Tanzania - Financial Institutions Development Project

Document of The World Bank Report No. 13713-TA STAFF APPRAISAL REPORT TANZANIA FINANCIAL INSTITUTIONS DEVELOPMENT MAY 23, 1995 Public and Private Enterprise Division Eastern Africa Department  CURRENCY EQUIVALENTS Currency Unit: Tanzanian Shilling (Tsh.) Official Rate: US$1.00 = Tsh. 530 ACRONYMS AND ABBREVIATIONS BOT Bank of Tanzania BSD Bank Supervision Directorate CMSA Capital Markets Security Authority CRDB Cooperative and Rural Development Bank DANIDA Danish International Development Agency DJIT Diamond Jubilee Investment Trust ERP Economic Recovery Program FMID Financial Markets Directorate FSAC Financial Sector Adjustment Credit GOT Government of Tanzania LART Loans and Advances Recovery Trust MOF Ministry of Finance NBAA National Board of Accountants and Auditors NBC National Bank of Commerce NGO Non-Governmental Organization NIC National Insurance Corporation NPF National Provident Fund PBZ People's Bank of Zanzibar PC Planning Commission PPRP Parastatal and Public Sector Reform Project PSRC Parastatal Sector Reform Commission PTF Privatization Trust Fund SAC Structural Adjustment Credit GOVERNMENT FISCAL YEAR July 1 to June 30 This report is prepared by IDA in collaboration with Government of Tanzania. The IDA team consisted of Mr. Gerard Byam (Task Manager), Redha Behbehani, Dong He, Nancy McInemey- Lacombe and Paul Murgatroyd. The team also included consultants Wendy Abt, Ray Astin, Robin Marriott. Eric Postel, Qamar Siddiqi and Paul Vonckx. The Government team consisted of Dr. I. Rashidi (Governor, BOT), Mr. G. Mgonja and Mr. A. Myinyimvua (BOT) and Mr. G. Mbowe (Chairman, PSRC). The mission was assisted in preparation of this document by Ellen Martin and Mariel Fiat. The Lead Advisor is Mr. R. Pardy and Peer Reviewers are Luigi Passamonti (IFC), and Charles Enoch (IMF). The Sector Division Chief and the Acting Country Director are R. E. Hindle and Micahel Carter, respectively.  TANZANIA FINANCIAL INSTITUTIONS DEVELOPMENT PROJECT STAFF APPRAISAL REPORT Table of Contents CREDIT AND PROJECT SUMMARY SECTION I - BACKGROUND ................................................I SECTION n - THE FINANCIAL SECTOR ................................................2 A. Overview .................................................2 B. Macro-economic Framework ..................................................4 C. Bank Supervision ................................................6 D. Competition .................................................8 E. Bank Restructuring ........8.........................................8 F. IDA's Previous Role and Lessons Learned ................................................ 14 G. Rationale for IDA's Involvement ................................................ 15 SECTION - THE PROJECT ................................................. 16 A. Project Objectives ................................................ 16 B. Summary Project Description ................................................ 16 C. Detailed Project Description ................................................. 18 D. Project Costs and Financing Plan ................................................ 29 SECTION IV - IMPLEMENTATION ARRANGEMENTS . .................................... 30 A. Implementation Arrangements ................................................. 30 B. Procurement ................................................ 31 C. Disbursements . ................................................ 33 D. Auditing and Reporting Requirements ................................................ 33 E. The Role of Technical Assistance ................................................ 34 F. Supervision ................................................ 34 G. Environmental Impact ................................................ 35 SECTION V - BENEFITS & RISKS ................................................ 35 SECTION VI- AGREEMENTS AND RECOMMENDATION.. ............................. 36  Tables in the Main Text 1. Project Components 2. Project Cost Summary 3. Project Financing Plan 4. Procurement Arrangements 5. Disbursement Schedule ANNEXES ANNEX1 LETTER OF FINANCIAL POLICY ANNEX 2 DIVESTITURE STRATEGY SCHEDULE ANNEX 3 NBC FINANCIAL DATA ANNEX 4 BANK SUPERVISION IMPLEMENTATION PLAN ANNEX 5 BANK SUPERVISION TRAINING PROGRAM ANNEX 6 PRIVATIZATION TRUST FUND ANNEX 7 TERMS OF REFERENCE ANNEX 8 PROJECT COST ANNEX9 PROJECT LAUNCH WORKSHOP ANNEX10 PROJECT SUPERVISION PLAN ANNEX11 MONITORABLE INDICATORS ANNEX 12 DOCUMENTS IN PROJECT FILES  REPUBLIC OF TANZANIA FINANCIAL INSTITUTIONS DEVELOPMENT PROJECT CREDIT AND PROJECT SUMMARY Borrower: Government of Tanzania Implementing Agency: Bank of Tanzania Beneficiaries: Bank of Tanzania, National Bank of Commerce, People's Bank of Zanzibar, Capital Markets and Securities Authority, Private Financial Institutions. Poverty: Not applicable Amount: SDR 7.5 million (US$10.9 million equivalent) Terms: Standard, with 40 years maturity Commitment Fee: 0. 50% on undisbursed balances, beginning 60 days after signing, less any waiver. Financing Plan: See Section III D, Table 3 Net Present Value: Not applicable Project Identification No.: TZ PA 35620   I. BACKGROUND 1. 1. In 1991, the Government of Tanzania initiated its financial sector reform program with the support from an IDA credit for financial sector adjustment (FSAC). The aim of the program was to create a financial system that operates on the basis of market- oriented principles, is efficient in mobilizing and allocating resources, and effective in fostering long-term economic growth. Conceptually, the program was intended to: (i) support a stable, market-oriented macro-economic framework; (ii) strengthen the financial infrastructure, including banking and associated legislation; (iii) create a competitive environment and introduce private participation in the banking sector; and (iv) strengthen the existing banks. It was recognized, however, that the reforms needed to achieve these objectives could not be speedily implemented, given the precarious situation of the financial institutions. The short to medium-term objective was, therefore, to create an appropriate policy and regulatory environment conducive to private sector entry of both domestic and foreign banks while increasing private sector participation in existing financial institutions. Specifically, the program included passage of new banking laws and prudential regulations, restructuring of the three Government-owned commercial banks, legislation to promote private sector participation in the insurance industry, and initial steps to promote the emergence of a capital market in Tanzania through the enactment of the Capital Markets and Securities Act. 1.2. The reform program proceeded much slower than planned. Despite a number of advances, the portfolios of the government-owned banks - of which a large share consisted of loans to parastatals - were in more serious shape than foreseen and the reforms in the parastatal sector were slow to materialize. In August 1993, the Government released its Master Plan for Parastatal Privatization and Reform. The Plan entails the privatization, closure and liquidation of parastatals and the restructuring of remaining parastatals to enhance their financial and operating performance. Technical assistance is financed by an IDA credit for Parastatal and Public Sector Reform (PPRP) and the policy reforms will be supported by a proposed Structural Adjustment Credit (SAC), which will also support the continuation of policy reforms in the financial sector. 1.3. The proposed Financial Institutions Development Project would build upon FSAC and would complement the proposed Structural Adjustment Credit (SAC). Specifically, FIDP would finance the technical assistance required to assist with the implementation of reforms in the financial sector supported by SAC. Total financing of about $13.4 million equivalent, including $8.4 million in foreign exchange, would be required for the project. The proposed IDA credit of $10.9 million equivalent would support the following components: (a) the restructuring and privatization of the National Bank of Commerce (NBC) and the People's Bank of Zanzibar (PBZ); (b) continued strengthening of the Bank Supervision Directorate (BSD) at the Bank of Tanzania; (c) studies to upgrade the payments system and a business plan for a private credit information bureau; and (d) support for the development of the insurance industry and capital markets.  2 1.4. The proposed project is one of a series which aim to support the medium- to long-term development of Tanzania's financial sector. The restructuring of Tanzania's major financial institutions will lead, perforce, to a substantial reduction in basic financial services in some of Tanzania's remotest areas. The next financial sector credit, which would support a proposed Rural Finance project, would attempt to build upon the achievements of this project and sustain the expansion of financial services into rural areas. II. THE FINANCIAL SECTOR A. Overview 2.1. Since the Arusha Declaration of 1967, the Tanzanian financial sector was mainly Government-owned and comprised of (i) The Bank of Tanzania (BOT), the Central Bank, (ii) three commercial banks--the National Bank of Commerce (NBC), the Cooperative and Rural Development Bank (CRDB) and the People's Bank of Zanzibar (PBZ), (iii) two development banks--the Tanzania Investment Bank and the Tanzania Development Finance Limited, (iv) an assortment of smaller special-purpose non-bank financial institutions--the Tanzania Post Office Savings Bank, the Tanzania Housing Bank, the National Insurance Corporation, the National Provident Fund, the Parastatal Pension Fund and a hire purchase company; and (v) the Diamond Jubilee Investment Trust. Tanzania also had roughly 400 savings and credit societies, mainly located in urban areas and over 200 cooperatives involved in financial intermediation in rural areas. There were no capital or money markets, other than Government bonds and Treasury Bills issued primarily to the insurance company, pension funds and savings bank. However, the informal financial markets were active in foreign exchange dealings, fund transfers and debt financing. 2.2. By 1988, the financial sector was in a state of crisis, due mainly to the pervasive interference of the Government in the financial system. Credit was directed on the basis of Government priorities without regard to creditworthiness, and banks were convenient agents of fiscal policy. The lack of separation between fiscal and financial activities, combined with an unfavorable economic environment and an inadequate regulatory framework, led to a significant misallocation of credit to banking system clientele who were bankrupt and mostly in arrears; an ineffective monetary policy and an unstable macro-economic framework characterized by the unchecked growth in the money supply; and a lack of competition. Weak bank supervision further contributed to the crisis in the sector. 2.3. In August 1988, a Commission of Enquiry into the Monetary and Banking system was established by the Government. Its mission was to examine the sector and make  3 recommendations on how to improve its overall performance and support economic growth. The Commission presented its recommendations to the President in July 1990. These recommendations mainly focused on: (i) stimulating competition by encouraging private banks and joint ventures; (ii) strengthening the existing financial institutions; (iii) developing management accountability; and (iv) the recovery of non-performing loans. 2.4. Building on the findings of the Banking Commission, the Government implemented a series of measures in 1991. The Government issued a Policy Statement on financial sector reform which acknowledged the perverse impact on the sector caused by a lack of competition and Government interference. In an important reversal of policy, the Banking and Financial Institutions Act was enacted. The Act permitted the entry of private banks into the market and vested BOT with supervisory and regulatory controls. Also, interest rates were liberalized and banks were allowed to set lending rates below an announced maximum and to set deposit rates freely, subject to the twelve- month deposit rate being positive in real terms. The Government also enacted the Loans and Advances Realization Trust Act to create an expeditious machinery for the recovery of overdue debts. Finally, banking supervision in BOT was expanded and strengthened. 2.5. The reform program, which was supported by FSAC, consisted of four components. The first component aimed to support a stable macro-economic framework, including the development of a money market and indirect methods of monetary policy control, within which financial institutions would be able to operate autonomously. The second component of the program supported the strengthening of the regulatory environment including a revision and streamlining of banking and associated legislation, the introduction of banking supervision and regulation functions at the Bank of Tanzania and a review of the accounting and auditing framework. The third component supported the creation of a competitive environment and the introduction of private participation in the banking sector. The fourth component addressed institutional strengthening of the existing banks, including financial, organizational and managerial restructuring, recapitalization based upon both public and private participation; and the establishment of a mechanism for removing some non-performing assets from the banking system and for facilitating collection and liquidation where necessary. 2.6. Measured against the expected achievements of each of these four components of the reform strategy, FSAC enjoyed only minimal success. The program's major accomplishment was to deregulate and liberalize the banking system. However, a competitive banking industry is yet to emerge in Tanzania and a large reform agenda remains in each of the four areas of the strategy. The performance of FSAC's four components are discussed below.  4 B. Macro-economic Framework and Money Market Development 2.7. Economic Performance. Macro-economic performance has deteriorated since 1992/93 (i.e FY93). A fiscal surplus (including grants) which amounted to 2.3% of GDP in FY92 was reduced to a deficit of 8.1% in FY93 primarily due to a sharp decline in indirect tax revenues. Partly as a result of an accommodating monetary policy, the money supply increased by 40%, and inflation remained over 20% in FY93. In an effort to improve the fiscal situation, the Government passed a supplementary finance bill in January 1993 which increased tax rates and user charges, reduced tax exemptions, strengthened tax enforcement, and aimed to reduce expenditures. BOT also took steps to contain the growth of the money supply; these included the introduction of a treasury bill auction as part of BOT's efforts to use indirect methods of monetary control. These measures were augmented by the 1993/94 budget which called for substantial tax increases, including increases in customs sales taxes, introduction of a real estate tax, increases in various fees and user charges for Government services, inclusion of excise taxes on imports in the base used to calculate sales taxes, and further strengthening of tax administration. The budget also limited increases in recurrent expenditure. 2.8. Despite the introduction of these measures, macro economic performance declined further in FY94. Government borrowing from domestic sources amounted to approximately 5% of GDP in the second quarter of the fiscal year, indicating a serious loss of monetary control. This was largely due to very high levels of expenditure, particularly wage increases granted to the defense and security establishment and a large check float from the previous year. On the revenue side, collections of taxes on imports equaled less than half of assessed values due, in part, to a new policy of granting tax exemptions to a number of industries for their imported inputs. In addition, there were substantial leakages through the financial system as NBC extended credit to agricultural cooperatives. 2.9. In January 1994, the Government reached agreement with the IMF on a Fund staff monitored program. The program included the introduction of a comprehensive package of fiscal measures including the effective rescinding of the customs duty exemptions order and a review of tax exemptions with a view to decreasing their number. The program also included measures to improve the performance of NBC, including the reconstitution of the Board and steps toward the privatization of the bank (see below). 2.10. Money Market Development. In July 1993, the Government removed the remaining control on interest rates - the ceiling on lending rates of 31 percent per annum. Commercial banks were allowed to set their own interest rates on loans, subject to the rate being greater than the inflation rate. During that month, the Government also held its first foreign exchange auction and, in August, the Government introduced regular auctions of short-term treasury bills. The former was an important tool in unifying the  5 official and parallel currency exchange rates, while the latter was to establish a reference point for interest rates. Both auctions are important in soaking up excess liquidity and putting downward pressure on inflation and inflationary expectations. Since the introduction of the foreign exchange auction, the exchange rate has moved within a narrow band of between Tsh 515 to Tsh 544 to the dollar. On the other hand, T bill rates have varied sharply moving from 28 percent in September 1993 to over 90 percent and then to 47 percent at the end of 1994". However, the full impact of the T bill auction on reducing excess liquidity was offset by NBC which continued to inject liquidity into the economy by operating on minimal spreads and incurring operational losses. 2.11. One of the most important changes that the T-bill auction heralds is the establishment of a market-driven benchmark for other interest rates. Also, the T-bill auction can reduce liquidity in the system, and thereby reduce the historically high inflation rates in Tanzania. However, there are potential risks. First, the government may see the process as a new financing mechanism for future deficits. Second, the theory of market-driven interest rates is based on competition in the marketplace so that no single party can substantially influence the behavior of others. NBC dominates the financial sector and its behavior affects T-bill pricing. Participation in the market is very thin. Hence, improvements to the operations of the market will require: (i) stricter control of the deficit, coupled with better coordination between the Treasury and BOT on the former's cash flow requirements; (ii) a substantial reduction of NBC's dominance in the financial sector; and (iii) the creation of a secondary market for T bills. 2.12. More fundamentally, the development of a money market will require significant improvements to Tanzania's payments system. The system is based mainly on cash with checks used primarily by government ministries. The creation of the Dar es Salaam Clearing House in July 1993 was an important improvement to the payments system. However, the system is still at a very early stage of development and there are still long check clearing delays as a result of deficiencies in communications and transportation infrastructure. The time for a collecting bank to credit cleared funds to payee accounts is six working days in Dar es Salaam and up to 28 days for branches in the rest of Tanzania. This is one reason the Tanzanian public is very reluctant to use checks as a system of domestic payments. This is reflected in the unusually high ratio of currency in circulation to money supply (.36). The slowness and inefficiencies of the clearing system also pose serious problems for monetary policy management since large payment system floats make liquidity levels very difficult to manage. 11 The Government introduced a tax on T bills in July 1994.  6 C. Bank Supervision. 2.13. The Banking and Financial Institutions Act of 1991 strengthened BOT's bank supervision authority and, in November 1992, banking supervision was elevated to the status of a Directorate and staffing levels were increased. The directorate has evolved quite strongly as a result of a new series of banking laws and prudential regulations. It has begun to develop most of the basic skills necessary to conduct banking examinations and has conducted a series of on-site examinations. The initial design of examination methodologies for both on and off-site supervision has been undertaken and the development of regulations to support the legislative framework, including policy and procedural guidelines for the licensing of new banks and other financial institutions, has been issued. 2.14. A significant portion of the necessary upgrading of staff technical skills is being adequately addressed. The major weakness remains in the delays in implementing an effective off-site monitoring system. A number of standardized forms have been developed. However, implementation and compliance by the financial institutions have not been consistent. Also, a major constraint to effective bank supervision is the lack of integrity overall of the financial data. Accounting standards are very weak and disclosure poor; although a significant effort has been made to establish an off-site surveillance system, the struggle to ensure integrity in the data has been onerous. This difficulty is amplified in attempts to determine bank solvency through loan portfolio reviews. Consequently, a measure of the non-performing assets in the system is rudimentary, at best. The analytical skills and acumen of examiners need to be above average when dealing with such poor quality of information in order to glean from it some level of reliable analysis. 2.15. The directorate has a set of enforcement regulations which allow for issuance of "cease and desist" orders and/or monetary penalties to be imposed on the banks for non- submission of periodic reports. They can also take punitive action in the case of non- compliance of required liquidity or capital adequacy ratios. Hence, the BOT, upon the recommendation of the Directorate of Bank Supervision, has imposed penalty interest charges for failure to maintain the required levels of liquidity reserves. Until this year, the payments were simply debited from the banks' accounts with BOT, and the penalties were not sufficiently onerous to modify the behavior of the banks. 2.16. The Directorate is divided into three units (banks, non-bank institutions, and foreign exchange bureaus), each of which has an on-site examination section and a central financial analysis section which is mandated to undertake off-site surveillance activities. Unfortunately, the current staffing of these sections is heavily skewed towards the examination groups. The financial analysis sections are understaffed, and off-site supervision activities have suffered as a result. This understaffing only compounds the  7 basic problem as the financial institutions themselves do not take the reporting requirements seriously and have not complied with the basic financial reporting regulations on a timely basis. 2.17. The efforts of Bank Supervision to date can best be described as limited in scope but expanding on an ambitious scale. The Directorate's work has concentrated mainly on examinations of the larger NBC branches and protracted exams of both CRDB and the Tanzania Investment Bank in anticipation of the implementation of their scheduled restructuring programs. The examination sections have conducted on-site examinations at each of the five Government banks and have reported on the virtual insolvency of each of these institutions. Their examinations have revealed that over 70% of all loans in these banks are non-performing and that all are operating in an unsafe and unsound manner. 2.18. The severe problems within the financial institutions make the role of the Directorate all the more critical and complex. Gross errors in basic loan approval systems and accounting techniques continue despite many warnings by Bank Supervision. The capital requirements necessary to rectify the situation as found in these examinations and restore the financial system to solvency are massive. Over the next few months, the Directorate will have to devote even more attention to the problem banks, even as new banks enter the market. This will severely strain the Directorate's capacity, test the skills of its staff, and curtail its ability to conduct new on-site examinations. 2.19. The Directorate also must make greater use of its enforcement powers, including the ability to impose monetary penalties and issue cease and desist orders as well as the ability to remove bank management when it continues to ignore directives. The office must increase its staffing levels with particular emphasis on off-site surveillance analysts in order to strengthen its off-site monitoring capabilities. 2.20. The complex and difficult restructuring programs which will require substantial oversight by Directorate personnel will severely test the technical abilities and staffing levels of Bank Supervision. The Directorate needs to expand substantially if it is to properly perform its functions as one of the architects of the future financial system, as well as conduct the number of in-depth on-site examinations it must be able to undertake annually. While the expansion of staff levels is clearly needed, the ability to effect this growth while simultaneously training the new staff is critical. Placing inexperienced and untrained bank examiners in the field too early can be counterproductive. The ongoing series of staff training programs must be continued in order for Bank Supervision to reach its potential as an effective regulatory unit. The programs also must be augmented to expand its focus on the internal control environment and the corporate governance processes required to mitigate risk. This is of particular importance as the financial system expands and diversifies.  8 2.21. These issues must be addressed and resolved if the Directorate is to carry out its role to protect the interests of depositors, implement BOT policies and maintain the safety and soundness of the financial system. D. Competition 2.22. The reform program encouraged the emergence of a competitive environment through the introduction of private sector participation in the banking sector. Participation was envisaged through the entry of new banks and the restructuring and privatization of existing banks. Two new banks began operations in late 1993 and four other banks have been licensed2. Understandably, the new banks have been very cautious and have been limiting their activities in terms of deposit mobilization and lending. Their behavior, to some extent, is dictated by the overall economic environment, but also to the disappointingly slow pace of restructuring of the National Bank of Commerce. E. Bank Restructurinz 2.23. FSAC supported the strengthening of the existing banks, including restructuring and recapitalization. Progress in this area was disappointing. Although the Government- owned financial institutions were to be recapitalized with significant portions of their non- performing assets transferred to the specially created Loans and Advances Recovery Trust (LART), the banks are still insolvent and incurring substantial losses. 2.24. Loans and Advances Realization Trust (LART). LART was created in June 1991 and became fully operational in early 1993 following the appointments of the Administrator, Board and Tribunal members in June 1992; and the signing of Memoranda of Understanding (MOU) specifying the responsibilities and obligations of the banks and the Government pertaining to the transfers of non-performing assets. Following the completion of portfolio reviews and loans classification by BOT, approximately Tsh 36 billion of the non-performing assets of NBC, CRDB and TIB were transferred to LART in 1993. These assets represented 91 separate corporate customers, including 24 parastatals and incorporated 104 actual credit facilities. As of January 1995, eighty (80) firms have been placed under receivership including 22 parastatals; 8 firms were sold, including 2 parastatals, and of these 8, 4 firms have completed the dissolution process. Loan recoveries by LART to year end 1994 amounted to Tsh 1.6 billion or 23% of the total estimated recoveries of Tsh 7 billion. The legislation which created LART requires that it be wound up by the end of 1995. 2.25. Restructuring the National Bank of Commerce. Given NBC's doininance in the financial sector, the pace of its restructuring essentially determines the pace of financial 2/ One of the new banks was closed in March, 1995 and subsequently taken over by another foreign private bank.  9 sector reform in Tanzania. The largest and oldest commercial bank in Tanzania, NBC has, for the past 28 years, enjoyed a virtual monopoly in terms of branch network, savings mobilization and extension of credit and other commercial banking services. Faced with rising costs, high levels of non-performing assets and declining efficiency, the bank is undergoing financial and organizational restructuring, and at the same time redefining its market niche as private commercial banks enter the market. In 1992, the Government began implementation of a plan to restructure the bank. The plan called for the gradual restructuring of the loan portfolio using guidelines for classifying risk assets and provisioning, the downsizing of NBC's branch network and staffing, and a structural reorganization aimed at separating business development functions from credit management while placing new emphasis upon account and portfolio management. 2.26. NBC was recapitalized by the Government in a two-part transaction in November 1992 and in October 1993. The recapitalization required the issuance of Tsh5O billion in treasury bonds at an annual expense to the Government of Tsh 8.6 billion. The transaction was relatively complicated: subsequent to a loan portfolio review as of December 1991 that was completed in December 1992, some Tsh 28 billion loans were turned over to LART for collection; Tsh47 billion of outstandings were effectively charged-off but NBC continued to manage collections for the benefit of Government under a fee arrangement; at least Tsh8.8 billion were guaranteed by the Government and, thus, were retained as loans to Central Government; and some Tsh4.3 billion loans were characterized as long-term loans. In addition, as part of the overall restructuring program, 23 loss making branches were closed and 2,000 staff were retrenched. 2.27. In the second half of 1993, there were a number of setbacks to the restructuring program especially in terms of branch closings, staff retrenchment, and credit policies. Also, with the introduction of the T bills auction system, NBC was slow to raise deposit rates to face the competition from the auction, and was equally slow in adjusting its lending rates in an increasingly illiquid environment. These factors, plus a substantial increase in the minimum reserve requirements from 4 percent to 10 percent, placed the bank in a precarious financial position by January 1994. 2.28. A short term action plan to curtail losses and to begin preparations for a more radical restructuring of NBC was adopted in February 1994. A ceiling on outstanding loans was imposed at the level of January 31, 1994. Data through March 1995 indicate that NBC is complying with the ceiling, which will continue until a new and professional management team in NBC has prepared and begun implementation of a new business plan. NBC also was directed to cease lending to non-performing borrowers. The Board of Directors was reconstituted at the end of March 1994, and they, with the senior management, quickly undertook to institute a number of measures to redress the situation, examples of which included: (a) suspension of new credit facilities and scaling down of existing facilities by 20% to all but the most liquid and performing borrowers,  10 (b) intensification of loan management and recovery efforts including foreclosure of securities pledged on past due accounts, (c) credit training, and (d) instituting disciplinary action against dishonest employees as well as retrenching 800 additional staff by April 1994. The NBC Act was amended in August 1994 to provide for private shareholding. A detailed portfolio review was completed in September, 1994 as part of a diagnostic evaluation of the bank. The evaluation will firm up the details of the Government's privatization strategy for NBC. 2.29. NBC's loan portfolio grew by 10% per annum during the three year period from June 1991 to June 1994. This represents a significant reduction in real terms. The distribution of the most seriously classified loans (doubtful and loss) across sectors, according to both NBC and a diagnostic evaluation, is not proportionate to loans outstanding. The private portfolio grew from 41% of gross loans outstanding in June 1993 to 50% in June 1994, but constituted only approximately 30% of the doubtful and loss loans. The proportion of NBC's portfolio that is cooperative and marketing boards has decreased by 9% since June 1993, but it still represents around 34% of the losses. The percentage of NBC's portfolio devoted to parastatals has declined by 5%, from 26% to 21% and represents approximately 23% of the loss and doubtful loan portfolio. Updated numbers to December 1994, show the portfolio continues to deteriorate with only 9% of the portfolio unclassified as at that date. 2.30. The three portfolio reviews completed in 1994 indicate that the portfolio has continued to deteriorate over the year. The last review in December 1994 confirmed that non-performing loans i.e. classified sub-standard or worse had reached a level of 77% of the total portfolio, as compared to previous estimates of 50% to 70%. The varying estimates reflect previous major uncertainties about the bank's current financial condition stemming in particular from the integrity of Tsh 58 billion of reported interest income, and the appropriateness of characterizing Tsh 21 billion of liabilities as equity. Hence, despite the implementation of the action plan in February 1994, it is now apparent that the bank again is seriously insolvent and requires a very dramatic downsizing and restructuring if it is to stem current losses and successfully reach self-sustainability (see Annex 3 for a summary of NBC's unaudited balance sheet and income statement as of June, 1994). 2.31. The gap between NBC's third posting of June, 1994 numbers as provided in Annex 3 and financials reflecting the adjustments that have been recommended as a result of the diagnostic review are vast. NBC's numbers showed a Tsh 20 billion profit for the year, despite current year provision expenses of Tsh 38.6 billion. With the financial adjustments made to the June 1993/1994 statements, NBC will record a loss of over Tsh 50 billion. The magnitude of the loss is due to a number of items. Operationally, NBC has been accruing interest income on non-performing loans and Tsh 10 to 14 billion is to be added to the losses, as accrued interest income is correctly reversed for loans which  11 were past due 90 days or more. Even if only 50% of the loan portfolio had been non- performing throughout the year, Tsh58 billion of interest income equates to a stunning 62% yield on the remaining accruing loans. Interest income increased by 60% or Tsh22 billion over FY93. While the yield on gross loans reached 33%, the cost of deposits declined to 7%. 2.32. In addition to the questionable net interest margin, other sources of NBC's FY94 income seem unsustainable, at best. Exchange gains reached Tsh22.4 billion, a 167% increase supposedly reflecting successful trading activities of NBC. Much of this gain has had to be reversed as NBC's auditors have disallowed the income. Meanwhile, non- interest expenses have increased by 40% from Tshl8.6 billion to Tsh26.1 billion. The biggest increases were in retrenchment costs, depreciation, and maintenance. If exchange equalization gains and revaluation of real estate are excluded from equity and all of the currently most conservative estimates of provisions, reserves and interest income reversals are used, then equity could fall to between a negative Tsh 55 and 75 billion. 2.33. The sizable adjustments to NBC's financial statements was caused by: .considerable difficulties in clearing interbranch transactions including uncleared checks, money transfers and other risk assets (for example, mishandled funds). The extent of the problem was reflected in the large and unreconciled balances in the Head Office Suspense and Interbranch Clearing accounts. These are the result of NBC's cumbersome interbranch clearing system and the absence of proper internal controls to prevent loss or funds manipulation. As a result of a major effort by NBC to clean up this problem, the previous 80 troublesome branches have been reduced to 8 to 10, with the unreconciled balances reduced to a small fraction (10%) of their former level, however, still recording a large unreconciled position requiring a reserve of Tsh 17 billion. . previous substantial unreconciled balances in the House account. This account is the repository of other transactions which have not been settled, i.e suspended items other than normal checks and money transfers. Examples of such items include forged checks. Although the Board set a date of September 30, 1994 to clear all long-standing items in this account, this was not achieved and the diagnostic review identified a required reserve of Tsh 12 billion. . the lack of internal controls and inadequate reconciliation and audit procedures over a number of other internal accounts. Consequently, a number of additional adjustments relating to nostro balances, bills negotiated, contingent liabilities, among others were required. The discrepancy for these accounts alone amounted to over Tsh 25 billion.  12 . NBC's staff lack of experience with, and understanding of, the loan classification process. The Credit Department charged with responsibility for credit analysis and loan review has been unable to reconcile the quarterly provision reports, which enumerate and classify the branch's loans, with either the loan balances reported on the general ledger or the balances removed and/or guaranteed by the Government as part of the recapitalizations; . the accounting associated with the transfer of loans to LART and the recapitalizations in FY1993 and FY1994 has neither been timely nor well understood. As a result, NBC's management has not been able to track trends in the quality of its loan portfolio given their inability to segregate non- performing loans from those of subsequent periods. As well, the 11% coupon to service the bonds which replaced the assets moved to LART, has never been paid by the Government, severely hampering NBC's ability to operate on a commercial basis. 2.34. NBC's management and staff are making substantial efforts to deal with its significant non-performing loan portfolio, as well as institute proper control procedures across the bank. Measurement of loan collection results has been introduced bankwide. Staff are fully aware of the new priority and their success in collection is being strictly monitored and will impact the personnel appraisal system. A new loan recovery unit has been established to deal with the largest and toughest credits. A detailed loan recovery plan for the largest 50 credits has been finalized and is under implementation and this coupled with evidence of tangible collection results is a precondition for appraisal of the proposed SAC. However, despite these diligent efforts to restructure and strengthen its operations, the bank again appears to be on the brink of insolvency and is imposing an increasing burden on Tanzania's real sectors. It is urgent and essential that NBC is far more fundamentally restructured than what has been envisaged to date. 2.35. Restructuring the Cooperative and Rural Development Bank. After a delay due to problems in securing funding for technical assistance, a detailed restructuring plan for CRDB was finalized. The problems stemmed from donor requests in 1992 for a change in CRDB's senior management and for the appointment of a private external auditor. From July 1992 through June 1993 CRDB's net worth deficit deteriorated substantially. Company prepared financial statements for 1993 contained gross accounting errors which overstated collected interest income which had actually been capitalized, under provided for non-performing assets, and erroneously recorded the bond received. Hence, it is difficult to provide the exact extent of the deterioration in the bank's net worth. However, estimates range from a deficit of Tsh. 27.3 billion to a deficit of Tsh 35 billion as of June 30, 1993, particularly if the in-house suspense items are reconciled and the loss position is recognized. In either case, this is a significant increase over the Tsh  13 21.5 billion deficit reported in the June 30, 1992 audited financial statements and illustrated the continuing deterioration of the institution. 2.36. There has been an improvement in performance as the management moved aggressively to implement the restructuring plan. The plan calls for the privatization of CRDB through the sale of shares to cooperatives and private individuals, with up to 30 per cent of the shares retained by a Trust, capitalized by DANIDA, pending their sale to the public. A new organizational structure for headquarters, zonal and branch offices was prepared and, as a result, a total of 600 staff members were retrenched. However, CRDB's losses continued to grow and the bank's viability remained questionable. Furthermore, in recapitalizing CRDB, some donor financed lines of credits were erroneously omitted from the bank's balance sheet. The result was that CRDB remained undercapitalized even after the last capital injection by the Government in October 1993. 2.37. The BOT has imposed a freeze on lending until completion of the recapitalization program. To date, CRDB has made some progress: C Capital. CRDB completed its privatization program in January. Sale of shares to the public has been much stronger than anticipated with 9,962 individuals holding 41% of the approx. 200,000 offered. Danida's shares represent 29%, cooperatives 16%, and corporations 14%. Notwithstanding this success, the capital adequacy of the bank remains in question until the external audit of its books is completed and the level of recovery, provisioning and write-off of impaired assets is finalized and the statements are approved by BOT. * Management. Senior management are very committed, although their experience in restructuring a troubled commercial bank is very thin. Retrenchment to date has been sizeable with total staff decreasing from 1,600 to 1,000 to date. Further staff reductions may be undertaken. The impact of the retrenchment has allowed CRDB to reduce its operating expense from over 60 per cent to 54 per cent of financial income by June 1994. The targeted level is 33 per cent. The annual statements, once finalized, will indicate annual performance against target. * Earnings. Due to accounting problems, it is difficult to determine if CRDB is profitable. By CRDB's rough calculation, it has had loan recoveries of Tsh 10.5 billion, although the booking of these recoveries has been credited, in error, to the wrong general ledger accounts. Consequently, both income and asset accounts need to be reconstructed to enable CRDB to audit its books and issue its financial statements.  14 Liquidity. Despite a strong deposit mobilization effort, CRDB's liquidity position was very weak during 1994 causing, at times, their expulsion from the clearing house and fines by the BOT for non-compliance with the cash reserve ratio. Its large non-performing portfolio has been the main reason for its tight liquidity. The BOT has worked with CRDB to manage its liquidity position and the Bank Supervision Directorate monitors the position weekly. By the third and fourth quarters, loan recoveries coupled with some deposit mobilization enabled CRDB to comply with the liquidity regulations. Strong management of this position, however, continues to be required. 2.38. Despite the bank's reported successes in loan recovery and equity mobilization, the overall financial position remains in question until the significant accounting problems are resolved and the audit finalized. Only following resolution of these issues and demonstrated compliance with all prudential guidelines, will the BOT allow a change in licensing status. Until then, a freeze on further lending will remain in place. 2.39. Restructuring of Tanzania Investment Bank (TIB). Prior to FSAC, TIB mainly lent to industrial parastatals and over 90 per cent of its portfolio was in arrears of one year or more. The bank also was illiquid. An advisory team was appointed in October 1992 and a restructuring plan was finalized and agreed with IDA. Major elements of the plan included a redefinition of TIB's role and its transformation into a merchant bank; and its privatization through sale of a majority of its shares to a foreign partner. TIB has ceased all lending, pending its transformation and privatization. 2.40. Restructuring of Other Banks. A restructuring plan for TDFL was finalized in 1992 and the institution was recapitalized by its shareholders. A restructuring plan for the Tanzania Housing Bank was finalized in April 1994. The People's Bank of Zanzibar remained undercapitalized for most of the program period. Although PBZ's non- performing assets were transferred to LART in November 1993 and the bank was recapitalized, a restructuring plan was not finalized. Preparation of the restructuring plan did not begin until February 1994 and the plan is yet to be finalized although a draft is now available. F. IDA's Previous Role and Lessons Learned 2.41. IDA supported the Government's policy reforms in the financial sector through FSAC. The program legally deregulated and liberalized the banking system. However, it failed to accomplish the intended restructuring of NBC, and consequently, although private banks have opened, the major problem in the sector remains the absence of meaningful competition.  15 2.42. There are three major reasons why FSAC failed to accomplish the significant restructuring of the banking system which was envisaged. These factors would all be addressed by the proposed Financial Institutions Development Project. First, the program assumed that the emergence of competitive private banks would gradually erode NBC's market share. Although there has been some loss of market share, future expansion by the private banks will be constrained by their limited Dar es Salaam branch networks and, more importantly, their strategic targeting of relatively narrow niches. As a result, NBC remains dominant and will continue to dominate. A more aggressive strategy, which is supported by the proposed project, is required to reduce NBC's market share. Second, FSAC financed advisers to NBC's management. However there was no incentive for NBC's management to change and no incentive for the experts to perform. Until recently, there had been no discernible change in NBC's banking culture. The proposed project would finance a management team for NBC who would be evaluated, in part, on the basis of NBC's financial performance. Third, FSAC did not include timebound performance targets against which NBC's performance could be judged. The proposed project includes dated monitorable targets. G. Rationale for IDA's Involvement 2.43. Country Strategy. The Bank's lending strategy is to assist the Government to reduce poverty through an acceleration in the pace of structural reform and the provision of infrastructure and social services (especially targeted to the poor), while ensuring an environmentally sustainable development path. The strategy articulates specific criteria for determining Tanzania's eligibility for substantial IDA support, including adjustment loans. The criteria include improvements in the operation of public sector banks, including stemming losses, increases in the quality of their portfolios, the introduction of private management, and eventual divestiture. The proposed Financial Institutions Development project seeks to strengthen the banking sector and, more broadly, improve the access of the private sector to the banking system in general and to capital markets. IDA also is assisting the Government with the formulation of a strategy for the development of rural banking. 2.44. The development of a market-oriented financial system is a complex process which will require sustained efforts over many years and will need to be supported by a series of IDA operations. The Government's reform program, which was supported by FSAC, enjoyed some success in creating a regulatory environment conducive to the entry of both domestic and foreign private banks. The proposed Financial Institutions Development Project would address the major remaining impediments by: (a) increasing efficiency and competition in the sector; (b) strengthening the financial infrastructure; and (c) putting in place an appropriate regulatory environment for the orderly evolution of a capital market. The project would complement the proposed Structural Adjustment  16 Credit which supports the Government's parastatal reform program as well as policy reforms in the financial sector. lIl. THE PROJECT A. Project Objectives 3.1. Obiectives. The progress of the Financial Sector Adjustment program was reviewed above. The review revealed that the sector is still very weak and that the reform agenda is far from complete. Furthermore, in 1993 there was a reversal in some major elements of the program. Although the Government has implemented a short term program to stem the losses in the sector, it wishes to regain the momentum for financial sector reform by implementing a strategy which would address the fundamental weaknesses in the sector while building the foundation for the diversification of financial instruments. The main elements of the strategy are (by order of priority): (i) encouraging competition in the commercial banking sector; (ii) strengthening banking regulation and supervision; (iii) improving the payments mechanism especially in rural areas; iv) promoting and supporting comprehensive parastatal reforms, including privatization, of state owned enterprises; (v) developing a market for Government securities; (vi) establishing a regulatory structure for securities and insurance markets; and (vii) developing a corporate securities market. In this context, the primary objectives of the project, which are articulated in the Government's Letter of Financial Policy (see Annex 1), are to develop a market-oriented financial system and to ensure the orderly and gradual evolution of capital markets in Tanzania while supporting the privatization process. B. Summary Project Descrivtion 3.2. The scope of the project, which would be supported by a $10.9 million credit, is described in detail below. The proposed project would include the following components: (i) restructuring and privatization of NBC and PBZ within an agreed timetable; (ii) strengthening of BOT's Bank Supervision Directorate; (iii) developing a mechanism for regulating the insurance industry; (iv) studies on possible improvements to the payments system and the feasibility of a private credit information bureau; and (v) technical assistance to develop an appropriate mechanism for regulating and overseeing the evolution of a capital market, as well as appropriate vehicles for facilitating broad based participation in the privatization program.  17 3.3. The project would consist of three components: (1) The Banks Restructuring Component would support a strategy for aggressively downsizing NBC and restructuring PBZ. Support would be provided for: (a) implementing the divestiture of at least one of NBC's urban branch networks and establishing a joint venture subsidiary to focus on corporate and international finance; (b) a management team for the remaining NBC; (c) a management team for PBZ; and (d) non-resident banking advisors to the Ministries of Finance (as the sole shareholders of NBC, THB, TIEB and PBZ). (2) Financial Infrastructure Strengthening Component would support: (a) an intensive program aimed at rapidly developing Bank Supervision in BOT; (b) establishment of an Insurance Commission; and (c) a technical assistance fund to finance a series of studies on improvements to the payments system and the possible creation of a Credit Information Bureau. (3) The Capital Markets Development Component would support the establishment of a Capital Markets and Securities Authority and the first three years of operations of a Privatization Investment Fund. Table 1: Project Components Summary (US$ million) Item Technical Computer & Office Assistance Training Studies Office Equip. Vehicles & Res. Accom. Other Total BANK RESTRUCTURING 4.3 0.0 0.0 0.3 0.0 1.1 0.0 5.7 NBC 2.7 0.0 0.0 0.3 0.0 0.6 0.0 3.6 PBZ 1.0 0.0 0.0 0.0 0.0 0.4 0.0 1.4 MOF 0.6 0.0 0.0 0.0 0.0 0.1 0.0 0.7 FINANCIAL 2.0 0.7 1.7 0.0 0.0 0.6 0.0 5.1 INFRASTRUCTURE STRENGTHENING BOT 0.0 0.0 1.7 0.0 0.0 0.0 0.0 1.7 Bank Supervision 1.7 0.6 0.0 0.0 0.0 0.5 0.0 2.8 Insurance Commission 0.3 0.0 0.0 0.0 0.0 0.1 0.0 0.5 CAPITAL MARKETS 1.5 0.0 0.0 0.1 0.0 0.5 0.0 2.1 CapitalMarketsand 0.6 0.0 0.0 0.1 0.0 0.3 0.0 1.1 Security Authority Privatization Trust Fund 0.8 0.0 0.0 0.0 0.0 0.2 0.0 1.0 PROJECT 0.0 0.0 0.0 0.0 0.0 0.0 0.5 0.5 MANAGEMENTl TOTAL 7.8 0.7 1.7 0.4 0.1 2.3 0.5 13.4 Note: Includes contingencies. Also, totals may not add due to rounding.  18 C. Detailed Proiect Description Banks Restructuring ($5.6 million) 3.4 NBC ($3.6 million). The project would support implementation of a restructuring and privatization strategy for NBC. In normal circumstances, the appropriate prudential response to NBC's current financial position would be to stop it from lending or taking new deposits, pending rapid action to recapitalize the bank or liquidate it. Given the dominance of NBC in the financial sector, and the consequent macro-economic effects of its demise, liquidation is not practical at this time. The strategy therefore is to constrain NBC's activities as much as possible, to avoid macro- economic instability while allowing the bank to meet the legitimate needs of the productive sectors. NBC would be downsized, until such time as it can meet prudential requirements and be fully privatized (or liquidated, if it is unable to compete). Meanwhile new banks are encouraged to enter the market. 3.5. Details of the strategy will be defined by an ongoing diagnostic evaluation of NBC. However, the strategy's broad elements entail: (a) carving out from NBC one or two profitable urban branch networks (each network consisting of 8 to 10 branches) for divestiture while retaining within a partially privatized NBC a national presence in urban areas and a strong rural branch network; (b) the possible creation of a joint venture subsidiary of NBC (in partnership with a strong private bank with an international network) to focus on corporate and international transactions; (c) the restructuring of the retained NBC under new and professional management. 3.6. A schedule of activities which constitutes the broad elements of the strategy is attached as Annex 2. First, the diagnostic evaluation, including an updated portfolio review, would define the strategy for restructuring NBC including recommendations for divestiture and the disposition of the impaired assets. The Government also has recruited three senior, experienced commercial bankers as Deputy Managing Director\Chief Operating Officer, Director of Finance and Credit Manager in NBC. Second, a review of the features of the strategy would occur during the diagnostic evaluation so that the remainder of the diagnostic evaluation could concentrate on: (a) analyses of the implementation implications for NBC; (b) rapidly outlining a strategy that will maximize the value of the branch network(s) sale and maximize the benefit of NBC's downsizing on the financial sector overall; and (c) getting the joint venture underway. Third, the pro formas for the entities and/or facilities to be offered for sale would be finalized and agreed by the Government and NBC. This would likely include the removal of some portion of the non-performing loans to a recovery unit that would be moved to a subsidiary for collection. The residual NBC, after charging off the loans, would be a smaller organization and would add some urgency to the tasks of reducing head office  19 administrative costs and rationalizing the rural branch network. Fourth. terms and conditions for the sale of urban branch network(s) and the joint venture international/corporate subsidiary would be prepared. Sales memoranda, authority to disclose terms and contact particular buyers would be agreed. The schedule calls for the opening of the urban network(s) under new ownership and for the joint venture to begin operations by October, 1995. Conditions of the credit's effectiveness include the completion of the diagnostic evaluation with a time-bound business plan, satisfactory to IDA, for the implementation of the downsizing and restructuring of NBC and the appointment of a consulting firm or an investment bank to implement the divestiture strategy. 3.7. Implementation of the strategy required a clearer understanding of NBC's current financial position. The uncertainties surrounding NBC's financial situation were described in Section II and reflect three major problems: (a) inappropriate accrual of interest income on non-performing loans; (b) substantially higher provision requirements for loans, other assets, and contingent liabilities; and (c) mischaracterization of certain asset and liability accounts. Adjustments required by external auditors were made to NBC's FY 1993/94 accounts prior to their finalization. The adjustments included the write-off of all loans classified as loss. During negotiations, IDA received assurances that, beginning with 1994\95, NBC will submit to IDA, annual audited accounts within six months of the end of NBC's financial year and appropriate adjustments will be made and all loans classified as loss will be written-off prior to the finalization of the accounts. 3.8. The project will finance a senior management tean in NBC for three years. The team, which consists of a Chief Operating Officer, a Director of Finance, and a Credit Manager, will prepare a business plan acceptable to IDA. The plan will: (i) provide for continued credit restraint as NBC is restructured; (ii) address the significant portfolio of non-performing assets; and (iii) aim to restructure the remaining bank into a self sustaining and viable going concern. The plan will include time-bound performance targets e.g. reductions in the ratio of operating costs to average total assets, increases on the return on average total assets, reductions in the percentage of non-performing loans in the portfolio, establishment of an appropriate loan to deposit ratio, increases on the ratio of loan collections to scheduled collections and the adequate diversification of credit risk. These ratios will be defined to ensure that aggregate lending could only increase if there is a substantial strengthening of profitability and the quality of the asset portfolio. The plan also will serve as a yardstick for prudential supervision until such time as NBC meets prudential requirements. The management team has been appointed with terms of reference acceptable to IDA. 3.9. During negotiations, IDA obtained the Government's assurance that the NBC interim business plan, including a recovery plan for the non-performing  20 loans, would be sent to IDA for approval and that NBC would be required to adhere to the plan's performance targets. Also, assurances were obtained on the continuation of the ceiling on NBC's overall lending as well as on lending to parastatals until the business plan is prepared and under implementation. In order to monitor lending to non-performing borrowers, IDA also received the Government's assurance that NBC will submit monthly reports to BOT on outstanding loans to large borrowers. The finalized business plan would be furnished to IDA no later than October 31, 1995. 3.10. PBZ ($1.4 million). PBZ is the principal commercial banking institution in Zanzibar. The recent examination of PBZ in December 1994 revealed that the bank was insolvent and that roughly 70 per cent of its portfolio were rated substandard, doubtful or loss. The main reasons for its poor financial status include a very weak loan portfolio resulting from poor credit policies, a failure to previously recognize non-performing assets (including continued interest accrual on such assets), and previous failure to establish sufficient provisions for uncollectible loans. 3.11. Part of the difficulty experienced by the PBZ is that prior to December 1993 the bank performed functions on behalf of the Government of Zanzibar which were not traditionally associated with commercial banking. These included the maintenance of substantial foreign exchange reserves on behalf of its parastatal clients who eam foreign exchange for their exports. Presumably, this arrangement was meant to ensure the availability of foreign exchange when needed to cover imports. However, this hoarding of foreign exchange resulted in unnecessary interest being paid on foreign borrowings and a funding cost to PBZ, which had to borrow from the BOT to compensate for the non- receipt of the T shillings counterpart. Additionally, the bank had subsidized the import of basic food items by financing imports for sale in the local market below cost; this would normally have been a treasury function. 3.12. The Government of Tanzania recognizes that the development of the financial system in Zanzibar will depend critically on the restructuring of PBZ. The objective is to convert the bank into a viable commercial bank and to transfer all non-commercial banking activities to BOT and the Ministry of Finance in Zanzibar. Furthermore, all services rendered to the Government would be fully paid for and priced at market rates. The immediate aim would be to restructure PBZ and place it under private management. The credit would finance the remuneration of two experts as General Manager and Financial Controller for two years. Their main responsibilities will be to oversee the restructuring of the bank. Specifically, this will include the preparation of a business plan, the formulation of appropriate policies and operating procedures, installation of effective internal control, the design of a marketing strategy, and the introduction of new financial services. During negotiations, IDA received the commitment of the Government that: (a) a General Manager and Financial Controller, acceptable to  21 the Borrower and IDA, would be appointed to manage PBZ by October 31, 1995; and (b) a restructuring plan would be adopted for PBZ. In addition, beginning with 1994/1995, PBZ will submit to IDA, annual audited accounts within six months of the end of its financial year and appropriate adjustments will be made and all loans classified as loss will be written-off prior to the finalization of the accounts. 3.13. Ministry of Finance. ($0.6 million) The credit would also finance the services of up to two advisers to the Ministries of Finance on the mainland and in Zanzibar and to the Boards of NBC, THB, TIB and PBZ within the respective ministries. The appointment of Banking Advisors under terms of reference acceptable to IDA is a condition of effectiveness. Financial Infrastructure Strengthening ($4.9 million) 3.14. Bank Supervision ($2.7 million). A Bank Supervision Advisor has been provided to BOT as part of the IM's program of technical assistance. This component would complement the IM's technical assistance by providing focused technical assistance to the Bank Supervision Directorate for the supervision of problem institutions, on site examinations, methodology development, and training. 3.15. Problem Institution Supervision (US$ 0.9 million). A major role of Banking Supervision will be to closely monitor the restructuring or liquidation of the state-owned financial institutions. This regulatory role is a critical one to ensure these institutions are returned to viability or liquidated in a manner which would not be disruptive to the financial system. While the regulator should not interfere with the commercial transaction relating to a sale or purchase of a problem institution, its approval of the transaction is a prerequisite to its conclusion. Also, Banking Supervision's credibility will be greatly enhanced if it is widely viewed as integral to the resolution of problem institutions. Hence, the project would finance consultancies to: (1) monitor the restructuring of the five state-owned banks; (2) advise on the progress of the respective restructuring plans; (3) assist with problem institution supervision of NBFIs and foreign exchange bureaus; and (4) direct the design and delivery of the Problem Institution Management (PIM) training course for all the examination staff of Banking Supervision. 3.16. On-Site Examination (US$ 0.4 million). Specialist support is required for roughly up to one year to bring the skills of the Bank SLLpervision Directorate up to an adequate level in all high risk areas. The main focus will be on the development of the on-site methodology pertaining to the internal control environment. Emphasis will be placed on the role of the Board, as well as the treasury and systems areas, including wire payments and money laundering. The consultant(s) wouldi report directly to the Director, Banking Supervision but will be supervised by the IMF Advisor. However, when on-site, this  22 specialist would work in a line examination role and report to the Manager, Examination or the Examiner-in-Charge. 3.17. This expert(s) would work with the examiners to support them in risk identification and risk mitigation. In addition, the specialist would be required to assess risk management systems in each financial institution and provide feedback to these institutions on their ranking relative to their peers. One output of such an exercise would be the development of a best practices/minimum standards paper on key risk areas which would be provided to existing institutions and to new financial institutions as a requirement of the licensing process. In addition, this consultant(s) would be called upon to: (1) develop the treasury and systems examination modules under the direction and guidance of the IMF Advisor; (2) assist with the design and delivery of internal control training programs in the high risk areas including but not limited to treasury and systems; and (3) revisit the existing guidelines and regulations in the key risk areas, especially relating to liquidity, interest rate risk, open market operations, as well as off-balance sheet and off-shore operations. 3.18. Methodology ($0.8 million). The IMF Advisor is to provide technical assistance for the development and completion of the methodology efforts of the Banking Supervision Directorate. There are three key areas where methodology needs to be designed, articulated and documented for use in the field. These include: o Off-site examination - A rudimentary system of off-site surveillance has been developed and is in operation. However, the reporting requirements are incomplete, onerous and not well integrated with other information requirements of the BOT. The banks have responded either by not reporting or by reporting too late to have the information serve any useful purpose. Also, the information reported is of questionable accuracy. As well the existing system does not include early warning triggers to warn of the development of negative trends in the industry such that corrective regulatory action can be taken. In order to resolve the problem, the project would finance both short and long term consultancies required for the implementation of the following three stage program. First, Banking Supervision with the assistance of legal and technical expertise under the direction and coordination-ordination of the IMF Advisor, needs to review the current laws, regulations and guidelines in order to ensure all major areas of risk are well addressed by the regulatory framework. Second, once this review has been completed, the regulatory reporting requirements can be amended, updated and refined, as necessary. Also, the  23 National Board of Accountants and Auditors (NBAA), will be commissioned to upgrade the accounting and disclosure requirements for financial institutions. It is well recognized by BOT that consultation with the industry during this process will be critical to improving the level, quality and timeliness of the revised regulatory reporting. The IMF Advisor will be responsible for coordinating the NBAA project, the results of the regulatory review exercise and the results of the interface between Banking Supervision, the industry and NBAA. Banking Supervision will devote the part-time assistance of at least one member from each of its Financial Analysis and On-site Examination teams to promote the consultative role with the industry and to ensure the IMF Advisor, specialists, and the NBAA project team have adequate practical feedback from the actual users of the data. Third, following the regulatory reporting refinement exercise, Banking Supervision needs to develop a data base to store the data from the regulatory filings, to display and compute the necessary financial data and ratios for use by its examiners and analysts in their examination and surveillance roles, as well as provide an early warning system for the Director of Banking Supervision and the BOT of the trends developing in the industry and/or a specific peer group. The development of the data base for the, weekly, monthly and quarterly monitoring activities of the Banking Supervision Department is to be funded outside of the scope of this project. o On-site examination - Some of this work has already been developed, albeit in a piecemeal fashion. It now needs to be brought together in a usable modular form for the examiners to apply during their annual examinations. Funding for this component was to have been provided by USAID. The timing of this USAID support is now uncertain, and in the event it does not materialize, the consultant(s), under the guidance of the IMF Advisor, will undertake this on-site methodology role, in addition to the off-site and legal framework components with the assistance of the specialists noted above, who will be charged with reviewing and developing adequate methodology and modules in their areas of expertise. o Ladders of Compliance - The Banking Act, Regulations and Guidelines gives Banking Supervision enforcement powers necessary to protect depositors' funds and cement their role in guarding the safety and soundness of the financial system. The project will finance the completion of guidelines on the application of these powers, the circumstances, and the legal, accounting or other constraints. It is envisaged that this work would be spearheaded by the IMF Advisor Specialist and enlist the expertise of consultants, including the Restructuring and Internal  24 Control Consultants in designing practical, transparent and consistent responses to areas of non-compliance with the Act and/or Regulations/Guidelines. 3.19. Training ($0.6 million). Much of the required training will be on-the-job. In addition, it is proposed that as the new methodology is developed, the resulting examination modules would be introduced in an internal training session, following which these would be utilized in the on-site examination process. On-the-job training will be supplemented by courses in the major risk areas. Annex 4 details the types of courses, the skills to be developed, the duration and estimated cost. The majority of the training will be in Tanzania and will be provided by local consultants, with expatriate assistance only if local consultants cannot be found. In addition, the majority of the foreign training relates to short term assignments in other regulatory agencies to broaden the exposure of the on and off-site examiners to other complimentary regulatory jurisdictions. All training courses are designed for Banking Supervision personnel but will be promoted to the financial system at large to encourage widespread participation of bankers and financial institution personnel and management. 3.20. During negotiations, agreement was reached on the terms of reference and work program for the consultants required for this component. Additionally, the Government has agreed to provide for IDA's review and comment by October 31, 1995 and thereafter by September 30 in each year commencing 1996, annual reports on the status of all financial institutions with action plans for the problem institutions. The action plans will include a timetable for reaching regulatory targets. 3.21. Insurance Regulations. ($0.5 million) The insurance sector consists of the government owned National Insurance Corporation (NIC) and Zanzibar Investment Corporation (ZIC). The distribution system includes 26 NIC branches located throughout the country, approximately 400 privately owned agents of which 260 are active, one broker which is wholly owned by NIC, and various privately owned loss adjuster services, etc. There is no domestic reinsurance market. NIC cedes directly to the international market via one foreign broker. Reinsurance as a percent of gross written premium, has decreased each year since its high of almost 35 per cent in 1981. In 1991, it was approximately 21 per cent. 3.22. A new insurance act was recently drafted. The Act provides the framework for the entry of private participants into the Tanzanian insurance market, based on objective, minimal but prudent requirements. In addition, for the first time, the legislation provides for prudent regulation of the industry to promote on-going confidence in the system. The Govemment intends to establish a supervisory authority (an Insurance Commission). The Commission would develop a supervisory methodology and policy framework, including the drafting of regulatory guidelines and the supporting accounting principles  25 and standards to be adopted by the industry to meet the legislative requirements. In addition, and concurrent with this activity, the Government intends to address the dearth of actuarial expertise in Tanzania which is required to support the development of the sector. 3.23. This component will finance a technical advisor for a period of up to two years. The advisor will be required to: * draft prudential regulations for licensing, regulating and supervising insurance companies. The regulations would establish prudential controls and limits, such as exposure limits, capital adequacy guidelines, and controls on related parties and enforce corrective measures with specific guidance on dealing with troubled institutions. * develop an implementation plan for the prudential regulations with specific targets and time parameters to ensure that compliance is achieved within the phase-in period, * develop a plan for the establishment of the Commission, addressing staffing and training requirements; * review and recommend changes to other legislation affecting the insurance industry to ensure harmony among the various acts. Such acts include but are not limited to the Companies Ordinance Act and the Tax Act. 3.24. The Advisor would reside in Tanzania and assist the Commissioner with the design and implementation of supervisory functions. During negotiations, the Government agreed to submit to IDA by December 31, 1995 for review and comments, the work plan for the establishment of the Commission, including details of the resource requirements (e.g., size, scope, staffing, technology, etc.) 3.25. Studies Fund.($1.7 million). The project will finance studies for the development of a national payments system and a Credit Information Bureau. 3.26. Payments and Clearing System ($1.5 million). The effective functioning of a financial system depends on the efficiency with which financial transactions are carried out. An inefficient payments system hinders economic growth and is a binding constraint to domestic and foreign trade. Specifically, a well-functioning payment system is essential to the development of interbank money markets and securities markets.  26 3.27. The present system of clearing payments in Tanzania is essentially a document clearing system which depends upon physical transport of documents and therefore on existing mail and transport systems. As such, while marginal improvements to the system can be made, substantial improvements are unlikely. An alternative clearing system would be one where the information content of the document is exchanged, rather than the physical document, and would be based on telecommunications. Although this alternative requires high-quality telecommunications to function efficiently, it is possible to begin to develop such a system even with the relatively lower quality of telecommunications currently available in Tanzania. 3.28. The study will be conducted in two phases. The first phase would collect and analyze data about the payment traffic in Tanzania, assess the related institutional, legal and financial infrastructure, estimate the costs of transactions, and generate realistic projections of the transacting environment 5 years hence. The second phase would be the design of improvements to the national payments system including an assessment of the feasibility of the electronic exchange of data. The study's TORs would emphasize common guiding principles including: (a) universality of access; (b) cost efficiency and self financing through cost recovery; (c) integrity and reliability; (d) the minimization of payment system risk; and (e) the involvement of major participants in the design of the system. The master design study would make recommendations on the appropriate division of labor between BOT and commercial banks with respect to the operations of the system, and the extent to which operational resiliency needs to be built into the payment system. 3.29. Credit Information Bureau ($0.2 million). There is no formal mechanism in Tanzania for the sharing of credit information. Prior to the financial reform program, when the market was dominated by Government-owned banks and when there were few private borrowers, there was no demand nor need for it. The opening of the financial sector to private banks will increase the demand for reliable financial and credit data over time. Conversely, the lack of reliable financial information is a major deterrent to new banks and to the development of the financial sector and capital markets. 3.30. This component will finance a feasibility study to determine: (i) if there is a potential market for a credit information bureau in Tanzania; and (ii) if so, whether it could become self-sustaining within a three year time frame. Specifically, the study will be undertaken in two phases. The first phase would: o assess the readiness of private and state-owned companies and financial institutions to participate in such an agency on a structured fee basis; o assess whether there is enough capacity in the market to support such an agency.  27 o review potential ownership/membership structures; o review the legal framework and identify impediments and required changes; o cost justify (or not) the establishment of an agency; and o identify technical and other assistance requirements, including educating participants, both banks and borrowers, on the value and use of such a vehicle. 3.31. The second phase would be contingent upon the outcome of the feasibility study and would entail the preparation of a detailed five year business plan including a recommendation for the ownership structure. 3.32. Agreement on the terms of reference for the studies were reached during negotiations. Capital Market ($2.1 million) 3.33. The impetus for capital market development stems from the financing needs of the private sector and the Government's objective of broad-based ownership of privatized enterprises. The recorded pipeline of private investment projects has grown steadily on the strength of Tanzania's economic reform program. Loan applications to the local and external DFIs have grown substantially. However, disbursements have been modest partly because of the inability of local investors to satisfy the related equity requirements. The limited supply of medium-term credit and outside equity financing is a widely- perceived constraint to the further growth of the private sector. The Government's perception also is that the privatization program has been hampered by the absence of a developed capital market which would enable broad participation in the program. The Government has retained shares (ranging from 20 per cent to 50 per cent) in many of the parastatals which have been privatized; the aim is to divest these shares to the public when appropriate mechanisms for doing so have been developed. 3.34. Capital Markets and Securities Authority ($1.1 million). The Government recognizes that a capital market requires certain pre-conditions for its successful operation. These include Macro-economic stability, low inflation, public confidence in the economic and political environment, a sound banking system, and adequate accounting standards. Many of these conditions do not exist in Tanzania, and their attainment will not be quick. Consequently, the Government has elected to adopt a gradual approach to the development of capital markets. To this end, in January 1994 the Parliament approved a Capital Markets and Securities Act to promote the gradual development of an efficient and fair capital market in Tanzania. The Act envisages the  28 creation of an Authority to oversee the securities market. Initially, the focus will be on the development of a simple over-the-counter (OTC) dealer market in securities. 3.35. The project will provide technical assistance to promote the development of a capital market keeping in mind the Government's preference for a simple and evolutionary approach. Specifically, assistance would be provided for: the drafting and completion of a core set of enabling regulations; an external advisor to provide regular assistance over the course of two years to the Authority on a wide variety of regulatory and market development matters; basic training of would-be stock brokers; basic publicity and educational program for the general public, including nationwide distribution of information; technical assistance to complete the first public issue including design of distribution procedures, determination of offer prices, determination of allotment procedures; provision of short 1-2 hour training sessions for personnel nationwide on how to handle the public issue, supervision of the allotment processing and so forth); the preparation of a stock exchange blueprint and item-by-item action plan together with donor funding requests for start-up costs. 3.36. During negotiations, agreement was reached that the Borrower would furnish to IDA an annual work program and budget for the Authority by October 31, 1995 and thereafter by September 30 in each year commencing in 1996. IDA also received assurance of the Government that they would retain a Chief Executive Officer, with qualifications and under terms of reference acceptable to IDA, during the term of the project. 3.37. Privatization Trust Fund ($1.0 million) This component would also provide funding for the establishment, on a pilot basis, and management of the first three years of the Privatization Trust Fund (PTF). The Government intends to establish the PTF mainly to broaden local participation in the privatization program. The Government would transfer retained shares of privatized parastatals to the Trust in exchange for a deferred payment and, upon successful disposition of an asset, the Government would be paid. Blocks of shares could be broad'y distributed to the public through coUlective instruments ( Unit Trust/Mutual Fund) or Stock Exchange.  29 3.38. The PTF would be established for a period of five years by a Trust Deed. Its day to day operations will be carried out by a private management company with access to merchant banking expertise. The company's remuneration would be a combination of fixed and performance related fees. 3.39. During negotiations, agreement was reached on the draft management contract for the managers of the PTF and that the Borrower would ensure selection of a management team by December 31, 1995. D. Proiect Costs and Financing Plan 3.40. Costs. Table 2 provides estimates of the project total costs. The estimates are based on the costs of recruiting consultants for similar activities in Tanzania. These costs include price contingencies of US$0.3 million (2 per cent of base costs) which were based on projected international inflation rates of 2.0 per cent for 1995, 2.5 per cent for 1996, 2.7 per cent for 1997 and 2.5 per cent for 1998. Base costs have been estimated as of August 31, 1994. It is assumed that the exchange rate will vary during the period to adjust for the difference between local and foreign inflation. Estimates are based on projected exchange rates (per US$) of Tsh 538 in 1995, Tsh 558 in 1996, Tsh 568 in 1997 and Tsh 571 in 1998. The first project year is assumed to run from July 1, 1995 to June 30, 1996, and the completion date is expected to be September 30, 1998. The costs exclude taxes and duties. TABLE 2: ESTIMATED TOTAL PROJECT COST Millions of TSh Millions of US$ Foreign as Local Foreign Total Local Foreign Total % of Total Bank Restructurina 876.0 2.219.6 3,095.6 1.6 4.0 5.6 72% NBC 612.7 1,350.2 1,962.9 1.1 2.4 3.6 69% PBZ 218.6 556.4 775.0 0.4 1.0 1.4 72% MOF 44.7 313.0 357.7 0.1 0.6 0.6 88% Financial Infrastructure Strengthening 1037.3 1,693.1 2,730.4 1.9 3.1 4.9 62% Bank Supervision 386.4 1,130.6 1,517.1 0.7 2.0 2.7 75% Insurance 71.2 203.7 274.9 0.1 0.4 0.5 74% Studies Fund 579.6 358.8 938.4 1.1 0.7 1.7 38% Capital Markets 284.8 874.3 1,159.1 0.5 1.6 2.1 75% Capital Markets Securities Authority 174.4 432.7 607.1 0.3 0.8 1.1 71% PTF 110.4 441.6 552.0 0.2 0.8 1.0 80% Proiect Management 245.6 0.0 245.6 0.4 0.0 0.4 0% Base Cost 2,443.8 4,787.0 7,230.8 4.4 8.7 13.1 66% Contingencies 58.0 1 110.8 168.8 0.1 0.2 0.3 66% Total 2,501.7 4,897.8 7,399.5 4.5 8.9 13.4 66% Note: Totals may not add due to rounding.  30 3.41. Financing. The proposed financing plan for the project is summarized in Table 3. Govemment financing would pay for incremental costs including the costs of providing facilities for training and a proportion of the costs of goods purchased locally. All project financing would be passed on to beneficiary project institutions as grants from the Government of Tanzania. TABLE 3: PROJECT FINANCING PLAN (US$ million equivalent) Local Foreign Total % of Cost IDA 1.9 8.9 10.9 81% Government 2.6 0.0 2.6 19% Total 4.5 8.9 13.4 100% Note: Includes contingencies. Also, totals may not add due to rounding. 3.42. Government Counterpart Funds. The proposed IDA credit of $10.9 million would finance 90 per cent of the project's costs net of taxes and duties. The Government's contribution will be provided partly by the Ministry of Finance and partly by BOT. The proposed project has been designated a core investment project and finding for the Government's share will be budgeted annually. IV. IMPLEMENTATION ARRANGEMENTS A. Implementation Arraneeements 4.1. The United Republic of Tanzania would be the Borrower (represented by the Ministry of Finance) and the project executing agency would be the Bank of Tanzania. The Bank of Tanzania would manage the program, coordinate its implementation, and monitor its progress. The Director of the Financial Markets Directorate in the Bank of Tanzania would be responsible for: (i) administering project funding and procurement processing (including the employment of consultants) and managing the Project Accounts and the Special Account; (ii) overseeing project implementation activities by various institutions and coordinating activities; (iii) following up on the agreed conditionalities and financial provisions and proposing any necessary adjustments and amendments to implementation: (iv) providing periodic project progress reports; and (v) acting as the focal point of contacts between the Government of Tanzania and IDA during the project implementation period. The Financial Markets Directorate managed adequately the technical assistance component of FSAC. However, its performance will be reviewed on an on-going basis and adjustments, in terms of personnel, will be made by BOT if necessary.  31 4.2. Although BOT would assume day-to-day responsibility for implementation, the Ministries of Finance, as the shareholders of NBC/TIB/THB and PBZ respectively, will bear ultimate responsibility for the restructuring of these institutions. Given the complexity of the issues involved, an experienced commercial banker will be recruited to advise both Ministries on the overall progress of the program. On the mainland, the Advisors would report to the Ministry of Finance and work closely with the Parastatal Sector Reform Commission. Issues raised by the Advisors would then be discussed by the respective ministries during meetings of the Boards of Directors. The Advisors would not be expected to reside in Tanzania but would be contracted to visit three times per year. This arrangement will be reviewed as the project is supervised and will be amended, if necessary. The terms of reference for the advisors were agreed during negotiations. 4.3. BOT will organize a project launch workshop shortly after the Board presentation. The workshop would be intended to acquaint the project's beneficiaries with the implementation arrangements. B. Procurement 4.4. Procurement of goods and services would be implemented in accordance with relevant World Bank Guidelines. For all contracts under Intemational Competitive Bidding (ICB) and internationally recruited consultants the Bank's standard bidding and contract documents will be used. Goods would include vehicles, computers, and computer software, office furniture and equipment for a total value of $0.4 million equivalent including contingencies. Goods amounting to roughly $0.2 million, mainly consisting of personal computers for some of NBC's rural branches, would be grouped into minimum packages of roughly US$100,000 each to be procured through ICB. Where ICB procedures are used, a preferential margin of 15 per cent, or the applicable customs duty, whichever is less, over the c.i.f prices of competing goods would be given to domestic manufacturers in accordance with the Bank's guidelines. Vehicles, amounting to roughly $0.1 million, would be purchased in accordance with local competitive bidding (LCB) procedures. Items or groups of items for goods which cannot be packaged in contracts larger than $50,000 (mainly office equipment and supplies) would be purchased on the basis of prudent international and \or local shopping based on price quotations obtained from at least three reliable suppliers. The total value of goods to be procured through prudent shopping procedures would not exceed an aggregate amount of $100,000. 4.5. Consultants, financed by IDA, totaling $10 million equivalent would be contracted in accordance with the Bank's Guidelines for the Use of Consultants issued in August 1981. Consultancy services would include experts in commercial bank  32 management and restructuring - two highly specialized fields. Other consultants would be recruited for training activities and the preparation of manuals. 4.6. Procurement Review. All contracts for goods procured under ICB would be subject to IDA prior review procedures. All other contracts less than $100,000 each would be subject to IDA post review procedures. All consultancy contracts, with firms, valued at the equivalent of $50,000 or more will be subject to IDA prior review procedures. Prior review procedures would apply regardless of the value of the contracts with respect to terms of reference, single source contracts, critical assignments, and contract amendments valued at more than $50,000 or that raise total contract value above $50,000 equivalent. In addition, an understanding was reached that before the first contract below $50,000 is awarded, IDA would still review all stages of the consultants' contract. For individual consultants, all contracts would be subject to IDA's prior review. GOT would promptly report on contract awards and furnish to IDA quarterly reports giving updated information on bidding packages and contracting. Assurances were obtained at negotiations that the borrower would apply the procurement procedures outlined above. Also, during negotiations standard procurement processing time was agreed with the borrower and incorporated in the implementation schedule. Finalization of Standard Bidding Documents for critical contracts was a condition of Board Presentation. Table 4 summarizes the proposed procurement arrangements. Table 4: Summary of Proposed Procurement Arrangements (US$ million) Total ICB LCB Other Cost Goods Vehicles 0.1 0.1 (0.1) (0.1) Computers & Office Equip. 0.2 0.2 0.4 (0.2) (0.2) (0.4) Consultancies Technical Assistance 10.1 10.1 (8.3) (8.3) Studies 1.7 1.7 (1.5) (1.5) Trainin 0.7 0.7 (0.7) (0.7). Incremental Operating 0.5 0.5 Costs (0.0) (0. 0) Total Costs 0.2 0.1 13.2 13.4 |IDA Financed (0.2) (0.1) (10.7) (10.9) Note: Totals do not add due to rounding.  33 C. Disbursements 4.7. The proposed project is expected to be implemented in four years and to be completed by December 1998. The official closing date will be June 30, 1999. Disbursements of IDA funds would be made against major categories as shown in Table 5. To facilitate timely project implementation, it is proposed that the borrower establish, maintain and operate, under terms and conditions satisfactory to IDA a Special Account in US dollars with an authorized allocation of US$250,000 in a bank acceptable to IDA. This allocation represents four months of projected expenditures. The Special Account will be replenished on a timely basis either when the balance of the Special Account is half of the initial deposit or on a one to three month basis, whichever occurs earlier. All IDA disbursements should be channeled through the Special Account except for large payments (10% of the value of the initial deposit) which would cause it to be significantly depleted and would be submitted directly for processing outside of the Special Account. Table 5: Disbursement Categories US$ Million Proposed Disbursement Equipment, vehicles and 0.5 100% foreign and 75% local computers. Training 0.7 100% Technical Assistance 7.0 80% Studies 1.5 80% Refund of PPF 0.8 Unallocated 0.4 TOTAL 10.9 4.8. Disbursements for all IDA financed expenditures under the project would be made against full documentation except as outlined below. Reimbursement of eligible expenditures in both local and foreign currency would be made solely on the basis of statements of expenditure (SOEs) in respect of contracts for goods valued for less than $100,000 equivalent, consulting services for firms valued for less than $50,000 and all local training and study programs. All documentation related to such expenditures would be retained by the Borrower for IDA review during project supervision. D. Auditing and Reporting Requirements 4.9. BOT will maintain records of all transactions under the Credit in accordance with sound accounting practices. No later than six months after the end of each fiscal year, all accounts will be audited by independent auditors acceptable IDA and submitted to the Association. Audit reports will include a separate opinion with regard to the claims submitted to IDA on the basis of SOEs and would state whether the claims were made in accordance with the terms of the Credit Agreement. The Government would document  34 local cost contributions within the Credit's financial control procedures for appropriate auditing. Assurances were obtained at negotiations that the borrower would implement the provisions described above with regard to project accounting and auditing. The borrower also is required to submit annually the audited accounts of NBC and PBZ within six months of the end of each bank's financial year. E. The Role of Technical Assistance 4.10 Attempts would be made to recruit resident and non-resident Tanzanians as well as nationals of other African countries for the consultancies financed under the proposed credit. Nevertheless, the TORs for all consultants would require consultants to progressively transfer their knowledge, know how and responsibilities to their local counterparts. Because of the highly specialized and complex nature of the tasks involved, the majority of the technical assistance will be long term. In some cases, a two year resident contract would be followed by a one year non-resident contract. All contracts would be performance based and the incumbents would be evaluated against identified monitorable indicators. A part of the remuneration under the management contracts for NBC and the PTF would be related to the financial performance of both institutions. Draft TORs for all consultancies are included in Annex 7. 4.11 The bulk of the training program will be targeted to Bank Supervision in BOT, however, financial sector personnel and management will be encouraged to attend. A detailed program is included in Annex 3. All training would be in country although it is envisaged that foreign trainers would be brought in to deliver and/or assist the resident consultants with the courses. This is necessary because of the lack of bank restructuring experts in Tanzania. There is also a small provision in the training budget to fund exposure for select supervision personnel in other compatible regulatory agencies e.g. USA and South Africa. F. Supervision 4.12. IDA supervision missions would be staffed to facilitate a transfer of know-how in the complex areas addressed by the project. Consequently, the supervision requirements would be higher than normal technical assistance projects and it is envisaged that IDA would field three supervision missions per year. In addition, the Resident Mission, which would play a lead role in assisting the Government with the formulation of a rural banking strategy, would be expected to play a major role in supervision. A joint IDA- Government mid-term review of the project would be conducted about 20 months into the project (approximately March, 1997) as a basis for determining implementation progress and mid-course adjustments, if necessary.  35 G. Environmental ImDact 4.13 Category C. The project would have no adverse impact on the environment. V. BENEFITS AND RISKS A. Benefits. 5.1. The project will address a major market imperfection by supporting a strategy for aggressively reducing the market share of the Government owned banks, thereby placing the issue of privatization within the context of an appropriate competition policy for the sector. Increased competition would improve the quality of banking services. This, coupled with improvements to the financial infrastructure, should lower the costs of financial intermediation while facilitating overall economic management. Also, stronger bank supervision will help build public confidence and mobilize savings. The financial sector would thus stimulate, as opposed to retard, economic growth. The project also would address a Government concern about the need for broad based participation in the privatization effort by creating the appropriate regulatory environment for capital market instruments. B. Risks. 5.2. The project is designed to mitigate the major risk to NBC's successful restructuring: a reversal of Government's stated commitment to the bank's commercialization. Consequently, the actions required for the significant downsizing of NBC are all either up front or very early in the project's implementation. In addition, NBC's management would be required to adhere to strict performance targets. Conversely, the aggressive downsizing of NBC could result in the rapid entry of new banks to fill the void and could stretch the limited capacity of Bank Supervision. The extensive amount of technical assistance provided under the credit to Bank Supervision is meant to reduce this risk. 5.3. Another risk addressed by the project stems from the rapid opening up of Tanzania's capital market in the absence of an appropriate regulatory framework. The project would support the gradual evolution of the capital market while putting in place an appropriate regulatory framework. 5.4. Finally, despite the technical assistance provided under the project, implementation could suffer from a lack of capacity within Tanzania to address the project's complex issues. In addition to regular supervision visits, IDA staff, including staff at the Resident Mission, will liaise closely with Government officials during the project's implementation.  36 VI. AGREEMENTS AND ASSURANCES 6.1 The conditions of effectiveness would be: a. Completion of the diagnostic evaluation of NBC and a time-bound action plan (including an interim business plan and a recovery plan for NBC's top 50 non-performing loans), satisfactory to IDA for the downsizing and restructuring of NBC (para 3.6); b. Appointment of consultants to implement the fourth element of the divestiture strategy on the basis of terms of reference acceptable to IDA (para 3.6); c. Contracting of the Banking Advisors under terms of reference acceptable to IDA (para 3.13). 6.2 The following assurances also were received during negotiations: a. Government will implement the program described in the Letter of Financial Policy (para 3.1); b. NBC. The NBC divestiture strategy, including the divestiture of at least one urban branch network and the identification of a joint venture partner for the coporate subsidiary, will be completed by October 31, 1995 (para 3.6); c. Beginning with 1994\1995, NBC will submit annual audited accounts within six months of the end of NBC's financial year and appropriate adjustments will be made and all loans classified as loss will be written-off prior to the finalization of the accounts (para 3.7); d. A final business plan would be furnished to IDA, no later than October 31, 1995 and thereafter NBC would abide by the business plan's performance targets; and the ceiling on NBC's overall lending as well as on lending to parastatals would remain until the plan is finalized (para 3.9); e. NBC will submit monthly reports to BOT on outstanding loans to large borrowers (para 3.9); f. PBZ. A General Manager and Financial Controller, with terms of reference and with qualifications acceptable to the Borrower and IDA,  37 would be appointed by October 31, 1995 and the Borrower would ensure that the restructuring plan would be implemented (para 3.12); g. Beginning with 1994/1995, PBZ will submit annual audited accounts within six months of the end of its financial year and appropriate adjustments will be made and all loans classified as loss will be written-off prior to the finalization of the accounts (para 3.12); h. Bank Supervision. The annual work program for 1995/1996 for the Bank Supervision Directorate, including terms of reference and work program for the consultants required for this component, would be submitted for IDA's review and comments by October 31, 1995; the annual work programs for the following years (beginning with 1996) will be submitted for IDA's review and comments by March 31 in each year (para 3.20); i. The submission by October 31, 1995, for IDA's review and comments, of a report on the status of all financial institutions with action plans for the problem institutions; and an annual report on the status of all financial institutions by September 30 in each year commencing. The action plans would include a timetable for reaching regulatory targets (para 3.20); Insurance. The submission for IDA's review and comments, by December 31, 1995 of the work plan for the establishment of the Commission, including details of the resource requirements (e.g., size, scope, staffing, technology, etc.) (para 3.24); k. Capital Markets. Agreement is to be reached on the 1996 annual work program and budget for the Authority by October 31, 1995. The annual work programs for the following years (beginning with 1996) will be submitted for IDA's review and comments by September 30 for the year next following each such year. A CEO with qualifications and under TORs acceptable to IDA is to be maintained during the term of the project. (para 3.36); 1. PTF. Draft management contract and the selection of a management team acceptable to IDA is to be completed by December 31, 1995 (para 3.39); 6.3 Subject to the above conditions, the proposed project would constitute a suitable basis for an IDA credit of SDR7.5 million (US$10.9 million) on standard IDA terms.  Annex 1 Page 1 of 7 TE TAsv-Y, P.O. Box 9111. u Ls SA.LA.- THE UNIIED RPUBLIC O? TA-LZAA THE MINSTSU FOR FLs,VsCS Ref No: TYC,C.'380 30 23th Februar. 1995 Mr. Lewis T. Preston President The World Bank 1818 H Street. N.W. Washinaton. D.C. 20433 United States of Amenica Dear Mr. Preston. RE:- FINA _NCIAL INSTITUTIONS DEVELOPMEUNT PROJECT LETTER OF FIN-kNCLAL POLICY Recognizing the vital importance of ensuring the effective mobilization and allocation of capital through the use of efficient financial svstems. the Government of Tanzania initiated the financial sector reform program in 1991 with the support of an IDA credit for financial sector adjustment (FSAC). The program included the development of a money mark-et and indirect methods of monetary policv controL passage of new banking laws and prudential rezulations. the creation of a competitive environment and the introduction of private participation in the banking sector. restructuring of the three government-owned commercial banks. and initial steps to promote the emergence of a capital market in Tanzania through the enactment of the Capital Markets and Securities Act. The Government is satisfied that the prooram has been successful in deregulating and liberalizing the banking system. We now have a financial svstem in which the basic legislation and regulations necessarv for a market-oriented financial infrastructure are in place. and monev and foreign exchange markets are emer2ins where both interest rates and exchange rates are deter-mined by market forces. However. we realize that the financial sector is still verv weak and the reform agenda is far from complete. Although the reforrn prosram has opened Tanzania s  39 Annex 1 Page 2 of 7 financial sector to private participaits. the government-owned banlks still domiiinate the sector. Furthermiiore. the pace of their restruLICtUring lhas been slower than expected and the banks remaini undercapitalized and illiquid. T'he payments system remiiainis very rudimienitary and inefficieit, and there are no financial instruments and mlarkets to satisfN thle demianid lor term financing. On the regulatory side, althougl thiere has been improvements in Bank Supervisioni. this functioni remainis weak andincapable of overseeing the complex banlk restructuring programs as well as the expansioni of the sector. The Government realizes that the development of a market oriented financial system is a complex process wvhich will require sustained efforts over many years and it wishes to reaffirm its commitmenit to the attainmenit of an efficient financial system whiciI is competitive and which operates on sound commercial principles. To achieve this objective and to regain the momentum for financial sector reform. the Govenimenit is implementinga a strategy which would address the renainiin v weaknesses in thie sector while building the foundation for the diversification of financial instruments. Tlhe main elements of the strategy are: 1) encouraging competition in the commercial banking sector. 2) strengtlheniitng banking rezulation and supervision; 3) improving the payments mechaniismii in the country; 4) implementing comprehensive parastatal reforms. including privatization. of state owned enterprises; 5) developing a market for Government securiLies 6) establishing a regulatorv structure for securities and insuranice markets, and 7) developing a corporate securities market. ENCOURAGING BANKING COMPETITION _ - The Government is committed to allowing banking institutons to operate free from governmient intervention witlhin the norms of prudenitial regulation. The Government intends to foster competition and improve efficiency in the banking sector by continuing to encourage the entry of private and foreign financial institutions. and by reducinig the size and diversifving the ownership of government owned banks. This encouragement to new entranits. however. will be based on a rigorouls and transparenit licensing process which complemenits the Government's vision for a safe and sound financial sector.  40 Annex 1 Page 3 of 7 Our aim is to ensure that the financial sector is capable of meeting the credit and investment needs of a broad range of customers. New banks have tended to remain in Dar Es Salaam and have been very selective both in terms of the breadth of their client base and their product lines. Consequently. the eXisting concentration in the banking sector is undesirable and is not conducive to the development of the sector. We, therefore. wish to reafiirm our commitment to increased competition in the banking sector through the down sizing of National Bank of Commerce (NBC). We have explored many options and our preferred course of action includes a staged approach to reduce NBC's domination of the sector. This would include implementation of a divestiture strategy for NBC, including: (a) the divestiture of at least one urban branch network based on the diagnostic evaluation; (b) the strengthening and reorganization of NBC and its operations under professional management (c) the establishment of a joint venture corporate subsidiary between NBC and a major international banking partner to enable NBC to compete with its counterparts in the market, and (d) developing a plan for addressing NCB's impaired loan portfolio. A number of organizational and operational changes have been implemented within NBC. The Bank was recapitalized in 1993 by a government bond. The Board of Directors was reconstituted at the end of March 1994. A total of 23 loss-making branches have been closed and roughly 2,800 staff have been retrenched. Lending to non-performing borrowers has stopped and an overall ceiling has been imposed. This ceiling will continue until NBC's Restructuring Plan is complete and measurable rcontrol targets are instituted. The NBC Act has been amended to clear the way for the bank's privatization. With the support of the proposed Financial Institutions Development Project (FIDP), a privatization strategy will be adopted and following completion of the diagnostic study., a detailed timetable will be drawn up by the Board to implement the divestiture strategy. However, the Government intends to complete this aspect of NBC s divestiture by September 1995. In the meantime. a number of qualified commercial bankers will be recruited for. at a minimum. the kev line management positions of Chief Operating Officer. Chief Financial Officer and Treasurer. and the senior credit risk management role at NBC. It is the intention that these newly-recruited managers will bring about a change in the culture of NBC and improve its operational efficiencv. Once  41 Annex 1 Page 4 of 7 installed, this management team will be mandated with the development of the Restructuring Plan, includina a recovery for the non performing loans, to ensure that NBC attains self-sustainabilitv. Should NBC fail to improve its operational efficiency and continue to make losses, however, the Government is no longer prepared to recapitalize it. In order to meet capital adequacy requirements, the bank will have to eithet reduce its asset base through sales or look for additional equity capital from other sources. A restructured NBC will operate solely on a commercial basis. While addressing the future strategy of NBC, the Government is very cognizant of the importance of rural finance to the economic and social development of Tanzania. Consequently, the Government is committed to maintaining a banking presence in the rural areas, and will strive to develop mechanisms to ensure financial services are supplied on a national basis. The Government would also like to restate its commitment to the privatization of CRDB, and to the objective of CRDB meeting prudential standards. The CRDB management is working closely with DANIDA and committing significant effort to its restructuring program and loan recovery. It is understood, however, that the restructuring process cannot go on forever and consequently, we have established May 1995 as the date by which CRDB will complete its restructuring program and meet the capital adequacy standards. Until such time as its recapitalization prozram is complete, CRDB will freeze all lending. Should the bank's eventual viability prove to be unsustainable by June 1995 and the bank is unable to statisfy the normal prudential requirements by this time, the authorities will revoke CRDB's provisional bank-ing license. The complex and difficult restructuring programs will require a highly competent and capable banking supervision function. The Banking and Financial Institutions Act of 1991 strengthened BOT's supervision authority and. in November 1992, banking supervision was elevated to the status of Directorate and staffing levels were increased. However, the technical abilities and staffing levels of the Directorate of Bank Supervision (DBS) at BOT. at present. are insufficient to meet the requirements of a market oriented financial system. The Directorate needs to improve substantially if it is to perform its functions properly as one of the architects of the emerging financial svstem. The Government, therefore, assigns a high priority to the strengthening of the capacitv of BOT to supervise the financial systern. The  42 Annex 1 Page S of 7 govemment would also like to restate its full support to DBS in its effort to make greater use of its enforcement powers. including the ability to impose penalties and issue cease and desist orders as well as the abilit; to remove bank management as necessary. DEVELOPING CAPITAL MARKETS In order to address the financing needs of the private sector and to promote broad-based ownership of privatized enterprises, the Government intends to facilitate the development of capital markets in Tanzania. Although the recorded pipeline of private investment projects has grown steadilv since the start of the economic reform program, there has been only modest disbursement by local and external DFIs and foreign investors. The limited supply of medium-term credit and outside equity financing is a widelv-perceived constraint to the further growth of the private sector. Furthermore, the Government wishes to make use of the capital markets to promote broad participation in the parastatals privatization program. In the absence of a formal capital markets, the Government has retained shares (ranging from 20% to 50%) in many of the parastatals which have been privatized. But the Government intends to divest these shares to the public when appropriate mechanisms for doing so have been developed. The Government recognizes that capital market development requires certain pre-conditions. These include macroeconomic stability, low inflation, public confidence in the economy and political environment, a sound banking systern, an efficient pavments system. adequate accounting standards and investor sophistication. Many of these conditions are not met in Tanzania at the current time. Achieving these conditions will iot be quick, and in fact, only some of these issues are within the government's direct power to deliver. What the government can do is to provide an adequate regulatory environment which is conducive to the emergence of a capital market. On the one hand. the Government is committed to maintaining macroeconomic stability throuzh stringent fiscal discipline and prudent monetarv policy, and on the other hand, the Government will facilitate the co-operation between the relevant parties to create the necessary market infrastructure and enactment of legislation and re2ulations. For instance. Bank of Tanzania will take the lead and co-ordinate between commercial banks to improve our payments system. In terms of building up an approprinate legal environment. a "Capital Markets and Securities Industry  43 Annex 1 Page 6 of 7 Act" has been enacted and a Capital Mark-ets and Securities Authority has been created. Both these vehicles seek to promote the development of an efficient, orderly. transparent and safe capital mark-et and securities industrv in Tanzania. The securities market will operate initiallv as-a dealer market on an over-the-counter basis. The Government also recognizes that the lack of market intermedianres (brokers and dealers) is the missing link between suppliers of and investors in securities. To promote the development of mark-et intermediaries, the treasury bill mark-et seems to be the logical starting point. At present, participation in the treasury bill auction is open to all institutions, companies and individuals, and therefore, the incentive for the development of a secondary market in which dealers maintain and trade inventories of securities is weak. To facilitate the formation of a secondary market and to promote the development of dealers, Bank of Tanzania is considering limiting participation in the treasury bill auction to "approved dealers". Dealing in other fixed-income, and eventually, in equity securities will develop as these dealers gain experience, capital and customers. In the mean time, should the private sector seek to establish a stock exchange, the CMSA should ensure that its membership, organization, trading and settlement mechanism are in the public interests. The Authoritv should also make public education and promotion programs connected with securities markets a basic market responsibility of the stock exchange until conditions have been met to commence listing and trading. The government wishes to reaffirm its commitment to the continuation of the parastatal sector reform process. The Parastatal Sector Reform -commission (PSRC) is implementing an action plan under which'about 227 parastatals will be privatizatized dunrng the period from 1993 through 1997. It is hoped that some companies will be suitable for public flotation and such initial public offerings will provide an impetus to the development of a securities market in Tanzania. The Government wishes to see that a large section of the population will become shareholders in these companies and the achievement of this objective will be facilitated by the creation of collective investment schemes such as unit trusts. Since the establishment of unit trusts is likely to take time before they become operational. the Government intends to establish a Privatization Trust Fund to -warehouse" minority Government share-holdings of privatized parastatals while conditions for proper unit trusts mature.  44 Annex 1 Page 7 of 7 CONCLUSION In view of the financial sector reform measures that have already been initiated and those that are expected to be implemented in the near future. as discussed above, the Government requests your favourable consideration of the proposed Financial Institutions Development Project. I am sure that this project will significantly contribute to the improvement of our financial system and we are committed to the implementation of the project with the utmost efficiency and quality. Very truly yours Lt. ER FRya FiNkwete }NlBISER FOR FINANCE  1994-95 NBC DIVESTITURE STRATEGY SCHEDULE Task Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct 1. Complete Preliminary Portfolio Review _ i _ _ _ _ _ 2. Agree Privatization Strategy Schedule v _ _ ____ _ 3. Begin Diagnostic Evaluation 4 = _ = = 4. Begin Recruitment of 3 Experienced Bank Line 4 Managers _ _ _ _ 5. Update Portfolio Review, including Disposition 4_ 6. Review Privatization Options with NBC and BOT = 4 = . = 7. Finalize Pro Formas and/or Identify Branches To 4 Be Sold __ _____ ____ 8. Board Approval logistical Plan Associated with Privatization Option, including systems, rural 4 branch rationalization etc. _ _ .__ _ _ 9. Approve Terms and Conditions for 4 Bidders/Investors _ _ ___ __ 10. Select New Experienced Bank Line Management 4 Team at NBC 11. Board approval of Restructuring Plan of retained 4 NBC _ _ __ 12. Implement Rural Branch Reconfiguration and 4 "Bad"Bank Subsidiary 13. Negotiate Sale/lnvestment/Joint Venture = 4 4 4 4 14. NBC NV InternationaLUCorporate Subsidiary 4 opens ____ ______ _ 15. Begin Operations of Branches Under New 4 Management _  46 Page 1 of 2 ,Ivaaandi Bank of Commerce 30-Jun-r91 30-Jun-92 30-Jun-93 30-Jun-94 CAGR Summary Balanca Sheet (Tsh Billion) Cash 3.1 3.9 5.8 6.7 28% BOT: Statuatory Minimum 0.0 0.0 10.9 20.0 NA BOT: Current Account 2.0 5.1 7.8 0.0 NA Other Due From Banks iS du 7, 1o4 2 43% Due From Eanks 35.4 60.3 77.9 104.2 43% Gross Loans 29.9 30.2 29.0 28.8 -1