Turkey - Financial Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY ReportNo: 24210 IMPLEMENTATION COMPLETION REPORT (SCL-45880) ON A LOAN IN THE AMOUNT OF US$ 777.78 MILLION TO THE REPUBLIC OF TURKEY FOR A FINANCIAL SECTOR ADJUSTMENT LOAN May 7, 2002 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (Exchange Rate Effective May 7, 2002) Currency Unit = Turkish Lira TL I = US$ 0.00000073 US$ 1 = TL 1,366,862 FISCAL YEAR January 1 December 31 ABBREVIATIONS AND ACRONYMS AMU - Asset Management Unit BRSA - Bank Regulation and Supervision Agency CAS - Country Assistance Strategy CPI - Consumer Price Index EFIL - Export Finance Intermediation Loan ERL - Economic Reform Loan EU - European Union FDI - Foreign Direct Investment FX - Foreign Exchange FSAL - Financial Sector Adjustment Loan GNP - Gross National Product GOT - Government of Turkey IAS - Intemational Accounting Standards IFI - Intemational Financial Institutions IMF - Intemational Monetary Fund NBFI - Non-Bank Financial Institutions PSAL - Public Sector Adjustment Loan SBRPP - State Bank Restructuring and Privatization Project SDIF - Savings Deposit Insurance Fund WPI - Wholesale Price Index Vice President: Johannes F. Linn Country Director: Ajay Chhibber Sector Director: Paul Siegelbaum Program Team Manager: Lalit Raina  FOR OFFICIAL USE ONLY TURKEY Financial Sector Adjustment Loan CONTENTS Page No. 1. Project Data I 2. Principal Performance Ratings I 3. Assessment of Development Objective and Design, and of Quality at Entry 1 4. Achievement of Objective and Outputs 4 5. Major Factors Affecting Implementation and Outcome 7 6. Sustainability 8 7. Bank and Borrower Performance 8 8. Lessons Learned 10 9. Partner Comments 10 10. Additional Information IS Annex 1. Key Performance Indicators/Log Frame Matrix 16 Annex 2. Project Costs and Financing 17 Annex 3. Economic Costs and Benefits 19 Annex 4. Bank Inputs 20 Annex 5. Ratings for Achievement of Objectives/Outputs of Components 21 Annex 6. Ratings of Bank and Borrower Performance 22 Annex 7. List of Supporting Documents 23 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   Project ID: P0665 11 Project Name Financial Sector Adjustment Loan Team Leader: Lalit Raina TL Unit: ECSPF ICR Type: Core ICR Report Date- May, 7, 2002 1. Project Data Name: Financial Sector Adjustment Loan L/C/TF Number. SCL-45880 Country/Department: TURKEY Region: Europe and Central Asia Region Sector/subsector: FF - Financial Adjustment KEY DATES Original Revised/Actual PCD: 12/06/99 Effective: 01/15/2001 12/22/2000 Appraisal: 01/19/2000 MTR: Approval: 12/21/2000 Closing: 03/31/2002 06/20/2001 Borrowver/InplemenitingAgenicy: REPUBLIC OF TURKEY/UNDERSECRETARIAT OF TREASURY/BRSA Other Partners: STAFF Current At Appraisal Vice President: Johannes F. Linn Johannes F. Linn Country Manager: Ajay Chhibber Ajay Chhibber Sector Manager: Paul Siegelbaum Paul Siegelbaum Team Leader at ICR: Lalit Raina Lalit Raina ICR Primary Avthor: Michael Gascoyne 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: S Sustainability: L Institutional Developmnent Impact: M Bank Performance: S Bo0rower Performance: S QAG (if available) ICR Quality at Entry: S Project at Risk at Any Time: No 3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: The main objective of the Financial Sector Adjustment Loan (FSAL) was to address the Government of Turkey's (GOT's) financial sector reform priorities in order to lay the foundation for an efficient, sound and healthy banking system which could be competitive in quality and performance at the international level.  The Turkish banking system expanded rapidly during the 1990s and, in spite of the 1994-95 banking crisis, total system assets in absolute terms more than doubled from US$52.0 billion in 1994 to US$135.5 billion as of end 1999. However, the rapid growth in the size of the banking sector also had some negative consequences. Prudential regulations and enforcement capacity had lagged behind considerably, and there had been a significant proliferation of connected and insider lending and excessive concentration of exposure and default risks. The explosive asset growth had allowed banks to hide the deteriorating quality of a major proportion of their credit portfolios; while at the same time credit risks had been significantly understated due to previous lenient loan loss provisioning rules. Excesses in foreign currency exposures and in maturity tramnsformation generating significant duration mismatches had also created enhanced foreign currency and liquidity risks in addition to the credit risks. There was therefore a clear need for a sectoral reform program which would raise regulatory standards, increase enforcement capacity and support the resolution of non-viable banks. Following the April 1999 parliamentary elections, the new Government launched a sweeping economic reforn program designed to tame inflation and restore the economy to a stable path of high growth. The program combined: (a) tighter fiscal policies, designed to put public finances on a sustainable path, with (b) a nominal exchange rate anchor designed to lower inflationary expectations, (c) tighter incomes policies centered on the adjustment of civil service salaries to targeted inflation, and (d) structural reforms aimed at restoring growth and underpinning fiscal adjustment. The program's macro-economic framework was endorsed by the IMF through a multi-year, US$4 billion Standby arrangement approved in December 1999. The Bank and IMF collaborated closely on the structural measures in the program, including those supported by the FSAL, through intensive day-to-day cooperation between the two institutions, participation by Bank staff in the Standby program discussions, and joint IMF/Bank missions on financial sector reform issues. 3.2 Revised Objective: Starting in late November 2000, Turkey experienced a banking system liquidity crisis which saw overnight interest rates climb above 2,000% per annum. The crisis was caused by increased market skepticism about the ongoing GOT fiscal and monetary program and was triggered by the need of a medium-sized private bank (Demir) to refinance an excessive stock of Government securities. The root of the problem however actually lay in the needs of two state owned banks, Ziraat and Halk, to finance illiquid "duty losses" (claims on the GOT arising from subsidised loans made at the behest of the government); at the time of the crisis, these duty losses accounted for 13% of total banking system assets. In light of the crisis, the Government moved rapidly to implement the remaining required actions for the FSAL, especially regarding the reforms of the state owned banks. The FSAL, a two tranche loan, was approved by the Board on December 21, 2000, and the first tranche of US$ 392.8 million was disbursed the following day. Despite this, the markets remained concemed that the pace of reform was slowing and in February 2001, following the public airing of tensions between the President and Prime Minister (on an unrelated topic), there was another, much more serious crisis. This set off a new wave of turbulence in the financial sector as investors liquidated Turkish Lira (TL) positions and fled to foreign currencies in expectation of a full fledged political crisis. Interest rates once again spiked, this time as high - 2 -  as 6,200% per annum, and with a rapid depletion of the Central Bank of Turkey's (CBT's) foreign currency reserves apparent, the authorities were forced to abandon the IMF backed crawling-peg exchange rate mechanism and float the TL. Following these two crises, it became clear to the GOT that it was necessary to accelerate and broaden the reform agenda while retaining considerable flexibility in the immnediate post-crisis period. To this end, the GOT and the Bank agreed to implement a series of 5-6 single tranche programmatic loans in both the financial and public sectors. The first of these loans, the US$ 1.1 billion Programmatic Financial and Public Sector Adjustment Loan (structured as two loans, one for US$ 400 million on SSAL terms and one for US$ 700 million on standard IBRD terms), was approved by the Board on July 12, 2001 and disbursed on July 17, 2001. Though the immediate cause of the February crisis was attributable to weaknesses in the financial sector, its deeper roots lay in the structure and management of the public sector, which were at the core of Turkey's chronic macroeconomic instability. Recognising that neither sector could move forward in a sustainable manner without parallel improvements in the other sector, the financial and public sector reform programs were bound together in the PFPSAL (and the subsequent PFPSAL II). The financial sector reform program was restructured as a series of Programmatic Adjustment Loans (two PFSALs are envisaged to follow PFPSAL II) to be implemented over a three year period. Any goals originally established under FSAL, to the extent that they remain relevant but were not incorporated into PFPSAL, will be picked up in subsequent operations. A similar strategy has been mapped out for the public sector for which two PPSALs, scheduled through to the end of 2003, are envisaged to follow PFPSAL II. Following approval of PFPSAL, at the request of the GOT, the second tranche of FSAL (US$ 385.0 million) was cancelled and the loan was closed as of June 20, 2001. 3.3 Original Components: 38. The main objective of the Financial Sector Adjustment Loan was to address the Government's reform priorities in order to create the foundation for an efficient, sound and healthy banking system which can be competitive in quality and performance at the international level. The reform actions required to achieve this objective in FSAL included; (i) creation of a competent and independent Banking Regulation and Supervision Agency (BRSA); (ii) bringing all the prudential regulations up to international best practice standards; (iii) empowerment of the bank failure resolution entity, the Savings Deposit Insurance Fund (SDIF) with a new set of legal tools and operating guidelines; and (iv) making a major tangible push towards restructuring and privatization of state-owned banks and getting the Government out of the business of owning and running commercial banks. 3.4 Revised Components: As noted above, many of the components of FSAL were subsequently subsumed into PFPSAL, and the remaining ones have been included in the remaining reform program encompassing the proposed subsequent financial sector Program loans. 3.5 Quality at Entnr: Quality at Entry is rated satisfactory, based on (i) the consistency of objectives with the priorities for financial sector development (ii) the sequencing of actions undertaken in prior operations and planned for in future operations (see below), and (iii) the integrated use of both a top down (FSAL) and bottom up (the Export Finance Intermediation Loan was used to begin a reform dialogue with Turkey's largest private - 3 -  banks) approach ensuring broad based support for the reform agenda. The project was consistent with the Bank's Country Assistance Strategy for Turkey, which was discussed by the Board in December 2000. The CAS recognised the critical importance of the financial sector in Turkey's economic stabilisation and called for a program "focusing on reducing systemic risks and vulnerabilities, while increasing the sophistication, productivity and competitiveness of the financial sector". Extract from FSAL President's Report showing the sequencing of the financial sector program: { ridc ~~~~~~~mmgement financial r Baddag > \ ~~~~audits - 4 other instiftudons M bans revie / Comprebensive > 4 Worehensive risk management { cneesv audit - riangmo \ Pilot bank x The MOP documented the project and its background particularly well. It also clearly stated there was a high level of risk that the project might be compromised by a "potential lack of political consensus" and a "lack of political will to implement the reform of the state-owned banks"; the market's perception of the lack of political will to carry through the reforms was a major contributor to the February economic crisis. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: As noted previously, following the February 2001 financial crisis, the second tranche of FSAL was cancelled approximately 6 months after effectiveness and hence many of the actions envisaged for second tranche release were not carried out under this program. However, these actions were subsumed into PFPSAL (and subsequently implemented prior to disbursement of the PFPSAL in July 2001), or are planned to be carried out under PFPSAL H (during or before April 2002). Given the significant disruption caused by the crises in November 2000 and February 2001, the GOT and the Undersecretariat of Treasury (the primary implementing agency for FSAL) deserve considerable credit for having achieved the targets for. first tranche release (see below) as set forth in the MOP. Though the measures undertaken as part of the FSAL were not sufficient to avert the second macroeconomic crisis in February 2001, the additional powers granted to the BRSA and the arrangements set in place to ensure its efficient operation probably reduced the fiscal cost of the post-crisis clean up by facilitating the speedy resolution of problem banks and preventing a systemic collapse. 4.2 Outputts by conmponents: The following actions, which were undertaken prior to Board presentation, were vital for kick starting the banking sector reform program, especially in the area of the restructuring and privatization of state-owned banks: Many of these actions have been designed and planned during -4 -  the FSAL preparation period. They included: Bank Regulatory and Supervision Entitv * Passage of the agreed amendment to the banking law (the amendment to enhance the independence and strengthen the authority of the new BRSA, put in place tightened large/connected exposure limits, and clarify and strengthen the problem bank and the bank failure resolution roles and authorities of the BRSA and the SDIF respectively) (completed in late December 1999); * Appointment of the Board members of the BRSA (completed in March 2000): Prudential rules for banks * Issuance of a substantially overhauled loan loss provisioning rule (completed in December 1999), including supporting documentation (revised regulatory report formats & disclosure requirements and a communique detailing borrower creditworthiness criteria) (completed in March and June 2000); * Issuance of an addendum to the FX exposure rule applying FX exposure limits on a consolidated basis (completed in late December 1999); * Issuance of an addendum to the capital adequacy rule applying the minimum capital adequacy requirement on a consolidated basis (completed in late December 1999); Problem bank/bank failure resolution * Initiation of an action plan by Treasury covering all problem banks encompassmg corrective action programs administered by the bank regulatory authority and SDIF interventions (initiated in late December 1999); State bank commercialisation and privatisation * Enactment of an amendment to the existing law on Vakif bank to enable the bank's full privatization (completed in November 2000); * Passage by the Board of Directors of a decision to initiate the privatization of Vakif bank(completed in August 2000); * Introduction of the new mechanism for the determination of credit subsidy rates to be used by Ziraat bank and Halk bank (completed in late December 1999); * Budgetizing the flow of duty losses arising from new subsidized lending by Ziraat bank and Halk bank in 2000 (completed with the adoption of the year 2000 budget); * Enactment of legislation that will: (i) allow Emlak bank, Halk bank and Ziraat bank to be privatized; (ii) remove the application of state economic enterprise legislation (Decree Law No. 233 and related laws) to Emlak bank, Halk bankand Ziraat bank; and (iii) allow Ziraat bank to be transformed into a joint stock company, (completed in November 2000); * Passage by the Council of Ministers of a decision to initiate the privatization of Emlak bankand Halk bank, that will allow the Treasury a limited, predetermined period of -5-  time to undertake pre-privatization restructuring and formulate privatization strategies, and upon expiry of such time, commit the Government to subsequent divestiture in accordance with the agreed privatization strategies (to be completed in December 2000); and * Contracting for a first time IAS audit for Ziraat bank for year-end 1999 (completed in November 2000). The following actions, second tranche goals under FSAL, were carried out under that program prior to its cancellation or were carried out under the PFPSAL prior to disbursement of that loan on July 17, 2001: Bank Regulatory and Supervision Entity * Signing of a Memorandum of Understanding between the BRSA, the Central Bank of Turkey and other relevant agencies to ensure proper information exchange and policy coordination in the financial sector (completed August 2000); Prudential rules for banks * Introduction of full tax deductibility of specific loan loss provisions; the implementation of tax deductibility (completed May 2001); * Further revision of the loan classification and loan loss provisioning rule to lift the exemption for agricultural support loans for which the Government has not explicitly assumed the credit risk and to include a specific provisioning requirement for equity exposures (completed June 2001); * Issuance of a BRSA regulation that will fully operationalize the new large/connected exposure limits introduced through the December 1999 Banking Law amendment (completed June 2001); * The BRSA to announce its intention to undertake surprise on-site examinations, in coordination with foreign supervisors where necessary (i.e., for banks with foreign branches/subsidiaries), to verify compliance with consolidated FX open position limits between reporting dates (14 overseas branches/subsidiaries have been subject to surprise inspection); * Issuance of a risk management system best practice regulation for banks (completed February 2001); and * Introduction in the bank capital adequacy rule of market risk charges (regulations issued in October 2001 and January 2002); State bank commercialisation and privatisation * The Government to develop a time bound action plan to resolve the stock of duty losses on the books of Ziraat and Halk and to issue Government bonds paying cash interest in line with the action plan (implemenation of action plan began in March 2001); and * Initiating the process of developing and implementing commercialization, restructuring - 6 -  and institutional development measures for Ziraat, through the development of a comprehensive strategic plan and detailed corporate action plans for the bank (completed February 2001); A number of other measures to be taken prior to second tranche release were modified/strengthened in light of the rapidly deteriorating state of the banking sector, for example: * FSAL had mandated that banks submit quarterly regulatory reports on consolidated capital adequacy - this was revised to monthly reporting under PFPSAL. * the financial condition of the state owned Emlak bank had deteriorated to such an extent that the commercialisation/privatisation plans laid out in FSAL were abandoned and the bank was merged into Ziraat bank. It can be seen therefore that, though the FSAL was closed early, the objectives were carried forward and the actions taken prior to first tranche release formed the foundations for the reforms already carried out, or to be carried out, under PFPSAL I/Il. 4.3 Net Present Value/Economic rate ofreturn: N/A 4.4 Financial rate of return: N/A 4.5 Institutional development impact: Creation of a separate, independent banking regulator, the BRSA, with sufficient powers to effectively monitor the banking sector was a product of the first tranche of FSAL. The Bank funded the cost of an experienced bank examiner to work with the BRSA to devise an appropriate management structure and to develop modem operating procedures and information systems. Though much has been achieved, the institution still has much to do and, constrained by public sector pay guidelines and a legal system which holds staff personally liable for their actions, there is a risk that the BRSA will lose its more capable and dynamic staff to the private sector, impeding its ability to move forward. The Bank continues to work closely with the BRSA and to liaise with the GOT on its behalf to ensure it has the resources to effectively carry out its mandate. 5. Major Factors Affecting Implementation and Outcome 5.1 Factors outside the control of government or implementing agency: The financial crisis of February 2001 threw the government's macroeconomic strategy in to turmoil. It was forced to abandon its exchange rate based disinflation program and float the Lira, which immediately lost 30% of its value. The weakness of many of the banks, overly reliant on the overnight interbank and repo markets for liquidity and with excessive short foreign currency positions, were quickly exposed. With the banking system in danger of collapsing, the government was forced to recommit itself to its financial sector reform program and to overcome the strong political forces which had previously slowed the pace of reform. 5.2 Factors generally subject to government control: The policy actions supported by the FSAL that were subject to Government's control and were scheduled for implementation prior to the February economic crisis were implemented - 7 -  satisfactorily. As mentioned in section 4.2, many of the actions scheduled for implementation prior to the release of the second tranche were carried out, either in their original or in a modified form, in the months preceding the signing of the PFPSAL. 5.3 Factors generally sutbject to implementing agency control: The actions supported by the FSAL that were subject to Treasury's/BRSA's control and were scheduled for implementation prior to the February economic crisis were implemented satisfactorily. As mentioned in section 4.2, many of the actions scheduled for implementation prior to the release of the second tranche were carried out, either in their original or in a modified form, in the months preceding the signing of the PFPSAL. 5 4 Costs andfi nancinig N/A 6. Sustainability 6.1 Rationale for sustainability rating: One of the major risks to the success of the FSAL program was that the political will to carry through the banking reforms and to resist those members of the Government with a vested interest in maintaining the status-quo would not be sustained. Many of the early actions undertaken as part of the FSAL program were designed to transfer direct power away from central government to quasi-autonomous professional bodies. Thus the powers of the BRSA have been expanded and a professional management structure, supported by modem information systems, is being developed. Control of the State banks has been transferred from line ministries to a professional management board, mandated to restructure the banks and prepare them for privatisation. The SDIF, which prior to the 1999 Banking Act was part of the Central Bank of Turkey, and had for many years been unsuccessful in the resolution of insolvent banks, has since 1999 dealt with 18 insolvent banks and has either sold or closed 10 of these banks. In the regulatory field, much of the groundwork for FSAL was laid during the execution of the Export Finance Intermediation Loan (EFIL), which became effective in October 1999. EFIL, intermediated by Turkey's leading banks, mandated that participating banks adhere to intemational standards in the areas of credit, foreign exchange and capital management. The Turkish bankers' Association took a great deal of interest in this 'comprehensive risk management' approach and subsequently, with the assistance of the Bank, organised a risk management seminar for the country's leading bankers. Thus a consensus began to develop among Turkey's leading banks for the need for regulatory changes in the banking sector and for the adoption of modern banking practices. The crises of November 2000 and February 2001 have highlighted to the whole community the necessity for change in the sector and have helped to anchor the reforms adopted under FSAL. 6.2 Transition arrangement to regutlar operations: N/A 7. Bank and Borrower Performance Bank 7.1 Lending: The Bank's performance during loan preparation was highly satisfactory. The August 1998 crisis in Russia and the situation in the Asian countries, necessitated a review and analysis of Turkey's policy and regulatory framework and a vulnerability assessment of the banking sector. Such a review was undertaken by a Bank mission in November 1998, and based on the assessment of this - 8 -  mission, a financial sector reform agenda and the Bank's financial sector assistance strategy for Turkey was developed. This assistance strategy was further reviewed and updated during 1999 and early 2000 as part of ongoing sector dialogue and the new Country Assistance Strategy. Subsequently, the Bank worked in close collaboration with the GOT and the regulatory agencies to agree on the policy measures that would form the basis of the adjustment operation. During loan preparation, Bank staff specialized in banking regulation and supervision provided assistance to Treasury's technical staff in drafting new norms and regulations. The Bank was also quick to respond to a request for technical/advisory support when the Savings Deposit Insurance Fund (SDIF) was considering intervening in 5 insolvent banks in late 1999. The banking sector liquidity crisis in November 2000 threatened to derail or, at the very least, delay the implementation of the program. The Bank and the Borrower committed considerable resources to the project and despite the problems occurring in the sector, the project was declared effective several weeks ahead of schedule. 7.2 Stupervision: FSAL was a heavily front-loaded operation, with much of the policy and regulatory reforms being carried out prior to Board presentation. Following the February economic crisis, the second phase of FSAL was cancelled, however, the Bank continues to actively engage the Government in dialogue over reform issues and through the PFPSAL and the PFPSAL II (approved by the Board April 16, 2002) remains committed to support the broad reform agenda laid out in the FSAL MOP. 7.3 Overall Bank perfonnance: Overall, the Bank performance in this operation has been satisfactory. Borrower 7.4 Preparation: The Borrower's performance during preparation was satisfactory. The Undersecretariat of Treasury and the BRSA worked in close collaboration with the Bank in defining the scope and content of the policy measures to be implemented under this operation. However, during preparation, there were some delays by the Borrower in the implementation of the FSAL conditions related to restructuring and privatization of state owned banks which delayed the FSAL by approximately six months 7.5 Governnment implementation perfornzance: The Government implemented all the agreed first tranche policy measures before Board presentation. The Government's performance was satisfactory. 7.6 Implementing Agency: The two main agencies involved in implementing the policy measures supported by this operation were the Undersecretariat of Treasury and the BRSA. The performance of both agencies was highly satisfactory. 7.7 Overall Borrower performance: Overall, the Borrower's performance in this operation was satisfactory. -9-  8. Lessons Learned The critical lessons from this operation are summarized below: * a serious macroeconomic stabilization program for the overall economy, which is successfully implemented and adhered to by the Government is essential for the success of financial sector reforms (and vice-versa); * a high degree of political ownership and consensus behind the reform program are necessary preconditions for the successful adoption and implementation of financial sector reforms. In an environment like Turkey, where the counterparts are often not the decision makers but are answerable to elected officials with vested interests in maintaining the status-quo, there is a problem of ownership of the reforms; * good preparatory work needs to be conducted and consensus developed amongst all stakeholders. The intellectual groundwork laid by the Bank through the Banking Sector Review, EFIL and the risk management workshop allowed it to react quickly and to take on a leadership role in the resolution of the banking crisis. * there is sometimes a risk of overestimating institutional capacity; programs need to be designed with a sharp focus on institutional issues. 9. Partner Comments (a) Bor-ower/implementing agency: I. THE EVALUATION OF OBJECTIVES, DESIGN AND IMPLEMENTATION OF FSAL FSAL (Financial Sector Adjustment Loan) included specific targets designed to achieve an efficient, sound and healthy banking system. To achieve these objectives, the required strategic actions were planned and scheduled in a matrix. This framework was well-specified and reflected the necessary stages to achieve the ultimate goal of establishing an ideal banking system competitive in quality and performance at international standards. However, we suppose that in trying to accomplish the objectives of the FSAL the anticipated performance of the BRSA and the Treasury could have been much more satisfactory if more realistic FSAL benchmarks had been targeted and full consensus of WB mission and the BRSA staff had been achieved on some of those targets, considering the prevailing economic conditions. The FSAL objectives along with related measures taken in each area are summarized below. i. Creation of the BRSA According to the Banking Law, enacted in late December 1999, the Banking Regulation and Supervision Agency (BRSA) was established with high independence and authority. - 10 -  ii. Bringing regulations up to intemational standards Under the regulations that were issued to meet the international standards, the FX position rule and the capital adequacy rule started to be required both on consolidated and unconsolidated basis. Moreover, the loan loss provisioning rule has been anended to determine the principles and procedures for the classification of loans and other receivables of banks according to their characteristics and for the provisions to be set aside. Also new, it is stated in the "Regulation on Bank's Intemal Control and Risk Management System" issued on 8 February 2001 that banks shall establish an intemal supervision (control/audit) system and risk management systems in order to monitor and control the risks they are exposed to. In addition, revised limits have been imposed on the banks participation in non-financial institutions. Banks' non-financial subsidiaries are limited to 15% of total net worth and the sum of all such subsidiaries is limited to 60% of total net worth with a transition period until 2009. In addition, other regulations finalized under the FSAL conditions are as follows; the "Regulation on the Establishment and Operations of the Banks" issued on 27 June 2001 identified the definition of indirect ownership of shares in order to extend the concept of connected lending. The communique on the establishment and operations of banks has been put in force in order to strengthen the regulatory framework. Regarding to this amendment, lending principles and procedures definitions of indirect shareholding, indirect lending and indirect participation and non-cash credits have been taken into account in calculation of lending limits. In line with the new Bank Capital Accord, the market risks both on consolidated and solo basis have been incorporated in the calculation of Capital Adequacy Ratio and implementation of the rule will start by 2002. uii. Resolution of non-viable banks The Savings Deposit Insurance Fund (SDIF), which is charged with the resolution of insolvent banks, was transferred from the Central Bank of Turkey (CBT) to the BRSA in August 1999. In order to provide empowerment to the "bank failure resolution entity", a new set of legal tools was introduced, operating guidelines were stated and the bank failure resolution roles and authorities were shared between the BRSA and the SDIF respectively. However, FSAL has envisaged that the SDIF should follow the principle of "least cost resolution" for the existing pipeline of the problem banks. Closing SDIF banks and putting them into liquidation would be a good idea if there were enough funds to pay off all deposits. We believe this could have been a resolution alternative in a rising economy with no potential to generate new non-viable institutions or when there are substantial back-up funds to finance all such operations. Also, the blanket guarantee imposed over all liabilities of the SDIF banks by FSAL has paradoxically brought an unpredictable burden on SDIF although there wasn't a serious deposit withdrawal rationalizing such a scheme. iv. Resolution of the present pipeline of problem banks -1 1-  Despite being dropped in PFPSAL, the FSAL condition for the establishment of a special unit to deal with problem banks was inappropriate taking into account the difficulty to preserve confidentiality in such circumstances. We consider the existing segmentation of duties at the BRSA and the functions of the Enforcement Department enables us to handle bank failure resolutions effectively without endangering reputation of any bank. v. Privatisation of state-owned banks In order to prepare the state-owned banks for privatisation, the Government has appointed a joint board for the management of these banks. The sizeable overnight liquidity needs of these banks was eliminated, and the stock of repurchase agreements of state and the SDIF banks with the CBT was brought to reasonable amounts. The three state banks, Ziraat, Halk, and Emlak with negative net worth have been recapitalised. Since its initiation, the FSAL program successfully encompasses the basic incentives, objectives and policies necessary for the comprehensive strengthening of the Turkish financial system. As stated in the report prepared by the World Bank, significant improvements have been achieved in restructuring of the banking sector during the maturity of the FSAL credit; in particular, creation of the Banking Regulation and Supervision Agency (BRSA), strengthening the prudential regulations and restructuring of state-owned banks. The potential distortions created by the state-owned banks were prevented by both additional regulations and capital injections. "The Basel approach" requires that a bank should maintain minimum capital in relation to its risks. In Turkey, it is still debatable for most of banks that capital or the risks corresponding to it are measured accurately. However, given the risk of a banking sector originated crisis that accumulated in the last decade, prudent supervision along with transparency of the banking sector has been a key issue to overcome for a long time. In this context, designing a reform program with the objective of efficient, sound and healthy banking system was very essential and appropriate. Even though Bank regulatory and supervision Entity (BRSA) has been established and prudent supervision rules have been put in force, after February crisis and the following months with negative growth rates in the economy, one may still doubt about the transparency of the banking system, especially in terms of quality of assets. This is very important as we prepared a draft law for restructuring the real sector debt to financial sector, based on "Istanbul approach". State banks having restructured assets may look healthier for the time being. Even if that's true, Istanbul approach may have a fiscal cost. Recently, the recapitalisation issue has always been the Treasury's liability at the end as it was for SDIF banks, except for some big private banks. Therefore, before restructuring the real sector debt we need to know if the current picture of the - 12 -  NPL is accurate to estimate how much burden is coming. Then we can debate about how much or any of the burden can the Treasury undertake. Designing a restructuring plan for the real sector without incorporating financial data in it in today's macro-economic conditions is risky. This underlines the importance of information exchange among related parties about restructuring issues. As for the commercialisation and privatisation of the state banks, so much has been done. In summary, financial restructuring is mostly finished while operational restructuring is to be finished by end 2002. The new board of management is capable of decision making within the recent extensive legal amendments. It could be argued that, in this component, there should have been a management-contract signed by the board members and the government in order to minimize the risks while saving some precious time in debates of restructuring. Turkey adopted a three-year disinflation and economic stabilisation program in 1999. The most important reason that led Turkey to imnplement this program was an increasingly deteriorating public finance and its impacts on the economy. This prograrn also covered structural reforms including strengthening the banking regulation. To this end, FSAL was implemented. The resource available within FSAL to tackle the financial sector problems, mainly caused by increasing public sector borrowing requirements and deteriorating fiscal position of public banks as well as loose banking system control which definitely did not contribute to a healthy growth, is believed to be insufficient to alleviate the negative impact of a rapid reform process on public resource/utilisation disequilibrium. The squeezing of the public spending imposed by tight fiscal policies has created a controversial environment when it coincided with the need for sizeable spending to make the necessary adjustments to financial sector. This is why the Bank financing under FSAL devoted to this purpose was not sufficient, taking into account the financial constraints. As for the preparation and implementation stages of FSAL, falling into the same time schedule with Stand-By Arrangement, it would not be wrong to say that the delay in signalling a political commitment to further implementation of the programme followed by some negative externalities led to an inevitable underperformance of the borrower. During the healing of the economy, the reforms related to financial sector are the most costly ones to the government. A rapid progress in this area is against the facts of the fiscal stance of Turkey. Although FSAL aimed to assist the country in laying the basis for reducing financial vulnerability, the stiff measures and constraints imposed, which had to be achieved in a short period of time, hindered its further success. Nevertheless, significant progress has been maintained and measures undertaken under the shadow of two financial crises. Reform measures had to be implemented with parallel to the country's structure. The Bank should have weighed and appraised the authorities' point of view while adopting certain measures and - 13 -  actions in the reform program. Promises and policy goals had to be reviewed and designed whether they could be materialized in such a limited period. Instead of bringing limits, intervals could have been imposed for the measures both by taking into consideration Turkey's country specific conditions and financial system's fragility. FSAL's second tranche was cancelled 61/2 months after effectiveness and hence many of the actions envisaged for second tranche release were not carried out under this program but with the PFPSAL. Programmatic errors should have foreseen beforehand and the scope of the reform program had to be planned attentively at the outset. II. THE GOVERNMENT OF TURKEY'S PERFORMANCE DURING PREPARATION AND IMPLEMENTATION OF THE FSAL The three state banks, Ziraat, Halk, and Emlak with negative net worth have been recapitalised, with the net cost to the public sector amounting to TL 27.6 quadrillion. Similarly, the SDIF banks have been recapitalised to cover their negative net worth, with a net cost to the public sector of TL 16.3 quadrillion. Overall, the government has provided a serious effort to restructure the Turkish banking system. The financial crises of November 2000 and February 2001 both increased the cost of the restructuring of the banking sector on government finance and created additional burden on the banks as well as the real sector. The long-standing weaknesses of the system were well realised by the Government of Turkey (GOT) and the November 2000 and February 2001 crises made it inevitable and critical to speed up the process for taking urgent and timely measures. The GOT, at every stage, moved rapidly to implement the required actions as far as conditions permitted. On the other hand, the severe contraction in the economy has aggravated the problem of non-performing loans of the banking sector. The collaborative works between banks and firms have been continuing to eliminate the problem. We believe that alternative approaches regarding the recapitalisation of the banking sector and the solution of non-performiing loans' problem should be considered in the following programs together with the satisfactory additional funding. Regarding the comments on SDIF as part of the Central Bank expressed in the first paragraph of Section 6.1 of ICR, we would like to stress out the fact that until the June and December 1999 amendments to the Banking Law which aimed at strengthening the exit conditions and resolution criteria for problem banks, there did not exist a sufficient regulatory framework for the effective resolution of such banks. Furthermore, the strengthening of such a framework is an ongoing process which necessitated further steps even in May 2001 amendments to the Banking Law. - 14 -  Additionally, the fact that a successful financial sector reform is definitely essential for implementing an effective macroeconomic stabilization program for the overall economy should not be overlooked. The role of the Central Bank within this framework and in maintaining macroeconomic stability is crucial. The independence of the Central Bank is enhanced by the May 2001 amendments to its Law and following the establishment of the BRSA, the Central Bank now assumes more comprehensive responsibilities in macroprudential supervision of the financial institutions based on its main target of maintaining "price stability" and hence, "financial stability". Within this framework, the Central Bank is an essential and a complementary component of the supervisory and regulatory process and the importance of close cooperation and consensus amongst all the responsible bodies involved in this process should be a priority for the continued success of the operation. HI. THE WORLD BANK'S PERFORMANCE DURING PREPARATION AND IMPLEMENTATION OF FSAL The World Bank put extensive time, effort and resources to the operation in close cooperation with GOT, to thoroughly understand the structure and components of the system, main practices as well as the regulatory and supervisory processes in order to come up with problem areas and the necessary solutions. In our opinion, all the parties to the FSAL program has shown a satisfactory performance despite the tough conditions of two severe crises. At this stage of the operation, the prospects are promising. The timing of the assistance was very critical for the success of the financial sector program within the framework of FSAL. Nevertheless, Turkey did not have immediate access to funds by the Bank but in the aftermath of two shocks. We believe the total cost of banking restructuring could have been much less if we had these resources available in time to help avert the risk of financial crisis before they transform to systemic risks. (b) Cofinanciers: N/A (c) Other partners (NGOs/pi-ivate sector): N/A 10. Additional Information -15 -  Annex 1. Key Performance Indicators/Log Frame Matrix Outcome I Impact Indicators: ____________ndlcat6r1Mdtr_i__ IrkDaist. I- r Jct ,1' d as Pb 'Est|mat, i Not applicable as this is an adjustment opemrtion. Output Indicators: -.''-; InIeatbrIMaix ' r ! proJect d In last PSR.e.-. ; . -. -_tual/Latest Estimate? Not applicable as this is an adjustment operatlon. End of project -16 -  Annex 2. Project Costs and Financing Project Cost by Component (in USS million equivalent) t . .k S-- , !,' " ; =to. X,, ,rgoE.,ct,,Co, st'