Nepal - Financial Sector Technical Assistance Project

Document of The World Bank Report No: 23992 NEP PROJECT APPRAISAL DOCUMENT ONA PROPOSED CREDIT IN THE AMOUNT OF SDR12.4 MILLION (US$16.0 MILLION EQUIVALENT) TO THE KINGDOM OF NEPAL FOR A FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT November 13, 2002 Finance and Private Sector Development South Asia Regional Office  CURRENCY EQUIVALENTS (Exchange Rate Effective May 31, 2002) Currency Unit = Nepalese rupee I rupee = US$0.01284 US$1.00 = rupee 77.881 FISCAL YEAR July 15 - July 14 ABBREVIATIONS AND ACRONYMS Vice President: Mieko Nishirnizu Country Manager/Director: Kenichi Ohashi Sector Manager/Director: Joseph Del Mar Pernia Task Team Leader/Task Manager: Simon C. Bell  NEPAL FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT CONTENTS A. Project Development Objective Page 1. Project development objective 2 2. Key performance indicators 2 B. Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 3 2. Main sector issues and Government strategy 4 3. Sector issues to be addressed by the project and strategic choices 8 C. Project Description Summary 1. Project components 10 2. Key policy and institutional reforms supported by the project 10 3. Benefits and target population 11 4. Institutional and implementation arrangements 11 D. Project Rationale 1. Project alternatives considered and reasons for rejection 11 2. Major related projects financed by the Bank and other development agencies 12 3. Lessons learned and reflected in the project design 14 4. Indications of borrower commitment and ownership 15 5. Value added of Bank support in this project 16 E. Summary Project Analysis 1. Economic 16 2. Financial 16 3. Technical 17 4. Institutional 17 5. Environmental 18 6. Social 18 7. Safeguard Policies 19  F. Sustainability and Risks 1. Sustainability 20 2. Critical risks 20 3. Possible controversial aspects 21 G. Main Conditions 1. Effectiveness Condition 21 2. Other 22 H. Readiness for lmplementation 22 I. Compliance with Bank Policies 22 Annexes Annex 1: Project Design Summary 23 Annex 2: Detailed Project Description 26 Annex 3: Estimated Project Costs 31 Annex 4: Cost-Benefit Analysis Summary, or Cost-Effectiveness Analysis Summary 33 Annex 5: Financial Summary for Revenue-Earning Project Entities, or Financial Summary 34 Annex 6: Procurement and Disbursement Arrangements 35 Annex 7: Project Processing Schedule 43 Annex 8: Documents in the Project File 44 Annex 9: Statement of Loans and Credits 45 Annex 10: Country at a Glance 46 Annex 11: Financial Sector Strategy Statement 48 MAP(S)  NEPAL Financial Sector Technical Assistance Project Project Appraisal Document South Asia Regional Office SASFP Date: November 13, 2002 Team Leader: Simon C. Bell Sector Manager/Director: Joseph Del Mar Pernia Sector(s): Banking (100%) Country Manager/Director: Kenichi Ohashi Theme(s): State enterprise/bank restructuring and Project ID: P071291 privatization (P), Corporate governance (S), Regulation Lending Instrument: Technical Assistance Loan (TAL) and competition policy (S), Standards and financial reporting (S) Project Financing Data [ Loan [X] Credit [ ] Grant [ ] Guarantee [ ] Other: For Loans/Credits/Others: Amount (US$m): 16.0 Proposed Terms (IDA): Standard Credit Grace period (years): 10 Years to maturity: 40 Commitment fee: 0.5 Service charge: 0.75% Financing Plan (US$m): Source Local Foreign Total BORROWER 4.10 0.00 4.10 IDA 0.00 16.00 16.00 UK: BRITISH DEPARTMENT FOR INTERNATIONAL 0.00 10.00 10.00 DEVELOPMENT (DFID) Total: 4.10 26.00 30.10 Borrower: THE KINGDOM OF NEPAL Responsible agency: NEPAL RASTRA BANK Address: Nepal Rastra Bank, Baluwatar, Kathmandu, NEPAL Contact Person: Governor, Nepal Ratsra Bank Tel: 977-1-410386 Fax: 977-1-410159 Email: bkprornotahtp.com.np - another email - nrbgov(rnos.co.np Other Agency(ies): Ministry of Finance Address: Ministry of Finance, Bag Dubar, Kathmandu, NEPAL Contact Person: Secretary, Ministry of Finance Tel: 977-1-259880 Fax: 977-1-259891 Email: facd_mof@gov.np Estimated Disbursements ( Bank FY/US$m): FY 2003 2004 2005 2006 2007 Annual 2.50 4.60 4.00 3.37 1.53 Cumulative 2.50 7.10 11.10 14.47 16.00 Project implementation period: March 2003 to June 2007 Expected effectiveness date: 03/31/2003 Expected closing date: 06/30/2007 OCS PAC Fe,, fl. .d R_fl 20  A. Project Development Objective t. Project development objective: (see Annex 1) The overarching objective of the Reform Program in the Financial Sector is to support the renewed efforts of His Majesty's Government of Nepal (HMGN) to improve the sector in order to bring macroeconomic stability and promote private-sector-led economic growth. The proposed Financial Sector Technical Assistance Project is the first major step in this process and focuses on three broad objectives (a) helping to restructure and re-engineer the Central Bank (Nepal Rastra Bank - NRB), so that it can effectively perform its key central banking functions; (b) commencing commercial banking reform in the two large ailing commercial banks that dominate the sector (Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL)) -- by introducing stronger bank management that protects the financial integrity of the two banks and would take on a conservator role to prepare the banks for the next steps of restructuring; and (c) supporting a better environment for financial sector reform in areas such as enhanced credit information, better financial news reporting, and better training for staff in financial institutions. These actions will help create a more prudently operated and commercially viable commercial banking system that is overseen by a modem, effective, and technically competent central bank. If sufficient progress is made during this first phase of reform, then subsequent IDA support would focus on more longer term objectives. These include further deepening and broadening of the sector, supporting worker retrenchment in the banks, bank privatization and/or liquidation, and helping to cover the financial losses in the large publically owned banks. It is anticipated that IDA's support for the overall financial sector reform program will be in the form of several, sequential projects. The first of these - the Financial Sector Technical Assistance Project - is centered around the re-engineering of Nepal Rastra Bank (particularly in its core central banking functions; supervision, monetary policy, banking legislation, accounting and auditing, information technology; human resources, and training); reform of the two large commercial banks - RBB and NBL (through the recruitment of Management Teams to put these two banks in conservatorship on behalf of the central bank); and support for capacity building in the financial sector (through support for training, financial journalism, and a credit information bureau). This project will finance a range of activities that are necessary to prepare for a major reform operation. This initial phase will also serve to demonstrate and confirm broad-based commitment to undertake difficult reforms. This sequential approach to financial sector reform has been endorsed by colleagues in the International Monetary Fund (IMF), the Department for International Development (DFID) U.K., and the Asian Development Bank (ADB). The Financial Sector Reform Program is also important in terms of enhancing poverty alleviation. It is expected to (a) support private-sector-led economic growth and job creation; and (b) reduce the number of nonperforming loans made through the banking system to the politically powerful elite in Kathmandu. As the large non-recoverable losses in the banking system will have to ultimately be borne by the Govermment -- this represents a transfer of resources from the tax payer in Nepal to the urban rich (who represent some of the largest defaulting borrowers in the banking system). A more efficient intermediation of funds should also result in a better allocation of financial resources and hence stronger economic growth. 2. Key performance indicators: (see Annex i) SECTORAL INDICATORS: Comprehensive financial sector reform that eliminates the need for additional (real or contingent) budgetary support for the financial system -- once the banks have been restructured and privatized or liquidated. -2 -  OUTCOME/IMPACT INDICATORS: 1. Lay the basis for a modem legal framework for the financial sector; 2. A strengthening of Nepal Rastra Bank's supervisory function -- in particular, its ability to enforce prudential regulations and relevant banking legislation - based on internationally accepted norms; 3. An increase in the range and sophistication of financial instruments and services available at competitive prices; 4. Enhanced accounting and auditing standards within the banking sector; and 5. A more prudently operated financial sector with better trained staff, a better informed general public, and an enhanced system of credit information. OUTPUT INDICATORS: 1. Producing quarterly off-site and annual on-site bank supervision reports (with accompanying analysis), on a timely basis, for each of the banks operating in Nepal; 2. Finalizing a new Central Banking Act (completed), a Banking and Financial Institutions Act (in process), and other ancillary financial sector legislation (Companies Act, Bankruptcy Law) with associated regulations; 3. Producing audited financial data for RBB and NBL, which conforms with international accounting standards, within four months of the end of the financial year; 4. Preparing a restructuring plan for privatization/liquidation of RBB and NBL; 5. Creating a leaner, more efficient, and professional Central Bank; 6. A strengthened Bankers' Training Center and more reliable and timely data from the Credit Information Bureau; and 7. The production of increasingly better financial data and an enhanced financial performance within the two largest banks managed by the professional management teams. B. Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex I) Document number: IDA/R98-168 Date of latest CAS discussion: 12/15/98 The overarching theme of the 1998 Country Assistance Strategy (CAS) was to help improve public sector govemance. Poor management of financial resources at RBB and NBL has been one of the most important ways by which the powerful elite has been able to abuse the public institutions. The inefficiency of the financial sector, in part, occasioned by heavy-handed state involvement. This has resulted in liquidity problems within the banks, growing nonperforming assets, problems of capital adequacy, and an increased scope for systemic risk within the sector. The Government's commitment to stopping this will be a major departure from the past and serve to send a clear signal that the old standards of govemance are no longer acceptable. The CAS also emphasizes faster growth in Nepal in support of sustained poverty alleviation. It notes that although the macroeconomy has been stable (even though budgets have been consistently unrealistic), growth has been slow and the pace of structural reform "in areas such as privatization and banking hasfaltered, and growth hasfallenfrom 5.5% in FY91-94 and 4.4% in FY95-96 to an estimated 4.0% in FY97 and 1.9% in FY98. " Annex 1 of the CAS -- on sectoral strategies - identifies the need for the World Bank to focus on four - 3 -  key areas: 1. the restructuring/privatization of the two largest commercial banks, RBB and NBL; 2. the development of NRB's regulatory and supervisory capacity; 3. the development of a simple uniforn legal framework for Nepal's financial system; and 4. the establishment of additional private financial institutions, using the International Finance Corporation (IFC). Nepal's macroeconomic situation has deteriorated signiificantly since the last CAS was written -- with growing fiscal imbalances, lower levels of investment, and slower growth. Given these problems and increased macroeconomic uncertainty, avoiding a banking crisis has become even more urgent. The proposed Financial Sector Program will address these concerns and provide technical assistance to HMGN to implement the reform agenda. 2. Main sector issues and Government strategy: Financial Sector Background. Nepal has 15 commercial banks -- RBB, NBL, 9 Joint Venture Banks (JVB's), which are mixed public/privately owned, and 4 local banks. In addition, the sector also includes 2 large development banks (the Agricultural Development Bank of Nepal (ADB/N) and the Nepal Industrial Development Corporation (NIDC)), 48 finance companies, 13 insurance companies, numerous microfinance institutions, 7 Grameen Replicator Banks, 35 financial cooperatives, 25 financial Non-Government Organizations (NGO's), and a stock exchange. The two large banks - RBB and NBL -- account for around 50 percent of total banking system assets, and are in a very precarious financial position. Political intervention, weak management, disruptive unions, poor financial information systems, and a deeply entrenched culture of non-repayment of loans has resulted in a rapid deterioration of their financial health. RBB, which represents 27 percent of commercial banking system assets, is estimated to have a large negative net worth and therefore a capital base that is well below the levels required by generally accepted international norms. Although in slightly better financial condition, NBL has similar problems including a high negative net worth. This could have serious ramifications for the Government in terms of systemic risk and could prove to be a severe financial strain on an already delicate budget should either of these two banks face a crisis of confidence with concomitant adverse macroeconomic implications. A 2000 review of RBB and NBL indicated that these banks together had estimated losses, as of mid-1998, as much as $426 million - equivalent to around 46 percent of the Government budget or about 8.6 percent of GDP. The situation in these two banks has inevitably deteriorated considerably since this date. In general, Nepal's financial system suffers from the following problems that are also recognized by the Government: The Government's Role. His Majesty's Government of Nepal (HMGN) plays a large direct role in the financial sector. From ownership of key financial institutions such as RBB, ADBN, the Grameen banks, the insurance industry, and, until recently, the Nepal Bank Limited (where it is still the largest single shareholder); to significant influence over the Joint Venture Banks; the Government's involvement is evident in almost every aspect of financial sector activity. This has resulted in strong political interference in banking activities which, in turn, has resulted in non-repayment of loans, and poor financial health throughout the system. -4 -  Nepal Rastra Bank - the Central Bank. Until January 2002, when a new NRB Act was approved, the NRB fell under the authority of the Ministry of Finance. This historical lack of autonomy has hindered the NRB's ability to supervise and regulate the banking system adequately. Political influence in the RBB and NBL - as well as their sheer dominance within the banking system - placed these banks outside the influence and control of the central banking authorities. Although it may take time to become fully operational, the new 2002 Act provides the NRB with sufficient autonomy and full authority over the entire banking system. Recently approved banking regulations will also provide the regulatory basis for NRB to move the system closer to international banking norms while permitting the bank supervisors to deal expeditiously with errant banks. For the immediate future, the NRB's challenge will be to enforce the rules that have now been established. The Government and the NRB need to reorient their activities away from being active participants (as owners and operators) in the financial sector to increasingly focus on becoming more effective regulators and supervisors. Rastriya Banijya Bank (RBB) is 100 percent Government owned. As the largest commercial bank, with more than 200 branches, RBB has an important role to play in the economy. However, burdened by political demands, an active and disruptive union movement, management weaknesses, poor accounting and auditing functions, and high levels of non-performing assets, RBB has reached a particularly parlous financial state. A recent audit points to a high negative net worth, weak internal systems, poor internal financial management, and shabby operating methods. At the request of the government, a diagnostic review of the RBB and NBL was carried out by KPMG/Barents in 1999/2000. This study's major findings confirm that (a) the banks' management is basically dysfunctional; (b) there are no reliable data available on the loan portfolio; (c) financial accounting is primitive and not according to international standards (accounts are virtually all manual and annual statements have not been produced for over six years); (d) business strategies are not in place; (e) human resource policy is weak and counterproductive; (f) management information systems and record keeping are very basic; and (g) governance and management are highly politically driven and lacking a commercial focus. This work was financially supported under a Policy and Human Resources Development Fund (PHRD) grant (TF 025473) for both RBB and NBL. The Nepal Bank Limited (NBL). While in somewhat better financial condition, NBL is still a weak institution. Its dominant role in the financial sector creates scope for inefficiency and a low level of banking competition. Over the 1990s, the Government reduced its stake in NBL by selling parcels of shares to the private sector. The Government has reduced its shareholding to a minority 41 percent, although it remains the single biggest shareholder in the bank. This disinvestment by HMGN was carried out with the objective of reducing political interference in NBL's management and promoting private sector participation in the bank so that it could operate in a more commercial and business-like manner. The Government's policy of successively selling shares to the general public has, however, left the bank without a single strategic partner with a strong background in commercial banking and international linkages with the global economy. Connected lending activities by the new private owners are thought to have further compromised its operations. As such, it also has many of the same problems as RBB (see above) as identified in the KPMG diagnostic. The Agricultural Development Bank of Nepal (ADB/N). The financial and operational situation of the ADB/N, the third biggest bank in Nepal, is also poor. The ADB/N will require restructuring, system development, changes in govemance arrangements, and a review of its ultimate role and ownership arrangements. This bank is being dealt with by the Asian Development Bank. Close coordination between IDA and the ADB mean that actions taken in RBB and NBL are likely to be applied to ADB/N -5-  to ensure a consistency of approach. A Weak and Fragmented Legal Financial Environment. Nepal has a proliferation of both laws and regulations that are institutionally rather than functionally focused. This has created a fragmented legal environment. * The Nepal Rastra Bank Act, now superseded by a January 2002 Act, was seriously outdated and deficient with respect to issues of central bank autonomy, accountability, and governance. Now that new legislation has been approved, the challenge will be to ensure that NRB can effectively enforce the provisions of the new legal and regulatory environment. * The 1974 Commercial Bank Act is also defective. Most importantly, the act does not cover all deposit-taking institutions. Other nonbank deposit-taking institutions are governed by their own laws - the Development Bank Act of 1996, the Agricultural Development Bank Act of 1967, and so on. A proliferation of laws covering various classes of deposit-taking institutions has permitted legal arbitrage. NRB has recently completed drafting a new Banking and Financial Institutions Act that covers all major deposit-taking institutions. This Act is expected to become law in 2003. * Ancillary Laws. Once the above two key pieces of legislation have been amended, it will be important to ensure that other ancillary laws are developed in support of a modem banking system. New legislation is required in such areas as collateral, credit activity, bankruptcy law, and so on. A Weak and Fragmented Accounting and Auditing Environment. A weak accounting and auditing tradition has meant that the timeliness and reliability of financial data (particularly from the largest banks) is extremely poor. Corporate sector accounting is also weak, making lending decisions difficult for the banks. If Nepal's financial system is to operate in a prudentially sound and efficient manner, strengthening of accounting and auditing is essential. Competition in the Banking Sector. Reform of the state-owned banking sector should be designed to reduce fragmentation and support the more efficient intermediation of funds within the banks and nonbanks. This would increase competitive pressures and thereby provide more efficient and cost-effective solutions to the banking public. Market-oriented approaches also need to be developed to enhance competitive pressures. These are preferable to mandated efforts such as those developed to control interest rate spreads and priority and deprived sector lending. Other Issues. In addition to the above, the financial sector environment needs to be strengthened in several fundamental ways. For example, credit information systems have not been effective tools against non-performing borrowers; capacity building in the sector remains very weak; and the general public's low level of financial sophistication means that it does not serve as an effective check and balance within the system. These weaknesses also require attention. These issues call for urgent reform and modernization. Nepal needs to create the preconditions for the development of an efficient banking system that is capable of developing new financing mechanisms and instruments to meet private sector needs. Without such reforms, the prospects for faster growth and ultimately poverty reduction will be constrained. However, financial sector development is a long and complex process that will take many years, particularly given the very low starting point in Nepal. The proposed program will start this process and deal with only the most serious of these problems -- specifically central banking, the two largest banks, and strengthening the financial environment. - 6 -  Government Strategy. Over the past few years, the Government has undertaken general reform measures in the financial sector. These include interest rate deregulation, the phase out of Statutory Liquidity Requirements (SLR), introduction of modem banking regulations, capital market reforms, and foreign exchange liberalization. However, much remains to be done, particularly with respect to institutional reform. To help establish a framework for the way forward, the Government has formulated a Financial Sector Strategy Statement (FSSS) that consolidates its thinking and develops a comprehensive and interlinked reform program. The FSSS has been discussed widely within Nepal - within the private sector and the financial sector - and it has been adopted as Government policy. The FSSS was publicly released and published in the Nepali and English press at the end of 2000. The desire for reform in the financial sector is further reflected by the fact that the Government has asked for World Bank, IMF, and Department for International Development (DFID) assistance to proceed with the reform agenda. Initial support has been provided through a PHRD grant and a Project Preparation Facility (PPF). The main elements of the HMGN's FSSS sector strategy include: * Reduce the role of the Government in the financial sector as a direct owner of financial institutions while strengthening its role as a supervisor and regulator of banks and financial institutions; * Require strong corporate governance by ensuring that banks (in particular the two largest commercial banks) are owned and managed by "fit and proper" private investors; * Strengthen the role of Nepal Rastra Bank in the overall financial system by drafting a new Act to provide sufficient autonomy in the conduct of monetary policy, banking system regulation and supervision, and the licensing of banks and nonbanks; * Improve existing banking and financial legislation and judicial processes for enforcing financial contracts; * Improve auditing and accountancy standards within the banking sector; and * Promote financial discipline through adequate disclosure and competition. The reforms in the financial sector, particularly with respect to the state-owned banks, require strong political commitment. As in many countries, bank restructuring issues are likely to be difficult for the Government when the time comes for action. For example, although liquidation of RBB is one of the options that will be considered, this may not be politically acceptable. Even privatizing the bank to good foreign-banking interests or splitting its activities into several distinct components may prove difficult to implement (given its poor financial health, its long public-sector association, and the weak state of the Nepali economy). 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 and irreversible contribution to overall economic development. Government commitment to reform, to date, has been demonstrated by its contracting of KPMG to assess future options for RBB and NBL; the installation of a professional management team in NBL in July 2002 and a CEO in RBB in late 2002; development of a modern legal and regulatory environment for banking; and the issuance of an overarching Government policy on financial sector reform. These activities provide the World Bank with comfort that the Government is willing to transparently assess the condition of the banks and to develop credible corrective action plans. -7 -  3. Sector issues to be addressed by the project and strategic choices: Sector Issues to be Addressed. To support HMGN's financial reform efforts, the World Bank proposes starting with a strictly limited, but nonetheless ambitious, menu of actions. These focus on key concepts of strengthening prudential oversight, enhancing the banking sector's financial integrity, and increasing transparency and information. To this end, the Credit will support an initial program of Central Bank strengthening in core areas, focusing initially on human resources, on-site and off-site banking supervision support, legal, research, accounting and auditing, and information technology. The project will also support professional conservator arrangements (the management teams) in the two large banks (RBB and NBL) ultimately preparing them for restructuring and privatization. In addition, the Credit will assist in strengthening the overall financial sector through technical and financial support for the Bankers' Training Center, Credit Information Bureau, and financial journalism. See Annex 2 for a detailed description of project components. The Goverunent's past performance record demonstrates that carrying out meaningful and far-reaching reform requires significant political capital. Hence, the reform program has specifically been designed to be narrow and precise. In addition, the absorptive capacity of the Central Bank and the publicly-owned commercial banks is such that advances beyond the lirmited (but fundamental) reforms envisaged may not be possible. Therefore, the program focuses on a limited set of actions within the Central Bank combined with initial support for restructuring the two largest banks and capacity building for selected institutions. Future support will need to address broader policy issues, including supporting the ultimate privatization of RBB and the restructuring and reform of NBL. In terms of sequencing and timing, the technical assistance program is already ongoing with support from a PHRD grant and a PPF used to begin initial consultancies. The PHRD grant supported an initial bank supervisory consultancy and a review of strategic options for RBB and NBL carried out by KPMG/Barents. Subsequent support has been provided by a PPF, which funded a second (longer term) phase of the bank supervision consultancy and the initial costs of the management team contract. Strategic Choices. Given the politically difficult problems to be addressed and the ongoing political instability within Nepal, it was considered strategic to commence with a focused Technical Assistance (TA) operation to support key, fundamental reform elements in the three identified areas. Support under future World Bank operations would provide the resources to deal with the financial problems in the state banks and possible retrenchment in the two large banks prior to their privatization or liquidation. COOPERATION/COLLABORATION. Given the strong political commitment required to carry out a comprehensive program of financial sector reform, the World Bank sought to develop this program in close collaboration with the key donors involved in this sector (the IMF, DFID of UK, and the ADB) and the Government of Nepal. Close cooperation between the main donors is designed to provide strategic leverage to help ensure that difficult political decisions are made when the occasion arises. Ensuring mutually consistent and reinforcing messages through the envisioned IMF Poverty Reduction and Growth Facility (PRGF) and the ADB's proposed restructuring of the Agricultural Development Bank of Nepal is also important. COFINANCING ARRANGEMENTS WITH DFID. DFID has fully endorsed the HMGN's financial sector reform agenda and will provide financial and technical support for this project. DFID has committed a US$ 10.0 million equivalent grant to supplement the IDA Credit. The project will be jointly financed by DFID and IDA. The funds will be disbursed in agreed proportions, 62 percent IDA and 38 - 8 -  percent DFID) on all agreed expenditure items. DFID has agreed that their grant will be administered by IDA and expenditures will be made according to IDA's financial management, disbursement, and procurement guidelines. A Memorandum of Understanding (MOU) between IDA and DFID has been prepared which outlines more detailed administrative arrangements between the two donors. INDEPENDENCE OF NEPAL RASTRA BANK. Although the NRB now has legal independence from the Government, it may take time before the Central Bank is willing or able to exercise real autonomy. This independence must also have strong political support, most importantly from the Minister and the Ministry of Finance. Therefore, the preparation team believes that it is strategically important to work with the Ministry of Finance when seeking increased independence for NRB. The project also seeks to ensure the development of a stronger and more professional Central Bank so that it can ultimately become a stronger constituency for financial sector change (becoming a stronger and more credible advocate for its own enhanced independent status). RASTRIYA BANLTYA BANK (RBB) AND NEPAL BANK LIMITED (NBL). In June 2000, KPMG/Barents provided HMGN with a diagnostic assessment of the financial and operational position of the RBB and NBL as well as a list of options for their future operation. The report recommended several immediate steps be taken to stem further hemorrhaging of the banks' financial resources. These included (a) issuing a statement of government commitment to depoliticize the banking system; (b) bringing in a management team to take over all aspects of banking operations; and (c) ultimately privatizing the bank to a good name "fit and proper" buyer. The management team would be expected to (a) take complete control of the day-to-day running of the bank; (b) immediately help to stabilize the operational and financial position of the bank; (c) bring in an accounting team to help strengthen the accounts of the bank; (d) develop a human resources program for the bank which would determine, inter alia, a training program, a retrenchment program, and a more appropriate remuneration package for bank staff; and (e) prepare the bank for privatization/re-privatization. The government accepted these recommendations and has taken action accordingly. BUDGETARY PROVISIONS FOR DEALING WITH RBB AND NBL. The existing stock of loan losses within these two banks is estimated to be between Rs25 to 29 billion (US$368 to US$426 million). This represents 7.5 to 8.6 percent of Nepal's GDP and between 40 - 46 percent of Nepal's budget. Considering the magnitude of these losses, this is a national issue. Losses associated with the privatization of the banks will also need to be budgeted by the Government. PROTECTION FOR DEPOSITORS. As the reform program proceeds, monitoring liquidity management within the banking system will be important to make sure that depositors' funds are protected. The World Bank has been working with the IMF and the bank supervisors in NRB to monitor this situation. SOCIAL DIMENSIONS OF BANKING. The Government's strong emphasis on the social dimensions of banking will need to be addressed delicately and with some sensitivity. An appropriate balance will need to be struck between ensuring that there is a reasonable country-wide coverage of basic banking services and interventions that distort the operation of the banking system. Strategic, ongoing dialogue with the Government and with the restructuring/privatization agents will be essential in sensitizing both sides to the concerns of all parties involved. GOVERNANCE ISSUES. Additional work on governance issues will be pursued by the management teams - particularly as they relate to action on non-performing borrowers and the production of audited financial data from RBB and NBL. -9-  C. Project Description Summary 1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed cost breakdown): The project has three main components (Table below). Based on its cofinancing agreement, DFID will provide US$10.0 million equivalent in the form ofjoint financing for this project. The respective DFID shares for the three components will be: US$1.56 million for re-engineering of NRB; US$8.10 million for restructuring of RBB and NBL; and US$0.34 million for capacity building in the financial sector. The balance of US$4.1 million will be provided by HMGN. Indicative Bank- % of Component Costs % of financing Bank- (US$M) Total (USSM) financing Re-engineering Nepal Rastra Bank 4.68 15.5 2.64 16.5 Restructuring the Two Big Banks (RBB and NBL) 24.43 81.2 12.81 80.1 Capacity Building in the Financial Sector 0.99 3.3 0.55 3.4 Total Project Costs 30.10 100.0 16.00 100.0 Total Financing Required 30.10 100.0 16.00 100.0 Note: The amounts indicated above are inclusive of the PPF of US$ 1.15 Million. Details are in Annex 3. 2. Key policy and institutional reforms supported by the project: The Financial Sector Technical Assistance Credit represents the first step in a long process of reform which will seek to reorient the role of the Government from active participant in the sector to a strong regulator and supervisor of the financial system. Efforts will be made to achieve this through reforms in three key areas. Re-engineering the Nepal Rastra Bank. The Central Bank of Nepal (Nepal Rastra Bank) is a particularly weak institution. Failure to supervise and regulate banks, produce robust accounting information, and conduct appropriate monetary policy - are all exacerbated by a weak legal structure, politicization of the Central Bank, a lack of computerization, and weak human resource management capabilities, which has resulted in few appropriate incentives for good work. NRB's problems need to be addressed on many fronts, although the FSTA project will focus initially on a smaller subset of the most important issues. The ultimate aim is to develop a well-run, fully professional public-sector institution with adequate oversight of the financial system and monetary policy. Restructuring RBB and NBL. This will involve commencing a process, with professional management teams, which will ultimately permit a fundamental change in the existing ownership and governance arrangements within these two banks. After a period of intense restructuring, the Government's preferred option is to privatize these two banks to "fit and proper" international bankers. The reality, however, may be that alternative options will have to be pursued. The ultimate objective is to ensure a fundamental and sustainable change in these banks so that they no longer act as a drag on financial and real sector development. Capacity Building in the Financial Sector. In support of the above reforms, it will also be necessary to improve human resource capacities in the financial sector and to ensure better checks and balances within the system by developing greater public awareness of financial sector issues. Training for the financial sector will be provided through an upgrading of the Bankers' Training Center activities, and its - 10-  conversion into a more independent Bankers' Institute. Improved public awareness will be achieved by supporting better financial journalism in Nepal. Lastly, better credit information will be supported under a program of assistance for the Credit Information Bureau. 3. Benefits and target population: The project will begin to create a financially sound, prudently-managed, and well-supervised financial sector, which will contribute to macroeconomic stability and growth. A secondary benefit of the program will be the emergence of a more dynamic, competitive, and customer-focused banking sector. These developments will benefit the banking public in particular and the total population in general by lending support to the establishment of a more dynamic, private-sector led and potentially faster growing economy. 4. Institutional and implementation arrangements: A Coordination and Support Team (CST) has been formed within Nepal Rastra Bank under the Banking Operations Department to administer this project. The Executive Director of the Banking Operations Department heads the CST and provides overall guidance and leadership on matters of project implementation. The CST is supported by a dedicated Financial Management Specialist who is a qualified professional accountant and by a dedicated Procurement Specialist. The CST is also supported by adequate ancillary staff and facilities. The operating costs of the CST will be funded under the project on a declining cost basis over the project implementation period. These operating costs include communications, office supplies and materials, incremental staff costs, and other expenses which will be jointly financed by the IDA Credit and the DFID Grant. Staff salaries are excluded. Financial Management (also see Section E - Summary Project Analysis and Annex 6) A financial management capacity assessment of the implementing agency, Nepal Rastra Bank, was carried out by World Bank financial management specialists during appraisal. The project has adequate financial management arrangements in place to account for and report on project expenditures. To mitigate potential financial management risks and to strengthen the financial management capabilities of NRB, a financial management improvement component has been designed and built into the project to ensure that noted deficiencies are appropriately addressed. Terms of reference for consultancy services to help improve the accounting capacity of NRB have been agreed and advertised in the local and international press (including the UN Development Business). The proposed consultancy services are expected to be carried out in three phases. The first phase is a diagnostic and planning phase and will identify the areas that need improvement resulting in the development of a time-bound action plan to address any weaknesses. The second phase will implement the agreed actions. The third phase will include intensive training for NRB staff and a follow-up evaluation of the impact of the financial management improvement program. These steps will build on the good initiatives that are already underway within NRB to ensure the establishment of a robust financial management system. Annual project financial statements, SOE's, and special account statements will be audited by the Office of the Auditor General and submitted to IDA within six months after the end of the fiscal year. NRB entity financial statements will be audited by a certified private auditor who will be appointed by the Auditor General and submitted to IDA within six months after the end of the fiscal year. D. Project Rationale 1. Project alternatives considered and reasons for rejection: An alternative approach to dealing with Nepal's financial sector problems could be to pursue a broader financial sector reform agenda providing support on a wide range of fronts to a large array of institutions -1 1-  - particularly some of the other weak (but significantly smaller) privately-owned commercial banks and the two development finance institutions. However, given the primacy of the problems in the Central Bank and the two largest commercial banks, in combination with the Government's own limited implementation capacity, the project team decided to focus on a narrower agenda of issues. Re-engineering the Central Bank and strengthening its core functions while simultaneously dealing with the problems in the largest state-owned banks -- are initial steps in the overall reform program that are likely to have the biggest impact. Going beyond this initial agenda is not considered plausible at this stage given the limited capacity of the Government. Another option could be to have an even more limited agenda - only focusing on the largest bank (RBB) and the Central Bank - while omitting fundamental policy change in NBL (which is, in theory, a private bank). However, this option was strongly rejected by our donor partners, the IMF and DFID, as well as by ourselves, as representing an "unduly limited" reform agenda, which may not have the desired demonstration effects for the next phase of reform. The design team therefore ruled out the omission of NBL (which represents over 20 percent of banking system assets), from this initial phase of reform. 2. Major related projects financed by the Bank and/or other development agencies (completed, ongoing and planned). Latest Supervision Sector Issue Project (PSR) Ratings (Bank-financed projects only) Implementation Development Bank-financed Progress (IP) Objective (DO) Financial sector reform -- including Structural Adjustment Credit S S CBPASS under which RBB and NBL (SAL) II (June 1989) were both recapitalized Second Structural Adjustment Credit (Cr. No. 2046-NEP) - was approved in June 1989 and was closed in July 1992. The Implementation Completion Report (Report No. 12871) was prepared in March 1994. Financial Sector Adjustment Operation Banking Sector Adjustment (planned for FY05) to cover the cost of Operation retrenchments in RBB and NBL (to prepare them for privatization) and NRB (to assist in the Central Bank's re-engineering process). Other development agencies Asian Development Bank (ADB): Third Small Farmers' Support for small farmers' Development development. $30 million. October 1990, Credit Number 1037. Asian Development Bank: Credit lines Sixth Agricultural Credit in support of rural credit through the Agricultural Development Bank of - 12 -  Nepal. $35 million. October 1991, Credit Number 1112. Asian Development Bank: Support for Capital Market Development I the development and strengthening of a Capital Market Development H Stock Exchange in Nepal. CMD I, $187,000, April 1992, TA Number 1689. CMD II, $596,000, July 1997, TA Number 2834. Asian Development Bank: Micro-Credit for Women Micro-credit support project for women. $5.0 million June 1993, Credit Number 1237. Asian Development Bank: Support for Rural Micro-Finance micro-finance activities in rural areas of Nepal. $20.0 million December 1998, Credit Number 1650. Asian Development Bank: Financial Sector Regulation Strengthening corporate and financial and Governance governance in the private and financial sectors. $150,000 August 1997, TA Number 3134. Asian Development Bank: Ongoing Improvement of Disclosures strengthening of corporate governance and Corporate Governance and disclosure standards. $150,000 December 1998, TA Number 3136. Asian Development Bank: Reviewing Sector Development Program non-bank financial institution (NBFI) disclosure standards, supervision of finance companies, as well as an investment and technical assistance component. Asian Development Bank: Review of Rural Credit Review rural credit in Nepal. $588,000 January 1991, TANumber 1476. Asian Development Bank: Review of Feasibility of Establishing a the establishment of a leasing company Leasing Operation in the in Nepal. $74,000 February 1991, TA Private Sector Number 1484. Asian Development Bank: Review of Institutional Strengthening of - 13 -  ways to strengthen the operations of the ADB/N Agricultural Development Bank of Nepal. $690,000 April 1993, TA Number 1871. Asian Development Bank: Review of Rural Finance rural finance in Nepal. $500,000 August 1997, TA Numnber 2836. International Monetary Fund: General PRGF Program - with Program Support. Preparatory Mission emphasis on financial sector in December 2000. reform, fiscal reform, etc. KFW: Funding of the Nepal Industrial Industrial Finance II Development Corporation (NIDC). DM2.0 million (1996) Industrial Finance m DM3.0 million (1974) Industrial Finance IV DM5.0 million (1982) Industrial Finance V DM5.0 million (1989) DEG, Germany. Equity Participation DMI.0 million (1991) GTZ, Germany. Small Farmers' Development Program SFDP (TA). Phase I DM3.7 million (1987-92) SFDP (TA) Phase II DM2.0 million SFDP (TA) Phase HI DM2.6 million IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory) 3. Lessons learned and renected in the project design: 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: (i) Lack of commitment by the Government to change its basic attitude towards the state-owned banks, including a much stronger emphasis on commercial orientation and on preparation for eventual privatization; (ii) Absence of an Action Program did not require the Govemment to introduce drastic changes in the managerial culture to ensure that managers were professionals with autonomy and accountability; and (iii) Lack of specific fundamental reforms needed to achieve a major improvement in financial and operational performance of the banks." The current operation has dealt with these lessons by not proceeding with IDA financing until there has been upfront commnitment and action by the Government to carry out fundamental reforms in banking supervision generally and in the governance arrangements within the state owned bank RBB and in NBL, - 14 -  in particular - starting with the placement of external management teams in the two banks. The development of an overarching framework for financial sector reform - as encapsulated in the Financial Sector Strategy Statement -- will also help ensure consistency and commitment. In addition, generic lessons learned from previous projects in the financial sector include: (a) Sustainable banking sector reforms require that the autonomy and technical skills of the regulator be enhanced. This project aims to enhance the bank supervisory technical skill of NRB so that it can become increasingly more professional and autonomous; (b) Legal framework reforms are critical to ensure successful implementation. This project has supported the revision and modernization of key banking legislation. A new NRB Act, providing the Central Bank with significantly more autonomy, was approved in January 2002. A new Banking and Financial Institutions Act is currently under discussion within the banking community. Further legal reforms, including measures for debt recovery, and registration and prioritization of liens, are also envisaged in the immediate future; (c) Sequencing is important for successful financial sector reform. Strengthening the Central Bank, as anticipated under this project, is a high priority and should be carried out with a program of initial commercial banking reform; (d) Reforms should include rationalization of processes and procedures and should be backed by vigorous enforcement. The project will deal with procedures in the Central Bank and will provide assistance to ensure strict enforcement of prudential regulations and legal requirements; (e) Reforms should focus on a limited number of key activities. This project will support a purposely limited agenda of focused activities; (f) Forcing reforms from outside is not sustainable. Strong borrower commitment will produce the greatest chance of success. This commitment appears to be in place as evidenced by the development of the Financial Sector Strategy Statement, the appointment of a professional management team in NBL and a professional CEO in RBB, and the ongoing close liaison between NRB and the Ministry of Finance on all aspects of the financial reform process; and (g) Re-capitalizing commercial banks without fundamental reforms in the ownership and governance structures of the banks is not likely to be successful. Any injection of capital into RBB and NBL will only be supported at the point of privatization/liquidation or some other acceptable change in governance arrangements within these banks. 4. Indications of borrower commitment and ownership: HMGN has requested World Bank support for financial sector reform. The Government recognizes the problems caused by RBB and the fact that its unhealthy financial position poses a serious problem for the sector and, potentially, for macroeconomic stability. There is also recognition that the process of privatizing NBL (without a strategic banking partner) has not been particularly successful. Further demonstrations of the Government's commitment to the reform include: adding RBB to a list of state-owned companies to be privatized; contracting TA under a PHRD grant to reconstruct the accounts of RBB (for 1996 to 1998); contracting a consulting company to review options for the future of RBB and NBL; and appointing an external bank supervisor to help strengthen the bank supervisory capacities of NRB. It has agreed to the options laid out in the consultant's study, including recruiting two management teams to take over RBB and NBL and completing the FSSS and adopting it as official Government policy. To maintain the momentum of these preparatory activities, the Government - 15 -  requested a Project Preparation Facility advance. The PPF (No. Q183-0-NEP), in an amount of US$550,000, was approved in September 1999, for the financing of required consultancies and training activities. It was supplemented with another PPF of US$600,000 (No. Ql83-l-NEP) in 2002 for partial payment for the NBL Management Contract and consultancies of RBB. These actions indicate that the Government recognizes the problems it faces in the financial sector and that it wishes to pursue a transparent process of clarifying and quantifying the true extent of the problem, reaching agreement on the most workable options for dealing with these issues, and acting in a decisive manner. The Government of Nepal has also kept a close dialogue with DFID on various development issues including financial sector reform. The FSSS outlines and clarifies for both the Government and the World Bank the issues within the sector that the Government has prioritized. Equally important has been the Central Bank's action to remove the old board of NBL, as the private sector members were particularly disruptive in moving towards the placement of the professional management team within Nepal Bank Limited. 5. Value added of Bank support in this project: The Bank has a growing background in the area of financial sector reform operations which will be useful in the implementation of the proposed Nepal program. The Bank is also a significant source of development assistance in Nepal and - in concert with the IMF, DFID, and the ADB - will be able to present a strong case for making the appropriate decisions and tough choices. In this regard, project preparation and appraisal has coincided with IMF and DFID missions which has provided an opportunity for close collaboration. Financial sector reform (along with fiscal reform) are also central tenets of the IMF's support program for Nepal. DFID's contribution of US$ 10 million equivalent for this joint project will reinforce IDA's efforts and will establish a track record of cooperation between our two agencies in the area of financial sector reform -- for the next phase of the reform effort. E. Summary Project Analysis (Detailed assessments are in the project file, see Annex 8) l. Economic (see Annex 4): C Cost benefit NPV=USS millioi; ERR = % (see Annex 4) CL Cost effectiveness * Other (specify) As a Technical Assistance project there is no Economic Evaluation Methodology. Nevertheless, as indicated in numerous World Bank and IMF reports, a deepening of RBB and NBL's financial difficulties would have serious systemic consequences with a clear adverse impact on overall macroeconomic stability. 2. Financial (see Annex 4 and Annex 5): NPV=US$ million; FRR = % (see Annex 4) The financial cost of systemic failure within the banking system -- or even an isolated failure within RBB or NBL -- would create serious financial/fiscal constraints on the Government as the largest owner of these banks. There are losses in RBB and NBL of as much as $450 million and these losses need to be recognized and dealt with as part of a privatization and/or liquidation exercise. This will need to be budgeted by HMGN. - 16 -  Fiscal Impact: The proposed project will assist the Government in reducing its involvement in the financial sector and thereby in reducing its exposure to losses within the banking system. While strengthening the Central Bank and restructuring of RBB and NBL will require considerable government financing in the short- to medium-term, the long-term fiscal impact is likely to be positive if the expected results flow from the project. The obligation to repay the IDA loan will also be over 40 years during which time the government's control and involvement in the financial sector will be minimized. At the same time, a stronger financial sector is expected to support more rapid private-sector-led economic growth. 3. Technical: The proposed project, and in particular the restructuring of RBB and NBL, are complex and require high quality advice and expertise. The proposed IDA Credit will fund expert managers to provide this support over a three-year period. Within the Central Bank reform component, technical assistance will also be provided to support high quality central banking technical support. 4. Institutional: This project focuses largely on issues of institutional reform. The most relevant of these pertains to NRB. The re-engineering of NRB is considered crucial to the establishment of better macro-monetary and financial system management. This institutional strengthening program will, nonetheless, take time. Dealing with the state-owned banking institutions, their restructuring and eventual privatization/liquidation, and staffing retrenchment issues will also be difficult and delicate tasks. 4.1 Executing agencies: The program will be overseen by the three key Government economic policy-making bodies - the Ministry of Finance, NRB and the National Planning Commission (NPC). The primary implementation responsibility, however, will rest with NRB and the Coordination Support Team (CST) within the Banking Operations Department. The establishment of a capable CST and the delegation of full project administration responsibilities to this team have been important prerequisites in ensuring smooth implementation. 4.2 Project management: The CST has established an efficient management information system and has finalized the Borrower's Project Implementation Plan (PIP) with clear guidelines, procedures, and terms of reference for key staff. In addition, the CST has been housed in the Banking Operations Department, which has the biggest role under the project in overseeing the work of the management teams within the two commercial banks. 4.3 Procurement issues: Most of the funding under this IDA credit will be used to engage the services of several long-term consulting companies -- most importantly, the management teams in the two commercial banks. Procurement of goods and selection of consultants under the project has been and will continue to be according to the World Bank Guidelines (Standard Bidding Documents: Procurement of Goods - January 1995, Revised March 2000 and Standard Request for Proposals: Selection of consultants - July 1997, Revised April 1998 and July 1999). These documents have been made available to the borrower. Given problems with procurement in the past, the CST has recruited an experienced procurement expert to help streamline procedures. 4.4 Financial management issues: Financial Management Risks and Risk Mitigation Measures. The financial management risk at the project level is low with the integration of the CST with the Banking Operations Department of NRB and - 17 -  the recruitment of a qualified professional accountant as the financial management specialist and a qualified procurement specialist. However, there are some potential risks at the project level which will be mitigated through the following actions: (a) deploying full staff in the CST, including support staff; (b) delegating authority to the CST by NRB to execute procurement activity and disbursement processes as per IDA's procurement guidelines and disbursement procedures; (c) instituting a mechanism to minimize layers of bureaucracy in procurement decisions inherent in NRB; and (d) assuring that the core CST staff will be deployed for the duration of the project. At the entity level, financial management risks are moderate. The NRB has failed to comply with its own legal requirement to submit audited Financial Statements within four months of the end of the financial year. Currently, the average delay in auditing the financial statements is about ten months. Through the capacity building component this issue will be addressed by assisting NRB to upgrade its capacity to meet its own fiduciary requirements of completing the annual audited financial statements within four months and improve the quality of financial statements in a timely manner. These changes also meet the World Bank's minimum requirements. The new NRB Act has given a high priority to improved financial management within NRB and requires it to (a) upgrade accounting to international accounting standards; (b) ensure that at least one of the Board members has professional expertise in finance or accounting or banking; (c) constitute an Audit Comnmtittee headed by one of the Board members; and (d) strengthen the internal audit capacity and commission an internal auditor either through allotting staff or by recruiting professional audit finrns from the market, and conduct the internal audit as per international audit standards. 5. Environmental: Environmental Category: C (Not Required) 5.1 Summarize the steps undertaken for environmental assessment and EMP preparation (including consultationi and disclosure) and the significant issues and their treatnent emerging from this analysis. 5.2 What are the main features of the EMP and are they adequate? 5.3 For Category A and B projects, timeline and status of EA: Date of receipt of final draft: 5.4 How have stakeholders been consulted at the stage of (a) environmental screeninig and (b) draft EA report on the environmental impacts and proposed environmient management plan? Describe mechanisms of consultation that were used and which groups were consulted? 5.5 What mechanisms have been established to monitor and evaluate the impact of the project on the environment? Do the indicators reflect the objectives and results of the EMP? 6. Social: 6.1 Summarize key social issues relevant to the project objectives, and specify the project's social development outcomes. The proposed project will have positive social impacts of protecting the small depositors who are likely to be hurt if a banking crisis develop. There is a potential social impact from the suggested reforms in terms of their impact on banking services in rural areas. There are also possible social imnplications from large scale redundancies following restructuring and privatization of RBB and NBL. Given the perceived delicacy and political sensitivity of the proposed reform and the understanding that this is - 18 -  likely to be an extended process over a number of years, these issues will need to be properly studied and sensitively administered. An analysis of various stakeholder perceptions of the reform agenda could provide a clearer picture of where advances might be possible, as well as where the barriers to progress and the potential points for leveraging support lie. The deployment of human resource professionals will assist in dealing with redundancies within the banks. This will only be carried out on a voluntary basis and not until a later stage in the restructuring process. In addition, work with other financial sector institutions (development banks and microfinance institutions in particular) will be undertaken to ensure that issues related to the 'social dimensions of banking' are dealt with sensitively and with a view to the social, economic, and political dimensions of providing a range of banking services across Nepal. 6.2 Participatory Approach: How are key stakeholders participating in the project? NRB, the Ministry of Finance, and the National Planning Commission are the key implementing institutions. A participatory approach to working closely with the Ministry of Finance, NRB and NPC through a Working Group -- was established in mid-1999. This has extended to full consultation with the IMF, the ADB, and DFID, which has taken place at every step of program development and has involved (a) informnation sharing; (b) consultation; (c) collaboration; and (d) joint missions. Within Nepal, key stakeholder meetings have also been held with the bankers and members of the private sector to review the draft central banking and banking acts, as well as the associated regulations supporting these acts. 6.3 Hlow does the project involve consultations or collaboration with NGOs or other civil society organizations? Given the macro-banking focus of this project, it has not involved consultations or collaboration with NGOs. However, key consultations have taken place with the banks through the Bankers' Association and with the wider donor community. In addition, the need for financial sector reform have been vigorously debated at the Public Accounts Committee on several occasion, and that forthright presentations by MOF/NRB have broadened the understanding of the issues and support for the reform efforts. 6.4 What institutional arrangements have been provided to ensure the project achieves its social development outcomes? The project will employ human resource professionals in all three main institutions covered by this project to deal sensitively and compassionately with the issue of re-engineering of human resources within these banks. 6.5 How will the project monitor perfonnance in tenns of social development outcomes? 7. Safeguard Policies: 7.1 Do any of the following safeguard policies apply to the project? Policy Applicability Environmental Assessment (OP 4.01, BP 4.01, GP 4.01) ( Yes 0 No Natural Habitats (OP 4.04, BP 4.04, GP 4.04) 9 Yes 0 No Forestry (OP 4.36, GP 4.36) (9 Yes * No Pest Management (OP 4.09) _ Yes No Cultural Property (OPN 11.03) (9 Yes * No Indigenous Peoples (OD 4.20) (9 Yes 0 No Involuntary Resettlement (OPIBP 4.12) (_ Yes * No -19 -  Safety of Dams (OP 4.37, BP 4.37) (.) Ycs No Projects in International Waters (OP 7.50, BP 7.50, GP 7.50) (. Yes * No Projects in Disputed Areas (OP 7.60, BP 7.60, GP 7.60)* K Yes No 7.2 Describe provisions made by the project to ensure compliance with applicable safeguard policies. Not applicable. F. Sustainability and Risks 1. Sustainability: The sustainability of the financial reform program will depend upon the commitment of the Govenmment to take hard political decisions on govemance issues in the two large banks. Given the politicization of these institutions, it may prove difficult to ensure the proper commitment to lasting restructuring (and ultimately privatization or liquidation) that is required. Nonetheless, some actions demonstrating govemment commnitment have already been taken upfront, and the project team feels that the program has a significantly enhanced chance of success as a result. The Financial Sector Strategy Statement is thorough and sound in its approach to fundamental financial sector reform, and it reflects an appropriate set of policies. An expert management team has also taken over the management of NBL and a Chief Executive Officer has been selected to take over RBB -- in all their key functions. Overcoming the political resistance to the introduction of extemal management teams already demonstrates considerable resolve on the part of the government and increases the likelihood of sustainability of the reform process. Sustainability could be adversely impacted by political uncertainly within Nepal. Weak coalitions and frequent changes in Governments, which seek to curry political favor with their electorate, may result in a policy reversal. Close cooperation with the IMF, the ADB, DFID and the rest of the donor community will also be important to ensure that adequate pressure is brought to bear against any perceived reversal in policy gains. 2. Critical Risks (reflecting the failure of critical assumptions found in the fourth column of Annex I): Risk Risk Rating Risk Mitigation Measure From Outputs to Objective NRB is dominated by the Ministry of M The government has approved a new central Finance and is not in a position to banking act which confers full autonomy on conduct its activities in an autonomous NRB. Continued close cooperation and and independent manner. monitoring with the IMF and DFID will also ensure maximum leverage. NRB does not take swift and decisive H Management teams/CEOs (conservator action (including taking curatorship) arrangements) have been put into place in the when a bank is found to be in two worst offending banks prior to project noncompliance with Central Bank approval. Close cooperation with the IMF and requirements, even when the bank is a DFID will also help ensure maximum leverage. publicly-owned institution. Insistence on other upfront actions, wherever possible, is necessary. From Components to Outputs Lack of adequate cooperation between M Ongoing dialogue and intensive use of the - 20-  the World Bank and the MOF and NRB. World Bank Kathmandu Field Office. Inability to access accountancy skills of N Sufficient skills are available in the local sufficient quality or in sufficient market. quantities. Government's resistance to restructure H Imnpact on World Bank lending and IMF the state-owned banks and ultimately support for Nepal. give up control over them (as stated in official policy). Institution building is made impossible S With support from this project through which due to a lack of commitment to skills' technical and financial assistance will be upgrading by financial sector provided for capacity building, and participants. determination of NRB to make changes in the financial sector, it is expected that this risk will be mitigated to a large extend. Late provision of counterpart funds as H NRB and Ministry of Finance are required to agreed in the project plan. indicate the availability of upfront counterpart funding from the budget. Overall Risk Rating H High Risk High Reward Project Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N(Negligible or Low Risk) 3. Possible Controversial Aspects: (a) Having foreign managers take over the two largest state dominated banks; (b) Need for significant staff retrenchments in the three banks (RBB, NBL, and NRB); (c) Possible bank branch rationalization as a result of the restructuring in RBB and NBL; and (d) Defaulting borrowers will be taken to court to reclaim on their outstanding borrowings. G. Main Loan Conditions l. Effectiveness Condition There are no conditions of Effectiveness. However, the following were conditions of negotiations. (a) The Financial Sector Strategy Statement (FSSS) has been discussed and publicly disseminated; (b) Contracts have been signed with the management teams coming into NBL and RBB (As mentioned in Annex 2, the management team for RBB pulled out right after the project was negotiated. NRB and the Bank agreed an alternative arrangement for RBB management - - i.e., to hire a CEO and a team of experts. The selection process is near completion, and a CEO will be appointed shortly.); (c) The Nepal Rastra Bank Act has been approved and has come into effect; (d) The Banking and Financial Institutions Act has been drafted; (e) Banking Regulations have been issued as directives to the banks; (f) All main technical assistance positions within NRB have been advertized; - 21 -  (g) The Banking Operations Department has purchased 30 computers; (h) The Borrowers' Project Implementation Plan is in final form; (i) The Coordination Support Team has been created and all staff have been appointed; and (j) The Ministry of Finance has provided the World Bank with a letter (dated August 8, 2001) either exempting all foreign consultant contracts from taxation or alternatively undertaking to make the requisite budget allocation in the upcoming budget. In addition, the Ministry of Finance also commits in a letter that any other counterpart funding will be provisioned in the Government budget. 2. Other (classify according to covenant types used in the Legal Agreements.] H. Readiness for Implementation Li 1. a) The engineering design documents for the first year's activities are complete and ready for the start of project implementation. _ 1. b) Not applicable. K 2. The procurement documents for the first year's activities are complete and ready for the start of project implementation. L3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactory quality. L. J4. The following items are lacking and are discussed under loan conditions (Section G): 1. Compliance with Bank Policies L I 1. This project complies with all applicable Bank policies. n 2. The following exceptions to Bank policies are recommended for approval. The project complies with all other applicable Bank policies. J& ,- Simon C. Bell I Mar Pernia \ ic i Ohashi Team Leader Sector Manager/Director Country Manager/Director - 22 -  Annex 1: Project Design Summary NEPAL: Financial Sector Technical Assistance Project Key Performance Data Collection Strategy Hierarchy of Objectives Indicators Critical Assumptions Sector-related CAS Goal: Sector Indicators: Sector/ country reports: (from Goal to Bank Mission) Improve the efficiency and Comprehensive financial Periodic review of national Stability in the financial sector stability of the financial sector sector reform that eliminates accounts, NRB's monetary and will help set the stage for to facilitate private-sector led the need for (real or financial data, and commercial longer term growth and more growth and ongoing contingent) budgetary support bank audited financial rapid poverty alleviation in macroeconomic stability. for the financial system. statements. Nepal. Reorient the role of the state in Periodic Economic and Sector A lower level of Government the financial sector from that Work, including a Financial involvement within the of an owner of financial Sector Study (completed). financial sector will also free institutions to that of a up budgetary resources for regulator and supervisor of the increased social sector entire financial system. expenditures. A deeper and broader financial sector will also ultimately, have a positive impact upon rural banking in Nepal. Project Development Outcome / Impact Project reports: (from Objective to Goal) Objective: Indicators: NRB operates independently A record of timely, effective, Annual Report of NRB and Sufficient political stability to and effectively regulates the and independent supervision and achieve the overall goals of banking sector to ensure that implementation of central implementation reports. the program. commercial banks operate on banking policies. a prudent and commercial basis. Timely and effective Periodic supervision and Positive response by the intervention by NRB to evaluation reporting. private sector to banking enforce prudential regulations sector reforms leading to and relevant banking higher levels of both domestic legislation. and foreign investment and consequent higher growth. Increased share of financial Commercial bank financial system owned and operated by statements, NRB reports, and private-sector players. supervision missions. Increase in range and Annual reports of commercial sophistication of financial banks and supervision instruments and services missions. available at competitive prices. - 23 -  Key Performance Data Collection Strategy Hierarchy of Objectives Indicators Critical Assumptions Output from each Output Indicators: Project reports: (from Outputs to Objective) Component: I . Capacity of banking Production of timely quarterly NRB reports, supervision The Ministry of Finance is supervision department within off-site and annual on-site missions, midterm project willing to allow NRB to NRB strengthened to conduct banking supervision reports reviews. enforce the bank supervisory examinations of financial for each of the banks operating regulations unfettered by institutions competently and in Nepal with accompanying political considerations. undertake appropriate relevant analysis. remedial action. Review of the audited NRB is prepared to take swift financial statements of all and decisive action (even commercial banks. taking curatorship) when a bank is found to be in noncompliance with Central Bank requirements even when the bank is a publicly-owned institution. 2. Timely and reliable Production of good quality (to Review of draft legislation and banking information published intemational standards) regulations. for general use, improved audited financial data for the central and commercial banks within four months of Supervision missions and banking legislation (and the end of the financial year. midterm project reviews. accompanying regulations) drafted and ready for Finalization of a new Central adoption. Banking Act (done) and a Banking and Financial Institutions Act and associated regulations. 3. Progress made on Gradually improved financial Review of annual financial restructuring of RBB and health of RBB and NBL. statements. NBL. 4. Final decisions made on Progress made on: liquidation, privatization, splitting, or other options for (a) The promulgation of a RBB and NBL. new central banking and commercial banking act. (b) Issuance of new regulations to cover the above legislation. (c) Revocation of existing restrictions on foreign accountancy companies from operating in Nepal. (d) Changed rules on majority banking ownership in Nepal. (e) Cessation of directed lending to priority sectors. - 24 -  Key Performance Data Collection Strategy Hierarchy of Objectives Indicators Critical Assumptions Project Components / Inputs: (budget for each Project reports: (from Components to Sub-components: component) Outputs) 1. Re-engineering NRB. US$4.68 million, of which: Quarterly disbursement Close cooperation between the IDA will finance US$2.64 reports; quarterly progress World Bank, MOF and NRB. million, and reports and supervision Close cooperation between the DFID will finance US$1.56 reports. World Bank, the IMF, DFID, million. and the ADB. Accountancy skills can be developed or imported to meet the increased needs. 2. Restructuring the two US$24.43 million of which: HMGN is willing to privatize largest commercial banks, IDA will finance US$12.81 and/or liquidate the RBB and NBL. million, and DFID will finance state-owned banks and lose US$8. 10 million. control over them as stated in official policy. Timely provision of counterpart funds as agreed in the project plan. 3. Capacity building in the US$0.99 million, of which: Institution building will be financial sector IDA will finance US$0.55 possible through a million, and commitment to skills' DFID will finance US$0.34 upgrading by financial sector million. participants. TOTAL Project Cost US$30.10 million IDA financing of US$16.00 million, DFID financing of US$10.00 million. HMGN will flance the balance of US54.10 million. - 25-  Annex 2: Detailed Project Description NEPAL: Financial Sector Technical Assistance Project The proposed project includes three main components. By Component: Project Component I - US$4.68 million RE-ENGINEERING OF NEPAL RASTRA BANK. The Central Bank of Nepal, Nepal Rastra Bank (NRB), is a weak and poorly performing institution. It does not undertake many core central bank functions effectively and has been relatively weak vis a vis the two largest commercial banks. NRB's ability to oversee the development of a prudently operated and well-managed financial system is poor. NRB needs strengthening in all of its core central-banking functions including human resource management, banking supervision and regulation, accounting and auditing, research and monetary policy analysis, information technology, and internal auditing. These changes need to take place within the context of a complete re-engineering of NRB. (a) HUMAN RESOURCES DEPARTMENT. At the heart of NRB's disfunctionality is its poor human resource management capabilities. NRB operates with a ratio of support to professional staff of around 5.5 to 1. Salaries are so compressed that the head of a department earns only two to three times the wage of the lowest paid staff member. There are no rewards for good behavior and no penalties for nonperformance. Although NRB has effective individual staff members, the institution seems to operate with poor incentive mechanism. It is necessary to recruit human resources (HR) professional to completely revise existing policies to give staff appropriate incentives to work hard and have pride in their employer. The work of this HR professional will also involve identifying staff for retrenchment and designing a Voluntary Retirement Scheme (VRS). It is thought that the NRB has potentially over 1,000 excess staff, out of a total staff of around 2,000. Movement on a VRS will permit NRB to thereafter decompress salaries so that appropriate financial rewards are paid to higher level and better performing staff. Consultancy and hardware support to computerize the HR function, develop new HR policies, design a VRS, and implement a decompressed salary system will be the main components of this support. This is anticipated to help improve professionalism within NRB and gradually ensure that it becomes one of Nepal's premier public institutions. (b) BANK OPERATION AND BANK INSPECTION DEPARTMENTS. The strengthening of NRB's supervisory capabilities requires the recruitment of a number of longer term, experienced, bank supervisors to assist it to implement its strategic plan with respect to regulatory development, on-site supervision, off-site supervision, and the implementation of a training plan. This component of the technical assistance will support the establishment of an appropriate system of supervision and regulation of banks and non-banks -- both on-site supervision and off-site supervision. Banking regulations such as bank licensing, capital adequacy, loan loss provisioning, accounting policies, and so on, have been developed as part of the ongoing support to the Bank Operation and Bank Inspection Departments. Two additional on-site bank inspectors are now required to help implement these new banking regulations through a program of vigorous on-site visits to banks. These bank inspectors will also have an important role in training the staff of the Bank Inspections Department in on-site bank supervision. In addition, it is anticipated that the role of the off-site bank supervisor could be extended beyond the current two-year term. The project will also provide computing hardware and software to ensure that the bank supervisors can do their work as efficiently and effectively as possible. - 26 -  (c) SUPERVISION OF THE MANAGEMENT TEAMS. The management teams in RBB and NBL will effectively perform the conservator role that a Central Bank in a more sophisticated context would play. Both teams have/will have specific roles, functions, and well-defined performance criteria to meet over the three-year period of their contracts. Carefully monitoring their activities will be critical to ensuring a reasonable level of success in their work. Given NRB's lack of experience in monitoring bank restructuring work in large financial institutions, it has been agreed to recruit a bank restructuring expert to work closely with the Banking Operations Department of the NRB, over a two-year period, to supervise these contracts on a day-to-day basis. Given the high cost of these teams and the reputational risk that would result from poor performance under these contracts, this oversight function is considered imperative in helping secure the maximum chances of success for this work. (d) ACCOUNTING AND AUDITING DEPARTMENT. As with many other core functions, accounting and auditing are weak within NRB. Accounts are not produced on a timely basis and their quality is dubious. Long delays in producing the accounts are, in part, blamed on the use of the large state-owned bank's network to effect payments in outlying regions. Inefficiencies and an inability to consolidate financial data from RBB and NBL impact NRB's own efforts in this area. Reform work envisaged under the commercial banking component of this project -- in conjunction with accounting and auditing strengthening within the NRB through the recruitment of expert technical assistance - will help the bank produce better quality and more timely financial data. This will be particularly important in assisting the Research Department develop money supply information and formulate monetary policy. Hence, this component will support the recruitment of accountants who will strengthen the accounting and auditing capacities of NRB and gradually move them to intemationally accepted accounting standards. (e) RESEARCH DEPARTMENT SUPPORT. Although arguably one of the best departments in the Central Bank, the Research Department also requires support for the professional development of its staff. The project will support a training program involving both formal higher degree training as well as capacity building through attendance at seminars and conferences. The project will also support the further development of the NRB library as an important research facility for the staff of the NRB (and others), as well as the further computerization of the department. Gradually the project will support the development and dissemination of more economic research papers from the Central Bank through Quarterly Bulletins and the Annual Report. (f) INFORMATION TECHNOLOGY SUPPORT. NRB has nine branches conducting banking activities throughout Nepal. In addition to these branches, it has 17 departments, of which 13 are located at the central office buildings in Baluwatar and four departments are outside the central office. While all the branches and departments have some computers and their operations are automated, NRB lacks a uniform and efficient Information Technology (IT) strategy and IT system. Each of the branches has its own local area network (LAN) and only one computer in each branch is connected to the computer system in the central office through a nondedicated telephone line. Some departments are linked to the LAN while others have stand-alone PCs, used mostly by the support staff for routine administrative tasks and word processing. Data collection, compilation, and analysis are carried out inconsistently and on an ad hoc basis. Each department collects data from various sources according to its own need, creating problems of data redundancy, inconsistency, and ambiguity. This component of the project will support the development of a holistic IT strategy and IT infrastructure within the NRB, through technical assistance and some limited hardware and software support. (g) ADDITIONAL SUPPORT FOR NEPAL RASTRA BANK. Support will also be provided to other NRB departments, including: - 27 -  * LEGAL DEPARTMENT. Although the new NRB Act has been approved, the Banking and Financial Institutions Act is still under review and discussion. Thereafter there will be a requirement to reform the ancillary financial sector legislation including, in particular, bankruptcy law, prioritization of liens, and so on. IDA will provide technical and financial support to engage consultants and legal experts to review the legislative framework in the financial sector and assist HMGN in the implementation of this component. * INTERNAL AUDIT. As indicated, the internal audit function of the NRB is particularly weak. Support will be provided under this project to boost the capacities of this important activity. * TRAINING SUPPORT. Training will also be provided under the project for NRB staff, but within the context of a Comprehensive Training Plan based on a review of existing skills, required skills, and a properly undertaken gap analysis. * OTHER DEPARTMENTS. Small amounts of additional funding will be provided to meet needs for consultancies and studies as and when they arise. A contract for (a), (b), (c), and (d) above has been let and a winning bidder has been identified. The re-engineering team for these specific components is expected to be in place by December 2002/early January 2003. IDA's contribution to the re-engineering of NRB will be US$2.64 million for financing the cost of consultancies, equipment, and training. DFID's contribution to joint finance the expenditures for this component will be US$1.56 milion, and the remaining balance of US$0.48 million will be covered by HMGN. Project Component 2 - US$24.43 million RESTRUCTURMG RBB AND NBL. The two large commercial banks (RBB and NBL) have, through their poor performance, established an environment of inefficiency within the banking sector. Swift and decisive action needs to be taken to deal with the worst problems and, in particular, stop the leakage of funds from these banks. The KPMG/Barents report (which estimates that the losses in these two institutions may be as high as $426 million, or 8.6 percent of GDP) recommended that several immediate steps needed to be taken to stem the further hemorrhaging of financial resources from the bank. These include (a) issuing a statement of government commitment to de-politicize the banking system; (b) bringing in management teams to take over all aspects of banking operations; and (c) ultimately privatizing the banks to good name "fit and proper" buyers. The management teams are expected to (a) take complete control of the day-to-day running of the banks; (b) immediately help to stabilize the operational and financial position of the banks; (c) bring in an accounting team to help strengthen the accounts of the banks; (d) develop human resource programs for the banks which would determnine, inter alia, a training program, a retrenchment program, and a more appropriate remuneration package for bank staff; and (e) prepare the banks for privatization/re-privatization or liquidation. In view of the recommendations of the report (which have been accepted by HMGN), a large share of the IDA credit has been allocated to support the initial stage of the proposed restructuring and privatization/re-privatization (or liquidation) programs of RBB and NBL. The IDA Credit will provide technical and financial support to HMGN to hire the management teams to take over the banks for a three-year period. These professional management teams will be supported by locally recruited accountancy teams to help improve the quality and timeliness of the accounts of these two commercial banks. These contracts were advertised in The Economist Magazine in September 2000. Subsequently, - 28-  the NRB chose Deloitte Touche Tomatsu (DTT) to undertake the management team work in RBB and ICC Bank (Ireland)/Bank of Scotland to undertake the management team work in NBL. Although the DTT contract was signed in January 2002 DTT never commenced the work and eventually pulled out of the contract in late-June 2002. To make up for this sudden and unexpected pull-out by DTT, the central bank decided to rapidly recruit a professional Chief Executive Office (already identified and expected to be in place by early December 2002) - and then to subsequently recruit the remaining seven department heads into the RBB during the early part of 2003. These additional positions have already been advertised in the international press and are expected to be in place over the next two to three months. The ICC/Bank of Scotland contract was signed on June 17, 2002 and the management team began work in Kathmandu in July 2002. The management teams are responsible for the day-to-day running of these two banks. Each team will consist of eight professional staff operating in line positions, including a chief executive officer, a head of credit, head of loan recoveries, a head of accounting, an internal auditor, a head of IT, a head of treasury, and a head of personnel. These teams are expected to be in Nepal for a minimurn of two years with a likelihood of contract extension for at least one additional year, and possibly two. Follow-up work, to be more fully designed at a later stage of project development, could include the establishment of a privately operated Asset Management Corporation (AMC) and the recruitment of sales advisors to help prepare prospectuses from these two banks, undertake a road show, and ultimately sell them to "fit and proper" private buyers. IDA's contribution to this component will be US$12.81 million toward the cost of consultancies, some IT support, and training. DFID's contribution will be US$8.10 million. The balance of US$3.52 million will be provided by HMGN. Project Component 3 - USS 0.99 million CAPACITY BUILDING IN THE FINANCIAL SECTOR. (a) BANKERS' TRAINING CENTER. The project will support addition capacity building in the financial sector through support for the Bankers' Training Center. Strengthening the role of this institution through the development of a strategic plan, design of appropriate course work, modem and enhanced teaching methodologies and equipment (including computers), and through support for enhanced training capabilities will all feature as components of this credit. Under this component, the capacity to establish twining arrangements with a good foreign Banker's Training Institute will also be investigated. (b) CREDIT INFORMATION BUREAU (CIB). Run by NRB the CIB's operations are generally considered very weak. This appears to be due to inefficient operation by NRB and the fact that the two largest banks are not particularly good at blacklisting nonperforming banking customers. This tends to undercut the usefulness of the credit information system. Strengthening the credit information process is considered an important building block within the overall financial sector reform effort that will be supported under the project. (c) FINANCIAL JOURNALISM. Improving the general public's capacities to operate as a more effective check and balance on bad banking behavior is also an important objective of this credit. Developing the capacity of local journalists to better convey financial sector issues to a relatively unsophisticated banking public will be an integral objective. Providing some regional training, attachments, as well as bringing financial journalists from India to interact with Nepali journalists will all be supported under the credit. - 29 -  (d) COORDINATION SUPPORT TEAM (CST). This support will finance the longer term costs of project financial management capabilities, project procurement capabilities, and project coordination capabilities within the CST. IDA will provide financial and technical assistance for consultants and experts, training, and related institutional strengthening measures. The allocation from IDA will be US$0.55 million and that from DFID will be US$0.34 million. The balance of US$0.1 million will be covered by HMGN. - 30-  Annex 3: Estimated Project Costs NEPAL: Financial Sector Technical Assistance Project Annex 3: Table A - Estimated Project Costs by Components Ebse Cosls _hyslosI Flis Tdal incd DA ORD ftjedcmwwb ~~~~~~~~~~~~~~~~~~~Rnaidn Rnidng Fakli Lmca TOW ease (60%d (40%d EP * e RiiiD ufg DAles a Cd ohic. %d bWli bWgi Fbnul EBaL Taxs TTes Taxes Amuxt Tdal finandnqD fl nidh bsfsLdtmt en406s / 1,1WX 17Z500 1,322,I 1, 1,15, s 1,15, I ~uundM N 1B 408,1 27 4 1 l2IX ___ _I - 1 RrwmaieFdcpiun 224,12_ 33.619 257.744 t11 7,72 276.6 0.85 141.1a 94,01K Bang" 94misim erd Ing)clim SD7,21C _ 76,08 MM 25,361 17,499 53215 _ 2 0.85 319,374 212911 A=unUng9 Adtin 104,7W 15,705 12405 5s,2a a612 129 109,8 Qa 6919 43a Oaighf&r FEECaotrts 487,00 73,050 5O50 24,YS 16,80 Wi 511,081 0.85 3n6 204,43 P D ad U9 ,4C 12,690 103,0 4,520 . 10, 9 1 Qa86 57,0" 38a0 InbmationTKhi y 278a7D 33,D5 312,00 13, _ 9,3W 3353 0188 177,1 11 11 ~Lao r,wbtma 99 175c 14,0 107,813 4,6 _ 234 115, 983BE, 0. 59,01 39, hbtral Aiut Dqbrb t 144,5 21,6 1 7,229 4,988 178, 151,72 85 91, 60, FporlaM aDprtm1ts 159,50X 23,925 1ea4a 7,97 5,50 196,9 167,38 10 66, NFlBTraiurMgsm 1,316,14 = = 1,316,14 6, 39,484 1,421,431 1,421,431 1.0 852 568, N SLoeslOista 274,450 41,168 315,611 1723 9.469 338 28021 a85 171 11 hb_xnbt actsd 19,127,5 :2, 7_ 1,112 31 MM,7 6_ 2350 Z,11 -fi" ..27! 1 ets for FIBBard Ira4poit 9,841,87C 1,426,281 11,288151 492C9 338,04 12,C 10,347, 33 0.86 ,1B 4,164,91 Mkeugiita1mDt fort'Lard IT S9POtt 9,285, 63 1,342," 10,68,4 464M 3118 11,411,61 9,7635596 0. 5,85,11 3,93Q41 01 Rnwicdal 9d Assl* n,e 7L __ 77W 8TI91 39,71! 28,11 _ 7 m ml531 S*Wils TTrsnrO CeW 411, 00C _ 41,15S 45Z1 S 2___ 1 ___ . 436, O90 261 174,6 QStlrVbmtrtirniCe1 72,5C 10,8 8 37E 3,2 ,50 89.0 76, 0.85' 45 30,4M oaXdnakn d SLmax Thm (CST) 19,2C 194,1 25, 228,98 10, 7,169 256, 27, 0. 1361 87, Trak Fir,rwdi isls 97,!! - 97,5 4,! 29 105, 12, 1.01 63,12 42,1 TOAL 24,511,31 541 , X 8a3R 2Z1,11Uq 1,18011 i 30,11 1l 1/ As of the date of Negotiations, the US$ amount equivalent of SDR 12.4 million was USS 15.89 million; however, for the purposes of project costing, this amount was rounded to US$ 16.0 million. 2/ A PPF of US$ 550,000 (0-1834-NEP) was approved in 1999 and was supplemented by a PPF (0-183-1-NEP) of USS 600,000 for financing consultancy services for banking supervision and other consultancies for RBB and NBL as well as selected training. The costs of these consultancies and training were adjusted accordingly. The PPF will be refinanced as part of the Credit. The total Credit amount is inclusive of the PPF. 31 The total project costs and IDA+DFID finances are rounded off to the last decimal point. Total project cost is estimated at USS 30.1 million and foreign financing by IDA and DFID together will be US$26.0 million. - 31 -  Annex 3: Table B - Estimated Project Costs by Categories Base Coat Physical Price Total indc. Contngencies Contngencies ContIngprncie Fo pn FiI ndn_ Profect Catgoes _ IDA Foreign Local Total Base (60ofg FinancingD Exchange Financing Dutes an Costs Inc. TOtal % of fomign (40% of orelgn Financing Excl. Taxer Taxes Taxes Amnount Total financing) finening) I. Investment Costs (wbtotai) _ _ Project Preparation Facilty - financed consultant services 11 1,150,Ki01 1 172,500 1,322,5 1,322,50 1,150,000 0.87 1,10o,000 Goods - fT Equipment (subtotal) 23 25, 24 2647 120,3n 79,411 2,848,771 2,569 3 0.90 1,541 1,027,88 NRB Ubrary 17,4001 1 ,740 19140 870 574 20,584 18,540 0.90 11,128 7,419 NRB Vaious Depanments 170,00t 17,000 187,000 8,500 5,610 201,110 181,200 0.90 to8,72jo 72,480 RBS 1,000,OOt 100,000 1,100,000 50,000 33,000 1 183,000 1,068,249 0.90 640,949 427,300 NBL 1,000. _Oti 100.O0 1,100,000 50,000 33,000 1,183,00 1,068,249 0.90 640,949 427.300 Bankers Trahin3 Center 194,0 _0 19.400 213,400 9,700 6,402 229,502 206,781 0.90 124.069 82,713 CST Suppon 25,211 2,500 2'500 1,250 825 29,575 26,847 0.90 15,988 10 659 Itrnational Consultant Srvices fr NRB (subtotal) 2,047, 307,135 2,354,70i 102,37 70,641 2,527,71 2,148,78 0.85 1,289,2 859,51 Human R esources Development 224,12! _ _ 33,619 257,7432 - 7 276,682 235,208 0.85 141,125 94,083 Banking Superv*son and Inspecion 11 507,21 76,082 583,292 25,361 17,499 626,151 532,291 0.85 319.374 212,91 Accountng and AuLitinr 104,70t 15,705 120,405 5,235 3,612 129,252 109,86 0.85 65,919 43,946 Oversighit for RBB/NBL Contracts 487,00 73,050 560,050 24,350 16,802 601.202 511,081 0.85 30,8649 204,433 Research Dept. and Ubrary 73,0 _ 1 10,950 83,950 3,650 2,519 90,119 76,610 0.85 45,966 30,644 lrlomiaion Technology 108,700 1 16,305 125,005 5,435 3,750 134,190 114075 0.85 68.445 45,630 Leat Depariment 93,75 __ 14.063 107,813 4,688 3,234 115,734 98,386 0.85 59,031 39.354 Internal Audt Depaftment 144,58t 21,687 166,2 7,229 4,988 178,484 151,729 0.85 91,038 60.692 Suport br Other Departm s 159,500 .23925 183,425 7.975 5,503 196,903 167,387 0.85 100.432 66,955 Bankers Trainirr Center 145,0X 21,750 16675 7,250 5,003 179,003 152,152 0.85 91,291 60o.re Conulbnt Senc - Management Contracts (subotal) 17,127,5 __ 2,569,126 19,696,631 856,375 590,8 21,1439 17,974,43 0.8 10,725,63 7,248,79 Management Consmttances for RBB 8,841,870 1,326,281 10 5168,151 442,094 305,045 10,91528 9,279,08 0.85 5.541,471 3.737,616 Management Contract tor NBL 8,285,6 2 1,242,845 9,528,480 414,282 285,854 10,228,61 8695347 0Q85 s514,166 3.511,181 Local Consultants 4__2__0_ 0 70,808 542,858 23 16,28 582,748 49,38 0.85 297 198,147 Credit Intor. Center 72,50 10,875 83,375 3,625 2,501 89,501 76,076 0.85 45,646 30,430 Coordination and Suppon Team (CST) 12-0 1,765 13 6,255 4,316 154,436 131,271 0.85 78,762 52,508 Oters - NRB Support (Accountirg, HR, Other Dept.) 274,450 41,168 315,618 13,723 9,469 338,809 288,021 0.85 172,813 115,208 Training Progrars - Foreign (subtotal) 1,504,04 _ 1,504,840 75,24 45,14 1,625,227 1,625,22, 1.00 975,13 650,091 NRB Training Program 1,316,140 1,316,140 65,807 394 1,4221,431 1,421,431 1.00 852,869 568.572 Bankers Trarining Center 72,000 72,000 3,600 2,160 77,760 77,760 1.00 46,865 31,104 Traning Fin. Joumalists 97, 50 97,500 4,875 2,925 105,300 105,300 1.00 63,a18 42.120 Coordina.on and Suppor Team (CST) 19, 19,20 961 571 20,73,' 20,73, 1 .00 12,442 8,294 Total Invstnent costs 24,211,31 497, 3,360,2 2e,068, 1,177,91! 80382 30, 25,963,8 0861 15,979,08 9,984,41i IL Recurrent Costa (subtotal) 4-4 4- 48,400 _2,2Q 1,45 52,052 0.75 28 15,616 Operatirg Costs (variable costs for CST Operations) 44,000 4,400 48,400 2,200 1,452 52,052 39,039 0.75 23,423 15,616 TOTAL 24,211,310 541,050 3,364,608 28,116,96M 1,180,118 803,83 30,100,920 26,002,523 0.8 16,002,490 10,000,033 % ot-ra - 0.80 0.02 0.11 0.93 0.04 0.03 1.00 0.88 0.6; 0.38 Note: While each individual expenditure wilt be cost shared between IDA and DFID on 60/40 basis during implementaton, the total IDA allocation will be about 62 percent of total foreign financing mainly due to PPF of US$ 1.15 million provided by IDA for preparation of the project. - 32 -  Annex 4: Cost-Benefit Analysis NEPAL: Financial Sector Technical Assistance Project Not Applicable - 33 -  Annex 5: Financial Summary NEPAL: Financial Sector Technical Assistance Project Years Ending June 30 Figures are in US$000 IMPLEMENTATION PERIOD | Year 1| Year 2 Year 3 Year 4 Year 5 Year 6 | Year 7 Total Financing Required Project Costs Investment Costs 4681.0 8660.0 7512.0 6310.0 2885.0 0.0 0.0 Recurrent Costs 8.0 15.0 13.0 11.0 5.0 0.0 0.0 Total Project Costs 4689.0 8675.0 7525.0 6321.0 2890.0 0.0 0.0 Total Financing 4689.0 8675.0 7525.0 6321.0 2890.0 0.0 0.0 Financing IBRD/IDA 2502.0 4614.0 4001.0 3371.0 1536.0 0.0 0.0 Government 637.0 1181.0 1024.0 840.0 394.0 0.0 0.0 Central 0.0 0.0 Provincial 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Co-financiersDFID 1550.0 2880.0 2500.0 2110.0 960.0 0.0 0.0 User Fees/Beneficiaries 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Other 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total Project Financing 4689.0 8675.0 7525.0 6321.0 2890.0 0.0 0.0 Main assumptions: Total project cost is US$30.1 million of which US$16.0 rnillion will be financed by IDA, and US$ 10.0 million will be provided by DFID. The two Project Preparation Facilities of US$1.15 million are included in the total costs. The estimated project cost in Annex 3 is rounded off to the closest decimal point. - 34 -  Annex 6: Procurement and Disbursement Arrangements NEPAL: Financial Sector Technical Assistance Project Procurement Procurement Capacity and Risk A review of the procurement capacity of NRB shows that it has no experience conducting procurement in accordance with World Bank guidelines or procedures. Therefore, the formation of a specialized team within NRB, with the appropriate administrative and financial authority to successfully implement the project activities, is a necessary prerequisite. To this end, a Coordination Support Team (CST), housed in the Banking Operations Department of NRB, has been forned. Presently, this team includes a financial management specialist and a locally recruited procurement expert with experience in World Bank-funded procurement of goods and works. However, except for some purchase of small value goods, procurement under the project will mainly involve the selection and employment of consultants and the implementation of the ensuing contracts. To ensure that the procurement consultant is able to handle this successfully, it is desirable that he and another NRB staff delegated to work with the consultant avail themselves of the specialized training in the selection and employment of consultants that is regularly conducted by institutions in India such as the Administrative Staff College at Hyderabad and National Institute of Financial Management at Faridabad. Goods Procurement (US$2.8 million): This is almost exclusively procurement of IT equipment such as computers, servers, networking, etc., for the library and other NRB departments, the two commercial banks (RBB and NBL), and the Bankers' Training Center. However, some select goods can be procured for NRB, including necessary equipment for CST. It is estimated that these items will be procured under separate contracts of which two (for RBB and NBL) would be ICB contracts of estimated value of approximately US$ 1.1 million each. These items plus other contracts (for NRB restructuring and the Bankers' Training Center) of total estimated value US$400,000 would be procured through NCB. Services (US$27.25 million): 1. Consultancy Contracts (US$25.60 million). In addition to the ongoing contracts with the management team in NBL and the CEO in RBB, two other contracts with international consultants are envisaged: (a) the seven person support team to work with the CEO of RBB (US$7.0 million); and (b) a team of five individuals to work on the re-engineering assignment within Nepal Rastra Bank (US$3.0 million). Other consultants (of estimated values ranging from approximately US$90,000 to US$200,000 ) will be selected locally under the NRB restructuring component. 2. Foreign Training Programs (US$1.65 million). This includes higher degree studies for NRB staff as well as training for financial journalists and staff of the Bankers' Training Center. Procurement Methods (Table A): The procurement method will apply to both IDA and DFIDfunds. In the Tables below, where there is a reference to IDA financing, it would mean jointfinancing by IDA and DFID according to the respective shares as indicated in Annex 3. - 35 -  IDA financed goods will be procured using the Bank's Guidelines of January 1995, revised January and August 1996, September 1997 and January 1999. IDA financed services will be procured using the Bank's Guidelines of January 1997, revised September 1997 and January 1999. The Bank's standard bidding and RFP documents will be used for the above procurement. Contracts for purchase of goods valued at more than US$30,000 but less than US$200,000 may be awarded on the basis of NCB procedures acceptable to the Bank. Items or groups of items valued at US$30,000 equivalent or less per contract may be procured on the basis of national shopping procedures. Other items or small groups of items such as furniture, books, and periodicals valued at less than US$5,000 equivalent per contract may be procured through Direct Contracting or National Shopping procedures. Consultants (for assignments with estimated value exceeding US$200,000 per contract) will be selected through QCBS or QBS procedures. For assignments valued at US$200,000 or less per contract, the shortlist may be comprised entirely of local consultants. Overall Procurement Risk Assessment - AVERAGE Frequency of procurement supervision missions proposed: Once every three months during the first year of project, reducing to once every four months in subsequent years (including special procurement support). Procurement methods (Table A) Figures in parenthesis in the following tables include amounts to be financed by IDA and DFID Table A: Project Costs by Procurement Arrangements (US$ million equivalent) Procurement Method Expenditure Category ICB NCB Other' N.B.F. Total Cost 1. Works 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 2. Goods 2.14 0.40 0.26 0.00 2.80 (2.05) (0.38) (0.14) (0.00) (2.57) 3. Services 23.00 3.50 0.75 0.00 27.25 (19.90) (2.90) (0.59) (0.00) (23.39) 4. Miscellaneous - Operating 0.00 0.00 0.05 0.00 0.05 Costs of CST (0.00) (0.00) (0.04) (0.00) (0.04) Total 25.14 3.90 1.06 0.00 30.10 (21.95) (3.28) (0.77) (0.00) (26.00) 'Figures in parenthesis arc the amounts to bc financcd by the IDA Credit. All costs include contingencics. 2. Includes civil works and goods to be procured throuigh national shopping, consulting services, serviccs of contracted staff of the project management office, training, technical assistance services, and incrcmental operating costs related to (i) managing the project and (ii) re-lending project funds to local government units. Note: With rcgards to procurement using NCB method, Goods estimated to cost less than US$200,000 equivalcnt per contract, up to an aggregatc amount not to excecd US$400,000 equivalent, may be procured under contracts - 36 -  awarded in accordance with thc provisions of paragraphs 3.3 and 3.4 of the Guidelines. In addition, thc following guidelines will bc in effcct which arc particular to Ncpal only and wcrc agrecd on betwccn the Govcrnment of Ncpal and World Bank Legal Departmcnt. In order to ensure economy, cfficicncy. transparency and broad consistcncy with thc provisions of Section I of the Guidclines: (i) invitations to bid shall bc advertised in at Icast onc widely circulated national daily ncwspapcr, at Icast 30 days prior to the dcadline for the submission of bids; (ii) bid documents shall bc madc available, by mail or in person, to all who are willing to pay the required fcc; (iii) evaluation of bids shall bc madc in strict adherence to the critcria disclosed in the bidding documcnts, in a format and'specified period agreed with the Association; (iv) bids shall be opened in public in one placc, immediately aftcr the dcadline for submission of bids; (v) foreign bidders shall not be precluded from bidding and no prefercnce of any kind shall be given to national bidders; (vi) qualification criteria (in case pre-qualifications were not carricd out) shall bc statcd in the bidding documents, and if a rcgistration process is required, a forcign firm de6larcd as the lowest evaluated bidder shall be given a reasonable opportunity of registering, without Ict or hindrance: (vii) contracts shall bc awarded to the lowest cvaluated bidders. (viii) post-bidding ncgotiations shall not be allowed with the lowest evaluated bidders or any othcr bidders: (ix) bids shall not be rejected merely on the basis of a comparison with an official estimate without the prior concurrcnce of the Association; (x) contracts shall not be awarded on the basis of nationally negotiated rates: (xi) re-bidding shall not be carried out without the prior concurrence of the Association: (xii) all bidders/contractors shall provide bid/performiance security as indicated in the bidding/contract documents; (xiii) a bidder's bid security shall apply only to a specific bid. and a contractor's performance security shall apply only to the specific contract under which it was furnished; (xiv) split award or lottery in award of contracts shall not be carried out. When two or morc bidders quote the same lowest price, an investigation shall bc made to determine any evidence of collusion, following which: (a) if collusion is determined, the parties involved shall be disqualified and the award shall then be made to the next lowest evaluated and qualified bidder; and (b) if no evidencc of collusion can bc confiriiied, then fresh bids shall be invited after receiving the concurrence of the Association; (xv) extension of bid validity shall not bc allowed without the prior concurrcnce of the Association (i) for the first request for extcnsion if it is longer than eight wccks and (ii) for all subsequent rcqucsts for cxtension irrespectivc of the period; (xvi) bids shall not be invited on the basis of percentage plrcmium or discount over the cstimated cost; and (xvii) thcre shall not be any restrictions on the mcans of dclivcry of the bids. - 37 -  Table Al: Consultant Selection Arrangements (optional) (US$ million equivalent) Selection Method Consultant Services Expenditure Category QCBS QBS SFB LCS CQ Other N.B.F. Total Cost A. Firms 15.60 0.00 0.00 0.00 2.15 0.00 0.00 17.75 (13.35) (0.00) (0.00) (0.00) (1.74) (0.00) (0.00) (15.09) B. Individuals 0.00 0.00 0.00 0.00 9.50 0.00 0.00 9.50 (0.00) (0.00) (0.00) (0.00) (8.30) (0.00) (0.00) (8.30) Total 15.60 0.00 0.00 0.00 11.65 0.00 0.00 27.25 _ (13.35) (0.00) (0.00) (0.00) (10.04) (0.00) (0.00) (23.39) 1\ Including contingencies Note: QCBS = Quality- and Cost-Based Selection QBS = Quality-based Selection SF8 = Selection under a Fixed Budget LCS = Least-Cost Selection CQ = Selection Based on Consultants' Qualifications Other = Selection of individual consultants (per Section V of Consultants Guidelines), Commercial Practices, etc. N.B.F. = Not Bank-financed Figures in parenthesis are the amounts to be financed by the Bank Credit. Prior review thresholds (Table B) Table B: Thresholds for Procurement Methods and Prior Review Expenditure Category Contract Value Threshold Procurement Method Contracts Subject to Prior Review (US$000) 1. Goods (i) Goods estimated to cost more ICB Prior review Fumiture, equipment, than the equivalent of books, etc. US$200,000 per contract (ii) Goods estimated to cost more than the equivalent of NCB First contract to be prior review US$30,000 but less than US$200,000 per contract (iii) Books, periodicals, and proprietary items up to an aggregate amount not exceeding Post review US$50,000 equivalent Direct Contracting 2. Services Prior review of all consultant a) Management teams, (i) More than US$200,000 per QCBS contracts shall be govemed by the consultants for contract provisions in paragraphs (i) to (iv) re-engineering of NRB, below. b) Oversight of RBB (ii) US$200,000 or less per QCBS, or QBS with and NBL management contract shortlist (shortlist could (i) With respect to each contract for contracts, selection of comprise entirely of the employment of consulting firms training institutions national consultants) estimated to cost the equivalent of - 38 -  US$ 100,000 or more, the procedures set forth in paragraphs 1, 2 [other (iii) Individual Consultants In accordance with the than the third sub-para of paragraph provisions of paragraphs 2(a)] and 5 of Appendix I to the 5.1 to 5.3 of the Consultant Consultant Guidelines shall apply. Guidelines (ii) With respect to each contract for the employment of consulting firms estimated to cost the equivalent of US$30,000 or more but less than the equivalent of US$100,000, the procedures set forth in paragraphs 1, 2 [other than the second sub-para of paragraph 2(a)] and 5 of Appendix I to the Consultant Guidelines shall apply. (iii) With respect to each contract for the employment of individual consultants estimated to cost the equivalent of US$10,000 or more, the qualifications, experience, terms of reference and terms of employment of the consultants shall be furnished to the Association for its prior review and approval. The contract shall be awarded only after such prior approval has been given. (iv) The Terms of Reference for all consultant contracts estimated to cost the equivalent of US$20,000 or more per contract in the case of firms and US$5,000 or more per contract in the case of individuals shall be furnished to the Association for its prior review and approval. The contract shall be awarded only after such prior approval has been given. 3. Miscellaneous Direct Contracting Post review only operating costs for CST_ - 39 -  Disbursement Allocation of credit proceeds (Table C) Expenditure Category IDA Contribution DFID Contribution Total Contribution Financing IDA4 DFID Percentages Amount in USS Amount in US$ Amount In US$ Million Million Million 1. Consultant Services 12.31 8.31 20.62 85% 90% of total purchases; foreign 2. Goods 1.54 1.03 2.57 or local 3. Training 0.98 0.65 1.63 100% 75% on Average - 90% 1styear, 80%, 4. Incremental Operating 70%, and 60% the Costs 0.02 0.02 0.04 following years 5. Project Preparation Facility (PPF) 1.15 0.00 1.15 85% 6. Unallocated 0.00 0.00 0.00 Total Project Costs 16.00 10.00 26.00 E l The US$26.0 million foreign financing will be provided by IDA (US$16.0 million) and DFID (US$10.0 million). A PPF of US$1.15 million financed the cost of consultancies for NRB banking supervision and partial payments for other consultant services -- including the start of the Management Team work in Nepal Bank Limited. The PPF will be refinanced as part of the total Credit amount. Use of statements of expenditures (SOEs): At least initially, withdrawals from the Credit account will be made using traditional disbursement procedures. which include full documentation of expenses and SOEs. SOEs will be used for the following expenditures: (a) for goods under contracts costing less than US$200,000 equivalent each; (b) for consultants' services contracts costing less than US$30,000 in case of firms, and less than US$10,000 equivalent in case of individuals; (c) for all training costs; and (d) for all incremental operating costs. A decision on moving the project to FMR-based disbursements may be made once the capacity of the implementing agencies to meet all FMR requirements is fully established. Special account: A Special Account in U.S. dollars will be established on terms and conditions satisfactory to IDA. The authorized allocation will be initially limited to US$1,000,000 until the aggregate amount of withdrawals from the credit account, plus the total amount of all outstanding special commitments entered into by IDA is equal to, or exceed the equivalent of SDR3,500,000. The authorized allocation may then be increased to US$2,000,000. If the project moves to FMR-based disbursements, the authorized allocation may go up to 20% of the Credit amount. The IDA Special Account will be managed under the joint signature of the executive director (CST Coordinator) and the financial management specialist in the CST. As per government requirements, the special account will be maintained at the Kathmandu banking office of NRB. The project will follow the prescribed accounting procedures as per the Financial Administration Rules of NRB. The CST will ensure that the bank/cash books are reconciled with bank statements regularly every month. The CST will submit replenishment applications for the special account on a monthly basis, or when 25 percent of the authorized allocation has been used, whichever occurs first. Replenishment applications will be - 40 -  accompanied by reconciled statements from the bank in which the account is maintained, showing all transactions in the special account. Supporting documentation will be maintained by the CST for at least one fiscal year after the year in which the last disbursement from the credit took place, and will be available to be reviewed by IDA staff and independent auditors. The Ministry of Finance will designate the CST coordinator and the CST financial management officer as joint signatories for withdrawing funds from the Credit for the implementation of the project activities. Financial Manaaement Project Budgeting - Project planning and budgeting will follow HMGN's planning and budgeting system. The CST will be responsible for preparation of a project budget plan as per its agreed work program. The CST will send its budget request to the MOF which will assign separate budget codes in the Red Book to facilitate budgeting and accounting of expenditures. HMGN will ensure timely release of funds including the counterpart funds required for project implementation. Adequate resources will be provided to the CST for overall project administration and management. IDA supervision missions will review the annual program and budget of the project before they are submitted to the MOF each year. Flow of Funds and Banking Arrangements - The CST will have direct access to the use of the Special Account -- managed under the joint signatures of the CST Coordinator and the financial management specialist. HMGN will make budgetary arrangements for the project which will be reflected in its annual budget. For large payments exceeding the special account threshold, direct payments will be made by IDA. The NRB will provide budgetary resources to the CST to pre-finance small expenditures -- such as operating and training costs. These will later be charged to the Special Account after the reconciliation of accounts: Financial Management Staffing - NRB has designated a qualified professional accountant for financial management of the project. A support-level accountant will assist the accounting and procurement function. Appropriate training will be provided to upgrade the capacity of the CST's financial management staff so they may efficiently operate the financial management and reporting functions. Through the financial management improvement component, the overall capacity of NRB's accounting staff will also be upgraded with training and skill building. Project Financial Accounting, Reporting, and Internal Controls - Project expenditures will follow the government cash-based accounting system. The CST will supplement manual records required under government regulations with simple spreadsheet-based subsidiary records. These will be regularly reconciled to the official accounts, to facilitate the timely compilation of additional information required for disbursements and FMR preparation. The CST will compile the monthly statement of expenditures within seven days following the end of each month. From the outset, the CST will produce Financial Monitoring Reports (FMRs) on a trimesterly basis, in formats agreed upon at negotiations. Eighteen months after the project's start, the desirability and feasibility of switching to FMR-based disbursement will be assessed. To match the government planning and reporting cycle, the FMRs and other reports will be produced trimesterly and submitted within 45 days from the end of the preceding trimester. Adequate staffing and proper segregation of duties and defined responsibilities in the CST will ensure the project's internal control. Policies, procedures, and guidelines to safeguard project resources and assets and to ensure smooth implementation of the project will be described in the Borrower's Project Implementation Plan (BPIP). Until the Internal Audit and Inspection Department is strengthened, the NRB will arrange to recruit a qualified, local audit firm for the internal audit of the project accounts, as - 41 -  authorized by the new NRB Act. Internal audit reports would be made available to IDA on request. External Audit - The following audit requirements will be tracked through ARCS: * Annual project financial statements, SOE schedule, and Special Account statement will be audited by the Office of the Auditor General, which is considered acceptable by IDA for this purpose, and submitted to IDA within six months after the end of the fiscal year. A draft terms of reference, acceptable to IDA, was discussed with the Auditor General. * NRB entity financial statements will be audited by a certified private auditor who will be appointed by the Auditor General and submitted to IDA within six months after the end of the fiscal year. To promote timely audits, it has been agreed that the unaudited financial statements will be prepared within three months after the end of the fiscal year for submission to the auditors and copied to IDA. All records, including contracts, orders, invoices, bills, receipts and other relevant documents evidencing all expenditures, will be kept properly and the Bank's representative will have access to them for exaniination purposes. Financial Management Action Plan - Action plans to strengthen the financial management capacity of the CST were agreed between NRB and IDA and are summarized below: (i) NRB will sanction full authority to the CSTto implement the project activities as per IDA 's procurement, disbursement, andfinancial management guidelines, and the decision-making layers with respect to project procurement will be minimized. A written authority to this effect provided to the CST and copied to IDA. (ii) CST staff will be trained in IDA procurement and disbursement procedures. (iii) CSTstaff will prepare a computerizedfinancial management system, satisfactory to IDA, by project effectiveness. - 42 -  Annex 7: Project Processing Schedule NEPAL: Financial Sector Technical Assistance Project Project Schedule Planned Actual Time taken to prepare the project (months) 12 38 First Bank mission (identification) 12/01/1999 12/01/1999 Appraisal mission departure 11/12/2000 01/31/2002 Negotiations 02/15/2001 06/24/2002 Planned Date of Effectiveness 06/15/2001 03/31/2003 Prepared by: The Government of Nepal and the World Bank with assistance from the IMF and DFID. Mr. Lawreiice DeMilner, IMF Resident Representative, participated in the appraisal mission. Mr. Chris Jackson from DFID participated in the appraisal mission and preparation activities under this project. DFID will cofinance this project. Preparation assistance: A PHRD Grant (TF025473) in an amount of US$620,000 A Project Preparation Facility (No. Q 183-0-NEP) in an amount of US$550,000 and supplemented by US$600,000 (Q 183-1 -NEP) Bank staff who worked on the project included: Name Speciality Simon C. Bell Lead Financial Economist Nagavalli Annamalai Senior Counsel Alain Vedrenne-Lacombe Banking Supervision Advisor Shideh Hadian Operations Officer, PSD Mudassir Khan Sr. Financial Sector Specialist Bigyan B. Pradhan Sr. Financial Management Specialist Uche G. Mbanefo Consultant - Financial Management Specialist Shakti Prasad Shrestha Economist Kiran Ranjan Baral Procurement Specialist Margaret Murray Team Assistant Niraj Lal Shrestha Information Technology Expert Mozanmiial Haque Sr. Financial Management Specialist - 43 -  Annex 8: Documents in the Project File* NEPAL: Financial Sector Technical Assistance Project A. Project Implementation Plan * Borrower Project Implementation Plan (PIP) B. Bank Staff Assessments Bank's Financial Sector Study Financial Management Assessment of Nepal Rastra Bank Procurement Assessment of Nepal Rastra Bank C. Other DFID's Concept note and any other documentation on this project. Memorandum of Understanding between DFID and IDA Including electronic files - 44 -  Annex 9: Statement of Loans and Credits NEPAL: Financial Sector Technical Assistance Project 04-Nov-2002 Difference between expected and actual Original Amount in USS Millions disbursements Project ID FY Purpose IBRD IDA Cancel. Undisb. Orig Frm Revd P050671 2002 Telacon inlcadons Sector Reform Pnoect 0.00 22.56 0.00 22.68 -0.50 0.00 P045052 2000 ROAD MAINTENANCE AND DEVELOPMENT 0.00 54.50 0.00 35.47 46 43 0.83 P040612 1999 BASIC & PRIMARY ED. 11 0.00 12.50 0.00 5.44 6.14 0.48 P045053 1999 RURAL INFRA UL 0.00 5.00 0.00 0.78 0.87 -0.53 P010530 1998 IRRIG SECTOR DEVT 0.00 79.77 8.01 12.44 21.87 2.96 P010509 1998 MULTIMODALTRANSIT 0.00 23.50 0.00 4.21 5.16 3.98 P010516 1997 RURAL WS& SANITATION 0.00 16.30 1.55 3.30 6.29 2.28 Total: 0.00 216.13 9.56 84.32 86 26 9.99 NEPAL STATEMENT OF IFC's Held and Disbursed Portfolio Jun 30 - 2002 In Millions US Dollars Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1996 Bhote Koshi 19.26 2.95 0.00 29.45 19.26 2.95 0.00 29.45 1994 Himal Power 25.89 0.00 4.50 0.00 25.89 0.00 4.05 0.00 2001 ILFC - Nepal 0.00 0.30 0.00 0.00 0.00 0.30 0.00 0.00 1998 Jomsom Resort 4.00 0.00 0.00 0.00 4.00 0.00 0.00 0.00 Total Portfolio: 49.15 3.25 4.50 29.45 49.15 3.25 4.05 29.4! Approvals Pending Commitment FY Approval Company Loan Equity Quasi Partic Total Pending Commitment: 0.00 0.00 0.00 0.00 -45 -  Annex 10: Country at a Glance NEPAL: Financial Sector Technical Assistance Project POVERTY and SOCIAL South Low- -- Nepal Asia Income Devlopment dlamon 2001 Population, mi-year (nillions) 23.6 1,380 2,511 LIfe expectancy GNI per capita (Atlas nmethod, USS) 260 450 430 GNI (Atlas method, USS blilonts) 5.8 616 1,069 Average annual growth, 1995401 Population (X) 24 1.9 1.9 Labor force() 2.5 2.4 2.3 GNI Gross per H-- i pnmary Most recnt emate (latest year available, 1995-01) capita enrollment Poverty (% ofpopulation below national poverty line) 42 Urban population (X of total poplation) 12 28 31 Ufe exqictancy at birth (years) 59 62 59 Infant mortality (per 1,000 live births) 74 73 76 Child malnutrition (X of children under 5) 47 49 Access to irnproved water source Access to an improved water source (% ofpopulation) 81 87 76 Illiteracy (% ofpopulation age 15+) 57 44 37 Gross primary enrollment (X of school-age population) 126 101 96 Nepal Low-income group MaW 140 109 103 Female 112 93 88 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1981 199i1 2000 2001 __ Economic ratloe GOP (USS billions) 2.3 3.9 5.5 5.6 Gross domestic investment/GDP 17.6 20.8 24.2 24.3 Trade Expofts of goods and servicestGDP 12.9 11.8 23.3 22.4 Gross domestic savingstGDP 10.9 9.6 15.0 14.7 Gross natonal savings/GDP 24.7 25.4 Current account balancelGDP al -2.3 -7.5 2.1 2.8 Domestic Investment interest paymentstGDP 0.1 0.7 0.5 0.5 savings Total debtlGDP 12.2 45.7 51.5 48.5 Total debt servicelexports 3.3 11.1 5.6 4.9 Present value of debt/GDP 28.4 Present value of debttexports 87.3 Indebtedness 1981-91 199141 2000 2001 200145 (average annuat growth) Nepal Loteincome group GDP 4.7 4.9 6.2 4.8 4.1 GDP per capita 2.4 2.4 3.7 2.4 1.8 STRUCTURE of the ECONOMY 1981 1991 2000 2001 Growth oInvestrent and GDP (%) (% of GOP) Agriculture 60.9 48.6 40.7 39.1 Industry 12.4 17.9 22.1 22.0 Manufacturing 4.1 6.9 9.4 9.3 4 Services 26.7 33.5 37.2 38.9 2 Private consumption 82.1 81.2 75.9 75.4 as 7 oa sa oo General govemment consumption 7.0 9.2 91 10.0 I GDP Imports of goods and services 19.6 23.1 32.4 32.0 198141 199141 2000 2001 (average annual grwth) Agriculture 3.8 2.8 4.9 4.3 Industry 8.7 6.4 8.7 2.5 Manufacturing 9.2 7.4 7.2 3.6 Services 4.5 6.0 5.8 6.6 Note: 2001 data are prelirminary estirnates. The ciamonds show tour key indicators in the country (in bold) compared vAth its incomegroup average. If data are nisisng, tIe diamond All be Incompneta. -46 -  Nepal PRICES and GOVERNMENT FINANCE 1981 1991 2000 2001 Inflatlon Domrestic prtces (% change) 15 Consumer prices 13.6 13.8 3.4 2.4 1A Implicit GDP deflator 7.9 9.1 4.4 3.1 Govenmment finance . (% of GDP, inctudes current grants) o Current revenue .. 8.9 10.7 11.4 9G 97 as s oo o01 Current budget balance .. -2.8 1.1 0.2 GDP deflator CPI Overall surplus/deficit -10.7 -3.5 -4.5 TRADE 1981 1991 2000 2001 Export and Import levels (US mill.) (US$ mtltions) Total exports (fob) 135 228 971 942 2.0W0 Food 61 65 1.0W SW U Pulses . . 46 56 1.00W 4fl Manufactures .. .. 230 256 SW Total imports (cdf) 371 715 1,713 1,774 0 Food .. 87 157 81 95 as s7 as 99 o 01 Fuel and energy .. 70 273 338 Exot imrs Capital goods 1184 297 312 * BALANCE of PAYMENTS (US$ millions) 1981 1991 2000 2001 Current acunt balance to GDP (%) Exports of goods and services 294 437 1433 1359 4 Imports of goods and services 403 854 1,922 1,984 Resource balance -109 -417 489 625 2 Net inoome 10 66 20 9 o Net current transfers 46 60 582 774 g Y 03 Current account balance -52 -290 113 158 Financing items (net) 39 417 101 -82 4 Changes In net reserves 13 -127 -214 -76 Meno: Reserves including gold (USS miltions) .. 451 952 1,027 Conversion rata (DEC, tocaltUS$) 12.0 31.0 69.3 73.8 EXTERNAL DEBT and RESOURCE FLOWS 1981 1991 2000 20011 (US$ milions) Composition of 2001 debt (USS mill.) Total debt outstanding and disbursed 279 1.776 2,823 2.700 IBRO 0 0 0 0 F:5G: 50 IDA 109 719 1.134 1,127 E:279 Totaldebtservice 12 66 100 89 IBRD 0 0 0 0 IDA 1 8 24 25 ; *_ B: 1,127 Composition of net resource fbws Offcial grants 72 52 76 36,',.*. Offieal creditors 65 139 97 60 Private creditors 0 -11 -8 0 0 1,23 - Foreign direct Investment 0 2 3 6 _ - Portfolio equity 0 0 0 0 C:A World Bank program Commitments 32 62 55 0 A - IBRD E - Oidatera Disbursements 33 49 46 47 B- IDA D - Othar rmirlilataral F - Private Prinripal repayments 0 3 16 17 C - IMF G - Short-terrn Net flows 33 47 31 30 Interest payments 1 5 9 8 Net transfers 32 42 22 21 ueveiopment Economics i 1izmz Note: Overall Surplus/defidt indudes grants. -47 -  Additional Annex 11: Financial Sector Strategy Statement NEPAL: Financial Sector Technical Assistance Project Strategy Paper of HMG/Nepal on the Financial Sector Reform Program Background Nepal began financial reforms in mid-1980 with a view to enhance efficiency in financial services. Accordingly, the licensing policy for banks and other financial intermediaries have been liberalized. As a consequence, the number of banks and financial institutions have been increased substantially. Presently, 13 commercial banks, 46 finance companies, 35 cooperative institutions, 25 non-government organizations (NGOs) and postal saving banks have been in operation. Along with liberal entry policy, commercial banks and other financial institutions have been given freedom to fix interest rates on their deposit and loan portfolio. As such, the statutory liquidity ratio (SLR) has been withdrawn to enable commercial banks in allocating funds on their own discretion; foreign exchange exposure has been granted and cash reserve ratio reduced. Recently, bank rates have been revised with a view to enhancing investments in agricultural and industrial sector, including export as well as redirecting larger financial resources towards poverty alleviation in rural sector. Further prudential and regulatory norms for banks and financial institution is in the process of revision under World Bank technical assistance and the new set of prudential regulation will be implemented in a time bound manner from the beginning of the next fiscal year. The initiation of these measures has made the need for further reform and consolidation a matter of urgency. HMG/N's own concern on the financial sector reform has found good support and backing by the multilateral donor agencies. In particular, the World Bank, the International Monetary Fund and the Asian Development Bank are prepared to support substantive and comprehensive reforms by HMG/N in its efforts and endeavors related to financial sector reform strategy and program. At a time when two large state owned banks, having nearly two-third of market share in commercial banking industry, are in serious trouble, the proposed reform program would definitely help to improve the functioning of these banks. In addition, the overall financial sector reform program is expected to make a vital contribution towards supporting private sector led economic growth through enhanced resource allocation to potential growth sectors. Against this background, the objective of this paper is to highlight and emphasize the urgency of reform program needed for the development of a competitive, efficient and healthy financial sector. This paper also sets out the Central Bank's views on the role of the banking and non-banking financial sectors and their relationship with the government, and amplifies government's policy on some key issues affecting the performance of the financial sector. In this context, the program is expected to assist in creating a sound, prudently managed and well-supervised financial sector in Nepal that is competitive, dynamic and capable of contributing towards macro-economic stability and more rapid and sustained economic growth. The Banking Sector As in any other economy, the banking sector has to play a vital role in the economic development of the country through facilitating the intermediary process in between capital surplus and deficit units. The banking sector has to play dual role of mobilizing as well as allocating the limnited resources towards -48-  people' needs so as to develop the economic system. For the efficacy and efficiency of the banking system, all banks have to be prudent and have commercial orientation in their activities. The banking business has to be conducted on commercial basis and the responsibility and accountability of the banking sector for its activities has to be defined clearly. The banking activities should also be compliant with the regulations issued by Nepal Rastra Bank, and should not in general, be directed by the government and other interested parties to serve their own interest, such as assisting particular sector, borrowers or groups on a non-commercial basis and undertaking social programs. Accordingly, Nepal Rastra Bank will have to enforce the internationally accepted standards of loan classification and provisioning requirements, liquidity and reserve requirement, capital adequacy requirement, exposure limits, single borrower limit etc. for the effective, efficient and sound banking system. Consequently, the poor lending decisions motivated by personal interest and benefit would be stopped by ensuring transparency for all stakeholders i.e. the shareholders, depositors, creditors, investors and the bank management. A sound system of corporate governance is much demanded for the maintenance and development of a well-managed banking system. In this regard, the Nepal Rastra Bank would also come up with appropriate prudential regulations that amplify a code of governance for all banks to follow. This code will have to clearly set out the rights and duties of directors, owners as well as management and also specify the functions reserved for the board. In the last few years, the government has undertaken general reform measures, viz. Interest Rate Deregulation, Phasing out of Statutory Liquidity Requirement (SLR), Bad Loan Provisioning, Capital Market Reforms, Foreign Exchange Liberalization, some of which were encompassed in the CBPASS package. However, still much remains to be done, and there is now an urgent need to undertake important measures to strengthen and deepen the reform process. This will require a concerted effort from all the concerned parties involved. In this regard, the government will need to provide an overall stable and positive macro-environment along with financial support or capital injection if needed. The Nepal Rastra Bank will have to provide effective regulatory oversight, supervision and strict enforcement. Similarly, the banking sector will have to improve its efficiency, strengthen its financial condition and undertake more prudent lending. The industrial and business sector could augment this process by providing proactive support toward reducing the NPA and instill confidence in the banking system by improving their corporate governance behavior The Non-Banking Sector The non-banking sector consisting of finance companies, development banks, cooperatives and non-government organizations doing limited banking business, constitutes as yet a small but ever growing component of financial sector. The non-banking sector provides ample opportunity to improve financial intermediation process in course of economic development of the country. Indeed, non-bank financial institutions can frequently generate a more competitive financial system than can the entry of additional commercial banks. Thus, this sector would be diversified for the complementary role and new areas of services they provide in relation to the commercial banks. In particular, the central bank realizes the restructuring need of the large two government owned development banks, bringing financial cooperatives under its supervisory domain, and ensuring healthy growth of the finance companies and the micro finance sector. There is a further need to bring non-bank financial institutions like The Employees Provident Fund and The Citizen Investment Trust under the regulatory and supervisory domain of the -49 -  Central Bank The stock market should also be working in a transparent, predictable and stable manner to mobilize long term capital in the industrial sector. The Government's Role There is a critical need to reform, revitalize and modernize the financial sector. The government is endeavoring to achieve a privately owned and managed banking system, which provides economic, and efficient financial intermediation in the economy. The inefficiency of the banking sector stems mainly because of the problems in two state owned banks, viz., Nepal Bank Limited and Rastriya Banijya Bank. Meanwhile, the Agricultural Development Bank and Nepal Industrial Development Corporation are also facing similar type of problems. This condition provides little incentive for the other private joint venture banks to become innovative, competitive, and efficient in extending their services. In the past, the government has played a vital role in the establishment and operation of the financial system; and that has resulted in strong political influence over the operation of most banking activities. In addition, lack of adequate supervisory and regulatory oversight in the Nepal Rastra Bank has led to structural and operational weaknesses in the financial system, which need to be urgently addressed. Thus, the government and also the central bank need to re-orient their activities from being active participants in the financial sector and should proceed towards being a stronger regulator and supervisor of the overall financial system. In view of these, the banking sector reform strategy would: initiate a strong corporate governance by ensuring that banks are owned and managed by private investors and professionals by implying the progressive withdrawal of HMG/N from the ownership of all financial institutions and also refraining from promoting financial institutions primarily with the equity participation of the government or government owned institutions. enhance the authority and the ability of the Nepal Rastra Bank for effective supervision of banks and non-bank financial institutions and enforce regulations as well as move towards increased autonomy of the central bank, * improve the existing legal and judicial processes for enforcing financial contracts, * inmproving auditing and accountancy standards within the banking sector, and * promote financial discipline through adequate disclosure and competition. The Role and Strategy of Nepal Rastra Bank To enhance the role of the Nepal Rastra Bank in the overall financial system of the country, it becomes necessary to think over various models, which confers greater autoromy and independence to the Nepal Rastra Bank. Thus, the Nepal Rastra Bank will work closely with the World Bank and IMF team for the amendment of the existing Nepal Rastra Bank Act, 1955 to provide sufficient autonomy in conducting monetary policy, regulation and supervision of banking and non-banking financial sector and licensing of banks and non-banking financial institution. The central bank also recognizes the critical importance of effective supervision within an appropriate regulatory framework to ensure that the banking sector fulfills its dual responsibility of protecting depositors' savings and allocating such saving in the most productive sectors for faster economic growth. The Nepal Rastra Bank would also encourage transparency in disclosing the financial information by banks particularly through the introduction of higher auditing and accounting standards that enables depositors in making prudent decision on the selection of banks they want to deal with. The Nepal Rastra Bank would also ensure that banks adopt standard practices in their operations: mainly in their lending behavior and interest calculation methods. Besides this, the Nepal - 50 -  Rastra Bank would also need to develop policies encouraging the establishment of privately managed institutions, industrial financing, capital market development and export financing. The establishment of credit rating agency, cooperative bank, export import bank and investment bank could be a case in point towards this direction. The govemment fully supports the effort of Nepal Rastra Bank in strengthening banking supervision, enforcement and regulation. The Nepal Rastra Bank would focus on the following reform measures in the financial sector. 1. Reform in the Financial Sector Legislation The need for financial legislative reform will involve the amendment,or promulgation of a new Nepal Rastra Bank Act, Commercial Bank Act and other Financial Institutions act. Alternatively, a Financial Institutions Act, which covers both commercial banks and other deposit taking financial institutions, could be promulgated as one piece of legislation. These acts will accommodate modem and supportive regulations, especially in the area of banking supervision. Reform of ancillary financial sector legislation will also be necessary to replace the currently highly fragmented legal system. Debt Recovery Act, Bankruptcy Act, Merger and Acquisition Act would be the major output of the reform process. The promulgation of these acts will help the consolidation of the financial sector in many ways, especially on enhancement of fair and efficiency based competition. The central bank is committed to instill strict financial discipline in order to break the default trend by enhancing competitions, efficiencies and controlling the malpractice, cartelling & monopolistic or oligopolistic behavior. 2. Strengthening Bank Supervision and Inspection The strengthening of the supervisory capabilities of the Nepal Rastra Bank should also be initiated under the financial sector reform program. This will require the recruitment of a longer term, experienced bank supervisor to assist the implementation of strategic plan for regulatory development, on-site supervision, off-site supervision and the implementation of a human resource development plan. The program should improve on-site bank supervision capacity by recruiting more accountants, improving training and introducing risk rating (Credit Rating) system. However, it is worthwhile to explore other modalities of monitoring and supervision including independent Monitoring and Supervision body. This will also extend the supervisory capacity to cover nonbanks and development banks. This is one area where technical assistance from the International Monetary Fund and World Bank could also be sought. The entire bank examination of RBB and NBL would clearly be a priority for an initial phase of enhanced banking supervision. 3. Restructuring and Privatization of NBL and RBB As the largest commercial bank, RBB has a potentially important role to play in the economy. However, political intervention, weak management, poor financial information system and ever growing bad loans have tremendously impacted on RBB's financial health. Recent auditing work has also revealed a high negative net worth, weak internal control and information systems, and poor internal financial management. In the samne way, NBL has also suffered from the overall inefficiency, a negative net worth and low level of competition in the banking system. The government's policy of successively selling shares to the general public and increasing private sector representation on its board, was aimed at avoiding the deteriorating situation as of the RBB. Nonetheless, NBL still does not operate like a private bank, does not have a strategic banking partner amongst its private shareholders and lacks a strategic direction and medium term vision. Addressing these problems within NBL will be an important component of the restructuring process. Thus, after ascertaining the true financial and operational position of RBB and NBL, it will be important to employ technical support to assist in developing a strategic plan for the implementation, such as, downsizing, privatization, splitting, merger, acquisition, - 51 -  etc. In the same way, technical support will also be required to implement any strengthening work identified by the reform proposal, which will be working on the financial and operational position of RBB and NBL. 4. Enhance Competition in the Banking Sector The basic purpose of reform of the NBL and RBB should be designed to correct anomaly in the banking sector, enhance competition and increase an efficient intermediary role of the banks and non-banks. The government as well as the Nepal Rastra Bank aim to foster competitive banking and non- banking sectors in the country so as to ensure that the banking services are provided at the lowest possible intermediation cost. In this regard, the government will not allow the banking industry to be dominated by a single bank or group of banks. Therefore, the present ownership structure of NBL and RBB will be gradually changed by their privatization and entry of new reputed, fit and proper private sector banks and financial institutions. To ensure continuing effective competition, the Nepal Rastra Bank would pernit new banks to be set up only by qualified, professional and experienced promoters. Similarly, the Nepal Rastra Bank will also relax some of the provisions in providing licenses especially for the foreign banks coming in joint venture by increasing the percentage shareholding that they can retain in a bank in Nepal above the current 50 percent. The detail criteria and qualifications, following internationally accepted standard practices, uniformn criteria and norms, will be re-announced publicly by the Nepal Rastra Bank and accordingly provide licenses to new banks. Furthermore establishment of branches of internationally reputed banks will be promoted under the terms and conditions and procedures set by the NRB. 5. Reform on Auditing and Accounting Capabilities Information on operations, performance and status of banks and other financial institutions or overall transparency of the whole financial system is highly important. Publishing of financial statements, their performances and auditing reports etc. on a regular basis is also needed to make the financial sector more transparent. However, the prevailing weak accounting and auditing practice has indicated that the timelines and reliability of financial data, particularly of NBL, RBB and NIDC is extremely poor. Thus, in order to operate the financial system efficiently, the accounting and auditing status of the poorly managed banks should be strengthened. To cope with this, the phase wise introduction of internationally accepted accounting and auditing standards for the banking and non-banking financial sector should be initiated. Further in respect of bank branches which cross specified ceiling of transactions, Branch audit will be made mandatory. Moreover, an appropriate environment will be created for international accounting firms to be operated in the kingdom. 6. Broad-Based Banking The government's emphasis on broad based banking service will be met by providing adequate mix of financial services to all the needed sectors / persons. These services should be provided through appropriate private institutions at market interest rate. Alternatively, these services could be provided through proper budgetary provisions for any subsidy to be provided in any areas. The directed and subsidized lending through banking system will ultimately be phased out with the provision of alternative private financial institutions catering such services. 7. Streamlining Ownership Structure Appropriate policy action will also be taken to avoid undue concentration on the ownership of banks and - 52 -  financial institutions. As such, no single person and group will be allowed to hold a controlling stake in more than one banking institution. In the case of poorly managed banks, a reputed and strategic investor will be allowed to hold controlling shares in that bank. Cross holding of capital in the commercial banking industry will be eliminated and promoters having significant shareholding will be barred from accessing financial resources from their own institutions in which they hold significant ownership. 8. Establishment of Bankers' Training Institute In addition to the aforementioned policy goals, other financial support activities should also be initiated by the Nepal Rastra Bank jointly with the coordination of all commercial banks and the governnent. In this regard, the NRB will endeavor to establish a separate Bankers' Training Institute, jointly financed and managed by the NRB and other banks. The newly established institute will provide ample opportunity to up-grade the working skills and research capacity of the staff involved in the commercial banks. 9. Restructuring of Credit Information Bureau To make the lending activities more prudent, the genuine credit information about the borrowers is required. In this regard, the present Credit Infornation Bureau would be revamped to provide effective and efficient information service. Essential technical support would also be given to the Bureau to restructure and improve its modus operandi. 10. Establishment of Assets Reconstruction Company The program would also initiate an appropriate plan to improve loan recovery and reduce Non Performing Loan of banking and non banking financial institutions. Hence, efforts will be made to initiate an Assets Reconstruction Company in the coming fiscal year to improve the loan portfolio status of the banking system. 11. Revamping Research and Financial Monitoring Strength of the Central Bank In order to keep the policy makers well abreast of the financial market condition and for facilitating prudent decision making, the research and statistical wings of the Nepal Rastra Bank would be strengthened. 12. Broadening and Deepening the Financial System in Nepal It is also felt that there is an important need to establish an environment in which a broad range of financial institutions and financial instruments are developed. Nevertheless, the commercial banking is likely to remain the largest component of the financial system for some time, there is also a need to develop debt and equity markets, leasing companies, venture capital facilities, further strengthen the stock market, insurance markets, micro-finance, pension and provident funds, and so on. Thus, the establishment of a broad range of instruments into which savers can deposit their funds as well as a broad range of lending instruments, involving both debt and equity, will also assist the overall development of the economy. 13. Meeting Sectoral Financing Requirements As the country is overwhelmingly based on rural economy, it has also been envisaged to ensure that the adequate financial services are provided to support the activities of this sector. Moreover, other sectoral -53 -  needs, such as industrial financing, housing finance and so on, would also be provided on the competitive cost. 14. Other Measures The NRB has also envisaged to announce a specific time bound plan to restructure Agricultural Development Bank and Nepal Industrial Development Corporation in the next phase. Meanwhile, the government feels that the establishment of a sound and properly regulated banking system is the key principle and the regulation of deposit taking institution is fundamental. Thus, appropriate measures would also be introduced to regulate all deposit taking institutions as the commercial banks. 15. Establishment of Development Banks at Regional Level Efforts will also be made to augment the flow of rural credit by giving priority to establish development banks at regional and local level. However, the general thrust of the government will be less government involvement in the financial sector. 16. Strengthening of Rural Development Banks The NRB will also undertake organizational and financial strengthening programs for rural development banks established with the objectives of alleviating poverty in the rural areas. Recognizing the importance of rural sector and development finance, the government aims the development of rural credit and development finance via the private sector, including divestiture of such rural and development financial institutions currently owned or controlled by HMG and/or NRB. 17. Establishment of Credit Rating Agency The NRB will also put efforts in establishing Credit Rating Agency in the coming fiscal year so as to make the debt instruments more confidential and trustworthy to the potential investors, and it is expected that it will contribute to the development of capital market in the country. 18. Timetable The implementation of the aforesaid regulations and reform policies will be initiated from the next fiscal year. - 54 -  1BRD 26085 BR' 82' 8A' 86' 88' '-C---) ,C-u i tt N E PA L 30' ,/30 -- So -D -HUPRIMARY ALL-WEATHER HIGHWAYS AIRPORTS: f' 2,;/ D d_JANG . 9 1' --' r-: GRAVELLED/EARTHEN ROADS INTERNATIONAL r rZ r ...... v =g -- '- c H I N A----- ROADS UNDER CONSTRUCTION