Docurnent of

The World Bank

Report No: 22178 CEFOR OFFICIAL USE ONLY

PROJECT APPRAISAL DOCUMENT

ONA

PROPOSED CREDIT

IN THE AMOUNT OF SDR 23.9 MILLION

(US$30.3 MILLION EQUIVALENT)

TO THE

DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA

FOR THE

SRI LANKA CENTRAL BANK STRENGTHENING

May 23, 2001

South Asia Regional OfficeFinance and Private Sector Development Unit

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bankauthorization.

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

CURRENCY EQUIVALENTS

(Exchange Rate Effective )

Currency Unit = Sri Lanka Rupee (LKR)LKR 90.0 = US$1.0

US$0.0111 = LKR 1.0

FISCAL YEARJanuary I -- December 31

ABBREVIATIONS AND ACRONYMS

AU Administrative UnitBPIP Borrower Project Implementation PlanCAS Country Assistance StrategyCBSL Central Bank of Sri LankaDvP Delivery Vs. PaymentEPF Employees' Provident FundGL General LedgerGOSL Government of Sri LankaICB International Competitive BiddingICR Implementation Completion ReportIDA International Development AgencyIRR Internal Rate of ReturnLKR Sri Lankan RupeesMDC Management Development CenterMOFP Ministry of Finance and PlanningNCB National Competitive BiddingOMO Open Market OperationPMR Project Management ReportsPPF Project Preparation FacilityQCBS Quality & Cost Based SelectionRFP Request for ProposalRTGS Real Time Gross SettlementSGSS Scripless Government Security SystemSIDA Swedish International Development AgencySLASH Sri Lanka Automated Clearing HouseSOE Statement of ExpensesTA Technical AssistanceTOR Terms of Reference

Vice President: Mieko Nishin-iizuCountry Manager/Director: Mariana Todorova

Sector Manager/Director: Marilou Jane D. UyTask Team Leader/Task Manager: Simon C. Bell

SRI LANKASRI LANKA CENTRAL BANK STRENGTHENING

FOR OFFICIAL USE ONLY

CONTENTS

A. Project Development Objective Page

1. Project development objective 22. Key performance indicators 2

B. Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 22. Main sector issues and Govemment strategy 33. Sector issues to be addressed by the project and strategic choices 7

C. Project Description Sumnimary

1. Project components 82. Key policy and institutional reforms supported by the project 93. Benefits and target population 104. Institutional and implementation arrangements 11

D. Project Rationale

1. Project altematives considered and reasons for rejection 132. Major related projects financed by the Bank and other development agencies 153. Lessons learned and reflected in proposed project design 164. Indications of borrower commitnent and ownership 185. Value added of Bank support in this project 19

E. Summary Project Analysis

1. Economic 192. Financial 203. Technical 204. Institutional 205. Environmental 216. Social 217. Safeguard Policies 22

F. Sustainability and Risks

1. Sustainability 232. Critical risks 233. Possible controversial aspects 24

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

G. Main Conditions

1. Effectiveness Condition 252. Other 25

H. Readiness for Implementation 25

I. Compliance with Bank Policies 26

Annexes

Annex 1: Project Design Summary 27Annex 2: Detailed Project Description 31Annex 3: Estimated Project Costs 49Annex 4: Cost Benefit Analysis Summary, or Cost-Effectiveness Analysis Summary 50Annex 5: Financial Summary for Revenue-Earning Project Entities, or Financial Sumunary 57Annex 6: Procurement and Disbursement Arrangements 58Annex 7: Project Processing Schedule 67Annex 8: Documents in the Project File 68Annex 9: Statement of Loans and Credits 69Annex 10: Country at a Glance 71Annex 11: Letter of Development Policies for the Central Bank of Sri Lanka 73

MAP(S)

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank

| authorization.

SRI LANKA

Sri Lanka Central Bank Strengthening

Project Appraisal Document

South Asia Regional OfficeSASFP

Date: May 21, 2001 Team Leader: Simon C. BellCountry Manager/Director: Mariana Todorova Sector Manager/Director: Marilou Jane D. UyProject ID: P071131 Sector(s): FS - Financial Sector DevelopmentLending Instrument: Specific Investment Loan (SIL) Theme(s): Financial Sector

Poverty Targeted Intervention: N

Program Financing Data[ ] Loan [X] Credit [ ]Grant [ IGuarantee [ ]Other:

For Loans/Credits/Others:Amount (US$m): 30.3

Proposed Terms (IDA): Standard CreditGrace period (years): 10 Years to maturity: 40Commitment fee: Standard, between 0 to 0.5 percent. Service charge: 0.75% l

Financing Plan (US$m): Source Local Foreign TotalBORROWER 8.00 2.70 10.70IDA 17.70 12.60 30.30SWEDISH INTERNATIONAL DEVELOPMENT 0.00 1.00 1.00COOPERATION AGENCY (SIDA)

Total: 25.70 16.30 42.00Borrower: GOVERNMENT OF SRI LANKAResponsible agency: CENTRAL BANK OF SRI LANKA (CBSL)Address: Central Bank of Sri Lanka, 30 Janadhipathi Mawatha, Colombo 1, SRI LANKAContact Person: A.S. Jayawardena, GovernorTel: 94 1 477 176 Fax: 94 1 477 712 Email: gov_.cb(slt.lk

Other Agency(ies):MINISTRY OF FINANCE AND PLANNINGAddress: The Secretariat, Colombo 1, SRI LANKAContact Person: P. B. Jayasundera, SecretaryTel: 94 1 431 761 Fax: 94 1 449 823 Email: rosedgfpa@hotmail.comEstimated disbursements ( Bank FY/US$m):

FY 2002 2003 1 2004 2005Annual 6.80 10.80 11.50 1.20

Cumulative 6.80 17.60 29.10 30.30

Project implementation period: 4Expected effectiveness date: 07/31/2001 Expected closing date: 07/31/2005

CS PAD F-or: R.V M.rh 2DW

A. Project Development Objective

1. Project development objective: (see Annex 1)

The objective of the proposed central bank strengthening project is to support the Central Bank ofSri Lanka (CBSL) in its efforts to affect a fundamental restructuring and reorganization program.The reform effort, which is being spear-headed by the central banking authorities aims to create alean, well functioning, modernized, and efficient central bank capable of supporting strongeconomic growth over the medium to long term. The proposed project is expected to pave theway for further financial sector reform with the ultimate objective of establishing a fully private,competitive, and prudently managed banking system. The project will support: (a) the CentralBank's Reorganization and Restructuring efforts which include completely revamping the humanresource management function within the CBSL and rewarding staff based upon merit rather thantime-in-service; devolving non-core central banking functions to other agencies; strengthening thecore CBSL functions (economic management and financial system stability); and implementing aVoluntary Retirement Scheme (VRS) in line with the above objectives; (b) Upgrading thePayments System and other key Central Banking Functions including the introduction of a realtime gross settlement system (RTGS); developing and integrating a scripless Governmentsecurities system with the RTGS; and computerizing the general ledger of the central bank; and(c) other studies and technical consultancies within the central bank.

2. Key performance indicators: (see Annex 1)

Effectiveness of the CBSL in managing its core functions as well as progress towardsimplementation of the proposed reorganization: (i) devolution of non-core functions of thecentral bank; (ii) strengthening of remaining core functions (price stability and financial sectorstability); (iii) implementation of organizational changes within the CBSL; (iv) adoption of newhuman resource policies -- which reward merit over time-in-grade; (v) implementation of theVoluntary Retirement Scheme (VRS); (vi) time taken to settle interbank transactions; and (vii)integration of the General Ledger of the CBSL into a useful Management Information tool for thegoverning board of the central bank. A system of monitoring and evaluation will be establishedand a baseline evaluated, against which each step of project implementation be measured. Thesystem will also evaluate the impact of the project components on the efficiency of financialmarkets -- and the economy as a whole. The implementing agency will also seek feedback fromstakeholders (particularly the private sector and the banking sector) through interviews andorganized stakeholder workshops/meetings.

B. Strategic Context1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1)Document number: Country Assistance Strategy (CAS) -- Document number: 15633-LK (May 21,1996) which was discussed by the Board on June 13, 1996. Date of latest CAS discussion:December 23, 1998 Progress Report discussed by the Board on January 19, 1999.

The 1996 CAS focused on Sri Lanka's need to complete the transition from socialism to a marketeconomy while reinforcing the country's commitment to equity and social development andsuggested, among other things, improvement in the policy environment for private sectorinvestment (both domestic and foreign). The government recognizes the need for a sound and

- 2 -

strong financial sector to support private sector development and more rapid growth. The CASplaced great importance on financial sector development and stability and also on IDA's continueddialogue and assistance to further promote and deepen the sector. A comprehensive FinancialSector Study (Report No. 17236-CE) was prepared in July 1998 and since then, the World Bank,in close collaboration with the IMF and IFC, has also been working with the Sri Lanka authoritiesto deepen the financial sector reforms. In January 1999, the Board approved the Year 2000Emergency Assistance Credit (Report No. 18729-CE) which has since been satisfactorilyimplemented. Encouraged by recent modest liberalization of investment rules for state-ownedinsurance and provident funds and government efforts at establishing a regulatory framework forprivate pension/provident funds, IDA is also prepared to support a broad program of pensionrefonm. A PHRD Grant is already in place to assist the government to further improve theregulatory framework in the insurance sector and to support the preparation of a possible projectin this sector. In addition, the World Bank has responded positively to the Government's requestto prepare this credit to strengthen the Central Bank. The proposed operation directly supportsthe CAS goal of assisting the government in its efforts to prepare the country for the next phaseof financial sector reforms. An up-dated CAS, currently under preparation, will continue thisemphasis on private and financial sector reform.

2. Main sector issues and Government strategy:

Background - Sri Lanka's financial sector comprises diverse institutions. The banking systemconsists of 2 large state-owned commercial banks (accounting for about 55 percent of bankingsystem assets), 9 domestic private banks and 16 foreign commercial bank branches; a NationalSavings Bank (NSB); 6 Regional Development Banks; and a State Mortgage and InvestmentBank (SMIB). There are four Development Finance Institutions (DFI) that specialize in termlending. Twenty five finance companies (FC) provide lease financing and installment credit.There are also 5 leasing companies, 10 merchant banks, and 7 venture capital companies.Contractual savings are accounted for mainly by the two government sponsored provident fundsfor private sector employees, the Employees' Provident Fund (EPF) and the Employees' TrustFund (ETF). There are also 204 approved private provident funds, 12 unit trusts and 9 insurancecompanies. The government employee pension fund is unfunded, and benefits are financed fromthe general budget. These contractual savings institutions mobilize large pools of long-termresources but invest these funds principally in short-term government securities.

Main Sector Issues and Problems -- Sri Lanka's financial system is relatively shallow, withassets concentrated in government securities (38 percent) and liabilities in bank deposits (33percent). The banking sector is dominated by the two state commercial banks (SCBs), Bank ofCeylon (BOC) and People's Bank (PB), which between them account for 55 percent of bankingsector assets. There are considerable inefficiencies in the banking sector as evidenced by highintermediation costs and a high level of non-perforning assets (NPA). The state-owned banks'NPA as of end of 2000 was about 15.4 percent compared to NPA of 14.9 percent for privatebanks and 12.7 percent for foreign bank. This indicates that the state banks have brought downtheir NPA more in line with the other banks in the country. The state also dominates the marketin life insurance (45 percent), general insurance (60 percent) and pension funds (over 90 percent).These inefficiencies have been at the expense of both depositors and borrowers.

-3 -

Since 1991/92, significant reforms have commenced in the financial sector. These include:(a) improved financial disclosure through the adoption of international accounting and auditingstandards in banking and corporate sectors;(b) the ability of banks to recover loans has been strengthened;(c) Central Bank refinancing of directed credits has been virtually stopped;(e) measures to improve the regulatory, supervisory and institutional infrastructure have helpedto establish a world-class stock market in Colombo;(f) government recapitalization of the two state-owned commercial banks in 1993 and 1996,respectively. This, however, was undertaken without adequate governance reforms -- therebymissing an opportunity for meaningful structural change;(g) the finance company crisis that started in the late 1 980s has been stemmed, although theresolution of five failed FCs remains pending.

MONETARY POLICY MANAGEMENT. Banks are required to hold liquid assets (Treasurybills, cash and deposits) equivalent to 20 percent of their deposit liabilities. A greater burden forthe commercial banks, however, is the cash reserve requirement of 11 percent of liabilities.CBSL's measures to control prices in past 3 years has been relatively successful. The CBSL hasmanaged to keep average wholesale prices and consumer prices at 3 percent and 6.6 percentrespectively, over the past three years. However, during the 4th quarter of 2000, an increase infuel prices and the depreciation of the rupee had an inflationary impact. This resulted in theaverage CPI reaching 6.2 percent and the point-to-point CPI reaching 10.2 percent by December2000. The increasing inflationary trends had already impacted interest rates with a deterioratingimpact on the investment climate. With the introduction of the open economic policies in 1977,the Central Bank moved from a dual exchange rate policy to a managed floating exchange ratewith a crawling band. The band was increased from 2 to 5 percent in June 2000 to allow the rateto be determined by market forces within the band better reflecting forces of demand and supply.In January 2001, the Central Bank floated the rupee and the flotation was introduced withoutmajor disruption to the economy. In principle, interest rate policy is market oriented, and theCBSL's main monetary instrument has been setting of the repo and reverse repo interest rates.However, through open market operations, the Central Bank still influences the determination ofinterest rates. In addition, with state banks dominating the banking sector, the Government as themarket leader can also indirectly influence interest rates within the system.

BANK SUPERVISION AND REGULATION. Compared to bank regulation in most developingcountries the scope of CBSL authority is substaniial -- and the bank regulatory and supervisoryenvironment in Sri Lanka has improved substantially over the past decade. The Banking Act of1988 empowered the Monetary Board to require more extensive bank disclosure and higherreporting standards (including submission of annual audited statements), increased capitalrequirements, and more rigorous central banking supervision. In the ensuing years, additionalregulatory requirements have been introduced including suspension of interest on non-performingloans and more stringent provisioning requirements against bad and doubtful debts. Many ofthese changes followed the recommendations of the Presidential Commission on Finance andBanking. Amendments to the Banking Act in 1995 fiurther strengthened commercial banksupervision and regulation, established minimum capital standards for Specialized Banks, andextended CBSL supervision to these institutions. Despite these developments bank supervision

- 4 -

requires further strengthening. Examiner training is still inadequate and growth in staff size andexperience has lagged behind the growth in the number, size, and complexity of institutions to besupervised. Under the IDA financed Private Finance Development Project, the CBSL wasprovided with technical assistance to prepare on-site and off-site supervision manuals. Theseefforts are being further strengthened under Swedish bilateral assistance.

MONEY MARKETS. Primary debt markets are nascent and are dominated by short-termgovernment securities. There is less activity in secondary debt markets. The main financialmarket instrument is the Treasury bill, with maturities of 3, 6, and 12 months, auctioned weeklythrough a primary dealer system. Almost two-thirds of the Government debt is sold directly tothe National Savings Bank, the provident funds, and other government-owned banks. These aremostly fixed rate, non-marketable, intermediate-term instruments. In 1997, the governmentintroduced treasury bonds with longer maturities ranging from 2-6 years. These instruments aremarket based and auctioned through the primary dealer system. This initiative has assisted thedevelopment of a medium term yield curve and, as a result, the volume of corporate debentureshas increased significantly.

The CBSL and GOSL need to gradually increase their reliance on market-priced governmentsecurities and less on govermment-owned investors and non-marketable instruments in order todeepen the government securities market and to provide a better benchmark for pricing privatebond issues. There is a growing secondary market for long term debt instruments. Nonetheless,developing private bond markets will requlre other significant changes, including greater price andexchange rate stability, more confidence in stable government policy, and more consistenteconomic growth. Call money markets in Sri Lanka are thin and overnight money interest rateshave exhibited substantial volatility. On some occasions, rates have been as high as 100 percentper annum. While CBSL accepts the use of open market operations as the principal tool forfinancial market intervention and management, it has yet to fully integrate the use of this tool in itsfinancial market activities. IDA, the International Monetary Fund (IMF) and USAID have beenworking with CBSL to help improve open market operations.

INFORMATION (INCLUDING PAYMENTS) TECHNOLOGY. Although there has beeninitiatives to modernize Information Technology (IT) systems in the CBSL, the IT function is stillfragmented with stand alone non-standard and multiple platform systems. There is a need tomove to an integrated policy environment, with modern information management practices toensure accuracy and consistency of information. In general, there are systemic weaknesses in theareas of: (i) Communication Network; (ii) IT Policy and Procedures; and (iii) Major Applications(such as the payment system). The payment systems in Sri Lanka is run by an Automated CheckClearing System (SLACH) and the Sri Lanka Interbank Payments System (SLIPS). The currentinfrastructure is basically an off-line electronic funds transfer system which does not need banks tobe linked to the Automated Clearing House (ACH). The system involves exchange of magnetictapes or diskettes through the ACH, on a daily basis. In addition to magnetic tapes, printedreports of accounts are also provided for non-automated banks. An on-line funds transfer systemswith integrated communication network is not currently available in Sri Lanka. An on-line fundstransfer system requires each bank to have a front end computer linked to the SLACH via acommunication line. This technology will facilitate the immediate real time settlement and funds

- 5-

transfer between banks and with Central Bank. Currently, the CBSL is working on developing acommunication network including a local area network (LAN) and wide area network (WAN) toimprove financial transactions within the Central Bank and with other financial institutions. Underthe IDA financed Year 2000 Emergency Assistance Project, support was provided to CBSL toestablish an integrated IT security system.

CENTRAL BANK'S ORGANIZATION STRUCTURE, ITS FUNCTIONS, AND HUMANRESOURCES. The Central Bank of Sri Lanka (CBSL) is governed by a three-person MonetaryBoard consisting of the Governor of CBSL, the Secretary of the Ministry of Finance and Planning(MOFP) and a non-government appointee. The CBSL operates with a considerable degree ofindependence in most areas and has a significant role in influencing government policy andmanaging the financial system. The CBSL performs a broad range of traditional central bankactivities including conducting monetary policy, controlling inflation, advising the Treasury onpublic debt management issues, supervising and regulating commercial banks and other financialinstitutions to assure stability within financial markets, and managing the nation's internationalreserves. CBSL also carries out financial activities not traditionally associated with central banks-- including managing the GOSL sponsored provident plans and providing financing to selectedsectors (agriculture, exports, and troubled finance companies) -- a function that has been reducedin recent years. The CBSL now recognizes, however, that a strong and well focused central bankthat oversees monetary policy and appropriately regulates banks is an essential ingredient for thedevelopment of a sound and competitive banking system. The twin deficits -- fiscal and trade --have made CBSL's task extremely challenging, although it has been assisted by forced savingsmobilized by the above mentioned govermnent-owned banks and provident funds, and by financialassistance from external donors and creditors.

CBSL's involvement in many functions not associated with central banking business has weakenedits focus on its core central banking competencies. In early 2000, the CBSL decided to review itscore role and identify gaps in its present organizational structure which hinder the achievement ofits objectives and the delivery of its core functions. This review identified that the CBSL lacks aproper Human Resource planning and strategy capacity which has resulted in serious deficienciesin many areas of human resource management. This is a problem of some years standing --beginning with unfocused recruitment which did not address proper institutional skill requirements-- resulting in serious over-staffing and demoralization. Non-adherence to standards foremployees and proper placement of employees, coupled with inadequate training, has resulted in aserious skills gap. These problems have been exacerbated by an absence of incentive schemes toreward strong performers within the institution and penalty schemes for poor performance.

CAPITAL MARKETS. Over the last few years, the government has taken several steps toinvigorate the capital market by modernizing the stock exchange facilities, promoting foreignparticipation, developing the investment fund industry, enforcing higher disclosure standards,providing tax incentives and promoting investor awareness. During second half of the 1 990sprimary issues of corporate debentures increased, especially by commercial banks, supplying themarket with new instruments for capital mobilization. Despite these actions, the size of SriLanka's capital market in relation to GDP remains small. With assistance from the ADB and IFC

- 6 -

the Central Bank established a rating agency in 1999 to help develop the debt market.

THE TWO STATE OWNED COMMERCIAL BANKS. Perhaps the single biggest problem inthe financial sector relates to the performance and operation of the two state owned commercialbanks -- People's Bank and Bank of Ceylon. Accounting for over half of all commercial bankingassets, they create an environment of inefficiency and weak commercial orientation, behind whichthe other banks shelter. Efforts to improve these banks within the existing governancearrangements have not, to date, proved successful. The Government is at present not prepared toconsider privatization of these two institutions and has alternatively elected to bring in a newBoard and recruit new chief executives to run the banks. However, the Government will have toadopt a "hands-off' approach to the state banks, and permnit them to be established on a trulyconmmercial footing, for real structural changes to take place in the financial sector.

Government Strategy and Priority Areas - The GOSL continues to place importance ondeveloping the financial sector and it has approached the World Bank for technical and financialassistance to re-engineer the CBSL to help it transforn into a premier central bank within Asia.Support has been particularly requested in the following areas:

* Reorganization and Institutional Strengthening (including human resources development andinstitution right-sizing) of the CBSL;

* Devolution of non-core functions from the CBSL;* Strengthening of the remaining Core Functions;* Implementation of a Voluntary Retirement Scheme to right-size the bank;* Automation of the Payment and Settlement Systems (RTGS);* Linkage of the Scripless Government Securities system with the RTGS;* Computerization of the General Ledger of the CBSL; and* Fina;cial Markets Development and Regulation.

3. Sector issues to be addressed by the project and strategic choices:

In light of the above issues and the Government priority areas of the first phase of the financialsector reform, the project will aim at modernization and improvement of the CBSL as this isexpected to facilitate the implementation of the next phase of financial sector reform. The threebroad elements of this proposed project are:

1. Central Bank Reorganization and Restructuring.2. Payments System Development.3. Financial Market Regulation and Development.

The project will provide only limited assistance in the area of pension reforms if necessary. Thereasons for this are two fold. Firstly, pension reforn appeared to be out of line with the mainfocus of the other elements of this particular project -- which were all very much related to centralbanking. Second, support for pension and provident fund reform will likely be provided through adifferent intervention when these reforms are more fully developed. As the Employees ProvidentFund (EPF) is the largest pension fund in the country and comes under the purview of the CentralBank, the limited assistance provided under this project is intended to help the Ministry of Finance

-7 -

and the CBSL to plan, strategize and ultimately implement the transfer of the management of theEPF from the central bank to some other independent institution.

C. Project Description Summary

1. Project components (see Annex 2 for a detailed description and Ainex 3 for a detailed costbreakdown):

The proposed project has three main over-arching components and several sub-components:

1. Central Bank Reorganization and Restructuring(a) Human Resource Development (including new HR policies).(b) Support for a Voluntary Retirement Scheme (VRS).(c) General Support for Capacity Building of various departments.

2. Payments and Securities Clearing & Settlement Improvement(a) Introduction of a Real Time Gross Settlement (RTGS) system(b) Upgrading the Scripless Government Securities System (SGSS)(c) Automation of the General Ledger in the central bank

3. Financial Market Regulation and Development(a) Legal Reforms(b) Other Financial Sector Studies in Priority Areas.

The proposed project will also support implementation and administration arrangements in theform of technical and financial assistance for procurement and financial management of the projectto ensure that implementation is in line with World Bank guidelines. To permit preparatory workon the project, the CBSL requested a Project Preparation Facility (PPF) in an amount of US$600,000 to support (a) a technical assessment of the payment systems and (b) the design of newHR policies and the development/design of a VRS. The PPF was approved and the PPFAgreement was signed on October 19, 2000.

The Swedish International Development Agency (SIDA) has agreed to co-finance theproposed project in an amount of one million US dollars equivalent. As the Swedish CentralBank (Riksbank) already has a twinning program with the Central Bank of Sri Lanka, thisagreement to jointly finance the project is seen as a useful way of better coordinating our jointdonor efforts in support of the Government of Sri Lanka. This proposal has been discussed andagreed with the Ministry of Finance representatives. The SIDA financing will be in the form of agrant.

With financing contributions from IDA (US$ 30.3 million) and SIDA (US$ 1.0 million), theGovernment of Sri Lanka will be required to provide counterpart funding of US$ 10.7 millionover the next four years.

-8 -

Indicative- i Bank- % ofComponent Sector Costs % of financing Bank-

____ __ (US$M) Total (USSM financing1. Central Bank Reorganization and Financial SectorRestructuring. Development(a) Human Resource Development. 0.54 1.3 0.48 1.6(b) Support for a Voluntary Retirement 25.00 59.5 17.50 57.8Scheme (VRS).(c) General Support for Various 5.80 13.8 2.03 6.7Departments.2. Payment System Financial Sector

Development(a) Introduction of a Real Time Gross 5.02 12.0 4.74 15.6Settlement (RTGS) system.(b) Support for upgrading the Scripless 3.11 7.4 3.11 10.3Government Securities System (SGSS).(c) Automation of the General 1.08 2.6 1.08 3.6Ledger in the central bank.

3. Financial Markets Regulation and Financial SectorDevelopment Development(a) Legal Reform. 0.46 1.1 0.41 1.4(b) Other Financial Sector Studies in 0.37 0.9 0.33 1.1Priority Areas.

Implementation Support. 0.02 0.0 0.02 0.1Project Preparation Facility (PPF) Financial Sector 0.60 1.4 0.60 2.0

_ DevelopmentTotal Project Costs 42.00 100.0 30.30 100.0

Front-end fee 0.00 0.0 0.00 0.0Total Financing Required 42.00 100.0 30.30 100.0

2. Key policy and institutional reforms supported by the project:

The -aim of the proposed project is to help the GOSL to modernize the country's Central Bank tosupport economic and financial system stability in support of faster private sector led growth inSri Lanka and to meet the challenges of an increasingly globalized world. The project also seeksto improve and strengthen the financial sector through a program of policy reform and institutionbuilding at the Central Bank. While this project will not address all the weaknesses in the financialsector, it will support a selected set of priority activities identified by the CBSL as a first phase ofa broader financial sector reform. The project is designed to provide the central bank with thetools required to, at a later date, implement a follow up round of even deeper financial sectorreforms within the commercial banking sector.

At the Annual Meetings in September 1999 and again in May, 2000, the GOSL made a formal

-9-

request to IDA for a project to assist the CBSL. The Government proposed program consisted of5 main areas of policy reform as follows:

I. Reorganization and Institution Building of the CBSL - Revisit the role and functionsof the CBSL in the context of financial market developments and reorganize and restructure theinstitution with the objective of improving its core functions and responsibilities.

H. Training, Research, and Library Upgrading - In light of its plan to reorganize theinstitution's structure and functions the CBSL envisaged a need for further building staff capacityin the form of training -- both foreign and local.

III. Automation of the Payments System, the Government Securities Market and theGeneral Ledger of the central bank - establishment of a Real Time Gross Settlement (RTGS)system for large value and time sensitive payments within the economy and the development of anautomated Government securities and depository system in the CBSL.

IV. Financial Market Regulation and Development - The Government seeks to: review thelegal fmancial framework within which the financial system currently operates with a view to itsmodernization to permit Sri Lanka to compete better in an increasingly globalized world. To alsoprepare the appropriate legal backing for transactions which involve electronic fund transfers insupport of E-Commerce and E-Business activities.

V. Reform of the Social Security System and Capital Market Development - Reform andregulate the contractual savings institutions (pension and provident funds) in the country; and totake necessary measures to increase the liquidity and size of the stock market.

The proposed project will support the programs I to IV. As for the pension reform program, theWorld Bank has completed a study in this area and helped the Government to organize a PensionsWorkshop in Colombo in 2000. Pension reform is likely to be supported under a separate IDAfunded project.

3. Benefits and target population:

A sound and efficient central bank, with limited focus, is likely to be more successful in ensuringboth price stability and financial system stability. This is increasingly the way that modem centralbanks are evolving in the developed world. Such action by the CBSL will help to better serve theneeds of a modem economy to the benefit of the private sector, increased investment, and overalleconomic growth. The project will have a positive impact on the overall macro-economy throughmore effective and more professional macro-monetary management. It will directly benefit thestaff and management of the CBSL. Automation of the payments system, along with improvingthe environment within which the payment system operates will increase the efficiency andaccountability of the payment and settlement infrastructure in the country and will better met theneeds of the enterprise sector. Staff training will improve the CBSL's institutional capacity.

- 10 -

4. Institutional and implementation arrangements:

The Central Bank of Sri Lanka will take the lead in implementing this project. A SteeringCommittee was appointed by the Monetary Board in mid-2000 to lead the transformationprocess of the Central Bank to meet the challenges of the global environment in the newmillennium. A Deputy Governor of the Central Bank chairs the Steering Committee. The processof change is considered continuous, and the steering committee publishes quarterly reports for theMonetary Board and regular newsletters for the rest of the staff of the Central Bank to keep theminformed of the restructuring/re-engineering process.

The re-engineering process has been supported by the work of five Focus Groups selected fromvarious departments from within the Central Bank (see Annex 2 for details). These Focus Groupscompleted their review work in December, 2000 and reported their recommendations to theSteering Committee. The implementation of the Focus Group recommendations will beundertaken by a Task Force to ensure participation and coordination by all key departments. TheTask Force is expected to make the preparatory arrangements for:

* Co-ordination of the reorganization of departments under the proposed new organizationalstructure approved by the Monetary Board

* Monitoring financial sector developments, making policy recommendations for regulating andsupervising financial institutions, and maintaining financial stability.

* Development of a plan for the phasing out the agency functions of the CB SL* Carrying out necessary improvements in the function and management of ancillary and

administrative functions that remain in the CBSL after the restructuring exercise.* Carrying out any other necessary tasks for the implementation of the transformation process.

Continuous dialogue at all levels within the CBSL has been an important part of there-engineering process. One of the five focus groups is dedicated to "Consensus Building" andhas been designed to convey, to all staff, the implications of the transformation process -- so as toensure that there would be no adverse publicity and resistance at a later stage of thereorganization process. This is particularly important with respect to the implementation of theVRS. As indicated, unions have been consulted about the VRS from the outset and endorse thecentral bank's initiative in this regard. Due to a concern about Fundamental Legal Rights in SriLanka, the VRS will only be offered on a voluntary basis to the staff. This requires that thepackage must be designed in a sufficiently attractive manner to ensure that the desired number ofstaff will leave on a voluntary basis.

Members of the Consensus Building Focus Group (as well as the other four) have been drawnfrom different levels of staff grades throughout the CBSL to ensure that the views of the staffbelow the senior management level will be incorporated into the focus group recommendations.The Focus Group on Consensus Building has also introduced an internal newsletter "Kavuluwa"(meaning "Window") to provide a forum for employees to express their views on thetransformation process and the VRS.

The VRS has been designed on a similar basis for all employees to avoid allegations ofdiscrimination between different classes of workers. In general, the VRS will be offered to the

- 11 -

employees (more than 45 years old) and to staff in minor grades of all ages. For these employees,the staff will receive 0.75 months salary for every year of service and 2 months of salary for everyyear of service foregone. Pensions will be paid on a graduated scale between age 45 and thenormal retirement age of 55 (when full pension is received). For staff in minor grades who areunder 45 and have less than 10 years of service, the payment will be on the basis of 2 monthssalary for every year of completed service and 2 months salary for every year of service foregone.Re-hiring of workers who accept VRS will also be avoided by the signing of an agreement thatthey will not work for the central bank again, after the separation package has been paid.Safeguards will also be put in place to ensure that IDA is only reimbursing the actual paymentsmade to staff who accept the VRS. More detail on the proposed VRS scheme is included inAnnex 4.

Administrative Arrangements - The Central Bank has appointed specialized financial andprocurement specialists to facilitate procurement and disbursement under the project. The CBSLhas already allocated office space for these staff and other facilities to support the administrativeand implementation process. Training in procurement and financial management guidelines of theWorld Bank will be provided to the staff, as needed. The administrative arrangement will beunder the direction of the CBSL's Steering Committee.

Most importantly, the CBSL has appointed a full time Transformation (Change) Manager whohas been vested with full delegated responsibility to oversee the overall implementation of thetransformation process. The Transformation Manager will ensure that the re-engineering takesplace in a holistic, well-integrated and timely manner.

Due to the importance and complexity of the Payment System, a permanent "Payment Council"has been established. This body will be responsible for the development of the Payment andSettlement System. The three CBSL departments (Information Technology Department, PublicDebt Department, and Banking Department) that will be principally engaged in the developmentof the Payment Settlement System, are expected to utilize existing staff in most of the Projectactivities, while personnel for specialized areas of work may need to be recruited.

As reform of the Human Resources function is a very important part of the CBSL'stransformation, the CBSL also intends to recruit a dynamic HR Director to lead the HRDepartment. This individual is expected to direct and manage the human capital of the bank tothe highest professional standards. This will enable the CBSL to efficiently face the challenges ofthe local and international financial markets with human capital that has reached internationalstandards through excellence in their operations. As such expertise is not available within thebank, CBSL intends to recruit a local HR Advisor on a contract basis, initially, for a period of twoyears.

Reporting Requirements. A system for monitoring, evaluation, and proper recording will beestablished by the project administrator and the accountant. This system will include QuarterlyReports on implementation progress of the project for the Chairman of the Steering Committeeand for IDA.

- 12 -

FINANCIAL MANAGEMENT

Summary - Central Bank of Sri Lanka (CBSL) has adequate financial management capacity asper the requirements of OP/BP 10.02 for implementing the proposed project. CBSL is currentlythe implementing agency for the Year 2000 Emergency Assistance Project (Cr.3 162-CE),scheduled to close on June 30, 2001, and has a record of satisfactory performnance in financialmanagement for that project.

The overall objective of the proposed project is to restructure and reorganize the CBSL to meetthe challenges of the new millennium, which also includes modernization of its accountingfunctions. However, the accounting function of CBSL is broader than merely accounting foradministrative matters. It encompasses accounting for a wide range of central bank activities,such as, payments settlements of all commercial banks in Sri Lanka, being the banker to thegovernment, and so on. The project will fund the deployment of payment systems and a GeneralLedger which will interface with the payment system and will be used for processing limitedadministrative financial transactions of CBSL.

The project will disburse on the traditional method but will produce simplified ProjectManagement Report (PMR) from the start of the project. The PMR formats will be reviewedafter the first year of implementation, and a joint decision will be taken by GOSL, CBSL, and theBank on whether the project should switch over to PMR disbursements. CBSL will maintain theproject accounts on an excel spreadsheet and periodically reconcile this with the General Ledgersystem. Financial statements of the project will be audited by the Auditor General of Sri Lankaand will be submitted to IDA within six months of the end of each fiscal year. CBSL will alsosubmit to IDA within six months of the end of each fiscal year the audited annual financialstatements of CBSL. CBSL has assigned a qualified and experienced project accountant tooversee the financial management of the project.

D. Project Rationale

1. Project alternatives considered and reasons for rejection:

In general, there are several issues in the financial sector that need to be addressed by theGovernment. As a first step, however, both the World Bank and the Government believe that aprogram for strengthening and modernizing the CBSL is a necessary component for a morecomprehensive financial sector reform program in the future -- particularly in the area ofcommercial banking. Financial sector reform is a long term process and needs to be implementedin a phased manner. The following alternatives in design and scope of the project wereconsidered but rejected.

One alternative considered was to include reforms in the social security and pension system in thisproject (indeed, this was a request of the CBSL). However, as the main focus of the project is torestructure the central bank and to pare down its activities to only those which are consideredcore -- including devolution of management responsibilities for the Employees Provident Fund --the inclusion of social security reform was considered to be out of line with the general objectivesof the support program. In addition, the World Bank is involved in parallel work in the area of

- 13 -

pension and provident funds which is expected to provide support at some future date through adifferent instrument. Hence, it was decided to keep the focus of this project strictly on the CBSL-- institution, functions, and economic management.

Another alternative considered was to address the issues and problems in the state ownedcommercial banks -- with a support program to bring in external management teams andultimately privatize these banks. However, since the government is not yet prepared (mainly dueto existing political and economic problems) to tackle the more fundamental banking sectorreforms at this stage, it was decided that IDA's continuing support for strengthening the CBSLwill benefit the country while preparing the CBSL for longer term commercial banking reform, ata later date.

Another alternative was to finance the technical assistance and payments system components ofthe credit and not fund the VRS. Indeed, the CBSL's decision to include the VRS came at a muchlater stage of project preparation. The project team favorably considered the inclusion of supportfor the VRS package in the overall project for several reasons. Downsizing the CBSL in terms ofstaff numbers is in line with the overall objectives of the re-engineering of the central bank.Shedding functions and focusing on core areas of operation necessarily had direct staffingimplications. In addition, moving towards a more streamlined mode of operation meant thatadministrative and other support functions could be provided at lower cost, and possibly withbetter service, from outsourced, private sector providers. Lastly, given the synergies between there-engineering exercise and the down-sizing of the bank, IDA financing was consideredappropriate, particularly for a government which is facing an increasing fiscal deficit (and thepotential loss of central bank profits to pay for the VRS which would otherwise accrue to theMinistry of Finance).

Another alternative was to provide no support. A dysfunctional financial system in which no keypolicy changes are made may result in central banking reformns having less than the optimallydesired result. However, as reform of the financial system is an essential ingredient in supportingprivate sector development this was not considered a serious alternative. In addition, IDA wishesto maintain a dialogue and continue with its key objectives on financial and private sector refornas enunciated in the country assistance strategy. Therefore, even a smaller project including thegovernment priority areas will help the government and will assist in maintaining a closer workingrelationship between IDA and GOSL.

- 14 -

2. Major related projects financed by the Bank and/or other development agencies (completed,ongoing and planned).

I 1 t . Latest SupervisionSector Issue I Project (PSR) Ratings

_____ I__________ ____________ (Bank-financed projects only)Implementation Development

Bank-financed Progress (IP) Objective (DO)

To assist the MOFP and the CBSL to Year 2000 Emergency S Sprevent possible business disruption Assistance Projectdue to Y2K problem. (Cr.2361-CE) - ongoing

Improving efficiency of financial Private Finance Development S Sintermediation and domestic resource Project (Cr. 2484-CE) - closed.mobilization for long term investment;deepening the financial system andinstitution building of major players inthe financial sector.

Support the development and growth of Four SMI and three IDP S SLarge, Medium, and Small Scale financial intermediationIndustries through seven lines of operation projects - closed. Allcredits, as well as technical assistance of these projects werefor institution building and policy co-financed by the Asianreforms in the areas of trade, industry Development Bank (ADB)and financial sector. which were also completed

satisfactorily.

Improve the efficiency of legal and Legal and Judicial Reform S Sjudicial systems and build the capacity project (Cr. 3384-CE). Thisof decision makers in this sector. project was approved by the

Board on June 20, 2000 andbecame effective on August 11,2000.

Other development agencies

-15-

JBIC, ADB KFW -- Support to further JBIC: Small and Microdevelop the SMI and Microenterprise Industries Leader andsectors in the country and strengthen Entrepreneur Promotion Projectand support the Sri Lankan financial (SMILE) - US$ 46 million.institutions to develop capacity for Closing date: July 2003.credit lending to SMIs.

ADB - SMAP - Small andMedium Enterprises AssistanceProject - $ 55 million; of whichUS$ 50 is from a consortium ofinternational financiersguaranteed by the ADB and theGovernment and US$ 5 millionfrom the ADB. Closing DateOctober 31, 2002

KfW - DM 2 million - NDBMicro Credit program. Closingdate December 31, 2001

KfNW - DM 60 million directloan to government in 1999 foronlending to NDB.

KfW - DM 65 million directloan to governnent in 2000 foronlending to DFCC.

JBIC- E Friends -Environmentally FriendlySolutions fund - US$ 22million. Closing date isDecember 31, 2001.

Strengthening the CBSL's banking SIDA (Swedish Foreignsupervision capacity. Assistance) - Swedish kroner 8

million for upgrading banksupervision for Central Bank

1P/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory)

3. Lessons learned and reflected in the project design:

Lessons from other IDA-financed TA projects in Sri Lanka indicate that these projects are usuallyslow to implement and disburse, and are difficult to administer. This is more of a problem forlarge projects with many components, over-ambitious objectives, and several implementingagencies. The following are some of the lessons learned in managing IDA financed operations,listed in the above table.

- 16 -

(i) Managing the Internal Change Process: Adequately internalizing and main-streaming themanagement arrangements for the change process can make a significant contribution to thesuccess of projects -- particularly if this process is led by senior personnel within the concernedinstitution. It is also important that these management arrangements are well coordinated with allconcerned stakeholders;(ii) Lead taken by the CBSL and MOFP in the Policy Dialogue: in the areas where politicalresistance was less, these two institutions took progressive steps and also managed to keep thereform program on track;(iii) IDA's close and continuous coordination with senior staff of the CBSL and MOFP providean opportunity for IDA to bring to the notice of the senior policy makers issues relating to slowprogress in the financial sector;(iv) Proper monitoring and reporting -- regular reviews enabled the credit funds to be disbursedeffectively. This is a practice IDA needs to replicate in all projects. This not only helped in bettersupervision but also the institution became identified with the project;(v) Need for greater coordination between departments within the same organization: this is ageneral weakness in Sri Lanka; and(vi) Designing projects with achievable objectives tend to be more successful: lessons learnedfrom the above mentioned PFDP project with over-ambitious objectives and several componentsconfirms the difficulties in project implementation. A lack of coordination also created resistancefrom different departments within the same organization. It would have been more effective if thestaff of the these implementing institutions were well briefed on the overall financial sectordevelopment strategy and their specific roles.

Another fundamental problem identified in other projects was the absence of a consistent andcomprehensive Framework for Financial Sector Development. Due to the absence of a reformframework, the Government had the tendency to approach reforms in an ad-hoc manner,whichever they believed was politically feasible, and with the assistance from other donors.Hence, some activities which had no strong ownership from the implementing agencies were notpursued even though they played a major role in the overall financial system (such as insurance).For the proposed project, it is the CBSL itself which has prepared a well thought out programwith specific objectives and expected outputs. These comprehensive commitments have also beenlaid out in a Letter of Development Policies sent by the Governor of the CBSL to the VicePresident of the South Asia Region.

Nonetheless, in light of the above issues, the project took measures at the design stage tominimize the risk of these problems. Keeping the project small and focused should help remedysome of these problems.

IDA will also need to coordinate with other donors working within the CBSL to avoid duplicationof work and maximize the efficiency and transparency of the project. In this regard, the proposedproject will benefit from technical assistance by competent Bank staff who have Global experiencein payments system development and reform; staff within the IMF with good experience inCentral Bank reorganization and financial market development; and similarly skilled staff from theCentral Bank of Sweden.

- 17 -

Government ownership is key to the success of any project. In addition, a participatory approachin project development and implementation is important in building ownership and successfuloutcomes. For this project, the CBSL's commitment is evident as discussed below.

The project also sought to learn from the implementation of other VRS schemes in Sri Lanka.Experience from a 1990 Public Sector Restructuring (ERC) and a recent Mahaweli (electricitycompany) VRS were NOT considered particularly successful. These less than optimal resultsappear to be a consequence of the fact that a consultative process was not followed inimplementing the VRS package; there was political interference in the process; and some staffwere re-hired after obtaining a golden handshake. These issues are being addressed by followinga significantly more consultative process -- with full discussion with the Labor Unions as well aspublic outreach through a specific CBSL Focus Group committee committed to this purpose. Inaddition, the central bank is more autonomous and political interference is minimal. Lastly, incomparison to the other two government VRS schemes, the total staff strength is much less andwill therefore be much more monitorable. Separated staff, as well as the CBSL, will be expectedto sign an agreement not to not work for the central bank again. These two schemes, as well asexperience with other private sector schemes in Sri Lanka, were reviewed when designing thecurrent program to ensure that lessons learned were taken into account. The lessons learned fromprevious experiences are documented in greater detail in Annex 2.

4. Indications of borrower commitment and ownership:

The Government and in particular the MOFP and the CBSL are fully committed to this project --they have approached the Bank on several occasions requesting technical and financial support forthe central bank. The project implementation capacity and commitment of the CBSL wasdemonstrated under the Y2K project which was prepared and implemented in record time. Inearly 2000, the CBSL and MOFP requested the Bank to reallocate un-utilized balances from theY2K project to the further enhancement of the Information Technology systems (payments andresettlement systems) within the CBSL. Simultaneously the Government requested a supportprogram for a broader strengthening of the CBSL, including institutionreorganization/restructuring, staff capacity building, and improving financial market regulationand development.

In May 2000, the government prepared a well designed proposal and made a formal request forIDA's assistance in the priority areas mentioned above. The Government invited a mission todiscuss its proposal and reached agreement on the main elements of the proposed project. TheCBSL had taken a management decision to reorganize and restructure the institution to improveits efficiency and effectiveness so that it would be better able to face the challenges encounteredby the ongoing global transformation in the financial sector. A Central Bank retreat attended bykey senior officers of the Bank on the 8th and 9th July 2000, identified several areas within theCBSL where reform and transformation were necessary. A Steering Committee was appointed toact as a catalyst for this transformation process and five Focus Groups were established by theSteering Committee to study the following areas:

1 . The Objectives of the CBSL

- 18 -

2. The Organizational Structure of the CBSL3. The Management Processes of the CBSL4. Human Resource Management of CBSL ; and5. Consensus Building within the CBSL

The focus groups completed their review and proposals in the above areas and have shared theirreports with IDA. Project preparation activities have already started in the areas of paymentsystems and human resources development (including the development/design of the VRS) andare being funded by a Project Preparation Facility (Q-250-CE) for a total of US$ 600,000. ThePPF Agreement was signed on October 19, 2000.

5. Value added of Bank support in this project:

The GOSL requested assistance from the World Bank because of its experience in countriesaround the World and recently in crisis management in the countries of East Asia. The WorldBank has experience in public sector restructuring and management around the world and also hasextensive experience in private sector development, an important element of which is a soundfinancial sector. IDA can complement the efforts by the government and other donors andprovide required technical and financial assistance. As indicated above, IDA's involvement inselected areas of reform and development resulted in satisfactory outcomes in other projectswhich have benefited the private sector, the government and the public at large. Financialassistance from the IDA credit will facilitate the project implementation and is an added value forthe CBSL's home grown transformation program.

E. Summary Project Analysis (Detailed assessments are in the project file, see Anmex 8)

1. Economic (see Annex 4):* Cost benefit NPV=US$ million; ERR = % (see Annex 4)O Cost effectivenessO Other (specify)The streamlining and reduction of staff in the central bank should ideally be recognized as a costof the re-engineering processes within the CBSL. The VRS costs should be expensed by theCBSL as they occur. However, neither the central bank nor the Ministry of Finance can affordthis cost from their current budgets. As a second best alternative, the IDA support for the VRS isbeing justified as an investment operation. The cost of staff rationalization within the CentralBank of Sri Lanka will be expensed over a three year period, as the expectation is that the VRSpackage will need to be offered more than once. The implementation of the VRS component isexpected to yield a significant stream of cost savings to the CBSL over time. As such theeconomic justification of the VRS component of the investtnent operation is sensitive to: (a) theeconomic life of the investment (how many years of cost savings are counted towards the initial"investment" of the VRS); and (b) the non-quantifiable macro economic benefits of creating amore efficient and stream lined central bank. See Annex 4.

It is important to fully account for the less quantifiable, but nonetheless important,macro-economic effects of a stronger and more focused CBSL. An enhanced focus on macroeconomic stability and financial system stability should yield benefits in terms of enhanced

- 19-

investment and economic growth -- as well as the avoidance of possible banking crises and thenegative impacts that can result. A strengthen central bank and a streamlined payments systemwill also support greater economic activity in Sri Lanka.

2. Financial (see Annex 4 and Annex 5):NPV=US$ million; FRR = % (see Annex 4)The payback period for the VRS component of this investment is just under four years -- andprovides a positive net inflow during the fourth year after the VRS has been fully implemented.This appears to be an overly long pay-back period when compared to the ideal situation ofexpensing the costs of the VRS during the year in which they take place (and not treating them asan investment). See Annex 4.

Fiscal Impact:

To the extent that the Central Bank of Sri Lanka contributes 30 percent of the cost of the VRSscheme ($7.5 million over a three year period) this represents funding (from central bank profits)which would otherwise have accrued to the Ministry of Finance. Hence, this ultimately representsforegone fiscal revenues for the Ministry.

3. Technical:Improvement of the Payment System is one of the two major components of the project.Technical studies will be undertaken by experts to ensure that the payment system is properlydesigned for the country's overall institutional, legal, and regulatory environment as well as itsfinancial systems development policies in years to come.

To maximize the benefits of the VRS, the program should be mandatory and should targetseparating the less productive staff. The CBSL has decided, however, that a mandatory programis not desirable in view of possible legal challenges in defense of "Fundamental Rights".However, some targeting can be achieved even in a voluntary program. This will be done byout-sourcing most non-core staff (guards, drivers, canteen workers, and so on) and by othertargeted design approaches.

4. Institutional:This project mainly focuses on institution building within the Central Bank of Sri Lanka. It willfocus on administrative, organizational and legal reform as well as a strengthening of the humanresource base of the central bank. Its ability to monitor the financial system and ensure macromonetary stability will also be enhanced.

There is strong management and institutional capacity to implement the VRS component withinthe CBSL. However, given the relative lack of experience with such schemes in Sri Lanka, theprogram will be implemented slowly and carefully over a two to three year period to enhance thelikelihood of successful implementation. It will also be managed by an expert HR Manager to berecruited from the local Sri Lankan market with support from an expert HR Advisor to berecruited from the international market.

- 20 -

4.1 Executing agencies:

Central Bank of Sri Lanka (CBSL)

4.2 Project management:

Central Bank of Sri Lanka (CBSL)

4.3 Procurement issues:

There will be a need to procure expensive software and hardware for the payments systemcomponent of this credit. Ensuring proper pre-design and technical specifications will be vital andthis is being provided by an in-house payments system specialist (from FSD) who will also be ableto advise on the optimal sources of procurement for these types of systems. Support is also beingprovided by a specialized payments system consulting company to draft up the technicalspecifications and request for proposal.

4.4 Financial management issues:

During the project appraisal, a review of CBSL financial management systems and procedureswas carried out during project appraisal and it was determined that CBSL has the capacity tomeet the requirement of OP/BP 10.02.

5. Environmental: Environmental Category: C (Not Required)5.1 Summarize the steps undertaken for environmental assessment and EMP preparation (includingconsultation and disclosure) and the significant issues and their treatment emerging from this analysis.

Not applicable.

5.2 What are the main features of the EMP and are they adequate?

Not applicable.

5.3 For Category A and B projects, timeline and status of EA:Date of receipt of final draft: Not Applicable

5.4 How have stakeholders been consulted at the stage of (a) environmental screening and (b) draft EAreport on the environmental impacts and proposed enviromnent management plan? Describe mechanismsof consultation that were used and which groups were consulted?

Not applicable.

5.5 What mechanisms have been established to monitor and evaluate the impact of the project on theenvironment? Do the indicators reflect the objectives and results of the EMP?

Not applicable.

6. Social:6.1 Summarize key social issues relevant to the project objectives, and specify the project's socialdevelopment outcomes.

There are no major social issues expected from this project. There will be some staffretrenchment in the Central Bank of Sri Lanka (CBSL) as part of the overall restructuring andreorganization process. However, this is unlikely to have any negative social impact as reasonablearrangements will be made by the CBSL for these staff -- in terms of financial support and

- 21 -

alternative career counselling. The CBSL has already started consultation and discussions on theVRS with the labor unions. The design of the VRS package will consider all aspects of possiblepresent and future financial and social impact on the employees. As such, it is expected that someof the rules and policies regarding staff pensions will be revised in favor of the employees tominimize any potential future negative impact.

The impact of a prudently managed financial sector and the conduct of sound macro monetarypolicy should directly benefit investors and depositors. Efficiency in the financial systems and thebanking sector will reduce the cost of funds available to investors -- the benefit of which will bepassed on to the public at large.

6.2 Participatory Approach: How are key stakeholders participating in the project?

The Financial Sector Reform Committee and the Task Force working on this project includesrepresentation from the Central Bank of Sri Lanka, the Ministry of Finance, the financial sectorcommunity, and the private sector. The banking community, who are the main stakeholders inthis project, will be closely consulted. IDA will encourage participation of all stakeholdersthrough workshops and regular meetings.

Labor Unions have already been consulted on the VRS program and a continuous out-reachprogram is on-going with staff likely to be impacted by retirement. Labor Unions will continue tobe consulted to ensure the smooth implementation of the program.

6.3 How does the project involve consultations or collaboration with NGOs or other civil societyorganizations?

Not applicable.

6.4 What institutional arrangements have been provided to ensure the project achieves its socialdevelopment outcomes?

The CBSL's focus group on consensus building has taken appropriate actions and adequateprecautions to ensure that the views of the employees are taken into consideration in thetransformnation process and that any adverse social implications due to the VRS will be minimized.Labor unions have been consulted and staff at all levels have been drawn into the focus groups. Alarge number of staff have been involved in the reorganization process to ensure that the processis not seen as a "top down exercise".

6.5 How will the project monitor performance in terms of social development outcomes?

Not applicable

7. Safeguard Policies:7.1 Do any of the following safeguard policies apply to the project?

Policy ApplicabilityEnvironmental Assessment (OP 4.01, BP 4.01, GP 4.01) C Yes * NoNatural habitats (OP 4.04, BP 4.04, GP 4.04) 0 Yes * NoForestry (OP 4.36, GP 4.36) I Yes 0 NoPest Management (OP 4.09) C Yes 0 NoCultural Property (OPN 11.03) 0 Yes 0 No

- 22 -

Indigenous Peoples (OD 4.20) 0 Yes * NoInvoluntary Resettlement (OD 4.30) 0 Yes * NoSafety of Dams (OP 4.37, BP 4.37) 0 Yes * NoProjects in International Waters (OP 7.50, BP 7.50, GP 7.50) 0 Yes 0 NoProjects in Disputed Areas (OP 7.60, BP 7.60, GP 7.60) 0 Yes 0 No

7.2 Describe provisions made by the project to ensure compliance with applicable safeguard policies.

Not applicable.

F. Sustainability and Risks

1. Sustainability:

The main risk is that the re-engineering of the central bank may not be successful because either:

(a) the central bank has not been able to implement merit based systems of reward for staff -- and

move away from their current system of "time-in-grade" rewards and promotions; (b) the central

bank is not able to devolve itself of the non-core central banking functions which it has identified;

(c) the Voluntary Retirement Scheme is reversed by a subsequent re-employment of large

numbers of staff; and (d) the CBSL is not able to implement its own ambitious agenda of

"transformation".

Another potential risk may come from supporting a highly sophisticated payments system which

proves to either be over designed for the requirements of the country at its current stage of

development -- or alternatively not utilized to its full potential due to a lack of sophistication in

the sector. This will, however, be dealt with in the design stage of this component of the project

-- when these considerations will be taken into account.

2. Critical Risks (reflecting the failure of critical assumptions found in the fourth column of Annex 1):

Risk Risk Rating Risk Mitigation MeasureFrom Outputs to ObjectivePayments System is over-designed for the M Expert analysis and design of the Paymentsstage of financial system development in System component.Sri Lanka.

CBSL is not able to implement merit H CBSL has already commenced discussions withbased systems of reward for staff -- the unions on the restructuring of CBSL and

moving away from the current system of moving towards a more merit based system oftime-in-grade rewards and promotions rewards. The VRS will also assist in the

redeployment of staff at lower levels (out of thebank) who tend to be more heavily unionized.

CBSL is not able to devolve itself of the M Discussions have already commenced with the

non-core central banking functions which MOFP on the devolution of core responsibilities.it has identified. More additional work, supported by the project,

will nonetheless need to be undertaken.

- 23 -

The VRS is reversed by a subsequent M Governor's commitment in the Letter ofre-employment of large numbers of staff. Development Policies to retain the staffing

complement that is required for the restructuredinstitution; agreement that any staffing increaseswill require Monetary Board approval; andcomplete removal of certain functions willreduce the total need for staff.

The CBSL is not able to implement its M There has been a managemnent decision withinown ambitious agenda of CBSL to change. To support this, the Governor"transformation". intends to appoint a Transformation (or Change)

Agent to oversee the complete re-engineeringprocess -- answerable to the Steering Committeeand the Monetary Board.

From Components to OutputsEnacting financial sector regulations may S To ensure the Government commitment andtake longer than the project life. plans for an effective participatory approach for

proposed regulatory and policy changes thatmay result in a more consensus building at earlystage of the refonn process.

The Voluntary Retirement Scheme may S The Central Bank will carefully design the VRSnot yield the most desirable result; core package which is sufficiently attractive but notand qualified staff may decide to take the overly generous. At the same time, thepackage and leave. sequencing of re-organizing, transfer of

functions, decompression of salaries, andprovision of the VRS package will also need tobe carefully designed.

Overall Risk Rating S

Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N(Negligible or Low Risk)

3. Possible Controversial Aspects:

The only aspect of the project that may become controversial is the component related to theVoluntary Retirement Scheme -- as there could be some resistance from the Labor Unions.Careful design and proper implementation of the scheme is very critical to the success of thiscomponent. Keeping the scheme as purely "voluntary" should also assist in this regard.

- 24 -

G. Main Loan Conditions

1. Effectiveness Condition

There is only one condition for Effectiveness and that is finalization of a Subsidiary AdministrativeAgreement.

2. Other [classify according to covenant types used in the Legal Agreements.)

The following conditions were for Negotiations and Board which have already been met by theborrower and CBSL.

(a) appointment of a Transformation (or Change) Agent to oversee the entire re-engineeringprocess;(b) appointment of a Procurement Proficient staff member to conduct all procurements underthe project;(c) finalization of the Borrower Project Implementation Plan (BPIP);(d) completion of the first draft of the new Human Resource policies;(e) finalization of the preliminary design of the Voluntary Retirement Scheme.

H. Readiness for Implementation

1 1. a) The engineering design documents for the first year's activities are complete and ready for the startof project implementation.

1 1. b) Not applicable.

1 2. The procurement documents for the first year's activities are complete and ready for the start ofproject implementation.

Z 3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactoryquality.

0 4. The following items are lacking and are discussed under loan conditions (Section G):

- 25 -

1. Compliance with Bank Policies

Z 1. This project complies with all applicable Bank policies.E 2. The following exceptions to Bank policies are recormnended for approval. The project complies with

all other applicable Bank policies.

_ I W L A .ii / C 1 v

Simon C. Bell anlou e D. Uy Mariana TodorovaTeam Leader Sector?anager/Director Country Manager/Director

- 26 -

Annex 1: Project Design SummarySRI LANKA: Sri Lanka Central Bank Strengthening

l ~ Key PerformanceHierarchy of Objectives Indicators Monitoring & Evaluation Critical Assumptions

Sector-related CAS Goal: Sector Indicators: Sector/ country reports: (from Goal to Bank Mission)To improve the policy and Strengthen the efficiency and Economic and Financial Government initiation andregulatory environment to competitiveness of the Central Sector Reports. commitments to continue thepromote private sector Bank, through: (a) upgrading financial sector reformsinvestment, through financial the payments system; (b) Continued dialogue on agenda started earlier.sector reforms. improving organization financial sector reforms and

structure and functions; and private sector development Formal government request tofinancial sector through various projects and IDA for support in theirpolicy/regulations studies. efforts to strengthen the CBSL

in order to better performs itsregulatory and supervisoryfunctions.

Improve the efficiency and Substantial preparatory workdepth of the financial system. already undertaken by the

CBSL

Project Development Outcome / Impact Project reports: (from Objective to Goal)Objective: Indicators:Fundamental restructuring of A central bank more focused Quarterly reporting by the Firm commitment from thethe Central bank to transform on core central banking CBSL on the progress of the Government and in particularthe institution to a modern, business; improved and better project. the CBSL to embark on thesestrong, and efficient central functioning organization reforms.bank. structure; trained, qualified, IDA's effective supervision

and motivated staff. missions. Central Bank has made a1. the process involves: business decision to change

Important and Effective reorganization of the Feedback from the banking and strengthen its institution,fundamental changes of CBSL to meet the need of community during the project its function, and regulatoryits human resources and modern and global economy. supervision. framework.right-sizing theinstitution through An efficient and modem HR Central Bank has taken theimplementation of the department that can lead through several workingvoluntary Retirement efficiently address policies on focus groups and managementScheme (VRS). recruitment, placement, steering committee to forward

2. Upgrading the payments compensation, mobility, etc. its objective.and settlement system.

Effective CBSL staff trainingto meet the needs of neworganizational structure.

A right-sized CBSL thatefficiently focuses on the corefunctions.

Automation of the paymentssystem by introducing a realtime gross settlement system.

-27 -

Improving the monetary Expansion of open markets Demand from the bankingpolicy, exchange and foreign operations and improved sector for these reforms.reserve management and to foreign exchange and interestpromote govemment rate regulations for moresecurities market. effective monetary

management.

Strengthening the regulatory Improved govemment Competent key senior officialsframework to pave the way for securities market, introduction and effective leadership ofbroader range of financial of scripless and electronic MOFP and CBSL.activities in debt and trading systems, andsecurities market. e-business.

Govemment request to IDAfor technical and financialassistance.Establishment of a projectunit in the CBSL and forminga Steering Committee toreview the regulation, proposechanges and oversee theprogress. Appointment of a"Transformation Agent" tooversee the implementationprogress and report to theSteering Committee (OrTransformation Committee)and the Monetary Board.

- 28 -

.irach o Oeties Key PerformanceHrwchy of Obictives Indicators Monitoring & Evaluation Critical Assumptions

Output from each Output Indicators: Project reports: (from Outputs to Objective)Component:A stronger, more effective, Proposed organization CBSL and consultants studies. CBSL's management decisionand right-sized organization structure and a program for to change, involving all staffstructure with well trained efficient staff development at various departments,staff at all levels. program to meet the needs of Periodic progress reports from initiation of discussions with

new structure and functions. the implementing agency. the labor union, commencingMore capable and efficient substantial preparatory work.staff with professional Expert analysis and design for Procurements documentsexpertise to handle the CBSL the HR policy and functions, and contracts. Design and proposal of afunctions. as well as VRS. more effective and efficient

institution structure that isEstablishment of an efficient In-depth study of the capable of competing in aand modem payment system payments system to identify global and modem economies.to allow for real time gross the weaknesses andsettlement system. requirements, identify the best Identifications of non-core

possible solution for the functions to be devolve over aCBSL's payments system. short to medium term.

Detailed expert studies andevaluation to put in place amore efficient and reliablepayments and resettlementsystem in the CBSL.

Close collaboration betweenthe CBSL working groups andtask force and the consultants.

More stable foreign and Proposing regulations related Draft laws and/or CBSL's studies and proposalexchange rate regime and use to the proposed changes; amendments to existing laws as well as technical assistanceof open market operations for approval from monetary allowing necessary changes. by experts in the selectedintervention in financial Board; Cabinet approvals. areas identified as priority.markets and monetary policy.

A more developed debt Preparing regulations related Bi- annual reports on the newmarkets to allow to primary and secondary regulations.market-priced government government securities market.securities, and establishment Review and propose scriplessof scripless and electronic trading system.screen-based securitiestrading and increased use ofe-business.

Increased participation of theprivate sector in economicactivities.

29 -

K e Y Performance :Hierarchy:of Obiectives Indicators Monitoring & Evaluation Critical Assumptions

Project Components I Inputs: (budget for each Project reports: (from Components toSub-components: component) Outputs)1. Central Bank US$ 31.34 million An accounting and Study of the payments systemReorganization and of which IDA: $ 20.01 monitoring system established by an expert. Timely hiringRestructuring. million at the CBSL provide periodic of consultant to identify

reports on implementation specifications of the CBSL'sprogress, procurement, and requirements.disbursements.

l.a. Human Resource US$ 0.54 million Annual audit of the project Timely proposal for anDevelopment of which IDA: $ 0.48 million accounts. organization structure and

functions by the CBSL.

Lb. Voluntary Retirement US$ 25.0 million IDA's supervision missions A well thought of staffScheme (VRS) of which IDA: $ 17.5 million with details on project training program that fits with

implementation. the new organization set up,functions and long termneeds of the institution.

I.c. Support for Capacity US$ 5.8 million Regular meetings by theBuilding in CBSL's Various of which IDA: $ 2.03 million Steering Committee to reviewDepartments. the areas of change.

2. Improving Payments and US$ 9.22 million Hiring consultant, if needed toSettlement Systems. of which IDA: $ 8.94 million provide advise on the best

practices and state-of the-artsautomation techniquessuitable for Sri Lankafinancial and economicenvironment.

3. Financial Markets US$ 0.83 millionRegulation and of which IDA: $ 0.74 millionDevelopment.

3.a. Legal Reform US$ 0.46 millionof which IDA: $ 0.41 million

3.b. Other Financial Sector US$ 0.37 millionStudies in Priority Areas. of which IDA: $ 0.33 million

Project Preparation Facility US$ 0.6 million

Implementation Support US$ 0.023 million

TOTAL COST US$ 42.0 millionIDA FINANCING US$ 30.3 millionSIDA US$ 1.0 millionGOVERNMENT US$ 10.7 millionFINANCING

- 30 -

Annex 2: Detailed Project Description

SRI LANKA: Sri Lanka Central Bank Strengthening

By Component:

Project Component 1 - US$31.34 million1. General Support for Central Bank Restructuring and Reorganization. The CentralBank of Sri Lanka (CBSL) has made a management decision to commence a program offundamental restructuring and reorganization of its activities in order to be able to realign thebank with the rapid changes and the globalization of financial markets which have taken placeover the past two decades. The Central Bank has already started reviewing its role, functionsand operations with the objective of redesigning its objectives, functions, organizational structureof the institution, work processes, and its human resources needs and policies.

The CBSL has put a lot of effort into the preparation of background work and conceptualizationof the issues and action plans which such a re-engineering will imply. Three retreats, culminatingin a Central Bank Retreat over the period July 8 to 9, 2000 identified several areas within theBank where reform and transformation are necessary. In order to effect the requiredtransformation process, a Transformation Management Committee was appointed to act as acatalyst for this re-engineering process. Five Focus Groups were established to further study andanalyze the following key areas: (i) objectives of the CBSL; (ii) organizational structure; (iii)management processes; (iv) human resource management; and (v) consensus building anddecision making within the CBSL.

The five Focus Groups have studied their respective areas in detail and identified weaknesseswhich need to be addressed by management. Tne Focus Groups' final reports were completed inDecember 2000 (a copy of these reports are available in the Project Files). The Monetary Boardof the CBSL has also approved the proposed actions for transfornation of the CBSL. Both IDAand CBSL are cognizant of the importance of this project -- as its successful implementation isexpected to provide an important blue print for wider civil service reform and restructuring."Getting it right" therefore has significantly wider ramifications beyond the central bank.

An important recommendation of the focus group was that the CBSL should narrow its role downto two core responsibilities -- Price Stability and Financial System Stability. Focusing on thesecore central banking functions, the members of the focus group have identified non-core activitieswhich will need to eventually be devolved out of the CBSL (including management of theEmployees Provident Fund, Public Debt Management, Development Finance, ExchangeManagement, and so on). These changes have important ramifications for the organizationalstructure, training requirements, as well as the implementation of a Voluntary Retirement Scheme(VRS) to reduce staffing levels, within the CBSL.

In addition, to ensure that the CBSL continues to develop as an institution of excellence withinSri Lanka, there is an important need to change existing personnel policies which focus on "timein grade" requirements rather than individual merit and performance. This will necessitatechanges in recruitment policies, evaluation policies, compensation policies, promotion policies,incentive policies, policies related to mobility, and training policies. The CBSL will need to

- 31 -

develop a comprehensive Human Resources Master Plan, which addresses all of thesefundamental issues.

This project has been designed to assist the CBSL to implement the re-engineering process whichwill support the changed, and narrower focus, of the central bank -- as well as bringing in relevantexperience from countries which have undertaken similar restructuring exercises. The proposedproject will support the re-engineering by supporting the redrafting of central banking legislation,developing new organizational structures, re-writing job descriptions for staff, developing newHuman Resource policies, study visits to review similar experiences elsewhere, and so on. Thisactivity will be undertaken in close cooperation and coordination with the International MonetaryFund and the central bank of Sweden (Riksbank) which both have considerable experience incentral bank restructuring.

IDA's assistance for this component will include consultancies and training for the establishmentof a fully professional HR department, the preparation and implementation of the new HR policiesand functions, strengthening support for various departments within the CBSL, and support for aVRS to right-size the bank in line with its realigned core priorities -- in an amount of US$ 14.93million. This component will include support in the following three (3) areas.

(1.1) Human Resource Development

Establishing a Fully Professional Human Resource Department - The CBSL wishes to groupall matters pertaining to Human Resource (HR) functions into one department. This will requirethe merger of the Establishments Department, Training Department, Center for Banking Studiesand some of the functions of the Welfare Department -- into a single Human ResourcesDepartment. This new HR Department will play a key role in effecting the re-engineering of thecentral bank. Functions of the new department will include, inter alia, the following:

I. Development of a holistic vision for human resource management within the CBSL;2. Assessment of human resource needs, key competency's and skills required by Departments.

Conduct skills competency gap analysis;3. Preparation of job descriptions relating to employee functions;4. Development of policies relating to recruitment, placement and mobility, training and staff

development, performance evaluation, rewards management, terminal benefits, etc.;5. Development of training modules, organizing training programs to meet the emerging needs

for staff at all levels, and making funding arrangements;6. Conducting post-training evaluation of performance;7. Offering advice and guidance on career development;8. Preparation of a succession plan;9. Preparation of a staff manual;

10. Development of suitable cost-effective welfare packages;11. Advising management on appropriate terminal benefits; and12. Development of conflict resolution system.

-32 -

Reform of HR policies- CBSL is in the process of developing a comprehensive HR Master Planwhich will address HR policies of recruitment, placement, evaluation, compensation, promotionincentives, mobility, and training. The Central Bank also needs to develop a comprehensivetraining plan which will address the future training needs of the Bank. A new Staff Manual alsoneeds to be prepared. To assist the Central Bank in the development of these activities, a shortterm Human Resource consultancy was secured to support the establishment of the new HRDepartment. This HR consultancy commenced on March 26, 2001 and is being financed underthe PPF (Q 250-0 CE).

In order to carry out the above functions of the newly formed HR Department, the CBSL intendsto recruit an HR Director to lead the HR Department supported by an internationally recruitedHR Advisor. As such expertise is not available within the central bank, the CBSL intends torecruit the HR Director on a contract basis, from the local market -- initially, for a period of twoyears. To ensure the smooth functioning of the HR related issues and processes within thecontext of the modernization process, a resident international HR Advisor will also be recruitedfor a period of two years. The HR Advisor will assist the Change Management Team of theCBSL and the HR Department in all matters relating to the Organization and Human ResourcesReforms. To better address and manage HR issues it will be important to develop the skills of theHR personnel who will be working in the newly formed HR Departmnent. These practitioners willbe trained in areas such as project management, consultancy, entrepreneurship, leadership,communication, presentations, diagnostic and problem solving, financial management, mediationand arbitration, mentoring and counseling, need assessment surveys, succession planning, strategicstaffing, man power planning, and computer training. As most of the HR work is currentlyundertaken on an manual basis, it is envisaged that HR functions to be computerized as part of theoverall CBSL modernization process.

(1.2) Voluntary Retirement Sdceme (VRS)

The restructuring process of the CBSL will also include the transfer of non-core activities outsidethe CBSL and the development of a new organization structure based on the two core objectivesof the bank. It will further involve the streamlining of existing functions and the outsourcing ofsome of the necessary, but non-core, support functions to the private sector. This process willrequire a re-assessment of the overall human resource needs of the central bank. In the process,some categories of workers, and some functions, will become redundant. Redundancy is likely tobe greater in the minor employee grades (where the bulk of the work is menial) and also in thenon-staff grades (where the work is of a routine nature and is mainly undertaken on a manualbasis). In the Staff Class grades (professional staff) redundancy is likely in departments wheremore administrative matters and support services are handled; it will also occur in areas wherefunctions have been devolved to other institutions; and it will also be aimed at older workers in aneffort to reduce the age structure of the CBSL which is currently a relatively "old institution".However, to avoid union problems, it is premised that the VRS scheme will be designed in asufficiently attractive manner as to encourage employees who wish to leave the Bank early, to doso on a purely voluntary basis.

- 33 -

The Focus Group on the Human Resources issues has undertaken an assessment of the staffingproblems with the objectives of: (i) identifying redundant categonres of employees; (ii) evaluatingvarious schemes to be offered to the staff who would voluntarily leave the CBSL; (iii) facilitatingre-deployment of staff, (iii) reducing the operational cost in the coming years; (iv) improveworkers productivity; and (v) reduce the future commitment of the pension fund. The FocusGroup has examined various Voluntary Retirement Schemes, their estimated cost, as well as theirimplications for staff and on the functioning of the central bank to ensure that the institution'sobjectives continue to be met and that the institution does not loose its essential staff, whenoffering the VRS. The CBSL is currently reviewing schemes to assess their impact upon cost (toavoid paying too much for redundancies), adverse selection, and the development of safeguards toavoid re-hiring separated staff. The above mentioned short-tenn consultancy assignment is alsoassisting in the design of the VRS. It is expected that the VRS process takes about two to threeyears.

Based on the preliminary result of the ongoing work on VRS, the total cost is estimated at aboutUS$ 25.0 million. The target group would be about 200 Staff Level, and 500 of non-staff, and309 minor employees. This program will be voluntary on both sides: Employees and employers.Complete details of the VRS are provided in Annex 4. The following table provides descriptionof various schemes in Sri Lanka.

LESSONS LEARNEDVoluntary Retirement Schemes Offered by Other Agencies in Sri Lanka

1. Hatton National Bank

In the 1990's Hatton National Bank (HNB) developed a scheme for early retirement for its employees. Under thisscheme, those who opted to retire enjoyed a monthly pension at retirement. The formula adopted by HNB todetermine the monthly pension was as follows -- the last drawn monthly salary/55 years x the number of years ofservice + 5 years. The maximum number of years of service in this formula was limited to 40 years. The highestpension one was able to draw was limited to 72.6% of the last drawn monthly salary. According to the DeputyGeneral Manager/Administration, this scheme was not a success because the package offered to the employees wasnot sufficiently attractive. He was of the view that in addition to the pension it would be advisable to offer agratuity payment of half a month's or one month's salary per year of service.

A second scheme, in the late 1 990s by HNB was offered to staff with more than ten years of service and who werebetween the ages of 40 to 53. This scheme targeted 125 people but only 75 took it up. Compensation was paid onthe basis of 2.5 months salary for every completed year of service plus 0.5 months of salary for every year of serviceforegone. No pension was paid and outstanding staff loans had to be repaid. This scheme was considered to haveworked reasonably successfully. It was felt that the requirement that all staff loans be repaid to HNB was onereason limiting the number of staff who were prepared to take up this package.2. Grindlays Bank

When Grindlays Bank and Standard Chartered Bank were merged in 2000, the merged institution set out to reducelevels of surplus staffing within the combined bank. The package was only offered to staff who were over 40 yearsof age. The package included: (a) 3 months salary for every year of service; (b) 0.5 months of salary for every yearof service foregone; and (c) reimbursement of compulsory contributions to the Employers Provident Fund and theEmployees Trust Fund. Staff who took up the scheme were not offered a pension and had to repay staff loansoutstanding within one year of retirement. This scheme is still being implemented and, as such, no conclusiveassessment can be made as to its potential success or shortcomings.

- 34 -

3. Standard Chartered Bank

In 1999 Standard Chartered Bank offered a scheme which included 2.5 months salary for every year of service plus0.5 months salary for every year of foregone service. No pension was paid out but mandatory contributions to theEmployers Provident Fund and the Employees Trust Fund were reimbursed to the retirees. Staff loans had to berepaid. This scheme targeted 60 individuals but only 40 took it up. However, one drawback of this scheme wasthat the bank lost good staff,4. Steel Corporation

At the time of privatization the Steel Corporation offered 100 months' salary up to a maximum of Rs.500,000.This had been adopted with the approval of the Ministry of Finance. According to the Human Resource Manager,those who enjoyed the maximum benefit were those who had over 19 years of service.

5. The Bulumulla Report

The Bulumulla report on compensation for redundant staff in government corporations and statutory bodiessuggested the following:

Half a month's salary for every 12 months service plusone month's salary for every 12 months service denied up to the optional retirement age.

6. B C Perera Report

B C Perera report on payment of compensation to those in the public enterprises suggested compensation asfollows:

One month's salary for every 12 months of past serviceFor service foregone, one and half months' salary for every 12 months service x age at retirement and period ofpast service/55 and 30 respectively.

7. Government Scheme

The Government scheme introduced for employees in the government and local government services in 1990offered public servants to retire on the following terms:

A public officer who had completed 10 years of pensionable service, but has less than 20 years of service, waseligible on retirement to receive a pension calculated on the basis of 90% of his salary at retirement as follows:

the commuted pension on retirement; and the reduced monthly pension (ie. 80% of the salary at retirement) whenhe completes 20 years from the date of his first appointment or on completion of 55 years of age, whichever occursearlier.He was also entitled to the restoration of the unreduced monthly pension (90% of salary) after completion of 120months from the date of commencement of the reduced monthly pension.

A public officer who had completed 20 years of pensionable service, but has less than 30 years service, will beeligible on retirement, to receive a pension calculated at 90% of his salary at retirement, as follows:

the commuted pension and the reduced monthly pension (ie 80% of the last drawn salary) on retirement.He was entitled to the restoration of the unreduced monthly pension (90% of salary) on completion of 120 monthsfrom the date of commencement of the reduced monthly pension.

A public officer who has completed 30 years of service and over, will be eligible on retirement, to receive a pensioncalculated on the basis of 90% of his salary at retirement as follows:the commuted pension and the unreduced monthly pension of (90% of salary at retirement) notwithstanding thefact that he has drawn a commuted pension on retirement.

- 35 -

8. Mahaweli Restructuring and Rehabilitation Program (IDA Funded project)Voluntary Early Separation Package (VESP).

The project addressed the staffing problems by offering a voluntary early separation package for selectedcategories of staff, and by retraining of remaining staff to perform productive work in the organization.

Several early retirement incentive plans previously used in downsizing state-owned businesses in Sri Lanka wereanalyzed to design a sufficiently, but not overly generous voluntary early retirement program for MahaweliAuthority of Sri Lanka (MASL). Main Assumptions Used to Calculate VESP:The projected cost of the VESP was about Rs. 1,500 million (approximately US$24.0 million) for about a 57%staff reduction. The average cost per staff was approximately about Rs.240,845 (equivalent to US$3,853).The VESP was graduated by number of years of service, as indicated in the following Table. The Table also showsthe overall percentage of work force having different years of service. The same work force percentage distributionwas assumed for each staff category for computing the cost of the VESP.

Years of Service Compensation Proposed Percentage of Workforce

Less than 5 18 months salary* 16%

More than 5 and Less than 10 36 months salary* 47%

More than 10 and less than 15 42 months salary* 25%

More than 15 50 months salary* 12%

* The maximum payment to any individual within executive grades is Rs 450,000 (US$7,940 ) and within nioni-executive grades is Rs.350,000(US$6170).

About 57% staff were selected to receive VESP. However, due to staff salary increases just before the exercise andchanges in the incentive structure, about 7607 staff, i.e.,70 % of the total MASL workforce applied for VESP, withthe number increased to over 10,000 staff later. While the VESP implemented within the desired time frame, theimplementation experience indicates that the staff reduction was not sustainable, as the MASL rehired staff back andincreased the workforce.

(1.3) Support for Various Departments

The new organizational structure of the CBSL will require the merging of departments,establishment of new departments, and the transfer of some functions currently undertaken by theCBSL. To facilitate the process, IDA has allocated funds to support departmental requirementsfor automation, development of systems, consultancies and training. This component includessupport for the following departments.

(1.3.a) Banking Department (Foreign Exchange Reserves Management)The Banking Department of the CBSL is responsible for the management of the country's officialForeign Reserve portfolio. Considering the importance of foreign reserve management it has beendetermined that this function needs to be upgraded with more technical skills and more efficientsystems. The current operational systems involve duplication of manual entry of data at differentstages as there are gaps in the automation process. There is a need for a fully automated systemwith adequate controls. The automation requirements for this department also need to be

- 36 -

inter-linked with the work on the automation of the General Ledger (see below), thereby enablingreal time updating of accounts and the generation of management reports.

(1.3.b) Banking Department (Market Oriented Open Market Operations)Open Market Operations (OMO) are an important tool used by the CBSL to influence the moneysupply, interest rate levels, and hence the rate of inflation. Currently, the Open MarketOperations Committee (OMOC) relying on liquidity estimates produced by the OMO division andvarious other parameters, decide the rate for OMO (rate targeting) and allow the market to decidethe quantum of high-powered money required. However, other than this passive strategy, nodirect market intervention is undertaken to achieve the objectives of the CBSL. The idea ofmarket oriented OMO is to target the quantity of money in the system and thereafter allow themarket to decide rates accordingly. The need for a more market-oriented approach to OMOusing Repurchase (repo) and Reverse Repurchase (rev-repo) agreements has been identified.

Currently OMO are implemented by the OMO Division of the Banking Department. Under theproposed organization structure for the CBSL, OMOs will be placed under a new departmentnamed Domestic Market Operations Department. In order to carry out the proposed marketoriented operations more effectively the division will require qualified and trained staff, andimproved infrastructure. The IT requirements foreseen under a market-oriented OMO systeminclude personal computers connected to the Local Area Network and printers; software andhardware required for a Wide Area Network system between the CBSL and the Primary Dealers(a WAN system with commercial banks is already in place). There is also a need for: (i)installation of Reuters terminals to permit the monitoring of market developments; (ii)development of software to conduct the auctions on a network system; (iii) development orpurchasing of software for liquidity estimation, forecast and management; and (iv) development ofan automated system for data collection from commercial banks for the purpose of makingliquidity estimates.

(1.3.c) Management Audit DepartmentStrengthening the Management Audit Departmnent has also been identified by the CBSL as one ofthe priority areas for reform. CBSL intends to develop this department as a Value Adding Unitand to upgrade it on a priority basis with skills and systems required for auditing with specialemphasis in areas such as financial and information systems auditing. It has been recognized thatthe Management Audit Department should move away from its traditional role and repositionitself with a process driven or value-added approach instead of a compliance base approach; as aquasi-consultanting function helping with control instead of the owner of control; as beingobjective oriented instead of being purely finance oriented; and as a training ground for seniormanagement. The Management Audit Department will be expanded and strengthened in order toundertake these new specialized audit functions. Separate audit units will also be established toconduct performance audits and information systems audits. This will necessitate the upgradingof skills in these specialized areas and the recruitment of qualified and experienced personnel fromoutside the CBSL. The Steering Committee has appointed a Committee, to look into therestructuring of this department and it has also decided to engage the services of a consultant toconduct a study and submit a proposal to achieve this objective.

- 37 -

(1.3.d) Secretariat DepartmentThe CBSL needs an efficient Records Management System in order to increase productivity and

efficiency of operations and processes. A consultancy will be contracted: (i) to study the existing

records management system and plan the establishment of a centralized records management unit;

(ii) to prepare documentation and a manual of operations to be maintained electronically; and (iii)

to prepare specifications for the hardware and software requirements for the records management

unit.

(1.3.e) Information Department - Support For LibraryThe CBSL library, which was completely destroyed in a bomb explosion in 1996, was the best

research library in Sri Lanka in the fields of economics, statistics, Central Banking, international

affairs and related subjects. The library also had an invaluable collection of periodicals, journals

and other literature. The CBSL obtained assistance from the World Bank (an IDF Grant) to

rebuild the library after the bomb blast. Consultants were engaged to prepare a strategic program

and make recommendations for its implementation and to assist in collection building and creation

of a web presence for the Library and Information Center (LIC). In the rebuilding process,

printed books, journals, publications, CD ROMS and CD ROM Data bases have been purchased

to meet the information needs of CBSL staff. In addition, the IDF grant supported foreign

training for library staff -- mainly through familiarization programs. The CBSL library is now

semi automated, however, to bring it to the status of a fuilly fledged automated library, the

establishment of a electronic data base of socio-economic information is necessary. This data

base will assist in resource collection by: surveying and acquiring literature available from the Net

Work; selecting and acquiring CD ROMs, Micro Films, databases outside the country; and

establishing a Wide Area Network for resource sharing. The services of an expert in automated

information systems will be secured to enable the library staff to develop skills in operational

issues involved in the establishment of a fully fledged economic information base. The expert will

be expected to provide on the job training for library staff. Assistance will also be sought to meet

the costs associated with the establishment of an electronic data base.

(1.3.f) Training of PersonnelThe current policy of the CBSL is to recruit to the staff class at the most junior level and provide

them with on the job, as well as postgraduate, training. As a result skills have been developed in

areas such as general banking, commerce, business administration, general economics, and so on.

Nonetheless, skills development has not been strictly in line with the evolving needs of the Central

Bank. For example, over the years, 40 percent of postgraduate training has been in the field of

development economics, as against six persons trained in monetary economics, and two persons

trained in econometrics and quantitative economics. At the middle level, serious skill deficiencies

exist in both core and support departments. In addition, at the present time, most departments

operate with a serious skills gap despite elaborate short term training both locally and overseas.

An important component of the CBSL reorganization plan will be an assessment of existing staff

skills, a review of institutional skill requirements to meet the re-focused objectives of the

reorganized institution, and an evaluation of the gap between the two. Bridging this gap can be

achieved in various ways, one of the most important of which will be training. The proposed

organizational structure of the Central Bank entrusts the Central Bank's primary objective of

- 38 -

maintaining price stability to the Economic Research Department, Economic AnalysisDepartment, Domestic Market Operations Department and the International Market OperationsDepartment. The task of maintaining financial sector stability has been entrusted to the BankSupervision Department, Supervision of Non Bank Financial Institutions Department andFinancial Markets Department. Within the reorganized structure the IT Department and LegalDepartment too will play a significant role. Thus, these departments will need extensive trainingin order to achieve the newly sharpened Central Bank objectives. The CBSL's objective is toacquire a strong group of macro-economists, statisticians, fund managers, dealers, accountants,supervisors, IT personnel and human resource managers.

The CBSL has prepared a draft Training Plan; however, as the overall reorganization activities getunderway and work on the change management process within the bank and skill requirementsbecome clearer, more work will need to be undertaken on this Plan (a copy is available in theproject files). Supporting this plan will be an important component of the proposed operation. Inview of SIDA's financial support of US$ 1.0 million as co-financing for this project, most of whichis expected to be allocated for staff training, IDA will limit its support for the training program toabout 26 percent of the total training costs.

(1.3.g) Management Development - At the CBSL's Retreat, held in July 2000. manyparticipants voiced the need for an improvement in management practices within CBSL. This wasalso reiterated in the deliberations of the Focus Group on Management Processes. The SteeringCommittee agreed with the need to establish a Management Development Center (MDC) withinthe CBSL to support the improvement of managerial skills and work practices in a modernizedCBSL. The MDC is expected to serve as a resource center for management related materials.The objective is to create management awareness through seminars. courses, newsletters andvarious events on a continuous basis. Courses will be offered in areas such as Modem OfficeProcedures, Delegation, Conduct of Meetings, Public Relations, Team Building, RecordsManagement, Change Management, Conducting Perfonnance Appraisals, Conflict Management,Time Management, Committee Management, Strategic Planning. Leadership Skills for Managers,Effective Presentation Skills, Successful Business Writing, Comnmunication Skills for Managers,Project Management, Stress Management, Effective Mentoring and Motivating Staff.

The MDC will be headed by a competent and dynamic person with extensive internationalbusiness and management experience. Due to the lack of skills within CBSL, the Head will needto be hired externally. Training courses will be directed at high, mid, and low level management.The MDC will offer one high level and two mid/low level training courses per month. They willbe conducted by both local and international management experts who will be hired on acourse-by-course basis. The newly re-organized CBSL will operate with around 240 managerialand supervisory level staff compared to about 400 tnder the current structure.

Project Component 2 - US$9.22 million2. Payments and Securities Clearing and Settlement System Improvements - As anintegral component of its overall re-structuring; the Central Bank of Sri Lanka (CBSL) hasrecognized the need to upgrade the core financial system infrastructure to satisfy the needs of an

-39 -

evolving economy in a manner that balances operational cost, processing efficiency and credit,liquidity, and systemic risk. The scope of the reform initiative supported by this project includesthe acquisition, testing, and implementation of:

* A Real-Time Gross Settlement (RTGS) capability to process large value and other timecritical funds transfers;

* A scripless central depository, registry and settlement system for government debt securitiesand its integration with the RTGS system to provide model 1 DvP Delivery versus Payment inwhich securities are transferred to the buyer if and only if funds are available to complete thepurchase.; and

* An automated general ledger and accounting system to support CBSL's current and futurefinancial operations.

System reform objectives - CBSL's system reform objectives are to:

* Establish the infrastructure required to support the development of Sri Lanka's financialmarkets and banking sector;

* Reduce settlement risks in the payments system and securities settlement system in line withemerging best international practice;

* Enhance the integrity and tradability of Sri Lanka's public debt;Improve the efficiency and quality of CBSL's financial and business operations; and

* Establish an appropriate legal & regulatory framework to underpin the new operationalmechanisms.

Background and guiding principles - CBSL has already initiated a consensus building programwith the key impacted financial sector institutions through meetings with Commercial Bank ChiefExecutives, the Sri Lankan Bankers' Association, the Primary Dealers, the Colombo StockExchange and the SEC. These discussions are paving the way for the essential cooperation that isrequired to understand and satisfy the needs of all users of the envisaged systems.

CBSL has recently introduced a Wide Area Network (WAN) connecting the head offices of allcommercial banks and primary dealers to the CBSL computing facilities making use of the SriLanka Telecom Ltd. (SLT) data communications network. The CBSL is currently upgrading theAS 400 computing facilities from Model 9402-400 to Model 9406-720 machines and isintroducing a disaster recovery capability. CBSL has also implemented a robust LAN connectingsome 200 PCs to the main processor. The Sri Lanka Automated Clearing House (SLACH) isowned and operated by CB SL and uses Unisys A series equipment at the primary site and aClearPath HMP NX Host system with dual Pentium processors at the back-up site.Consideration is being given by CBSL to divest SLACH, in the future, to a new company jointlyowned by the commercial banks and CBSL.

- 40 -

A significant system design and requirement specification initiative was undertaken in 1998. Theresulting business and technical specifications reflected the identified needs that existed at thattime. CBSL recognize that subsequent developments have taken place both within the Sri Lankanfinancial sector and in regard to the availability of relevant RTGS application software packages.A consultant supported initiative is now underway to review and update the work undertaken in1998. This review is also taking account of the work that has been undertaken recently relating tothe design of initial versions both of a scripless system for processing the sale and purchase ofGovernment securities and the semi-automated transfer of funds between participant currentaccounts maintained at the CBSL. The resulting system specifications will satisfy the needs ofcurrent and future users, be based on best international practice as reflected in the recentlypromulgated BIS Core Principles for Systemically Important Payment Systems, BIS - IOSCOrecommendations relating to Securities Clearance and Settlement, and reflect local realities. Thefollowing guiding principles will also be satisfied. The systems will;

* be convenient and easy to use;* be flexible and modularly expandable and thus accommodate future changes in volumes and

financial sector services;o allow for universality of access and thus make it possible for all potential direct participants,

when accepted, to connect to the systems;* have high levels of reliability with particular emphasis on data integrity and security thus

preventing unauthorized disclosure or change of information;o have high levels of service availability utilizing appropriate back-up facilities and failure

recovery mechanisms;* allow for auditing and tracing of all transactions;* have appropriate levels of operational performance ensuring reasonable response times; and* be affordable to use.

Conceptual System Architecture - Integrated RTGS/Securities system - As described above,the systems infrastructure component of the proposed project consists of the following:

1. A Real-Time Gross Settlement (RTGS) capability to process large value and other timecritical funds transfers;

2. A scripless central depository, registry and settlement system for government debt securitiesand its integration with the RTGS system to provide model 1 DvP; and

3. An automated general ledger and accounting system to support CBSL's current and futurefinancial operations.

Because of the essential close interrelationship between the RTGS and Scripless Securitiessystems; these two sub-components will be acquired from the same suitably experienced andqualified vendor. A separate procurement process will be used to acquire the envisagedAutomated General Ledger system.

The RTGS system will become the core system supporting the settlement of all transactionsacross the books of CB SL including settlement of the net positions resulting from the SLACH

- 41 -

system. The SLACH system will continue to operate as now. However, the Settlementarchitecture will also accommodate possible future bulk electronic net settlement systems. Theresulting overall future payments system architecture is depicted in the following simplisticdiagram:

Participant Installations

RTGS Slc h SecuritiesParticipant Slach Participant

Workstations (Interface) Workstations

Central Installations

Securities RG| Ftr Secu ~~RTGS Future

Sefflement Bulk NettingStDelWery System Periodio System

System _ _ payment

Real Time Gross Settlement System - Core Features - The specific user requirements will beavailable by end July 2001 and will be prepared to a level of detail to convey CBSL needs toqualified vendors in a non-ambiguous manner. Core features of the RTGS system will be asfollows:

* compliance with international standards;* final settlement across the books of the CBSL;* a single tier system in which all licensed banks and other authorized institutions maintain

settlement accounts with the CBSL;* while no daylight overdraft is allowed, banks can obtain intraday liquidity through intraday

repurchase (repo) with the CBSL, using mainly government paper; and* allowance for domestic and international linkages to facilitate real time delivery versus

payment (DvP) and real time payment versus payment (PvP).

The RTGS system will likely use a Y-shaped topology with all authorized participants havingdirect access to the system. The Y-shaped topology of information and payment flow means thatthe system will be simple and direct. While a participant will input the full details of its paymentinstructions, including customer information, to a central transaction processor (Interbank Fund

-42 -

Transfer Processor), the instruction will be 'stripped' so that only the settlement instruction, i.e.information on the amount, the paying institution and the receiving institution, will be passed ontothe Settlement Account Processor and be known by the CBSL.

When a payment has been settled across the books of the CBSL, it will be final and irrevocable.The Settlement Accounts maintained by the participants with the CBSL will not be allowed by theCBSL to go into overdraft except in very exceptional circumstances. Hence, participants withoutsufficient credit balance or securities for intraday repo to effect outgoing payment instructions willhave their instructions queued in the system. The queuing mechanism will allow participants tomanage their own queues of payment instructions through cancellation, re-sequencing andamendments.

Under an RTGS system, it is necessary to address how intraday liquidity can be provided to theparticipants in order to reduce the chance of gridlock being developed since every payment has tobe settled on an individual and gross basis. A related issue is whether the liquidity should beunsecured or collateralized. In the Sri Lankan RTGS system, there will be a seamless interfacebetween the funds transfer system (IFTP) and the Government Scripless Securities system (SSS)which will also be operated by the CBSL. Participants will be able to obtain interest-free intradayliquidity through intraday repo using prescribed eligible securities. The intraday repo transactionswill be fully automated. If a participant does not have sufficient balance in its settlement accountto effect an outgoing payment but has sufficient eligible securities in its intraday repo account, thesystem will automatically trigger an intraday repo transaction to generate the required amount ofcredit balance to cover the shortfall. A participant with excess liquidity in its Settlement Accountmay reverse the repo transaction any time. In any case, the intraday repo will be reversed beforethe close of the business day. A number of additional gridlock busting facilities will also beavailable including both bi-lateral and multi-lateral off-set arrangements to ensure optimum use ofthe available liquidity.

Scripless Securities Settlement (SSS) system -- Core Features - SSS is the central system forthe settlement of securities. SSS will maintain the electronic record of participants' holdings. It isbeing designed to support intemational standards and best practice in securities settlement. It willsupport 'Model 1' delivery versus payment as defined by the Bank for International Settlementsi.e. gross settlement of both securities and payments (in central bank money) with immediatefinality.

The specific user requirements will be available by end July 2001 and will be prepared to a level ofdetail to convey CBSL needs to qualified vendors in a non-ambiguous manner. The SSS willsupport the entire life-cycle of government securities from initial introduction to the market,through subsequent trading or movements, including interest payment, through to maturity. SSSwill provide the following critical features:

* maintenance of holdings of dematerialized government debt securities (bills, bonds, etc.);* settlement of both the primary market and secondary market transactions, including

intra-participant movements, security sales and purchases, and repos;* delivery versus payment via a link to RTGS;* settlement on a T+n and / or a T+ zero basis;

- 43 -

* matching of sales and purchases on day of trade;* queuing of securities transactions for settlement until sufficient funds are available in the

purchasers account;* support for different types of participants, including those without accounts in RTGS;

Hardware and Telecommunications related security equipment - As noted above, CBSL hasrecently introduced a Wide Area Network (WAN) connecting the head offices of all commercialbanks and primary dealers to the CBSL computing facilities making use of the Sri Lanka TelecomLtd. (SLT) data communications network. CBSL are currently upgrading the AS 400 computingfacilities from Model 9402-400 to Model 9406-720 machines and is introducing a disasterrecovery capability. CBSL has also implemented a robust LAN connecting some 200 PCs to themain processor.

It is anticipated that the existing processing and data communications infrastructure will becapable of supporting the two envisaged new systems. This assumption will be confirmed ormodified during the on-going consulting engagement. However, as both the RTGS and SSSsystems require the highest possible data protection and other security measures; it is clear that acommunications line security strategy and appropriate additional equipment will be required.

The only method of securing data integrity whilst in transmission over physical communicationcircuits is through appropriate strength encryption. The traditional means of implementing dataencryption was through the use of line encryptors. However, the preferred method today is toincorporate encryption mechanisms into routers. This is possible due to the growingsophistication of routers, in which exchange of keys is performed automatically by the routersthemselves at regular parameter driven intervals.

As an integral component of the on-going consulting engagement, CBSL will discuss the technicalstatus of telecommunications technology in Sri Lanka with Sri Lanka Telecom Ltd. (SLT) todetermine what data integrity support is offered as well as the associated costs that will beincurred at both participant and central locations. In most countries, the telecommunicationsservice provider, recognizes the need to provide such services as an integral part of a secureclosed user group arrangement. It is likely that an appropriate sole source procurement of suchequipment will be required. This will be catered for in the project procurement arrangements.

Automated General Ledger System - Specific user requirements for the automated generalledger system will be available by end July 2001 and will be prepared to a level of detail to conveyCBSL needs to qualified vendors in a non-ambiguous manner. Preliminary views of CBSLaccounting personnel are that the system to be acquired should support the following criticalfeatures:

* Financial books for multiple entities;* Multiple years' history;* Multiple periods within the year;* Value dated posting of transactions by specified calendar date;* Automatic accrual reversals by value date;

-44 -

* Account reconciliation;* Control parameters for controlling postings to account centers;* On-line real-time and off-line batch postings;* Standing journals;* Foreign currency denominated accounts with periodic revaluation;* Prior period adjustments within current year and immediate past year;* User controlled period and year end opening and closing functions;* Aggregate account balances;* Forward dated transaction handling;* Statistical accounting activities;* User-controlled archiving;* Specified account coding structures and balance fields;* Cost centers; and* A Report Writer facility

The above features are standard and are supported in a range of commercially available generalledger software packages; thus acquisition of an appropriate solution to satisfy CBSL detailedrequirements will not present problems. A potential Accounting Structure to satisfy both thecurrent and future needs of CBSL was prepared by an International Accounting firm in 1998 andis being used as a core starting point for the user requirement specification process. Care is beingtaken to ensure that implementation of the targeted new arrangements can be accomplished on astep-by-step basis.

Training and Dissemination - Clearly training on the use of these systems will be critical to theirsuccessful implementation and installation. In all cases, training and technical support will need tobe provided by the supplier of the acquired software products. This will also need to beincorporated into the requirement specifications to be drafted by the consultant. Furtherdissemination and discussion on the RTGS and SGSS will also be required with the Banker'sAssociation and other market players to ensure an enhanced understanding of the workings andthe benefits of implementing such a system in Sri Lanka. The CBSL's "Payments Council" will beused to secure the active involvement of all impacted stakeholders.

IDA will finance US$ 8.94 million of cost of the development of Payment Systems.

Project Component 3 - US$ 0.83 million3. Financial Markets Regulation and Development. Finally, the CBSL has asked for fundingto support studies and consultancies focusing on financial system development. Thissub-component will seek to strengthen the Central Bank's monetary management capabilities aswell as the overall legal financial infrastructure -- bringing the latter more in line with the new roleenvisaged for the central bank after its restructuring.

3.1 - Support for Legal Reform/Review. The CBSL recognized that there is a need toundertake a review of the overall legal financial infrastructure. Current laws are fragmented and,at times, contradictory. For example, banks and financial institutions are covered by a multiplicityof laws include the Banking Act, institution specific acts for the People's Bank and the Bank ofCeylon, specific legislation for development finance corporations (some of which also take

- 45 -

deposits), and finance company legislation. Achieving a better consistency and possibly evenrepealing some of the institution specific legislation requires an overall review of the legislativeframework and identifications of the shortcomings in the existing specific laws. The CBSL LegalDepartment has suggested that the Legal Review should focus on the following three areas:

(3.1.a) Overview of the Financial and Banking legislation

Review of legislation relating to banking and financial sector to identify areas, which requirerationalization and/or modernization -- and making proposals for legislative reform. Thiscomponent will consist of an examination of legislation applicable to the financial sector includingcore legislation such as the Monetary Law Act, Banking Act, Finance Companies Act, LeasingAct, Insurance Act, and the Securities and Exchange Commission Act as well as any otherlegislation which has an indirect impact on financial institutions. The review of the existing legalframework is proposed to be undertaken as follows. A Committee consisting of representativesof the Central Bank, Ministry of Justice, Ministry of Finance, Legal and Judicial Reforms Projectof the Ministry of Justice, Securities and Exchange Commission, Sri Lanka Bankers' Associationbe appointed to coordinate the review. In addition to this core group, the Committee would alsoseek suggestions and input from other relevant institutions or persons as the need arises.

The study will address the following specific areas in addition to the general overview of thebanking and financial sector legislation:

* Mergers and consolidation of financial institutions - risks involved and matters to be consideredin approving such amalgamations including consumer protection and anti-competitive aspects;

* Provisions to deal with troubled financial institutions to prevent systemic risk in the financialsystem; and

* Legislation dealing with payment and settlement systems in general such as finality of transactions,provisions relating to authorization of payment systems operated by banks, supervision andregulation of such payment systems

Services of consultants with legal and operational expertise in the financial sector will be securedto work with the Legal Review Committee. Due to the magnitude of the work involved, theoverview of the legislation will be undertaken in two stages:

* Initial review of existing legislation -- including a critique of the existing legislative frameworkhighlighting its deficiencies and areas for improvement. This phase of the project should alsopropose an appropriate conceptual framework for rationalizing and revising the existinglegislation; and

* Based on the findings of the first phase the consultants will work with the Legal ReviewCommittee to draft amendments to the existing legislation and implement the agreed legalfinancial reform program coming out of Phase One.

-46 -

(3.1.b) Development of a legislative framework for Payment and Settlement Systems andpreparation of legal documentation required for RTGS and Scripless Securities TradingSystem

This area involves the formulation of rules and other legal documentation required for the RTGSand Scripless Securities Trading System and making proposals for legislative provisions relatingto payment and settlement systems in general. The CBSL is working on a RTGS and a ScriplessSecurities Trading System in which licensed commercial banks and primary dealers will participateinitially. Enabling legislative provisions for the systems are contained broadly in the MonetaryLaw Act, the Registered Stock and Securities Ordinance and the Local Treasury Bills Ordinance.There are however, areas which may require further legislation. For example, it may be necessaryfor participants to enter into Agreements with counter parties. Technical assistance will berequired for the formulation of specific rules and other legal documentation for the RTGS andScripless Securities Trading System. This component of the Project will be closely coordinatedwith the technical component relating to the RTGS and Scripless Securities Trading System.

(3.1.c) Development of Legislative Framework for Electronic Transactions

Preliminary work for the development of legislation in the area of E-Commerce, E-Business, andElectronic Funds Transfers (EFT) has been carried out by several institutions in Sri Lankaincluding the Central Bank, the Legal and Judicial Reforms Project of the Ministry of Justice, andCINTEC. Documentation (including draft legislation) has been prepared in several areas (i.e. adraft Electronic Transactions Act) and draft legislation relating to electronic evidence, dataprotection, computer crimes and the use of electronic cards and access devices has been prepared.Completion of this work and the finalization of legislation are taking time because of uncertaintyas to the suitability of the proposed legislation and the lack of information and experience relatingto possible implementation problems. The CBSL has requested consultancy support under theproject to review the work already undertaken and submit a report on the establishment of anappropriate legal framework for such activities. A draft Terms of Reference for the Consultantwere prepared and is available in the project files.

3.2 Other Financial Sector Development - CBSL also intends to undertake some research onthe following areas and has requested support under this project.

(3.2.a) Development of E-Business - The main objectives for this study are:

* To asses the adequacy of existing facilities, institutional mechanisms and legal and regulatoryframework to support E-Business; and

* To study and make recommendation on the role of the central bank and banking institutions,in facilitating E-Business and identify steps for implementation.

(3.2.b) Development of the Forward Market in foreign Exchange and to Develop InterestRate Risk Management Instruments.

The Sri Lankan experience in forward foreign exchange contracts has been limited to a few

- 47 -

authorized foreign exchange dealers and a handful of importers and exporters in the country.There are a number of limitations for the enhancement of the forward foreign exchange market inSri Lanka. Some if these limitations are inherent to any developing market while some are uniqueand inter-linked with several other factors such as fiscal and monetary policy functions. Some ofthe obvious limitations are inadequate knowledge, the high job turnover in the field of treasuryactivities, lack of liquidity in the domestic market, and lack of a legislative framework to coverthese transactions. The main focus of this study will be to: (a) propose steps to be taken todevelop the forward and futures market in the local foreign exchange market; and (b) makerecommendations for the development and regulation of financial derivatives for hedging foreignexchange and interest rate risk

(3.2.c) Supervision of the Government Debt Exchange

The Primary Dealers (PDs) in Government Securities (Treasury Bills and Treasury Bonds)proposed to establish a Government Debt Exchange for secondary market retail tradingoperations. The PDs will set up a public limited liability company (Sri Lanka Central DebtOffice/Exchange) with the equity participation of all PDs to handle these operations. The Boardof Directors of the Company will be representations of the PD companies. The main functions ofthe company will be out-sourced to the Colombo Stock Exchange who will provide automatedtrade matching and central depository system. The Primary Dealers Association (PDA) hassigned a Memorandum of Understanding with the Colombo Stock Exchange for the services to beprovided and the system specifications. The CBSL is the supervisory authority for the PDs andwill be empowered to supervise the activities of the SLCDO (the PD Debt Exchange Company).The SLCDO will be required to provide on-line real time information to the CBSL forsurveillance purposes. As the CBSL does not have expertise in supervising a Debt Exchange, itwill be necessary to engage a Consultant for the following purposes:* To advise the CBSL in designing an effective supervisory system for the Debt Exchange; and* To train CBSL staff on appropriate surveillance techniques relating to the supervision of the

Debt Exchange.

- 48 -

Annex 3: Estimated Project Costs

SRI LANKA: Sri Lanka Central Bank Strengthening

Local Foreign TotalProject Cost By Component US$ Million USS Million US$ Million

A. Central Bank Restructuring and Reorganization 25.4 5.5 30.9

1. Human Resources Development 25.1 0.4 25.5

Establishment of the HR Department 0.1 0.4 0.5

Voluntary Retirement Scheme 25.0 0.0 25.0

2. Capacity Building of Departments 0.4 5.1 5.4

Banking Department 0.0 0.2 0.2

Management Audit Department 0.0 0.0 0.0

Secretariat Department 0.0 0.0 0.0

Information Department - Library 0.0 0.1 0.1

Training Program 0.3 4.6 4.9

B. Development of Payment Settlement System 0.0 8.5 8.5

Introduction of a Real Time Gross Settlement 0.0 4.6 4.6

Development of the Scripless Government Securities System 0.0 2.9 2.9

Automation of the General Ledger 0.0 1.0 1.0

C. Financial Sector Development and Regulation 0.1 0.6 0.8

Legal Reforms 0.1 0.3 0.4

Other Financial Sector Development 0.0 0.3 0.3

D. Implementation Support 0.0 0.0 0.0

E. Project Preparation Facility (PPF) 0.0 0.6 0.6Total Base Cost 25.6 15.2 40.8

Physical Contingencies 0.0 0.2 0.2

Price Contingencies 0.1 0.9 1.0

Total Including Contingencies 25. 16.3 42.0

_ - ~~~~~LocalUS$ Million(Including Foreign Total

Project Cost By Category Taxes) USS Million US$ Million

Goods 0.0 8.8 8.8

Works 0.0 0.0 0.0

Services (Consultancy) 0.3 1.5 1.8

Training 0.4 4.9 5.3

Voluntary Retirement Scheme (VRS) 25.0 0.0 25.0

Recurrent Costs 0.1 0.5 0.6

Project preparation Facility (PPF) 0.0 0.6 0.6

Total Project cost 25.7 16.3 42.0

- 49 -

Annex 4: Cost Benefit Analysis SummarySRI LANKA: Sri Lanka Central Bank Strengthening

Summary of Benefits and Costs:The benefits of the scheme will come from a smaller, more streamlined central banking institutionwith a narrow focus on two key objectives -- private stability and financial system stability. Theinitial outlay ($25 million) for the scheme -- paid out over a three year period -- will take two tothree years to recoup in terms of lower staffing costs to the central bank. This is shown in thecost-benefit analysis table below.

Main Assumptions:VOLUNTARY RETIREMENT SCHEME

The restructuring process of the CBSL entails, among other things, redesigning the objectives,finctions and the structure of the Bank, studying the work process and automation of activities,re-assessment of the human resource needs, redesigning jobs and assigning some of the functionsto outside agencies.

Consequently, the Bank has found that some categories of employees are likely to becomeredundant as part of this process. Redundancy is most likely to take place in the Minor Employeegrades where the bulk of the work is done manually and also in the Non-Staff Class grades wherethe work is of a routine nature and the decisions are of programmed type. In the Staff Class(professional) grades too, redundancy will occur mainly in departments where administrativematters and support services are handled. The CBSL wishes to rectify this situation as a mainobjective of the re-engineering process is to increase staff productivity and to reduce costs. Thus,the CBSL has designed a VRS scheme where it encourages targeted employees who may wish toleave the Bank early to do so voluntarily. For its part, the CBSL will have to offer such staff anadequate retirement/compensation package to encourage them to decide to leave voluntarily.

The main aim of the voluntary retirement scheme (VRS) is to reduce the operational cost and toimprove worker productivity. It is envisaged to substantially reduce the overall staff of the Bankwithin about three years, parallel to the restructuring of the CBSL's overall activities. As theaverage age of staff and non-staff officers is around 47 years, such a scheme will help the Bank tore-new its age structure to thereby make it a younger bank and to consequently help in dealingwith succession planning for the future. It is also important to link a performance based incentive& evaluation scheme with the VRS in order to retain the services of officers who are required.The VRS would also be a safety net for those who would not wish to continue after therestructuring.

Hence the VRS has been designed to address the concerns and aspirations of the employees, andat the same time be cost effective for the CBSL. Also, the impact of such a package on theworking population has been taken into account.

- 50 -

PricewaterhouseCoopers Ltd. (PwC) consultants have been retained to, inter alia, design and costan appropriate VRS scheme for the CBSL. As part of this process, PwC has analyzed variousVRS packages offered by other institutions in Sri Lanka and the Central Government's VRSscheme (1990), see Annex 2. They have identified that the implementation of these schemesresulted in staff reductions of only about 13 to 15 percent. Since the CBSL target is around 50percent of the existing work force, the package offered by CBSL will need to be commensuratelymore attractive.

The staffing profile of the CBSL as at mid-October 2000 is shown in the following table (it hassince declined to 1953 due to retirements and natural attrition):

Age Structure of the Central Bank of Sri Lanka (as at 17/10/2000)

59-60 56-58 51-55 46-50 41-45 36-40 31-35 <30TOTAL

1. Deputy Govemors 5 5 4 14Executive DirectorsAssistants to Governor

2. Heads of Department 6 3 17 6 323. Deputy Heads 4 2 13 5 244. Staff Class Grade 3 9 13 29 11 29 2 935. StaffClass Grade 2 17 31 35 33 51 55 7 2296. StaffClassGrade I 4 11 49 26 17 12 28 31 178

TOTAL STAFF CLASS 45 65 147 81 97 69 35 31 570

7. Supra Grades 14 26 126 67 1 2348. Staff Assistants &NSC4 1 5 51 158 123 16 3549. NSC Grade 3,2, and 1 4 9 81 125 152 97 26 27 521

TOTAL NON-STAFF 19 40 258 350 276 113 26 27 1,109

10. Minor Employees 2 3 34 99 78 42 40 13 311

GRAND TOTAL 66 108 439 530 451 224 101 71 1,990

- 51 -

Under the proposed scheme, the CBSL wishes to reduce staff in these various categories on the followingbasis:

Number Expected AverageOf Staff VRS Applicants Age

Staff Officers 550 200 47 yearsNon-Staff Officers 1094 500 47 yearsMinor Employees 309 309 43 years

Total Staff 1953 1,009 47 years

The salient features of the proposed VRS are set out below:

A. For Staff Class

Eligibility: Employees aged 45 years and above and minimum 10 years service.The Scheme: (The lump-sum compensation is subject to a maximum of current average monthlysalary x number of months of balance service)

Age 55 years and above Age between 45 & 55 years

Pension 90 percent salary at retirement 70 to 80 percent of salary atretirement

0.75 months salary for eachCompensation for Past Service year of past service 0.75 months salary for each

year of past serviceCompensation for Future 2 months salary for each yearService of future service 2 months salary for each year

of future serviceHouse Loan Repayment Till age 70 years as per

present rules Loan to be recovered fromVRS compensation.

Medical Benefits To continue after retirement asper present rules No medical benefits after

retirement.

- 52 -

B. For Non Staff Class

Eligibility: Employees aged 45 years and above and minimum 10 years service.The Scheme: (The lump-sun compensation is subject to a maximum of current average monthly salary xnumber of months of balance service)

Age 55 years and above Age between 45 & 55 years

Pension 90 percent salary at retirement 70 to 80 percent of salary atretirement

0.75 months salary for eachCompensation for Past Service year of past service 0.75 months salary for each

year of past serviceCompensation for Future 2 months salary for each yearService of future service 2 months salary for each year

of future serviceHouse Loan Repayment Till age 70 years as per

present rules Loan to be recovered fromVRS compensation.

Medical Benefits To continue after retirement asper present rules No medical benefits after

retirement.

C. For Minor Employees

Eligibility: All employeesScheme (i): For employees with 10 years service or more (The lump-sum compensation is subject to amaximum of current average monthly salary x number of months of balance service)

Age 55 years and above Age between 45 & 55 Age below 45 years

years

Pension 90% salary at retirement 70% to 80% of salary at 70% of salary at retirementretirement payment to commence at age

45 years

Compensation for 0.75 months salary for 0.75 months salary for each 1.25 months salary for eachPast Service each year of past service year of past service year of past service

Compensation for 2 months salary for each 2 months salary for each 2 months salary for each yearFuture Service year of future service year of future service of future service

House Loan Till age 70 years as per Loan to be recovered from Loan to be recovered from VRRepayment present rules VR compensation? compensation?

To continue after No medical benefits after No medical benefits afterMedical Benefits retirement as per present retirement? retirement ?

rules

- 53 -

C. For Minor Employees (continued)

Scheme (ii): For employees with less than 10 years service (The lump-sum compensation is subject to amaximum of current average monthly salary x number of months of balance service)

Age 55 years and above Age between 45 & 55 Age below 45 years

years

Pension No pension. Gratuity as per No pension. Gratuity as per No pension. Gratuity as perrules rules rules

Compensation forPast Service 2 months salary for each 2 months salary for each 2 months salary for each year

year of past service year of past service of past serviceCompensation forFuture Service 2 months salary for each 2 months salary for each 2 months salary for each year

year of future service year of future service of future serviceHouse LoanRepayment Loan to be recovered from Loan to be recovered from Loan to be recovered from VR

VR compensation? VR compensation? compensation?Medical Benefits

No medical benefits after No medical benefits after No medical benefits afterretirement as per present retirement? retirement?rules

Other Considerations

The Central Bank of Sri Lanka is aiming to reduce staff by around 1,009 (from a total of 1,953).These are broadly expected to come from minor grades (200); non-staff grades (500) and staffgrades (309).

Staff who participate in the Voluntary Retirement Scheme will be asked to jointly sign a waiverwith the Central Bank of Sri Lanka which specifically excludes them from future employment withthe CBSL after taking up the VRS package.

Payments from the VRS will be based upon the above formula and will be adrckniistered by a, soonto be recruited, Human Resources line manager (recruited from the domestic market) and rn HRprofessional advisor (recruited from the international market) who will oversee its fairimplementation over a three year period.

The scheme is not designed as a meritocracy and it has not been designed to stop the best staffleaving -- even though the CBSL does reserve the right to accept or reject an applicant for thescheme (acceptance must be mutually agreeable). Nonetheless, it is anticipated that in such asmall institution, moral suasion can be exerted to stop the best staff from leaving, combined withthe expectation of a decompression of the salary structure at some later date. As a prestigiousinstitution with the Sri Lankan civil service, it is expected that good performers can be persuadedto continue working in the bank.

- 54 -

A full investigation has indicated that there are no evident gender or ethnic issues involved in theapplication of the VRS package.

Lastly, as a purely voluntary scheme -- the ultimate decision to accept or reject such a packagewill lie with the two parties involved -- the CBSL and the staff wishing to avail himself/herself ofthe scheme. The Labor Unions have been consulted, on an on going basis, with the design anddevelopment of the VRS program. Continuous monitoring after the application of the programwill also be undertaken. It has been reported by the CBSL that Unions have been receptive of theidea and that they are waiting for more information and design of the VRS. CBSL has selected 4members of the labor unions and sent them to India to look at the VRS experiences in the CentralBank of India and other banking sectors that have been recently undertaken. As the design of theVRS are more firmed up in next few months, more close consultations with unions will takeplace.

- 55 -

Sensitivity analysis / Switching values of critical items:Cy"Oa Vk 5d okm

TAilECFPAR4MElS

Year1 Yew r2 Yewr3tANboSk* F W I IIt,009id A 40E 30 30h*raO* 309 309 0 0

Nm~ 500 100 290 200

SbffOmcs 200 O IOD 10D

SktfCs ln LIS$ (G sk PrYE

lK&"BrO 25a9

NmM 3,~~~~~~~103

Swrfabs 6,776

Yawl1 Ye8r2 Yer3

^ p agCot-SP ! ffrv

ww& S 697R6Z 697,g7 o O

NliSbkf 1S5941 310S88 E21,176 621,1763

SteOmos 1,1s4 0 677,647 677,647TO 1M,965 129$Z32 1,298824

PswadTdEi 27ScP/o 33.a2%/ 3F%MI/

;RD,ACASH RO/Y

V4S1 2 3 4 s 6 7 8 9

NRUM

SdWySmiigdRkd SUT 1=565 Z,307,W8 3,60&212 3,606212 3,606212 3,60&212 3,69312 3,606&212 3,606,21

P6VMS&t 847,194 1Z&W 3,029218 3M,218 3,0,2918 3,029218 3.02218 3,M3218 3,029218

Saison,s fads 32Z998 8O7,596 1262174 1,26174 128174 1,2&2,174 1262174 12&2?174 12ER174

ToAL SRM 2tlE757 5A53.18D 789aN $7,604 7 ,897 ,604 7 ,897,604 7a9a4 97,604 7,897,4 7M87,604

CUFRD

%MOD

d OPacUeo 6,99,85 9PXD,071 9,04,071

Ccda ori l1Z°41 174,494 174,494 174,4°4 174,494 174,494 174,494 174,494 174,494

Adrffriia Cost EO,OCO 100,000 100,0CO

lUALaJIRR T,1%4798 9X555 9a78,f 174A 174E4 INA94 174A43 174,451 174,943

NEC R aN tM 4,976042 4,25,B -t3a= 7,723,110 7,723,110 7,723,110 7,723,110 7,723,110 7,723,110

DcRiFtb lo,/. 11°h 1iT/o 13'J.NrPETRrALLE 16,ZSXO7 14,968,0 13,806764 lZ727,146

RR 3937931/6

TQWke*t 250'MY ~~~~~~~~~327

-56 -

Annex 5: Financial Summary

SRI LANKA: Sri Lanka Central Bank Strengthening

Years EndingIn UD$ 000

- ~~MPLEMENTATION PERIOD .

TtYear Fnc Yearn2 17Year 3 1 0.0 Year0 7Total Finaning RequiredProject CostsInvestment Costs 10700.0 14840.0 14840.0 1600.0 0.0 0.0Recurrent Costs 60.0 70.0 300.0 0.0 0.0 0.0

Total Project Costs 10700.0 14840.0 14840.0 1600.0 0.0 0.0 0.0Total Financing 10700.0 14840.0 14840.0 1600.0 0.0 0.0 0.0

FinancingIBRD/IDA 6800.0 10800.0 11500.0 1200.0 0.0 0.0Government 3650.0 3790.0 3090.0 150.0 0.0 0.0

Central 0.0 0.0 0.0 0.0 0.0 0.0 0.0Provincial 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Co-financiers 250.0 250.0 250.0 250.0 0.0 0.0 0.0User Fees/Beneficiaries 0.0 0.0 0.0 0.0 0.0 0.0 0.0Others 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Total Project Financing 10700.0 14840.0 14840.0 1600.0 0.0 0.0 0.0Main assumptions:

- 57 -

Annex 6: Procurement and Disbursement ArrangementsSRI LANKA: Sri Lanka Central Bank Strengthening

Procurement

Institutional Capacity. An assessment was carried out to determine the institutional capacity ofthe project administrative unit (AU). The assessment was based on the information provided byCBSL and also on the basis of the experience with the Bank financed Emergency Y2K Project.AU will be the focal point for procurement related activities; it will need to coordinate, monitor,and provide guidance on procurement matters. The CB should appoint a senior officer in chargeof procurement in the AU who will be provided with additional training if required. The goods tobe procured under the project includes: (i) Information system for RTGS and SGSS estimated at$7.6 m; (ii) Software for General Ledger (GL) estimated at $ 1.1 m; (iii) equipment for library andbanking department estimated at $53,000; and (iv) computers estimated at $ 28,300. Consultantservices would be required: (i) as an intemational human resources specialist ($ 469,000); (ii) asa human resources manager ($ 68,000); (iii) for advisory services to various departments of CB ($314,800); (iv) to develop a library system ($ 88,900); (v) for legal reforms ($324,300); (vi) otherfinancial sector development reforms ($377.600); and (vii) other technical assistance ($ 15,800).

Procurement schedules including contract packages will be prepared by the AU. Procurement ofgoods, and services under the project, will be carried out in accordance with the provisions ofBank's Guidelines: Procurement under IBRD Loans and IDA Credit published January 1995,and revised January and August 1996, September 1997 ,and January 1999. Procurement ofConsultants would be carried out in accordance with the provisions of the Bank' s Guidelines:Selection and Employment of Consultants by World Bank Borrowers published January 1997,and revised September 1997, and January 1999. The procurement methods applicable to variousexpenditure categories are summarized in Table A. Procurement thresholds and prior reviewrequirements are outlined in Table B.

Procurement Methods (Table A)

Goods ($8.79 million!. Unless otherwise agreed by IDA the procurement of information systemsfor RTGS and SGSS would be done under a single contract using International CompetitiveBidding (ICB). Procurement of software for the General Ledger up to an aggregate amount ofUS$ 1.1 million will also be undertaken using ICB. Computers, library equipment, and otheroffice equipment estimated to cost less than $ 50,000 equivalent per contract to an aggregateamount not exceeding US$ 140,000 equivalent would be procured following shopping procedure.

Consultancy Services ($ 7.1 million!. All the consultancies expected to cost more than $100,000equivalent would be awarded on the basis of QCBS procedures. The Human ResourcesSpecialist will be selected following Selection of Individual Consultants, in accordance withSection V of the guidelines. With IDA's concurrence, small contracts estimated to cost less thanUS$ 100,000 for firms and less than US$ 50,000 for individual consultants, may be procuredthrough Single-Source Selection or Selection Based on Consultants Qualifications. Training

- 58 -

services in established institutions and universities would be procured directly, subject to theBank's clearance on the overall training plans. Other training services would be procuredfollowing procedures acceptable to IDA.

The Bank's Review Procurement Decisions (Table B)

Procurement planning. Prior to the issuance of any invitations to bid for contracts, the proposedprocurement plan for the project shall be furnished to the Bank for its review and approval, inaccordance with the provisions of paragraph 1 of Appendix 1 to the Guidelines. Procurement ofall goods and works shall be undertaken in accordance with the procurement plan which shallhave been approved by the Bank and with the provisions of said paragraph 1. Annualprocurement plans will be reviewed by IDA/Bank.

Prior review of contracts:

Goods and Equipment. All contracts exceeding equivalent of $50,000 would be fully documentedand subject to prior review by the Bank provided in paragraphs 2 and 3, of Appendix 1, to theBank's Guidelines.

Consultancv contracts. Prior review procedures would be as follows:

(a) with respect to each contract for employment of consulting firms/institutions, estimated tocost the equivalent of $100,000 or more, the procedures set forth in paragraphs 1, 2 (other thanthe third subparagraph of paragraph 2(a)) and 5 of Appendix I to the Consultant Guidelines shallapply;

(b) with respect to each contract for employment of consulting firms/institutions estimated tocost the equivalent of $50,000 or more but less than the equivalent of $100,000, the proceduresset forth in paragraphs 1, 2 (other than the second subparagraph of paragraph 2(a)) and 5 ofAppendix 1 to the Consultant Guidelines shall apply; and

(c) with respect to each contract for the employment of individual consultants estimated to costthe equivalent of $50,000 or more, the qualifications, experience, terms of reference, and terms ofemployment of the consultants shall be furnished to the IDA for its prior review and approval.

The contracts shall be awarded only after said approval shall have been given.

Post review

Goods. The contracts below the prior review threshold for works and goods shall be subject topost-review provided in the procedure set forth in paragraph 4 of Appendix 1 of the Bank'sGuidelines; and

Technical Assistance, Studies and Training. Contracts for the employment of consulting firmsestimated to cost less than $100,000 equivalent per contract, and contracts for the employment of

- 59 -

individuals estimated to cost less than $50,000 equivalent per contract, shall be subject topost-review, provided that the generic TORs and shortlists for critical assignments have beencleared by the Bank.

Procurement Information

Procurement information would be collected and recorded as follows:

(a) Prompt reporting of contract award information by AU;

(b) Comprehensive semiannual reports by AU indicating:

(i) Revised cost estimates for individual contracts and the total cost;

(ii) revised timings of procurement actions, including advertising, bidding, contract award,and completion time for individual contracts; and

(iii) compliance with aggregate limits on the specified methods of procurement.

(c) The Borrower's completion report to be received by the Bank within three months of thecredit's closing date.

Procurement Schedule and Proposed Procurement Arrangements

The proposed packages and the Procurement Schedules for goods/equipment required for theproject have been provided by the AU. The project elements, their estimated costs, and proposedmethods of procurement are summarized in Table A. Figures in parentheses are the respectiveamounts to be financed through the IDA/Bank.

-60 -

Procurement methods (Table A)

Table A: Project Costs by Procurement Arrangements(US$ million equivalent)

Procurement MethodExpenditure Category ICB NCB Other2 N.B.F. Total Cost

1. Works 0.00 0.00 0.00 0.00 0.00

(0.00) (0.00) (0.00) (0.00) (0.00)2. Goods 8.65 0.00 0.14 0.00 8.79

(8.65) (0.00) (0.12) (0.00) (8.77)3. Services 0.00 0.00 6.10 1.00 7.10Consultancies (0.00) (0.00) (3.07) (0.00) (3.07)4. Miscellaneous 0.00 0.00 25.00 0.00 25.00VRS (0.00) (0.00) (17.50) (0.00) (17.50)

5. Operation and Maintenance 0.00 0.00 0.56 0.00 0.56(0.00) (0.00) (0.28) (0.00) (0.28)

6. PPF 0.00 0.00 0.60 0.00 0.60(0.00) (0.00) (0.60) (0.00) (0.60)

Total 8.65 0.00 32.40 1.00 42.05

(8.65) (0.00) (21.57) (0.00) (30.22)

Figures in parenthesis are the amounts to be financed by the IDA Credit. All costs include contingencies.

includes goods to be procured through limited international bidding and international\national shopping,consulting services, training, and technical assistance services related to managing the project.

Prior review thresholds (Table B)

Table B: Thresholds for Procurement Methods and Prior Review

Expenditure Category Contract.Value Threshold Procurement Method Contracts Subject to Prior(US$ thousands) Review

(US$ Ms)

1. Goods > =50 ICB All contracts

= <25 Shopping Post Award Review

-61 -

2. Services Firms>100 QCBS All contracts

<100 As per Bank guidelines: For contracts of valueQCBS, SSS, CQ, IC SI 00,000 and above theetc. procedures set forth in

paragraph 1, 2 (other thantlhird sub-paragraph ofparagraph 2(a)) and 5 ofAppendix I of ConsultantGuidelines shall apply.

For contracts of value$50,000 or more but lessthan $ 100,000 theprocedures set forth inparagraphs 1, 2 (other thansecond subparagraph of

Individuals paragraph 2(a)) and 5 ofAppendix I of Consultant

>50 Guidelines shall apply

For employment of< 50 individual consultants of

contract value $50,000 ormore, the qualifications,experience, terms ofreference and terms ofemployment shall besubject to prior review.

Terms of reference and costestimates shall be priorreviewed

Procurement Risk - AVERAGEFrequency of procurement supervision missions proposed: One every four months for the first year ofimplementation and one every six months for the subsequent years (includes special procurementsupervision for post-review).

- 62 -

Disbursement

Allocation of credit proceeds (Table C)

Financial Management and Disbursement Arrangements

I. Assessment of the Financial Management System of CBSL

(a) Present Financial Management Arrangements of CBSL: Accounting for financialtransactions of the CBSL is split between the Banking Department and the Secretariat. TheSecretariat is responsible for maintaining records of the 'Charges' account, whilst the BankingDepartment is responsible for maintaining records of all operational transactions, such as,commercial bank deposits, investments in Treasury Bills, foreign debts and debt service payments.The 'Charges' account has numerous sub-accounts to record administrative expenses of theCBSL, including expenditure on staff salaries, office occupancy, acquisition and maintenance ofpremises, office equipment, vehicles, furniture, and so on. The Banking Department consolidatesaccounts of all financial transactions of the CBSL, including the 'Charges' account. Theaccounting systems of the CBSL are partly computerized.

(b) Audit: CBSL's accounts are audited by the Auditor General of Sri Lanka (AG). Asrequired by statute, CBSL prepares monthly expenditure statements and balance sheets andsubmits them to the AG within seven days after the end of each month. These monthly statementsare verified and certified by the AG and published in the national Gazette. In addition to theexternal audit, CBSL has a 'Management Audit Division', which periodically reviews financialtransactions, accounting procedures, internal controls, and reports directly to the Governor.

(c) Proposed Financial Management Arrangements of the Reorganized CBSL: In there-organized CBSL, the functions of the Banking Department and the Secretariat will be changedsignificantly. The payment settlement function of the Banking Department will be taken over bythe Payments Settlements Department to be established under the Financial Sector StabilityGroup, and the current administrative accounting functions of the Secretariat will be transferredto the Finance Department to be established under the Corporate Services 1 Group. The'Management Audit Division' will be retained, but its scope of work will be expanded to includeauditing of automated systems, performance evaluation, and value added audits.

(d) Scope of the Project: The project has as one main objective the automation of thepayment settlement system of the CBSL. This will include funding for the following three majorinformation systems.

* Real-Time Gross Settlement (RTGS) system to provide the necessary infrastructure to clearand settle payments between financial institutions and CBSL in a secure and timely manner.

* Scripless Government Securities System (SGSS) to establish a scripless central depository,registry and settlement system for transacting government debt securities and to interface withthe RTGS system.

- 63 -

* General Ledger (GL) system to maintain the financial records of CBSL and other relevantinstitutions of the financial sector, so as to consolidate CBSL's financial position on a dailybasis. The GL system will include provisions for expense control, processing someadministrative accounting transactions, and generating primary financial reports, i.e. profit andloss account and balance sheets. Specific accounting functions relating to fixed assets,accounts payable, personnel and payroll expenses, and specific purpose current accounts, maystill be maintained outside of the GL, but will be reconcilable to specific control accounts inthe GL system. It is expected that both the Finance Department and the PaymentsSettlements Department will use the GL system.

(e) Conclusion: As stated above, the proposed re-organization plan of CBSL includessignificant imnprovements to the financial accounting system. Details of the new accountingsystem will be worked out during development and implementation of the GL system. For theimplementation of the project, CBSL has adequate financial management capacity as per therequirements of OP/BP 10.02 (see below).

II. Proiect Financial Mana2tement System

(a) Internal Controls: The project will adopt the CBSL's existing internal controlprocedures and, where applicable, the Financial Regulations (FRs) of the Government of SriLanka. The internal procedures and controls of the CBSL are specified in the 'CBSL Manual'.This manual covers in detail the authority and approval levels, cash receipts and disbursements,procurement and payables, employee compensation, accounting systems, and safekeeping ofcapital assets, etc. The FRs, which are well established and documented, cover almost everyaspect of financial administration and will provide necessary safeguards for ensuring orderly andefficient conduct of project activities. A review of the FRs can be found in the Country Profile ofFinancial Accountability report and in the Country Financial Accountability Assessment studycarried out by the consultants.

(b) Accounting System: The Project Management Unit (AU) will maintain separate set ofaccounts for recording all financial transactions of the project in accordance with soundaccounting practices. The Chart of Accounts developed for the project (Annex 1) will facilitaterecording of project expenditure by financing source, disbursement category, project componentsand expenditure type and will also enable production of the quarterly Project ManagementReports (PMR) as per the agreed formats (Annex 2). Cash basis of accounting will be adoptedfor this project. Project accounts will be maintained electronically in a simple spreadsheetapplication to be developed by the Project Accountant, and periodically reconciled with the GLsystem.

(e) Reporting: The project will report on a quarterly basis according to the agreed PMRformats. The simplified PMR cash model format was adopted for this project. (Refer Annex 1 forthe Financial Management Reports and the Project Progress Report).

(d) Staffing: The Project Accountant will be responsible for ensuring timely recording and

- 64 -

reliable reporting of all financial transactions of the project. CBSL has already assigned aqualified and experienced accountant to work on this project. IDA has concurred with thisappointment.

(e) Auditing: The AG will audit the annual financial statements of the project. The AU willbe required to submit the audited project financial statements and the audited CBSL annualaccounts within six months of the end of each financial year. The project/SOE audit report, SAreport and the entity audit reports will be monitored in the ARCS system.

(t) Status of Compliance with Audit Covenants in Existing Bank-financed Projects:CBSL, as the implementing agency for the Year 2000 Emergency Assistance, has satisfactorilycomplied with the audit covenants of that project.

III. Disbursement Arrangements

The project will adopt the traditional disbursement method and will produce simplified PMRs on aquarterly basis from the start of the project. Nevertheless, after the first year of implementation,GOSL, CBSL, and the Bank can jointly consider the appropriateness of adopting the PMRdisbursements after the PMR procedure is revised by the Loan Department.

(a) Special Account (SA): CBSL will be responsible for opening and operating a SA at theBanking Department of Central Bank of Sri Lanka, according to terms and conditions acceptableto the IDA. The SA will be denominated in US Dollars. The amount of advance in the SAshould not, at any given time, exceed the equivalent of US$ 2,300,000. The initial authorizedallocation at the beginning of the project will be limited to US$ 1,000,000, until cumulativedisbursement reach SDR 2,500,000.

(b) Statement of Expenditure (SOE): Withdrawals under the credit may be made on thebasis of Statement of Expenditure (SOE) procedure for:

* Contracts for goods and equipment costing less than $ 50,000 each.* Contracts for consultancy services with individuals costing less than $ 50,000* Contracts for consultancy services with finms costing less than $ 100,000* All Voluntary Retirement Scheme (VRS), training, workshop expenses, and operation and

maintenance of equipment.

(c) Project Management Reports: CBSL will produce the simplified PMRs from theinception of the project although the reports will not be used as the basis for disbursements.(Refer Annex I for the PMR formats). The PMR formats will be reviewed and modified, ifnecessary, after one year of project implementation.

(d) Allocation of Credit Proceeds: The disbursement categories to be used for the projectand allocations of the credit proceeds amongst these categories are given in the table below. Costof the new payment system and the VRS was finalized during credit negotiations. The creditallocations are given below.

-65 -

Table C: Allocation of Credit Proceeds

Expenditure Category Amount in US$million Financing PercentageGoods 8.50 100% of foreign expenditure;

100% of local expenditure (ex-factorycost);

and 85% of local expenditure for otheritems procured locally.

Consultants' Services and Training 3.05 100%Voluntary Retirement Scheme 17.50 70%Operation and Maintenance of 0.27 50%EquipmentProject Preparation Facility 0.60Unallocated 0.38

Total Project Costs 30.30

Total 30.30

- 66 -

Annex 7: Project Processing Schedule

SRI LANKA: Sri Lanka Central Bank Strengthening

Project Schedule Plannred Actual

Time taken to prepare the project (months) 11 1_1

First Bank mission (identification) 05/12/2000 05/12/2000Appraisal mission departure 04/06/2001 04/06/2001Negotiations 05/07/2001 05/14/2001Planned Date of Effectiveness 07/31/2001

Prepared by:

Preparation assistance:

Bank staff who worked on the project included:

Name SpecialitySimon C. Bell Sr. Financial Economist, SASFP (Task Manager)Robert Keppler Sr. Advisor, FSDHans Eric Berggren Human Resources Advisor, HR DepartnentSriyani Hulugalle Industrial Economist, SASFPShideh Hadian Operations Officer (PSD), SASFPIrene Julitta Rasiah Financial Management Specialist, SARFMJayantha De Mel Procurement Specialist, SACSFDeepal Fernando Implementation / Procurement Specialist, SACSLSanthanam Krishnan Procurement Specialist, India HubMary Agnes Evidente Team Assistant, SASFP

Kenneth Miller Sr. Disbursement Officer, LOAG2Dolly Aziz Disbursement Analyst, LOAG2Ghada Youness Country lawyer, LEGOPMohammed Nawaz Consultant Lawyer, LEGOP

-67 -

Annex 8: Documents in the Project File*SRI LANKA: Sri Lanka Central Bank Strengthening

A. Project Implementation Plan

1. First Government proposal for technical assistance.2. Borrower Project Implementation Plan (BPIP)3 . Final Report by the 5 Focus Group on the Transformation of CBSL4. Various Terms of reference for the consultants.5. 5-Year Training Plan for the CBSL staff.6. One Year Procurement Plan7. Circular issued by the CBSL to the employees on the proposal for the Voluntary RetirementScheme (VRS) and Human Resource Management Plan (this is a draft for discussion only).

B. Bank Staff Assessments

Identification mission's reports

C. Other

Proposed Model for the VRS*Including electronic files

- 68 -

Annex 9: Statement of Loans and Credits

SRI LANKA: Sri Lanka Central Bank StrengtheningMay-2001

Difference between expectedand actual

Original Amount in US$ Millions disbursements'

Project ID FY Purpose ISRD IDA GEF Cancel. Undisb. Orig Frm Rev'd

P050738 2001 LAND TIT. & REL.SERV (LIL) 0.00 5.00 0.00 0.00 4.94 0.00 0.00

P069784 2001 Distance Learning Initiative - LIL 0.00 2.00 0.00 0.00 2.03 0.00 0.00

P044809 2000 LEGAL AND JUDICIAL REFORMS 0.00 18.20 0.00 0.00 15.82 -1.37 0.00

P058070 2000 North-East Imgated Agnculture Project 0.00 27.00 0.00 0.00 24.58 -0.85 0.00

P063472 1999 EMERGENCYY2KTA 0.00 29.00 0.00 8.49 4.19 13.98 0.00

P035828 1998 CONS OF MEDIC PLANTS 0.00 0.00 4.60 0.00 2.49 0.79 0.00

P034212 1998 MAHAWEU RESTRUCTURI 0.00 57.00 0.00 0.00 29.58 12.94 0.00

P010525 1998 GENERAL EDUCATION II 0.00 70.30 0.00 0.88 48.43 31.3B 0.00

P039965 1997 ENERGY SERV.DLVY. 0.00 24.20 5.90 0.00 3.05 0.80 0.00

P010498 1997 ENERGY SERVICES OLVY 0.00 24.20 5.90 0.00 8.83 2.54 0.00

P010513 1997 ENVIRONMENTAL ACTION 0.00 14.80 0.00 0.00 7.33 7.35 0.00

P010526 1997 HEALTH SERVICES DEV 0.00 18.80 0.00 3.46 3.91 6.45 0.00

P042266 1996 TEACH EDSDEPLOYMENT 0.00 64.10 0.DO 0.00 26.17 29.89 0.00

P010517 1996 PVTSECTINFRASDEV 0.00 77.00 0.00 0.00 61.40 65.56 19.00

P010467 1995 COL. ENV. IMPROV. 0.00 39.00 0.00 7.76 4.37 17.42 0.00

Total: 0.00 470.60 16.40 20.56 245.13 186.87 19.00

- 69 -

SRI LANKASTATEMENT OF IFC's

Held and Disbursed PortfolioMay-200 1

In Millions US Dollars

Committed DisbursedIFC IFC

FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic1999 Aitken Spence 0.00 2.73 0.00 0.00 0.00 2.73 0.00 0.001996/97 Asia Power 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.001999 DCR Lanka 0.00 0.09 0.00 0.00 0.00 0.05 0.00 0.001992 Eagle NDB 0.00 0.06 0.00 0.00 0.00 0.06 0.00 0.00198] Lanka Hotels 0.00 0.64 0.00 0.00 0.00 0.64 0.00 0.001997 Lanka Orix 1.50 0.30 0.00 0.00 0.60 0.16 0.00 0.001996 Lanka Orix Lease 0.92 0.00 0.00 0.00 0.92 0.00 0.00 0.001998 MLL 0.00 0.00 1.55 0.00 0.00 0.00 1.55 0.002000 NDB Housing Corp 0.00 1.09 0.00 0.00 0.00 0.00 0.00 0.001999 Nations Trust 0.00 1.09 0.00 0.00 0.00 1.09 0.00 0.001997 Packages Lanka 0.00 1.11 0.00 0.00 0.00 1.11 0.00 0.001992 Pyramid Trust 0.00 0.25 0.00 0.00 0.00 0.25 0.00 0.001999 SAGT 35.00 7.30 0.00 0.00 5.00 2.33 0.00 0.002000 Suntel 0.00 7.50 0.00 0.00 0.00 7.50 0.00 0.001988/95 Union Assurance 0.00 0.50 0.00 0.00 0.00 0.50 0.00 0.00

Total Portfolio: 37.42 22.66 1.55 0.00 6.52 16.42 1.55 0.00

Approvals Pending Commitment

FY Approval Company Loan Equity Quasi Partic

1998 Apollo Lanka 5.00 0.00 1.56 0.002000 NDB Credit Line 35.00 3.50 0.00 0.00

Total Pending Commitment: 40.00 3.50 1.56 0.00

- 70 -

Annex 10: Country at a Glance

SRI LANKA: Sri Lanka Central Bank StrengtheningLower-

POVERTY and SOCIAL Sri South middles-Lanka Asia Income Development diamond'

1999Population. mid-vear (millionsl 19.0 1.329 2,094 Life expectancyGNP per capita (Atlas method, US$) 820 440 1,200GNP (Atlas method, US$ billions) 15.6 581 2,513

Averaae annual growth. 1993-99

Population ̀ %) 1 3 1.9 1.1Labor force (%J 1.6 2.3 1.2 GNP Gross

per ~ . primaryMost recent estimate (latest year available, 1993-99) capita / enrollment

Povertv (/% of poPulation below national poverty line) 25Urban Population (% of totel population) 22 28 43Life expectanev at birth (vears) 73 62 69 .Infan: mortalitv (per 1,000 live births) 17 75 33Child malnutrition (% of children under 51 38 51 15 Access to safe waterAccess to improved water source (% of oopulation) 64 77 86Illiteracy (% of population age 15+) 11 46 16 Sri LankaGross Primarv enrollment (% of school-age population) 109 100 114

Male 110 110 114 --- Lower-middle-income groupFemale 108 90 116

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1979 1989 1998 1999Economic ratios'

GDP (USS billions) 3.4 7.0 15.4 16.0Gross domestic investmient/GDP 25.8 21.7 25.1 27.1 TradeExports of Qoods and services/GDP 33.7 27.3 36 2 35.3Gross domestic savinaslGDP 13.5 12.2 19 1 19.8Gross national savings/GDP .. 14.6 23.8 23.9 TCurrent account balance/GDP -6 7 -5.9 -1 5 -3.1 Domestic .. 4Interest oavments/GDP 0.8 1.6 0.8 1.0 Sn. f9A InvestmentTotal debt/GDP 46.2 74.1 55.4 54.7 -sTotal dobt service/exports 12.9 18.6 6.5 10.0 1Present value of debt/GDP . . 40.8Present value of debt/exports . Idb90e8dns

Indebtedness1979-89 1989-99 1998 1999 1999-03

(averaoe annual growth)GDP 5.0 5.3 4.7 4.3 5. -Sn LankaGNP per capita 3.4 4.0 3.4 2.4 3.6 Lower-middle-income groupExports a1 ooods and servtces 5.5 7.4 t.0 4.0 4.7

STRUCTURE of the ECONOMY1979 1989 1998 1999 Growth of investment and GDP (%)

(% of GDP) a5Agriculture 26.9 25.6 21.1 20.7 37Industrv 28.2 26.8 27.5 27.3

Manufacturinq 19.1 15.3 16.5 16.4 sServices 44.8 47.6 51.4 52.1 D

Private consumption 77.1 77.3 71.1 71.2 94 95 96 97 98 99General government consumption 9.2 10.5 9.8 9.0 -- GDI -_-GDPImports of goods and services 45.8 36.8 42.2 42.6

1979-89 1989-99 1998 1999 Growth of exports and imports (%)(average annual growth)Agriculture 3.5 2.1 2.5 4.5 15tIndustry 5.0 7.1 5.9 6.0

Manufacturinq 5.5 8.3 6.3 4.4 10Services 6.5 5.6 5.1 4.0 s

Private consumption 5.7 5.7 7.5 6.4General government consumption 7.0 5.9 3.4 -2.5 oGross domestic investment 7.5 6.9 15.2 6.4 .Exports -- *-ImpsrtsImports of qoods and services 8.0 8.4 11.5 7.0Gross national Product 5.0 5.3 4.6 3.9

Note: 1999 data are preliminary estimates.

- The diamonds show four kev indicators in the countrv (in bold) compared with its income-aroup average. If data are missina. the diamond willbe incomplete.

- 71 -

Sri Lanka

PRICES and GOVERNMENT FINANCE1979 1989 1998 1999 Inflation (%)

Domestic pnices(% chanqe) 20Consumer prices 10.8 11.6 9.4 4.7 15Implicit GDP deflator 81 9.2 4.6 10

Govemment finance S t(% of GDP, includes current grants) oCurrent revenue .. 24.0 17.9 18.2 94 95 94 97 98 9Current budget balance .. 1.4 -1.7 -0.4 -GDP delator -0-CPIOverall surplus/deficit .. -8.7 -8.4 -6.9

TRADE

1979 1989 1998 1999 Export and import levels (USS mill.)tUSS millions)Total exports (fob) .. 1,558 4,798 4,600 6

Tea .. 379 780 621Other agricultural goods .. .. 352 373 4 00c

Manufactures .. 490 2,460 2,425 TTotal imports (cif) .. 2,226 5,890 5,899

Food .. 94 723 655 2,000iiii IFuel and enerqy .. 165 215 257Capital goods .. 333 1,477 1,565 96 97

Export price index (1995=100) . .. 141 139Import price index (1995=100) .. .. 116 122 aExports EImportsTerms of trade (1995=100) .. .. 121 114

BALANCE of PAYMENTS

1979 1989 1998 1999 Current account balance to GDP (%/.)(US$ mil/lions)Exports of goods and services 1,134 1,851 5,712 5,565 IiImports of goods and services 1,537 2.565 6,659 6,718Resource balance -403 -714 -947 -1,153 2

Net income -15 -163 -180 -253 *flNet current transfers .. .. 900 911 4 l

Current account balance -226 -414 -227 495 -6

Financing items (net) .. ., 190 758Changes in net reserves .. .. 37 -263 -a

Memo:Reserves includinq gold (USS millions) .. .. 1,984 1,639Conversion rate (DEC, locallUS$) 15.6 36.0 66.1 69.6

EXTERNAL DEBT and RESOURCE FLOWS1979 1989 1998 1999

(US$ millions) Composition of 1999 debt (USS mill.)Total debt outstanding and disbursed 1,554 5,181 8,526 8,727

IBRD 33 82 26 15 G:433 A: 15IDA 78 702 1,648 1,651 F: 556 B. 1,651

Total debt service 159 422 452 683IBRO 7 12 8 8IDA 1 7 24 27 C:265

Composition of net resource flowsOfficialgrants 116 195 114Official creditors 103 298 379 504Private creditors 10 -48 126 -201 E: 4,049 _. D: 1,758Foreign direct investment 47 20 193Portfolio equitv 0 0 6

World Bank proqramCommitments 68 20 57 56 A - IBRD E -BilateralDisbursements 15 59 97 48 B - IDA D - Other multilateral F - PrvatePrincipal repayments 4 7 19 4 C - IMF G - Short-termNet flows 11 53 78 44Interest payments 3 12 14 14Net transfers 7 41 64 30

Development Economics 9/9/2000

- 72 -

Central Bank of Sri Lanla30, Janadhlpat Mwawss

A. S. Jayawardea CoIb 1, Sri Leaka.The Governor *I May 2001

Ms. Mieko Nishimizu,Vice President,South Asia RegionThe World Bank1818 H Street, N.W.,Washington, D.C., 20433UNITED STATES OF AMERICA

Dear Ms. Nishimizu,

Letter of Development Policiesfor the Central Bank of Sri Lanka

As you are aware, the Central Bank of Sri Lanka has been working for over a year on a fundamentalrestructuring and re-engineering of the CBSL. We believe that we can transform our institution into apremier central bank in the region - fully modernized and re-vamped to meet the challenges posed w&ithin theSri Lankan economy over the medium to long term. To this end, we were pleased that you participated in asession in which we were able to explain the process of reform and our vision of our Bank during your recentvisit to Sri Lanka in February, 2001.

I would like to reiterate several important aspects of the re-engineering process and to confirm ourstrong commitment to the reform process that we have embarked upon and for which we have sought WorldBank support and assistance.

Re-focussing on Core Functions. Firstly, the Central Bank of Sri Lanka intends to confine itsfuture activities almost exclusively to those, which we believe are core central banking areas of focus. As weindicated to you, these include price stability (through appropriate macro-economic management) andfinancial system stability (mainly through our role as a supervisor and regulator of the financial sector). Thiswill include the devolution of other non-core functions from the CBSL over the next four to five year period.Our focus groups working on the re-engineering process have identified for reform: (a) the control of foreignexchange which we hope to phase out as our domestic conditions permit; (b) development finance activities'(c) management of the Employees Provident Fund (EPF): (d) management of public debt functions on behalfof the Government of Sri Lanka; and (e) most administrative functions which will be streamlined throughoutsourcing.

Devolution of Non-core Functions. With respect to the devolution of non-core tasks we havedeveloped the following plan:

(a) Exchange Control is no longer an important function of the CBSL, and it is intended to downsize thestaff in this area of the bank and convert it to a significantly smaller exchange monitoring unit whichwill be subsumed into the International Department during the second year of the project.Legislative amendments will also be adopted, as required, to support the proposed changes (2002/3);

(b) The public debt management function will be transferred to the Treasury and a much smaller publicdebt monitoring function will be maintained in the Research Departnent of the central bank.. alsoduring the second year of the project (2002/3);

-73 -

(c) With respect to the development finance function, it is our intention to continue this role but on alimited basis for donor on-lending programs (although, as much as possible, we will encouragedonors to identify private apex agencies outside of the Central Bank). The Central Bank will,however, continue to advise on the development of financial markets throughout the country. Underthe World Bank credit we further intend to engage a consultant to advise on the sale of CBSL sharesin the six regional development banks and also to advise on other appropriate steps in instanceswhere the shares in loss making development banks cannot be sold - so that the central bank canremove itself as an owner of these institutions by the end of the proposed project period (by June2005);

(d) Management of the Employees Provident Fund will be devolved to an independent agency outside ofthe CBSL (by June 2004);

(e) Finally, the CBSL will develop an out-sourcing plan for most administrative and ancillary functionsby September 2001 - leading to the implementing/out-sourcing of these functions during the secondyear of the project (2002/03).

It should further be noted that we are well advanced in spinning off the clearing house function to aseparate company with shares owned by the Central Bank and the various commercial banks operating in SriLanka. Consequently, it is anticipated that all five areas of activity mentioned above will be devolved by theend of the project period, permitting the newly re-engineered central bank to effectively focus on its coreobjectives of price stability and financial system stability.

Changes in Human Resource Management within the CBSL. Simultaneously the CBSL intendsto completely revamp its human resource policies to move from the current system of "time-in-grade"performance criteria to one based upon performance and merit. This represents a sea change in the way thatthe CBSL deals with its staff and will need to be implemented carefully and cautiously. It will require achange in policies related to entry and exit from the CBSL, promotions, portability of pensions, staffevaluation, compensation and pensions, and so on. It will further require an experienced Human ResourcesManager to head the Human Resources Department to assist in the implementation of these reforms. In thisregard we intend to recruit an expert under the World Bank project to undertake this function. We anticipatethat such a change in pclicies will enable the promotion of our best and brightest within the bank as well asthe removal of non-performers and the provision of lower rewards for marginal performers.

Developing Management Capital. Over the years the CBSL has found that its managerial skillshave become inadequate to meet the needs of a modem central bank. In addition, a different type ofmanagement will be required in our re-vamped, merit focused, institution. To assist in the development ofmodem managers within the CBSL we intend to establish a dynamic Management Development Center(MDC) which will play a key role in our change management process through education, awareness raisingand critical analysis, and continuous evaluation of our processes and activities. Funds from the World Bankproject will be used to staff this center with international expertise and fund its research and training for aninitial period.

The Voluntary Retirement Scheme. As indicated, we intend to implement a Voluntary RetirementScheme (VRS) - the cost of which will be bome 30/70 between the CBSL and the World Bank to retirepersonnel who are currently working in functions no longer considered part of the core work of the centralbank and to reduce the overall size of the bank by around 50 percent to just under 1,000 staff within aboutthree years. Although the scheme will be offered on a voluntary basis throughout the bank, it will need to beimplemented in conjunction with a plan of higher incentives for the good performers to ensure theircontinuation within the CBSL. Higher financial rewards will also be offered in conjunction with the changein human resource policies indicated above to incentivise the good performers to stay with the bank and notaccept the VRS.

2

Since we wish to vigorously pursue out-sourcing options, it is our intention to make certain positionsredundant and offer staff at these levels a Voluntary Retirement Scheme (VRS) which will be supportedfinancially by the World Bank. This should reasonably quickly remove 300 to 400 staff in such activitiesfrom the payroll of the CBSL. All such redundant staff will be encouraged to avail themselves of the VRSand this process should take place as quickly as possible - but certainly within the first year ofimplementation of the project.

As you can well imagine, such a system of voluntary retirement, appropriate incentives, and removalof functions is key to the re-engineering of the bank and will have to be carefully and appropriatelysequenced to ensure optimal results. These activities will be overseen by the Human Resource Managerhired under the World Bank credit - who will assist in the delicate implementation of this complex reformprogram.

Up-Grading CBSL Professionalism. CBSL modernization involves moving to a new streamlinedmanagement structure, which will require a heightened degree of professionalism. To this end we will moveto hire a number of professionals at senior level from the market within the first year of the project. This willenable the CBSL to quickly acquire new skills as well as move towards a new corporate culture.

Maintaining the Appropriate Size of the CBSL. We are aware that, in many institutions,including previous experiences in Sri Lanka, the implementation of a VRS program has been followed by asubsequent inflation of staff numbers - back to, or beyond, the original staffing complement. I propose fivemethods of ensuring that our efforts at right sizing are not reversed in the future. First, our commitment, asindicated by this letter, backed up by the approval of the Monetary Board (which has reviewed and endorsedthe contents of this note). Second, a reduction of finctions, as part of the overall re-engineering exercise,which will necessitate a lower level of staffing within the institution. Third, all expansions of positions willcontinue to be subject to Monetary Board oversight and approval. Fourth, CBSL will commit to a staffcomplement/cadre of 1,000 or less. Lastly, Central Bank shall make it a condition of voluntary retirement,that those who exercise the right to voluntarily retire will not be re-employed in the Central Bank, in thefuture. It is our expectation that these five safeguards will ensure that the CBSL remains at around the levelof staffing supported by the World Bank under the VRS.

Legal Reform. With a new modern focus for the CBSL, it will also be necessary to amend ourexisting legislation to bring this into line with the new realities of the bank. Within this context we will berequesting World Bank support to help the legal department of the CBSL undertake a comprehensive reviewof the existing financial legal infrastructure and to make recommendations for its amendment. As this willinitially be a process task, we will require support to work with a group of concerned lawyers and other stakeholders from the financial and legal community and the various concerned ministries to ensure buy-in andcommitment to this review task. We are then hopeful that, once consensus has been reached for thenecessary changes, that we will be able to move into an implementation phase with the same group of stakeholders, again supported by World Bank assistance, and led and coordinated from the CBSL. We anticipatethat this will be undertaken over the first four years of the project.

Payments System Support. Support for the implementation of a Real Time Gross SettlementSystem (RTGS), its inter-linkage with the Scripless Government Securities System (SGSS), and theautomation of the general ledger are also integral components of the overall re-engineering andmodernization of the CBSL. Real time settlement of large and other time-critical, transactions and its inter-linkage with the SGSS is an important part of central bank support for a more efficient payments systemwithin Sri Larlka. Automation of the general ledger of the Central Bank will help to integrate various centralbanking functions into a single, seamless management information system which will further enhance ourown internal efficiency and effectiveness.

3

Project Processing Details. As you can appreciate, the reformn exercise to date has been a large andall consuming task for my staff. I personally feel that the progress that we have made together has beenextremely encouraging and that we now stand on the cusp of a radical institutional reform unprecedented inthis country. In addition, for the first time in the history of Sri Lanka, the reform process has been initiated,designed, and implemented by a Sri Lankan institution. As we move into the implementation phase we arelikely to encounter constraints and resistance which may divert us from the important task at hand.Currently, the re-engineering is operating with the support of five Focus Groups staffed by some of ouryoung, brightest staff in the bank (working on issues pertaining to Objectives, Organizational Structure,Management Processes, Human Resources Management, and Consensus Building). These five focus groupsreport to a Steering Committee including the Deputy Governors, my Advisors and other senior staff of thebank. In addition, support to project implementation is provided by a small team of staff in a designated unit.As the lines of responsibility and accountability are sometimes blurred between these various groups, I havedecided to appoint a full-time "Transformation (or Change) Agent" who will oversee and be responsible forimplementing the agreements reached by the Steering Committee and approved by the Monetary Board. Thetransformation agent will be the main implementor of the re-engineering process and will oversee all aspectsof the transformation from an implementation perspective. The role of this individual will be central inensuring that the re-engineering takes place in a holistic and well-integrated manner rather than on a unit byunit, or function by function basis which might otherwise be the case. This individual will also be providedwith sufficient delegated authority to ensure that he/she can undertake all required tasks in an expeditiousmanner as possible without continuous reversion to senior management for approval. This individual willalso ensure that the transformation process is implemented in a timely manner and will assist in thecoordination of donor support efforts for the CBSL.

In conclusion I am extremely encouraged by the process that the staff of the CBSL has put in motionand am grateful for the support that the World Bank, the International Monetary Fund and the Government ofSweden have lent to our efforts. Our vision is of a fundamentally rejuvenated and modern institution withinfive years - streamlined, efficient, focusing on two core objectives and ancillary services , and released fromother activities not deemed to lie within our core competencies and objectives. We believe that this re-orientation will both play a key role in increasing our capacities to support stronger economic developmentin Sri Lanka as well as act as a prototype of successful re-engineering for other public sector institutions inthis country.

urs Sincerely,

A.S. Jaa re nGovernor, Central ri Lanka

cc International Monetary Fund;Government of Sweden/S.I.D.A.

4

MAP SECTION

IBRD 27509

< m~~~

1] -

DECEMBER1996