra Bank A c t to provide NRB sufficient powers to rehabilitate and restructure the institution and for coordinating with the Securities Board and the Nepal Stock Exchange to arrange for NBL shares to be de-listed f rom the stock exchange.

The NRB will be responsible for designing a program o f on-going re-engineering o f the central bank to build upon the progress made to date under the FSTA. The NRB will be assisted by experts in the areas o f human resource, accounting, bank supervision and regulation, and information technology.

The M o F and NRB will be the implementing agencies for the restructuring and other policy reforms supported by the proposed project. The ICC/Bank o f Scotland i s expected to provide management support for NBL and the team o f individual consultants for RBB during the remainder o f their term (two- year term with an option for one-year extension). Continued management support beyond the three year period will be overseen by NRB.

The project will be implemented over a five-year period (2004-2008) with the bulk o f loan proceeds (US$56.5 mi l l ion or close to 75 percent) disbursed in 2004 and 2005 to finance the VRS o f the two banks. The costs o f Sales Advisors, Phase I1 NRB re-engineering, and the on-going Management Team support wil l be spread over a four-to-five year period.

Whilst NRB was the only implementing agency for FSTA, M o F and NBL/RBB are active participants.

33

For the proposed project, a l l these agencies - NRB, MoF, and RBB/NBL will have implementation responsibilities.

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Annex 7: Financial Management and Disbursement Arrangements NEPAL: Financial Sector Restructuring Project (Phase I1 Reforms)

Summary of Project Description: The proposed credit i s a second phase project o f the on-going Financial Sector Reform Project (Phase I). The project implementation arrangements under the current project will continue in the next phase. The financial management (FM) assessment has been carried out aiming at (i) reviewing current project FM arrangements, including weaknesses, and (ii) proposing arrangements for improved financial management. One o f the key objectives o f the proposed project i s to provide further assistance to improve N R B ’ s accounting, reporting and auditing standards and make them I A S compliant within a reasonable time-frame. The project activities are grouped under four broad components. The details o f the components and their sub-components are described in Annex 4 o f the PAD.

Country Issues: The IMF’s Safeguard Assessment o f the financial sector identified institutional weaknesses in the area o f financial management and the IMF has been working with NRB towards improving financial management through an agreed action plan. The ongoing project includes a component which has been addressing N R B ’ s current weaknesses in the area o f accounting, reporting, extemalhnternal audit and training. The proposed IDA grant wil l further compliment the on-going FM reforms in NRB and would further strengthen i t s FM capacity in line with international standards. The component for Phase I1 NRB re-engineering includes a revision o f the Accounting Manual to reflect I A S requirements, extemal audit by an internationally reputed audit firm, installation o f a computerized accounting system, and training. These actions will greatly contribute towards improving overall FM system within the NRB.

Adequacy of FM arrangements: The CST under the direct supervision o f an Executive Director within NRB has been functioning wel l in the on-going project. The CST will be further expanded in the proposed project with additional staff and logistics. Financial Administration Rules o f the NRB are adequate to ensure appropriate controls over project transactions. The duties and responsibilities o f the CST are segregated properly so as to ensure that financial transactions are initiated, approved and executed at different levels. The FM staff are wel l conversant with the Bank’s FM policies and procedures. Overall, the FM arrangements for the project are adequate for the in i t ia l stage o f project implementation. However, these need to be further improved in the areas indicated below to ensure a satisfactory FM system throughout the entire project implementation period.

Risk Analysis: From a financial management perspective, there i s l o w risk affecting the project. This i s because a large portion (almost 75 percent) o f the credit proceeds would be uti l ized to reimburse NBL and RBB for Voluntary Retirement Schemes (VRS). N R B ’ s appointment o f a full time Procurement Specialist and FM expert in the CST has greatly contributed towards avoiding any potential risk in the procurement o f consultancy services and performing the ex-ante audit functions efficiently and effectively. Further, implementation experience gathered through the on-going Phase I project has provided adequate knowledge and sk i l ls in managing IDA funded credits.

Strengths: The proposed project aims to build on the successes o f the current project and will have the following strengths in the area o f financial management: (i) the existing FM expert, who has familiarized himself with the Wor ld Bank’s FM pol icy and procedures, will continue to work in the new project. Moreover, the need for additional support has been identified and it has been agreed that these staff will be put in place by March 3 1,2004; and (ii) the high level commitment o f the government and N R B ’ s management to various reform initiatives will greatly contribute to addressing any potential problems which may arise during project implementation.

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Weakness and Resolution: An important weakness i s poor logistic and other administiative support to the CST. The CST staff are operating in a constrained environment in terms o f staffing resources. Financial information i s maintained in spreadsheets, but there i s scope for computerization o f accounts to keep track o f project expenditures, compilation and reporting - with additional staff. It i s recommended that this be addressed by the appointment o f additional staff. The CST i s also planning to upgrade i t s computer facilities under the current project. The Finance Officer will be appointed by March 2004.

Funds Flow: To utilize IDA’S share o f eligible expenditures, NRB will open a Special Deposit Account (SA) under terms and conditions acceptable to IDA. The Executive Director (ED) o f the NRB and Financial Institutions Regulations Department will continue to work as the Coordinator in the new project and will continue to be the authorizing authority for checks, making payment request to CST, and the withdrawal o f funds from the IDA creditlgrant. The S A wil l be managed under the jo in t signature o f the ED and an FM expert with a provision for an alternate signature o f another Assistant Director (finance).

With regard to VRS payments, NBL and RBB have a proper system in place to properly monitor the eligibil i ty o f VRS payments and maintain records thereof in their system. NRB has agreed to a reporting format with NBL and RBB. NBL and RBB will maintain a l l supporting documents related to VRS payments and they will be maintained within the respective accounting departments o f the two commercial banks. These documents will be made available upon demand to NRB, external auditors and other concerned authorities including Wor ld Bank supervision missions. Reporting formats have also been agreed with NRB, and the two commercial banks wil l prepare a summary statement o f a l l VRS payments which will be completed by the Accounts Departments o f the respective banks, certified by the Chief Financial Officers, and the Heads o f the Internal Audit Departments. VRS payments wil l be based o n pol icy documents approved by the concerned authorities o f the two commercial banks and the resolution o f the management committee approving claims for amounts paid under the VRS.

HMGN will ensure timely release o f counterpart funds to the CST through a separate project bank account. Transaction based disbursement procedures will be applicable for withdrawal o f funds from the creditlgrant.

Budgeting, Accounting and Internal Controls: Project planning and budgeting will fo l low HMGN’s existing planning and budgeting system, which i s adequate for the new project. This has already been reviewed during the on-going project preparation and i s outlined in the PAD. Cash based accounting systems wil l be followed. The accounting policies and procedures will be the same as for the on-going project and will be governed by the existing accounting procedures outlined in the Financial Administration Rules o f the NRB. Separate books/records (cash and bank-book, General Ledger, Fixed Assets register, Bank Reconciliation, etc) for the project would be maintained by NRB. The accounts will continue to be maintained on computer spreadsheets which i s adequate to keep track o f project financial transactions. Approval authority and proper segregation o f duties in the CST has been functioning wel l in the on-going project. The same delegation o f financial powers and approval authorities will be followed for the new project and will further strengthen with the appointment o f a finance officer.

Financial Reporting and Monitoring: The CST will be responsible for summarizing financial transactions, maintaining supporting papers and preparing timely consolidated Financial Statements on a monthly basis. A set o f customized formats o f project Financial Monitoring Reports (FMRs) were agreed in the on-going project. The first set o f reports were received in December 2003. NRB will propose formats to report project progress based on the existing agreed reporting formats. FMRs will be submitted o n a trimester basis within 45 days o f the end o f each trimester. It has been agreed that a set o f customized reports for the proposed project will be submitted to IDA and wil l be finalized based o n IDA’S comments by January 3 1,2004.

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External Audit: The f i r s t audit report o f the on-going project, and for NRB, are for FY2002/03 and are due on January 15,2004. NRB was notif ied o f the need for the audit reports by the due date - including being notif ied o f the implications o f delays that could lead to delays in project processing o f the current operation. The option o f N R B ' s audited financial statement being merged with identifiable information o n IDA funds, under an agreed Terms o f Reference (TOR), was explored. I t was concluded that NRB i s not yet ready to merge project financial data into i t s financial statements and it would prefer to have project financial statements audited by a private audit firm appointed by the Auditor General (AG), acceptable to IDA. The audit TOR, which has been agreed in the on-going project, will be followed for the proposed project and the audit report will be submitted to the Bank within six months o f the end o f each fiscal year. In addition, N R B ' s statutory auditor will carry out an annual audit o f i t s financial statements. A copy o f such audit reports will be submitted to IDA by January 15 o f each fiscal year.

Implementing Agency

NRB

NRB

The following audit reports would be monitored in the Audit Report Compliance system (ARCS):

Audit Auditors Audit Due Date

Project Financial 6 months after the end Statements appointed by the ,Auditor o f fiscal year (January

Entity (NRB) Financial 6 months after the end Statements appointed by the Auditor o f fiscal year (January

Private Sector Audit Firm

General (AG) 1 5 'h) Private Sector Audit Firm

General (AG) 15')

Actions 1. Appointment of Support Staff in the CST 2. Upgradation o f Computer Hardware/ Software in CST to move to a computerized information system 3. Finalization o f FMRs formats and contents 4. Appointment o f private audit firm accentable to IDA

Responsibility Completion date NRB March 3 1, 2004 NRB December 3 1,2004

IDA and NRB OAG

January 3 1,2004 M a y 15" o f every year

Supervision Plan: The init ial supervision focus will be on the progress o f implementation o f the agreed actions, and facilitating NRB in maintaining sound Financial Management arrangements throughout the project implementation period.

Disbursement

Allocation of credit/grant proceeds (Table C): Disbursement under the proposed crediugrant will be made as indicated in Table C, which indicates the percentage o f financing for different categories o f expenditures o f the project. I t i s expected that IDA funds will be disbursed over a period o f f ive years. The fiscal year disbursement estimate i s provided o n page one (the Project Summary) o f the PAD. The Closing Date o f the credit/grant i s March 2009.

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Allocation of Credit Proceeds

Expenditure Category 1. Voluntary Retirement

Amount in U S $ Million Financing Percentage 56.5 100% o f disbursed amount

Scheme 2. Consulting Services 13.0 85% 3. Goods

Unallocated

Use of Statement of Expenditures (SOEs): IDA will require full documentation for a l l prior review cases where contracts exceed the equivalent of: (a) U S $200,000 for goods; (b) U S $100,000 for services contracts with f i rms; and (c) U S $25,000 for individuals. Expenditures below the above thresholds and a l l expenditures under voluntary retirement schemes (VRS), will be claimed o n SOEs. During the init ial supervision by IDA, the mission will closely review the SOE claims to ensure that the funds are utilized for the intended purposes. Any deviations noticed during such reviews would be noted for remedy and improvement.

4.0 100% o f foreign expenditures and 85% o f local expenditures

2.0

Special Account: For utilization o f IDA’S share o f project expenditures, NRE3 may open and maintain a Special Deposit Account in U S dollars under terms and conditions acceptable to IDA. The authorized allocation to the Special Deposit Account will be l imited to 3 to 4 months estimated expenditure o f IDA’S share o f the proposed project. The authorized allocation will be l imi ted to $4,000,000. At the start o f the project, the ini t ia l deposit wil l be limited to $2,000,000. The remaining $2,000,000 o f the authorized allocation may be withdrawn once the total withdrawal f rom the creditlgrant reaches SDR 5,000,000.

Retroactive Financing: In order to expedite project implementation, there i s a need for retroactive financing in excess o f the current 10 percent authorized limit which has required Regional Vice President (RVP) and Managing Director (MD) approval. Bank reimbursement f rom the proceeds o f the IDA credit will be made for VRS payments undertaken in advance o f the anticipated Board date. In order to be eligible for retroactive financing, procedures for procurement, the use o f consultants, processing and clearance, are subject to Bank’s Procurement and Consultants Guidelines. In addition, documentation requirements for expenditures claimed under retroactive financing are the same as those for disbursements against payments made after the Financing Agreement i s signed and effective.

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Annex 8: Procurement NEPAL: Financial Sector Restructuring Project

Table A: Project Costs by Procurement Arrangements (US$ m i l l i o n equivalent)

Procurement Method Expenditure Category ICB NCB Other' N.B.F. Total Cost 1. Works 0.00 0.00 0.00 0.00 0.00

2. Goods 3.83 0.17 0.00 0.00 4.00'

3. Services 0.00 0.00 13.003 0.00 13.00

4. Miscellaneous4 0.00 0.00 56.50 0.00 56.50

5. Unallocated' 0.00 0.00 2.00 0.00 2.00

Total 3.83 0.17 71.50 0.00 75.50

' Includes consultant selection arrangements and V R S payments,

Computer purchases and IT upgrading for NRB.

This comprises consultancy services for NRJ3 reengineering, management team support and sales advisors,

Voluntary Retirement Schemes - $ 56.5 m i l l i on

Unallocated amount could go into External Audit and IT Platform shortfall bo th under NRB re-engineering or possible shortfall in FSTA budget for payment to Management Team for Year 3 ,

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Table A1 : Consultant Selection Arrangements (optional) (US$ million equivalent)

Selection Method

Total QCBS QBS SFB LCS CQ Other N.B.F. Consultant Services Expenditure Category

A. Firms 6.18 0.00 0.00 0.00 0.00 6.00 0.00 12.18

B. Individuals 0.82 0.00 0.00 0.00 0.00 0.00 0.00 0.82

Total 7.00 0.00 0.00 0.00 0.00 6.00 0.00 13.00

Note: Other refers to sole sourcing.

Table B: Thresholds for Procurement Methods and Prior Review'

Contract Value Contracts Subject to Expenditure Category Threshold Procurement Method Prior Review

(US$ thousands) (US$ millions) 1. Works NA 2. Goods a) < 200,000 NCB 0.00

a) < 100,000 QCBS,CQ, Other 0.00

b) > 200,000 ICB 4.00 3. Services A. Firms:

b) > 100,000 QCBS 7.15 LC, SFB, Other 7.25

B. Individuals: CQ, Other 0.10 >25,000

Thresholds generally dif fer by country and project. Consult OD 11.04 "Review o f Procurement Documentation" and contact the Regional Procurement Adviser for guidance.

Total value o f contracts subject to prior review: {US$ 18.5 mi l l ion}

Overall Procurement Risk Assessment: {Average}

Frequency o f procurement supervision missions proposed: One every {four} months (includes special procurement supervision for post-review/audits)

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Table C: Al location o f Credit Proceeds

Expenditure Category Amount in US$ mill ion Financing Percentage Goods 3 -62 100% Services 13.38 85% Miscellaneous (VRS) 56.50 100% Unallocated 2.00 85%

Total Project Costs 75.50 Interest during construction

Front-end Fee

Use o f statements o f expenditures (SOEs): { i f applicable}

Special Account: {if applicable}

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Annex 9: Economic and Financial Analysis NEPAL: Financial Sector Restructuring Project

IRR & Pavback Period Reduce Annual Savings by/

10% 20% 30% 40%

1999 2000 2001 2002 2003 Nepal Bank Limited

Staff Expense (Rs. mil) 763 1,048 871 1,228 1,005 Annual Savings after VRS (Rs. mil) Cost (Incentive) o f VRS - (20.1 % o f Rs. 2,037 mn)

- - - - -

244 409

Increase Investment Cost by 5 yo 10% 15% 20%

53% (1.86) 48% (2.05) 46% (2.14) 44% (2.23) 47% (2.10) 42% (2.30) 40% (2.41) 38% (2.51) 40% (2.39) 36% (2.63) 34% (2.75) 33% (2.87) 34% (2.79) 30% (3.07) 29% (3.21) 27% (3.35)

IRR (10 year period) - % 59% Payback (years) 1.68

NE3L management hopes to reduce staff expenses f rom 25 percent o f total operating expense to 16 percent annually if their VRS plan i s successful. This translates to annual saving in operating costs o f Rs 244 mi l l ion. W h i l s t the total cost o f VRS i s Rs 2,037 mill ion, the incentive portion built into the scheme i s only 20.1 percent o f the total, i.e. Rs 409 mill ion, which i s the figure used as the investment cost for the project.

This results in internal rate o f return o f 59 percent with a payback period of 1.68 years. Given that data on future cash flows are not available, annual savings and investment cost (taking into cognizance the possibility of an increase in incentive costs) have been sensitized under different scenarios, viz:

Even if projected cash f l ow i s sensitized with 40 per cent reduction in annual savings and increase in investment cost by 20 percent, N B L ' s IRR remains satisfactory at 27 percent (with a payback o f 3.4 years).

1999 2000 2001 2002 2003 Rastriva Baniiva Bank

Staff Expense (NPR mil) 560 1,279 1,385 759 3,258 Annual Savings after VRS (NPR mil)

- - - - -

264 537

IRR (1 0 year period) - YO 48% Payback (years) 2.03 Note - Staffexpenses in 2000, 2001 and 2003 includes provision made for Provident Fund and other staffbenefts.

Cost (Incentive) o f VRS - (1 8.7 % of NPR 2873 mn)

Based o n estimates provided by RBB management, projected annual savings are Rs 264 mi l l ion after implementing their VRS (both phases). Investment i s estimated at Rs 537 million, i.e. the incentive

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portion f rom the total VRS cost o f Rs 2,837 mill ion. This yields an IRR o f 48 percent with a pay back period o f slightly more than 2 years.

IRR & Pavback Period Reduce Annual Savings bd

10% 20% 30% 40%

As information o n RBB's future cash f low i s not available, annual savings and investment cost have been sensitized under various scenarios in line with NBL, viz:

Increase Investment Cost by 5 y o 10% 15% 20%

41% (2.37) 39% (2.49) 37% (2.60) 35% (2.71) 36% (2.67) 34% (2.80) 32% (2.92) 30% (3.05) 30% (3.05) 29% (3.20) 27% (3.34) 26% (3.49) 25% (3.56) 24% (3.73) 22% (3.90) 21% (4.07)

Hence, under a worst case scenario - a 40 percent reduction in projected annual savings and a 20 per cent increase in investment cost - results in an IRR o f 21 percent (payback o f 4 years).

Due to the lack o f data, the above calculations did not take into account the indirect costs o f the VRS including the cost o f outsourcing, and the cost o f new hires. Similarly, indirect benefits such as subsidies o n staff loans, and the overhead costs o f displaced staff have not been factored in. Hence, sensitivity analysis was done under various adverse conditions as shown above which s t i l l results in satisfactory returns to the investment.

The retum to the Bank's investment operation are quantifiable benefits in terms o f cost savings as shown above and the unquantifiable benefits in terms o f increased efficiency o f the banking system through lower lending spread and wider choice o f banking services.

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Annex 10: Safeguard Policy Issues NEPAL: Financial Sector Restructuring Project

N o Wor ld Bank Safeguard policies have been triggered by this project - therefore issues pertaining to the identification and minimization o f safeguards do not apply. This Annex does, however, cover social safeguard issues considered by the project team in the preparation o f this project.

Social and Safeguard Issues

Introduction

As part o f the Financial Sector Technical Restructuring Program (FSRP - Phase 11) in Nepal, a Voluntary Retirement Scheme (VRS) i s to be implemented in two commercial banks - Nepal Bank L imi ted (NBL) and Rastriya Banijya Bank (RBB). The project team originally built in a training and counseling component in an effort to meet the genuine retraining needs o f these retired staff and to address potential criticisms arising f rom the implementation o f the VRS which could pose a reputation risk for the Bank. The inclusion o f this component was also prompted by the desire to meet Bank safeguard requirements. The team felt that there was a real or perceived harm resulting f rom the retrenchment o f workers at the two banks. The VRS component has been developed in a participatory process that involves a l l stakeholders (including the affected parties or their representatives) and, as a result o f this undertaking, has established that there i s only minimal demand for training and counseling at the current time. Formal and open consultations were held with al l affected parties - and a social assessment o f the training and counseling component was carried out with the conclusion that i t was not needed. Extensive discussions were held with the unions, focus groups and others -by the Management Teams in the banks, the Appraisal Mission team members, and a social consultancy consultant - to ascertain interest. I t was clear that there i s very l itt le interest f rom the workers or the Government in these activities. The team has, nonetheless, undertaken extensive due diligence o n this issue.

What has been done?

At the early stage o f project conceptualization, i t was thought that there could be considerable social implications associated with the implementation o f the VRS. I t was recognized early on that although n o safeguards issues were triggered, there was nonetheless concem about the l ikely negative social impact on those workers that chose early retirement without proper planning. Included in the range o f social r isks were: (1) the inabil ity o f employees to re-enter and compete within the labor market; and (2) the risk o f lower level o f bank employees being forced into poverty as a result o f their choosing early retirement. With this in mind, a training and counseling component was developed to mitigate the potential adverse impacts listed above.

Details of the Training and Counseling Component

A detailed training and counseling component was developed to support the approximately 4,700 retiring staff f rom these banks. This program had three main objectives: (1) to promote income generation activities for the worker or h isher family members; (2) to assist workers in designing their investment strategies for their lump sum severance pay; and (3) to provide networhng and general empowerment training to worker and family members. The plan was to provide assistance to staff expected to retire

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under the VRS package in NBL and RBB. This component was thereby designed as an added social safety net for workers who take up the VRS package.

Conduct of Social Assessment

A focus group discussion with employees comprising Officer and Assistant o f the accounts, Banking Business, General Service, and Internal Audit departments was held in October 2003 at the RBB headquarters in Kathmandu, Nepal. An additional focus group discussion with RBB employees consisting o f the Head Assistant, Assistant Officer, Senior Record Keeper, Assistant Manager, Assistant Manager, and Deputy Manager was held o n in November 2003 at the RBB office headquarters. In total, six focus group discussions were conducted with approximately 60 employees from both banks in October and in November 2003. Consultations were also held with representatives o f the unions and o f the c iv i l society including the NGOs, international donor community and government agencies concerned with workers’ welfare.

W h y was this training and social component abandoned?

After undertaking considerable due diligence init ially in October 2003, and then again in November 2003 as part o f the appraisal mission, several areas o f concem arose which resulted in the decision by the project team to drop the training and counseling component o f the project. The reasons included: (1) the lack o f government buy-in for the component which raised the issue o f whether the project team was being truly “client responsive”; (2) the absence o f an effective on-the-ground agency with the abil ity to handle the complexity o f this component; and (3) the absence o f support by bilateral partners and international NGOs (DFID and GTZ) for this component. Most importantly, the retirees themselves, many with second jobs while working for the bank, are not considered the poor or the vulnerable groups in Nepalese society. By Nepalese standards, the employees o f these two public sector banks are relatively wel l o f f by many standards and, during meetings with and without union representation, RBB and NBL employees did not v iew the training and counseling component as especially pertinent to their lives.

Social Tracking and Exit Surveys

Nonetheless, in an effort to learn about the effects o f retrenchment and discontinuation o f employment in Nepal, two surveys will be carried out as part o f this project. An exithetraining survey will provide vital information on the attributes and profi le o f a l l staff retiring f rom NBL and RBB. A second, more long term, tracking survey wil l be conducted among a smaller sub-sample o f these retiring workers to track their progress in their post- retirement lives so that future programs can be adequately adapted to meet the special needs o f this sub-group o f retiring ex-state owned enterprise workers. The Bank has been in contact with DFID concerning the ExiURetraining Survey and the subsequent traclung survey and there i s an agreement in principal that the UK Government will fund this survey work.

The project team has identified MARG Nepal, a subsidiary o f ACNielsen based in Kathmandu, as the most appropriate research agency to conduct and analyze both surveys. MARG Nepal i s a large multidisciplinary research and consultancy agency which i s registered with the Ministry o f Commerce (Nepal) and with the Bank in the South Asia region. MARG i s experienced with handling large studies in urban and rural settings, in a wide range o f subject areas (health practices, corruption, poverty alleviation opinion polls) for agencies such as the United Nations, DFID, and Transparency International

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Annex 11: Project Preparation and Supervision NEPAL: Financial Sector Restructuring Project

Planned Actual

1 0/3 0/03 PCN review 09/15/03 9/03/2003 Initial PID to PIC Initial ISDS to PIC 10/25/03 10/21/2003 Appr ai s a1 11/10/03 11/10/2003 Negotiations 01/15/04 BoardRVP approval 03/16/04 02/24/2004 Planned date o f effectiveness 05/3 1/04 Planned date o f mid-term review 09/10//06 09/10/2006 Planned closing date 034 6/09 03/16/2009

Key institutions responsible for preparation o f the project:

Wor ld Bank, IDA International Monetary Fund, IMF Department o f International Development, DFID (UK)

Bank staff and consultants who worked o n the project included:

Name Title Unit Simon Be l l Sector Manager SASFP Sabin Raj Shrestha Juan Costain Kiatchai Sophastienphong Nagavalli Annamalai Lead Counsel K i ran Baral Sr. Procurement Officer Suraiya Zannath Bigyan Pradhan Nina Bhatt Project Safeguard Specialist Caroline Fawcett Consultant Margaret Murray Executive Assistant

Financial Sector Specialist Lead Fin. Sector Specialist Sr. Financial Sector Specialist

Sr. Fin. Mgmt. Specialist Sr. Fin. Mgmt. Specialist

Bank funds expended to date o n project preparation: 1. Bank resources: 150.0 K 2. Trust funds: 0.0 3. Total: 150.0 K

SASFP SASFP SASFP LEGPS s m s S A R F M S A R F M

S D V IMPAQ International, L L C

SASFP

Estimated Approval and Supervision costs: 1, Remaining costs to approval: 35.0 K Estimated annual supervision cost: 75.0 K

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Annex 12: Documents in the Project Fi le NEPAL: Financial Sector Restructuring Project

A. Government Documents -Original Signed Letter o f Financial Policies f rom the Minister o f Finance in Nepal. -Financial Sector Strategy Statement (FSSS)

B. Bank Staff Assessments -Bank's Financial Sector Study -Financial Management Assessment o f Nepal Rastra Bank -Procurement Assessment o f Nepal Rastra Bank

C. Other -various Management Team reports for Rastriya Banijya Bank and Nepal Bank Limited.

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Annex 12A: Letter o f Financial Policies

Dr. Prakashchandra Lohani Ministry o f Finance

%%&ber 9,2003

Mr. Praful Patel, Vice President, South Asia Region The W o r l d Bank 1818 H Street, N.W., Washington, D.C., 20433 UNITED STATES OF AMERICA

Dear Mr. Patel,

Letter of Financial Policies - Financial Sector Restructuring in Nepal

His Majesty’s Government o f Nepal (HMGN) has embarked o n a comprehensive program o f financial sector re form and The W o r l d Bank and the UK Department for Intemational Development (DFID) have provided important financial support t o the f i s t phase o f this reform through the Financial Sector Technical Assistance (FSTA) Project. Under this project, the government has placed two professional management teams into the two largest banks in Nepal - Rastriya Banijya Bank (RBB) and Nepal Bank L im i ted (NBL) - to restructure these institutions and ultimately prepare them for privatization.

Progress in RBB and NBL. In i t ia l indications are that good progress i s being made in these two banks. For example, non-performing loan recoveries have reached more than Rs2.0 b i l l i o n in RBB and we l l over Rs2.5 b i l l i on in NBL. B o t h banks are n o w producing financial accounts o n a regular quarterly basis. Externally audited accounts are expected to b e produced for 2002/03 within the f ive month t ime frame stipulated by Nepal Rastra Bank (NRB). B o t h banks are in the process o f install ing a basic IT platform to improve their management information systems and their accounting functions and Treasury management has been tightened in the two banks. B o t h banks managed to reduce their losses o n current year operations compared to last f inancial year. These banks are being restructured in ways that wou ld not have been possible two years ago. In this, we are grateful for the ongoing support o f the Wor ld Bank and DFID.

Voluntary Retirement Schemes in the two Commercial Banks. However, before additional substantive progress can be made in mov ing these banks towards privatization, further efficiency gains will need to be undertaken. The most evident area where productivity needs to b e achieved i s with respect to staffing. The human resource managers in these t w o banks have estimated that the banks are between 40 to 50 percent overstaffed and that i t i s necessary to shed 5,500 staff f r o m these banks. Only once the staffing levels are reduced to numbers wh ich are viable in the longer term wil l it be practical t o undertake the training and the upgrading necessary to improve

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service and efficiency. This process i s also expected to acheve substantive gains with respect t o cutting administrative costs - enhancing the abil ity t o ult imately privatize these banks. As you are aware, supporting the Voluntary Retirement Schemes (VRS) in these two banks i s a major focus o f the proposed Financial Sector Restructuring Program that we have n o w embarked upon - again with proposed support f r o m the W o r l d Bank.

Nepal Bank Limited. In moving ahead with the V R S we are cognizant o f the fact that Nepal Bank L im i ted i s a privately (59.1 percent) owned bank - even though His Majesty’s Government i s the single largest shareholder. As part o f the FSTA, the private sector board o f the bank was replaced by a board o f officials designated by the central bank and a new Management Team was installed - effectively placing the bank under N R B ’ s control.

Given these serious problems - plus the steep negative net wor th o f the bank (conservatively estimated at around $150 mil l ion) - there i s a need to take over full control o f this bank to protect the interests o f depositors, and to facilitate the ultimate objective o f turning this bank over to new “fit and proper” owners once the bank has been restructured. T o bring about this change in ownership, it is the intention o f HMGN to amend Art icle 86 o f the NRB A c t to provide NRB sufficient powers to, not only assume control o f NBL, as it has already done, but also rehabilitate and restructure the latter through asset and l iab i l i ty transfers. This arrangement i s specifically designed to address the issue o f troubled banks such as NBL which have private sector shareholders. To this end, HMGN intends to have this amendment approved by the Cabinet by December 2003.

In addition, it has been a considered v iew o f the Government as we l l as the Central Bank that, given the significant negative net wor th o f the NBL, the continuation o f i t s listing in the stock exchange could facilitate the trading o f shares at prices l ike ly to prove to be unsustainable, to the ultimate detriment o f potential investors. Consequently, initiatives have recently been taken through appropriate measures, currently in the f o r m o f suspension o f share trading, to de-list NBL shares f r o m the stock exchange. The government wants to assure you that the suspension wil l continue until the de-listing process wil l b e completed. The government expects to complete this process by December 2003, taking into account a l l necessary, including legal and financial implications o f the move.

Rastriya Banijya Bank. Issues relating to ownership do not exist with RBB as it i s a 100 percent government owned bank. HMGN will therefore be able to dispose o f the assets o f the bank in any way in wh ich i t sees fit. Nonetheless, in bo th banks, there wil l be the customary problems associated with V R S schemes, notably, questions o f adverse selection, revolving door policies, and concem that changes in governance arrangements (Le. privatization) may no t ult imately be acheved. In this respect we are working with the HR specialists o n the two Management Teams to reduce the staff complement o f these banks to a much lower level; ensure that acceptance o f the V R S i s on ly with the agreement o f bo th parties - the bank and the individual (to avoid adverse selection); and to move towards rap id privatization to ensure that satisfactory long t e r m governance arrangements are put in to place within these two banks as soon as possible.

The “End Game” for the Two Large Banks. Over the past twelve months, there has been considerable discussion o f the “End Game” with respect to these banks. W e have discussed with W o r l d Bank and Intemational Monetary Fund officials many possible options including liquidation, merging the banks, privatizing the banks as separate entities, and splitting their functions and combining them with other financial institutions. However, we

49

have decided to remain with the original p lan la id out in Government’s Financial Sector Strategy statement (FSSS) o f November 2000 which clearly states that the two banks wi l l be ultimately privatized - to “fit and proper” bankers - as two separate entities. I t i s our intention to move towards privatization as rapidly as possible and hence we have decided to recruit a Sales Advisor to advise o n the privatization as part o f the proposed Phase I1 financial sector re form operation supported by the W o r l d Bank. Therefore, the HMGN’s end game with respect to RBB and NBL i s rapid privatization o f these banks to fit and proper buyers, as separate banking entities, in as short a t ime period as possible - preferably before t h e end o f 2006.

Retraining and Counseling. The government wants to see that bank staff who accept the voluntary retirement packages are given as much support as possible in making smooth the transition f r o m working l i fe in the banking sector to retirement, self employment, or some other productive economic activity, by counseling these workers, providing training to them o r their family members, who can help earn alternative sources o f household income. W e therefore request that this component o f the proposed Phase I1 package o f the financial sector re form be exclusively grant-funded with the support o f the W o r l d Bank or any other development partner.

Hiring Sales Advisors. Hiring Sales Advisors for the two banks i s an integral component o f our p lan to reach the end game o f separate privatization. Again we welcome W o r l d Bank support to hire th is expertise, prepare sales memoranda for the two restructured institutions, undertake a road show for their sale, and ultimately take the banks through to the point o f privatization. I t i s our intention to have completed this process by the end o f 2006 - with a v iew that one bank could be sold some time earlier.

On-going Management Team Support. W e also wish to maintain the banks under professional management arrangements up to the point o f privatization. The current management teams wil l almost certainly have their contracts extended for a third year - although the composition o f the teams may change. However, given the uncertainties surrounding the restructuring program and the timing o f the privatization process itself, i t may be necessary to keep these Management Teams, or an acceptable alternative, engaged beyond a thud year. In this light, we welcome the proposed W o r l d Bank assistance to cover the costs o f such Management Team support up until the point o f privatization.

Nepal Rastra Bank. The most crit ical institution with respect to our nation’s financial sector i s the central bank itself, i.e. Nepal Rastra Bank. The support provided under the F S T A project has been instrumental in helping commence the process o f re-engineering the human resources, the accounting, and the bank supervisory functions o f the bank. W e n o w feel that it i s important to broaden and deepen these in i t ia l gains. W e therefore v iew a second phase o f NRB re-engineering as being important in consolidating the gains already achieved with respect to NRB and widening these further to the other banks and finance companies operating within the economy. I would l i ke to emphasize some areas where we have agreed that W o r l d Bank support will b e required within NRB:

Human Resource Reform. First, the compete restructuring o f the Human Resources function i s crit ical t o providing appropriate incentives to staff and to ult imately turning the bank in to a fully professional wor ld class institution. To th i s end, the NRB i s taking steps to energize this important function. The bank has reduced i t s staffing numbers f r o m 2,500 to 1,700. In our view the bank i s st i l l substantially over-staffed and needs to reduce staffing to a level somewhat lower than 1,000 with further reductions once the IT platform has been put in place. The bank i s embarking upon a VRS scheme under which it intends to retrench staff who are currently involved in

50

functional areas which are to be outsourced - mainly non-core central banlung activities (gardening, security, drivers, cleaners, canteen, etc), as we l l as lower level administrative jobs where the bank is currently overstaffed. This will be further supported by the introduction o f a new organizational structure f r o m January 1, 2004 (agreed with IDA and the IMF) and new human resource policies related to recruitment, promotion, transfer, performance management, and retirement. In combination with a continuation o f the existing no-transfer rule o n staff in key departments and on-going HR support under the fo l low up financial sector operation, we expect to witness a strong movement in the desired direction for Nepal Rastra Bank over the next several years. Establishing a leaner, more professional central bank also permits the Ministry to put forward a stronger case for the salary decompression which i s required in NRB for attracting and retaining the right professional talent in the institution.

Banking Supervision. The progress achieved within bank supervision in NRB over the past three years, n o w needs to be consolidated and deepened. T o this end, the NRB has established a two-year cycle o f o n site bank examinations for a l l 17 commercial banks in the country. Under the Financial Sector Restructuring Project, we anticipate that substantive professional support wil l provide the necessary training and quality assurance required for these on-site bank exams. Computing assistance for the bank supervision and operations department wil l also assist in this process. Strengthening NRB's supervisory and regulatory role i s key to the success o f the overall financial re form agenda. Equally important wil l be fol low up actions resulting f r o m the recommendations o f these consolidated on-site bank examination reports, which HMGN will b e pursuing with the full force o f the law.

Auditing and Accounting. In l ine with agreements with IDA and the IMF, Nepal Rastra Bank wil l be adopting an accounting manual w h c h meets International Accounting Standards and wil l i tself be externally audited to I A S in 2002/03 and 2003/04 by an international firm experienced in central bank audit. T o assist in this process, we welcome the on-going IDA support under the F S T A Project t o assist the central bank in meeting these important goals.

Information Technology. The central bank requires a significant upgrading o f i t s IT platform. I t currently operates with very l i t t le computing power and without a computerized General Ledger. W e are pleased to note the support o f IDA in agreeing to finance the development o f an institution wide IT Strategy for the bank, the hardware (including a computerized general ledger system), the software, and the staff training requirements for th is function. I t i s only with a substantially enhanced computerized capacity that the central bank wil l be able to achieve i t s full potential with respect to the vision that HMGN n o w has for the bank.

Other Support. I would also l ike to request that the W o r l d Bank operation retain some f lexibi l i ty to finance other pertinent areas o f support within Nepal Rastra Bank - as the need arises. This wil l be particularly important in helping us meet our medium te rm objectives o f establishing a f i r s t class central over the next three to f ive years.

Public Awareness and Public Concerns. I a m pleased to note that the general public has become increasingly aware o f the issues surrounding the financial sector re form in Nepal. The maturity o f the public debate o n these issues has been encouraging. Nonetheless, as we move forward, I anticipate that various vested interests wil l apply pressure in the media and beyond in an effort t o protect the economic rents that they have managed to extract f r o m the system. T o this end, an up-scaling o f the public awareness component o f the Phase I F S T A project wil l be important and we look to NRB and IDA in assisting us in publicizing the reform message adequately and at an appropriate level to reach the general public in Nepal. W e are firmly o f the v iew that a well-informed public i s a crucial ingredient o f success in the overall reform agenda.

51

In Conclusion. I trust that the progress that we have acheved over the past two years clearly demonstrates HMGN’s support for the financial sector re form agenda. The way forward i s focused o n three very clear and tangible objectives: (a) the separate privatization o f RBB and NEiL to “fit and proper” buyers within the next three years; (b) an intensification o f the consolidated supervision o f a l l the commercial banks in Nepal (including fo l low through o n appropriate remedial actions); and (c) a further streamlining and professionalization o f the central bank with a particular focus o n on-going HR reform, strengthening o f auditing and accounting capacities, considerably enhanced support for on-site bank examination, and an important capacitization o f the IT function. As such, we envisage that the W o r l d Bank Phase I1 Financial Sector Reform project will provide $77.0 m i l l i on for support in these areas.

I a m encouraged about the way forward for our financial sector reform agenda and a m grateful for the support that the IDA, the IMF and DFID have lent t o our efforts. Our vision i s o f a fundamentally rejuvenated and modernized financial sector - providing support for the better overall economic health o f the economy, for the benefit o f a l l Nepalis.

Yours Sincerely,

Dr. Prakash Chandra Lohani Minister o f Finance, His Majesty’s Government o f Nepal

cc International Monetary Fund; (IMF) Department for International Development (DFID

52

Annex 13: Statement o f Loans and Credits

NEPAL: Financial Sector Restructuring Project

Original Amount in US$ Millions

Difference between expected and actual

disbursements

Project ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm. Rev’d ~~~

PO10516 1997 Rural Water Supply and Sanitation 0.00 18.28 0.00 0.00 1.55 0.59 3.37 1.74

PO10530 1998 Irrigation Sector Development 0.00 79.77 0.00 0.00 8.01 5.22 14.64 3.77

PO40612 1999 Basic and Primary Education I1 0.00 12.50 0.00 0.00 0.00 0.52 0.81 -0.63

PO45052 2000 Road Maintenance and Development 0.00 54.50 0.00 0.00 0.00 33.13 49.43 9.40

PO50671 2002 Telecommunications Sector Reform 0.00 22.56 0.00 0.00 0.00 23.24 11.30 0.22

PO82646 2003 Community School Support Project LIL 0.00 5.00 0.00 0.00 0.00 4.95 0.13 0.00

PO71291 2003 Financial Sector Technical Assistance 0.00 16.00 0.00 0.00 0.00 14.26 -2.75 0.00

PO4331 1 2003 Power Development Project 0.00 75.60 0.00 0.00 0.00 78.46 3.00 0.00

PO74686 2004 Poverty Reduction Support Project 0.00 70.00 0.00 0.00 0.00 74.17 0.00 0.00

Total: 0.00 354.21 0.00 0.00 9.56 235.54 79.93 14.51

N E P A L STATEMENT OF IFC’s

Held and Disbursed Portfolio In Mi l l ions o f U S Dollars

Committed Disbursed

IFC IFC

FY Approval Company Loan Equity Quasi Partic. Loan Equity Quasi Partic.

1994 Himal Power 23.40 0.00 3.40 0.00 23.40 0.00 3.40 0.00

1996 Bhote Koshi 17.96 2.95 0.00 26.90 17.96 2.95 0.00 26.90

1998 Jomsom Resort 4.00 0.00 0.00 0.00 4.00 0.00 0.00 0.00

2001 ILFC -Nepal 0.00 0.29 0.00 0.00 0.00 0.30 0.00 0.00

Total portfolio: 45.36 3.24 3.40 26.90 45.36 3.25 3.40 26.90

Approvals Pending Commitment

FY Approval Company ~

Loan Equity Quasi Partic.

Total pending commitment: 0.00 0.00 0.00 0.00

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Annex 14: Country at a Glance NEPAL: Financial Sector Restructuring Project

POVERTY and SOCIAL

2003 Population, mid-year (million) GNi per capita (Atlas method, US$J GDP per capita (US$) GNI (Atlas method, US$ billion)

Average annual growth, 199743

Population (%) Labor force (%)

Most recent estimate (latest year available, 1997-03) Poverty (% of population below national poverty line, 1996) Urban population (% of total population) Life expectancy at birth (years) Infant mortality (per 1,000 live birlhsl Child malnutrition (% of children under 5) Access to an improved water source (% of population) illiteracy (% ofpopulation age 15+) Gross primary enrollment I% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1983

GDP (US$ billions) 2.4 (in percent) Gross domestic investmenVGDP 19.6 Exports of goods and ServicedGDP 10.2 Gross domestic savings/GDP 8.5 Gross national savings/GDP 10.7

Current account balanceiGDP -7.4 Interest payments on external debtlGDP 0.2 Total external debVGDP 18.5 Total debt service/exports 6.5 Present value of debffGDP (2001) Present value of debffexports (2001)

1983-93 1993-03 (average annual growth) GDP 5.1 4.3 GDP per capita 2.7 2.0

Nepal

24.2 240 238 5.7

2.2 2.6

42 13 60 66 48 88 55

118 128 108

1993

3.7

22.6 18.4 12.2 14.5

-8.1 0.8

54.9 8.8

2002

-0.5 -2.7

South Asia

1,401 460

€40

1.8 2.3

28 63 71

84 44 97

108 89

2002

5.5

24.6 16.1 11.8 25.7

2.6 0.4

52.9 4.6

28.1 74.0

2003

2.3 0.1

LOW. income

2,495 430

1,072

1.9 2.3

30 59 81

76 37 95

103 87

2003

5.7

26.1 14.6 11.3 25.6

-0.9 0.4

51.8 5.2

2003-07

4.8 2.2

Development diamond'

Life expectancy

T 3NI ier :apita

1

Access to improved water source

-Nepal Low-income group

Economic ratios.

Trade

T

I 1

I Indebtedness

1 -Nepal Low-income group

STRUCTURE of the ECONOMY

(% of GDP) Agriculture Industry

Services

Private consumption General govemment consumption Imports of goods and services

Manufacturing

1983 lSs3 2o02 Growth of GDp (*A)

12.8 20.2 20.9 60.3 41.3 39.6

4.6 8.6 8.1 26.9 38.4 39.5 39.7

81.3 79.3 78.1 78.2 -2 10.1 8.5 10.0 10.5 21.3 28.8 28.8 29.3

fig< ' O ' G D P

(average annual growth) Agriculture Industry

Services Manufacturing

1983-93 1993-03 2002 2003

3.4 3.3 2.2 2.1 9.2 4.9 -3.3 2.3

10.1 4.2 -10.0 0.4 4.7 5.5 -1.4 2.7

Note: 2003=2002/03. * The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will

be incomplete.

54

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplusldeficit

TRADE

(US$ millionsl Total exports (fob)

Food Pulses Manufactures

Total imports (cif) Food Fuel and energy Capital goods

BALANCE of PAYMENTS

(US$ millions) Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance Official transfers

Financing items (net) Changes in net reserves (-=increase)

Memo: Reserves including gold (US$ millions) Conversion rate (DEC, local/US$)

EXTERNAL DEBT and RESOURCE FLOWS

/US$ millions) Total debt outstanding and disbursed

IBRD IDA

Total debt service IBRD IDA

Composition of net resource flows Official grants Official creditors Private creditors Foreign direct investment Portfolio equity

World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

1983

14.0 12.3

1983

82

457

1983

249 483

-233

12 36

-185 4

137 44

13.8

1983

453 0

172

20 0 2

94 68 I

-1 0

45 31 0

31 1

29

1993

9.9 11.2

I993

379

860 101 84

169

1993

675 1,053 -378

8 75

-295 77

380 -162

571 48.0

I993

2,010 0

832

69 0

10

77 156 -1 0

6 0

0 69 4

66 6

60

2002

2.9 3.2

11.5 -0.1 -5.7

2001

942 65 56

256 1,773

81 338 312

2002

1,060 1,687 -626

-7 777

143 143

-323 36

1,055 75.9

2002

2,933 0

1,156

88 0

26

143 4 0

-4 0

23 38 18 20 8

12

2003

4.7 3.5

12.3 -4.0 -4.0

2003

782

1,707

2003

949 1,821 -872

-6 825

-53 161

-143 -123

1,184 77.8

2003

2,975 0

1,185

96 0

30

161

0 -2 0

97 27 21

6 9

-3

lnflatlon (%)

l5 T I ,I I 1 O' 98 99 00 i 02 .]

-GDP deflator ' O ' C P I

I Export and Import levels (US0 mill.) 12,010 T

97 98 99 00 01 02

Exports w Imports

Current account balance to GDP (%)

lo T

1.5 1

Comporltlon of 2002 debt (US0 mlll.)

~~5 G 3 6

A. IBRD E - Bilateral B - IDA D . Other multilateral F - Private C. IMF G. Short-term

Development Economics 10/7/03

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MAP SECTION