Uzbekistan - Financial Institution Building Project

Document of The World Bank Report No: 19026-UZ PROJECT APPRAISAL DOCUMENT ON A PROPOSED LOAN IN THE AMOUNT OF US$25.0 MILLION TO THE REPUBLIC OF UZBEKISTAN FOR A FINANCIAL INSTITUTION BUILDING PROJECT APRIL 28, 1999 Private and Financial Sector Development ECCOl Europe and Central Asia Regional Office  CURRENCY EQUIVALENTS (Exchange Rate Effective March 1, 1999) Currency Unit = Som 105 Soln = US$1 FISCAL YEAR July 1 - June 30 ABBREVIATIONS AND ACRONYMS CAS - Country Assistance Strategy CBU - Central Bank of Uzbekistan COM - Cabinet of Ministers DO - Development Objective EIBL - Enterprise Institutional Building Loan ERL - Enterprise Reform Loan ESW - Economic and Sector Work FIBL - Financial tnstitutional Building Loan FSD - Financial Sector Development Department FSR - Financial Sector Review FSU - Former Soviet Union FY - Fiscal Year GDP - Gross Domestic Product GOU - Government of Uzbekistan IBRD - International Bank for Reconstruction and Development IDA - International Development Agency IFC - International Finance Corporation IMF - International Monetary Fund IP - Implementation Progress LIBOR - London Interbank Offer Rate MOF - Ministry of Finance NBU - National Bank of Uzbekistan NIP - National Investment Plan NPAs- Non-Performing Assets PISLA - Project Implementation and Subsidiary Loan Agreement SME - Small and Medium Enterprise STF - Social Transformation Fund PPF - Project Preparation Facility TACIS - Technical Assistance for the Commonwealth of Independent States USAID - United States Agency for International Development Vice President: Johannes Linn Country Director: Ishrat Husain Sector Director: Lajos Bokros Sector Leader: Yasuo Izumi Team Leader: Itzhak Goldberg  PROJECT APPRAISAL DOCUMENT Uzbekistan Financial Institution Building Project CONTENTS Pages A. Project Development Objective .......................................................2 1. Project development objective and key performance indicators ......................2 B. Strategic Context ............... . . . . . . ..2 1. Sector-related CAS goal supported by the project ...........................................2 2. Main sector issues and Government strategy .................................................4 3. Sector issues to be addressed by the project and strategic choices ..................7 C. Project Description Summary ....................................................... 11 1. Project components ......................................................I 1 2. Key policy and institutional reforms supported by the project ...................... 12 3. Benefits and target population .......................................... 12 4. Institutional and implementation arrangements ...........................................,.12 D. Project Rationale ................. 14 1. Project alternatives considered and reasons for rejection ............................... 14 2. Major related projects financed by the Bank and/or other development agencies ................................................ 14 3. Lessons learned and reflected in proposed project design .............................. 15 4. Indications of borrower commitment and ownership ........................... ......... 15 5. Value added of Bank support in this project ................................................ 16 E. Summary Project Analyses ........................................ . ...... 17 1. Economic ................................................ 17 2. Financial ........ 18 3. Technical ........ 18 4. Institutional ........ 18 5. Social ........ 18 6. Environmental assessment ...................... 18 7. Participatory approach ...................... 19 F. Sustainability and Risks ............................ 19 1. Sustainability ............................ 19 2. Critical risks ............................ 20 3. Possible controversial aspects ............................ 21  G. Main Loan Conditions ................................ 21 1. Disbursement and other conditions ................................ 21 H. Readiness for Implementation .. .............................. 22 I. Compliance with Bank Policies .. .............................. 22 Annexes Annex 1. Project Design Summary .23 Annex 2. Detailed Project Description .27 Annex 3. Estimated Project Costs .36 Annex 4. Financial Summary .38 Annex 5. Procurement and Disbursement Arrangements .39 Table A. Project Costs by Procurement Arrangements .40 Table B. Thresholds for Procurement Methods and Prior Review . 41 Table C. Procurement Plan .44 Table D. Allocation of Loan Proceeds .48 Annex 6. Financial Management .49 Annex 7. Project Processing Budget and Schedule .54 Annex 8. Documents in Project File .55 Annex 9. Statement of Loans and Credits .56 Annex 10. Country at a Glance .57  UZBEKISTAN FINANCIAL INSTITUTION BUILDING LOAN (FIBL) Project Appraisal Document Europe and Central Asia ECCOI Date April 20, 1999 Team Leader Itzhak Goldberg Country Director Ishrat Husain Sector Director/Leader: Lajos Bokros/Yasuo Izumi ProjectlD- UZ-PE-9131 Sector: FSD Program Objective Category: LendinglInstrument: TA Program of Targeted Intervention: I Yes [x] No Project Financing Data [x] Loan 1 Credit [i Guarantee I] Other tSpecifyl Amount (US$m/SDRm) US$25 0 Proposed terms. [ Multicurrency [X] Single currency, US Dollar Grace period (years)' 5 [ Standard Variable [ Fixed [X] LIBOR-based Years to maturity' 20 Commitmnent fee: 0 75 percent Front End Fee: 1.0 percent Financing plan (US$m): Source Local Foreign Total Government 2 3 2.6 4 9 IBRD 12 23 8 25 0 Total 3 5 26 4 29.9 Estimated disbursements (Bank FYIUS$M) 2000 2001 2002 2003 2004 Annual 3 7 6 2 6.5 5 3 3 3 Cumulative 3 7 9 9 16.4 21 7 25.0 Borrower Republic of Uzbekistan Guarantor Not Applicable Responsible agencies Central Bank of Uzbekistan (CBU), Ministry of Finance (MOF), Cabinet of Ministers (COM) Project implementation period: 5 years Expected effectiveness date' August 1, 1999 Expected closing date: June 30, 2004  -2- A: Project Development Objective 1. Project development objective and key performance indicators (see Anne-x 1): * Objective: Improve the corporate governance and management capacitv of the commercial banks in preparation for privatization over the medium tern. Indicators: (i) Short-term: improvements in the bank capacity, including strategic planning, organizational structure; information technology and accounting; and credit analysis procedures; (ii) Medium-term: increase in commercial lending to the private sector; and (iii) Long-run: attracting foreign banks to participate in the privatization of selected Uzbek banks. * Objective: Increase competition between commercial banks and boost efficiency and innovation of banking system. Indicators: reduced market concentration; decreased sectoral segmentation of existing banks; increased corporate borrowing; and better customer service and introduction of new financial products. * Objective: Improve prudential regulations and strengthen the supervision capacity of the Central Bank of Uzbekistan (CBU), including better reporting capacity by the commercial banks. Indicators: Stronger and more transparent internal and external reporting in commercial banks to facilitate supervision by the CBU, particularly for the purposes of the CBU's on-site and off- site audits; higher level of skills and better organization of the Supervision Department of the CBU. B: Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project (see Annex 1): CAS document number: 17376 UZ, discussed by the Board on March 10, 1998. The CAS envisages three possible scenarios. A high case would include an International Monetary Fund (IMF) program combined with a program of structural reform and liberalization supported by World Bank policy adjustment loans. Under the current intermediate scenario, the Bank supports institutional building in the agricultural, enterprise and financial sectors and provides investment loans in health, the social sector and infrastructure. Background: An IMF stand-by program, signed in December 1995, went off-track in November 1996 when the Government of Uzbekistan (GOU) introduced multiple currency practices and foreign exchange rationing. The Bank's Enterprise Reform Loan (ERL) and Financial Sector Adjustment Loan (FSAL) have been on hold since that time; the ERL has been ready for presentation to the Board in November 1996. In 1997, a Financial Sector Review (FSR) provided an analysis of the sector and a strategy for refonnr. Preparation of the FSAL continued after 1996, financed by a Project Preparation Facility (PPF) of $1.2 million: advisory work under the PPF prepared the basis for a legal and regulatory framework for the banking sector. The proposed FIBL would, inter alia, support the implementation of the PPF's recommendations. The CAS is designed to address the Government's concerns about the possible negative consequences of reforms by demonstrating the benefits and results of policy and institutional reforms in the context of pilot investment operations, and through continuing dialogue. The Bank believes that the success of pilot operations, backed by intensified dialogue and technical assistance to build the capacity for economic management, will demonstrate the benefits of reform and thereby provide a solid basis for replicating these reforms throughout the economy. In the intermediate CAS scenario, a series of pilot operations would provide the main vehicle for delivering The World Bank, 1997, Uzbekistan: Creating Financial Markets-A Review of the Financial Sector, Report No. 15430-UZ  - 3 - In the intermediate CAS scenario, a series of pilot operations would provide the main vehicle for delivering assistance to the Government. These operations would demonstrate the benefits of the key structural reforms (i.e., agricultural restructuring and privatization), and support institutional development, which would induce the Government to replicate these changes across the economy. The Enterprise Institution Building Loan (EIBL), approved by the Board in June 1998, together with the FIBL are key components of this scenario: the EIBL extends the gradual approach to privatization taken under the Privatization Investment Funds program; supports a new case-by-case privatization program for large strategic enterprises as the cornerstone for further industrial enterprise restructuring; and provides institution building in the enterprise and financial sector. Building on reforms under the EIBL, the proposed FIBL is designed to correspond with the intermediate CAS scenario by supporting the GOU's cautious and gradual approach to financial sector reform through creation of an adequate legal and regulatory framework for financial intermediation, and development of the sector's technical and institutional capacity. The key objective is to boost the operational autonomy, increase the level of competition, and improve the financial and management capacity of Uzbekistan's banking sector. The anticipated results of this strengthening are that the banks will become an independent constituency for banking sector reform, they will increase lending to the private sector over the medium term (another important potential reform constituency), and will foster more competition within the banking sector. At the same time, FIBL's goals are consistent with preparations for the high case CAS scenario. In July 1998, the President issued a decree in which he announced his intention to achieve current account convertibility by 2000, according to a graduated schedule. It was indicated that the World Bank's financial sector program was a priority for Uzbekistan, specifically because of the GOU's desire for the banking sector to be fully prepared for currency convertibility. The GOU requested that the Bank assist in avoiding the problems experienced elsewhere in the Former Soviet Union (FSU) as a result of economic liberalization. The PPF began this process - which is an ongoing one - by working with the central bank to strengthen the legal and regulatory environment for banking supervision. As Russia demonstrated by default, strong and effective supervision is a key element of a stable banking system; this requires adequate disclosure capacity of the commercial banks as well as strengthening of the regulatory/supervisory framework. Improved corporate governance and supervision are essential to lower the risk that bank managers, following liberalization, be subject to increased moral hazard, which would likely lead to de-capitalizing of the banks at the expense of shareholders and individual depositors. The International Finance Corporation's (IFC's) overall strategy for Uzbekistan is to foster private sector development by assisting SMEs, the financial sector, and the enabling business environment. IFC has followed an integrated approach in Uzbekistan by: (i) including the country under the Extended Reach program providing access to the Small Enterprise Fund to finance SMEs; (ii) developing financial intermediaries, such as leasing companies, to extend credit to SMEs; (iii) working closely with the World Bank in defining technical assistance required for the privatization and development of the financial sector; (iv) exploring smaller ancillary projects attached to large foreign investments; and, (v) providing, togetlher with the World Bank Institute, management and accounting training for local entrepreneurs wlhile working to attract private sector investment in this area. In line with this strategy, IFC's proposed credit lines, which will be submitted to the Board in this year, have two important objectives. In the short to medium term, they will address the scarcity of term finance in Uzbekistan to privatized and newly created private SMEs. The medium to long term objective is to foster the development of the financial sector through a program aimed at strengthening the financial resources and technical expertise of state owned banks, which the government intends to privatize, as well as private banks in the country, so that over time they can become effective and efficient conduits for channeling term financing to the private sector.  - 4 - 2. Main sector issues and Government strategy: Main Sector Issues: According to the recently completed Economic Report2, Uzbekistan's financial sector depth, as measured by M2/GDP, reached only 16.6 percent in 1997, well below that, for instance, of Poland (40 percent). Total financial intermediation (Domestic Credit/GDP) was 25.2 percent in that year. Withiln the FSU, for example, Ukraine's ratio was lower, at 19 percent. The foreign exchange controls, discussed above, serve as a critical constraint oni development of Uzbekistan's financial sector. Four additional factors constraining financial intermediation are discussed below: A. Corporate Governance and State Ownership The state dominates the ownership structure of Uzbekistan's banking system. Three of the five largest banks, representing approximately 65 percent of banking system assets, are 100 percent owned by the state or state owned enterprises. In addition, a number of the other banks, including spin-offs from the state owned banks, still retain significant state ownership, either directly by the state or through quasi state structures such as production associations. In addition to direct ownership, the state gains influence via directed lending under the National Investment Plan (NIP). Typically funded by the Central Bank and/or guaranteed by the Ministry of Finance (MOF), Bank lending under the NIP is still used for state- sponsored investment projects. The President's Decree "On Measures to Improve the Operation of Joint Stock Commercial Banks" of October 2, 1998 requires the state's share in such banks to be reduced and not to exceed 50 percent after July 1, 1999. The obvious but critical obstacle to properly implementing this Decree in the designated timeframe is the lack of foreign or new local capital to buy the shares of the banks. This could pressure banks to comply with the decree in ways that could actually weaken corporate governance. The decree specifically names "banks' clients" among the proposed investors. This conflicts with prudential banking standards because it increases the risk that shareholders may unduly influence bank-lending activities via related party lending. Experience in other countries confirms that Central Bank restrictions on related party lending are easily circumvented, and require special diligence in bank supervision. Encouraging clients to buy shares will complicate this further. In the Aide Memoire of December 20, 1998, the Appraisal Mission stressed the extreme importance of ensuring that banks are governed by financial institutions and not industrial or trade companies. The potential for moral hazard would be very large if a non-financial client of a bank were to acquire a controlling shareholding in the bank. An even worse scenario may arise when an enterprise owns a significant stake in a bank and the bank acquires shares in the same enterprise. The experience of Russia in 1998, of Korea in 1997 and of Mexico in 1995 shows that permitting such ownership structures might lead to bank crisis and collapse in both the industrial and financial sector. The GOU has responded to this concern in a Cabinet of Ministers (COM) Resolution dated January 15, 1999 (see below). B. Market Concentration and Segmentation. Uzbekistan's banking system is characterized by an extreme degree of market concentration: the National Bank of Uzbekistan (NBU) accounts for 56 percent of banking system assets and has equity stakes in several smaller institutions. The nearest rival, the state-owned cotton bank Pakhta, accounts for 17 2 This section draws heavily on the comprehensive review in Chapter 4 of Structural Policy Review Economic Report, February 1999.  - 5 - percent of total assets. The leading five banks in Uzbekistan together account for almost 90 percent of the banking assets. In comparison, the share of the five largest banks is 60 percent in the Czech and Slovak Republics and 50 percent in Russia. In addition, the requirement, until recently, that domestic companies maintain settlement accounts at only one bank has acted to preserve NBU's position. NBU's advantage in international transactions is being extended into domestic commerce, as NBU develops a domestic branch network. As a result of its market power, regulations constraining competition, and relative sophistication, NBU has become a dominanit force in the financial system. Banking segmentation has been a serious problem in the early period following independence, (see the 1997 FSR) but this constraint is being eased as the sectoral banks attempt to become universal banks. The important examples are Asaka Bank, which has undertaken to diversify away from the automotive sector and ZhilsberBank, whiclh was specialized in construction. C. Prudential Regulations and Banking Supervision Following the work of the PPF and the United States Agency for International Development (USAID) teams, a comprehensive set of prudential regulations for the banking system is now in place. These are based on the legislation on financial activities enacted since 1995, including the laws on banks and banking, the central bank, collateral, and the chart of accounts for commercial banks introduced with the assistance of the Bank, through the IBTA loan. Key elements are: Capital. The capital adequacy ratio is set at 10 percent, which is higher than the Basle standard ratio of 8 percent of capital to total risk-weighted assets. In addition, the minimum capital requirement for joint-stock banks has recently been raised to US$2.5 million in Tashkent, $1.25 million elsewhere; $5 million for banks with foreign participation. Exposure Limits. Based oni the PPF's recommendations, exposure limits were set: to a single client - 15 percent (shares and bonds, excluding GKOs out of Tier I capital); to all issuers combined, 50 percent for investment and 25 percent for trading. Loan Classification. The rules for classifying loanis were introduced in 1996 and revised in 1998 in greater conformity with International Accounting Standards. Nevertheless, a number of issues remain unresolved. Among these are: allowing banks to deduct loan loss provisions from the tax base and correctly assessing the large amounts of government-guaranteed loans to ailing state-owned enterprises in the loan portfolios of some commercial banks. This is a major concern from the system stability point of view and from that of a potential strategic investor: these guarantees reflect a contingent liability of the GOU which in case of crisis will either impose a burden on the budget or, if the guarantees are not honored, a collapse of the banks. Deposit Insurance, A draft law on deposit insurance is currently under consideration by the Government. The World Bank has expressed the concern (on July 9, 1998 and on October 31, 1998) that implementation of a deposit insurance scheme, while ultimately a reasonable goal, is premature at this time. In order to minimize the risk of moral hazard and reduce the potential for negative systemic impact, a number of policy issues need to be resolved prior to creation of a deposit insurance scheme, including: stabilization of the banking industry, passage of a comprehensive bank-bankruptcy code, and strengthening of the Central Bank's ability to supervise the banking system and take appropriate actions regarding problem institutions.  - 6 - D. Financial Repression/Liberalization: Banking Sector and Tax Administration. Uzbekistan's banking system currently plays a role in both tax enforcement and collection. A key element of this system is the distinction between cash and non- cash transactions. Cash withdrawals by enterprises are permitted only for purposes of payment of wages, pensions, and travel expenses. The Bank's views the distinction between cash and non-cash continues as the single most important constraint on the intermediation offinancialflows, inhibiting the development of the financial sector, and encouraging a large informal sector and hard currency curb market. The GOU position is that maintaining this system is essential to preventing the collapse of tax collection which has afflicted many of the FSU countries, particularly Russia. Single Account Restriction. Until recently, enterprises (other than joint ventures) have been allowed to maintain only one settlement account. This meant that an enterprise was able to conduct business witlh only one bank at a time. By creating a prohibitively high switching cost for bank clients, this arrangement increased the cost of doing business and severely curtailed inter-bank competition. As a result, banks had little incentive to serve their clients well or to attract new customers. In January 1999, the Government announced the progressive elimination of this restriction by June 1, 2000. The interest rate regime is administered by the CBU rather than market-determined. While the CBU sets the refinance rate, the rate does not appear to be closely linked with other interest rates. Real interest rates for 1996-97 have been negative and suggest significant financial repression. 1996 1997 A. 3-month T-Bill Rate (% yield, 42.9 29.3 December issue)3 B. Inflation (% change, year-end)4 64.0 50.0 C. Real Interest Rate (A-B) -21.1 -20.7 Comparable data for average lending and borrowing rates is not available for the calculation of interest rate spreads though these spreads are likely to be high reflecting, among other factors, the lack of competition in the banking sector, and the inordinately high reserve requirement. Government Strategy: Bank Governance and Privatization: The President's Decree UP-2084 "On Measures oni Improvement of the Activity of Joint-Stock Commercial Banks" issued on October 2, 1998 is an indication of the Government's commitment to strengthening the banking industry. There is a widespread agreement within the GOU and the commercial banks about the desirability of attracting foreign strategic investors to Uzbek banks in order to strengthen skills, governance and competition. Foreign Strategic Investors. The GOU accepts the Bank's view that the most advantageous solution to the bank governance problem is attracting a foreign bank as a strategic investor; the best example of the success of this approach is Hungary. COM Resolution 477 of November 17, 1998 allows the sale of 40 percent of the shares of NBU and COM Resolution of January 15, 1999 allows the sale of an unspecified stake in the shares of Asaka Bank. CBU refinance rate for 1997 was 40 percent (Source: CBU). 4 Source: IMF  - 7 - In order to attract strategic foreign investors to Uzbek banks, several steps need to be taken. First, "clean" or unqualified audits must be obtained for each bank to be sold. However, in certain cases, the secrecy of bank credit documentation has made it impossible for international auditors to issue a "clean" opinion on the bank's financial statements. Any bank receiving a qualified opinion in 1998 or 1999 would not be able to attract a reputable, strategic international investor. It has been agreed that the COM would take all steps necessary that the 1998 reports will not be qualified due to "secrecy" restrictions imposed on the auditors. Ownership of banks by non-financial enterprises: As mentioned in Section 2-A above, theAide Memoire of the Appraisal Mission recommends that "cross and circular ownership be prohibited and that a single non-financial company would not be allowed to hold more than 5 percent of the outstanding shares of a bank." Addressing the Bank's recommendations, Article 3 of the January 15 COM resolution says: "From January 1, 2000 share of one share-holder in the statutory capital of a commercial bank cannot exceed 20 percent, from January 1, 2001 - 13 percent and from January 1, 2002 - 7 percent of the total volume of the statutory capital (except state share, as well as banks with participation of foreign capital and private banks). From January 1, 1999 participation of the bank in the statutory capital of a newly registered bank is not acceptable, except cases when banks with foreign capital and bank affiliations are established. Before January 1, 2001 commercial banks must sell shares they currently own in the statutory capitals of other banks". The latter addresses the concerns regarding circular and cross- ownership while the limitations on the stake of a single shareholder in a bank are introduced gradually, setting the limit at 7 percent. Bank Restructuring. The process of bank restructuring-which has been awaiting the development of adequate legal and regulatory frameworks and the development of institutional capacity-has just begun in Uzbekistan. Some movement in this direction may follow the October 2, 1998 Presidential Decrees calling for the restructuring of the banks' loan portfolios, including loans whose repayments have been delayed in accordance with Government decisions. Bank restructuring needs to be handled carefully so as not to create the moral hazard problem and a drain on budgetary resources.5 In addition, Government policy toward directed credits is critical. Past credits need to be restructured or otherwise addressed with assistance of the Government. Future loans must be made only on the basis of the issuing bank's market-based credit evaluation. The GOU stated that there would be no pressures on banks to extend new loans in 1999, which are not considered commercially creditworthy by the bank's management. Promstroi management assures us that all new loans are given on a commercial basis and that no new loans to the large loss-making Tapoich Aircraft Company will be extended in 1999. The proposed covenants of the loan address the use of the Selected Banks (see Section 3 below) as a conduit of directed credits. 3. Sector issues to be addressed by the project and strategic choices: The proposed project will support the development of financial system infrastructure through five main components: * Intensive Technical Assistance to Selected Banks (Component 1): channeling of intensive support to a select group of medium-sized and smaller banks with the best prospects for commercial viability; * Sector-wide Technical Assistance (Component 2): providing support to all banks via group training and individualized advisory work in areas including automated credit analysis; The World Bank, 1997, Uzbekistan: Creating Financial Markets-A Review of the Financial Sector, Report No. 15430-UZ provides detailed proposals for bank restructuring.  - 8 - internal auditing, implementation of International Accounting Standards (IAS), training to assist in implementation of management information systems (MIS) development under Component 4, and financing of 1999 and 2000 external audits conducted under IAS; * Regulatory/Supervisory Capacity Building (Component 3): strengthening legal/regulatory framework and supervisory capacity of CBU - building on support provided under PPF and by other donors; * Financial Sector Information System - FSIS (Component 4): strengthening of bank Management Information Systems (MIS), upgrading the payment system; and improved performance of telecommunications in support of MIS and payment systems; * Bank Privatization and Restructuring (Component 5): assistance for restructuring of non- performing assets of commercial banks and sale to strategic investors. The project contributes to three out of the four sector policy issues described above: lack of private governance, lack of competition, and weak regulatory and supervisory environment. Although the project does not directly address financial repression (except through the important step of relaxing the restriction on multiple bank accounts), it will support institutional development and micro-level reforms, which may contribute to increasing the Government's confidence in proceeding with deeper structural reforms. The FIBL is also intended to supplement the World Bank's sister project, the Enterprise Institution Building Loan (EIBL). A healthy banking sector directly contributes to success in building the private enterprise sector. One key objective of the FIBL is to strengthen credit risk management in banks, which should reassure the banks that lending to the private sector can be managed and profitable. Stronger credit practices are also necessary to attract foreign credit lines. IFC has worked closely with the FIBL team to identify banks that can implement proper lending practices. Governance and Management. In general, the key to sustainable change in governance and management is privatization: sale of a controlling stake to a financial institution with the capacity to restructure the bank. However, given the current macroeconomic environment as well as some long-term "objective" obstacles, one cannot look to foreign investment as a realistic solution in the short term. The Team believes that the project includes a number of provisions to support increased independence and improved management of the banking sector: The Technical Assistance to Selected Banks component will strengthen a select group of medium-sized and smaller banks with the best prospects for independent commercially based operation. The banks included in the program are: Asaka Bank, UzPromstoiBank, ZhilsberBank, UzDaewoo Bank, Andijan Bank and Ipak Yuli. These banks were selected on the basis of their financial condition (e.g., as indicated by a rating of "3" or better, in the CBU/USAID supervision on-site audits), commitment to operation as private commercial bank, prospects of privatization and a demonstrated commitment to implementation of TA program. This intensive assistance would focus on bank strategy and planning; treasury and credit risk management; and accounting, auditing and management information systems. This component is also expected to increase attractiveness of participants to strategic international investors, possibly with the participation of IFC, EBRD, and Central Asian American Enterprise Fund; The Sector-wide Technical Assistance component provides similar support to all banks, with the aim of strengthening commercial viability and independent operation. Although the most promising banks are covered in component 1, this component is intended to meet demands from other institutions which arise from a demonstration effect of the intensive TA program while also spreading costs via training of interest to all banks;  -9- The Financial Sector Information System (FSIS) component will build the capacity of banks to assess risk and manage operations through strengthening of MIS. First, the systems upgrading will strengthen management of liquidity and risk within commercial banks - thus increasing their ability for independent, technically competent administration. Second, the payment system reform to undertake intra-bank c'.;aring and settlement on a net basis manage by each bank's head office eliminates direct Central Bank involvement in this core function of commercial banks. Currently each transaction is settled in central bank accounts on a gross basis for each bank branch, increasing potential for government interference while significantly reducing efficiency and increasing liquidity costs. Finally, the proposed investment will accommodate a modest growth in volume of transactions in relation to the current low levels. As activity grows, the Government ability to micromanage the system (feasible only with conditions of light activity) will progressively diminish. By providing payment system infrastructure and network technology, Component 4 will also allow banks to consolidate their daily financial statements and maintain a single settlement account with the Central Bank.6 This will permit improved liquidity management whereby a bank can make intra-bank transfers from branches with excess funds to branches where there is excess loan demand. In addition, the component will introduce the concept of inter-bank netting for low value transactions, thus permitting banks to reduce the balances they currently maintain for payments. The Bank Privatization and Restructuring Component will deal with the design of work-out modalities of non-performing assets resulting from previous directed lending programs of the Government, so as to allow managers to focus on the current problems of new credit appraisal and risk-management. The component will also, support the privatization of selected institutions. Competition The project aims to strengthen viable institutions, which could become effective competitors to the dominant bank - and to each other. Many of the samne impacts cited under state ownership and influence, above, apply equally to this issue. TA to Selected Banks (Component 1) would channel intensive upgrading to banks with a high degree of demonstrated commercial viability. Design of Component 2 (Sector-wide TA) and Component 4 (FSIS) will channel support to medium and smaller-sized banks, thereby serving to increase competition. Following the Aide Memoire of the Appraisal Mission submitted to the GOU on December 20, 1998, a COM Resolution issued on January 15, 1999 includes Article 6 as follows: "Juridical persons, located on the territory of the Republic are to be rendered the right to open accounts in several banks, with obligatory informing of the taxing agencies at the tax payment departnent: Enterprises with a staff of more that 1,000 people - from June 1, 1999; Enterprises with staff of more than 200 people - from December 1, 1999; Otherjuridical persons - from June 1, 2000. The removal of the restriction is important: Enterprises will then be able to shop for banking services without having to move all accounts and other business simultaneously. Component 4 (Financial Sector Information System) directly supports this important reform by utilizing a unique identification number 6 Presently, each branch maintains its own account with the Central Bank branch in its area. Thus, excessive liquidity is maintained.  - 10- for each firm, thereby allowing the collection of tax data across multip]e bank accounts. The gradual removal by size of enterprise is intended to allow the commercial banks and the CBU to develop credit information facilities which will prevent clients with debts in one bank to apply for credit in another without proper information exchange among banks. It is the CBU's view that the information problem is more complicated for smaller enterprises. Regulatory Framework and Supervision. As noted above, the Uzbek legal/regulatory framework and supervision in the banking sector have been strengthened in recent years but remain weak. The project, therefore, includes a component of institutional strengthening for the CBU precisely in these areas, building on previous efforts under the PPF, USAID and TACIS. A detailed matrix of the implementation status of the PPF's recommendations is available in the Project Files. Component 2 will include courses on the legal aspects of banking and finance and provide for training for lawyers from various government departments and agencies. Training will include the following topics: (i) rules regarding entry and authorization of banks and banking activities; (ii) standards and requirements for capital adequacy, liquidity and solvency of banks; (iii) prudential regulation of banking activities and supervision of banks; (iv) depositor protection regulations; (v) monetary and foreign exchange regulation; (v) trade and investment regulation; and (vi) rules regarding restructuring and exit of banks. Liberalization: At the request of the GOU, the FIBL will provide a Foreign Exchange Adviser under Component 3 who will be responsible for implementing in CBU and the commercial banks of adequate procedures related to foreign exchange (FX) trading and risk management. The primary focus will be on the skills required by CBU officials and commercial banks in a market-determined foreign-currency regime where the CBU intervenes by buying and selling currency. Training will be provided, inter alia, by organizing computer- based simulated FX trading.  - Ii - C: Project Description Summary 1. Project components (see Annex 2for a detailed description and Annex 3for a detailed cost breakdown): Components Category Cost, % of Bank- (US$) Total financing (UJS$) 1. Institution Building - Selected Banks Institutional 3,120,000 10.4 2,920,000 Strengthening 2. Institution Building - Sector Wide Institutional 5,112,000 17.1 4,512,000 Strengthening Intertnal Audit (in house & center) Credit Analysis (programs & training) Bank Accounting Management Information System 1999 and 2000 IAS Audits banks 3. Institution Building - CBU Policy/ 848,000 2.8 648,000 Institutional Strength eniing 4. Financial Sector Information Systems Institutional 10,791,000 36.0 7,711,000 Strengthening Payment System MIS System Telecommunication Network 5. Bank Privatization and Policy/ 4,768,000 15.9 4,568,000 Restructuring Institutional Strengthening Legal advisory support Restructuring/privatization support 6. Project Implementation Unit Institutional 2,195,000 7.3 1,745,000 Strengthening Total (Base Cost) 26,834,000 89.5 22,104,000 Contingencies 1,682,000 5.6 1,446,000 PPF 1,200,000 4.0 1,200,000 Fee 250,000 0.8 250,000 TOTAL PROJECT COST2 29,966,000 100.0 25,000,000 'Salaries based on experience under PPF and EIBL. US$18,000 monthly salary, including US$2,000 in expenses. 2The counterpart contribution is 16.6 percent of the total project cost. See Annex 3 for breakdown by component.  - 12- 2. Key policy and institutional reforms supported by the project: The project aims to: (i) Reduce systemic risk via strengthening bank management, introduction of tight restrictions on ownership of banks by industrial groups, improving prudential regulation and supervision, and improvement of the payment system; (ii) Increase independence of banking sector from state control and ownership through strengthening bank commercial viability and attractiveness to strategic foreign investors, improving efficiency via investment in MIS and telecommunications, and facilitating restructuring of non-performing debts; (iii) Promote competition and reduce market concentration by boosting capacity of viable medium and smaller banks, remove important regulatory constraints to competition (multiple bank accounts), and improving efficiency of payments system - particularly for medium-sized banks; (iv) Improve the legal/regulatory framework for banking and development of a supervisory capacity in the CBU via implementation of recommended actions under PPF and extension of TA program undertaken by other donors. The net intended effect of the project is to help create a stable, commercially-oriented banking sector, which takes on an increasing role in the finance of private commercial activity over the medium term. 3. Benefits and target population: Benefits * Reduced systemic risk; ? Improved corporate governance of banking sector via strategic foreign investors and increased independence from Government; * Strengthened ability of banks to channel savings (foreign and domestic) to productive investment opportunities; * Greater operational efficiency of banks as a result of increased competition and investment in institutional strengthening; * Increased transparency and bank supervision through improved auditing procedures; Target Population * Owners, managers, and employees of participating banks; * Clients of participating banks, including private firms and consumers; * Local professional groups, including auditors and accountants; * Central Bank professional staff. 4. Institutional and implementation arrangements: Overall Project Structure. Due to the clarification of the implementation arrangements during negotiations, signing of a Project Implementation and Subsidiary Loan Agreement (PISLA) between the Borrower and the CBU (as acceptable to Bank) was incorporated as a condition of effectiveness. A Supervisory Board, consisting of representatives of CBU, MOF, and COM, will be encharged with  - 13 - oversight of all project activities. Under the Supervisory Board, a Project Implementation Unit (PIU) will be encharged with project management and coordination of the activities under each of the loan components. The PIU will be supervised and controlled by the Supervisory Board. Created for implementation of the PPF, the PIU will be strengthened in the following areas in order to execute the Project: Project Management, Procurement, and Financial Management/Information Systems. Foreign resident advisors would be hired under each of the three areas. The PIU would be responsible for management of the two Special Accounts (SA) corresponding to activities of CBU and MOF, respectively, procurement of goods and hiring of consultants, disbursement, coordination of consultants, and overall financial management. The organizational structure of the PIU will be as follows: The PIU will hire a Project Management Consulting (PMC) firm which will operate under the supervision of the Director General. The PMC will provide the PIU with specialists in the various fields mentioned above as well as train local staff who will serve as counterparts to the international experts. The PMC will coordinate the implementation of the loan components and, together with the Director General, maintain the policy dialogue with the GOU regarding banking sector reform issues, including those highlighted by the PPF. It will also assist the PIU in capacity building. There will also be a team of long- term foreign banking experts resident in the pilot banks. The GOU will provide an in-kind contribution to the PIU in the form of adequate premises at the Central Bank of Uzbekistan (CBU). Required capital investment (office space, furniture, computers office equipment, and vehicles) will be funded from the FIBL, according to a budget jointly agreed between the Bank and the GOU. Finance, Accounting, and Auditing Arrangements. The PIU will maintain all project accounts. The Project Management Consulting (PMC) firm will supply a foreign resident consultant to serve as financial manager who will prepare a financial management plan for the project (including full description of procedures and staff responsibilities), and control all expenditures made against the loan. The financial management plan will be reviewed by an independent auditor acceptable to the Bank. Prior to loan effectiveness, the auditor will offer an opinion stating that the financial management plan conforms to the Bank guidelines as expressed in OP and BP 10.02. A Financial Management Specialist of the World Bank will review the financial management plan for compliance with Bank requirements prior to effectiveness. The PIU project accounts will be audited on an annual basis in accordance with international standards as acceptable to the Bank. This audit will be financed as incremental operating expenses from the proceeds of the loan. Reporting Arrangements. Semi-annual progress reports will be prepared by the PIU. The format of the reports will be mutually agreed upon prior to the first submission six months after project effectiveness. Implementation Completion Report. The PIU will prepare, in conjunction with the Bank, an ICR upon completion of the project, and not later than six months after final distribution of Loan proceeds. Included in the ICR will be an assessment of the execution and initial operation of the project, costs and benefits derived or to be derived, the performance of the Borrower, the Bank, and other agencies involved in the Project in their respective obligations and accomplishments, and lessons learned. Project Monitoring and Evaluation. Project monitoring and evaluation will be carried out in the following areas: (a) procurement of goods and services; (b) financial management and use of project resources; and (c) progress towards project objectives. The evaluation will be made with reference to the key Performance Indicators (to be agreed at Negotiations), and project outcomes will be evaluated in terms of improvements in the pilot banks, and the impact of this improvement on the banking sector as a whole.  - 14- Procurement Arrangement. The procurement of goods and services of the Bank financed components will be procured in accordance with the Bank's procurement guidelines. The project activities not financed by the Bank will be procured in accordance with the national regulations of the Borrower. The project elements, their estimated cost and procurement methods, schedules including capability of the implementing agency, are presented in Annex 5. D: Project Rationale 1. Project alternatives considered and reasons for rejection: The main alternative to proceeding with this project at the current time would be to delay the activities until agreement is reached regarding a full structural adjustment program to address macroeconomic distortions described above (section B.1). Although it is evident that progress under the proposed project may be inhibited by the need for macroeconomic policy reform, there are strong reasons for proceeding under current conditions. First, the Government has indicated a growing receptiveness to reform. In anticipation of currency reforms planned for 2000, the Government has announced a series of initiatives to liberalize and privatize the financial sector. The proposed project would serve to strengthen and deepen the existing dialogue in advance of expected structural reforms. The FIBL would thereby facilitate a dialogue on microeconomic issues with potential positive implications for the stability of the financial system. A major goal of the proposed FfBL is to create momentum for competition and a new constituency for economic reform outside of the Government. The creation of additional reform lobbies is a potentially promising means of accelerating the reform process in Uzbekistan and thereby addressing issues that are of greatest concern to the Bank. The proposed FIBL will also play an important role in complementing reforms already begun in the enterprise sector under the Enterprise Institution Building Project or EIBL (Loan 4345-UZ), thus supporting Uzbekistan's newly emerging private sector. In addition, the project would build upon previous financial sector technical assistance initiatives and provide a vehicle for implementing their recommendations. 2. Major related projects financed by the Bank and/or other development agencies (completed, ongoing and planned): Sector Issue Project Latest Supervision (Form 590) Ratings (Bank-financed projects only) Implementation Development Progress (IP) Objective (DO) Bank-financed Case-by-Case Privatization, Uzbekistan EIBL (UZ-PE- S S Post-Privatization Advisory 55159) Services, Capital Markets Development IFC SME Credit Lines IFC 8700, 8701 N/A N/A Technical Assistance to banks, Poland FIDL (PL-PE-8585) S HS partnering Technical Assistance to banks, Hungary FSMP (HU-PE- S S modernization 8478)  - 15- Privatization of banks through Hungary EFSAL (HU-PE- S S foreign investment 8498) Other development agencies Credit Lines and technical EBRD N/A N/A assistance to banks Technical assistance in USAID N/A N/A accounting standards, banking regulation/supervision Technical assistance to banks, TACIS N/A N/A and Privatization Investment Fund (PIF) program IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory) 3. Lessons learned and reflected in the project design: * Financial sector liberalization in other CIS countries was undertaken with insufficient attention to institution- and capacity-building, with severe implications for systemic stability and risk. The aim in Uzbekistan is to begin this process during early stages of reform. - A high degree of ownership in the Government and participating banks is the most critical success factor in TA operations. The Government has showed Strong indications of ownership; provisions for cost recovery and participation in tailoring of technical assistance help assure buy-in of banks. * Twinning arrangements, which link local and foreign banks, have shown to be effective only when a strong incentive for an ongoing business relationship between the banks is in place. Given the current business climate in Uzbekistan, this incentive was considered to be weak, and the option of twinning was rejected. e Strong institution-building elements and hands-on assistance must accompany any TA in the form of equipment or computerization in order to maximize the utility of the procured goods. * Intensive supervision by the World Bank is necessary, particularly at the early stages of implementation. 4. Indications of borrower commitmient and ownership: The Government has demonstrated a strong commitment to implementation of the proposed project. Given the financial crisis experienced elsewhere in the region and the country's own macroeconomic situation, the Government has announced intentions to accelerate a number of key micro-level reforms. A Presidential decree of July 1998 announced the Government's intention to achieve current account convertibility by 2000. In September the GOU indicated that Bank assistance for financial sector reform was a top priority in light of preparations for currency convertibility. Subsequently, in October a decree was issued requiring that state participation in all banks be reduced to a maximum of 50 percent by July 1, 1999. In December 1998, the President requested further expansion of Bank assistance in restructuring the financial sector. Finally, in January 1999, a resolution was issued to address a variety of financial sector reforms recommended by the Bank, including tighter controls on bank ownership and capitalization as well as a progressive relaxation of the restriction on multiple bank accounts. Experience under ongoing technical assistance programs (PPF, TACIS, and USAID) gives evidence of the Government's support for financial sector development. These projects have sponsored long-term resident advisers in the Central Bank of Uzbekistan working in the areas of bank supervision, accounting reform and legal reform. The GOU has also been highly proactive in the design of the proposed FIBL  - 16 - and designated a Vice-Chairman of the CBU as a counterpart of the FIBL Team. A Senior Foreign Adviser, financed by a PHRD grant, is based in the CBU, assisted by a local lawyer, and facilitates the dialogue between the CBU and the FIBL Team. Another foreign adviser is based in UzPromstroibank advising its management on re-organization of the credit function. Both advisers have been in the field for six months and created close contacts with bank managers and CBU personnel. 5. Value added of Bank support in this project: The Bank has gained considerable experience in institutional building in the enterprise sectors: a corollary operation the EIBL (a $28 million loan) provides assistance to privatization; restructurinig of the real sector is a pre-condition of banking sector restructuring. In the Financial Sector, the IBTA loan has provided the initial funding for the establishing the chart of accounts for IAS in the commercial banks (using Arthur Andersen) and the CBU and for the establislhment of the Payments System. The 1997 FSR provided the basis for our policy dialogue since and the PPF has laid out the basis for a regulatory framework. The FIBL will suppolt the implementation of the PPF's recommendations for the regulatory framework and fund the corollary support for the commercial bank. The efforts of USAID support the work at the CBU and TACIS plays a role with EDI in training of bankers. IFC has closely coordinated the design of its credit line with the EIBL team responsible for enterprise institution building and development of private sector SMEs, as well as the proposed FIBL. In support of SMEs the Bank approved the above mentioned EIBL and is currently working on development of the Social Transformationi Fund Loan (STF) which is expected to be presented to the Board in Fall 1999. The EIBL provided funding for a Post Privatization Bureau that assists new or privatized SME enterprises in the development of their business plans for modernization and development. The Bureau, working withl the IFC project team, has identified a number of potential clients for funding through the credit lines and will work closely with the Banks to facilitate access by private SMEs to term financing provided by this project. In addition, the Bureau, through its extensive network of contacts, will provide assistance to IFC in screening potential sub-borrowers to insure that loans are being provided to truly private sector SMEs. The STF will provide technical assistance to at least three small private banks outside Tashkent, which will focus on upgrading their management and credit skills and allow them to start small business term lending to SMEs. STF will also make available a line of credit that may be accessed by the selected banks for on lending to small SME borrowers. IFC has been coordinating with the STF project team and may consider an investment through STF to one of the banks that will benefit from STF technical assistance. The IFC credit line will provide additional financial resources for the banking sector, thereby allowing it to play a more effective role in the development of the private sector through financial intermediation. As part of this project, IFC will mobilize trust funds as required to supplement the technical assistance that will be provided to the participating banks through the FIBL. IFC's credit line will lead to an increase in the number of staff at local banks who will perform project finance and credit risk aiialysis. These banking skills will form a basis for these institutions' future ability to do further financial intermediation. Finally, having to adhere to IFC's loan conditions will give added incentives for the selected banks to follow prudent asset/liability management and international banking standards. By playing this institution-building role and introducing commercial banking practices in this highly controlled banking system, the Bank and IFC are jointly assisting the country to prepare for a more market-based environment and for the privatization of the banking sector which has been made a priority by the government  - 17- The close coordination between the FIBL and IFC teams in project appraisal and design has facilitated the development of a joint approach to provide support to SMEs and development of the banking sector. IFC staff have participated in joint appraisal missions with the Bank for FIBL and Bank staff have participated in the IFC appraisal of six banks that were being considered as potential conduits for a credit line under this project. IFC has identified the technical assistance needs of Asaka Bank and three additional banks (Promstroybank, UzDaewoo Bank and Zhilsberbank - all of which may be considered for investment by IFC in the future) which the World Bank and the government have agreed to fund under FIBL. Coordination was further enhanced by IFC staff serving as peer reviewer of FIBL and World Bank staff participating in IFC's CIC consideration of this project and subsequent management meetings regarding project design. Both the IFC and the EBRD are cooperating with the FIBL team in the design of Component 5 to establish bank privatization and bank non-performing assets restructuring bureaus within the Ministry of Finance. The Bank will take the lead in the design of the privatization process, building on the experience acquired under the case-by-case component of the EIBL, while the IFC and EBRD will play a key role in attracting foreign investors and possibly participating in equity investment or lending. E: Summary Project Analysis (Detailed assessments are in the project file, see Annex 8) 1. Economic: [X] Cost-Benefit Analysis [X] Cost Effectiveness Analysis: An important premise of the proposed FIBL is that the selected banks will be able to take advantage of the TA and change their behavior within a difficult economic and policy environment. The primary shortcoming in the economic environment is the dominant role of the state and state-owned enterprises, in particular the state's control over key variables such as the exchange rate and commodity prices. This environment clearly prevents banks from making lending decisions on the basis of objective, market- generated information. While fully acknowledging this difficulty, this TA is based on the argument that risk management can be applied within a market environment as well as within a less flexible environment. The fundamental nature of risk analysis is the same in both environments; it entails such factors as financial statement analysis, assessing the reliability of the financial information, cash flow projections, competition and market analysis, and ownership and management assessment. Our review of the candidate pilot banks' current risk analysis and risk management processes has confirmed that their current loan review practices do not adequately take these factors into account. As a result, the pilot banks will be able to utilize this TA both to improve their current practices and to adapt to market reforms as they take place. In addition, the strategic planning, accounting, and auditing aspects of the TA are less constrained by Uzbekistan's current economic environment and are essential components of market-based infrastructure. As mentioned in Section B of the PAD, a major risk of this project is that liberalization will be delayed and in the presence of the existing price distortions, enterprises lack the necessary signals to make proper decisions with regard to restructuring. In general, neither an enterprise manger nor a bank's loan officer can appraise a project if prices are distorted by the exchange rate or trade regime. However, small and medium enterprises are relatively free to make decisions regarding the informal portion of their business: those are small and medium enterprises which do not belong to associations, produce products which are in high demand locally or are easily exportable to neighboring countries. In this informal economy prices are, more or less, freely determined and based on the curb exchange rate. Needless to say that economy- wide restructuring will be possible only when the trade regime is liberalized and the limited objective of this project is to build institutional capacity until the trade regime is liberalized.  - 18- Cost Effectiveness Analysis: The proposed project would channel support in the most cost-effective means possible through maximum use of competitive bidding, as described in Annex 5. Alternatives for provision of technical assistance, e.g. twinning arrangements, were rejected on the grounds of excessive cost and low expected benefits based on experience elsewhere (particularly in Russia). The design of support to the Administrative Secretariat is intended to maximize use of local consultants while maximizing efficiency in the contracting and oversight of consultants. 2. Financial (see Annex 4): Partial cost recovery of the TA by the commercial banks to the CBU is expected. The repayment will be in Soms, at the CBU refinance-rate, over a period of 20 years including a five-year grace period. (These terms will apply to the three large banks: the small private banks will repay only part of the cost). The requirement of payment for service on the part of participating banks is intended to strengthen their ownership and commitment to the program of institutional strengthening. Fiscal Impact: The element of subsidy to participating banks would be small, as the three larger banks will repay at the CBU refinance interest rate and the JV bank in dollars. Furthermore, investments in technical assistance should result in higher bank profitability and therefore increased tax revenues to the government. 3. Technical: The technical design of the project draws heavily on experience in implementation of financial sector technical assistance under the PPF, as well as the experiences of other donors (USAID, TACIS). In addition, the project makes use of experience under the Uzbekistan Enterprise Institution Building Project approved by the Board in June 1998. Declared effective in October 1998, this project has yielded important lessons in design of the PIU and other implementation arrangements. 4. Institutional: The following institutions will be the target of institutional building under this project: (i) the commercial banks; (ii) the Supervisory and IT Departments of the CBU; (iii) the Bank Privatization Bureau under the MOF; and (iv) the Asset Resolution Agency (see component 5) under MOF. In this respect, lessons from the implementation of the EIBL and the PPF will be applied in the FIBL. In particular, the experiences of the Post-Privatization Restructuring and the Case-by-case Privatization Bureaus will be applied. 5. Social: The project would foster long-term social development of Uzbekistan through improved supply and access to credit to small enterprises and individuals. In addition, the project would serve to increase economic activity, employment, and wages. 6. Environmental assessment: Environmental Category []A []B [X] C The project is expected to have no major environmental impact.  - 19 - 7. Participatory approach. ____________________________ Preparation Implementation Operation Primary beneficiaries Participating banks IS/CON/COL IS/CON/COL IS/CON/COL Bank Clients IS IS/CON IS/CON/COL Professional groups (auditors, IS/CON/COL IS/CON/COL IS/CON/COL accountants) Central Bank IS/CON/COL IS/CON/COL IS/CON/COL Other key stakeholders Enterprise managers and IS IS IS employees Taxpayers IS IS Investors and savers IS IS Classified as IS (Information sharing), CON (Consultation), and/or COL (Collaboration) This project was prepared in close consultation and collaboration with the selected commercial banks, bank auditing professionals, and the Central Bank of Uzbekistan. It is anticipated that consultation, collaboration, and information sharing will continue through the implementation and operational phases of the project. Enterprise managers and employees - particularly those in the private sector, taxpayers, investors, and savers will also benefit from the greater supply of and access to credit facilitated by the project. F: Sustainability and Risks 1. Sustainability: The sustainability of bank restructuring depends on better governance, competition and improved supervision capacity. In the longer term the sustainability of this program can be ensured only through participation of strategic investors in the governance of the banks. Attracting foreign investment depends critically on macroeconomic stability and liberalization. Thus, the prospects of the project's sustainability in the high case CAS scenario are the highest. In the medium-case CAS scenario, which assumes stability but no liberalization, strengthening of independent local private actors in the financial system, along with attraction of foreign strategic investors, might help to build a critical mass in support of continued reform. If the economy deteriorates into a low-case scenario, with major instability in the Uzbek financial system, short-term returns to specific bank TA investments may prove to be negative. However, the assistance should help participating banks to emerge from the potential turmoil in a relatively strong position. Furthermore, the economic value of training to individuals within a failed institution may not be entirely dissipated - they would likely be able to apply knowledge gained as employees of a successor institution or competitor.  -20 - 2. Critical Risks (reflecting assumptions in thefourth column of Annex 1): Risk Risk Rating Risk Minimization Measure Annex 1, cell "from Outputs to Objective" 1. Non-sustainable institution building due to S 1.1 Demonstrated commitment lack of incentives; lack of cooperation with of participating banks, including consultants and slow implementation of their advice willingness to pay for TA if caused by weak governance due to slow necessary. privatization. 1.2 Eventual participation of strategic foreign investors will ensure sustainability. 2. Inadequate national infrastructure for M 2. Anticipated and budgeted for information clearing (especially communications) within the project, based on Bank experience in other CIS countries 3. Supervision is extremely detailed and procedure M 3. Simplifying reporting oriented; bankers and bank supervisors are requirements in Component 4 inundated with instructions and forms. and training of supervisors and bankers in Components 2 and 3. 4. Large banks are required by the GOU to lend to H 4. Loan covenants will provide a non-creditworthy projects or on non-commercial trigger to control this risk for terms. participating banks. In addition, a major goal of the TA is to provide the banks with the technical expertise and financial/political clout necessary to be able to satisfy the GOU's lending requirements when necessary without sacrificing loan portfolio quality. 5. Asian banks may be attracted 5. Strategic foreign investors cannot be identified. S due to proximity; multi-nationals may invest, through a financial subsidiary, to establish a trading base; EBRD and IFC's participation could provide a political umbrella ("comfort"). Currency liberalization would have to precede investment. Annex 1, cell "from Components to Outputs" Overall Risk Rating S  - 21 - 3. Possible Controversial Aspects: Risk Type of Risk Rating Risk Minimization Measure _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ R isk_ _ _ _ _ _ Failure to implement liberalization; G H Building institutional capacity Balance of payments crisis will enhance receptivity of GOU for sequenced, sustainable reform; strengthening of constituency for liberalization in banking sector. Type of Risk - S (Social), E (Ecological), P (Pollution), G (Governance), M (Management capacity), 0 (Other) Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N (Negligible or Low Risk) G: Main Loan Conditions 1. Disbursement Conditions: * The Borrower shall establish and maintain a Supervisory Board, comprising representatives of the COM, MOF, and CBU, to supervise and coordinate the implementation of the Project. * The Borrower shall establish and maintain a Project Implementation Unit to assist MOF and the CBU to carry out their respective parts of the Project, and shall entrust such functions and powers, and provide such funds, facilities and resources thereto, including qualified and experienced staff in adequate numbers, as may be deemed necessary by the Bank. * To enable the CBU to carry out its responsibilities under the Project, the Borrower shall make a part of the proceeds of the Loan available to the CBU under a Project Implementation and Subsidiary Loan Agreement (PISLA) entered or to be entered into between the Borrower and the CBU, under terms and conditions which shall have been approved by the Bank. * The Borrower shall exercise its rights under the PISLA in such manner as to protect the interests of the Borrower and the Bank and to accomplish the purposes of the Loan, and, except as the Bank shall otherwise agree, the Borrower shall not assign, amend, abrogate or waive the PISLA or any provision thereof. * The Borrower shall cause the CBU to enter into Participation Arrangements (PAs), through the PIU, with each of the Participating Banks for providing technical assistance to them on a cost recovery basis on terms and conditions satisfactory to the Bank, including the following: (i) each Participating Bank shall pay the cost of said services within 20 years, including 5 years grace period for payment; (ii) the payment of the cost will be in the Borrower's local currency and at the CBU's refinancing rate at time of payment; and (iii) each Participating Bank shall adopt written lending policies which shall, inter alia, include a requirement for the concerned Participating Bank to extend credit on a commercial basis in accordance with criteria acceptable to the Bank. * The Borrower shall cause the CBU/PIU to exercise its rights under the PAs in such manner as to protect the interests of the Bank and to accomplish the purposes of the Loan, and shall ensure that, except as the Borrower and the Bank may otherwise agree, the CBU/PIU do not assign, amend, abrogate or waive any of the PAs or any provision thereof. * The Borrower shall cause the CBU/PIU to select commercial banks, in consultation with the Bank, for the provision of services under Component 2 of the Project and enter into service arrangements with each of the selected banks on terms and conditions satisfactory to the Bank. * The Borrower shall take all necessary measures to ensure that privatization and restructuring of Participating Banks are carried out effectively and shall ensure that the Participating Banks extend credit only on a commercial basis in a manner satisfactory to the Bank.  - 22 - * The Borrower shall ensure that COM Resolution No. 24 of January 15, 1999 on "Measures for Further Reforning of the Banking System" remains in full force and effect until completion of the Project and shall not impose any restrictions on the freedom of enterprises in using multiple bank accounts. * The Borrower shall require commercial banks to publish financial information annually and shall ensure strict enforcement of this requirement in a manner satisfactory to the Bank. Conditions of effectiveness: * The Project Implementation and Subsidiary Loan Agreement (PISLA) between the Borrower and the CBU will be executed and submitted to the Bank. * The Participation Arrangements (PAs) between the PIU (on behalf of the CBU) and at least two Participating banks (UzPromstroy and Asaka Bank) will have been submitted to the Bank. * An opinion from and independent auditor acceptable to the Bank, stating that the financial management plan of the PIU conforms with the Bank guidelines will have been furnished to the Bank. * A Supervisory Board encharged with supervision and coordination of implementation (comprised of representatives of the COM, MOF, and CBU) and the Project Implementation Unit will have been established. H: Readiness for Implementation f ] The engineering design documents for the first year's activities are complete and ready for the start of project implementation. [X] Not applicable. [ 1 The procurement documents for the first year's activities are complete and ready for the start of project implementation. [ X] The Project Implementation Plan has been appraised and found to be realistic and of satisfactory quality. 1: Compliance with Bank Policies [XI This project complies with all applicable Bank policies. Itzhak Goldberg, ogr Leader Ishrat Husain, Country Director Lajos tokros, Sector firector  - 23 - Annex 1 Uzbekistan: Financial Institution Building Project Project Design Summary Narrative Summary Key Performance Monitoring Critical Assumptions Indicators and Evaluation Sector-related CAS (CAS Goal to Bank Mission) Objective "Rapid, sustainable Economic growth CBU, IMF, Risk: Base-case scenario in economic growth" rate. World Bank CAS does not occur due to delay (CAS, p. 7). data in liberalization. Project Development (Development Objectives to Objectives CAS Goal) Improve the corporate Higher CBU data. Risk: capital erosion due to governance and credit/GDP, negative real interest rates; management capacity M2/GDP ratios in directed lending, regulatory of the commercial longer term. regime. banks. Increased competition Increased private CBU data. Risk: Regulatory constraints to in banking sector commercial competition are not reduced; lending; better political/market power of large customer service bank continues to impede and introduction competition. of new financial products. Improved prudential Improved safety CBU data. Risk: Independence of regulation/supervision and soundness of supervision under CBU is banking system undermined.  -24 - Project Outputs (Outputs to Development Objectives) Non-sustainable institution Improved bank Increased Bank annual building due to lack of management profitability of financial and incentives; lack of cooperation participating audit reports. with consultants and slow banks, implementation of their advice unqualified 1999 caused by weak governance IAS audits. In medium-term, attracting foreign banks as strategic investors in selected Uzbek banks Increased Concentration CBU data Risk: banks unable to upgrade competitiveness of ratios, performance due to lack of banks profitability and profitable lending activities. growth of banks. Decreased sectoral segmentation of existing banks. Improved bank Stronger and Semi-annual Risk: supervision continues to regulation/supervision, more transparent supervision be extremely detailed and including improved internal and reports, CBU procedure oriented; bankers and reporting by external reporting data. bank supervisors are inundated commercial banks. by commercial with instructions and forms. banks, including on-site and off- site audits; improved organization and skills set of supervision function in CBU.  - 25 - Project Components (Components to Outputs) Risk: investment in human 1. Intensive Technical Improved bank Consultant development provides benefits Assistance to Selected strategy/planning reports, client only in medium- to longer-term Banks and feedback from due to hostile macro and sectoral organizational interviews/ policy environment. structure; questionnaires treasury/credit risk management; accounting, and auditing of selected banks. Build highly skilled/ specialized human resources for sector 2. Sector-wide Improved bank Consultant Risk: investment in human Technical Assistance strategy/planning reports, client development provides benefits and feedback from only in medium- to longer-term organizational interviews/ due to hostile macro and sectoral structure; questionnaires policy environment. treasury/credit risk management; accounting, auditing, and training to support MIS management (in conjunction with Component 4). 3. Strengthening Implementation Semi-annual Risk: institutional strengthening regulatory/supervisory of reforms supervision is delayed due to bureaucratic capacity of CBU proposed under missions. resistance, procedural PPF and difficulties. additional reforms as determined under project.  -26 - 4. Financial Sector Reduced Evaluation of Assumption: upgrading of Information System transaction system accounting, audit, and including upgrading of time/increased performance operational systems will provide payment systems, bank volume of against necessary data for input to MIS. MIS, and payment system; baseline data; telecommunications reduced bank bank financial systems operational cost statements. and improved risk management. 5. Debt Recovery Asset Resolution Semi-annual Risks: Privatization of banks is Management to assist Agency identifies monitoring hampered by macroeconomic banks in workout of and assists in reports with conditions and lack of non-performing assets management of data collected restructuring in banks. The (NPAs). Bank NPAs; Bank by the PIU. workout of NPAs is slowed Privatization Bureau Privatization down by lack of restructuring of to assist the MOF Bureau organizes enterprises. privatize selected tenders to select banks. Investment Banks for privatization of two banks.  -27 - Annex 2 Uzbekistan: Finance Institution Building Project Project Description Project Component 1: US$3.1 million Technical Assistance to Selected Banks This component aims to directly improve the management, financial performance, and attractiveness to strategic foreign investors of participating banks. Intensive institutional strengthening programs tailored to the needs of each participating bank would address critical issues for bank management, including treasury and financial risk management, strategic planning, accounting, internal audits, Management Information Systems (MIS), and credit risk management. To achieve sustained institutional change, experts will be placed in participating banks for a multi-annual period sufficient to design and implement reforms. Selection of Participating Banks. The project aims to focus scarce resources on a limited number of institutions best situated to benefit from the assistanlCe. Six banks have been pre-selected for participation: UzPromstroybank, UzZhilsberbank, Asaka Bank, Andijan Bank, UzDaewoo Bank, and Ipak Yuli Bank. The selection of banks was done in close cooperation with the Central Bank of Uzbekistan, the Ministry of Finance, and the Government according to the following criteria: D Acceptable financial condition: banks must have earned a rating of "3' or better in CBU on-site examinations, and must at all times be in good standing with the CBU; * Commitment to the development of the private sector: the bank's current lending activities, percentage of assets in commercial loans, and utilization of foreign credit lines are considered as positive indicators; * Demonstrated commitment/ownership of TA program: Several participating banks have already demonstrated their commitment by implementing recommendations received from other foreign advisers (EBRD, TACIS). In other cases, commitment may only be judged from interviews and the bank's willingness to pay for TA; and * Private Ownership: For state-owned banks, a Government commitment to selling the majority of shares and/or control to a foreign investor (or a local private financial institution, except another bank), within the time period of project implementation. The application of these criteria to the six selected banks is provided in the Project Files in the document "Bank Selection Criteria". A pilot for this TA component has been underway at UzPromstroybank (UPSB). In addition to the benefits to UPSB, this inside-perspective has significantly added to the knowledge of the FIBL team, by making clearer what additional work is needed in areas such as International Accounting Standards (IAS), and transparency. The perspective from the commercial bank side has also enriched the understanding of what regulatory matters are still problematic and what still needs to be done by the CBU and GOU to strengthen the industry.  - 28 - Scope of Technical Assistance. Technical assistance will focus primarily on the risks inherent in commercial bank operations and management. The following program was developed in close collaboration with Uzbek banks, with input from foreign auditors, examiners, and trainers with experience in the country. * Bank Strategy and Planning: strategic planning process and variance analysis; bank organizational structure, including strategy for management of branches. * Treasury Risk Management: liquidity risk management; asset-liability management (ALM), interest rate risk management; foreign exchange risk management, especially derivatives (e.g., forwards, swaps); and budgeting (individually-tailored programs may address under this module or under Bank Strategy and Planning). * Credit risk management: written credit policies and procedures; loan analysis methodology and approval procedures; loan structuring and documentation; loan booking and billing procedures; data base management and reporting; loan review; loan monitoring; problem loan identification and management; management of the loan portfolio; identification, analysis and management of non-loan forms of credit risk, such as counter-party risk for treasury transactions; and securities evaluation and investment policy. * Bank Accounting, MIS, and Internal Auditing: training to improve capacity of accounting and MIS management to provide timely, accurate, and complete information (to assist in implementation of Component 4); internal accounting organization, reporting structure, policies and procedures; internal auditing organization, reporting structure, policies and procedures; compliance with CBU and IAS standards of accounting and internal audit. Tailoring to Individual Bank Needs. The participating banks have different capacities and needs. For example, initial analysis indicates that the young banks have newer information systems and be further along in the implementation of IAS. Banks with large loan portfolios may need assistance in problem loan management, while banks with few loans may need help developing lending capacity. For this reason, the generic TA package identified in the preceding paragraph has been adjusted to reflect the capacity and needs of each bank, resulting in six "bank-specific" TA programs (available in Project Files). Notwithstanding these variations, each bank-specific program will include a review of the four areas described above (strategy/planning; treasury and credit risk management, and accounting/ MIS/auditing). The amount of TA to be provided in each area will differ in accordance with (a) the bank's relative capacity and needs; (b) TA received from other sources; and (c) stated preferences of the participating bank. Implementation Arrangements. A single provider will be selected to implement the component for all participating banks, with several expected benefits: to increase the consultant's attraction anid commitment to the project, to minimize contract work at the PIU, and most importantly to maximize flexibility, facilitate sharing of experience/information and quality of the programs. Short-term advisers will be used by the contractor to supplement expertise of long-term advisers in specialty areas. For example, a short-term adviser could be used to strengthen interest rate hedging (swaps, futures), where low current activity is growing rapidly and may pose a significant risk in future.  - 29 - Component 2: US$5.1 million Sector Wide Technical Assistance To provide technical assistance to all Uzbek commercial banks, Component 2 provides training in critical risk management areas via two channels: an established Regional Training Center and directly to each bank. Staff training ranks as the top need throughout the banking system, and for the majority of topics would be provided most effectively via joint training. The objectives of training for each of the areas identified for sector-wide training are as follows: * Automated credit analysis. Software programs for credit analysis will be developed and made available to all banks, covering both the review of past performance and the financial projections associated with business plans. Attention will be paid to the local corporate accounting format in order to facilitate data entry. The pure development phase will require four to five months including preparation of the manuals. Training sessions for interpretation of the output of these programs will follow, organized for small teams or in one-to-one sessions. When this preparatory phase has been completed, each bank conduct analysis for selected borrowers. A professional credit analysis trainer will be required for an estimated period of 18 months. * Internal auditing. In addition to skills traininlg, this module will emphasize implementation. After obtaining the explicit support of the chairman of each bank, a proper audit plan will be prepared in each bank. Its execution will be secured by monthly in-house working sessions with this adviser (for the Banks based in Tashkent) or in the Regional Training Center (for the banks outside Tashkent).