Nepal - Financial Sector Reform Project

Report No. PID8170 Project Name Nepal-Financial Sector Technical Assistance... Project Region South Asia Regional Office Sector Public Sector Management; Finance Project NPPE49384 Borrower(s) His Majesty's Government of Nepal (HMG/N) Implementing Agency Ministry of Finance, Nepal Rastra Bank/Central Bank, and the National Planning Commission Date PID Prepared September 23, 1999 Projected Appraisal Date July 15, 2000 Projected Board Date October 15, 2000 1. Country and Sector Background Nepal made good progress in banking reform in the mid-1980's and early 1990's as the economy was opened up to greater competition and was generally liberalized. However, half hearted measures since then have failed to address fundamental problems in the three largest (mainly) state owned banks. As a result, there is now a critical need to reform, revitalize and modernize the financial sector. A large share of the sector is accounted for by these three large and inefficient banks - and they now act as a dead-weight on the financial system and provide little incentive for the private banks to become innovative and competitive. It is important to establish the pre-conditions for the development of an efficient and effective financial sector which is capable of developing new financing mechanisms/ instruments to meet to the needs of a growing private sector. Such reforms hold out the prospect of supporting faster growth, and ultimately increased poverty reduction. In addition, the three state owned banks - Rastriya Banijya Bank (RBB), the Nepal Bank Limited (NBL) and the Agricultural Development Bank of Nepal (ADB/N) - are in a precarious financial position. The RBB, which represents 34 percent of the entire commercial banking system, has an extremely high percentage of non-performing loans. Although in somewhat better financial condition, the NBL and ADB/N have similar financial problems. Financial sector development is a long and complex process that will take many years. The current proposed program will only commence this process and deal with the most egregious of these concerns - specifically by dealing with governance issues within the banking sector, by strengthening central banking oversight capacities, and by increasing the involvement of private strategic banking interest in the sector (and reducing the public sector's role). Recent missions to Nepal have identified the following eight issues as the areas of major concern within the financial sector: The Government's Role. The Government of Nepal plays a large direct role in the operation of the Financial Sector. From ownership of key financial institutions such as RBB, ADB/N, the Grameen banks, the insurance industry,  and until recently the NBL - to significant influence over the activities of the Joint Venture Banks - the Government's hand is evident in almost every aspect of financial sector activity. On the other hand, insufficient supervisory and regulatory oversight has led to weaknesses which need to be addressed. The Government needs to re-orient its activities from being an active participant in the financial sector toward being a stronger regulator and supervisor of the total system. The Role of Nepal Rastra Bank (NRB -- the Central Bank). Currently, the NRB falls under the authority of the Ministry of Finance. In addition, political influences over RBB - as well as its sheer dominance within the overall banking system - place this institution largely outside the influence and control of the regulatory authority, which is the central bank. It may well be appropriate to now consider a different model which confers greater autonomy and independence to the Nepal Rastra Bank while providing it with full authority over the entire banking system (enshrined in legislation). For example, the bank supervisors must have a clear hand to force the exit of insolvent banks from the system. A Weak/Fragmented Legal Financial Environment. Nepal has a proliferation of both laws and regulations, which tend to be very institution specific rather than functionally specific. This has created a fragmented legal environment. Legal reform in the banking sector should be articulated around two main themes. The first theme should be the restructuring, improvement and modernization of the central banking act (Nepal Rastra Bank Act, 1955) and the banking act (Commercial Bank Act, 1974). The second theme should be the establishment of an appropriate body of lending legislation, such as laws pertaining (in particular) to collateral, credit activity, and bankruptcy. A Weak/Fragmented Accounting and Auditing Environment. A weak accounting and auditing tradition has further meant that the timeliness and reliability of financial data (particularly from the largest of the banks) is extremely poor. Significant accounting and auditing strengthening is required - if Nepal's financial system is to operate in a prudentially sound and efficient manner. Rastriya Banijya Bank (RBB). As the largest commercial bank, with more than 200 branches, RBB has an important role to play in the economy. However, burdened with political demands, difficult relations with unions, management weaknesses, poor accounting and auditing functions, and bad loan recoveries - RBB has reached a particularly parlous financial state. Recent auditing work points to a high level of non-performing loans, weak internal systems and poor internal financial management. This dominant bank sets the environment for an overall inefficient and poorly performing financial sector resulting in a poor allocation of savings within the economy, and inadequate and poor banking services to the majority of the banking public. Swift and decisive action needs to be taken to deal with its worst problems, review possible options for its future, and ensure that appropriate action is taken to remedy the bank's problems. This work will commence shortly, supported under a PHRD grant for both RBB and NBL. The Nepal Bank Limited (NBL). While in somewhat better financial condition, NBL is still comparatively weak. Its large size (along with that of RBB), adds to the overall inefficiency and low level of competition in the banking system. The Government's policy of successively selling shares to the - 2 -  general public, and the increasing private sector representation on its board, have helped NBL avoid the worst excesses of the RBB. However, the lack of a single strategic partner with a strong background in commercial banking, and international linkages with the global economy, has meant that NBL has not been able to play the pro-active, market leadership role, that could be expected from such a large bank. The Joint Venture Banks. Government direct involvement and indirect influence is also evident in the joint-venture (JV) banks operating in Nepal. Although this has not adversely impacted the profitability of most of the JV commercial banks (the best of which are very profitable), it nonetheless represents additional restrictions and limitations placed upon their activities in Nepal - and needs to be addressed. Competition in the Banking Sector. Reform of the state owned banking sector should be designed to reduce fragmentation in the banking sector and increase the efficient intermediation role of the banks and non-banks. Market oriented approaches should be developed to enhance competitive pressures. The Agricultural Development Bank of Nepal (ADBN). The financial and operational situation of the ADB/N is also poor and it will similarly require restructuring, system development, and a review of its ultimate role and ownership arrangements within the banking sector. The issues relating to this institution will, however, be addressed by the Asian Development Bank rather than the World Bank. Government Strategy. At present the Government does not have a clear strategy for the financial sector. Nonetheless, it does appear to be committed to privatizing RBB and appears to recognize that there are problems with the manner in which NBL has been privatized. The Government also wishes to strengthen the central bank's supervisory and regulatory function. The desire for reform in the financial sector is reflected in the fact that the Government has asked for World Bank and International Monetary Fund assistance in these areas. As a consequence of this the World Bank has arranged a PHRD grant to commence preparatory work on the financial sector reform program. To help develop a comprehensive vision of financial sector reform, IDA has requested the Government to formulate a Statement of Financial Sector Policies - which would consolidate their existing thinking and assist in developing an inter-linked program of reform. The fundamental reforms in the financial sector - particularly with respect to the state owned banks - will require strong political commitment. As in many countries, banking restructuring issues are likely to be difficult for the Government when the time actually comes for action. Nonetheless, fundamental reform is required and strong political commitment will be necessary if the reform measures are to be carried through to a point where they make a lasting contribution to overall economic development. Government commitment to reform, to date, has been demonstrated by its willingness to move ahead with the reconstruction of the RBB accounts (which had been three years in arrears); the contracting of a "Big Five" accountancy firm to make an assessment of future options for RBB and NBL; Nepal Rastra Bank's agreement to contract banking supervision technical assistance to help - 3 -  develop their own internal capabilities; and the fact that RBB is slated to be privatized. All these activities are indicative of government willingness to pursue a transparent assessment of the condition of the banks and to develop credible corrective action plans. 2. Objectives The over-arching objective of the overall Financial Sector Reform Program is to support the efforts of His Majesty's Government of Nepal to create a sound-market oriented financial system which will support macro-economic stability and private sector led economic growth. The Financial Sector Technical Assistance Project, however, has a much narrower and immediate objective of creating a more prudently operated and commercially viable commercial banking system which is overseen by a central bank with sufficient technical capacity to address issues within the areas of bank supervision and regulation; legal financial reform; and strengthened auditing and accounting capabilities. Subsequent support could help in the achievement of longer term objectives and the further strengthening and deepening of the system. The Financial Sector Technical Assistance Project is a small, focused, technical assistance operation - centered around the strengthening of supervisory capabilities, reform of banking legislation, auditing and accountancy support, commercial bank training, and TA to restructure/privatize the two largest banks. This overall reform program is considered fundamental to the World Bank's central focus of poverty alleviation. Although the causality may be indirect, the overall Financial Sector Reform Program is important in terms of supporting private sector led economic growth and ultimately impacting positively upon a reduction in poverty in Nepal. 3. Rationale for Bank's Involvement The Bank has a growing background in the area of financial sector reform operations which will be useful in the implementation of the proposed Nepal program. Given the mutuality of interest in this program, the World Bank is adamant about full joint cooperation with the International Monetary Fund and the Asian Development Bank - without which, success cannot be guaranteed. 4. Description Central Bank Supervision Banking Governance (a) accountancy; and (b) legal Commercial Banking Reform Policy Based Support ($50 mill) 5. Financing Total ( US$m) Government 0.5 IBRD 0 IDA 5 Total Project Cost 5.5 6. Implementation -4-  The program will be implemented by the three key Government economic policy making bodies namely, the Ministry of Finance, Nepal Rastra Bank (the central bank) and the National Planning Commission. A working group, comprising one senior member from each of the above agencies, has already been appointed to oversee the financial sector reform program. They will provide their agency's input into the development of the reform program as well as providing a direct report-back mechanism to the key Ministers involved. At some point in the future it will be necessary to establish an implementation unit to provide management, accounting and other support services to the Technical Assistance project. This unit could be located in either the Ministry of Finance or the Nepal Rastra Bank 7. Sustainability The sustainability of the financial reform program will depend upon the commitment of the Government to take hard political decisions with respect to governance issues in the three largest banks (RBB, NBL and ADB/N). Given the politicization of these three institutions, it may prove difficult to ensure the proper commitment to lasting restructuring/privatization that is required. However, if these commitments can be provided up front, the program will have a significantly enhanced chance of success. It will therefore be important to ensure that the Statement of Financial Policies is comprehensive and sound in its approach to fully integrated financial sector reform. 8. Lessons learned from past operations in the country/sector The OED Performance Audit Report for the "Second Structural Adjustment Credit" (Credit 2046-NEP), May 17, 1995 concluded that: "The basic cause of the weakness of the financial sector design [in that project] was: (a) the lack of commitment by the Government; (b) no significant changes in the managerial culture to ensure professionalism, autonomy and accountability. (c) fundamental reforms to achieve a major improvement in financial and operational performance of the banks were not specified" This project will deal with these past lessons by not proceeding with the Financial Sector Reform Program unless there is written, up-front commitment, by the Government, to fundamental reforms in the state owned banks (and NBL) involving a radical change in existing governance relationships. These commitments would be incorporated into a Statement of Financial Policies and formally adopted as Government policy. 9. Program of Targeted Intervention (PTI) No 10. Environment Aspects (including any public consultation) Issues: 11. Contact Points: -5-  The InfoShop The World Bank 1818 H Street, N.W. Washington, D.C. 20433 Tel. No. (202)458 5454 Fax No. (202) 522 1500 Simon C. Bell Team Leader The World Bank 1818 H Street, NW Washington D.C. 20433 Telephone: (202) 473 4931 Fax: (202) 522 1145 Note: This is information on an evolving project. Certain activities and/or components may not be included in the final project. Processed by the InfoShop week ending September 24, 1999. - 6 -