Second Financial Sector Program in the Lao People's Democratic Republic

8/2/2019 Second Financial Sector Program in the Lao People's Democratic Republic

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Performance Evaluation Report____________________________________________________________________________

Project Number: PPE: LAO 26563Loan Number: 1458-LAO (SF)February 2006

Lao Peoples Democratic Republic:Second Financial Sector Program

Operations Evaluation Department

Asian Development Bank


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ASIAN DEVELOPMENT BANKOperations Evaluation Department

PROGRAM PERFORMANCE EVALUATION REPORT

FOR

LAO, PEOPLES DEMOCRATIC REPUBLIC

In this electronic file, the report is followed by Managements response.


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CURRENCY EQUIVALENTS

Currency Unit kip (KN)

ABBREVIATIONS

NOTES(i) In this report, $ refers to US dollars.(ii) The fiscal year (FY) of the Government ends on 31 December. FY

before a calendar year denotes the year in which the fiscal year ends.

Director General B. Murray, Operations Evaluation Department (OED)Director D. Edwards, Operations Evaluation Division 2, OED

Team leader H. Feig, Principal Evaluation Specialist, OEDTeam members J. Dimayuga, Evaluation Officer, OED

A. Silverio, Operations Evaluation Assistant, OED

Operations Evaluation Department, PE-678

At Appraisal(1 July 1996)

At Project Completion(30 April 2001)

At Operations Evaluation(31 October 2005)

KN1,000 = $1.049 = $1.179 = $0.093$1.00 = KN9,530 = KN8,482.5 = KN10,800

ADB Asian Development Bank APB Agricultural Promotion BankBCEL Banque pour le Commerce Extrieur LaoBOL Bank of Lao PDRBSRP Banking Sector Reform ProgramDMC developing member countryESAF Enhanced Structural Adjustment FacilityFSPL I First Financial Sector Program LoanGDP gross domestic productIFI international financial institution

Lao PDR Lao Peoples Democratic RepublicLDB Lao Development BankLMB Lao May Bank Ltd.LXB Lane Xang Bank Ltd.MOF Ministry of FinanceNPL nonperforming loanOEM operations evaluation missionPCR project completion reportPPER program performance evaluation reportRRP report and recommendation of the PresidentSAC III Third Structural Adjustment CreditSCB state commercial bank

SOE state-owned enterpriseSSO Social Security OrganizationTA technical assistance


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CONTENTS

Page

BASIC DATA iii

EXECUTIVE SUMMARY iv

I. INTRODUCTION 1 A. Evaluation Purpose and Process B. Program Objectives 1

II. DESIGN AND IMPLEMENTATION 2 A. Rationale B. Formulation 3C. Cost, Financing, and Executing Arrangements 4D. Procurement and Application of Counterpart Funds 4E. Consultants 4F. Outputs 5

III. PERFORMANCE ASSESSMENT 7 A. Overall Assessment B. Relevance 7C. Effectiveness 12D. Efficiency 16E. Sustainability 16F. Institutional Development 17G. Impact 17

IV. OTHER ASSESSMENTS 17 A. ADB and Executing Agency Performance 17

B. Technical Assistance 19

V. ISSUES AND LESSONS 20 A. Issues B. Lessons 22

The guidelines formally adopted by the Operations Evaluation Department (OED) on avoidingconflict of interest in its independent evaluations were observed in the preparation of this report.The report was prepared by the team leader. Field work was undertaken by the team leader andKirsten Boe (international consultant/banking specialist) with the assistance of KhamsoukPhommarath (domestic consultant/legal specialist). To the knowledge of the management of

OED, there were no conflicts of interest among the persons preparing, reviewing, or approvingthis report.


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Page

APPENDIXES

1. Summary of the Status of Compliance with Program Components and Conditions 242. Macroeconomic, Financial Sector, and Social and Poverty Indicators 19952004

and Financial Statements of State Commercial Banks 303. Design and Monitoring Framework 35

Attachment: Management Response


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BASIC DATALoan 1458-LAO(SF): Second Financial Sector Program

PROGRAM IMPLEMENTATION

TANumber TA Title Type

Person-Months

Amount($000) Approval Date

TA 2642 Restructuring and Consolidation of the

State-Owned Commercial Banks

ADTA 27 954 12 September 1996

TA 2643 Development of an Interbank Market ADTA 3 130 12 September 1996

KEY PROGRAM DATA ($ million) As per ADBLoan

Documents Actual

Total Program Cost 25.0 23.6ADB Loan Amount/Utilization

a25.0 23.6

ADB Loan Amount/Cancellation 0.0 0.0

KEY DATES

Expected Actual

Fact-Finding 23 Jan5 Feb 1996Loan Negotiations 1415 Aug 1996

Board Approval 12 Sep 1996Loan Agreement 6 Nov 1996Loan Effectiveness 13 Nov 1996 6 Dec 1996First Tranche Release 6 Dec 1996 6 Dec 1996Second Tranche Release 31 Oct 1998 4 Aug 2000Program Completion 31 Oct 1999 30 Apr 2001Loan Closing 6 Jun 2000 30 Apr 2001Months (effectiveness to completion) 36 54

TRANCHE RELEASES

Amount Number of Policy Conditions($ million) Met Substantially Met Partially Met Not Met

First Tranche Release Conditionsb

12.4 4 0 0 0Second Tranche Release Conditions

c11.2 12 0 1 0

Other Program Conditionsc 7 1 1 1

All Conditionsd 15 2 11 1

BORROWER Lao Peoples Democratic RepublicEXECUTING AGENCY Bank of Lao PDR

MISSION DATA

Type of MissionNumber ofMissions

Number ofPerson-Days

Pre-Fact-Finding/Fact-Finding 2 102 Appraisal 1 75Review 14 146Program Completion Review 1 16Operations Evaluation 1 11

ADB = Asian Development Bank, ADTA = advisory technical assistance, TA = technical assistance.a

Equivalent to SDR17.15 million.b

ADB. 1996. Report and Recommendation of the President to the Board of Directors on a Proposed Loan andTechnical Assistance Grant to the Lao Peoples Democratic Republic for the Second Financial Sector Program.Manila. (Loan 1458-LAO[SF], for $25 million, approved on 12 September 1996).

cAssessment of Board Information Paper on Second Tranche Release (Loan 1458-LAO[SF], for $25 million,approved on 12 September 1996).

d Operations evaluation mission assessment.


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EXECUTIVE SUMMARY

The Asian Development Bank (ADB) has been supporting financial sector developmentin the Lao Peoples Democratic Republic (Lao PDR) since 1988, first through technicalassistance, and then through the first Financial Sector Program Loan (FSPL I), to facilitate theestablishment of a market-oriented economic system. FSPL I sought to (i) strengthen the overall

financial sector policy and legal environment, (ii) enhance its institutional base, and (iii) promotethe reform of state-owned enterprises (SOEs) and the development of private enterprise. Therecapitalization of the insolvent state commercial banks (SCBs) was a cornerstone of FSPL I.However, as recapitalization was delinked from any meaningful operational restructuring of theSCBs, including improvements of their credit systems, or measures to strengthen corporategovernance, improvements in their financial performance proved to be unsustainable. A numberof financial-sector related laws promoted under FSPL I still required approval oroperationalization through implementing decrees and capacity-building measures to make themeffective. To continue its support for policy reforms begun under FSPL I, ADB approved Loan1458-LAO(SF): Second Financial Sector Program (the Program) for $25 million equivalent on12 September 1996. The Program was to (i) improve SCB operations through consolidation,corporatization, capacity building, and exploration of joint-venture and other divestment options;

(ii) improve banking supervision; and (iii) put in place the required financial infrastructureincluding the institutional and regulatory framework for an interbank market, a credit informationbureau, and a deposit protection fund, and the legal basis for secured transactions, negotiableinstruments, leasing, and pension funds. The first tranche was disbursed shortly after the loantook effect on 6 December 1996. The second tranche was released in August 2000, about 21months later than first planned.

The Program is rated partly successful bordering on unsuccessful. It sought to addressa number of pertinent structural issues for longer-term financial sector development in thecountry. However, Program relevance was reduced by design flaws, most notably in the area ofSCB restructuring. The findings of ADB-financed reviews of SCB loan portfolios as of 30 June1995 should have resulted in (i) concrete measures to make the SCBs more profitable, resolve

significant nonperforming loan (NPL) problems, and limit the potential for more bad loans.Tranche releases under the Program should have been linked to improvements in bankperformance, debt recovery, and meaningful operational restructuring. Instead, the Programpursued a hand-off approach to operational restructuring and sought to improve SCBgovernance mainly through corporatization, consolidation, and external investment ormanagement without realizing that there was not enough support from senior decision makersat central and provincial government levels for the underlying principle of increased SCBautonomy, as evidenced by continued non-commercially motivated lending. The stronginfluence of regional governments on SCB branch operations and of line ministries on SCBlending decisions should have warranted more attention. While SOE restructuring wasidentified as an important condition for SCB restructuring, related conditionality was omittedfrom the Program, as this and other public sector management issues were to be addressed

under parallel programs supported by the International Monetary Fund and the World Bank.These programs were later suspended during the financial crisis, which hit the country in 1998.The countrys crisis was mainly the result of imprudent macro-economic managementfiscalexpansion was financed through monetizationand significant reductions in new investmentsand trade by Thailand in the aftermath of the Asian financial crisis. While the crisis did not havea direct bearing on the achievability of the ADB-supported Program, which mainly comprisedmedium-term structural measures, it did affect the performance of the banking system and,therefore, the achievement of Program outcomes. The Program should have included specificconditionality related to the discontinuation of non-commercially motivated lending or, at the


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very least, required that such lending be guaranteed by the Government. A number of othersector, macroeconomic, and overall governance problems and conditions were not sufficientlyassessed despite ADBs previous involvement in the sector and the country. For example, thepotentially negative impact of dollarization on monetary management and bank restructuringwas neither considered nor actively addressed at the program design stage, although the rateof dollarization exceeded 42% in 1995.

Although the majority of the policy conditions under the Program were met, many failedto achieve the intended outputs and, ultimately, outcomes. The key objectives of the Programaccording to the report and recommendation of the President were to (i) mobilize more domesticsavings, particularly long-term savings, and allocate them efficiently to promote private sectordevelopment; and (ii) strengthen macroeconomic management by developing a sound andmarket-responsive banking system. While financial depth and savings levels have increasedslightly since 1995, banking sector efficiency and soundness have not improved. The growth ofcredit as a share of gross domestic product (GDP) stagnated, and the share of private sectorcredit decreased from about 80% of net domestic credit to the economy in 1995 to about 60% inrecent years. NPL levels for SCBs, which continue to dominate the countrys banking system,increased from 33% of total SCB loans in mid-1995 to about 52% in 2000, and a reported 64%in 2004. SCB restructuring measures under the Program, in particular the consolidation andformal governance changes, did not lead to any improvements in credit and risk managementpractices. Because of lack of progress with SOE, fiscal, and overall governance reforms, SCBscontinued to be subject to external pressures to lend on a noncommercial basis. Plans toimprove the autonomy and commercial orientation of SCBs through joint ventures, divestment,and other arrangements proved to be unrealistic, as foreign investors showed no interest inacquiring or managing any of the state banks. Program efforts to improve banking sectoroperations through strengthened banking supervision remained ineffective because of theconflicting roles of Bank of Lao PDR (BOL) staff as SCB managers and banking systemsupervisors. The negative capital positions of SCBs did not trigger an adequate supervisoryresponse from the BOL during the Program period. Despite useful program achievements inestablishing an institutional and regulatory framework for interbank market operations, a formalmarket has not evolved because of weaknesses in the macroeconomic environment and the

lack of incentives for banks to improve liquidity management. The establishment of an effectivesecured transactions regime continued to be constrained by deficiencies in the legislationapproved under the Program. Nevertheless, a number of program conditions were effective.

Among these were (i) the adoption of a chart of accounts by all banks and the completion ofinternational audits for SCBs, which gave the Government and the international financialinstitutions (IFIs) a better understanding of the financial position and performance of the banks;(ii) the establishment of a credit information bureau within BOL, which is being used, albeit notas comprehensively as might be desired; (iii) the creation of a legal basis for negotiableinstruments; and (iv) the passage of legislation to establish a social security fund/pensionscheme for employees of public and private enterprises.

Sustainability of program outcomes is less likely. The Program began the consolidation

and corporatization of SCBs and thus provided a platform for expanded policy dialogue onthese issues under the ongoing ADB-supported 2002 Banking Sector Reform Program (BSRP).

As a result of performance-based governance agreements entered into in April 2003 by theMinistry of Finance, BOL, and SCB managements under BSRP, noncommercial lending andassociated NPL levels have reportedly been reduced. However, significant efforts will need tobe made to (i) reduce pressure for non-commercial lending through further SOE restructuringand strengthened fiscal management, (ii) improve governance in the banking system, and (iii)


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reinforce the secured transactions regime to ensure the full effectiveness and sustainability ofthe Program.

The Program and its associated technical assistance grants contributed only in a limitedway toward building capacity to undertake financial reforms and bank restructuring. AssociatedTAs 2642-LAO and 2643-LAO are rated as partly successful mainly due to limitedeffectiveness. The Program did not significantly improve the incentive systems under which theSCBs operate. This situation was worsened by the Programs unstructured approach to SCBconsolidation. Experience with financial sector assistance in the Lao PDR highlights the needfor a comprehensive capacity development strategy that is not limited to addressingrequirements for training and advisory services, but also covers overall policy, governance, andother incentive structures that have an impact on the effectiveness of such assistance.

The OEM confirms international experience gained with policy-based lending and statebank restructuring in similar countries. Lessons identified in conjunction with the Programinclude the need to (i) carefully assess political economy and overall governance factors thataffect banking sector performance determine, particularly credit allocation and recoverydecisions; (ii) obtain up-front high-level commitment to a comprehensive reform agenda thataddresses all relevant issues; (iii) properly sequence various financial sector reform efforts, andcoordinate them with simultaneous reform efforts related to SOE restructuring, and publicsector and fiscal management, as well as with legal and judicial reforms that improve theenvironment for secured transactions and debt recovery, as necessary; (iv) carefully assess thefinancial position of banks prior to their restructuring, agree on time-bound state bankrestructuring plans with meaningful financial and operational performance targets, and linkdisbursement of program tranches to compliance with targets; (v) adequately consider andmitigate capacity constraints to the identification and implementation of reforms; and (vi)consider the potential impact of the macroeconomic environment on the feasibility of financialsector reforms.

Bruce MurrayDirector GeneralOperations Evaluation Department


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I. INTRODUCTION

A. Evaluation Purpose and Process

1. Loan 1458-LAO(SF): Second Financial Sector Program1 (the Program) was selected forevaluation. As the Asian Development Bank (ADB) has ongoing and planned operations in the

financial sector in the Lao Peoples Democratic Republic (Lao PDR), the evaluation findingsshould be useful in helping determine future activities and follow-up policy dialogue to ensurethe achievement and sustainability of program outcomes. The assessment was based on thefollowing broad criteria proposed in the ADB Guidelines for the Preparation of PerformanceEvaluation Reports for Public Sector Operations: (i) relevance, (ii) effectiveness, (iii) efficiency,(iv) sustainability, and (v) institutional development impact. International experience gained inbank restructuring was considered in evaluating the adequacy of the approach. The programperformance evaluation report (PPER) also suggests lessons for future ADB assistance forfinancial sector reforms and bank restructuring. This report was prepared by the operationsevaluation mission (OEM) that visited Lao PDR from 24 October to 3 November 2005. The OEMreviewed program-related documentation and other background materials, and met with ADBstaff involved in the design and formulation of the Program and with key stakeholders in Lao

PDR including representatives of Bank of Lao PDR (BOL), the Ministry of Finance (MOF), statecommercial banks (SCBs), the Social Security Organization, private commercial banks, theInternational Monetary Fund, and the World Bank.

2. A comprehensive and informative program completion report (PCR) prepared by theGovernance, Finance, and Trade Division of Mekong Department in January 2002 rated theProgram only partly successful because of deficiencies in program design and implementation,and its limited contribution to its broad objectives of deposit mobilization and improvedmacroeconomic management. Although many policy actions had not yet achieved their intendedeffects, the PCR nevertheless assessed a number of the reforms promoted under the Programto be sustainable and to have contributed to creating conditions for the further development of amarket-driven financial system. The reforms fell into the following categories: (i) institutional

(establishment of a credit bureau and of a separate banking supervision department in BOL); (ii)regulatory (adoption of regulations on interbank borrowing and supervision of the interbankforeign exchange market, and of an implementing decree for secured transactions legislation);and (iii) legal (adoption of laws on leasing and social security, and of a decree on bills ofexchange and promissory notes). According to the PCR, the Program had underestimatedcapacity constraints, the complex legislative process, and the level of government ownershipand commitment to reform.

B. Program Objectives

1. Loan 1458-LAO(SF)

3. The key objectives of the Program were to (i) mobilize more domestic savings,particularly long-term savings, and allocate them efficiently to promote private sectordevelopment; and (ii) strengthen macroeconomic management by developing a sound andmarket-responsive banking system. Program components comprised (i) restructuring andconsolidation of the seven SCBs; (ii) strengthening of the autonomy and commercial orientation

1ADB. 1996. Report and Recommendation of the President to the Board of Directors on a Proposed Loan andTechnical Assistance Grant to the Lao Peoples Democratic Republic for the Second Financial Sector Program.Manila. (Loan 1458-LAO[SF], for $25 million, approved on 12 September 1996).


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of SCBs; (iii) strengthening of the supervisory function of BOL through the adoption andenforcement of prudential regulations; (iv) establishment of market infrastructure; and(v) development of human resources and capacity building in the SCBs and the AgriculturalPromotion Bank (APB).

2. TA 2642-LAO: Restructuring and Consolidation of the State-Owned

Commercial Banks, and TA 2643-LAO: Development of an Interbank Market

4. The aim of technical assistance (TA) grant 2642 was to restructure and consolidateSCBs, strengthen their financial and management capabilities, enhance their public image,increase public confidence in their stability and viability, and make them respond efficiently tothe banking demands of the private sector. The TA was to assist the Government and BOL in(i) carrying out the key implementation components of the Program; (ii) consolidating the SCBsand reducing their number from seven to two, to make them efficient and financially sound;(iii) setting up a deposit protection scheme; (iv) paving the way for a joint venture bycorporatizing SCBs, valuing the assets, and fixing a selling price; (v) identifying joint-venturepartners, management contracts, and ways of reducing government ownership of SCBs;(vi) establishing a credit information bureau; and (vii) developing an effective campaign for

mobilizing more deposits.

5. The main objective of TA 2643 was to assist the Lao PDR monetary authorities inpromoting the development of an interbank market by (i) identifying the best strategy for marketdevelopment; (ii) helping to establish the institutional framework, procedures, and guidelines toensure the normal operation and adequate supervision of the market; and (iii) training bankersinvolved in the market.

II. DESIGN AND IMPLEMENTATION

A. Rationale

6. ADB has supported financial sector development in Lao PDR since 1988, first throughTA programs, and later through the first Financial Sector Program Loan (FSPL I), 2 which was tohelp create a basic framework for a market-oriented financial system by (i) strengthening theoverall financial sector policy environment, (ii) enhancing its institutional base, and(iii) promoting state-owned enterprise (SOE) reform and private enterprise development. Therecapitalization of the insolvent SCBs was a cornerstone of FSPL I. However, as recapitalizationwas delinked from any meaningful operational restructuring of the SCBs or measures tostrengthen corporate governance, improvements in their financial performance proved to beunsustainable. A number of laws promoted under FSPL I still required approval oroperationalization through implementing decrees and capacity-building measures to make themeffective. To continue ADBs support for policy reforms begun under FSPL I, FSPL II was to (i)improve SCB operations through consolidation, corporatization, capacity building, and

exploration of joint-venture and other divestment options; (ii) improve banking supervision; and(iii) put in place the required financial infrastructure including (a) the institutional and regulatoryframework for an interbank market, (b) a credit information bureau and a deposit protectionfund, and (c) the legal basis for secured transactions, negotiable instruments, leasing, andpension funds. Program content was in line with stated government priorities and ADB country

2ADB. 1990. Report and Recommendation of the President to the Board of Directors on a Proposed Loan andTechnical Assistance to the Lao Peoples Democratic Republic for the Financial Sector Program. Manila. (Loan1061-LAO[SF], for $25 million, approved on 6 December 1990).


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strategic objectives at the time, which supported the transition of Lao PDR to a market-basedeconomy.

B. Formulation

7. The Program was formulated without the benefit of a project preparatory technical

assistance (PPTA) in a relatively short time (about 19 months from the first discussions with theGovernment to Board consideration). It was felt that ADBs prior involvement in the sector andthe country made a PPTA unnecessary. A large part of the program measures were acontinuation of ADBs earlier policy dialogue on financial sector reforms, and many of thePrograms policy conditions related to legal reforms were indeed carried over from FSPL I.However, other policy conditions, particularly those related to SCB corporatization, theestablishment of a deposit protection scheme, and the establishment of a legal framework forleasing, were apparently derived from ADB-supported sector programs in other developingmember countries (DMCs), notably Viet Nam,3 rather than being reform priorities appropriate forLao PDR. In addition, several conditions, namely those related to the establishment of aninterbank market and the strengthening of BOLs banking supervision function, followed fromparallel efforts by the International Monetary Fund under the Enhanced Structural Adjustment

Facility (ESAF) and the World Bank under the third Structural Adjustment Credit (SAC III), withwhich the Program was coordinated. Structural ESAF benchmarks included the(i) implementation of a foreign exchange auction system, (ii) implementation of a reserve moneyprogram, (iii) adoption of prudential regulation on foreign currency exposure in commercialbanks, (iv) adoption of a plan to enhance banking supervision, (v) adoption of a plan torestructure SCBs, (vi) removal of minimum interest guidelines on deposits, (vii) completion of areview of agricultural lending policies, and (ix) passage of legislation on negotiable instruments.Besides public sector management and SOE reforms, SAC III supported the (i) introduction ofprudential banking regulations for capital exposure, exposure limits, asset classificationstandards, enforcement powers, and treatment of failed banks; (ii) adoption of a uniform chart ofaccounts for SCBs; (iii) enforcement of loan loss provisions for SCBs; and (iv) independentaudits of the 1995 SCB accounts. However, as the Government could not meet its

macroeconomic targets during the Asian financial crisis, the ESAF was suspended in May 1997,and the second tranche of SAC III canceled in December 1998.

8. A review of project files and interviews with ADB staff and government officials did notindicate that different policy options had been considered in the design stage, or that theproposed policy actions and their underlying objectives and principles had in fact beendiscussed in detail. Various issues and their possible solutions were to be analyzed in detailunder the associated TA after the Program was approved. This explained in part the lack ofdiscussion at the design stage but also made it difficult to gauge and obtain up-front governmentcommitment to the full reform Program. BOL nevertheless affirmed that government ownershipof the program reform agenda was high. ADB does not appear to have imposed any policyconditions against the Governments wishes. If there were objections to the program reform

agenda, they were not raised formally during processing. Implicit objectives presumably playeda role in the Governments support for the Program. The current account deficit had widened to15% of gross domestic product (GDP) by the end of 1994, causing inflation to accelerate tomore than 20% in 19951996. The overall fiscal deficit on a commitment basis was 9.7% ofGDP in fiscal year 19941995, and was funded mainly through foreign financing.

3ADB. 1996. Report and Recommendation of the President to the Board of Directors on a Proposed Loan andTechnical Assistance Grant to the Socialist Republic of Viet Nam for the Financial Sector Program. Manila. (Loan1485-VIE[SF], for $90 million, approved on 19 November 1996).


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C. Cost, Financing, and Executing Arrangements

9. The Program was approved on 12 September 1996 and comprised (i) a policy loan of$25 million equivalent (SDR17,151,000) to be disbursed in two equal tranches, and (ii) two TAgrants to (a) support the restructuring and consolidation of SCBs, and (b) develop an interbank

market. The costs associated with the Program were estimated at between $28 million and $38million, mainly for SCB recapitalization needs, market infrastructure, and capacity-buildingexpenses. The first tranche was disbursed shortly after the loan took effect on6 December 1996. The second tranche was released in August 2000, more than 22 monthslater than planned. The Program was originally scheduled to end in December 1999 but actuallyclosed in April 2001. BOL was the Executing Agency for the Program with responsibility foroverall program implementation, and coordination with MOF and other relevant authorities.

D. Procurement and Application of Counterpart Funds

10. Program loan proceeds were withdrawn according to ADBs standard disbursementprocedures and used to finance imports of goods and services produced in and procured from

ADB member countries. Most of the imported foods came from Thailand (48%), Singapore(38%), and Viet Nam (14%).

E. Consultants

11. Under TA 2642, consulting firm was hired to provide 30.5 person-months of advisoryservices. The consulting team comprised seven experts, who delivered services of generallyacceptable, but varying, quality. The project department considered the firms performance assatisfactory bordering on marginal because of non-delivery of the SCB restructuring plans, lackof efforts in identifying external management options, and non-performance of the legal andregulatory specialist, who had to be replaced, which delayed the implementation of relatedconditionality. However, failure to produce the restructuring plans was due to a range of factors

including lack of relevant focus under ADBs policy dialogue, delayed availability of financialinformation, the SCB consolidation process. In the first phase, the consultants reviewed bankingand other relevant legislation, and produced plans for SCB corporatization and consolidation, astrategy for deposit mobilization, and blueprints for a deposit protection scheme and the creditinformation bureau. With respect to the deposit mobilization strategy and the deposit protectionscheme, consultant performance was considered as average. Consultant recommendationswere appropriate, although the task at hand was less relevant. In the second phase of the TA,the team leader assisted BOL in program implementation, coordination, and reporting. Notraining was provided under the TA. With the savings from the TA, individual consultants wererecruited in the latter part of 1999 to review the credit portfolios of the SCBs and assist them indeveloping loan recovery strategies, and to draft an implementing decree for securedtransactions. Under TA 2643, consultants were contracted through another consulting firm for a

total of 3 person-months to produce (i) a strategy outlining recommended policy and institutionalactions for the establishment of an interbank market, (ii) related regulations including aclearinghouse agreement, and (iii) a manual for interbank trading. These consultantsperformance was rated good. They developed an appropriate framework for interbank marketoperations, mentored relevant BOL staff on technical issues, and conducted a 1-day trainingseminar on interbank trading for bankers.


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F. Outputs

12. According to the Board information paper for the release of the second tranche, 20 of the23 policy conditions under the Program that were not related to the release of the first tranchehad been fully complied with. The PCR, in contrast, declared full compliance with only 19 ofthese conditions; it said that there was only partial rather than full compliance with the

conditionality related to the review of subsidized lending for agriculture. Both documents found(i) no compliance with the requirement to increase the SCBs autonomy by introducing externalownership or management, (ii) partial compliance with the required enforcement of prudentialregulations for SCBs, and (iii) substantial compliance with the requirement to facilitate Treasurybill (T-bill) auctions. Using a narrower definition of compliance, which also considers the effect ofthe policy measures taken on program output and outcome, the OEM found full compliance withonly 13 of the 23 policy measures that were not related to the release of the first tranche (see

Appendix 1 for a detailed analysis). Two conditions were substantially complied with, accordingto the OEM, seven were partially complied with, and one was not complied with. With regard tothe four conditions related to the release of the first tranche, OEM determined that only threewere fully complied with before tranche release. With regard to conditionality requiring BOL toconfirm actual SCB compliance with reporting requirements related to prudential regulations,

ADB accepted written confirmation from the SCBs themselves as evidence of compliance.

13. The key outputs achieved by the Program were as follows.

14. Restructuring and Consolidating the State-Owned Commercial Banks. In 19981999, six of the seven SCBs were consolidated into a southern and a northern bank, namedafter the dominant constituent banks in the respective groupings, i.e., Lane Xang and Lao MayBank. The other state bank, Banque pour le Commerce Extrieur Lao (BCEL), remained intact.The three banks were incorporated in April 1999. The consolidation of the SCBs did not result inany other significant bank restructuring. In 2003, continued lack of performance led to themerger of Lane Xang and Lao May Bank into Lao Development Bank (LDB) under the follow-upBanking Sector Reform Program (BSRP) supported by ADB.4

15. Strengthening the Autonomy and Commercial Orientation of SCBs. Amendmentsmade in 1997 to the Decree on the Management of Commercial Banks stipulated that (i) theSCB board of directors would determine SCB polices, and (ii) MOF would appoint the chairmanand other SCB board members. MOF appointed to the boards MOF and retired governmentofficials with no commercial banking or finance experience. In 2000, the law was amendedagain to make MOF, rather than BOL, responsible for appointing and removing the managingdirector and other SCB senior managers. However, despite the change, MOF has not fullyexercised its right to appoint management, and has instead continued to rely on BOL in thisregard. As a condition for loan negotiations, BOL issued an instruction to the SCBs and the APBrequiring all lending to be based on technical, financial and economic considerations.However, noncommercially motivated credit decisions by SCBs were uncovered in subsequent

audits. Compulsory lending to the agriculture sector by the SCBs was discontinued under theProgram, although agricultural loans are still being subsidized. APB continues to act as a policybank.

4ADB. 2002. Report and Recommendation of the President to the Board of Directors on a Proposed Loan andTechnical Assistance Grant to the Lao Peoples Democratic Republic for the Banking Sector Reform Program. Manila. (Loan 1946-LAO[SF], for $15 million, approved on 28 November 2002).


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16. The Program helped implement other operational restructuring measures for SCBs. InDecember 1998 BCEL formally adopted operations manuals establishing procedures for creditmanagement and other operations, and business plans, which also included depositmobilization measures. In June 1999, the merged SCBs did the same. To increasetransparency and boost incentives to improve performance, the financial statements of theSCBs have been subjected to external independent audits. However, there is little evidence of

improved SCB performance as a result of these actions. In fact, SCB performance, includinglevels of capitalization, capital adequacy, profitability, and portfolio quality, continued todeteriorate after 1996, according to the results of independent audits (Appendix 2). Also, whilethe expansion in branch operations resulted at first in an increase in deposit volumes, the 19971998 financial crisis led to negative real interest rates, which thwarted further depositmobilization efforts.

17. Strengthening BOLs Supervisory Function. The Program helped establish aseparate banking supervision function within BOL. It also supported the adoption andimplementation of a unified chart of accounts for all banks. BOL has conducted on-site (since1998) and off-site supervision to help enforce strengthened prudential regulations, which arelargely in line with international standards. During the program period, BOL implemented mostly

appropriate enforcement actions for private commercial and foreign banks, but exercisedregulatory forbearance for SCBs that failed to comply with BOL loan classification/provisioningand capital adequacy standards. Meaningful remedial action plans were formalized only in 2003under BSRP.

18. Building Market Infrastructure. The Program laid the foundations for the establishmentof an interbank market by supporting (i) the issuance of relevant BOL regulations andprocedures, (ii) the sale of T-bills through auctions, and (iii) the circulation of higher-denomination kip notes in the market. To help banks screen potential borrowers, BOLestablished a credit information bureau under the Program. To help mobilize bank deposits, adepositor protection fund was set up within BOL to safeguard small depositors. The Programalso helped establish the legal basis for the use of bills of exchange and promissory notes, and

for the establishment of a social security system including a pension fund for private sectoremployees.

19. Upgrading Commercial Banking Skills.A training needs assessment was conductedunder TA 2642. The ADB-financed TA 31465 later used the findings in designing a credittraining program for SCB and BOL staff that comprised training of trainers, workshops, and on-the-job training. Comprehensive training programs for BOL and SCB staff on all aspects ofcommercial banking operations have been conducted since 2003 by BOLs Bank TrainingCenter with support from a bank training project funded by the European Union. The WorldBank financed the training of BOL staff in 1998 on the implementation of the new prudentialregulations. Under TAs 2642, 3146, and 3466,6 SCBs received further assistance in theimplementation of the BOL regulations, as well as in loan classification and provisioning.

5ADB. 1998. Technical Assistance to the Lao Peoples Democratic Republic for Commercial Banking Capacity forEfficiency Enhancement. Manila. (TA 3146, approved on 24 December 1998, for $500,000).

6ADB. 1998. Technical Assistance to the Lao Peoples Democratic Republic for Strengthening CorporateGovernance and Management of State-Owned Commercial Banks. Manila. (TA 3466, approved on 7 July 2000, for$900,000).


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III. PERFORMANCE ASSESSMENT

A. Overall Assessment

20. The PPER rates the Program partly successful bordering on unsuccessful.

Table 1: Overall Performance Assessment

CriterionWeight

(%) Rating Value Rating

1. Relevance 20 1 0.202. Effectiveness 25 1 0.253. Efficiency 25 1 0.254. Sustainability 30 1 0.30

Total Ratinga 1.00

aHighly successful > 2.7; successful 2.7 < S < 1.6; partly successful 1.6 < PS < 0.8; unsuccessful < 0.8.Source: OEM Mission

B. Relevance

21. The Program was partly relevant. A sound and efficient financial sector is a condition forsustainable economic growth. The development of a functioning market-based banking systemis a key reform area for transitional economies like Lao PDR. The scope and focus of theProgram were in line with stated country development priorities and ADB country and sectorstrategies at the time of appraisal. The Program sought to address issues pertinent to financialsector development in Lao PDR, including state bank restructuring, interbank market

development, and strengthened banking supervision. However, individual program measureswithin these broad output areas were not always identified, formulated, and sequenced in a waythat was appropriate and suitable for the country, as explained below.

1. Adequacy of Problem Analysis and Design Assumptions

22. Lack of Design and Monitoring Framework to Guide Program Formulation. Nosuch framework was prepared during program formulation. The reconstituted programframework (Appendix 3) shows that a significant number of program conditions, if implementedmore effectively, could have contributed to the achievement of program outputs. Mostenvisaged program outputs were consistent with intended program outcomes, although morecareful problem analysis at the outset could have resulted in the inclusion of additional reform

measures, particularly in the areas of banking competition, secured transactions and debtrecovery, and policy lending.

23. Inadequate Problem Analysis. A number of program actions, particularly theintroduction of a deposit insurance system and the hands-off approach to bank restructuringpursued under the Program, would have been more suitable for an essentially stable (or at leastsufficiently capitalized) banking system with scope for further strengthening.


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24. The findings of ADB-financed reviews of SCB loan portfolios as of 30 June 1995 couldhave alerted program designers to the high probability of a further deterioration in the SCBsloan portfolio quality and financial performance in the years to come, which should haveresulted in concrete measures to remedy the situation and limit the potential for more badloans. The portfolio reviews, which were conducted by ADB during program processing,showed average nonperforming loan (NPL) levels (i.e., substandard, doubtful, and loss-

classified loans) of about 33% for the six regional SCBs and BCEL, with a range of 19100%.As a result, two of the regional SCBs needed additional recapitalization just 6 months after theyhad been recapitalized and their NPLs transferred to a central debt recovery unit. In fact, theinternational audits of the 1996 accounts under the Program, which were completed only inJune 1998, showed significant portfolio and capital problems for the SCBs. By the end of 1997,NPL levels in the various SCBs ranged from 25% to 70%, and all SCBs had negative capital.

25. Further analysis of the nature and causes of the NPL problem would have revealed notonly capacity problems, which were recognized at the design stage, but also continued noncommercially motivated lending stemming from unresolved issues in the SOE restructuring,fiscal, and governance areas. Although directed credit programs had been officiallydiscontinued, the SCBs were still under pressure to make loans based on noncommercial

considerations. SOE-related NPLs actually account for the majority of SCB NPLs,7 as evenunrestructured SOEs continue to be funded through the banking system rather than the budget.

Another issue in this regard that warranted more attention at the program design stage is thestrong influence that regional governments exert over SCB branch operations. While theconsolidation of the SCBs under the Program somewhat diminished the scope for provincialgovernments to influence banking decisions, local government interference with branch lendingdecisions continued, as reflected in the use of SCBs to fund local government constructionprojects.8

26. Inadequate Institutional Analysis. Such an analysis would have revealed the need forBOL to be more independent to ensure adequate checks and balances, and for incentives forbanking sector supervision and restructuring. The Program sought to improve framework

conditions for SCB operations by strengthening banking supervision through (i) theestablishment of a separate banking supervision department, (ii) the adoption of a chart ofaccounts for all banks, and (iii) the enforcement of strengthened prudential regulations.However, BOL continued to be part of the government structure. Moreover, as BOL effectivelyretained control over the appointment of SCB management, and often seconded staff to assumethese functions, its effectiveness as supervisor was reduced.

27. Insufficient Consideration of Macroeconomic Environment. Other sector andmacroeconomic problems and conditions were not sufficiently assessed despite ADBs previousinvolvement in the sector and the country. For example, the potential effects of dollarization onmonetary management and bank restructuring were neither considered nor actively addressedat the program design stage,9 although the rate of dollarization exceeded 42% in 1995. When

7According to estimates by consultants financed under TA 3146, SOE loans accounted for 45% of all SCB loans atthe end of 1999, but NPLs associated with SOE loans accounted for 53% of all NPLs. Eighty percent of SCB loansto SOEs were nonperforming at that time.

8SCBs actually made loans to private construction companies contracted by local governments to buildinfrastructure projects. When contractors did not get paid for their services, they defaulted on their loans to statebanks.

9The fact that foreign currencies account for the largest component of domestic money supply encourages financialintermediation in a country with poorly developed financial institutions. However, high levels of dollarization alsoincrease the risk of banking crises as commercial banks are induced to become exposed in foreign currencies,while the central bank loses its ability to act as lender of last resort.


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expansionary fiscal policies, coupled with a decrease in foreign investments in the aftermath ofthe Asian financial crisis, resulted in a depreciation of the kip by 300%, many unhedgedborrowers defaulted on their loans, further increasing already high NPL levels. Banks alsosuffered revaluation losses associated with unhedged balance sheets. The Program shouldhave recognized the possibility of an increased dollarization of the economythe rate ofdollarization actually went up from about 40%, at the time of loan approval, to more than 90% in

1999and its impact on the banking system. At the very least, the Program should haveincluded explicit measures to reduce the net open positions of banks and foreign currencylending to unhedged borrowers.

2. Adequacy of Program Design

28. Lack of Coherent Strategy for SCB Restructuring. Given the poor financial situationof most SCBs during the program design phase, the conditionality under the Program shouldhave specifically required the preparation and enforcement of remedial action plans for thebanks with time-bound restructuring and performance targets from the outset to avoid a furtherdeterioration of SCBs financial performance. The situation was further complicated by the factthat improved loan classification standards were approved only in 1998. Proper sequencing of

the bank restructuring process would have involved (i) the adoption of adequate prudentialregulations and loan classification and provisioning standards, (ii) the completion ofinternational audits of the SCBs, (iii) the preparation of an analysis of the causes of portfolioand other bank performance problems, (iv) the design of a bank restructuring program, (v) high-level support for the program and other suitable measures to stop the flow of NPLs, and(vi) continued enforcement of the restructuring program. SCB consolidation should have beenpart of overall operational bank restructuring efforts.

29. The underlying rationale for the consolidation of seven regional SCBs into less than fourSCBs, a key condition under the Program, was designed to make the resulting banks morecompetitive by increasing their efficiency and the size of their capital and asset bases. However,without a bank restructuring strategy, these objectives were not achieved. During program

implementation, it was decided to merge the six regional SCBs into two groups: (i) Lao MayBank Limited (comprising Lao May Bank, Phak Tai Bank, and Nakhoneluang Bank), and (ii)Lane Xang Bank Limited (comprising Lane Xang Bank, Aroun May Bank, and SethathirathBank). TA consultants had recommended a different grouping to maximize the strengths of thethree southern banks (i.e., Lao May Bank, Phak Tai Bank, and Sethathirath Bank), given theirbranch networks and the anticipated increase in commercial activity in the southern part of thecountry due to improved road linkages with Thailand and Viet Nam. The Government and BOL,however, insisted on having regional banking groups of equal size. Although much time andenergy was spent on allocating banks to the regional groupings, project files and interviews withgovernment, SCB, and ADB staff did not indicate why two regional banking groups werecontemplated at all. Lane Xang Bank and Lao May Bank were later merged under BSRP to formthe new LDB. The interim solution of two regional SCB groups added operational complexities

and costs, and delayed the unification of policies, systems, and procedures throughout thebranch network. More importantly, as the rationale for this consolidation was not made explicit,no meaningful actions were taken to benefit from the consolidation in terms of (i) branchrationalization, (ii) the adoption of a unified corporate culture, and (iii) the establishment of bettersystems. The only tangible effect seems to have been an upscaling of lending operations, i.e.,the extension of larger loans. Presumably, banking consolidation was also motivated by thedesire to delink banks from regional government influence and to increase economies of scale.In this case, a direct consolidation of the six SCBs into one SCB would have made more sense.If the rationale and principles for bank consolidation had been made explicit and had been


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agreed upon during program formulation, and the costs and benefits associated with variousmerger options assessed during program preparation, a more rational approach, i.e.,consolidation into one SCB, might have been pursued. It would have facilitated the timelyintroduction of common policies, systems, and procedures, as well as the supervision andoversight of the bank by BOL and MOF. Instead, time and money were spent on developingbusiness plans and strategies for entities that existed for less than 3 years. A completely

different approach to decreasing the number of banks in the system that should have at leastwarranted consideration would have been to close down the worst-performing SCBs and buildthe remaining banks into strong regional players. However, this option might have had its ownset of problems, and probably would not have been politically feasible.

30. Despite significant NPL levels at the time of program approval, the Program did notinclude any measures or performance targets to encourage debt recovery by SCBs or stop theflow of new NPLs. Concerted efforts by the Program to strengthen the capacity and incentivesof banks for NPL resolution might have improved its outcome.

31. Insufficient Consideration of Other Economic and Governance Reform Needs . Although lack of progress with real sector reforms, in particular with regard to the

commercialization and privatization of SOEs, was identified as a potential risk, ADB decided notto address these issues directly under the Program, and instead rely on the Government toadvance structural reforms in these areas in conjunction with the International Monetary FundsESAF and the World Banks SAC III. Despite the continued privatization of SOEs after 1995 andthe increasingly dominant role of private investment, credit to the private sector as a share oftotal credit decreased from about 75% in 1995 to 63% in 2004. Large utilities and other strategicindustries were not included in the privatization program and continue to be state-owned, like anumber of other nonstrategic enterprises.10 While a division of responsibilities for policy dialogueamong international financial institutions (IFIs) was a reasonable strategy for designing afocused policy program, the Program should have included a specific conditionalitydiscontinuing noncommercially motivated lending or requiring that such lending be guaranteedby the Government.11 A suitable policy response with regard to the prevention of lending for

construction projects by local authorities would have been to require banks to verify theexistence of special budgetary allocations before lending to private construction companiesundertaking public investment projects, and to ask that such lending be backed up withappropriate government guarantees.

32. Overall, banking sector restructuring under the Program might have been more effectiveif macroeconomic and fiscal management issues had also been proactively addressed intandem. As a matter of principle, any subsidies for public sector projects and state enterprisesshould be paid from the budget. Timely efforts to enhance public expenditure managementthrough improvements in expenditure planning and budgeting, budget execution, accounting,and reporting both at the central and provincial level, as later envisaged under the new PublicExpenditure Management Strengthening Program, could have helped reduce NPLs associated

with government investments.

33. Program attempts to strengthen SCB governance through corporatization, in anenvironment that did not provide the right incentives and conditions for commercial decision

10There are currently 140 SOEs operating in the country.

11The issuance of a BOL instruction to state banks requiring them to lend only on the basis of technical, financial,and economic considerations that were not further defined was a condition for loan negotiations. However,compliance with this instruction was not subsequently monitored or enforced.


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making, were doomed to fail. Support from senior decision makers at central and provincialgovernment levels for more SCB autonomy should have been evidenced by formalcommitments to abstain from influencing lending and other bank management decisions.

34. The Program did not continue ADBs support for private sector development startedunder FSPL I, which promoted the establishment of a legal framework for private business and

a central company registry. A number of constraints related to enterprise registration andlicensing, property rights, taxation, business development services, and foreign investmentcontinue to hamper enterprise development, and thus limit banks range of viable borrowers. Inaddition, debt recovery problems and lack of non-collateral-based credit skills have affected theability of banks to lend to small and medium enterprises.

35. Suitability of Program Measures for the Country. Efforts to increase SCB autonomythrough divestment to and joint ventures with foreign banks did not succeed. While TA 2642assessed divestment options, there was little interest on the part of potential foreign strategicinvestors to acquire a stake in any of the SCBs. A review at the program design stage of thefactors driving strategic bank investments would probably have determined this option to benonviable in the short term.12

36. Generally, international commercial banks setting up operations in foreign countrieswould rather build up these operations from scratch than buy existing banks. The Program didnot contemplate any measures to increase competition from private domestic and foreignbanks, and thus provide SCBs with incentives to improve their performance, nor did it activelypursue other external management options such as twinning arrangements or the placement ofinternational bank advisers.

37. Inadequate Sequencing of Financial Sector Reforms. Successful bank restructuringis a condition for interbank market development and the introduction of a deposit insurancescheme, as is a certain degree of macroeconomic stability. Deposit protection schemes areusually introduced only when banking systems are stable and the likelihood of a banking crisis

is remote. This has not been the situation in Lao PDR, given the negative capital position of thelargest banks and the inability of the central bank to act as lender of last resort. Assumingcurrent deposit levels, it will take many years before the deposit protection fund will haveenough resources to provide the envisaged coverage of up to KN15 million per kip account. Inthe meantime, the Government would have to make up any shortfalls in the fund in case of bankfailures. It is not clear whether the inherent capping of implicit government guarantees for SCBdepositors would be politically acceptable should an SCB fail. The stated objective for such adeposit protection fund at the time of program formulation was to help mobilize deposits bystrengthening depositor confidence in the banking system. Overall deposit volumes as a shareof GDP did not increase significantly after the scheme was introduced in January 2000. From14.2% as of year-end 1999 their share rose to only 16.9% in 2003, although the share ofdeposits held in non-state banks grew from 21.6% to 26.4% over the same period. The trade-

offs between building up a dedicated depositor protection fund over time and having to deal withthe financial burden this poses on undercapitalized banks need to be carefully assessed.

12Only a very few international banks have been actively looking to invest in banks in ADBs DMCs. Their interesthas been usually limited to well-established midsize banks in the larger and more developed banking markets inthe region. Exceptions to this situation have been investments in smaller markets with viable project financepotential, in which case commercial banking activities are usually only pursued on a limited scale.


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C. Effectiveness

38. The Program was less effective. The key objectives of the Program, according to thereport and recommendation of the President (RRP), were to (i) mobilize more domestic savings,particularly long-term savings, and allocate them efficiently to promote private sectordevelopment; and (ii) strengthen macroeconomic management by developing a sound

andresponsive banking system. As no program framework was prepared at the time of Programprocessing, this evaluation considered increased financial intermediation levels as the intendedprogram impact, and improved soundness and efficiency of the financial system as the intendedprogram outcomes. While financial depth (M2/GDP) and savings levels (deposits/GDP)increased, the banking system has not become more sound and efficient. The share of credit tothe private sector in net domestic credit to the economy decreased during that period, whiledomestic credit as a share of GDP grew only marginally, from 9.8% to 10%. The NPL levels ofthe SCBs increased substantially from 1995 to 2004 (also see Appendix 2).

Table 2: Program Effectiveness

GDP = gross domestic product, NPL = nonperforming loan, SCB = state commercial bank.a As of 30 June 1995, according to estimates of ADB consultants.b

As estimated by ADB consultants.c

As reported by SCBs.Source: IMF. 2004 and 2005. International Financial Statistics. Washington, DC.

39. Financial intermediation might have increased more significantly without the 19971998 Asian financial crisis. The crisis, particularly the overshooting of the exchange rate (inflationincreased by 150% while the exchange rate depreciated by 300%), contributed to temporarilyreduced intermediation levels and an increase in NPL levels. Unaddressed deficiencies in thefinancial systemparticularly continued unsound lending practicesand their role in thedollarization of the economy made the country more vulnerable to macroeconomic instability.

40. While most Program conditions were technically met, many of them failed to produce theoutputs needed to achieve intended outcomes. In some cases (e.g., SCB restructuring andconsolidation), this was the result of inadequate identification and selection of Programmeasures due to deficiencies in problem analysis and design. In other cases (e.g., legalreforms, enforcement of prudential regulations by SCB), measures were not properlyimplemented which could be indicative of inadequate assessment and consultation at theprogram formulation stage. Other factors responsible for shortfalls in the intended programoutcomes include (i) the focus during Program design and implementation on policy conditionsrather than outcomes; (ii) the opaque wording of Program actions, which did not include a

Item Indicators

1995During Program

Processing(%)

2000At Program

End(%)

2004At ProgramEvaluation

(%)FinancialDepth

M2 to GDP ratio 13.6 16.5 20.9

Deposits to GDP ratio 10.6 15.9 18.2

Efficiency Credit to private sector to Netdomestic credit to the economy

82.2 60.0 62.7

Interest rate margin 6.0 10.0 9.0

Soundness NPLs to Total SCB loans ratio 33.0a

52.0b

64.0c


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description of underlying principles and intent of the conditionality, making it difficult to reach acommon understanding on what constitutes compliance and to monitor achievements (butmaking it easier to justify tranche releases even without meaningful reform efforts); and (iii) poorfollow-up of continued compliance.

1. Ineffective Program Measures

41. Areas in which little progress was made include (i) SCB restructuring, (ii) thedevelopment of a formal interbank market, (iii) the development of a leasing market, and (iv) theestablishment of an effective secured transactions regime.

42. SCB Restructuring. SCB consolidation and formal governance changes did not lead toany meaningful operational restructuring or improvements in credit and risk managementpractices of SCBs, which are necessary for banking sector soundness. Capacity-building effortsrelated to the preparation and adoption of operations manuals and business plans provided inconjunction with the Program were just as ineffective. While the Program required SCBs toadopt operations manuals and business plans, the principles underlying the use of thesedocuments were not specified. The business plans developed by the banks under the Program

in 1998 and 1999 were not suitable for guiding the necessary changes in the operations of thebanks. Performance indicators were not based on audited financial information and meaningfulanalysis, focusing on growth-oriented deposit and lending targets instead of profitability.Operations manuals were not conducive to assisting staff in making sound credit decisions, asthey consisted mainly of BOL policy instructions rather than operating procedures. TA 3466(footnote 6) in 2000 aimed, among other things, to make the operational manuals more usefulfor credit management with the help of operational guidelines and work aids. In 2003, theinternational bank advisers in the SCBs produced yet another set of credit manuals. Despite thecorporatization of the SCBs under the Program, the overall corporate governance frameworkand continued external interference in lending decisions at the time did not encourage bankmanagement to improve credit and risk management practices, as evidenced by the persistentlypoor financial results of the banks and the high NPL levels after 1996. To facilitate better

enforcement of prudential regulations for SCBs and justify the release of the second trancheunder the Program, ADB, in 2000, required BOL and the SCBs to submit an enforcement planto bring SCBs in line with required standards and achieve sustainable operations by 2002. Theplan comprised actions related to (i) debt recovery (the organization of an internal debt recoveryunit and the recruitment of workout specialists); (ii) governance (improved loan lossprovisioning, reporting, adequate recognition of off-balance-sheet items and loan losses, theestablishment of an MOF unit to exercise MOFs ownership rights in SCBs, the approval ofcorporate governance policies, and the requirement that all directed lending would need priorMOF approval); and (iii) operational restructuring measures to enhance the banks efficiency.TA 3466-LAO was designed to assist BOL and the state banks in implementing the plan.However, as there were few incentives to comply with the plan after the second tranche of theProgram was released in August 2000, the plan was not fully implemented. As a result, the

financial performance and capital position of the SCBs continued to deteriorate between April 2000 and early 2003, with NPL levels for loans approved during that period exceeding50%. The Government continued to use SCBs for financing not only local but also centralgovernment investment projects that did not have the necessary budget provisions.13 Theseloans are estimated to account for about half of the flow NPLs, i.e., NPLs that were approvedafter 31 December 1999.

13 The Government eventually started to issue bonds to banks in exchange for these loans, albeit with significant timelags and below-market pricing, at the inflation rate plus 1%.


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43. Banks report that NPL levels for loans made since performance-based governanceagreements between SCB managements, the MOF, and BOL took effect on 1 April 2003 havefallen significantly compared with NPL levels associated with earlier loans. This will have to beverified through the ongoing independent audits of the 2004 SCB accounts. Significantimprovements in lending performance would indicate that FSPL II could have been more

effective if the Program had promoted the more hands-on approach to state bank restructuringtaken under BSRP, i.e., (i) the use of performance-based governance agreements betweenbank managements, BOL, and MOF; (ii) the strengthening of SCB management throughinternational advisers who are consulted in lending decisions; and (iii) the linking of tranchereleases to actual performance improvements. If, on the other hand, BSRP turns out to beequally ineffective and noncommercial lending continues, it can probably be concluded that (i)the Government is not prepared to accept the establishment of a truly market-based bankingsystem free of government intervention; and (ii) policy conditionality does not address the morefundamental issues related to the political economy of the country.

44. Interbank Market Development. There has not been any significant formal interbankmarket activity, although there are informal arrangements among the state banks to help one

another out by using excess liquidity at one bank for lending by another bank. Most of thesedeals do not involve payment of interest, and therefore do not contribute to the development ofa pricing mechanism for money market funds. Other factors also explain the lack ofdevelopment of a formal interbank market. The macroeconomic and fiscal situation has notbeen conducive to the development of the market, which requires a stable macro environment,and the regular issuance of treasury paper that can be held by banks and used for repurchasetransactions. T-bills have been issued only from time to time, at low volumes, according to fiscalrequirements. For example, no T-bills were issued between October 1996 and January 1999.The only maturity for T-bills is 12 months. There is no secondary market in government paper,and the high levels of dollarization do not leave much scope for monetary management by BOL.

Also, banks with excess liquidity do not provide these funds to other banks, with the exceptionsnoted above. Given the lack of readily available and reliable information on the financial

condition of banks, this is hardly surprising. There are some interbank foreign exchangetransactions. However, expectations of a further depreciation of the kip and future inflationcause banks to hold on to foreign currency. There also has been a general lack of commercialawareness within banks of the opportunities afforded by interbank markets within an overallasset-liability management framework.

45. Leasing Development. The approval of leasing legislation under the Program did notresult in any significant leasing activity. Apart from some limited motorcycle and car leasing byvendors, no leasing has developed, although a number of banks would be interested inestablishing leasing operations, if the registration issue can be resolved. At this moment, theregistration of movable property does not appear to be reliable, making the repossession of aleased asset difficult should the lessee be in breach of terms of the lease. It will also have to be

assessed whether existing tax and accounting rules need to be changed to encourage leasing.

46. Debt Recovery Framework. The Program had only limited impact on improving theenvironment for debt recovery, mainly because of deficiencies in the relevant legislation and theoverall enforcement framework. The 1994 Secured Transactions Law and the related 1999Implementing Decree adopted under the Program did not provide for direct repossession anddisposition of collateral by the creditor without recourse through the court system. This madeenforcement of collateral difficult in view of a largely inefficient and unpredictable court process.The 2000 implementing decree adopted under the Program did not help operationalize existing


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bankruptcy legislation. No bankruptcy case has been decided under the 1994 Bankruptcy Law.Bankruptcy legislation is not suitable for larger, more complex company bankruptcies andeffectively suspends the rights of secured creditors over pledged collateral during thebankruptcy process.

2. More Effective Program Measures

47. A number of program conditions were largely effective. These include (i) the adoption ofa chart of accounts by all banks and completion of international audits of SCBs, (ii) the adoptionof a legal basis for negotiable instruments, (iii) the establishment of a credit information bureauwithin BOL, and (iv) the passage of legislation to establish a social security fund/pensionscheme for employees of public and private enterprises.

48. Increased Financial Transparency. The adoption of a chart of accounts for commercialbanks and the requirement of international audits of SCB accounts under the Program, and laterin conjunction with the monitoring of governance agreements under BSRP, are majorachievements. They have given the BOL and IFIs a better understanding of the financialposition and performance of the banks. This served as a basis for continued policy dialogue on

SCB restructuring.

49. A credit information bureau was established within BOL under the Program. It is stilloperating and is reportedly being used (no related data could be provided by BOL), albeit not ascomprehensively as envisaged. Although not all loans are reported, banks use the service tocheck on the creditworthiness of their borrowers. However, they also draw on other sources ofinformation to determine the payment behavior of potential clients.

50. Establishment of a Legal Basis for Negotiable Instruments. The creation of a legalbasis for promissory notes and bills of exchange has been somewhat effective, as banks areactively using bills of exchange for import finance. However, foreign banks would use bills only ifthere is additional collateral to secure their exposure. Promissory notes are not widely used.

51. Establishment of a Legal Basis for Pension Funds. The adoption of the Decree onthe Social Security System for Enterprise Employees under the Program provided thenecessary legal basis for the introduction of a social security system including a pensionscheme for nongovernment employees, which is being administered by the newly establishedSocial Security Organization (SSO). There has been a steady increase in the number ofparticipants since the mandatory scheme began operating in June 2001. Currently, 25% of allnongovernment employees in Vientiane are covered under the various schemes, and the fundhas assets of about $3 million equivalent. One of the challenges of the fund will be to findsuitable investment opportunities in Lao PDR, as T-bills are not readily available, and theinterest paid on SSO funds in savings accounts and term deposits has been slightly below theinflation rate, resulting in a negative return on investments. The legal framework for the

investment of these funds needs to support the SSO in having access to viable investmentalternatives, to protect the value of its reserves.


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D. Efficiency

52. The Program was less efficient. Had the Program been more effective, the loan amountof $25 million equivalent would have been appropriate in view of the envisaged policy contentand costs associated with SCB restructuring and the development of financial infrastructure. Asthe Program failed to improve economic allocation mechanisms, the provision of budgetary

support might have actually lessened incentives to undertake reform. With regard to efficiencyof process, while the Program was prepared with comparatively little staff and staff consultancyinputs, program implementation required a high level of ADB resources and 14 review missions.Ten out of 14 review missions were fielded after the original program completion date. By thatdate, only two out of 13 conditions for the release of the second tranche had been met. Thesecond tranche was eventually disbursed with 19 months delay caused by a combination offactors. The approval of several decrees took longer than expected because of (i) internalcoordination problems, (ii) the complexity of the subject matter, (iii) delays in related consultingoutputs, and (iv) lack of understanding and buy-in at all relevant levels for the proposedlegislation. Also, BOL did not take timely action to enforce prudential regulations for SCBs,partly because BOL management was preoccupied with the management of the 1998 crisis anddid not have the experience, and initially assistance,14 to develop effective remedial measures

for the insolvent banks. A major constraint on program monitoring was the lack of timelines forthe implementation of each program condition.

E. Sustainability

53. Program sustainability is less likely.As explained, the Program failed to achieve many ofits intended outputs and, therefore, outcomes. However, it sought to put in place basicconditions for further banking sector development by initiating the corporatization andconsolidation of SCBs and promoting measures to strengthen banking supervision. It thereforeprovided a platform for expanded policy dialogue under subsequent ADB sector interventions inthe country including the ongoing BSRP and the planned microfinance program loan. Continuednoncommercial lending, implying a certain lack of commitment to SCB autonomy, indicates that

significant additional efforts are needed to ensure the Programs full effectiveness andsustainability. This is to be expected, considering that the implementation of banking sectorreforms in transitional economies usually entails a lengthy process involving significantinstitutional and cultural change. The process should be even lengthier and more complex in thecase of Lao PDR, which has comparatively large capacity and governance problems to beginwith15. If the overall governance environment can be enhanced, program measures related tomarket infrastructure development will bear fruit. For example, the creation of the necessaryregulatory framework for interbank market operations is likely to be sustainable and will assistmarket development, once conditions improve.

14ADB. 1998. Technical Assistance to the Lao Peoples Democratic Republic for Human Resource Development inBanks. Manila. (TA 2160, approved on 21 September 1994, for $350,000).

15Transparency International ranks Lao PDR 77th out of 159 countries in its 2005 Corruption Perception Index with ascore of 3.3. The score, however, has a significant error of estimate as it is based on only three surveys. WorldBank. 2003. Country Policy and Institutional Assessment. Washington, DC, by comparison, found that Lao PDRwas perceived to have larger problems with governance and corruption issues than its neighboring countries in theGreater Mekong Subregion. There is anecdotal evidence that corruption might be partly responsible for the highlevel of NPLs. The upcoming country assistance program evaluation for Lao PDR includes a more in-depth reviewof governance and corruption issues.


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F. Institutional Development

54. The contribution of the Program and its associated TAs to institutional development andcapacity building for financial reforms and bank restructuring was moderate. A number of

program conditionsincluding (i) measures to improve operational autonomy, (ii) the adoptionof operations manuals and business plans, and (iii) improvements in accounting requirementswere intended to strengthen the capacity of SCBs. However, these measures were notimplemented effectively because of a combination of factors including lack of political supportand stakeholder buy-in,and limited institutional capacity. The institutional development impactwas limited to (i) the establishment of a separate banking supervision department, a creditinformation bureau, and a deposit protection fund; (ii) BOL and SCB management exposure torestructuring concepts; (iii) familiarization with interbank market development concepts and theestablishment of the related regulatory framework; and (iv) the introduction of new corporategovernance structures for the SCBs. Most inputs under TAs associated with the Program wererelated to sector assessments, the identification of policy measures, and the preparation of draftlegislation or financial reviews by consultants, rather than training or other forms of capacity

building. The capacity-development measures under the Program were not part of a coherentand comprehensive plan for strengthening BOL and SCB capacity. There was no prior in-depthreview of the framework conditions under which banks operate, including (i) their inherentgovernance and incentive structures; (ii) their ability to take independent decisions; (iii) theadequacy of their policies, systems, and procedures; (iii) the human and financial resourcesneeded to fulfill their mandate; and (iv) skill levels and gaps. Such a review could have formedthe basis for a longer-term capacity development strategy to guide the design andimplementation of individual interventions.

G. Impact

55. Program impact across other sectors of the economy and on the society at large was

moderate to negligible. As most measures to improve financial infrastructure have not beeneffective and SCB restructuring under the Program did not result in significantly improved creditallocation mechanisms, it is unlikely that allocative efficiencies improved or credit to the privateenterprise sector increased as a result of the Program. There is therefore also no evidence thatthe Program accelerated reforms in other sectors. On the contrary, the Program was probablynot as effective as it could have been because reforms of the state enterprise sector and fiscalreforms were not actively pursued at the time. The introduction of the social security system forprivate sector employees could help reduce the risk of falling into poverty due to ill health,incapacity, or old age. It is unlikely that the Program had any negative impact on the economy,the environment, or poverty reduction efforts. Indicators for poverty and economic growth havebeen showing positive developments (Appendix 2). The OEM did not assess the impact ofbudgetary support associated with program lending at Asian Development Fund terms on the

economy of the country, as this would have been beyond the scope of a PPER.

IV. OTHER ASSESSMENTS

A. ADB and Executing Agency Performance

56. ADBs performance was less than satisfactory. Program performance was significantlyaffected by the poor quality of the design. Despite ADBs experience and knowledge gained withthe sector in Lao PDR under one prior program loan and numerous TAs, ADB did not


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adequately assess the extent of sector and macroeconomic problems. The insufficientinstitutional, sector, and economic analyses and resulting deficiencies in problem identification,and policy selection and sequencing have been described in preceding sections. The findings of

ADB-financed reviews of SCB portfolios were not properly interpreted and used as inputs instrategizing effective bank restructuring and consolidation measures. Many policy measureswere not fully formulated during processing, but instead were to be detailed during program

implementation with the help of TA. Meaningful compliance with and ownership of policyconditionality was adversely affected by the fact that underlying principles were apparently notsufficiently discussed and agreed with the Government and other stakeholders at the time ofprogram processing. This situation was further complicated by the fact that there were frequentchanges in ADB dealing officers (staff movements necessitated the assignment of two differentmission leaders during program processing and four ADB professional staff tasked with programimplementation), raising questions about ADBs accountability for the Program and suggestingloss of institutional knowledge. It might have been helpful if a suitably qualified resident missionstaff had been assigned to at least monitor sector and other relevant developments throughoutprogram implementation. Substantial efforts by ADB in the supervision of the Program,particularly in 19992000, did not overcome these problems. Most of the earlier program reviewmissions focused entirely on output achievements (i.e., compliance with program conditionality).

ADB relied substantially on consultants to shape and conduct policy dialogue during theprogram implementation phase. The ADB staffs lack of understanding of the relevant policy andlegal issues and inability to control and guide the legal consultants resulted in ADBsacceptance of a draft implementing decree on secured transactions that was not conducive toachieving the intended program outcomes. Another problem was that ADB intensified itssupervision efforts only after the date originally set for the release of the second tranche. As aresult, the deteriorating financial performance of the SCBs did not trigger any significantresponse by ADB until 19992000, when ADB insisted on formulating an enforcement plan forprudential regulation, in an effort to facilitate the release of the second tranche.

57. Government and BOL performance was less than satisfactory. During programprocessing, the Government appeared to be embarking on a new phase of reforms to shift the

country to a market-based economy. However, in the run-up to and immediate aftermath of the1998 financial crisis, economic reforms stalled, as Lao PDR struggled with seriousmacroeconomic problems. The economy stabilized in 2000 and a number of structural reformswere continued in 2001. Given continued noncommercially motivated lending in SCBs andproblems in recovering associated NPLs, the full commitment of all government entities tobanking reform and its objectives has been questionable. Also, as mentioned, BOL continued toexert a strong influence on the management of SCBs, which was not in line with the statedprogram intention to enhance the autonomy of SCBs. While the Government and BOL did makeefforts to comply with the conditionality as they understood it, meaningful reforms did not ensue.In hindsight, it is difficult to determine whether this was due to a change in the level ofcommitment or to a lack of understanding of the meaning and potential ramifications ofconditions. The fact that BOL questioned the need for MOF to appoint SCB boards, for

independent external SCB audits to be carried out, and for subsidized credit for agriculture to bediscontinued within 1 year of program approval indicates that commitment was an issue. ADBsdecision to waive four conditions for the release of the second tranche for FSPL I probably ledthe Government to expect that program conditionality could be negotiated at any time. The lackof continuity of senior BOL managementthere were three different governors during programimplementationcontributed to implementation delays and shortcomings, although direct BOLcounterpart staff for the Program did not change. The approval of required legal documents tookfairly long, indicating perhaps a lack of up-front consultation and agreement on the reformagenda with other government entities and levels, such as the Prime Ministers Office and the


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Ministry of Justice. In a number of cases, the originating or sponsoring government entityresponsible for producing the first draft of new legislation was difficult to determine. Also, it tooktime to establish at what level legislation should be prepared or amended. In general, thedecision-making process in Lao PDR is not clearly defined and is therefore perceived to beopaque by outsiders, who often have difficulties determining which government entities andlevels to approach. Overall, however, the Government and BOL staff made sincere efforts to

implement program conditions, but were constrained by country conditions and capacityproblems.

B. Technical Assistance

58. The OEM confirms the PCR ratings of TAs 2642 and 2643 as partly successful.

59. Both TAs contributed significantly toward achieving compliance with Programconditionality. However, Program conditionality did not necessarily translate into theachievement of the envisaged program outputs and outcomes. The design of TA 2642 wasdeficient, as it assumed a banking system and SCB sector capable of being further developedand changed than was actually the case, given the lack of skills and management autonomy of

SCBs. For example, the T