Sri Lanka - Private Finance Development Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No: 20149 IMPLEMENTATION COMPLETION REPORT SRI LANKA PRIVATE FINANCE DEVELOPMENT PROJECT (CREDIT 2484-CE) March 8,2000 Finance and Private Sector Development Unit South Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Rs. Per US 1.00 US$ Per Rs. 1.00 1993 48.32 0.021 1994 49.42 0.020 1995 51.25 0.019 1996 55.27 0.018 1997 58.99 0.017 1998 64.59 0.015 1999 (till May) 69.34 0.014 ABBREVIATIONS AND ACRONYMS AASMB Accounting and Auditing Standards Monitoring Board ADB Asian Development Bank AU Administrative Unit AWDR Average Weighted Deposit Rate BOC Bank Of Ceylon CBSL Central Bank of Sri Lanka CCC Ceylon Chamber of Commerce CSI Contractual Savings Institution DFCC Development Finance Corporation of Ceylon DFI Development Finance Institution EPF Employees' Provident Fund ETF Employees' Trust Fund FIL Financial Intermediation Loan HNB Hatton National Bank IDA International Development Corporation IFC International Finance Corporation KfW KfW-Kreditanstalt fur Wiederaufbau MOFP Ministry of Finance and Planning NDB National Development Bank NIC National Insurance Corporation NSB National Savings Bank OMO Open Market Operations PB Peoples' Bank PCAF Pollution Control and Abatement Fund PCI Participating Credit Institutions PERC Public Enterprise Reforms Commission PFDP Private Finance Development Project SCB State Commercial Banks SLIC Sri Lanka Insurance Corporation SMI Small and Medium Industries TA Technical Assistance USAID United States Agency for International Development FISCAL YEARS GOSL, National development Bank & Commercial Banks = January 1 to December 31 Development Finance Corporation of Ceylon = April 1 to March 31 Vice President: Ms. Mieko Nishimizu Country Director- Sri Lanka: Ms. Mariana Todorova Sector Director: Ms. Marilou Uy Team Leader: Mr. Joseph Pemia Task Leader/Economist: Ms. Sriyani Hulugalle Peer Reviewer: Mr. Robert M. Buckley  FOR OFFICIAL USE ONLY IMPLEMENTATION COMPLETION REPORT SRI LANKA PRIVATE FINANCE DEVELOPMENT PROJECT (CR. 2484-CE) CONTENTS Page No. Preface Evaluation Summary ....................................................................i Project Implementation Assessment ....................................................................1 A. Statement/Evaluation of Objectives ...................................................................I B. Achievement of Objectives .....................................................................2 C. Major Factors Affecting the Project ...................................................................3 D. Project Sustainability ....................................................................4 E. IDA Performance .................................................................... 5 F. Borrower Performance ......................... ...........................................6 G. Assessment of Outcome ....................................................................7 H. Future Operations ................................................................... 15 I . Key Lessons Learned ........................ ........................................... 16 Implementation of Policy Measures Agreed at Negotiations .................. . 18 Statistical Tables Table 1 : Summary of Assessments ........................................................ 24 Table 2 : Related Bank Loans/Credits .................................................. ..... 25 Table 3 : Project Timetable ........................................................ 26 Table 4 Loan/Credit Disbursements: Cumulative Estimated and Actual ......... 27 Table 5 : Key Indicators for Project Implementation ........................... .............. 28 Table 6 : Key Indicators for Project Operations ................................................. 29 Table 7 : Studies Included in the Project ....................................................... 31 Table 8A: Project Costs ....................................................... 32 Table 8B: Project Financing ............................................ , , 33 Table 9 : Economic Costs and Benefits ............................................. 34 Table 10: Status of Legal Covenants ............................................ 35 Table 11: Compliance with Operational Manual Statements ....................... ........ 37 Table 12: Bank Resources: Staff Inputs ............................................ 38 Table 13: Bank Resources: Missions ............................................ 39 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Page No. Statistical Annexes Annex 1 : Legislative Enactments Relating to Financial Sector Reforms ............ 40 Annex 2 : Relative Size of the Financial Sector 1993 & 1998 .............................. 43 Annex 3 Summary of Commercial Bank Performance ....................................... 44 Annex 4 : Compliance of the Agreements: Bank of Ceylon and People's Bank .. 47 Annex 5 : Investments of Contractual Savings Institutes (CISs) in Non-government Securities .................................. .................. 48 Annex 6: Credit Component .................................................... 49 Annex 7 Pollution Control and Abatement Fund ................................................ 51 Annex 8 Technical Assistance .................................................... 52 Annex 9 Brief Report on Studies Conducted under the Project .......................... 55 Annex 10: Compliance of Eligibility Criteria by PCIs . .......................................... 60 Annex 11: Brief Note on Site Visits ..................... ............................... 61 Appendixes A. Aide Memoire of August 1999 ICR Mission B. Borrower's contribution to ICR and comments  IMPLEMENTATION COMPLETION REPORT SRI LANKA PRIVATE FINANCE DEVELOPMENT PROJECT (CR. 2484-CE) PREFACE This is the Implementation Completion Report (ICR) for the Private Finance Development Project in Sri Lanka, for which Cr. 2484-CE in the amount of [SDR 43.2 million] equivalent was approved on April 20, 1993 and made effective on August 2, 1993. Final disbursement took place on December 8, 1999 and a balance of SDR 3,794,514.33 was canceled. The ICR was prepared by Sriyani Hulugalle, Finance and Private Sector Development Unit of South Asia and reviewed by Marilou Uy and Joseph Pernia. Robert M. Buckley was the peer reviewer for the ICR. The Borrower provided comments that are included as appendixes to the ICR. Preparation of this ICR was begun during the Bank's final supervision/completion mission in August 1999. It is based on material in the project file. The Borrower contributed to the preparation of the ICR by providing data and information.   IMPLEMENTATION COMPLETION REPORT SRI LANKA PRIVATE FINANCE DEVELOPMENT PROJECT (CR. 2484-CE) Evaluation Summary' 1. Introduction - The Private Finance Development Project (PFDP) was a follow-up of seven industrial/financial credit lines from International Development Association (IDA) since 1979, totaling US$212.8 million. It was the first credit line to deviate from being directed to a selected category within the industrial sector (e.g., small and medium or large scale industries). This was mainly because the IDA felt that Sri Lanka's financial sector had developed adequate institutional capacity to allocate resources fairly efficiently. The total cost of the project was US$153.0 million with the IDA contributing US$60.0 million. The balance was provided by United Nations Agency for International Development (USAID), KfW2, participating credit institutions(PCIs), entrepreneurs and the Government. The USAID and the KfW provided funds under their bilateral lending programs even though at the appraisal stage they had agreed to co-finance. 2. Proiect Objectives - The main project objectives of the PFDP were: (a) improving efficiency of financial intermediation by supporting policy and regulatory reforms in the financial sector; (b) assisting domestic resource mobilization for long term investment by stimulating the development of the local bond market; (c) enabling private sector to respond to the changing economic environment by providing investment finance; and (d) help deepening the financial system and strengthening the key players in the financial sector. The main project components to support the above objectives were: (i) a credit component of US$138.8 million (IDA - US$57.2 million; PCIs and entrepreneurs - US$81.6 million) to provide investment capital for the industrial sector; and (ii) a technical assistance (TA) component of US$14. 5 million (IDA - US$2.5 million; USAID - US$7.0 million, KfW - US$5.0 million) for, (a) establishing a viable domestic bond market; (b) preparing the state-owned commercial banks for restructuring and recapitalization; (c) implementing the new accounting and auditing standards, debt recovery legislation and strengthening the bank supervision function of the Central Bank of Sri Lanka (CBSL); (d) continuing to upgrade the capabilities of Participating Credit Institutions (PCIs); and (e) supporting implementation of environmental standards by entrepreneurs, PCIs and regulatory agencies. The USAID provided technical assistance mainly for capital market development (Para. 68), while the KfW funded the Pollution Control and Abatement Fund (PCAF) (Para. 63 & 64). 3. The PFDP project objectives conforned to the country assistance strategy and provided the much needed investment capital for the private sector through the private banks. The project provided an impetus to creating a conducive legal framework for enhancing the domestic resource mobilization capacity of the private financial institutions. It also helped in increasing the supervisory role and the supervisory capacity of the CBSL and assisted capacity building in the PCIs. The risks identified at the appraisal (e.g., macro economic stability and I Provides cross-reference to paragraphs from Part I that provide more details. 2 KfW - Kreditanstaltfur Wiederaufbau 1  the conflict situation) affected the pace of policy reforms, especially the restructuring of the state banks and insurance sector as well as the investment climate. 4. Implementation Experience and Results of Policy Reforms - The results of policy component of the project were unsatisfactory. Some actions were taken but in most cases they did not result in achieving the desired outcomes as they addressed only the symptoms rather than the cause of the problems. The actions taken are reflected in the Attachment 1 of the main report. The Central Bank of Sri Lanka (CBSL) provided necessary legal framework to facilitate issuing of long term debt instruments. It also enhanced the market orientation of the debt market by introducing publication of information relating to treasury bill auctions (Para. 29-32). In addition, preliminary work had been initiated to introduce scripless trading of government debt securities and develop the secondary market (Para. 33-34). Furthermore, during the project period, the CBSL has taken several progressive steps to increase the diversification of the investment portfolio of the Employees Provident Fund (EPF) and also to improve the management efficiency of the EPF, thereby, bringing better returns to the beneficiaries (Para. 37-38). However, the Government's deficit financing policy would continue to constrain the ability of the EPF's management to increase flexibility in their investment decisions. The Government has taken several progressive steps towards increasing investment in non-governmental paper by the contractual savings funds. This is supplemented by measures to improve market orientation of open market operations (Para. 33 & 34). 5. The CBSL enhanced its supervisory capacity bringing the specialized licensed banks also under its supervision and improved the reporting systems (Para. 40-41). The MOFP and the CBSL also took positive steps to introduce disclosure policies that would improve the financial management, in not only the banking sector but also in the corporate sector (Para. 56). The required legal framework and the institutional arrangements are in place to ensure monitoring compliance. The banking sector continue to improve the technical expertise of their staff in the private as well as public sector banks to ensure sustainability of these reform programs. 6. However, the Ministry of Finance and Planning (MOFP) and the CBSL failed to commence on a major restructuring program of the state banks to improve their financial performance. They only had taken limited damage control measures to contain the expansion of the state banks (Para. 42-47). In addition, the Government could not finalize the new insurance law that would enable setting up the regulatory authority to provide a level playing field for the industry (Para. 48-49). 7. Implementation Experience and Results of the Credit Component - The performance of the credit component was rated satisfactory (Para. 58-62). The Government onlent funds directly to the PCIs, on a variable basis at the Average Weighted Deposit rate (AWDR)3. AWDR was selected as a reference rate specially to reflect the average cost of funds in the absence of a long-term yield curve. The credit was fully committed and the disbursements amounted to 96% of the approved amount. Although the PCIs included three commercial banks and the two Development Finance Institutions (DFIs), the DFIs accounted for 95% of the total commitments. The private banks' liquidity position was favorable with the increase in deposit mobilization and also due to a significant reduction in the CBSL' s statutory reserve requirements. The project assisted in generating capital investment of US$138.8 million in the industrial sector while the total employment generated was approximately 12,184. 8. The metal, chemical and plastic sub-sector led the lending portfolio (20.7%) under the PFDP followed by the services (17.5%), hotels (16.0%), textiles and garments (11.6%) and 3 Please to refer Part I- Page I foot note. .it  rubber and leather sub-sectors (9%) (Annex 6 -- Table 2). The funds were mostly accessed by the services sector mainly because there were other lines of credit available for small and medium scale industries from the IDA and the Asian Development Bank (ADB) during the initial period. Of the approved sub-loans, 80% was concentrated in the Western Province. (Annex 6-Table 3.). The continuing ethnic conflict and inadequate physical and economic infrastructure outside the Western Province contributed to this high concentration. 9. The textiles sector led the employment generation with 31% followed by metal, chemical sector with 18%, services with 12%, rubber and leather with 10% and hotels with 9%. The geographical distribution of employment creation almost reflected a similar trend except for Galle where employment generation was significantly higher with 11% compared to the credit disbursement of 3.4% (Annex 6: Table 2 & 3 ). 10. Most of the credit funds were committed ahead of schedule. In addition, with the effective monitoring by World Bank Colombo Office and National Development Bank (NDB), the undisbursed loans were reallocated several times in consultation with the PCIs to optimize the utilization of funds. 11. Implementation Results of the TA Component - The TA component was marginally satisfactory (Para 65-73) as both the MOFP and the Central Bank took more time than necessary to initiate the studies which were background work for some of the proposed reforms. Consequently the reforms in state bank restructuring, increasing domestic resource mobilization capacity and development of the debt market got further delayed. With the significant depreciation of the dollar against the SDR, the amount available for TA was substantially higher than the original allocation. The TA component was fully committed and disbursed by the close of the project. This was mainly due to the close coordination the IDA had with the implementing agencies. In addition, the Bank missions closely monitored the progress and ensured that the identified studies were prioritized and also ensured that proper procurement procedures were followed (Annex 8 - Table 1). 12. (a) Capacity Building of PCIs and other Financial SectorInstitutions - (US$921,232): The staff of the four PCIs, MOFP and CBSL participated in overseas training programs. In addition, Harvard University conducted two training programs on project appraisal which were organized by the two DFIs. It was an economical way of providing high quality training to a large number. In total, 198 PCI staff were trained in various aspects of banking such as credit management, financial management, treasury management, environment appraisal and project rehabilitation (Annex 8 - Table 2). The training courses were approved on the basis of relevance to the institutions and also on the skills of the staff trained. 13. The staff who were trained under the project belonged to all categories; junior, middle and senior management. Training focussed more on academic courses and less emphasis was given for exposure tours. In addition, the institutions were encouraged to select training courses in the Region and also focussed on capacity building. All the institutions continue their staff development programs using their own budget, which makes these training programs, funded under PFDP sustainable in the long run. This reflects the emphasis the bank management in Sri Lanka has placed on staff development. 14. (b) Domestic Resource Mobilization (Annex 9): Two major studies were conducted to improve the domestic resource mobilization capacity. One was for the development of portfolio management and capacity building in the Employees Provident Fund and the other was the automation of banking activities and government debt securities market. Central Bank of Sri Lanka has taken a series of steps to develop the government securities market and this study aimed at furthering these efforts. Both were successfully completed and the recommendations iii  are being followed up by the Central Bank. The USAID provided technical assistance for capital market development. 15. (c) Portfolio Audits of State Commercial Banks (Annex 9): The portfolio audits of the two state banks were completed on time despite the industrial action taken by the employees' unions during this period. The portfolio audits showed that with proper provisioning for bad loans, one of the state banks would require substantial capital infusion. It reflected the magnitude of the problems faced by the two state banks and provided background material for the MOFP and the CBSL to initiate a restructuring program in the state banks. 16. (d) CleaNet: One of the objectives of the TA provided under PFDP was to support implementation of environmental standards. With this in view, Pollution Control Abatement Fund (PCAF) was established with funding from the KfW. In addition, the IDA also identified during supervision that there was a need for creating a full service center on cleaner technology providing assistance to private industrial entities to complement PCAF activities. This facility has initiated the use of cleaner technology by the industrial sector and promoted strengthening public and private sector partnership. 17. Project Cost, Financing and Time 3chedules - The project was implemented satisfactorily without major problems. The project cost was estimated to be US$153.6 million at appraisal and the actual cost was US$153.0 million (Table 8A & 8B). PFDP was prepared, signed and became effective as originally planned. The disbursements were well ahead of the appraisal estimates in FY 95 & 96. As all the funds were committed on time, the project was closed on the originally planned date. 18. Project Sustainability - The overall commitment by the govemment for the industrial sector continued despite the change of government in 1994 and private sector continued to be the engine of growth. The internal efficiency and the strong financial performance of the PCIs continued during the period under review. The CBSL improved its bank supervisory capacity, which also strengthened the commercial banking sector especially during the East Asian crisis. The sub projects visited during the implementation completion mission revealed that the projects are financially viable and are planning expansion of their current operations. In addition, the PFDP also has strengthened the enforcement of environmental standards in the industrial sector. Despite weak compliance monitoring by the environmental regulatory authorities, the industries themselves seem to have adopted cleaner technology and also have introduced waste treatment facilities. In addition, due to the success of the project, other international financiers have been interested in the financial sector. Most of the other donors expect the IDA to take the lead in the financial sector reforms. However, the government's reluctance to proceed with the privatization of the state banks and insurance companies has had adverse implications on the financial sector development. The continued state dominance in the banking and insurance sector raises concerns on the long term sustainability of the sector. 19. II)A and Borrower Performance - At the identification, preparation and appraisal stages the political scenario was more conducive for financial sector reforms. The IDA had correctly identified the potential risks at the outset, which may affect the project. However, the project was too dispersed and lacked focus and contained many disconnected activities. Consequently, supervision was loaded with the task of following up scores of activities across the entire economy (Para. 19-23), thus, losing focus on policy reforms. 20. Initially the project was task managed by headquarters with support from the Colombo Office. After the task management was transferred to the Colombo Office, the supervision became more effective as there was close coordination between the implementing agencies and the IDA. In addition, frequent monitoring alerted the Govemment when the progress slowed iv  down. Especially with the close coordination with the PCIs, credit component was optimally utilized. The TA programs were frequently discussed with the MOFP and the CBSL and in consultation with the implementing agencies were modified to reflect the reform priorities and financial requirements. In addition, the task manager always sought technical advice from headquarters staff, which was promptly provided. The missions always demonstrated flexibility in reflecting the country's priorities and also coordinated well with the other donors and played the role of the financier of last resort while never relinquishing the mantle of taking the lead in the financial sector policy dialogue. The IDA, however, could not suspend the project as it would have affected the private sector banks. 21. The increased importance placed by the IDA during the last two years on procurement procedures indirectly slowed the procurement process of consultants. Major delays occurred in procurement as the Government did not have a strong central unit to attend to procurement of various consultants. As the security risk increased in the country after the Central Bank bomb explosion in 1996, they found it extremely difficult to obtain the services of consultants of high quality. Therefore, the implementing units had to spend a longer time searching for consultants. 22. The Borrower's performance was satisfactory on the credit component but was less than satisfactory on the policy implementation (Para. 24-28). Financial sector reforms committee was initially headed by the Secretary, MOFP till 1996 and was supported by a secretariat with staff dedicated for reforms. Subsequently, this function was brought under the CBSL and the Department of Financial Markets, in addition, to their routine work provided the secretarial support. Therefore, the coordination and monitoring was not as effective as the earlier institutional arrangement. Even though the project management of the TA component was weak, financial management was very satisfactory and the audit reports for the project as well as the PCIs were submitted on time. 23. The administration unit (AU) of the National Development Bank (NDB) handled the coordination of the credit component. The role of the AU was efficiently executed by the NDB and quarterly reports were submitted regularly. They also maintained a comprehensive database and administered the Pollution Control and Abatement Fund and coordinated the CleaNet sub-project (Para. 71). In addition, there was excellent coordination with the IDA, which helped, in optimal utilization of the PFDP funds. 24. Future/Follow-up Operations Findings and Lessons Learned - Following from the current financial and civil service reform programs, the MOFP and the CBSL have identified the urgent need for pension reform (Para. 74-76). In addition to addressing the demographic changes, the Government is keen to create a better investment climate for the contractual savings funds. The Government has commenced discussions with the IDA to design an overall reform program reflecting the priorities. The Bank has already responded positively to the request by obtaining a PHRD Grant for pension reforms and is preparing an overall strategy for pension reforms to be discussed with the Govemment. 25. In addition, the Government has also requested the IDA to assist them in the second phase of the financial reforms in further strengthening the regulatory environment while providing an intermediation loan. The IDA responded that if the Government is prepared to proceed with a private management contract for the two state banks, IDA would be happy to be associated with the second phase of the reform agenda. CBSL has identified that they require the services of consultants for several studies, even though, funding arrangements have not yet been finalized. They are, (i) the preparation of legislation for supervision of merchant banks, (ii) the formulation of a legal framework for licensing and supervision of money and foreign exchange brokers, and (iii) OMO operations. v  26. The PFDP provided an opportunity for the Bank to reflect the effectiveness of using a Financial Intermediation Loan (FIL) to address policy reforms in the financial sector. The findings and lessons learnt (Para. 77-89) from PFDP for future Bank operations are summarized below. On the positive side, PFDP demonstrated that the following measures contributed to the success of the project: Existence of an efficient administrative unit, Supporting reforms through different governments, * Lead taken by the CBSL and MOFP in the policy dialogue, *\ . IDA's continuous coordination with the senior staff of the CBSL and MOFP, Awareness of the need for reform among all the financial sector policy makers as well as senior officials in the financial sector institutions, and * Timely quarterly reviews. 27. While on the negative side, the following deficiencies adversely affected the impact of the project: Lack of commitment by MOFP at the implementation stage, Lack of a central coordinating unit in the Central Bank with representation from MOFP for sector reforms, Bureaucracy being too sensitive to the political environment, Absence of an overall framework for financial sector, Lack of coordination among departments within the same organization, Inability to set up strong regulatory authorities to improve governance, and . Less leverage for reforms under a FIL. vi  IMPLEMENTATION COMPLETION REPORT SRI LANKA PRIVATE FINANCE DEVELOPMENT PROJECT (CR. 2484-CE) PROJECT IMPLEMENTATION ASSESSMENT A. Statement/Evaluation of Objectives 1. The Private Finance Development Project (PFDP) was a follow-up of seven industrial/financial credit lines since 1979 from International Development Association (IDA), totaling US$212.8 million. It was the first credit line to deviate from being directed to a selected category within the industrial sector, specially as the IDA felt that Sri Lanka's financial sector had developed adequate institutional capacity to allocate resources fairly efficiently. The total cost of the project was US$153.0 million with IDA contributing US$60.Omillion. The balance was provided by United Nations Agency for International Development (USAID), KfWD, participating credit institutions (PCIs), entrepreneurs and the Government. The USAID and the KfW provided funds under their bilateral lending programs even though at the appraisal stage they had agreed to co-finance. 2. The main project objectives were: (a) improving efficiency of financial intermediation by supporting policy and regulatory reforms in the financial sector; (b) assisting domestic resource mobilization for long term investment by stimulating the development of the local bond market; (c) enabling private sector to respond to the changing economic enviromnent by providing investment finance; and (d) helping deepening the financial system and strengthening the key players in the financial sector. 3. Project Components: To achieve the above project objectives, PFDP had identified the following specific project components to be funded: (a) Improvements in Policy Framework: The project was expected to support wide ranging reforrns in the policy and regulatory environment in the financial sector, especially mobilization of domestic resources for investments through commercial channels. (b) Investment Credit Component (IDA-US$57.5 million, PCIs and entrepreneurs - US$81.6 million): This component was expected to provide funds to Participating Credit Institutions (PCIs) for term loans to private enterprises, irrespective of their size or sub-sector. The Government on lent funds directly to the PCIs, on a variable rate at the Weighted Average Deposit Rate(AWDR)2. The project also was intended to increase domestic resource mobilization capacity of PCIs by financing only 60% of the loan amount. The project was also to create a Pollution Control and Abatement Fund to help existing industries to comply with environmental standards. KfW- Kreditanstaltfur WiederauJbau 2 AWDR - Represents the weighted average of the interest rates paid to depositors by branches in the greater Colombo area of domestic commercial banks (other than national savings bank) on interest bearing term deposits, as issued weekly by the Central bank of Sri Lanka, calculated on the basis of the previous 26 week period. 1  (c) Technical Assistance (TA) Component (IDA - US$2.5 million, USAID - US$7 million, KfW - US$5 million): The project was expected to provide assistance in preparation and implementation of policy reforms including, (i) establishing a viable domestic bond market, (ii) preparing the state-owned commercial banks for restructuring and recapitalization, (iii) implementing the new accounting and auditing standards, debt recovery legislation and strengthening the bank supervision function of the Central Bank of Sri Lanka (CBSL), (iv) continuing to upgrade the capabilities of PCIs, and (v) supporting implementation of environmental standards by entrepreneurs, PCIs and regulatory agencies. The USAID provided technical assistance for capital market development while the KfW funded the Pollution Control and Abatement Fund (PCAF). B. Achievement of Objectives 4. The objectives of the PFDP conformed to the Country Assistance Strategy. When extensive financial sector reforms were proposed in early 1 990s, there was political stability in the country. At the outset of the project in 1993 and 1994, the draft legislation -- relating to introduction of long term debt instruments, increasing the scope of bank supervision by the Central Bank, increasing investments of National Savings Bank (NSB) and other institutional investors in non-government paper -- were prepared by the financial sector reforms committee. This was done in consultation with the stakeholders such as private and public sector financial institutions as well as the industry to develop the long-term debt market (Annex 1). The legislations have assisted in developing the debt market introducing debt instruments of longer term maturities, better supervision of the banking sector by the Central Bank and increasing the ability of the banking sector to mobilize resources in the domestic as well as international financial markets. However, with the assassination of the incumbent President in 1993 and a series of parliamentary and presidential elections and the eventual change of Government in 1994, the reform program was delayed till 1995. Despite the change of Government, the Central Bank's and the Ministry of Finance's focus of financial sector reforms, remained on improving the performance of the two state banks and improving the regulatory framework for the financial sector, particularly, in the domestic resource mobilization arena by continuing to provide the required legislative framework. 5. The PFDP line of credit catered to the much needed investment capital for the corporate sector. It complemented the Small and Medium Industries (SMI) IV Project which provided financial resources mainly to the small and medium industries and also Asian Development Bank's (ADB) Development Finance line of credit. The project could generate investments to the tune of US$137.0 million in the industrial sector while providing additional employment opportunities for 12,184 during a period of six years. 6. The technical assistance provided for the capacity building of the PCIs and the other financial institutions has been found effective. All these institutions continue with their staff development programs even after the close of the project, thus ensuring sustainability. In addition, it is remarkable that while in most countries the Development Finance Institutions (DFIs) failed, the two DFIs in Sri Lanka during the project, diversified their activities while maintaining the focus on development finance and became premier financial institutions in the country. At the end of the project both were functioning purely as private sector companies. 7. The support in enforcing environmental regulations in the industrial sector, which commenced under SMI IV, was continued under PFDP by enhancing pollution control and abatement measures. In addition, the project also assisted in increasing awareness among industrialists, the need to introduce cleaner technology, which would eventually reduce cost of production. High level of environmental awareness by industries was evident during the site visits. 2  8. During the implementation of the project, the main objectives were not changed. However, the desired level of success in reforms could not be achieved as the government commitment slackened during the implementation stage due to the fact that some of the reforms were seen as politically sensitive measures. The financial sector reforrns were delayed but were pursued at a slower pace without any backsliding. The MOFP and the CBSL failed to commence on major restructuring program of the state banks to improve their financial performance. They had only taken limited damage control measures to contain expansion and the continued state dominance in the financial sector raises serious concerns about the long term sustainability of the financial sector. C. Major Factors Affecting the Project 9. Factors not generally subject to Government Control: The Central Bank and the Ministry of Finance and Planning (MOFP) were affected twice by the terrorist bomb explosions, one in 1996 and the other in 1997. These events severely affected the reform program as well as the technical assistance program. In addition, the assassination of the incumbent President in 1993 and the subsequent series of elections and the eventual change in Government in 1994, further delayed the reform program. The severe power outages in 1996 also had an adverse impact on the industrial sector and the disbursements and collections were affected slightly during 1997/98 (Table 4). The conflict situation continued in the North and East and sporadic attacks in the main cities including Colombo, affected the investment climate in the country. 10. Factors subject to Government Control: There was overall commitment on the financial sector policy reforms from the inception of the project specially as the reform program was based on recommendations of the presidential commission on financial sector reforms. However, the Government continued with deficit financing which lessened the ability of the pension funds to diversify their portfolio. Despite the Government introducing a favorable regulatory environment for the long-term debt market, the inability to maintain fiscal discipline adversely affected the implementation capacity. However, there was lack of commitment on the part of the MOFP with regard to the proposed insurance law despite extensive consultations with the stakeholders. In addition, after 1995, the secretariat of the financial sector reforms committee was not as effective as the previous one. After it was absorbed by the Central Bank, the functions got diluted with the routine bank work and with the bomb explosion in 1996, the staff also got displaced. However, most of the activities that came under the purview of the CBSL were effectively carried out eventhough with delays while the work that came under the purview of the MOFP was not effectively coordinated by the secretariat. In addition, the MOFP was unduly concerned of possible bank employee trade union action and kept on deferring the decision to restructure the two state banks. I1. Factors subject to the Implementation Agencies Control: There was no strong institutional arrangement for the coordination of the technical assistance program. Therefore, the IDA had to take the lead in initiating the TA activities except for PCI training. With the signing of the performance agreements in 1993 and 1998 with the two state banks, more autonomy was vested with the state bank management. However, there is little evidence that the management of both banks exercising the autonomy they were granted under the agreements. The positive measures such as compliance with branch rationalization and staff recruitment were taken as damage control measures rather than proactively restructuring the banks to improve efficiency. The MOFP also did not provide leadership to the reforms required in the insurance sector. 3  D. Project Sustainability 12. Finance Sector Policy reforms: The overall commitment by the Government for the industrial sector continued even after the change of Government and adequate funds were made available for SMI lending specially with both IDA and ADB funds. In addition, the two state banks financed SMI sector with their own resources and PFDP funds were channeled to the corporate sector. Especially during 1993/1994, the tourist industry improved significantly and the investments escalated in the services sector. The Government continued to consider the private sector, the engine of growth. However, the Government's reluctance to proceed with the privatization of the state banks and the insurance companies and the state dominance in these two major sub sectors raise serious concerns on the long term sustainability of the financial sector. 13. Participating Credit Institutions: The internal efficiency and the strong financial performance of the participating private commercial banks and the two development financial institutions continued during this period. In addition, the supervisory capacity of the Central Bank was also strengthened. Eventhough during 1998/99 there was some concern over the perfonnance of few domestic banks, the CBSL is following closely the developments in the banking sector and certain measures have been recommended to arrest any further deterioration. Since 1998, some of the private banks seemed to feel the lagged impact of the contagion effect of the East Asian crisis. 14. Industrial Sector: The recent site visits (Annex 1 1) undertaken by the implementation completion mission revealed, that except for one, all the projects visited would be sustainable in the long run and also most of them are planning expansion of their current operations. In addition, the project also has strengthened the enforcement of environmental standards in the industrial sector. Despite weak compliance monitoring by the environmental regulatory authorities, the industries themselves seem to have adopted cleaner technology and also they have introduced waste treatment facilities. 15. In addition, due to the success of the project, other international financiers have been interested in the financial sector. However, most of the other donors expect the IDA to take the lead in the financial sector reforms. Even the ADB and the OECF follow most of the tenns and conditions of the IDA. However, the continued absence of IDA in an active role for a long period might result in creating distortions in the financial sector. Unlike the IDA, other donors have a tendency to fund ad-hoc TA sub projects in the financial sector without requiring the Government to carry out reform measures. 16. The Government has taken several progressive steps towards increasing investment in non- governmental securities by the contractual savings funds3. This is supplemented by measures to improve market oriented open market operations (Para. 31 & 34). The MOFP and the Central Bank also took positive steps to introduce disclosure policies in the financial sector which will improve the financial management, in not only the banking sector, but also in the corporate sector. The required legal framework and the institutional arrangements are in place to ensure monitoring compliance. The banking sector continue to improve the technical expertise of their staff in the private as well as public sectors to ensure sustainability of this reform programs. 17. In addition, the impact of improvement of debt recovery legislation has reflected in increasing the recovery of bad loans by exercisingparate execution powers. The project and the other donor-funded projects with their coordinated effort have been able to enhance the domestic resource mobilization capacity of the financial institutions. The financial institutions have started mobilizing resources from the financial market issuing corporate debentures. During the last two 3 Employees Provident Fund (EPF), Employees Trust Fund (ETF), Insurance companies and National Savings Bank 4  years the corporate debentures of Rs. 3.9 billion have been raised in the market. In addition, the issue of commercial paper (Rs. 8.3 billion in 1999 up to June, Rs. 16.5 billion in 1998 and Rs. 11.1 billion in 1997) too has increased significantly. 18. In May 1997, ADB guaranteed a loan of US$55 million to National Development Bank (NDB) for the SMI sector. Government signed an agreement with OECF for another loan of US$46 million for small and micro enterprises. KfW has also granted DM 2 million for micro credit to be channeled through the NGO system. In addition, NDB raised US$20 million for the industrial sector on commercial terms from FMO, Netherlands Development Finance Company. Another loan of US$22 million from the OECF was obtained by the NDB to top up the Pollution Control and Abatement Fund. This facility extended the scope to existing as well as new companies addressing pollution abatement techniques while the KfW provided DM 5 million also for the PCAF in addition to the previous DM 5 million they had provided. Another US$1.2 million had been made available from USAID for capital market development in addition to the initial US$7.0 million. E. IlDA's Performance 19. At the identification, preparation and appraisal stage the political scenario was more conducive for financial sector reform. The IDA had identified the potential risks, which may affect the project but the project was too dispersed and lacked focus and contained many disconnected activities. Consequently, supervision was loaded with the task of following up scores of activities across the entire economy. Therefore, the identification and preparation of the project cannot be considered satisfactory. (Table 1) 20. IDA's identification of the project was consistent with the Government development strategy. It was commendable that even with a change of Government and current ruling party being a coalition of socialist parties, the MOFP and CBSL still continued with the proposed reform program. It was also commendable that the senior bureaucrats, who led the reform program prior to 1994, could convince successfully the new political leaders, the need for reform. Initially the project was task managed by headquarters with support from the Colombo Office. After the task management was transferred to the Colombo Office, the supervision became more effective as there was close coordination between the implementing agencies and the IDA. In addition, frequent monitoring alerted the Government when the progress slowed down. Especially with the close coordination with the PCIs, credit component was optimally utilized with several rounds of cancellations and subsequent replacements prior to the commitment deadline in March 1998 to remove slow moving subprojects. This project demonstrated the difficulty in using a financial intermediation loan as a vehicle for sector reforms as the suspension would have caused problems for the private banks and investors. The IDA, however, sent a strong message to the Government that unless Government makes a firm commitment and proceed with financial sector reforms at a faster pace and minimize the role of the state in the financial sector, the IDA would limit its financial sector operations to policy dialogue on sector reforms. 21. In addition, the TA programs were frequently discussed with the MOFP and the Central Bank and in consultation with them were modified to reflect the reform priorities and financial requirements. With regard to the disbursement and implementation it was an effective mechanism. Supervision was more effective from Colombo office as quick decisions on procurement could be taken on time. In addition, the task manager always sought technical advice from headquarters staff, which was promptly provided. The missions always demonstrated flexibility in reflecting the country's priorities and also coordinated well with the other donors and played the role of the financier of last resort while never relinquishing the mantle of taking a lead in the financial sector policy dialogue. However, the Government perceived that the IDA' s interest in the country's 5  financial sector had lessened specially as the Bank did not frequently field high powered missions during the last few years and made use of the annual meetings in Washington to discuss the financial sector issues. 22. The increased importance placed by the IDA during the last two years on procurement procedures indirectly slowed the procurement process of consultants. Major delays occurred, especially, as the Government did not have a strong central unit to attend to procurement of consultancy services. As the security risk increased in the country after the Central Bank bomb explosion in 1996, they found it extremely difficult to obtain the best services possible. Therefore, the implementing units had to spend a longer time searching for consultants. 23. Iii addition, the IDA worked very closely with the IMF to ensure that there was consistency with the approach taken towards the financial sector reform. All the other donor agencies --- ADB, SIDA and USAID --- followed the leadership provided by the IDA creating a consensus on the reform program among the major donors. F. Borrower Performance 24. Financial sector reforms committee was initially headed by the Secretary, Ministry of Finance and was supported by a secretariat with staff dedicated for reforms till 1996. Subsequently, this function was brought under the Central Bank and the Department of Financial Markets in CBSL, in addition to their routine work, provided the secretarial support. Therefore, the coordination and monitoring was not as effective as the earlier institutional arrangement. However, despite delays, the Governor and the Senior Deputy Governor of the Central Bank coordinated the reform program. Some of the activities that came under the purview of the MOFP had been disappointing as there was lack of ownership of the reform program especially in the insurance and state bank restructuring. (Para. 49 & 50) 25. The administration unit (AU) of the National Development Bank (NDB) handled the coordination of the credit component. The role of the AU was efficiently executed by the NDB and quarterly reports were submitted regularly. The quarterly reports were also forwarded to all the PCIs for their information. They also maintained a comprehensive database and administered the Pollution Control and Abatement Fund and coordinated the CleaNet sub-project (Para. 70). In addition, there was excellent coordination with the IDA, which helped, in optimal utilization of the PFDP funds. In addition, financial management of the project was satisfactory and all the audited financial accounts of the PCIs and the audit report of the project were submitted on time. 26. The lending proceeded well. The funds were committed on schedule and with close supervision by the IDA, the undisbursed loans were cancelled and the PCIs were given the opportunity to submit new applications, which increased the disbursement level. Of the eligible PCIs, about 95% of the disbursements was handled through the DFIs as the commercial banks had excess liquidity during the project period due to increased deposit mobilization. 27. However, this project provided an opportunity for financial sector policy dialogue and the missions' findings were well appreciated by the Ministry of Finance and the Central Bank. The senior managers of both institutions as well as other public and private financial institutions were cooperative in providing information and discussing the issues with the IDA missions. Also during this period, despite the political resistance to reform, the senior management in these institutions have commendably tried to proceed in the right direction. 6  28. The PCIs continued to meet -with the requirements of eligibility criteria and the collection performance of all the banks continued to be above the required minimum of 80% and all the PCIs met the capital adequacy ratios. G. Assessment of Outcome Implementation Results of Policy Reforms (Attachment 1) 29. Strengthening Monetary Policy and Domestic Resource Mobilization: The Monetary Board approved a package of reforms in August 1995 to commence active market-based open market operations and to develop the secondary market for government securities. In order to introduce these measures, a series of amendments to legislation governing these activities were introduced (Annex 1). The reforms addressed both short and long term debt instruments. 30. Short-term debt instruments were made more market oriented, with the commencement of publication of information relating to treasury bill auctions and the introduction of more competitive bidding through the primary dealers. In addition, Non Bank Financial Institutions were excluded from the inter-bank call money market activities to ensure a level playing field for all participants. 31. As agreed the CBSL established an open market operations division and also a committee to implement the proposed measures introduced through legislation. Open Market operations are being conducted on an increased scale and the CBSL is increasingly improving their daily liquidity assessment system linking with the commercial banks. 32. The most important step taken during the period under review was the introduction of long-term treasury bonds commencing with the two year treasury bonds with fixed coupon rate of interest in March 1997. These are market based and are permitted to be transferred by endorsement. Since then, the CBSL has progressively introduced treasury bonds with longer-term maturities reaching 6 years in 1999. This measure assisted in developing a medium term yield curve and as a result the number and the volume of corporate debenture issues have also increased significantly during the last two years (Rs. 3.9 Billion). By increasing issue of more market based long term maturities, CBSL is planning to phase out rupee securities which however, had a the stock of Rs. 255.3 billion as at end of August 1999. By improving the trading system of government securities through dedicated primary dealers, the CBSL envisage promoting the secondary market for debt instruments. In addition, the CBSL expects an active role by the primary dealers in the debt securities market and intend to set up a primary dealer surveillance system funded by the IDA during year 2000. 33. CBSL has completed a feasibility study to automate the CBSL and inter bank transactions in order to introduce a scripless trading system for government securities and set up Real Time Gross Settlement Systems (RTGS). These measures were aimed at strengthening the open market operations, improving the effectiveness of monetary instruments and the development of a secondary market for government debt securities (Annex 9). The proposed system in addition to quick settlement, would facilitate cheque clearing in districts outside Colombo. In addition, the CBSL finds it difficult to issue bonds with longer-term maturities exceeding six years without scripless trading. The expected foreign participation in government securities market would not be possible with the current manual system. 34. This will inevitably increase the volume of transactions and the fund transfer system will significantly improve. At present due to the long transaction time taken, the transactions are limited and create market distortions. In addition, the securities market has been confined to 7  Colombo. If the Central Bank expedite the automation of banking sector and scripless trading, the market participants will also increase significantly. 35. The Cabinet has already approved amendments to the Monetary Law Act to, (a) make price stability the main objective of CBSL in order to avoid possible policy conflicts, (b) revise the definition of money supply to take into account "broad money", (c) remove the maximum and minimum limits on statutory reserve ratios, (d) provide more flexibility to the Monetary Board to decide the basis for computation of the required reserves, (e) enable payment of interest on reserves, and (f) enable imposition of reserve requirements on the financial liabilities other than deposit liabilities. The Legal Draftsman is preparing the second draft and it is expected to be submitted to the Parliament by end of 1999. However, as the legislative procedure takes a long time it is likely to get postponed to the first quarter of 2000. 36. The CBSL has promoted the setting up of a Credit Rating Agency(CRA) in collaboration with the International Finance Corporation (IFC). The Credit Rating Agency has been established as a joint venture public company with a leading international rating agency in USA and other international and local financial institutions. The office has been established and the CEO and the key staff have been recruited and been given initial training overseas by their international technical partner. This will assist in developing the debt market by servicing the investors and the market expects an increase of foreign investor participation. 37. Another significant step for domestic resource mobilization was the decision of the Central Bank to diversify the Employees Provident Fund's (EPF) investment portfolio. A consultant has prepared investment guidelines for the (EPF) and also the selection criteria for external fund managers. In addition, the PFDP provided partial funding for the development of internal portfolio management expertise and it is expected to be continued under the proposed PHRD Preparation Grant for pension reforms. The EPF is in the process of implementing the recommendations of the study. As the investment guidelines have been prepared, EPF intends to continue further diversifying its investment portfolio. EPF has also embarked on a computerization and modernization program in order to improve its operational efficiency and keep abreast of the changing technological development which will bring better returns to the savers. 38. In addition, proposals are being explored to amalgamate the EPF and Employees Trust Fund (ETF) to minimize administration costs. The ETF is reportedly exploring possibilities of converting the ETF to a pension fund and also annuitizing the payments. However, it would be advisable to take this measure after careful study and also conducting a proper actuarial assessment to ensure the sustainability of such a scheme. Measures are also being taken by the EPF to eliminate double counting and eliminate a large number of dormant and multiple accounts once Labor Department and the EPF complete the computerization exercise. In addition, in 1999, the EPF has been able to absorb all administration costs by the generated capital gains from operations in the secondary market for treasury bonds and equities. The EPF performance has been impressive during the last few years and the Central Bank seems to be serious with the reform agenda. 39. The DFIs and the private domestic commercial banks continue to suffer from lack of low cost funds. However the resource mobilization capacity of the banking sector has improved significantly. The annual accounts for 1997 and 1998 reflect a significant increase in their deposit base by 24.3% and 22.4% respectively. In addition, there were medium term debenture issues by financial institutions to raise funds amounting to Rs. 3.9 billion during the last two years, which were all over subscribed. Most of the banks argue that they have a mismatch of funds; short term deposits which need to be matched with long-term investment needs. DFIs are facing the problem of lack of funds specially as they are not deposit taking institutions, which had led them to diversify their activities. However, with the drying up of multilateral funds on concessionary terms 8  the banks are exploring possibilities of using innovative financial instruments to be more competitive in the financial sector. Improving Efficiency in the Banking Sector 40. Bank Supervision by Central Bank: The 1995 amendments to the Banking Act strengthened the supervisory powers for the CBSL and extended supervision to specialized licensed banks 'and incorporated all prudential requirements based on international standards. CBSL continued its efforts in improving bank supervision especially in the light of the recent East Asian financial crisis. Central Bank has improved the on-site and offsite supervision, making that a primary function of the CBSL. By requiring financial disclosure polices, the CBSL has improved the financial discipline of the banks and has addressed the issues in a more systematic manner to avert any major crisis in the banking system. Central Bank is well aware of the need to monitor foreign exchange exposure of the banking sector to avoid a similar problem faced by the East Asian countries. Central Bank is taking proactive measures to ensure bringing foreign currency banking units under the supervision of the CBSL. The avenues of communication between the CBSL and banks have been remarkably strengthened by appointing compliance officers at the commercial banks to ensure compliance in banking and other statutory requirements. In addition, the CBSL is planning to introduce a deposit insurance scheme to provide a level playing field for the private banks. Central Bank also proposes to tighten the loan loss provisioning to ensure the financial viability of the banking sector. 41. The bank supervision department staff is at present about 80 of which 50 are professional staff. In mid 1998, setting up a faculty for bank supervision in the CBSL has intensified the training of examiners. Three specialists with commercial banking and bank supervision experts were recruited. During the project period the Central Bank had taken significant steps towards strengthening the supervision capacity of the Central Bank and the Monetary Board has seen this as one of the most important functions of the Central Bank. In view of the recent East Asian crisis the Central Bank has identified the need to keep the foreign exchange exposure of the banks also under close scrutiny. 42. Performance of State Commercial Banks (SCBs): One of the main objectives of the project was to down size the state banks through restructuring and eventual privatization. Due to strong political resistance, the MOFP and the CBSL could not proceed with the privatization but the share, in terms of total assets, deposits and advances of the state commercial banks, had gradually declined. 43. The SCBs accounted for 55% of the total commercial bank assets in 1998 compared with 64% in 1993. The share of the deposit base of the SCBs during the last 4 years has declined by 7.0% reaching 56.6% while the advances have declined by 9% reaching 53.3% in 1998 (Annex 3). A notable feature is that the branch network of the state commercial banks has declined marginally to 618 in 1998 from 620 in 1995 while the private domestic banks have increased the branch network significantly by increasing the branches from 214 to 296 during the same period. 44. Comparing the efficiency ratios (Annex 3) it was observed that the net interest margins of the state banks (4.4%) were marginally higher than the private banks (4.1%) in 1998 while the employee expenses were 2.5% for state banks while for the private domestic banks was 1.8% in 1998. Non-performing ratio in state banks was 17.3 % while in the private sector domestic banks it reached 11.0%. The recent portfolio audits of the state banks revealed that this figure was much higher reflecting the need to address this issue immediately. Total employees in the state commercial banking sector was 20,732 while private banks had 10, 223 in 1998. It is notable that 4DFCC, NDB, NSB, SMIB, Pramuka, SANASA and 6 Regional Development Banks 9  the average employees per bank branch is 34 for state banks while the private sector had 35 in 1998. This is in the background of having a large internal security staff in the two state banks due to the conflict in the country since the 1980s. However, it is creditable to note that the Ministry of Finance and the Central Bank with their close monitoring and supervision had been able to contain the branch network and resist any political pressure for mass recruitment to the state commercial banking sector despite a series of elections since the project commenced in 1993. This can be attributed to the agreements signed with the two state banks and also the continuous supervision and dialogue the MOFP and the CBSL had with the banks and IDA despite its failure to make the two state banks more commercially viable. 45. During 1993 and 1996 there had been two rounds of capital infusion by the Government in terms of long term bonds; Rs. 23 billion and Rs. 20 billion respectively. Despite the inability of the two state banks to comply with the targets set out in the two agreements, one in 1993 (Annex 4:Table 1) and another in 1998, the MOFP had not taken any serious remedial measures due to the political instability in the country. As seen in the Annex 4: Table 2, Bank of Ceylon (BOC) failed to reach the agreed targets on profits, return on assets and return on capital but achieved loan recovery targets, staff and overhead costs. Peoples' Bank (PB) however has not achieved any of the targets agreed except loan recovery for 1998. Non-performing loans has reached a significantly high level and required provisioning would entail significant capital infusion. 46. According to the CBSL evaluation report the Government had not issued any directives to any of the two banks during 1998 and 1999. After an evaluation by a committee consisting of CBSL and MOFP, both banks have been requested to adopt a uniform transfer pricing system. Even though the loss making branches have been reduced none of the loss making branches were closed due to political pressure. 47. The Central Bank and MOFP have taken measures to bring in advisors to the two state banks with international commercial banking experience and also the BOC will conduct a study to explore the possibility of restructuring the bank and there is a likelihood of a management contract for the state banks in the future. The IDA has offered assistance to the Government if the Government is prepared to initiate a private management contract for the two state banks. However, the continued state dominance in the banking sector will have an adverse impact on the banking sector and raises serious concerns on the sustainability of the financial sector in the long run. 48. Improving Competitiveness in the Insurance Sector: Government has not been consistent with the decision to privatize the two state insurance companies. At last in 1999 after a long delay, a steering committee to restructure National Insurance Corporation (NIC) was set up with representation from PERC, MOFP, NIC, CBSL which can be considered a significant step in the right direction. On their recommendation, the Cabinet approved divesting up to 39% of NIC and also there is no restriction on foreign investor participation. It was also reported that the committee had initiated discussions with the employees of NIC to ensure their support for restructuring. If this proves to be successful, the GOSL is likely to proceed with the divestment of Sri Lanka Insurance Corporation Ltd. too. 49. Insurance Act: After the initial drafting of the new Insurance Law in 1996, the taskforce was extremely slow in finalizing it. It has been reviewed by various stakeholders over the past four years causing undue delay mainly due to lack of leadership provided by the MOFP. The proposed amendments would improve regulatory framework, enable insurance companies to pursue more diversified portfolio management, reduce market segmentation and increase competition. The draft Law also provides for an autonomous regulatory authority for insurance. At present, the Insurance Controller functions on a part time basis and is unable to obtain the required technical staff under the present institutional structure. The Controller's office lack the capacity to regulate and 10  supervise the industry and cannot attract qualified staff in its present form. The agreed target date of presenting the Insurance Bill to Parliament keeps getting postponed indefinitely. The industry feel that the passage of the new Insurance Law would provide an opportunity to establish a strong technical secretariat to supervise the industry. Recent missions of the World Bank who visited Sri Lanka during April and also in June 1999 to assist the Finance Ministry in setting up a Regulatory Authority for Private Pension Funds advised them that due to lack of qualified people in this field it would be better to set up a single regulatory authority for both pension/provident funds and insurance. Despite repeated assurance given by the MOFP during the last few years, the law has not yet been enacted. 50. Diversifying investment portfolio of Contractual Savings Institutions (CSls): The CSIs were expected to diversify their investment portfolios by investing minimum previously agreed amounts in non-government securities (Annex 5). 51. EPF: At the commencement of the project it was proposed that the EPF Act should be amended to permit the EPF to invest in non-government securities. There was resistance from the trade unions. Subsequently, the CBSL managed to obtain a ruling from the Attorney General confirming that the EPF Act provides for investment in non-government securities and decision making powers are vested with the Monetary Board. EPF invested Rs. 300 million in 1995 and about Rs. 712 million in DFCC and NDB long-term debentures in 1996. In addition, EPF invested about Rs. 418 million in 1998 and Rs. 417.0 million in 1999. 52. ETF: Setting up the ETF was to increase share ownership of the employees in private companies. However, due to lack of fund management capabilities of the ETF board of management, returns on investments had not been better than the EPF as most of the funds were invested in government securities. 53. NSB: According to the NSB Act 60% of their investment should be in government securities which allow them to invest up to 40% in non-government securities. The investments in non-government securities have gone up from 11.1% in 1993 to 19. 4% in 1998. 54. Insurance: Both insurance companies' investment in the non-government securities have been in the region of 35-56% during 1993-98. 55. The contractual savings institutions seem to lack fund management expertise and hence the investments are made for short-term gains. Either in-house fund management capacity needs to be enhanced or experienced external fund managers should manage the funds with a proper surveillance system in place. This is the approach EPF is taking presently with regard to portfolio management and other institutions will also need to follow their strategy, which will provide an impetus to the capital and debt market. In addition, the fund management of the CSIs should be insulated from any external pressure. 56. Better Accounting andAuditing Standards: Accounting and Auditing Standards Act was passed in 1995 which provides for Institute of Chartered Accountants of Sri Lanka (ICASL) to legally enforce accounting standards adopted by ICASL. Law provides for an accounting and auditing standards committee whose task is to recommend to ICASL the adoption of standards. It also mandates the Accounting and Auditing Standards Monitoring Board (AASMB) to monitor compliance with the standards. Both committees have been appointed and the AASMB was constituted in January 1997. In 1999 February, all the standards were gazetted and all the companies listed or specified in the regulations were required to comply with the standards for the annual audits of 1999. The secretariat of the AASMB was constituted after some delay but still has a skeleton staff. However, the effectiveness of monitoring compliance by this institution is yet to be seen as they have not yet commenced official monitoring. They have already prepared the 11  procedures for compliance monitoring. In'addition, both Central Bank and the Securities Exchange Commission (SEC) require the banks and listed companies respectively to follow the gazetted accounting standards to in the corporate and financial sectors. It is important that staff of regulatory authorities be compensated adequately if they are to function effectively. If the government does not act to provide adequate compensation, it will hamper not only the recruitment of qualified and competent staff for AASMB but also for all the other existing and proposed regulatory authorities. These measures will invariably improve corporate governance. 57. Taxation Incentives for Financial Instruments: Announcements were made in the 1998 and 1999 budgets to reduce taxation of the financial instruments to develop the capital and debt markets. The removal of most of the taxes on debt instruments helped the creation of a level playing field for both debt and the equity markets. This has been evident in the increase of corporate debenture issues by financial institutions in 1998 and 1999. 58. Implementation Results of the Credit Component: This was the first of a series of credit lines made available to the industrial sector as IDA was moving away from directed credit and the funds were on-lent by the GOSL directly to PCIs, on a variable basis at the Average Weighted Deposit rate(AWDR). AWDR was selected as a reference rate specially to reflect the average cost of funds in the absence of a long-term yield curve. 59. By March 31, 1998, the credit component was fully committed; (68% above free limit; the average loan size was about Rs. 8.8 million). The current disbursements amounted to US$54.6 million or 96% of the approved amount. Although the PCIs included three commercial banks and the two DFIs, the DFIs accounted for 95% of the total commitments (NDB 46%, DFCC 49%). The private banks' liquidity position was favorable with the increase in deposit mobilization and also due to a significant reduction in the Central Bank's statutory reserve requirements. According to the number of subloans approved, DFCC accounted for 62% while the NDB accounted for 33% (Annex 6: Tablel). The project assisted in generating capital investment of US$137.1 million in the industrial sector while the total employment generated was approximately 12,184. 60. The metal, chemical and plastic sub-sector led the lending portfolio (20.7%) under the PFDP followed by the services sector (17.5%), hotel sector (16.0%), textiles and garments (11.6%) and rubber and leather (9%) (Annex 6 - Table 2). This was mainly due to the availability of other credit lines from IDA and Asian Development Bank (ADB) during the initial period. At the later stages except for the DFIs other banks had excess liquidity with the slump in the stock market as well as with the reduction in reserve requirements of commercial banks by the Central Bank. Of the approved sub-loans 80% was concentrated in Colombo, Kalutara and Gampaha districts followed by 11.2% in Kandy and Matale, 3.4% in Galle and 3.2% in Anuradhapura. (Annex 6- Table 3.). The continuing ethnic conflict and inadequate physical and economic infrastructure outside the western province contributes to this high concentration. Same trend has been reflected in other lines of credit as well. In addition, it'has also been reported that the companies find it difficult to attract professionals out of the Western Province due to lack of infrastructure facilities. 61. The textiles sector led the employment generation with 31 % followed by Metal, Chemical sector with 18%, services with 12%, rubber and leather with 10% and hotels with 9%. The geographical distribution of employment creation almost reflected the same trend except for Galle where employment generation was significantly high with 11 % compared to the credit disbursement of 3.4%. (Annex 6: Table 2 & 3 ) 62. Most of the credit funds were committed ahead of schedule. In addition, with the Colombo office and NDB's effective monitoring, the undisbursed loans were cancelled several times in consultation with the PCIs and they were requested to submit new applications, which improved the level of utilization of the credit. 12  63. Pollution Control and Abatement Fund (PCAF) : PCAF was a fund established to provide investment funds at low cost to industrial enterprises for waste minimization, resource recovery, pollution control and abatement. This component was originally to be co-financed by the Government of Netherland. However, their assistance program was pruned down and KfW agreed with the government to co-finance PCAF. This was available for industrial enterprises established before January 1995. In 1994 by law, all the new institutions were required to obtain environmental protection licenses from the Central Environmental Authority. Therefore, on the premise that all new industries would ensure compliance with environmental standards at the outset itself, the existing industries were provided with financial assistance at zero real interest rates to ensure pollution control and abatement. 64. Initially KfW, provided GOSL with US$5.0 million for the PCAF which NDB administered on behalf of the GOSL. The fund became operative in April 1995 and was fully committed (Rs. 331.4 million for 88 projects). Of the total projects, they are distributed evenly among all sectors; textiles, food and beverages, agro-industries and fisheries, rubber, plastic and leather and hotel sector (Annex 7-Table 1). Of these, 52% were located in Colombo, Gampaha and Kalutara while the other significant area was Puttalam where prawn farms were concentrated (Annex 7-Table 2). In addition, KFW provided an additional US$3.5 million for the PCAF. Another credit line of US$22.0 million has been signed up by the OECF called "E-friends". The scope of the OECF project is broader than the PCAF. In addition, to the new projects they have also included energy conservation. The PFDP;s involvement in environmental subprojects generated interest of other donors as well. 65. Implementation Results of the TA Component: The TA component was marginally satisfactory as both the MOFP and the Central Bank took more time than necessary to initiate the studies which were background papers for some of the proposed reforms. With the significant depreciation of the dollar against the SDR, the amount available for TA was substantially higher than the original allocation. The TA component was also fully committed and fully disbursed by the close of the project. This was mainly due to the close coordination, the IDA had with the implementing agencies, especially the Central Bank and National Development Bank. In addition, the missions closely monitored the progress and ensured that the identified studies were prioritized and also ensured that proper procurement procedures were followed. Most of the studies had to be postponed as the bomb explosion in 1996 adversely affected the Central Bank reform activities. Some of the staff who were involved in those activities were killed or badly injured. With the dislocation of the Central Bank the work could not be continued on a normal scale. (Annex 8 - Table 1) 66. Capacity Building of PCIs and otherfi-nancial sector institutions: (US$921,232) The four participating credit agencies, NDB, DFCC, Sampath Bank and Hatton National Bank staff participated in overseas training programs. In addition, Harvard University conducted two training programs on project appraisal which were organized by the two DFIs. In total, 198 PCI staff were trained in various aspects of banking such as credit management, financial management, treasury management, environment appraisal and project rehabilitation (Annex 8 - Table 2). The Harvard courses on project appraisal that were held in the country trained about 70 PCI staff and the organizers felt that it was a cost effective way of providing high quality training to a large number. The participants also have reported that the courses were useful and helped in enhancing their knowledge. In addition, international training was provided for staff in the Ministry of Finance, Institute of Policy Studies, Central Bank and the Inland Revenue Department. The training courses were approved on the basis of relevance to the institution and also to suit the skills of the staff trained. 67. The staff who had been trained were junior, middle and senior management. Training focussed more on academic courses and less emphasis was given for exposure tours. In addition, 13  the institutions were encouraged to select training courses in the region and also focused on capacity building. All the institutions continue their staff development programs using their own budget, which makes these training programs, funded under PFDP sustainable in the long run. This reflects the emphasis the bank management in Sri Lanka has placed on staff development. 68. Domestic Resource Mobilization ( Annex 9): Most of the technical assistance came from the U SAID for the development of debt market in the form of consultants. Under the USAID Financial Markets project, technical assistance was provided for ICASL, CSE, SEC and CBSL to, (i) improve quality of capital market information, (ii) draft legislation for long term debt instruments, (iii) design a computerized system for bank supervision, (iv) improve analytical capability of market participants by conducting Chartered Financial Analysts programs, and (v) capacity building. Some of the draft legislation relating to developing domestic resource mobilization were supported through these technical assistance programs. Under the IDA Technical assistance component two major studies were carried out. One was for the development of portfolio management and capacity building of the Employees Provident Fund and the other was the automation of banking activities and government debt securities market. The Central Bank has taken series of steps to develop the government securities market and this study aimed at furthering these efforts. Both were successfully completed and the recommendations are being followed by the Central Bank. 69. Portfolio Audits of State Commercial Banks (Annex 9): The portfolio audits of the two state banks were completed on time despite the industrial action taken by the employees' trade unions during this period. The portfolio audits show that with proper provisioning for bad loans, one of thie state banks would require capital infusion. In order to improve the management capacity, the Ministry of Finance has advertised for management advisors with international commercial banking experience to assist the two state banks. The MOFP is yet to launch a major restructuring programs for the two state banks and raises concerns on the financial viability of these institutions which will have adverse implications on the overall banking sector. 70. CleaNet: One of the objectives of the TA provided under PFDP was to support implementation of environmental standards. With this in view the PCAF was established with co- financing. In addition, the IDA also identified during supervision that there was a need for creating a full service center on cleaner technology providing assistance to private industrial entities to complement PCAF activities. The CleaNet is to assist clients to identify the most cost effective option for meeting environmental regulations and improving production efficiency through clearing house and information brokering, networking and training, facilitating pollution prevention audits and eventually promoting waste exchange among industrial units. The main activities undertaken were: (a) Training: Training was provided for the implementing agencies to familiarize with the management and networking systems required for an information clearinghouse function and attended international seminars, (b) Public awareness: Both CCC and ITI engaged in advertising to draw attention of the industrialists to the availability of this facility through different forms of media. (c) Outreach: The function was to widen the out reach, which was successfully accomplished by the project unit. 71. Impact of the CleaNet activities: The Internet connections provided by the CleaNet signaled the genesis of virtual outreach activities. Clients could request information in electronic form. The envisaged waste exchange program was also launched in cyberspace. CleaNet is well equipped to facilitate potential waste exchange. The training provided under the CleaNet for staff of the implementing agencies provided opportunities to ascertain the positive and negative aspects of this facility in other countries. Visits to other countries reveal that without external support this activity cannot be sustained and therefore the CleaNet focussed on revenue generating activities such as workshops and seminars. The CleaNet also has established international links with databases. The CCC has also signed a memorandum of understanding with the Confederation of 14  Indian Industry (CII) to facilitate information and training and would be able to facilitate cost- effective Indian technology to Sri Lankan industries. A list of sources of audio visuals on cleaner production case studies, clean technology data bases, a comprehensive listing of internet resources have been compiled for use of industrialists. 72. The outreach activities have created a keen awareness among the industrialists and it is evident from the inquiries received by the CCC. Also through increased coordination the clients are informed of the PCAF facilities. It is evident that the two institutions have been able to reach the industrialists and have achieved the objectives of this sub project. In addition, the business manager has been absorbed into the CCC and also the ITI continue these activities as part of their work plan which show the commitment of these two institutions in improving environmental standards of the industrial sector in the country. The project has been able to create a core group of staff in both these institutions who will continue with the functions after the close of this project. They have created a website to disseminate information on cleaner technology. Both CleaNet and PCAF had promoted the industries to be more self regulated in pollution control and created an awareness for adopting cleaner technology projects. 73. With the close of the PFDP CleaNet has requested funds from the Environmental Action 1 Project funded by IDA. In keeping with the original scope of work to become a full service center for private industries, CleaNet is expected to design and deliver activities in the following areas: (a) Environmental Policy Services : to facilitate industry representation on various policy-making fora of the government. (b) Training and Advisory Services : to continue with one-on-one advisory services and continue with training seminars. (c) Information Dissemination and Outreach Services: to continue with strengthening the databases, publications, and CleaNet newsletter. (d) Information and Clean Technology Brokering Services : to facilitate technology transfer to business entities and act as a middleman to assist industries contacting possible suppliers of clean technology. (e) Facilitation of Pollution Prevention and Audits: Actively promote the benefits of cleaner production through training and awareness programs. (f) Waste Exchange Program : Facilitate waste exchange by industrialists. H. Future Operations 74. Following from the current financial and civil service reforn programs, the MOFP and the CBSL have identified the urgent need for pension reforms. In addition to addressing the demographic changes the Government is keen to create a better investment climate for the contractual funds. The Government has commenced discussions with the IDA to design an overall reform program reflecting the priorities. The Bank has already responded positively to the request by obtaining a PHRD Grant for the pension reforms and is preparing an overall strategy for pension reform to be discussed with the Government. 75. In addition, the Government also has requested the IDA to assist them in the second phase of the financial reforms in further strengthening the regulatory environment while providing an intermediation loan. The Bank responded that if the Government was prepared to proceed with a private management contract for the two state banks, the IDA would be happy to be associated with the second phase of the reform agenda. 76. The CBSL has identified that they require the services of consultants for several studies eventhough, funding arrangements have not been finalized. The areas are: (i) the preparation of 15  legislation for supervision of merchant banks, (ii) the formulation of a legal framework for licensing and supervision of money and foreign exchange brokers, and (iii) assisting OMO operations. I. Key Lessons Learned 77. EfficientAdministrative Unit: Setting up an efficient administrative unit(AU) made a very significant contribution to the success of the project. This unit has been identified not only by the IDA but also by other donors such as ADB, KfW and OECF as the AU to execute their projects. 78. Supporting Reforms through different governments - If IDA can identify champions for "reforms" in the bureaucracy, reform programs are sustainable even through different political regimes. 79. Lead taken by the CBSL and MOFP in the Policy Dialogue: In the areas where political resistance was less, these two institutions took progressive steps and also managed to keep the reform program on track. 80. IDA's continuous coordination with the senior staff of the CBSL and MOFP: It provided an opportunity for IDA to bring to the notice of the senior policy makers the issues relating to the slow progress in the financial sector. 81. Awareness of the needfor reform among all the financial sector policy makers as well as officials in the financial sector institutions : There was enthusiasm on the part of the senior management on policy issues. In addition, the officials of the CBSL and few senior officials of the MOFP were aware of the need and made every effort to implement the reform measures despite political resistance. 82. Timely Quarterly Reviews: The regular quarterly reviews enabled the credit funds to be disbursed effectively. This is a practice the IDA needs to replicate in all projects. This not only helped in better supervision but also the institution became identified with the project. In addition, there was capacity building in project management. 83. Lack of Commitment by MOFP at the implementation stage: The decision making process in the MOFP was rather slow which affected the reform program. In addition the policy makers did not adequately impress upon the political leaders the need for reform measures in the state banks. That was mainly due to the absence of regular meetings by the financial sector reform committee. Despite the fact that MOFP came under the direct purview of the President, the Financial Sector Reform Committee did not make that an opportunity to forge ahead with the reform program. 84. Lack of a Central Coordinating Unit in the Central Bank with representation from MOFP: At the inception of the project the secretariat was headed by senior well accepted officials in the financial sector. However, with the transfer of the secretarial work to the Central Bank, even minor issues had to be cleared with the top management of the CBSL. In addition, the CBSL believed that they had no mandate to coordinate reform measures outside the CBSL. Therefore, in future IDA should require that the government set up a strong full time coordinating unit to ensure effective follow-up. 85. Bureaucracy being too sensitive to the political environment: The MOFP and the CBSL could have prepared technical papers to convince the political leaders the need for reform in many 16  sectors. Therefore, the financial sector reform committee should periodically keep the cabinet and parliament informed of the reform agenda. 86. Absence of a Framework for Financial Sector: Due to the absence of a reforrn framework, the Government had the tendency to approach reforms in an ad-hoc manner whichever they believed were politically feasible. Hence, some of the activities, which had no strong ownership by implementing agencies, were not pursued eventhough they played a major role in the overall program such as insurance. 87. Lack of Coordination among Departments within the Same Organization : This is a weakness in Sri Lanka in general. However, lack of coordination also created resistance from different departments of the same organization. It would have been more effective if the staff of the implementing institutions were well briefed of the overall financial sector development strategy and what their specific role was. 88. Inability to set up Strong Regulatory Authorities to improve Governance: The Government's inability to offer adequate compensation for staff of the regulatory authorities hamper establishment of strong regulatory authorities to improve good governance. 89. Project Leverage small but ownership by reformers was strong although diminished over time: This project reflected that the difficulty of using a financial intermediation loan as a vehicle for sector reforms. If the project funds were suspended the private sector banks and investors would have been affected. 17  Attachment 1 Implementation of Policy Measures Agreed at Negotiations Agreed Conditions Reform measures taken Compliance Remarks Rating Improve domestic The Monetary Board approved a package of reforms in August 1995 to Legal framework resource mobilization commence active market-based open market operations and to develop the - satisfactory. secondary market for govermnent securities. Measures included closure of the secondary treasury bill window and repurchase window, commencement of open market operations at market rates, activating the bank rate, exclusion of non-bank financial institutions (NBFIs) from inter-bank call money market and granting permission for non-bank primary dealers to maintain accounts at the CBSL for the purpose of settling securities transactions. Increase market Since May 1995, CBSL has been publishing the maturity structure of the Marginally The Central Bank was orientation of short term Treasury Bills at each auction on a weekly basis together with the average yield satisfactory cautious implementing as debt instruments rates to make the short term debt instruments more market oriented. Competitive they did not have the bidding by captive sources such as National Savings Bank (NSB) and expertise. In addition, the Employees' Provident Fund (EPF) commenced in May 1995. The captive bomb explosion and the re- sources were phased out from direct bidding to bidding through the primary location of the bank also dealer system. In addition, non-bank financial institutions were excluded from had an adverse impact on the inter-bank call money market activities to ensure a level playing field for all the performance. participants. To ensure that the rules governing OMO operations are legally enforceable the guidelines for open market operations certain regulations are being drawn up by the Central Bank. Regulations relating to OMO for outright sales, purchases, repurchase and reverse repurchase of Treasury bills and bonds and CBSL securities are being currently drafted by the CBSL and are expected to be gazetted in early 2000. In the interim, the CBSL has re-introduced the reverse repurchase facility for treasury bills and bonds for commercial banks and primary dealers from November 1998 at a pre-determined rate. The secondary treasury bill window and repurchase window at pre-determined rates will be 18  Agreed Conditions Reform measures taken Compliance Remarks Rating replaced when market oriented OMO commences. The bank rate has also been activated as informed earlier. Introduce long terni debt The CBSL publishes the treasury calendar for the treasury bonds, every quarter Satisfactory instruments and improve in advance, to provide market information for the primary dealers. During 1997 the secondary debt the government had issued Rs. 10 billion worth of treasury bonds, mostly two- market for government year bonds. Treasury bonds to the tune of Rs. 39.0 billion were issued in 1998 securities and about Rs. 67.5 billion would be issued by end of 1999 of which Rs.4. billion would be with 5 year maturities. Six-year treasury bonds were issued in September 1999 for the first time. CBSL is also taking measures to expand the volume of treasury bonds to match the rate at which rupee securities are maturing and eventually the rupee securities will be phased out. However, at the moment the stock of rupee securities amounts to Rs. 255.3 billion as at end of August 1999. The CBSL has approved accepting treasury bonds as collaterals for reverse repurchase which promotes developing the secondary market for the long-term government securities. In order to enforce requirements for creating a market and specifying a minimum level of participation in the primary auctions and secondary markets, the public debt department has issued guidelines on minimum level of participation for primary dealers in treasury bill and bond auctions, which are being monitored continuously. Inactive primary dealers are being de-listed. Primary dealers have formed an association (PDA). The CBSL requires the primary dealers to set up their own separate company, which will develop the government debt securities market; primary and secondary. They are to be dedicated only to trading in government securities. At present most of them are commercial banks and there is conflict of interest in promoting debt instruments. At present, CBSL has a stock of Rs. 200 Billion worth of short and long termn government securities for trading. However, in the long run, the primary dealers should also be permitted to trade corporate bonds as well to develop the secondary market. In addition, the primary dealers are in the process of _ preparing a code of conduct. A study on primary dealer surveillance was 19  Agreed Conditions Reform measures taken Compliance Remarks Rating expected to commence in September 1999 but has been postponed due to the non-availability of some of the consultants proposed. However, CBSL is keen to set up a surveillance system to monitor the primary dealers as they play a major role in government securities market. Therefore, this study is an integral part of the main reform program and the development of the debt market. A private company has developed a trade matching system for the primary dealers, which will be purchased by them, once the new companies are formalized. Consultants assisted the CBSL to design a system and drawing up technical specifications for hardware and software in order to set up a scripless securities settlement system and electronic fund transfer system. However, the CBSL feels that the current volume of transactions is not sufficient to justify initial investment that is required. Therefore, the CBSL is exploring other options. Improving Bank The following measures have been taken: Satisfactory supervision capacity