Ghana - Financial Sector Adjustment Project

Document of The World Bank FOR OFCIAL USE ONLY Report No. P-4781-GH REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXLCUTIVE DIRECTORS ON A PROPOSED CRErIT OF SDR 72.1 MILLION TO THE REPUBLIC OF GHANA FOR A FINANCIAL SECTOR ADJUSTMENT PROJECT May 9, 1988 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 Current Unit - Cedi Cedi 1.00 = US$0.0055 US$1.00 - 181 cedis (Februiary 1988) GLOSSARY OF ABBREVIATIONS ADB - Agricultural Development Bank AfDB - African Development Bank ASM - Accra Securities Market Barclays - Barclays Bank of Ghana BHC - Bank for Housing and Construction BOG - Bank of Ghana CCH - Credit Clearing House CDH - Consolidated Discourt House COCOBOD - Cocoa Marketing Board Coep Bank - Ghana Cooperative Bank ERP - Economic Recovery Program GCB - Ghanq Conmmercial Bank GIC - Gha.aa Investments Cei.ter GOG - Government of Ghana NIB - National Investment Bank NSCB - National Savings and Credit Bank PNDC - Provisional National Defense Council SOE - State-Owned Enterprises SSB - Social Security Bank SSNIT - Social Security and National Insurance Trust Standard - Standard Chartered Bank of Ghana  FM OFFMAL US ONLY GHANA FINANCIAL SECTOR ADJUSTMENT CREDIT Table of Contents Page No. CREDIT AND PROJECT SUMHARY ..................................i I. THE ECONOMY . ............................................1 A. Background ........................................1 B. The Economic Recovery Program ..... ................1 C. Medium-Term Prospects ............................. 3 II. THE FINANCIAL SECTOR ....... ........................ . 4 A. Background ................................... . 4 B. The Structure of the Financial Sector ............. 4 C. The Policy and Regulatory Framework .... ........... 5 1. Deposit Mobilization ......................... 5 2. Credit Allocation ............................ 6 3. Liquidity Management ......................... 7 4. Money Market ................................. 8 5. Capital Market ..... ..... .................... 9 6. Regulatory Policies .......................... 10 7. Banking Supervision .......................... 11 III. AN AGENDA FOR ACTION .................... ............... 11 A. Measures to Improve Deposit Mobilization and to Increase the Efficiency of Credit Ailocation .... 12 1. Deposit Mobilization ......................... 12 2. Efficiency of Credit Allocation .... .......... 12 3. Efficiency of Banking Operations .... ......... 13 4. Money Market ................................13 5. Capital Market ..... ...... ................... 13 B. Amending Laws and Regulations ........ . .......... 14 C, Bankinp Supervision ............................... 15 D. Bank Restructuring ................................ 15 E. Corporate Restructuring ........................... 17 F. Rural Finance ..................................... 17 C. Foreign Exchange Risk ............................. 18 IV. THE PROPOSED CREDIT ......... ........................... 18 A. Origin and Objectives .................8....... ... i B. The Macroeconomic Context ............. ..... 19 C. Description ....................................... 19 1. Sector Reform Component ................. I ... 19 2. Technical Assistance Component .... ....... ... 19 D. Procurement and Disbursement .. 20 1. Sector Reform Component ...................... 20 2. Technical Assistance Component .... ........... 21 This dorumeni 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 authorintin  Pale No. 3. Monitorable Actions . 21 1. Conditions for Effectiveness .21 2. Conditions for Second Tranche Release 22 3. Conditions for Third Tranche Release 22 F. Justification and Risks ..23 1. Justification .23 2. Risks . 23 V. UAK GROUP OPERTIONS _ 24 VI. COLLABORATION WITH THE IF . ..25 1. Fund Relations with Ghana. 25 2. Bank-Fund Collaboration .25 VII. UICOHHNDATION .. 25 1-1 Key Economic Indicators '-2 balance of Payments 1-3 External Financing Requirements 2-1 Assets and Liabilities of Banks 2-2 CDP/Money Supply 2-3 Deposits and Their St:ucture 2-4 Total Bank Credit to Private Sector and Public Enterprises by Sector 3-1 Study of Measures Needed to Enhance the Money Markets 3-2 Study of Potential for a Stock Market 3-3 Technical Assistance Program for the Bank of Ghana 3-4 Technical Assistance to Support the Establishment of a Credit Cloaring House 3-5 Technical Assistance for the Institute of Chartered Accountants 3-6 Technical Assistance Program for Bankers' Training 3-7 Terms of Reference for a Bank Restructuring Adviser 3-S Corporate Restructuring 3-9 Technical Assistance and Studies - Summary of Costs 4 Stat em nt of Financial Policy 5 Status cf Bank Group Operations in Ghana Map  - i - GHANA FINANCIAL SECTOR ADJUSTMENT CREDIT Credit and Proiect Summary Borrower: Republic of Ghana Credit Amount: IDA: SDR 72.1 million (US$100 million equivalent) Tcrms : Standard IDA terms with 40 years maturity Progrum Description: The credit would support a comprehensive and far-reaching Government program for the development of a well functioning -nd broadly-based financial sector, through the implementation of in-depth policy and institutional reforms. An action program has been prepared with Bank assistance to cover the 1988-1990 period and to be supported by the proposed credit. The main objectives of the program are (i) the enhanced soundness of banking institutions, through an improved regulatory framework, strengthened banking supervision by the Central Bank (Bank of Ghana), and the restructuring of financially distressed banks, (ii) improved deposit mobilization and increased efficiency in credit allocation, and (iii) development of money and securities markets. Program Benefits: The reform program is expected to foster the development of a strong, efficient, and responsive financial sector, with an effective banking system at its core, to provide the needed support for the ongoing structural adjustment effort. The liberalization of interest rates and removal of sectoral ceilings will gr?atly contribute to enhancing the efficiency of financial intermediation by channeling savings to higher yielding investments. The restructuring of financially distressed banks, training programs for their employees, and improvement in the supervision by the Bank of Ghana should ensure the soundness of future banking activities and increase confidence in the banking system. The development of money and capital markets and an initial program for corporate r4structuring would stimulate private investment. The reform program would also provide for the development of the profession of auditors and accountants. Program Risks: The main risk relates to the inherent complexity of undertaking a sector-wide restructuring of the banking system which requires the strong commitment ,.f the Ghanaian authorities as well as the full cooperation of the 3anks' management. Other risks include the timely and adequate availability of resources, and the strain the project will place on the country's implementation capabilities.  - ii - These risk. are, however, mitigated by (a) the Government's commitment to undertake banking restructuring on a sound basis, in accordance with principles formulated in consultation with IDA, and to se%. IDA's agreement on individual restructuring plans prior to their implementation; (b) the tranching of the credit, which would further ensure satisfactory progress in the implementation of the sector reform program overall, and of banking restructuring in particular; and (c) finally, the sector reforms contained in the Action Program, in particular the liberalization of interest rates, the improvement of the regulatory framework and strengthening of Central Bank supervisory functions, which are expected to go a long way in ensuring the future competitiveness, efficiency, and soundness of the banking system. Financ in Plan: (US$ million) IDA US$100 Cofinanciers US$140 Government (1) US$ 60 Private Sector USS 25 TIS $3 25 (1) Principally through the conversion of loans into equity/quasi-equity and repurchase by Government of Ghana (GOG) of non-performing loans to state-owned enterpr(ses (SOEs.. Eat imated Disbursements: The credit would be disbursed in three tranches: The first tranche of US$45 million equivalent would be available upon effectiveness, the second of US$30 million after a first performance review to be held around February 1989 and the third tranche of US$20 million equivalent after a second performance review to be held around December 1989. IDA's disbursements have been adjusted to take into consideration the fact that contributions from two main other doftors, Japan (US$55-70 million equiv'alent.., and African Development Bai'k (AfDB--US$50 million equivalent) would be available for second and third tranches only. Disbursements of the US$5 million equivalent technical assistance component are not tranched, but will be monitored through an implementation schedule. Staff Araisal Report: This is a combined President's and Appraisal Report. No. 18112R1  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT TO THE REPUBLIC OF GHANA FOR A FINANCIAL 'PCTOR ADJUSTMENT PROJECT 1. I submit the following report and recommendation on a proposed development credit for the equivalent of SDR 72.1 million (US$100 million equivalent) to the Republic of Ghana on standard IDA terms to help finance a Financial Sector Adjustment Project. I. THE ECONOMY A. Bac1ixround 2. A report entitled Ghana: Pc'.cies and Issues of Structural Adjustment (Report No. 6635-GH) was distributed to the Executive Directors in March :987. Key economic indicators appear in Annex ;-1. 3. Ghana once enjoyed a high standard of living compared with most other West African nations. But drought, poor economic policies, and increases in oil prices led to a significant decline in per capita income during the 1970s and early 1980s. Ever since the inception of the Economic Recovery Program (ERP) in 1983, however, GDP growth has averaged above 5Z a year, about 2Z over the growth rate of the population. But the per capita income remains low at $380 (1985), and an estimated half of the population lives in absolute poverty (Annex 1-1). 4. The country is well endowed with natural and human resources. Agriculture accounts for 412 of GDP and provides income for about 70Z of the population. Ghana is the world's third largest producer of cocoa, which accounts for about two-thirds of the country's export earnings. The country also possesses valuable mineral deposits, particularly gold, and hydropower generates most electricity, some of which is exported to neighboring countries. Manufacturing output increased substantially after Independence in 1957, due to government policies that encouraged import substitution industries behind a wall of protection. Services, which account for over a third of GDP, are dominated by retail and wholesale trade. B. The Economic Recovery Program 5. Between 1970 and 1982, per capita income in Ghana declined by 30Z, import volumes fell by a third, real export earnings halved, domestic savings and investment fell to almost negligible levels, and inflation ran at an average of 44Z a year. In 1983, the newly constituted Provisional National Defense Council (PNDC) introduced an Economic Recovery Program to reverse the decline in living standards and restore growth to the economy. 6. The ERP's major objectives were to: (a) shift relative prices in favor of production, particularly for exports and efficient import substi- tution; (b) restore fiscal and monetary discipline; (c) initiate the restoration of the country's social and economic infrastructure; and (d) encourage private investment. The centerpiece of the reform was a move to  - J. - introduce a more realistiL exchange rate. The cedi was devalued from 2.75 cedis to the U.S. dollar in April 1983 to 90 cedis to the U.S. dollar by January 1986. In September 1986, the Government introduced a second tier auction system, and in February 1987 the auction and official exchange rates were officially unified. Initially the auction was limited to producer goods, but its coverage has been expanded steadily, and by February 1988 all imported gcods were eligible for funds from the auction. Administered prices, particularlf cocoa and petroleum, have been adjusted at regular intervals to reflect changes in the exchange rate, and widespread price and distribution controls have been abolished. Interest rates were adjusted upwards steadily, and finally in September 1987 all interest rates except those for savings deposits were liberalized. In the area of fiscal policy, the Government's efforts have concentrated on eliminating subsidies, mobilizing resources through improved Lax collection and selective increases in taxes, and providing more adequately for maintenance and capital expenditures. In addition, the Government raised public sector wages and salaries to offset partially the drastic erosion of real incomes in previous years. At the same time, it reversed the previous severe compression of salary differentials between the lowest and highest paid members of the civil service. 7. The response of the economy was crippled initially by the drought in 1983 and insufficient aid flows. Since 1984, however, performance improved on several counts. Growth averaged over 5? a year, the Government's fiscal position inproved markedly, the rapid growth of the money supply was curbed, and the trade balance improved substantially (Annex 1-2). In addition, the Government introduced significant improvements in public expenditure policies. It initiated rehabilitation programs for infrastructure in the cocoa, timber, gold, and transport sectors. At the same time, the Government prepared a rolling three-year development program based on reviews of public expenditures conducted jointly with IDA. At this stage, the high level of inflation (39X in 1987) remains a major concern. The main reasons are (i) the significant devaluation of the currency in 1986, (ii) the decline in food production, (iii) the increase in domestic petroleum prices, (iv) a 50X rise in M2 in the latter half of 1986. However, there are signs that inflation is decelerating. The national consumer price index rose only 5.1? in the second semester of 1987. 8. The second phase of the Government's ERP (sometimes termed the Structural Adjustment Program) is currently under implementation and has as its principal objectives continued economic growth, sustained fiscal and monetary discipline, increased levels of domestic savings and investment, improvements in the efficiency of public resource management, and further development of the private sector. To achieve these goals, the Government is moving on five broad fronts. It is progressively liberalizing its trade and exchange rate policies by expanding the official foreign excharge market to include banks and authorized dealers, and by rationalizing the structure of trade taxes and tariffs. To maintain racent production gains in the cocoa sector, additional incentives are being provided for cocoa producers and steps are being taken to improve the efficiency of COCOBOD's operations. The Government is improving public resource management by further improvements in tax policy and administration and in refining the public expenditure planning process. The efficiency of the public sector is being enhanced through a reform of the state-owned enterprise sector, which includes policy changes to encourage the commercial operation of SOEs, rehabilitation of priority SOEs, and a divestiture program for SOEs through liquidation or outright sale to  - 3 - the private sector. And finally, the Government is improving its manage nt of the public sector by reducing the number of surplus civil servants, recruiting skilled Ghanaians to strengthen policy planning and coordination in the higher reaches of the Government, and providing logistical support to agencies responsible for implementing the Structural Adjustment Program. 9. Ghana's total external debt in 1987 was estimated at US$2.6 billion, including 1.76 billion medium and long-term foreign debt. According to IMF and World Bank estimates, the country's foreign debt is likely to increase over the years, reaching 3.24 billion in 1990 and 4.6 billion in 1995, with medium and long-term debt reaching 2.49 and 3.74 billion, respectively. In 1987, the debt service ratio excluding IMF and arrears was 26.3Z (60.52 including IMP deb service and payment of arrears), down from 37.4Z the previous year. However, this debt-service ratio is expected to decline steadily in the future, reaching 30.1Z (including DMP debt-service and payments of arrears) by 1990 (Annex 1-3). 10. To support the ongoing reforms, and to facilitate the restructuring and rehabilitation of the economy, Ghana needs an efficient and dynamic financial sector that both mobilizes domestic resources and allocatee them efficiently to different sectors of the economy. However, like some other sectors of the economy, the formal financial sector remains burdened by the legacy of its past, and is consequently unable to cope with the demands placed upon it by the Structural Adjustment Program. The banking system, in particular, faces severe financial difficuities, which if left unaddressed, could hamper the future progress of the economy, and constrain seriously the supply response to the new incentive framework that the Government has intioduced. To address these problems, and to place the entire financial system in Ghana on firmer foundations, the Government has prepared a comprehensive financial sector action program that it has already begun to implement. The proposed credit would support the implementation of the program and finance technical assistance to strengthen key financial institutions. C. Medium-Term Prospects 11. The Government's medium-term objectives, as stated in its policy framework paper, are to achieve an annual average growth rate of real CDP of about 5Z, reduce the inflation rate to 8SZ by 1990, and maintain a healthy ualance of payments position after meeting its program for the liquidation of external arrears. The GDP growth target of 52 per year will require a strong performance from both agriculture and industry. In agriculture, cocoa is expected to continue its recovery, and the prospects for food and industrial crops appear bright. And in the industrial sector, the rehabilitation of Ghana's mines will permit the steady expansion of mining output, and manufacturing is projected to respond to improved incentives and the greater availability of spare parts and inputs. Ghana's macroeconomic prospects, however, are contingent upon a continuation of its present structural adjustment program and a tavorable international economic environment, particularly for its principal exports of cocoa and gold. In addition, the expansion of the economy will depend crucially on the availability cf concessional assistanc3 at the projected levels.  II. THE FINANCIAL SECTOR A. Backaround 12. Work on Ghana's financial sector began some two years ago, as the structural adjuatment process was underway, because the financial system appeared to be potentially a serious constraint to grcwth in the real sectors. This culminated in a major review in April 1S87 by V joint 'working group' of Ghanaians and Bank staff which identified key problems and proposed a wide ranging program of reforms (the Action Program) which the present operation intends to support. B. The Structure of the Financial Sector 13. The formal financial system is dominated by three primary commercial banks (the Ghana Commercial Bank (GCB), the Standard Chartered BAnk of Ghana (Standard), and the Barclays Bank of Ghana (Barclays)), seven secondary banks (the Soci&l Security Bank (SSB), the Bank of Housing and Construction (BHC), the Agricultural Development Bank (ADB), the National Savings and Credit Bank (NSCB), the National Investment Bank (NIB), the Merchant Bank, and the Bank of Credit and Commerce), a small cooperative bank, Ghana Cooperative Bank (Coop Bank), and over one hundred rural banks. Of the total assets of the banking system of around 156 billicn cedis (about 25Z of GDP), some 57Z are in the three primary banks, although the secondary and rural banks have been growing faster. All the primary and secondary banks accept deposits from the public and with the exception of the Bank of Credit and Commerce, are either partly or wholly owned by the Government. Annex 2-1 details the aggregate assets and liabilities of the banking system. 14. The three government-owned development finance i;lstitutions have increased their level of commercial banking activity in recent years, and at the end of 1986, one-quarter of their outstanding liabilities was accounted for by demand, savings, and time deposits. Nevertheless, they face serious financial difficulties arising from a huge foreign exchange exposure and/or loss, a substantial non-performing portfolio, and a complete erosion of net worth. 15. The rural banks are owned and managed by their respective local communities. They are private unit banks established to mobilize resources in rural areas and extend credit locally. The Bank of Ghana has usually contributed to the initial capital of each rural bank with the intention of divesting its holdings to the private owners at a later stage. Despite the large number of rural banks, the rural banking sector accounts for under ,Z of the total deposits mobilized by the banking system as a whole. A large number of rural banks are in financial difficulties, but their "unit nature has contained the effect of this problem on the banking system. 16. The money market is composed of the recently opened Consolidated Discount House Ltd. The Discount House is charged with the task of acting as an inter-bank intermediary for short-term assets to enable banks to manage better their liquidity position. The Consolidated Discount House is permitted to deal in treasury bills, short-dated governmeat securities, bankers' acceptances, cocoa bills, negotiable short term certificates of deposit, and commercial paper.  - 5 - 17. Ghana possesses a very rudimentary capital market that has been unable to make a substantial contribution to the mobilization of long term resources. The few transactions that occur are usually in long dated government stock, and shares of private companies change hands occasionally. The National Trust Holding Company quotes shares of eighteen companies on a monthly basis, but its insufficient capital base and the limited number of tradeable shares in the system have prevented it from playing a more active part in capital market transactions. 18. The remaining non-banking sector is limited principally to the Social Security and National Insurance Tru6t (SSNIr) and eleven insurance companies. SSNIT is a government-owned institution charged with providing social security payments to workers upon their retirement from service. All enterprises with five or more employees must become members of SSNIT and contributions amount to 17.52 of the wage bill, 52 of which are contributed by workers and 12.52 by employers. Out of a membership of 1.5 million, however, only about 600,000 pay their monthly dues. Until late 1986, SSNIT was compelled to invest its funds in government stock specially created for It, yielding 5.52 to 62, but it now has the freedom to invest its funds in assets of its own chocesing. As a result it has been a major purchaser of treasury bills and long dated government securities. 19. Like the rest of the economy, the banking system in Ghana has suffered adversely from the generally low-level of productive activities during the period of economic decline, although a few institutions are reportedly profitable and relatively efficient. Its current distressed situation can be characterized inter alia by (i) huge non-performing loan portfolios, (ii) inadequate provisions for portfolio losses, (iii) inflated profits, (iv) high operational costs, (v) potential/actual foreign exchange exposure, (vi) insolvency, (vii) capital inadequacy, and (viii) inadequate accounting systems, management information and internal controls. Comprehensive externai diagnostic audits by international auditors have been undertaken for the nine main banks (GCB, SSB, Barclays, BHC, NIB, ADB, Standard, NSCB and Coop Bank) to obtain an indepth and accurate assessment of the operating and financial condition of each of these banks, and provide a basis for determining their restructuring prospects and requirements. C. The Policy and Regulatory Framework 1. Deposit Mobilization 20. The formal financial system has not proved an effective vehicle for mobilizing domestic resources. The M2/GDP ratio in Ghana is low by international standards, and indicates the low level of financial interme- diation in the economy (Annex 2-2). During the 1970s and early 1980s, liquidity expansion was fuelled by large government deficits finticed domestically by the Central Ba;k. Excessive money creation at a time of stagnant growth and investment stoked inflation and turned government- determined deposit rates deeply negative in real terms. In addition, the lack of longer term lending opportunities provided few incentives for banks to attract term savings. Instead those with surplus ftunds tended to invest in inflation-hedged assets such as real estate. 21. Since 1983, the Ghanaian authorities have pursued a flexible interest rate policy aimed at mobilizing domestic savings (Annex 2-3), in line with their growth and stabilization objectives. Accordingly, minimum  - 6 - rates for savings and time derosits were adjusted upwards repeatedly from 8.251-9Z in 1983 to 222-232 in 1987. In addition, declining inflation during this period as a result of fiscal and monetary discipline on the part of the Goverr.ment helped turn real deposit rates positive for the first time in more than a decade. However, as the rate of inflation climbed in 1986 and 1987, real interest rates once again turned negative. In September 1987, the Government liberalized all interest rates excepi for savings deposits which have been pegged at a minimum of 21.52. Full liberalization has been achieved in February 1988. 22. The disincentives to depositors during the 1970s and early 1980s arising from negative real interest rates were compounded by a series of ad hoc monetary measures which shook the confidence of the public in the banking system. These measures included the demonetization of 50 cedi notes, the freezing of bank deposit accounts in excess of 50,000 cedis and investigation for tax liability and possible corruption or fraud, the recall of bank loans for the financing of trading inventories, and the compulsory payment by checks for all business transactions in excess of 1,000 cedis. The immediate response by firms and individuals was to rechannel their financial resources into the unregulated informal f.nancial sector. 23. There are signs that confidence in the banking system is returning gradually. Currency held outside the banking system as a proportion of narrow money fell to below 502 in 1986, and the Government's recent announce- ment that it would compensate those affected by the demonetization of the 50 cedi notee should serve to reinforce this trend. However, there remains a lingering distrust which can only be removed by assurances in word and deed that the Government will respect confidentiality of bank accounts, avoid undue interferenci in financial transactions, and take actions to Dreserve the sound financial health of banking institutions. 24. The poor record of deposit mobilization by the banking system can also be attributed to the inferior quality of customer services of a number of banks and the limited range of financial instruments aimed at mobilizing savings. In addition, banks find it difficult to improve the efficiency of their operations and red intermediation costs because of antiquated systems and procedures and the shortage of trained and qualified staff. The Bank of Ghana regulates charges that banks can levy on their customers, thereby curtailing competition between banks and reducing incentives to improve efficiency. The efficiency of banks is also affected by the lack of high denomination currency notes. The Bank of Ghana recently issued a 500 cedi note and plans to introduce a 1000 cedi note shortly. But a case can be made for yet higher denominations which can shorten queues in banks and reduce the costs of counting large wads of notes. As far as the branch network of the banks are concerned, the banks are required to obtain the permission of the GOB before altering their opening and closing hcurs. This practice reduces the ability of banks to respond effectively to the needs of their clientele, and could therefore be discontinued. 2. Credit Allocation 25. The BOG has been controlling the growth and allocation of credit by the bankihg system through global and sectoral credit ceilings. To determir... the total quarterly credit expansion by any individual bank, the BOG first determines the overall rate of credit expansion consistent with projections of real economic growth and inflation. Until February 1988, sectoral growth  -7 - rates were established according to the development priorities of the Government, and guidelines were then issued to individual banks based on the application of these growth rates to the outstanding loans at the beginning of the period. The allocation for agricultural lending (202 of the total) was serving as a minimum whereas for other sectors it was usually a maximum. All secvoral lending targets have now been removed, except for agricultural lending. 26. Until recently lending rates also were controlled by the Bank of Ghana. Before 1986, agriculture was favored with preferential lending rates. But while this encouraged the demand for credit, it also discouraged the banks from lending to the sector, with the result that agricultural lending invariably fell short of the targets required of each bank. After 1986, however, lending rates were more or less unified, and in September 1987 lending rates were completely liberalized. Between September and December, lending rates appear to have barely moved and continue to be negative in real terms. Some rates have edged upwards, particularly for riskier loans, but despite excess liquidity in the banking system, the rate structure has not changed substantially because the binding credit ceiling precludes any further expansion of credit. 27. Partly as a result of interest rate controls, term transformation has been a problem for the Ghanaian banking system. Banks were unable to compensate for risk and maturity by varying their interest rates. In addition, the high proportion of banks' liabilities at the short end of the maturity structure (mainly demand deposits) have constrained their ability tc lend long term. Furthermore, large holders of long term funds, such as the Social Security and National Insurance Trust, were compelled to purchase low yielding government stock to finance the government deficit. These constraints, along with the limited number of viable investment opportunities brought to the attention of the banks, served to hinder the flow of financial resources for investment. The banks have tended to lend short term, mainly to their established customers, a high proportion of whom are in the trade and service sectors. In 1986, it is estimated that only around 152 of commercial bank loans outstanding (including those of development finance institutions) were of maturities over three years, and nearly 502 of al loans were to trade and services (Annex 2-4). 3. Liquidity Management 28. In addition to quarterly credit guidelines, the BOG uses two kinds of minimum reserve ratios to control the expansion of credit. The first is a minimum cash reserve ratio that relates a bank's cash and deposit holdings with the BOG to its total deposits. And the second is a minimum liquidity reserve ratio that relates a bank's secondary holdings (approved bills and securities) to its total deposits. For many years the minimum reserve ratios were not effective in controlling liquidity because bank financing of the government deficit was far in excess of what could be absorbed at the prevailing reserve ratios. But with the rapid depreciation of the currency, the excess liquidity was soon mopped up and the BOG reduced its minimum cash reserve ratio gradually until it reached 1OZ on demand deposits and 52 on time and savings deposits in October 1986. 29. In late 1987, however, a situation of excess liquidity once again emerged. The banking system appears unable to absorb the net repayments by the Government, especially since it cannot rechannel these to the private  - 8 - sector on account of the credit ceilings. As a result, some banks have been turning depositors away, and private enterprises with surplus savings are finding means of lending to deficit enterprises directly rather than going through banking institutions. The 'crowding out' of private sector financial savings was exacerbated by the substantial expansion of credit by the BOG to the cocoa sector which has added liquidity to the system adversely affecting as a result, the operations of the newly opened Discount House, and sending interest rates at the BOG's recently introduced treasu'ry bill auction below the minimum savings rate and the rediscount rate. 30. The present situation of excess liquidity in the banking system is coincidental with a shcrtage of liquidity in parts of the manufacturing sector. The demand for credit in the manufacturing sector has risen sharply as a result of increased import costs, lOOZ deposit requirements for the foreign exchange auction, and improvements in the efficiency of tax collection. But the banking system has been unable to intermediate between the resource-rich cocoa and mining sectors and the resource-hungry manufac- turing and foodcr ps sectors. The distortions created by the credit ceilings are beginning to make it difficult for the Central Bank to manage liquidity, and this points to the need to develop as rapidly as possible indirect instruments for monetary management that are capable of absorbing or injecting liquidity as and when required. But the issue also goes beyond one of just introducing new instruments. It means that the financial sector needs to develop a secondary market in government backed securities and commercial paper, and use it to manage its twin objectives of liquidity and profitability. The Government is putting together a plan to address these issues, including the sale to commercial banks of cocoa bills, a better monitoring of banks' cash reserves and the timely issuance by BOG of short-term paper. 4. Money Market 31. The potential usefulness of a money market in Ghana has been recognized for some time, and one discount house, Consolidated Discount House Ltd (CDH), which is owned by banks and insurance companies, has recently become operational. After opening for business on 30th November 1987, however, and an initial flurry of activity during the first days, few transactions have subsequently been done by CDH. This disappointing performance can be traced to a combination of inadequate detailed agreement between CDH and BOG on an operational framework, unrealistic expectations by banks as to the absorptive capacity of CDH, and imprecise definition of the scope of CDH by all parties. The Ghanaian authorities are now in the process of taking the requisite steps to facilitate the development of a smoothly functioning money market. These will include consideration and resolution of the following defects and shortcomings: (i) prudential limits on the composition of CDH assets; (ii) liquidity status of money-at-call with CDH; (iii) CDH's method of computing interest; (iv) access by CDH to rediscount facility with BOG, or to any assured supply of treasury bills; (v) status of call money deposits by banks with CDH; (vi) the effect of the banking licence issued to CDH; (vii) continued access of banks to BOG for accommodation of their liquidity; (viii) definition of bankers' acceptances eligible for rediscount at BOG; (ix) BOG's policies for the sale to non-banks of bankers' acceptances; (x) further to (iv) basis on which CDH and BOG deal in longer-dated Government stock.  -9- 5. Capital Market 32. Ever since the early 1960's, when a comprehensive companies code was enacted, Ghana has been considering the introduction of a formal Stock Exchange. The clear benefits of such an institution, in Ghana, as elsewhere, would be to enable corporate issuers to access long-term funds provided by investors, both individual and institutional, and to provide liquidity in the secondary market for shares and bonds. The Accra Securities Market Ltd (ASM) has been formed for some years, but not activated. Ghana, however, already has public issues of companies. Some eighteen companies, owned primarily by foreign shareholders, were converted into public companies during 1375 and 1976, under the operation of the Investment Policy Implementation Decree. The only other issues since 1976 have been one issue involving the capitalization of reserves, and a failed rights issue, which was less than 252 subscribed. It may be generally observed that these public companies, some of which are among the largest enterprises in the land, either have not needed to raise capital from the public during the last decade or have determined that it would not be available at a reasonable cost. It may be argued that the program of divestiture of state-owned enterprises could best be accomplished through a Stock Exchange. Indeed, if such an exchange existed, it would be a natural conduit for such transactions. However, it is unlikely to be satisfactory for either the Government, or the future development of the capital market in Ghana, for an Exchange to be created based mainly on such a short-term flow of captive business. Furthermore, divestiture sales are not primary issues, since no funds are raised for the subject company, unless the sales are combined wich a new issue of stock by the company. 33. One practical way to test the proposition that both supply and demand in primary market will be available in quantity, is to provide some incentives to private placement of equities, and to monitor the resultant flow of investment. Incentives to corporate issues could range from elimination or reduction of the 2Z stamp duty on capital increases, to a permanent or temporary reduction of the corporate tax rate for companies attracting new capital. Investors might be encouraged to make equity investments by exoneration from capital gains taxation, by equalization of the tax treatment of bank interest and dividends, or by the ability to make investments up to a stated maximum limit out of pre-tax income. It seems that dividends in Ghana were treated as tax-free for some years in the 1970s. In addition to the above consideration, there are a number of other concerns that need to be addressed. These include: (i) the review of auditing standards applicable to public companies should be accelerated, such that any recommendation for improvement may be implemented well in advance of any Stock Exchange activity; (ii) the institutional and regulatory framework for any Exchange must be devised and erected before any attempt is made to activate the ASM; (iii) the possibil.ty of forming a vehicle for provision of venture or development capital could be considered, which would hold the prospect of acting as a nursery for companies which could, on maturity, be sold to public investors through the Exchange; and (iv) the pricing policy and mechanism for new issues on the ASM should, ideally, be left in the hands of professional advisers to corporate issuers. The Technical sub-committee fcr the Establishment of a Stock Exchange, reported in 1986 that a Capital Issues Commission, under the auspices of the Ghana Investments Centre (GIC), should fulfil this pricing function. Although such a proposal seeks to utilize the skills which are available within GIC to provide an objective  - 10 - framework for price-setting, it may be seen by the manager and shareholders of potential issues as unduly prejudicial to their interests. 6. Regulatory Policies 34. Regulation is intended to provide monetary stability, protection of depositors, and an efficient and competitive financial system. In Ghana, banking activities are governed by the Banking Act of 1970, the Banking Regulations of 1973, the Bank of Ghana Act of 1963, and amendments or decrees issued in due course since the enactment of the foregoing legislation. 35. Several serious omissions in this body of legislation, together with weak bank supervision, have led to the concentration of risk in the portfolios of banks, inadequate capital and reserves, inflated profits, and unrecognized loan losses. 36. The BOG has never specified the limits for unsecured credit as a limit of each bank's paid-up capital and reserves, and has never specified the percentage, thus banks have frequently extended credit to single borrowers far in excess of the bank's capital funds in clear violation of prudent banking practice, and with the result that these borrowers, in effect, control the future of the banks. 37. Because banks in Ghana operate without the benefit of uniform accounting standards, their treatment of interest on non-performing assets varies. In many cases, banks continue to count interest on assets as income even when collection of such assets is in doubt. This implies necessarily that a uniform definition of non-performing assets must be established. The lack of uniform accounting standards has als,- led to inadequate loan loss provisions and reserves. Currently, most banks make no attempt to accurately quantify the risk which exists in their asset portfolios and to provide adequate loan loss reserves. Diagnostic studies of the banks clearly indicate the need for banks to better assess the quality of their assets. Mandatory minimum provisions should be established in order to ensure that management is not overly optimistic over the eventual collection or recovery of the asset when determining an adequate level of loan loss reserves. 38. The problem of assessing asset quality properly carries over to the issue of capital adequacy. Not only are banks failing to recognize loan losses and set aside adequate reserves, but their assets have grown at rates far surpassing the growth in capital funds through retained earnings. As a result, the proportion of capital to assets has become insufficient to prudently support the banks' ongoing operations. In fact, if banks were required to recognize the loan losses currently existing in their portfolios, many would be technically insolvent. Unfortunately, existing banking legislation does not mandate a minimum capital adequacy ratio which would ensure that banks grow at a controlled pace with due attention to asset quality and off-balance sheet risk. 39. Other weaknesses or omissions exist in the current body of banking legislation. Development finance institutions which are engaged in commercial banking activities are not su.bject to the same requirements regarding the transfer of retained profits to the reserve fund. Monetary penalties cited within the legislation have not been revised upward to reflect the effects of inflation and, therefore, no longer serve to dis- courage illegal or imprudent acts. Prudential reports and audit reports  - 11 - submitted to the Bank of Ghana are inadequate as sources of information with which to conduct off-site or early warning analysis. And a mechanism such as a credit clearing house does not exist to provide for the sharing of credit information between banks. 7. Banking Supervision 40. Supervision of the banking system is the responsibility of the Bank of Ghana, a functior. it provides through its Bank Examination Department. All banks, including rural banks, commercial banks, development finance institutions, and the discount house, come under its purview. Supervision is carried out through on-site examinations and off-site analysis of prudential returns. However, serious shortcomings exist in the Examination Department's u&pability to perform these tasks. 41. On-site examinations of each bank are required annually, yet only three banks were examined in the last year using comprehensive examination procedures. Furthermore, the three largest banks have never been examined in depth. Of the approximately 110 rural banks, only about 40 were examined. Implementation and enforcement of banking laws and regulations is ineffective and supervision weak. The existing examination methodology focuses primarily on a "snapshot, of the bank's condition at a given point of time rather than on strengthening the bank's management systems which are the first line of defense against imprudent and/or illegal banking practice. Besides, prudential reporting is limited to a handful of reports, and notwithstanding the lack of suitable prudential reports, no capability has been developed for conducting offsite analysis even if the proper reporting framework was in place. 42. There are several seasons for the Bank Examination Department's deficiency in meeting its responsibilities. The present staffing of 45 persons includes approximately 30 examiners; however, only five are judged by the Head of the Department as being capable to lead examination teams. Of the thirty individuals, only one has more than ten years experience, and only four have experience of between five and ten years. Low civil service salary levels make it difficult for the Bank Examination Department to attract and retain qualified examiners. And training is inadequate given the very specialized skills nieeded by the bank supervision staff. If the Bank Examination Department is to meet its responsibilities, the number of staff must be increased, salaries improved, and both skills and experience levels strengthened. III. AN AGENDA FOR ACTION 43. The development of an efficient and broadly-based financial sector is crucial for the continued adjustment effort of the Ghanaian economy. The Government has prepared a Statement of Financial Policy which details the policy framework for reforms to be undertaken (including an Implementation Schedule) which the proposed credit would support (Annex 4). The main objectives of this program are outlined below.  - 12 - A. Measures to Improve Deposit Mobilization and to increase the Efficiency of Credit Allocation 1. Deposit Mobilization 44. A key factor in improving the deposit mobilization potential of the financial sector is to restore public confidence in the banking system. The Government is, therefore, considering the repeal of the Banking and Financial Institutions (Request for Information) Decree, with a view to stipulating that all disclosures of information from banks, including cases where criminal cases are pending in courts of law, will be in conformity with the Banking Act of 1970. In addition, the Government intends to amend the Banking Act of 1970 to incorporate provisions requiring the maintenance of secrecy in respect of customers' accounts by the banks' Directors, officers, staff, and auditors. The banks would also mount a public relations campaign to educate the public on the new laws and their implications for individual or corporate depositors, and thereby lessen any lingering fears about the maintenance of secrecy of bank accounts. Finally, measures to enhance the soundness of banking institutions under the proposed project will contribute towards the restoration of public confidence in the banking system. Consideration may be given to establishing a Deposit Insurance Scheme once the financial distress of banks has been alleviated and Government's shareholding in banks has been substantially reduced. 45. In recognition of the importance of improving customer services and as a means of mobilizing deposits, the banks will be permitted under a new regulation to vary the working hours and business days of their branches. This will allow them to respond flexibly to customer needs in different areas. In addition, the BOG intends to review the system for collecting and clearing local and outstation checks, with the principal aim of determining the reforms necessary to reduce substantially the extensive time and high costs involved in the present system. 46. The increased flexibility in the Government's policy towards interest rates has led to a discernible increase in the willingness of the public to hold deposits with the banking system. In addition, the BOG will agree with IDA on a timetable for decontrolling banking charges prior to February 1989. 2. Efficiency of Credit Allocation 47. The BOG has already taken the commendable step of liberalizing lending rates of banks. To follow up on this step, it issued on February 29, 1988 new credit guidelines abolishing all sectoral ceilings while maintaining the requirement that banks lend a minimum of 20? of their total lending to agriculture. BOG interprets "agriculture lending" in the broad sense to include, beyond primary agriculture, the processing, warehousing, and marketing of agricultural produce as well as forestry activities. Prior to December 1989, the BOG will review the results of the recent liberalization of the credit policy and determine in consultation with IDA whether the floor on agricultural lending should be maintained. To ensure that refinancing facilities, special lines of credit, and other special credit schemes are used only in exceptional cirWumstances, the BOG will prepare criteria and mechanisms for their use. These criteria should ensure that such credits are only employed when it is clearly established that there is a market failure preventing funds from reaching disadvantaged or priority groups, and that the  - 13 - most appropriate way of dealing with the market failure is through a special line of credit. If and when such credit schemes are used, they will be kept to a minimum and their costs will be budgeted and made transparent. Finally, using similar criteria, the BOG will review the Credit Guarantee Scheme and in consultation with IDA, determine whether the scheme should be wound up. In the meantime, the scheme will not issue any further guarantees. 3. Efficiency of Banking Operations 48. To encourage banks to improve the efficiency of their operations yet further, the BOG will uneertake a review of their operating practices with the aim of preparing and circulating semi-annually a set of average efficiency indicators so that banks can compare their performance vis-a-vis other banks. In addition, to reduce the costs of banking operations that arise from low denomination currency note, the BOG will issue notes of higher denomination. Recently the BOG brought out the 500 cedi note, and a 1000 cedi note has been approved by the Board and the Government. The BOG will keep this policy under constant review and issue notes of yet higher denomination when and as necessary. Besides, the need for introducing more modern banking methods and technology, upgrading the skills of the existing personnel, and recruiting and developing of new talent, would necessitate training programs, which given their magnitude, would be better undertaken centrally to serve the ertire banking industry. Technical assistance to that end would be financei under the project (Annex 3-;). 4. Money Market 49. The emerging money market in Ghana, the principal institutional member of which is the newly established CDH, is laboring under the difficulty of an inadequately defined operational and regulatory environment (para 31). The indicative list of problem areas for the money market, and CDH in particular, covers a wide spectrum. These problems would be addressed through the preparation and subsequent implementation of a priority reinforcement plan, to be implemented prior to February 1989, including the drafting of a Statement of Operating Policy for CDH to be endorsed by BOG and developed after careful consultation with banks, BOG and CDH management and supported by technical assistance financed under the proposed credit (Annex 3-1). Speed would be an important factor to avoid loss of impetus in CDH's development. Meanwhile, pending the implementation of the reinforcement plan, CDH's activities would be expected to be on a modest scale and limited principally to facilitating overnight transactions between banks and channelling of funds between the banking sector and BOG. 5. Capital Market 50. The concept of establishing a capital market in Accra, probably through Accra Securities Market Ltd (ASM), has been fostered for some time by the notion that a strong demand exists for such services from potential investors and corporate issuers. Quantification of these factors will always be imprecise, but it is necessary for the foundation of a capital market to be as secure as possible. Accordingly, an assessment of the likely demand for, and supply of, quoted securities should be made covering the primary and secondary markets. This assessment would be undertaken in a study financed under the proposed credit (Annex 3-2) which in addition would cover the following areas (i) design of a package of suitable incentives to attract both investors and potential corporate issuers; (ii) design of an adequate  - 14 - regulatory and institutional framework to generate users confidence and prevent financial abuse; and (iii) assessment of the suitability of establishing a specialized financial institution providing venture and development capital. In the meantime, and pending the review of the study's outcome, no substantial action should be undertaken leading to major institutional changes in capital-market related institutions (ASM, National Trust Holding Company, the proposed Capital Issue Commission). B. Amending Laws and Regulations 51. In order to strengthen the hand of banking supervisors, the existing body of laws, rules, and regulations will be amended or revised to address the serious shortcomings described earlier. To facilitate this, a committee has been established at the behest of the government to review existing legislation, draft the changes necessary to improve the regulatory framework, and establish prudent standards to ensure the viability of the banking system (even if this means that many banks may not immediately conform to the new legal requirements). To assist in the revision of this body of laws, rulings, and regulations, a technical assistance component is included in Annex 3-3 to provide for the employment of a banking law expert on an ad hoc basis. 52. GOG has agreed to a number of critical changes or additions to the legal framework. Risk exposure limits as a percentage of capital will be set on a bank's exposure to a single customer or related group. These limits will encompass secured as well as unsecured credit to (and investments in) a single party or group of related parties. To the extent that credits to existing customers exceed the new limits, the banks should establish plans to reduce them to conforming levels within a reasonable time frame. Modifications to existing legislation will also place stricter limits on credit extended to directors' interests by subjecting them to similar exposure limits based upon the bank's capital. 53. A minimum capital-adequacy ratio will be established. This ratio should take into account the riskiness of the bank's assets as well as its off-balance-sheet risk. Banking supervisors will have the ability to mandate even greater capital when, in their opinion, conditions warrant. Banks which do not meet the minimum guideline will not be allowed to pay dividends. Following implementation of new minimum capital guidelines, banks should prepare, and update on an annual basis, a capital plan for maintaining or restoring capital to an adequate level. In addition, the amount of paid-up capital to establish a new bank will be adjusted upwards to reflect the effects of inflation. The BOG will be delegated authority to revise this minimum amount as warranted. Development finance institutions which are engaged in cornmercial banking will also meet minimum capital adequacy requiremen-.s, although such limits may differ from commercial banks because of the added risk of the development portfolio. Development finance institutions will also be required to transfer a portion of their net profits to reserves in accordance with the relevant provisions of the Banking Act for commercial banks. 54. Regulations will specify the format and content of audit reports and the minimum scope of audit reviews. Uniform accounting and auditing standards and prudential reporting requirements will also be established. The accounting standards will include guidelines for loan portfolio review and classification, the treatment of interest on non-performing loans, and  - 15 - provisioning for potential loan losses. To assist in eRcablishing these standards and reporting requirements, the project would finance the services of an international accounting firm. 55. The establishment of a credit clearing house is a complex undertaking which will require a technical advisor to consult on its establishment, operation, and legal framework. A technical asaistance program is proposed in Annex 3-4. 56. Lastly, monetary penalties for violations of laws and regulations will be strengthened and periodically revised to serve as a deterrent to illegal and imprudent acts. Initially, the penalties contained in the existing Banking Act are to be increased by a factor of 100 and revised thereafter as needed. C. Banking Supervision 57. To enable the BOG to effectively carry out its role of monitoring and preserving the health of the financial system, the skills, training, staffing, and methodology of its Bank Examination Department must be strengthened. To this end, a number of steps are being taken. First, twc banking supervision experts are in the process of being recruited to serve as technical advisors to the BOG. The proposed technical assistance program is outlined in Annex 3-3 including the terms of reference of the banking supervision experts, whose assistance is critical to the success of strengthening the supervision function. Besides, increases in compensation are critical to attract and retain high quality individuals in the Bank Examination Department. Therefore, the BOG will, in line with the overall review of compensation for civil servants as part of the structural adjustment program, reassess staffing and compensation in conjunction with the possible reorganization of the department. 58. Prudential supervision of banks is also provided in the forms of external audits and financial disclosure. Audits of banks conducted in the past failed to disclose the extent of problems subsequently identified in the diagnostic studies. It is apparent that not only auditing standards must be strengthened but training of auditors must receive high priority. In this regard, the Institute of Chartered Accountants has an important role to play in providing leadership to the auditing profession in Ghana. A technical assistance program is envisaged for the training of auditors (Annex 3-5). The program also includes a component for a consultant to assist in developing auditing standards. 59. Financial disclosure can help to instill discipline. However, given the present state of the banking system generally, full financial disclosure is considered inappropriate at this time. Nonetheless, certain information, such as deposit account statements and schedules of charges, should be made available to the public. In this regard, the Banking Law Committee will establish standard patterns of information disclosure to the public. D. Bank Restructuring 60. As stated in para 19, a large number of Ghanaian banks are facing severe financial difficulties, which are threatening their liquidity and solvency and thereby the stability of the financial system overall. This is  - 16 - particularly the case of the three development banks, but to a lesser extent also of some major commercial banks. This situation was attributable to inappropriate sector policies and regulations affecting the operation of the banks in the past, inadequate banking supervision by the authorities, internal weaknesses on the part of the banks themselves (in particular deficient management team and poor procedures and controls), as well as the massive devaluations in recent years which have considerably increased the corporate sector's indebtedness and reduced its capacity to service its debt to the banks, exacerbating the latter's portfolio arrears. The Goverrnment realizes the critical need to restore the financial health and operational capacity of the distressed Gharsian banks. Comprehensive diagnostic studies by international auditing firms have been carried out for the three development banks and six major commercial banks to determine accurately their financial and operational condition and the appropriate remedial measures required. These audit reports constitute the first step in a review process which would determine for each bank its prospects for future viable operation and restructuring requirements. External audits under the aegis of BOG will be repeated for the coming two to three years until such a time as BOG's examination department has been satisfactorily strengthened. 61. The basic principles that are to govern the restructuring of the banks, have been agreed between the Government and IDA and are spelled out in the Statement of Financial Policy (Annex 4--paras 7 to 9), along with specific targets for restructuring plans (Implementation Schedule Section II - 4 to 7). The systematic review of audit reports by the Ghanaian authorities and IDA, will provide a basis for deciding on a future course of action (recapitalization/restructuring, merger, liquidation) for each bank. The eventual decision to recapitalize an individual bank will be based on a realistic assessment of this bank's prospects for viable operation within a reformed banking system more liberalized and competitive and with much reduced reliance on GOG/BOG funding and other concessional funding. This will entail a three-phased process of which the first step would be the preparation of detailed business projections for at leas.. a 5-year period based on realistic assumptions of future operations. The iterative process by which these projections will be undertaken would involve consideration of fundamental issues such as sectoral specialization vs universal banking, the options of mergers and liquidations, degree of appropriate state financial support. Once satisfactory projections are obtained for an individual bank, a specific restructuring plan will be prepared for it, stipulating the arrangements (operational, financial, managerial, legal) for the bank's future operation. Monitorable steps for the implementation of the restructuring plan will be embodied in a performance contract to be signed between the Government/BOG and the bank setting out the respective obligations and commitments of each party. All restructuring plans for individual banks will be sent to IDA for review and agreement prior to their implementation. 62. In addition to immediate safeguard measures to be taken as necessary so as to arrest further financial deterioration (i.e., discontinuation/curtailment of new lending; concentration on loan recovery, reduction in operating costs; reconciliation of accounts), specific modalities will be worked out to settle the accumulated deficits involving an appropriate mix of cash injections and non-cash adjustments, in particular (i) rescheduling/conversion of external and GOG/BOG loans to banks; (ii) transfer to the Government of the banks' portfolio of non-performing loans to state-owned enterprises and/or those guaranteed by the Government. Beyond  - 17 - internal measures at the level of each individual bank, arrangements for loan recovery might include the transfer of the banks' non-performing loan portfolio to a separate entity (collection agency, managed fund, restructuring fund) or its sale at a discount. 63. Financial requirements for restructuring Ghanaian banks (both for resorbing the aggregate deficits of the whole banking system and for recapitalization of selected banks) can only be roughly estimated at this stage, pending the completion/analysis of their audits and the subsequent decision-making process leading to their recapitalization/restructuring. Initial estimates indicate that overall needs would approximate US$280 million. Of this amount about US$40 million could be met with the conversion into quasi-equity of loans from GOG/BOG and external lenders to the banks (principally the development banks) and US$20 million through the repurchase by GOG of non-performing loans to state enterprises. To monitor the proper implementation of the bank restructuring program, the Government is in the process of establishing a Technical Committee, reporting to the Financial Sector Adjustment Committee (para 77). Given the magnitude and complexity of the exercise, the project would finance a bank restructuring adviser for a period of 18 months, acting as special adviser to the Technical Committee, to be recruited by September 1988 (Annex 3-7). E. Corporate RestructurinR 64. As evidenced by the banks' audits available to date, a number of Ghanaian enterprises, particularly thoe with foreign debts/or depending largely on imported inputs, are in need of both physical and financial restructuring, in the aftermath of recent niassive devaluations, high inflation rates, and adjustment policies (trade liberalization, reduction in effective protection). This situation warrants the consideration of a nationwide program for corporate restructuring, the basic objective of which would be to offer comprehensive financial packages linking future debt repayments to the cash-generation capacity of individual firms, using such instruments as debt/equity swaps, reschedulings of remaining debts over longer maturities, interest capitalization, partial write-off of accumulated penalty charges, and injection of fresh money for increased liquidity and new fixed assets. Significant managerial and operational restructuring would have to be considered as well. Restructuring will be selective and confined to those enterprises temporarily in financial distress but with clear medium-term prospects for profitable operation. The provision of technical assistance and expert guidance to the banks and the enterprises will be needed for the design as well as the implementation of restructuring proposals. Although the responsibility for enterprise restructuring should normally rest with the banks, the magnitude and complexity of the problem appear to require putting in place, at the country level, an institutional framework that would (a) generally oversee the implementation by the banking system of the nationwide enterprise restructuring program; (b) refinance a part of the restructuring credits/investments by the banks; and (c) provide the technical assistance required. The Government has requested IDA's assistance in initiating a study toward the design and establishment of a corporate restructuring program along the foregoing lines (Annex 3-8). F. Rural Finance 65. The Government places a high priority on J.mproving the efficiency of rural .inancial mechanisms to support economic, particularl, agricultural,  - 18 - activity in rural areas. Financial intermediation in rural areas requires, however, special treatment because of the infoirmal nature of the financial intermediaries that operate there, and the reluctance of formal financial institutions to undertake high-cost high-risk intermediation activities in rural areas. The Government is therefore conducting two studies of the rural financial subsector with the support of IDA. The first will be a comprehensive study of the entire range of rural financial intermediation required for the rural population. The second will focus on a diagnosis of a ample of ruzal banks (ten to fifteen) to provide the basis for the BOG to formulate a program of action vis-a-vis these banks. These two studies together will be used to design a sector specific action program, to be supported by a forthcoming Rural Finance project, and which will be fully consistent with the thrust of the present financial sector adjustv.ent program. G. Foreign Exchanae Risk 66. Exchange losses resulting from loans denominated in foreign currency account for a large share of the financial sector deficit (about US$100 million). Although exchange rate fluctuations comparable to those observed between 1983 and 1986 are less likely in the future as long as the Government pursues ts liberalized trade and exchange rate policies combined with monetary and fiscal discipline, it would be advisable to consider a mechanism by which borrowers could be adequately protected against unexpected future variations of the exchange rate. To that end the BOG intends to study and develop a model to forecast the foreign exchange risk and determine an appropriate level for the fee that borrowers would have to pay to BOG in exchange for exchange risk p.otection. This study will be financed under the proposed project. Based on the study's findings, it is envisaged that a fund managed by BOG would be established to cover actual losses as needed. Seed funding would be provided by the Government. IV. THE PROPOSED CREDIT A. Origin and Objectives 67. The proposed credit has originated from the Bank's sector work initiated in Ghana since 1985. Critical to continued progress in the structural adjustment effort is the need to develop a well functioning and broadly based financial sector. To that end, the Government has designed a comprehensive and far-reaching action program with the following main objectives: (i) to enhance the soundness of banking institutions through reforms of the regulatory framework and the restructuring of distressed financial institutions; (ii) to improve deposit mobilization and efficiency in credit allocation; (iii) to develop money and capital markets. Significant steps have already been taken towards the implementation of this program: interest rates have been liberalized in September 1987 and February 1988, external audits undertaken for the nine major banks, two specialists in banking supervision have been recruited by the BOG and a study on improved standards for banks' accounting and reporting has been initiatei recently. The credit would support the initial action program of policy and institutional reforms as set out in the Government's Statement of Financial Policy (Annex 4).  - 19 - B. The Macroeconomic Context 68. The financial sector adjustment program is a key element of the Government's economy-wide structural adjustment program (see paras 5-11). The total external financing required to support the structural adjustment program during the period 1988-90 is projected to be about US$2,200 million (see Annex 1-3). The proposed financial sector adjustment credit of US$100 million will meet 4.5 percent of this external financing requirement. A large part of the remainder (US$1,300 million) has been identified from existing and expected commitments from bilateral and multilateral donors. The residual financing gap of about US$800 million is expected to be met by the IMP enhanced structural adjustment facility, IDA's contribution to the African debt initiative, ard additional financing from cofinanciers. C. Description 69. The IDA credit of US$100.0 million will be made to the Government at standard IDA terms with 40 years maturity. The credit would have a sector reform component and a technical assistance component. 1. Sector Reform Component 70. This component of TS$95 million equivalent would be in support of ongoing and new policy and institutional reforms undertaken in the financial sector over the 1987-1990 period, as outlined by the Government in the StAtement of Financial Policy, the major objectives of which are to: (a) enhance the soundness of banking institutions through (i) a review of the legal framework, (ii) improved modalities for bank supervision, (iii) strengthening the training of bankers, (iv) strengthening the accounting and auditing professions, (v) support to the financial restructuring of the corporate sector. (b) restructure financially distressed banks on the basis of full external audits, followed by a thorough review of each bank's prospects for future viability within a liberalized and competitive system (with much reduced reliance on GOG funding and other financial privileges), and restructuring needs therefor. The decision on a future course of action for each bank (recapitalization/restructuring, merger, liquidation), on the basis of this review, would lead to the preparation of a specific restructuring plan, the implementation of which would be monitored by a performance contract. (c) improve resource mobilization and allocation through (i) measures aimed at further restoring public confidence in banks. (ii) liberalization of interest rates, bank charges and commissions and sectoral credit ceilings, (iii) developrient of money and capital markets through the rationalization and strengthening of the CDH and the introduction of policies and institutional vehicles for capital market development. 2. Technical Assistance Component 71. This component of US$5 million will finance (i) a comprehensive program of technical assistance to the BOG (Annex 3-3 and 3-4), (ii) training  - 20 - programs for the Institute of Chartered Accountants (Annex 3-5), (iii) training programs aimed at improving the profession of bankers (Annex 3-6), advisory services to the Technical Committee for Banking Restructuring (Annex 3-7), (iv) technical assistance to CDH (Annex 3-1), (v) an assessment of the potential for capital market development and rela,ed studies (Annex 3-2), (vi) a study to assess the need for corporate restructuring and the initiation of a pilot program (Annex 3-8), and (vii) a study on exchange risk protection (par& 66). Costs of technical assistance and studies are summarized in Annex 3-9. D. Procurement and Disbursement 1. Sector Reform Component 72. Procedures for procurement and disbursement would be largely patterned upon those applied for the recently approved SAC to Ghana. The proceeds of the proposed sector reform component (US$95 million equivalent) would be used exclusively for the financing of the foreign exchange cost of eligible imports through the foreign exchange auction in the BOG. Procurement procedures have been designed to permit rapid use of the funds while ensuring efficiency and economy. Except for a few exclusions such as luxury and defense items, any imports would be eligible for financing. Not more than SDR 20 million equivalent of the proceeds of the credit would be used for petroleum imports. In order to speed up disbursements, imports below US$2 million by private entities would be procured in accordance with their normal procedures; the Government and SOE procedures for imports below US$2 million equivalent would be acceptable to the Association. Imports worth US$2 million or more would be subject to international competit ve bidding according to Bank Guidelines, using current standard bidding documents, which are acceptable to IDA. International suppliers are well represented in Ghana; this, together with the ongoing auction s'stem and trade liberalization, should ensure an internationally competitive market in which importers can be relied on to procure their goods and services fiom the least costly and most reliable sources. 100 percent of the costs of technical assistance and studies would be financed under the project. 73. To facilitate procurement and disbursement, multiple special accounts (up to six), would be established in U.S. dollars at commercial banks, on terms and conditions acceptable to the Association. Initially, US$18 million of the IDA credit will be deposited in these special accounts. Applications for replenishment of the special accounts will be submitted monthly, or when withdrawals equal one-sixth of the amount advanced. Applications will be fully documented with respect to payments against contracts of more than US$500,000 equivalernt. Reimbursements for payments against smaller contracts will be mcde on the basis of statements of expenditure certified by the BOG with supporting documents retained for review by visiting missions. Annual audit reports will include a separate audit of amounts withdrawn on the basis of statements of expenditure and on special accounts. 74. The proceeds of the proposed sector reform component would be disbursed in three tranches as follows: (a) a first tranche of US$45 million equivalent (SDR 32.5 million) would becL'me available immediately upon e&fectiveness (by August 1988);  - 21 - (b) a second tranche of US$30 million (SDR 21.6 million) would be made available following a review of performance, six months after effectiveness, that would determine that the reform program is being satisfactorily implemented and in particular that the conditions stipulated in para 77.2 have been fulfilled. (c) a third tranche of US$20 million (SDR 18.0 million) would be made available following a review of performance, nine months after second tranche release that would determine that the conditions stipulated in para 77.3 have been fulfilled. Conditions for tranche release are detailed below under section E "Monitorable Actions'. 75. Cofinancing of US$140 million is being sought under this project. The Swiss Government has indicated at negotiations its intention to contribute to the cofinancing of this project in an amount of Swiss Francs 15 million while AfDB and the Japanese Government (OECF) are expected to contribute in amounts of US$50 million and US$55 to 70 million equivalent, respectively. The British and Canadian Governments have also been approached. On the basis of the reactions received so far from these sources, it is expected that the target amount for cofinancing will be achieved. It is intended, to the extent possible, that these cofinancing funds be tranched in such a way as to ensure balanced tranche disbursements. 2. Technical Assistance Component 76. Consultancy services for the various technical assistance subcomponents will be obtained as per the Bank's Guidelines for Recruitment of Consultants. Procurement of other items such as vehicle and office equipment will be as per the procurement procedure described in para 71 above. Disbursement under the technical assistance component will not be subject to the tranche release conditions. Statement of expenditures would be used for expenditures not exceeding US$50,000. A special account of US$1,000,000 representing about four month's expenditures would be established at a commercial bank to expedite disbursements. Audit requirements would be similar to those of the sector reform component (paras 72-73). E. Monitorable Actions 77. The Statement of Financial Policy (Annex 4) describes the specific reform measures that have been or will be taken during this phase of the adjustment program. These measures are summarized in the Implementation Schedule attached to this Statement. A high level Financial Sector Adjustment Committee chaireA by the Secretary for Finance and Economic Planning, with the Governor of the BOG as Vice-Chairman, and reporting to the Chairman, Committee of Secretaries will oversee the implementation of the program. Conditions for tranche releases are listed below. 1. Conditions for Effectiveness (i) agreement with IDA on amendments to the Banking Act and other relevant regulations covering prudential rules relating in particular to capital adequacy of banks, reserve requirements, exposure limits, penalties and reporting requirements to the BOG.  - 22 - (ii) Agreement with IDA on a proposal setting out uniform auditing and accounting standards for banks. 2. Conditions for Second Tranche Release (i) Satisfactory implementation of amendments to the Banking Act and other regulations referred to under para 77.. (i). (ii) Satisfactory monitoring by BOG of compliance by banks with uniform accourting and auditing standards. (iii) Agreement with IDA on a timetable for a phased decontrol of banking charges. (iv) Enactment of the amended Social Security Decree. (v) Receipt of a Government Statement satisfactory to IDA specifying the modalities for the restructuring of banks and in particular (i) the restructuring/conversion of loans and deposits extended to banks by GOG/BOG and external lenders; (ii) measures for dealing with banks' portfolio of non-performing loans; and (iii) additional measures for dealing with non-performing loans to State Enterprises. (vi) Agreement with IDA and implementation of a specific proposal for the reduction by at least 50 of doubtful loans and off-balance sheet items in the aggregate portfolio of banks. (vii) Agreement with IDA on restructuring plans for banks accounting for at least 50 of commercial banks' assets and 50X of development banks' assets. (viii) Preparation and implementation of an action program for the strengthening of CDH. (ix) Completion of a study on the potential for capital market development and related requirements. (x) Completion of a study on exchange risk protection. 3. Conditions for Third Tranche Release (i) Review of the sectoral credit floor for agriculture in consultation with IDA and implementation of the resulting agreement. (ii) Satisfactory implementation of the plan for the reduction of non-performing loans and off balance-sheet items in the portfolio of banks and of the banking restructuring plans agreed upon under paras 77.2 (vi) and (vii). (iii) Agreement on a program for the residual portfolio of non-performing loans and off-balance sheet items and on restructuring plans for the remaining commercial and development banks.  - 23 - (iv) Satisfactory implementation of the recommendations of the study on the capital market (para 77.2 (ix)). (v) Establishment of the Credit Clearing House. F. Justification and Risks 1. Justification 78. An efficient, broadly based financial sector, with an effective banking system at its core, is necessary to provide the support for the continued structural adjustment effort. Ghana does not yet have this. The formal financial system is at an early stage of development and has been handicapped by significant institutional weaknesses, limited mobilization of financial resources and deficiencies in credit al'location, all of which have constrained the supply of credit to the productive sectors. The initial action program seeks to address these handicaps. It aims to strengthen the financial institutions, expand the scope of the formal financial system and improve the efficiency of financial intermediation in Ghana. Emphasis is placed on priority policy and institutional reforms necessary to overcome the key constraints or imperfections in the financial system which are hindering the flow of funds to the efficient productive sectors, thus limiting investment and production responses to the ongoing adjustments of trade and incentive policies. Increased efficiency of the financial sector will thus enhance growth, both by increasing savings and by channelling them to higher yielding investments. The enhanced soundness of the banking institutions, which will be pursued through their restructuring, and training programs for banLks' employees, together with the proposed amendments to the Banking law and other relevant regulations, and the improvement in the supervision and surveillance of the banking system by the BOG will increase confidence in the banking system, thus inducing its further growth. The credit will also address the development of the money market and capital market, which together with an initial program aiming at restructuring the corporate sector should contribute both to a broadening of the financial system and stimulate private investment. In addition, the development of the profession of accounting and auditing, and improved accounting systems will in the long-run improve the Government's budgetary control, improve monitoring of state enterprises performance and tax collection. In the private sector, efforts at productivity improvement and restructuring will be facilitated. 2. Risks 79. The main risk relates to the inherent complexity of undertaking a sector-wide restructuring of the banking system which requires not only the strong commitment of the Ghanaian authorities but also the full cooperation of the banks' management. Other risks include the timely and adequate availability of resources, and the strain the project will place on the country's implementation capabilities. These risks are, however, mitigated by (a) the Government's commitment to undertake banking restructuring on a sound basis, in accordance with principles formulated in consultation with IDA, and to seek IDA's agreement on individual restructuring plans prior tn their implementation; (b) the tranching of the credit, which would further ensure satisfactory progress in the implementation of the sector reform program overall, and of banking restructuring in particular; and (c) finally, the sector reforms contained in the Action Program, in particular the recent liberalization of interest rates and the proposed improvement of the  - 24 - regulatory framework and strengthening of Central Bank supervisory functions, are expected to go a long way in ensuring the competitiveness, efficiency, and soundness of the banking system in the future. V. BANK GROUP OPERATIONS 80. Until March 1983, when lending was resumed after an 18-month hiatus, the Bank Group's assistance to Ghana was oriented towards projects with a strong emphasis on export promotion and rehabilitation of basic infrastructure. But the acuteness of the economic crisis of the past several years and the magnitude of structural distortions led the Government to develop a program of far-reaching economic reform which it announced in April 1983. This resulted in a major shift in the Bank's strategy. The main elements of this strategy are: (a) to assist the Government, through the Bank's economic and sector work, supported where appropriate through technical assistance and program lending, to improve incentives for production, to increase the efficiency of economic management, and to restore in the medium term a sound financial basis for growth; (b) to promote the long-term growth and development of the economy by underpinning structural adjustment lending with infrastructure rehabilitation and sector adjustment operations within a framework of apprapriate sectoral policies, the latter encompassing industry and education; and (c) to contribute to improved aid effectiveness in Ghana by acting as the focal point or aid coordination between donors and Ghana as the Government strengthens its own planning and aid coordination ability. 81. Based on the strategy outlined above, the Bank is supporting changes in incentive policies and improvements in economic management through a series of program credits designed to provide critically needed imports, particularly to export sectors and supporting economic infrastructure such as transportation. The latest in this series of credits is the Structural Adjustment Credit approved in April 1987. The Bank supplemented this with a Structural Adjustment Institutional Support Project to support and strengtnen the implementation agencies involved in the structural adjustment program. All program credits taken together amount to 57.1 of total commitments. To prepare for these credits, the Bank carried out a public expenditure review, an agricultural sector review, an industrial sector study and an assessment of issues and options in the energy sector, supervised cocoa sector studies under an ongoing project, and acted as Executing Agency for a UNDP-financed study of the public enterprise sector. In addition, an economic memorandum (Report No. 6635-GH, dated March 30, 1987) was prepared and used as a background document at the last Consultative Group meeting in May 1987. 82. Over the medium term, IDA lending will include a second structural adjustment operation, sector operations, and complementary project lending. Future project lending will concentrate on infrastructural rehabilitation, and focus on sectoral strategies, a sound policy framework, investment programs, public sector reforms, and institutional improvements.  - 25 - VI. COLLABORATION WITH THE IMF 1. Fund Relations w_th Ghana 83. Since the inception of the ERP, the Fund's Executive Board has approved three successive stand-by arrangements and two Compensatory Financing Facility purchases by Ghana resulting in a total use of Fund credit by end December 1986 of SDR 611 million or 299 percent of quota. The third stand-by arrangement equivalent to SDR 81.8 million (40 percent of quota) was approved on October 15, 1986. On November 6, 1987, the IMF Board approved the request by GOG for a three-year extended arrangement (SDR 245.5 million) and a three-year structural adjustment arrangement (SDR 129.9 million). 2. Bank-Fund Collaboration 84. Collaboration between the Bank and Fund staff has been good, both in the field, where there have been parallel and joint missions, and where the Bank's Resident Mission is in close touch with the Fund Resident Representative, and at headquarters, where there are frequent consultations. The staff of the two institutions have worked extremely closely with the authorities in designing the structural adjustment program. The Fund staff have focused in particular on exchange and trade policy, fiscal and domestic resource mobilization issues, and external debt management, while the Bank staff have focused on incentive policies including cocoa policy and trade liberalization, and puElic sector reform, including public expenditure policy, state enterprise reform, and public sector management. A Policy Framework Paper prepared jointly by the Government, the Bank, and the Fund, provided the framework for Ghana's recourse to the Extended Arrangement and the Structural Adjustment Facility approved by the Fund Board in November 1987. VII. RECOHMENDATION 85. I am satisfied that the proposed Development Credit would comply with tne Articles of Agreement of the Association. 86. I recommend that the Executive Directors approve the proposed Development Credit. Barber Conable President Attachments Washington, DC May 9, 1988  - 26 - ANNEX 1-1 GHANA FINANCIAL SECTOR ADJUSTMENT CREDIT KEY ECONOMIC INDICATORS Actual Prelim. Projected 1984 1985 1986 1987 1988 1989 1990 ------------------------(in Z)