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 DevelopmentSouth Asia Regional Office

CURRENCY EQUIVALENTS

(Exchange Rate Effective May 31, 2002)

Currency Unit = Nepalese rupeeI rupee = US$0.01284

US$1.00 = rupee 77.881

FISCAL YEARJuly 15 - July 14

ABBREVIATIONS AND ACRONYMS

Vice President: Mieko NishirnizuCountry Manager/Director: Kenichi Ohashi

Sector Manager/Director: Joseph Del Mar PerniaTask Team Leader/Task Manager: Simon C. Bell

NEPALFINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT

CONTENTS

A. Project Development Objective Page

1. Project development objective 22. Key performance indicators 2

B. Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 32. Main sector issues and Government strategy 43. Sector issues to be addressed by the project and strategic choices 8

C. Project Description Summary

1. Project components 102. Key policy and institutional reforms supported by the project 103. Benefits and target population 114. Institutional and implementation arrangements 11

D. Project Rationale

1. Project alternatives considered and reasons for rejection 112. Major related projects financed by the Bank and other development agencies 123. Lessons learned and reflected in the project design 144. Indications of borrower commitment and ownership 155. Value added of Bank support in this project 16

E. Summary Project Analysis

1. Economic 162. Financial 163. Technical 174. Institutional 175. Environmental 186. Social 187. Safeguard Policies 19

F. Sustainability and Risks

1. Sustainability 202. Critical risks 203. Possible controversial aspects 21

G. Main Conditions

1. Effectiveness Condition 212. Other 22

H. Readiness for lmplementation 22

I. Compliance with Bank Policies 22

Annexes

Annex 1: Project Design Summary 23Annex 2: Detailed Project Description 26

Annex 3: Estimated Project Costs 31Annex 4: Cost-Benefit Analysis Summary, or Cost-Effectiveness Analysis Summary 33Annex 5: Financial Summary for Revenue-Earning Project Entities, or Financial Summary 34Annex 6: Procurement and Disbursement Arrangements 35Annex 7: Project Processing Schedule 43Annex 8: Documents in the Project File 44

Annex 9: Statement of Loans and Credits 45Annex 10: Country at a Glance 46Annex 11: Financial Sector Strategy Statement 48

MAP(S)

NEPAL

Financial Sector Technical Assistance Project

Project Appraisal DocumentSouth Asia Regional Office

SASFP

Date: November 13, 2002 Team Leader: Simon C. BellSector Manager/Director: Joseph Del Mar Pernia Sector(s): Banking (100%)Country Manager/Director: Kenichi Ohashi Theme(s): State enterprise/bank restructuring andProject ID: P071291 privatization (P), Corporate governance (S), RegulationLending 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 CreditGrace period (years): 10 Years to maturity: 40Commitment fee: 0.5 Service charge: 0.75%Financing Plan (US$m): Source Local Foreign TotalBORROWER 4.10 0.00 4.10IDA 0.00 16.00 16.00UK: BRITISH DEPARTMENT FOR INTERNATIONAL 0.00 10.00 10.00DEVELOPMENT (DFID)Total: 4.10 26.00 30.10

Borrower: THE KINGDOM OF NEPALResponsible agency: NEPAL RASTRA BANKAddress: Nepal Rastra Bank, Baluwatar, Kathmandu, NEPALContact Person: Governor, Nepal Ratsra BankTel: 977-1-410386 Fax: 977-1-410159 Email: bkprornotahtp.com.np - another email -

nrbgov(rnos.co.np

Other Agency(ies):Ministry of FinanceAddress: Ministry of Finance, Bag Dubar, Kathmandu, NEPALContact Person: Secretary, Ministry of FinanceTel: 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 1.53Cumulative 2.50 7.10 11.10 14.47 16.00

Project implementation period: March 2003 to June 2007Expected 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 renewedefforts of His Majesty's Government of Nepal (HMGN) to improve the sector in order to bringmacroeconomic stability and promote private-sector-led economic growth. The proposed FinancialSector Technical Assistance Project is the first major step in this process and focuses on three broadobjectives (a) helping to restructure and re-engineer the Central Bank (Nepal Rastra Bank - NRB), so thatit can effectively perform its key central banking functions; (b) commencing commercial banking reformin the two large ailing commercial banks that dominate the sector (Rastriya Banijya Bank (RBB) andNepal Bank Limited (NBL)) -- by introducing stronger bank management that protects the financialintegrity of the two banks and would take on a conservator role to prepare the banks for the next steps ofrestructuring; and (c) supporting a better environment for financial sector reform in areas such asenhanced credit information, better financial news reporting, and better training for staff in financialinstitutions. These actions will help create a more prudently operated and commercially viablecommercial banking system that is overseen by a modem, effective, and technically competent centralbank. If sufficient progress is made during this first phase of reform, then subsequent IDA support wouldfocus 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 coverthe 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 ofseveral, sequential projects. The first of these - the Financial Sector Technical Assistance Project - iscentered around the re-engineering of Nepal Rastra Bank (particularly in its core central bankingfunctions; supervision, monetary policy, banking legislation, accounting and auditing, informationtechnology; 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 ofthe 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 thatare necessary to prepare for a major reform operation. This initial phase will also serve to demonstrateand confirm broad-based commitment to undertake difficult reforms. This sequential approach tofinancial sector reform has been endorsed by colleagues in the International Monetary Fund (IMF), theDepartment 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 isexpected to (a) support private-sector-led economic growth and job creation; and (b) reduce the numberof 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 theGovermment -- this represents a transfer of resources from the tax payer in Nepal to the urban rich (whorepresent some of the largest defaulting borrowers in the banking system). A more efficientintermediation of funds should also result in a better allocation of financial resources and hence strongereconomic 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 orliquidated.

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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 enforceprudential regulations and relevant banking legislation - based on internationally accepted norms;

3. An increase in the range and sophistication of financial instruments and services available atcompetitive 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 accompanyinganalysis), 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 (inprocess), and other ancillary financial sector legislation (Companies Act, Bankruptcy Law) withassociated regulations;

3. Producing audited financial data for RBB and NBL, which conforms with international accountingstandards, 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 CreditInformation Bureau; and

7. The production of increasingly better financial data and an enhanced financial performance withinthe 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 sectorgovemance. Poor management of financial resources at RBB and NBL has been one of the mostimportant ways by which the powerful elite has been able to abuse the public institutions. Theinefficiency of the financial sector, in part, occasioned by heavy-handed state involvement. This hasresulted in liquidity problems within the banks, growing nonperforming assets, problems of capitaladequacy, and an increased scope for systemic risk within the sector. The Government's commitment tostopping this will be a major departure from the past and serve to send a clear signal that the oldstandards of govemance are no longer acceptable. The CAS also emphasizes faster growth in Nepal insupport of sustained poverty alleviation. It notes that although the macroeconomy has been stable (eventhough budgets have been consistently unrealistic), growth has been slow and the pace of structuralreform "in areas such as privatization and banking hasfaltered, and growth hasfallenfrom 5.5% inFY91-94 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

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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; and4. the establishment of additional private financial institutions, using the International FinanceCorporation (IFC).

Nepal's macroeconomic situation has deteriorated signiificantly since the last CAS was written -- withgrowing fiscal imbalances, lower levels of investment, and slower growth. Given these problems andincreased macroeconomic uncertainty, avoiding a banking crisis has become even more urgent.

The proposed Financial Sector Program will address these concerns and provide technical assistance toHMGN 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 includes2 large development banks (the Agricultural Development Bank of Nepal (ADB/N) and the NepalIndustrial Development Corporation (NIDC)), 48 finance companies, 13 insurance companies, numerousmicrofinance institutions, 7 Grameen Replicator Banks, 35 financial cooperatives, 25 financialNon-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 financialposition. Political intervention, weak management, disruptive unions, poor financial informationsystems, and a deeply entrenched culture of non-repayment of loans has resulted in a rapid deteriorationof their financial health.

RBB, which represents 27 percent of commercial banking system assets, is estimated to have a largenegative net worth and therefore a capital base that is well below the levels required by generallyaccepted international norms. Although in slightly better financial condition, NBL has similar problemsincluding a high negative net worth. This could have serious ramifications for the Government in termsof systemic risk and could prove to be a severe financial strain on an already delicate budget shouldeither of these two banks face a crisis of confidence with concomitant adverse macroeconomicimplications. 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 orabout 8.6 percent of GDP. The situation in these two banks has inevitably deteriorated considerablysince this date.

In general, Nepal's financial system suffers from the following problems that are also recognized by theGovernment:

The Government's Role. His Majesty's Government of Nepal (HMGN) plays a large direct role in thefinancial 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 singleshareholder); to significant influence over the Joint Venture Banks; the Government's involvement isevident in almost every aspect of financial sector activity. This has resulted in strong politicalinterference in banking activities which, in turn, has resulted in non-repayment of loans, and poorfinancial health throughout the system.

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Nepal Rastra Bank - the Central Bank. Until January 2002, when a new NRB Act was approved, theNRB fell under the authority of the Ministry of Finance. This historical lack of autonomy has hinderedthe NRB's ability to supervise and regulate the banking system adequately. Political influence in theRBB and NBL - as well as their sheer dominance within the banking system - placed these banksoutside the influence and control of the central banking authorities. Although it may take time to becomefully operational, the new 2002 Act provides the NRB with sufficient autonomy and full authority overthe entire banking system. Recently approved banking regulations will also provide the regulatory basisfor NRB to move the system closer to international banking norms while permitting the bank supervisorsto deal expeditiously with errant banks. For the immediate future, the NRB's challenge will be to enforcethe rules that have now been established.

The Government and the NRB need to reorient their activities away from being active participants (asowners and operators) in the financial sector to increasingly focus on becoming more effective regulatorsand 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 bypolitical demands, an active and disruptive union movement, management weaknesses, poor accountingand auditing functions, and high levels of non-performing assets, RBB has reached a particularly parlousfinancial state. A recent audit points to a high negative net worth, weak internal systems, poor internalfinancial management, and shabby operating methods. At the request of the government, a diagnosticreview of the RBB and NBL was carried out by KPMG/Barents in 1999/2000. This study's majorfindings confirm that (a) the banks' management is basically dysfunctional; (b) there are no reliable dataavailable on the loan portfolio; (c) financial accounting is primitive and not according to internationalstandards (accounts are virtually all manual and annual statements have not been produced for over sixyears); (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 andmanagement are highly politically driven and lacking a commercial focus. This work was financiallysupported under a Policy and Human Resources Development Fund (PHRD) grant (TF 025473) for bothRBB and NBL.

The Nepal Bank Limited (NBL). While in somewhat better financial condition, NBL is still a weakinstitution. Its dominant role in the financial sector creates scope for inefficiency and a low level ofbanking competition. Over the 1990s, the Government reduced its stake in NBL by selling parcels ofshares 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 carriedout with the objective of reducing political interference in NBL's management and promoting privatesector 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 bankwithout a single strategic partner with a strong background in commercial banking and internationallinkages with the global economy. Connected lending activities by the new private owners are thought tohave further compromised its operations. As such, it also has many of the same problems as RBB (seeabove) as identified in the KPMG diagnostic.

The Agricultural Development Bank of Nepal (ADB/N). The financial and operational situation of theADB/N, the third biggest bank in Nepal, is also poor. The ADB/N will require restructuring, systemdevelopment, changes in govemance arrangements, and a review of its ultimate role and ownershiparrangements. This bank is being dealt with by the Asian Development Bank. Close coordinationbetween IDA and the ADB mean that actions taken in RBB and NBL are likely to be applied to ADB/N

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to ensure a consistency of approach.

A Weak and Fragmented Legal Financial Environment. Nepal has a proliferation of both laws andregulations that are institutionally rather than functionally focused. This has created a fragmented legalenvironment.

* The Nepal Rastra Bank Act, now superseded by a January 2002 Act, was seriously outdated anddeficient with respect to issues of central bank autonomy, accountability, and governance. Now thatnew legislation has been approved, the challenge will be to ensure that NRB can effectively enforcethe provisions of the new legal and regulatory environment.

* The 1974 Commercial Bank Act is also defective. Most importantly, the act does not cover alldeposit-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 legalarbitrage. NRB has recently completed drafting a new Banking and Financial Institutions Act thatcovers 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 beimportant 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 auditingtradition has meant that the timeliness and reliability of financial data (particularly from the largestbanks) is extremely poor. Corporate sector accounting is also weak, making lending decisions difficultfor 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 toreduce fragmentation and support the more efficient intermediation of funds within the banks andnonbanks. This would increase competitive pressures and thereby provide more efficient andcost-effective solutions to the banking public. Market-oriented approaches also need to be developed toenhance competitive pressures. These are preferable to mandated efforts such as those developed tocontrol interest rate spreads and priority and deprived sector lending.

Other Issues. In addition to the above, the financial sector environment needs to be strengthened inseveral fundamental ways. For example, credit information systems have not been effective tools againstnon-performing borrowers; capacity building in the sector remains very weak; and the general public'slow level of financial sophistication means that it does not serve as an effective check and balance withinthe system. These weaknesses also require attention.

These issues call for urgent reform and modernization. Nepal needs to create the preconditions for thedevelopment of an efficient banking system that is capable of developing new financing mechanisms andinstruments to meet private sector needs. Without such reforms, the prospects for faster growth andultimately poverty reduction will be constrained. However, financial sector development is a long andcomplex process that will take many years, particularly given the very low starting point in Nepal. Theproposed 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.

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Government Strategy. Over the past few years, the Government has undertaken general reformmeasures in the financial sector. These include interest rate deregulation, the phase out of StatutoryLiquidity Requirements (SLR), introduction of modem banking regulations, capital market reforms, andforeign exchange liberalization. However, much remains to be done, particularly with respect toinstitutional reform. To help establish a framework for the way forward, the Government has formulateda Financial Sector Strategy Statement (FSSS) that consolidates its thinking and develops acomprehensive 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. TheFSSS was publicly released and published in the Nepali and English press at the end of 2000. The desirefor reform in the financial sector is further reflected by the fact that the Government has asked for WorldBank, IMF, and Department for International Development (DFID) assistance to proceed with the reformagenda. 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 institutionswhile 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 commercialbanks) 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 toprovide sufficient autonomy in the conduct of monetary policy, banking system regulation andsupervision, and the licensing of banks and nonbanks;

* Improve existing banking and financial legislation and judicial processes for enforcing financialcontracts;

* 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 strongpolitical commitment. As in many countries, bank restructuring issues are likely to be difficult for theGovernment when the time comes for action. For example, although liquidation of RBB is one of theoptions that will be considered, this may not be politically acceptable. Even privatizing the bank to goodforeign-banking interests or splitting its activities into several distinct components may prove difficult toimplement (given its poor financial health, its long public-sector association, and the weak state of theNepali economy). Nonetheless, fundamental reform is required and strong political commitment will benecessary if the reform measures are to be carried through to a point where they make a lasting andirreversible 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; theinstallation 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 anoverarching Government policy on financial sector reform. These activities provide the World Bankwith comfort that the Government is willing to transparently assess the condition of the banks and todevelop credible corrective action plans.

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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 proposesstarting with a strictly limited, but nonetheless ambitious, menu of actions. These focus on key conceptsof strengthening prudential oversight, enhancing the banking sector's financial integrity, and increasingtransparency 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 professionalconservator arrangements (the management teams) in the two large banks (RBB and NBL) ultimatelypreparing them for restructuring and privatization. In addition, the Credit will assist in strengthening theoverall financial sector through technical and financial support for the Bankers' Training Center, CreditInformation Bureau, and financial journalism. See Annex 2 for a detailed description of projectcomponents.

The Goverunent's past performance record demonstrates that carrying out meaningful and far-reachingreform requires significant political capital. Hence, the reform program has specifically been designed tobe narrow and precise. In addition, the absorptive capacity of the Central Bank and the publicly-ownedcommercial banks is such that advances beyond the lirmited (but fundamental) reforms envisaged may notbe possible. Therefore, the program focuses on a limited set of actions within the Central Bankcombined with initial support for restructuring the two largest banks and capacity building for selectedinstitutions. Future support will need to address broader policy issues, including supporting the ultimateprivatization of RBB and the restructuring and reform of NBL.

In terms of sequencing and timing, the technical assistance program is already ongoing with support froma PHRD grant and a PPF used to begin initial consultancies. The PHRD grant supported an initial banksupervisory consultancy and a review of strategic options for RBB and NBL carried out byKPMG/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 politicalinstability 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 underfuture World Bank operations would provide the resources to deal with the financial problems in the statebanks 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 acomprehensive program of financial sector reform, the World Bank sought to develop this program inclose collaboration with the key donors involved in this sector (the IMF, DFID of UK, and the ADB) andthe Government of Nepal. Close cooperation between the main donors is designed to provide strategicleverage to help ensure that difficult political decisions are made when the occasion arises. Ensuringmutually consistent and reinforcing messages through the envisioned IMF Poverty Reduction and GrowthFacility (PRGF) and the ADB's proposed restructuring of the Agricultural Development Bank of Nepal isalso important.

COFINANCING ARRANGEMENTS WITH DFID. DFID has fully endorsed the HMGN's financialsector reform agenda and will provide financial and technical support for this project. DFID hascommitted a US$ 10.0 million equivalent grant to supplement the IDA Credit. The project will be jointlyfinanced by DFID and IDA. The funds will be disbursed in agreed proportions, 62 percent IDA and 38

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percent DFID) on all agreed expenditure items. DFID has agreed that their grant will be administered byIDA and expenditures will be made according to IDA's financial management, disbursement, andprocurement guidelines. A Memorandum of Understanding (MOU) between IDA and DFID has beenprepared which outlines more detailed administrative arrangements between the two donors.

INDEPENDENCE OF NEPAL RASTRA BANK. Although the NRB now has legal independence fromthe 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 theMinistry of Finance. Therefore, the preparation team believes that it is strategically important to workwith the Ministry of Finance when seeking increased independence for NRB. The project also seeks toensure the development of a stronger and more professional Central Bank so that it can ultimatelybecome a stronger constituency for financial sector change (becoming a stronger and more credibleadvocate 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 positionof the RBB and NBL as well as a list of options for their future operation. The report recommendedseveral immediate steps be taken to stem further hemorrhaging of the banks' financial resources. Theseincluded (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) ultimatelyprivatizing 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 theoperational and financial position of the bank; (c) bring in an accounting team to help strengthen theaccounts of the bank; (d) develop a human resources program for the bank which would determine, interalia, a training program, a retrenchment program, and a more appropriate remuneration package for bankstaff; and (e) prepare the bank for privatization/re-privatization. The government accepted theserecommendations and has taken action accordingly.

BUDGETARY PROVISIONS FOR DEALING WITH RBB AND NBL. The existing stock of loanlosses 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 theprivatization of the banks will also need to be budgeted by the Government.

PROTECTION FOR DEPOSITORS. As the reform program proceeds, monitoring liquidity managementwithin the banking system will be important to make sure that depositors' funds are protected. The WorldBank 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 ofbanking will need to be addressed delicately and with some sensitivity. An appropriate balance will needto be struck between ensuring that there is a reasonable country-wide coverage of basic banking servicesand interventions that distort the operation of the banking system. Strategic, ongoing dialogue with theGovernment and with the restructuring/privatization agents will be essential in sensitizing both sides tothe concerns of all parties involved.

GOVERNANCE ISSUES. Additional work on governance issues will be pursued by the managementteams - particularly as they relate to action on non-performing borrowers and the production of auditedfinancial data from RBB and NBL.

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C. Project Description Summary

1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed costbreakdown):

The project has three main components (Table below). Based on its cofinancing agreement, DFID willprovide US$10.0 million equivalent in the form ofjoint financing for this project. The respective DFIDshares for the three components will be: US$1.56 million for re-engineering of NRB; US$8.10 millionfor 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- % ofComponent Costs % of financing Bank-

(US$M) Total (USSM) financingRe-engineering Nepal Rastra Bank 4.68 15.5 2.64 16.5Restructuring 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 3.4Total Project Costs 30.10 100.0 16.00 100.0

Total Financing Required 30.10 100.0 16.00 100.0Note: 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 reformwhich will seek to reorient the role of the Government from active participant in the sector to a strongregulator and supervisor of the financial system. Efforts will be made to achieve this through reforms inthree key areas.

Re-engineering the Nepal Rastra Bank. The Central Bank of Nepal (Nepal Rastra Bank) is aparticularly weak institution. Failure to supervise and regulate banks, produce robust accountinginformation, 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 managementcapabilities, which has resulted in few appropriate incentives for good work. NRB's problems need to beaddressed on many fronts, although the FSTA project will focus initially on a smaller subset of the mostimportant issues. The ultimate aim is to develop a well-run, fully professional public-sector institutionwith adequate oversight of the financial system and monetary policy.

Restructuring RBB and NBL. This will involve commencing a process, with professional managementteams, which will ultimately permit a fundamental change in the existing ownership and governancearrangements within these two banks. After a period of intense restructuring, the Government's preferredoption 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 afundamental and sustainable change in these banks so that they no longer act as a drag on financial andreal sector development.

Capacity Building in the Financial Sector. In support of the above reforms, it will also be necessary toimprove human resource capacities in the financial sector and to ensure better checks and balanceswithin the system by developing greater public awareness of financial sector issues. Training for thefinancial sector will be provided through an upgrading of the Bankers' Training Center activities, and its

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conversion into a more independent Bankers' Institute. Improved public awareness will be achieved bysupporting better financial journalism in Nepal. Lastly, better credit information will be supported undera 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 financialsector, which will contribute to macroeconomic stability and growth. A secondary benefit of theprogram 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 bylending support to the establishment of a more dynamic, private-sector led and potentially faster growingeconomy.

4. Institutional and implementation arrangements:

A Coordination and Support Team (CST) has been formed within Nepal Rastra Bank under the BankingOperations Department to administer this project. The Executive Director of the Banking OperationsDepartment heads the CST and provides overall guidance and leadership on matters of projectimplementation. The CST is supported by a dedicated Financial Management Specialist who is aqualified professional accountant and by a dedicated Procurement Specialist. The CST is also supportedby adequate ancillary staff and facilities. The operating costs of the CST will be funded under theproject on a declining cost basis over the project implementation period. These operating costs includecommunications, office supplies and materials, incremental staff costs, and other expenses which will bejointly 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 financialmanagement capacity assessment of the implementing agency, Nepal Rastra Bank, was carried out byWorld Bank financial management specialists during appraisal. The project has adequate financialmanagement arrangements in place to account for and report on project expenditures. To mitigatepotential financial management risks and to strengthen the financial management capabilities of NRB, afinancial management improvement component has been designed and built into the project to ensurethat noted deficiencies are appropriately addressed. Terms of reference for consultancy services to helpimprove the accounting capacity of NRB have been agreed and advertised in the local and internationalpress (including the UN Development Business). The proposed consultancy services are expected to becarried out in three phases. The first phase is a diagnostic and planning phase and will identify the areasthat need improvement resulting in the development of a time-bound action plan to address anyweaknesses. The second phase will implement the agreed actions. The third phase will include intensivetraining for NRB staff and a follow-up evaluation of the impact of the financial managementimprovement program. These steps will build on the good initiatives that are already underway withinNRB to ensure the establishment of a robust financial management system. Annual project financialstatements, SOE's, and special account statements will be audited by the Office of the Auditor Generaland submitted to IDA within six months after the end of the fiscal year. NRB entity financial statementswill be audited by a certified private auditor who will be appointed by the Auditor General and submittedto 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 broaderfinancial 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 andthe two development finance institutions. However, given the primacy of the problems in the CentralBank and the two largest commercial banks, in combination with the Government's own limitedimplementation 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 withthe problems in the largest state-owned banks -- are initial steps in the overall reform program that arelikely to have the biggest impact. Going beyond this initial agenda is not considered plausible at thisstage 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 privatebank). However, this option was strongly rejected by our donor partners, the IMF and DFID, as well asby ourselves, as representing an "unduly limited" reform agenda, which may not have the desireddemonstration effects for the next phase of reform. The design team therefore ruled out the omission ofNBL (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 SupervisionSector Issue Project (PSR) Ratings

(Bank-financed projects only)Implementation Development

Bank-financed Progress (IP) Objective (DO)

Financial sector reform -- including Structural Adjustment Credit S SCBPASS under which RBB and NBL (SAL) II (June 1989)were both recapitalizedSecond Structural Adjustment Credit(Cr. No. 2046-NEP) - was approved inJune 1989 and was closed in July1992. The ImplementationCompletion Report (Report No. 12871)was prepared in March 1994.

Financial Sector Adjustment Operation Banking Sector Adjustment(planned for FY05) to cover the cost of Operationretrenchments in RBB and NBL (toprepare them for privatization) andNRB (to assist in the Central Bank'sre-engineering process).

Other development agenciesAsian Development Bank (ADB): Third Small Farmers'Support for small farmers' Developmentdevelopment. $30 million. October1990, Credit Number 1037.

Asian Development Bank: Credit lines Sixth Agricultural Creditin support of rural credit through theAgricultural Development Bank of

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Nepal. $35 million. October 1991,Credit Number 1112.

Asian Development Bank: Support for Capital Market Development Ithe development and strengthening of a Capital Market Development HStock Exchange in Nepal. CMD I,$187,000, April 1992, TA Number1689. CMD II, $596,000, July 1997,TA Number 2834.

Asian Development Bank: Micro-Credit for WomenMicro-credit support project forwomen.$5.0 million June 1993, CreditNumber 1237.

Asian Development Bank: Support for Rural Micro-Financemicro-finance activities in rural areasof Nepal. $20.0 millionDecember 1998, Credit Number 1650.

Asian Development Bank: Financial Sector RegulationStrengthening corporate and financial and Governancegovernance in the private and financialsectors. $150,000 August 1997, TANumber 3134.

Asian Development Bank: Ongoing Improvement of Disclosuresstrengthening of corporate governance and Corporate Governanceand disclosure standards.$150,000 December 1998, TA Number3136.

Asian Development Bank: Reviewing Sector Development Programnon-bank financial institution (NBFI)disclosure standards, supervision offinance companies, as well as aninvestment and technical assistancecomponent.

Asian Development Bank: Review of Rural Credit Reviewrural credit in Nepal.$588,000 January 1991, TANumber1476.

Asian Development Bank: Review of Feasibility of Establishing athe establishment of a leasing company Leasing Operation in thein Nepal. $74,000 February 1991, TA Private SectorNumber 1484.

Asian Development Bank: Review of Institutional Strengthening of

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ways to strengthen the operations of the ADB/NAgricultural Development Bank ofNepal. $690,000 April 1993, TANumber 1871.

Asian Development Bank: Review of Rural Financerural finance in Nepal. $500,000August 1997, TA Numnber 2836.

International Monetary Fund: General PRGF Program - withProgram Support. Preparatory Mission emphasis on financial sectorin December 2000. reform, fiscal reform, etc.

KFW: Funding of the Nepal Industrial Industrial Finance IIDevelopment Corporation (NIDC). DM2.0 million (1996)

Industrial Finance mDM3.0 million (1974)Industrial Finance IVDM5.0 million (1982)Industrial Finance VDM5.0 million (1989)

DEG, Germany. Equity Participation DMI.0million (1991)

GTZ, Germany. Small Farmers' DevelopmentProgram SFDP (TA). Phase IDM3.7 million (1987-92)SFDP (TA) Phase IIDM2.0 millionSFDP (TA) Phase HIDM2.6 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 thatproject] was:

(i) Lack of commitment by the Government to change its basic attitude towards the state-ownedbanks, including a much stronger emphasis on commercial orientation and on preparation for eventualprivatization;

(ii) Absence of an Action Program did not require the Govemment to introduce drastic changes inthe 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 andoperational performance of the banks."

The current operation has dealt with these lessons by not proceeding with IDA financing until there hasbeen upfront commnitment and action by the Government to carry out fundamental reforms in bankingsupervision generally and in the governance arrangements within the state owned bank RBB and in NBL,

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in particular - starting with the placement of external management teams in the two banks. Thedevelopment of an overarching framework for financial sector reform - as encapsulated in the FinancialSector 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 regulatorbe enhanced. This project aims to enhance the bank supervisory technical skill of NRB so that it canbecome increasingly more professional and autonomous;

(b) Legal framework reforms are critical to ensure successful implementation. This project hassupported the revision and modernization of key banking legislation. A new NRB Act, providing theCentral Bank with significantly more autonomy, was approved in January 2002. A new Banking andFinancial Institutions Act is currently under discussion within the banking community. Further legalreforms, including measures for debt recovery, and registration and prioritization of liens, are alsoenvisaged 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 initialcommercial banking reform;

(d) Reforms should include rationalization of processes and procedures and should be backed byvigorous enforcement. The project will deal with procedures in the Central Bank and will provideassistance 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 apurposely limited agenda of focused activities;

(f) Forcing reforms from outside is not sustainable. Strong borrower commitment will produce thegreatest chance of success. This commitment appears to be in place as evidenced by the development ofthe Financial Sector Strategy Statement, the appointment of a professional management team in NBLand a professional CEO in RBB, and the ongoing close liaison between NRB and the Ministry ofFinance on all aspects of the financial reform process; and

(g) Re-capitalizing commercial banks without fundamental reforms in the ownership and governancestructures of the banks is not likely to be successful. Any injection of capital into RBB and NBL willonly be supported at the point of privatization/liquidation or some other acceptable change ingovernance arrangements within these banks.

4. Indications of borrower commitment and ownership:

HMGN has requested World Bank support for financial sector reform. The Government recognizes theproblems caused by RBB and the fact that its unhealthy financial position poses a serious problem for thesector and, potentially, for macroeconomic stability. There is also recognition that the process ofprivatizing 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 ofstate-owned companies to be privatized; contracting TA under a PHRD grant to reconstruct the accountsof RBB (for 1996 to 1998); contracting a consulting company to review options for the future of RBBand NBL; and appointing an external bank supervisor to help strengthen the bank supervisory capacitiesof NRB. It has agreed to the options laid out in the consultant's study, including recruiting twomanagement teams to take over RBB and NBL and completing the FSSS and adopting it as officialGovernment policy. To maintain the momentum of these preparatory activities, the Government

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requested a Project Preparation Facility advance. The PPF (No. Q183-0-NEP), in an amount ofUS$550,000, was approved in September 1999, for the financing of required consultancies and trainingactivities. It was supplemented with another PPF of US$600,000 (No. Ql83-l-NEP) in 2002 for partialpayment for the NBL Management Contract and consultancies of RBB. These actions indicate that theGovernment recognizes the problems it faces in the financial sector and that it wishes to pursue atransparent process of clarifying and quantifying the true extent of the problem, reaching agreement onthe most workable options for dealing with these issues, and acting in a decisive manner. TheGovernment of Nepal has also kept a close dialogue with DFID on various development issues includingfinancial sector reform.

The FSSS outlines and clarifies for both the Government and the World Bank the issues within the sectorthat the Government has prioritized. Equally important has been the Central Bank's action to remove theold board of NBL, as the private sector members were particularly disruptive in moving towards theplacement 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 beuseful in the implementation of the proposed Nepal program. The Bank is also a significant source ofdevelopment assistance in Nepal and - in concert with the IMF, DFID, and the ADB - will be able topresent 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 hasprovided an opportunity for close collaboration. Financial sector reform (along with fiscal reform) arealso 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 andwill establish a track record of cooperation between our two agencies in the area of financial sectorreform -- 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'sfinancial difficulties would have serious systemic consequences with a clear adverse impact on overallmacroeconomic 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 RBBor NBL -- would create serious financial/fiscal constraints on the Government as the largest owner ofthese banks. There are losses in RBB and NBL of as much as $450 million and these losses need to berecognized and dealt with as part of a privatization and/or liquidation exercise. This will need to bebudgeted by HMGN.

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Fiscal Impact:

The proposed project will assist the Government in reducing its involvement in the financial sector andthereby in reducing its exposure to losses within the banking system. While strengthening the CentralBank and restructuring of RBB and NBL will require considerable government financing in the short- tomedium-term, the long-term fiscal impact is likely to be positive if the expected results flow from theproject. The obligation to repay the IDA loan will also be over 40 years during which time thegovernment's control and involvement in the financial sector will be minimized. At the same time, astronger 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 highquality advice and expertise. The proposed IDA Credit will fund expert managers to provide this supportover a three-year period. Within the Central Bank reform component, technical assistance will also beprovided 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 toNRB. The re-engineering of NRB is considered crucial to the establishment of better macro-monetaryand financial system management. This institutional strengthening program will, nonetheless, take time.Dealing with the state-owned banking institutions, their restructuring and eventualprivatization/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 - theMinistry of Finance, NRB and the National Planning Commission (NPC). The primary implementationresponsibility, however, will rest with NRB and the Coordination Support Team (CST) within theBanking Operations Department. The establishment of a capable CST and the delegation of full projectadministration responsibilities to this team have been important prerequisites in ensuring smoothimplementation.

4.2 Project management:

The CST has established an efficient management information system and has finalized the Borrower'sProject 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 roleunder 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-termconsulting 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 beaccording to the World Bank Guidelines (Standard Bidding Documents: Procurement of Goods - January1995, 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 expertto help streamline procedures.

4.4 Financial management issues:

Financial Management Risks and Risk Mitigation Measures. The financial management risk at theproject level is low with the integration of the CST with the Banking Operations Department of NRB and

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the recruitment of a qualified professional accountant as the financial management specialist and aqualified procurement specialist. However, there are some potential risks at the project level which willbe 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 processesas per IDA's procurement guidelines and disbursement procedures; (c) instituting a mechanism tominimize layers of bureaucracy in procurement decisions inherent in NRB; and (d) assuring that the coreCST 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 ownlegal requirement to submit audited Financial Statements within four months of the end of the financialyear. Currently, the average delay in auditing the financial statements is about ten months. Through thecapacity building component this issue will be addressed by assisting NRB to upgrade its capacity tomeet its own fiduciary requirements of completing the annual audited financial statements within fourmonths and improve the quality of financial statements in a timely manner. These changes also meet theWorld Bank's minimum requirements.

The new NRB Act has given a high priority to improved financial management within NRB and requiresit to (a) upgrade accounting to international accounting standards; (b) ensure that at least one of theBoard members has professional expertise in finance or accounting or banking; (c) constitute an AuditComnmtittee headed by one of the Board members; and (d) strengthen the internal audit capacity andcommission an internal auditor either through allotting staff or by recruiting professional audit finrnsfrom 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 (includingconsultationi 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 EAreport on the environmental impacts and proposed environmient management plan? Describemechanisms 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 theenvironment? 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 socialdevelopment outcomes.

The proposed project will have positive social impacts of protecting the small depositors who are likelyto be hurt if a banking crisis develop. There is a potential social impact from the suggested reforms interms of their impact on banking services in rural areas. There are also possible social imnplications fromlarge scale redundancies following restructuring and privatization of RBB and NBL. Given theperceived delicacy and political sensitivity of the proposed reform and the understanding that this is

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likely to be an extended process over a number of years, these issues will need to be properly studied andsensitively administered. An analysis of various stakeholder perceptions of the reform agenda couldprovide a clearer picture of where advances might be possible, as well as where the barriers to progressand the potential points for leveraging support lie. The deployment of human resource professionals willassist in dealing with redundancies within the banks. This will only be carried out on a voluntary basisand not until a later stage in the restructuring process. In addition, work with other financial sectorinstitutions (development banks and microfinance institutions in particular) will be undertaken to ensurethat issues related to the 'social dimensions of banking' are dealt with sensitively and with a view to thesocial, 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 implementinginstitutions. A participatory approach to working closely with the Ministry of Finance, NRB and NPCthrough a Working Group -- was established in mid-1999. This has extended to full consultation with theIMF, 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 privatesector to review the draft central banking and banking acts, as well as the associated regulationssupporting these acts.

6.3 Hlow does the project involve consultations or collaboration with NGOs or other civil societyorganizations?

Given the macro-banking focus of this project, it has not involved consultations or collaboration withNGOs. However, key consultations have taken place with the banks through the Bankers' Associationand with the wider donor community. In addition, the need for financial sector reform have beenvigorously debated at the Public Accounts Committee on several occasion, and that forthrightpresentations by MOF/NRB have broadened the understanding of the issues and support for the reformefforts.

6.4 What institutional arrangements have been provided to ensure the project achieves its socialdevelopment outcomes?

The project will employ human resource professionals in all three main institutions covered by thisproject to deal sensitively and compassionately with the issue of re-engineering of human resourceswithin 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 ApplicabilityEnvironmental Assessment (OP 4.01, BP 4.01, GP 4.01) ( Yes 0 NoNatural Habitats (OP 4.04, BP 4.04, GP 4.04) 9 Yes 0 No

Forestry (OP 4.36, GP 4.36) (9 Yes * NoPest Management (OP 4.09) _ Yes No

Cultural Property (OPN 11.03) (9 Yes * No

Indigenous Peoples (OD 4.20) (9 Yes 0 NoInvoluntary Resettlement (OPIBP 4.12) (_ Yes * No

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Safety of Dams (OP 4.37, BP 4.37) (.) Ycs NoProjects in International Waters (OP 7.50, BP 7.50, GP 7.50) (. Yes * NoProjects 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 Govenmmentto take hard political decisions on govemance issues in the two large banks. Given the politicization ofthese institutions, it may prove difficult to ensure the proper commitment to lasting restructuring (andultimately privatization or liquidation) that is required. Nonetheless, some actions demonstratinggovemment commnitment have already been taken upfront, and the project team feels that the program hasa significantly enhanced chance of success as a result. The Financial Sector Strategy Statement isthorough and sound in its approach to fundamental financial sector reform, and it reflects an appropriateset of policies. An expert management team has also taken over the management of NBL and a ChiefExecutive Officer has been selected to take over RBB -- in all their key functions. Overcoming thepolitical resistance to the introduction of extemal management teams already demonstrates considerableresolve 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 andfrequent changes in Governments, which seek to curry political favor with their electorate, may result ina policy reversal. Close cooperation with the IMF, the ADB, DFID and the rest of the donor communitywill also be important to ensure that adequate pressure is brought to bear against any perceived reversalin policy gains.

2. Critical Risks (reflecting the failure of critical assumptions found in the fourth column of Annex I):

Risk Risk Rating Risk Mitigation MeasureFrom Outputs to ObjectiveNRB is dominated by the Ministry of M The government has approved a new centralFinance and is not in a position to banking act which confers full autonomy onconduct its activities in an autonomous NRB. Continued close cooperation andand independent manner. monitoring with the IMF and DFID will also

ensure maximum leverage.

NRB does not take swift and decisive H Management teams/CEOs (conservatoraction (including taking curatorship) arrangements) have been put into place in thewhen a bank is found to be in two worst offending banks prior to projectnoncompliance with Central Bank approval. Close cooperation with the IMF andrequirements, 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 OutputsLack of adequate cooperation between M Ongoing dialogue and intensive use of the

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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 localsufficient quality or in sufficient market.quantities.

Government's resistance to restructure H Imnpact on World Bank lending and IMFthe state-owned banks and ultimately support for Nepal.give up control over them (as stated inofficial policy).

Institution building is made impossible S With support from this project through whichdue to a lack of commitment to skills' technical and financial assistance will beupgrading by financial sector provided for capacity building, andparticipants. determination of NRB to make changes in the

financial sector, it is expected that this risk willbe mitigated to a large extend.

Late provision of counterpart funds as H NRB and Ministry of Finance are required toagreed 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 publiclydisseminated;

(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 theproject was negotiated. NRB and the Bank agreed an alternative arrangement forRBB management - - i.e., to hire a CEO and a team of experts. The selectionprocess 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;

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(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 alternativelyundertaking to make the requisite budget allocation in the upcoming budget. Inaddition, the Ministry of Finance also commits in a letter that any other counterpartfunding 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 thestart 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 ofproject implementation.

L3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactoryquality.

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 OhashiTeam Leader Sector Manager/Director Country Manager/Director

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Annex 1: Project Design Summary

NEPAL: Financial Sector Technical Assistance Project

Key Performance Data Collection StrategyHierarchy 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 sectorstability of the financial sector sector reform that eliminates accounts, NRB's monetary and will help set the stage forto facilitate private-sector led the need for (real or financial data, and commercial longer term growth and moregrowth and ongoing contingent) budgetary support bank audited financial rapid poverty alleviation inmacroeconomic stability. for the financial system. statements. Nepal.

Reorient the role of the state in Periodic Economic and Sector A lower level of Governmentthe financial sector from that Work, including a Financial involvement within theof an owner of financial Sector Study (completed). financial sector will also freeinstitutions to that of a up budgetary resources forregulator and supervisor of the increased social sectorentire financial system. expenditures.

A deeper and broader financialsector will also ultimately,have a positive impact uponrural 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 toand effectively regulates the and independent supervision and achieve the overall goals ofbanking sector to ensure that implementation of central implementation reports. the program.commercial banks operate on banking policies.a prudent and commercialbasis.

Timely and effective Periodic supervision and Positive response by theintervention by NRB to evaluation reporting. private sector to bankingenforce prudential regulations sector reforms leading toand relevant banking higher levels of both domesticlegislation. and foreign investment and

consequent higher growth.Increased share of financial Commercial bank financialsystem owned and operated by statements, NRB reports, andprivate-sector players. supervision missions.

Increase in range and Annual reports of commercialsophistication of financial banks and supervisioninstruments and services missions.available at competitiveprices.

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Key Performance Data Collection StrategyHierarchy 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 issupervision department within off-site and annual on-site missions, midterm project willing to allow NRB toNRB strengthened to conduct banking supervision reports reviews. enforce the bank supervisoryexaminations of financial for each of the banks operating regulations unfettered byinstitutions 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 (evencommercial banks. taking curatorship) when a

bank is found to be innoncompliance with CentralBank requirements even whenthe bank is a publicly-ownedinstitution.

2. Timely and reliable Production of good quality (to Review of draft legislation andbanking information published intemational standards) regulations.for general use, improved audited financial data for thecentral and commercial banks within four months of Supervision missions andbanking legislation (and the end of the financial year. midterm project reviews.accompanying regulations)drafted and ready for Finalization of a new Centraladoption. Banking Act (done) and a

Banking and FinancialInstitutions Act and associatedregulations.

3. Progress made on Gradually improved financial Review of annual financialrestructuring 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 aRBB and NBL. new central banking and

commercial banking act.(b) Issuance of newregulations to cover the abovelegislation.(c) Revocation of existingrestrictions on foreignaccountancy companies fromoperating in Nepal.(d) Changed rules onmajority banking ownership inNepal.(e) Cessation of directedlending to priority sectors.

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Key Performance Data Collection StrategyHierarchy of Objectives Indicators Critical Assumptions

Project Components / Inputs: (budget for each Project reports: (from Components toSub-components: component) Outputs)

1. Re-engineering NRB. US$4.68 million, of which: Quarterly disbursement Close cooperation between theIDA will finance US$2.64 reports; quarterly progress World Bank, MOF and NRB.million, and reports and supervision Close cooperation between theDFID will finance US$1.56 reports. World Bank, the IMF, DFID,million. and the ADB.

Accountancy skills can bedeveloped or imported to meetthe increased needs.

2. Restructuring the two US$24.43 million of which: HMGN is willing to privatizelargest commercial banks, IDA will finance US$12.81 and/or liquidate theRBB and NBL. million, and DFID will finance state-owned banks and lose

US$8. 10 million. control over them as stated inofficial policy.

Timely provision ofcounterpart funds as agreed inthe project plan.

3. Capacity building in the US$0.99 million, of which: Institution building will befinancial sector IDA will finance US$0.55 possible through a

million, and commitment to skills'DFID will finance US$0.34 upgrading by financial sectormillion. participants.

TOTAL Project Cost US$30.10 millionIDA financing of US$16.00million,DFID financing of US$10.00million.HMGN will flance thebalance of US54.10 million.

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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 millionRE-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 bankfunctions effectively and has been relatively weak vis a vis the two largest commercial banks. NRB'sability 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 resourcemanagement, banking supervision and regulation, accounting and auditing, research and monetary policyanalysis, information technology, and internal auditing. These changes need to take place within thecontext of a complete re-engineering of NRB.

(a) HUMAN RESOURCES DEPARTMENT. At the heart of NRB's disfunctionality is its poorhuman resource management capabilities. NRB operates with a ratio of support to professional staff ofaround 5.5 to 1. Salaries are so compressed that the head of a department earns only two to three timesthe wage of the lowest paid staff member. There are no rewards for good behavior and no penalties fornonperformance. Although NRB has effective individual staff members, the institution seems to operatewith poor incentive mechanism. It is necessary to recruit human resources (HR) professional tocompletely revise existing policies to give staff appropriate incentives to work hard and have pride intheir employer. The work of this HR professional will also involve identifying staff for retrenchment anddesigning a Voluntary Retirement Scheme (VRS). It is thought that the NRB has potentially over 1,000excess staff, out of a total staff of around 2,000. Movement on a VRS will permit NRB to thereafterdecompress salaries so that appropriate financial rewards are paid to higher level and better performingstaff. 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 oneof Nepal's premier public institutions.

(b) BANK OPERATION AND BANK INSPECTION DEPARTMENTS. The strengthening ofNRB's supervisory capabilities requires the recruitment of a number of longer term, experienced, banksupervisors to assist it to implement its strategic plan with respect to regulatory development, on-sitesupervision, off-site supervision, and the implementation of a training plan. This component of thetechnical assistance will support the establishment of an appropriate system of supervision and regulationof banks and non-banks -- both on-site supervision and off-site supervision. Banking regulations such asbank licensing, capital adequacy, loan loss provisioning, accounting policies, and so on, have beendeveloped as part of the ongoing support to the Bank Operation and Bank Inspection Departments. Twoadditional on-site bank inspectors are now required to help implement these new banking regulationsthrough a program of vigorous on-site visits to banks. These bank inspectors will also have an importantrole in training the staff of the Bank Inspections Department in on-site bank supervision. In addition, it isanticipated that the role of the off-site bank supervisor could be extended beyond the current two-yearterm. The project will also provide computing hardware and software to ensure that the bank supervisorscan do their work as efficiently and effectively as possible.

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(c) SUPERVISION OF THE MANAGEMENT TEAMS. The management teams in RBB and NBLwill effectively perform the conservator role that a Central Bank in a more sophisticated context wouldplay. Both teams have/will have specific roles, functions, and well-defined performance criteria to meetover the three-year period of their contracts. Carefully monitoring their activities will be critical toensuring a reasonable level of success in their work. Given NRB's lack of experience in monitoring bankrestructuring work in large financial institutions, it has been agreed to recruit a bank restructuring expertto work closely with the Banking Operations Department of the NRB, over a two-year period, tosupervise these contracts on a day-to-day basis. Given the high cost of these teams and the reputationalrisk that would result from poor performance under these contracts, this oversight function is consideredimperative 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 theirquality is dubious. Long delays in producing the accounts are, in part, blamed on the use of the largestate-owned bank's network to effect payments in outlying regions. Inefficiencies and an inability toconsolidate financial data from RBB and NBL impact NRB's own efforts in this area. Reform workenvisaged under the commercial banking component of this project -- in conjunction with accounting andauditing strengthening within the NRB through the recruitment of expert technical assistance - will helpthe bank produce better quality and more timely financial data. This will be particularly important inassisting the Research Department develop money supply information and formulate monetary policy.Hence, this component will support the recruitment of accountants who will strengthen the accountingand auditing capacities of NRB and gradually move them to intemationally accepted accountingstandards.

(e) RESEARCH DEPARTMENT SUPPORT. Although arguably one of the best departments in theCentral Bank, the Research Department also requires support for the professional development of itsstaff. The project will support a training program involving both formal higher degree training as well ascapacity building through attendance at seminars and conferences. The project will also support thefurther development of the NRB library as an important research facility for the staff of the NRB (andothers), as well as the further computerization of the department. Gradually the project will support thedevelopment and dissemination of more economic research papers from the Central Bank throughQuarterly Bulletins and the Annual Report.

(f) INFORMATION TECHNOLOGY SUPPORT. NRB has nine branches conducting bankingactivities throughout Nepal. In addition to these branches, it has 17 departments, of which 13 are locatedat the central office buildings in Baluwatar and four departments are outside the central office. While allthe branches and departments have some computers and their operations are automated, NRB lacks auniform and efficient Information Technology (IT) strategy and IT system. Each of the branches has itsown local area network (LAN) and only one computer in each branch is connected to the computersystem in the central office through a nondedicated telephone line. Some departments are linked to theLAN while others have stand-alone PCs, used mostly by the support staff for routine administrative tasksand word processing. Data collection, compilation, and analysis are carried out inconsistently and on anad hoc basis. Each department collects data from various sources according to its own need, creatingproblems of data redundancy, inconsistency, and ambiguity. This component of the project will supportthe development of a holistic IT strategy and IT infrastructure within the NRB, through technicalassistance and some limited hardware and software support.

(g) ADDITIONAL SUPPORT FOR NEPAL RASTRA BANK. Support will also be provided toother NRB departments, including:

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* LEGAL DEPARTMENT. Although the new NRB Act has been approved, the Banking andFinancial Institutions Act is still under review and discussion. Thereafter there will be arequirement to reform the ancillary financial sector legislation including, in particular,bankruptcy law, prioritization of liens, and so on. IDA will provide technical and financialsupport to engage consultants and legal experts to review the legislative framework in thefinancial sector and assist HMGN in the implementation of this component.

* INTERNAL AUDIT. As indicated, the internal audit function of the NRB is particularlyweak. Support will be provided under this project to boost the capacities of this importantactivity.

* TRAINING SUPPORT. Training will also be provided under the project for NRB staff, butwithin 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 meetneeds 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. There-engineering team for these specific components is expected to be in place by December 2002/earlyJanuary 2003.

IDA's contribution to the re-engineering of NRB will be US$2.64 million for financing the cost ofconsultancies, equipment, and training. DFID's contribution to joint finance the expenditures for thiscomponent will be US$1.56 milion, and the remaining balance of US$0.48 million will be coveredby HMGN.

Project Component 2 - US$24.43 million

RESTRUCTURMG RBB AND NBL. The two large commercial banks (RBB and NBL) have, throughtheir poor performance, established an environment of inefficiency within the banking sector. Swift anddecisive action needs to be taken to deal with the worst problems and, in particular, stop the leakage offunds from these banks. The KPMG/Barents report (which estimates that the losses in these twoinstitutions may be as high as $426 million, or 8.6 percent of GDP) recommended that several immediatesteps needed to be taken to stem the further hemorrhaging of financial resources from the bank. Theseinclude (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) ultimatelyprivatizing 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 theoperational and financial position of the banks; (c) bring in an accounting team to help strengthen theaccounts of the banks; (d) develop human resource programs for the banks which would determnine, interalia, a training program, a retrenchment program, and a more appropriate remuneration package for bankstaff; 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 theIDA credit has been allocated to support the initial stage of the proposed restructuring andprivatization/re-privatization (or liquidation) programs of RBB and NBL. The IDA Credit will providetechnical and financial support to HMGN to hire the management teams to take over the banks for athree-year period. These professional management teams will be supported by locally recruitedaccountancy teams to help improve the quality and timeliness of the accounts of these two commercialbanks. These contracts were advertised in The Economist Magazine in September 2000. Subsequently,

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the NRB chose Deloitte Touche Tomatsu (DTT) to undertake the management team work in RBB andICC Bank (Ireland)/Bank of Scotland to undertake the management team work in NBL. Although theDTT contract was signed in January 2002 DTT never commenced the work and eventually pulled out ofthe contract in late-June 2002. To make up for this sudden and unexpected pull-out by DTT, the centralbank decided to rapidly recruit a professional Chief Executive Office (already identified and expected tobe in place by early December 2002) - and then to subsequently recruit the remaining seven departmentheads into the RBB during the early part of 2003. These additional positions have already beenadvertised 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 workin Kathmandu in July 2002.

The management teams are responsible for the day-to-day running of these two banks. Each team willconsist of eight professional staff operating in line positions, including a chief executive officer, a headof credit, head of loan recoveries, a head of accounting, an internal auditor, a head of IT, a head oftreasury, and a head of personnel. These teams are expected to be in Nepal for a minimurn of two yearswith 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 theestablishment of a privately operated Asset Management Corporation (AMC) and the recruitment of salesadvisors to help prepare prospectuses from these two banks, undertake a road show, and ultimately sellthem to "fit and proper" private buyers.

IDA's contribution to this component will be US$12.81 million toward the cost of consultancies, some ITsupport, and training. DFID's contribution will be US$8.10 million. The balance of US$3.52 millionwill 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 thefinancial sector through support for the Bankers' Training Center. Strengthening the role of thisinstitution through the development of a strategic plan, design of appropriate course work, modem andenhanced teaching methodologies and equipment (including computers), and through support forenhanced training capabilities will all feature as components of this credit. Under this component, thecapacity to establish twining arrangements with a good foreign Banker's Training Institute will also beinvestigated.

(b) CREDIT INFORMATION BUREAU (CIB). Run by NRB the CIB's operations are generallyconsidered very weak. This appears to be due to inefficient operation by NRB and the fact that the twolargest banks are not particularly good at blacklisting nonperforming banking customers. This tends toundercut the usefulness of the credit information system. Strengthening the credit information process isconsidered an important building block within the overall financial sector reform effort that will besupported under the project.

(c) FINANCIAL JOURNALISM. Improving the general public's capacities to operate as a moreeffective 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 relativelyunsophisticated 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 allbe supported under the credit.

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(d) COORDINATION SUPPORT TEAM (CST). This support will finance the longer term costs ofproject financial management capabilities, project procurement capabilities, and project coordinationcapabilities within the CST.

IDA will provide financial and technical assistance for consultants and experts, training, and relatedinstitutional strengthening measures. The allocation from IDA will be US$0.55 million and that fromDFID will be US$0.34 million. The balance of US$0.1 million will be covered by HMGN.

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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 ORDftjedcmwwb ~~~~~~~~~~~~~~~~~~~Rnaidn Rnidng

Fakli Lmca TOW ease (60%d (40%dEP * e RiiiD ufg DAles a Cd ohic. %d bWli bWgiFbnul 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 - 1RrwmaieFdcpiun 224,12_ 33.619 257.744 t11 7,72 276.6 0.85 141.1a 94,01KBang" 94misim erd Ing)clim SD7,21C _ 76,08 MM 25,361 17,499 53215 _ 2 0.85 319,374 212911A=unUng9 Adtin 104,7W 15,705 12405 5s,2a a612 129 109,8 Qa 6919 43aOaighf&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" 38a0InbmationTKhi 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! 1ets 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 ITS9POtt 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 ml531S*Wils TTrsnrO CeW 411, 00C _ 41,15S 45Z1 S 2___ 1 ___ . 436, O90 261 174,6QStlrVbmtrtirniCe1 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 42,1TOAL 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 ofproject 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 forfinancing consultancy services for banking supervision and other consultancies for RBB and NBL as well as selected training. The costs ofthese consultancies and training were adjusted accordingly. The PPF will be refinanced as part of the Credit. The total Credit amount isinclusive 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 30.1million and foreign financing by IDA and DFID together will be US$26.0 million.

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Annex 3: Table B - Estimated Project Costs by Categories

Base Coat Physical Price Total indc.Contngencies Contngencies ContIngprncie Fo pn FiI ndn_

Profect Catgoes _ IDAForeign Local Total Base (60ofg FinancingD

Exchange Financing Dutes an Costs Inc. TOtal % of fomign (40% of orelgnFinancing Excl. Taxer Taxes Taxes Amnount Total financing) finening)

I. Investment Costs (wbtotai) _ _

Project Preparation Facilty -financedconsultant 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 1,027,88NRB Ubrary 17,4001 1 ,740 19140 870 574 20,584 18,540 0.90 11,128 7,419NRB Vaious Depanments 170,00t 17,000 187,000 8,500 5,610 201,110 181,200 0.90 to8,72jo 72,480RBS 1,000,OOt 100,000 1,100,000 50,000 33,000 1 183,000 1,068,249 0.90 640,949 427,300NBL 1,000. _Oti 100.O0 1,100,000 50,000 33,000 1,183,00 1,068,249 0.90 640,949 427.300Bankers Trahin3 Center 194,0 _0 19.400 213,400 9,700 6,402 229,502 206,781 0.90 124.069 82,713CST Suppon 25,211 2,500 2'500 1,250 825 29,575 26,847 0.90 15,988 10 659

Itrnational Consultant Srvices frNRB (subtotal) 2,047, 307,135 2,354,70i 102,37 70,641 2,527,71 2,148,78 0.85 1,289,2 859,51Human 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 0.85 319.374 212,91Accountng and AuLitinr 104,70t 15,705 120,405 5,235 3,612 129,252 109,86 0.85 65,919 43,946Oversighit for RBB/NBL Contracts 487,00 73,050 560,050 24,350 16,802 601.202 511,081 0.85 30,8649 204,433Research Dept. and Ubrary 73,0 _ 1 10,950 83,950 3,650 2,519 90,119 76,610 0.85 45,966 30,644lrlomiaion Technology 108,700 1 16,305 125,005 5,435 3,750 134,190 114075 0.85 68.445 45,630Leat Depariment 93,75 __ 14.063 107,813 4,688 3,234 115,734 98,386 0.85 59,031 39.354Internal Audt Depaftment 144,58t 21,687 166,2 7,229 4,988 178,484 151,729 0.85 91,038 60.692Suport br Other Departm s 159,500 .23925 183,425 7.975 5,503 196,903 167,387 0.85 100.432 66,955Bankers Trainirr Center 145,0X 21,750 16675 7,250 5,003 179,003 152,152 0.85 91,291 60o.re

Conulbnt Senc -ManagementContracts (subotal) 17,127,5 __ 2,569,126 19,696,631 856,375 590,8 21,1439 17,974,43 0.8 10,725,63 7,248,79Management 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 3.737,616Management 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 0.85 297 198,147Credit 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, 1.00 975,13 650,091NRB Training Program 1,316,140 1,316,140 65,807 394 1,4221,431 1,421,431 1.00 852,869 568.572Bankers Trarining Center 72,000 72,000 3,600 2,160 77,760 77,760 1.00 46,865 31,104Traning 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 15,616Operatirg Costs (variable costs for CSTOperations) 44,000 4,400 48,400 2,200 1,452 52,052 39,039 0.75 23,423 15,616TOTAL 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; 0.38Note: While each individual expenditure wilt be cost shared between IDA and DFID on 60/40 basis during implementaton, the total IDAallocation 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.

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Annex 4: Cost-Benefit AnalysisNEPAL: Financial Sector Technical Assistance Project

Not Applicable

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Annex 5: Financial SummaryNEPAL: Financial Sector Technical Assistance Project

Years EndingJune 30

Figures are in US$000

IMPLEMENTATION PERIOD

| Year 1| Year 2 Year 3 Year 4 Year 5 Year 6 | Year 7Total Financing RequiredProject CostsInvestment Costs 4681.0 8660.0 7512.0 6310.0 2885.0 0.0 0.0Recurrent 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 0.0Total Financing 4689.0 8675.0 7525.0 6321.0 2890.0 0.0 0.0

FinancingIBRD/IDA 2502.0 4614.0 4001.0 3371.0 1536.0 0.0 0.0Government 637.0 1181.0 1024.0 840.0 394.0 0.0 0.0

Central 0.0 0.0Provincial 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 0.0User Fees/Beneficiaries 0.0 0.0 0.0 0.0 0.0 0.0 0.0Other 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 0.0Main assumptions:Total project cost is US$30.1 million of which US$16.0 rnillion will be financed by IDA, and US$ 10.0million will be provided by DFID.The two Project Preparation Facilities of US$1.15 million are included in the total costs. The estimatedproject cost in Annex 3 is rounded off to the closest decimal point.

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Annex 6: Procurement and Disbursement ArrangementsNEPAL: 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 inaccordance with World Bank guidelines or procedures. Therefore, the formation of a specialized teamwithin NRB, with the appropriate administrative and financial authority to successfully implement theproject activities, is a necessary prerequisite.

To this end, a Coordination Support Team (CST), housed in the Banking Operations Department ofNRB, has been forned. Presently, this team includes a financial management specialist and a locallyrecruited 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 mainlyinvolve 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 andanother NRB staff delegated to work with the consultant avail themselves of the specialized training inthe selection and employment of consultants that is regularly conducted by institutions in India such asthe Administrative Staff College at Hyderabad and National Institute of Financial Management atFaridabad.

Goods Procurement (US$2.8 million):

This is almost exclusively procurement of IT equipment such as computers, servers, networking, etc., forthe 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 equipmentfor CST. It is estimated that these items will be procured under separate contracts of which two (forRBB and NBL) would be ICB contracts of estimated value of approximately US$ 1.1 million each. Theseitems plus other contracts (for NRB restructuring and the Bankers' Training Center) of total estimatedvalue 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 themanagement team in NBL and the CEO in RBB, two other contracts with international consultants areenvisaged: (a) the seven person support team to work with the CEO of RBB (US$7.0 million); and (b) ateam of five individuals to work on the re-engineering assignment within Nepal Rastra Bank (US$3.0million). 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 staffas 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. Inthe Tables below, where there is a reference to IDA financing, it would mean jointfinancing by IDAand DFID according to the respective shares as indicated in Annex 3.

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IDA financed goods will be procured using the Bank's Guidelines of January 1995, revised January andAugust 1996, September 1997 and January 1999. IDA financed services will be procured using theBank's Guidelines of January 1997, revised September 1997 and January 1999. The Bank's standardbidding 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 beawarded on the basis of NCB procedures acceptable to the Bank. Items or groups of items valued atUS$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 thanUS$5,000 equivalent per contract may be procured through Direct Contracting or National Shoppingprocedures.

Consultants (for assignments with estimated value exceeding US$200,000 per contract) will be selectedthrough QCBS or QBS procedures. For assignments valued at US$200,000 or less per contract, theshortlist 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 yearof project, reducing to once every four months in subsequent years (including special procurementsupport).

Procurement methods (Table A)

Figures in parenthesis in the following tables include amounts to be financed by IDA and DFIDTable A: Project Costs by Procurement Arrangements

(US$ million equivalent)

Procurement MethodExpenditure 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 0.05Costs 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 ofcontracted staff of the project management office, training, technical assistance services, and incrcmentaloperating costs related to (i) managing the project and (ii) re-lending project funds to local governmentunits.

Note: With rcgards to procurement using NCB method, Goods estimated to cost less than US$200,000 equivalcntper contract, up to an aggregatc amount not to excecd US$400,000 equivalent, may be procured under contracts

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awarded in accordance with thc provisions of paragraphs 3.3 and 3.4 of the Guidelines. In addition, thc followingguidelines will bc in effcct which arc particular to Ncpal only and wcrc agrecd on betwccn the Govcrnment of Ncpaland World Bank Legal Departmcnt.In order to ensure economy, cfficicncy. transparency and broad consistcncy with thc provisions of Section I of theGuidclines:(i) invitations to bid shall bc advertised in at Icast onc widely circulated national daily ncwspapcr, at Icast 30days 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 aformat 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 nationalbidders;(vi) qualification criteria (in case pre-qualifications were not carricd out) shall bc statcd in the biddingdocuments, and if a rcgistration process is required, a forcign firm de6larcd as the lowest evaluated bidder shall begiven 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 priorconcurrcnce 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/contractdocuments;(xiii) a bidder's bid security shall apply only to a specific bid. and a contractor's performance security shall applyonly 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 thesame 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 nextlowest evaluated and qualified bidder; and(b) if no evidencc of collusion can bc confiriiied, then fresh bids shall be invited after receiving the concurrence ofthe Association;(xv) extension of bid validity shall not bc allowed without the prior concurrcnce of the Association (i) for thefirst request for extcnsion if it is longer than eight wccks and (ii) for all subsequent rcqucsts for cxtensionirrespectivc 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.

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Table Al: Consultant Selection Arrangements (optional)(US$ million equivalent)

Selection MethodConsultant 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 SelectionQBS = Quality-based SelectionSF8 = Selection under a Fixed BudgetLCS = Least-Cost SelectionCQ = Selection Based on Consultants' QualificationsOther = Selection of individual consultants (per Section V of Consultants Guidelines), CommercialPractices, etc.N.B.F. = Not Bank-financedFigures 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 reviewFumiture, equipment, than the equivalent ofbooks, etc. US$200,000 per contract

(ii) Goods estimated to costmore than the equivalent of NCB First contract to be prior reviewUS$30,000 but less thanUS$200,000 per contract

(iii) Books, periodicals, andproprietary items up to anaggregate amount not exceeding Post reviewUS$50,000 equivalent Direct Contracting

2. Services Prior review of all consultanta) Management teams, (i) More than US$200,000 per QCBS contracts shall be govemed by theconsultants 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 withand NBL management contract shortlist (shortlist could (i) With respect to each contract forcontracts, selection of comprise entirely of the employment of consulting firmstraining institutions national consultants) estimated to cost the equivalent of

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US$ 100,000 or more, the proceduresset forth in paragraphs 1, 2 [other

(iii) Individual Consultants In accordance with the than the third sub-para of paragraphprovisions of paragraphs 2(a)] and 5 of Appendix I to the5.1 to 5.3 of the Consultant Consultant Guidelines shall apply.Guidelines

(ii) With respect to each contract forthe employment of consulting firmsestimated to cost the equivalent ofUS$30,000 or more but less than theequivalent of US$100,000, theprocedures set forth in paragraphs 1,2 [other than the second sub-para ofparagraph 2(a)] and 5 of Appendix Ito the Consultant Guidelines shallapply.

(iii) With respect to each contract forthe employment of individualconsultants estimated to cost theequivalent of US$10,000 or more, thequalifications, experience, terms ofreference and terms of employment ofthe consultants shall be furnished tothe Association for its prior reviewand approval. The contract shall beawarded only after such priorapproval has been given.

(iv) The Terms of Reference for allconsultant contracts estimated to costthe equivalent of US$20,000 or moreper contract in the case of firms andUS$5,000 or more per contract in thecase of individuals shall be furnishedto the Association for its prior reviewand approval. The contract shall beawarded only after such priorapproval has been given.

3. Miscellaneous Direct Contracting Post review onlyoperating costs for CST_

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Disbursement

Allocation of credit proceeds (Table C)

Expenditure Category IDA Contribution DFID Contribution Total Contribution FinancingIDA4 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; foreign2. Goods 1.54 1.03 2.57 or local3. Training 0.98 0.65 1.63 100%

75% on Average -90% 1styear, 80%,

4. Incremental Operating 70%, and 60% theCosts 0.02 0.02 0.04 following years5. Project PreparationFacility (PPF) 1.15 0.00 1.15 85%6. Unallocated 0.00 0.00 0.00Total Project Costs 16.00 10.00 26.00 E lThe US$26.0 million foreign financing will be provided by IDA (US$16.0 million) and DFID (US$10.0million).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 NepalBank 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 disbursementprocedures. which include full documentation of expenses and SOEs. SOEs will be used for thefollowing 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$10,000equivalent in case of individuals; (c) for all training costs; and (d) for all incremental operating costs. Adecision on moving the project to FMR-based disbursements may be made once the capacity of theimplementing 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. Theauthorized allocation will be initially limited to US$1,000,000 until the aggregate amount of withdrawalsfrom the credit account, plus the total amount of all outstanding special commitments entered into byIDA is equal to, or exceed the equivalent of SDR3,500,000. The authorized allocation may then beincreased to US$2,000,000. If the project moves to FMR-based disbursements, the authorized allocationmay go up to 20% of the Credit amount.

The IDA Special Account will be managed under the joint signature of the executive director (CSTCoordinator) and the financial management specialist in the CST. As per government requirements, thespecial account will be maintained at the Kathmandu banking office of NRB. The project will follow theprescribed accounting procedures as per the Financial Administration Rules of NRB. The CST willensure that the bank/cash books are reconciled with bank statements regularly every month. The CSTwill submit replenishment applications for the special account on a monthly basis, or when 25 percent ofthe authorized allocation has been used, whichever occurs first. Replenishment applications will be

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accompanied by reconciled statements from the bank in which the account is maintained, showing alltransactions in the special account. Supporting documentation will be maintained by the CST for at leastone fiscal year after the year in which the last disbursement from the credit took place, and will beavailable to be reviewed by IDA staff and independent auditors.

The Ministry of Finance will designate the CST coordinator and the CST financial management officeras 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 budgetingsystem. The CST will be responsible for preparation of a project budget plan as per its agreed workprogram. The CST will send its budget request to the MOF which will assign separate budget codes inthe Red Book to facilitate budgeting and accounting of expenditures. HMGN will ensure timely releaseof funds including the counterpart funds required for project implementation. Adequate resources will beprovided to the CST for overall project administration and management. IDA supervision missions willreview 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 SpecialAccount -- managed under the joint signatures of the CST Coordinator and the financial managementspecialist. HMGN will make budgetary arrangements for the project which will be reflected in its annualbudget. For large payments exceeding the special account threshold, direct payments will be made byIDA. The NRB will provide budgetary resources to the CST to pre-finance small expenditures -- such asoperating and training costs. These will later be charged to the Special Account after the reconciliationof accounts:

Financial Management Staffing - NRB has designated a qualified professional accountant for financialmanagement of the project. A support-level accountant will assist the accounting and procurementfunction. Appropriate training will be provided to upgrade the capacity of the CST's financialmanagement staff so they may efficiently operate the financial management and reporting functions.Through the financial management improvement component, the overall capacity of NRB's accountingstaff will also be upgraded with training and skill building.

Project Financial Accounting, Reporting, and Internal Controls - Project expenditures will followthe government cash-based accounting system. The CST will supplement manual records required undergovernment regulations with simple spreadsheet-based subsidiary records. These will be regularlyreconciled to the official accounts, to facilitate the timely compilation of additional information requiredfor disbursements and FMR preparation. The CST will compile the monthly statement of expenditureswithin seven days following the end of each month. From the outset, the CST will produce FinancialMonitoring Reports (FMRs) on a trimesterly basis, in formats agreed upon at negotiations. Eighteenmonths after the project's start, the desirability and feasibility of switching to FMR-based disbursementwill be assessed. To match the government planning and reporting cycle, the FMRs and other reportswill 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 theproject's internal control. Policies, procedures, and guidelines to safeguard project resources and assetsand to ensure smooth implementation of the project will be described in the Borrower's ProjectImplementation Plan (BPIP). Until the Internal Audit and Inspection Department is strengthened, theNRB will arrange to recruit a qualified, local audit firm for the internal audit of the project accounts, as

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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 bythe Office of the Auditor General, which is considered acceptable by IDA for this purpose, andsubmitted 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 appointedby 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 preparedwithin three months after the end of the fiscal year for submission to the auditors and copied to IDA. Allrecords, including contracts, orders, invoices, bills, receipts and other relevant documents evidencing allexpenditures, will be kept properly and the Bank's representative will have access to them forexaniination purposes.

Financial Management Action Plan - Action plans to strengthen the financial management capacity ofthe 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 perIDA 's procurement, disbursement, andfinancial management guidelines, and thedecision-making layers with respect to project procurement will be minimized. A writtenauthority 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.

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Annex 7: Project Processing Schedule

NEPAL: Financial Sector Technical Assistance Project

Project Schedule Planned ActualTime 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. LawreiiceDeMilner, IMF Resident Representative, participated in the appraisal mission. Mr. Chris Jackson fromDFID participated in the appraisal mission and preparation activities under this project. DFID willcofinance this project.

Preparation assistance:A PHRD Grant (TF025473) in an amount of US$620,000A Project Preparation Facility (No. Q 183-0-NEP) in an amount of US$550,000 and supplemented byUS$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 AdvisorShideh Hadian Operations Officer, PSD

Mudassir Khan Sr. Financial Sector SpecialistBigyan B. Pradhan Sr. Financial Management SpecialistUche G. Mbanefo Consultant - Financial Management Specialist

Shakti Prasad Shrestha EconomistKiran Ranjan Baral Procurement Specialist

Margaret Murray Team AssistantNiraj Lal Shrestha Information Technology ExpertMozanmiial Haque Sr. Financial Management Specialist

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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 StudyFinancial Management Assessment of Nepal Rastra BankProcurement Assessment of Nepal Rastra Bank

C. Other

DFID's Concept note and any other documentation on this project.Memorandum of Understanding between DFID and IDAIncluding electronic files

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Annex 9: Statement of Loans and CreditsNEPAL: Financial Sector Technical Assistance Project

04-Nov-2002Difference between expected

and actualOriginal Amount in USS Millions disbursements

Project ID FY Purpose IBRD IDA Cancel. Undisb. Orig Frm RevdP050671 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

NEPALSTATEMENT OF IFC's

Held and Disbursed PortfolioJun 30 - 2002

In Millions US Dollars

Committed DisbursedIFC IFC

FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic1996 Bhote Koshi 19.26 2.95 0.00 29.45 19.26 2.95 0.00 29.451994 Himal Power 25.89 0.00 4.50 0.00 25.89 0.00 4.05 0.002001 ILFC - Nepal 0.00 0.30 0.00 0.00 0.00 0.30 0.00 0.001998 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 CommitmentFY Approval Company Loan Equity Quasi Partic

Total Pending Commitment: 0.00 0.00 0.00 0.00

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Annex 10: Country at a GlanceNEPAL: Financial Sector Technical Assistance Project

POVERTY and SOCIAL South Low- --Nepal Asia Income Devlopment dlamon

2001Population, mi-year (nillions) 23.6 1,380 2,511 LIfe expectancyGNI per capita (Atlas nmethod, USS) 260 450 430GNI (Atlas method, USS blilonts) 5.8 616 1,069

Average annual growth, 1995401

Population (X) 24 1.9 1.9Labor force() 2.5 2.4 2.3 GNI Gross

per H-- i pnmaryMost recnt emate (latest year available, 1995-01) capita enrollment

Poverty (% ofpopulation below national poverty line) 42Urban population (X of total poplation) 12 28 31Ufe exqictancy at birth (years) 59 62 59Infant mortality (per 1,000 live births) 74 73 76Child malnutrition (X of children under 5) 47 49 Access to irnproved water sourceAccess to an improved water source (% ofpopulation) 81 87 76Illiteracy (% ofpopulation age 15+) 57 44 37Gross primary enrollment (X of school-age population) 126 101 96 Nepal Low-income group

MaW 140 109 103Female 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 5.6Gross domestic investment/GDP 17.6 20.8 24.2 24.3 TradeExpofts of goods and servicestGDP 12.9 11.8 23.3 22.4Gross domestic savingstGDP 10.9 9.6 15.0 14.7Gross natonal savings/GDP 24.7 25.4

Current account balancelGDP al -2.3 -7.5 2.1 2.8 Domestic Investmentinterest paymentstGDP 0.1 0.7 0.5 0.5 savingsTotal debtlGDP 12.2 45.7 51.5 48.5Total debt servicelexports 3.3 11.1 5.6 4.9Present value of debt/GDP 28.4Present value of debttexports 87.3 Indebtedness

1981-91 199141 2000 2001 200145(average annuat growth) Nepal Loteincome groupGDP 4.7 4.9 6.2 4.8 4.1GDP per capita 2.4 2.4 3.7 2.4 1.8

STRUCTURE of the ECONOMY1981 1991 2000 2001 Growth oInvestrent and GDP (%)

(% of GOP)Agriculture 60.9 48.6 40.7 39.1Industry 12.4 17.9 22.1 22.0

Manufacturing 4.1 6.9 9.4 9.3 4Services 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 GDPImports 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 4.3Industry 8.7 6.4 8.7 2.5

Manufacturing 9.2 7.4 7.2 3.6Services 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.

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Nepal

PRICES and GOVERNMENT FINANCE1981 1991 2000 2001 Inflatlon

Domrestic prtces(% change) 15Consumer prices 13.6 13.8 3.4 2.4 1AImplicit GDP deflator 7.9 9.1 4.4 3.1

Govenmment finance .(% of GDP, inctudes current grants) oCurrent revenue .. 8.9 10.7 11.4 9G 97 as s oo o01Current budget balance .. -2.8 1.1 0.2 GDP deflator CPIOverall surplus/deficit -10.7 -3.5 -4.5

TRADE1981 1991 2000 2001 Export and Import levels (US mill.)

(US$ mtltions)

Total exports (fob) 135 228 971 942 2.0W0Food 61 65 1.0W SW UPulses . . 46 56 1.00W 4fl Manufactures .. .. 230 256 SW

Total imports (cdf) 371 715 1,713 1,774 0Food .. 87 157 81 95 as s7 as 99 o 01Fuel and energy .. 70 273 338 Exot imrsCapital 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 4Imports of goods and services 403 854 1,922 1,984Resource balance -109 -417 489 625 2

Net inoome 10 66 20 9 oNet current transfers 46 60 582 774 g Y 03Current account balance -52 -290 113 158

Financing items (net) 39 417 101 -82 4Changes In net reserves 13 -127 -214 -76

Meno:Reserves including gold (USS miltions) .. 451 952 1,027Conversion rata (DEC, tocaltUS$) 12.0 31.0 69.3 73.8

EXTERNAL DEBT and RESOURCE FLOWS1981 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: 50IDA 109 719 1.134 1,127 E:279

Totaldebtservice 12 66 100 89IBRD 0 0 0 0IDA 1 8 24 25 ; *_ B: 1,127

Composition of net resource fbws Offcial grants 72 52 76 36,',.*.Offieal creditors 65 139 97 60Private 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 programCommitments 32 62 55 0 A -IBRD E -OidateraDisbursements 33 49 46 47 B- IDA D -Othar rmirlilataral F -PrivatePrinripal repayments 0 3 16 17 C - IMF G -Short-terrnNet flows 33 47 31 30Interest payments 1 5 9 8Net transfers 32 42 22 21

ueveiopment Economics i 1izmzNote: Overall Surplus/defidt indudes grants.

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Additional Annex 11: Financial Sector Strategy StatementNEPAL: Financial Sector Technical Assistance Project

Strategy Paper of HMG/Nepal on theFinancial 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. Asa consequence, the number of banks and financial institutions have been increased substantially.Presently, 13 commercial banks, 46 finance companies, 35 cooperative institutions, 25 non-governmentorganizations (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 theirdeposit and loan portfolio. As such, the statutory liquidity ratio (SLR) has been withdrawn to enablecommercial banks in allocating funds on their own discretion; foreign exchange exposure has beengranted and cash reserve ratio reduced. Recently, bank rates have been revised with a view to enhancinginvestments in agricultural and industrial sector, including export as well as redirecting larger financialresources towards poverty alleviation in rural sector. Further prudential and regulatory norms for banksand financial institution is in the process of revision under World Bank technical assistance and the newset of prudential regulation will be implemented in a time bound manner from the beginning of the nextfiscal year.

The initiation of these measures has made the need for further reform and consolidation a matter ofurgency. HMG/N's own concern on the financial sector reform has found good support and backing bythe multilateral donor agencies. In particular, the World Bank, the International Monetary Fund and theAsian Development Bank are prepared to support substantive and comprehensive reforms by HMG/N inits efforts and endeavors related to financial sector reform strategy and program. At a time when twolarge state owned banks, having nearly two-third of market share in commercial banking industry, are inserious trouble, the proposed reform program would definitely help to improve the functioning of thesebanks. In addition, the overall financial sector reform program is expected to make a vital contributiontowards supporting private sector led economic growth through enhanced resource allocation to potentialgrowth sectors.

Against this background, the objective of this paper is to highlight and emphasize the urgency of reformprogram needed for the development of a competitive, efficient and healthy financial sector. This paperalso sets out the Central Bank's views on the role of the banking and non-banking financial sectors andtheir relationship with the government, and amplifies government's policy on some key issues affectingthe performance of the financial sector. In this context, the program is expected to assist in creating asound, prudently managed and well-supervised financial sector in Nepal that is competitive, dynamic andcapable of contributing towards macro-economic stability and more rapid and sustained economicgrowth.

The Banking Sector

As in any other economy, the banking sector has to play a vital role in the economic development of thecountry through facilitating the intermediary process in between capital surplus and deficit units. Thebanking sector has to play dual role of mobilizing as well as allocating the limnited resources towards

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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 commercialorientation 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 definedclearly. The banking activities should also be compliant with the regulations issued by Nepal RastraBank, and should not in general, be directed by the government and other interested parties to serve theirown interest, such as assisting particular sector, borrowers or groups on a non-commercial basis andundertaking social programs.

Accordingly, Nepal Rastra Bank will have to enforce the internationally accepted standards of loanclassification and provisioning requirements, liquidity and reserve requirement, capital adequacyrequirement, exposure limits, single borrower limit etc. for the effective, efficient and sound bankingsystem. Consequently, the poor lending decisions motivated by personal interest and benefit would bestopped 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 awell-managed banking system. In this regard, the Nepal Rastra Bank would also come up withappropriate prudential regulations that amplify a code of governance for all banks to follow. This codewill have to clearly set out the rights and duties of directors, owners as well as management and alsospecify the functions reserved for the board.

In the last few years, the government has undertaken general reform measures, viz. Interest RateDeregulation, Phasing out of Statutory Liquidity Requirement (SLR), Bad Loan Provisioning, CapitalMarket Reforms, Foreign Exchange Liberalization, some of which were encompassed in the CBPASSpackage. However, still much remains to be done, and there is now an urgent need to undertakeimportant measures to strengthen and deepen the reform process. This will require a concerted effortfrom all the concerned parties involved. In this regard, the government will need to provide an overallstable and positive macro-environment along with financial support or capital injection if needed. TheNepal Rastra Bank will have to provide effective regulatory oversight, supervision and strictenforcement. Similarly, the banking sector will have to improve its efficiency, strengthen its financialcondition and undertake more prudent lending. The industrial and business sector could augment thisprocess by providing proactive support toward reducing the NPA and instill confidence in the bankingsystem by improving their corporate governance behavior

The Non-Banking Sector

The non-banking sector consisting of finance companies, development banks, cooperatives andnon-government organizations doing limited banking business, constitutes as yet a small but evergrowing component of financial sector. The non-banking sector provides ample opportunity to improvefinancial intermediation process in course of economic development of the country. Indeed, non-bankfinancial institutions can frequently generate a more competitive financial system than can the entry ofadditional commercial banks. Thus, this sector would be diversified for the complementary role and newareas of services they provide in relation to the commercial banks. In particular, the central bank realizesthe restructuring need of the large two government owned development banks, bringing financialcooperatives under its supervisory domain, and ensuring healthy growth of the finance companies and themicro finance sector. There is a further need to bring non-bank financial institutions like The EmployeesProvident Fund and The Citizen Investment Trust under the regulatory and supervisory domain of the

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Central Bank The stock market should also be working in a transparent, predictable and stable mannerto 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 isendeavoring to achieve a privately owned and managed banking system, which provides economic, andefficient 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 BanijyaBank. Meanwhile, the Agricultural Development Bank and Nepal Industrial Development Corporationare also facing similar type of problems. This condition provides little incentive for the other privatejoint 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 financialsystem; 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 tostructural 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 activeparticipants in the financial sector and should proceed towards being a stronger regulator and supervisorof 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 privateinvestors and professionals by implying the progressive withdrawal of HMG/N from the ownership of allfinancial institutions and also refraining from promoting financial institutions primarily with the equityparticipation of the government or government owned institutions.

enhance the authority and the ability of the Nepal Rastra Bank for effective supervision of banks andnon-bank financial institutions and enforce regulations as well as move towards increased autonomy ofthe 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 becomesnecessary to think over various models, which confers greater autoromy and independence to the NepalRastra Bank. Thus, the Nepal Rastra Bank will work closely with the World Bank and IMF team for theamendment of the existing Nepal Rastra Bank Act, 1955 to provide sufficient autonomy in conductingmonetary policy, regulation and supervision of banking and non-banking financial sector and licensing ofbanks and non-banking financial institution. The central bank also recognizes the critical importance ofeffective supervision within an appropriate regulatory framework to ensure that the banking sector fulfillsits dual responsibility of protecting depositors' savings and allocating such saving in the most productivesectors for faster economic growth. The Nepal Rastra Bank would also encourage transparency indisclosing the financial information by banks particularly through the introduction of higher auditing andaccounting standards that enables depositors in making prudent decision on the selection of banks theywant to deal with. The Nepal Rastra Bank would also ensure that banks adopt standard practices in theiroperations: mainly in their lending behavior and interest calculation methods. Besides this, the Nepal

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Rastra Bank would also need to develop policies encouraging the establishment of privately managedinstitutions, industrial financing, capital market development and export financing. The establishment ofcredit rating agency, cooperative bank, export import bank and investment bank could be a case in pointtowards this direction. The govemment fully supports the effort of Nepal Rastra Bank in strengtheningbanking supervision, enforcement and regulation. The Nepal Rastra Bank would focus on the followingreform 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 NepalRastra Bank Act, Commercial Bank Act and other Financial Institutions act. Alternatively, a FinancialInstitutions 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 supportiveregulations, especially in the area of banking supervision. Reform of ancillary financial sector legislationwill 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. Thepromulgation of these acts will help the consolidation of the financial sector in many ways, especially onenhancement of fair and efficiency based competition. The central bank is committed to instill strictfinancial discipline in order to break the default trend by enhancing competitions, efficiencies andcontrolling 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 underthe financial sector reform program. This will require the recruitment of a longer term, experienced banksupervisor 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 shouldimprove on-site bank supervision capacity by recruiting more accountants, improving training andintroducing risk rating (Credit Rating) system. However, it is worthwhile to explore other modalities ofmonitoring and supervision including independent Monitoring and Supervision body. This will alsoextend the supervisory capacity to cover nonbanks and development banks. This is one area wheretechnical assistance from the International Monetary Fund and World Bank could also be sought. Theentire bank examination of RBB and NBL would clearly be a priority for an initial phase of enhancedbanking 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 loanshave tremendously impacted on RBB's financial health. Recent auditing work has also revealed a highnegative net worth, weak internal control and information systems, and poor internal financialmanagement. In the samne way, NBL has also suffered from the overall inefficiency, a negative net worthand low level of competition in the banking system. The government's policy of successively sellingshares to the general public and increasing private sector representation on its board, was aimed atavoiding the deteriorating situation as of the RBB. Nonetheless, NBL still does not operate like a privatebank, does not have a strategic banking partner amongst its private shareholders and lacks a strategicdirection and medium term vision. Addressing these problems within NBL will be an importantcomponent of the restructuring process. Thus, after ascertaining the true financial and operationalposition of RBB and NBL, it will be important to employ technical support to assist in developing astrategic plan for the implementation, such as, downsizing, privatization, splitting, merger, acquisition,

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etc. In the same way, technical support will also be required to implement any strengthening workidentified by the reform proposal, which will be working on the financial and operational position ofRBB 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 bankingsector, enhance competition and increase an efficient intermediary role of the banks and non-banks. Thegovernment 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 lowestpossible intermediation cost. In this regard, the government will not allow the banking industry to bedominated by a single bank or group of banks. Therefore, the present ownership structure of NBL andRBB will be gradually changed by their privatization and entry of new reputed, fit and proper privatesector banks and financial institutions. To ensure continuing effective competition, the Nepal RastraBank 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 especiallyfor the foreign banks coming in joint venture by increasing the percentage shareholding that they canretain in a bank in Nepal above the current 50 percent. The detail criteria and qualifications, followinginternationally accepted standard practices, uniformn criteria and norms, will be re-announced publicly bythe Nepal Rastra Bank and accordingly provide licenses to new banks. Furthermore establishment ofbranches of internationally reputed banks will be promoted under the terms and conditions andprocedures set by the NRB.

5. Reform on Auditing and Accounting Capabilities

Information on operations, performance and status of banks and other financial institutions or overalltransparency of the whole financial system is highly important. Publishing of financial statements, theirperformances and auditing reports etc. on a regular basis is also needed to make the financial sector moretransparent. However, the prevailing weak accounting and auditing practice has indicated that thetimelines 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 poorlymanaged banks should be strengthened. To cope with this, the phase wise introduction of internationallyaccepted accounting and auditing standards for the banking and non-banking financial sector should beinitiated. Further in respect of bank branches which cross specified ceiling of transactions, Branch auditwill be made mandatory. Moreover, an appropriate environment will be created for internationalaccounting 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 offinancial services to all the needed sectors / persons. These services should be provided throughappropriate private institutions at market interest rate. Alternatively, these services could be providedthrough proper budgetary provisions for any subsidy to be provided in any areas. The directed andsubsidized lending through banking system will ultimately be phased out with the provision of alternativeprivate 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

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financial institutions. As such, no single person and group will be allowed to hold a controlling stake inmore than one banking institution. In the case of poorly managed banks, a reputed and strategic investorwill be allowed to hold controlling shares in that bank. Cross holding of capital in the commercialbanking industry will be eliminated and promoters having significant shareholding will be barred fromaccessing 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 initiatedby the Nepal Rastra Bank jointly with the coordination of all commercial banks and the governnent. Inthis regard, the NRB will endeavor to establish a separate Bankers' Training Institute, jointly financedand managed by the NRB and other banks. The newly established institute will provide ampleopportunity to up-grade the working skills and research capacity of the staff involved in the commercialbanks.

9. Restructuring of Credit Information Bureau

To make the lending activities more prudent, the genuine credit information about the borrowers isrequired. In this regard, the present Credit Infornation Bureau would be revamped to provide effectiveand efficient information service. Essential technical support would also be given to the Bureau torestructure 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 NonPerforming Loan of banking and non banking financial institutions. Hence, efforts will be made toinitiate an Assets Reconstruction Company in the coming fiscal year to improve the loan portfolio statusof 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 facilitatingprudent decision making, the research and statistical wings of the Nepal Rastra Bank would bestrengthened.

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 offinancial institutions and financial instruments are developed. Nevertheless, the commercial banking islikely to remain the largest component of the financial system for some time, there is also a need todevelop debt and equity markets, leasing companies, venture capital facilities, further strengthen thestock market, insurance markets, micro-finance, pension and provident funds, and so on. Thus, theestablishment of a broad range of instruments into which savers can deposit their funds as well as a broadrange of lending instruments, involving both debt and equity, will also assist the overall development ofthe economy.

13. Meeting Sectoral Financing Requirements

As the country is overwhelmingly based on rural economy, it has also been envisaged to ensure that theadequate financial services are provided to support the activities of this sector. Moreover, other sectoral

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needs, such as industrial financing, housing finance and so on, would also be provided on the competitivecost.

14. Other Measures

The NRB has also envisaged to announce a specific time bound plan to restructure AgriculturalDevelopment Bank and Nepal Industrial Development Corporation in the next phase. Meanwhile, thegovernment feels that the establishment of a sound and properly regulated banking system is the keyprinciple and the regulation of deposit taking institution is fundamental. Thus, appropriate measureswould 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 developmentbanks at regional and local level. However, the general thrust of the government will be less governmentinvolvement in the financial sector.

16. Strengthening of Rural Development Banks

The NRB will also undertake organizational and financial strengthening programs for rural developmentbanks established with the objectives of alleviating poverty in the rural areas. Recognizing theimportance of rural sector and development finance, the government aims the development of rural creditand development finance via the private sector, including divestiture of such rural and developmentfinancial 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 tomake the debt instruments more confidential and trustworthy to the potential investors, and it is expectedthat 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 fiscalyear.

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